Korchak v. Comm'r

T.C. Memo. 2005-244

UNITED STATES TAX COURT

ERNEST I. KORCHAK, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 22105-03. Filed October 18, 2005.

Robert T. Connors, for petitioner.

James Brian Urie and Gerald A. Thorpe, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

MARVEL, Judge: Respondent determined additions to

petitioner’s Federal income tax for 1982 of $7,019.40 under

section 6653(a)(1),1 of an amount equal to 50 percent of the

interest due on a $140,388 underpayment under section

1

All section references are to the Internal Revenue Code in

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

Tax Court Rules of Practice and Procedure.

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6653(a)(2),2 and of $34,322.10 under section 6659.3 Respondent

also determined that interest on the $140,388 underpayment must

be assessed at 120 percent of the statutory rate under section

6621(c).4

The issues for decision are: (1) Whether petitioner is

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

(2) whether petitioner is liable for the addition to tax under

section 6659; (3) whether we have jurisdiction to decide if

petitioner is liable for additional interest5 under section

2

Respondent concedes that the notice of deficiency

incorrectly refers to sec. 6653(a)(1) and (2) as sec.

6653(a)(1)(A) and (B).

3

Sec. 6659 was repealed by the Omnibus Budget Reconciliation

Act of 1989 (OBRA), Pub. L. 101-239, sec. 7721(c)(2), 103 Stat.

2399, effective for tax returns due after Dec. 31, 1989, OBRA

sec. 7721(d), 103 Stat. 2400. The repeal does not affect this

case.

4

Sec. 6621(c) was repealed by OBRA sec. 7721(b), 103 Stat.

2399, effective with respect to returns due after Dec. 31, 1989,

OBRA sec. 7721(d). The repeal does not affect this case.

5

In this opinion, the term “additional interest” means the

interest prescribed by sec. 6601, with the rate of interest

increasing to 120 percent of the underpayment rate under sec.

6621(c). White v. Commissioner, 95 T.C. 209, 214 (1990).

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6621(c); and (4) if we have jurisdiction to decide a taxpayer’s

liability for additional interest under section 6621(c), whether

petitioner is liable for additional interest under section

6621(c).6

FINDINGS OF FACT

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

The stipulation of facts is incorporated herein by this

reference. Petitioner resided in Bryn Mawr, Pennsylvania, when

his petition in this case was filed.

The Plastics Recycling Transactions

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

The additions to tax and interest arise from the disallowance of

a loss, an investment credit, and an energy credit claimed by

6

Petitioner also claimed in his petition that “The

deficiencies as determined by the Commissioner are in income

taxes for the calendar year 1982 in the amount of $140,388.00 of

which at least $37,500.00 are in dispute.” The $140,388,

however, represents petitioner’s allocable share of the

adjustments respondent made to the items on Madison Recycling

Associates’ (Madison) Federal income tax return for 1982, and the

notice of deficiency reflects only additions to tax under secs.

6653(a)(1) and (2) and 6659 and increased interest under sec.

6621(c). Petitioner did not dispute the $140,388 at trial or on

brief, and we consider this argument abandoned. See Leahy v.

Commissioner, 87 T.C. 56, 73-74 (1986).

Petitioner also claimed in his petition that respondent did

not issue the required notices in connection with the

partnership-level proceeding. See sec. 6223. Petitioner has not

pursued this issue at trial or on brief, and we consider it

abandoned. See Leahy v. Commissioner, supra.

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petitioner with respect to a partnership known as Madison

Recycling Associates (Madison).7 For a detailed discussion of

the transactions involved in the Plastics Recycling cases, see

Provizer v. Commissioner, T.C. Memo. 1992-177, affd. per curiam

without published opinion 996 F.2d 1216 (6th Cir. 1993). The

parties have stipulated that the underlying transactions in this

case are substantially similar to the transactions in Barlow v.

Commissioner, T.C. Memo. 2000-339 (where we found that the

underlying transactions at issue were substantially identical to

the transactions in Provizer), affd. 301 F.3d 714 (6th Cir.

2002), and Provizer v. Commissioner, supra.

In a series of simultaneous transactions, Plastics

Industries Group, Inc. (PI), sold8 four Sentinel EPS Recyclers9

7

Madison was formed on Oct. 1, 1982, by Richard Roberts (Mr.

Roberts), as general partner, and Denise Sausa, as limited

partner, and sold 18 limited partnerships at $50,000 per unit.

8

Terms such as “sale” and “lease”, as well as their

derivatives, are used for convenience only and do not imply that

the particular transaction was a sale or lease for Federal tax

purposes. Similarly, terms such as “joint venture” and

“agreement” are also used for convenience only and do not imply

that the particular arrangement was a joint venture or agreement

for Federal tax purposes.

9

Sentinel EPS Recyclers were used in a process designed to

transform scrap polystyrene into resin pellets that could be sold

on the open market.

Although the transactions in Provizer v. Commissioner, T.C.

Memo. 1992-177, affd. per curiam without published opinion 996

F.2d 1216 (6th Cir. 1993), involved Sentinel EPE (expanded

polyethylene) Recyclers, the recycling partnerships that leased

both the Sentinel EPS and Sentinel EPE Recyclers are

(continued...)

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(recyclers) to Ethynol Cogeneration, Inc. (ECI), for $1,520,000

each. ECI paid for the recyclers with $481,000 cash and a 12-

year nonrecourse promissory note in the amount of $5,599,000,

which was secured by a lien on the four recyclers.

ECI simultaneously resold the four recyclers to F&G

Equipment Corp. (F&G) for $1,750,000 each. F&G paid for the

recyclers with $553,000 cash and a 12-year promissory note in the

amount of $6,447,000, 80 percent of which was nonrecourse. The

nonrecourse portion of the note was senior to the recourse

portion, and the note was secured by a second lien on the four

recyclers.

F&G simultaneously leased the four recyclers to Madison, and

Madison simultaneously entered into a joint venture agreement

with PI and Resin Recyclers, Inc. (RRI), to place the recyclers

with end users. Under the joint venture agreement, which was to

last 9-1/2 years, Madison received a fixed, monthly joint venture

fee equal to the monthly lease payment made to F&G. The fixed

monthly joint venture fee also equaled the payments both F&G and

ECI were obligated to make under their respective promissory

9

(...continued)

substantially identical. We shall refer to both Sentinel EPS and

Sentinel EPE Recyclers as “recyclers”. See Cohen v.

Commissioner, T.C. Memo. 2003-303; Barlow v. Commissioner, T.C.

Memo. 2000-339, affd. 301 F.3d 714 (6th Cir. 2002); Davenport

Recycling Associates v. Commissioner, T.C. Memo. 1998-347, affd.

220 F.3d 1255 (11th Cir. 2000); see also Gottsegen v.

Commissioner, T.C. Memo. 1997-314 (involving both EPE and EPS

recyclers).

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notes. In connection with these arrangements, PI, ECI, F&G, RRI,

and Madison entered into offset agreements so that the foregoing

payments were bookkeeping entries only and were never in fact

paid.10

Petitioner’s Education and Professional Experience

In 1957, petitioner graduated from the University of

Melbourne with a bachelor’s degree in chemical engineering.

Petitioner worked for 2 years at Imperial Chemical Industries

(Imperial) in Australia and New Zealand as a research post

engineer. Petitioner worked on recycling and waste treatment

projects while at Imperial; his first project there involved

experimental work regarding the waste treatment of an aqueous

wetland stream from a chemical plant. Petitioner also

participated in projects at Imperial that involved the treatment

of internal streams for recycling.

In 1964, petitioner received a master’s degree and a Ph.D.

degree in chemical engineering from the Massachusetts Institute

of Technology (MIT). While at MIT, petitioner worked

intermittently for Monsanto Research Corp. (Monsanto) in Everett,

Massachusetts. At Monsanto, petitioner performed experimental

work on the treatment of waste products from a polyphenol

10

The parties have stipulated that the relationships between

Madison’s general partner and the shareholders and officers of

PI, ECI, F&G, and RRI are the same as those described in Barlow

v. Commissioner, supra.

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process11 and created cost estimates relating to the waste

treatment project.

After graduating from MIT, petitioner worked for the

Scientific Design Corp. (SDC), a subsidiary of The Halcon SD

Group, Inc. (Halcon), for 22 years. Petitioner worked as a

research engineer while at SDC, and his duties included

performing experimental work, evaluating the experimental work,

using the evaluations for preliminary design plans, and

determining preliminary investment costs and operation costs.

When valuing equipment for SDC, petitioner initially sketched out

a general outline of what equipment he thought would be required

for a project and its installation costs, guessing at the cost.

If the project appeared viable, petitioner used cost estimators

whose job it was to develop a more detailed cost picture and to

refine the cost estimates. During 1982, petitioner was SDC’s

president of research and development.

While at SDC, petitioner participated in a joint venture

with Arco Chemical Co. (Arco), called Opstrand Corp. (Opstrand).

The venture was based on petitioner’s first project at SDC and

11

Petitioner described the “polyphenol process” as follows:

Polyphenols were used as coolants for nuclear reactors,

and as these coolants pass through the reactors, they

are exposed to quite high temperatures and degrade to a

certain extent unless they form higher polymers, which

what we did with them is really to hydrogenate so they

could basically break them down again into lower

molecular polyphenols which could be reused in the

process.

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was dependent on internal recycling. The nature of the recycle

stream was relevant to the economics of the project. The

recycling process oxidized ethylbenzene and propylene to produce

propylene oxide as the main product, and dehydrogenated

methybenzyl alcohol to produce styrene, the monomer of

polystyrene, as a secondary product. SDC performed most of the

technical work for the Opstrand venture, and Arco was responsible

for the financing.

Petitioner’s Investment History

Before 1980, petitioner’s investment portfolio consisted of

stocks and bonds. In 1980, petitioner became a client of Marcus

V. Cole (Mr. Cole), a financial adviser for Merrill Lynch. In

1980, petitioner also purchased rental property on Hilton Head

Island.

Petitioner’s income increased significantly from 1980 to

1981 because of a $1 million bonus. After he received the $1

million bonus, petitioner diversified his investments. During

1981, petitioner invested in several limited partnerships,

including at least three oil and gas partnerships. Petitioner

received documents related to the oil and gas investments, but he

did not have anyone else review them. During 1981, petitioner

also invested in a bus rental activity. Petitioner incurred

losses as a result of the oil and gas investments and the bus and

property rental activities.

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Petitioner’s Introduction to Madison

In 1982, petitioner continued to be employed by and receive

wages from Halcon. During 1982, petitioner knew that his income

for that year would be substantial.

Also during 1982, Mr. Cole joined the staff of Hamilton

Gregg & Co. (HG&C), a personal financial planning firm. After

joining HG&C, Mr. Cole proposed the Madison investment to

petitioner in part because Mr. Cole thought it would appeal to

petitioner given his background.

On or about December 6, 1982, petitioner became a client of

HG&C. Hamilton S. Gregg II was the chairman and chief executive

officer of HG&C. Hamilton Gregg Securities Corp. (HGSC), an SEC

registered broker/dealer, and Hamilton Gregg Capital Corp.

(HGCC), an SEC registered investment adviser, were affiliated

with HG&C.12 Mr. Cole was petitioner’s financial adviser and

primary contact person at HG&C during 1982.

12

On or about Dec. 6, 1982, petitioner received and reviewed

a document entitled “Hamilton Gregg & Company, Inc. SEC/ADV

Brochure”. The brochure informed petitioner that when an HG&C

client’s financial situation warranted advice concerning

securities or private placement investments, HG&C would rely upon

the advice of HGCC and HGSC and that such advice from an

affiliated company would be disclosed to the client. The

brochure also informed petitioner that HGSC was owned by the

Gregg Group, Inc., that Hamilton S. Gregg II and the officers of

HG&C were dually registered as investment adviser agents with

HG&C and as registered representatives of HGSC, that proper

disclosure was given to the client when an agent was acting in

dual capacity, and that all of the affiliated subsidiaries shared

some principals and employees with HG&C.

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The Private Offering Memorandum

On or about November 24, 1982, petitioner received Madison’s

private offering memorandum (POM) and an accompanying cover

memorandum from Mr. Cole. The POM informed potential investors

that Madison’s business would be conducted in accordance with the

plastics recycling transactions described above. The POM also

stated that

The [partnership] Units are being offered through * * *

[HGSC] as Placement Agent on a best efforts basis.

* * * [HGSC] will be paid a selling commission equal to

10% of the per Unit offering price for each Unit sold.

This selling commission may also be paid to other

qualified broker-dealers as selling agents for each

Unit sold by them.

Additionally, the POM listed significant business and tax risk

factors associated with an investment in Madison. Specifically,

the POM warned: (1) There was a substantial likelihood of an

audit by the Internal Revenue Service (IRS); (2) the IRS may

challenge the purchase price of the recyclers to be paid by F&G

to ECI as being in excess of the recyclers’ fair market value;

(3) the partnership had a limited operating history; (4) the

general partner had limited experience in marketing recycling or

similar equipment; (5) the limited partners would have no control

over the conduct of the partnership’s business; (6) there was no

established market for the recyclers and they had no history of

commercial use; (7) patent protection would not be sought for the

recyclers; (8) there were no assurances that market prices for

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virgin resin would remain at then-current prices per pound or

that the recycled pellets would be as marketable as virgin resin

pellets; and (9) certain potential conflicts of interest existed.

The POM also stated on its first page that “THIS OFFERING

INVOLVES A HIGH DEGREE OF RISK” and repeatedly urged potential

investors to seek independent advice and counsel before investing

in Madison.

The POM stated that the projected tax benefits for the

initial year of investment for an investor contributing $50,000

would include investment and energy tax credits in the aggregate

amount of $77,000, plus tax deductions in the amount of $38,610.

The POM also stated that, assuming each recycler processed an

average of 1,872,000 pounds of polystyrene scrap per year and

the market price of virgin pellets increased approximately 11

percent annually over the term of the venture, the net projected

profits to the partnership through 1992 would equal $2,873,144.13

13

The POM projected net profits over the life of the venture

as follows:

1982 -0-

1983 $40,365

1984 185,679

1985 213,531

1986 245,560

1987 282,394

1988 324,754

1989 373,467

1990 429,487

1991 493,909

1992 283,998

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The POM included a marketing report by Stanley Ulanoff (Mr.

Ulanoff), a marketing consultant and professor, and a technical

opinion by Samuel Z. Burstein, a mathematics professor. The POM

also included a tax opinion by the law firm of Boylan & Evans

concerning the tax issues involved in the plastics recycling

program (general partner opinion). The general partner opinion

was addressed to Richard Roberts (Mr. Roberts), the general

partner of Madison, and stated that it was intended for Mr.

Roberts’s “own individual guidance and for the purpose of

assisting prospective purchasers and their tax advisors in making

their own analysis, and no prospective purchaser is entitled to

rely upon this letter.” The general partner opinion also warned

that the projected investment and energy credits would be reduced

or eliminated if the partnership could not demonstrate that the

price paid for the recyclers approximated their fair market

value. The general partner opinion did not purport to rely on

any independent confirmation of the fair market value of the

recyclers, however. Instead, the opinion relied on Mr. Ulanoff’s

conclusion that the purchase price to be paid by F&G was

reasonable and on representations by PI, ECI, F&G, and Madison

that the prices paid by ECI and F&G and the terms of the lease

were negotiated at arm’s length. The opinion concluded that the

basis upon which the partnership’s aggregate investment and

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energy tax credits would be computed would equal the price F&G

paid for the recyclers. The opinion was not signed.

Mr. Cole’s cover letter specifically directed petitioner’s

attention to the section of the POM entitled “Tax Benefits” and

to the Boylan & Evans opinion. The cover letter also informed

petitioner that HGSC had received an additional opinion from

Boylan & Evans on behalf of the limited partners (limited partner

opinion) that would be available upon request after the closing

of the partnership and that Madison’s general partner would

reimburse HGSC for the expense incurred in obtaining the opinion.

Correspondingly, the POM estimated that Madison would use $45,000

of the offering proceeds to reimburse HGSC for legal fees.14

Petitioner read both the cover letter and the POM.

Petitioner did not show the POM to his tax return preparer

because he considered HG&C to be his tax adviser and because HG&C

went over the POM and sought a legal opinion regarding the

investment. Petitioner was aware at that time, however, that

HG&C did not have a background in chemical engineering.

Petitioner was also aware that Mr. Cole was neither a plastics

recycling expert nor a chemical engineering expert and that Mr.

Cole did not have the knowledge required to assess the accuracy

of the financial projections contained in the POM.

14

The parties stipulated that HG&C, rather than HGSC, paid

Boylan & Evans $45,000 to obtain the limited partner opinion and

was reimbursed by Madison.

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On November 30, 1982, petitioner signed MADISON RECYCLING

ASSOCIATES SUBSCRIPTION AGREEMENT AND PURCHASER SUITABILITY

REPRESENTATIONS (agreement), agreeing to purchase 1-1/2 units of

Madison for $75,000. Petitioner was aware of the risks addressed

in the POM when he signed the agreement. Petitioner was also

aware that if he invested in Madison, he would receive tax

benefits greater than the amount of his investment.

Petitioner’s Investigation of Madison

In addition to reading the POM and cover letter, petitioner

performed an economic analysis, using information in the POM, to

determine whether it was reasonable for him to invest in Madison.

Petitioner calculated the potential return on the investment to

both Madison and himself, as well as the financial incentives of

the other companies involved in the venture to participate in the

investment. Petitioner also calculated the expenses he believed

end users would save by disposing of polystyrene foam using

Madison rather than transporting the foam by truck. Petitioner

concluded that there would be a good return for all of the

parties he considered, and he hoped for an 18-percent return on

his investment. Although petitioner had no expertise in

marketing plastics or the recycled resin pellets Madison was

supposed to produce, he performed the calculations regarding the

investment himself because he believed he could address them

better than most people.

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Petitioner also attempted to analyze the value of the

recyclers because he initially felt that the $1.5 million cost

per recycler did not make sense. However, he found it difficult

to determine the value of the actual recyclers. After looking at

the design of the equipment and the process as a whole, however,

petitioner believed that the cost of $1.5 million per recycler

was reasonable. Petitioner also believed that the relationship

between the annual rental cost and the value of the recyclers

contained in the POM was reasonable because the relationship

resembled that in his bus investment. Petitioner did not visit

PI or observe a recycler in action before investing in Madison.15

In making his calculations, petitioner testified that he did

not rely solely on the figures in the POM. Petitioner took what

he believed to be a more conservative discount for the “virgin

material” and used more conservative estimates for the price of

polystyrene and the projected return on the investment.

Petitioner believed there was a direct relationship between the

price of oil and the price of polystyrene and its components, and

he consulted various sources regarding the price of crude oil,

polystyrene, and related products. Additionally, petitioner

contacted Madison’s general partner, Mr. Roberts, about the

partnership. Petitioner asked Mr. Roberts about the investment

15

Petitioner did ask for a recycler manual. The record does

not disclose, however, whether petitioner ever received or

reviewed such a manual.

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generally, the basis for the polystyrene forecasts contained in

the POM, the history of the equipment, and whether and how the

equipment was running. Petitioner never spoke with an expert in

plastic recycling either before or after he made his investment,

however, because he felt he had a better understanding than most

regarding the technology of styrene, polystyrene, and recycling.

In performing his research, petitioner considered that

Madison had no operating history, and he was aware that the POM

stated that “[PI] has no experience in the manufacturing and

operation of the Sentinel EPS Recyclers, nor does RRI or PI have

any experience in using or selling the resin pellets resulting

from the second stage of recycling.” Mr. Roberts informed

petitioner, however, that, contrary to the statements in the POM,

PI had been running the recyclers for some time.

Petitioner did not seek independent legal advice regarding

Madison between November 24, 1982, the date he received the POM,

and November 30, 1982, the date he invested in Madison.

Petitioner did request, however, a copy of the limited partner

opinion referenced in the HG&C cover letter accompanying the POM.

Petitioner received the limited partner opinion sometime after

December 21, 1982, the date Mr. Roberts countersigned the

agreement, and after petitioner had tendered his money for the

investment. The limited partner opinion was nearly identical to

the general partner opinion. The only differences were that the

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limited partner opinion was addressed to the limited partners

rather than the general partner, contained no statement that the

limited partners could not rely on the opinion, included a

section on the impact of the investment on State and local taxes,

and was signed by Boylan & Evans. Petitioner believed Boylan &

Evans worked for Madison at the time it issued the limited

partner opinion. Petitioner reviewed the limited partner opinion

before he filed his 1982 tax return, compared it to the general

partner opinion, and relied on its assessment of the risks

described in the POM.

On or around January 12, 1983, petitioner received a letter

from Mr. Roberts confirming the close of the partnership on

December 21, 1982, and transmitting an executed copy of

petitioner’s subscription agreement.

Petitioner’s Monitoring of the Madison Investment

On or around March 9, 1983, petitioner received a Financial

Planning Report (report) and corresponding cover letter prepared

by HG&C. Petitioner reviewed the cover letter and report. The

report informed petitioner that he had invested $850,000 in

“limited partnerships with tax advantages” and, among other

things, the report promoted HGSC and participation in “tax-

sheltered investments”. The report further informed petitioner

that if he invested in a tax sheltered investment,

[HGSC] will receive a commission on the sale. Also,

because [HGSC] is an affiliate of our organization, we

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cannot act as your offeree representative. You should

seek guidance from a tax attorney or CPA who is

qualified to give you advice in this matter.

The report also notified petitioner that HG&C would “endeavor to

keep * * * [him] informed of developments as they occur with

Madison Recycling” so that petitioner believed HG&C would alert

him if something went wrong with the Madison investment.

After the spring of 1983, petitioner received documents from

Madison, including reports from RRI on how many pounds of

polystyrene were bought, processed, and sold. To monitor his

investment, petitioner kept in touch with HG&C and read the

reports. From the spring of 1983 through 1987, however,

petitioner took no action regarding his investment, even though

Madison was performing poorly.

Madison’s and Petitioner’s Tax Returns

On March 14, 1983, Madison filed its Form 1065, U.S.

Partnership Return of Income, for 1982. Madison reported that

the four recyclers had an aggregate basis of $7 million, or

$1,750,000 each, for purposes of investment and energy tax

credits. Madison also reported a net ordinary loss of $704,111.

Petitioner’s allocable share of the bases, credits, and losses

was passed through to him and reported on a Schedule K-1,

Partner’s Share of Income, Credits, Deductions, etc. - 1982.

Petitioner received his Schedule K-1 from Mr. Roberts on or

around February 1, 1983. Petitioner reviewed the Schedule K-1

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and provided it to his tax return preparer, who did not question

the Schedule K-1 or the Madison investment when preparing

petitioner’s return. Petitioner reviewed and signed his Form

1040, U.S. Individual Income Tax Return, for 1982, which was

filed with respondent on May 6, 1983.

On his 1982 return, petitioner reported gross income of

$317,784, which was derived from $567,723 of wages, dividends,

interest, and other income, a $24,961 loss from the bus rental

activity, a $30,010 loss from his Hilton Head rental activity,

$131,876 of losses from his oil and gas partnerships, and a

$58,089 loss from Madison. Petitioner also claimed a $116,492

investment credit, which consisted of a $59,835 regular

investment credit and a $56,657 business energy investment

credit, and he reported a $577,500 basis in the recyclers as

qualified investment property. Due to his losses and credits,

petitioner’s tax was reduced to $3,198, and he reported an

overpayment of $92,970. Petitioner received a corresponding

refund.

Respondent’s Examination of Madison

On or about February 19, 1985, respondent issued to Mr.

Roberts, as Madison’s tax matters partner, a Notice of the

Beginning of an Administrative Proceeding at the Partnership

Level With Respect to Partnership Items (NBAP), which stated that

the IRS was commencing an examination of partnership items

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reported on Madison’s 1982 return. Shortly thereafter,

petitioner received a copy of the NBAP from Mr. Roberts.

Petitioner also received a letter from Mr. Roberts informing him

that Madison would keep him advised of all pertinent developments

regarding the audit and related matters. Petitioner showed the

letter to his tax return preparer.

On December 24, 1987, respondent issued to Madison a Notice

of Final Partnership Administrative Adjustment (FPAA) for 1982

and 1983. Petitioner received a copy of the FPAA.

In the FPAA, respondent adjusted both the investment tax

credit and business energy investment credit property basis from

the $7 million Madison had reported to zero and explained that

“The investment tax credit and the business energy investment

credit in the amount of $7,000,000.00 for the year 1982 is

disallowed because you have not established the amount, if any,

of qualified investment and the extent, if any, of entitlement to

the credit.” In the Explanation of Partnership Adjustments

accompanying the FPAA, respondent further explained:

All items of income, loss deductions and credits

reported with respect to your equipment leasing

activities for the years 1982 and 1983 are disallowed.

For purposes of federal income taxation you cannot be

considered the owner or lessee of the equipment with

respect to which said items of income, loss, deductions

and credits are reported because, after examination of

all of the facts and circumstances, you are found not

to have incurred the benefits and burdens of ownership

or lease of the equipment or to have made, in

substance, a true economic investment in the equipment.

The transactions entered into with respect to you [sic]

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nominal equipment leasing activities were either shams

or devoid of the substance necessary for recognition

for federal income tax purposes, and the transactions

were not, in substance, true leases.

Respondent also explained that the partnership’s tax benefits

were disallowed because the partnership (1) did not engage in or

conduct for profit the activity of the acquisition of and

transfer of right in the recyclers, (2) failed to substantiate

its deductions, and (3) failed to show that the deductions were

incurred, constituted ordinary and necessary business expenses,

were properly paid or accrued, or were deductible in the year

claimed. Respondent also stated that, because the liabilities to

which the recyclers were subject were “nonrecourse, contingent

and lacking in true economic substance, they cannot be considered

a component of the value of the equipment” for purposes of

computing tax credits or the value of the equipment for any other

reason.

An attachment entitled “INFORMATION REGARDING ADDITIONS TO

TAX” was also included with the FPAA. The attachment referenced

sections 6653(a), 6659, and 6621(c), indicated that the sections

would be applied in appropriate cases, and stated that amounts

determined under those sections would be assessed separately

after the completion of the partnership proceeding.

Petitioner’s Post-FPAA Activities

In late 1987 or early 1988, after respondent had issued the

FPAA, petitioner performed an analysis of the economics of the

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Madison investment. Petitioner also sought out other Madison

partners and contacted approximately 30 companies to assess the

relevant market. Additionally, petitioner contacted PI regarding

the investment, went to look at the recyclers, proposed changes

to Madison’s original business plan, and spent approximately 2

months attempting to have the recyclers at PI placed with end

users. However, petitioner discontinued his efforts to resurrect

Madison because PI was uncooperative.

The Partnership Litigation

On May 17, 1988, a partner other than Madison’s tax matters

partner filed a petition in this Court (docket No. 10601-88) to

challenge the determinations made in the FPAA. On April 9, 2001,

we filed an opinion in docket No. 10601-88, see Madison Recycling

Associates v. Commissioner, T.C. Memo. 2001-85, affd. 295 F.3d

280 (2d Cir. 2002), holding that Madison was a partnership

subject to the provisions of the Tax Equity and Fiscal

Responsibility Act of 1982 (TEFRA), Pub. L. 97-248, sec. 402(a),

96 Stat. 648, and that the period of limitations on assessment

had not expired before the FPAA was issued.16 The opinion was

affirmed on appeal, and our decision sustaining respondent’s

partnership adjustments became final on October 7, 2002.

16

By the time we issued our opinion in Madison Recycling

Associates v. Commissioner, T.C. Memo. 2001-85, affd. 295 F.3d

280 (2d Cir. 2002), the parties to the decision had agreed that

respondent’s adjustments in the FPAA were correct.

- 23 -

Respondent’s Affected Items Adjustments

On October 6, 2003, respondent issued a notice of deficiency

(notice) for 1982 to petitioner. Respondent determined that

petitioner was liable for additions to tax under sections

6653(a)(1) and (2) and 6659, and increased interest under section

6621. In the Form 886-A, Explanation of Items, accompanying the

notice, respondent explained that he had adjusted petitioner’s

reported basis in the recyclers to zero and disallowed the loss

and the investment and business energy credits petitioner claimed

with respect to Madison pursuant to our decision in docket No.

10601-88. In Form 4549A, Income Tax Examination Changes,

accompanying the notice, respondent informed petitioner that the

notice reflected only additions to tax.

On December 29, 2003, petitioner’s petition disputing

respondent’s adjustments, denying that petitioner had acted

negligently in the preparation of his tax return or in the

valuation of the assets on the underlying return, and denying

that he had engaged in a tax-motivated transaction was filed.

The resulting case was tried on September 9, 2004, and both

parties submitted posttrial briefs.

OPINION

We have decided many Plastics Recycling cases. Most of

these cases, like the present case, raised issues regarding

additions to tax for negligence and valuation overstatement.

- 24 -

See, e.g., Thornsjo v. Commissioner, T.C. Memo. 2001-129; West v.

Commissioner, T.C. Memo. 2000-389; Barber v. Commissioner, T.C.

Memo. 2000-372; Barlow v. Commissioner, T.C. Memo. 2000-339;

Ulanoff v. Commissioner, T.C. Memo. 1999-170; Merino v.

Commissioner, T.C. Memo. 1997-385, affd. 196 F.3d 147 (3d Cir.

1999); Gottsegen v. Commissioner, T.C. Memo. 1997-314. In all

but two of these cases, we found the taxpayers liable for the

additions to tax for negligence.17 In all of these cases in

which the issue was presented, we found the taxpayers liable for

additions to tax for overvaluation.

In Provizer v. Commissioner, T.C. Memo. 1992-177, the test

case for the Plastics Recycling cases, we (1) found that each

recycler had a fair market value of not more than $50,000; (2)

held that the transaction, which is virtually identical to the

transaction in the present case, 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 underpayment of taxes was directly

related to the overvaluation of the recyclers; and (5) held that

the partnership losses and tax credits claimed with respect to

17

In Dyckman v. Commissioner, T.C. Memo. 1999-79, and

Zidanich v. Commissioner, T.C. Memo. 1995-382, we held that the

taxpayers were not negligent with respect to their participation

in the plastics recycling program. Both cases involved unusual

circumstances not present in this case.

- 25 -

the partnership at issue were attributable to tax-motivated

transactions within the meaning of section 6621(c). We also

found that other recyclers were commercially available during the

year in issue,18 and we relied heavily on the overvaluation of

the recyclers in reaching the conclusion that the transaction

lacked a business purpose. Id.

A. Section 6653(a)(1) and (2)

Section 6653(a)(1) provides for an addition to tax equal to

5 percent of the underpayment if any part of the underpayment is

due to negligence or intentional disregard of rules and

regulations. Section 6653(a)(2) provides for an addition to tax

equal to 50 percent of the interest payable with respect to the

portion of the underpayment attributable to negligence or

intentional disregard of the rules. Respondent’s determination

of negligence is presumed correct, and petitioner has the burden

of proving that he was not negligent.19 See Rule 142(a); Welch

18

See also, e.g., Barlow v. Commissioner, T.C. Memo. 2000-

339; Ferraro v. Commissioner, T.C. Memo. 1999-324; Ulanoff v.

Commissioner, T.C. Memo. 1999-170; Merino v. Commissioner, T.C.

Memo. 1997-385, affd. 196 F.3d 147 (3d Cir. 1999), where we found

that several machines capable of densifying polyethylene and

polystyrene were commercially available in 1982 for $20,000 to

$200,000.

19

Effective for court proceedings arising in connection with

examinations commencing after July 22, 1998, sec. 7491(c) places

the burden of production on the Commissioner with respect to a

taxpayer’s liability for penalties and additions to tax.

Petitioner does not contend, nor is there any evidence, that his

examination commenced after July 22, 1998 or that sec. 7491(c) is

(continued...)

- 26 -

v. Helvering, 290 U.S. 111, 115 (1933); Luman v. Commissioner, 79

T.C. 846, 860-861 (1982); Bixby v. Commissioner, 58 T.C. 757,

791-792 (1972).

Negligence is defined as the failure to exercise the due

care that a reasonable and ordinarily prudent person would

exercise under the circumstances. See Neely v. Commissioner, 85

T.C. 934, 947 (1985). When considering the negligence addition

to tax, we evaluate the particular facts of each case, judging

the relative sophistication of the taxpayer and the manner in

which he approached his investment. See Merino v. Commissioner,

196 F.3d 147, 154 (3d Cir. 1999) (“The inquiry into a taxpayer’s

negligence is highly individualized, and turns on all of the

surrounding circumstances including the taxpayer’s education,

intellect, and sophistication.”), affg. T.C. Memo. 1997-385; see

also McPike v. Commissioner, T.C. Memo. 1996-46; Turner v.

Commissioner, T.C. Memo. 1995-363.

A taxpayer may avoid liability for the addition to tax for

negligence under section 6653(a)(1) and (2) if he reasonably

relied on competent professional advice. United States v. Boyle,

469 U.S. 241, 250-251 (1985); Freytag v. Commissioner, 89 T.C.

849, 888 (1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501

U.S. 868 (1991). However, reliance on professional advice,

19

(...continued)

applicable in this case.

- 27 -

standing alone, is not an absolute defense to negligence; rather,

it is a factor to be considered. Neonatology Associates, P.A. v.

Commissioner, 299 F.3d 221, 234 (3d Cir. 2002) (“the reliance

itself must be objectively reasonable in the sense that the

taxpayer supplied the professional with all the necessary

information to assess the tax matter and that the professional

himself does not suffer from a conflict of interest or lack of

expertise that the taxpayer knew of or should have known about”),

affg. 115 T.C. 43 (2000); Freytag v. Commissioner, supra. In

order to establish that he reasonably relied on competent

professional advice, the taxpayer must show that the adviser had

the expertise and knowledge of the pertinent facts to provide

informed advice on the subject matter.20 David v. Commissioner,

43 F.3d 788, 789-790 (2d Cir. 1995), affg. T.C. Memo. 1993-621;

20

Petitioner relies on Thompson v. United States, 223 F.3d

1206 (10th Cir. 2000), to support an argument that a trier of

fact is obligated to accept a taxpayer’s reliance on professional

advice as a defense to the negligence addition to tax under sec.

6653. However, Thompson does not support petitioner’s argument.

In Thompson, the Court of Appeals for the Tenth Circuit upheld a

jury instruction that reasonable, good-faith reliance on a

professional adviser constitutes a defense to the negligence

addition to tax under sec. 6653. The Court of Appeals found that

the instruction was warranted based on (1) the evidence in the

case, which included testimony regarding the adviser’s expertise,

his investigation of the investment and his conclusions

therefrom, and the information he provided the taxpayer; (2) the

professional relationship between the adviser and the taxpayer;

and (3) the rule that a taxpayer may reasonably rely on advice

when that advice involves the application of the adviser’s

relevant expertise. Thompson v. United States, supra at 1210-

1211.

- 28 -

Goldman v. Commissioner, 39 F.3d 402, 408 (2d Cir. 1994), affg.

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

A taxpayer’s reliance on representations by insiders,

promoters, or offering materials is not sufficient to establish

that a taxpayer reasonably relied on competent professional

advice. Neonatology Associates, P.A. v. Commissioner, supra;

Goldman v. Commissioner, supra at 408; LaVerne v. Commissioner,

94 T.C. 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);

Berry v. Commissioner, T.C. Memo. 2001-311; Ferraro v.

Commissioner, T.C. Memo. 1999-324. Pleas of reliance have also

been rejected when the adviser knew nothing about the nontax

business aspects of the contemplated venture. See Freytag v.

Commissioner, supra at 888; Beck v. Commissioner, 85 T.C. 557,

572-573 (1985); Buck v. Commissioner, T.C. Memo. 1997-191.

Petitioner contends that he acted with due care and did not

fail to do what a reasonable or ordinarily prudent person would

do under the circumstances because: (1) His background was in

the fields necessary for him to have conducted a thorough

analysis of the scientific and economic merits of the investment,

and he conducted such an analysis; (2) he relied on his tax

return preparer, HG&C, and Boylan & Evans; and (3) he invested in

Madison primarily to earn a profit and only secondarily for its

- 29 -

tax benefits. Petitioner also contends that respondent’s

determination of negligence is not entitled to a presumption of

correctness in this case and that petitioner, therefore, should

not bear the burden of proof on the issue of negligence.

1. Petitioner’s Burden of Proof Argument

Petitioner contends that because the inquiry into an

individual’s negligence is highly individualized and turns on the

surrounding circumstances, respondent’s determination should not

be entitled to a presumption of correctness “if he has not made

any inquiry into those individualized circumstances before

asserting the penalty”. Petitioner also contends that respondent

should bear the burden of proof on the issue. Petitioner

concedes, however, that section 7491(c) does not apply to this

case and that his position is not supported by caselaw.

It is well established that a determination of negligence by

the Commissioner is entitled to a presumption of correctness and

that the burden is on the taxpayer to establish that the

Commissioner’s determination is incorrect. See, e.g., Rule

142(a); Welch v. Helvering, 290 U.S. at 115; Luman v.

Commissioner, 79 T.C. at 860-861; Bixby v. Commissioner, 58 T.C.

at 791-792; Berry v. Commissioner, supra; Barlow v. Commissioner,

T.C. Memo. 2000-339; Kowalchuk v. Commissioner, T.C. Memo. 2000-

153; Ferraro v. Commissioner, supra. Petitioner concedes that

his arguments are not supported by caselaw, and he has failed to

- 30 -

show that respondent’s determination is not entitled to the

presumption of correctness. Petitioner, therefore, bears the

burden of proof on this issue.

2. Petitioner’s Reasonableness Argument

a. Petitioner’s Analysis of Madison

Petitioner contends that he exercised the due care of a

reasonable and ordinarily prudent person by performing a

scientific and economic analysis of Madison. Petitioner supports

his contention by arguing that his reasonableness is evidenced by

his review of the POM, his review of Government and private

sector publications that predicted oil prices would continue to

rise, his analysis of the incentives for the parties to the

venture, and his projected 18-percent return for himself over the

life of the venture. Petitioner, however, has failed to

establish that he gave due consideration to the numerous caveats

and warnings in the POM, that he was qualified to value the

recyclers and related equipment, or that he otherwise acted

reasonably in performing his analysis of Madison.

In determining that Madison was an economically viable

investment, there is no evidence that petitioner considered Mr.

Roberts’s lack of relevant experience, the lack of market and

patent protection for the recyclers, or the uncertainty of future

virgin resin prices and the marketability of recycled pellets.

Petitioner also ignored the inconsistency between the POM’s

- 31 -

warnings that PI had no experience in manufacturing or operating

the recyclers and Mr. Roberts’s statement that PI had been

running the recyclers for some time. Although this inconsistency

should have alerted petitioner that further investigation was

warranted, he did not investigate further. Petitioner also

failed to show that his efforts to evaluate the economics of the

Madison transaction were reasonable or that he relied on

reasonable assumptions.21 An examination of petitioner’s

arguments in relationship to the record in this case demonstrates

why.

Although petitioner testified that, in addition to his

reliance on the POM, he made his own more “conservative

estimates” in performing his economic analysis, he provided no

21

For example, petitioner argued that the “so-called oil

crisis” of the late 1970s and early 1980s provided the historical

backdrop for his investment in Madison and that his calculations

were dependent on his assumption that the price of polystyrene

and oil were connected and that the price of oil would rise. The

argument that it was reasonable for a taxpayer to invest in a

plastics recycling partnership because of the “so-called oil

crisis” and the belief that the price of plastic would increase

because it is an oil derivative has been made in more than 20

Plastics Recycling cases. See, e.g., Ferraro v. Commissioner,

T.C. Memo. 1999-324; Merino v. Commissioner, T.C. Memo. 1997-385;

Singer v. Commissioner, T.C. Memo. 1997-325; Sann v.

Commissioner, T.C. Memo. 1997-259, affd. sub nom. Addington v.

Commissioner, 205 F.3d 54 (2d Cir. 2000). We have found this

argument unpersuasive in every one of these cases. The Court of

Appeals for the Third Circuit also has rejected the argument as

unpersuasive. Merino v. Commissioner, 196 F.3d 147 (3d Cir.

1999). Petitioner’s argument is substantially the same as that

rejected in the above-cited cases and does not provide a

reasonable basis for petitioner’s analysis or for his investment

in Madison.

- 32 -

explanation of how he arrived at these estimates. We are unable

to determine from the record whether petitioner’s estimates were

reasonable under the circumstances.

Petitioner also argues that the cost per recycler was

reasonable based on his examination of the recyclers’ design and

“the process as a whole”. However, petitioner did not visit PI,

he did not inspect a recycler, and he did not observe the

recycling process before making his investment in Madison or

filing his 1982 return. Although petitioner claimed that he

requested a copy of the recycler manual, petitioner did not

introduce any evidence that he actually received or reviewed the

manual before making his investment. Petitioner also admitted he

had difficulty ascertaining the actual value of the recycler.

Even if we accept petitioner’s assertion that he had the

requisite education and experience to conduct a reasonable

evaluation of the Madison recyclers and the recyling process,

petitioner has not established that he had the factual

information necessary to evaluate the recyclers’ design or the

merits of the recycling process as a whole.

Petitioner’s argument is also based on a faulty premise. In

Merino v. Commissioner, T.C. Memo. 1997-385, we rejected the

valuation of a recycler in the context of the “overall system” as

unreasonable because it assumed that the underlying sham

transaction was valid. Like the taxpayer in Merino, petitioner

- 33 -

assumed that the simultaneous sales of the recyclers were

meaningful economic transactions that would be respected for tax

purposes. Petitioner made no effort to evaluate the tax aspects

of the Madison transactions beyond reviewing the Boylan & Evans

tax opinions, and he did not obtain an evaluation of the Madison

investment from an independent and competent tax professional.

Finally, petitioner failed to prove that his reliance on his

bus rental activity, another investment that was reaping large

tax benefits for petitioner, to validate his Madison investment

was reasonable. Petitioner did not introduce any evidence to

establish that there was any legitimate economic or legal reason

for comparing the two investments, that he had adequately and

reasonably investigated the bus rental activity before investing

in it, or that the bus investment had itself withstood scrutiny

by respondent.

Although petitioner is a highly educated man with

substantial experience in chemical engineering, petitioner did

not exercise the kind of due diligence that a reasonable and

prudent person with his education and experience should have

exercised under the circumstances. He did not visit or inspect

the recyclers, he did not observe and evaluate the recycling

process, he did not obtain a professional appraisal of the value

of the recyclers even though he had doubts about their value,

and he did not obtain an independent evaluation of the tax

- 34 -

aspects of the Madison transactions despite the warnings

contained in the POM. Consequently, we conclude that

petitioner’s investigation of the Madison investment was not

reasonable.

b. Petitioner’s Reliance on Advisers

Petitioner also contends that he acted reasonably, in part,

because (1) he heeded the warnings in the POM and delegated his

tax return preparation to his longstanding tax return preparer,

(2) he relied on HG&C to monitor his investment, and (3) he

requested and reviewed the Boylan & Evans limited partner

opinion. Petitioner argues that “Not one of these three

professionals ever advised Petitioner that anything was amiss.

* * * What more could a reasonable and prudent person, not

versed in tax law, do to fulfill his duty to the Commissioner?

Infallibility is not required.” We are not persuaded that

petitioner’s reliance was reasonable.

i. Petitioner’s Tax Return Preparer

The warnings about the potential for an audit and the

promises of large tax benefits contained in the POM should have

caused a prudent investor to question the legitimacy of the

promised tax benefits. Petitioner, however, did not provide his

tax return preparer with a copy of the POM or ask him to

evaluate the Madison investment before petitioner invested in

it. Petitioner nevertheless argues that relying on his return

- 35 -

preparer was reasonable because petitioner provided him with

Madison’s Schedule K-1 and because petitioner’s return preparer

prepared petitioner’s 1982 return using the Schedule K-1 without

questioning the investment. Petitioner’s argument does not

persuade us.

Petitioner admitted that he did not give the POM to his

return preparer, and he did not ask his return preparer to

evaluate the Madison investment before he made it. These facts

alone are enough to reject petitioner’s argument. Petitioner

also failed to present any evidence that the return preparer had

the necessary experience, training, or information to evaluate

the Madison investment, even if petitioner had asked him to

perform an evaluation. Petitioner has not carried his burden of

proving that his claimed reliance on his return preparer was

credible or reasonable.

ii. HG&C

Petitioner contends that he did not provide the POM to his

tax return preparer because he believed HG&C was his tax adviser

and because HG&C went over the POM in detail and obtained the

Boylan & Evans limited partner opinion. Petitioner’s reliance

on HG&C was not reasonable, however, because he knew that HG&C

had no background in plastics recycling technology and that Mr.

Cole, his primary contact at HG&C, not only lacked expertise in

- 36 -

plastics recycling technology but also lacked the knowledge

necessary to assess the accuracy of the financial projections

contained in the POM.

Petitioner’s claimed reliance on HG&C was also unreasonable

because petitioner should have known HG&C had a conflict of

interest in advising petitioner to invest in Madison. On

November 24, 1982, petitioner received Madison’s POM from Mr.

Cole, an HG&C employee. The POM informed petitioner that HGSC

and any other qualified broker-dealer would receive a 10-percent

commission for Madison units sold by them. On or around

December 6, 1982, petitioner became a client of HG&C, and HG&C

informed petitioner that it was affiliated with HGSC, that it

relied on HGSC in providing investment advice, and that the two

entities shared some principals and employees. On or around

March 9, 1983, HG&C provided petitioner with a report that

promoted the use of HGSC and tax-sheltered investments and

informed petitioner that HGSC would receive a commission if

petitioner participated in a tax-sheltered investment.

Petitioner’s claimed reliance on HG&C was neither credible

nor reasonable.

iii. Boylan & Evans

Petitioner also claims he reasonably relied on the Boylan &

Evans limited partner opinion. However, petitioner admitted

that he believed Boylan & Evans worked for Madison when it

- 37 -

issued the opinion. Furthermore, the limited partner opinion

prepared by Boylan & Evans made clear that Boylan & Evans had

not independently investigated the Madison transactions. These

facts should have alerted petitioner that the limited partner

opinion was more like offering material than independent advice

and that it was unreasonable to rely on the limited partner

opinion in claiming Madison-related tax benefits.

An additional reason to reject petitioner’s claim of

reliance is that petitioner did not receive the limited partner

opinion until after he had already invested in the Madison

partnership. Although petitioner had read the general partner

opinion contained in the POM, the opinion clearly stated that no

one but the general partner could rely on it. Petitioner could

not have relied on the limited partner opinion in deciding to

invest in the Madison partnership because he did not see it

until after he had invested.

c. Profit Motive

Petitioner also contends that he acted reasonably in

investing in Madison because he intended to make a profit from

his investment and considered the tax benefits secondary.

Petitioner supports this contention by arguing that he (1)

lacked employment security, (2) had other energy-related

investments, (3) “did not know his tax status” until his return

was complete in May 1983, (4) did not use the investment to

- 38 -

carry back losses and credits to prior tax years, and (5)

attempted to monitor and resurrect the investment. Again, we

must reject petitioner’s argument.

We find it incredible that someone with petitioner’s

education and experience would rely on an investment in Madison

to ease immediate employment concerns. Madison did not offer

sufficient cashflow to petitioner to operate as a substitute for

petitioner’s salary, even if the representations in the POM were

accepted at face value.

We also find incredible petitioner’s claim that he did not

know his “tax status” before he invested in Madison. Even if

petitioner was unaware of the exact amount of his 1982 tax

liability when he invested in Madison, he admitted at trial that

he knew his income from Halcon in 1982 would be substantial. A

person with petitioner’s education and experience who knew his

1982 income would be substantial would certainly have reason to

believe that he was facing a significant tax liability for 1982.

Petitioner’s argument that his choice not to invest more

than $75,000 in Madison demonstrates a secondary concern about

tax benefits also defies logic. Claiming large tax benefits

rather than even larger tax benefits does not evidence a profit

motive. Furthermore, if petitioner truly had a profit motive,

the argument could just as easily be made that he would have

invested a larger amount in Madison to get a larger profit.

- 39 -

Finally, petitioner’s attempts to monitor and salvage his

Madison investment do not demonstrate that petitioner made his

investment in Madison primarily to make a profit. His attempts

are consistent with a concern about losing his $75,000

investment but do not disprove a concern about tax benefits.

d. Conclusion

When petitioner filed his 1982 return, he had some

investment experience and the knowledge and experience

associated with a successful career as a chemical engineer.

However, petitioner has failed to establish that he reasonably

investigated or analyzed Madison, or that he reasonably relied

on competent and informed professional advice in deciding to

invest in Madison and in claiming Madison’s tax benefits on his

1982 return. We hold, therefore, that petitioner is liable for

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

B. Section 6659

Under section 6659, a graduated addition to tax is imposed

if an individual has an underpayment of at least $1,000 that is

attributable to a valuation overstatement. Sec. 6659(a), (d).

A valuation overstatement exists if the value of any property,

or the adjusted basis of any property, claimed on any return

exceeds 150 percent of the amount determined to be the correct

amount of such valuation or adjusted basis. Sec. 6659(c)(1).

If the claimed valuation exceeds 250 percent of the correct

- 40 -

value, the addition to tax is equal to 30 percent of the

underpayment. Sec. 6659(b). Petitioner bears the burden of

proving that respondent’s determination of the section 6659

addition to tax is erroneous. Rule 142(a); Luman v.

Commissioner, 79 T.C. at 860-861.

Petitioner claimed an investment tax credit based on a

purported basis in the recyclers of $577,500, petitioner’s

allocable share of Madison’s purported $7 million basis in the

recyclers. In the FPAA, however, respondent determined that

Madison’s actual basis in the recyclers was zero, in part

because Madison was a sham and lacked economic substance.

Respondent adjusted petitioner’s return in accordance with

Madison’s examination results, reducing both his basis of

$577,500 in the recyclers to zero and his Madison-related

credits to zero. If the disallowance of petitioner’s claimed

tax benefits is attributable to the valuation overstatement of

his basis in the recyclers, he is liable for the section 6659

addition to tax at the rate of 30 percent of the underpayment of

tax attributable to the tax benefits claimed with respect to

Madison unless he establishes that he is entitled to a waiver of

the penalty under section 6659(e). E.g., Thornsjo v.

Commissioner, T.C. Memo. 2001-129.

Petitioner contends that section 6659 does not apply in

this case because (1) respondent’s disallowance of the claimed

- 41 -

tax benefits was attributable to other than a valuation

overstatement, and (2) respondent erroneously failed to waive

the section 6659 addition to tax. We reject each of these

arguments for the reasons set forth below.

1. The Grounds for Petitioner’s Underpayments

Section 6659 does not apply to an underpayment of tax that

is not attributable to a valuation overstatement. See McCrary

v. Commissioner, 92 T.C. 827 (1989); Todd v. Commissioner, 89

T.C. 912 (1987), affd. 862 F.2d 540 (5th Cir. 1988). To the

extent a taxpayer claims tax benefits that are disallowed on

grounds separate and independent from an alleged valuation

overstatement, the resulting underpayment of tax is not

attributable to a valuation overstatement. Krause v.

Commissioner, 99 T.C. 132, 178 (1992) (citing Todd v.

Commissioner, supra), affd. sub nom. Hildebrand v. Commissioner,

28 F.3d 1024 (10th Cir. 1994). However, when valuation is an

integral factor in disallowing deductions and credits, section

6659 is applicable. See Illes v. Commissioner, 982 F.2d 163,

167 (6th Cir. 1992), affg. T.C. Memo. 1991-449; Masters v.

Commissioner, T.C. Memo. 1994-197, affd. without published

opinion 70 F.3d 1262 (4th Cir. 1995).

Petitioner contends that the section 6659 addition to tax

does not apply in his case because “the Commissioner totally

disallowed all credits and deductions in the underlying TEFRA

- 42 -

action, [so that] there is no valuation overstatement, but

rather an underpayment attributable to improper deductions and

credits.” Petitioner relies on Heasley v. Commissioner, 902

F.2d 380 (5th Cir. 1990), revg. T.C. Memo. 1988-408, to support

his argument. Petitioner’s reliance is misplaced.

In Heasley, the taxpayers had not graduated from high

school (although one of the taxpayers had earned a G.E.D.), held

blue collar jobs, and had no significant investment experience.

Id. at 381. Because the taxpayers were worried about their

family’s future and were aware they were not knowledgeable

enough to make investments on their own, they relied on an

investment adviser. Id. The adviser, however, led them into an

investment that involved leasing energy “units” from a

corporation and resulted in the loss of the entire amount of

their investment, as well as the Commissioner’s disallowance of

the tax benefits the taxpayers had claimed in relation to the

investment. Id. at 381-382. Because the Heasleys had

overvalued the units, the Commissioner also imposed additions to

tax under section 6659, which we upheld. Id. at 382; see also

Heasley v. Commissioner, T.C. Memo. 1988-408.

On appeal, the Court of Appeals for the Fifth Circuit held

that the taxpayers were not subject to the section 6659 addition

to tax, reasoning that when the Commissioner totally disallows a

deduction or credit, the underpayment is attributable to

- 43 -

claiming an improper deduction or credit rather than to a

valuation overstatement. Heasley v. Commissioner, 902 F.2d at

383. To support its holding, the Court of Appeals for the Fifth

Circuit in Heasley relied on Todd v. Commissioner, 862 F.2d 540

(5th Cir. 1988), in which it held that a valuation overstatement

did not contribute to the underpayment of taxes where the

underpayment was due exclusively to the fact that the property

providing the basis for the tax benefits at issue had not been

placed in service in the year the benefits were claimed.

On facts similar to the facts in this case, the Court of

Appeals for the Third Circuit, the court to which this case is

appealable, has distinguished Heasley. In Merino v.

Commissioner, 196 F.3d 147 (3d Cir. 1999), the taxpayer had

invested in a tax shelter that involved the leasing of

recyclers. The taxpayer was a successful engineer with a Ph.D.

degree in managerial economics and experience in the

petrochemical industry, who, like petitioner in this case,

claimed that he was an acknowledged expert in plastics

technology. Id. at 149. The taxpayer investigated the tax

shelter for a friend and invested for himself as a result of his

findings. Id. at 148-149. The Commissioner ultimately

determined that the investment lacked economic substance,

disallowed the tax benefits the taxpayer claimed in relation to

the investment, and imposed additions to tax as a result of the

- 44 -

underpayment, including an addition for overvaluation, which we

upheld. See Merino v. Commissioner, T.C. Memo. 1997-385. The

Court of Appeals for the Third Circuit sustained our

determination and held that section 6659 is properly imposed

where a claimed tax benefit is disallowed because it is an

integral part of a transaction lacking economic substance.

Merino v. Commissioner, 196 F.3d at 159. The Court of Appeals

for the Third Circuit distinguished the Court of Appeals for the

Fifth Circuit’s holding in Heasley that section 6659 was

inapplicable where there were no grounds for the disallowance of

the taxpayers’ claimed benefits other than overvaluation,

“because the Court’s decision appears to have been driven by

understandable sympathy for the Heasleys rather than by a

technical analysis of the statute.” Merino v. Commissioner, 196

F.3d at 158-159.

In arriving at its decision, the Court of Appeals for the

Third Circuit relied on Gilman v. Commissioner, 933 F.2d 143,

152 (2d Cir. 1991), affg. T.C. Memo. 1989-684, in which the

Court of Appeals for the Second Circuit stated:

Where a transaction is not respected for lack of

economic substance, the resulting underpayment is

attributable to the implicit overvaluation. A

transaction that lacks economic substance generally

reflects an arrangement in which the basis of the

property was misvalued in the context of the

transaction. While this interpretation of

underpayment “attributable to a valuation

- 45 -

overstatement” represents a less common application of

section 6659, we believe it comprehends the tax return

representations that Congress intended to penalize.

Merino v. Commissioner, 196 F.3d at 158-159 (quoting Gilman v.

Commissioner, supra at 152). Petitioner argues, however, that

the Court of Appeals for the Third Circuit tempered its reliance

on Gilman by holding that “where a claimed tax benefit is

disallowed because it is an integral part of a transaction

lacking economic substance, the imposition of the valuation

overstatement penalty is properly imposed, absent considerations

that are not present here.” Merino v. Commissioner, 196 F.3d at

159 (emphasis added). Petitioner thus compares himself to the

Heasleys and contends that those considerations “might * * *

include the fact that the Heasleys were ripped off like Dr.

Korchak”. We are not persuaded by petitioner’s comparison.

The Court of Appeals for the Third Circuit reasoned that

the Court of Appeals for the Fifth Circuit’s decision in Heasley

was based on “understandable sympathy” for the Heasleys and

highlighted the facts that the Heasleys were blue-collar workers

without a high school education who relied completely on an

investment adviser out of concern for their family’s future and

awareness that they were not knowledgeable enough to invest on

their own. Id. at 158. The Court of Appeals for the Third

Circuit also reasoned, however, that “the Merinos [were] not the

Heasleys” and that due to the significant differences between

- 46 -

the Heasleys and Merinos, Heasley did not provide “an analytical

umbrella for the Merinos”. Id. at 158. Because of petitioner’s

education and experience, as well as his repeated arguments that

he was qualified to analyze the Madison investment and did so,

petitioner is also “not the Heasleys”, and section 6659 is

properly imposed if petitioner’s claimed tax benefits were

disallowed because they were an integral part of a transaction

lacking economic substance.

In this case, respondent reduced petitioner’s reported

basis in his investment property, the recyclers, from $577,500

to zero so that the corresponding credits he had claimed were

also reduced to zero. Petitioner’s basis was reduced to zero in

accordance with respondent’s determination at the partnership

level that Madison’s basis in the recyclers was zero because

Madison had not incurred the benefits and burdens of ownership

of the recyclers, it had not made a true economic investment in

the recyclers, the liabilities to which the recyclers were

subject lacked economic substance and could not be considered a

cost of the equipment, and the recycler leasing activities were

shams without economic substance. The underpayment in this case

thus flows from respondent’s determination at the partnership

level that Madison did not have an economic investment in the

recyclers, a determination petitioner may not challenge here.

N.C.F. Energy Partners v. Commissioner, 89 T.C. 741, 745 (1987)

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(the prior partnership-level proceeding will be res judicata as

to partnership adjustments at an affected items proceeding).22

A determination of whether section 6659 may be applied to a

partner upon the resolution of a partnership proceeding

nevertheless may require findings of fact peculiar to the

taxpayer, including that the taxpayer is an individual, a

closely held corporation, or a personal service corporation and

that the taxpayer’s underpayment attributable to an

overstatement is at least $1,000. See N.C.F. Energy Partners v.

Commissioner, supra at 746. Petitioner, however, has failed to

present any evidence that would lead us to conclude his

22

Because Madison is a TEFRA partnership, the tax treatment

of any partnership item is determined at the partnership level

pursuant to the TEFRA provisions. See secs. 6221 to 6233; see

also Sparks v. Commissioner, 87 T.C. 1279, 1284 (1986) (the TEFRA

provisions apply generally to partnerships for taxable years

beginning after Sept. 3, 1982). Under the TEFRA provisions, the

tax treatment of partnership items is decided at the partnership

level in a unified partnership proceeding rather than in a

separate proceeding for each partner. Boyd v. Commissioner, 101

T.C. 365, 369 (1993). Partnership items include, for example,

the partnership aggregate and each partner’s share of items of

income, gain, loss, deduction, or credit of the partnership, and

other amounts determinable at the partnership level with respect

to partnership assets, investments, transactions, and operations

necessary to enable the partnership or the partners to determine

the allowable investment credit. See sec. 6231(a)(3); sec.

301.6231(a)(3)-1(a)(1)(i), (vi)(A), Proced. & Admin. Regs.

Affected items, i.e., items affected by the treatment of

partnership items such as certain additions to tax and interest,

can only be assessed following the conclusion of the partnership

proceeding. See secs. 6225(a), 6231(a)(5); White v.

Commissioner, 95 T.C. at 211; N.C.F. Energy Partners v.

Commissioner, 89 T.C. 741, 745 (1987); Maxwell v. Commissioner,

87 T.C. 783, 791 n.6 (1986).

- 48 -

underpayment did not result from Madison’s lack of economic

investment in the recyclers or from Madison’s overall sham

nature, nor has petitioner shown that section 6659 is otherwise

inapplicable.

2. Section 6659(e)

Under section 6659(e), the Commissioner may waive all or

part of the addition to tax for valuation overstatement based on

a showing by the taxpayer that there was a reasonable basis for

the valuation or adjusted basis claimed on the return and that

such claim was made in good faith. The Commissioner’s decision

to grant or deny the waiver is discretionary and is reviewable

only for an abuse of discretion, such as where the denial of the

waiver is arbitrary, capricious, or unreasonable. See Krause v.

Commissioner, 99 T.C. at 179; Haught v. Commissioner, T.C. Memo.

1993-58.

Respondent contends that petitioner may not challenge the

section 6659 penalty because petitioner “has not asked

respondent to waive all or a portion of that addition”. In the

alternative, respondent contends that petitioner failed to show

that there was a reasonable basis for the valuation or adjusted

basis he claimed on his return. Petitioner contends that he

first learned of respondent’s imposition of the section 6659

addition to tax in the notice of deficiency and that he was

unable to request a waiver through administrative channels

- 49 -

during the 90-day period in which he was allowed to petition the

imposition of the penalty to this Court. Petitioner further

contends, however, that his case was assigned to the IRS Office

of Appeals for several months before the trial and that during

that time “All present issues were discussed at length and

ultimately rejected by the Service”, so that “the failure of the

Commissioner to waive the overvaluation penalty while this case

was in Appeals, amounts to an abuse of discretion”.

Petitioner has failed to persuade us that he requested a

waiver before trial as he alleges. Petitioner did not request a

waiver in his petition, nor did he allege that he had requested

a waiver or that he had reasonable cause for the valuation of

the partnership’s assets claimed on his return. Petitioner did

not introduce any evidence at trial to prove that he had

requested a waiver or that he submitted any information to

respondent in support of a waiver. See, e.g., Mailman v.

Commissioner, 91 T.C. 1079, 1084 (1988); Haught v. Commissioner,

supra; Magnus v. Commissioner, T.C. Memo. 1990-596. Because

petitioner has failed to establish that he made a timely request

for waiver, we cannot conclude that respondent abused his

discretion in failing to waive the section 6659 addition to tax.

Merino v. Commissioner, 196 F.3d at 159 (the Tax Court cannot

order the Commissioner to affirmatively do something that is

within the original discretion of the Commissioner where there

- 50 -

is no record evidence of an abuse of administrative discretion

because “the taxpayers and their counsel * * * ought to request

any such waiver, not the Tax Court”); Osowski v. Commissioner,

T.C. Memo. 2000-367; Ulanoff v. Commissioner, T.C. Memo. 1999-

170; Jaroff v. Commissioner, T.C. Memo. 1996-527; Haught v.

Commissioner, supra.

Because petitioner’s underpayment is the result of an

overvaluation of more than 250 percent and because petitioner

did not prove that he requested a waiver of the section 6659

addition to tax, we sustain respondent’s determination that

petitioner is liable for the section 6659 addition to tax at the

rate of 30 percent of the underpayment of tax attributable to

the disallowed tax benefits.

C. Section 6621(c)

Section 6621(c) provides for an increased rate of interest

on an underpayment of tax equal to 120 percent of the normal

rate under section 6601, but only if such underpayment exceeds

$1,000 and is attributable to a tax-motivated transaction.

Section 6621(c)(3) defines the term “tax-motivated transaction”

to include any valuation overstatement within the meaning of

section 6659(c) and any sham or fraudulent transaction. Sec.

6621(c)(3)(A)(i), (v). The increased rate of interest is

effective with respect to interest accruing after December 31,

1984, even if the transaction was entered into before that date.

- 51 -

See Solowiejczyk v. Commissioner, 85 T.C. 552 (1985), affd.

without published opinion 795 F.2d 1005 (2d Cir. 1986); Barlow

v. Commissioner, T.C. Memo. 2000-339.

Petitioner contends that he should not be held liable for

the increased interest rate under section 6621(c) because he

invested in Madison with the intent to earn a profit.

Respondent contends that we lack jurisdiction to determine

whether petitioner is liable for the increased interest rate,

citing our Opinion in White v. Commissioner, 95 T.C. 209 (1990).

We agree with respondent. As explained below, we lack both

affected item jurisdiction under section 6230 and section

6621(c)(4) jurisdiction to determine whether petitioner is

liable for additional interest under section 6621(c). See White

v. Commissioner, supra.

1. Affected Item Jurisdiction

An affected item is any “item to the extent such item is

affected by a partnership item.” Sec. 6231(a)(5). Affected

items are of two types. The first type is a computational

adjustment made to reflect a change in a partner’s tax liability

resulting from partnership-level adjustments. Sec. 6231(a)(6);

N.C.F. Energy Partners v. Commissioner, 89 T.C. at 744. The

Commissioner may assess a computational adjustment against a

partner without issuing a notice of deficiency once the

partnership proceeding is completed. Sec. 6230(a)(1); N.C.F.

- 52 -

Energy Partners v. Commissioner, supra at 744. The second type

requires a determination that must be made at the partner level.

N.C.F. Energy Partners v. Commissioner, supra at 744. In

appropriate circumstances, once the partnership proceeding is

completed, the Commissioner may issue a notice of deficiency to

a partner for additional deficiencies attributable to an

affected item requiring partner-level determinations. Sec.

6230(a)(2)(A)(i); N.C.F. Energy Partners v. Commissioner, supra

at 743-744.

Additional interest is an affected item that requires a

partner-level determination. White v. Commissioner, supra at

212; N.C.F. Energy Partners v. Commissioner, supra at 745.

Section 6230(a)(2)(A)(i) provides that subchapter B shall apply

to any deficiency attributable to affected items that require

partner-level determinations. Subchapter B of chapter 63 sets

forth deficiency procedures in the case of income, estate, gift,

and certain excise taxes.

Section 6213(a) of subchapter B authorizes the Tax Court to

redetermine a deficiency provided a timely petition is filed.

(Hereinafter subchapter B of chapter 63 will be referred to as

the “deficiency procedures”.) Section 6211(a) defines

“deficiency”, in general, as the amount by which the tax imposed

exceeds the sum of the amount of tax shown on the return and the

- 53 -

amount of tax previously assessed over any rebates. White v.

Commissioner, supra at 213.

In White, a case involving substantially the same

procedural facts as this case,23 we considered whether additional

interest is a “deficiency” within the meaning of section

6211(a). We held that it was not and that, therefore, we did

not have jurisdiction under section 6230(a)(2)(A)(i) to

redetermine additional interest. We explained that section

6601(e)(1), which provides generally that any reference in the

Code to any tax “shall be deemed also to refer to interest”,

excludes subchapter B of chapter 63 from that general rule.

Consequently, references to tax in the definition of deficiency

contained in section 6211(a) do not include interest. Because

our affected item jurisdiction under section 6230 is limited to

“a deficiency attributable to affected items which require

partner level determinations” and because additional interest is

not a deficiency within the meaning of section 6211(a), we

23

In White v. Commissioner, 95 T.C. 209, 210 (1990), the

Commissioner issued an FPAA to the tax matters partner of a

partnership determining adjustments to a partnership’s return.

The taxpayers received a copy of the FPAA from the Commissioner

as notice partners, and neither the tax matters partner nor the

notice partners filed a petition disputing the FPAA. Id.

Thereafter, the Commissioner assessed the deficiency in tax

resulting from the partnership adjustments against the taxpayers

as a computational adjustment. Id. By a subsequent statutory

notice of deficiency, the Commissioner determined that the

taxpayers were liable for additional interest under section

6621(c), as well as additions to tax under secs. 6653(a)(1) and

(2) and 6659, and the taxpayers disputed the determination. Id.

- 54 -

concluded that we did not have jurisdiction under section 6230

to redetermine additional interest. White v. Commissioner,

supra at 212-214.

Petitioner is in the same procedural posture as the

taxpayer in White, and our holding in White is controlling. Our

affected item jurisdiction under section 6230(a)(2)(A)(i) does

not include jurisdiction to redetermine whether petitioner is

liable for additional interest. Id.

2. Section 6621(c)(4) Jurisdiction

Section 6621(c)(4) provides that

In the case of any proceeding in the Tax Court for a

redetermination of deficiency, the Tax Court shall

also have jurisdiction to determine the portion (if

any) of such deficiency which is a substantial

underpayment attributable to tax motivated

transactions.

The Tax Court, therefore, has jurisdiction in a deficiency

proceeding to determine the portion of such deficiency that is a

substantial underpayment attributable to tax-motivated

transactions. The language “such deficiency” refers to the

deficiency that the Court is redetermining. White v.

Commissioner, supra at 216.

In White, we also decided whether section 6621(c)(4) gave

us jurisdiction to redetermine the taxpayer’s liability for

additional interest. We held that it did not. Section

6621(c)(2) provides that a “substantial underpayment

attributable to tax motivated transactions” means any

- 55 -

underpayment of taxes imposed by subtitle A for any taxable year

that is attributable to one or more tax-motivated transactions

if the amount exceeds $1,000. We concluded in White that no

part of the deficiency fit within the definition of a

substantial underpayment attributable to tax-motivated

transactions contained in section 6621(c). An underpayment

within the meaning of section 6621(c)(2) is an underpayment of

tax imposed by subtitle A. The only deficiencies in tax at

issue in White24 were deficiencies resulting from additions to

tax that are imposed by subtitle F.

In this case, the only items at issue other than additional

interest are additions to tax, and the additions to tax are

imposed by subtitle F, not subtitle A. No portion of the

deficiency involves an underpayment of tax imposed by subtitle

A. Because no portion of the deficiency before the Court is

attributable to tax imposed by subtitle A, no portion of the

deficiency before the Court can be a substantial underpayment

attributable to tax-motivated transactions. White v.

Commissioner, 95 T.C. at 216. Consequently, we also lack

24

Sec. 6662(a)(2) provides that “Any reference in this title

to ‘tax’ imposed by this title shall be deemed also to refer to

the additions to the tax, additional amounts, and penalties

provided by this chapter.” Although sec. 6662(b) provides that

sec. 6662(a) shall not apply to certain additions to tax, we

concluded in White v. Commissioner, 95 T.C. at 215, that the

additions to tax imposed under secs. 6653(a)(1) and (2), and

6659, which were at issue therein, were taxes for purposes of the

deficiency procedures under sec. 6662(a)(2).

- 56 -

jurisdiction under section 6621(c)(4) to redetermine additional

interest.25

D. Conclusion

We have carefully considered all remaining arguments by the

parties for results contrary to those expressed herein and, to

the extent not discussed above, conclude that those arguments

are without merit.

To reflect the foregoing,

Decision will be entered

for respondent.

25

If petitioner had paid some or all of the additional

interest that was determined by respondent under sec. 6621,

petitioner would have had the opportunity to contest his

liability for such interest pursuant to the Court’s overpayment

jurisdiction. See sec. 6512(b); Barton v. Commissioner, 97 T.C.

548 (1991); Barlow v. Commissioner, T.C. Memo. 2000-339.

Petitioner does not contend that he paid any of the additional

interest.