The opinion
T.C. Memo. 2008-276
UNITED STATES TAX COURT
DEELDA L. WATSON, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11370-06. Filed December 10, 2008.
Peter J. Ressler, for petitioner.
James H. Harris, Jr., for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HALPERN, Judge: Respondent has determined additions to tax
arising from disallowed partnership losses relating to a
partnership in which petitioner and her deceased husband invested
in 1983. The additions to tax are for petitioner’s 1983 and 1985
taxable (calendar) years and are as follows:
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Additions to Tax
Year Sec. 6653(a)(1) Sec. 6653(a)(2)
1983 $220.10 To be determined1
1985 23.75 To be determined2
1
Fifty percent of the statutory interest due
on the $4,402 underpayment of tax for 1983.
2
Fifty percent of the statutory interest due
on the $475 underpayment of tax for 1985.
All section references are to the Internal Revenue Code in
effect for the years in issue. We must decide whether negligence
caused any of petitioner’s 1983 and 1985 underpayments in tax,
thereby rendering petitioner subject to the section 6653(a)(1)
and (2) additions to tax. Petitioner bears the burden of proof.
FINDINGS OF FACT
Some facts are stipulated and are so found. The stipulation
of facts, with accompanying exhibits, is incorporated herein by
this reference. At the time she filed the petition, petitioner
resided in Pennsylvania.
The Investment
In 1983, petitioner and her husband, U.S. Army Colonel
Dwayne C. Watson (Colonel Watson; together, the Watsons),
invested in Contra Costa Jojoba Research Partners (CCJRP).1 The
Watsons had been investing for 10 years and had at least $157,000
invested in mutual funds and various real estate, oil and gas,
1
The parties have so stipulated, although stipulated
documents relating to the Watsons’ investment all refer to Contra
Costa Jojoba Research Limited Partnership. We assume that the
two descriptions are to the same partnership and will refer to
that partnership as CCJRP, in accordance with the parties’
stipulation of the Watsons’ investment.
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leasing, and cable television ventures. In 1983, Colonel Watson
was teaching at the U.S. Army War College in Carlisle,
Pennsylvania, and petitioner had a small business for decorative
painting.
Paul E. Vallely (Major General Vallely2) was a student of
Colonel Watson’s at the War College. He was also the general
partner of CCJRP. Major General Vallely and Colonel Watson
discussed CCJRP one day at the Watsons’ home. After about an
hour reviewing documents, Colonel Watson decided to invest in
CCJRP, and both he and petitioner signed the necessary documents.
For $5,500 cash and a promissory note for $8,250, the Watsons
purchased a 2.857-percent limited partnership interest. In
evaluating the potential risks and rewards of CCJRP, Colonel
Watson relied exclusively on Major General Vallely for advice.
Neither Colonel Watson nor petitioner made any independent
investigation of CCJRP. Among the documents that petitioners
signed that day were a promissory note, an offeree questionnaire,
a subscription agreement, and a limited guaranty agreement. The
subscription agreement represents that the subscriber has
received a copy of a private placement memorandum with respect to
CCJRP and CCJRP’s agreement of limited partnership (CCJRP
agreement). The private placement memorandum claims among other
things that the investment has “significant first year tax
deductions of approximately 232% with subsequent year tax
2
Apparently, Paul E. Vallely retired from the U.S. Army as
a major general in 1991. See McConnell v. Commissioner, T.C.
Memo. 2008-167 n.7.
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deductions.” The CCJRP agreement, including attachments (a
research and development agreement and a license agreement),
consists of 39 single-spaced pages.
For 1983 and 1985, the Watsons filed joint Federal income
tax returns. H&R Block prepared the Watsons’ 1983 Federal income
tax return. Steven Clever (Mr. Clever), a certified public
accountant, prepared the Watsons’ 1985 Federal income tax return.
With respect to CCJRP, the Watsons gave H&R Block and Mr. Clever
only the relevant Schedules K-1, Partner’s Share of Income,
Credits, Deductions, etc. The Watsons claimed losses from CCJRP
of $12,500 and $1,290 on their Federal income tax returns for
1983 and 1985, respectively.
The Underpayments of Tax
On April 12, 1989, respondent mailed to CCJRP’s tax matters
partner notices of final partnership administrative adjustment
for CCJRP’s 1983, 1984, and 1985 tax years that disallowed
certain losses claimed by CCJRP. On July 13, 1989, in response
to those notices, CCJRP’s tax matters partner filed a petition in
this court for review of the adjustments in a case styled Contra
Costa Jojoba Research Partners, Charles B. Toepfer, Tax Matters
Partner v. Commissioner, docket No. 17323-89 (Contra Costa). On
January 28, 1994, the parties to Contra Costa filed a stipulation
to be bound by the Court’s findings and decisions in Utah Jojoba
I Research v. Commissioner, docket No. 7619-90 (Utah Jojoba I).
We sustained the Commissioner’s disallowance of claimed losses in
Utah Jojoba I Research v. Commissioner, T.C. Memo. 1998-6, and
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entered a decision on January 8, 1998, which became final on
April 9, 1998. On the basis of the stipulation to be bound, and
following protracted efforts to find CCJRP’s tax matters partner,
the Court entered decision in Contra Costa on April 11, 2005.
Notices of Deficiency and Petition
Respondent issued to petitioner notices of deficiency dated
March 13, 2006, for both 1983 and 1985, which (1) informed
petitioner that the losses of $12,500 and $1,290 that she and her
husband had claimed for 1983 and 1985 had been disallowed in
accordance with the agreement of the parties in Contra Costa and
(2) determined the additions to tax here in issue. In response
to the notices, petitioner filed the petition.
OPINION
I. Section 6653(a)
Section 6653(a)(1) imposes an addition to tax equal to 5
percent of the underpayment of tax if “any part of any
underpayment * * * is due to negligence or intentional disregard
of rules or regulations”. Section 6653(a)(2) imposes a further
addition to tax equal to 50 percent of the interest due on the
“portion of the underpayment * * * attributable to * * *
negligence or intentional disregard”.
“Negligence is lack of due care or failure to do what a
reasonable and ordinarily prudent person would do under the
circumstances.” Fincher v. Commissioner, 105 T.C. 126, 140
(1995); Santa Monica Pictures, L.L.C. v. Commissioner, T.C. Memo.
2005-104. In cases involving deductions resulting from a
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taxpayer’s investments, courts generally look both to the
reasonableness of the underlying investment and to the taxpayer’s
position taken on the return in evaluating whether the taxpayer
was negligent. E.g., McDonough v. Commissioner, T.C. Memo. 2007-
101. In Neonatology Associates, P.A. v. Commissioner, 299 F.3d
221, 234 (3d Cir. 2002), affg. 115 T.C. 43 (2000), the Court of
Appeals said: “When * * * a taxpayer is presented with what
would appear to be a fabulous opportunity to avoid tax
obligations, he should recognize that he proceeds at his own
peril.” That is, a taxpayer must make a “proper investigation or
exercise due diligence to verify the * * * tax legitimacy” of
such an investment. Id. at 233.
II. Arguments of the Parties
Petitioner argues that the negligence additions are
inappropriate because she and her husband were moderate-income
investors who invested to make a profit rather than to obtain tax
benefits and who relied in good faith on investment advisers and
tax professionals.
Respondent counters that the negligence additions are
appropriate because petitioner and her husband were experienced
investors who had a duty to investigate CCJRP because of the
obviously suspect tax benefits. Moreover, the Watsons consulted
only with the promoter of CCJRP before making the investment and
provided insufficient facts to their return preparers to claim
reliance on their tax expertise.
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III. Discussion
This is one of a series of cases involving additions to tax
for negligence associated with investments in CCJRP. E.g.,
Heller v. Commissioner, T.C. Memo. 2008-232; McConnell v.
Commissioner, T.C. Memo. 2008-167; Ghose v. Commissioner, T.C.
Memo. 2008-80. In Heller, we said the following about CCJRP:
CCJRP’s underlying activity lacked legitimacy, as
we decided in Utah Jojoba I. See Utah Jojoba I
Research v. Commissioner, supra (“[W]e hold that Utah I
was not actively involved in a trade or business and
also lacked a realistic prospect of entering a trade or
business.”); see also Welch v. Commissioner, T.C. Memo.
2002-39. Because CCJRP and the jojoba partnership at
issue in Utah Jojoba I are essentially identical, we
need not rehash in detail the license agreement and the
research and development (R & D) agreement entered into
between CCJRP and U.S. Agri Research & Development Corp
(the same entity with which the partnership at issue in
Utah Jojoba I entered into a license agreement and an R
& D agreement). Suffice it to say that “the R & D
agreement was designed and entered into solely to
provide a mechanism to disguise the capital
contributions of the limited partners as currently
deductible expenditures and thus reduce the cost of
their participation in the farming venture.” Utah
Jojoba I Research v. Commissioner, supra. As the Court
has stated in a number of other cases involving nearly
identical jojoba partnerships:
First, the principal flaw in the
structure of Blythe II [another jojoba R & D
partnership subject to a stipulation to be
bound by the outcome in Utah Jojoba I] was
evident from the face of the very documents
included in the offering. A reading of the R
& D agreement and licensing agreement, both
of which were included as part of the
offering, plainly shows that the licensing
agreement canceled or rendered ineffective
the R & D agreement because of the concurrent
execution of the two documents. Thus, the
partnership was never engaged, either
directly or indirectly, in the conduct of any
research or experimentation. Rather, the
partnership was merely a passive investor
seeking royalty returns pursuant to the
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licensing agreement. Any experienced
attorney capable of reading and understanding
the subject documents should have understood
the legal ramifications of the licensing
agreement canceling out the R & D agreement.
However, petitioners never consulted an
attorney in connection with this investment,
nor does it appear that they carefully
scrutinized the offering themselves.
Christensen v. Commissioner, T.C. Memo. 2001-185; see
Finazzo v. Commissioner, T.C. Memo. 2002-56; Serfustini
v. Commissioner, T.C. Memo. 2001-183; Carmena v.
Commissioner, T.C. Memo. 2001-177; Nilsen v.
Commissioner, T.C. Memo. 2001-163.
The foregoing analysis leads to the conclusion that an
investment in CCJRP was not a reasonable investment from an
income tax perspective. Petitioner argues, however, that she and
her husband did not invest in CCJRP for income tax benefits. She
testified that Colonel Watson never mentioned to her any tax
breaks associated with the investment, and she argues: “Here the
record clearly establishes that * * * Petitioner and Colonel
Watson entered * * * [into CCJRP] for the purposes of making
money, rather than to * * * [obtain] tax breaks.” Even were we
to accept that no purpose of the Watsons’ in investing in CCJRP
was to obtain tax breaks (which we do not), the tax benefits
associated with an investment in CCJRP were prominently announced
in the private placement memorandum that we assume Colonel Watson
received from Major General Vallely. The private placement
memorandum represents that an investment in CCJRP yields first-
year tax deductions of approximately 232 percent and subsequent
tax year deductions. Even if Colonel Watson were indifferent to
the approximately 2½-to-1 tax writeoff that he would claim for
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1983, and the deductions he would claim for subsequent years, he
was on notice that a generous tax benefit accompanied an
investment in CCJRP. The Watsons were sufficiently experienced
investors that the generous tax benefits accompanying an
investment in CCJRP should have raised a red flag. See Ghose v.
Commissioner, supra (“The deduction of such a large loss in
proportion to petitioners’ investment claimed so close to when
that investment was made should have raised a red flag to
petitioners regarding the propriety of deductions for losses
related to their investment in CCJRP.”); Christensen v.
Commissioner, T.C. Memo. 2001-185 (rejecting argument that
investment motivated “solely by the potential to earn a profit”
immunized taxpayers from obligation to understand tax
consequences of investment). A reasonable and ordinarily prudent
person would have seen that red flag and would have made a proper
investigation or would have exercised due diligence to verify the
tax legitimacy of the advertised tax benefits. See Neonatology
Associates, P.A. v. Commissioner, supra. Petitioner apparently
agrees that that was the proper course of action because she
claims that she and her husband relied on investment advisers and
tax professionals.
Reasonable reliance on professional advice may serve as a
defense to additions to tax for negligence. See United States v.
Boyle, 469 U.S. 241, 251 (1985). In evaluating the potential
risks and rewards of CCJRP, Colonel Watson relied exclusively on
Major General Vallely for advice. Nevertheless, petitioner has
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failed to show that Major General Vallely had any demonstrated
tax expertise. Moreover, she testified that Major General
Vallely was the man “selling” the investment in CCJRP to her and
Colonel Watson. A reasonable and ordinarily prudent person would
not rely exclusively on the promoter of such an obviously tax-
risky and complex investment. See LaVerne v. Commissioner, 94
T.C. 637, 652 (1990) (“The failure of petitioners to look beyond
the promotional materials supplied by the salespeople or to
consult independent advisers on so complex a matter as the
proposed investments in The Barbados partnerships is unreasonable
and is not in keeping with the standard of the ordinarily prudent
person.”), affd. without published opinion 956 F.2d 274 (9th Cir.
1992), affd. without published opinion sub nom. Cowles v.
Commissioner, 949 F.2d 401 (10th Cir. 1991); McConnell v.
Commissioner, T.C. Memo. 2008-167 (rejecting reliance on Major
General Vallely’s advice as a defense to negligence additions
relating to an investment in CCJRP). The Watsons’ apparent blind
faith in Major General Vallely constitutes a failure to exercise
due care before investing in CCJRP.
Finally, petitioner argues that she and Colonel Watson
relied on professional tax return preparers to prepare their 1983
and 1985 returns. The fact that professional tax return
preparers prepared those returns is insufficient to shield them
from liability for the negligence additions in question. In all
likelihood, the Watsons’ tax return preparers merely transferred
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the losses from the Schedules K-1 provided by CCJRP onto the
Watsons’ returns. There is no evidence that suggests otherwise.
Petitioner has failed in her defense to the section
6653(a)(1) and (2) additions to tax determined by respondent.
IV. Conclusion
On the premises stated,
Decision will be entered
for respondent.