T.C. Memo. 1996-41

UNITED STATES TAX COURT

BEVEL M. AND PATRICIA N. HOFFPAUIR, Petitioners v. 

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 6475-87. Filed February 5, 1996.

Bevel M. and Patricia N. Hoffpauir, pro se.

Julie M.T. Foster, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COLVIN, Judge: Respondent determined deficiencies in

petitioners' income tax and additions to tax as follows:

Additions to Tax

Year Deficiency Sec. 6653(a)(1) Sec. 6659

1980 $2,924 $146 $877

1981 1,969 98 591

1982 2,381 119 714

1983 1,940 97 582
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Respondent also determined that petitioners are liable for

increased interest under section 6621(c) for the portion of the

underpayment attributable to tax-motivated transactions. 

After concessions, we must decide the following issues:

1. Whether petitioners may deduct an amount equal to their

cash investment in Century Concepts, Inc., in the years in issue. 

We hold that they may not.

2. Whether petitioners are liable for additions to tax for

the years in issue for: (a) Negligence under section 6653(a),

and (b) valuation overstatement under section 6659. We hold that

they are.

3. Whether petitioners are liable for increased interest

on substantial underpayments due to tax-motivated transactions

under section 6621(c) for the years in issue. We hold that they

are.

Petitioners concede that they are not entitled to claim the

investment tax credit for their investment in Century Concepts.

References to petitioner are to Bevel M. Hoffpauir. Section

references are to the Internal Revenue Code in effect for the

taxable years in issue. Rule references are to the Tax Court

Rules of Practice and Procedure.
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FINDINGS OF FACT

1. Petitioners

Petitioners resided in Maple Valley, Washington, when they

filed the petition in this case. 

Petitioner has a 2-year associate's degree in computer

science and data processing and worked as a computer operator and

programmer, systems analyst, and data processing manager before

1983. 

Petitioners founded a firm called Seattle Distribution

Service, Inc. (SDSI), around 1980. Petitioner wife was the

bookkeeper for SDSI. SDSI distributed merchandise for importers.

Petitioner researched buying computer hardware and software for

SDSI. Petitioners bought a Burroughs system and off-the-shelf

software from a company called R&D Systems Development, which

petitioners had customized for their business. One reason

petitioner chose Burroughs was that it provided technical support

to its customers. Petitioner also investigated computer systems

offered by Honeywell, IBM, and Tandy. 

2. Petitioners' Purchase of an Interest in Century Concepts

Petitioners first heard about Century Concepts, Inc.

(Century), from one of their friends, Dan Marinelli (Marinelli).

Marinelli was the office manager of a company named ITC Business

and Tax Counseling (ITC), which was run by Frank Dollar (Dollar).
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Petitioner wife attended a seminar with about 30 people held

at ITC around August 1983. Petitioner attended a seminar at ITC

a couple of weeks later which was attended by 10 or 15 people.

Petitioners later met one-on-one with Dollar and received Century

promotional materials. Petitioners believed that Century's

promotional materials looked very professional, that Dollar made

credible presentations, and that Century was founded by wellknown people with appropriate expertise. Petitioners did not

investigate Century's founders. The Century program was marketed

as a "tax advantaged equipment lease". 

Petitioner wife saw Century accounting software demonstrated

at Dollar's office. Petitioner was out of town at that time and

did not see it demonstrated. Petitioners did not have their own

copy of the software. Petitioners believed there was a good

marketing plan for the accounting software.

Petitioners saw literature from Century that stated, and

they believed, that home use of computers and software would grow

tremendously in the coming years.

Petitioner's accounting program was in a cassette format.

Petitioner believed that a cassette format was suitable for home

and small business use, but that it would not be adequate for a

business the size of SDSI, which used a hard disk format.

On November 2, 1983, petitioners leased an interest in

accounting software entitled "Accounting Control System; Accounts
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Receivable" from Century. Petitioners paid $4,850 for their

interest in the software. They paid $2,975 on November 2, 1983,

and $1,875 on April 30, 1984. Petitioners invested in the

accounting software through a purported joint venture with three

other parties whom they never met. Petitioners' one-fourth

interest in the software (for which they paid $4,850) was valued

by Century at $93,750 (one-fourth of $375,000). Petitioners did

not arrange for an independent appraisal of the software. 

Petitioners signed an agreement provided to them by Dollar under

which they hired ALA Enterprises (ALA) on November 25, 1983, to

distribute the software. The distribution agreement said ALA

would sell 500 copies of the accounting software package for the

fee petitioners paid ALA. Petitioners never estimated how many

copies of the accounting software package would have to be sold

to make a profit. 

Petitioners invested in accounting software instead of video

game software because petitioner heard from Alan Stone with Far

East Video, a client of SDSI which had exclusive distribution

rights in the United States from Nintendo for the Space Fever and

Sheriff video games, that the video game market was soft in 1983. 

Petitioners did not talk to a tax or financial adviser

(other than Dollar) before they invested in the accounting

software. 
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Petitioners received a $60.48 distribution related to the

accounting software a few months after making the investment. 

They were told the payment was based on sales of 32 units. 

3. Petitioners’ Other Investments

Petitioners bought silver bullion from a company called

Monex through Marinelli and Dollar at Century soon after buying

an interest in the accounting program. Petitioners also invested

in a Denver company started by a friend of petitioner called

Pyrodisc, which produced a newly invented product similar to a

Frisbee. Petitioners did not own stock except in SDSI and

Pyrodisc. Petitioners did not earn a profit from their silver or

Pyrodisc investments, and they lost the money they had invested

in them. 

4. Petitioners' Tax Returns

Before 1983, Stanton's Accounting and Tax Service prepared

petitioners' and SDSI's tax returns. Dollar prepared

petitioners' 1983 tax return. He was not a C.P.A. Petitioner

reviewed the 1983 return before it was filed. Petitioners did

not have a financial or tax adviser or attorney on retainer in

1983. Petitioners have prepared their own tax returns since 1984

or 1985. 

Petitioners reported a $1,131 loss and claimed a $9,375

investment tax credit (of which they used $1,774) on their 1983

tax return. Petitioners carried back unused investment tax
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credits of $2,924 for 1980, $1,970 for 1981, and $2,381 for 1982. 

Respondent disallowed the loss and the investment tax credit.

Petitioners received a total tax refund of $9,629.10 from

their $4,850 payment for an interest in Century, based on

claiming an investment tax credit in 1983, which they carried

back to 1980, 1981, and 1982. By notice of deficiency dated

December 11, 1986, respondent disallowed the investment tax

credit for petitioners' investment in Century for 1980, 1981,

1982, and 1983. 

 OPINION

1. Whether Petitioners May Deduct the Amount of Cash That

They Invested in Century Concepts, Inc. 

Respondent determined that the Century investment program

was a sham designed to obtain deductions for purported tax

losses, tax credits, and nondeductible items. Respondent's

determination is presumed to be correct, and petitioners bear

the burden of proving otherwise. Rule 142(a).

Petitioners contend that they may deduct the cash they

invested in Century software because they had a profit objective

and because their investment was not tax motivated.

A taxpayer may not deduct out-of-pocket cash losses

under section 165(c)(2) from a tax shelter which lacks economic

substance, even if the taxpayer intended to make a profit. 

Mahoney v. Commissioner, 808 F.2d 1219, 1220 (6th Cir. 1987),

affg. Forseth v. Commissioner, 85 T.C. 127 (1985); Cherin v.
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Commissioner, 89 T.C. 986, 993-994 (1987) (even if a taxpayer

has a profit objective, the investment is not recognized for

tax purposes if the transaction lacks economic substance). 

Petitioners have not shown that this case is different from

Mahoney or Cherin; that is, petitioners have not argued or shown

that the Century transaction had economic substance. Petitioners

do not dispute respondent's determination that the Century

transaction was a sham. We conclude that the Century investment

program was an economic sham and that it should be disregarded

for Federal income tax purposes. Pasternak v. Commissioner, 990

F.2d 893, 898 (6th Cir. 1993), affg. Donahue v. Commissioner,

T.C. Memo. 1991-181; Illes v. Commissioner, 982 F.2d 163, 166

(6th Cir. 1992) ("If the transaction lacks economic substance,

then the deduction must be disallowed without regard to the

'niceties' of the taxpayer's intent"), affg. T.C. Memo. 1991-449. 

Therefore, petitioners may not deduct their cash investment. In

view of our conclusion, we need not decide whether petitioners

invested in the Century program with a profit objective or

whether their investment was tax motivated.

Petitioners claim that they may deduct their cash investment

in Century because Century took their cash contributions

fraudulently. Petitioners have not shown that Century acted with

criminal intent to deprive them of their cash contributions. 

Thus, no theft loss deduction is allowable. Nor may petitioners
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deduct their cash investment in Century based upon principles

of equity. See Paxman v. Commissioner, 50 T.C. 567, 576 (1968),

affd. 414 F.2d 265 (10th Cir. 1969); Farmer v. Commissioner, T.C.

Memo. 1994-342.

2. Whether Petitioners Were Negligent

Negligence is a lack of due care or failure to do what a

reasonable and ordinarily prudent person would do under the

circumstances. Zmuda v. Commissioner, 731 F.2d 1417, 1422 (9th

Cir. 1984), affg. 79 T.C. 714 (1982); Marcello v. Commissioner,

380 F.2d 499, 506 (5th Cir. 1967), affg. in part and remanding

in part 43 T.C. 168 (1964) and T.C. Memo. 1964-299; Neely v.

Commissioner, 85 T.C. 934, 947 (1985). To prevail on the issue

of negligence, petitioners must prove that their actions in

connection with this transaction were reasonable in light of

their experience and business sophistication. Avellini v.

Commissioner, T.C. Memo. 1995-489; Lucas v. Commissioner, T.C.

Memo. 1995-341; Poplar v. Commissioner, T.C. Memo. 1995-337; see

Henry Schwartz Corp. v. Commissioner, 60 T.C. 728, 740 (1973). 

If a taxpayer is misguided, is unsophisticated in tax law, and

acts in good faith, we may conclude that he or she is not liable

for the addition to tax for negligence. Collins v. Commissioner,

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

Commissioner, T.C. Memo. 1987-217; Hanson v. Commissioner, 820
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F.2d 1464, 1469 (9th Cir. 1987); Haman v. Commissioner, 500 F.2d

401, 403 (9th Cir. 1974), affg. T.C. Memo. 1972-118. 

Petitioners contend that they were not negligent. They

argue that they did extensive computer and software-related

research before investing in Century. They testified that they

believed their product had great potential, was earning income

until the Internal Revenue Service (IRS) investigation began, and

was valued reasonably compared to similar products. Petitioners

also argue that it is unrealistic to hold them negligent because

it took respondent 2 years to discover that Century had defrauded

its investors.

Petitioner's research for the software he used in his

business was not related to research for the accounting software

investment. An inquiry into the best computer system for a

business is much different than an inquiry whether an accounting

program will be a financial success. We disagree with

petitioner’s claim that he adequately investigated the Century

program.

Petitioners contend that they reasonably relied on people

who held themselves out to be experts, i.e., the management of

the companies in which they invested. Petitioners argue that

they lacked expertise and financial sophistication and that

"due care does not require moderate-income investors * * * to

independently investigate their investments", quoting Heasley v.
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Commissioner, 902 F.2d 380, 383 (5th Cir. 1990), revg. T.C. Memo.

1988-408 (taxpayers held not negligent because they were

unsophisticated with limited prior investment experience and

had no formal education beyond high school).

In Heasley v. Commissioner, supra at 381, the taxpayers

sought the advice of an accountant who independently reviewed the

prospectus and the accompanying tax and legal opinions and found

everything to be in order. Because the taxpayers in Heasley

previously had not employed an accountant, they hired an

accountant referred to them by the promoter of the tax shelter. 

Id. There is no indication, however, that the accountant was an

employee of the promoter or otherwise had any financial interest

in the tax shelter. Id.

Petitioners' situation is not like that in Heasley. 

Petitioners did not have a C.P.A. or other tax or business

professional independently review their investment in Century. 

They did not investigate Dollar or Century before investing. 

Dollar was the promoter; he was not independent. There is no

showing that he was a qualified tax professional. They relied on

the advice of Dollar. It was not reasonable or prudent to have

done so. Advice of the promoters or their agents is not advice

of independent professionals. Pasternak v. Commissioner, 990

F.2d at 903; Gilman v. Commissioner, T.C. Memo. 1990-205, affd.

933 F.2d 143 (2d Cir. 1991) (lessees of computer software lack
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profit objective where the only appraisals relied upon by

taxpayer-investors were made by a tax shelter promoter). 

Petitioners did not investigate Dollar’s professional

qualifications. Cf. Allen v. Commissioner, 925 F.2d 348, 354

(9th Cir. 1991), affg. 92 T.C. 1 (1989). 

Petitioners used an independent tax preparation service to

prepare their returns before 1983. In 1983, they relied on

someone who had a financial interest in the shelter in which they

were investing to prepare their return. Unlike the Heasleys,

petitioners obtained tax advice only from the shelter promoter. 

See Klieger v. Commissioner, T.C. Memo. 1992-734 (taxpayers were

negligent because they relied unreasonably on advice of shelter

promoters). To avoid the addition to tax for negligence on the

ground of reasonable reliance, petitioners must show that they

reasonably relied on the advice of a qualified and independent

tax professional, not the tax shelter promoter. Id.; see Estate

of Strober v. Commissioner, T.C. Memo. 1992-350. 

Petitioners made no real effort to monitor their investment

or conduct any meaningful review of the computer software in

which they had bought an interest. Heasley v. Commissioner,

supra (taxpayers who actively monitored their investment and made

inquiries of servicing agent were not negligent). Petitioners'

receipt of a $60.48 distribution is not significant because it

is only 1-1/4 percent of petitioners' payment; they would have to
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have received 81 times that amount to make a profit on their

investment. 

The fact that Dollar leased petitioners an interest

purportedly worth $93,750 for $4,850, which immediately generated

tax savings of $9,629.10, should have prompted petitioners to

look beyond Dollar for advice. See Allen v. Commissioner, supra

at 353 (taxpayer negligent where tax savings were almost double

the amount of their cash outlay). 

We hold that petitioners are liable for the additions to tax

under section 6653(a) for 1980, 1981, 1982, and 1983.

3. Whether Petitioners Overvalued the Video Games

Respondent determined that petitioners are liable for

additions to tax for valuation overstatement under section 6659. 

That section provides for an addition to tax of up to 30 percent

of the underpayment of tax (of at least $1,000) attributable to a

valuation overstatement. Sec. 6659(a) and (b). A valuation

overstatement occurs where the claimed value or adjusted basis

of property is 150 percent or more of the value or adjusted basis

that is "determined to be the correct amount." Sec. 6659(c).

The Secretary may waive this addition to tax if the taxpayer

shows that there was a reasonable basis for the valuation

claimed, and that the claim was made in good faith. Sec.

6659(e). The Court reviews this determination for abuse of

discretion. Krause v. Commissioner, 99 T.C. 132, 179 (1992).
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Petitioners point out that the IRS did not appraise the

accounting software. They challenge respondent's position that

it was worth zero. They argue that because Century is no longer

in business, it is impossible to determine that the product was

overvalued. Petitioners bear the burden of proving that they did

not overvalue the Century software. Rule 142(a).

Century valued the software at $375,000, of which

petitioners' one-fourth share was $93,750. The $375,000 amount

bears no relation to the fair market value of the software. 

Petitioners received a $60 return (purportedly based on sales of

32 units) on their $4,850 investment. There is no credible

evidence that petitioners could expect 2,570 sales, the number

needed for petitioners to recover their cash investment. 

When an underpayment results from disallowed depreciation

deductions or investment credits due to lack of economic

substance, section 6659 applies because the correct basis is zero

and any basis in excess of that is a valuation overstatement. 

Gilman v. Commissioner, 933 F.2d at 151; Massengill v.

Commissioner, 876 F.2d 616, 619-620 (8th Cir. 1989), affg. T.C.

Memo. 1988-427; Rybak v. Commissioner, 91 T.C. 524, 566-567

(1988); Clayden v. Commissioner, 90 T.C. 656, 677-678 (1988).

We concluded above that petitioners' interest in Century

lacked economic substance. Petitioners conceded that they were

not entitled to an investment credit for their investment. The
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valuation overstatement was integral to a finding that the

investment program lacked economic substance. Thus, we hold

that petitioners are liable for the addition to tax for valuation

overstatement.

4. Whether Petitioners Are Liable for Increased Interest

Respondent determined that petitioners are liable for

increased interest under section 6621(c) on substantial

underpayments attributable to tax-motivated transactions for the

years in issue. Petitioners contend that they were motivated by

profit and not tax reasons when they invested in Century.

Section 6621(c) (formerly section 6621(d)) provides for an

increase in the interest rate where there is a "substantial

underpayment" (an underpayment exceeding $1,000) in any taxable

year "attributable to 1 or more tax motivated transactions." 

Section 6621(c)(3) defines certain transactions as tax motivated. 

The increased rate of interest applies to interest which accrues

after December 31, 1984 (the date of enactment of section

6621(d)), even though the tax-motivated transaction was entered

into before that date and "regardless of the date the return was

filed." H. Conf. Rept. 98-861 (1984), 1984-3 C.B. (Vol. 2) 1,

239; Solowiejczyk v. Commissioner, 85 T.C. 552, 556 (1985), affd.

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

A valuation overstatement under section 6659 is a "taxmotivated transaction." Sec. 6621(c)(3)(A)(i). We have held
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that there is a valuation overstatement in this case to which

section 6659 applies. Thus, the increased rate of interest under

section 6621(c) automatically applies to underpayments of tax

attributable to petitioners' investment in Century.

To reflect the foregoing,

 Decision will be entered

 under Rule 155.