T.C. Summary Opinion 2001-96

UNITED STATES TAX COURT

DAVID AND IRA KAYE KESSEL, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 16482-98S. Filed June 26, 2001.

David Kessel and Ira Kaye Kessel, pro sese.

Rodney J. Bartlett, for respondent.

PAJAK, Special Trial Judge: This case was heard pursuant to

the provisions of section 7463 of the Internal Revenue Code in

effect at the time the petition was filed. The decision to be

entered is not reviewable by any other court, and this opinion

should not be cited as authority. Unless otherwise indicated,
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subsequent section references are to the Internal Revenue Code in

effect for the year in issue.

Respondent determined that petitioners were liable for the

following additions to tax for taxable year 1982: $523 under

section 6653(a)(1); 50 percent of the interest due on an

underpayment of $10,460 under section 6653(a)(2); and $2,615

under section 6661. The issues for decision are: (1) Whether

petitioners are liable for additions to tax for negligence under

section 6653(a); and (2) whether petitioners are liable for the

addition to tax for a substantial understatement under section

6661. The issues in this case concern the participation of

petitioners as limited partners in the Utah Jojoba I Research

limited partnership (Utah I). 

Some of the facts in this case have been stipulated and are

so found. Petitioners resided in Arvada, Colorado, at the time

they filed their petition. 

In 1982, David Kessel (petitioner) was a pediatrician, and

Ira Kaye Kessel (Mrs. Kessel) was a registered nurse. In 1979 or

1980, petitioner was referred by another physician to Elroy Jones

(Mr. Jones) for his financial planning needs. Petitioners

believed that Mr. Jones was an independent certified financial

planner. During the times they made their investments,

petitioners did not know that Mr. Jones worked for Coordinated
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Financial Services (CFS). CFS was involved with Utah I as well

as some other endeavors. Petitioner assumed Mr. Jones received a

commission on every transaction he did for petitioner. 

Petitioner did not know whether Mr. Jones had a college education

or a background in agriculture or research and development

endeavors.

For 2 or 3 years prior to petitioners' investment in Utah I,

Mr. Jones acted as financial manager and adviser on investments

for petitioner's medical practice pension plan. Mr. Jones

advised petitioner to invest in stocks, bonds, and mutual funds,

as well as in CFS investments. One of the CFS investments was in

a real estate investment trust. Mr. Jones also prepared an

estate plan for petitioners and showed them how their investments

would grow. Petitioners received a rate of return between 10 and

20 percent on their investments during the first 2 or 3 years

while using Mr. Jones as their financial adviser. Petitioner

considered Mr. Jones a trusted adviser who gave sound advice.

Mr. Jones approached petitioner in early November 1982 about

the investment in Utah I. Petitioner was aware that there was a

substantial tax advantage from the Utah I investment in the first

year. Petitioner did not read the materials provided by the

partnership very carefully. He read an article about jojoba that

explained that there were many potential uses for it, that the
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price of the beans was continuing to increase, and that it was an

excellent long-term investment. Petitioner believed that income

would come from the production of the jojoba beans and from

research and development royalties.

Petitioner talked to his certified public accountant Fred

Schutz (Mr. Schutz) about the Utah I investment. Petitioner did

not know whether he provided Mr. Schutz with a copy of the

private placement memorandum. Mr. Schutz reviewed the investment

and concluded there was nothing wrong with it from a tax

standpoint. Mr. Schutz prepared petitioners' 1982 tax return. 

Petitioners decided to invest in Utah I. In 1982, they paid

$10,000 and gave a promissory note to the partnership. Based on

their $10,000 “investment”, petitioners deducted a $20,919 loss

on their Federal tax return in the same year.

Over time, petitioners completely paid off their promissory

note to Utah I. In 1989, when petitioners knew CFS was in

bankruptcy, CFS sent out a letter asking for the partners to pay

their last payments. Petitioners paid Utah I a total of $23,000. 

Petitioners lost over $100,000 when Utah I and their other CFS

investments went under. 

On their joint 1982 Federal income tax return, petitioners

reported wages from petitioner's medical practice of $129,260 and

wages from Mrs. Kessel's job of $30,045. They also deducted
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losses of $20,919 from Utah I. Utah I was eventually audited,

and the matter was resolved in Utah Jojoba I Research v.

Commissioner, T.C. Memo. 1998-6, which found that the activities

of the partnership did not constitute a trade or business and

that the agreements between the partnership and U.S. Agri

Research & Development Corp. had been designed and entered into

solely to provide a mechanism to disguise the capital

contributions of limited partners as currently deductible

expenditures. 

As noted, in the notice of deficiency issued on July 17,

1998, respondent determined that petitioners are liable for

additions to tax for negligence pursuant to section 6653(a)(1)

and (2) and for a substantial understatement addition to tax

pursuant to section 6661.

Section 6653(a)(1) imposes an addition to tax in an amount

equal to 5 percent of an underpayment of tax if any part of the

underpayment is due to negligence or intentional disregard of

rules or regulations. Section 6653(a)(2) imposes an addition to

tax in an amount equal to 50 percent of the interest due on the

portion of the underpayment attributable to negligence or

intentional disregard of rules or regulations.

Respondent maintains that petitioners' underpayment was due

to negligence. Negligence is defined as the failure to exercise
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the due care that a reasonable and ordinarily prudent person

would exercise under like circumstances. Neely v. Commissioner,

85 T.C. 934, 947 (1985). The focus of our inquiry is on the

reasonableness of the taxpayer's actions in light of his

experience and the nature of the investment. Henry Schwartz

Corp. v. Commissioner, 60 T.C. 728, 740 (1973); Fawson v.

Commissioner, T.C. Memo. 2000-195. Whether a taxpayer is

negligent in claiming a tax deduction "depends upon both the

legitimacy of the underlying investment, and due care in the

claiming of the deduction." Sacks v. Commissioner, 82 F.3d 918,

920 (9th Cir. 1996), affg. T.C. Memo. 1994-217. 

Under some circumstances, a taxpayer may avoid liability for

negligence penalties if the taxpayer reasonably relied on

competent professional advice. Freytag v. Commissioner, 89 T.C.

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

other issue 501 U.S. 868 (1991). However, such reliance is "not

an absolute defense to negligence, but rather a factor to be

considered." Id. To be able to rely on professional advice as

an excuse from the negligence additions to tax, the taxpayer must

show that the professional adviser had the expertise and

knowledge of the pertinent facts to provide informed advice on

the subject matter. Id.
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Petitioners were well aware of the substantial tax savings

the investment would provide. Petitioners argued that giving

Utah I $23,000 for a $10,000 tax savings would not be a logical

tax dodge. But at the time they invested, petitioners expected

to receive both the tax benefits and the royalties and profits

from the investment. They did not expect to lose the money

invested.

In making the decision to invest in Utah I, petitioners

relied on a cursory reading of the offering and an article. 

Petitioners did not have any expertise in or knowledge of jojoba

farming, and they did not seek the advice of an expert in this

area. The offering clearly stated that the investment was risky. 

Petitioners did not have an experienced attorney review the

offering as the offering itself suggested. In contrast to their

approach to this investment, petitioner relied upon attorneys for

legal advice in the formation of a personal service corporation,

in the establishment of the corporation’s pension plans, in the

preparation of contracts with doctors, and in the preparation of

wills and estate plans. A close reading of the offering by an

experienced attorney would have alerted petitioners that the

"partnership was merely a passive investor seeking royalty

returns pursuant to the licensing agreement." Fawson v.

Commissioner, supra. Petitioner's minimal reading about jojoba
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could not have provided him with the expertise necessary for

determining whether the partnership was viable and had the

potential to be profitable. 

Petitioners also relied on Mr. Jones' and Mr. Schutz'

advice. Unfortunately, petitioners never asked whether Mr. Jones

had any expertise in agriculture or research and development, nor

even if he had a college education. Mr. Schutz had no expertise

in agriculture or research and development issues. We have no

evidence of the extent to which Mr. Schutz examined the offering. 

Petitioners did not establish that Mr. Jones or Mr. Schutz had

the expertise and knowledge of the pertinent facts to provide

informed advice on the investment in Utah I.

Petitioners claim that they were unsophisticated investors

like the taxpayers in Dyckman v. Commissioner, T.C. Memo. 1999-

79. They claim this is demonstrated by the fact that they lost

around $100,000 on their various investments. The facts of

Dyckman are different from the facts of this case. In Dyckman,

the taxpayers relied on their long-time friend who was a C.P.A.; 

they were not aware that the investment in the partnership was

designed to produce tax benefits; and they had virtually no

experience in financial or investment matters. Id. Petitioners

relied on Mr. Jones, whose educational background they were

unaware of; they were aware that the investment would produce
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substantial tax benefits; and they had been investing for at

least two to three years with Mr. Jones. Unfortunately, they

relied on Mr. Jones, who had an inherent conflict of interest

because of his ties to CFS. Unlike the taxpayers in Dyckman v.

Commissioner, supra, petitioners were provided with a private

placement memorandum which warned that the offering involved a

high degree of risk.

We sympathize with petitioners and what they have been

through. However, based on the facts of this case, we find that

when petitioners claimed the substantial deduction on their

return, they had not exercised the due care of reasonable and

ordinarily prudent persons under similar circumstances. 

Accordingly, we hold that petitioners are liable for the

negligence additions to tax imposed under section 6653(a)(1) and

(2).

Respondent determined that petitioners are liable for an

addition to tax under section 6661(a) for a substantial

understatement of tax for 1982. Section 6661(a), as amended by

the Omnibus Budget Reconciliation Act of 1986, Pub. L. 99-509,

sec. 8002, 100 Stat. 1951, provides for an addition to tax equal

to 25 percent of the amount of any underpayment attributable to a

substantial understatement. An understatement is substantial

when the understatement for the taxable year exceeds the greater
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of (1) 10 percent of the tax required to be shown on the return

or (2) $5,000. The understatement is reduced to the extent that

the taxpayer (1) has substantial authority for the tax treatment

of an item or (2) has adequately disclosed his or her position. 

Sec. 6661(b)(2)(B)(i) and (ii). 

However, if an understatement is attributable to a tax

shelter item, adequate disclosure will not reduce the amount of

the understatement, and, in addition to showing the existence of

substantial authority, the taxpayer must show that he reasonably

believed that the tax treatment claimed was more likely than not

proper. Sec. 6661(b)(2)(C)(i). Substantial authority exists

when "the weight of the authorities supporting the treatment is

substantial in relation to the weight of the authorities

supporting contrary positions." Sec. 1.6661-3(b)(1), Income Tax

Regs. Moreover, good faith reliance on the advice of an

accountant, without evidence of what authority the accountant

relied upon in determining the treatment of such items, is

insufficient to show substantial authority. Deplano v.

Commissioner, T.C. Memo. 1998-303; Buck v. Commissioner, T.C.

Memo. 1997-191.

In this case, petitioners did not provide this Court with

any evidence of the authority on which they or Mr. Schutz relied. 

Petitioners did not adequately disclose their position, nor did
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they produce substantial authority for their position. The

underpayment upon which the addition to tax was imposed was

$10,460. The understatement is substantial because it exceeds

the greater of $5,000 or 10 percent of the amount required to be

shown on the return. Accordingly, we sustain respondent's

determination as to the addition to tax under section 6661(a).

To the extent that we have not addressed any of the parties'

arguments, we have considered them and conclude they are without

merit.

Reviewed and adopted as the report of the Small Tax Case

Division.

Decision will be entered

for respondent.