Carl L. & Eugenia T. Henn, Petitioner

S RVIC T.C. Memo. 2002-261 UNITED STATES TAX COURT CARL L. HENN AND EUGENIA T. HENN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket No. 9895-00.

Filed October 9, 2002.

E. Martin Davidoff, for petitioners.

Rodney J. Bartlett and Timothy S. Sinnott, for respondent.

MEMORANDUM OPINION

DINAN, Special Trial Judge: Respondent determined that petitioners are liable for additions to tax for taxable year 1982 under section 6653(a)(1) and (2) in the respective amounts of $256 and 50 percent of the interest due on a $5,124 deficiency.

Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the year in issue, and all SERVED _0CT 9 2002 University.

He also attended an advanced management program at Harvard following the completion of his degree there, as well as postgraduate courses in economics at the University of California at Berkeley. Petitioner's primary career path was in the United States Navy.

Among other duties, petitioner was responsible for various budgetary, financial, and accounting matters, and spent time as an instructor in management, economics, and international • affairs at the Industrial College of the Armed Forces. After retiring from the Navy and from a subsequent financiallyrelated career at American Standard, petitioner began working for E.F.

Hutton in 1982. While there, he participated in a 3-month investment training course for brokers.

He earned certification as a certified financial planner, and was licensed by approximately 10 insurance companies for work related to annuities and life insurance products.

Around 1980, while petitioner was employed by American Standard, he learned of jojoba as an investment opportunity.

In the following years, petitioner learned more about jojoba by word of mouth and by reading articles concerning it. Near or prior to the time petitioner joined E.F. Hutton in 1982, he invested in Jojoba Research Partners of Newport Beach, California ("the partnership").

A colleague had recommended petitioner contact the partnership's general partner, Robert E. Cole. Petitioner discussed the partnership with Mr. Cole on several occasions via Federal Income Tax Consequences:

An investment in the Units involves material forth below. his own tax advisor with respect as state and local) investment.

tax risks, some of which are set Each prospective investor is urged to consult income tax consequences of such an to complex federal (as well .

* * * * * * * (c) Validity of Tax Deductions and Allocations.

The partnership will claim all deductions for income tax purposes which it reasonably federal believes it is entitled to claim. assurance that disallowed by the Service * * * challenge may include * * * expenditures under the R & D contract * * these deductions may not be contested or There can be no Such areas of * .

.

.

* * * * * * * The Service is presently vigorously auditing partnerships, scrutinizing in particular certain * claimed tax deductions. rendered as of representations of shall not review the Partnership's tax returns.

the date hereof based upon the the General Partner * * Counsel's opinion is * * * . Counsel * * * (d) Deductibility of Research and Experimental Expenditures.

The General Partner anticipates that a substantial the capital contributions of the Limited portion of Partners to the Partnership will be used for research and experimental expenditures of covered by Section 174 of prospective investors should be aware that little published authority dealing with the specific types of expenditures which will qualify as research or experimental expenditures within the meaning of Section 174, and most of the expenditures contemplated by the Partnership have not been the subject of any prior cases or administrative determinations.

the Code. However, the type generally there is There are various theories under which such deductions might be disallowed or required to be deferred. ruling by the Service has been or will be sought regarding deductibility of the Code. of the proposed expenditures under Section 174 * No * * this investment, in accordance with the Schedule K-1, Partner's Share of Income, Credits, Deductions, etc., which the partnership had provided to petitioner. Petitioners did not consult with any attorney or accountant with tax expertise prior to filing their return and they filed the return without the assistance of a return preparer, relying on the return preparation instructions provided by the Internal Revenue Service.

As the result of partnership level proceedings concerning Jojoba Research Partners, this Court ultimately entered a decision disallowing in full the partnership's claimed ordinary loss of $678,439 for taxable year 1982. This decision was based upon a stipulation by the partnership and the Commissioner to be bound by the outcome of the case in which this Court rendered our opinion in Utah Joioba I Research v. Commissioner, T.C. Memo.

1998-6.

In that case, we found that the Utah Jojoba I Research partnership ("Utah I") was not entitled to a section 174(a) research or experimental expense deduction (or a section 162(a) trade or business expense deduction) because (a) Utah I did not directly or indirectly engage in research or experimentation, and (b) the activities of Utah I did not constitute a trade or business, nor was there a realistic prospect of Utah I ever entering into a trade or business.

Id Following the entry of the decision concerning the partnership, respondent adjusted petitioners' 1982 return by statutory argument or address the assertion that respondent's determination was arbitrary: Who bears the burden of proof is immaterial because the record is sufficient to decide this case on the basis of a preponderance of the evidence.

See, e.g., Martin Ice Cream Co. v. Commissioner, 110 T.C. 189, 210 n.¹⁶ (1998).

We note, however, that respondent does bear the burden of proof with respect to the substantial understatement addition • to tax because it was asserted for the first time in his answer.

Rule 142(a).

Neoligence Section 6653(a)(1) imposes an addition to tax equal to 5 percent of the underpayment of tax if any part of the underpayment is attributable to negligence or intentional disregard of rules or regulations. Section 6653(a)(2) provides for 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 of rules or regulations. Negligence is defined to include "any failure to reasonably comply with the Tax Code, including the lack of due care or the failure to do what a reasonable or ordinarily prudent person would do under the circumstances." Merino v. Commissioner, 196 F.3d 147, 154 (3d Cir. 1999) (quoting Heaslev v. Commissioner, 902 F.2d 380, 383 (5th Cir. 1990)), affg. T.C. Memo. 1997-385.

Petitioners argue that they were not negligent under the standard set forth by the Fifth Circuit Court of Appeals in Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), revg. T.C.

Memo. 1988-408.

In Heasley, the court found that the taxpayers-- who were moderate-income, blue-collar investors with little prior investment experience--were to be held to a lower standard of due care when evaluating whether they were negligent in making an investment. Petitioners do not merit such a lower standard.

On the contrary, petitioner's excellent business education and extensive financial experience requires a higher standard.

See Henry Schwartz Corp. v. Commissioner, 60 T.C. 728, 740 (1973); Harvey v. Commissioner, T.C. Memo. 2001-16. Consequently, Heasley is not applicable to the case at hand.³ Petitioners cite several cases⁴ for the proposition that taxpayers cannot be negligent where the relevant legal issue was "unsettled" or "reasonably debatable". Petitioners, however, did not receive substantive advice concerning the deduction from anyone independent of the investment, nor did they conduct their own investigation into the propriety of the deduction.

Indeed, 3Likewise inapplicable is this Court's opinion in Dyckman v.

Commissioner, T.C. Memo. 1999-79, regarding the standard to be applied for taxpayers with a "complete lack of sophistication in investment matters."

to which petitioners cite, 4Everson v. United States, 108 F.3d 234 (9th Cir. 1997); Foster v. Commissioner, 756 F.2d 1430 (9th Cir. 1985), affg. part and vacating in part 80 T.C. 34 (1983); Hummer v. Commissioner, T.C. Memo. 1988-528.

in stated only the following as counsel's opinion concerning a section 174 deduction:

The deductions which may be available to the partnership under Section 174 (Research and Development) of Revenue Code are dependent upon the acceptance by the Internal Revenue Service or the courts of characterization of and development fees to the Contractor.

the transaction as a payment of research the Partnership's the Internal It appears.that counsel in fact expressed no opinion concerning the propriety of the deduction, but instead merely stated that the partnership would take the deduction. Although it may have been reasonable if petitioners had overlooked certain minor .

details in the summary of the letter, petitioners should have been alerted to the importance of this claimed deduction:

The memorandum clearly stated that approximately 95 percent of the capital contributed to the partnership would be immediately expended under the research and development contracts.

Among the various cautionary statements in the memorandum was a discussion concerning the risks involved in the partnership's claiming a deduction with respect to this expense, and the memorandum also specifically stated that no ruling would be requested by the partnership from the Internal Revenue Service regarding this issue.

As support for a reliance defense, petitioners cite the unpublished opinion of the Court of Appeals for the Ninth Circuit in Balboa Energy Fund 1981 v. Commissioner, 85 F.3d 634 (9th Cir.

1996), affg.

in part and revg.

in part sub nom. without published 6229(a), (d). Once this Court has jurisdiction pursuant to a timely issued notice of deficiency, our jurisdiction allows us to redetermine the correct amount of the deficiency and any additions to tax--even in an amount greater than that determined in the notice of deficiency--so long as the Secretary asserts a claim for the increase at or before the hearing of the case.

Secs. 6213(a), 6214(a).

Because respondent asserted a claim for the increased amount of the section 6661(a) addition to tax prior to trial, this Court has jurisdiction to redetermine the correct amount thereof.

Sec. 6214(a).

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 of 25 percent of the amount of any underpayment attributable to a substantial understatement of income tax for the taxable year.

A substantial understatement of income tax exists if the amount of the understatement exceeds the greater of 10 percent of the tax required to be shown on the return, or $5,000.

Sec. 6661(b)(1) (A). Generally, the amount of an understatement is reduced by the portion of the understatement which the taxpayer shows is attributable to either (1) the tax treatment of any item for which there was substantial authority, or (2) the tax treatment of any item with respect to which the relevant facts were adequately disclosed on the return.

Sec.

6661(b)(2)(B)·.

If an understatement is attributable to a tax tax opinion letter referenced in the private placement memorandum. However, the memorandum, and presumably the letter itself, did not refer to any specific authority for deducting the loss based on the research and experimental expense deduction.

Adequate disclosure, another defense to the substantial understatement addition to tax, may be made either in a statement attached to the return or on the return itself if in accordance with the requirements of Rev. Proc. 83-21, 1983-1 C.B. 680.. Sec.

1.6661-4(b), (c), Income Tax Regs. Petitioners did not attach such a statement to their 1982 return. Rev. Proc. 83-21, applicable to tax returns filed in 1983, lists information which is deemed sufficient disclosure with respect to certain items, none of which are involved in this case.

If disclosure is not made in compliance with the regulations or the revenue procedure, adequate disclosure on the return may still be satisfied if sufficient information is provided to enable the Commissioner to identify the potential contrpversy involved. Schirmer v.

Commissioner, 89 T.C. 277, 285-286 (1987). Merely claiming the loss without further explanation, as petitioners did in this case, was not sufficient to alert respondent to the controversial section 174 deduction of which the partnership loss consisted.

See, e.g., Hunt v. Commissioner, supra; Robnett v. Commissioner, supra.

To reflect the foregoing, Decision will be entered for respondent for the increased additions to tax.