Wednesday, February 11, 2009

An except from the Swanson case that was just published provides guidance on the term “negligence.” Gary W. Swanson v. Commissioner, Dkt. No. 14032-06 , TC Memo. 2009-31, February 10, 2009.

Negligence is defined as the failure to exercise the due care that a reasonable and ordinarily prudent person would exercise under the circumstances. See Anderson v. Commissioner, 62 F.3d 1266, 1271 (10th Cir. 1995), affg. T.C. Memo. 1993-607; Neely v. Commissioner, 85 T.C. 934, 947 (1985). The focus of the inquiry is the reasonableness of the taxpayer's actions in view of the taxpayer's experience, the nature of the investment, and the taxpayer's actions in connection with the transaction. See Henry Schwartz Corp. v. Commissioner, 60 T.C. 728, 740 (1973). When considering the negligence addition, we evaluate the particular facts of each case, judging the relative sophistication of the taxpayers as well as the manner in which the taxpayers approached their 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; Korchak v. Commissioner, T.C. Memo. 2005-244; Turner v. Commissioner, T.C. Memo. 1995-363; see also Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), revg. T.C. Memo. 1988-408. 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; see also Greene v. Commissioner, T.C. Memo. 1998-101, affd. without published opinion 187 F.3d 629 (4th Cir. 1999).
A taxpayer may avoid liability for negligence penalties under certain circumstances if the taxpayer reasonably relied on competent professional advice. See Freytag v. Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd. on another issue 501 U.S. 868 (1991). Such reliance, however, is "not an absolute defense to negligence, but rather a factor to be considered." Id. For reliance on professional advice to relieve a taxpayer from the negligence addition 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. See id.; see also Nilsen v. Commissioner, T.C. Memo. 2001-163. The advice must be from competent and independent parties, not from the promoters of the investment. LaVerne v. Commissioner, 94 T.C. 637, 652-653 (1990), 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). Reliance on a professional adviser can be inadequate when the taxpayer and his adviser knew nothing about the nontax business aspects of the venture. Beck v. Commissioner, 85 T.C. 557 (1985); Flowers v. Commissioner, 80 T.C. 914 (1983). In order for reliance on professional advice to excuse a taxpayer from the negligence addition to tax, the reliance must be reasonable, in good faith, and based upon full disclosure. Zfass v. Commissioner, 118 F.3d 184, 188 (4th Cir. 1997), affg. T.C. Memo. 1996-167; Freytag v. Commissioner, supra at 888. The Supreme Court has stated that because most taxpayers are not competent to discern errors in the substantive advice of an adviser, to require that taxpayer to seek a second opinion "would nullify the very purpose of seeking the advice of a presumed expert in the first place." United States v. Boyle, 469 U.S. 241, 251 (1985) (discussing the availability of a defense of reliance on an adviser for substantive tax advice but not for attempted reliance on an adviser concerning the timely filing of a return).
Reliance is unreasonable if the individual upon whom the taxpayer was claiming reliance had a financial interest in the sale of the shelter. The presence of an obvious conflict of interest in the sale of those partnership units should have triggered a more in-depth review by the respective taxpayers. See, e.g., Watson v. Commissioner, T.C. Memo. 2008-276; Ghose v. Commissioner, T.C. Memo. 2008-80; Bronson v. Commissioner, T.C. Memo. 2002-260; Finazzo v. Commissioner, T.C. Memo. 2002-56; Kellen v. Commissioner, T.C. Memo. 2002-19; Christensen v. Commissioner, T.C. Memo. 2001-185; Robnett v. Commissioner, T.C. Memo. 2001-17; Harvey v. Commissioner, T.C. Memo. 2001-16; Hunt v. Commissioner, T.C. Memo. 2001-15; Fawson v. Commissioner, T.C. Memo. 2000-195; Downs v. Commissioner, T.C. Memo. 2000-155.
In other situations, we have found reliance to be unreasonable where a taxpayer claimed to have relied upon an independent adviser because the adviser either did not testify or testified too vaguely to convince us that the taxpayer was reasonable in relying on the adviser's advice regarding the propriety of the claimed deductions. See, e.g., Helbig v. Commissioner, T.C. Memo. 2008-243; Heller v. Commissioner, T.C. Memo. 2008-232; Welch v. Commissioner, T.C. Memo. 2002-39; Christensen v. Commissioner, supra; Serfustini v. Commissioner, T.C. Memo. 2001-183; Nilsen v. Commissioner, T.C. Memo. 2001-163; Hunt v. Commissioner, supra; Glassley v. Commissioner, T.C. Memo. 1996-206.
We have also rejected as unreasonable a taxpayer's claimed reliance on an independent adviser where the record did not show that the adviser did any independent research regarding the deductions claimed by the taxpayer. See, e.g., Lopez v. Commissioner, T.C. Memo. 2001-278, affd. 92 Fed. Appx. 571 (9th Cir. 2004); Christensen v. Commissioner, supra; Carmena v. Commissioner, T.C. Memo. 2001-177.
We have also found taxpayers negligent where they claimed reliance on the offering and placement memoranda the taxpayers reviewed when evaluating the investment opportunity. We have found this argument unpersuasive because the documents did not express an opinion regarding the propriety of the taxpayer's claimed deductions. See Bass v. Commissioner, T.C. Memo. 2007-361; Henn v. Commissioner, T.C. Memo. 2002-261.
In other cases we have found taxpayers negligent where they did not even bother to examine any documents relating to the investment before making a decision to invest. See Ruggiero v. Commissioner, T.C. Memo. 2001-162.
Taxpayers have in other situations attempted to show reasonable cause by claiming reliance on their tax return preparers. However, we have found this reliance unreasonable where the record showed only that a return preparer simply copied information from the partnership return to the taxpayer's return without any investigation into the propriety of the claimed deductions. See McConnell v. Commissioner, T.C. Memo. 2008-167; Bronson v. Commissioner, supra.
Lastly, taxpayers have often attempted to avoid the imposition of penalties by claiming reliance on professors or other individuals, uneducated concerning tax matters, involved in the farming or commercial use of jojoba. We have found reliance on these advisers unreasonable because they lacked any knowledge of tax law. See, e.g., Finazzo v. Commissioner, supra; Kellen v. Commissioner, supra.
Notwithstanding the foregoing, petitioner argues that he was not negligent because he was totally unsophisticated in tax matters, believed he was investing in a legitimate business that would return a steady stream of income, and relied on the advice of a professional, Mr. Markel. Although we have upheld the imposition of section 6653 additions to tax in all jojoba partnership-related cases to come before us, investment in a jojoba partnership does not make a taxpayer strictly liable for negligence penalties. To uphold additions to tax simply because a taxpayer invested in a jojoba partnership that was later found to be improper would violate the requirement that we consider the taxpayer's actions in the light of his experiences and his actions in connection with the transaction. See Henry Schwartz Corp. v. Commissioner, 60 T.C. at 740. As stated above, we must consider all of the facts and circumstances surrounding his case in order to determine whether petitioner was negligent.
Petitioner testified convincingly that he was not seeking an unreasonable tax benefit in making the investment because he knew that the tax benefit would be less than his cash outlay. Mr. Markel and petitioner both testified convincingly that petitioner's primary motivation in making the investment was to profit, and the objective circumstances of petitioner's tax bracket support this testimony. Obviously, petitioner was misinformed. However, petitioner did not have much formal education in tax or financial matters nor any significant financial or investment experience.
Petitioner trusted Mr. Markel and provided him with documents relevant to the investment. Mr. Markel was a licensed tax return preparer in California, one of only two States to require tax preparers to be licensed. Along with this licensing requirement, California requires tax return preparers to meet annual continuing education requirements.
Mr. Markel testified that he (1) visited the jojoba farm in 1983 and (2) reviewed the documents himself and discussed the investment and tax aspects with two C.P.A.s who were independent of Hermes & Milano.

We find that petitioner had a good-faith belief that Mr. Markel was acting in his best interest and was recommending a valid financial investment. The issue for us to decide is whether petitioner was negligent in believing this was a legitimate investment both financially and for tax purposes. We find that petitioner entered into this investment with a good-faith belief that it was legitimate as a financial investment. His cash investment represented his life savings in 1983; and even if petitioner realized that he would recover almost 80 percent of the cash with the additional tax refund he would receive, the remaining $1,100 petitioner invested after the tax benefit was a major expenditure for him. Petitioner also had virtually no prior investment experience. Therefore, we believe petitioner trusted Mr. Markel's advice that this was a good financial risk separate from any tax benefits he might receive. Taking into account petitioner's limited educational background in finance and Federal income tax and his employment history, we must next determine whether petitioner's decision to claim the deduction on his Federal tax return was reasonable. We first must determine whether the tax benefit was "too good to be true." See McCrary v. Commissioner, 92 T.C. 827, 850 (1989). Petitioner's tax refund was less than his cash investment, and he was an unsophisticated investor. We find these factors distinguish petitioner's situation from those in which the tax benefit was unreasonable on its face.
Petitioner was not a high-income individual seeking a tax shelter; rather, he had a naive belief that he was taking a reasonable financial risk in order to receive a significant nontax return over time. Petitioner was involved in monitoring his investment. To his unsophisticated analysis, the loss on his return was not out of line considering the fact that California Jojoba had contacted the partners in the hopes of raising additional funds.
Although he was wrong about the vitality of the investment, petitioner's belief in its economic substance was in good faith. At the time petitioner filed his 1983 Form 1040, he believed that Mr. Markel was a tax professional who was independent of Hermes & Milano, was competent to prepare petitioner's tax returns, and had verified the tax consequences of the transaction with independent C.P.A.s. Petitioner did not seek any tax advice beyond that of Mr. Markel, but we do not find his failure to do so to be negligent given his modest resources and lack of financial sophistication. See United States v. Boyle, 469 U.S. at 251. Looking at these specific facts as we must, we find that the section 6653(a)(1) and (2) additions to tax should not be imposed.

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