196 F.3d 147 (3rd Cir.

1999)

DONALD MERINO; ROSEMARIE MERINO, Appellants,

v.
COMMISSIONER OF INTERNAL REVENUE, Defendents
No. 98-7159

UNITED STATES COURT OF APPEALS FOR THE THIRD

CIRCUIT
Argued: February 10, 1999
Decided October 29, 1999

On Appeal from the United States Tax Court Tax Court Judge: Hon.
Howard A. DawsonBERNARD S. MARK, ESQ. (Argued) RICHARD S.
KESTENBAUM, ESQ. Of Counsel Kestenbaum & Mark 40 Cutter Mill
Road Suite 300 Great Neck, New York 11021
LORETTA C. ARGETT, ESQ. Assistant Attorney General JONATHAN
S. COHEN, ESQ. JOAN I. OPPENHEIMER, ESQ. (Argued) Attorneys,
Tax Division United States Department of Justice Tax Division Post
Office Box 502 Washington, D.C. 20044
Before: BECKER, Chief Judge, McKEE, Circuit Judge, and LEE,*
District Judge
OPINION OF THE COURT
McKEE, Circuit Judge.

Donald and Rosemarie Merino appeal the ruling of the United States Tax Court
sustaining the Commissioner of Internal Revenue's imposition of additional
taxes for their negligent underpayment of tax pursuant to IRC SS 6653(a) and
(a)(1), and for underpayment of tax attributable to a valuation overstatement
pursuant to IRC S 6659.1 The Commissioner's decision was based upon the
taxpayers' attempt to claim tax credits and losses purportedly resulting from
their 1981 investment in Northeast Resource Recovery Associates ("Northeast")
a tax shelter that was a limited partnership involved in the plastics recycling
business. Northeast is almost identical to the plastics recycling shelter described

in Provizer v. Commissioner of Internal Revenue, 63 T.C.M. (CCH) 2531

(1992), aff'd without pub. op., 996 F.2d 1216 (6th Cir. 1993), cert. denied, 510
U.S. 1163 (1994). In Provizer, the Tax Court upheld the Commissioner's
imposition of additional tax and penalties because the tax shelter at issue was a
"sham" lacking economic substance and business purpose.
2

For the reasons that follow, we will affirm the Tax Court's ruling here.
I.

Donald Merino is one of many investors who invested in a tax shelter involving
the leasing of Sentinel Recyclers and "Plastics Recycling Programs." These
programs promoted expanded polyethylene ("EPE") recyclers during 1981 and
expanded polystyrene ("EPS") recyclers during 1982. Merino is a professional
engineer with a Ph.D. in managerial economics and has spent his entire working
life in various capacities of the petrochemical industry. He claims that he is an
"acknowledged expert in hydro-carbon and plastics technology." Appellants'
Br. at 16. 2 He learned of Northeast through a CPA friend who was considering
recommending the tax shelter to clients and who asked Merino to examine it.
At the time of the request, Merino's job involved forecasting the price of oil and
petroleum-based products such as plastics, and he was actively involved in
predicting market trends in the petroleum industry. As a result of the
investigation that Merino undertook for his friend, Merino subsequently
invested in Northeast himself.

Northeast was created by several simultaneous transactions involving

Packaging Industries, Inc. ("PI"), a company that manufactured and sold seven
Sentinel EPE recyclers to ECI Corp. for $981,000 each.3 ECI then resold the
EPE recyclers to F & G Group for $1,162,666. The $1,162,666 purchase price
consisted of cash in the amount of $79,371.00 and a note in the amount of
$1,083,294.00. Ninety percent of the note was nonrecourse, and the remaining
ten percent recourse portion was due only after the nonrecourse portion was
paid. F & G Group then leased the recyclers to Northeast for 12 years (a lease
term equal to 150% of the class life of the assets), for monthly rental payments
of $110,000. Northeast, in turn, licensed the recyclers to FMEC Corp. for 12
years at a guaranteed minimum royalty of $110,000 per month. Northeast was
also to receive additional royalties based on profits realized by FMEC or a
sublicensee.4 Then, FMEC sublicensed the recyclers back to PI.

All of the monthly payments required by and among the various entities offset
each other. The payments consisted solely of offsetting bookkeeping entries,

and no money ever changed hands. PI sublicensed the recyclers to end-users

that would actually use them to recycle plastic scrap. The sublicense
agreements provided that the end-users would transfer to PI 100% of the
recycled scrap in exchange for a payment from FMEC based on the quality and
quantity of recycled scrap. In reality, however, the terms of these sublicenses
were regularly ignored.
6

The purchase price of $1,162,666 per recycler that F & G "paid" ECI, and for
which Northeast "leased" each recycler from F & G, was used as the basis for
each recycler in computing a Northeast investor's investment and energy tax
credits. However, the EPE recyclers had a manufacturing cost of only $18,000
each and the fair market value of each EPE recycler did not exceed $50,000 in
1981. Northeast's prospectus informed potential investors of the terms of the
simultaneous transactions and stated that each investor would be entitled to
claim income tax credits of $84,813 and tax deductions of $40,174 for every
$50,000 invested. The prospectus also advised investors of the high degree of
business and tax risk associated with an investment in a tax shelter and warned
that only people who could afford to lose all of their cash investment and
anticipated tax benefits should invest.

The prospectus further warned that Northeast had no operating history, that
there was no established market for the recyclers, and that there were no
assurances that the market prices for virgin resin would remain at their current
level or that the recycled plastic would even be marketable as virgin resin. The
prospectus informed investors that the general partner who was solely
responsible for the management and operation of the business had no
significant experience in marketing recycled products and that he had other
business commitments requiring a substantial portion of his time. It also
advised of the possibility of significant competition from current manufacturers
of recycling equipment and of PI's (the recycler's manufacturer) decision not to
apply for a patent to protect its trade secrets.

Although the prospectus contained a copy of a favorable tax opinion by an

attorney, it warned that investors should rely on their own advisors rather than
the tax opinion letter. The opinions of two evaluators, both of whom owned
interests in partnerships that leased EPE recyclers, were also contained in the
prospectus. One of these evaluators concluded that the price that F & G was to
pay for the recyclers was fair and reasonable, although the evaluator did not
state the price, and he appeared to be unaware of it. The other evaluator did not
appraise the recyclers and only concluded that they would be operational.
II.

When Merino undertook his investigation he obtained a copy of Northeast's

prospectus from Northeast's general partner and spent two hours reading it. The
general partner suggested that Merino visit PI's Massachusetts plant. Merino did
so, but he had to sign a secrecy agreement before PI personnel would allow him
to see the operation. Moreover, PI personnel still refused to show Merino PI's
records even after he signed the agreement.

10

While at the plant, Merino watched the operation and talked to PI's president,
who told Merino that PI received bulk deliveries by truck instead of by train,
and that this resulted in a penalty of four cents per pound. PI's president also
told Merino that the plant was in a location which was difficult for trucks to
access, especially in the summer. The difficult access resulted in a "location
differential" which Merino estimated to be several cents per pound. Merino also
learned that PI was not the sole supplier of recycled plastic to any of its
customers. In fact, most of PI's customers had between three and five suppliers.

11

After his inquiry into Northeast, Merino decided to invest $24,000 of his own
money through his CPA friend who acted as his nominee. As a result, Merino
indirectly owned a 2.5% interest in the partnership. No one, including Merino,
ever made a profit in any year from an investment in Northeast.
III.

12

F & G leased the recyclers to Northeast, and elected to pass the investment and
energy tax credits through to Northeast. Consequently, on their 1981 tax return,
the Merinos claimed their proportionate share of Northeast's tax credits and
losses in the amounts of $22,431 and $19,526 respectively. The credits were
based on a claimed value of $1,162,666 per recycler. The Merinos' 1981
income was $109,634, but the tax benefits from Northeast eliminated their 1981
income tax liability in its entirety. Moreover, since the Merinos did not
completely use all of the tax credits on their 1981 return, they claimed credit
carrybacks to 1978, 1979 and 1980, thereby reducing their tax liabilities for
those years.

13

The Commissioner ruled that Northeast lacked economic substance and

business purpose, disallowed the claimed tax benefits, and assessed
deficiencies in the Merinos' federal income taxes based upon the
Commissioner's conclusion that the limited partnership was nothing more than
a tax scheme. The deficiencies for the years in question aggregated to $50,000.
In addition, the Commissioner determined that interest on the deficiencies after
December 31, 1984, would be calculated at 120 percent of the statutory rate

under IRC S 6621(c) because the underpayments were tax motivated

transactions.5
14

The taxpayers responded by filing a petition in Tax Court challenging the

Commissioner's determination of deficiency. Thereafter, the Commissioner
filed an amended answer in which he asserted additions to the tax for 1978,
1979, and 1980 in the respective amounts of $25, $632 and $239 under IRC S
6653(a) because the underpayment of tax was due to taxpayer's negligence;
$1,582 for 1981 under IRC S 6653(a)(1) and 50 percent of the interest due on
$31,645 under IRC S 6653(a)(2). The Commissioner also asserted an additional
tax for 1981 in the amount of $6,645 for a valuation overstatement under IRC S
6659.

15

Prior to trial, the taxpayers stipulated that the limited partnership transaction
lacked economic substance and that they would not therefore, be entitled to any
deductions, losses, credits or any other tax benefits. They further stipulated that
the underpayments made in their tax return were attributable to tax motivated
transactions and that they were therefore subject to the increased interest rates
under IRC S 6621(c). Finally, the taxpayers also stipulated that they did not
intend to contest that the recycler had a fair market value that was less than
$50,000 in 1981 and 1982 and that there was, therefore, a valuation
overstatement.6 Accordingly, the only issue at trial was the propriety of the
Commissioner's imposition of the penalties7 for negligence and valuation
overstatement.
IV.
A.

16

The Commissioner had the burden of proving Merino's negligence by a

preponderance of the evidence because the Commissioner first asserted the
additions for negligence and valuation overstatement in an amended answer to
the Merinos' petition for review. T. C. Rule 142(a); Vecchio v. Commissioner,
103 T. C. 170, 196 (1994); Achiro v. Commissioner, 77 T. C. 881, 890-91
(1981). At trial, the Commissioner introduced the expert reports of Steven
Grossman and Richard S. Lindstrom. Grossman has a Ph.D. in Polymer Science
and, at the time of the trial, was a Professor in Plastics Engineering at the
University of Massachusetts. His report concluded that the Sentinel EPE
recycler did not represent any technology that was new to the industry at the
time of its offering. Moreover, his report concluded that comparable and more
efficient technology to recycle polyethylene scrap was available elsewhere. For

example, he testified that a machine called the "Foremost Densilator" provided

equivalent capability, had been available since 1978, and that it sold for about
$20,000 in 1981. Grossman's report further concluded that the Sentinel EPE
recycler was not viable from the start because it lacked new technology, a
continuous source of suitable scrap, and an established market for the recycled
pellets. Grossman believed that a reasonable investigation of the recycling
industry in 1981 would have shown that the Sentinel EPE recycler had little, if
any, commercial value.
17

Richard Lindstrom, a consultant in plastics and plastics equipment at Arthur D.

Little, Inc., from 1956 to 1989, concluded in his report that in 1981 commercial
units were available that were equal to the Sentinel EPE recycler in function,
product quality and capacity, and that they cost $50,000 or less. Consequently,
Lindstrom opined that the value of the Sentinel EPE recycler did not exceed
$50,000.

18

Despite this evidence, Merino insisted that he had not negligently underpaid his
tax because the record also demonstrated that he "undertook a high level of due
diligence in investigating the bona fides of the investment." Appellants' Br. at
21. This inquiry included, inter alia, spending several hours reviewing the
Offering Memorandum, questioning the general partner about the recycler and
its manufacturer, visiting the plant in Massachusetts, and investigating whether
the EPE recycler was unique because it was capable of recycling low density
polyethylene foam. Merino claimed that the evidence of this due diligence
supports his contention that he believed that the recycler was a unique product
employing novel technology when he first considered investing in Northeast in
1981, and that his investment and the resulting underpayment could not,
therefore, have been negligent under the Tax Code.

19

Merino also argued that, in addition to his due diligence inquiry, he performed
an economic analysis of the investment in which he assumed that the price of
oil was the critical factor. Merino's investment in Northeast was made in 1981,
during the oil crisis. Merino argued that the conventional wisdom when he
made his investment was that there was a reasonable expectation that crude oil
prices would continue to rise significantly, and he maintained that the price of
plastic is directly proportional to the price of crude oil. Therefore, in light of the
expected rise in oil prices it would make economic sense for plastics
manufacturers to purchase recycled resin pellets rather than new plastic resin,
because plastic resin is a petroleum based product. Consequently, Merino
asserted that, in 1981, an investment in a plastic recycling operation was
reasonable, and should not have invited any penalty based upon negligence or
intentional overvaluation.

20

Merino conceded that his economic analysis proved wrong. Even though the
price of crude oil continued to rise in the latter part of 1981 and 1982, the price
of low density polyethylene did not. In fact, it went down. However, Merino
argued that he can not be found negligent under the Tax Code simply because a
reasoned economic analysis of the future value of petroleum-based plastics
turned out to be incorrect. Lastly, Merino argued that even though, in 1981, the
recycler had a manufacturing cost of $18,000, the fair market value of a
Sentinel EPE recycler was $1,162,666, which was the amount F & G "paid"
ECI for each recycler. In arriving at that valuation, Merino did not value the
recycler by itself. Instead, he asserted that manufacturing cost was not a
consideration, and that the fair market value of the Sentinel EPE recycler could
not be determined in isolation from the overall recycling system. When viewed
in that context, he asserted, the recycler had a fair market value of $1,162,666.

21

To support the argument that the Sentinel EPE recycler had a value higher than
Lindstrom's estimate of $50,000, Merino submitted a report to the Tax Court
that had been prepared by Ernest D. Carmagnola, the president of Professional
Plastic Associates. Ironically, Carmagnola had originally been retained by the
Commissioner in 1984 to evaluate Sentinel EPE recyclers. Based on his
information then, Carmagnola estimated that the value of a Sentinel EPE
recycler was $250,000. However, Carmagnola subsequently revised his report
after receiving additional information. The additional information caused
Carmagnola to state in a signed affidavit, dated March 16, 1993, that the fair
market value in the recycler in the fall of 1981 was not more than $50,000.

22

Despite his efforts to support the reasonableness of his valuation of the Sentinel
EPE recycler, Merino conceded that he was aware of a number of other
commercially available plastic recyclers that he knew ranged in price from
$20,000 to $200,000 in 1981. Further, in apparent contradiction of his claim
that the Sentinel EPE recycler's ability to recycle low density polyethylene
foam made it unique, he stipulated that information published prior to his
investment in Northeast indicated that there were several machines capable of
recycling low density polyethylene foam that were already on the market in
1981. Merino testified that it was difficult to make money in the plastics
recycling business, and Grossman refuted Merino's claim that the price of
plastic is directly proportional to the price of crude oil. According to Grossman,
a 300% increase in the price of crude oil results in only a 30% to 40% increase
in the price of plastics products.

23

After hearing the evidence, the Tax Court concluded that the Merinos "failed to
exercise due care in claiming a large deduction and tax credits with respect to
Northeast.. . ." Tax Ct. Op. at 33-34. The court wrote:

24

In view of [Donald Merino's]8 educational background and extensive

experience in plastics and the nature and extent of his investigation, he learned
or should have learned that the Sentinel EPE recycler was not unique and not
worth in excess of $50,000, and that Northeast lacked economic substance and
had no potential for profit. [His] self-serving testimony to the contrary is not
credible, and this Court is not required to accept it as true. In contrast, the
reports of[the Commissioner's] experts Lindstrom and Grossman, which reach
opposite conclusions from petitioner's, are reasonable and persuasive, and the
testimony of these experts is supported by other portions of the record.

25

Id. at 33. Consequently, it sustained the Commissioner's imposition of the

negligence penalty.

26

In support of its conclusions that Merino knew or should have known about the
lack of profit potential, the Tax Court relied on the risk factors outlined in
Northeast's prospectus, PI's high costs, Merino's knowledge of the difficulty of
making money in plastics recycling, and the uncooperative attitude of PI
employees during his inspection of PI's plant. The Tax Court based its
conclusion that Merino knew, or should have known, that the recycler was not
worth $1,162,666, on Merino's knowledge that equivalent recyclers were only
worth $20,000 to $200,000, the lack of patent protection for the EPE recycler,
and the resultant potential for competitors to appropriate any unique features
the EPE recycler may have had. The court rejected Merino's claim that the
recycler was worth $1,162,667 in the context of the overall system because that
argument required the court to consider the sham transaction as though it were
valid, and value the overall system accordingly. The court discounted Merino's
reliance on the oil crises because it believed the Commissioner's contrary
evidence that the price of plastics is not directly proportional to the price of oil.
The court gave no weight to the Carmagnola valuation report because it was
based upon incomplete information and had subsequently been repudiated by
Carmagnola. Finally, the Tax Court noted that the taxpayers' claimed tax
benefits equaled 170% of their cash investment and therefore, except for a few
weeks at the very beginning, they never had any money in the transaction and
invested solely as a tax avoidance measure.
B.

27

IRC SS 6653(a), and 6653(a)(1), provide for an addition to tax equal to 5% of

any underpayment of tax if any part of the underpayment is due to negligence
or intentional disregard of rules and regulations.9 Beginning with tax year 1981,
IRC S 6653(a) further provided for an addition to tax equal to 50% of the
interest payable on that portion of the underpayment which is attributable to

negligence or intentional disregard of rules and regulations.10 The

Commissioner assessed negligence penalties including interest that Merino
purportedly owed for the tax years in question. Merino's counsel has informed
this court that, as of the time this appeal was argued, the total amount of the
negligence penalty, including interest, had grown to more than $400,000.
28

IRC S 6653 defines "negligence" as follows: "negligence includes 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." Heasley v. Commissioner, 902 F.2d 380, 383 (5th Cir. 1990).
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. See David v. Commissioner, 43 F.3d 788, 789 (2d
Cir. 1995).

29

We review the Tax Court's conclusion that Merino negligently claimed the
credits and losses to determine if it is "clearly erroneous". Goldman v.
Commissioner, 39 F.3d 40-2, 406 (2d Cir. 1994). A finding is clearly erroneous
"when, although there is evidence to support it, the reviewing court on the
entire evidence is left with the definite and firm conviction that a mistake has
been committed." United States v. United States Gypsum Co., 333 U. S. 364,
395 (1948). If the Tax Court

30

account of the evidence is plausible in light of the record viewed in its entirety,
[we] may not reverse it even though convinced that had [we] been sitting as a
trier of fact, [we] would have weighed the evidence differently. Where there are
two permissible views of the evidence, the factfinder's choice between them
cannot be clearly erroneous.

31

Anderson v. City of Bessemer City, 470 U. S. 564, 575 (1985)(citation

omitted).

32

We can not conclude on this record that the Tax Court's decision was clearly
erroneous. Donald Merino admitted that, as a result of his experience in the
plastics industry, he knew that it was difficult to make money in the plastics
recycling business, and testified that he knew equivalent recyclers were
available in the marketplace with market values between $20,000 and
$200,000. Moreover, he was unable to precisely demonstrate how he arrived at
his conclusion that the Sentinel EPE recycler which had a manufacturing cost of
$18,000 had a tax basis of $1,162,666, other than his unconvincing explanation
that it had to be valued as part of the overall recycling system. The Tax Court

properly rejected that explanation. It would strain credulity, given all of the
testimony before the Tax Court, to hold that Merino was not negligent in
underpaying his taxes. Accordingly, we hold that the Tax Court correctly
sustained the imposition of the negligence penalty.
C.
33

IRC S 6659(a) provides, in pertinent part, that "[i]f an individual . . . has an

underpayment of the [income] tax . . . Which is attributable to a valuation
overstatement, then there shall be added to the tax" a graduated penalty.11 IRC
S 6659(c) defined a "valuation overstatement" as occurring whenever "the
value of any property, or the adjusted basis of any property, claimed on any
return" is overstated by 150 percent or more. The valuation overstatement
penalty applies only to the tax year 1981 because that was the year in which the
overstatement was made. Here, the claimed valuation exceeded 250 percent of
the actual value. Accordingly, the additional tax is 30% of the underpayment.
IRC S 6659(b). The Commissioner has calculated the valuation overstatement
penalty to be $6,645.

34

An inquiry into an overstatement penalty must focus upon whether the

underpayment is attributable to the overvaluation. A majority of the Courts of
Appeals that have addressed this issue have held that "when an underpayment
stems from deductions that are disallowed due to a lack of economic substance,
the deficiency is attributable to an overstatement of value and is subject to the
penalty of S 6659." Zfass v. Commissioner, 118 F.3d 184, 190 (4th Cir. 1997)
(citing Illes v. Commissioner, 982 F.2d 163, 167 (6th Cir. 1992); Gilman v.
Commissioner, 933 F.2d 143, 151 (2d Cir. 1991); Massengill v. Commissioner,
876 F.2d 616, 619-20 (8th Cir. 1989)). Under this view, whenever a taxpayer
knowingly invests in a tax avoidance entity which the taxpayer should know
has no economic substance, the valuation overstatement penalty is applied as a
matter of course.

35

Here, the Tax Court found that Northeast was a sham in that it had no economic
substance, and no potential for profit. Tax Ct. Op. at 20; 33. It also found that
the Sentinel EPE recycler was not worth more than $50,000. Id. at 33.
Furthermore, the Merinos stipulated that the actual basis for a Sentinel EPE
recycler in 1981 was not more than $50,000. The Merinos also agreed not to
contest the existence of a valuation overstatement on their return. Under these
circumstances, the Tax Court correctly concluded that the underpayment on the
1981 return was "attributable to" a valuation overstatement.12 Tax Ct. Op. at
35.

36

The Merinos argue that where, as here, the Commissioner completely disallows
a claimed tax benefit, the tax underpayment cannot be attributable to a
valuation overstatement. They base that argument on two cases decided by the
Court of Appeals for the Fifth Circuit, viz., Todd v. Commissioner, 862 F.2d
540 (5th Cir. 1988), and Heasley v. Commissioner, 902 F.2d 380 (5th Cir.
1990). Todd v. Commissioner, involved husband and wife taxpayers who
invested in FoodSource, Inc., which sold interests in refrigerated food
containers to investors. The containers were designed to preserve perishable
agricultural products during shipment to foreign and domestic markets. Each
investor paid a fraction of the alleged purchase price of part or all of a
refrigerated unit and signed a promissory note for the balance. FoodSource
managed the containers, rented them to food transporters, and regularly
reported "profits" each investor purportedly earned.

37

The Todds purchased two containers on December 8, 1981 and a third on

October 14, 1982. They paid FoodSource $52,000 for each container, and
signed promissory notes that raised the price of each container to $260,000. The
Todds then used the $260,000 figure as the basis of each refrigerated unit,
claimed investment tax credits and depreciation deductions for the 1981 and
1982 tax years, and carried unused portions of the investment tax credits back
to 1979 and 1980. However, FoodSource did not place the Todds' containers
into service until 1983 because of a payment dispute.

38

The IRS assessed deficiencies and penalties against the Todds and a host of
other FoodSource investors who participated in a test case before the Tax
Court. In that case, Noonan v. Commissioner, T.C. Memo. 1986-449, 52
T.C.M. (CCH) 534 (1986), the Tax Court held that the Todds were not entitled
to their claimed deductions and credits for 1979 to 1982 because their
containers had not been placed in service until 1983. However, other investors
like the Hillendahls and the Hendricks, had their containers placed in service
during the years for which they claimed tax benefits. The Tax Court
nevertheless also ruled against them because the obligations represented by the
promissory notes those investors signed were illusory. Accordingly, the Tax
Court limited the adjusted basis each taxpayer could claim to the lesser of the
$60,000 fair market value of the container or the actual cash payment made by
the taxpayer for the unit. Accordingly, investors like the Hillendahls and the
Hendricks received substantially smaller deductions and credits than they
claimed because of their reduced basis in the refrigerated units. They were also
found liable for an addition to tax for a valuation overstatement pursuant to
IRC S 6659, and the Tax Court remanded the matter so that the Commissioner
could calculate the amount of the deficiencies.

39

On remand, the Commissioner assessed the IRC S 6659 valuation

overstatement penalty against the Todds, who timely petitioned the Tax Court
and challenged the penalty. The Tax Court held that since the Todds' claimed
benefits were disallowed because the refrigerated units were not placed in
service during the tax years in question, their underpayment of tax was not
attributable to the valuation overstatement contained in their returns. Thus, the
Tax Court overruled the Commissioner's imposition of the overvaluation
penalty. Not unexpectedly, the Commissioner appealed.

40

The Court of Appeals for the Fifth Circuit concluded that the language of IRC
S 6659 was ambiguous, and proceeded to examine legislative history. It stated:

41

Congress initially enacted S 6659 as part of the Economic Recovery Tax Act of
1981. The House Ways and Means Committee recognized the large number of
property valuation disputes clogging the tax collection system, and added the
overvaluation penalty to discourage those taxpayers who would inflate the
value of property on their tax returns in hopes of "dividing the difference" with
the IRS. Unfortunately, none of the formal legislative history provides a
method for calculating whether a given tax underpayment is attributable to a
valuation overstatement.

42

862 F.2d at 542. However, the court applied a formula found in the General
Explanation of the Economic Recovery Tax Act, a book prepared by the staff
on the Joint Committee on Taxation. Id. Under that formula:

43

The portion of a tax underpayment that is attributable to a valuation

overstatement will be determined after taking into account any other proper
adjustments to tax liability. Thus, the underpayment resulting from a valuation
overstatement will be determined by comparing the taxpayer's (1) actual tax
liability (i.e., the tax liability that results from a proper valuation and which
takes into account any other proper adjustments) with (2) actual tax liability as
reduced by taking into account the valuation overstatement. The difference
between these two amounts will be the underpayment that is attributable to the
valuation overstatement.

44

Id. at 542-43. The court offered the following illustration of how the formula
would work:

45

The determination of the portion of a tax underpayment that is attributable to a

valuation overstatement may be illustrated by the following example. Assume
that in 1982 an individual files a joint return showing taxable income of

$40,000 and tax liability of $9,195. Assume, further, that a $30,000 deduction
which was claimed by the taxpayer as the result of a valuation overstatement is
adjusted down to $10,000, and that another deduction of $20,000 is disallowed
totally for reasons apart from the valuation overstatement. These adjustments
result in correct taxable income of $80,000 and correct tax liability of $27,505.
Accordingly, the underpayment due to the valuation overstatement is the
difference between the tax on $80,000 ($27,505) and the tax on $60,000
($17,505) (i.e., actual tax liability reduced by taking into account the
deductions disallowed because of the valuation overstatement), or $9,800 [sic].
46

Id. at 543.

47

Applying the formula to the Todds' situation, the Court of Appeals ruled that
the Tax Court had properly held that the Todds were not liable for the
overvaluation penalty because "no portion of the Todds' tax underpayment was
attributable to their valuation overstatements." Id. Under the formula, the

48

Todds' actual tax liability, after adjusting for the failure to place the food
containers in service before 1983, did not differ from their actual tax liability
adjusted for the valuation overstatements. In other words, where the deductions
and credits for these refrigeration units were inappropriate altogether, the
Todds' valuation of the property supposedly generating the tax benefits had no
impact whatsoever on the amount of tax actually owed.

49

Id. at 543 (emphasis added). Consequently, the Todds were not liable for the
valuation overstatement penalty.

50

The Merinos argue that the Todd rationale should govern the adjudication of
their case. The Commissioner did not reduce the basis of the Sentinel EPE
recycler from $1,162,666 to $50,000 and then adjust their tax liability for the
valuation overstatement. Instead, the Commissioner disallowed the claimed tax
benefit entirely. As a result of the complete disallowance, the Merinos argue
that the overvaluation of the recycler had no effect on the amount of the tax
they owed. In other words, the Merinos argue that the Joint Committee on
Taxation's formula cannot be applied here because there is no difference
between the actual tax liability resulting from the disallowance and the actual
tax liability as reduced by taking into account the valuation overstatement. The
Merinos argue that the Commissioner effectively reduced their basis in the
recycler to zero and made the formula unworkable by completely disallowing
the claimed benefit.

51

However, there are significant differences between the Todds and the Merinos.
First, even though FoodSource was a tax shelter, it was not lacking in economic
substance. See Noonan v. Commissioner, T.C. Memo 1986-449 ("In this case,
as contrasted to many of the so-called `tax shelter' cases in which we have
determined that investors did not have an actual and honest profit objective, the
subject property [i.e., the refrigerated unit] was actually produced and the plan
of operation had some commercial potential."). In contrast, the Northeast
plastics recycling shelter was a pure, unadulterated, tax avoidance scheme
totally devoid of economic substance. Second, the deduction in Todd was
disallowed because the refrigerated unit was not placed in service during the
taxable years in which the taxpayers claimed the deduction. The claimed
benefit was not disallowed because the Todds overvalued the property. Thus,
the Todds' overvaluation had nothing to do with the Commissioner's
disallowance. The tax benefit claimed by the Merinos was disallowed because
the valuation overstatement was an integral part of a tax avoidance scheme.
There was no other reason for the disallowance. See Zfass v. Commissioner,
118 F.3d at 190-191 (rejecting taxpayer's Todd-inspired argument where the
claimed benefit was disallowed solely because the asset was overvalued and
part of a tax scheme).

52

Nonetheless, the Court of Appeals for the Fifth Circuit has extended Todd to a
case where an overvaluation of an asset resulted solely from a taxpayer's
interest in a tax avoidance scheme. In Heasley v. Commissioner, 902 F.3d 380
(5th Cir. 1990), the court wrote:

53

We see no reason to treat this case any differently than Todd. Whenever the
I.R.S. totally disallows a deduction or credit, the I.R.S. may not penalize the
taxpayer for a valuation overstatement included in that deduction or credit. In
such a case, the underpayment is not attributable to a valuation overstatement.
Instead, it is attributable to claiming an improper deduction or credit.

54

Id. at 383. Consequently, the court found that the "IRS erred when it assessed
the valuation overstatement penalty and the Tax Court erred as a matter of law
by upholding that assessment." Id. In Heasley, unlike Todd, there were no
grounds for the disallowance of the claimed benefit other than the
overvaluation.

55

However, we do not find the Heasley rationale persuasive here because the
court's decision appears to have been driven by understandable sympathy for
the Heasleys rather than by a technical analysis of the statute. We do not
disagree with the analysis there, however, it has no application here. Mr. and

Mrs. Heasley were blue-collar workers who had not graduated from high
school.13 The Heasleys had four children, were concerned about their children's
futures, and were aware that they were not knowledgeable enough to invest on
their own. Consequently, they relied completely on the advice of an investment
advisor who led them into the challenged tax avoidance scheme. Id. at 381. The
Court of Appeals concluded that the Heasleys should not be subjected to the
additional interest penalty for a tax-motivated transaction because they had a
good faith expectation of profit, even though the court accepted the Tax Court's
findings that the entity in which the Heasleys invested lacked economic
substance and generated only tax deductions and credits and not income. Id. at
385-86. Thus, as the Court of Appeals for the Fourth Circuit subsequently
observed, "the Heasleys were indeed scammed out of a considerable sum of
money." Zfass, 118 F.3d at 190 n.8. However, the Merinos are not the
Heasleys.
56

We do not believe that Todd and Heasley provide an analytical umbrella for the
Merinos because of the significant differences between the Merinos and the
Heasleys. Moreover, we do not believe that the complete disallowance of the
claimed benefit here precludes the imposition of the valuation overstatement
penalty for the simple reason that, given the facts that were either stipulated to
or established before the Tax Court, the overvaluation of the property in
question here is an essential component of the tax avoidance scheme.

57

Where a transaction is not recognized because it lacks economic substance, the

resulting underpayment is attributable to the implicit overvaluation. A
transaction that lacks economic substance generally reflects an arrangement in
which the basis of the property was misvalued in the context of the transaction.
While this interpretation of underpayment "attributable to a valuation
overstatement" represents a less common application of section 6659, we
believe it comprehends the tax return representations that Congress intended to
penalize.

58

Gilman v. Commissioner, 933 F.2d 143, 152 (2d Cir. 1991). Consequently,
where a claimed tax benefit is disallowed because it is an integral part of a
transaction lacking economic substance, the imposition of the valuation
overstatement penalty is properly imposed, absent considerations that are not
present here.
D.

59

IRC S 6659(e) permits the Commissioner to waive the valuation overstatement

penalty "on a showing by the taxpayer that there was a reasonable basis for the
valuation or adjusted basis claimed on the return and that such claim was made
in good faith." The Commissioner's refusal to waive a S 6659 addition to tax is
reviewable for abuse of discretion. Krause v. Commissioner, 99 T.C. 132, 179
(1992).
60

The Merinos do not argue that there was an abuse of discretion by the
Commissioner in failing to waive the penalty. Indeed, they cannot make that
argument because they never requested a waiver from the Commissioner. They
can not now argue that the Commissioner abused his discretion by refusing a
request they never made. See McCoy Enterprises, Inc. v. Commissioner, 58
F.3d 557, 563 (10th Cir. 1995)("It is a well established principle of
administrative law that where a party fails to present a claim to the proper
administrative agency, courts will decline to consider that party's claim.").
Instead, they make the rather novel argument that the Tax Court erred by not
requiring the Commissioner to waive the valuation overstatement penalty.

61

Not surprisingly, the Merinos do not provide any authority for the proposition
that the Tax Court can order the Commissioner to affirmatively do something
that is within the original discretion of the Commissioner where there is
absolutely no record evidence of an abuse of administrative discretion. We
believe that it is the taxpayers and their counsel who ought to request any such
waiver, not the Tax Court.
V.

62

For all of the above reasons, we will affirm the decision of the Tax Court. In
doing so, however, we note that we are not completely unsympathetic to the
Merinos' plight. The Merinos' calculation of their tax liability for the years in
question deprived the Commissioner of approximately $50,000 in taxes. The
operation of IRC SS 6653 and 6659 have now resulted in a liability that is
approaching one-half of one million dollars. Although the taxpayers did not
request a waiver of the penalty for overstatement under IRC SS 6659(e), we
would hope that the Commissioner would still seriously entertain such a request
if the taxpayers make it at this late date. We assume that, if such a request is
made the Commissioner will afford it whatever consideration would have been
appropriate had it been made in a timely manner.14

63

As we noted earlier, the Merinos are not the Heasleys. Nevertheless, we can
not help but express our concern over the proportionality of the Commissioner's
actions here. Nevertheless, the decision of the Tax Court will be affirmed.

Notes:
*

The Honorable Donald J. Lee, United States District Court Judge for the
Western District of Pennsylvania, sitting by designation.

The IRC sections at issue here, IRC S 6653 and 6659, were repealed by the
Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 1001239, 103 Stat.
2106, S 7721(c)(2), effective for returns due after 1989. However, negligence
and substantial valuation misstatements are both components of the accuracyrelated penalty found in IRC S 6662. See IRC SS 6662(b)(1), (b)(3) and (e).

Ironically, Merino appeared as an expert witness for the taxpayers in Provizer

v. Commissioner.

The Tax Court described the Sentinel EPE recycler as "a simple batch type
machine designed to grind expanded polyethylene foam and film into a
densified form called `popcorn' that could be further processed to produce resin
pellets suitable for some uses in the plastics industry. [It] was incapable of
recycling low density polyethylene by itself and had to be used in connection
with grinders, extruders and pelletizers." Merino v. Commissioner, T.C. Memo.
1997-385, slip op. at 8 (Aug. 21,1997).

No profit was involved with the guaranteed minimum royalty. The prospectus
stated that only additional royalties would produce a profit, and Northeast was
entitled to additional royalties only if FMEC, or a sublicensee made a profit.

The Commissioner's deficiency notice refers to IRC S 6621(d). However, this

section was redesignated as S 6621(c) by S 1511(c)(1)(A) of the Tax Reform
Act of 1986, Publ. 99-514, 100 Stat. 2085, 2744, which was later repealed by S
7721(c) of the Omnibus Budget Reconciliation Act of 1989, Publ. 101-239, 103
Stat. 2400. The repeal does not affect this case.

Stipulations pursuant to Tax Court Rule 91 have been described as "the bedrock
of Tax Court practice and [are] considered largely responsible for the courts'
ability to keep current with the thousands of cases docketed each year." Farrell
v. Commissioner of Internal Revenue, 136 F.3d 889, 893 (citations and internal
quotations omitted).

The additional taxes assessed for negligence and valuation overstatement are
not taxes which the taxpayers owed but failed to pay. Rather, they are a penalty
due in addition to any tax underpayment. Farrell v. Commissioner of Internal
Revenue, 136 F.3d at 892.

Rosemarie Merino is a party to these proceedings because the Merinos filed

joint returns for the years in question. Apparently, however, she had little, if
anything, to do with the decision to invest in Northeast. Consequently, the Tax
Court negligence analysis focused exclusively on Donald Merino. However,
since the Merinos filed a joint return we refer to the "taxpayers" here.

S 6653(a)(1) provides for this penalty beginning in tax year 1981.

10

See n.1 supra.

11

See n. 1 supra.

12

The Tax Court finding that a tax underpayment is attributable to a valuation

overstatement is also subject to the clearly erroneous standard of review. Wolf
v. Commissioner, 4 F.3d 709, 715 (9th Cir. 1993). However, the question of
whether the valuation overstatement statute applies to a particular taxpayer's
situation is a question of law that we subject to plenary review. See Gainer v.
Commissioner, 893 F.2d 225, 226 (9th Cir. 1990).

13

Mrs. Heasley did, however, have a GED and she had earned 18 college credits.

14

Of course, we take no position as to whether the Commisioner's denial of any

such request would be viewed as an abuse of discretion. That is not before us.