Heasley v. C.I.R.

• Decision Date: 05 June 1990
• Docket Number: No. 88-4950,88-4950
• Citation: 902 F.2d 380
• Parties: -5068, 90-1 USTC P 50,314 David E. HEASLEY and Kathleen Heasley, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 380

902 F.2d 380

66 A.F.T.R.2d 90-5068, 90-1 USTC P 50,314

David E. HEASLEY and Kathleen Heasley, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 88-4950.

United States Court of Appeals, Fifth Circuit.

June 5, 1990.

Andrea Winters, John D. Copeland, Dallas, Tex., for petitioners.

Gary R. Allen, William Rose, Asst. Atty. Gen., William S. Estabrook, Tax Div. U.S. Dept. of Justice, William F. Nelson, Chief Counsel, I.R.S., Washington, D.C., for respondent.

Appeal from the Decision of the United States Tax Court.

Before GOLDBERG, POLITZ, and JONES, Circuit Judges.

GOLDBERG, Circuit Judge:

Statement of Facts

Between 1981 and 1983, Gaylen Danner, a self-styled economic and financial consultant and securities dealer, introduced Kathleen and David Heasley to numerous investment plans. Before meeting Danner, the Heasleys invested in a mutual fund plan and held $3,000 in stocks as part of Mr. Heasley's job benefit plan. They had no other investment experience. Both held blue collar jobs. Neither Heasley graduated from high school, although Ms. Heasley earned a G.E.D. and 18 college credits, one course at a time. Worried about their future and that of their four children, but not knowledgeable enough to invest on their own, the Heasleys accepted Danner's investment advice.

In December, 1983, Danner introduced the Heasleys to the investment that generated this lawsuit. Danner told the Heasleys that the O.E.C. Leasing Corporation ("O.E.C.") had an energy conservation program ("the plan") that would generate the future income they sought. The plan required the Heasleys to lease energy savings units ("units") from O.E.C. at $5,000 per unit per year. O.E.C. valued the units at $100,000 each. A service company then installed the units in businesses ("end users"). The units reduce energy consumption, thus reducing end users' energy bills. The end users would pay a percentage of their utility savings to investors such as the Heasleys. The higher the price of energy, the more money saved, and the greater the return on the investment. ¹

Danner reviewed the O.E.C. prospectus with the Heasleys. They focused on the cash flow charts, which showed a positive cash flow of $2,000 in 1984 increasing to $11,876 in 1992. Danner also discussed the investment's tax advantages. Already somewhat familiar with the home version of the energy savings unit, the Heasleys believed the O.E.C. investment would generate future income.

The Heasleys invested $10,000 to buy two units and $4,161 for start-up costs, including installation, telephone hook-ups, and insurance. In a late December closing, they signed documents Danner prepared, including service agreements for the two units. The manufacturer of the units later sent the Heasleys warranty cards, unit serial numbers, and photographs of the units. The servicing agent sent them photographs and addresses of the businesses where the servicing agent installed the two units.

In the past, the Heasleys always prepared their own tax returns. However, they did not know how to report the O.E.C. investment. At Danner's suggestion, the Heasleys employed Gene Smith, a C.P.A., to prepare their 1983 tax return. Smith reviewed the O.E.C. prospectus and the accompanying tax and legal opinions and found everything in order. He then deducted the $10,000 advance rents for the two units and claimed a $20,000 investment tax credit. ² Because the investment generated a larger investment tax credit than the Heasleys could use in 1983, Smith carried the investment tax credit back to 1980 and 1981. As a result of the O.E.C.-generated deduction and investment tax credit, the Heasleys received more than $23,000 in refunds for the three years from the Internal Revenue Service ("I.R.S."). The Heasleys used the refunds to recoup the money they invested in the plan. They also invested $3,000 of the refunds in a time share plan recommended by Danner. They put $10,000 of the money into a certificate of deposit as collateral for one of Danner's business loans.

Despite Danner's rosy predictions and the Heasleys' high hopes, the Heasleys earned not one penny off of the units or any other of Danner's suggested investments. Even worse, they lost every penny they invested with Danner (more than $25,000). Their loss exceeded the tax refund generated by the plan.

In 1986, the I.R.S. sent the Heasleys a prefiling notification letter. The Heasleys contacted Danner. He assured them that their investment would pass muster with the I.R.S. Danner was wrong. In September, 1986, the I.R.S. totally disallowed the $10,000 advance rental payments and the $20,000 investment tax credit. As a result, the Heasleys' income tax liability increased by approximately $23,000 plus interest. The I.R.S. also assessed penalties totaling $7,419.75: a $1,153.05 negligence penalty allowed by 26 U.S.C. Section 6653(a)(1); a $5,940.90 valuation overstatement penalty allowed by 26 U.S.C. Section 6659; and a $325.80 substantial understatement penalty allowed by 26 U.S.C. Section 6661. The I.R.S. also increased the interest due on the disallowed investment tax credit under 26 U.S.C. Section 6621(c).

After exhausting their administrative remedies, the Heasleys sued the I.R.S. They do not dispute the tax deficiency but instead challenge the I.R.S.'s assessment of penalties. The tax court found for the I.R.S. The Heasleys appealed. We must decide whether the tax court erred in upholding the I.R.S.'s assessment of the penalties and interest. We need not decide, nor did the tax court decide, the Heasleys' tax liability.

Standard of Review

We presume that the I.R.S. correctly determined the Heasleys' taxes and penalties. See Sandvall v. I.R.S., 898 F.2d 455, 457-58 (5th Cir.1990). The Heasleys bear the burden of proving otherwise. See Welch v. Helvering, 290 U.S. 111, 54 S.Ct. 8, 78 L.Ed. 212 (1933); Sandvall, 898 F.2d at 457-58; C.A. White Trucking Co. v. I.R.S., 601 F.2d 867, 869 (5th Cir.1979). We reverse the tax court's factual finding that the Heasleys did not support their claimed deductions only if the tax court clearly erred; Sandvall, 898 F.2d at 458; Masat v. I.R.S., 784 F.2d 573, 575 (5th Cir.1981); but review the tax court's findings of law de novo. San Antonio Savings Ass'n v. I.R.S., 887 F.2d 577, 581 (5th Cir.1989), reh. den. 894 F.2d 1335. We find clear error if we firmly and definitely believe that the tax court made a mistake. Brock v. Mr. W. Fireworks, Inc., 814 F.2d 1042, 1044 (5th Cir.1987).

Discussion

Section 6659:

The Valuation Overstatement Penalty

The I.R.S. may impose a valuation overstatement penalty for any underpayment of tax "attributable to a valuation overstatement." ³ Section 6659(a). The Heasleys overvalued each unit by $95,000. ⁴ Because the Heasleys overvalued the units, the I.R.S. imposed the valuation overstatement penalty. The tax court upheld the penalty. The court reasoned that the Heasleys's $10,000 investment tax credit depended upon the value of the units. "Thus," the court concluded, "to the extent the underpayment is due to the disallowed credits, the underpayment is attributable to a valuation overstatement." Mem. Op. at 21.

After the tax court issued its opinion in this case, we interpreted the meaning of "attributable to a valuation overstatement" in Todd v. I.R.S., 862 F.2d 540 (5th Cir.1988). ⁵ In Todd, as in this case, the I.R.S. completely disallowed the taxpayer's deductions and credits. On appeal, we compared Todd's actual tax liability (without the improperly claimed deductions and credits) with his actual tax liability including the valuation overstatement. Todd, 862 F.2d at 542-543. We arrived at the same figure for both calculations because the I.R.S. completely disallowed the deductions and credits containing the valuation overstatement. Because we arrived at the same figure, we concluded that Todd's valuation overstatement did not attribute to the underpayment. Therefore, the I.R.S. could not assess a valuation overstatement penalty.

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. In this case, the Heasleys' actual tax liability does not differ one cent from their tax liability with the valuation overstatement included. In other words, the Heasleys' valuation overstatement does not change the amount of tax actually owed. Therefore, the I.R.S. erred when it assessed the valuation overstatement penalty and the tax court erred as a matter of law by upholding that assessment. ⁶

Section 6653:

The Negligence Penalty

The I.R.S. may penalize taxpayers for any underpayment due to negligence or disregard of rules and regulations. ⁷ Section 6653(a). "Negligence" includes any failure to reasonably attempt to 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. Sandvall, 898 F.2d at 458; Marcello v. I.R.S., 380 F.2d 499, 506 (5th Cir.1967); Section 6653(a)(1). "Disregard" includes careless, reckless, or intentional disregard. Section 6653(a)(3). A taxpayer may not be negligent but still may intentionally disregard rules and regulations, and thus violate Section 6653(a). Marcello, 380 F.2d at 506.

The tax court found that the Heasleys acted negligently because they neither independently investigated O.E.C. nor read the entire prospectus or the closing documents. However, the tax court held the Heasleys to a far too-stringent standard for determining negligence.

First, due care does not require moderate-income investors such as the Heasleys to independently investigate their investments. They may rely on the expertise of their financial...