                                                                                                                           Opinions of the United
1999 Decisions                                                                                                             States Court of Appeals
                                                                                                                              for the Third Circuit


10-29-1999

Merino v IRS
Precedential or Non-Precedential:

Docket 98-7159




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Filed October 29, 1999

UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT

No. 98-7159

DONALD MERINO; ROSEMARIE MERINO,

       Appellants

v.

COMMISSIONER OF INTERNAL REVENUE

On Appeal from the United States Tax Court
Tax Court Judge: Hon. Howard A. Dawson

Argued: February 10, 1999

Before: BECKER, Chief Judge, McKEE, Ci rcuit Judge, and
LEE,* District Judge

(Opinion Filed: October 29, 1999)

       BERNARD S. MARK, ESQ. (Argued)
       RICHARD S. KESTENBAUM, ESQ.
       Of Counsel
       Kestenbaum & Mark
       40 Cutter Mill Road
       Suite 300
       Great Neck, New York 11021
       Attorneys for Appellants



_________________________________________________________________

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

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.
_________________________________________________________________

1. The IRC sections at issue here, IRC S 6653 and 6659, were repealed
by the Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 1001-
239, 103 Stat. 2106, S 7721(c)(2), effective for returns due after 1989.
However, negligence and substantial valuation misstatements are both
components of the accuracy-related penalty found in IRC S 6662. See
IRC SS 6662(b)(1), (b)(3) and (e).

                               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
_________________________________________________________________

2. Ironically, Merino appeared as an expert witness for the taxpayers in
Provizer v. Commissioner.

3. 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).

                               3
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.

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.
_________________________________________________________________

4. 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.

                               4
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.

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

                               5
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.

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.

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.

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

                                6
percent of the statutory rate under IRC S 6621(c) because
the underpayments were tax motivated transactions.5

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.

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.
_________________________________________________________________

5. The Commissioner's deficiency notice refers to IRC S 6621(d). However,
this section was redesignated as S 6621(c) byS 1511(c)(1)(A) of the Tax
Reform Act of 1986, Pub.L. 99-514, 100 Stat. 2085, 2744, which was
later repealed by S 7721(c) of the Omnibus Budget Reconciliation Act of
1989, Pub.L. 101-239, 103 Stat. 2400. The repeal does not affect this
case.

6. 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).

7. 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.

                               7
IV.

A.

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.

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.

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."

                                8
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.

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.

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

                               9
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.

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.

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.

After hearing the evidence, the Tax Court concluded that
the Merinos "failed to exercise due care in claiming a large

                               10
deduction and tax credits with respect to Northeast.. . ."
Tax Ct. Op. at 33-34. The court wrote:

       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.

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

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
_________________________________________________________________

8. 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.

                                11
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.

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.

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).
_________________________________________________________________

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

10. See n.1 supra.

                               12
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

       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.

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

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.

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

                               13
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.

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.

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
_________________________________________________________________

11. See n. 1 supra.

                               14
"attributable to" a valuation overstatement. 12 Tax Ct. Op. at
35.

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.

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.

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
_________________________________________________________________

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).

                               15
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.

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.

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:

       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

                               16
       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.

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:

       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.

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

       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

                               17
       into account the deductions disallowed because of the
       valuation overstatement), or $9,800 [sic].

Id. at 543.

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

       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.

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

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.

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

                               18
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).

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:

       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.

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.

                               19
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.

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.

       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
_________________________________________________________________

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

                               20
       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.

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.

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).

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.

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

                                21
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.

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

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.

A True Copy:
Teste:

       Clerk of the United States Court of Appeals
       for the Third Circuit
_________________________________________________________________

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.
                                22
