the mine was not an operating mine. Although he found that the mine was potentially viable, its viability was contingent on proper funding and completion of development.
On October 8, 1985, the IRS notified Becker that it believed that an adjustment to his tax liability for tax year 1982 was necessary. On October 16, 1987, the IRS issued a Notice of Deficiency to plaintiff, assessing an income tax deficiency of $ 10,061.00.
In its Notice of Deficiency, the IRS, citing various provisions of the Internal Revenue Code ("I.R.C."),
set forth several alternative reasons for disallowing the deduction, including: 1) Becker failed to establish that the venture has economic substance or that it was entered into with a profit motive; 2) Becker had not establish that any bona fide mine development expenses were paid or incurred; 3) Becker had not established that he had any economic interest in the mine for which the existence of ore or minerals in commercially marketable quantities has been disclosed; and 4) Becker failed to establish that any funds were actually paid on the note or that he was "at risk" with regard to the note.
On March 9, 1988, various additions to tax were assessed in the amount of $ 14,515.37, making the total amount due $ 24,576.37. Becker paid the full amount of the assessment and now seeks a refund.
II. Conclusions of Law
A. Burden of Proof
Income tax deductions are a matter of "legislative grace." New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440, 78 L. Ed. 1348, 54 S. Ct. 788 (1934). Smith v. Commissioner, T.C. Mem. 1986-101. Accordingly, the taxpayer has the burden of proving a deduction. The taxpayer must demonstrate that he comes within the terms of the statute under which he is claiming the deduction. New Colonial Ice Co., 292 U.S. at 440. A deficiency determination by the IRS is presumed correct and the taxpayer therefore has the burden of proving that it is erroneous. Welch v. Helvering, 290 U.S. 111, 115, 78 L. Ed. 212, 54 S. Ct. 8 (1933). A taxpayer may satisfy this burden only by adequately presenting relevant facts and cannot rely on mere assumptions. Smith, T.C. Mem. 1986-101.
In order to qualify for a deduction under §§ 162, 165, 212 or 616 of the I.R.C.,
the activity giving rise to the expenditure for which the deduction is claimed must constitute an activity engaged in by the taxpayer with the primary purpose and objective of making a profit. Horn v. Commissioner, 90 T.C. 908, 932-33 (1988); see, e.g., Simon v. C.I.R., 830 F.2d 499, 500 (3d Cir. 1987) (§§ 162, 212); Bryant v. C.I.R., 928 F.2d 745, 748 (6th Cir. 1991) (§ 616); Mahoney v. C.I.R., 808 F.2d 1219, 1219-20 (6th Cir. 1987) (§ 165); I.R.C. § 183. Before a court may inquire into the taxpayer's primary objective, however, it must first determine whether the transaction was a sham, i.e., whether it lacked economic substance. Bryant, 928 F.2d at 748; Collins v. Commissioner, 857 F.2d 1383, 1385 (9th Cir. 1988). As stated by the Sixth Circuit,
the question of whether a transaction has economic substance is a threshold issue designed to winnow out the most abusive tax shelters without engaging in the more difficult question of whether a transaction was profit-motivated.
Bryant, 928 F.2d at 749. Thus, once a court determines that a transaction is a sham, no further inquiry into intent or motive is necessary. Kirchman v. C.I.R., 862 F.2d 1486, 1492 (11th Cir. 1989). In other words, a sham transaction will simply not be recognized for federal tax purposes. Lerman v. C.I.R., 939 F.2d 44, 45 (3d Cir.), cert. denied, 116 L. Ed. 2d 615, 112 S. Ct. 590 (1991).
Whether a transaction is a sham depends on "whether the transaction has any practicable economic effects other than the creation of income tax losses." Rose v. Commissioner, 868 F.2d 851, 853 (6th Cir. 1989); accord Collins, 857 F.2d at 1385. Thus, a transaction "intended solely to generate tax benefits in the form of deductible losses" is without economic substance and therefore a sham. Lerman, 939 F.2d at 52. In making its determination, the court must look at the substance of the transaction and not its form. Gregory v. Helvering, 293 U.S. 465, 469-70, 79 L. Ed. 596, 55 S. Ct. 266 (1935); Lerman, 939 F.2d at 54. Further, the taxpayer's subjective business purpose, as well as the transaction's economic substance, may be relevant to the sham inquiry. Bryant, 928 F.2d at 748.
1. Economic Substance
The facts and circumstances surrounding Becker's investment in Panamint indicate that the transaction lacked economic substance. The promotional documents reviewed by Becker focused largely on the tax benefits available through the venture. Thus, for example, the one-page document setting forth the investment benefits to the taxpayer highlights the $ 20,000 tax deduction and $ 10,000 savings on expense deduction. Although the promotional materials also discuss the profit potential on silver, this must be read in light of the prospectus' emphasis on the highly speculative and risky nature of silver mining.
The structure of the actual transaction entered into by Becker also indicates lack of economic substance. "The presence of deferred debt that is in substance or in fact not likely to be paid is an indicium of lack of, or exaggeration of, economic substance." Horn, 90 T.C. at 938. Thus, even if a promissory note is full recourse on its face, it is the substance, not the form that controls. Id. "The law is clear that courts may look behind a paper facade to find the actual substance and economic realities of the transactions." Id. at 939.
On its face, the promissory note executed by Becker was full recourse as to principal only and prescribed a fixed rate of interest. In addition, the note was secured by the mineral interests and silver proceeds - which under the circumstances were nothing more than "illusory security." Id. at 938. Becker made only two interest payments on the note and discontinued making payments at the direction of the promoter of the mining venture. Although under the terms of the note, principal and the remaining interest became due in 1987, Becker has made no further payment on the note. Finally, no one has ever attempted to collect on the note. "Under these circumstances, it does not appear that [the taxpayer] had a legitimate obligation or incentive to repay the note or to pay the interest due on the note." Davis v. Commissioner, T.C. Mem. 1989-635.
In addition, it is doubtful whether any amounts were in fact borrowed under this loan arrangement with Melby and Mineop. Becker has not established that Melby paid any money to Mineop. Instead, the testimony of Hamilton, the IRS investigator, indicates that Pruett never received any of the investors' money from the promoters and that the construction that had taken place was paid for with his own money.
Under these circumstances, I find that the note, recourse in form, was in fact worthless. See Horn, 90 T.C. at 938 (describing similar loan arrangements as "worthless pieces of paper").
The fact that Becker made two interest payments on the note does not dictate a different conclusion. In early 1984, Becker stopped making payments at the instruction of Melby. In any event, I conclude in light of all the facts and circumstances surrounding the loan arrangement that the two interest payments constituted "'window dressing' - an attempt to give the note the appearance of a substance that just did not exist." Horn, 90 T.C. at 939.
Another indication that the transaction was a sham is that Mineop was never adequately capitalized to conduct mining operations. From the outset, Mineop was operating at a loss and had a work deficit.
Also indicative of a sham transaction is the Schedule C distributed by Melby, setting forth the alleged mine development expenses. Becker simply turned the schedule over to his accountant who prepared his tax return. Becker never discussed the propriety of taking a deduction with his accountant nor did he do anything to verify that the figures set forth in the schedule were accurate. At trial, Becker failed to provide any evidence, other than his own testimony, that the purported mining development costs actually existed.
The final indication that the Panamint investment had no economic substance is that, in the end, Becker never received any minerals or silver.
Becker argues that his investment in Panamint was a bona fide transaction, inasmuch as the mine was a "potentially profitable operation" and had proven mine reserves. Becker's argument, however, misses the mark. The critical inquiry is whether the transaction entered into by Becker had economic substance, not whether the mine itself could potentially produce silver at some future date and yield a profit.
In sum, I find that Becker has failed to prove that the transaction had economic substance.
2. Business Purpose
Although Becker testified that he was motivated by profit, this contention is not supported by the record. Rather, the record demonstrates a general indifference to the prospects of making a profit from the venture. Becker is a highly experienced attorney and has been a member of the New Jersey Bar for many years. Yet, he entered into an investment in a highly speculative and risky mining venture based solely on a few conversations with Celver, the promoter's agent, and a review of the documents provided to him by Celver.
The prospectus warned Becker over and over about the speculative and risky nature of mining, the instability of silver prices, and about Mineop's thin capitalization, operating losses, and lack of management experience. Becker had no expertise in mining and had never invested in a mine before. Yet he failed to conduct any independent investigation of the investment and never consulted a mining engineer or geologist.
Becker never visited the mine, nor did he send anyone to visit the mine. The only person he spoke to who had visited the mine was Celver. Indeed, at trial Becker was unable to recall in which state the mine was located.
Becker never contacted any of the directors or officers listed on the prospectus. Nor did he request to review Mineop's financial records. Although Becker had never heard of Melby, he failed to conduct an independent investigation of Melby. Becker had never met Celver before this investment. In light of these factors, I find that Becker's reliance solely on Celver's statements and on the offering documents furnished by Melby simply was not reasonable. See Horn, 90 T.C. at 936.
Becker's conduct is strikingly similar to that of the taxpayers in Patin v. Commissioner:
The record demonstrates petitioners' complete indifference to the gold program's chances for economic success. We note that none of the petitioners had any experience in gold or silver mining, nor were they actively involved in carrying out the program in which they invested. We, therefore, find significant the fact that petitioners chose to rely exclusively on the promoters' representations concerning the quantity and quality of ore reserves at [the mine property].
* * *
Petitioners are all sophisticated businessmen. We simply do not believe that they would enter into profit-motivated transactions with an unknown party and rely solely on the representations of such party with respect to the most crucial aspect affecting the viability of the proposed venture. Only the promised six-to-one tax deduction can adequately explain petitioners' entry into the gold program under such circumstances.
88 T.C. 1086, 1118-19 (1987), aff'd, Hatheway v. Commissioner, 856 F.2d 186 (4th Cir. 1988), Skeen v. Commissioner, 864 F.2d 93 (9th Cir. 1989), Gomberg v. Commissioner, 868 F.2d 865 (6th Cir. 1989).
Nor does Becker's conduct following his investment indicate a business purpose. To the contrary, his conduct further evinces a complacent attitude towards Panamint's chances for success.
For example, Becker did not join the lawsuit brought by Melby and some of the investors against Mineop.
Becker never made any request or demand for his silver, even after he learned of the lawsuit. He never brought a lawsuit himself, nor did he take any action to be released from the obligation under the note. Becker, in sum, took a very passive role with regard to his investment.
Becker argues that he kept in contact with the attorneys who were prosecuting the Nevada action, thus evincing business purpose. I disagree. Becker's "occasional inquiry into the activities of [the promoters] and [the mining company] rose merely to the level of curiosity, and certainly did not reflect the level of concern which would normally attend a business activity and subsequent potential loss of a substantial investment." Patin, 88 T.C. at 1122.
Becker also points to the relatively high prices of silver in the years both preceding and following 1982 and argues that investing in precious metals has been historically regarded as a hedge against inflation. However, while silver mining in general may have been attractive to investors seeking economic benefits, this does not change the conclusion that this particular venture was intended to produce, and that Becker was motivated by, tax benefits. See Simon v. Commissioner, T. C. Mem. 1986-156, aff'd, 830 F.2d 499 (3d Cir. 1987).
Becker also relies heavily on the report of the IRS investigator who found that Panamint mine was a "potentially profitable operation," and the opinion of the Nevada court to similar effect.
Neither Hamilton's report nor the Nevada court's opinion, however, were available to Becker at the time he was deciding to invest in the mine. Becker instead relied solely on the representations made by Celver and the offering documents.
Based on all these findings, I conclude that Becker has failed to demonstrate that he invested in Panamint with a business purpose.
I therefore conclude, based on all the facts and circumstances, that Becker's investment was intended solely to generate tax benefits. As such, the investment was a sham and should not be recognized for federal tax purposes. Becker's deductions were correctly disallowed by the IRS.
C. Additions to Tax
In addition to disallowing the deduction, the IRS imposed various additions to tax under I.R.C. §§ 6653(a)(1), 6653(a)(2), 6661, and 6621. I will now consider these additions in turn.
1. § 6653(a)
Section 6653(a) provides for an addition to tax, or penalty, where any part of an underpayment of tax is due to "negligence or intentional disregard of rules and regulations."
The determination of the IRS is presumptively correct and the taxpayer has the burden of proving that the addition is erroneous. Collins, 857 F.2d at 1386; Horn, 90 T.C. at 941.
Under Section 6653(a), negligence is defined as the "lack of due care or failure to do what a reasonable and ordinary prudent person would do under the circumstances." Horn, 90 T.C. at 941-42. In making this determination, the court may consider the taxpayer's education and intelligence. Vick v. Commissioner, T.C. Mem. 1984-353.
Here, Becker, an experienced attorney who has admitted to making many investments, invested in Panamint based solely on his review of the offering documents furnished by Melby and on his conversations with Celver. Although the prospectus warned of the highly speculative and risky nature of the venture, Becker failed to consult an expert, or make any independent investigation of the venture or the promoters. Under these circumstances, I find that Becker failed to act like a reasonable person making a business decision. See Zmuda v. C.I.R., 731 F.2d 1417, 1422 (9th Cir. 1984) (taxpayer has duty to make reasonable inquiry before investing). I therefore find that Becker is liable for the additions to tax under Sections 6653(a)(1) and 6653(a)(2) as determined by the IRS.
2. Section 6661
Section 6661 imposes an addition to tax where there has been a substantial understatement of income tax. An understatement is substantial when it exceeds the greater of $ 5,000 or 10% of the amount of tax required to be shown on the tax return.
Where the underpayment involves a tax shelter, the understatement can be reduced by an amount attributable to the tax treatment by the taxpayer if there is or was substantial authority for such treatment, and the taxpayer reasonably believed that such tax treatment was more likely than not the proper treatment. § 6661(b)(2)(c).
A taxpayer will be deemed to have had a reasonable belief that the tax treatment was proper if, after analyzing the relevant facts and authorities, the taxpayer reasonably concluded that there was a greater than 50% likelihood that the tax treatment would be upheld in litigation, or if the taxpayer in good faith relied on the opinion of a professional tax advisor, provided that the opinion was based on an analysis of the relevant facts and authorities. Treas. Reg. 1.6661-5(d).
For the reasons stated above, I have determined that the mining venture was a sham. "The Supreme Court has held for many years that claims based on unreal and sham transactions are not recognizable for tax purposes." Horn, 90 T.C. at 943 (citing Gregory, 293 U.S. 465, 79 L. Ed. 596, 55 S. Ct. 266 ; Higgins v. Smith, 308 U.S. 473, 84 L. Ed. 406, 60 S. Ct. 355 (1940)). Becker has failed to present any authority, let alone substantial authority, for his treatment of the alleged mine development expenses, nor has he demonstrated a reasonable belief that such treatment was proper. I therefore find that the assessment of an addition to tax under Section 6661 was appropriate.
3. Section 6621(c)
Section 6621(c) provides for the imposition of increased interest where there has been a substantial underpayment attributable to a "tax-motivated transaction." A "sham" is explicitly included within the definition of a tax-motivated transaction. § 6621(c)(3)(A)(v). Under Section 6621(c), a sham is defined as a transaction without economic substance. Horn, 90 T.C. at 944.
For the reasons stated above, I have determined that Becker's investment in Panamint was a mere sham, devoid of economic substance. I therefore find that the assessment of interest was appropriate.
For all the foregoing reasons, I find that Becker has failed to demonstrate his entitlement to a deduction based on his investment in Panamint and that the IRS therefore properly disallowed Becker's deduction of $ 20,421.00. I also find that under the facts and circumstances, the additions to tax imposed on Becker in the amount of $ 14,515.37 were appropriate.