Coleman v. Commissioner
Opinion
MEMORANDUM FINDINGS OF FACT AND OPINION
In these consolidated proceedings, 1 respondent determined deficiencies in and additions to petitioners' Federal income taxes as follows:
| Additions To Tax | |||
| Petitioners | Year | Deficiency | 2Under Section 6653(a) |
| Jerome P. Coleman | 1981 | $ 10,598.00 | |
| Edward and | |||
| Margaret Maher | 1981 | * 12,974.40 | $ 648.72 ** |
| 1982 | 148.88 |
Respondent moved for leave to file an amendment to answer out of time so as to assert additions to tax under section 6653(a) against petitioner Jerome Coleman. The Court denied respondent's motion as prejudicial to petitioner Jerome Coleman. *375
The instant case involves the allowability of deductions for losses arising out of petitioners' investment in the York Research Silver Technology Limited Partnership (the "Partnership"). After concessions, the issues for our consideration are: (1) whether certain research and experimental expenditures of the Partnership were made "in connection with trade or business" of the Partnership; (2) whether certain miscellaneous expenses of the Partnership were properly deductible; (3) whether petitioners Edward and Margaret Maher are liable for additions to tax for negligence for the year 1981; and (4) whether the increased rate of interest on substantial underpayments attributable to tax-motivated transactions is applicable for the year 1981.
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulation of facts and accompanying exhibits are incorporated herein by this reference.
At the time of filing his petition in the instant case, petitioner Jerome Coleman was a resident of New York, New York. At the time of filing their petition in the instant case, petitioners Edward and Margaret Maher were husband and wife and resided in Scarsdale, New York.
Combustion Equipment Associates *376 ("CEA") was founded in 1953 by Robert Beningson ("Mr. Beningson"), the promoter of the Partnership in the instant case. CEA engaged in business as a manufacturer, marketer, and contractor in the field of environmental and energy conservation. Mr. Beningson served as chief executive officer of CEA until 1981.
York Research Corporation ("York") was incorporated in 1959 to engage in the business of scientific research, industrial planning, manufacturing and related activities. In 1969, CEA purchased 54 percent of the stock of York from its original founder. In connection with such acquisition, Mr. Beningson became the Chairman of the Board of Directors of York. The balance of York's stock was publicly held. Mr. Beningson hired Mr. Frances Govan, a scientist he had met while serving on a National Academy of Sciences panel, to be the President of York. Under Mr. Govan's direction, York became a major contractor for the Environmental Protection Agency, among other clients. In approximately 1971, Mr. Beningson acquired an additional block of approximately 20,000 shares of York stock which originally was placed in a trustee account for his children.
In 1976, Mr. Govan left his position *377 at York and was transferred to one of CEA's medium-sized divisions. Mr. Beningson hired the former Environmental Commissioner of the State of Connecticut, Mr. Beck, to succeed Mr. Govan, but Mr. Beck left CEA a few months later. Mr. Beningson then hired Dr. Kenneth Melmed, a first cousin of Mr. Beningson, to serve as President of York, on Mr. Govan's recommendation.
In approximately 1978, Dr. Melmed became the majority shareholder of York by purchasing the block of York stock owned by CEA. Mr. Beningson resigned his position as Chairman of the Board of Directors of York, but did not dispose of the approximately 20,000 shares of York stock which had been held in trust for his children.
In 1980, Mr. Beningson acquired 90,000 shares of York stock from Dr. Melmed, in an effort to assist his cousin out of personal bankruptcy.
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MEMORANDUM FINDINGS OF FACT AND OPINION
In these consolidated proceedings, 1 respondent determined deficiencies in and additions to petitioners' Federal income taxes as follows:
| Additions To Tax | |||
| Petitioners | Year | Deficiency | 2Under Section 6653(a) |
| Jerome P. Coleman | 1981 | $ 10,598.00 | |
| Edward and | |||
| Margaret Maher | 1981 | * 12,974.40 | $ 648.72 ** |
| 1982 | 148.88 |
Respondent moved for leave to file an amendment to answer out of time so as to assert additions to tax under section 6653(a) against petitioner Jerome Coleman. The Court denied respondent's motion as prejudicial to petitioner Jerome Coleman. *375
The instant case involves the allowability of deductions for losses arising out of petitioners' investment in the York Research Silver Technology Limited Partnership (the "Partnership"). After concessions, the issues for our consideration are: (1) whether certain research and experimental expenditures of the Partnership were made "in connection with trade or business" of the Partnership; (2) whether certain miscellaneous expenses of the Partnership were properly deductible; (3) whether petitioners Edward and Margaret Maher are liable for additions to tax for negligence for the year 1981; and (4) whether the increased rate of interest on substantial underpayments attributable to tax-motivated transactions is applicable for the year 1981.
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulation of facts and accompanying exhibits are incorporated herein by this reference.
At the time of filing his petition in the instant case, petitioner Jerome Coleman was a resident of New York, New York. At the time of filing their petition in the instant case, petitioners Edward and Margaret Maher were husband and wife and resided in Scarsdale, New York.
Combustion Equipment Associates *376 ("CEA") was founded in 1953 by Robert Beningson ("Mr. Beningson"), the promoter of the Partnership in the instant case. CEA engaged in business as a manufacturer, marketer, and contractor in the field of environmental and energy conservation. Mr. Beningson served as chief executive officer of CEA until 1981.
York Research Corporation ("York") was incorporated in 1959 to engage in the business of scientific research, industrial planning, manufacturing and related activities. In 1969, CEA purchased 54 percent of the stock of York from its original founder. In connection with such acquisition, Mr. Beningson became the Chairman of the Board of Directors of York. The balance of York's stock was publicly held. Mr. Beningson hired Mr. Frances Govan, a scientist he had met while serving on a National Academy of Sciences panel, to be the President of York. Under Mr. Govan's direction, York became a major contractor for the Environmental Protection Agency, among other clients. In approximately 1971, Mr. Beningson acquired an additional block of approximately 20,000 shares of York stock which originally was placed in a trustee account for his children.
In 1976, Mr. Govan left his position *377 at York and was transferred to one of CEA's medium-sized divisions. Mr. Beningson hired the former Environmental Commissioner of the State of Connecticut, Mr. Beck, to succeed Mr. Govan, but Mr. Beck left CEA a few months later. Mr. Beningson then hired Dr. Kenneth Melmed, a first cousin of Mr. Beningson, to serve as President of York, on Mr. Govan's recommendation.
In approximately 1978, Dr. Melmed became the majority shareholder of York by purchasing the block of York stock owned by CEA. Mr. Beningson resigned his position as Chairman of the Board of Directors of York, but did not dispose of the approximately 20,000 shares of York stock which had been held in trust for his children.
In 1980, Mr. Beningson acquired 90,000 shares of York stock from Dr. Melmed, in an effort to assist his cousin out of personal bankruptcy. By the fall of 1981, York began experiencing financial difficulties due to changes in the political climate that adversely affected York's environmental consulting business. York was occupying a large building which was partly empty, and badly needed cash to defray its overhead. York also hoped to convince its stockholders that it had a future. Mr. Beningson *378 was asked by members of the Board of Directors of York to rejoin the Board in order to help York find new business opportunities, and rejoined the Board in October 1981.
Shortly after rejoining York's Board of Directors, Mr. Beningson learned of a concept for the recovery of silver from scrap metal (the "silver recovery process") from its two inventors, Dr. Melmed and Dr. Norman Lyshkow, a consultant to York who previously had worked for CEA. Mr. Beningson felt that such concept had profit potential in light of expectations that the price of silver would rise and decided to raise funds for the development of the technology. It was hoped that a silver recovery system could be developed which would be useful in various businesses including the jewelry and dental businesses. On December 24, 1981, Mr. Beningson formed the Partnership, under Connecticut law, to promote and fund research and development of the silver recovery process. Mr. Beningson's personal holding company, RRR's Ventures, Ltd. ("RRR") (an acronym standing for the first names of Mr. Beningson's immediate family) was incorporated on December 23, 1981, and became the general partner of the Partnership.
Mr. Beningson was *379 a long-standing client of the law firm of Townley and Updike at the time that he formed the Partnership. Of the 12 individuals that became limited partners in the Partnership, a majority were or subsequently became partners in that law firm, which also prepared the Private Placement Memorandum offering units in the Partnership (the "Private Placement Memorandum").
On December 29, 1981, Drs. Melmed and Lyshkow executed assignments granting all of their rights in the then-existing silver recovery process to the Partnership in exchange for $ 1,000. On December 31, 1981, the Partnership issued two checks, each in the amount of $ 500, to Drs. Melmed and Lyshkow. Both Dr. Melmed and Dr. Lyshkow endorsed their checks over to York. The Partnership also entered into the following agreements with York on December 31, 1981: (1) a Research and Development Agreement (the "R&D Agreement"), (2) an Option and Non-Exclusive License Agreement (the "Non-Exclusive Option Agreement"), (3) an Option and Exclusive License Agreement (the "Exclusive Option Agreement"), and (4) an Option and Purchase Agreement (the "Purchase Option Agreement").
The R&D Agreement required York to use its "best efforts" to *380 conduct a research and development program for the Partnership related to the silver recovery process. In exchange for such research and development services, the Partnership agreed to pay York $ 592,000 as follows: (1) $ 92,000 in cash upon execution of the R&D Agreement, (2) $ 50,000 by delivery of a non-interest bearing promissory note of the Partnership due June 15, 1982, together with agreements under which each limited partner of the Partnership assumed liability for his proportionate share of such note; (3) $ 225,000 by delivery of a non-interest bearing promissory note of the Partnership due January 15, 1986, together with assumption agreements from the limited partners of the Partnership, and (4) $ 225,000 by delivery of a non-interest bearing promissory note of the Partnership due January 15, 1987 together with assumption agreements from the limited partners of the Partnership. On its financial statements filed with the SEC and in the reports to its stockholders, York recorded revenues of $ 197,000 for its fiscal year ended September 30, 1982 and $ 395,000 for its fiscal year ended September 30, 1983 with respect to its fees under the R&D Agreement. The promissory notes *381 and related assumption agreements under the R&D Agreement were valuable to York as collateral for obtaining needed loans.
The R&D Agreement stated the Partnership's intent to secure section 174 treatment for payments made thereunder, and on its 1981 Federal income tax return, the Partnership deducted the $ 592,000 fee provided for by that agreement. Petitioners, in turn, deducted their allocable shares of such fee, which, along with the deductions for miscellaneous expenses of the Partnership, have been disallowed by respondent. The deductions claimed by petitioners under section 174 for the year 1981 were approximately equal to three times the cash contributions they were required to make to the Partnership in 1981 and 1982.
The R&D Agreement was typed, except for the recitation of amounts due from the Partnership, which were handwritten in spaces left blank in the Agreement. The fee to be paid to York under the Agreement was determined only after the number of Partnership Units sold was known; the purchase price of such Units consisted of an up-front payment of $ 11,500 plus an assumption of liability for the deferred payments to be made by the Partnership under the R&D Agreement. *382 Under the Agreement of Limited Partnership for the Partnership, however, RRR could, between January 1, 1983, and December 31, 1985, by agreement with each limited partner, purchase such limited partner's Unit(s) in the Partnership in exchange for 100 shares of York common stock. Such purchase would relieve the limited partner of any further liability with respect to the deferred payments due from the Partnership under the R&D Agreement. In the event that the holders of two-thirds of the Partnership Units agreed to sell their Units to RRR under such provision, the remaining limited partners would be required to sell.
The R&D Agreement provided that York would deliver a prototype of the silver recovery process and related diagrams, manuals, etc. to the Partnership by December 31, 1982, but also stated that the payments due thereunder were nonrefundable even if a "production ready Prototype" was not delivered by York. York generally was not paid for its services with promissory notes.
The Non-Exclusive Option Agreement gave York the option to acquire a non-exclusive license of the Silver recovery process (the "Non-Exclusive Option") for the purpose of manufacturing, marketing, leasing, *383 selling, or otherwise disposing of or using such technology. The Non-Exclusive Option was exercisable within 10 days after York's delivery of a product prototype to the Partnership, and the nonexclusive license was to continue for 5 years unless terminated sooner by York's exercise of its rights under the Exclusive Option or Purchase Option Agreements. The Non-Exclusive Option Agreement called for the payment of royalties by York to the Partnership in the amount of 14 percent of York's gross revenues related to the silver recovery process or 14 percent of the actual silver recovered by York. York also was granted "most favored licensee" status under the agreement, which meant that if the Partnership licensed the silver recovery process to any entity other than York, York would be entitled to a royalty rate equal to the most favorable royalty rate granted by the Partnership. The Non-Exclusive Option Agreement further provided that York's rights under the Exclusive Option and Purchase Option Agreements were exercisable during the last 4 years of the 5-year nonexclusive license period, and that the nonexclusive license would terminate upon York's exercise of the rights provided under *384 either of such other agreements.
The Exclusive Option Agreement provided York with the right to obtain an exclusive, worldwide, perpetual license of the silver recovery process (the "Exclusive Option") for the purpose of manufacturing, marketing, leasing, selling, or otherwise disposing of or using such technology, in exchange for royalties generally equal to 20 percent of York's gross revenues from the technology. Such royalties were to be payable until the expiration of any patents on the silver recovery process or, if no such patents were issued, for 17 years. No mention was made in the Exclusive Option Agreement of the possibility that the Partnership might previously have granted nonexclusive licenses to entities other than York, and no provision was made in the Exclusive Option Agreement with respect to such contingency. 3
The Purchase Option Agreement gave York the right to purchase all of the Partnership's interest in the silver recovery process for the sum of $ 2,250,000 (the "Purchase Option"). (Like the R&D Agreement, the Purchase Option Agreement *385 was typed, except for recitation of the contract price.) The Purchase Option Agreement also stated that the amount payable thereunder would be "treated as revenues paid * * * under the Recourse Promissory Notes due January 15, 1986 and 1987 from the Partnership to York" and that payment of the Purchase Option price could be made (upon agreement of the parties) in stock of York. (For purposes of valuation of the York stock, the determination of the York Board of Directors would be final.) The Partnership was not obligated to sell the silver recovery process to York under the Purchase Option Agreement
The R&D Agreement obligated the Partnership to apply at least 50 percent of all revenues received from York pursuant to one or more of the above option agreements to the payment of the *386 promissory notes due under the R&D Agreement in 1986 and 1987.
The summary contained on page one of the Private Placement Memorandum stated that the proposed activities of the Partnership were "to promote and fund the design and development" of the silver recovery process. The Private Placement Memorandum later stated that the Partnership's "principal objective" was:
to and further noted that: The Partnership will receive all ownership rights to the System, No plans were provided in the Private Placement Memorandum with respect to the possibility that York might fail to exercise the Exclusive Option or Purchase Option; the Private Placement Memorandum contained no discussion of manufacturing or marketing activities by the Partnership or of the funds that would be needed for such activities. 4 The funds received by the Partnership from *387 the sale of Partnership Units were to be used in their entirety to satisfy the Partnership's obligations under the R&D Agreement and to pay other initial expenses of the Partnership. Limited partners were not required to make capital contributions or loans to the Partnership beyond the initial cash purchase price for the Units ($ 11,500 per Unit) plus the assumptions of liability for the deferred payments due under the R&D Agreement. The Private Placement Memorandum also cautioned investors that the General Partner of the Partnership was "engaged in business activities other than the Partnership and will spend only such time in the conduct of the Partnership's affairs as it deems necessary."
The Private Placement Memorandum described the Non-Exclusive Option Agreement, *388 Exclusive Option Agreement, and Purchase Option Agreement, noting the 14 percent and 20 percent royalties payable under the first two agreements, respectively, but quoting the purchase price of the technology under the Purchase Option Agreement as $ 9,000,000. Only 12.5 Partnership Units eventually were sold (25 percent of the Units offered), and the purchase price under the Purchase Option Agreement was adjusted accordingly to $ 2,250,000 (25 percent of the $ 9,000,000).
Although the Table of Contents of the Private Placement Memorandum listed "Projection of Revenue and Royalties" as a subheading, the text of the Private Placement Memorandum contained no such subsection. There were no profit projections, economic forecasts, market surveys, or appraisals contained in the Private Placement Memorandum other than a brief statement of the "potential return" based on York's exercise of its Purchase Option for $ 9,000,000. Approximately 22 of the 43 pages of the Private Placement Memorandum were devoted to a discussion of tax consequences, and a 62-page tax opinion comprised an exhibit to the Private Placement Memorandum. The tax discussion and opinion stated that any gain to the Partnership *389 pursuant to York's exercise of the Exclusive Option or Purchase Option was expected to qualify as long-term capital gain (noting the one-year period before such options were exercisable in addition to section 1235).
On December 31, 1981, when the agreements between York and the Partnership were entered into, Mr. Beningson owned 18.9 percent of the stock of York, directly and through RRR. The Private Placement Memorandum noted the potential conflict of interest arising out of such stock ownership. In February 1982, Dr. Melmed resigned as President of York due to personal problems. He was placed in charge, however, of the research on the silver recovery process. Mr. Beningson replaced Dr. Melmed as Chairman of the Board of Directors, President, and Chief Executive Officer of York in February 1982. Mr. Beningson also purchased an additional 225,000 shares of York stock for $ 450,000, along with a warrant for another 225,000 of such shares, at such time.
During the years in issue, York provided record-keeping services to the Partnership, including gathering and drawing checks on behalf of the Partnership, collecting amounts due from the limited partners in 1982, and preparing information *390 for the Partnership's outside accountants. On December 31, 1982, the following letter was sent from Mr. Michael Beckerich, Vice President and Chief Financial Officer of York, to Mr. Robert Beningson:
Dear Bob:
This is to advise the Partnership that the research and development contract between York Research Silver Technology Partnership and York Research has been concluded. Enclosed is a memo from Ken Melmed which summarizes the deliverables and other items.
In addition, we hereby exercise an option for a non-exclusive license.
Very truly yours,
/s/ Michael P. Beckerich
Vice President and Chief
Financial Officer
The letter was addressed to Mr. Beningson, President of RRR, at an address which was the same as that of York. Like Dr. Lyshkow, Mr. Beckerich was a former employee of CEA.
On March 11, 1983, approximately 9 months before York's rights under the Exclusive Option Agreement were to become exercisable, York and the Partnership entered into an agreement entitled "Amended License Purchase Agreement" (the "Amended Agreement"). The Amended Agreement eliminated the one-year waiting period for exercise of the exclusive option and provided York with an immediate exclusive, worldwide, *391 and perpetual license of the silver recovery process in exchange for 300 shares of newly-authorized convertible $ 1,000 preferred stock of York. Each share of the preferred stock was convertible at the holder's option into 200 shares of York common stock. Except with respect to any shares that previously had been converted into common stock, York had the absolute right to redeem each share of the preferred stock for a price between $ 1,000 and $ 1,250 (depending on the year of redemption). 5*392 Although Mr. Beningson was President, CEO, and Chairman of the Board of Directors of York at the time that the Amended Agreement was entered into, he signed such agreement on behalf of the Partnership (as President of RRR). In addition to substituting shares of York stock for royalty payments as consideration, the Amended Agreement deleted the requirement (contained in the Exclusive Option Agreement) that York use its best efforts to produce and market the silver recovery process.
Notwithstanding the assumption agreements executed by the limited partners of the Partnership, the Partnership satisfied the 1986 payment due under the R&D Agreement by borrowing from another entity, using Partnership assets as collateral. As of the date of trial of the instant case (December 13, 1988), the payment due under the R&D Agreement in January 1987 had not been made by the Partnership.
Petitioner Edward Maher was associated with the law firm of Townley and Updike between 1944 and 1985 and knew Mr. Beningson personally at the time that he invested in the Partnership, having worked on several securities offerings for CEA. In his decision to invest in the Partnership, Mr. Maher was influenced by Mr. Beningson's reputation as an "aggressive boy," but never spoke directly to Mr. Beningson *393 about the investment. In deducting his share of the Partnership's loss on his 1981 tax return, Mr. Maher relied upon the tax opinion of Townley and Updike (attached as an exhibit to the Private Placement Memorandum) and on the K-1 he received from the Partnership (which was prepared by Coopers and Lybrand). The Private Placement Memorandum warned potential investors that an Internal Revenue Service challenge to tax positions taken by the Partnership "may well be successful" and that "There is a high degree of risk that * * * the Partnership's treatment of its activities for tax purposes may
OPINION
1. Trade or Business Requirement of Section 174 .
Section 174(a) allows a deduction for "research or experimental expenditures" paid or incurred by a taxpayer during the taxable year "in connection with" the taxpayer's trade or business. Respondent concedes that York actually engaged in research and experimentation. It is respondent's contention, however, that the Partnership's *394 expenditures for such research and experimentation were not incurred in connection with a trade or business
The phrase "in connection with" a trade or business, as used in section 174, has been interpreted by the Supreme Court so as not to require
In situations such as that involved herein, in which a partnership does not divest itself
In the instant case, respondent argues that the terms of the Non-Exclusive Option Agreement (which provided York with "most favored licensee" status), and the existence of the Exclusive Option and Purchase Option Agreements, rendered the Partnership's prospects of entering a trade or business involving the silver recovery process unrealistic. Respondent also notes the absence, in the Private Placement Memorandum, of plans for the exploitation of such technology by the Partnership and the focus of such document on York's options with respect to the technology. Respondent further argues that *397 the actions of the Partnership after 1981 confirm that the parties never intended the Partnership to commercially exploit the silver recovery process.
Petitioners argue that it was highly
The only "evidence" offered by petitioners in support of the allegedly onerous terms of the option agreements comes from the testimony of Mr. Beningson. Mr. Beningson testified that, despite his substantial ownership interest in York at the time that the agreements were entered into, he negotiated such agreements solely on behalf of the Partnership and as an adversary to York. He further testified that the royalty percentages under the Non-Exclusive Option and Exclusive Option Agreements were much higher than industry norms and that the 20 percent *398 royalty under the Exclusive Option Agreement would absorb any profit York might otherwise earn with respect to the technology. Regarding the Exclusive Option, Mr. Beningson stated: "I really didn't think anybody would ever exercise it at 20 percent royalty rate. They would either have to come back and negotiate with us." He also stated that: "It was the same as giving [York] the right to buy the moon. It wasn't going to happen," and described the options granted under the various agreements as "three options that effectively meant [York] could never own the product." Regarding the relative abilities of the Partnership and York to manufacture and market the technology, Mr. Beningson testified as follows:
Q: In December 1981, as between the partnership and York Research Corporation, which entity was more likely in your view to be able to manufacture and market the results of the project?
* * *
A: Without a doubt, the partnership because that's where I was and that's where I had my incentives.
Q: Well, what difference did it make that it was where you were? I don't understand that.
A: Because of all the experience and background that I have which you've taken me through and because *399 of the lack of any experience or expertise or background of any of the people in York in doing the things that you are talking about. Notably lacking from the evidence offered by petitioners is a satisfactory explanation of the inconsistency between Mr. Beningson's testimony -- that he imposed very onerous terms on York in the option agreements -- and Mr. Beningson's subsequent action in becoming the majority stockholder, President and CEO of York only two months later. If Mr. Beningson had in fact succeeded in negotiating contract terms that would effectively prevent York from retaining any profit on the exercise of the Exclusive Option, he would not have been expected to immediately purchase a majority of York's stock and become its President. 6*400 Petitioners fail to explain how and why York We find Mr. Beningson's testimony about his negotiation with York unconvincing in light of his long-standing history of involvement with York. Mr. Beningson served as Chairman of the Board of Directors of York between 1969 and 1978, at which time the majority interest in York was sold to his first cousin, Dr. Melmed. In 1981, when York began experiencing financial difficulties, Mr. Beningson was asked to and did rejoin York's Board of Directors to aid York in finding new business opportunities. Mr. Beningson's testimony herein is, effectively, that he reinvolved himself with York in 1981 only to "steal" the idea he obtained there for the benefit of the Partnership. Mr. Beningson's testimony that only the Petitioners' argument that York was unlikely to acquire the silver recovery process because of the onerous terms of the option agreements is also weakened by an examination of what actually occurred. See Mr. Beningson explained the circumstances surrounding the amendment of the Exclusive Option Agreement: At having negotiated on behalf of the partnership this extremely rich license agreement with the contractor which in my view never would be exercised for a long period of time and would have probably either gone null and void or been renegotiate [sic], having since that time come into the position of being on the other side now. Now I was chief executive and a major investor in this contractor which held these options. Having the *403 problem that as I saw it, that the technology developed was good but maybe not great and that the inventors were coming up with new ideas that might be good and look like they might very well be great and that there was a gray area between the R&D work completed during 1982 and the R&D work that might be done going forward that might be even better, I had a real problem, in corporate opportunity, conflict of interest. I'm stuck on both sides. I couldn't take York on into that area leaving the partnership hanging with its rights. The royalty payments would have been too high. I wanted to develop the business that I had started out to develop. So, it seemed to me that the best way of resolving this and maximizing on the opportunity was to renegotiate the agreements and come up with a new measure of involvement in 1983 which would give the limited partners potentially a significant play, would allow York then to become the vehicle, since I was now York, whereas I hadn't been at the time we had done this, for commercializing this and allow me to use my talents in building the business now in York with the limited partners investing. We find the above-quoted explanation -- that York's *404 role as marketer of the technology came about as a result of Mr. Beningson's new role with respect to York ("I was now York, whereas I hadn't been at the time we had done this") -- unconvincing and contradictory to Mr. Beningson's assertions concerning his actions during 1981. With respect to his role in negotiating the agreements executed in 1981, Mr. Beningson testified that his sole loyalty was to the Partnership, despite the conflict of interest present at We also agree with respondent that the absence of plans in the Private Placement Memorandum for the Partnership's exploitation of the silver recovery process suggests that the likelihood of such activity was insignificant. Mr. Beningson admitted on direct examination that *405 the commercialization of the silver recovery process would require funds beyond those required to be contributed by the limited partners of the Partnership and suggested that such activity might be done by a new entity. The following testimony by Mr. Beningson is revealing: Q: But I don't understand what it was that the partnership was going to do after the R&D was completed? What was it going to do with this process? A: Have machines built for it. Put its name on it, I'd probably not manufacture ourselves, go out and market them in the field, have the chemicals packaged up with nice pretty bundles in an easy way to use and go sell those to the potential users. Possibly license other people to use it or if not build its own refineries. It depended on the success of the project. Q: And how were these activities to be financed? A: Well, it would depend on the situation at the time. Venture capital is very much available.
Finally, the absence of any marketing projections or estimates of revenues from goods sold is one further indication that the programs had no profit objective. The absence of profit projections or information about the market for the silver recovery process in the Private Placement *414 Memorandum contrasts with the extensive discussion of tax benefits and other tax information included therein. Other facts in the record also suggest an absence of profit objective on the part of the Partnership. The circumstances surrounding the execution of the Amended Agreement also strike us as inconsistent with businesslike conduct or focus on Partnership profit. In his testimony concerning such circumstances, Mr. Beningson first described the Exclusive Option Agreement as an "extremely *415 rich license agreement." He went on to explain that he basically had renegotiated the agreement to avoid his own conflict of interest dilemma. In the process of such renegotiation, the Partnership lost all rights to exploit the silver recovery process on its own and also parted with any hope of obtaining the "extremely rich" royalties provided for under the Exclusive Option Agreement. While Mr. Beningson described the York stock received under the Amended Agreement as giving the limited partners "potentially a significant play," the value of such preferred stock at the time the Amended Agreement was entered into was, according to his testimony, only $ 300,000. The redemption provisions applicable to the preferred stock under the Amended Agreement also indicate that such agreement was entered into without regard to its impact on Partnership profitability. Specifically, under the Amended Agreement, the 300 shares of preferred stock were redeemable in the discretion of the York Board of Directors for amounts between $ 300,000 and $ 375,000 (depending on the year of redemption) as compared with the $ 592,000 fee called for under the R&D Agreement. Assuming no prior conversion to common *416 stock or payment of dividends on the preferred, such redemption would have Another factor generally indicative of a lack of profit objective is the payment of "inflated purchase prices," the amount of which is unrelated to economic considerations. See By its nature, research and development should be funded as quickly as possible so that the research can be completed and the results put into operation. * * * A binding agreement to pay substantial and fixed amounts far in the future without regard to the success of this venture simply does not make sense from a business standpoint.
Finally, the amount of the R&D fee -- $ 592,000 -- does not square with the $ 1,000 "purchase price" paid by the Partnership (two days before the R&D Agreement was signed) for the stated purpose of acquiring all rights to the then-existing technology. 12*419
We have considered all of the other arguments raised by petitioners and find them without merit. For the foregoing reasons, we find that petitioners have failed to establish that the Partnership was engaged in an activity for profit within the meaning of section 183.
Accordingly, the Partnership's deductions for miscellaneous expenses are allowable only to the extent permitted under section 183. 13
3. Additions to Tax for Negligence
Respondent determined additions to tax for negligence under section 6653(a) against petitioners Edward and Margaret Maher for the year 1981. Petitioners bear the burden of proving the incorrectness of such *421 determination. Rule 142(a).
Negligence is defined as a lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances.
Although reliance on the advice of professionals may defeat a finding of negligence under certain circumstances, Mr. Maher's reliance on the tax opinion attached to the Private Placement Memorandum is not "the type of reliance" contemplated by that rule. See
Petitioners' contention concerning Mr. Maher's reliance upon the K-1 prepared by Coopers and Lybrand is without merit in that no showing has been made that the accounting firm evaluated the merits of the claimed deductions rather than simply preparing the tax return based on information supplied by the Partnership. We also find no merit in Mr. Maher's alleged reliance on the business reputation of Mr. Beningson. *423 Cf.
Accordingly, we sustain respondent's determination of additions to tax for negligence against petitioners Edward and Margaret Maher.
4. Increased Interest Under Section 6621(c)
Having found that the Partnership's activities were not engaged in for profit under section 183, the increased rate of interest provided by section 6621(c) applies with respect to the disallowed losses of the Partnership for the year 1981. 14 Section 301.6621-2T, Q4 and A4, Proced. and Admin. Regs.;
In light of our holdings above, we need not address respondent's argument that petitioners were not "at risk" under section 465 with respect to their proportionate shares of the promissory notes issued by the Partnership to York.
To reflect the foregoing,
Footnotes
1. The cases consolidated herein are collectively referred to as "the instant case."↩
2. Unless otherwise indicated, all section references are to the Internal Revenue Code, as amended and in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
*. plus increased interest under section 6621(c)↩
**. plus 50 percent of the interest payable on the portion of the underpayment due to negligence↩
3. Under the Exclusive Option Agreement, the Partnership represented that it had executed no other agreement in conflict therewith.↩
4. The only mention of such activities came under the heading "Application of Cash Receipts," in which it was stated that cash receipts of the Partnership could be applied "To acquire for leasing or sale any of the machinery or equipment designed and developed by the Contractor pursuant to the R&D Agreement," but only after the payment of all Partnership obligations and expenses and the establishment of reasonable reserves.↩
5. Section 3(c) of the Amended Agreement provided that the preferred stock was redeemable by York at the following prices per share during the 12 month period beginning March 31 of the years indicated:
Year Redemption Price 1983 $ 1,250 1984 1,250 1985 1,200 1986 1,200 1987 1,150 1988 1,150 1989 1,100 1990 1,100 1991 1,050 1992 1,050 1993 and thereafter 1,000 The preferred stock was entitled to biannual dividends (when and as declared by the York Board of Directors out of available funds) commencing March 31, 1985, at the rate of 20 troy ounces of fine silver (99.9 percent purity) payable in silver, in its cash equivalent, or in common stock of York. The value of any declared but unpaid dividends was to be added to the above-stated redemption prices.
6. Mr. Beningson's only apparent attempt to reconcile such circumstances was his testimony that he took over the management of York after Dr. Melmed's resignation because of his concern over the future of the R&D Agreement (presumably from the Partnership's perspective).
7.
The Explanation of Adjustments in the notice of deficiency issued to petitioner Coleman stated as the reason for disallowance that petitioner had failed to establish entitlement to "any portion of the loss claimed under any provision of the Internal Revenue Code." The Explanation of Adjustments in the notice of deficiency issued to petitioners Maher stated that the Partnership was not an activity engaged in for profit and also noted various other grounds for disallowance. 8.
In Estate of Baron v. Commissioner , 798 F.2d 65, 72 (2d Cir. 1986)the Second Circuit found it unnecessary to comment on "the precise extent to which a transaction must be profit-motivated" for a taxpayer to be entitled to tax benefits therefrom. The taxpayer in Estate of Baron had failed to demonstrate "any reasonable expectation" of profit, rendering further consideration of the "quantity" of profit objective required to fall outside section 183 unnecessary.798 F.2d at 72 .In the Tax Court, the requisite profit objective is "actual and honest." Levy v. Commissioner , 91 T.C. 838, 871↩ (1988)9.
The following testimony of Mr. Beningson is particularly illustrative: Q: Mr. Beningson, I want you to look further at [the Private Placement Memorandum]. Were any projections of revenues and royalties done as to the success of the R&D that would be done? A: No. The people invested primarily in their knowledge or what they had heard about me and what I would do and then the fact that I took a big piece of the back end and a small piece of the front end so they figured I was deeply -- going to be deeply involved.↩ 10. We recognize that the Amended Agreement was entered into subsequent to the years in issue herein, but find that such subsequent action is consistent with our view as to the Partnership's objectives during the years in issue. See
Levin v. Commissioner , 832 F.2d 403, 406↩ n. 3 (7th Cir. 1987)11. The R&D Agreement only required that York use its "best efforts" in performing the designated research tasks.↩
12. Notwithstanding Mr. Beningson's testimony that a one-year term for the research engagement was selected because creative ideas occur fairly quickly, the tax aspects discussion in the Private Placement Memorandum suggests that the one-year term may have been selected with a view toward avoiding disallowance of deductions on the grounds of "material distortion of income." See section 446. Moreover, despite the fact that the R&D Agreement technically terminated after one year, Dr. Melmed, on behalf of York, continued his research on the silver recovery process for several additional years.
13. Petitioners have not shown that any of the miscellaneous expenses are allowable as deductions irrespective of profit objective. Section 183(b)(1). A deduction of $ 485 is allowable for 1982 under section 183(b)(2).↩
14. A motion by respondent to amend his answer so as to assert the increased rate of interest against petitioner Jerome Coleman was originally denied. The denial of respondent's motion will be vacated, and the motion will be granted. The increased rate of interest thus applies with respect to all petitioners herein.↩
15. Prior to the Tax Reform Act of 1986, subsec. (c) of section 6621 was designated subsec. (d). Sec. 1511(a), Pub. L. 99-514, 100 Stat. 2085, 2744. The additional interest provided thereunder applies after December 31, 1984, even with respect to transactions entered into prior to that date.
Solowiejczyk v. Commissioner , 85 T.C. 552 (1985)795 F.2d 1005↩ (2d Cir. 1986) .
1990 T.C. Memo. 357 (Coleman v. Commissioner) — published by Counsel Stack Legal Research, free access to 12M+ legal documents.