Jay v. Commissioner
Opinion
*260 Ps made contributions to a research fund maintained by EACB, a corporation formed to develop, produce, and market a motor vehicle powered by electricity. Under the terms of agreements between Ps and EACB, Ps would receive, in exchange for their contributions to the research fund, royalties for each electric vehicle sold by EACB for ultimate use or resale in the State of California. The agreements provided Ps with no ownership rights to any technology financed by their contributions and no power to direct the research conducted by EACB or its subcontractors. Further, the agreements called for Ps to make their entire contributions to the research fund in advance. Finally, such agreements provided no time schedule for the performance of research and imposed no requirement that EACB report to Ps as research was conducted.
(2) Ps are liable for the addition to tax for negligence under sec. 6653(a) and sec. 6653(a)(1) and (a)(2),
*261 (3) Ps are subject to the increased rate of interest under
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*260 Ps made contributions to a research fund maintained by EACB, a corporation formed to develop, produce, and market a motor vehicle powered by electricity. Under the terms of agreements between Ps and EACB, Ps would receive, in exchange for their contributions to the research fund, royalties for each electric vehicle sold by EACB for ultimate use or resale in the State of California. The agreements provided Ps with no ownership rights to any technology financed by their contributions and no power to direct the research conducted by EACB or its subcontractors. Further, the agreements called for Ps to make their entire contributions to the research fund in advance. Finally, such agreements provided no time schedule for the performance of research and imposed no requirement that EACB report to Ps as research was conducted.
(2) Ps are liable for the addition to tax for negligence under sec. 6653(a) and sec. 6653(a)(1) and (a)(2),
*261 (3) Ps are subject to the increased rate of interest under
MEMORANDUM FINDINGS OF FACT AND OPINION
SIMPSON,
| Additions to Tax | |||
| Sec. 6653(a) | |||
| Petitioner | Year | Deficiency | 2 I.R.C. 1954 |
| Russell C. Jay | 1980 | $ 137,256.00 | $ 6,863.00 |
| and June A. Jay | |||
| 1981 | 232,919.00 | -- | |
| Josef Ben-Porat | 1980 | 18,776.00 | 938.00 |
| and Claire Ben-Porat | |||
| 1981 | 27,300.00 | -- | |
| Ben Rochelle and | 1980 | 173,943.00 | 8,697.15 |
| Estate of Jane | |||
| Beebe Rochelle, | |||
| Deceased, | 1981 | 346,636.46 | -- |
| Ben Rochelle, | |||
| Executor | |||
| Gerald P. Baron | 1980 | 23,715.65 | 1,185,78 |
| and Bonnie Baron | |||
| 1981 | 23,412.73 | -- | |
| Irvin L. Morhar | 1980 | 8,045.00 | 402.25 |
| and Janet Morhar | |||
| 1981 | 8,311.00 | -- | |
| Sec. 6653(a)(1) | Sec. 6653(a)(2) | |
| Petitioner | I.R.C. 1954 | I.R.C. 1954 |
| Russell C. Jay | -- | -- |
| and June A. Jay | 50% of interest | |
| due on | ||
| $ 11,646.00 | $ 232,919.00 | |
| Josef Ben-Porat | -- | -- |
| and Claire Ben-Porat | 50% of interest | |
| due on | ||
| 1,365.00 | $ 27,300.00 | |
| Ben Rochelle and | -- | -- |
| Estate of Jane | 50% of interest | |
| Beebe Rochelle, | due on | |
| Deceased, | 17,331.82 | $ 346,636.46 |
| Ben Rochelle, | ||
| Executor | ||
| Gerald P. Baron | -- | -- |
| and Bonnie Baron | 50% of interest | |
| due on | ||
| 1,170.64 | $ 23,412.73 | |
| Irvin L. Morhar | -- | -- |
| and Janet Morhar | 50% of interest | |
| due on | ||
| 415.55 | $ 8,311.00 |
In addition, the Commissioner determined, either by notice of deficiency or by amending its answer, that part of the deficiency owed by each of the petitioners was attributable to tax motivated transactions and subject to the increased rate of interest on deficiencies under
FINDINGS OF FACT
Some of the facts have been stipulated, and those facts are so found.
At the time the petitions were filed in this case, petitioners Russell C. and June A. Jay, husband and wife, maintained*265 their legal residence in Corona Del Mar, California, petitioners Josef and Claire Ben-Porat, husband and wife, maintained their legal residence in Van Nuys, California; petitioner Ben Rochelle, both in his individual capacity and in his capacity as the executor of the Estate of Jane Beebe Rochelle, maintained his legal residence in Los Angeles, California; petitioners Gerald and Bonnie Baron, husband and wife, maintained their legal residence in Chatsworth, California; and petitioners Irvin and Janet Morhar, husband and wife, maintained their legal residence in Studio City, California. The petitioners filed their Federal income tax returns for the years in issue with the Internal Revenue Service Center at Fresno, California.
Until 1957, Mr. and Mrs. Jay performed together as acrobats. Mr. and Mrs. Rochelle performed together as a dance team and appeared in motion pictures. After retiring from show business, Mr. Jay and Mr. Rochelle formed a real estate partnership with another individual. The partnership became active and very successful as the developer and owner of shopping centers, motels, and mobile home parks. Mr. Ben-Porat was a stockbroker with a brokerage firm in Los*266 Angeles, California. He also wrote and published his own investment advisory newsletter. Mr. Baron owned an insurance agency for many years. Mr. Morhar worked for the County of Los Angeles. For a time, he served as the Road Commissioner for the County of Los Angeles.
The issues in this case result from the petitioners' involvement in transactions purportedly designated to lead to the development, manufacture, and marketing of a vehicle powered by electricity. In the 1970s, concern arose that the nation's reliance on imported oil for its energy needs had become a serious drain on the economy and posed a significant threat to national security. At the time, it was proposed that one solution to the problem was the increased use of vehicles which were totally or partially powered by electricity. Although similar in basic design to conventional gasoline-powered vehicles, electric vehicles are powered by electric energy stored in batteries. The use of electric vehicles offers the opportunity for significant oil savings, since approximately 85 percent of all the nation's electricity is produced from fuels other than oil, such as coal or nuclear energy. In addition, electric vehicles*267 are considered to be quieter and to leave fewer harmful emissions in the environment than conventional vehicles. However, in the 1970s, the speed and range of electric vehicles was limited by the amount of electricity which could be stored in the batteries and converted through the propulsion system. The main technological obstacle to the commercialization of electric vehicles was the lack of a battery which could be charged quickly and provide power to drive the vehicle an acceptable distance between charges.
Research and development efforts in the electric vehicle field were dominated by large corporations and research organizations, including General Motors, Ford, General Electric, and the Jet Propulsion Laboratories. However, smaller groups and even individuals were also active in the field.
Robert R. Aronson has been involved in the production of batteries and electric vehicles for all of his adult life. From 1948 to 1965, he was in charge of several companies devoted to the development, manufacture, and marketing of lead-acid storage batteries. In 1966, Mr. Aronson formed Electric Fuel Propulsion, Incorporated (EFP), and built his first electric car, the Mars I. A*268 new battery developed by Mr. Aronson enabled the Mars I to travel 120 miles on a charge, to accelerate from zero to 40 miles per hour in 10 seconds, and to reach a top speed of 52 miles per hour.
In January 1967, Mr. Aronson built his second electric car, the Mars II, which had a more advanced propulsion system and could be recharged more rapidly than other electric cars operating at that time. Tests revealed that the Mars II had a maximum range of 146 miles on a charge in steady driving and 73 miles in stop and go driving. Further efforts produced vehicles with progressively higher maximum speeds and better acceleration. Although the research and manufacturing facilities available to EFP did not match those of the large organizations active in the development of electric vehicles, Mr. Aronson was able to come up with a number of technical innovations, which he incorporated in the Mars series and other electric vehicles. Such innovations earned him respect in the field.
Between 1966 and 1976, EFP built approximately 100 electric vehicles and sold them primarily to electric utility companies. However, the revenue from such sales was insufficient to cover the high development*269 costs of the vehicles. For such reason, by 1976, EFP had accumulated substantial net operating losses and was in financial difficulty. At such time, Robert Wenz, a shareholder and director of EFP, suggested to Mr. Aronson a method by which the corporation could obtain much-needed funds.
Mr. Wenz proposed that EFP obtain financing by entering into a series of related development and license agreements (the 1976 transactions). In one representative transaction, a group of 10 individuals formed a subchapter S corporation. Such individuals purchased stock in such corporation for $ 437,500. They borrowed $ 375,000 of the purchase price of the stock from a commercial bank and executed promissory notes in favor of the bank secured only by the stock of the corporation.
At the same time, EFP and the subchapter S corporation entered into a development agreement, in which EFP agreed to develop for the subchapter S corporation a product which could be used as a component in an electric vehicle. The development agreement provided that any invention produced as a result of EFP's efforts would become the property of the subchapter S corporation.
EFP and the subchapter S corporation*270 also entered into a license agreement, in which the subchapter S corporation granted EFP a license to market the invention produced under the development agreement. The development agreement also provided that EFP would receive a fee of $ 437,500 for its efforts. EFP used $ 375,000 of the development fee to purchase certificates of deposit at the commercial bank which held the notes executed by the shareholders in the subchapter C corporation. EFP later used the proceeds of such certificates to purchase such notes from the bank. Thus, EFP received $ 62,500 in cash, before commissions and other expenses, as a result of such transaction.
Mr. Aronson and Mr. Wenz were successful in attracting participants to enter into the 1976 transactions. However, most of the fees generated by such transactions were returned to the commercial bank by EFP to satisfy the loans issued to the participants. In addition, Mr. Wenz retained a portion of the cash received by EFP as his commission for arranging the transactions. As a result, EFP was left with only a small percentage of the fees received pursuant to the development agreement. Because Mr. Aronson felt that Mr. Wenz retained an unreasonably*271 large amount of cash as his commission, Mr. Aronson determined that it was not in EFP's interest to allow Mr. Wenz to promote the transactions after 1976.
In 1977, Mr. Aronson shifted his attention toward developing a new electric vehicle, to be called the Silver Volt. In addition, he formed a new corporation, Electric Auto Corporation of Puerto Rico (EAPR), to take advantage of 10-year exemptions from income and property taxes offered by the Puerto Rican government to companies beginning operations there. Mr. Aronson determined that all research and development activities relating to the Silver Volt would be carried on through EAPR.
At about the same time, Mr. Aronson decided to devise his own plan to attract the participation of outside parties in the research conducted by EAPR. He engaged Howard L. Braitman, who was associated with Price Waterhouse & Co., a large public accounting firm, to assist him in developing such a plan and to prepare a tax opinion on the proposed transactions.
Pursuant to the plan developed by Mr. Braitman, EAPR took part in several different transactions. In one such transaction, EAPR entered into a series of development agreements with subchapter*272 S corporations, under which EAPR agreed to develop, in exchange for fees, specific products to be used as components in an electric vehicle. Under such agreements, each subchapter S corporation owned the rights to any such product developed. However, under a separate license agreement which EAPR and the subchapter S corporation executed contemporaneously with the development agreement, EAPR was granted the exclusive right to use such product in the electric vehicle it was developing.
The shareholders in the subchapter S corporations borrowed from a commercial bank a portion of the funds used to purchase their shares in such corporations. The shareholders executed promissory notes in favor of the bank, and such notes were secured only by the shares in the subchapter S corporation. EAPR used a portion of the fees received under the development agreements equal to the amount borrowed to purchase the shareholders' promissory notes held by the bank.
EAPR also entered into distributorship agreements with subchapter S corporations. In such agreements, the corporations were granted the right to distribute within a specified territory an electric vehicle produced by EAPR. In return, *273 such corporations made contributions to a general research fund established by EAPR.
Similar to the shareholders of the corporations involved in the development agreements, the shareholders in the corporations involved in the distributorship agreements borrowed from a commercial bank a portion of the funds used to purchase shares in their corporation. Such shareholders executed promissory notes in favor of the bank, and such notes were secured by the stock in the corporations. EAPR used a portion of the proceeds received under the distributorship agreements equal to the amount borrowed to purchase the shareholders' promissory notes held by the bank.
EAPR again used most of the fees received under the transactions to purchase the promissory notes executed by the participants. For such reason, the company was able to retain only a small percentage of such fees. It was suggested that EAPR would be left with more cash from future transactions if a third party could be found to make loans to participants in such transactions or to purchase promissory notes executed by such participants. Through an intermediary, Mr. Aronson met Peter (H. Y.) Wong, an accountant in Hong Kong, who*274 was acting as a representative of Mashand Investments Limited (Mashand), a Hong Kong investment company. In 1978 and in later years, Mr. Aronson entered into agreements with Mr. Wong under which Mashand would provide loans to participants in electric vehicle transactions.
In 1977, Mr. Aronson met Robert T. Gilleran, an attorney practicing in Los Angeles, California, and told him of the EAPR transactions developed by Mr. Braitman. Mr. Aronson presented Mr. Gilleran with copies of the EAPR business plan and tax opinion prepared by Mr. Braitman, materials on EFP's and EAPR's business history, and information compiled by the United States Department of Energy on the potential market for electric vehicles. Mr. Aronson later sent Mr. Gilleran additional material relating to EAPR, including copies of the agreements in which Mashand agreed to loan funds to participants in the EAPR transactions. While Mr. Gilleran was interested in Mr. Aronson's activities, he did not participate in any EAPR transactions in 1977.
In 1978, Mr. Aronson sent Mr. Gilleran additional materials relating to EAPR, including copies of other agreements between EAPR and Mashand. Mr. Gilleran reviewed such materials*275 and corresponded with Mr. Braitman concerning EAPR's business plan. At such time, Mr. Gilleran agreed to provide an opinion discussing the Federal income tax implications arising from the EAPR transactions. In addition, he agreed to promote the EAPR transactions to others. Finally, he agreed, in the event the positions taken by participants in such transactions on their Federal income tax returns were challenged, that he would represent such participants in any proceedings before the Internal Revenue Service and in this Court. In exchange, he received a fee for each transaction entered into by the participants.
In August 1978, Mr. Gilleran met Bernard Kurtin, a certified public accountant who owned a tax return preparation service, and Sol Gerber, an automobile dealer and businessman. Both Mr. Kurtin and Mr. Gerber expressed interest in the EAPR transactions. With Mr. Aronson's permission, Mr. Gilleran made available to Mr. Kurtin and Mr. Gerber all his materials relating to EAPR.
Mr. Kurtin reviewed the materials he received from Mr. Gilleran relating to EAPR and spoke with Mr. Braitman concerning EAPR's business plan. Mr. Kurtin also spoke with experts in the area of*276 electric vehicles, who assured him that Mr. Aronson was respected in the field. In addition, Mr. Gerber asked his son Richard, who was an electronics engineer, to visit EAPR's facility. When he did so, Richard found that the facility was in the very early stages of developing the Silver Volt. He determined that EFP had not produced a drivable prototype of the Silver Volt at the time of his visit.
After considering the materials relating to EAPR and after talking with Richard Gerber and others, Mr. Kurtin decided to participate in the 1978 transactions. In addition, he agreed to promote the transactions to others. In exchange for his efforts, it was agreed that he would receive a commission equal to 20 percent of the cash paid by each participant he persuaded to enter into a transaction.
Mr. Kurtin recommended the 1978 transactions to Mr. Jay, Mr. Rochelle, and Mr. Ben-Porat. In 1978, Mr. Jay and Mr. Rochelle, both acting on Mr. Kurtin's recommendation, purchased shares in Battery R & D Corporation. In 1978, Mr. Ben-Porat became a stockholder in Nickel Hydrogen Corporation. Such corporations were purportedly formed to develop products to be used in an electric vehicle.
*277 In 1979, Mr. Aronson developed another set of transactions designed to finance EAPR's activities. The transactions contemplated for 1979 again called for individuals to purchase stock in subchapter S corporations. Such corporations in turn acquired rights in certain components or technological processes which Mr. Aronson thought useful to the development of the Silver Volt. Such corporations then entered into agreements with either EAPR or EFP which called for EAPR or EFP to develop such components or processes.
The 1979 transactions differed from the prior transactions in one important respect. Because of changes in the Internal Revenue Code relating to non-recourse financing, Mr. Aronson deemed such financing to be inappropriate for transactions after 1978. 4 For such reason, the 1979 transactions called for the shareholders of the Subchapter S corporations to finance their contributions by selling options for the stock held by them to an unrelated company, Anglo-American Research Limited (AAR). AAR was a Bahamian company purportedly engaged in research and development activities.
*278 All of the petitioners participated in the 1979 transactions. Mr. Jay and Mr. Ben-Porat purchased stock in Galvanic Battery Development Corporation, which was involved in developing a galvanic battery post for use in electric vehicles. Mr. Rochelle purchased stock in Gravity Fuel Gauge Development Corporation. In addition, Mr. Morhar became a shareholder in Battery Cycle Heating System Corporation. He had heard about Mr. Aronson's activities from his son Richard, who worked in Mr. Kurtin's office. Mr. Baron purchased stock in Electric Auto Controller Development Corporation. He had heard about the electric vehicle transactions from a co-worker in his office.
After EAPR experienced delays in securing approval from the government of Puerto Rico for the anticipated exemptions from income and property tax, Mr. Aronson decided to locate his operations in the Bahamas. In 1979, Mr. Aronson formed Electric Auto Corporation of the Bahamas (Electric Auto) and secured facilities in an industrial area in the Bahamas. He decided that all efforts to develop the Silver Volt would be carried on through Electric Auto. The shareholders of EFP owned 49 percent of the outstanding shares of*279 Electric Auto, and an unidentified Bahamian entity owned 51 percent of such shares.
In 1980, Mr. Aronson developed a different plan to obtain funds to finance Electric Auto's activities. He proposed that individuals make direct contributions to a research and development fund established by Electric Auto, in return for royalties based on the number of Silver Volts manufactured and sold by the company. In an effort to make the transaction more attractive to potential participants, Mr. Aronson and Electric Auto entered into an agreement with Artoc Bank and Trust Limited (Artoc). In a letter dated October 1, 1980, Artoc agreed to loan, through its subsidiary Comanche Investments N.V. (Comanche), up to $ 12,000,000 to parties interested in contributing to Electric Auto's research and development fund. In return for such agreement by Artoc, Electric Auto agreed to pay to Artoc a commission of 5 percent of the factory price of all electric vehicles sold by the company in California. In addition, Electric Auto agreed to maintain funds in a cash collateral account at Artoc sufficient to cover the loans made by Artoc through Comanche.
In 1980, all the petitioners participated in*280 the transactions promoted by Mr. Aronson. They executed research and development agreements with Electric Auto (the 1980 agreements) which were identical in all respects, except for the date of execution, the amount contributed by each petitioner, and the amount of royalties to be received by each petitioner. The 1980 agreements provided in part:
WHEREAS, Electric Auto is engaged in the business of developing and proposes to manufacture a quality motor vehicle, powered by an electric propulsion system, to be sold in the State of California, and
WHEREAS, immediate and continuing efforts are required to fulfill the pressing needs of society for a pollution free and energy conserving electric vehicle; and
WHEREAS, Electric Auto and contributor acknowledge that in order for an electric vehicle to be marketed on a commercially successful basis, it will be necessary to engage in an extensive and continuous program of research and development on the electric propulsion system components, batteries,motors, controllers,, and related charging equipment; and
WHEREAS the research and development to be performed by Electric Auto as described hereunder will inure to the benefit of Electric*281 Auto and Contributor;
NOW, THEREFORE, in consideration of the mutual covenants hereinafter contained, it is agreed as follows:
1.
2.
3.
4.
5.
6.
* * *
Mr. Baron executed his copy of the 1980 agreement on December 3, 1980. He contributed $ 50,000.00 to the research fund, of which $ 40,000.00 was the proceeds of a loan from Comanche. 5 The agreement provided that he was entitled to receive royalties of $ 6.66 for each electric vehicle sold until he received $ 100,000.00 in royalty payments, after which time such royalties would be reduced to $ 3.33 per vehicle.
Mr. Ben-Porat executed his copy of the 1980 agreement on November 21, 1980. He contributed $ 48,000.00 to the research fund, of which $ 36,000.00 was the proceeds of a loan received from Micam Holdings N.V. (Micam), a subsidiary of Mashand. He was entitled to receive royalties of $ 7.99 per electric vehicle sold until he received $ 96,000.00 in royalty payments, after which time such royalties would be reduced to $ 3.99 per vehicle. Mr. Jay executed his copy of the 1980 agreement on December 2, 1980. He contributed $ 100,000.00*286 to the research fund, of which $ 80,000.00 was the proceeds of a loan received from Comanche. He was entitled to receive royalties of $ 13.32 per electric vehicle sold until he received $ 200,000.00 in royalty payments, after which time such royalties would be reduced to $ 6.66 per vehicle.
Mr. Morhar executed his copy of the 1980 agreement on December 19, 1980. He contributed $ 25,000.00 to the research fund, of which $ 20,000.00 was the proceeds of a loan received from Comanche. He was entitled to receive royalties of $ 3.33 per electric vehicle sold until he received $ 50,000.00 in royalty payments, after which time such royalties would be reduced to $ 1.66 per vehicle.
Mr. Rochelle executed his copy of the 1980 agreement on December 2, 1980. He contributed $ 250,000.00 to the research fund, of which $ 200,000.00 was the proceeds of a loan received from Comanche. He was entitled to receive royalties of $ 33.30 per electric vehicle sold until he received $ 500,000.00 in royalty payments, after which time such royalties would be reduced to $ 16.65 per vehicle.
All the petitioners executed promissory notes to support the amounts they purportedly borrowed in 1980 from*287 Comanche or Micam. Messrs. Jay, Rochelle, Baron, and Morhar executed notes with Comanche. Such notes are identical for each petitioner, except for the date of maturity and the amount borrowed. Such notes provided:
For value received, the undersigned,
On or after Ninety (90) days from the date hereof, the Maker may from time to time prepay without premium all or any portion of the amount to become due hereunder. Each prepayment shall be applied first to the principal and the remainder, if any, shall be applied to the accrued interest at the date of such prepayment. Prepayments shall be made out of the proceeds of all royalty payments received by the Maker from Electric Auto Corporation (Bahamas) Ltd. pursuant to a Research and Development Agreement between the maker and Electric Auto Corporation (Bahamas) Ltd. dated*288
The Payee covenants that this note is non-negotiable.
Principal and interest on this Note is due on
The Maker hereby represents and warrants that he has a net worth in excess of $ 250,000.00 Dollars.
The Maker hereby covenants that he will not sell or assign his rights under the above mentioned Research and Development Agreement without the prior written consent of the Payee.
The notes also stated that "The Maker shall at all times be personally liable for the payment of the entire principal and interest hereof."
Mr. Ben-Porat executed a promissory note to Micam on November 21, 1980. Such note provided:
For value received, the undersigned
Principal and interest on this note is due
Payments shall be made out of fifty percent of all royalty payments which may become due to maker from Electric Auto Corp. (Bahamas) Ltd. pursuant to a Research and Development Agreement between the maker and Electric Auto Corp. (Bahamas) Ltd. dated
In the event this note is not paid in full on its due date, then the balance of the note will be paid at the rate of ten (10%) percent of the principal balance per year until it has been paid in full. The maker will not be personally liable for the payment of interest hereof.
Such not also stated that it was non-negotiable and non-assignable. Despite such fact, Mr. Ben-Porat received a letter in January 1982 which suggested that the note had been assigned to Comanche. The letter requested that Mr. Ben-Porat agree to assign to Comanche 100 percent, rather than 50*290 percent, of any royalties received from Electric Auto upon the sale of Silver Volts. Mr Ben-Porat accepted such change on February 10, 1982. He never attempted to discover how the note executed by him was obtained by Comanche.
In 1981, all the petitioners again chose to participate in the Electric Auto transactions. They again executed research and development agreements with Electric Auto (the 1981 agreements) which were identical in all respects, except for the date of execution, the amount contributed by each petitioner, and the amount of royalties to be received by each petitioner. The terms of the 1981 agreements were substantially the same as those in the 1980 agreements.
Mr. Baron executed his copy of the 1981 agreement on August 4, 1981. He contributed $ 50,000.00 to the research fund, of which $ 40,000.00 was the proceeds of a loan received from Comanche. The agreement provided that he was entitled to receive royalties of $ 6.66 for each electric vehicle sold until he received $ 100,000.00 in royalty payments, at which time such royalties would be reduced to $ 3.33 per vehicle.
Mr. Ben-Porat executed his copy of the 1981 agreement on July 13, 1981. He contributed*291 $ 65,000.00 to the research fund, of which $ 52,000.00 was the proceeds of a loan received from Comanche. He was entitled to receive royalties of $ 8.66 per electric vehicle sold until he received royalty payments of $ 130,000.00, at which time such royalties would be reduced to $ 4.33 per vehicle.
Mr. Jay executed his copy of the 1981 agreement on July 14, 1981. He contributed $ 200,000.00 to the research fund, of which $ 160,000.00 was from the proceeds of a loan received from Comanche. He was entitled to receive royalties of $ 26.64 per electric vehicle sold until he received royalty payments of $ 400,000.00, at which time such royalties would be reduced to $ 13.32 per vehicle.
Mr. Jay made an additional contribution to the research fund on November 5, 1981. He contributed an additional $ 100,000.00 to such fund, of which $ 80,000.00 was from the proceeds of a loan from Comanche. Such additional contribution entitled him to receive royalties of $ 13.32 per electric vehicle sold until he received additional royalty payments of $ 200,000.00, at which time such royalties would be reduced to $ 6.66 per vehicle.
Mr. Morhar executed his copy of the 1981 agreement on October 7, 1981. *292 He contributed $ 25,000.00 to the research fund, of which $ 20,000.00 was from the proceeds of a loan received from Comanche. He was entitled to receive royalties of $ 3.33 per electric vehicle sold until he received royalty payments of $ 50,000.00, at which time such royalties would be reduced to $ 1.67 per vehicle.
Mr. Rochelle executed his copy of the 1981 agreement on July 14, 1981. He contributed $ 350,000.00 to the research fund, of which $ 280,000.00 was from the proceeds of a loan received from Comanche. He was entitled to receive royalties of $ 46.62 per electric vehicle sold until he received royalty payments of $ 700,000.00, at which time such royalties would be reduced to $ 23.31 per vehicle.
Mr. Rochelle made an additional contribution to the research fund on September 21, 1981. He contributed an addition $ 150,000.00 to such fund, of which $ 120,000.00 was from the proceeds of a loan received from Comanche. Such additional contributions entitled him to receive royalties of $ 19.98 per electric vehicle sold until he received royalty payments of $ 300,000.00, at which time such royalties would be reduced to $ 9.99 per vehicle.
All the petitioners executed*293 promissory notes to support the amounts they purportedly borrowed from Comanche in 1981. Such notes were similar to the 1980 notes, except that they provided:
The Maker shall at all times be personally liable for the payment of the entire principal hereof.
The Maker shall not be personally liable for the payment of interest hereof; however, should the Maker default on the payment of interest when due, he shall forfeit all subsequent royalties due from that time onward under the afore-mentioned Research and Development Agreement (Exhibit 1) and assign the right to receive such royalties to the Payee and shall instruct Electric Auto Corporation (Bahamas) Limited, or its successors to make all subsequent royalty payments directly to the Payee.
* * *
The 1981 notes matured 8 years from the date on which they were executed.
Electric Auto was able to retain only a small portion of the fees it received from the 1980 and 1981 transactions. Approximately 80 percent of such fees were deposited into the cash collateral account maintained at Artoc to cover the amounts advanced to the participants in the transactions. Approximately 4 percent of the fees were deposited into another*294 account maintained by Electric Auto at Artoc. Approximately 4 percent of the fees were paid as commissions to Mr. Kurtin, to Mr. Gilleran, and to others who promoted the transactions. Electric Auto was left with only 12 percent of the total proceeds to finance its activities and the activities of AAR in the United States and the Bahamas.
Before entering into the 1980 and 1981 transactions, the petitioners reviewed copies of the research and development agreements and the promissory notes. In addition, Mr. Kurtin showed potential participants in such transactions copies of a letter written on Comanche stationary and signed by a director of Comanche (the side letter). Such letter written with respect to the 1980 transactions stated:
Dear Sir,
With reference to the attached Promissory Note dated
In the event that Electric Auto Corp. (Bahamas) Ltd. does not achieve a minimum*295 annual average California sales volume of 2,000 Electric Vehicles during the period 1983-1993, the interest on this note will be considered nonrecourse to the maker of the note.
We also agree to cancel this note if at the end of the last maturity date, i.e., 38 years from the date the note was made, Electric Auto Corp. (Bahamas) Ltd., or its successors, has not achieved an annual rate of production on at least 50,000 electrically powered motor vehicles.
This letter shall be binding on Comanche Investments N.V. and its successors and assigns.
Mr. Baron and Mr. Jay had a copy of the side letter in the file of the documents they collected relating to Electric Auto. Although both such letters contained only the salutation "Dear Sir," both letters refer to the promissory notes executed by Mr. Baron and Mr. Jay. In addition, both letters made specific reference to the dates and amounts of the notes to Comanche executed by them.
In 1980, Electric Auto sent a form letter to the petitioners and to other participants in the 1980 transactions which indicated a number of steps which such individuals could take to create the impression that they were engaged in the research and development*296 business. Such letter suggested that the participants register a ficticious name for their company, obtain stationary imprinted with the new company's letterhead, and obtain information from government agencies and other organizations involved in the development of electric vehicles. The letter stated that "The time you devote to your new R&D business will be minimal but the rewards for being on the forefront of new technology can be very great. One of the biggest rewards is that you will be qualified to take R & D tax deductions not only for 1980, but also for 1981 and beyond." Electric Auto subsequently sent a similar letter to the petitioners and other participants in the 1981 transactions.
In January 1981, Electric Auto distributed a memorandum to tax attorneys, CPAs, and financial planners, which described the company's research and development program for 1981. Such memorandum included a copy of the 1981 agreement used in such year and a blank copy of an assignment from a contributor to Comanche of royalties due under the program. In addition, the memorandum contained a brief description of the program which indicated that Electric Auto would sell up to 300 "units" of*297 $ 50,000 each to fund its research program and stated that the company would pay royalties of $ 6.66 per unit for each electric vehicle sold in California, or a total of $ 1,998.00 per vehicle. Further, the memorandum contained a cash flow schedule, which detailed the royalties, note payments, taxable income or loss and associated tax results to be expected by a taxpayer in the 50-percent tax bracket. Finally, the memorandum included copies of published articles which described the growing popularity of "R and D tax shelters."
There is no evidence that Electric Auto ever directly performed research aimed at developing the Silver Volt. Instead, Electric Auto subcontracted with AAR to perform such research with respect to the 1978, 1979, 1980, and 1981 transactions. However, AAR did not have a fully operational research facility in the Bahamas until the end of 1980.
In December 1981, Electric Auto declared royalties to the participants in the 1980 and 1981 transactions based on the purported sale of three Silver Volts to a dealer in California. The participants received no royalty payments as a result of such purported sale. Rather, such amounts were assigned to Comanche and*298 treated as payments on the promissory notes held by it.
The purported sale upon which the royalties were based never in fact occurred. The three Silver Volts purportedly sold were not completed and not ready to be sold to the public. Although invoices and transfer documents intended to substantiate the sale were prepared, the dealer never actually took title to the automobiles.
Mr. Jay, Mr. Rochelle, and Mr. Ben-Porat relied almost entirely on Mr. Kurtin's opinion as to the business viability of the transactions involving EFP and Electric Auto. There is no indication in the record that they had the promotional material relating to the transactions reviewed by an attorney. There is no evidence that they, or anyone acting on their behalf, ever conducted an investigation of the commercial reasonableness of the sales projections for the Silver Volt or an investigation of the basis for such projections. In addition, there is no indication in the record that any of the petitioners have any formal training in engineering, physics, or chemistry. Finally, there is no evidence that they have had any experience in conducting research and development or supervising such activities.
*299 On the petitioners' Federal income tax returns for 1980, they each included a Schedule C relating to their participation in the 1980 Electric Auto transactions. On such schedules, they claimed deductions based upon the cash contributed by them and on the proceeds of the loans received by them. The petitioners claimed deductions for subcontracted research and development, and for various expenses, including wages, utilities, travel and entertainment, and automobile expenses. On the Schedule C filed by the Barons, no amounts were deducted for subcontracted research and development; rather, $ 47,937 was claimed as cost of goods sold.
The Schedule Cs filed by the petitioners with their Federal income tax returns for 1981 do not contain specific deductions, as did such schedules filed for 1980. Rather, they reflect lamp sum deductions for research and development. Such deductions were again based upon the cash contributed by the petitioners and on the proceeds of the loans received by them.
In the notices of deficiency issued to the Barons, Ben-Porats, Morhars, and Rochelles, the Commissioner disallowed the deductions claimed with respect to the 1980 and 1981 transactions on*300 the grounds that such petitioners failed to establish:
(1) That you were engaged in a trade or business during the taxable year within the meaning of
(2) That the claimed expenditures identifies with a research and development expenditure within the meaning of
(3) That you were "at risk" within the meaning of
(4) That the claimed deduction in the amount of
(5) That the amounts proven to be expended, if any, for alleged research and development are currently deductible, and are not capital expenditures.
In the notice of deficiency issued to the Jays, the Commissioner disallowed the deductions claimed by them with respect to the 1980 and 1981 transactions on the grounds that the "deductions claimed by you for research and development and other expenses*301 with respect to your alleged business activity of research and development of an electric car * * * are not allowable because it has not been established that you were engaged in a trade or business, that the transactions were entered into for profit, that the transactions were entered into for any purpose other than tax avoidance, that the expenses were paid or incurred for the purpose claimed."
In addition, the Commissioner determined, either in the notices of deficiency or by amending his answer, that all the petitioners are subject to additions to tax under section 6653(a) for 1980 and under section 6653(a)(1) and (a)(2) for 1981 and to increased interest under
OPINION
The first issue for our decision is whether the petitioners are entitled to the deductions claimed by them under
The Supreme Court established in
In
The existence of the required profit objective is usually determined by examining the objective of the entity which has control over the activity in scrutiny.
The question whether a taxpayer engages in an activity with the requisite intention of making a profit is one of fact to be resolved on the basis of all the facts and circumstances of the case.
The petitioners contend that they entered into the 1980 and 1981 transactions with the requisite profit objective, because such transactions had the bona fide purpose of developing and marketing the Silver Volt. They argue that, by entering into the transactions, they acquired the services of Mr. Aronson, who had considerable experience in the field of electric vehicles. They further claim that they made proper arrangements for the commercial exploitation of the Silver Volt and that the documents executed by them provided adequate protection for their interest in the revenues from such exploitation.
On the other hand, the Commissioner argues that the amounts paid or incurred by the petitioners pursuant to the 1980 and 1981 transactions are not deductible under
A careful examination of the 1980 and 1981 agreements and other documents executed by the petitioners and a review of their activities with respect to Electric Auto leads us to conclude that they never intended, nor were capable of, engaging in the trade or business of conducting research. We are convinced that the 1980 and 1981 transactions were structured in such a way as to allow Mr. Aronson to raise funds needed to develop the Silver Volt and to leave the petitioners in the restricted role of passive investors. Such transactions enabled Mr. Aronson and Electric Auto to retain effective control over the development, manufacture, and sale of the Silver Volt when such vehicle became commercially marketable, and left the petitioners with only a royalty interest in the Silver Volt and its technology.
We first examine the circumstances leading up to the execution of the agreements by the petitioners. Prior to entering into the 1980 and 1981 transactions, the petitioners received no formal offering describing such transactions. The petitioners were only shown*308 copies of the agreements and the promissory notes. In addition, in 1981 Mr. Kurtin had available for their review copies of the memorandum which described the transactions and which described the popularity of research and development tax shelters. Such memorandum also highlighted the tax advantages to be enjoyed by participants in the Electric Auto research program.
None of the petitioners had an attorney review the Electric Auto materials before they entered into the transactions. Nor did they take any steps to determine whether the projections of potential Silver Volt sales were feasible. Rather, all of the petitioners, except Mr. Baron, relied exclusively on the recommendations of Mr. Kurtin as to the suitability of the transactions. But Mr. Kurtin himself never investigated the viability of the transactions. Of course, it was not in his interest to do so, since he earned commissions for his efforts in bringing participants to the transactions.
If the petitioners had conducted a serious investigation into the viability of the transactions, they would have discovered that such transactions were not all they were represented to be. During trial, the Commissioner offered*309 the testimony and written report of George Frost as an expert opinion regarding the 1980 and 1981 transactions. Mr. Frost has been engaged in the practice of patent law for 40 years, both in private practice and as the director of the Patent Section for the General Motors Corporation (GM). In such position, he was responsible for all of GM's patent and intellectual property matters throughout the world. During his career, he has also been active teaching and writing about patent law and related subjects.
At the request of the Commissioner, Mr. Frost prepared an analysis of the 1980 and 1981 transactions. He reviewed the agreements and other promotional materials provided to the petitioners by Electric Auto. He also searched patent records to determine the legal status of the products and technology purportedly acquired by the petitioners. As a result of his review, Mr. Frost concluded that the development agreements executed by the petitioners did not represent a legitimate research and development contract.
Mr. Frost noted that the transactions were not entered into in a businesslike manner. While the petitioners signed numerous documents, not one was the product of an*310 arm's-length negotiation. The petitioners were simply presented with a package of documents to sign and never had the opportunity to comment on the provisions of the development agreements, the dollar value of the research contracted for, or the royalties promised in such agreements.
Mr. Frost also observed that the agreements expressly provided that the petitioners had no power to control or direct the research activities of Electric Auto. While the agreements required the petitioners to make their entire contribution to the research fund in advance, before any research was performed, they allowed Electric Auto, in its sole discretion, to invest such contributions so long as it saw fit or to spend the money conducting research.
Yet, the agreements provided no time schedule for the performance of research by Electric Auto or its subcontractors. Further, they imposed no reporting requirements designed to insure that whatever research was conducted was performed properly and achieved results. Both Mr. Frost and Richard Gerber indicated that a legitimate research and development agreement would not contain a provision allowing unlimited access to research funds without the imposition*311 of time limits or reporting requirements. Even Mr. Jay and Mr. Rochelle admitted that, in their prior business experience, they avoided transactions which called for advance payment of the full amount under the contract and which did not provide for any periodic progress reports by the contractor.
Perhaps most disturbing is the fact that the petitioners acquired no ownership interest in the results of the Electric Auto research financed by their contributions. Under the agreements, the petitioners were entitled only to royalties for each electric vehicle sold by Electric Auto or its subsidiaries for use or resale in California. Yet, the royalty interest granted to the petitioners was only a limited one, because the agreements could be easily circumvented by Electric Auto, either by selling Silver Volts outside of California, or by licensing any technology to a third party which would in turn sell the vehicles. Since the sale of each Silver Volt would produce $ 1,998 in royalties, there appears to be a substantial incentive for the company to attempt to avoid paying such royalties.
The loans received by the petitioners to fund their Electric Auto contributions also relate to*312 the determination whether they were engaged in a trade or business. See
As part of the transactions with Comanche and Micam, Electric Auto agreed to maintain funds in a cash collateral account at Artoc sufficient to cover the loans made to the petitioners, and in fact the company did so after the petitioners made their contributions to the research fund. In our judgment, the transactions surrounding this circular flow of the loan proceeds had no substance for tax purposes. Such transactions only had the effect of increasing by five times the contributions allegedly made by the petitioners and, correspondingly, the deductions which could be claimed by them. The fabricated nature of these loans designed to enhance the tax benefits of the transactions furnished additional evidence that the transactions were not entered into with an actual and bona fide*314 objective of making an economic profit.
The petitioners contend that their participation in the 1978 and 1979 transactions shows that they were in the electric vehicle business with the intent to earn a profit. They argue that such activity supports a conclusion that the expenditures made by them with respect to the 1980 and 1981 transactions were made in connection with a trade or business. However, an examination of the events leading up to the petitioners' investment in the subchapter S corporations involved in the 1978 and 1979 transactions also shows that they did not conduct activities such that they were engaged in a trade or business or ever had the prospect of being so engaged.
All the petitioners, except for Mr. Baron, relied heavily on Mr. Kurtin's recommendation as to the commercial viability of the 1978 and 1979 transactions. Mr. Kurtin's recommendation came after he received a report from Richard Gerber, who traveled to the Bahamas to visit Electric Auto's facilities in 1979. At such time, neither Electric Auto nor its research subcontractor, AAR, had produced a workable prototype of the Silver Volt. In fact, neither company even had actual research facilities*315 in the Bahamas.
None of the petitioners visited the Electric Auto facilities personally before participating in the 1978 and 1979 transactions. Further, they never took steps to investigate the validity of the patent rights purportedly acquired by the subchapter S corporations in which they invested. They made no effort to determine whether such corporations had clear title to the patents which were the subject of the research purportedly to be conducted by Electric Auto or AAR. Mr. Frost testified that his patent search, which was performed as part of his analysis of the transactions, revealed the original inventors of several of the patents purportedly acquired had never assigned the rights to such patents to the subchapter S corporations.
In our judgment, the 1980 and 1981 agreements entered into by the petitioners effectively precluded them from ever having any substantial rights in the results of the Electric Auto research and from ever using the results of such research in connection with a trade or business. We view the petitioners' role to be that of investors, contributing capital to Electric Auto. Their activities have never and will never surpass those of investors.
*316The management of investments is not a trade or business, no matter how extensive or complex the investment portfolio or how much time is required to manage such investments.
Because we find that the expenditures by the petitioners were not made in connection with a trade or business, we need not address the alternative positions advanced by the Commissioner. 7 In addition, we need not address the petitioners' other arguments, because such arguments are based upon a threshold finding that the Electric Auto expenditures were made in connection with a trade or business. 8
*318 The next issue for our decision is whether the petitioners are liable for the addition to tax for negligence under section 6653(a) for 1980 and section 6653(a)(1) and (a)(2) for 1981. Such addition to tax is imposed if any part of the underpayment of tax is due to negligence or intentional disregard of rules and regulations. Negligence, within the meaning of section 6653(a), constitutes a lack of due care, or a failure to do what a reasonable and ordinarily prudent person would do under the circumstances.
After carefully considering all the evidence before us, we conclude that the imposition of the negligence addition is justified. In our judgment, the petitioners ignored numerous indications that the Electric Auto transactions were not viable business ventures. The petitioners did not appear to be troubled by the fact that the 1980 and 1981 agreements required full payment of their contributions*319 in advance. They were also unconcerned that the agreements failed to provide for a time schedule for the performance of research and imposed no reporting requirements to insure that research was properly performed. To increase their claimed deductions, they executed the purported notes without expecting to be called upon to pay such notes. Finally, the petitioners executed the agreements even though such agreements expressly provided that they received no ownership interest in the result of the Electric Auto research and would be compensated only with royalties on sales of an electric vehicle which had little prospect of becoming commercially viable.
Despite such indications that the Electric Auto transactions were not all they were represented to be, the petitioners never consulted an attorney to determine what their rights were under the agreements. All of the petitioners are knowledgeable and successful businessmen and professionals. We cannot believe that they would not seek such protection in other business ventures in which they participate. For them to fail to further investigate the Electric Auto transactions in light of obvious warning signs seems to us to constitute*320 a lack of due care or, worse, an intentional disregard of the lack of commercial viability of such transactions.
The final issue for our decision is whether the deductions claimed by the petitioners with respect to their Electric Auto activities resulted in substantial underpayments of tax attributable to tax motivated transactions within the meaning of
In this case, we have held that the petitioners are not entitled to the deductions claimed by them under
Footnotes
1. Cases of the following petitioners have been consolidated herewith: Josef Ben-Porat and Claire Ben-Porat, docket No. 12700-85; Ben Rochelle and Estate of Jane Beebe Rochelle, Deceased, Ben Rochelle, Executor, docket No. 12705-85; Gerald P. Baron and Bonnie Baron, docket No. 24950-85; and Irvin L. Morhar and Janet Morhar, docket No. 44006-85. ↩
2. All statutory references are to the Internal Revenue Code of 1954 as in effect during the years in issue.↩
3. The Deficit Reduction Act of 1984, Pub. L. 98-369, 98 Stat. 494, 682-83, sec. 144, added
sec. 6621(d) to provide for increased interest on substantial understatements attributable to tax motivated transactions. Such increased amount applies to interest accruing after December 31, 1984. The Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085, 2744, sec. 1511(a), redesignatedsec. 6621(d) assec. 6621(c)↩ .4. The Revenue Act of 1978, Pub. L. 95-600, sec. 202, 92 Stat. 2763, 2816, extended the limitations on deductible losses contained in the "at risk" rules to subchapter S corporations. Such provision generally applied to tax years beginning after Dec. 31, 1978. Sec. 204(a), 92 Stat. 2817. ↩
5. The Commissioner contends that the purported contributions should not be treated as such for tax purposes. For convenience, we shall refer to them as contributions without intending to decide such issue. ↩
6. Any reference to a Rule is to the Tax Court Rules of Practice and Procedure. ↩
7. On brief, the Commissioner argues that the petitioners were not at risk for amounts purportedly borrowed from Micam and Comanche and that therefore such amounts cannot support deductions under
sec. 174↩ .8. On brief, the petitioners raise the issues whether they are entitled to use the accrual method to account for their Electric Auto activity and whether they are entitled to accrue the amounts purportedly borrowed to finance their contributions to Electric Auto. In addition, the petitioners alleged in their petitions that they are entitled to deductions for casualty or theft losses in the amounts of the cash contributed by them to Electric Auto. They failed to mention such issue in their trial memorandum, presented no evidence on such issue at trial, and made no arguments with respect to such issue on brief. For such reason, we conclude that they have abandoned their claim for casualty loss deductions. ↩
1988 T.C. Memo. 232 (Jay v. Commissioner) — published by Counsel Stack Legal Research, free access to 12M+ legal documents.