Peat Oil & Gas Assocs. v. Commissioner

100 T.C. No. 17, 100 T.C. 271, 1993 U.S. Tax Ct. LEXIS 18

• Court: United States Tax Court
• Decided: March 31, 1993
• Docket: Docket Nos. 30296-87, 20081-88, 20130-88, 820-91, 24514-91, 30440-91
• Status: Published

Opinions

Cohen, Judge:

Respondent sent notices of final partnership administrative adjustment (fpaa) disallowing certain deductions claimed on partnership returns of three partnerships. Petitions were filed for the years in issue as follows:

Docket No. Partnership Tax year

30296-87 Peat Oil and Gas Associates (POGA) 1983

20081-88 Syn-Fuel Associates 1982 (SFA-1982) 1982 1983

1984

1985

20130-88 POGA 1984

Docket No. Partnership Tax year

820-91 POGA 1986

24514-91 Syn-Fuel Associates 1983

(SFA) 1984

1985

1986

1987

30440-91 POGA 1987

The disputed items deducted on the partnership tax returns are as follows:

Partnership Return year Amount of license fee Amount of interest payment Research and development expenses

POGA 1983 $7,752,875 $943,086

1984 5,825,219 1,334,470

1986 1,569,093

1987 1,570,124

SFA-1982 1982 5,961,600 2,492

1983 5,779,000 399,938 $658,000

1984 5,783,400 721,367 162,000

1985 4,467,150 1,021,951

SFA 1983 2,660,750 323,666

1984 5,783,400 721,367

1985 538,719

1986 538,584

These deductions were claimed in addition to expenses relating to the oil and gas activities of the partnerships, which are not disputed by respondent.

The parties have stipulated:

15. If a final determination of the Tax Court holds that venue on appeal in these cases lies to the Sixth Circuit, then decisions should be entered which reflect that the Partnerships’ tax returns were correct as filed for each of the years at issue, pursuant to Golsen v. Commissioner, 54 T.C. 742 (1970), aff’d 445 F.2d 985 (10th Cir. 1971), cert. denied, 404 U.S. 940 (1971).

16. If a final determination of the Tax Court holds that venue on appeal lies anywhere but the Sixth Circuit, then decisions should be entered as shown on the following Exhibits, which reflect certain government concessions:

Partnership Tax year Exhibit No.

“SFA, 192” 1982 30-AD

1983 31-AE

1984 32-AF

Partnership Tax year Exhibit No.

1985 33-AG

“POGA” 1983 34-AH

1984 35-AI

1985 36-AJ

1986 37-AK

“SFA” 1983 38-AL

1984 39-AM

1985 40-AN

1986 41-AO

1987 42-AP

In addition, the Court’s decision should reflect its determination of the deductibility of the unagreed adjustments, as defined in paragraph 17, following.

17. Except as detailed in Exhibits 30-AD through 42-AP above, no adjustments are to be made to any items on any of the Partnerships’ income tax returns for the years at issue, except as determined by the Court with respect to unagreed adjustments. Unagreed adjustments are those items disallowed in the FPAA’s and not conceded by the government in Exhibits 30-AD through 42-AP above. Neither the petitioners nor the respondent concedes the unagreed adjustments.

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20. The parties incorporate herein by reference the entire record of the proceeding in the cases of Karr v. Commissioner, Docket No. 309-87, and Smith v. Commissioner, Docket No. 48306-86, including the transcripts of the proceeding before the United States Tax Court, the Stipulation of Facts in those cases, and the Exhibits, as if they had been presented to the Tax Court in the cases captioned herein.

21. The events surrounding the formation and operation of “SFA, 1982” were so similar to the facts presented with respect to “SFA” and “POGA” at the Smith and Karr trials that the Court shall determine, except as specifically agreed herein, the issues in this case based upon the record in the Smith and Karr cases. To amplify, it is the belief of the parties that due to the similarity of factual circumstances no purpose would be served by presenting additional evidence (other than evidence presented herein) to the Court, and the Court may decide this case as if the evidence presented in the Smith and Karr cases were presented with regard to “SFA, 1982.”

In T.C. Memo. 1993-130, filed this date, it has been found that the principal place of business of the three partnerships at the times the petitions were filed was in New York. Given that factual determination, appeal will lie to the Court of Appeals for the Second Circuit. Sec. 7482(b)(1)(E). The stipulation of the parties, therefore, requires that we again resolve the disputed deductions set forth above.

Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue and when the petitions were filed, and all Rule references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated facts are incorporated in our findings by this reference. The stipulation also incorporates the entire record in the cases of Smith v. Commissioner, 91 T.C. 733 (1988) (Smith and Karr), affd. sub nom. Karr v. Commissioner, 924 F.2d 1018 (11th Cir. 1991) (Karr), and revd. by the Court of Appeals for the Sixth Circuit in Smith v. Commissioner, 937 F.2d 1089 (6th Cir. 1991) (Smith). The findings of fact in our prior opinion, 91 T.C. at 734-754, are hereby reaffirmed and incorporated in haec verba.

ULTIMATE FINDINGS OF FACT

The synthetic fuel activities of the partnerships lacked economic substance. The partnerships did not engage in those activities for the purpose of or with an actual and honest objective of making a profit.

OPINION

We “follow a Court of Appeals decision which is squarely in point where appeal from our decision lies to that Court of Appeals and to that court alone.” Golsen v. Commissioner, 54 T.C. 742, 757 (1970), affd. 445 F.2d 985 (10th Cir. 1971). On the other hand, if appeal from our decision lies to a Court of Appeals that does not have a decision squarely in point, we, as a court of national jurisdiction, must thoroughly reconsider an issue in light of the reasoning of a reversing appellate court and, if still of the opinion that our original result was right, follow our own beliefs until the Supreme Court decides the point. Lawrence v. Commissioner, 27 T.C. 713, 716-717 (1957), revd. on other grounds 258 F.2d 562 (9th Cir. 1958). Here, of course, we also consider the opinion of the Court of Appeals for the Eleventh Circuit in Karr v. Commissioner, 924 F.2d 1018 (11th Cir. 1991), affg. Smith v. Commissioner, 91 T.C. 733 (1988).

In our opinion in Smith and Karr, 91 T.C. at 753, we discussed profit objective and economic substance under the unified approach adopted by this Court in Rose v. Commissioner, 88 T.C. 386, 414 (1987), affd. 868 F.2d 851 (6th Cir. 1989). Subsequent to our opinion in Smith and Karr, the Court of Appeals for the Sixth Circuit affirmed our decision in Rose but did not adopt the generic tax shelter analysis reflected in our opinion in that case. Rose v. Commissioner, 868 F.2d at 853.

In reversing our opinion, the Court of Appeals for the Sixth Circuit in Smith stated:

In its factual aspect, the Tax Court’s conclusion that the transactions in question lacked economic substance leaves us “with the definite and firm conviction that a mistake has been committed.” Anderson v. Bessemer City, 470 U.S. 564, 573 (1985) (quoting United States v. United States Gypsum Co., 333 U.S. 364, 395, 68 S.Ct. 525, 542, 92 L.Ed. 746 (1948)). We recognize that this result is at odds with the Eleventh Circuit’s decision in Karr (see note 1, supra), but under the law of this circuit the proper test is “whether the transaction has any practicable effects other than the creation of income tax losses.” Rose, 868 F.2d at 853 (emphasis supplied). It is crucial, moreover, that this inquiry be conducted from the vantage point of the taxpayer at the time the transactions occurred, rather than with the benefit of hindsight. Hayden [v. Commissioner], 889 F.2d [1548] at 1554-56 [(6th Cir. 1989)] (Nelson, J., dissenting); Treas. Reg. sec. 1.183-2(a). [Smith v. Commissioner, 937 F.2d at 1096.]

The Court of Appeals, relying on its opinion in Bryant v. Commissioner, 928 F.2d 745 (6th Cir. 1991), affg. in part and revg. in part T.C. Memo. 1989-527, continued:

The conclusion in Bryant was similar to the one we reach in this case— “a reasonable expectation of profit [subjectively] is not to be required;” rather we look to whether “the taxpayer entered the activity, or continued the activity, with the objective of making a profit . . . even though the expectation of profit might be considered unreasonable.” Id. at 750 (emphasis added) quoting S. Rep. No. 552, supra. Here, as in Bryant, we conclude that the Tax Court was in error in questioning the transaction on the basis of whether it “was likely to be profitable.” Id. [Smith v. Commissioner, 937 F.2d at 1097.]

In our view, “Rose did not depart from the principle that a reasonable expectation of profit (as contrasted to an actual and honest profit objective) is not required. See Rose v. Commissioner, 88 T.C. at 411, quoting Jasionowski v. Commissioner, 66 T.C. 312, 321 (1976).” McCrary v. Commissioner, 92 T.C. 827, 846 (1989). We stated in McCrary: “A transaction that has a business purpose or profit objective will survive the Rose analysis of economic substance. Rose simply reformulated a two-pronged test into a unified approach in certain types of cases.” McCrary v. Commissioner, 92 T.C. at 845.

Thus, we did not reach our conclusion in Smith and Karr on the basis of whether the transaction was “likely to be profitable.” The features of the arrangement were discussed by us as a predicate to determining the purpose of the partnerships in which the taxpayers invested. At 91 T.C. at 756, we stated:

respondent has conceded deductions and credits relating to * * * [the oil and gas] activities. Thus we cannot conclude that the partnerships totally lacked economic substance. The question remains: What, if anything, was the economic substance of the Koppelman Process activity of the partnerships? Specifically, were these partnerships engaged in the trade or business of developing energy sources from the Koppelman Process or were they in the business of financing the operations of other entities in exchange for tax benefits? The business activities of other entities directly involved in exploiting the Koppelman Process will not necessarily be attributed to the limited partnerships in which petitioners invested. See Beck v. Commissioner, 85 T.C. 557, 580 (1985).

Whether we are determining the existence of a profit objective or the status of an activity as a trade or business, we examine the appropriate factors at the partnership level. Brannen v. Commissioner, supra [78 T.C. 471 (1982), affd. 722 F.2d 695 (11th Cir. 1984)]; Madison Gas & Electric Co. v. Commissioner, 72 T.C. 521, 564-565 (1979), affd. 633 F.2d 512 (7th Cir. 1980). Citing Surloff v. Commissioner, 81 T.C. 210, 233 (1983), petitioners specify that “in determining whether the Partnerships had the requisite profit motive it is necessary to look at the motive and objectives of the promoters and managers of the Partnerships.” * * * [Fn. ref. omitted.]

Our opinion in Smith and Karr examined in detail the motive and objectives of the promoters and managers of the partnerships and concluded that the structure precluded any economic benefit to the limited partners — the petitioner taxpayers. Smith and Karr, 91 T.C. at 764-765. The Court of Appeals for the Sixth Circuit seemed to give the limited partners the benefit of the possibility that some “practicable effects other than the creation of tax losses” might be realized by other persons associated with the venture. Smith, 937 F.2d at 1096.

We need not here decide whether we will follow the Rose approach in the future in view of its failure to gain accept-anee by the Court of Appeals for the Sixth Circuit and others. See Hunt v. Commissioner, 938 F.2d 466, 471 n.5 (4th Cir. 1991), affg. T.C. Memo. 1989-660; Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988), affg. Dister v. Commissioner, T.C. Memo. 1987-217. Further, it is not our place here to decide whether the test stated by the Court of Appeals for the Sixth Circuit in Smith and in Bryant v. Commissioner, 928 F.2d 745 (6th Cir. 1991), revg. T.C. Memo. 1989-527, is consistent with the Supreme Court’s statement in Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987), that, in order for a taxpayer to be in a trade or business, within the meaning of section 162, the “primary purpose” for engaging in the activity must be for profit. Using the traditional subjective and objective analyses that preceded Rose, the Court of Appeals for the Eleventh Circuit in Karr and the dissenting judge in Smith reach the same conclusion as that reached by us in Smith and Karr.

The Court of Appeals for the Eleventh Circuit in Karr, 924 F.2d at 1024, stated:

Although the Commissioner presented no expert witnesses, the record contains substantial evidence from which one may conclude that POGA’s Koppelman process activity lacked economic substance and had no business purpose other than the creation of tax benefits. The offering memorandum emphasized the tax benefits of the partnership, including anticipated tax write-offs for the limited partners of four times their cash investment over the first four years of the partnership. The purchasers of partnership units did not negotiate for the price of their shares and knew of conflicting business interests.⁷ POGA held no tangible assets, and the limited rights to exploit the Koppelman process that POGA did possess were difficult to value. Moreover, the fees paid by POGA to Sci-Teck and FTRD were not the result of arm’s-length negotiations.

The amount and structure of the fees paid by the partnerships also lend support to the Tax Court’s conclusion that the transactions lacked economic substance. POGA and SFA incurred a fixed obligation to pay an amount potentially 56 to 112 times greater than the price paid by Ronodo; yet, the partnerships received fewer rights than did Ronodo to exploit the Koppelman process. Another noteworthy difference between Ronodo’s payments to Koppelman and POGA’s payments to Ronodo is that Ronodo’s payments were contingent on the completion and testing of the system’s construction and on the commercial success of the Koppelman process technology and exploitation. In contrast, POGA’s payments to Sci-Teck and FTRD were based on a multiple of the number of partnership units sold. Furthermore, the bulk of POGA’s payment consisted of promissory notes due in twenty-five years. Although they were recourse notes, the Tax Court found that the substantive liability that they represented was significantly less than the face amount of the notes.

The Court of Appeals for the Eleventh Circuit also affirmed our use of the testimony of Michael Zukerman (Zukerman), an attorney involved in structuring the transactions.

The majority of the Court of Appeals for the Sixth Circuit, in contrast, differed in its interpretation of Zukerman’s testimony. Smith v. Commissioner, 937 F.2d at 1094. After analyzing that testimony and other evidence in the record, the court concluded that, “On the basis of the evidence presented, it seems obvious to us that the investment was not a sham.” Id. at 1096.

Circuit Judge Charles W. Joiner, dissenting in Smith, discussed at length the application of regulations under section 183 and concluded:

It was perfectly apparent to purchasers of partnership units that the partnerships dealt only with corporations controlled by the promoters, that none of the web of commitments of the partnership had been negotiated at arms’ length, that the principals and contractors to the partnership had no experience in relevant endeavors, and other facts communicating the insubstantial nature of the enterprise. These partnerships were not business ventures, they were paper montages of likely Tax Court arguments.

It does not controvert the significance of the other facts at issue to say that the income from the oil and gas activities of the partnership might have covered the expenses of the Koppelman process activities. It may be that the Koppelman process itself is commercially feasible. However, as the Tax Court clearly pointed out, it was the structure of this venture, the conflicts of interest, and other factors separate from the economic viability of the processes at issue, which demonstrate that the investors had no profit motive. The experts offered by the taxpayers who found the oil and gas projections reasonable, addressed merely the surface question of the economic potential of the partnerships’ activities. However, there was no serious intent to pursue those activities, and the purchasers of the partnership units, to whom the partnerships were marketed as tax-oriented investments, had no expectation that the partnerships would be commer-dally successful. The principals of this venture had no incentive to make it a success, the venture had inadequate funding to make it a success, and there is no evidence of attempts to make the venture a success after the failure of the activities originally planned, despite the fact that the partners had an obligation to fund the partnerships for the next twenty years. Viewing the above circumstances as a whole, I would affirm the Tax Court’s finding that there was no profit motive under section 183, and that SPA was engaged in a sham transaction rather than a “trade or business” entitling it to deductions under section 174.

[Smith v. Commissioner, 937 F.2d at 1102-1103.]

Obviously, this is a case where judges disagree in their interpretation of the facts. The unanimous opinion of the Court of Appeals for the Eleventh Circuit and the dissenting judge sitting on the Court of Appeals for the Sixth Circuit agreed with us. Judge Joiner’s dissenting opinion concisely states our position.

We have given consideration to the reasoning of the Court of Appeals for the Sixth Circuit. We believe that the majority opinion failed to differentiate between the potential economic benefits that might be realized by persons other than the partners and the losses certain to be realized by the taxpayers before the Court. With due respect to their opinion, and in view of the support for our position from the Court of Appeals for the Eleventh Circuit and from the dissent in Smith, we respectfully conclude that our original result was correct. Cf. Bayer v. Commissioner, 98 T.C. 19, 22-23 (1992). Petitioners have not included in their briefs any new or additional argument that must be addressed. Accordingly,

Decisions will be entered under Rule 155.

Reviewed by the Court.

Shields, Clapp, Swift, Jacobs, Wright, Parr, Colvin, Halpern, Beghe, Chiechi, and Laro, JJ., agree with the majority opinion. Hamblen and Parker, JJ., concur in the result only.

7 For example, Basile’s personal interests conflicted with the interests of POGA and SFA. B asile was President and Chief Executive Officer of Genoco Industries, Inc. (Genoco), and a promoter of Petrogene Oil and Gas Associates (Petrogene). The partnership memorandum warned that Genoco would engage in oil and gas activities similar to those engaged in by FTOG, and that Genoco planned to convert bagasse into synthetic fuel. Basile had a proprietary interest in Petro-Syn, Sci-Teck, Ronodo, Genoco, and Petrogene, all entities which stood to profit at the expense of the partnerships.