Saykally v. Comm'r
This text of 2003 T.C. Memo. 152 (Saykally v. Comm'r) is published on Counsel Stack Legal Research, covering United States Tax Court primary law. Counsel Stack provides free access to over 12 million legal documents including statutes, case law, regulations, and constitutions.
Opinion
*150 Decisions will be entered in favor of the Commissioner with respect to taxpayers' disputed deductions. Decisions will be entered in favor of the Commissioner, in part, and in favor of the taxpayers, in part, with respect to the Commissioner's assessment of accuracy-related penalties.
P has extensive technical expertise in the computer software
industry. P's wholly owned corporation, C, was engaged in the
marketing of software products. P and C entered into an
agreement whereby P agreed to have research and development (R&
D) done in order to create developed technology. Under the
agreement, P would own the developed technology and license it
to C in exchange for royalties. P intended that C would market
the developed technology to its customers. P deducted his 1995
and
deductions on the ground that they were not incurred in a trade
or business.
Held: At all times, P intended to market the developed
technology through C. P did not have the objective intent to use
the developed technology in an activity that would constitute
his own trade or business and is not entitled to a current
deduction for his R&D expenses.
Held, further, Ps did not adequately substantiate
other deductions disallowed by R.
Held, further, *151 Ps are not liable for accuracy-
related penalties associated with the deduction of R&D
expenses. Ps are liable for accuracy-related penalties
with respect to their failure to substantiate other
disallowed deductions.
MEMORANDUM FINDINGS OF FACT AND OPINION
RUWE, Judge: These cases were consolidated by motion of the parties for purposes of trial, briefing, and opinion. In docket No. 1821-00, respondent determined a deficiency in Federal income tax of $ 103,250 and a
*152 Addition to Tax Penalties
Year Deficiency
1994 $ 11,729 $ 253 $ 2,346
1995
1996
For convenience, we refer to David M. and Teri L. Saykally as petitioners and David M. Saykally as petitioner throughout this opinion.
After concessions, 3 the remaining issues to be decided are as follows:
*153 (1) Whether petitioners are entitled to deduct expenses claimed
for research and development for taxable years 1995 and 1996 in
the respective amounts of $ 67,534 and $ 1,421,645;
(2) Whether petitioners are entitled to deduct certain expenses
on their Schedules C, Profit and Loss From Business, for the
taxable years 1994, 1995, and 1996; and
(3) Whether petitioners are liable for accuracy-related
penalties pursuant to
1995, and
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts, stipulations of settled issues, and the attached exhibits are incorporated herein by this reference. At the time of filing the petition, petitioners resided in Granite Bay, California.
Research and Development Expenses
Petitioner has extensive familiarity with, and technical expertise in, the computer software industry spanning more than 30 years. In 1991, Computer Power Group Limited (CPG) hired petitioner on a contract basis to provide it with consulting services. CPG is a large professional
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*150 Decisions will be entered in favor of the Commissioner with respect to taxpayers' disputed deductions. Decisions will be entered in favor of the Commissioner, in part, and in favor of the taxpayers, in part, with respect to the Commissioner's assessment of accuracy-related penalties.
P has extensive technical expertise in the computer software
industry. P's wholly owned corporation, C, was engaged in the
marketing of software products. P and C entered into an
agreement whereby P agreed to have research and development (R&
D) done in order to create developed technology. Under the
agreement, P would own the developed technology and license it
to C in exchange for royalties. P intended that C would market
the developed technology to its customers. P deducted his 1995
and
deductions on the ground that they were not incurred in a trade
or business.
Held: At all times, P intended to market the developed
technology through C. P did not have the objective intent to use
the developed technology in an activity that would constitute
his own trade or business and is not entitled to a current
deduction for his R&D expenses.
Held, further, Ps did not adequately substantiate
other deductions disallowed by R.
Held, further, *151 Ps are not liable for accuracy-
related penalties associated with the deduction of R&D
expenses. Ps are liable for accuracy-related penalties
with respect to their failure to substantiate other
disallowed deductions.
MEMORANDUM FINDINGS OF FACT AND OPINION
RUWE, Judge: These cases were consolidated by motion of the parties for purposes of trial, briefing, and opinion. In docket No. 1821-00, respondent determined a deficiency in Federal income tax of $ 103,250 and a
*152 Addition to Tax Penalties
Year Deficiency
1994 $ 11,729 $ 253 $ 2,346
1995
1996
For convenience, we refer to David M. and Teri L. Saykally as petitioners and David M. Saykally as petitioner throughout this opinion.
After concessions, 3 the remaining issues to be decided are as follows:
*153 (1) Whether petitioners are entitled to deduct expenses claimed
for research and development for taxable years 1995 and 1996 in
the respective amounts of $ 67,534 and $ 1,421,645;
(2) Whether petitioners are entitled to deduct certain expenses
on their Schedules C, Profit and Loss From Business, for the
taxable years 1994, 1995, and 1996; and
(3) Whether petitioners are liable for accuracy-related
penalties pursuant to
1995, and
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts, stipulations of settled issues, and the attached exhibits are incorporated herein by this reference. At the time of filing the petition, petitioners resided in Granite Bay, California.
Research and Development Expenses
Petitioner has extensive familiarity with, and technical expertise in, the computer software industry spanning more than 30 years. In 1991, Computer Power Group Limited (CPG) hired petitioner on a contract basis to provide it with consulting services. CPG is a large professional*154 services company organized under the laws of Australia. CPG was in the business of providing professional computer programmers to companies to create business software. Additionally, CPG was involved in the worldwide marketing of several lines of business software applications. CPG was losing money on the marketing of its software applications. Petitioner was hired on a short-term basis to provide consulting services to CPG to identify why CPG was losing money and how to stop such losses. 4
After conducting onsite inspections and reviewing pertinent information, petitioner reported to CPG's chief executive officer regarding his ideas on how to stop the "profit bleed". In response, CPG attempted to hire petitioner to implement his ideas. Instead of becoming an employee of CPG, the parties agreed to move the marketing of CPG's software out from under CPG and agreed that petitioner would organize his own corporation to market CPG's software*155 products for a stated royalty. Consequently, petitioner organized CPSG, Inc.
CPSG, Inc. is a computer software corporation that was organized in November 1992, pursuant to the laws of the State of California. During the taxable years at issue, petitioner owned all the outstanding shares of CPSG, Inc., and was its president, chief operating officer, and sole director.
Beginning in 1992, CPG was a party to contracts with three Australian syndicates that were engaged in software development (the syndicates). The syndicates were Australian tax-advantaged research and development partnerships. The syndicates provided financing to CPG for the development of new software technology. The syndicates raised approximately $ 20 million for CPG's software research and development work. Approximately 75 percent of the money raised, or $ 15 million was supposed to be used for the development of CPG's software. In return, the syndicates owned the rights to the software technology and licensed those rights to CPG.
On August 10, 1993, petitioner, CPSG, Inc., and CPG entered into a Software Marketing and Management Agreement (the management agreement) whereby CPSG, Inc. licensed certain rights to*156 market CPG's software technology and products, including InTEXT, Today, and Operating Control Systems. 5 The management agreement contemplated that CPSG, Inc. would form three subsidiaries, InTEXT Systems, Inc., Today Systems, Inc., and Operating Control Systems, Inc., to market specific lines of CPG's software products.
The management agreement purported to grant CPSG, Inc. the right to market CPG's software products as they existed before the development work funded by the syndicates. In exchange, CPSG, Inc. agreed to pay CPG a royalty. Under the terms of the management agreement, CPG agreed to use its best efforts to provide funds for software product development; the funds were to be obtained from the syndicates.
Appendix II to the management agreement was a Software Marketing Agreement (submarketer agreement) by and between CPSG, Inc. and CP Software Export Pty Ltd., an entity affiliated with CPG. Under this agreement, CPSG, Inc. would*157 acquire a sublicense to market certain software products developed with funding from the syndicates in exchange for royalty payments. Despite extensive negotiations, this agreement was never executed by the parties. Although the agreement was never executed, the parties decided to operate as if it had been.
In or about May 1995, CPG informed CPSG, Inc. that the syndicates' development funding would terminate in July 1995. In or about July 1995, the syndicates' development funding terminated. The planned development and improvement of the software was not completed. No new marketable and competitive products resulted from the underfunded and unfinished development. Without additional development funding, CPSG, Inc. and its subsidiaries would lose their current customers and would not have software products to attract new customers.
On July 7, 1995, the syndicates notified CPSG, Inc. to cease and desist marketing CPG's software technology purportedly licensed from CPG. 6 The syndicates took the position that CPSG, Inc. had no rights to the technology for which they had provided funding. Essentially, the syndicates, through their representative, informed CPSG, Inc. that the management*158 agreement by and between CPG and CPSG, Inc. to market the software technology conferred no rights on CPSG, Inc. as the syndicates had not approved the agreement.
Petitioner decided to continue the development without funding from the syndicates. Petitioner believed he would have more negotiating leverage with respect to the developed software if he finished development in his own name, instead of in the name of CPSG, Inc. Petitioner's reasons supporting this decision were: (1) CPSG, Inc., as a marketing entity, had no development capability; petitioner was the only person who had the skill set to do*159 the development; (2) it was prudent to create intellectual rights outside of CPSG, Inc. because (i) CPG could cancel the submarketer agreement in 1997 for no reason and, at other times as stated in the agreement; (ii) the syndicates took the position that they could modify or terminate CPSG, Inc.'s rights to the newly developed software technology because the grant from CPG was in conflict with the rights of the syndicates; and (iii) CPG controlled the syndicates and could cause the syndicates to require CPG to terminate the management agreement; (3) CPSG, Inc. did not have the financial resources to fund the development; and (4) petitioner had the financial resources to develop the software technology.
On October 1, 1995, petitioner, in his individual capacity, entered into a development agreement with his wholly owned corporation, CPSG, Inc. According to the terms and conditions of the development agreement, petitioner covenanted to provide software research and development to improve, enhance, modify, and change the software technology in his reasonable discretion and at his sole expense. The contract granted CPSG, Inc. the right to cancel the agreement at anytime with 1 month's*160 notice. The product of petitioner's R&D efforts was what the parties termed the "developed technology". Pursuant to the terms of the contract, petitioner retained all rights, title, and interest in the developed technology. 7 Simultaneously, under the development agreement, petitioner granted CPSG, Inc. a nonexclusive license to the developed technology in exchange for 36 quarterly payments in an amount equal to the greater of 10 percent or $ 26,250 from the sale, grant of licenses, or commercialization of products that incorporated the developed technology during the period January 31, 1997, through December 31, 2005. 8 Petitioner intended that the developed technology would be marketed through CPSG, Inc.
*161 On October 1, 1995, CPSG, Inc., Computer Power Software Group Australia Pty Ltd. 9 (CPSGAus), and petitioner entered into a service agreement whereby CPSGAus agreed to provide administrative and payroll services to petitioner in his efforts to develop the software technology. CPSGAus hired some of the Australian development staff that had been formerly employed by the syndicates to continue the research and development on petitioner's behalF. CPSGAus invoiced CPSG, Inc. for these costs. CPSG, Inc. paid the costs associated with the research and development on petitioner's behalf and recorded petitioner's indebtedness for the expenses on CPSG, Inc. 's accounting system.
Petitioner monitored the work performed by the Australian development*162 "team" via telephone, a visit to Australia, and electronic mail communications. Additionally, petitioner helped solve technical programming problems, prioritized tasks of the programmers, and was involved in beta testing the developed software.
Petitioner chose to secure development funding through CPSG, Inc. In order to memorialize his indebtedness to CPSG, Inc., on October 1, 1995, petitioner signed an unsecured, interest-bearing promissory note in favor of CPSG, Inc. for an amount not to exceed $ 1.4 million. According to the terms of the note, petitioner is personally liable for the amounts expended by CPSG, Inc. up to the stated maximum ($ 1.4 million), the principal of which is due on October 1, 2005. The interest rate was set quarterly to the prime rate and was payable in annual installments beginning on December 31, 1996.
CPSG, Inc. did not have sufficient cash to advance all the research and development costs to which petitioner obligated himselF. Accordingly, petitioner arranged for Uniplex Software, Inc.10 (Uniplex Software) to lend funds to CPSG, Inc. Uniplex Software advanced to CPSG, Inc. a total of $ 1.15 million in payments of $ 750,000 and $ 400,000 on February*163 5 and July 11, 1996, respectively. On October 1, 1996, CPSG, Inc. executed a promissory note to memorialize the loans made by Uniplex Software, not to exceed $ 1.15 million. Pursuant to the terms of the note, interest was set quarterly at the prime rate and was to be paid during the term of the note with the principal due on October 1, 2005.
Effective January 1, 1996, petitioner granted Uniplex Software a nonexclusive worldwide license for a renewable 3-year term to part of the developed technology. Effective July 8, 1996, CPSG, Inc. and Uniplex Software entered into a Software License Agreement (source code license) whereby CPSG, Inc. provided Uniplex Software with a worldwide, perpetual, nonexclusive license to the InTEXT proprietary software.*164 In exchange, Uniplex Software covenanted to pay CPSG, Inc. $ 500,000 for the source code license, $ 350,000 initial license prepayment, and a 2-percent royalty on Uniplex Software's net revenue from the distribution of the software until CPSG, Inc. received $ 300,000, and thereafter a 1-percent royalty of the net revenue from distribution of the software. The source code license provided Uniplex Software with security for the $ 1.15 million unsecured loan made to CPSG, Inc.
Annual sales of the InTEXT developed technology were approximately $ 1.5 million during the years at issue. Annual sales of the Operating Control System developed technology were approximately $ 1 million for the subject years. Annual sales of the Today developed technology approximated $ 2 million during the period 1995 through 1997.
During 1995 and 1996, CPSG, Inc., by and through its wholly owned subsidiaries, paid $ 67,543 and $ 1,361,006 of research and development costs on behalf of petitioner. These costs included:
Description 1995 1996
___________ ____ ____
Salaries 1 $ *165 28,584 $ 1,076,850
Contract labor 20,947 46,451
Building rent 5,644 54,293
Commissions 4,250 3,306
Telephone 428 33,001
Entertainment 106 659
Equipment rental 6,052 68,379
Repairs/maintenance 1,036 26,086
Freight 497 265
Janitorial -0- 426
Recruiting fees -0- 4,187
Travel -0- 3,016
Services -0- 13,495
Dues & subscriptions -0- 1,500
Electricity -0- 14,218
License fees -0- 12,050
Small equipment -0- 573
Office*166 supplies -0- 1,761
Postage/misc. -0- 491
CPSG, Inc. used its accounting system to track these costs. CPSG, Inc. initially deducted these research and development costs on its Federal income tax return for the year ended September 30, 1996. CPSG, Inc. subsequently amended its 1996 return eliminating the deduction.
Petitioners attached Schedules C for a computer software development business named "DMS Development Co." to their 1995 and 1996 returns. For the years at issue, petitioners reported no income on these Schedules C. Petitioners deducted the following research and development expenses on these schedules: 11
*167
Description 1995 1996
___________ ____ ____
Salaries $ 28,584 $ 1,076,850
Contract labor 20,947 46,451
Building rent 5,644 54,293
Commissions 4,250 3,306
Telephone 428 33,001
Meals/entertainment 106 329
Equipment rental 6,052 68,379
Repairs/maintenance 1,036 26,086
Freight 497 265
Janitorial -0- 426
Recruiting fees -0- 4,187
Travel -0- 3,016
Services -0- 13,495
Dues & subscriptions -0- *168 1,500
Electricity -0- 14,218
License fees -0- 12,050
Small equipment -0- 573
Office supplies -0- 1,761
Postage/misc. -0- 491
Interest -0- 1 60,967
TOTAL
CPSG, Inc. paid the following amounts to petitioner as minimum royalties pursuant*169 to the development agreement:
Date Amount For Period
____ ______ __________
01/28/97 $ 52,500 1/31/97 and 4/30/97 (Advance)
03/31/97 105,000 6/30/97 - 3/31/98
12/30/98 78,750 6/30/98 - 12/31/98
12/20/99 1 108,150 3/31/99 -12/31/99
_______
TOTAL 344,400
The $ 52,500 paid on January 28, 1997, included the January 31, 1997, minimum royalty payment as contemplated under the development agreement as well as an advance payment for the April 30, 1997, minimum royalty payment. *170 Petitioner paid CPSG, Inc. the following amounts as interest on his $ 1.4 million indebtedness to CPSG, Inc.:
12/29/96 $ 30,947.27 1
Other Schedule C Expenses
On their Schedules C, petitioners reported the following amounts as receipts and expenses for a consulting business named "CPSG Ventures" 12 for the years at issue:
1994
Receipts $ 194,317 $ 67,565 *171 $ 72,118
Expenses 79,881 30,912 79,349
Net profit/loss 114,436 36,653 (7,231)
The receipts reported for CPSG Ventures for 1994 on petitioners' Schedule C consisted of the following items:
CPSG, Inc. reimbursements 1 $ 61,640
CPSG, Inc. 2 40,000
Walker Interactive Systems 3 16,000
Uniplex Software Systems, Inc. 75,000
Granite Bay Montessori reimbursements 1,591
Miscellaneous 86
__________
TOTAL 194,317
*172 The receipts reported for CPSG Ventures for 1995 on petitioners' Schedule C consisted of the following items:
CPSG, Inc. reimbursements $ 53,187
Walker Interactive Systems 10,500
Airline ticket refund 3,878
______
TOTAL 67,565
The receipts reported for CPSG Ventures for 1996 on petitioners' Schedule C consisted of the following items:
CPSG, Inc. reimbursements $ 53,618
Walker Interactive Systems 18,500
TOTAL 72,118
Petitioners claimed as deductions the following expenses on their Schedules C for CPSG Ventures for the taxable years listed:
Description 1994 1995 1996
____ ____ ____
Depreciation $ 5,017 $ 10,053 *173 -0-
Car & truck -- 5,799 $ 5,807
Interest 386 -- --
Legal/
professional 1,374 79 30
Office expense 905 -- 202
Supplies 970 865 12,604
Travel 54,644 -- 41,870
Meals 2,353 4,439 1,900
Utilities 9,995 9,457 16,861
Auto-Std rate 4,133 -- --
Auto taxes 104 -- --
Miscellaneous -- 220 75
______ ______ ______
TOTAL 79,881 30,912 79,349
The above-listed expenses included amounts that were reimbursed by CPSG, Inc. for expenses such as travel and entertainment, supplies, and telephone. Additionally, these expenses included amounts not reimbursed by CPSG, Inc. In the notice of deficiency,*174 respondent allowed deductions for expenses to the extent they were reimbursed by CPSG, Inc. Additionally, respondent allowed the car and truck expenses as itemized deductions.
Charitable (Double) Deduction
On December 29, 1996, petitioners donated $ 60,000 to the Granite Bay Montessori School. On their 1996 income tax return, petitioners erroneously claimed a double deduction of $ 120,000. The parties have stipulated that petitioners are entitled to claim only a $ 60,000 charitable deduction with respect to the donation to the school for 1996. The only issue that remains with regard to this item is whether petitioners are liable for the accuracy-related penalty associated with the erroneous deduction.
OPINION
Determinations of the Commissioner in a notice of deficiency are generally presumed correct, and the burden is on the taxpayer to show that the determinations are incorrect. 13
A. Section 174 -- Research and Development Deductions
With regard to the claimed research and development (R&D) expenses for 1995 and 1996, the notice of deficiency states:
Schedule C -DMS Loss
Year 9512 9612
Claimed on return $ 67,534 $ 1,421,645
Allowed per audit -0- -0-
Adjustment 67,534 1,421,645
You have not shown that these expenses were ordinary and
necessary expenses paid or incurred*176 in connection with carrying
on a trade of business.
Since you have not established that the expenses claimed were
paid or incurred for research and experimental expenditures in
connection with your trade or business, they are not deductible.
Loss is limited to amount of capital you have at risk.
To resolve this issue, we must look to the statute granting deductions for expenses related to R&D and the cases interpreting it.
--
(1) In general. -- A taxpayer may treat research or experimental
expenditures which are paid or incurred by him during the
taxable year in connection with his trade or business as
expenses which are not chargeable to capital account. The
expenditures so treated shall be allowed as a deduction.
To qualify for a deduction, the expenditures must be (1) qualifying, (2) paid or incurred in connection with the taxpayer's trade or business, and (3) reasonable.
The term "research or experimental expenditures" as used in
In this case, respondent does not argue or allege that the expenses in question are not "research and development costs in the experimental or laboratory sense" or that the amounts claimed are unreasonable. Respondent's position is that petitioner did not pay or incur the research expenses in connection with his own trade or business and that petitioner did not have the objective intent to prospectively enter into his own trade or business with the developed technology.
Petitioners argue that "There was a realistic prospect that * * * [petitioner] would enter a trade or business*178 involving the software he developed." (Emphasis added.) Petitioners do not argue that at the time petitioner incurred the R&D expenses, he was already engaged in a trade or business; petitioners' focus is solely upon the prospective probability that petitioner would engage in a trade or business with the developed technology. 14 In its petition, CPSG, Inc. alleged that if the Court determines that Mr. and Mrs. Saykally are not entitled to the claimed R&D deductions, then CPSG, Inc. is so entitled. CPSG, Inc. abandoned this argument.
*179 The Trade or Business Requirement
With respect to
*180 This expansive interpretation allowing R&D deductions for expenses incurred prior to engaging in a trade or business is tempered by the requirement that there must be a "realistic prospect" that the taxpayer will subsequently enter into a trade or business utilizing the technology developed.
Whether a taxpayer has a realistic prospect of using the fruits of R&D expenditures in a future business of his own involves a two-part test. "[A] taxpayer demonstrates such a [realistic] prospect by manifesting both the objective intent to enter such a business and the capability of doing so." 16
"In order to qualify for the
To determine whether the taxpayer manifests the objective intent to enter into a business of his own with the fruits of R&D, we look to the facts and circumstances of the case. Of course, we examine any and all contracts and agreements in the record. See
At the time petitioner incurred the R&D expenditures, he did not have the objective intent to enter into a future business of his own with the developed technology. Rather, petitioner's purpose for engaging in the R&D was to create the developed technology that could be licensed to CPSG, Inc.*185 for use in CPSG, Inc. 's existing business. 17 For example, petitioner testified as follows:
Q: Okay. And had no further development had taken place, what
would have happened to CPSG?
A: It would have been literally out of business. Our [software]
products would have been 1992 ilk. I'm sure you appreciate just
reading the trade press how quickly technology moves in this
industry, and it would have had obsolete products that they
could no - not only could they not have sold them to any new
customers, their own customer base would have immediately
started looking for alternative technology. A large part of the
revenue for these companies came from customer support, customer
upgrade kinds of*186 revenue, and if they hadn't - if they hadn't
had any improvement to the product, the customers would have no
reason to spend that money, so CPSG would have simply been out
of business.
* * * * * * *
Q: How did you decide whether to do * * * [the development work]
as an employee of CPSG or -- or as your Schedule C?
A: * * * I was concerned that CPSG really didn't have any
leverage in a discussion with Computer Power Group. If they
cancelled the marketing agreement, if they cancelled the
sublicense -- or the submarketer agreement, Computer -- CPSG was
out of business.
So, my thought was to create some intellectual property
ownership outside of Computer Power Software Group, and the idea
being that, you know, you own the TV but I own the TV changer,
so we better cooperate in resolving any differences.
And so that was the thought was to kind of create an ownership
that I would have personally which would help us in protecting
CPSG as well.
A: * * * And again, having the intellectual property*187 ownership
in my hands personally meant at least we were going to have a
discussion about it.
A corporate resolution passed by CPSG, Inc. 's board of directors stated that petitioner "may undertake such reasonable research and development activities on * * * [CPSG, Inc. 's] behalf in order to render and maintain the Company's products as commercially viable". Indeed, on brief petitioners proposed that we find that "It was clear to petitioner that in order to save the business of CPSG more development had to be performed;" "Petitioner believed that by creating intellectual property rights outside of the CPSG nCPGSyndicate relationship he would have more negotiating leverage regarding any technology that he developed;" and "Petitioner believed that if he had rights to the technology he developed and CPG had rights to the underlying technology, CPG and the Syndicates would have to cooperate with him." On brief, petitioners explained that "When Syndicate funding ended, additional development had to be done for the business of CPSG to survive."
There is no evidence in the record, not even petitioner's testimony, that he intended to engage in a business of his own with*188 the developed technology. "The fact that a taxpayer may have taken an active role in directing the research does not, by itself, place a taxpayer in a trade or business."
The record does not demonstrate that petitioner's R&D activities amounted to anything more than the development of property rights that he intended to license to CPSG, Inc. for use in CPSG, Inc. 's business. As such, petitioner's activities amounted to nothing more than those of a prudent investor. 18"'[T] he management of investments is not a trade or business for purposes of
For the aforesaid reasons, *190 we find that at the time petitioner incurred the R&D expenditures, he did not have an objective intent to engage in his own trade or business with the developed technology.
Petitioners argue that the Court of Appeals for the Ninth Circuit's 19 opinion in
In
There is no question that Scoggins and Christensen had the objective intent to enter into the business of marketing the reactor if the reactor proved successful. The only question is whether they had a realistic prospect of engaging in the business as a partnership, or whether by virtue of the agreement with the corporation, they had deprived the partnership of the capability of doing so. [
The Court of Appeals then analyzed the taxpayers' "capability" of engaging in a trade or business with the fruits of R& D. In doing so, the Court considered the taxpayers' *192 technical expertise, their financial ability to conduct the business, and whether their contractual obligations precluded the likelihood of using the R&D in a future business. Id. The Court concluded that the taxpayers had the capability to use the R&D in a future business. 20 In contrast, in the instant case we have found that petitioner failed the first part of the realistic prospect test because he had no objective intent to use the R&D in a future business of his own.
In the notice of deficiency, respondent disallowed some of the expenses that petitioners claimed and deducted on their Schedules C for the taxable*193 years 1994 and 1996. 21 The amounts of the adjustments at issue are $ 18,241 and $ 25,731, respectively. In the notice of deficiency, respondent claimed that petitioners had not "established a business purpose for the expenses claimed."
Respondent argues that petitioners failed to substantiate the expenses deducted in excess of the amount allowed by respondent. 22 Petitioners argue that: (1) The notice of deficiency and respondent's court papers do not provide petitioners with notice of which expenses were denied, and (2) petitioners have sufficiently substantiated the deduction of expenses claimed. For the reasons detailed below, we believe petitioners failed to carry their burden.
*194 Petitioner testified that he received payments for, inter alia, consulting services performed on behalf of CPSG Ventures. 23 Assuming this to be true, we find that petitioners have not proven entitlement to the disallowed deductions. We do not find petitioners' argument that respondent failed to identify which deductions were denied persuasive. Respondent allowed petitioners to deduct expenses to the extent that they received reimbursement from CPSG, Inc. Petitioners are in the unique position to know those expenses for which they received reimbursement. The difference between the reimbursed expenses and the claimed expenses is the expenses for which respondent denied a deduction. The category of expenses denied becomes an important matter as the substantiation requirements vary depending upon the type of expense claimed as a deduction.
*195 Generally, ordinary and necessary expenses paid or incurred in carrying on a trade or business are deductible by an individual engaged in the trade or business.
Deductible expenses are subject to substantiation.
SEC. 6001. NOTICE OR REGULATIONS REQUIRING RECORDS, STATEMENTS,
AND SPECIAL RETURNS.
Every person liable for any tax imposed by this title, or for
the collection thereof, shall keep such records * * * and comply
with such rules and regulations as the Secretary may from time
to time prescribe. * * *
The regulations provide that "any person subject to tax * * * shall keep such permanent books of account or records * * * as are sufficient to establish the amount of * * * deductions."
The court's ability to estimate reasonably the amount of a deduction is curtailed in the case of certain classes of expenses.
shall be allowed --
(1) under
(including meals and lodging while away from home),
(2) for any item with respect*197 to an activity which is of a
type generally considered to constitute entertainment,
amusement, or recreation * * *
(3) for any expense for gifts, or
(4) with respect to any listed property (as defined in
unless the taxpayer substantiates by adequate records or by
sufficient evidence corroborating the taxpayer's own statement *
* *. [Emphasis added.]
See
To substantiate a deduction under
The parties stipulated that reimbursements received from CPSG, Inc. were "primarily" for travel and entertainment, supplies, and telephone expenses. Respondent allowed as a deduction the full amount of the expenses associated with the reimbursements. Additionally, respondent allowed petitioners to deduct their automobile expenses as an itemized deduction.
The substantiation requirements of
*199 Petitioners have failed to substantiate sufficiently the expenses claimed in excess of the amount respondent allowed in the notice of deficiency. Furthermore, petitioner's vague testimony that all the expenses claimed were for business purposes is not sufficient. "It is well settled that we are not required to accept petitioner's self-serving testimony in the absence of corroborating evidence."
Since petitioners failed to identify their deductions and the specific amounts, the knowledge of which is unique to them, we uphold respondent's determination that petitioners are not entitled to claim deductions in excess of those amounts determined in the notice of deficiency.
Respondent determined penalties pursuant to
"Negligence" is defined as "any failure to make a reasonable attempt to comply with the provisions of this title" and "disregard" means "any careless, reckless, or intentional disregard."
There is a "substantial understatement" of tax if "the amount of the understatement for the taxable year exceeds the greater of" (1) 10 percent, or (2) $ 5,000.
With respect to the deduction of R&D expenses, we cannot find under the facts before us that petitioners acted unreasonably by claiming the
With respect to the penalties relating to the other disallowed deductions claimed on petitioners Schedules C for the tax years 1994 and 1996, petitioners failed to substantiate the deductions claimed. As previously stated, petitioners are in the unique position to determine for which expenses CPSG, Inc. reimbursed them. The balance are those deductions which respondent denied. Incomplete copies of credit card statements and petitioner's self- serving testimony are not sufficient to substantiate the deductions claimed. Accordingly, petitioners have failed to demonstrate that they were not negligent in claiming these disallowed*204 deductions.
Lastly, we turn to whether a penalty is appropriate due to the double charitable contribution deduction claimed by petitioners on their 1996 return. The evidence demonstrates that petitioners made a mistake in preparing their 1996 return. On brief, petitioners argued that, relying upon
To reflect the foregoing,
Decisions will be entered under
Footnotes
1. All section references are to the Internal Revenue Code in effect for the taxable years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
The parties stipulated that petitioners deducted
$ 67,543 in research and development expenses. However, the column
totals to $ 67,544 and the notice of deficiency and petitioners' 1995
return state $ 67,534 as the amount deducted.
3. The parties have conceded that there will be no deficiency in tax due from or overpayment in tax due to petitioner CPSG, Inc. Therefore, an accuracy-related penalty under
sec. 6662(a) will not be imposed. Accordingly, the parties have resolved all the issues in docket No. 1821-00.With respect to petitioners in docket No. 555-00, respondent has conceded, inter alia, that petitioners are not liable for the
sec. 6651(a)(1)↩ addition to tax for the taxable year 1994.4. Petitioner was known in the computer industry as a turnaround specialist.↩
5. The agreement had a retroactive effective date of Sept. 30, 1992.↩
6. By the terms of the submarketer agreement, CPSG, Inc. was granted an exclusive license to the newly developed software technology. However, pursuant to par. 2.4, the management agreement provided that its terms could not violate the operating terms governing the syndicates. The terms of the syndicates forbade the grant of exclusive rights to the improved technology without explicit permission of the syndicates.↩
7. Petitioner testified that this was one of the primary reasons for conducting the development on his own behalf; personal ownership rights, outside of CPSG, Inc., would give him leverage over CPG and the syndicates.↩
8. The minimum quarterly payments of $ 26,250 were due and owing to petitioner regardless of whether CPSG, Inc. generated any income from the developed technology. The development agreement contemplated that petitioner would receive, at the very least, $ 945,000 over the term of the agreement (36 quarters).↩
9. Petitioner formed CPSGAus in 1994 to manage CPSG, Inc.'s business activities in Australia. CPSGAus provided development, sales, support, and administrative services to CPSG, Inc. 's subsidiaries: InTEXT Systems, Inc., Operating Control Systems, Inc., and Today Systems, Inc.↩
10. CPSG Ventures owned 50.1 percent of Uniplex Software, and IMI owned 49.9 percent. IMI is a United Kingdom publicly traded corporation. Petitioner owned 70 percent of CPSG Ventures, a general partnership, and Karan Erickson, an officer of CPSG, Inc., owned 30 percent.↩
1. The category "Salaries" represents the cumulative amount
paid to individuals living in Australia.↩
11. The deduction of these research and development expenses in 1996 substantially eliminated an approximately $ 1.4 million capital gain realized from the sale of Unify Corp. stock.↩
1. The parties agree that $ 30,020 of this interest is
not deductible on Schedule C, but it is deductible as investment
interest.↩
1. The $ 108,150 amount included the royalty payment of
$ 105,000 plus interest of $ 3,150 for the period 03/31/99 to 12/31/99.
On or about Aug. 1, 1997, CPSG, Inc. informed petitioner that it was
unable to make the minimum royalty payments under the development
agreement. The $ 3,150 is presumably accrued interest for the period
of nonpayment of minimum royalties.↩
1. For the period Oct. 1995 to Sept. 1996, the record
fails to state the actual days upon which interest accrued.↩
12. "CPSG Ventures" is the name of both a partnership in which petitioner was a general partner and petitioner's Schedule C business. See supra note 10.↩
1. Petitioner submitted expense reports to CPSG, Inc.
for his travel and other expenses that he incurred on its behalf and
CPSG, Inc. reimbursed him for these expenses.↩
2. The $ 40,000 was for a charitable contribution made by
CPSG, Inc. on behalf of petitioner.↩
3. Petitioner was a member of the board of directors of
Walker Interactive Systems.↩
13.
Sec. 7491↩ does not apply in this case to shift the burden of proof or production to respondent because the examination of the returns at issue commenced before the statute's effective date.14. Petitioners argue that petitioner was "capable of exploiting the new products;" "At the time the
section 174↩ expenses were paid, there was a realistic prospect that petitioner would enter a trade or business involving the new * * * products;" and that he "intended to market the Developed Technology to new customers as well as existing customers of CPSG." (Emphasis added.)15. In
Commissioner v. Groetzinger, 480 U.S. 23, 36, 94 L. Ed. 2d 25, 107 S. Ct. 980 (1987) , the Court stated that to determine whether or not an income- producing endeavor constitutes a trade or business "' requires an examination of the facts in each case. '" (quotingHiggins v. Commissioner, 312 U.S. 212, 217, 85 L. Ed. 783, 61 S. Ct. 475, 1941-1 C.B. 340 (1941)) . "We accept the fact that to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer's primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify."Id. at 35↩ .16. A taxpayer manifests his "capability" to enter into a business by his technical expertise to market the new technology and his financial ability to conduct the business.
Scoggins v. Commissioner, 46 F.3d 950, 953 (9th Cir. 1995) , revg.T.C. Memo. 1991-263↩ .17. CPSG, Inc. 's initial return position was to deduct the R&D expenditures on its tax return. CPSG, Inc. ultimately amended its return, eliminating the deduction, which petitioners then claimed on their individual tax return.↩
18. There is no evidence of how much time petitioner devoted to this R&D endeavor. Clearly, petitioner monitored the R&D process via telephone, one visit to Australia, and electronic mail communications. However, petitioners do not allege, and we cannot find, that petitioner's activities during the time the R&D expenditures were made were sufficient to constitute a trade or business.↩
19. To which this case is appealable.↩
20. There is a question whether petitioner had the right to use the developed technology. His use may have depended upon the enforceability of the terms of the contract between CPG and CPSG, Inc. which petitioner testified could be canceled by CPG. Indeed, this potential problem was one of the reasons why petitioner decided to structure the R&D contract the way he did.↩
21. Additionally, respondent determined that petitioners were entitled to deduct an additional $ 22,275 from their 1995 return. We presume 1995 is not at issue, since respondent allowed petitioners a greater deduction than was claimed.↩
22. Respondent permitted deductions for reimbursed employee expenses to the extent such reimbursements were included in petitioners' Schedules C gross receipts for the years at issue. The amounts reimbursed by CPSG, Inc. were $ 61,640 and $ 53,618 for 1994 and 1996, respectively.↩
23. For example, on their 1994 return, petitioners reported $ 194,317 in gross receipts for CPSG Ventures on which petitioners claimed an expense deduction of $ 79,881, leaving a net profit of $ 114,436. From the $ 79,881 in expenses claimed, respondent allowed $ 61,640 as a deduction, an amount equal to that which petitioners included in gross income as reimbursements received from CPSG, Inc.↩
24. Petitioner testified that part of the deductions claimed and disallowed were for computer equipment and cellular telephone. See
sec. 280F(d)(4)(A)(v) ;Vaksman v. Comm'r, T.C. Memo 2001-165 ;Nitschke v. Commissioner, T.C. Memo. 2000-230↩ .25. See supra note 13.↩
Related
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