Independent Elec. Supply, Inc. v. C.I.R.

• Decision Date: 24 January 1986
• Docket Number: Nos. 85-7060,85-7077,s. 85-7060
• Citation: 781 F.2d 724
• Parties: -665, 86-1 USTC P 9192 INDEPENDENT ELECTRIC SUPPLY, INC., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. Frank PRESTIPINO and Leana Prestipino, Hildegard K. Marks, and Jean D. Littlefield, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 724

781 F.2d 724

57 A.F.T.R.2d 86-665, 86-1 USTC P 9192

INDEPENDENT ELECTRIC SUPPLY, INC., Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Frank PRESTIPINO and Leana Prestipino, Hildegard K. Marks, and Jean D. Littlefield, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nos. 85-7060, 85-7077.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted Dec. 10, 1985.

Decided Jan. 24, 1986.

Clarence J. Ferrari, San Jose, Cal., for Independent Elec. Supply.

J. Richard Johnston, Johnston & Horton, Oakland, Cal., for petitioners-appellants.

Richard Driscoll, Ann Belanger Durney, Dept. of Justice, Tax Div., Washington, D.C., for respondent-appellee.

Appeal from the United States Tax Court.

Before WRIGHT, KENNEDY, and BEEZER, Circuit Judges.

KENNEDY, Circuit Judge:

The taxpayers in these consolidated cases appeal the Tax Court's disallowance of deductions for depreciation, ordinary and necessary business expenses, and research and development expenses. ¹ We affirm.

The appellants each invested in limited partnerships, trusts, or both, set up by Fred Solomon and George Nicoladze for the ostensible purpose of acquiring and exploiting patents. The patents were acquired for the partnerships and trusts by Solomon and Nicoladze for relatively small amounts of cash ($0 to $300,000) and relatively large nonrecourse obligations ($497,000 to $250,000,000). Many were acquired hastily in an effort to avoid limitations on distributive partnership losses attributable to nonrecourse debt which took effect on January 1, 1977. I.R.C. Sec. 704(d) (1976) (subsequently amended by Revenue Act of 1978, Pub.L. No. 95-600, Sec. 201(b), 92 Stat. 2763, 2815-16). The patents, over thirty-five in number, include rights to inventions as diverse as a geothermal turbine, acquired in December 1979 for $300,000 down and a $149,000,000 nonrecourse obligation, and a disintegrating golf tee, acquired, like approximately half the patents, for $3,000 down and a $2,000,000 nonrecourse obligation. None of the patents has earned any net income, and losses associated with the sixteen partnerships and trusts invested in by appellants have exceeded $90,000,000.

The appellants claimed, in their capacities as limited partners or trust beneficiaries deductions for depreciation under I.R.C. Sec. 167(a), ordinary and necessary business expenses under I.R.C. Sec. 162(a), and research and development expenses under I.R.C. Sec. 174(a). As a result of these deductions, the appellants reported large losses with respect to their interests in the partnerships and trusts, losses far in excess of their actual investments. The losses largely reflect the depreciation deductions taken against the inflated basis in the patents provided by the nonrecourse indebtedness.

The Commissioner determined deficiencies in the taxpayers' federal income taxes. The Tax Court denied the taxpayers' petitions for redetermination of the deficiencies, holding that the taxpayers' patent activities did not constitute a "trade or business" required for deductibility under I.R.C. Secs. 162(a), 167(a), and 174(a) since the patents were not held or exploited for profit. Rather, the court found that the primary motivation for the formation and continuance of the partnerships and trusts was tax avoidance, noting that " 'if anything can be described as an "abusive tax shelter," this is it'." Paul J. Lahr v. Commissioner, 53 T.C.M. (P-H) p 84,472, at 1884, 1893 (1984) (quoting Flowers v. Commissioner, 80 T.C. 914, 941 (1983)).

Appellants argue that the Tax Court clearly erred in finding that the trusts and partnerships were not created and continued with the intention of making a profit. Moreover, appellant Independent Electric Supply, Inc. (IES) argues that the court clearly erred in finding that it did not have a profit motive when it invested in three of the patent trusts. IES argues that its own motivation is relevant because, it claims, the existence of a profit motive for a trust should be determined with respect to each beneficiary. Because the Tax Court found no profit motive at either the trust or beneficiary level, it declined to decide at which level business motive should be assessed. We sustain the Tax Court's findings regarding the nonexistence of a profit motive, and we affirm.

The deductions taken by the appellants were claimed under I.R.C. Sec. 167(a), granting a deduction for depreciation of property "used in [a] trade or business" or "held for the production of income"; I.R.C. Sec. 162(a), granting a deduction for ordinary and necessary expenses "incurred ... in carrying on any trade or business"; and I.R.C. Sec. 174(a), granting a deduction for "research or experimental expenditures ... in connection with [a taxpayer's] trade or business." Consequently, in order for a deduction to be taken under any of these provisions, the expense must arise in or in connection with a "trade or business." We have recognized that the primary inquiry when determining whether a particular activity constitutes a trade or business is to ask whether the activity was undertaken or continued "in good faith, with the dominant hope and intent of realizing a profit, i.e., taxable income, therefrom." Hirsch v. Commissioner, 315 F.2d 731, 736 (9th Cir.1963) (interpreting former I.R.C. Sec. 23 (1939)); see Bolaris v. Commissioner, 776 F.2d 1428, 1432 (9th Cir.1985) (considering Secs. 167 and 212); Brannen v. Commissioner, 722 F.2d 695, 704 (11th Cir.1984) (citing Hirsch ); DePinto v. United States, 585 F.2d 405, 408 (9th Cir.1978) (quoting Hirsch ). In other words, the "basic and dominant" motive behind the taxpayer's activities must be "to make a profit or income from those very same activities." Hirsch, 315 F.2d at 736; see Mercer v. Commissioner, 376 F.2d 708, 710-11 (9th Cir.1967); Doggett v. Burnet, 65 F.2d 191, 194 (D.C.Cir.1933). While the focus of the test is thus on the subjective intention of the taxpayer, objective indicia may be cited to establish the taxpayer's true intent. Treas.Reg. Sec. 1.183-2(a) (1972). Treasury Regulation Sec. 1.183-2(b) lists factors to be considered when ascertaining a taxpayer's intent:

1. The manner in which the taxpayer carries on the activity;

2. The expertise of the taxpayer or his advisors;

3. The time and effort expended by the taxpayer 4. The expectation that assets used in the business may appreciate in value;

5. The success of the taxpayer in carrying on similar or dissimilar activities;

6. The taxpayer's history of income or losses with respect to the activity;

7. The amount of occasional profits, if any, which are earned;

8. The financial status of the taxpayer; and

9. Elements of personal pleasure or recreation.

Treas.Reg. Sec. 1.183-2(b) (1972). While it is true that I.R.C. section 183 itself does not come into play until after it is determined that an activity is not engaged in for profit, the courts have relied on the section 183 factors in conducting the profit motive analysis under section 162. Brannen, 722 F.2d at 704. This list is nonexclusive, id., and the assessment of motivation is made after considering all the facts and circumstances of each case, Treas.Reg. Sec. 1.183-2(a) (1972); see Hirsch, 315 F.2d at 737.

In reaching its conclusion that the patent activities in this case, whether viewed at the entity or investor level, were not undertaken primarily for profit, the Tax Court observed that (1) the purchase prices of the patents were "grossly inflated" through the use of nonrecourse indebtedness without any real negotiation or serious investigation of patent marketability; (2) the partnerships and trusts were promoted by emphasizing the projected tax benefits of investment in them, potential investors being provided with tax loss projections but little or no information on the economic viability of the patents; (3) no profits were realized by any of the trusts or partnerships at issue, while aggregate losses of over $90,000,000 have been claimed; (4) there was no possibility the patents themselves would increase in value given the grossly inflated price paid for them; and (5) the partnerships and trusts were not operated in a businesslike manner. This court will not disturb the Tax Court's determination unless it is clearly erroneous. Bolaris, 776 F.2d at 1432; Hirsch, 315 F.2d at 738. Moreover, the taxpayer bears the burden of proving "that the facts bring his case squarely within the deduction provisions of the statute." Hirsch, 315 F.2d at 738; see also Bolaris, 776 F.2d at 1432 (burden of proving a profit motive on taxpayer).

Appellants focus on the nine factors in Treasury Regulation Sec. 1.183-2(b) in urging that a profit motive existed for the trusts and partnerships. At best, however, appellants manage only to show that their activities might have had a profit motive; they do not show that the Tax Court was clearly erroneous in finding that the generation of large tax losses was in fact the dominant motivation behind the trusts and partnerships created and managed by Solomon and Nicoladze. For example, appellant IES argues that the three patent trusts in which it invested--the Geothermal Turbine Patent Trust, the A.C. Generator Trust, and the Apparatus for Sterilizing Meat Products Trust ²--were (at least at the time of its investment) well managed, employed skilled persons to develop the patents, had made steady progress toward developing prototypes, and received, along with the other trusts and partnerships, the full-time development efforts of Solomon and Nicoladze. Moreover, IES argues that the history of substantial losses suffered by the trusts so far has resulted from "unforeseen or fortuitous circumstances" beyond their control, and that the future profit potential for the patents is "enormous." Unfortunately, there is little support for the prediction of future profitability, there being no evidence of commercial (as...