86 T.C. 598 (1986), 8087-81, Hagler v. C.I.R.

Docket Nº:8087-81, 2813-83, 22334-82, 15159-83.
Citation:86 T.C. 598
Opinion Judge:SWIFT, JUDGE:
Party Name:JOEL HAGLER and IRENE HAGLER, ET AL., [1] Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Attorney:Jerome Kamerman and Steven Kamerman, for the petitioners. Alan J. Kaufman and Jody Tancer, for the respondent.
Case Date:April 03, 1986
Court:United States Tax Court

Page 598

86 T.C. 598 (1986)

JOEL HAGLER and IRENE HAGLER, ET AL., [1] Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 8087-81, 2813-83, 22334-82, 15159-83.

United States Tax Court

April 3, 1986

Petitioners invested in a partnership that acquired a license to enhance and sell a computer program for the preparation of income tax returns. The partnership entered into a research and development agreement with a corporation under which the enhancements to the computer program were to be made.

Held: a $1,200,000 nonrecourse promissory note issued by the partnership in connection with the license of the computer program was illusory on the day it was signed, December 31, 1976. The promissory note is therefore subject to the at-risk rule of sec. 704(d), I.R.C. 1954 (the predecessor to sec. 465(b), I.R.C. 1954), which became effective on January 1, 1977. HELD FURTHER, interest deductions claimed in 1977, 1978, and 1979 with respect to nonrecourse debt obligations of the partnership are not allowed because the debt obligations do not constitute genuine indebtedness.

HELD FURTHER, investment credits and deductions claimed by the partnership for research and development, depreciation, management fees, professional fees, and operating expenses are disallowed because the activities of the partnership relating to the license of the computer program and the research and development agreement did not constitute a trade or business or an activity entered into for profit. Other miscellaneous issues decided.

Jerome Kamerman and Steven Kamerman, for the petitioners.

Alan J. Kaufman and Jody Tancer, for the respondent.

Page 599

SWIFT, JUDGE:

In timely statutory notices of deficiency, respondent determined deficiencies in petitioners' Federal income tax liabilities as follows:

Petitioners Years Deficiencies
Joel Hagler and 1977 $2,621.00
Irene Hagler 1978 4,624.00
Frederick M. Dahlmeier and 1977 18,273.62
Jane G. Dahlmeier 1978 12,251.40
1979 6,968.96
Thomas C. Mullen and 1977 15,330.66
Joann Mullen 1978 12,760.56
1979 8,648.16
These cases were consolidated by Order of the Court dated March 23, 1983. The Federal income tax deficiencies in dispute herein relate to partnership losses arising from petitioners' investments in a limited partnership by the name of ‘ Reportco‘ . The primary issues for decision are: (1) Whether a $1,200,000 nonrecourse promissory note signed on December 31, 1976, was a genuine debt on that day; (2) whether amounts paid and accrued as interest on nonrecourse promissory notes constituted interest with respect to genuine indebtedness; and (3) whether activities of the partnership with respect to a license of a computer program and research and development to enhance the computer program constituted a trade or business or an activity entered into for profit. FINDINGS OF FACT Some of the facts have been stipulated and are so found. At the time of filing their petitions in this case, petitioners Joel and Irene Hagler were husband and wife and resided in Los Angeles, California; petitioners Frederick M. and Jane G. Dahlmeier were husband and wife and resided in Riviera Beach, Florida; and petitioners Thomas C. and Joann Mullen were husband and wife and resided in Woodbury, New York. Petitioners timely filed joint Federal income tax returns for the years in issue. FORMATION OF REPORTCO Reportco is a Connecticut limited partnership which was formed on June 25, 1975. The original name for the Page 600 partnership was Phoenix Associates XIV. At the time the partnership was formed, the sole general partner of Reportco was Phoenix Resources, Inc. (‘ Phoenix Resources‘ ), and the sole limited partner of Reportco was Carl Paffendorf (‘ Paffendorf‘ ). Originally, the profits, losses, and distributions of Reportco were allocated 95 percent to Paffendorf as the sole limited partner. The original allocation of the remaining five percent of Reportco's profits, losses, and distributions is not established in the record herein. The stated purpose of Reportco was to engage in the business of real estate development and sales. The stock of Phoenix Resources was owned 80 percent by Vanguard Ventures, Inc. (‘ Vanguard Ventures‘ ). The ownership of the remaining 20 percent of the stock of Phoenix Resources is not established in the record herein. The president of Phoenix Resources was Burton Kassell, and the secretary and chairman of the board of directors was Mr. Paffendorf. The stock of Vanguard Ventures was owned 88 percent by Paffendorf. The ownership of the remaining 12 percent of the stock of Vanguard Ventures is not established in the record. Paffendorf was the secretary and chairman of the board of directors of Vanguard Ventures. Vanguard Ventures was in the business of promoting tax shelters. THE LICENSE AGREEMENT AND THE NONRECOURSE PROMISSORY NOTE The partnership losses at issue herein arose in the context of certain agreements that Reportco entered into with Digitax, Inc. (‘ Digitax‘ ) and Hi-Tech Research, Inc. (‘ Hi-Tech‘ ), both of which were corporations that were wholly owned subsidiaries of COAP Systems, Inc. (‘ COAP‘ ). COAP was a publicly traded corporation of which Paffendorf was president, chairman of the board of directors, and controlling shareholder. [2] Vanguard Ventures also was a shareholder of COAP. [3] Page 601 Digitax was engaged in the business of preparing individual Federal and state income tax returns. Between 1973 and 1976, petitioner Joel Hagler (‘ Hagler‘ ), a certified public accountant, and Robert Keane (‘ Keane‘ ), a computer programmer, were employed by COAP to develop and maintain computer programs and computer systems used by Digitax. Digitax offered a computerized remote batch processing income tax service; that is, tax return preparers would send client tax information to Digitax on computer input forms. Digitax would process the information on its mainframe computer, after which completed returns would be mailed to the preparers. By 1976, Digitax had established a reputation and a national clientele. It had begun marketing its computerized income tax return preparation service in 1969 and prepared about 17,000 income tax returns in that year. Also in that year, Digitax entered into a marketing agreement with Prentice-Hall, Inc., under which Prentice-Hall agreed to sell the Digitax tax return preparation service. By 1976, Digitax had become one of the 12 leading computerized income tax return preparation services in the United States. In the fall of 1976, Paffendorf concluded that the Digitax computer program for the preparation of tax returns could be modified and thereafter the program itself could be sold or licensed to accountants and tax return preparers who then could use the modified program on their own minicomputers in their own offices. [4] The possibility of offering accountants and tax return preparers a product that would enable them to process tax returns on their own computers and in their own offices was regarded by Paffendorf as a potentially profitable business opportunity. Paffendorf approached Hagler and Keane about his idea. The three individuals agreed that the idea was feasible and potentially lucrative. Paffendorf agreed to be responsible for finding investors for the project. Paffendorf decided to use Reportco (then Phoenix Associates XIV) as the partnership through which funds for the project would be raised. He also decided that Reportco Page 602 would acquire from Digitax a license to use Digitax's existing computer program for the preparation of tax returns. Paffendorf did not pursue the project further until the afternoon of December 31, 1976, when he was reminded that contracts entered into after December 31, 1976, would be subject to a substantial change in the Federal tax laws that would limit the extent to which losses would be available with respect to nonrecourse indebtedness. Paffendorf, therefore, sometime in the late afternoon or early evening of December 31, 1976, wrote a handwritten document (hereinafter referred to as the ‘ License Agreement‘ ), in which it was stated that Digitax licensed to Reportco its computer program for the preparation of income tax returns for $1,500,050. The amount due under the License Agreement was to be paid by Reportco in the following manner: $50 cash upon signing, $300,000 cash due on or before May 31, 1977, and a $1,200,000 nonrecourse promissory note. Paffendorf alone established the terms and consideration set forth in the handwritten License Agreement. No independent appraisal of the value of the Digitax computer program, or of a license thereof, was obtained by Paffendorf until September of 1977, and no arm's-length negotiations took place between representatives of Reportco and Digitax. The exact language of the handwritten License Agreement is set forth below: License Agreement DATED: 12-31-76 Agreement made as of the 3lst day of December, 1976 by & between Digitax, Inc of Albertson, N.Y. (‘ Dig‘ ) and (Reportco) a Conn. limited partnership (‘ ptnshp‘ ). Whereas, Dig has a large scale remote processing federal 1040 income tax computer program and the state and city programs as described in Exhibit A; and Partnership, wishes to develop (sic) a minicomputer tax system for use within the tax preparer's office on a relatively low volume per installation basis. Now, therefore, in consideration of these premises, it is agreed: (1) LICENSE - Dig hereby licenses Ptnshp to make a copy of its 1040 programs as described in Exhibit A by transferring the information from Dig tapes to ptnshp tapes and use said information (‘ system‘ ) in developing a minicomputer tax system for use w/i the individual tax Page 603 preparer's office. Minicomputer shall be any computer selling for less than $100,000 new at current comparative rates. (2) TERM - The term of this license shall be until Dec. 15, 2015. (3) CONSIDERATION -...

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