86 T.C. 848 (1986), 1026-83, Waddell v. C.I.R.
|Citation:||86 T.C. 848|
|Opinion Judge:||PARKER, Judge:|
|Party Name:||WARNER R. WADDELL AND JEANETTE WADDELL, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent|
|Attorney:||Kenneth M. Barish, Anita G. Paleologos, Arthur H. Boelter, and Henry W. Walther, for the petitioners. Larry N. Johnson, for the respondent.|
|Case Date:||April 28, 1986|
|Court:||United States Tax Court|
Pursuant to Comp-U-Med's offering circular, Ps applied for four medical equipment franchises. Comp-U-Med approved Ps' application on December 30, 1980. Each franchise included the purchase of one of Comp-U-Med's computerized electrocardiogram (ECG) terminals. For each franchise and terminal, Ps paid $6,000 in cash and executed a note in the amount of $25,000. Comp-U-Med labeled $500 of the $6,000 as a ‘ franchise fee‘ and $3,000 as a ‘ first year royalty.‘ Comp-U-Med allocated the remaining $2,500 of cash and all of the $25,000 note to the ECG terminal, for a purported purchase price of $27,500 per terminal. The initial term of each franchise was seven years, but upon payment of a $200 fee, Ps could renew the franchise for an additional term of seven years. The note, also for an initial term of seven years, was labeled as recourse. Ps' only obligation during the initial seven-year term, however, was to make a minimum payment of $1,500 per year, which was denominated as interest at the stated rate of six percent of the stated principal of $25,000. Any payments of principal prior to maturity were due only out of Ps' net exploitation revenues. The note could be renewed for an additional seven years if Ps renewed the franchise; moreover, for payment of $1,000 (allocated to principal) during the extended term, Ps could ‘ convert‘ the note to nonrecourse.
Simultaneously with applying for their computerized ECG franchises, Ps executed distribution agreements with independent medical equipment distributors for each of the terminals they were to acquire, and executed a management services contract with an independent firm.
Held, Ps' computerized ECG terminal franchise venture was an activity engaged in for profit.
Held further, the ‘ first year royalty‘ fee Ps paid was a nondeductible capital expenditure, representing part of their franchise acquisition costs.
Held further, Ps' computerized ECG terminals were placed in service (for purposes of depreciation and the investment credit) during 1980, the taxable year in issue.
Held further, the bulk of Ps' purchase money note is too contingent to be treated as a true indebtedness for Federal tax purposes.
Held further, since the $25,000 note is not a true indebtedness for Federal tax purposes, the $1,500 minimum annual payment is not deductible as an interest payment.
Held further, amount of bona fide indebtedness determined. At most only the obligation represented by the minimum annual payments, the renewal fee, and the conversion payment is bona fide indebtedness and part of Ps' cost basis in their investment.
Held further, Ps' depreciable basis in the terminals is limited to their fair market value. Fair market value determined.
Held further, the balance of Ps' cost is part of their amortizable basis in their franchise rights. Lemmen v. Commissioner, 77 T.C. 1326 (1981), followed.
Held further, Ps are not at risk even with respect to the portion of their purchase money note that is bona fide debt because Comp-U-Med, their lender/seller, has an interest in the activity other than as a creditor. Sec. 465(a), (b), I.R.C. 1954. Thus, for 1980, the taxable year in issue, the amount for which Ps are at risk is limited to their cash investment.
Held further, Ps are liable for the delinquency addition under section 6651(a).
Respondent determined a deficiency of $4,833 in petitioners' 1980 Federal income tax and an addition to tax of $1,208 under section 66 1(a).  At issue in this case are various deductions and an investment tax credit claimed by petitioners in regard to their acquisition of four electrocardiogram (ECG) analysis computer terminals pursuant to franchise agreements with Comp-U-Med, the equipment's manufacturer. The issues for decision are:
(1) Whether petitioners' computerized ECG terminal franchise venture was an activity engaged in for profit;
(2) Whether, and if so to what extent, certain payments petitioners made to Comp-U-Med in 1980, denominated as royalties, are deductible expenses;
(3) Whether for purposes of depreciation and the investment tax credit petitioners' computerized ECG terminals were placed in service during 1980;
(4) Whether, and if so to what extent, petitioners' purchase money note, allocated to the computerized ECG terminals, was a ‘ true debt‘ for Federal tax purposes;
(5) Whether, and if so to what extent, petitioners were ‘ at risk‘ with respect to their computerized ECG terminal venture, within the meaning of section 465; and
(6) Whether petitioners' failure timely to file their 1980 Federal income tax return was due to reasonable cause and not due to willful neglect within the meaning of section 6651(a)(1).
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of fact and exhibits attached thereto are incorporated herein by this reference.
Petitioners, husband and wife, resided in Portland, Oregon at the time they filed their petition in this case. Petitioners filed a joint Federal income tax return (Form 1040) for l980. Their return preparer, an accountant, signed the return on April 13, 1981; Warner R. Waddell signed the return on May 5, 1981;  and the return was filed in respondent's Ogden, Utah Service Center on May 7, 1981.
Electrocardiography is a diagnostic process for studying the functioning of the heart. A device known as an electrocardiograph is used to measure the electrical activity of the heart, and this measurement is reported on a tracing or strip chart, called an electrocardiogram (ECG). First developed in the late nineteenth century, electrocardiography had by 1940 become an accepted diagnostic technique within the medical profession.
During the 1960's several medical institutions (including the United States Public Health Service, the Veterans' Administration and the Mayo Clinic) developed systems for using computers to receive and analyze electrocardiograms. After the Public Health Service had made public its program for ‘ computerized‘ electrocardiography in 1969, many private companies began developing and marketing computerized ECG systems. The early l970's saw a gradual increase in the accuracy of the computer analyses, due to improvements in the software (programming). By the middle to late l970's, computerized electrocardiography was well accepted in the medical community, and there were several established companies offering computerized ECG systems to various segments of the health care industry. The basic technology for the ECG equipment that performs the electrocardiogram
has remained essentially unchanged for the past 50 years. As noted above, the development has been in computerized analysis or interpretation of the electrocardiogram. Although there have been continuing improvements in the computer software to perform this analysis, no fundamental, radical changes in the hardware for computer ECG analysis was anticipated in the period of the early l980's. Changes in the ECG machines and computer terminals usually related to improvements to make them easier for the doctor or technician to use.
Comp-U-Med, Inc., is a company specializing in technology for medical diagnostic systems. Comp-U-Med, Inc., designs, develops, and manufactures computer-based electronic systems for use by physicians, clinics, hospitals, health-maintenance organizations (HMO's), and industrial and corporate health care facilities. Comp-U-Med Systems, a wholly owned subsidiary of Comp-U-Med, Inc., was formed to facilitate sales of Comp-U-Med's product by offering franchises to individual investors. For simplicity, we shall treat Comp-U-Med, Inc., and Comp-U-Med Systems as a single company (‘ Comp-U-Med‘ ). 
Comp-U-Med's principal product is its System 107 Computer ECG Terminal, a device used to administer an electrocardiogram, transmit the data to a mainframe computer for analysis, and then receive back the computer's analysis or interpretation. This model, essentially an updated, mass-produced version of its earlier prototype Model 103, was first sold in 1978.  From 1978 through 1982, Comp-U-Med marketed its System 107 exclusively through its franchise program, as described below. Comp-U-Med has sold no franchises since the early spring of 1982.
During the middle to late l970's, when Comp-U-Med was formulating its marketing plans for its System 107 terminals, venture capital was scarce. Comp-U-Med was unable to obtain ordinary equity financing. The computer industry had traditionally used third-party lessors as a technique for
financing computers. However, because it was new to the computerized ECG industry and had no track record, Comp-U-Med believed it could not use conventional third-party financing (i.e., sale and leaseback). Comp-U-Med wanted quickly to capture as large a market share as possible, which meant making the ECG terminals available with a minimal financial commitment by the various users. As an innovative financing method and to facilitate its ambitious marketing goals, Comp-U-Med devised its franchise system: Comp-U-Med would sell its terminals to individual investors (largely on credit), giving a right of access to its central processing (mainframe) computers on a fee-for-use basis. The individual investors would be primarily responsible for placement of their terminals with...
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