Diamond v. C.I.R., 89-2817

• Decision Date: 06 May 1991
• Docket Number: No. 89-2817,89-2817
• Citation: 930 F.2d 372
• Parties: -804, 91-1 USTC P 50,186 Louis H. DIAMOND, Madelene Diamond, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Fourth Circuit

Page 372

930 F.2d 372

67 A.F.T.R.2d 91-804, 91-1 USTC P 50,186

Louis H. DIAMOND, Madelene Diamond, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 89-2817.

United States Court of Appeals Fourth Circuit.

Argued May 8, 1990.

Decided April 11, 1991.

As Amended May 6, 1991.

Gerald William Heller, argued (Samuel P. Kastner, Robin K. Gold, on brief), Laxalt, Washington, Perito & Dubuc, Washington D.C., for petitioners-appellants.

Robert Leslie Baker, argued (Shirley D. Peterson, Asst. Atty. Gen., Gary R. Allen, Robert S. Pomerance, Peter K. Scott, Acting Chief Counsel, I.R.S., on brief), Tax Div., U.S. Dept. of Justice, Washington, D.C., for respondent-appellee.

Before PHILLIPS, Circuit Judge, SMITH, Senior United States Circuit Judge for the Federal Circuit sitting by designation, and YOUNG, Senior U.S. District Judge for the District of Maryland, sitting by designation.

EDWARD S. SMITH, Senior Circuit Judge:

Louis H. Diamond and Madelene Diamond appeal the decision of the United States Tax Court, entered July 20, 1989, pursuant to its opinion filed February 23, 1989. The Tax Court found taxpayers liable for deficiencies in income tax for the tax years 1981 and 1982 in the respective amounts $20,943.09 and $7,922.00, with interest. ¹

Taxpayers ² appeal only one issue decided by the trial court: Whether deductions of research and development expenditures by a partnership meet the requirements of Appellant's standing arises from his direct ownership of a limited partnership interest in a Maryland limited partnership which, for the purposes of this summary, was the vehicle for his indirect ownership of a limited partnership interest in an Israeli limited partnership. Under established "flow-through" principles of partnership income tax law, partnerships generally are not taxable entities in themselves. Therefore, income and deductions generated by partnerships are generally given tax effect in the returns of the individual partners. In this case, the "flow-through" item was taxpayer's distributive share of partnership net operating losses resulting principally from research and experimental expenditures.

                section 174(a)(1) of the Internal Revenue Code of 1954. 3   We affirm
                

The question to be answered in order to resolve the issue here is whether Elco R & D Associates, the Israeli limited partnership, was engaged during the tax years 1981 and 1982 in a trade or business within the meaning and intent of section 174(a)(1). In a well-reasoned opinion, the Tax Court made findings of facts upon which it concluded that neither partnership was so engaged. We agree with the trial court. The deduction, not qualifying as to the partnership, is therefore unavailable to the partners.

A comprehensive account of the complex facts of the case may be found by reference to the opinion of the trial court. Following are the facts pertinent to this appeal.

Elco R & D Associates (the project partnership), a joint venture in the form of an Israeli limited partnership, was formed for the project of developing and exploiting a robot arc welder and/or an optical seam follower for use in the automotive manufacturing industry (the project). The project partnership had one general partner, with a 5.88% ownership interest; and one limited partner, with a 94.12% ownership interest.

The sole limited partner of the project partnership was itself a partnership formed under Maryland law and known as Robotics Development Associates Limited Partnership (Robotics). Appellant's direct interest as a partner was through his limited partnership interest in Robotics. ⁴

The sole general partner of the project partnership was Elco Ltd. (Elco), a publicly held corporation organized under Israeli law. A subsidiary of Elco, also an Israeli corporation, was Elco Robotics Ltd. (Elco subsidiary).

For purposes of simplicity, we restate operational facts found by the trial court. The project was undertaken by the project partnership pursuant to an agreement (Project Partnership Agreement), to which Robotics and Elco were parties. Essentially, Robotics provided much of the necessary capital utilized by the project partnership, although contributions by Elco and loans from the Israeli government were involved. Technology and research were furnished to the project partnership by Elco. Other functions such as manufacturing, production, marketing and management were essentially subcontracted to Elco or to Elco subsidiary.

The bona fides of the purposes and operation of the project, the relevant expenditures, and the competency of those involved are not in issue. The question arises from additional rights and duties conferred upon Elco or Elco subsidiary by Paragraph 5 of the Project Partnership Agreement:

5. Obligations and Undertakings by [Elco]

(a) Research and Development; Exploitation.

* * * * * *

(ii) [ELCO] agrees that (1) the actual research and development work on the Project shall be carried out by [Elco], at its premises and using primarily its employees and equipment, (2) it will provide, within the framework of the budget of the Project approved by the Chief Scientist, such personnel and facilities and devote such time to the Project as shall be required for the diligent pursuit of the Project Partnership's objectives, (3) the undertakings of [Elco] under this Agreement shall be performed or otherwise carried out under the general supervision and management of Mr. Gideon Gelman or a suitable successor selected by [Elco]; provided, however, that [Elco] may employ a third party (including, without limitation, an affiliate) as sub-contractor to carry out all or part of the research and development work on the Project or may consult with any third party (including, without limitation, an affiliate) in connection with the research and development work on the Project if (y) such employment of a sub-contractor or consultation shall not violate the [Chief Scientist] Agreement and (z) such employment of a sub-contractor or consultation shall not in any manner relieve [Elco] of its obligations under this Agreement in respect of the research and development work on the Project.

(iii) In the event that [Elco] determines that the manufacturing, production and/or marketing of any product resulting from the research and development work of the Project should be carried out by [Elco] and/or any one or more of its affiliates, (1) such manufacturing, production and/or marketing activity shall be carried out exclusively by it and/or any such affiliate in the capacity of an exclusive and irrevocable licensee (such license to survive the termination of the Project Partnership), * * * and not in [Elco's] capacity as a general partner of the Project Partnership, * * *. Notwithstanding the foregoing provisions * * * it is hereby agreed that [Elco] or such affiliate shall have no obligation to carry out any manufacturing, production and/or marketing itself in the event that [Elco] shall determine that such manufacturing, production and/or marketing should be carried out wholly or partly by any third party or parties * * *.

The Tax Court found that the project partnership and Robotics could not reasonably be expected to carry on the trade or business of exploiting the robot project in light of the rights conferred upon Elco by these provisions of the Project Partnership Agreement. Thus, it concluded, as the facts existed in 1981 and 1982, there would never be a trade or business, conducted by a partnership in which appellant had an interest, in connection with which such research or experimental expenditures were or would be made.

Under early interpretations of section 174(a)(1), research or experimental expenses such as those involved here were held to be not deductible unless they were incurred or paid after the actual commencement of business. The Supreme Court departed from this approach in its decision and opinion in Snow v. Commissioner, 416 U.S. 500, 94 S.Ct. 1876, 40 L.Ed.2d 336 (1974). Accordingly, since the decision in Snow, a taxpayer need not be engaged in a trade or business at the time of expenditure in order to qualify for a deduction under section 174(a)(1), because that provision was intended to encourage high technology start-up ventures. However, for research or experimental expenses to be deductible under section 174, the requirement "in connection with his trade or business" must...