Diamond v. Comm'r of Internal Revenue
| Decision Date | 23 February 1989 |
| Docket Number | Docket No. 39473-86 |
| Citation | 92 T.C. 423,92 T.C. No. 25 |
| Parties | LOUIS H. AND MADELENE DIAMOND, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Petitioner was a limited partner in Robotics which was a limited partner in the Project Partnership, an Israeli limited partnership. The Project Partnership's general partner was Elco, a publicly held Israeli corporation. The Project Partnership was formed to conduct research and development work with respect to an arc welder with an optical seam follower. The Project Partnership Agreement gave Elco the right to manufacture, produce, and/or market the welder as exclusive and irrevocable licensee. HELD: expenditures of the Project Partnership were not in connection with any trade or business, and petitioner is not entitled to deductions under section 174. Spellman v. Commissioner, 845 F.2d 148 (7th Cir. 1988), followed; HELD FURTHER: deductibility of guaranteed payments, consulting fees, legal fees, accounting fees, and organizational expenses determined; HELD FURTHER: petitioner is not liable for an addition to tax pursuant to section 6659; HELD FURTHER: petitioner's liability for increased interest under section 6621(c) will be determined by the parties' Rule 155 computation. Joseph M. Jones, Samuel Paul Kastner, and Robin Kofsky Gold, for the petitioners.
Dianne Crosby and David Click, for the respondent.
By statutory notice dated July 14, 1986, respondent determined deficiencies in and additions to petitioners' Federal income tax for the years and in the amounts as follows:
+-----------------------------+
¦ ¦ ¦Addition to tax ¦
+----+-------+----------------¦
¦Year¦Amount ¦sec. 66591 ¦
+----+-------+----------------¦
¦1981¦$19,174¦$5,752.20 ¦
+----+-------+----------------¦
¦1982¦7,523 ¦2,256.90 ¦
+-----------------------------+
Respondent also determined that petitioner was liable for increased interest under section 6621(c). The issues are: (1) whether Elco R&D Associates (the Project Partnership), an Israeli limited partnership, was engaged in a trade or business so that expenses incurred by it in 1981 and 1982 for research and development may be deducted pursuant to section 174; (2) whether Robotics Development Associates, L.P., (Robotics), a Maryland limited partnership in which petitioner was a limited partner, is entitled to deduct payments to its partners for management fees; (3) whether and to what extent Robotics may amortize its claimed partnership organizational expenses over 60 months pursuant to section 709; (4) whether Robotics is entitled to deductions for legal, accounting and consulting expenses; (5) whether petitioner is liable for an addition to tax pursuant to section 6659; and (6) whether petitioner is liable for increased interest pursuant to section 6621(c). Should petitioner prevail on the primary issue pertaining to research and development expenditures, the parties have agreed that further briefing will be necessary to enable the Court to reach a decision as to the extent such research and development expenditures may be deducted under the Project Partnership's method of accounting.
Some of the facts are stipulated and are so found. The stipulation and attached exhibits are incorporated herein by this reference. At the time the petition was filed, Louis Diamond was a resident of Bethesda, Maryland, and Madelene Diamond 2 was a resident of Washington, D.C.
This dispute arises from petitioner Louis Diamond's ownership of an interest in Robotics, a Maryland limited partnership, which was a limited partner in the Project Partnership, an Israeli limited partnership. The Project Partnership's general partner is Elco Ltd. (Elco), a publicly held Israeli Corporation. Robotics was organized in 1981 with three general partners and initially one limited partner holding a 99-percent interest. This limited partner interest was divided into 26 limited partnership interests which were sold to investors including petitioner.
Robotics' general partners are Itzhak Yaakov (Yaakov), G-B Energy Systems, Inc. (G-B Energy), and the managing general partner, Capital Corporation of Washington (Capital), each of whom contributed $16,100 3 for a 1/3-percent interest in Robotics. Yaakov, who resided in New York during the years in issue, was formerly a general in the Israeli army in charge of research and development. From 1974 through 1977 he was the Chief Scientist in the Israeli Ministry of Industry. G-B Energy is a Connecticut corporation wholly owned by Jacob E. Goldman (Goldman), who was formerly director of Ford Motor Company's Scientific Research Laboratory and head of research and development at Xerox Corporation. Capital is a District of Columbia Corporation wholly owned by Robert E. Slavitt (Slavitt), who is an investment banker and is involved in organizing research and development projects in Israel. 4 Slavitt first became involved in organizing and funding research and development projects in Israel in 1981. From that time until the time of trial, he had been involved in projects with 13 different Israeli companies. Each of the Israeli companies with which he was involved was marketing in the United States through either joint ventures or OEM (other equipment manufacturer) contracts. 5 Slavitt had been involved with three Israeli companies which had tried unsuccessfully to penetrate the U.S. market on their own.
Slavitt and Yaakov first met in May 1981. They discussed the general climate for investment in high technology in Israel, and Yaakov introduced Slavitt to several specific projects, including a project proposed by Elco for the development of an arc welder with an optical seam follower (the Project or the robot). As a result of that meeting, Slavitt investigated each of the proposed investments. He subscribed to a number of professional magazines dealing with robotics and performed a certain amount of research to familiarize himself with the field. He obtained data from the Department of Commerce, and spoke with several technicians, including Goldman. From his investigation, Slavitt became convinced that robotics was a viable, promising industry. He learned that the United States was behind the Japanese in utilizing this technology, but was trying to catch up, thus creating a potentially large U.S. market for this kind of technology.
After identifying robotics as an area in which he might want to invest, Slavitt retained the services of Goldman and asked him to go to Israel to investigate certain aspects of the Project as then proposed. Particularly, Goldman was asked to assess the feasibility of the technology, the ability of Elco to pursue and develop the technology, and the market for any product which might be developed. Goldman returned with the opinion that, while there are no automobile manufacturers in Israel, robotics technology would be well-suited for that use in the United States. As a result of Goldman's investigation, Slavitt became convinced not only of the promise of robotics technology, but of the talent which Goldman possessed in both the technical and marketing areas.
On August 20, 1981, Slavitt himself went to Israel to further investigate the Project. While there, he consulted both American and Israeli counsel concerning tax and other matters. During this trip, he was introduced to representatives of Elco who gave him an overview of the Project, and convinced him that they had the ability to develop a marketable product. However, because Elco did not have the funds to pursue the research and development of the technology either alone or in conjunction with the Chief Scientist's office, it sought outside investors.
Elco had been approached by three different investors, but decided to team up with Robotics because of the expertise and connections of Yaakov and Goldman, both of whom were expected to contribute at later stages in the development of the robot. Elco expected to draw upon Yaakov's expertise in research and development and his connections with the Chief Scientist's office, while Goldman's participation was sought because of his connections with the U.S. automobile industry and his expertise in the technical and marketing areas. Elco desired that these two men be partners in any venture or entity that invested in the robot so as to give them some financial incentive.
Through its general partners, Yaakov and Slavitt, Robotics entered into negotiations with Elco for the formation of a joint venture for the development and exploitation of the Project. Elco was represented by its Vice-President for Finance, Uri Kviatek. These negotiations culminated in an agreement dated May 1, 1981, 6 which formed the Project Partnership. Pursuant to this Project Partnership Agreement, Elco was to contribute to the Project Partnership the lesser of 5.88 percent of the total investment 7 in the Project or $250,000. Elco was also to contribute ‘the exclusive right, title, and interest in all the Technology which it presently possesses as well as any Technology conceived, made, gained, acquired or developed in the course of or as a result of the implementation of the Project * * *.‘ For its part, Robotics was to contribute $500,000 upon the approval of the Project by the Chief Scientist and execution of a loan agreement with the Industrial Development Bank, and cash in installments during the following months and in the following amounts:
+-----------------------+
¦Month ¦Amount ¦
+--------------+--------¦
¦February 1982 ¦$325,000¦
+--------------+--------¦
¦July 1982 ¦75,000 ¦
+--------------+--------¦
¦February 1983 ¦325,000 ¦
+--------------+--------¦
¦July 1983 ¦275,000 ¦
+--------------+--------¦
¦February 1984 ¦325,000 ¦
+--------------+--------¦
¦May 1984 ¦150,000 ¦
+-----------------------+
The Project Partnership Agreement conferred upon Elco the following additional rights and...
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