Drobny v. Comm'r of Internal Revenue
| Decision Date | 26 June 1986 |
| Docket Number | Docket Nos. 16985-83,17602-83. |
| Citation | 86 T.C. No. 79,86 T.C. 1326 |
| Parties | SHELDON DROBNY AND ANITA DROBNY, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent v. LOUIS LIFSHITZ AND RUTH LIFSHITZ, Petitioners |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Ps were investors in two research and development programs, a partnership and a joint venture. The programs promised the investors a deduction of $5 for every $1 of cash invested. For each unit of participation, Ps invested $11,000 in cash and $45,000 from the proceeds of bank loans payable in 3 weeks, which were arranged through the programs. At the closing, the proceeds of the loans were transferred to a contractor and to subcontractors ostensibly to fund research; but in fact, they were invested in short-term commercial paper, and when the paper matured, the proceeds were used to pay off the bank loans. Ps claimed their pro rata share of losses resulting from deductions taken by the partnerships for research and experimental expenditures.
HELD: (1) The claimed losses are not deductible because the programs' activities were not engaged in with the actual and honest objective of making a profit; and (2) the claiming of the deductions by petitioner Drobny constituted fraud within the meaning of sec. 6653(b), I.R.C. 1954. Howard L. Stone, Steven B. Nagler, David A. McGuire, and Fred A. Bibeau, for the petitioners in docket No. 16985-83.
Randall S. Goulding, for the petitioners in docket No. 17602-83.
Lauren W. Gore and William C. Sabin, Jr., for the respondent.SIMPSON, JUDGE:
The Commissioner determined the following deficiencies in, and addition to, the petitioners' Federal income taxes for 1979:
+---------------------------------------------------------------+
¦ ¦ ¦Addition to tax ¦
+------------------------+----------+---------------------------¦
¦Petitioners ¦Deficiency¦sec. 6653(b) I.R.C. 19541 ¦
+------------------------+----------+---------------------------¦
¦Sheldon and Anita Drobny¦$10,877 ¦$5,439 ¦
+------------------------+----------+---------------------------¦
¦Louis and Ruth Lifshitz ¦32,052 ¦--- ¦
+---------------------------------------------------------------+
The issues for decision are: (1) Whether the petitioners are entitled to deductions for their proportionate share of losses resulting from alleged research and experimental expenditures by a joint venture and a partnership in 1979; and (2) whether Mr. Drobny is liable for the addition to tax for fraud under section 6653(b) for 1979.
Some of the facts have been stipulated, and those facts are so found.
The petitioners, Sheldon and Anita Drobny, husband and wife, maintained their legal residence in Highland Park, Ill., at the time their petition was filed. They filed their joint Federal income tax return for 1979 with the Internal Revenue Service Center at Kansas City, Mo. The petitioners, Louis and Ruth Lifshitz, husband and wife, maintained their legal residence in Wilmette, 111., at the time their petition was filed in this case. Their joint return for 1979 was filed with the Internal Revenue Service.
Twenty-two investors, 2 including Messrs. Drobny and Lifshitz, participated in two research and development investment programs, Farm Animal Product Venture (FAP) and AloEase Partnership (AloEase). Mr. Lifshitz purchased one unit, a one-twentieth interest, in each program; and Mr. Drobny purchased one-half a unit, a one-fortieth interest, in each program. FAP was a joint venture formed for the purpose of developing and marketing Pork Pardner, a medicine to be fed to farm animals, particularly hogs, for the prevention and treatment of various diseases that decrease the size of litters and adversely affect the health of small pigs. AloEase was formed for the purpose of acquiring, developing, and marketing a treatment to soothe aching or burning human eyes (AloEase product). The investors were treated as general partners in AloEase and were treated as owning FAP as tenants in common. The profits, losses, credits, and cash flow in each program were shared in relation to the investors' ownership interests.
Both Pork Pardner and the AloEase product were to contain aloe vera. Aloe vera is an extract from the Aloe Barbidensisi plant, of which there are approximately 270 species. Because it is thought to have medicinal, painkilling, and healing properties, it is used in a wide range of products for humans and animals.
Isle of Aloe, Inc. (Isle), was incorporated in 1967 for the purposes of conducting research, development, and marketing of aloe vera based products. Between 1967 and 1984, Isle developed and marketed-at least 35 such products. Robert White was one of the original incorporators of Isle and its president and majority shareholder in 1979 and 1980. In June 1979, he contacted Marvin Kamensky to secure funds to conduct the research, development, and marketing of Pork Pardner and the AloEase product. At the end of 1979, Isle had a $668,315 deficit in retained earnings, and in March 1981, it filed for bankruptcy under Chapter 11.
Mr. Kamensky was a partner in the law firm of Kamensky & Landan (the law firm). 3 He arranged research and development tax shelters and was known in Chicago as an attorney with experience in the formation of such tax shelters. He directed and controlled the creation of all of the research and development programs at issue, the creation of all the entities involved in such program (except for Isle), and the material relationships between such entities.
Marc Z. Samotny was an associate with the law firm during 1979 and early 1980. Under the direction of Mr. Kamensky, he prepared all of the documents involved in the transactions which were a part of the programs.
Sheldon Drobny was an Internal Revenue Service agent from 1967 through 1971 and has been a Certified Public Accountant in private practice since 1971. He received the Elijah Watts Sells Award from the American Institute of Certified Public Accountants for being in the top 27 out of 19,000 people who took the CPA exam. He taught income tax accounting for a CPA review course and was an instructor for the IRS while working there, teaching basic and advanced agent training courses in the area of taxation. At all relevant times, he was a partner with Louis Adler in Adler and Drobny, Ltd. (the accounting firm). In December 1978, Messrs. Adler and Drobny promoted four research and development investment programs with a total purchase price of $1,786,000. They promoted a $1,745,000 real estate investment program in December 1977.
In November 1979, Mr. Drobny was informed by Mr. Kamensky of the Pork Pardner and AloEase product programs. Because the necessary transactions had to be completed in December, Mr. Drobny was not initially interested; however, he agreed to review information concerning both programs. In a letter dated November 28, 1979, Mr. Samotny sent Mr. Drobny an outline of the transactions for the two programs, a chart showing the flow of the funds, and a statement of the cash to be invested and the tax benefits to be derived therefrom.
On November 30, 1979, Mr. Samotny wrote to Mr. Drobny again to provide him with a ‘sales kit‘ which contained a more detailed explanation of the FAP and AloEase programs and their tax consequences. In part, the letter stated:
The individual investors will compensate Isle of Aloe in an amount equal to $800,000.00 (comprised of $160,000 in cash and $640,000 in the form of bank loans) for the research and development of the subject animal product. Upon completion of the research and development, the individual investors, acting as tenants-in-common will apply for a patent on the animal product. It is currently contemplated that such application will be made by Isle of Aloe.
* * *
Isle of Aloe, Inc. will subcontract with Swain's corporation in order that it may provide the necessary research and development for the animal product. Isle of Aloe will pay Swain's corporation $750,000.00 pursuant to the subcontract for the research and development. In turn, Swain's corporation will pay to the investors on or about January 15, 1980 an advance minimum royalty equal to $750,000.00 attendant the right to commercially exploit the animal product.
Each individual investor will also be required to enter into a partnership for the exploitation of a second product. It is currently contemplated that this product will be an Isle of Aloe product to be used as an eye wash. The partnership will acquire all of Isle of Aloe's right, title and interest in and to the eye wash product. Subsequently, the partnership will enter into a research and development agreement with Isle of Aloe whereby the partnership will pay to Isle of Aloe $320,000.00 ($60,000.00 cash and $260,000.00 in the form of bank loans) to perform research and development on the product.
Isle of Aloe will, upon receipt of the $320,000.00, make a loan to a corporation to be owned and controlled by Paula Larson in the amount of $150,000.00. This corporation will in turn pay to the partnership $150,000.00 in the form of option money to have the right to commercially exploit the eye wash product. In order to exercise its option the corporation controlled by Paula Larson will also be required to pay $300,000.00 upon exercise of the option and in addition will pay the partnership group a royalty presently contemplated to be eight percent of gross sales. As you are aware, the grant of the option money to the partnership is a non-taxable event until such time as either the option is exercised or the option period lapses.
In the materials sent by Mr. Samotny to Mr. Drobny on November 30, 1979, one sentence was devoted to describing each product, and tax and cash analyses were included. It was indicated that a purchaser of a unit would contribute $11,000 in cash, that he would borrow $45,000, and that he would...
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