Herrick v. Comm'r of Internal Revenue
| Decision Date | 05 August 1985 |
| Docket Number | Docket No. 3649-83. |
| Citation | 85 T.C. No. 12,85 T.C. 237 |
| Parties | DONALD L. HERRICK AND MARJORIE P. HERRICK, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Petitioner executed the required paperwork to acquire TireSaver (a tire pressure monitoring system) distributorship. Petitioner also elected to distribute the combination TireSaver and radar detector system. Petitioner delivered (1) a check, in the amount of $36,834.99, as payment of the acquisition fee ($35,233.47), and the promotional expense for 1978 (*1,601.52); (2) a $147,339.97 nonrecourse promissory note as payment of the annual use fee for 1978; (3) a $36,834.99 nonrecourse promissory note as partial payment (two-thirds) of the annual use fee for 1979; (4) a $17,616.74 recourse promissory note as partial payment (one-third) of the annual use fee for 1979, to LSI, as promoter. Petitioners claimed a $150,863.77 loss, (3,523.80 of depreciation, and $147,339.97 as annual use fee) from the distributorship activity on their 1978 income tax return, and a $33,316 loss ($3,524 of depreciation, $16,496 interest deduction, and $13,296 of annual use fee) for 1979. HELD, petitioners have failed to carry their burden of proving that they entered into the TireSaver activity with the primary and predominant objective of realizing an economic profit. Therefore, petitioners are not entitled to deduct under secs. 162(a) and 1253(d)(1) any part of the nonrecourse and recourse notes delivered as payment of annual use fees for 1978 and 1979. HELD FURTHER, petitioners are not entitled to deduct interest expense for 1979 as the use of the exclusive right to distribute the combination TireSaver and radar detector system was impracticable; no gross profits were ever generated as no TireSaver products were manufactured; the underlying liabilities were not binding and enforceable, were contingent, and petitioner did not reasonably believe that the liabilities would be paid, therefore the interest was improperly accrued; and petitioners failed to prove that the purchase price and the principal amount of the nonrecourse note do not unreasonably exceed the value of the distributorship. HELD FURTHER, petitioners are not entitled to depreciation or amortization deductions for 1978 and 1979 with respect to the distributorship acquisition fee under sec. 1253(d)(2)(A), as a trade or business is required in order for such deductions to be allowed. HELD FURTHER, sec. 183(b)(2) is of no benefit to petitioners as no gross income was generated by the activity. BEN A. DOUGLAS and RANDALL C. JOHNSON, for the petitioners.
VAL J. ALBRIGHT and MARTY J. RAISANEN, for the respondent.
Respondent determined the following deficiencies in petitioners' Federal income taxes:
+-------------------------+
¦TYE Dec. 31-- ¦Deficiency¦
+--------------+----------¦
¦1978 ¦$61,684.88¦
+--------------+----------¦
¦1979 ¦13,491.35 ¦
+--------------+----------¦
¦Total ¦75,176.23 ¦
+-------------------------+
The issues for decision are whether petitioners are entitled to deduct depreciation or amortization expenses, interest expenses, and ‘annual use fees‘ in connection with an alleged new retail distributorship business.
Some of the facts have been stipulated and are so found. The stipulation of facts, supplemental stipulation of facts and exhibits attached thereto are incorporated herein by this reference.
Donald L. Herrick (hereinafter ‘Donald‘ or ‘petitioner‘) and Marjorie P. Herrick (hereinafter referred to, collectively, as ‘petitioners‘) were husband and wife and residents of Dallas, Texas, at the time of filing their petition in this Court. Petitioners timely filed their joint Federal income tax returns, Form 1040, for the taxable years ended December 31, 1978, and December 31, 1979. Petitioners filed an amended return for the year 1979, Form l040X, on September 25, 1980.
Donald was a financial consultant during 1978 and 1979. As of the date of trial, he was also the chief executive officer or general partner of 22 entities, the majority of which were engaged in investment banking, oil and gas, or real estate.
Petitioner graduated from William Jewell College in Liberty, Missouri, in 1960.1 From 1960 until August 1963, petitioner was employed by Connecticut General Life Insurance Company (hereinafter ‘Connecticut General ‘) in Hartford, Connecticut, except for a six-month period during which he was on active duty with the U.S. Army.
In August 1963 petitioner moved to Kansas City,2 and was employed, as an agent, by Connecticut General until 1967. While working for Connecticut General, petitioner became acquainted with Lewis F. Coppage (hereinafter ‘Coppage‘). Coppage was employed as an agent by Connecticut General in Denver. In 1967, petitioner left his employment with Connecticut General and formed his own insurance brokerage firm; he also became involved in real estate activities in 1967, and in oil and gas production in 1968.
In July 1978, petitioner was approached by Coppage, who was at the time the president of Foresee, Limited, regarding the possibility of becoming a TireSaver distributor. The promoter of the TireSaver was LSI International, Inc. (hereinafter ‘LSI‘), a Nevada corporation. LSI's goal, as stated in the promotional materials, was to establish local distributorships nationwide, with each local distributor having the exclusive right to distribute and sell all products covered by certain United States patents in a geographical territory in the United States. During 1978 and 1979, Marco Radomile was the president of LSI.
During 1978, petitioner received promotional materials3 containing a detailed description of the TireSaver device, market information concerning the TireSaver, statistical data, the distributor's program, a marketing study, information concerning the application procedures in order to become a distributor, and an opinion detailing the tax aspects of entering into a TireSaver distribution agreement. According to the aforesaid promotional materials, the TireSaver device consisted of a patented tire pressure monitoring system composed of several components operating together:
(1) a pressure sensor mounted on the rim inside the tire; (2) a radio frequency combination transmitter and receiver component located in each of the four wheel wells of the automobile; (3) a dash board component; and (4) the wiring necessary to connect the wheel well components to the dashboard component.
The promotional materials represented that the TireSaver tire pressure monitoring device was covered by United States patent number 3,873,965, issued on March 25, 1975, that the component located inside the tires was covered by United States patent number 4,023,415, issued on May 17, 1977, and that George E. Garcia of Tiburon, California, was the inventor of the TireSaver device. The marketing study contained copies of the aforesaid patents. The device was allegedly susceptible of being adapted for use in trucks, buses, and other vehicles. According to the prospectus, with some modifications not specified therein, the TireSaver had the capacity to alert the driver of a vehicle to surveillance by police radar.4
The marketing study contained in the prospectus was prepared by J. Walter Thompson Company Limited, of London. The marketing study estimated that the potential market for the TireSaver could average at least one percent of the total market for passenger cars and two percent of all trucks and buses during the 30 to 36 months following the introduction of the device. The study stated that as of 1978 there were 119,690,561 automobiles, and 29,429,126 trucks and buses in the United States. The study assumed that the corresponding percentage of the 3.9 percent new vehicles registered each year would also be equipped with the TireSaver. It was also assumed that the combination TireSaver tire pressure monitor and radar detector for use in automobiles would sell for $125 and that the combination unit for use in trucks and buses would retail for at least $235 during 1979.5 The marketing study assumed, further, that the TireSaver combination tire pressure monitor and radar detector automobile unit could be purchased from a manufacturer by the distributor at $33.25 per unit, and that the truck or bus combination could be purchased for $50.50. The projected gross profit for a TireSaver distributor with an average territory (a territory containing 70,000 vehicles) was as follows:6
+------------------+
¦Year¦Gross profit ¦
+----+-------------¦
¦1979¦$20,530 ¦
+----+-------------¦
¦1980¦23,040 ¦
+----+-------------¦
¦1981¦25,510 ¦
+----+-------------¦
¦1982¦28,734 ¦
+----+-------------¦
¦1983¦32,172 ¦
+------------------+
It was not explained in the marketing study, nor anywhere else in the promotional materials, how or what criteria were utilized in arriving at the assumed market penetration percentages, estimated retail prices for the TireSaver and combination TireSaver and radar detector system, or the cost of manufacturing the TireSaver and combination TireSaver and radar detection system.
As of the date that the marketing study was prepared, a model or prototype of the TireSaver or the combination TireSaver and radar detection system had not been tested, manufactured, or produced.7
The promotional materials stated that distributorship fees were payable partially in cash and partially by recourse and nonrecourse notes. According to the promotional materials, for every $1 of cash invested, a TireSaver distributor would receive $4 of Federal income tax deductions, for the taxable year 1978.8 For the taxable year 1979 the income tax write-off was to be $3 for every $1 of actual cash investment.9 The said cash investment was to be made by means of a recourse note payable in four installments during 1979.
The tax write-off was to be achieved by means of nonrecourse and...
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