Impact Research Corporation v. Commissioner
| Decision Date | 29 April 2002 |
| Docket Number | Docket No. 14873-98.,Docket No. 14872-98. |
| Citation | 83 T.C.M. 1569 |
| Parties | Impact Research Corporation, Joan C. Benz, Tax Matters Person v. Commissioner. Research Impact Corporation, Joan C. Benz, Tax Matters Person v. Commissioner. |
| Court | U.S. Tax Court |
Cheryl R. Frank and Gerald W. Kelly, Jr., for the petitioners.
Lindsey D. Stellwagen, for the respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
By separate notices of final S corporation administrative adjustment (hereinafter sometimes referred to as FSAA) respondent determined adjustments to the 1984 S corporation income tax returns of Impact Research Corporation (hereinafter sometimes referred to as IRC) and Research Impact Corporation (hereinafter sometimes referred to as RIC).2 For IRC, respondent determined (1) a $241,700 adjustment3 resulting from the disallowance of a deduction for research or experimental expenditures under section 1744 and (2) an $80,000 adjustment eliminating IRC's reported short-term capital gain. Petitioner in docket No. 14872-98 does not dispute the $80,000 adjustment. For RIC, respondent determined a $631,289 adjustment resulting from the disallowance of a deduction for research or experimental expenditures under section 174.5
These cases have been consolidated for trial, briefs, and opinion. After a concession by respondent,6 the issues for decision as to each of the S corporations are as follows:
(1) Whether the S corporation made research or experimental expenditures (within the meaning of section 174) in 1984 and, if so, then in what amount.
(2) Whether any such expenditures by the S corporation were made in connection with that corporation's trade or business.
Some of the facts have been stipulated; the stipulations and the stipulated exhibits are incorporated herein by this reference.7
IRC and RIC had their respective principal places of business in Sterling, Virginia, when the respective petitions were filed in the instant cases. Both IRC and RIC were cash basis taxpayers; each reported on its respective 1984 information return that it had no income but claimed a deduction for research and development expenses (IRC—$241,700; RIC—$631,000). RIC claimed a $289 deduction for other expenses.
In 1984, Systems Impact, Inc. (hereinafter sometimes referred to as Systems), was a nonpublicly traded C corporation seeking to develop interactive educational videodiscs, a relatively new technology at the time. Videodiscs are discs which contain information which users may access with a videodisc player. The videodisc player transmits the information contained in the videodisc to a computer monitor for display.
Systems sought to exploit the videodisc technology as an educational aid. Systems' videodiscs were about the size of a 78-rpm phonograph record; they contained information about various subjects including fractions, algebra, and earth science. As used in an educational setting, teachers could monitor student learning while the videodiscs presented the information to the students. Based on their observations, teachers could tailor the presentation of the information to what they perceived to be the needs of the students. For instance, if the class did not appear to grasp a portion of a lesson, then the teacher could replay the unclear portion of the lesson in a step-by-step process to reinforce or clarify key principles; conversely, if the class appeared to understand the lesson, then the teacher could continue with the lesson. The videodiscs also enabled teachers to present the information contained in the videodiscs in more than one manner.
By 1984, Systems had developed early prototypes of the videodiscs, but it needed an additional $5-8 million to bring them to market.
In 1984, Gordon Gould (hereinafter sometimes referred to as Gould) was the president of Heritage Financial Corp. (hereinafter sometimes referred to as Heritage Financial). Heritage Financial was a securities firm; a broker-dealer, it sold stocks, bonds, and other forms of investments.
In 1984, Gould met with Systems' representatives about raising the financial support Systems needed in order to expand its research and development activities. Gould considered the videodisc technology to be a "valid potential product for investors". After consulting with securities attorneys, Gould and Systems agreed that the formation of two S corporations represented the best way to (1) provide to Systems the additional financing it needed, and (2) secure an equity investment in the videodisc technology for shareholders in the to-be-formed S corporations.
Once Gould and Systems agreed to form the two S corporations, Gould began to locate potential shareholders in what would become IRC and RIC. Gould tried to locate shareholders who would qualify under the private placement rules of the Securities Act of 1933. To ensure qualification, prospective shareholders completed "investor qualification forms" which solicited the information necessary to determine whether potential shareholders satisfied the Securities and Exchange Commission's rules regarding private placement offerings. The investor qualification forms provided information about the potential shareholder's balance sheets, income statements, tax returns, and experience with investing in private placements. Potential shareholders in IRC and RIC had to have a minimum net worth of $200,000. Gould reviewed the investor qualification form of each potential shareholder. Shareholders in the S corporations were not selected on the basis of education and experience in manufacturing or in marketing.
A majority of the shareholders of IRC and RIC were professionals and had some managerial and business expertise. Frank Colenda (supra note 1) participated in the U.S. Navy's development of the "Sparrow" missile program. Among the shareholders of RIC were the following: Joan C. Benz, a Ph.D., who later became a high school principal; Francis E. Rundell, a retired U.S. Air Force colonel who managed missile research and development programs for the U.S. Air Force; and William A. Fleming, a former supervisor in the lunar lander program of the National Aeronautics and Space Administration and former supervisor in the Federal Aviation Administration.
On February 28, 1984, IRC was incorporated in Delaware. IRC elected S corporation status for its first taxable year (the short period from Mar. 1 through Dec. 31, 1984); it reported its income using the cash method of accounting.
On March 5, 1984, IRC opened a checking account with Maryland National Bank. IRC wrote four checks on that account: Two checks totaling $7,412 for legal fees and two checks totaling $20,900 to Heritage Financial for fees and commissions associated with the private placement of IRC stock.
On June 5, 1984, RIC was incorporated in Delaware. RIC elected S corporation status for its first taxable year (the short period from June 5 through Dec. 31, 1984); it reported its income using the cash method of accounting.
In June of 1984, RIC opened a checking account with Maryland National Bank. RIC wrote eight checks on that account: Two checks totaling $32,588 for legal fees, one $80,000 check for the repayment of a loan, two checks totaling $12,069 for refunds of investments in RIC stock, one $10,000 check to Systems as a transfer of funds, and two checks totaling $91,960 to Heritage Financial for sales commissions and legal fees associated with the private placement of RIC stock. RIC transferred an additional $100,000 to Systems by debit memorandum and Systems transferred $20,000 to RIC. RIC also transferred to Systems $331,092 by means of seven debit memoranda. RIC closed its checking account with Maryland National Bank and transferred the remaining balance of the account, $5,086.80, to Systems by debit memorandum on or about December 10, 1984. RIC transferred a net of $426,178.80 to Systems from its Maryland National Bank checking account ($100,000 + 10,000 - 20,000 + 331,092 + 5,086.80).
On or about July 10, 1984, RIC opened a checking account with McLachlen National Bank. RIC did not write any checks on the account. RIC closed the account and transferred the remaining balance, $205,137.20, to Systems on August 24, 1984. RIC transferred $631,316 to Systems from its two checking accounts ($426,178.80 (Maryland National Account) + $205,137.20 (McLachlen National Account)).
Neither IRC nor RIC performed educational videodisc research or development activities through its own employees. For that matter, neither S corporation had any employees. IRC and RIC did not prepare any written marketing or business plans. Neither IRC nor RIC held corporate board meetings, owned physical assets, owned or leased physical premises, or maintained inventory. Neither IRC nor RIC was adequately capitalized to market and license products, nor did either corporation make any provisions to raise additional capital. There are not any written documents reflecting that either IRC or RIC intended to enter the market for educational videodiscs.
IRC entered into three agreements with Systems: (1) A research and development agreement (hereinafter sometimes referred to as the R & D Agreement), (2) an exclusive license agreement, and (3) an option agreement. On June 13, 1984, IRC and Systems amended the R & D Agreement to make RIC a party thereto.9 At some point, IRC and Systems also amended the exclusive license agreement to make RIC a party thereto. See supra note 9. Also, at some point RIC became a party to an option agreement with Systems, but the record does not indicate whether this was accomplished by an IRC-Systems amendment to the original option agreement or a separate RIC-Systems agreement.
The R & D Agreement obligated IRC to pay to Systems a fixed fee of...
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