Kantor v. C.I.R., 91-70446

• Decision Date: 20 July 1993
• Docket Number: No. 91-70446,91-70446
• Citation: 998 F.2d 1514
• Parties: -5476, 93-2 USTC P 50,433 Sharon D. KANTOR, Robert E. Kantor, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 1514

998 F.2d 1514

72 A.F.T.R.2d 93-5476, 93-2 USTC P 50,433

Sharon D. KANTOR, Robert E. Kantor, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 91-70446.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted Oct. 9, 1992.

Decided July 20, 1993.

David L. Gibson, San Francisco, CA, and Edwin G. Hubert, Tucson, AZ, for petitioners-appellants.

Robert L. Baker and Teresa T. Milton, Tax Div., U.S. Dept. of Justice, Washington, DC, for respondent-appellee.

Appeal from a Decision of the United States Tax Court.

Before: HUG, FLETCHER, and BRUNETTI, Circuit Judges.

HUG, Circuit Judge:

This case presents the question of whether research expenditures made by a partnership in order to develop a new technology were incurred in connection with its own trade or business, within the meaning of 26 U.S.C. § 174, where the partnership had contracted another firm to conduct the research and had granted that firm the opportunity to obtain for a nominal sum the exclusive right to market the technology. The Tax Court held they were not, and thus were not deductible as current expenses. We affirm this determination. The appellants also contend that the Tax Court lacked jurisdiction because of a defect in the notice of deficiency and challenge the Tax Court's imposition of negligence penalties. We conclude the notice of deficiency was adequate, affording jurisdiction, but reverse the imposition of the negligence penalties.

I.

In 1981, appellants invested in PCS, Ltd., an Arizona limited partnership, whose stated purpose was to develop and exploit adaptations of an existing computer program called PRO-IV for use on various computer systems. On its tax return for that year, PCS, Ltd., claimed a $3.15 million deduction for research and experimentation expenses pursuant to 26 U.S.C. § 174, and posted an annual loss in excess of that amount. As limited partners, appellants claimed a distributive share of this loss as a "pass through" deduction on their 1981 joint income tax return. ¹

The Commissioner of Internal Revenue ("Commissioner") rejected appellants' deduction, determined a deficiency in their income tax, and assessed negligence penalties. Appellants subsequently sued the Commissioner in the United States Tax Court. The Commissioner did not dispute that the partnership's expenditures were incurred for research and experimentation, or that the enterprise was motivated by a genuine profit motive. Instead, the Commissioner determined that PCS, Ltd., had not incurred the expenditures in connection with a trade or business of its own as required by section 174 and that its partners therefore were not entitled to the deduction. The Tax Court affirmed the Commissioner's denial of the deduction and this appeal followed.

PCS, Ltd., was organized in 1981 by Edwin G. Hubert, who served as its general partner. In 1980, Hubert had learned of the PRO-IV software, tested it, and become interested in developing and exploiting adaptations of the program for use on various computer systems. At the time, Hubert had over 12 years of sales and technical experience in the computer industry. Hubert was unable to pursue the project on his own, however, because he was unable to secure a license to develop adaptations of the software from its owner, Data Technical Analysts, Inc. As a result, Hubert entered a series of business arrangements with two individuals, Merle Amundson and Calvin Lee, who had successfully acquired such licenses. Over a period of time, Hubert formed a number of limited partnerships to fund the adaptation of PRO-IV for use on various computer systems. PCS, Ltd., was one of these limited partnerships. Amundson and Lee meanwhile formed a number of companies to actually develop these adaptations. PCS, Inc., is the company which they formed to develop and market the particular version of PRO-IV whose development was funded by PCS, Ltd.

The relationship between PCS, Ltd. ("the partnership"), and PCS, Inc. ("the research firm"), was governed by two contracts simultaneously executed in 1981. The first contract was the Research and Development Agreement. Under this agreement the research firm agreed to perform the research and development work necessary to convert PRO-IV to run on IBM computers, the partnership agreed to pay the firm with cash and promissory notes for that work, and the partnership retained ownership of any resulting software ("the software").

The second contract was the Technology Transfer Agreement. Under this agreement, the partnership granted the research firm the right to buy for $5,000 an option on an exclusive and worldwide license to market any item of software resulting from the research effort. In conjunction with this option, the partnership granted the research firm a 13-month review period in which it was entitled to evaluate the marketing potential of the software without any interference to its prospective rights by the partnership. If the research firm chose to exercise its option, it was to do so by providing written notice to the partnership before the end of the 13-month period. By exercising the option, the research firm would obtain the exclusive right to market the software and would obligate itself to pay the partnership specified royalties based on prospective sales of the software.

During the years following the execution of these agreements, the research firm conducted research and development of the software. Hubert meanwhile maintained involvement in the research effort: he kept in contact with the research firm's computer programmers, participated in strategic research decisions, reviewed research status reports, provided technical advice, and ultimately arranged a test site for the software. In 1983 and 1984, the research firm required additional financing to complete the research effort. Hubert negotiated an arrangement to secure such financing, which involved both the cancellation of the Technology Transfer Agreement and the appointment of Hubert to the research firm's board of directors. In late 1984, the research firm completed its research and development of the software. In early 1985, on behalf of the partnership, Hubert negotiated new license agreements under which a number of firms agreed to market the program on behalf of the partnership in Europe and North America. Finally, in 1987, the McDonnell Douglas Corporation purchased all rights associated with the software, including those of the partnership.

II.

The Tax Court denied appellants' deduction because it concluded that in 1981 when the partnership made its research expenditure, it had no realistic prospect of marketing the resulting software in a business of its own. Appellants contend that the partnership not only had a prospect of conducting such a business, but actually did so.

Section 174 of the Internal Revenue Code permits a taxpayer to deduct from income "research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business." 26 U.S.C. § 174(a)(1). ² Neither the Code nor the Treasury regulations, however, defines "in connection with his trade or business." Prior to 1974, the Commissioner and the Tax Court narrowly construed this provision to grant a deduction for research expenditures only to those taxpayers who, at the time of the expenditure, were already engaged in the business of selling products and services. In 1974, however, the Supreme Court held that the section 174 deduction is also available to up-and-coming enterprises whose only "business" at the time they incur research expenditures is the research itself. Snow v. Commissioner, 416 U.S. 500, 94 S.Ct. 1876, 40 L.Ed.2d 336 (1974).

The Court observed that the language contained in section 174, "in connection with [the taxpayer's] trade or business," is broader than the language of section 162, which allows a taxpayer to deduct ordinary and necessary expenses incurred "in carrying on any trade or business." See 26 U.S.C. § 162; Snow, 416 U.S. at 502-03, 94 S.Ct. at 1877-78. An expense is generally not deductible under section 162 unless the taxpayer is engaged in an ongoing business at the time the expense is incurred. See, e.g., Madison Gas & Elec. Co. v. Commissioner, 633 F.2d 512, 517 (7th Cir.1980). As a result, a nascent business may not deduct its "start-up" or "pre-operational" expenses under section 162 and must instead capitalize them. After reviewing the legislative history of section 174, the Court concluded that it was intended to modify this requirement by providing new businesses, which are not yet selling goods or services, an immediate deduction for their research and experimental expenditures. Snow, 416 U.S. at 502-04, 94 S.Ct. at 1877-79.

Subsequent courts have made clear, however, that section 174 does not authorize the deduction of every outlay that is used for research or experimentation. Although a taxpayer need not be conducting a trade or business at the time it incurs the research expenditure, the taxpayer must demonstrate a "realistic prospect" of subsequently entering its own business in connection with the fruits of the research, assuming that the research is successful. See Zink v. United States, 929 F.2d 1015, 1023 (5th Cir.1991); Spellman v. Commissioner, 845 F.2d 148, 149 (7th Cir.1988). We hold that a taxpayer demonstrates such a prospect by manifesting both the objective intent to enter such a business and the capability of doing so. See Spellman, 845 F.2d at 150-51; Levin v. Commissioner 32 F.2d 403, 406-07 (7th Cir.1987); see also United Fibertech, Ltd. v. Commissioner, 976 F.2d 445, 446 (8th Cir.1992) (per curiam); Diamond v. Commissioner, 930 F.2d 372, 375 (4th Cir.1991).

In order to qualify for the section 174 deduction, a taxpayer's existing or prospective business must be its own and not that of another entity. See Levin, 832 F.2d at 405-06; Green v. Commissioner, 83 T.C. 667,...