Karr v. C.I.R.
| Decision Date | 27 February 1991 |
| Docket Number | No. 90-8000,90-8000 |
| Parties | -653, 91-1 USTC P 50,113 James KARR and Nancy L. Karr, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. |
| Court | U.S. Court of Appeals — Eleventh Circuit |
Dennis N. Brager, Jackson D. Hamilton, Spensley, Horn, Jubas & Lubitz, Los Angeles, Cal., for petitioners.
Shirley D. Peterson, Asst. Atty. Gen., Gary R. Allen, Chief, Appellate Section, Kenneth W. Rosenberg, Mary Frances Clark and David I. Pincus, Tax Div., Dept. of Justice, Washington, D.C., for respondent.
Appeal from a Decision of the United States Tax Court
Before JOHNSON and HATCHETT, Circuit Judges, and DYER, Senior Circuit Judge.
In this tax case, we affirm the Tax Court holding that the transactions in question constituted sham transactions, subjecting the taxpayers to deficiencies, additions to taxes, and interest.
Richard Basile was a promoter of energy-related limited partnerships. In 1981, he discussed a possible K-Fuel project with a Swiss investor, with whom Basile had an ongoing relationship. K-Fuel is a dry, stable, high heating value solid fuel, physically resembling coal, which is produced by placing wood, peat, lignite and other low-grade biomass or fossil fuel into a Koppelman reactor, where it is dried and carbonized at high temperatures and pressure (the Koppelman process). This technique was developed by Edward Koppelman.
As part of an intricate network of interrelated entities formed to exploit the Koppelman process, Intro-Continental Investment, B.V. (Intro-Continental) was established. Basile received a 15-percent interest in Intro-Continental and in its wholly owned subsidiary, Ronodo Corporation, N.V. (Ronodo). Basile also became Chairman, Chief Executive Officer, and President of Petro-Syn Corporation (Petro-Syn), in which he owned a 35-percent interest.
In August, 1981, Ronodo licensed from Koppelman the exclusive right (as well as other rights) to use the Koppelman process within the state of North Carolina to refine peat and wood into K-Fuel. All of these rights were sublicensed by Ronodo to its wholly owned subsidiary Sci-Teck Licensing Corporation (Sci-Teck).
Peat Oil and Gas Associates, Ltd. (POGA) and Syn-Fuel Associates, Ltd. (SFA) were also formed as part of the network, allegedly to exploit Koppelman process technology and to acquire and develop oil and gas interests. According to the nearly identical offering memoranda, each partnership offered 125 to 250 limited partnership interests. The memoranda described POGA's general partner as a certified public accountant and financial consultant and SFA's general partner as a tax and financial consultant. Neither general partner had any technical background relevant to the partnerships' proposed activities.
The memoranda estimated tax losses during the initial four years of the partnerships' operations to average 401 percent. Thus, each investor purchasing one partnership unit for a $37,500 cash investment could deduct $150,376 in tax losses over four years. In order to be eligible to purchase units in the partnership, a prospective limited partner was required to fill out an Offeree Suitability Questionnaire, representing that the person had a net worth of at least $250,000 (exclusive of home, furnishings and automobiles) and was subject to federal income tax at the highest brackets. The memoranda also clearly warned that financial success in terms of K-Fuel development was highly unlikely. Factors cited included (1) commercially unproven technology; (2) lack of experience; (3) conflict of interests; (4) large obligations incurred without arm's-length negotiations; (5) environmental and health problems; (6) severe competition; and (7) inadequate capital (after payments to the promoters and their associates).
POGA and SFA entered into a joint venture agreement to own and operate a pilot K-Fuel plant in North Carolina. 1 The partnerships licensed from Sci-Teck the exclusive right within the state of North Carolina to use the Koppelman process with respect to peat and wood as well as the nonexclusive right to use the Koppelman process in the remainder of the United States with respect to any material other than bagasse. At the end of 1981, the partnerships also entered into a research and development agreement with Fuel-Teck Research and Development (FTRD), a wholly owned subsidiary of Petro-Syn. FTRD's role was to conduct and coordinate the research and development efforts for the benefit of the partnerships, and to oversee construction of the Koppelman process plant.
POGA agreed to pay a license fee to Sci-Teck which included both cash and partnership notes of $112,175 for each partnership unit sold. Specifically, for each partnership unit sold, POGA agreed to pay $12,975 in cash between October 1, 1981, and October 1, 1984, and $99,200 in promissory notes due between October 1, 2006, and October 1, 2009. POGA also agreed to pay FTRD a fee for its services. The structure of this payment required POGA to pay FTRD, for each partnership unit sold, $5,000 in cash between October 1, 1981, and October 1, 1982, and $24,800 in promissory notes due between October 1, 2006, and October 1, 2007.
The partnerships' oil and gas investments were to partially subsidize the efforts to develop the Koppelman process. Fuel-Teck Oil and Gas, Inc. (FTOG), another wholly owned subsidiary of Petro-Syn, was to be responsible for those oil and gas activities. The revenue derived from oil and gas projects would be used to pay off POGA's notes to Sci-Teck and FTRD.
James Karr became a limited partner in POGA in December, 1981. He purchased one unit as a tenant in common with Robert Bluhm. Karr's purchase called for payment of $80,750 over a 26-year period. Karr's obligations to POGA were embodied in full recourse promissory notes. Karr timely made payments of all amounts, including interest due to POGA, between 1981 and 1984. On December 29, 1981, Karr entered into an agreement with Sci-Teck and FTRD pursuant to which he agreed to assume personal liability for POGA's obligations in the amounts of $49,600 and $12,400.
On its income tax return for 1981, POGA deducted $4,288,375 as a license fee to be paid to Sci-Teck and $4,288,375 as a research and development fee to be paid to FTRD. The amounts represented accrual of the notes and cash payments due on 211.25 partnership units, determined as of the date the 1981 income tax return was prepared. On its 1982 income tax return, POGA deducted $5,830,500 as a license fee to be paid to Sci-Teck and $1,964,625 as a research and development fee to be paid to FTRD. For 1982, POGA also deducted $505,897 as interest expense and reported $428,455 as interest income on notes receivable.
On their joint income tax returns for 1981 and 1982, James and Nancy Karr deducted $20,191 and $19,593, respectively, as their distributive share of partnership losses. The Commissioner of Internal Revenue disallowed these deductions on the ground that the activity in which POGA was engaged was not entered into for a profit. The Commissioner also asserted that the purported liability underlying POGA's claimed $505,897 interest expense deduction was contingent and that the notes lacked economic substance. Accordingly, the Commissioner determined deficiencies in the Karrs' federal income tax of $8,907 for 1981 and of $7,972 in 1982, and assessed an addition of $797 to their 1982 tax.
The Karrs petitioned the Tax Court to redetermine the tax deficiencies set forth in the notice of deficiency, and their case was selected as one of two test cases involving the POGA and SFA partnerships. 2 Following a week-long trial, the Commissioner conceded that the Karrs could deduct their distributive shares of partnership losses attributable to oil and gas investments. Consequently, the Tax Court addressed the Karrs' claimed deductions for distributive shares of losses represented by POGA's payments to Sci-Teck for license fees and to FTRD for research and development fees.
The Tax Court held that the Karrs were not entitled to the claimed deductions. Smith v. Commissioner, 91 T.C. 733 (1988). The Tax Court determined that tax motivations shaped the limited partnership transactions in question and that POGA's Koppelman process activity lacked economic substance apart from the anticipated tax benefits. In addition, the Tax Court determined that such activity was not within the scope of section 174 of the Internal Revenue Code. 3 The Tax Court also sustained the addition to tax under section 6661(a) for substantial understatement of income tax, and the imposition of additional interest under section 6621(c) on substantial underpayments attributable to tax motivated transactions.
The Karrs contend that the Tax Court erred in determining that POGA's Koppelman process activity was primarily motivated by tax benefits and lacked economic substance. The Karrs also contend that even if the primary purpose of POGA's activities was the avoidance of tax, the claimed amounts are deductible. Finally, the Karrs contend that without regard to whether the other expenses incurred in connection with the Koppelman process activity are deductible, the interest on the partnership notes is deductible.
The Commissioner contends that the Tax Court correctly ruled on all issues.
The issues are: (1) whether the Tax Court correctly determined that the Karrs are not entitled to deduct their allocable share of partnership losses from the Koppelman process activity; (2) whether the Tax Court correctly determined that the Karrs are liable for additions to tax for substantial understatement of their tax liability; and (3) whether the Tax Court correctly determined that the Karrs are required to pay additional interest for tax motivated transactions on any underpayment.
On their 1981 and 1982 income tax returns, the Karrs...
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