Kretschmer v. C.I.R., 051689 FEDTAX, 26365-83

Docket Nº:26365-83, 4111-84, 23664-84, 15788-85, 21191-85, 46852-86.
Opinion Judge:CLAPP, JUDGE:
Party Name:KEITH H. KRETSCHMER AND ADINE W. KRETSCHMER, ET AL., Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Attorney:Mark Bernsley, for the petitioners. Gregory A. Roth, for the respondent.
Case Date:May 16, 1989
Court:United States Tax Court
 
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57 T.C.M. (CCH) 441

KEITH H. KRETSCHMER AND ADINE W. KRETSCHMER, ET AL., Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Nos. 26365-83, 4111-84, 23664-84, 15788-85, 21191-85, 46852-86.

United States Tax Court

May 16, 1989

Mark Bernsley, for the petitioners.

Gregory A. Roth, for the respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

CLAPP, JUDGE:

The cases in these consolidated proceedings are the lead cases in the tax shelter group known as Read Only Chips. Respondent determined deficiencies in petitioners' Federal income tax and additions to tax as follows:

David and Marilyn Yanis - Docket No. 23664-84
Year Deficiency
1979 $13,669
1980 12,766
In answer and amendments thereto, respondent asserted the applicability of sections 6653(a) [2] and 6621(c). [3]
Keith H. and Adine W. Kretschmer - Docket No. 26365-83
Year Deficiency Addition to Tax sec. 6651(a)(1)
1978 $ 45,950 $1,371
1979 47,680 871
1980 189,073 7,362
1981 63,696 2,125
Docket No. 46852-86
Year Deficiency sec. 6653(b)(1)* sec. 6653(b)(2)* sec. 6621(c) sec. 6659 sec. 6661(a)
1982 $223,194 $111,597 ** applicable $18,806 $17,604
In answers and amendments thereto, respondent increased the deficiencies and additions to tax and asserted the applicability of section 6621(c) for 1978 through 1981; section 6653(b) for 1978 through 1981 (or, in the alternative, section 6653(a) for 1978 through 1980, and section 6653(a)(1) and (2) for 1981) and section 6659 for 1981.
Kenneth D. and Sandra G. Malamed Docket No. 4111-84
Year Deficiency Addition to Tax sec. 6653(a)
1979 $60,062 $3,003
1980 63,359 3,168
Docket No. 15788-85
Additions to Tax
Year Deficiency sec. 6653(a)(1) sec. 6653(a)(2) sec. 6621(c) sec. 6651(a)(1) sec. 6659
1981 $151,672 $10,097.85 ** applicable $45,921.50 $8,763.00
1982 154,404 7,720.20 ** applicable -0- 4,279.80
In his amendment to answer, respondent increased the deficiencies and additions to tax and asserted the applicability of section 6653(b) for 1979 through 1981 and section 6653(b)(1) and (2) for 1982 (or, in the alternative, section 6653(a) for 1979 and 1980 and section 6653(a)(1) and (2) for 1981 and 1982); section 6661 for 1982 and section 6621(c) for 1979 and 1980.
Carl N. Muchnick - Docket No. 21191-85
Year Deficiency Addition to Tax section 6651(a)(1)
1981 $8,253 $1,050.60
In answer and amendments thereto, respondent asserted the applicability of sections 6653(a)(1), (a)(2), and 6621(c). This proceeding is concerned only with the portions of the deficiencies and the additions to tax relating to the purchase of certain computer software. Petitioners have conceded that they are not entitled to investment tax credits or to accelerated depreciation on the software. The issues remaining for decision are: (1) the ability of all petitioners to take depreciation, interest and other deductions related to the software; (2) the liability of Malamed and Kretschmer under section 6653(b) for additions to tax for fraud or, in the alternative, under section 6653(a) for additions to tax for negligence; (3) the liability of Muchnick and Yanis under section 6653(a) for additions to tax for negligence; (4) the liability of Kretschmer and Malamed under section 6659 for additions to tax for valuation overstatements; (5) the liability of Kretschmer and Malamed under section 6661 for additions to tax for substantial understatements; and (6) the liability of all petitioners under 6621(c) for interest on substantial underpayments attributable to tax-motivated transactions. FINDINGS OF FACT This case involves over 800 pages of briefs, over 600 exhibits, nearly 1,100 pages of transcript, and opposing parties who agree on virtually nothing. We have attempted to limit our findings of fact to those facts which are material to the resolution of the case. Some of the facts are stipulated and are so found. The stipulation of facts and exhibits attached thereto are incorporated by this reference. At the time the petitions in these cases were filed, petitioners David and Marilyn Yanis were residents of Kings Point, New York; petitioners Keith H. and Adine W. Kretschmer were residents of Santa Monica, California (petition in docket No. 26365-83) and Hingham, Massachusetts (petition in docket No. 46852-86); petitioners Kenneth D. and Sandra G. Malamed were residents of Los Angeles, California; and petitioner Carl N. Muchnick was a resident of Rancho Palos Verdes, California. For simplicity, the following discussion will treat the husbands as if they are the only petitioners in the case. This case involves two systems of computer software programs, the OPSCREEN system and the GAASS system. Each system will be discussed separately. I. OPSCREEN Computer software is a sequence of instructions which tells a computer how to retrieve, manipulate, and store data in order to provide information to a computer user. Software is stored on a medium (such as a master tape or a chip) which is accessible by the computer. The Option Screening System (OPSCREEN) was a system of computer software programs designed to furnish various types of information to investors in options. The original OPSCREEN system was developed by David Bruce McMahan (McMahan), a stockbroker specializing in options. McMahan started working on the concepts underlying the OPSCREEN System in 1961 and first put the concepts on a computer in 1971. Around 1975, he put the programs on the Service Bureau Company (SBC) computer time-sharing network for his own use. A time-sharing company such as SBC makes available for a fee the use of its large central computer, with the computer simultaneously processing a number of different software programs for different persons. Through the use of his programs, McMahan built his firm's previously nonexistent institutional options department to 22 clients and gross commissions in excess of $50,000 per month. In 1976, SBC expressed interest in moving McMahan's programs to its commercial library so tat other brokerage firms could access the programs for a fee. At this time, SBC was one of the largest computer time-sharing vendors in the world and had a sales force of around 500 salesmen who marketed the various programs in its commercial library. In August 1977, McMahan granted SBC a nonexclusive license to make the original OPSCREEN programs available on its commercial library. The agreement provided that SBC would pay McMahan a percentage of the royalty payments it received for the use of the OPSCREEN programs and that McMahan would maintain (update and improve) the programs at his own expense. Subsequently, McMahan and James M. Russell (Russell), an attorney, decided to sell the individual OPSCREEN software programs. Each purchaser of a program acquired a tangible medium, either a read only chip (ROC) or a master tape, on which his software program was encrypted. Each purchaser also acquired all rights relating to the program. The term ‘ ROC‘ will be used to refer both to the chip (or tape) and the rights acquired by purchaser. The original 21 OPSCREEN ROCs (OPSCREEN Series I) were offered for sale in 1977 and 1978. Another 16 ROCs (OPSCREEN Series II) were offered for sale in 1978. The ROCs involved in this case are the OPSCREEN Series III programs, which were developments of programs written by Kurt Hiebaum (Hiebaum), who was hired by McMahan in January 1978. As a condition of his employment, Hiebaum transferred his entire interest in his programs to McMahan. Before Hiebaum's programs were sold as OPSCREEN Series III ROCs, they were modified to be ‘ user-friendly‘ so that they could be used by persons who were not computer experts. McMahan and Russell had initially planned to offer the Series III ROCs for sale in December 1978, but due to poor revenues they delayed the offering until June 1979. A few sales were made, however, before that time. A prospective purchaser of an OPSCREEN ROC received a confidential memorandum which, among other things, contained a tax opinion and tables showing cash flow and tax benefits under scenarios where no revenues were received from the ROC, where revenues were sufficient to pay the notes in full, and where revenues equalled twice the amount needed to pay the notes. If no revenues were received, the tables indicated that an investment in a ROC priced at $100,000 would result in total tax benefits of $60,000 over the first 7 years of the investment. According to the tax opinion, the ROCs constituted ‘ new‘ tangible personal property eligible for the investment tax credit and accelerated depreciation. Upon deciding to purchase a ROC, an OPSCREEN purchaser first executed a letter agreement which set forth the price and payment terms and which provided that the purchase was subject to the purchaser's receipt within the next 30 days of a complete set of documentation acceptable to the purchaser. The complete set of documentation included, among other documents, a purchase and sale agreement, the promissory notes, a security agreement, and two appraisals of the ROC. All of this documentation was dated as of the date on the letter agreement. In general, the letter agreements were dated as of the date they were prepared for mailing to the purchaser. Some documents never were signed, and the purchasers often did not receive the complete set of documentation within the required 30-day period. OPSCREEN purchasers generally paid 7.5 percent of the purchase price at purchase, with another 7.5 percent due within 6 months pursuant to a short-term note. The remaining 85 percent of the purchase price was due pursuant to a 25-year recourse...

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