Levin v. Comm'r of Internal Revenue

Citation87 T.C. No. 43,87 T.C. 698
Decision Date29 September 1986
Docket Number19999-83.,Docket Nos. 19971-83
PartiesBERNARD A. LEVIN and PHYLLIS LEVIN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentALAN T. HRABOSKY and DELORES Y. HRABOSKY, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
CourtUnited States Tax Court

OPINION TEXT STARTS HERE

Ps were limited partners in Israeli partnerships formed in Dec. 1979 to develop, manufacture, and market certain food- packaging machinery systems. Each partnership executed, on the same day, a development agreement, a manufacturing agreement, and a marketing agreement with respect to each system. Under the development agreements, the partnerships agreed to pay D, an Israeli corporation, certain amounts, stated in Israeli currency, to develop the systems into manufacturable and marketable products. Approximately one fourth of the development fees was payable immediately in cash. The remainder of such fees, called periodic payments, was payable, with interest of 10 percent per annum through 1982 and 8 percent thereafter, 50 percent in 1994 and 50 percent in 1995, unless sooner paid through a fixed percentage of the gross revenues from sales of the systems. The periodic payments liabilities were not linked to either the Israeli consumer price index or the value of a foreign currency, such as the U.S. dollar. D entered into a consulting agreement regarding each system with another Israeli corporation, T, whereby T would receive 95 percent (less D's expenses and amounts paid to other Israeli subcontractors) of the development fees in return for developing the systems. Under the manufacturing agreements and marketing agreements, the partnerships granted T the exclusive rights to manufacture, use, and market the systems, in return for certain manufacturing and marketing fees. The manufacturing agreements would terminate in 2027, and the marketing agreements would terminate in 2008. Employing the accrual method of accounting, the partnerships claimed deductions under sec. 174(a), I.R.C. 1954, for the U. S. dollar values of the entire amount of their development fees liabilities at exchange rates in effect in Dec. 1979. The partnerships also claimed deductions for the accrued interest on the periodic payments liabilities and for certain miscellaneous expenses.

HELD: (1) The partnerships' liabilities to D for research and development were not paid or incurred in connection with trades or businesses within the meaning of sec. 174(a) and therefore are not deductible under such section.

(2) The periodic payments liabilities served no economic purposes beyond generating deductions for research and experimental expenses and interest expenses, and therefore, the interest accrued thereon is not deductible. Sheldon Chertow, Lloyd E. Shefsky, Martin M. Lucente, Jr., Clifford E. Yuknis, and Joel J. Sprayregen, for the petitioners.

Thomas C. Borders and William E. Bogner, for the respondent.

SIMPSON, JUDGE:

The Commissioner determined deficiencies in the petitioners' Federal income taxes for 1979 as follows:

+--------------------------------------------------+
                ¦Docket No.¦Petitioner                  ¦Deficiency¦
                +----------+----------------------------+----------¦
                ¦19971-83  ¦Bernard A. and Phyllis Levin¦$18,633   ¦
                +----------+----------------------------+----------¦
                ¦19999-83  ¦Alan and Delores Hrabosky   ¦61,976    ¦
                +--------------------------------------------------+
                

The issues for decision are: (1) Whether the expenditures by certain partnerships formed for the stated purpose of developing, manufacturing, and marketing certain food-packaging machinery were paid or incurred in connection with a trade or business within the meaning of section 174 of the Internal Revenue Code of 1954 1; and (2) whether the interest on certain long-term obligations payable in Israeli currency is deductible.

FINDINGS OF FACT

Some of the facts have been stipulated, and those facts are so found. 2

When they filed their petitions in these cases, the petitioners Bernard A. and Phyllis Levin, husband and wife, resided in Skokie, Ill., and the petitioners Alan and Delores Hrabosky, husband and wife, resided in Lithonia, Ga. Mr. and Mrs. Levin and Mr. and Mrs. Hrabosky filed their Federal income tax returns for 1979 with the Internal Revenue Service Center, Kansas City, Mo.

In 1972, Ihor Wyslotsky, a mechanical engineer and an expert in the design of packaging machinery, founded Thermoplastics Engineering Company, Inc. (TEC). TEC, an Illinois corporation, was headquartered in Posen, Ill., until 1979, when the company was reincorporated under the laws of the State of Delaware as TEC, Inc., and its administrative, engineering, and manufacturing facilities were moved to Alsip, Ill. During its first 6 years, TEC designed and manufactured specialized and highly sophisticated packaging machinery for customers in the food and pharmaceutical industries. Each piece of equipment was one of a kind, being designed to meet the particular needs of the customer. The projects usually were funded by the customer on a fixed-price basis. TEC customers during this period included Carl Buddig and Company, 3M Company, Abbott Laboratories, Baxter Travenol Laboratories, Inc., and Rexhaum Corporation.

In 1975 or 1976, Mr. Wyslotsky sold a 25-percent interest in TEC to Lloyd Shefsky. Mr. Shefsky, a member of the Chicago law firm of Shefsky, Saitlin & Froelich, Ltd., and a certified public accountant, was legal counsel to Mr. Wyslotsky, TEC, and TEC-affiliated companies. By 1979, Mr. Wyslotsky owned 51 percent and Mr. Shefsky owned 49 percent of TEC's outstanding shares of stock.

Together, Messrs. Wyslotsky and Shefsky developed a long-range plan for TEC. They decided that TEC should use its expertise in the design of specialized packaging machines to develop a series of standardized, mass-producible packaging machines. The machines would incorporate the newest technologies (such as lasers and microprocessors) to achieve greater efficiencies and cost savings in the packaging of food and pharmaceuticals, processes which theretofore had been highly inefficient and not innovative. Initially, TEC would focus on machines for the meat packing industry because that industry had high packaging costs and very low profit margins; any packaging cost savings would translate directly into significantly higher profits, making TEC's machines attractive to the industry. TEC planned, eventually, to modify its packaging machines for use in the cheese and pharmaceutical industries.

In 1977 and 1978, TEC used its own funds to develop the TEC 1001, a high-speed vacuum packaging machine for luncheon meats and frankfurters. TEC began manufacturing and selling the TEC 1001 in 1978. TEC did not have the substantial amounts of money needed to develop the other machines which were to form its product line. TEC investigated the possibility of financing the development through financial institutions and certain government programs in the United States and Israel, but for various reasons, its attempts to secure such funding were unsuccessful. At Mr. Shefsky's suggestion, TEC eventually decided to raise the necessary funds through ‘off-balance- sheet‘ financing. The general features of this financing technique were described as follows in a ‘Report and Investment Proposal‘ prepared by TEC in December 1980:

FINANCING TECHNIQUES

On several occasions in the past, the company has allowed individual investors or groups of investors to contract with the company for the development of particular equipment or systems. Typically, these contracts entailed agreements whereby the investors would generate the cash necessary for the development of the desired equipment and systems, and, subsequently would own all right, title and interest to that equipment. Therefore, a substantial portion of the TEC product line technically is owned by outside investors and investor groups. TEC has long- term (40 years) contracts with these outside investors and investor groups, where by TEC is granted total and exclusive manufacturing and marketing rights. The income accruing to the outside investors and investor groups have not been reflected in the projected financial statements included in this report, and would not accrue to the benefit of TEC.

The development investment programs were structured in an attempt to provide maximum tax incentives to the investors.

In 1978, TEC used its off-balance-sheet financing technique to obtain development funds for three projects: (1) The slice, weigh, and pack (SWAP) system for bacon packaging; (2) the dieless vacuum packaging system, which would produce semi-rigid and flexible packaging for a variety of products; and (3) the tent-pak system, which would produce a recloseable package for luncheon meat and cheese. The outside investors who provided the money for the development of these three systems entered into development, manufacturing, and marketing agreements with companies owned by or affiliated with (through common ownership by Messrs. Wyslotsky and Shefsky) TEC and incorporated in the United States.

TEC obtained development funds for additional packaging machine systems in a slightly different fashion in the 4 years following 1978. The individual American investors purchased limited partnership interests in Israeli partnerships, which, in turn, entered into development, manufacturing, and marketing agreements with Israeli companies (including TEC affiliates) for particular pieces of equipment that TEC wished to add to its product line. The structure of the research and development investments involved in the present case was typical of those promoted by TEC in 1979 and thereafter.

Dispoard (Israel) and Co. (Dispoard) was organized as an Israeli limited partnership, and Labless (Israel) and Co. (Labless) was organized as an Israeli general partnership, in December 1979. Both partnerships are to terminate in the year 2009, unless sooner terminated by a vote of the partners...

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