Nickeson v. C.I.R., 90-9007

• Citation: 962 F.2d 973
• Decision Date: 24 April 1992
• Docket Number: No. 90-9007,90-9007
• Parties: -1161, 92-1 USTC P 50,233 Daniel B. NICKESON and Enid C. Nickeson; Norman E. Kuhl and Nancy J. Kuhl, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (10th Circuit)

Page 973

962 F.2d 973

69 A.F.T.R.2d 92-1161, 92-1 USTC P 50,233

Daniel B. NICKESON and Enid C. Nickeson; Norman E. Kuhl and Nancy J. Kuhl, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 90-9007.

United States Court of Appeals, Tenth Circuit.

April 24, 1992.

Declan J. O'Donnell, Englewood, Colo., for petitioners-appellants.

Bridget M. Rowan, Attorney, Tax Div. (Shirley D. Peterson, Asst. Atty. Gen., Gary R. Allen and Gilbert S. Rothenberg, Attorneys, Tax Div., with her on the brief), Dept. of Justice, Washington, D.C., for respondent-appellee.

Before LOGAN and SEYMOUR, Circuit Judges, and WINDER, District Judge. ^*

LOGAN, Circuit Judge.

Daniel B. and Enid C. Nickeson and Norman E. and Nancy J. Kuhl (taxpayers) appeal the decision of the United States Tax Court reported as Brock v. Commissioner, 58 T.C.M. (CCH) 826 (1989), which upheld the disallowance of deductions taken on taxpayers' 1982 returns for research and development expenses, the imposition of penalties under I.R.C. § 6661 for substantial understatement of tax and under I.R.C. § 6653(a) for negligence, and the imposition of the increased interest rate on the underpayment attributable to tax-motivated transactions under § 6621(b).

The primary issue on appeal is whether the Tax Court properly disallowed taxpayers' deductions of research and development expenses claimed under I.R.C. § 174(a). The deductions equalled the amount of money actually paid plus the face amount of promissory notes given in an agreement for purchase and development of components of an automatic meter reading device (AMR). A detailed exposition of the facts is contained in the Tax Court opinion. We recite here only the facts pertinent to this appeal.

The AMR program was promoted by George Risk, an inventor who had patented several inventions. He was also the principal in several corporations, including George Risk Industries, Inc. (GRI), manufacturer of computer keyboards and burglar alarm components, and G.R.I. Research and Development Laboratories (R & D Labs). Risk worked on improving the AMR throughout the 1970s, and although another entity, Harris Corporation, holds the patent on the improvements to the AMR, Risk negotiated to obtain a nonexclusive license to use eleven aspects of the patent. He did not have the right to sublicense, but could assign the licenses if the assignment was in connection with the sale of substantially the entire business.

In 1981, Risk began marketing the AMR by selling the individual aspects or components for a specified price, 25% in cash with the agreement requiring payment of the remainder in deferred promissory notes payable to R & D Labs. The offering documents emphasized the tax benefits of the transaction. The prospectus asserted a 100% return of investment cash paid through immediate tax benefits and a tax write-off equalling 400% of the initial cash payment. The purchase agreements did not provide a description of the research needed to develop the AMR to a marketable state, nor a time frame for the research. Moreover, there was no agreement for accounting to the taxpayers on progress or expenditures of funds.

The agreement gave the taxpayers the right to any technological information concerning the component they purchased, or possibly to information on the AMR as a whole. Thus, ostensibly the taxpayers could use the information to manufacture and sell their component, or they could sell the information to a licensee corporation created as part of the AMR project. It is significant, however, that the agreements did not provide transfer of ownership rights in the underlying technology.

After taking evidence for five days the Tax Court found that the taxpayers' investments in the AMR research and development program could not be the basis for any deduction. It also found that the additions to tax and increased interest rate were proper. We review the factual findings of the Tax Court under a clearly erroneous standard and its application of the law to those facts de novo. Jackson v. Commissioner, 864 F.2d 1521, 1524 (10th Cir.1989).

The Tax Court analyzed the AMR transaction using the two-step "generic tax shelter" and "economic substance" test from Rose v. Commissioner, 88 T.C. 386, 408-415 (1987), aff'd, 868 F.2d 851 (6th Cir.1989), a test that emphasizes objective factors. The Tax Court first found that the AMR program manifested several characteristics, outlined in Rose, that established a generic tax shelter. Specifically, it found that

The promotional materials focused on the tax benefits of the transaction; the demanded purchase price was accepted without negotiation; the right to commercially exploit the components was difficult to value in the abstract and the value placed on this right greatly exceeded the value of the components; the cost of producing the components was a fraction of the stated purchase price; and the bulk of the purchase price was deferred through the use of promissory notes which were nonrecourse in substance.

58 T.C.M. (CCH) at 834. The Tax Court then applied the test used in Rose to determine whether the investments were "devoid of economic substance." The factors examined included: "(1) the dealings between petitioners and the promoters; (2) the relationship between the sales price and the fair market value; (3) the structure of the financing; and (4) perceived congressional intent." 58 T.C.M. (CCH) at 834 (citing Rose v. Commissioner, 88 T.C. at 415-22). Applying these factors, the Tax Court found that the AMR transactions lacked economic substance, and that taxpayers entered the AMR transaction for tax benefits only, and not for profit.

I

The Rose test ¹ was developed to determine the validity of deductions and investment tax credits that require that a taxpayer's activities constituted either a "trade or business" or were undertaken for production of income. See Rose v. Commissioner, 868 F.2d 851, 853 (6th Cir.1989) (§ 167 depreciation deductions and § 48(a)(1) investment tax credits). The issue in the instant case, however, is the narrower question whether taxpayers were entitled to a § 174 deduction.

Congress provided under I.R.C. § 174(a)(1) that a taxpayer may deduct "research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business." As the statutory language indicates, research and experimental expenses are deductible only if they were incurred in connection with the taxpayer's trade or business. See Diamond v. Commissioner, 930 F.2d 372, 374 (4th Cir.1991); Zink v. United States, 929 F.2d 1015, 1021 (5th Cir.1991); Levin v. Commissioner, 832 F.2d 403, 405 (7th Cir.1987); Independent Elec. Supply, Inc. v. Commissioner, 781 F.2d 724, 726 (9th Cir.1986).

Whether a taxpayer incurred expenses in connection with his or her trade or business requires an initial inquiry into "whether the 'activity was undertaken or continued' in good faith, with the dominant hope and intent of realizing a profit, i.e., taxable income, therefrom." Independent Elec. Supply, 781 F.2d at 726 (quoting Hirsch v. Commissioner, 315 F.2d 731, 736 (9th Cir.1963)); see also Agro Science Co. v. Commissioner, 934 F.2d 573, 576 (5th Cir.) (deductions under § 174 allowable only if "the taxpayer made them primarily in furtherance of a bona fide profit objective independent of tax consequences" (emphasis added)), cert. denied, --- U.S. ----, 112 S.Ct. 300, 116 L.Ed.2d 243 (1991). Although the inquiry concerns the taxpayers' subjective intent, objective evidence may be used to establish that intent. See Independent Elec. Supply, 781 F.2d at 726. Taxpayers have the burden to show they had the requisite profit motive. See id. at 727; see also Welch v. Helvering, 290 U.S. 111, 54 S.Ct. 8, 78 L.Ed. 212 (1933) (taxpayer has burden of proving Commissioner wrong).

Taxpayers argue that in determining profit motive the Tax Court should not have applied the objective Rose test. The government responds that the Rose test is simply an application of factors that courts typically use to determine whether investments in activities asserted to be profit motivated were actually entered into for tax benefits. See Collins v. Commissioner, 857 F.2d 1383, 1385-86 (9th Cir.1988) (rejecting the Rose test as such but finding its analysis proper). We agree. In applying the broader "generic tax shelter" and "economic substance" tests, the Tax Court made the determination crucial to the instant case--whether the taxpayers had an actual and honest profit objective. See Karr v. Commissioner, 924 F.2d 1018, 1023 (11th Cir.1991) (court focused on substance of transaction to determine if transactions were sham), cert. denied, --- U.S. ----, 112 S.Ct. 992, 117 L.Ed.2d 153 (1992).

Courts have found the factors listed under Treas.Reg. § 1.183-2(b) pursuant to the § 183 hobby loss provision ² helpful in determining good faith intent to realize a profit as required by § 174 and other code sections. See, e.g., Independent Elec. Supply, 781 F.2d at 726-27 (using factors to determine §§ 162, 167 and 174 deductibility); Brannen v. Commissioner, 722 F.2d 695, 704 (11th Cir.1984) (using factors to determine § 183 deductibility). In the instant case the Tax Court specifically stated, in applying the Rose test, that "[i]n the cases before us, the result under the section 183 analysis would be the same as under the Rose economic substance analysis." 58 T.C.M. (CCH) at 834 n. 7. Although we believe that the § 183 factors are helpful in assessing subjective intent, see Independent Elec. Supply, 781 F.2d at 726; Brannen, 722 F.2d at 704, those factors are not exclusive; all of the unique circumstances of a case must be considered. See Treas.Reg. § 1.183-2(b); Independent Elec. Supply, 781 F.2d at 727.

Although each case is unique, a review of cases involving research and development programs and related types of activities reveals common components...