Roe v. Commissioner, Docket No. 9918-83

CourtUnited States Tax Court
Writing for the CourtTANNENWALD
Citation1986 TC Memo 510,52 TCM (CCH) 778
PartiesMargaret L. Roe, et al. v. Commissioner.
Docket Number20902-83,17978-84.,2364-84,Docket No. 9918-83,416-84
Decision Date08 October 1986

52 T.C.M. (CCH) 778 (1986)

T.C. Memo. 1986-510.

Margaret L. Roe, et al.1

Docket Nos. 9918-83, 20902-83, 416-84, 2364-84, 17978-84.

United States Tax Court.

Filed October 8, 1986.

52 TCM (CCH) 779

O. Jan Tyler and J. Duncan Webb IV, for the petitioners. George E. Gasper, Deborah A. Butler and Rebecca W. Wolfe, for the respondent.

Memorandum Findings of Fact and Opinion


These consolidated cases were assigned to and heard by Special Trial Judge Joan Seitz Pate pursuant to section 7456(d) and Rules 180, 181 and 183.2 The Court agrees with and adopts the opinion of the Special Trial Judge which is set forth below.

Opinion of the Special Trial Judge

PATE, Special Trial Judge:

These cases involved the following deficiencies in income tax:

 Petitioner Docket No. Year Deficiency
                Margaret L. Roe ................................ 9918-83 1979 $ 2,055.88
                Margaret L. Roe ................................ 17978-84 1980 1,994.00
                Michael L. & Patricia A. Sincleair ............. 20902-83 1979 8,097.10
                Louis L. Young ................................. 416-84 1978 27,327.06
                 1979 15,078.15
                 1980 5,945.11
                James & Teelaine Harvey ........................ 2364-84 1979 32,426.12

All of the issues arise from transactions between petitioners and Alpha Omega Publications, Inc. (hereinafter "Alpha Omega"). Petitioners claimed operating losses and investment credits attributable to franchises and video systems purchased from Alpha Omega. Respondent disallowed these losses and investment credits maintaining that: (1) petitioners did not have the requisite profit objective and, consequently, the losses are not deductible nor are the investment credits allowable; (2) these transactions were, in essence, non-interest bearing loans from petitioners to Alpha Omega; (3) the promissory notes executed by petitioners and payable to Alpha Omega did not represent genuine indebtedness and, therefore, interest thereon is not deductible nor may the notes be considered for purposes of computing amortization, depreciation and the investment credits; and (4) the video systems were not placed in service during the taxable years at issue nor were the films primarily educational or entertaining in nature as required by section 1.48-8(a)(3) and (5) of the Income Tax Regulations, and therefore, depreciation and investment credits attributable thereto are not allowable.

In summary, from 1978 through 1980, Alpha Omega sold franchises to various individuals, including petitioners, granting them the exclusive right to market Christian educational curriculum

52 TCM (CCH) 780
materials within specified geographical territories in the United States. In connection therewith, Alpha Omega's sales representatives offered their services to each of the franchisees to conduct a marketing program within each territory. The program was not successful. In 1983, Alpha Omega offered each franchisee the right to turn his franchise back to the company in return for (1) cancellation of the note representing the balance of his unpaid purchase price, and (2) installment payments of cash. Alpha Omega subsequently offered to exchange each installment contract for its common stock. As of the date of trial, all but one of the franchises had been surrendered.3

Petitioners reported income and claimed deductions which in all years resulted in losses on Schedule C. In addition, all petitioners, but one, claimed investment credits on video systems acquired with their franchises. Respondent disallowed the deductions and the investment credits.

Findings of Fact


Alpha Omega was founded by Dr. Rudolph Moore in the summer of 1977, when he formed Educational Media Corporation.4 He then engaged eight consultants,5 charging them with developing a Christian educational curriculum to be marketed primarily to churches and private schools. During numerous meetings, these consultants designed a curriculum based on a series of individual student workbooks known as "LIFEPACs." Each LIFEPAC was designed specifically for personalized instruction based upon measurable progress. In other words, the student had to master the learning materials contained in each LIFEPAC before progressing to the next. The consultants also formulated the basic parameters for developing each LIFEPAC and selecting the subject matter to be covered. Ten separate LIFEPACs were to be prepared for each subject for each year of study.

That summer Dr. Moore and the consultants set the criteria for selecting LIFEPAC writers. Each writer had to meet three major qualifications; each had to be a "born-again" Christian, hold a degree in the subject matter he would cover, and have at least three years of experience teaching the subject at the grade level at which he would be writing. Over three hundred persons applied for these positions. Ultimately, approximately 250 authors actively participated in the project.

The initial stage of the project, writing LIFEPACs for grades two through six, was completed by the spring of 1978. Later, LIFEPACs for the first grade and grades seven through twelve were developed. The second stage of the project (grade 1 and grades 7 through 12), was patterned on the original project and was completed in the latter part of 1978.

After a LIFEPAC was written, a consultant reviewed the material. It was then edited by Dr. Moore, and finally printed. It was a substantial undertaking. The average LIFEPAC is 50 pages long and there are ten LIFEPACs per grade level, hence, approximately 500 pages per subject per grade level had to be written. For the five basic subjects, this totaled approximately 2500 pages per grade level, which, for the initial stage, approximated 12,500 pages of material.6

A catalog prepared and distributed by Alpha Omega described the LIFEPACs offered for sale as follows:

The LIFEPAC series of study booklets is a complete developmental, academic, Christian curriculum. The LIFEPACs offer a curriculum based on Biblical truths and principles. The subjects of language, arts, mathemetics, science, and social studies are viewed through a Biblical perspective to assure individual growth in the Christian life-view. A complete Bible course encourages Christian growth as each student studies God's Word. Including Bible as one of the academic basics makes the LIFEPAC series the most comprehensive Christian curriculum available â with instruction leading to mental, social, and spiritual growth. ***

Other products offered by Alpha Omega included resource books, elective subjects, support materials, testing materials, spelling tapes and lists, supplies, promotional materials to be used with parents and church people, administrative materials, and training materials for administrators and teachers. Alpha Omega also

52 TCM (CCH) 781
offered materials and training to persons interested in starting their own Christian school.7

To finance the development of the LIFEPACs, two limited partnerships were formed. The first, Alpha Omega Publications, Ltd. (hereinafter "AOP I"), raised $350,000 in the fall of 1977 to develop LIFEPACs for grades 2 through 6, and the second, Alpha Omega Publications, Ltd. (hereinafter "AOP II"), raised $645,000 in the spring of 1978 to develop the LIFEPACs for grades 1 and 7 through 12. Alpha Omega was the general partner in both partnerships.

The first LIFEPACs were published in June of 1978, ready for the 1978-1979 academic year. Alpha Omega then established six training centers in which to train teachers in the use of its curriculum. By the fall of 1978 Alpha Omega was a going concern occupying 10,000 square feet of office and warehouse space, employing a staff of approximately 35 persons, including editors, typesetters, order processors, customer service representatives and warehouse staff. In addition, consultants and writers were retained as needed.

The Franchise Program

In the latter part of 1978, Alpha Omega required an infusion of capital to implement a full-scale marketing program. Various alternatives were discussed, including requesting additional capital from the limited partners of AOP I and AOP II; borrowing money from banks; issuing additional stock; and the franchise program. The franchise program had been proposed to several of Alpha Omega's Board members by John W. Duffell, III.8 After due consideration, the Board decided to offer for sale franchises granting the right to sell Alpha Omega's products within certain geographical areas located within the United States.

The franchise program was established in the latter part of 1978. The United States was divided into five hundred geographical territories, each denominated by a zip code. Each territory contained an average of 330 churches.9 By the end of the program, 214 individuals had purchased a total of 437 franchises.10

Each of the franchisees received an offering circular entitled "Alpha Omega Publications Presents a Franchise Investment for the Sale of

52 TCM (CCH) 782
Christian Curriculum" dated July 15, 1979 (hereinafter "1979 Offering Circular"). The 1979 Offering Circular described the transaction as the purchase of a video system11 and a franchise;12 related the history of AOP I, AOP II and Educational Media Corporation; listed the principals involved;13 included financial information such as unaudited financial statements; forecasted franchisee annual cash flow for the years 1979 through 1983 under various assumptions; and contained an extensive analysis dated December 15, 1978 describing the various tax aspects of the transaction. Also attached were forms for the license agreement, license promissory note, license security agreement, financial representation letter, and video system promissory note.14

The Franchise Agreement granted each petitioner the right to market and sell LIFEPACs in specific zip code areas under the supervision of and in accordance with the standards approved by Alpha Omega. The franchisee was required to...

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