Rosenberg v. Commissioner

• Decision Date: 31 August 1987
• Docket Number: Docket No. 8812-83.
• Citation: 1987 TC Memo 441,54 TCM(CCH) 392
• Parties: Reuben Rosenberg and Michele G. Rosenberg v. Commissioner.
• Court: U.S. Tax Court

54 TCM 392

1987 TC Memo 441

T.C. Memo. 1987-441

Reuben Rosenberg and Michele G. Rosenberg v. Commissioner.

Docket No. 8812-83.

United States Tax Court.

Filed August 31, 1987.

Paul C. Arshonsky, 120 S. LaSalle St., Chicago, Ill., Marvin Kamensky, and Michael A. Sandberg, for the petitioners. Andrew P. Fradkin, for the respondent.

Memorandum Findings of Fact and Opinion

HAMBLEN, Judge:

Respondent determined deficiencies, and an addition to tax, in petitioners' Federal income tax as follows:

                                                  Addition to Tax
                Taxable Year Ended     Deficiency     Section 6653(a)1
                December 31, 1979   $59,186.00      $2,959.00
                December 31, 1980    11,307.00       -
                

After concessions,² the issues for determination are: (1) whether petitioners are entitled to claim deductions for research and development expenditures for the taxable years at issue; (2) whether petitioners are liable for an addition to tax for negligence under section 6653(a) for the taxable year 1979; and (3) whether petitioners are liable for additional interest under section 6621(c).³

Findings of Fact

Some of the facts have been stipulated and are found accordingly. The stipulation of facts, the first supplemental stipulation of facts, and attached exhibits are incorporated herein by this reference.

Petitioners resided in Skokie, Illinois, when they filed their petition in this case.

Petitioner is a graduate of DePaul University and is a Certified Public Accountant (hereinafter "CPA").⁴ From 1962 through 1977, petitioner was an employee of the Internal Revenue Service (hereinafter "IRS"). Petitioner served as an IRS agent from 1962 through 1969. From 1969 until 1977, petitioner served in management positions at IRS including positions as a training instructor for new IRS agents and as a manager of large case audits. In addition, petitioner taught CPA review courses. In 1977, petitioner joined Engler, Zoghline & Mann, a pension consulting firm which administers and designs profit-sharing and pension plans. During the taxable years at issue, petitioner worked at Engler, Zoghline & Mann.

Roger Shiffman (hereinafter "Shiffman") and Edward Jacobson (hereinafter "Jacobson") are individuals who were actively engaged in the toy business prior to and during the taxable years at issue. Prior to 1979, Shiffman was employed at Tiger Electronic Toys, Inc., a subdivision of Interstate Industries. Shiffman has a B.S. in marketing from the University of Illinois and has been involved in the sales and marketing of toys throughout his working career. Jacobson was a senior engineer at Interstate Industries in charge of engineering and manufacturing toy products. In early 1979, while still at Interstate Industries, Shiffman and Jacobson discussed the concept of developing, manufacturing and marketing a hand-held electronic toy called "Mimic", a toy originally conceived of by Jacobson. As a result of this discussion, Shiffman and Jacobson decided to leave Interstate Industries and form their own toy manufacturing business. While Shiffman could market "Mimic" and Jacobson could work on the actual production, funds were needed to perform the research and development necessary to transform "Mimic" from Jacobson's concept into a tangible product.

Marvin Kamensky (hereinafter "Kamensky") was an attorney and partner in the law firm of Kamensky & Landan.⁵ During 1979, Michael Erens, Shiffman's brother-in-law, was an attorney practicing at Kamensky & Landan. In early 1979, Shiffman and Jacobson were introduced to Kamensky by Michael Erens. Shiffman and Jacobson attended an initial meeting at Kamensky's home to discuss their proposed toy business. Shiffman and Jacobson were in need of funds. Kamensky was interested in the proposed business and indicated he knew of other individuals who would also be interested in the business.

In 1979, Kamensky contacted petitioner concerning an investment opportunity in the production of electronic toys. Petitioner attended a meeting at Kamensky's office where Shiffman and Jacobson presented their toy business proposal. A Preorganization Subscription Agreement and Disclosure Statement (hereinafter the "Subscription Agreement") dated March 14, 1979, states that this investment opportunity involves ownership in two simultaneously-created entities, Koala "T" Toys, Inc. and Electronic Research Associates.

Koala "T" Toys, Inc. (hereinafter Koala "T"), an Illinois corporation, was to be formed by the issuance of 100,000 shares of common stock with no par value. In exchange for a capital contribution of $700, Shiffman and Jacobson received 70,000 shares of stock. For a capital contribution of $50, Kamensky & Landan received 5,000 shares. The remaining 25,000 shares were to be issued to 15 investors in exchange for a capital contribution of $10,000. All stock issued was to be placed in a Voting Trust to be voted by Shiffman, the proposed chief executive and operating officer of the corporation.⁶

In addition to organizing Koala "T," the Subscription Agreement contemplates the organization of a general partnership called Electronic Research Associates. The general partners of Electronic Research Associates were to be the stockholders of Koala "T" Toys with the exception of Shiffman and Jacobson.⁷

Finally, the Subscription Agreement states that:

1. It is contemplated that the $40,000.00 invested in the general partnership and then paid to KOALA T TOYS, INC. for research and development work to be performed on behalf of the general partnership, should be deductible as an ordinary income tax deduction.

2. It is contemplated that the royalties received by the general partners of ELECTRONIC RESEARCH ASSOCIATES will be taxable at long-term capital gains rate.

3. It is contemplated that in the event the proposed venture were to completely fail, that of the total $200,000.00 + invested by the proposed subscribers (comprised of $10,000.00 paid for the common stock of KOALA T TOYS INC., $40,000.00 + paid for general partnership interests in ELECTRONIC RESEARCH ASSOCIATES, and the $150,000.00 of guarantees for loans to KOALA T TOYS, INC.), all of such amount would be deductible for Federal income tax purposes as ordinary deductions.

Electronic Research Associates was formed in March of 1979. The Partnership Agreement states that the purpose of the partnership is to engage "in the development of an electronic toy." The principal office of the partnership is Kamensky's law office. The managing partner is Kamensky who has "authority to bind the partnership in the ordinary course of the partnership's business." As one of 15 general partners, petitioner's percentage interest in the partnership was 6.6667 percent and his capital account was $2,666.67.

By letter dated June 28, 1979, petitioner learned that since the Preorganization Subscription Agreement and Disclosure Statement dated March 14, 1979, various changes had been made to the corporate structure.⁸ Due to these changes, the sale of securities was not in compliance with Illinois Security Law of 1953 and petitioner was sent an offer of rescission. The offer of rescission was signed by Shiffman as President of Jay-Alden International Group, LTD. (hereinafter "Jay-Alden").

In addition to the letter and offer of rescission, petitioner received a memorandum outlining the modifications to the Preorganization Subscription Agreement and Disclosure Statement. In particular, the memorandum stated:

Although it was intended that the proposed Illinois corporation be named KOALA `T' TOYS, INC., after careful consideration of this matter by ourselves in consultation with our counsel, Kamensky & Landan, a new more flexible corporate structure was decided upon whereby the following three (3) Illinois corporations were formed. This revised corporate structure now enables us to take advantage of various business opportunities which otherwise may not have been available to us with a single corporate entity. However, you must also be aware that with an increase in business opportunity there is always the possibility of an increase in risk. Accordingly, the failure of one or more of these corporations could have a detrimental effect upon your investment.

(i) JAY-ALDEN INTERNATIONAL GROUP, LTD., an Illinois corporation, which has all of the attributes which KOALA `T' TOYS, INC. was to have had (except as otherwise noted herein), and is in fact the Illinois corporation which you invested in. In addition, JAY-ALDEN INTERNATIONAL GROUP, LTD. caused the formation and owns all of the issued and outstanding no par value common stock of JAYSON INTERNATIONAL, LTD. and KOALA `T' TOYS, INC. (further discussed in (ii) and (iii) below), both of which are also Illinois corporations.

(ii) JAYSON INTERNATIONAL, LTD. is a wholly owned subsidiary, as well as the design and manufacturing arm of JAY-ALDEN INTERNATIONAL GROUP, LTD.

(iii) KOALA `T' TOYS, INC. is a wholly owned subsidiary, as well as the marketing arm of JAY-ALDEN INTERNATIONAL GROUP, LTD.

Of key importance, the memorandum noted that:

The information set forth in * * * the said Preorganization Subscription Agreement and Disclosure Statement relating to the issuance of 8,893 additional shares pro rata to the shareholders other than Roger Shiffman, etc. were changed because of the fact that if the partners of ELECTRONIC RESEARCH ASSOCIATES, an Illinois general partnership, own collectively more than 25% of the issued and outstanding stock of JAY-ALDEN INTERNATIONAL GROUP, LTD., then the royalties received by the partners of said general partnership would be treated as ordinary income and not as capital gain. Accordingly, such provisions were changed as herein below indicated to provide that in the event such $50,000 line of credit is used in whole or in part, no additional shares would be issued until January 2, 1984, but that the put price would be increased from $800,000 in the aggregate to $1,000,000 in the aggregate for all shares owned by the

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