Smith v. C.I.R.
| Decision Date | 27 June 1991 |
| Docket Number | No. 90-1007,90-1007 |
| Citation | 937 F.2d 1089 |
| Parties | -5076, 91-2 USTC P 50,326 Dean B. SMITH and Irma Smith, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. |
| Court | U.S. Court of Appeals — Sixth Circuit |
Dennis N. Brager (argued), Jackson D. Hamilton, Spensley, Horn, Jubas & Lubitz, Los Angeles, Cal., for petitioners-appellants.
Peter K. Scott, I.R.S., Office of Chief Counsel, Gary R. Allen, Acting Chief, Mary F. Clark, David I. Pincus (argued), Kenneth W. Rosenberg, U.S. Dept. of Justice, Appellate Section Tax Div., Washington, D.C., for respondent-appellee.
Before NELSON, Circuit Judge, WELLFORD *, Senior Circuit Judge, and JOINER **, Senior District Judge.
Appellants, Dean B. Smith and Irma Smith, appeal from the decision of the United States Tax Court concerning deficiencies and penalties imposed upon their federal income tax for 1981 and 1982 by the Commissioner of Internal Revenue. The Tax Court determined that the 1981 and 1982 deficiencies constituted substantial underpayments attributed to a tax-motivated transaction under I.R.C. Sec. 6621 and that petitioners were liable for an additional assessment (in addition to Sec. 6661). Smith v. Commissioner, 91 T.C. 733 (1988). On this appeal, we must decide: (1) whether the Tax Court correctly determined the taxpayers were not entitled to deduct their allocable shares of partnership losses from the Koppelman Process activities; and (2) whether the Tax Court correctly sustained an addition to petitioners' tax under I.R.C. Sec. 6661 for a substantial understatement of tax and imposed additional interest under Sec. 6621(c) for substantial underpayments attributable to tax-motivated transactions.
The Tax Court decided that appellants were not entitled to deduct a pro rata share of the losses incurred by Syn-Field Associates, Ltd. (SFA). 1 The Tax Court determined that the taxpayers were not liable for an addition to tax pursuant to Sec. 6659. In 1989, the Tax Court issued a supplemental opinion concerning the calculation of the amount of the underpayment subject to the addition to tax under I.R.C. Sec. 6661. We have jurisdiction to hear this appeal under 26 U.S.C. Sec. 7482.
In 1981, the Smiths became limited partners in SFA. In 1981, James Karr became a limited partner in Peat Oil and Gas Associates, Ltd. (POGA). SFA and POGA (collectively the "partnerships") were formed for the purpose of (1) engaging in the exploration and development of oil and gas prospects and the acquisition and ownership of gas and oil interests; (2) owning, licensing or otherwise exploiting technology relating to the production of synthetic fuel (K-Fuel) (K-Fuel is a high heating value solid fuel, physically resembling coal, produced by placing wood, peat, lignite and other low grade fossil fuel into a Koppelman Reactor at temperatures and pressures) from peat and other materials; and (3) experimenting with, using, and licensing technology to try to demonstrate the commercial feasibility of producing synthetic fuel from peat and other cellulosic materials. The idea included the construction, operation, and management of a pilot plant that would attempt to convert peat and other cellulosic material into synthetic fuel for marketing purposes. We set out facts that are found essentially undisputed by the Tax Court. The partnerships entered into a joint venture agreement to own, operate, and manage a North Carolina pilot K-Fuel plant. This is known as the "Koppelman process."
The Koppelman process, reviewed and extensively written about in various technical and industry journals, was developed by Edward Koppelman. In 1980, the United States Department of Energy awarded Koppelman a substantial grant to study the feasibility of his process. Pursuant to this grant, Koppelman, SRI International (SRI), the University of Maine, a large investment banker, and others, including Ekono, Inc. and Central Maine Power Company, a utility and a large engineering firm, prepared a report concluding that the Koppelman process was "technically, environmentally, and economically feasible." 91 T.C. at 735. SRI is a research and development organization that provides research and consulting for business and government clients worldwide.
In the summer of 1981, Koppelman, together with SRI, completed a model plant capable of producing K-Fuel in small quantities. At the end of 1981, it was believed that the chances of completing successful construction of a K-Fuel plant were high.
In August 1981, Ronodo Corporation, N.V. (Ronodo) sublicensed from Koppelman the exclusive right to use the Koppelman process within the State of North Carolina to refine and convert peat and wood into K-Fuel. Koppelman also granted Ronodo certain additional rights, all of which were sublicensed by Ronodo to its wholly owned subsidiary Sci-Teck Licensing Corp. (Sci-Teck).
At the end of 1981, the partnerships involving Smith and Karr licensed from Sci-Teck the exclusive rights within the State of North Carolina to use the Koppelman process with respect to peat and wood, as well as the nonexclusive rights to use the Koppelman process in the remainder of the United States with respect to any material other than bagasse. The partnerships agreed to pay a license fee to Sci-Teck including payment by both cash and notes.
The partnerships also entered into research and development agreements with Fuel-Tech Research and Development (FTRD), which was to conduct and coordinate the research and development efforts of Koppelman, A.T. Kearney, and others, and to oversee the construction by Stone & Webster of a Koppelman process plant. The partnerships agreed to pay FTRD a fee for its services, again through cash and partnership notes. By 1984, a Koppelman process plant had been built in North Carolina.
Taxpayers purchased their one unit partnership interest for $161,500, pursuant to the following schedule of principal amounts:
$10,000 payable upon subscription to SFA
10,000 due Mar. 1, 1982
10,000 due Mar. 1, 1983
7,500 due Mar. 1, 1984
24,000 due Mar. 1, 1993
30,000 due Mar. 1, 1994
30,000 due Mar. 1, 1995
30,000 due Mar. 1, 1996
10,000 due Mar. 1, 2007
Taxpayers' obligations to SFA were in the form of full recourse promissory notes, and they made timely payments of principal through 1983. Their 1984 principal payment was not made until 1985. With Martin Kaye's 2 consent, taxpayers delayed until 1986 the interest payments due in 1982, 1983, and 1984. On December 30, 1981, the taxpayers entered into the described agreements with Sci-Teck and FTRD whereby they agreed to assume personal liability for SFA's obligations in the total amounts of $99,200 and $24,800, respectively.
On their disputed income tax returns for 1981 and 1982, taxpayers deducted $40,392 and $38,316, respectively, representing their distributive share of partnership losses. The Commissioner disallowed these deductions on the ground that it had not been established that the losses were actually incurred in connection with an activity in which the partnership was engaged for profit or with respect to a trade or business. The Commissioner also determined that taxpayers' investment in the partnership lacked economic substance other than the avoidance of tax.
The taxpayers then petitioned the Tax Court to redetermine the proposed tax deficiency. Their case was selected as one of two test cases involving the SFA and POGA partnerships. Following a week-long trial, the Commissioner conceded that the taxpayers could deduct their distributive shares of partnership losses attributable to oil and gas investments. The Tax Court opinion, which we review, addressed the partners' distributive shares of losses represented by payments to Sci-Teck for license fees and to FTRD for research and development. The Tax Court held that the partnerships were not entitled to the claimed deductions. Citing Rose v. Commissioner, 88 T.C. 386, 414 (1987), aff'd, 868 F.2d 851 (6th Cir.1989), the Tax Court determined that tax motivations shaped the limited partnership transactions in question and that Koppelman Process activities lacked economic substance apart from the anticipated tax benefits. 3 The Tax Court, moreover, determined that such activities were not "in connection" with the partnerships' trade or business under I.R.C. Sec. 174.
The Commissioner conceded that taxpayers may deduct their distributive shares of partnership losses attributable to oil and gas investments and may use their distributive shares of any credits attributable thereto. The only deductions in issue, then, are the distributive shares of losses represented by partnership payments to Sci-Teck for license fees and to FTRD for research and development. There is no dispute but that the claimed losses to be deducted must have been incurred in an activity in which taxpayers engaged for profit, and with respect to the research and development expenses, the losses must have been incurred in connection with a trade or business.
The Tax Court noted that ten percent of contributed funds to the various related partnerships was to go to working capital while seventy percent was to go to "promotions, attorneys, or network entities." The offering memorandum, however, provided that interest on the limited partners' short-term notes was to be added to working capital, estimated at $28,125 in 1982, $140,625 in 1983, and about $190,000 in 1984. Only 125 units (one-half of the total proposed) were sold. Working capital was to be maintained at $150,000. The opinion also noted that "up to 85 percent of the net cash flow generated by the oil and gas activities would be utilized to increase oil and gas holdings and to pay off the partnerships notes to FTRD (the entity created to oversee construction) and Sci-Teck." Analyses prepared by SFA and POGA, the Tax Court conceded, indicated that "projected revenues from oil...
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