Spellman v. C.I.R.

• Decision Date: 21 April 1988
• Docket Number: No. 87-2177,87-2177
• Citation: 845 F.2d 148
• Parties: -1162, 88-1 USTC P 9302, 6 U.S.P.Q.2d 1729 Burton L. SPELLMAN and Roslyn Spellman, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 148

845 F.2d 148

61 A.F.T.R.2d 88-1162, 88-1 USTC P 9302,

6 U.S.P.Q.2d 1729

Burton L. SPELLMAN and Roslyn Spellman, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 87-2177.

United States Court of Appeals Seventh Circuit.

Argued Feb. 26, 1988.

Decided April 21, 1988.

Bernard Wiczer, Wiczer & Associates, Chicago, Ill., for petitioners-appellants.

Gary D. Gray, Appellate Sec., Tax Div., Dept. of Justice, Washington, D.C., for respondent-appellee.

Before BAUER, Chief Judge, POSNER, Circuit Judge, and PELL, Senior Circuit Judge.

POSNER, Circuit Judge.

Since 1954 a taxpayer has been allowed to deduct from his income, as a current expense, "research or experimental expenditures which are paid or incurred ... during the taxable year in connection with his trade or business." 26 U.S.C. Sec. 174(a)(1). This exceptional treatment--exceptional because research and development expenditures are capital in nature, since they yield benefits over a period of time rather than when incurred--may reflect the fact that such expenditures create what economists call "external benefits." These are benefits that the producer cannot capture in the prices that he charges for the goods or services that he sells. Information, including an idea for a new product or process, is an example of a valuable product the producer of which often cannot reap the benefits, because information once created is easy to appropriate by competitors. Sometimes an inventor can capture the full social benefits of his inventive activity by patenting his inventions, but often not, since patent protection is limited in duration, costly, and uncertain. So there is an argument for giving such activity preferential tax treatment, though whether or not that is the reason behind section 174(a)(1) is speculative at best.

At first the Internal Revenue Service interpreted the statute to mean that the taxpayer must already be engaged in a trade or business (hereinafter just "business") in order to be allowed to take the deduction, but the Supreme Court disagreed and allowed the investor in a partnership formed to develop a new product to deduct his pro rata share of the partnership's research and development expenses. Snow v. Commissioner, 416 U.S. 500, 94 S.Ct. 1876, 40 L.Ed.2d 336 (1974). As a result, an expenditure can qualify for immediate deductibility even if it is in connection with a business that has not yet gotten off the ground.

Snow makes it important to determine whether the prospects for developing a new product that will be exploited in a business of the taxpayer are realistic, and that question is the focus of this case as it was of Levin v. Commissioner, 832 F.2d 403 (7th Cir.1987). If those prospects are not realistic, the expenditure cannot be "in connection with" a business of the taxpayer. In Levin, where the partnership was formed to develop food machinery, not only was the partnership not in the food machinery business already--that would not have been critical, after Snow--but the actual development of the machinery was to be done by another company, which would also have the right to sell the machinery it developed. The agreement gave the partnership some rights to technology developed by the company; but basically, as the Tax Court found after a trial, the partnership was a passive investor. It was seeking to deduct not a development expense in connection with its own current or prospective business--its own business was and in all likelihood would remain investments--but a capital contribution to a company that was in the business of developing new products. The partnership was not likely to become a producer, and the Tax Court therefore disallowed the deduction, and we affirmed.

This case is similar, except that here the Tax Court did not give the taxpayers a trial but instead granted summary judgment to the Internal Revenue Service. The taxpayers, Mr. and Mrs. Spellman, are limited partners in Elmer South Oil Partnership, which is in turn a limited partner in Sci-Med, the general partner of which is an Israeli company. The agreement creating Sci-Med provided that Sci-Med would enter into a research and development agreement with Teva Pharmaceutical Industries, Israel's largest drug manufacturer and the parent of Sci-Med's general partner. Sci-Med would contribute $855,000 to enable Teva to develop new antibiotics, specifically new penicillins. Teva would have exclusive rights to make, sell, license, etc. the new penicillins. The Spellmans claim that, as a matter of custom in the industry and therefore an implied term of the contract, these rights would not vest in Teva until the products were actually developed--until then they would remain with Sci-Med. This reservation of rights would be significant if Teva went broke during the developmental period, but probably not otherwise; and while, in the event of Teva's bankruptcy, the reservation would give Sci-Med additional assets, it would no more put it in the pharmaceutical business than foreclosing on a real estate mortgage would make a bank a real estate company.

The agreement provided that Teva would pay Sci-Med 5 percent of Teva's revenues from the new penicillins, as a royalty, until Sci-Med recovered its $855,000; the royalty would then drop to 1 percent. Antibiotics developed under the agreement but not as part of the specific project to develop new penicillins--byproducts, as the parties call them--would belong to Sci-Med, but Teva was given the right to purchase Sci-Med's rights to the byproducts for $20,000. Finally, the agreement granted Sci-Med the right to monitor Teva's research and development program in order to assure compliance with the agreement.

If Sci-Med had merely hired Teva to conduct research and development as its agent, the research and development expenditures would be Sci-Med's for purposes of the statute. See 1 Bittker, Federal Taxation of Income, Estates and Gifts p 26.4.2 at p. 26-23 (1981). Even so, it would...