62 T.C.M. (CCH) 229
VALLEY NATURAL FUELS, STEVEN ARTHUR RICHARDS, TAX MATTERS PARTNER, Petitioner
COMMISSIONER OF INTERNAL REVENUE, Respondent
United States Tax Court
July 25, 1991
Craig G. Christensen and John E. Barrus, for the petitioner.
Steven A. Wilson, for the respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
Respondent determined the following adjustments to Valley Natural Fuels' (VNF) partnership return for 1983, 1984, and 1985:
| ACRS Depreciation
|| $ 1,653
|| $ 90,098
| Credit Property
The issues for decision are (1) whether VNF's ethanol distillation plant was placed in service in December 1983 or June 1985 for purposes of depreciation and the investment tax credit and business energy credit; (2) whether an agreement executed in 1985 by VNF and the seller of the ethanol distillation plant changed the nature of VNF's promissory obligation to the seller; and (3) whether adjustments to the purchase price of the ethanol distillation plant in 1985 required VNF to recapture investment tax credit and business energy credit that it reported in 1983 and 1984. Unless otherwise indicated, all section references are to the Internal Revenue Code as amended and in effect for the years in issue. FINDINGS OF FACT Some of the facts have been stipulated, and the facts set forth in the stipulations are incorporated in our findings by this reference. VNF's principal place of business at the time the petition was filed was Fresno, California. Steven Arthur Richards (Richards) is the tax matters partner of VNF. Richards and Ken Leister (Leister) each own a 50-percent interest in, and are officers of, High Energy Fuels, Inc. (High Energy), the general partner of VNF. BACKGROUND VNF prepared an offering circular in connection with its formation. The offering circular stated that the business of the partnership was as follows: The principal business of the Partnership shall be to acquire and operate an ethanol distillation plant from FreeAn, Inc. The Partnership's objective is to produce and sell Anhydrous Ethanol (198.2+ proof Ethyl Alcohol). Petroleum companies purchase Ethanol to mix with unleaded gasoline to produce octane enhanced " Super Unleaded" gasoline. * * * Similarly, the marketing plan that was attached to the offering circular stated that VNF anticipated that the primary market for the ethanol that it produced would be independent oil companies in California who sell gasoline/ethanol fuel blends. The offering circular also described the " ethanol industry" and the process of blending ethanol with unleaded gasoline to produce " Super Unleaded" gasoline, a product originally marketed as gasohol. There was no mention of any other use for ethanol in the offering circular. The offering circular projected income and cash flow based on the sale of " 199+ proof ethanol." Prior to the time that VNF was formed, Leister, as well as certain officers of FreeAn, explored the potential uses of ethanol and found that there was a potential market in the Midwest for ethanol that was less than 198.2 proof. Such ethanol was used as fuel alcohol for certain farm machinery and equipment. VNF did not, however, include the sale of any such ethanol in its projection of income and cash flow in the offering circular. The actual cash contributions of the partners of VNF during the years in issue totaled $231,121. Two of the partners of VNF also executed promissory notes payable to VNF, dated December 30, 1983. These notes recited that they were executed by the maker " as evidence of the * * * [maker's] obligation to pay under the terms and conditions of that certain Certificate and Agreement of Limited Partnership of * * * [VNF]." VNF had not filed a certificate of limited partnership with the State of California as of the end of 1983. THE PURCHASE AGREEMENT On or about December 30, 1983, VNF agreed to purchase an ethanol distillation plant (the facility) from FreeAn, Inc. (FreeAn), a company formed for the purpose of building ethanol distillation plants. The material terms of that agreement were contained in an unexecuted draft of a purchase agreement (the purchase agreement). The facility constituted section 38 property for purposes of the investment tax credit and energy property for purposes of the business energy credit. VNF agreed to pay FreeAn the sum of $1,650,000 for the facility. On December 30, 1983, VNF executed a promissory note payable to FreeAn in the principal sum of $1,452,500, together with interest at the rate of 10 percent per annum (the FreeAn note). The FreeAn note provided that payments were to be made on an annual basis in the principal amount of $145,250, plus accrued interest. The first payment of principal and interest was due in January 1985. On its books, VNF allocated $160,000 of the purchase price to a construction-in-process account, which represented the approximate future cost of a molecular sieve and of the construction of a building. VNF did not include that amount in calculating its investment tax credit and business energy credit. FreeAn warranted that the facility would " operate at the minimum of 1500 gallons of Ethanol per day for a period of 24 months." The purchase agreement provided that VNF's obligation to pay was based upon the completion of the facility and the facility's " ability to produce 199+ proof Ethanol at a rate of 1,500 gallons per day." VNF anticipated problems with the ethanol production equipment. To insure that the plant operated as FreeAn had warranted, a penalty clause was included in the purchase agreement. OPERATION OF THE FACILITY The facility was first operated in December 1983. As of December 30, 1983, the ethanol produced at the facility was less than 198.2 proof; the facility could not produce 198.2 proof ethanol without a molecular sieve. Actual ethanol production in 1983 was less than 1,500 gallons. At least a portion of that production was used for experiments on machinery at the facility. A molecular sieve was installed in the spring of 1984. It was leased on a long-term basis by VNF from FreeAn for $70,000. Also, in 1984, a wood-framed, metal-clad building was constructed at the facility. In late 1984, VNF experienced certain problems with the operation of the facility and with the operation of the molecular sieve. VNF hired Ray Thacker (Thacker), a consultant, to correct these problems. Thacker inspected the facility on December 21, 1984, and provided certain recommendations to VNF. Based upon Thacker's recommendations, VNF installed additional equipment at the facility in 1985. After the installation of the molecular sieve in 1984 and the other equipment in 1985, VNF was able to produce ethanol at the 198.2 proof level. ADJUSTMENTS TO THE FREEAN NOTE By letter dated December 22, 1984, VNF informed FreeAn that the facility had not yet achieved optimum production and provided FreeAn a summary of Thacker's recommendations that were necessary " to get production to the level indicated by * * * [FreeAn's] warranty." On February 26, 1985, the letter was executed by representatives of VNF and of FreeAn to reflect agreement between them as to changes in VNF's obligation (the February agreement). FreeAn agreed to reduce the purchase price of the facility by $160,000 and to forgive principal and interest payments due in 1984 but not paid. The February agreement provided: * * * [FreeAn] agrees to forgive the principle [sic] and interest due to * * * [FreeAn] from * * * [VNF] for the year 1984 and treat it as being paid by * * * [VNF] and that the note due * * * [FreeAn] has been reduced by same. It is also agreed that * * * [VNF] will postpone the enforcement of the penalty clause of the Purchase Agreement for a period of 6 months to allow * * * [FreeAn] to make the required correction to have the plant in optimum production as warranted. It is also agreed that the purchase price as stated in the Purchase Agreement be reduced by $160,000.00. The * * * [FreeAn note] will be amended to show the corrected loan amount. * * * It is further agreed that all payments to * * * [FreeAn] from this time forward will [be] made on a percentage of sales made by * * * [VNF]. The terms of these payments are detailed in the accompanying Optional Payment Agreement. The $160,000 reduction to the purchase price reflected the parties' understanding that the molecular sieve was to be treated separately from the purchase agreement; the remainder of the reduction reflected an adjustment to compensate for some of the problems with the facility and for the building that was constructed in 1984. With respect to the " corrected loan amount" referred to in the February agreement, the parties agreed to reduce the FreeAn note by $148,183. VNF treated that amount as consulting income for services provided by Leister to FreeAn. FreeAn agreed to forgive interest in the amount of $150,463. In 1985, the production of ethanol became economically nonviable for VNF due to the declining price of oil and other external factors. On December 23, 1985, FreeAn agreed to reduce the FreeAn note in the amount of $636,823 (December agreement). The December agreement provided: It is hereby agreed between * * * [VNF] and * * * [FreeAn] that for consideration...