Zink v. U.S.
| Decision Date | 03 April 1991 |
| Docket Number | No. 90-4352,90-4352 |
| Citation | 929 F.2d 1015 |
| Parties | -906, 91-1 USTC P 50,219, 19 Fed.R.Serv.3d 1091 William L. ZINK and Frances P. Zink, Plaintiffs-Appellees, v. UNITED STATES of America, Defendant-Appellant. |
| Court | U.S. Court of Appeals — Fifth Circuit |
Ernest J. Brown, Laura M. O'Hanlon, Gary R. Allen, Ann B. Durney, William D.M. Holmes, U.S. Dept. of Justice, Tax Div., Washington, D.C., Joseph S. Cage, Jr., U.S. Atty., Shreveport, La., for defendant-appellant.
William J. Friedman, Jr., H. Lee Leonard, Lafayette, La., for plaintiffs-appellees.
Appeal from the United States District Court for the Western District of Louisiana.
Before BROWN, SMITH, and WIENER, Circuit Judges.
After Dr. William L. Zink and his wife, Frances P. Zink, plaintiffs-appellees, paid additional taxes and interest resulting from the Internal Revenue Service's (IRS) disallowance of the deductions that they claimed for research and experimentation
expenses in airplane components under section 174(a)(1) of the Internal Revenue Code, the Zinks filed a refund suit in the district court against the defendant-appellant, the United States. The district court, ruling for the Zinks, held that they were not merely investors and that their activities in connection with the airplane components were sufficiently substantial and regular to constitute a trade or business. Finding that the district court erred, we reverse.
Dr. Zink is a surgeon who retired from his medical practice in December of 1981. His wife is a college professor who teaches elementary education. At issue in this appeal are deductions for research and experimentation expenditures claimed by taxpayers under Internal Revenue Code section 174(a) with respect to funds and the face value of promissory notes given as consideration to Tri-Liner International, Ltd. (Tri-Liner) and Sea Star Industries, Ltd. (Sea Star) in 1981 and 1982 for the development of certain component parts for two amphibian aircraft.
Lawrence Matanski is a licensed pilot involved in aircraft design. He is the president and general manager of Tri-Liner, Sea Star, and Airmaster, Inc., a subsidiary of Tri-Liner. In 1981, the Zinks entered into a purchase agreement with Tri-Liner under which Tri-Liner would perform research and development of specified component parts--the left and right wings--of a single-engine amphibian aircraft called the Avalon 680. Pursuant to this agreement, taxpayers became owners of the plans and specifications that resulted from the research and development. 1 The agreement also provided that "the rights arising from the research and development cannot readily be sold since no public market exists [and] that it may not be possible to sell or dispose of such rights." As consideration for the purchase of this research, the Zinks paid Tri-Liner $92,000 and executed a promissory note for $184,000, payable in December of 1991.
The Zinks, pursuant to the terms of the "purchase agreement," were required to enter into a separate licensing agreement. Under this licensing agreement, the Zinks granted Tri-Liner and Airmaster "a nonexclusive world-wide manufacturing right and license to use, employ and exploit all plans, specifications and technological information resulting from the research and development ... performed on behalf of [the taxpayers] ... with respect to the Aircraft Components and assemblies for purposes of ... manufacture, sale and installation of said Components." In exchange for this license, Tri-Liner and Airmaster agreed to pay taxpayers a royalty payment of $1,849 for each finished airplane ultimately sold.
In 1982, the Zinks entered into an identical agreement with Sea Star to purchase the research and development of specified component parts--the rudder parts--of a twin-engine amphibian aircraft called the Avalon "Sea Star 2." Pursuant to this purchase agreement, the Zinks were required to enter into a nonexclusive licensing agreement with Airmaster under which they would receive a royalty of $1,417 per aircraft sold. As consideration for the purchase of this research, the Zinks paid Sea Star $47,234 and executed a promissory note for $94,466 payable in December of 1992.
Both Tri-Liner and Sea Star contracted with Airmaster to perform the research and development for the investors in the Tri-Liner and Sea Star programs. Airmaster, in turn, either subcontracted this research to other entities and individuals or performed the research itself. It also maintained drawings and specifications of the various component parts developed.
In December of 1981, about one month after the Zinks entered into the Tri-Liner The Zinks communicated with the companies regarding the progress of the development and marketing of the airplanes. In August of 1985, the Zinks traveled to Seattle, Washington, to inspect the progress of the research and development of the planes, as well as the plant facilities where the research and development was being conducted.
research agreement, Tri-Liner notified the Zinks that the research and development on their wing component parts had been completed. In December of 1982, about two months after the Zinks entered into the Sea Star research agreement, the Zinks were notified that the research and development on their rudder parts was complete.
To provide the needed financing to put the Avalon 680 and Sea Star 2 into production, a plan was set up to merge the research programs into a new corporation called Avalon. Corniche Resources then purchased Avalon. Participants in the Tri-Liner and Sea Star programs, including the Zinks, were offered shares of stock in the new corporation equivalent to the price paid by the participants for their research and development rights. The participants were then required to pay the balance of their Tri-Liner and Sea Star notes by returning an equivalent amount of the stock to the holder of the notes. The Zinks accepted this stock offering.
A prototype Avalon 680 aircraft was built and flight tested. The Federal Aviation Administration issued operating licenses on the Avalon 680 prototype for research and development purposes. The Avalon 680 has been the subject of various aviation magazine articles. Color brochures have been printed and distributed in an effort to market the aircraft. There are insufficient orders for the Avalon 680 single-engine plane to justify its production, but orders have been made for the Avalon Sea Star 2.
On Schedule C submitted with their 1981 and 1982 federal income tax returns, the Zinks claimed deductions for research and development in the amounts of $276,000 and $141,700, respectively. These amounts represent the total of the cash payments and the face value of the promissory notes given as consideration under the two research agreements. The IRS disallowed the Zinks' claimed research and experimentation deductions. 2
The Zinks paid the additional $125,178 in taxes and interest resulting from the IRS's disallowance of their claimed research deductions. Thereafter, they filed a claim for refund of this amount which was denied by the IRS. The Zinks then filed the instant refund suit against the United States. The government's position was that the Zinks' research deductions were improper because (1) taxpayers were not engaged in the trade or business of developing or marketing aircraft components, and (2) taxpayers had not established that the research and development of their component parts was completed in the years for which deductions were taken.
A trial in the case was held on March 13, 1989, and March 14, 1989. Taxpayer Frances P. Zink, the taxpayers' accountant, and Lawrence Matanski, the President of Tri-Liner, Sea Star, and Airmaster, testified on the taxpayers' behalf.
At trial, Mrs. Zink testified that she and her husband looked into Tri-Liner and Sea Star programs because they wanted to invest a large sum of oil royalty income. She states that they chose these specific programs because they lived in an oil area and the programs related to the oil business. According to Mrs. Zink, they had never participated in this type of investment before.
Mrs. Zink admitted that prior to entering the transactions neither she nor her husband had engaged in the aircraft business. She testified expressly that she and her husband did not actually participate in the Mrs. Zink further testified that they never received any royalty payments or income from the programs and that they subsequently exchanged their royalty rights and the research agreement to Avalon, Inc. for stock, which they used to pay off their outstanding promissory notes with Tri-Liner and Sea Star. Mrs. Zink also testified that, before entering into this stock agreement, they made no effort to sell either the research and development or the aircraft components.
business and that they were not qualified to do that type of work. She also testified that she and her husband kept up with letters that they received, reports and the progress of potential sales, and the locations where the plane would be exhibited--information that came to them by virtue of the companies' mailing lists. She also testified that they visited the plant in Seattle, saw the plane and the prototype, and went to an exhibit of the plane in Louisiana. Although Mrs. Zink testified that they saw the plans, drafts, and blue prints of their plane components on their Seattle visit, she admitted that she "didn't have the professional knowledge" to know what she was looking at. She also acknowledges that although the parts were labelled on these documents, they could not identify their parts of the airplane on the documents.
Lawrence Matanski testified that he never met the taxpayers until after the airplane flew and that he had shown them the plant and the facility on their trip to Seattle. He also testified that after Dr. Zink signed the research agreements in 1981 and 1982,...
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