Peat Oil & Gas Assocs. v. Commissioner

Ruwe, J., concurring: I agree with the result reached by the majority; however, because the Court of Appeals for the Sixth Circuit reversed our holding in Smith v. Commissioner, 91 T.C. 733 (1988), revd. 937 F.2d 1089 (6th Cir. 1991), and disagreed with our “generic tax shelter analysis”, I wish to express my views on the utility of continuing to use that analysis and on the profit-objective requirement of section 183.

The Generic Tax Shelter Analysis

The generic tax shelter analysis was first articulated in Rose v. Commissioner, 88 T.C. 386 (1987), affd. 868 F.2d 851 (6th Cir. 1989). It attempted to combine the test for determining whether there was a profit objective with the test for determining whether a transaction had economic substance. The goals of the unified test were to “emphasize objective factors”, “not require weighing the objective facts against a taxpayer’s statement of his intent,” “be more understandable to taxpayers who doubt our ability to determine their subjective state of mind”, and treat similarly situated taxpayers the same. Rose v. Commissioner, 88 T.C. at 414 .

While these goals were laudable, a close look at the analysis in Rose leads me to the conclusion that the unified approach required findings with respect to the same subjective and objective factors that the separate tests required. 1 That being the case, the results produced by the unified analysis will be the same as those produced by the separate tests. However, since many tax shelter-type cases can be totally disposed of by using either the subjective profit objective test, see Hayden v. Commissioner, 889 F.2d 1548 (6th Cir. 1989), affg. T.C. Memo. 1988-310 ; Thomas v. Commissioner, 792 F.2d 1256 (4th Cir. 1986), affg. 84 T.C. 1244 (1985); Seaman v. Commissioner, 84 T.C. 564 (1985), or the economic substance test, see Illes v. Commissioner, 982 F.2d 163 (6th Cir. 1992); 2 Cherin v. Commissioner, 89 T.C. 986 (1987); 3 James v. Commissioner, 87 T.C. 905 (1986), affd. 899 F.2d 905 (10th Cir. 1990), there is no apparent benefit to be gained by continuing to apply a unified approach requiring both tests.

The unified approach, if properly used, does not lead to erroneous results. See Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988), affg. T.C. Memo. 1987-217 . However, there has been some misunderstanding of what we intended. For example, the Court of Appeals for the Sixth Circuit in Smith v. Commissioner, 937 F.2d 1089 (6th Cir. 1991), concluded that we had used a profit-motive test that focused on whether the taxpayer’s subjective expectation of profit was “reasonable” rather than focusing on whether the profit objective was actual and honest. This was not our intention, see majority op. pp. 275-276. Nevertheless, because the unified approach has been misunderstood, has been rejected by several Courts of Appeals, 4 and is not particularly helpful, I would discontinue using it.

The Profit-Objective Test

The Court of Appeals for the Sixth Circuit in Smith believed that we were clearly erroneous in finding that there was no actual and honest profit objective.

We find it error to have concluded on the facts and record that the Smiths were motivated by “no business purposes” * * *. [Smith v. Commissioner, 937 F.2d at 1098-1099 ; emphasis in original.]

If our finding that the taxpayers had no profit objective was erroneous, our holding that the transaction was a sham under the unified generic tax shelter test would have been error. See McCrary v. Commissioner, 92 T.C. 827, 845 (1989). 5 However, the mere existence of a profit objective will not necessarily result in the allowance of deductions. A taxpayer still must meet the separate subjective test inherent in sections 162 and 183 requiring that the taxpayer’s primary purpose for engaging in the activity was to make a profit. See Cato v. Commissioner, 99 T.C. 633, 646 (1992). 6

The requirement that the activity be engaged in primarily for profit is the test used by the Court of Appeals for the Sixth Circuit. Hayden v. Commissioner, 889 F.2d 1548, 1552 (6th Cir. 1989), affg. T.C. Memo. 1988-310 . In Bryant v. Commissioner, 928 F.2d 745, 748 (6th Cir. 1991), affg. in part and revg. in part T.C. Memo. 1989-527 , the court stated:

A taxpayer may deduct development costs only if the primary objective of the mining venture was to make a profit. Collins v. Commissioner, 857 F.2d 1383, 1385 (9th Cir. 1988); sec. 183. However, the court shall not inquire into a transaction’s primary objective until it determines that the transaction is not a sham. Collins, 857 F.2d at 1385 ; Rose v. Commissioner, 868 F.2d 851, 853 (6th Cir. 1989).

In Bryant, as in Smith, the Court of Appeals reversed the Tax Court’s finding that the mining venture was a sham without economic substance. In Bryant, the Court of Appeals remanded the case to the Tax Court for a finding of whether the requisite profit objective was present. However, in Smith, the Court of Appeals did not remand the case in order for us to determine whether the requisite profit objective was present, nor did it make an independent finding that profit was the taxpayers’primary objective. 7

The distinction between finding that the taxpayers had a profit objective and finding that profit was their primary objective cannot be dismissed as mere semantics. Section 183 provides that, except as otherwise allowed in that section, no deduction is allowable that is attributable to an activity which is “not engaged in for profit”. 8 Section 183(c) states that the term “activity not engaged in for profit” should be defined by standards used in sections 162 and 212. The profit standards applicable to section 212 are the same as those used in section 162. See Agro Science Co. v. Commissioner, 934 F.2d 573 (5th Cir. 1991), affg. T.C. Memo. 1989-687 ; Antonides v. Commissioner, 893 F.2d 656 (4th Cir. 1990), affg. 91 T.C. 686 (1988). In order for expenses to be deductible under section 162, the activity in which they are incurred must meet the profit-objective standard necessary to be a “trade or business” within the meaning of section 162. As explained by the Supreme Court:

Section 162(a) provides a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Although the statute does not expressly require that a “trade or business” must be carried on with an intent to profit, this Court has ruled that a taxpayer’s activities fall within the scope of §162 only if an intent to profit has been shown. See Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987) * * * [Portland Golf Club v. Commissioner, 497 U.S. 154, 164 (1990).]

In Commissioner v. Groetzinger, 480 U.S. 23 (1987), the Supreme Court made clear that in order for a taxpayer to be in a trade or business, within the meaning of section 162, the “primary purpose” for engaging in the activity must be for profit. The Supreme Court stated:

the taxpayer must be involved in the activity with continuity and regularity and * * * the taxpayer’s primary purpose for engaging in the activity must be for income or profit. * * * [Commissioner v. Groetzinger, 480 U.S. at 35 . 9 ]

Accord Portland Golf Club v. Commissioner, supra.

Even before Groetzinger was decided, the Tax Court had held that deductibility under section 162 required that the taxpayer’s “primary purpose” for engaging in the activity be for profit.

In order to find that the partnership’s coal venture constituted the carrying on of a trade or business, we must first find that the partnership engaged in the activity with the primary and predominant purpose and objective of making a profit. Brannen v. Commissioner, 722 F.2d 695, 704 (11th Cir. 1984), affg. 78 T.C. 471 (1982); Ramsay v. Commissioner, supra at 810; Surloff v. Commissioner, supra at 232-233. As used in this context, “primary” means “of first importance” or “principally,” and “profit” means economic profit, independent of tax savings. Surloff v. Commissioner, supra at 233. While a reasonable expectation is not required, the profit objective must be bona fide. Fox v. Commissioner, 80 T.C. 972, 1006 (1983), affd. without published opinion 742 F.2d 1441 (2d Cir. 1984), affd. sub nom. Barnard v. Commissioner, 731 F.2d 230 (4th Cir. 1984), affd. without published opinion sub nom. Krasta v. Commissioner, 734 F.2d 6 (3d Cir. 1984), affd. without published opinion sub nom. Hook v. Commissioner, 734 F.2d 5 (3d Cir. 1984). [Seaman v. Commissioner, 84 T.C. 564, 588 (1985). 10 ]

Accord Thomas v. Commissioner, 84 T.C. 1244, 1269 (1985), affd. 792 F.2d 1256 (4th Cir. 1986).

This same requirement has been described by the Court of Appeals for the Sixth Circuit in the following terms:

The threshold inquiry in determining whether an activity is a trade or business or is carried on for the production of income is whether the activity is engaged in for the primary purpose and dominant hope and intent of realizing a profit. Godfrey v. Commissioner, 335 F.2d 82, 84 (6th Cir. 1964), cert. denied, 379 U.S. 966 , 85 S.Ct. 660 , 13 L.Ed.2d 560 (1965). In this context, “profit” means economic profit, independent of tax savings. Campbell, 868 F.2d at 836 . The burden of proving the requisite profit motive is on the taxpayer. Rules of Practice and Procedure of the United States Tax Court, Rule 142(a) (Jan. 1, 1984). A finding regarding a taxpayer’s motivation is purely one of fact, and as such may not be disturbed on appeal unless shown to be clearly erroneous. * * * [Hayden v. Commissioner, 889 F.2d 1548, 1552 (6th Cir. 1989), affg. T.C. Memo. 1988-310 ; fn. ref. omitted. 11 ]

“Primary” means first; principal; chief; leading; and first in rank or importance. Black’s Law Dictionary 1190 (6th ed. 1990); Webster’s Third New International Dictionary (1971), and we have previously held that “primary” means “of first importance” or “principally”. Fox v. Commissioner, 82 T.C. 1001, 1022 (1984), Seaman v. Commissioner, supra at 588; Thomas v. Commissioner, supra at 1269; see Malat v. Riddell, 383 U.S. 569, 572 (1966); Surloff v. Commissioner, 81 T.C. 210, 233 (1983). If two or more objectives or purposes motivated a taxpayer to engage in an activity,. courts must determine which one was “primary”. Thus, if a taxpayer was motivated by both profit and tax objectives, we must determine if profit was the “primary” objective. Seaman v. Commissioner, supra at 588, 590; 12 see Estate of Baron v. Commissioner, 83 T.C. 542, 558 (1984), affd. 798 F.2d 65 (2d Cir. 1986); cf. Commissioner v. Soliman, 506 U.S. _ , 113 S. Ct. 701, 702 (1993) (determining whether an office in a taxpayer’s home qualifies as his “principal” place of business requires a comparative analysis of the various business locations used by the taxpayer).

In applying the appropriate profit-motive standard, it must be recognized that tax considerations play a part in most, if not all, business decisions. Comparison of a taxpayer’s profit motive with other motives will sometimes be difficult. At times, it will be necessary to reconcile the profit-motive requirement with statutory tax incentives intended to promote certain types of activities. We have recognized that there are certain situations where deductions and credits are congressionally authorized even though an economic profit, independent of tax considerations, is not the primary objective. Fox v. Commissioner, supra at 1021. However, the deductions in the instant case do not fall within such an exception. It is true that some of the partnership deductions were for research and development expenditures, and that Congress provided some relief for research and development expenses in section 174 by allowing such expenses to be deducted if incurred “in connection with” a trade or business. That relief simply allowed deductions to be taken before the commencement of the trade or business operations as opposed to the normal section 162 requirement that deductions be limited to expenses incurred “in carrying on” a trade or business. See Snow v. Commissioner, 416 U.S. 500 (1974); Zink v. United States, 929 F.2d 1015 (5th Cir. 1991). Section 174 provided no relief from the requirement that the taxpayer must be engaged in a trade or business at some time, see Green v. Commissioner, 83 T.C. 667 (1984), nor did it provide relief from the requirement that in order to be a trade or business, the “primary” objective for engaging in the activity must be for profit. Nickeson v. Commissioner, 962 F.2d 973, 976 (10th Cir. 1992); Agro Science Co. v. Commissioner, 934 F.2d 573, 576 (5th Cir. 1991), affg. T.C. Memo. 1989-687 . 13

The generic tax shelter analysis used by us in Smith v. Commissioner, supra, did not require us to determine whether the taxpayers engaged in the activity with the primary purpose of making a profit. However, based on our opinion in Smith and the majority opinion in this case, it is clear tht Judge Cohen believed that profit was not the primary objective. In reversing our holding in Smith, the Court of Appeals for the Sixth Circuit did not find that the taxpayers engaged in their Koppelman-process activities with the primary objective of making a profit. Had that requirement been considered by the Court of Appeals, the result may well have been different. See Thomas v. Commissioner, 792 F.2d 1256, 1258, 1259 (4th Cir. 1986), affg. 84 T.C. 1244 (1985). 14

Respondent disallowed deductions for both lack of economic substance and lack of the requisite profit objective. Petitioners cannot prevail by simply proving that the activity had economic substance and thay they had a profit objective. They must also prove that profit was their “primary” purpose for engaging in the activity. This they have not done.

Chabot, Jacobs, Gerber, and Parr, JJ., agree with this concurring opinion. In Rose v. Commissioner, 88 T.C. 386 (1987), affd. 868 F.2d 851 (6th Cir. 1989), we found that the taxpayers did not have an actual and honest profit objective. 88 T.C. at 405, 415 . This finding alone would have been dispositive of the deductions and credits to which the unified generic tax shelter analysis was applied. We went on to find that there was no reasonable possibility that the transactions in issue would generate sales sufficient to recoup the taxpayer’s investment in order to produce a profit and that the transactions lacked economic substance. Id. at 405 . This second finding would have independently led to the conclusion that the activities in question should not be recognized for tax purposes even if the taxpayer had a profit objective. See Cherin v. Commissioner, 89 T.C. 986 (1987); James v. Commissioner, 87 T.C. 905, 924 (1986), affd. 899 F.2d 905 (10th Cir. 1990).

In Ules v. Commissioner, 982 F.2d 163, 165 (6th Cir. 1992), the court stated: “If the transaction lacks economic substance, then the deduction must be disallowed without regard to the ‘niceties’ of the taxpayer’s intent.” (Citations omitted.)

In Cherin v. Commissioner, supra at 994, we stated:

Subjective intent cannot supply economic substance to a business transaction. Where, as in the case at bar, we examine the transaction and conclude as we do in this case that Southern Star’s herd investment packages lack any realistic potential for profit, we need not examine the investor’s state of mind. This analysis, where it can be used, avoids the difficult task of weighing dual motives, such as we were forced to undertake in Fox v. Commissioner, 82 T.C. 1001 (1984).

See Hunt v. Commissioner, 938 F.2d 466 (4th Cir. 1991), affg. T.C. Memo. 1989-660 ; Smith v. Commissioner, 937 F.2d 1089 (6th Cir. 1991), revg. 91 T.C. 733 (1988); Rose v. Commissioner, 868 F.2d 851 (6th Cir. 1989), affg. 88 T.C. 386 (1987); see also Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988), affg. T.C. Memo. 1987-217 .

“A transaction that has a business purpose or profit objective will survive the Rose analysis of economic substance.” McCrary v. Commissioner, 92 T.C. 827, 845 (1989) (emphasis added).

If we were correct in Smith v. Commissioner, 91 T.C. 733 (1988), revd. 937 F.2d 1089 (6th Cir. 1991), in finding that there was no profit objective, it was not necessary to determine whether profit was the “primary” objective. See Estate of Baron v. Commissioner, 798 F.2d 65, 72 (2d Cir. 1986), affg. 83 T.C. 542 (1984). However, the often-stated requirement that there be an “actual and honest profit objective” does not replace the requirement that profit be the “primary purpose” for engaging in the activity.

The two-judge majority in the Court of Appeals in Smith acknowledged that whether the taxpayers had any profit objective was a close question and noted that four of the six appellate court judges who reviewed the facts agreed with the trial judge that the taxpayers had no profit objective. Smith v. Commissioner, 937 F.2d at 1089 . While the majority in Smith found that there was a profit objective, they did not decide whether the taxpayers had proven the more difficult requirement; i.e., that profit was their primary objective.

One of the reasons for respondent’s disallowance of the deductions in the instant case, and in Smith, was that the partnerships’ involvement in the Koppelman process was an activity not engaged in for profit.

Prior to Commissioner v. Groetzinger, 480 U.S. 23 (1987), the Supreme Court described the profit-motive requirement in the following words:

Section 162 permits a taxpayer to deduct “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Undoubtedly due to the desirability of tax deductions, §162 has spawned a rich and voluminous jurisprudence. The standard test for the existence of a trade or business for purposes of §162 is whether the activity “was entered into with the dominant hope and intent of realizing a profit.” Brannen v. Commissioner, 722 F.2d 695, 704 (CA11 1984). * * * [United States v. American Bar Endowment, 477 U.S. 105 , 110 n.1 (1986); emphasis added.]

In Levy v. Commissioner, 91 T.C. 838, 871 (1988), we stated that the existence of an “actual and honest profit objective” was sufficient and that the taxpayer need not show that profit was the primary purpose for the activity. Levy does not purport to overrule the “primary purpose” test adopted by the Tax Court, nor does it discuss or attempt to reconcile the opinions of the Supreme Court, Circuit Courts, and this Court dealing with the “primary purpose” test. It appears that the statement in Levy regarding the profit-objective requirement was intended to be limited to the unique circumstances of that case. See Levy v. Commissioner, supra at 871, 872. We have recognized that there are certain situations where deductions and credits are congres-sionally authorized even though profit is not the primary purpose for engaging in the activity. See Fox v. Commissioner, 82 T.C. 1001, 1021 (1984).

Most of the Courts of Appeals have expressly held that the primary or dominant purpose for engaging in the activity must be for profit. Simon v. Commissioner, 830 F.2d 449, 500 (3d Cir. 1987); Antonides v. Commissioner, 893 F.2d 656, 659 (4th Cir. 1990); Agro Science Co. v. Commissioner, 934 F.2d 573, 576 (5th Cir. 1991); Bryant v. Commissioner, 928 F.2d 745, 749 (6th Cir. 1991); Nickerson v. Commissioner, 700 F.2d 402, 404 (7th Cir. 1983); Vorsheck v. Commissioner, 933 F.2d 757, 758 (9th Cir. 1991); Nickeson v. Commissioner, 962 F.2d 973, 976 (10th Cir. 1992); Brannen v. Commissioner, 722 F.2d 695, 704 (11th Cir. 1984).

In Seaman v. Commissioner, 84 T.C. 564, 590 (1985), we stated:

Petitioners contend that the partnership is permitted to take advantage of tax deductions provided by law without destroying the validity of its profit objective. Of course, in so contending, petitioners miss the mark. The point is that the actions of the general partners, in elevating the importance of securing tax advantages over the importance of investigating the economic viability of the venture, belie a primary economic profit objective.

Congress allows deductions under 26 U.S.C. sec. 162 for expenses of carrying on activities that constitute a taxpayer’s trade or business, under 26 U.S.C. sec. 174 for research and development expenses in connection with a trade or business, and under 26 U.S.C. sec. 212 for expenses incurred in connection with activities undertaken to produce or collect income. Expenditures may only be deducted under sections 162, 174, and 212 if the facts and circumstances indicate that the taxpayer made them primarily in furtherance of a bona fide profit objective independent of tax consequences. 26 C.F.R. sec. 1.183-2(a) (1990); Mayrath v. Commissioner, 357 F.2d 209, 214 (5th Cir. 1966); Drobny v. Commissioner, 86 T.C. 1326, 1340 (1986). [Agro Science Co. v. Commissioner, supra at 576.]

In Thomas v. Commissioner, 792 F.2d 1256, 1258-1259 (4th Cir. 1986), affg. 84 T.C. 1244 (1985), the court explained that the determination of whether the activity was engaged in primarily for profit, is a test that is separate and apart from whether the transaction was a sham.

The taxpayers contend that the court should have applied the “sham transaction” test. * * *

We reject this argument. The Commissioner did not disallow the taxpayers’ deductions on the ground that the program was a sham. Instead, the Commissioner asserted that the program lacked the primary objective of making a profit. These are different grounds for invalidating deductions. See Sanderson v. Commissioner, 1985 T.C.M. (P-H) ¶ 85,477 at 2140 n. 15. If a business has the primary objective of making a profit, deductions pertaining to a specific transaction may or may not be allowed depending on whether the transaction is a sham. See, e.g., Rice's Toyota World, 752 F.2d at 91-92. The issue in this case is more fundamental. It is whether the mining venture itself has the primary objective of making a profit.