Harris v. Commissioner

United States Court of Appeals,

Fifth Circuit.

No. 92-5097.

Joseph R. HARRIS, Petitioner-Appellant,

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

March 10, 1994.

Appeal from a Decision of the United States Tax Court.

Before POLITZ, Chief Judge, REYNALDO G. GARZA, and JOLLY, Circuit

Judges.

E. GRADY JOLLY, Circuit Judge:

The taxpayer appeals from the Tax Court's denial of his

deduction of his distributive share of payments made by his

partnership to a corporation as a research and development expense

under 26 U.S.C. § 174(a)(1). Because we find the partnership did

not pay for research and development "in connection with" its own

trade or business, we affirm the Tax Court.

I

In 1981, Jake Bauer and Howard Leith carried out a plan to

attract capital for continued funding of their research and

development of cementitious composites for use as tooling in the

aerospace industry and of glass-reinforced cement for use in a

substitute for wood in shipping pallets. First, Bauer and Leith

formed CemCom Research Associates, Inc. ("CemCom") to own the

technology and conduct research. Bauer and Leith anticipated that

CemCom would license the finalized technology to other entities

that would manufacture and sell the resulting cement products.

1

Second, the two men retained an investment advisor, Mr. Townsend,

to form Research One Limited Partnership (the "Partnership") to

attract capital by selling limited partnership interests to the

public. Third, the Partnership executed a Research and Development

Agreement (the "R & D Agreement") under which the Partnership

contracted out all of the research work to CemCom. The R & D

Agreement provided that all property rights arising from CemCom's

research would vest in the Partnership, and the Partnership would

pay installments totalling $5,050,000 to CemCom for the research

services. Fourth, the Partnership and CemCom executed a Technology

Transfer Agreement (the "Transfer Agreement") under which CemCom

received the option of obtaining a perpetual exclusive license of

the resulting technology. CemCom would have to pay substantial

royalties to the Partnership if it exercised the option. If it did

not exercise the option, however, CemCom, Bauer, and Leith could

not engage in any research, development, or business activity

involving the cement technology for a period of five years.

Under the R & D Agreement, the first two installments payable

to CemCom, totalling $2,250,000, would be funded with capital paid

into the Partnership by the partners. The final installment of

$2,800,000 would be paid over an eight-year period beginning in

1984. The investment prospectus indicated that the promoters

anticipated the final installment to be offset by royalties paid by

CemCom to the Partnership after the exercise of the licensing

option. In the event these royalties were insufficient to provide

additional research funds to CemCom, the limited partners would be

2

personally liable for their proportionate share of the final

installment. Townsend told potential limited partners that

although it was not highly probable that CemCom would exercise its

current option with high royalty payments, it was highly probable

that CemCom would renegotiate the licensing option to provide for

lower royalty payments.

When the research and development did not produce results as

quickly as hoped, Mr. Townsend became involved in assisting CemCom

in negotiating sublicensing agreements with third parties and in

obtaining capital from outside sources. In September 1984, CemCom

negotiated a new licensing agreement with the Partnership that

provided for royalty payments that were lower than those projected

in the original option, but were still sufficient to avoid

requiring the limited partners to fund the third installment under

the R & D Agreement. Between 1984 and 1986, the Partnership, as

CemCom's assignee, received six patents on the cement technology.

In March 1986, CemCom granted an exclusive sublicense to a chemical

company to commercialize all of CemCom's technology and products

for twenty-five years.1 Four months later, the Partnership

1

On page 24 of his brief, Harris states:

Eventually, the Partnership did license the patented

technology, after further arm's length negotiations.

In the interim, CemCom's option had expired.

The record (Volume II, Exhibit 46-AT), however, shows that

it was CemCom—not the Partnership—that sublicensed the

patented technology to the chemical company. Although

CemCom's option to license the technology expired in March

1984 (Volume II, Ex. 39-AM), CemCom nevertheless entered

into a licensing agreement with the Partnership on September

22, 1984 (Volume II, Ex. 45-AS) and, thus, had the exclusive

3

renegotiated its licensing agreement with CemCom to provide for

lower minimum royalty payments, but higher maximum royalty

payments.

In 1981, the Partnership accrued a deduction of $5,050,000 for

research expenses under section 174(a)(1) of the Internal Revenue

Code. As a limited partner, Mr. Harris deducted his distributive

share of this amount, and the Commissioner disallowed the

deduction.

II

The Tax Court agreed with the Commissioner and disallowed the

deduction because it held that the Partnership did not expend the

funds "in connection with [its] trade or business." Specifically,

the Tax Court held that there was no "realistic prospect" that the

Partnership would develop and exploit the cement technology,

through manufacture of a product or licensing of technology, in a

trade or business of its own. Instead, the Partnership was a

passive investment vehicle. The Tax Court also found that the

transfer of the cement technology to CemCom via the licensing

agreement did not constitute a trade or business of the

Partnership. Further, the Tax Court held that the clause in the R

& D Agreement that stated that CemCom undertook the research

activities "on behalf" of the Partnership did not attribute the

trade or business of CemCom to the Partnership.

III

A

rights to sublicense the technology in the marketplace.

4

Before the enactment of section 174, the treatment of research

expenditures depended on whether the taxpayer incurring the

expenses was an ongoing business or a start-up business. Ongoing

businesses could deduct research expenditures as ordinary and

necessary expenses incurred in "carrying on a trade or business."

See 26 U.S.C. § 162 (1988). Start-up companies, however, were

prevented from deducting research expenses by the general rule that

companies that had not yet begun business could not deduct expenses

because they did not incur the expenses in "carrying on" a trade or

business.2 Accordingly, start-up companies had to capitalize these

expenditures and their future ability to recover the costs depended

on the ultimate and sometimes unpredictable results of the

research. If the research effort was ultimately unsuccessful, the

start-up company could deduct the cost incurred as an abandonment

loss.3 If the expenditures were successful and produced a result

that had a determinable useful life, such as a patent, the start-up

company could amortize the cost over the relevant useful life.4 If

2

Professor Willis states:

A principle of federal tax law that is axiomatic

is that costs incurred by a taxpayer prior to entering

into a business are not deductible currently. Although

disagreements may exist over whether business in fact

has begun, there no longer are viable grounds for

challenging the basic legal principle.

Willis, et al., Partnership Taxation § 41.08, p. 41-13 (4th

ed. 1993).

3

S.Rep. No. 1622, 83d Cong., 2d Sess. 1, 33 (1954),

reprinted in 1954 U.S.C.C.A.N. 4621, 4663.

4

Id. at 33, 1954 U.S.C.C.A.N. at 4663.

5

the successful effort produced a result without a determinable

useful life, the start-up company had no means of recovering the

cost of research results short of selling the project in toto to a

third party.5

In designing section 174, Congress intended to: (1) eliminate

the tax treatment uncertainty faced by start-up companies beginning

a research project where they could not anticipate whether their

efforts would result in patentable or nonpatentable results; and

(2) encourage research and experimentation.6 To this end, Congress

mollified the harsh effects of section 162's beginning business

requirement by drafting section 174 to allow a deduction of

research expenditures incurred "in connection with," instead of in

"carrying on," a trade or business language. Section 174(a)(1)

provides:

A taxpayer may treat research or experimental expenditures

which are paid or incurred by him during the taxable year in

connection with his trade or business as expenses which are

not chargeable to [the] capital account. The expenditures so

treated shall be allowed as a deduction.

(Emphasis added).

There has since been one Supreme Court case interpreting this

section. In Snow v. Commissioner, 416 U.S. 500, 94 S.Ct. 1876, 40

L.Ed.2d 336 (1974), the Supreme Court allowed a partnership to

deduct research expenses under section 174 for the development of

an incinerator even though the device had not been marketed at the

end of the relevant tax year. The Court viewed section 174's "in

5

Id. at 33, 1954 U.S.C.C.A.N. at 4664.

6

Id.

6

connection with" language—unlike section 162's "carrying on"

language—as allowing the partnership to deduct the research

expenses even though the expenditures were connected with a future

business of the partnership rather than its current business. Id.

at 504, 94 S.Ct. at 1878-79.

B

Although Snow settled that the temporal nexus of a research

project to the start of an active trade or business was not

dispositive of section 174's applicability, it left open the degree

of "connection" required between the expenditures and the operation

of the trade or business itself—the operational nexus—in order to

trigger section 174's exception to the general rule of

nondeductibility of pre-operation expenditures. In analyzing the

operational nexus facet of section 174, the courts have dealt with

a broad spectrum of financial arrangements. At one end of the

spectrum lie arrangements in which a partnership buys stock in a

corporation, which then uses the capital to fund research

activities, manages the research activities itself, manufactures

the resulting product, sells the product in the marketplace, and

returns a portion of the profits to the partnership as dividends.

In these situations, the partnership does not incur research

expenses in connection with its trade or business but, instead,

functions as an investment vehicle that cannot deduct the cash paid

to the corporation under section 174 even if the corporation used

that very cash to fund its research expenditures. At the other end

of the spectrum lie financial arrangements in which a partnership

7

uses its own funds to conduct research activities, manufactures the

product itself, and sells that product in the marketplace. In this

instance, the partnership incurs research and development

expenditures in connection with its trade or business and can

deduct them under section 174. It is between these clearly defined

ends of the spectrum that the cases that guide our decision today

lie.

In Snow, 416 U.S. at 502, 94 S.Ct. at 1878, the partnership

actually conducted research activities. The general partner was an

inventor and devoted a significant amount of time to the research

and development of the incinerator. Id. at 502, 94 S.Ct. at 1877-

78. The partnership also contracted out some of the research work

to an engineering firm. Id. at 502, 94 S.Ct. at 1878. Eventually,

the research was successful, the partnership incorporated and sold

the incinerators to the public. Id. at 502 & n. 3, 94 S.Ct. at

1878 & n. 3. Thus, the partnership incurred the research

expenditures "in connection with" its trade or business of

developing, manufacturing, and selling incinerators, and the court

allowed the section 174 deduction. Id. at 504, 94 S.Ct. at 1879.

In Smith v. Commissioner, 937 F.2d 1089, 1091 (6th Cir.1991),

the partnership obtained a license to use certain energy

technology. In order to construct and operate an energy plant, the

partnership contracted out all the research and the construction

oversight to an outside research firm. Id. After the plant was

completed, however, the partnership owned, operated, and managed

the plant to produce "synthetic fuel for marketing purposes." Id.

8

Because, the research fees paid to the outside firm were "in

connection with" the partnership's trade or business of developing,

owning, and operating an energy plant, and section 174 applied to

allow the deduction of research expenses. Id. at 1097-98.

In Zink v. United States, 929 F.2d 1015, 1017 (5th Cir.1991),

this court dealt with a financial arrangement in which individuals

owned plans for component airplane parts instead of partnership

interests. The taxpayers contracted out both the research work and

the manufacturing and marketing activities. Under the relevant

agreements, the individuals paid cash to an aircraft design company

to conduct the research on the airplane parts. Id. at 1017.

Although the individuals would own the resulting plans, these plans

had no market value because they were only for the components of an

overall design. Id. Further, as part of the initial agreements,

the individuals immediately licensed the right to use, sublicense,

and otherwise exploit the results of the research. Id. Thus,

there was no "realistic prospect" that the investors who admittedly

knew nothing about the airplane business would ever engage in

developing or marketing airplanes or airplane parts. Id. at 1022-

23. Accordingly, we denied the deduction under section 174. Id.

at 1023.

Spellman v. Commissioner, 845 F.2d 148 (7th Cir.1988) (Posner,

J.), is illustrative of cases the circuit courts have dealt with in

which a partnership did not immediately grant a license to the

research company to manufacture and market the results of the

research, but in which the economic realities of the arrangement

9

insured that the partnership would grant such a license instead of

exploiting the research results itself.7 In Spellman, 845 F.2d at

150, a limited partnership paid a pharmaceutical company to engage

in research to develop penicillins and granted the pharmaceutical

company the exclusive right to "make, sell, license, etc." the new

penicillins and the option to purchase any byproducts of the

research for a small fee. The court found that there was no

realistic prospect that the partnership would engage in the

business of manufacturing or marketing the penicillins because,

despite the partnership's claimed reversionary rights to the

penicillins, it was not prepared to exploit the drugs itself. Id.

Furthermore, even though the partnership had the rights to the

byproducts of the research, the fact that the pharmaceutical

company could purchase the rights to exploit the research

byproducts for a small fee dimmed the prospects that the

partnership itself would manufacture or market the byproducts. Id.

at 150-51. Thus, the court affirmed the Tax Court's grant of

summary judgment denying deductibility under section 174 because

there was no realistic prospect the results of the expenditures

would be used "in connection with" the partnership's trade or

7

See Kantor v. Commissioner, 998 F.2d 1514 (9th Cir.1993)

(denying section 174 deduction where partnership contracted all

software research out to research corporation and, although the

partnership would "own" the resulting software, the corporation

had a low-cost option to market the resulting software); Diamond

v. Commissioner, 930 F.2d 372 (4th Cir.1991) (denying section 174

deduction to partnership where the economic reality was that a

research corporation would perform all robotics research and,

although the partnership would "own" the results of the research,

the corporation had a no-cost option to manufacture and market

the results of that research).

10

business. Id. at 149, 151-52.

C

As with the courts before us, we must sift through research

and development agreements, technology transfer agreements,

options, licenses, etc., in order to ascertain whether the economic

realities of the financial arrangement in this case warrant

allowance of the section 174 deduction.8 All of the above

cases—both those allowing and disallowing the section 174

deduction—involved a profit motive. See, e.g., Zink, 929 F.2d at

1021 (stating that section 174's trade or business requirement

necessitates a profit motive). Consequently, the mere presence of

a profit motive in the financial arrangement here is not

determinative of whether the section 174 deduction will be allowed.

In our view, those cases in which a section 174 deduction was

upheld may be distinguished by one dispositive factor: In each of

the cases allowing the deduction, the entity that incurred the

research expenses actually managed and actually controlled the use

or marketing of the research results. The question here is whether

the Tax Court was clearly erroneous in finding the nexus of those

activities was to CemCom instead of the Partnership.9

8

As the Seventh Circuit noted in Spellman, 845 F.2d at 151,

"[T]he Supreme Court's interpretation of section 174(a)(1) fairly

invited the creation of R & D tax shelters, and the bar quickly

took up the invitation." The financial arrangement in the

instant case evidences an unusual degree of sophistication in

attempting to secure the benefits of section 174 for the limited

partner-investors.

9

Harris also argues that the application of post-1981 case

law—essentially post-Snow cases—to this case constitutes an

unjustified retroactive application of a new rule in a civil

11

IV

A

On appeal, Harris focuses his argument on the marketing of the

research results.10 He contends that the Partnership was in the

trade or business of licensing—marketing the right to use—the

cement technology that CemCom developed. See Louw v. Commissioner,

30 T.C.M. (CCH) 1421 (1971) (holding that the exploitation of

inventions through royalties, sales of patents, or otherwise may

constitute a business). Harris points out that the Partnership did

in fact obtain patents, as CemCom's assignee. Harris argues that

the Partnership had a realistic prospect of licensing those patents

in either of two ways. First, because of the very high royalty

expenses CemCom would incur if it exercised the option to license

the patents back from the Partnership—in contrast to the small fee

to license the research results that the research company was

confronted with in Spellman, 845 F.2d at 150-51—there was a

case. This contention is meritless. As previously discussed,

Snow dealt with the temporal nexus to a trade of business. The

post-Snow cases that have dealt with the operational nexus

requirement of section 174, in effect, interpret the pre-1981 "in

connection with" language using the economic realities, or

substance over form, doctrine. This doctrine also predates 1981.

See Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed.

596 (1935) (holding that a transaction, although qualifying in

form, failed to qualify in substance as a reorganization because

"[t]o hold otherwise would be to exalt artifice above reality

..."). Accordingly, the post-Snow cases did not develop or apply

a new rule.

10

This approach is Harris's only claim to the deduction

because CemCom performed all of the research and development

activities without significant oversight by the Partnership.

Further, evidence showed that the Partnership was interested in

"results only" and not the actual performance of research

activities as it had no plans to hire any staff.

12

significant possibility that CemCom would not license the

technology and, thus, the Partnership would have to license it in

the marketplace. Second, even if the Partnership did plan only to

license the patents to CemCom, the licensing of those patents alone

would constitute the trade or business of licensing the technology.

The Partnership did in fact license those patents to CemCom,

and the Partnership's general partner, Townsend, helped CemCom in

negotiating the ultimate sublicense to the chemical company. Thus,

Harris contends, the monies that the Partnership paid CemCom to

develop the patentable technology were in connection with the

Partnership's trade or business of licensing that technology. The

Commissioner asserts to the contrary that the Partnership was

merely an investor, and that the parties always intended that

CemCom would conduct all of the research and perform all of the

marketing activities with third parties which, in fact, it did.

We review de novo the Tax Court's legal conclusions,

including its interpretations of the Internal Revenue Code. Lukens

v. Commissioner, 945 F.2d 92, 97 (5th Cir.1991). We must, however,

accept the Tax Court's findings of fact unless they are clearly

erroneous. Commissioner v. Duberstein, 363 U.S. 278, 291, 80 S.Ct.

1190, 1200, 4 L.Ed.2d 1218 (1960). We must determine whether the

Tax Court was clearly erroneous in finding that, in 1981, there was

a realistic prospect that the Partnership, instead of CemCom, would

engage in the licensing of the cement technology. See Spellman,

845 F.2d at 149.

B

13

Harris's first contention—that there was a realistic prospect

that the Partnership would market the technology because CemCom

would not exercise its option—fails because the economic realities

of the instant financial arrangement do not support his contention.

From the face of the documents, it might appear that unlike the

research company in Spellman, 845 F.2d at 150, and similar cases

where the section 174 deduction was denied, CemCom would not

exercise its option because of the extraordinarily large royalty

payments. Thus, the documents might suggest that the Partnership

was going to license the technology in the marketplace itself.

When we look beyond the face of the documents, however, we cannot

characterize as clearly erroneous the Tax Court's finding that, in

1981, the parties actually intended to renegotiate the option at a

lower level of royalty payments, which would allow CemCom to

license the technology from the Partnership at a reasonable price.

This intent was evidenced by the covenant not to compete agreement

that would have put CemCom, Bauer, and Leith out of the cement

business for five years if they did not license the technology back

from the Partnership. Further, the partnership had no expertise in

the cement industry and no remaining capital to fund any marketing

efforts. Still further, Townsend told potential investors in the

Partnership that the licensing agreement would probably be

renegotiated to provide for lower royalty payments. The ultimate

disposition of the technology reflects the intent the parties had

in 1981: CemCom sublicensed the technology it developed to a third

party, the chemical company, that paid royalties to CemCom, and

14

CemCom forwarded a portion of these royalties to the Partnership

under a renegotiated licensing agreement. Thus, we hold that the

Tax Court was not clearly erroneous in finding that there was no

realistic prospect that the Partnership would market the technology

itself.11

Harris's second contention—that the intended licensing of the

patents to CemCom constituted the trade or business of marketing

the technology—fails because the Partnership's licensing of the

patents to CemCom did not possess the indicia of continuity and

regularity necessary to endow an activity with trade or business

status. The Partnership's prearranged license of the inventions

11

The various agreements simply do not attribute CemCom's

trade or business of licensing the technology to the Partnership.

Although the regulations provide that another entity may perform

research on behalf of the taxpayer, Treas.Reg. § 1.174-2(a)(2)

(1957), they do not provide that the other entity may conduct a

trade or business on behalf of the taxpayer. See Zink, 929 F.2d

at 1022 ("[T]he mere presence of a valid business purpose at one

level of a transaction does not automatically entitle passive

investors distant from the day-to-day operations of the

enterprise to the associated tax benefits") (internal citations

omitted). As Judge Posner hypothesized in Spellman, 845 F.2d at

150:

[I]t does not follow that [the partnership] could

deduct these expenditures under the statute if it had

dealt away to [the research company] the right to

[exploit] the products resulting from the research and

development. Having contracted out both the research

and development and the production and marketing, [the

partnership's] involvement in the product cycle might

be viewed as that of an investor rather than that of an

entrepreneur....

Judge Posner then stated that the remote possibility that

the partnership in Spellman would actually exploit the

byproducts was insufficient to detract from the economic

realities and resulting tax effects of the above

hypothetical. Id. at 150-51.

15

that resulted from CemCom's research back to CemCom was in essence

a single prearranged deal. One prearranged deal does not evidence

the continuity and regularity found in trades or businesses. See

Commissioner v. Groetzinger, 480 U.S. 23, 35, 107 S.Ct. 980, 987,

94 L.Ed.2d 25 (1987) (stating that it has long been the law that

the phrase "trade or business" involves an activity conducted "with

continuity and regularity"); Green v. Commissioner, 83 T.C. 667,

689, 1984 WL 15626 (1984) (holding that although the regular

licensing and sale of inventions can amount to a trade or business,

the intent to dispose of all the inventions in one transaction,

instead of regularly licensing inventions for profit, indicates

that such activity did not rise to the level of a trade or

business).12 Thus, we hold that the Partnership was not in the

trade or business of marketing the technology.

In sum, the operational nexus of the trade or business in this

financial arrangement was to CemCom in 1981, because the economic

realities clearly show that CemCom would conduct all the research

activities and would market the results of those activities to

12

Further, the record fully supports the view that the

Partnership and Cemcom entered into the licensing transaction to

allow CemCom to obtain revenue from outside third parties from

which it then would pay the Partnership royalties. Indeed,

CemCom itself did not have the financial resources necessary to

pay the Partnership royalties; a sale to an independent third

party was a necessary prerequisite to the financial success of

the arrangement. This case is not similar to those cases in

which a single product sold in a prearranged deal to an

independent third party constituted a trade or business. See,

e.g., S & H, Inc. v. Commissioner, 78 T.C. 234, 244, 1982 WL

11190 (1982) (holding that the sale of property acquired for the

purpose of selling to an independent buyer in a single

transaction constituted the trade or business of selling real

estate).

16

third parties. Thus, the research expenditures made by the

Partnership were not "in connection with" its trade or business,

and section 174 does not apply.

V

For the foregoing reasons, we AFFIRM the Tax Court's denial of

Harris's deduction for research and development expenditures made

in connection with the Partnership's trade or business.

AFFIRMED.

17