Dean B. Smith and Irma Smith v. Commissioner of Internal Revenue

JOINER, Senior District Judge,

dissenting.

I respectfully dissent from the majority opinion. Whether the partnerships were engaged in a trade or business, and whether the taxpayers entered into the transaction with a profit motive, are questions of fact, on which the Tax Court must be sustained unless its holdings were clearly erroneous. Rose v. Commissioner, 868 F.2d 851, 853 (6th Cir.1989). Notwithstanding that the Tax Court utilized the “generic tax shelter” inquiry disapproved of in Rose , here, as in Rose , its use of this test is not controlling. The Tax Court went on to address the appropriate questions for our purposes, and its conclusions based upon those inquiries are not clearly erroneous. The decision should be affirmed. 1

In Campbell v. Commissioner, 868 F.2d 833, 836 (6th Cir.1989), we noted that Treasury Regulations section 1.183-2(b)(1)-(9) lists nine factors used in evaluating whether a transaction has been entered into with a profit motive. These factors are not exclusive. They are prefaced in the regulations with:

In determining whether an activity is engaged in for profit, all facts and circumstances with respect to the activity are to be taken into account. No one factor is determinative in making this determination. In addition, it is not intended that only the factors described in this paragraph are to be taken into account in making the determination, or that a determination is to be made on the basis that the number of factors (whether or not listed in this paragraph) indicating a lack of profit objective exceeds the *1100 number of factors indicating a profit objective, or vice versa....

Treas.Reg. § 1.183-2(b).

Those of the listed factors which apply to the present situation favor the resolution reached by the Tax Court. The first of the factors is the manner in which the taxpayer carries on the activity. This inquiry is further explained by the regulations as follows:

The fact that the taxpayer carries on the activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity is engaged in for profit. Similarly, where an activity is carried on in a manner substantially similar to other activities of the same nature which are profitable, a profit motive may be indicated. A change of operating methods, adoption of new techniques or abandonment of unprofitable methods in a manner consistent with an intent to improve profitability may also indicate a profit motive.

Treas.Reg. § 1.183-2(b)(l). In this case, the record-keeping of the venture was so poor that the taxpayers were unable to produce a valid draft of the license agreement by which Ronodo derived the technology which is the heart of this venture from its inventor, making it impossible for the Tax Court to evaluate the relative value of the license in the hands of Ronodo and the partnerships. The agreement which was offered in evidence had handwritten amendments scrawled throughout, and included three addenda, one of which was also handwritten. The only paper among these which bore the signature of both the licensor and licensee was one of the addenda. The degree to which this venture was undercapitalized also distinguishes it from the normal business setting. The controllers of the venture only committed to fund each partnership with working capital of $150,000 per year. Further, had the partnerships been fully subscribed (half of the partnership units were actually sold), only $1,250,000 was to be invested in research and development in the first 23 years of the venture. Approximately 80 percent of the payments for research and development were not scheduled to be tendered until the year 2006. Lastly, the partnerships did not take steps to alter the conduct of the business in the face of the North Carolina plant’s difficulties with efficiencies of scale. As if to underscore the sham nature of this transaction, one tiny plant was planned, one tiny plant was built and produced a token few pounds of fuel, and there was evidence of only cursory attempts to find an actual market for the product, after the plant was under construction. Given that use of the K-fuel, as the Tax Court noted, would require modification of the users’ facilities, the taxpayers’ arguments going to the projected cost of producing K-fuel as compared to other fuels do not conclude the inquiry into whether they carried out reasonable investigation, before and during the venture, as to the process’ commercial viability, because the product’s users would be required to make additional expenditures. The minimal and belated efforts to identify and secure purchasers for this fuel in advance are completely inexplicable under ordinary business practice.

The second factor, the expertise of the partnership or its advisors, is discussed in the regulations as follows:

Preparation for the activity by extensive study of its accepted business, economic, and scientific practices, or consultation with those who are expert therein, may indicate that the taxpayer has a profit motive where the taxpayer carries on the activity in accordance with such practices. Where a taxpayer has such preparation or procures such expert advice, but does not carry on the activity in accordance with such practices, a lack of intent to derive profit may be indicated unless it appears that the taxpayer is attempting to develop new or superior techniques which may result in profits from the activity.

Treas.Reg. § 1.183-2(b)(2). While the partnership’s activities were allegedly carried out with assistance and input from the inventor of the process himself, and, therefore, it can be presumed that the partnership had expert technical advice, the feasibility of this venture as a commercial *1101 activity appears to have been the subject of only one study. The Tax Court found that this study, the Compunetics study, was buttressed by assumptions such as that the construction of a K-Fuel reactor was technically and financially feasible. As for taxpayer’s experts, while their post-hoc testimony is not relevant to the taxpayer’s preparations for this activity, their testimony about the commercial viability of this venture was also of negligible value because of its assumptions as to material facts. 2 The testimony also centered on the technical viability of the Koppelman process. However, the fact that K-fuel exists and can be produced is beside the point. The offering memorandum did not even make projections as to the profit-making potential of the Koppelman process activities. The paucity of evidence demonstrating any careful preparation for entry into commercial exploitation of the Koppelman process does not survive scrutiny under this factor.

The third of the factors is the time and energy expended by the partnership in carrying on this activity. Treas.Reg. § 1.183 — 2(b)(3). The partnership’s minimal activity goes more directly to a holding of the Tax Court we do not reach, the issue of whether this was a passive activity. However, the economic substance of the partnership is made abundantly clear from the fact that James Aronson, who oversaw the construction of the North Carolina physical plant by a contractor, appears to have been the only employee of either the partnerships or the three corporate hierarchies set up by the promoters, who performed actual services for the partnerships rather than being a mere salaried figurehead. The general partners, Goldman and Kaye, were accountants and financial consultants. They had no familiarity with the technical process, nor did they have entrepreneurial backgrounds, and the offering memoranda informed prospective partners that they were going to take little part in the partnerships’ activities. It appears that they took no part whatsoever.

The fourth factor offered by the regulations is the expectation that the assets of the partnership may appreciate in value. The record reveals that the partnership was virtually without true assets, with the exception of the small plant, which is not argued to have more than negligible value. The Tax Court regarded the principal assets of the partnerships as the- technology licenses, and noted that the offering memorandum stated that they were impossible to value. In addition, as discussed above, the validity of the underlying license to Ronodo is questionable at best, and the subsidiary licenses likewise.

The fifth factor suggested by the regulations is the success of the partnership in carrying on other similar or dissimilar activities:

The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable.

Treas.Reg. § 1.183 — 2(b)(5). As noted above, there was no evidence that the principals of this venture had entrepreneurial expertise outside of the tax-oriented investments field. As for the partnership itself, not only did its Koppelman process activities generate losses, its oil and gas exploration activities did also.

The sixth and seventh factors cited in the regulations go to the existence and extent of long-term profitability, which is inapplicable to the present situation, involving the initial years of the partnerships. The eighth factor addresses the extent to which the investment at issue involves a substantial investment by the taxpayer, which would suggest an emotional investment in the profitability of the activity (a form of at-risk inquiry). Here, the offering materials stipulated that the partners should have *1102 large outside incomes, in order to utilize the tax benefits from the partnerships. The taxpayers’ outlay for this venture was minimal, and the deductions taken by the taxpayers at issue realized the promoters’ four-to-one tax benefits projection. The ninth factor is not met here, since the taxpayers did not engage in the present activities for personal pleasure or recreation.

The facts related to the nine factors listed in Treasury Regulations section 1.183-2(b)(l)-(9) do not support a holding that the Tax Court’s conclusions were clearly in error, and inquiry into the totality of the circumstances evidences that the Tax Court, far from being in error, was clearly correct. A number of aspects of the transaction here emit a strong odor of sham. The trio of corporate hierarchies set up by the promoters to provide the “license” and “services” to the partnerships speak for themselves. Particularly absurd is the “research and development” services offered by FTRD, which was to “coordinate” the activities of Koppelman himself and others with K-Fuel experience that FTRD, or rather its sole active employee, Aronson, did not have. It is apparent that the corporate hierarchies were actually formulated as thinly-veiled means of channelling the majority of the partners’ investment back to the promoters, through the promoters’ equity interests in the corporations and through their salaried positions as officers and directors of the corporate entities. The economic substance of the arrangement, however, is that the promoters sold tax deductions to the partners.

The partners did not contemplate the partnerships as activities for profit not because the Koppelman process itself lacks validity — it was no doubt carefully chosen by the promoters expressly because it has arguable potential as an alternative energy source — but because the business entity which was set up here was impracticable in numerous respects. The Tax Court’s conclusion that “[ajctual- control rested in persons whose compensation from these partnerships depended solely on capital contributions, while they had interests in the profitability of competing ventures” (emphasis in original) is both uncontroverted and of undeniable import. There are other indications that the principals of the venture had no intention of seriously pursuing it, particularly the licensing arrangements. The imperfect documentation and non-recourse nature of Koppelman’s license to Ronodo clearly show the sham nature of the transaction. The Tax Court found also that the prices charged the partnerships for their licenses, as well as for other services, were not set by market forces, but were formulated with a view toward satisfactory return on the promoters’ capital, and accepted by the partners without negotiation. 3 I would argue that the fact that Koppelman later sold the United States rights to the Koppelman process for more than 20 times the price paid by Ronodo under the most generous construction of the “license” speaks not to the entrepreneurial savvy of the promoters, but to the fact that the partnerships were known to Koppelman and the purchasers of the rights to be tax-oriented rather than potential competitors.

It was perfectly apparent to purchasers of partnership units that the partnerships dealt only with corporations controlled by the promoters, that none of the web of commitments of the partnership had been negotiated at arms’ length, that the principals and contractors to the partnership had no experience in relevant endeavors, and other facts communicating the insubstantial nature of the enterprise. These partnerships were not business ventures, they were paper montages of likely Tax Court arguments.

*1103 It does not controvert the significance of the other facts at issue to say that the income from the oil and gas activities of the partnership might have covered the expenses of the Koppelman process activities. It may be that the Koppelman process itself is commercially feasible. However, as the Tax Court clearly pointed out, it was the structure of this venture, the conflicts of interest, and other factors separate from the economic viability of the processes at issue, which demonstrate that the investors had no profit motive. The experts offered by the taxpayers who found the oil and gas projections reasonable, addressed merely the surface question of the economic potential of the partnerships’ activities. However, there was no serious intent to pursue those activities, and the purchasers of the partnership units, to whom the partnerships were marketed as tax-oriented investments, had no expectation that the partnerships would be commercially successful. The principals of this venture had no incentive to make it a success, the venture had inadequate funding to make it a success, and there is no evidence of attempts to make the venture a success after the failure of the activities originally planned, despite the fact that the partners had an obligation to fund the partnerships for the next twenty years. Viewing the above circumstances as a whole, I would affirm the Tax Court’s finding that there was no profit motive under section 183, and that SFA was engaged in a sham transaction rather than a “trade or business” entitling it to deductions under section 174.

The rules announced in Bryant support the conclusion reached in this opinion. There is ample evidence, as pointed out above, to support the conclusion of the Tax Court, and independent de novo consideration of the evidence, also as outlined above, indicates that the transaction was a sham in that it had little possible economic effect other than the creation of income tax losses.

The majority’s reliance on Bryant for the proposition that the likelihood of profit does not control the determination whether the taxpayer had a profit motive, is misplaced. The Bryant opinion states that an “unreasonable” expectation of profit involves a “small chance for a large profit.” While this definition fit the gold- and silver-mining at issue in Bryant, it does not describe the situation here. In addition, the question of the commercial feasibility of the Koppelman process is far outweighed by other aspects of the transaction, all of which are relevant under the totality-of-the-circumstances inquiry dictated by the regulations.

Deduction of Interest

The Tax Court should also be affirmed as to its disallowance of deductions taken by the partners for interest on the partnerships’ notes to FTRD and Sci-Teck. The taxpayers rely on Rice’s Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir.1985), for the proposition that they are entitled to take deductions for obligations which have economic substance, even if entered into pursuant to a venture lacking substance. The taxpayers assert that the interest on the partnership’s notes to FTRD and Sci-Teck may be taken by them as a deduction. In Rice’s Toyota World, however, the taxpayer had given a full-recourse note obligating the taxpayer to pay both principal and interest. Here, the taxpayers’ note only assumed the obligation to pay their proportionate share of the principal amounts due to FTRD and Sci-Teck. The Tax Court found that the partnerships were unlikely ever to have funds to pay their interest obligations, therefore the interest payments of the partnerships could not be said to have economic substance as to the taxpayers. The Tax Court properly concluded, under the “all events” test of Treasury Regulations section 1.461-l(a)(2), that the taxpayers were not entitled to deduct the interest on the partnerships’ notes.

Penalties

I would also affirm the holdings of the Tax Court as to the penalty for substantial understatement of income tax under section 6661, and the penalty for understatement of income tax due to a tax-oriented *1104 investment under section 6621(c), for the reasons stated above.

. Karr v. Commissioner, 924 F.2d 1018 (11th Cir.1991), the appeal from a case that was consolidated with this case in the Tax Court, reaches the same conclusion.

. The first of the three reports offered by the taxpayers, that of Lam, addressed the oil and gas revenue projections and not the Koppelman process activities. The second, authored by Pomerantz, discussed the market potential of K-fuel slurry rather than the product produced by the North Carolina plant. The Plummer and Thomas report, third, was predicated on the assumption that the partnership would enter into a joint venture with a utility.

. The taxpayers' experts did not “justiffy] this practice."- The experts merely concluded that the fees charged were within the range of reasonableness. The fact that the amount of the fees might have been reasonable if they had been arrived at through market forces, however, is irrelevant to the significance of the testimony in the Tax Court that the method by which the fee was actually derived was from the promoters’ client’s stated expectations as to the return he wanted on his investment. This method of setting the fees had nothing to do with the "success” of the venture, since these fees were purportedly being paid to the corporate entities for their services, not to the promoters for their promotional expertise.