SERy I CE
Agency decision
Ask Donna
What actually matters in this document.
Text
50
acome
SERy I CE
86 T. C. No.
79
~
. JUD6E
FII S
UNITED STATES TAX COURT
SHELDON DROBNY and ANITA DROBNY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
LOUIS LIFSHITZ and RUTH LIFSHITZ, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 16985-83,
17602-83.
Filed June 26, 1986.
Ps were investors in two research and development
programs, a partnership and a joint venture. The programs
promised the investors a deduction of $5 for every $1 of
cash invested. For each unit of participation, Ps invested
$11,000 in cash and $45,000 from the proceeds of bank loans
payable in 3 weeks, which were arranged through the
programs. At the closing, the proceeds of the loans were
transferred to a contractor and to subcontractors
ostensibly to fund research; but in fact, they were
invested in short-term commercial paper, and when the paper
matured, the proceeds were used to pay off the bank loans.
Ps claimed their pro rata share of losses resulting from
deductions taken by the partnerships for research and
experimental expenditures.
Held:
(1) The claimed losses are not deductible
because the programs' activities were not engaged in with
the actual and honest objective of making a profit; and (2)
the claiming of the deductions by petitioner Drobny
ERYED JUN 26 1986
constituted fraud within the meaning of
I.R.C. 1954.
sec.
6653(b),
Howard L. Stone, Steven B. Nagler, David A. McGuire,
and Fred A. Bibeau, for the petitioners in docket No.
16985-83.
Randall S. Goulding, for the petitioners in docket No.
17602-83.
Lauren W. Gore and William C. Sabin, Jr.,
for the
respondent.
SIMPSON, Judge:
lowing deficiencies
The Commissioner determined the folin,
and addition to,
the petitioners'
Federal income taxes for 1979:
Petitioners
Deficiency
Addit..on to Tax
Sec. 6653(b
I.R.C. 1954
Sheldon and
Anita Drobny
$10,877
:45,439
Louis and Ruth
Lifshitz
32,052
The
issues for decision are:
(1) Whether the petitioners
are entitled to deductions for their proportiorate share of
losses
resulting
from
alleged
research
and
experimental
expenditures by a joint venture and a partnership in 1979;
1
All statutory references are to the Internal Revenue Code of 1954
as in effect during 1979, unless otherwise indicated.
- 3 and (2) whether Mr. Drobny is liable for the addition to tax
for fraud under section 6653(b) for 1979.
FINDINGS OF FACT
Some of the facts have been stipulated, and those facts
are so found.
The petitioners, Sheldon and Anita Drobny, .husband and
wife,
maintained
Ill.,
at
their
joint
the
their
their
residence
Highland
Park,
filed.
return
for
1979
with
the
Internal Revenue Service Center at Kansas
City,
Mo.
The
husband
and
wife,
maintained their legal residence in Wilmette,
Ill.,
at the
time their petition was
Their
joint
Federal
Louis
petition
in
was
petitioners,
time
legal
income
and
tax
Ruth
Lifshitz,
filed
in
this
case.
They
filed
return for 1979 was filed with the Internal Revenue Service.
Twenty-two
Lifshitz,
investors,2
participated
in
including
two
Messrs.
research
and
Drobny
development
investment programs,
Farm Animal Product Venture
AloEase Partnership
(AloEase).
unit,
a
one-twentieth
and
Lifshitz purchased one
in
each
interest,
FAP was
(FAP)
Mr.
Drobny purchased one-half a unit,
in each program.
and
a joint
program;
and
Mr.
a one-fortieth interest,
venture
formed
for the
purpose of developing and marketing Pork Pardner, a medicine
to
be
fed
to
farm
animals,
particularly
hogs,
for
the
2
The owners of an interest in the programs who are husband and wife
are considered one investor for purposes of this opinion.
9
- 4 prevention and
treatment of
various diseases
that decrease
the size of litters and adversely affect the health of small
pigs.
AloEase was
developing,
formed
and marketing
burning human eyes
for
the
purpose
a
treatment
(AloEase
product).
of
acquiring,
to soothe
aching or
The
investors
treated as general partners
in AloEase and were
owning
common.
The
profits,
each
program
were
FAP
credits,
as
and
tenants
cash
in
flow
in
were
treated as
losses,
shared
in
were
to
relation to the investors' ownership interests.
Both
Pork
Pardner
and
the
AloEase
product
contain aloe vera.
Aloe vera is an extract from the Aloe
Barbidensisi
of
species.
plant,
Because
it
which
is
there
thought
killing, and healing properties,
are
appkoximately
to have medicinal,
270
pain-
it is used in a wide range
of products for humans and animals.
Isle of Aloe, Inc. (Isle), was incorporated in 1967 for
the
purposes
of
conducting
marketing of aloe vera
research,
based products.
development,
and
Between
and
1967
1984, Isle developed and marketed at least 35 such products.
Robert White was one of the original incorpoçators of Isle
and its president and majority shareholder in 1979 and 1980.
In June 1979,
he contacted Marvin Kamensky to secure funds
to conduct the research, development, and marketing of Pork
Pardner and the AloEase product.
had a
$668,315 deficit
in
At the end of
retained earnings,
1981, it filed for bankruptcy under Chapter 11
1979,
and
Isle
in March
- 5 Mr. Kamensky was a partner in the law f irm of Kamensky
&
Landan
(the
development
tax
law
firm).3
He
arranged
research
shelters
and
was
known
in
Chicago
experience
in
the
formation
of
and
as
such
an
attorney
with
tax
shelters.
He directed and controlled the creation of all of
the research and development programs at issue,
the creation
of
(except
all
the
entities
involved
in
such
program
for
Isle), and the material relationships between such entities.
Marc
during
Z.
1979
Samotny was
and
early
an
associate
1980.
Under
with
the
the
law
direction
firm
of
Mr.
Kamensky, he prepared all of the documents involved in the
transactions which were a part of the programs.
Sheldon
from
1967
Drobny was
through
1971
an
Internal
Revenue
and
has
a
Accountant in private practice
Elijah
Watts
Sells
Award
been
Certified
since 1971.
from
the
Service
agent
Public
He received the
American
Institute
of
Certified Public Accountants for being in the top 27 out of
19,000 people who took the CPA exam.
He taught
income tax
accounting for a CPA review course and was an instructor for
the
IRS
agent
while
working
there,
teaching
basic
training
courses
in
area
taxation.
relevant times,
and Drobny, Ltd.
Messrs.
Adler
the
of
and
advanced
At
all
he was a partner with Louis Adler in Adler
(the accounting firm).
and
Drobny
promoted
In December 1978,
four
research
3
The law firm is now known as Kamensky & Rubinstein.
and
- 6 development.investment programs with a total purchase price
of
$1,786,000.
They
promoted
a
$1,745,000
real
estate
investment program in December 1977.
In
November
1979,
Mr.
Drobny
was
informed
by
Mr.
Kamensky of the Pork Pardner and AloEase pr duct programs.
Because
the necessary
transactions
had
to be
completed
in
December, Mr.
Drobny was not initially interested;
however,
he
review
both
programs.
Samotny
sent Mr.
agreed
In a
to
information
letter dated November 28,
concerning
1979,
Mr.
Drobny an outline of the transactions for the two programs,
a chart showing the flow of
the funds,
and a statement of
the cash to be invested and the tax benefits
to be derived
therefrom.
On November 30,
1979, Mr. Samotny wrote| to Mr.
Drobny
again to provide him with a "sales kit" whiph contained a
more detailed explanation of
and their tax consequences.
the
FAP and AloEase programs
In part, the letter stated:
The individual investors will compensate Isle of Aloe
in an amount equal to $800,000.00 (comprised of $160,000 in
cash and $640,000 in the form of bank loans) for the
research and development of the subject animal product.
Upon completion of the research and development, the
individual investors, acting as tenants-in-common will
apply for a patent on the animal product. It is currently
contemplated that such application will be made by Isle of
Aloe.
* * *
Isle of Aloe, Inc. will subcontract with Swain's
corporation in order that it may provide the necessary
research and development for the animal produed.
Isle of
Aloe will pay Swain's corporation $750,000.00 pursuant to
the subcontract for the research and development. In turn,
Swain's corporation will pay to the investors on or about
January 15, 1980 an advance minimum royalty equal to
$750,000.00 attendant the right to commercially exploit the
animal product.
Each
individual
investor will also be
required
to
enter into a partnership for the exploitation of a second
product.
It is currently contemplated that this product
will be an Isle of Aloe product to be used as an eye wash.
The partnership will acquire all of Isle of Aloe 's right,
title and interest in and to the eye wash product.
Subsequently, the partnership will enter into a research
and development agreement with Isle of Aloe whereby the
partnership will pay to Isle of Aloe $320,000.00
($60,000.00 cash and $260,000.00 in the form of bank loans)
to perform research and development on the product.
Isle of Aloe will, upon receipt of the $320,000.00,
make a loan to a corporation to be owned and controlled by
Paula Larson in the amount of $150,000.00.
This
corporation will in turn pay to the partnership $150,000.00
in the form of option money to have the right to
commercially exploit the eye wash product. In order to
exercise its option the corporation controlled by Paula
Larson will also be required to pay $300,000.00 upon
exercise of the option and in addition will pay the
partnership group a royalty presently contemplated to be
eight percent of gross sales. As you are aware, the grant
of the option money to the partnership is a non-taxable
event until such time as either the option is exercised or
the option period lapses.
In the materials sent by Mr. Samotny to Mr.
November
30,
1979,
one
sentence was devoted to
Drobny on
describing
each product, and tax and cash analyses were included.
was
indicated
It
that a purchaser of a unit would contribute
$11,000 in cash,
that he would borrow $45,000,
would claim a deduction for the entire $56,000.
and that he
The
1979
net tax benefit from the programs was expected to be $17,000
per unit
for
investors
in the
50-percent
tax bracket and
$28,200 for those in the 70-percent bracket.
The net total
tax
as $9,500
benefit
from
the
programs
was
listed
for
- 8 investors in the 50-percent bracket and $17,700 for those in
the 70-percent bracket.
from
the
losses
resulting
research and experimental payments
to
Isle
of
$1,120,000.
In
payment
was
listed
1980,
investors'
The large 1979 bene it would arise
the
nontaxable,
deduction
receipt
but
a
of
an
of
option
$750,000
advance
expected to be taxable at the
minimum
from
royalty
as
was
long-term capital gain rate,
thereby decreasing the net tax benef it of the programs.
and
Shortly
after
receiving
Drobny
discussed
the
such
letter,
similarities
Messrs.
between
Samotny
the
two
programs at issue and an earlier one of Mr. Kamensky's which
Mr.
Drobny had reviewed in August
were almost identical
Mr.
1979;
in structure,
Drobny then began soliciting
the three programs
form,
and tax effects.
investors
from among his
clients and associates; at least 7 of the 22 investors were
his clients.
Each
investment program was described and offered
the investors in its own private placement menorandum.
memorandums
require
that
each
investor
have
to
Such
sufficient
wealth or income to enable him to withstand the loss of his
investment
each
without
memorandum
undue
are
hardship.
dedicated
At
to
leas
10
explai ing
pages
in
the
tax
ramifications of the program, including the de uctibility of
research
stated
and
that
experimental
prior projects
expenditures.
t
seeking
ax objectives
similar
is
have been "set aside" in full or in part by the IRS.
clearly
There
_9_
is
a
warning
that
an
audit
by
the
IRS
may
lead
to
an
increase in an investor's tax liability.
Messrs.
Adler
and
Drobny
are
identified
as
the
promoters of the programs and as having previously promoted
research and development programs which were unsuccessful.
The accounting. firm is described as one
in
corporate,
individual,
trust
and
"which specializes
partnership
financial
and tax consultation."
The law firm is
identified as having been retained by
the promoters as special counsel with respect to certain tax
aspects of the programs.
Following a statement that the law
firm had not independently verified any of
the information
in the memorandum relative to any of the parties
each
memorandum
has
a
statement
in
involved,
capital
letters
encouraging investors to seek independent counsel concerning
the
merits
Elsewhere,
of
it
the
program
and
its
tax
consequences.
is stated that there will be no independent
management for the investors and no managing investor,
and
that
for
the
under
the
the
lack
investors,
thereof
as a group,
might
make
to enforce
it
difficult
their rights
agreements.
The memorandums state that the law firm is to receive
$17,500
for each program
from Isle
for drafting
documents
and providing tax advice and that the accounting firm is to
receive
$15,000
services.
In
per
fact,
program
from
Isle
for
accounting
although such $30,000 was paid
to the
- 10 accounting
firm,
Mr.
Drobny
never
examined
the
financial
records of any corporation involved in the programs, nor did
the
accounting
firm prepare
the
tax
returns
for
any
such
corporation.
The memorandums contain general statements, attributed
to
Isle,
about
the
marketability of
products,
study was ever made.
Income projections refer only
to the
option
the
to
received in 1980.
advance
that
no
There
and
no evidence
but
market survey data.
payment
is
the
minimum
any market
royalty
be
Visine and Murine are id ntified as the
primary competition for the AloEase product, while American
Cyanamid and
Pfizer products are
competition.
The memorandums state that eac
conceptual
idea
which
has
not,
listed as
and
Pork
perhaps
Pardner's
product
will
is a
not,
be
developed, but Isle will attempt to deliver such products by
September
30,
1980.
Cash
presented for 1979 and 1980.
each
program
are
described
and
tax
benefit
analyses
The transactions
in
detail
in
are
involved
its
in
memorandum,
except that there is no mention of any loans.
Two corporations were created in conjunption with the
programs,
Parm Animal
Research
Laboratories,
Laboratories,
Inc.
(ARL).
Inc.
(EAL),
The
and
Aloe
articles
of
incorporation for each were prepared by the law firm.
Such
articles for ARL were filed with the Secretary of State for
Illinois on December 7,
corporation
was
1979.
identified
In the earlier letters, such
as
one
controlled
by
Paula
- 11 Larson, but she was not listed as an officer or director of
such corporation
and never acted
for
it.
Gary Swain and
Paula Larson were listed as the directors of FAL, which took
the
place
of
a
corporation
referred
corporation in the earlier letters.
to
as
"Swain's"
On December 17,
1979,
such articles for FAL were filed with the Secretary of State
for Iowa.
In
letters
dated
provided
additional
concerning
possible
Concerning the
December
comments
tax
14,
to
1979,
the
consequences
possibility that
of
the
law
firm
accounting
firm
the
programs.
investors might be denied
any deductions for expenditures by AloEase because it was an
activity entered into solely for tax avoidance, the law firm
included the following:
Based upon the foregoing, it is conceivable that the
Service could take the position that this transaction is a
sham for tax avoidance purposes only, and presuming
arguendo that the Service could ultimately prevail on this
issue, then the Partnership's deductions in 1979 could be
limited to the cash which was actually advanced for the
research and development ($320,000.00 less the option
payment of $150,000.00).
The rule that the substance of a transaction, rather
that [sic] its mere form, controls tax liability, is one of
the most widely accepted principles under our form of
taxation.
Basically, "form" is a pattern or scheme, the
aspect under which a thing appears as distinguished from
"substance" that which underlies all outward manifestations
- the realty [sic] itself.
In this respect, the form of
the transaction may be disregarded if it has no purposes
other than reduction of taxes. Gregory v. Helvering, 298
U.S. 465 (1935). Furthermore, if a transaction is not at
arm's length, the question of substance versus form is
often raised in an attempt to disregard the apparent tax
results. Although no cases exist directly on this point,
the Service has been successful in many cases involving
controlled
or
related
taxpayers.
Crown
Cork
- 12 Internation[al] Corp., 4 T.C. 19, aff'd. 149 Fed [2d] 968
(4th Cir.; 1945); Limmericks, Inc., 7 T.C. 1129 aff'd. 165
F.2d. 483 (5th Cir.; 1948); Central Cuba Sugar Go., 16 T.C.
882, aff'd. 198 F2d. 214 (2d Cir.; 1952).
In the Estate of Franklin v. Commissioner, 544 F.2d
1045 (9th Cir.; 1976), the Court held that the failure on
the part of the purchaser of real estate to demonstrate
that the purchase price of the property wa at least
approximately equivalent to the fair market value of same
resulted in the exclusion of the entire non-recourse
obligation from the tax basis of the property for
depreciation purposes and the disallowance of interest on
the non-recourse obligation. Similarly, in Revenue Ruling
77-110, 1977-1, CB 16, the Service held that the liability
on a non-recourse interest bearing note given as part of
the purchase price of film distribution rights, whose value
could not be shown to approximate the amount of the note,
may not be included in the basis of the (rights for
depreciation purposes. Accordingly, if the SerQice were to
challenge the Partnership's deduction under Code Section
174 on [a] similar theory in the light of all of the facts
and circumstances, and the Partnership was not Able to show
that the amounts paid to Isle for research and development
were approximately equal to their value, then it is
possible that the Partnership could be denied a deduction
for a portion of the amounts paid to Isle.
Notwithstanding the foregoing, the Courts, including
the Supreme Court, have recognized that a taxpayer may
legally reduce his tax liability through stducturing a
transaction. U.S. v. Isham, 17 Wall 496 (1873) and Bullen
v. Wisconsin, FU.S. 625 (1916). Accordingly, this area
appears to remain a factual one, in which each chse must be
reviewed separately to determine the realities involved.
Similar comments appeared in the letter concerning FAP.
In
December
1979,
Mr.
Kamensky
requested
that
the
Harris Trust and Savings Bank (the bank) make loans to each
investor
for
programs.
He assured the bank's loan officer that the loans
would
repaid within
be
$45,000
per
3
unit
weeks
part of a "tax shelter deal."
of
and
investment
stated
hat
in
both
they were
He also explained to the bank
officer the proposed transactions, and under the arrangement
- 13 the
money
would
officer agreed
not,
in
to make
fact,
the
leave
the
bank.
The
loans only upon Mr.
loan
Kamensky's
personal assurance that the loans would promptly be repaid.
However, Mr. Kamensky did not guarantee such loans, and. the
investors had to qualify for them.
and
In a letter dated December 17,
1979,
Drobny,
all
involved
funds
Mr.
in
from
statement,
Samotny
financing
the
described
the
bank,
a
programs.
completed
to Messrs.
Adler
of
the
paper
In
order
to
personal
work
obtain
financial
"certificate re business loan," and an unsecured
note form had to be signed by each investor.
In December
1979, each investor holding one unit in each of the programs
would prepare three personal checks:
a check for $40,000 to
Isle for research and development of Pork Pardner;
one for
$16,000 to AloEase, as a capital contribution; and another,
dated January 15,
1980, for $45,600 to the bank.
As stated
in the letter, each investor's check to the bank was a loan
repayment check comprising $45,000 in principal and $600 in
interest.
Mr. Drobny was responsible for the collection of
such checks and the other papers.
A closing meeting for the transactions involved in the
two
projects
(the
December 26, 1979.
Messrs.
Drobny,
Charles Marker.
meeting)
was
held
at
the
law
firm
on
Present at such meeting were Ms. Larson;
Kamensky,
Mr.
Samotny,
Drobny signed
Swain,
all
and
relevant
White;
and
documents
presented at such meeting as the representative of AloEase.
- 14 At the meeting,
Mr.
behalf of Isle.
Among such documents were the research and
development
White signed all
agreements
between
relevant documents on
FAP
and
Isle
and
between
AloEase and Isle.
The contract with FAP called for Isle to
receive
for
$800,000
research
and
development
activities
concerning Pork Pardner and to deliver the results
on September
30,
1980.
Isle
was
to
be paid
thereof
$320,000
for
such services in connection with the AloEase product.
Ms. Larson was the developer of Pork Pardner.
During
1978 and 1979, she conducted field tests on Pork Pardner at
the direction of Mr. White.
Dean of Pharmacy
She has been a secretary to the
at Creighton University and
a supervisor
for a farm management corporation;
she has hpd no training
in
college
research
White's
and
does
request,
not
have
coupled
with
a
the
degree.
promise
of
At
at
Mr.
least
$25,000 to continue research, she attended the meeting.
As
the secretary of FAL,
she signed several doåuments
the
meeting;
have
she
did
not
an
opportunity
to
at
read
such
documents before signing them.
At
the
agreement
meeting,
between
Ms.
acquisition
(Stoma), a corporation Mr. Drobny had promoted in 1978.
She
received
Pork
Stoma's
Stoma
an
Inc.
of
and
signed
Laboratories,
all
herself
Larson
rights
in
the
unpatented
Pardner in exchange for $10 and 2 percent of gross sales in
excess of
$3,000,000.
At
the
same
time,
she
executed
an
acquisition agreement transferring her rights in the product
- 15 -
to FAP in return for $10 and a royalty fee of 6 percent of
the gross sales above $3,000,000.
Mr.
Swain has a college degree
in animal science and
was a salesman of farm products at all relevant times.
Mr. White's request, he attended the meeting.
At
Although he
was nominally the president of FAL, he was not permitted to
read
any
of
the
numerous
documents
signed
by
him
at
the
research
and
meeting.
Mr.
Swain
and
Ms.
Larson
signed
the
development agreement between Isle and FAL and the exclusive
license agreement between FAL and FAP.
agreement,
Isle
entered
into
a
Under such research
subcontract
with
FAL
to
perform the research and development of Pork Pardner;
such
product was to be delivered to Isle by September
1981.
15,
The license agreement provided FAL with the exclusive right
to manufacture, market, and exploit the product.
In return,
FAL promised to pay FAP a license fee equal to 25 percent of
gross sales of
on
sales
in
the product up to $3,000,000 and
excess
of
$3,000,000.
FAL
was
12 percent
to
make
an
advanced royalty payment of $750,000 on January 15, 1980.
Mr. Marker is a retired pharmacist who has worked in a
series
of
working
as
laboratory,
products.
drug
a
stores
and
pharmacist,
which
pharmacies
he
primarily
since
started
a
1949.
manufacturing
manufactured
Such endeavor was not very successful,
funding from his pharmacy wages.
While
aloe-based
requiring
During 1979, he worked on
- 16 developing the AloEase product for Mr. White
who requested
that he attend the meeting.
At the meeting, Mr. Marker signed numero s documents at
the direction of Messrs. White and Drobny.
Among the papers
signed by him was the option agreement, under which AloEase
granted ARL the exclusive option to enter into an exclusive
license
agreement
$150,000.
The
for
the
option may
AloEase
be
product
exercised
by
in
return
:he
payment of
$300,000 to AloEase prior to noon on December 31,
1989.
for
No
research and development agreement between AÑL and Isle was
ever executed.
Mr. Marker did not have the opportunity to
read any of
documents signed
the
by him,
that the day's activities would result
research.
Additionally,
he was
ard he
in $200,000
informed
that he
was
told
for his
was
the
president of ARL.
Mr. Marker's signature was the only authorized one for
the ARL checking account,
December 13, 1979.
which was opened at
the bank on
On the same day, a checking account in
the name of FAL was opened at the bank, with Ms.
Mr.
Swain as authorized signatories.
Drobny opened a checking account at
Larson and
Two weeks later, Mr.
the
bank
for AloEase.
His was the sole authorized signature on such account.
Mr.
White opened a checking account in the name of Isle at the
bank on December 27, 1979.
On December 27, 1979, the bank made the requested loans
to the investors and,
in return,
received a p'omissory note
- 17 -
from each investor designating January 16,
.
date.
Also on December 27,
loans
were
credited
to
1979,
the
1980, as the due
the proceeds of
Isle
account
at
the bank
the
bank,
$640,.000, and to the AloEase account at the bank., $260,000.
Such proceeds
the
were disbursed without any authorization by
investors.
As
anticipated,
collected from the investors;
$220,000
in
cash
was
$160,000 was deposited in the
Isle account and $60,000 in the AloEase account.
On December 27, 1979, $320,000 was transferred by debit
memo from the AloEase account to the Isle account.
same
day,
the
bank
debited
the
Isle
On the
account
$750,000
pursuant to a check drawn by Mr. White and payable to FAL,
and
$150,000
pursuant
payable to ARL.
to a
check
drawn by Mr.
White
and
Neither Ms. Larson nor Mr. Swain was aware
of the checks to FAL; nor was Mr. Marker aware that ARL had
received a check from Isle.
the bank debited the
checks
payable
to
On or after December 27,
Isle account
the
law firm,
$35,000
$30,000
checks payable to the accounting firm,
pursuant
arising
$10,000
1979,
to two
from
two
to a second
law firm, and $144,100 pursuant to a check payable to Isle;
all such checks were drawn by Mr. White.
On December 27, 1979,
the bank debited the FAL account
$750,000 pursuant to the instructions of Mr. Kamensky.
Such
funds were applied to the purchase of commercial paper
in
the
the
name
of
FAL.
The
$750,000
purchase
was
without
knowing authorization of Ms. Larson or Mr. Swain.
- 18 -
A
loan
from
Isle
to
ARL
was
part
of
the
series
of
transactions involved in the program for the development of
the AloEase product; a judgment note evidencing the loan was
signed by Mr. Marker without his knowledge
f its contents
or of the loan.
f the $150,000
Such loan was made by means
check from Isle which was deposited on December 27, 1979, in
the ARL account at the bank.
the
private
The loan was not described in
placement memorandum
relating
to
the
program.
Repayment of such loan has not been made and has not been
sought.
Pursuant to the instructions of Mr. Kamensky, the bank,
on December 27,
1979,
debited the ARL accoun
$150,000 and
purchased commercial paper in the name of ARL from the bank
for such amount.
The purchase of such commer ial paper was
made without the authorization of Mr. Marker.
On January 14,
matured.
The
principal
and
$151,004.18,
1980,
FAL
the FAL and ARL conmercial paper
account
interest.
principal
was
credited
$755,020.88,
ARL
account
was
The
and
interest.
On
i he
credited
same
day,
$750,000 was debited from the FAL account and $150,000 was
debited from the ARL account.
the
credit
recall
the
to
Mr. Marker wa
the
ARL
account,
debit
to
such
directions
of
Mr.
Kamensky,
distributed
to
the
22
and
at
not aware of
trial,
could
account.
Pursuant
such
were
investors
funds
in
the
not
to
the
combined
and
form of
cashiers'
checks payable to each of the investors in the amount of his
- 19 bank
loan.
Such
accounts of
were
the
checks
were
investors
by Mr.
used
to
pay
the
direction
of
Mr.
Kamensky,
deposited
principal
the
in
the
Drobny,
and
the proceeds
of
loans.
such
interest
checking
earned
At
the
on
the
commercial paper was distributed to the inve'stors by means
of checks signed by Ms. Larson.
19,
1980,
Mr.
Samotny
From January 24 to February
forwarded
to
the
bank
investors'
checks in payment of the interest due on their loans.
An outline of the research and development necessary to
develop
Pork
Pardner
was
prepared
by
Elars
Bioresearch
Laboratories (Elars) for FAL in 1980 and 1981.
Elars is an
independent research organization specializing in safety and
efficacy studies of drugs and vaccines for animal use.
Very
limited
field
testing
of
place
during
1980.
However,
according
Pork
Pardner
by
FAL
to Elars,
took
it would have
cost a minimum of $1,000,000 to conduct proper testing and
secure
the
government
approvals
necessary
Pardner.
FAL
received approximately
1980 and
1981
for testing and
1981,
because
of
the
$13,000
research.
insufficiency
to
of
market
from
Pork
Isle
in
In the spring of
funds,
Ms.
Larson
stopped work on Pork Pardner and began work on developing an
external animal medication using an aloe extract.
In 1982,
such a product was developed and marketed by FAL.
No laboratory work or testing was ever carried out on
the AloEase product.
in
Mr. Marker traveled to the Caribbean
1980 and secured 22,000 gallons of
aloe extract.
From
- 20 time
to
time,
he
was
reimbursed
by
Mr.
White
for
his
expenses, but in May 1981, he disassociated himself from ARL
because Mr.
White had
not honored
extract negotiated by Mr. Marker,
the
contracts
for aloe
had not paid him for his
services, and had not reimbursed him for money advanced by
him in the pursuit of aloe extract.
On their income tax returns for 1979,
deducted
the
following amounts as
the petitioners
their pro rata share of
losses resulting from the programs:
In
the
Petitioners
AloEase
FAP
Mr. & Mrs. Drobny
S 7,990
$19,998
Mr. & Mrs. Lifshitz
15,980
39,996
notices of deficiency,
the Commissioner disallowed
the claimed losses in full and determined that Mr. Drobny is
liable
for
the
addition
to
tax
for
fraud
under
section
6653(b).
•
OPINION
The
case
before
the
Court
is
representative
arising from two research and development programs.
for the addition to tax for fraud sought agains
of
cases
Except
Mr. Drobny,
all of the cases arising from these programs are factually
identical,
and the remaining docketed cases have agreed to
be bound by the determination reached in this c se.
The first issue for decision is whether the petitioners
are entitled to deductions for their proportionate share of
- 21 losses
resulting
from
claimed
research
and
expenditures by AloEase and FAP for 1979.
states,
as
a general
expenditures
taxpayer]
which
during
rule,
are
the
that
paid
taxable
experimental
Section 174(a)(1)
"research or experimental
or
incurred
year
in
by
*
connection
*
*
[a
with
his
trade or business," may, at the election of the taxpayer, be
treated as expenses not chargeable to capital account and,
therefore,
may
be
provisions
of
section
paid
incurred
or
experimentation
expenditures
deducted
the
174(a)(1)
by
the
undertaken
paid
in
year.
not
taxpayer
for
research
or
him
but
to
incurred
by
only
The
"apply
directly
or
taxable
for
to
costs
also
research
or
experimentation carried on in his behalf by another person
or organization
(such as a research
institute,
engineering company, or similar contractor)."
(a)(2),
foundation,
Sec.
1.174-2
Income Tax Regs.
A taxpayer need not currently be producing or selling
any product in order to obtain a deduction for research and
experimental expenditures.
Snow v.
500
(1974),
1029
T.C.
585
83 T.C.
revg.
(1972).
667,
time,
examination
payer's
still be
and
of
(6th Cir.
1973),
416 U.S.
affg.
58
As we observed in Green v. Commissioner,
686-687 (1984),
taxpayer must
some
482 F.2d
Commissioner,
we
the
activities
"For section 174 to apply, the
engaged
must
facts
in
in
still
of
each
connection
a
trade
or
business
at
determine,
throuah
an
case,
with
whether
a
the
tax-
product
are
- 22 sufficiently substantial and
or
business
for
purposes
regular
of
to constitute
such
section."
to
constitute
a
trade
(Fn.
ref.
omitted; emphasis in original.)
It
is
business,
and
well
settled
that
the activity must be engaged
honest
objective
Commissioner,
315
of
F.2d
making
731,
736
a
trade
in with an
a
profit."
(9th
Cir.
or
"actual
Hirsch
1963),
v.
affg.
a
Memorandum Opinion of this Court; Green v. Commissioner, 83
T.C.
667,
686-687
(1984);
914,
931
(1983);
Siegel v.
(1982);
Dreicer v.
affd.
without
Golanty
v.
without
published
Allen
v.
Flowers v.
702
Commissioner,
70 T.C.
715,
78 T.C.
T.C.
659,
699
642,
646
(1982),
1205
(D.C.
Cir.
1983);
T.C.
411,
425
(1979),
affd.
Cir.
1981);
647
72
78
80 T.C.
F.2d
72
opinion
Commissioner,
Commissioner,
Commissioner,
Commissioner,
opinion
Commissioner,
F.2d
T.C.
720
170
28,
(9th
33
(1978),
(1979);
affd.
615
Dunn
v.
F.2d
578
(2d Cir.
1980); Churchman v. Commissioner,
68 T.C. 696, 701
(1977);
Jasionowski
T.C.
(1976);
Benz
Bessenyey v.
379
F.2d
v.
Commissioner,
Commissioner,
Commissioner,
252
expectation
v.
(2d
of
Cir.
profit
is
66
312,
63
T.C.
375,
383
(1974);
45 T.C.
261,
274
(1965),
affd.
1967).
not
Although
required,
¡a
the
reasonable
taxpayer
have the intent and objective of realizing a profit.
v.
Commissioner,
78
T.C.
1984);
315 F.2d at 736;
471,
506
Dreicer
v.
(1982),
319
affd.
Commissioner,
Brannen v.
722
78
F.2d
T.C.
Hirsch
; ommissioner,
695
at
must
(llth
Cir.
644-645;
sec.
- 23 1.183-2(a), Income Tax Regs.
economic
profit,
"Profit" in this context means
independent
Commissioner,
85 T.C.
557
85
254-255
(1985);
T.C.
237,
of
tax
savings.
Beck
v.
(1985); Herrick v. Commissioner,
Surloff
v.
Commissioner,
81
T.C. 210, 233 (1983).
The issue of whether a taxpayer engages in an activity
with the
requisite intention of making a profit
is
fact
be
facts
to
resolved
on
the
circumstances of the case.
basis
of
all
the
one of
and
Hirsch v. Commissioner, 315 F.2d
at 737; Dreicer v. Commissioner, 78 T.C. at 645; Golanty v.
Commissioner, 72 T.C. at 426; Allen v. Commissioner, 72 T.C.
at 34; Dunn v. Commissioner, 70 T.C. at 720.
determination,
In making this
more weight must be given to the objective
facts than to the taxpayer's mere after-the-fact statements
of
intent.
Sec.
Commissioner,
84
1.183-2(a),
Income Tax Regs.;
T.C.
1269
1244,
(1985),
on
Thomas
appeal
v.
(4th
Cir., Sept. 13, 1985); Engdahl v. Commissioner, 72 T.C. 659,
666 (1979); Churchman v. Commissioner, 68 T.C.
petitioners bear the burden of proving that
the required profit objective.
of Practice and Procedure4;
69 T.C.
791,
521,
813
Sabelis
v.
at 701.
The
they possessed
Rule 142(a), Tax Court Rules
see also Boyer v. Commissioner,
537
(1977);
Johnson v.
(1973),
affd.
495
Commissioner,
37
F.2d
T.C.
Commissioner,
59 T.C.
1079
(6th
Cir,
1058,
1062
(1962).
1974);
The
4
Any reference to a Rule is to the Tax Court Rules of Practice and
Procedure.
- 24 -
existence
of
the
required
profit
o'ojective
is
usually
determined by the objective of the entity which has control
over the activity under scrutiny.
Brannen v.| Commissioner,
78 T.C. at 504-505; cf. Resnik v. Commissioner, 66 T.C. 74,
80-82 (1976).
Thus, the existence of a profit objective of
a
is
partnership
at
the
partnership
level.
Rosenfeld v. Commissioner, 82 T.C.
105,
112 ( 984);
Brannen
v.
determined
Commissioner,
78
T.C.
at
504-505;
Commissioner, 75 T.C. 424, 434-439 (1980).
appropriate
business
because each partner
of
his
partnership
is
and,
Goodwin
v.
Su h analysis is
really e gaged
in
the
therefore,
is
the
it
partnership which exercises control over the activity under
scrutiny.
Brannen
v.
Commissioner,
78
T.C.
at
504-505;
Butler v. Commissioner, 36 T.C. 1097, 1106-1107 (1961).
similar reasons,
For
the existence of a profit objective of a
joint venture is generally determined at the joint venture
level.
See Brannen
Madison Gas
&
v.
Commissioner,
Electric Co.
v.
78
T.Cs
Commissioner,
at
72
501-505;
T.C.
521,
557-565 (1979), affd. 633 F.2d 512 (7th Cir. 1980); Grove v.
Commissioner, 54 T.C. 799, 801-805 (1970).
Section 1.183-2(b),
Income Tax Regs.,
se s
forth some
of the relevant factors, derived principally from prior case
law,
which are
to be considered
in determinin
activity is engaged in for profit.
69 T.C.
at
537;
Benz v.
Such factors include:
Boyer v.
Commissioner,
63 T.C.
whether an
ommissioner,
at
382-383.
(1) The manner in which the taxpayer
- 25 carried on
or
his
the activity;
advisors;
(3)
(2)
the
taxpayer in carrying on
that
assets used
the
time
expertise of
and
effort
the activity;
the
taxpayer
expended
(4)
by
the
the expectation
in the activity may appreciate
in value;
(5) the success of the taxpayer in carrying on other similar
or
dissimilar
activities;
(6)
the
taxpayer's
income or loss with respect to the activity;
of
occasional
profit,
financial status of
if
any,
which
the taxpayer;
and
of personal pleasure or recreation are
history
(7)
of
the amount
is
earned;
(9)
whether elements
involved.
(8)
the
Allen v.
Commissioner, 72 T.C. at 33-34.
The petitioners contend
requisite profit
bona
fide
objective
purpose
products.5
of
that FAP and AloEase had the
because
developing
both operated
and
marketing
In support of such contention,
with
the
aloe-based
they argue that
FAP and AloEase contracted for the.research and development
work
to
in
such
activities and in whom they reasonably had confidence,
and
proper
be
performed
arrangements
exploitation
of
such
by
were
persons
with
experience
made
concerning
products.
However,
the
commercial
after
careful
5
Mr. Lifshitz asserts that the question of profit objective should
be stricken because it was raised by the Commissioner for the f irst
time in his brief in answer.
We disagree because such matter was
raised in the notice of deficiency and addressed in Mr. Lifshitz's
petition, his testimony at trial, and his opening brief.
F x
Chevrolet, Inc. v. Commissioner, 76 T.C. 708, 733-736 (1981); Estate of
Horvath v. Commissioner, 59 T.C. 551, 554-557 (1973); Rubin v.
Commissioner, 56 T.C. 1155, 1162-1164 (1971), affd. per curiam 460 F.2d
1216 (2d Cir. 1972).
- 26 consideration
of
all
the
facts
in
this
case,
that the investment programs entered into by
we
conclude
he petitioners
were primarily intended to produce tax savings without any
significant likelihood of an economic profit.
The
investors
information
about
were
the
offering memorandums
provided
products
for FAP
to
with
be
very
little
developed.
and AloEase
The
contained only a
few paragraphs describing their products; by
ontrast, over
10 pages were devoted to describing the tax consequences of
each program.
A detailed tax opinion letter was prepared by
the law firm, and no survey concerning the madketability of
the products was performed,
despite the known existence of
established
competition.
Clearly,
devoted
predicting
to
tax
more
resources
consequences
than
were
marketing
projections.
The
manner.
programs
were
carried
on
in
an
While numerous documents were signed,
the product of arm's length negotiation.
and Messrs.
behalf
unbusinesslike
not one was
Indeed, Ms. Larson
Marker and Swain, who signed many documents on
of
ARL
documents
and,
and
FAL,
were
generally,
not
permitted
executed
to
them
read
such
ithout
any
knowledge of their terms.
As a result of such ignorance,
Mr.
to
Kamensky
was
able
create
a
paper
trail
of
transactions for the proceeds of the bank loans, giving the
appearance of a series of bona fide business
without losing control over such proceeds.
transactions,
Such control was
- 27 absolute;
the
investors'
bank
loans
provided
without
him with
investor
the
proceeds
authorization
of
the
and
it
purchased $900,000 of commercial paper in the name of ARL
and
FAL
at
his
direction
without
the
authorization
or
knowledge of Ms. Larson or Messrs. Marker and Swain.
Particularly disturbing is the lack of any coordinated
management
power
on
the
part
of
the
investors.
Such
deficiency was plainly stated in both memorandums along with
a warning that
contracts.
it might lead to difficulties
Such
intentional
lack
of
in enforcing
management
clearly
indicates that investors were not concerned with enforcing
the terms of the various contracts involved in the programs
.
and
that
the programs
objective.
absolute
When
were
that
not
deficiency
power
held
by
compelling
that
the
investors
benefits,
and
not
instituted
Mr.
interests
is
combined
Kamensky,
were
in
with
bona
profit
with
the
inference
is
purchasing
tax
research
and
the
simply
a
fide
development programs.
The transactions between ARL and Isle were conducted in
an
unbusinesslike
corporations
was
manner.
never
A
signed,
contract
indicating
between
that
its
the
terms
were not important despite the contention that $320,000 was
to be spent on AloEase product research.
the
lack
collateral,
of
a
contract
Isle made a
Marker's knowledge.
or
any
$150,000
Without regard to
corporate
loan
to ARL,
assets
for
without Mr.
The loan proceeds were used to make the
- 28 -
option payment
to AloEase,
without Mr.
Marker's knowledge,
and no attempt has ever been made to collect upon such loan.
We conclude that under the AloEase program, n ither Isle nor
ARL was intended to perform meaningful resear h and that the
loan to ARL and the option payment to
means
of
completing
were
without
a
series
substance
of
AloEase were simply a
paper
and
were
between
FAL
transactions
designed
to
and
also
which
produce
substantial tax benef its.
The
transactions
conducted
between
in
an
such
unbusinesslike
corporations
Pardner by September 15,
FAP
to
deliver
such
manner.
required
1981,
Isle
The
FAL
to
were
agreement
develop
Pork
while Isle had agreed with
product
on
September
30,
1980.
Discrepancies in both the day and year of pro uct delivery,
which made
Isle's
failure
to
perform
very
likely,
would
certainly have been detected by either of the two attorneys
or
Mr.
Drobny
performance
conclusion
if
such
terms
were
dates
were
not
meaningful
that
the
purpose
of
meaningful.
That
upports
the
the
programs
was
the
executed
betwebn
Stoma
and
production of tax benefits.
The
Ms.
acquisition
agreement
Larson provided the appearance of a bona fide business
transaction but was totally unnecessary.
Ms. Larson, under
Mr. White's direction, was working on Pork Pardner in 1978
and
1979.
evidence
It
had
not
been
patented,
and
there
that Stoma or anyone else was engaged
is
no
in similar
- 29 research.
adds
The fact
support
to
that Stoma was promoted by Mr.
our
conclusion
that
such
Drobny
agreement
is
without substance and is indicative of a consistent pattern
of deception surrounding the programs.
The
individuals
assigned
the
responsibility
of
performing the research did not have the expertise necessary
to properly carry out such research.
While Mr.
have substantial relevant experience,
he was not an active
researcher
for
the
Larson
secretary
and
a
programs.
Ms.
supervisor,
Mr.
Marker
pharmacist, and Mr. Swain was a salesman.
an
interest
in
aloe-based
products
but
White
was
a
was
a
did
former
retired
Each of them had
did
not
have
the
training or history of successful product development that
would reasonably warrant entrusting
investors'
there
In
was
no
accumulated
managing
deficit
investor.
indicates
that
Mr.
fact,
money where
Isle's
White's
large
abilities
were limited and his motive survival rather than new product
development.
In
sharp
contrast
with
the
individuals
involved
in
research and development, exceptionally capable tax experts
were actively involved in both programs.
Messrs. Adler and
Drobny were both former IRS employees who had become CPAs.
Both
had
course.
been
instructors
for
the
IRS
and
a
CPA
review
Additionally, they specialized in tax matters.
Mr.
Kamensky had structured similar tax shelter transactions and
was known in Chicago as an attorney with experience in the
- 30 -
formation of research and development tax shelters.
personnel
were
development
clearly
staff,
far
superior
supporting
an
to
th
inference
The tax
research
and
that
tax
the
consequences were the primary objective of the programs.
Most significant is the fact that very little money was
actually spent on research and development work.
circular flow of
the
$900,000 proceeds of
the
After the
bank
loans,
the investors supplied only $220,000 of actual cash for the
programs.
the
After the payment of
accounting
f irm,
only
research and development.
than
the
$1,000,000
fees
$145,000
to the law firm and
was
àvailable
for
Such amount is substantially less
necessary
to
gain
the
required
government approvals for Pork Pardner, indicating that there
was no genuine intent to develop the product.
The transactions surrounding the circular flow of the
$900,000 proceeds of the bank loans had no substance for tax
purposes.
The $800,000 payment to Isle by FAP, the $750,000
payment by
Isle
from FAL
FAP
to
to
FAL,
and
the
constituted
series of transactions.
$750,000
nothing
more
ropalty payment
than
a
circular
Similarly, the $320,000 payment to
Isle by AloEase,
the loan from Isle to ARL of $150,000, and
the
ARL
payment
by
to
AloEase
transactions.
The
transactions
were
out
in
carried
increasing,
for
tax
one
day,
purposes
of
$150,000
took place
and
only,
had
the
were
circular
on paper
the
cost
only,
effect
of
of
services
- 31 purchased from Isle to five times
the actual cost;
no part
of the $900,000 was used for research and development.
.
The
investors
were
practically
loans would
guaranteed
be available
that
the
proceeds of
the bank
to satisfy
such loans.
The control retained by Mr. Kamensky over the
proceeds insured that the investors would not have any outof-pocket expense
for the
loan principal.
The
bank
loans
totaling $900,000 were followed immediately by a series of
paper transactions and by the purchase of commercial paper
for such amount at the bank.
on
January
14,
1980,
and
The commercial paper came due
the
proceeds
were
immediately
distributed to the investors, so that they were available to
satisfy the bank loans which came due on January 16,
1980.
The funds never left the bank; indeed, in December 1979, the
bank had post-dated checks from each investor in the amount
of his loan and interest.
The petitioners argue that because the commercial paper
was
purchased
in
the
name
of
ARL
and
prevented
the
investors
FAL,
entity
receiving
such
could
have
funds.
This argument is meritless because both corporations
were controlled by Mr.
Mr. White,
and Ms.
from
either
Kamensky, either directly or through
Larson and Messrs.
Marker and Swain had
no knowledge of the underlying transactions or the existence
of the commercial paper; while in theory such
interference
might
impossible.
have
Therefore,
occurred,
it
we conclude that
was
realistically
the transactions
that
resulted
.
- 32 in the circular flow of the
$900,000 proceeds of
the
bank
loans were shams entered into solely to create the illusion
of
research
substance
and
experimental
ex enditures,
while
in
insuring that no part of s¹uch funds would be so
used.
Cf.
Karme v.
(1980),
affd.
673
Commissioner,
F.2d
1062
731 T.C.
(9th
Cir.
1 63,
1982);
1185-1195
Bridges
v.
Commissioner, 39 T.C. 1064, 1076-1077 l(1963), .affd. 325 F.2d
180 (4th Cir. 1963).
In the unlikely event that a product was developed, the
intricate network of agreements
engineered b
Mr.
Kamensky
insured that any profits to AloEase or FAP wou..d be minimal.
Under the exclusive license agreement between FAL and FAP,
the
investors
received
advanced
minimum
FAP was
to receive
no
royalty
a
royalties
until
license
beyond
sales
the
reached
$750,000
$3,000,000.
25 per c ent
fee of
of gross
sales up to $3,000,000, with such license fee to be offset
against
the
advanced
minimum
royalty.
$3,000,000 or more, FAP was to receive
For
sales
of
12-per ent fee.
At
the same time, for sales over $3,000,000, FAP was to pay Ms.
Larson
a
6-percent
fee.
Because
the
advanced
minimum
royalty was merely a means of achieving a circular flow of
$750,000
of
the proceeds of
the bank
could not receive an economic return o
Pork
Pardner until
sales
reached
loans,
the
investors
their investment in
$3,000,000,
net would only be 6 percent of gross sales.
and
then
the
Such a return,
where the product research is severely underfu ded,
thereby
- 33 making product development unlikely, is so small as to allow
the inference that there was no profit objective.
ARL
paid
$150,000
for
the
option
agreement
with
AloEase; such transaction was merely a circular flow of the
proceeds of the bank loans and did not represent an economic
return on investment.
pay
an
additional
exercised,
there
To exercise the option, ARL had to
$300,000.
could
be
If
no
the
marketing
option
or
sales
was
not
of
the
AloEase product for 10 years.
The exercise of such option
was
ARL
highly
unlikely
because
was
a
new
corporation
created solely for the AloEase program with no assets and a
$150,000 debt to Isle.
It had no written contract with Isle
and had no prospects of ever earning or borrowing $300,000.
Finally,
estimates
the
of
absence
revenue
of
any marketing
from
goods
sold
projections
is
one
or
further
indication that the programs had no profit objective.
As
the petitioners properly point out, sales estimates for new
.
products may not be very reliable.
Howe.ver, the absence of
any effort to ascertain whether the investors would receive
a
return on
their $220,000
investment
indicates
they were
purchasing tax benefits.
The
petitioners
developing
an
point
external
to
animal
Ms.
Larson's
medication and
activities
Mr.
in
Marker's
search for a source of aloe extract as indicators that the
projects had a profit objective.
were
not
caused
by
changed
However, these activities
circumstances
and,
therefore,
- 34 -
could
Yet,
have
been
described
the activities
are
in
not
the
placemen;
described
in
memorandums.
the
memorandums,
and we are convinced that they were in no way contemplated
by the investors or the promoters.
Rather, they arose from
the interest of Ms. Larson and Messrs. Marker and White in
aloe-based medications in general and as such do not reflect
on the two programs or the investors.
Mr. Drobny's testimony that as of 1984 he had actually
lost $425,
including tax savings, as a
in the programs does not
result
indicate a profit
of
investing
bjective.
We
observe that such claim is not substantiated a d that such a
loss would not be relevant to his motive in 1979 because it
is
a
small
dollar
amount
and
is
remote
in
time.
Mr.
Lifshitz's assertion that he expected a cash flow from the
programs in excess of 8 percent is also not pÉrsuasive.
In
the
was
late
1970's,
expanding;
such
an
the
however,
aloe
vera
base
product
given the structu e of
expectation
would
have
been
pure
market
these programs,
fantasy.
The
self-serving nature of such claim, com ined wi h the absence
of any evidence in support, renders it limplausible.
Because
we
find
for
the
Commissioner
o
the
profit
objective issue, we do not address the alternative positions
advanced by him.
The second issue for decision is
liable
for
the
6653(b) for 1979.
addition
to
tax
for
Such section provide
hether Mr. Drobny is
fraud
under
section
that if any part of
- 35 any underpayment of tax required to be shown on a return is
due
to
fraud,
there
shall be
added to
such
equal to 50 percent of the underpayment.
tax
an amount
The Commissioner
has the burden of proving, by clear and convincing evidence,
that some part of the underpayment for such year was due to
fraud.
Sec.
7454(a);
Rule
States, 496 F.2d 651 (3d Cir.
53
T.C.
96,
105
142(b);
Levinson
v.
United
1974); Otsuki v. Commissioner,
(1969).
To
establish
fraud,
the
Commissioner must show that the petitioner intended to evade
taxes which he
intended
to
knew or believed
conceal,
mislead,
collection of such taxes.
366, 377-378
(5th Cir.
that
or
Webb v.
1968), affg.
this Court; Powell v. Granquist,
he owed,
otherwise
252 F.2d 56,
It
fraudulent
settled
that
a
the
394
F.2d
a Memorandum Opinion of
26 T.C.
well
prevent
Commissioner,
1958); Acker v. Commissioner,
is
by conduct
107,
60
(9th Cir.
111-112
(1956).
understatement
of
income can be accomplished by means of an overstatement of
deductions.
(1971),
Hicks Co.
affd.
Commissioner,
470
F.2d
52 T.C.
v.
Commissioner,
87
(1st
Cir.
532,
540
(1969),
56 T.C.
1972);
982,
1019
Neaderland
v.
424
639
affd.
F.2d
(2d Cir. 1970).
The presence or absence of fraud is a factual guestion
to
be
determined
Gaiewski
v.
without
published
by
an examination
Commissioner,
opinion
of
the
entire
67
T.C.
181,
199
578
F.2d
1383
(8th
Fraud will never be presumed.
Beaver v.
record.
(1976),
affd.
Cir.
1978).
Commissioner, ·55
- 36 T. C.
85,
92
( 1970 ) .
circumstantial
However ,
evidence
f raud
since
may
direct
petitioner's intent is rarely available.
be
proved
by
proof
of
the
His entire course
of conduct can often be relied on to establish the requisite
fraudulent
223-224
intent.
v.
Commissioner,
(1971); Otsuki v. Commissioner,
When a claim of
this
Stone
Court
education,
53 T.C.
ignorance or honest mistake
must
and
56
consider
the
tax expertise
in making
213,
at 195-106.
is
petitioner's
T.C.
set
forth,
intelligence,
its
determination.
Iley v. Commissioner, 19 T.C. 631, 635 (1952).
We have already held that the ded ctions
laimed by Mr.
Drobny for losses attributable to FAP and AloEase were not
allowable,
and the claiming of such deductions resulted in
an underpayment of his tax for 1979.
Therefore,
the only
remaining inquiry concerns the willfulness of his acts.
evidence
convincingly
establishes
that
he
The
fraudulently
underpaid his taxes for the year 1979.
There
fraud.
is
He is
experienced
considerable
an
tax
evidence
intelligent
specialist.
to
show Mr.
and educated
He
was
ma n,
aware
of
Drobny's
who
is an
all
the
transactions which constituted the FAP and Alobase programs.
The
letter from the law firm dated N vember 28,
1979,
forth the financial aspects of the programs including:
set
flow
6
See Toussaint v. Commissioner, T. C. Memo. 1984-25, affd. 743 F.2d
309 (5th Cir. 1984); Green v. Commissioner[ T. C. Memo. 1981-577;
Schwartz v.
Conmissioner, T. C.
Memo.
1974-245;
Langlois v.
Commissioner, T. C. Memo. 1955-56.
- 37 -
charts,
descriptions
analysis,
and
memorandums
a
of
the
transactions,
a
cash
flow
analysis.
The
placement
described
important
concerning
the
programs
tax
benefit
elements of such programs.
Mr.
Drobny was aware of the
general,
and
deductions,
research
in
and
particular.
law regarding taxes,
in
experimental
expenditure
His
as
knowledge
a
tax
specialist was supplemented by information appearing in the
tax opinion letters.
Such letters state that substance over
form
liability
controls
tax
and
that
the
form
of
a
transaction may be disregarded if it has no purpose other
than
reduction
of
taxes.
The
lack
of
arm's
length
transactions is identified as frequently giving rise to the
use of the substance-over-form rule to disregard the form of
the transaction.
it
cannot
be
Finally,
shown
the law firm points out that if
that
the
amount
paid
to
Isle
is
approximately equal to the value of services rendered, such
amounts might not be deductible.
With
the
understanding
information
of
such
available
affairs,
Mr.
to
him
and
with
his
Drobny knew
that
very
little of the money could in fact be used for research work.
Under the two programs, total deductions of $1,120,000 were
claimed, but the $900,000 borrowed from the bank was repaid
within a month.
available
for
Of the total,
research,
but
in
legal fees and accounting fees.
not more that $220,000 was
fact,
$75,000
was paid
as
Thus, only $145,000 could
- 38 be spent for research.
Some of the investors may not have
understood these
but
that Mr.
facts,
Drobny knew that
the conclusion
the
funds
is
inescapable
for which he claimed
deductions would not in fact be used for research.
case,
he purchased only a one-half udit;
thus,
In his
he put up
$5,500 and claimed a deduction of $27,988; yet, he knew that
most of that amount could not be used for research purposes.
Mr.
Drobny
argues
that
deductions were legitimate.
he
reas o nably
believed
the
In support of such contention,
he says that he reasonably relied on the expertise of the
law f irm and the f act that similar prbgrams structured by
1
Mr. Kamensky had not been challenged by the Commissioner.
Mr.
Drobny
is
a
tax expert
and
promgter
of
considerable
experience.
He was aware that the la
firm was receiving
$35,000
its
the
for
efforts
in
support
of
programs
and,
therefore,
had an interest in securing a positive investor
response.
Mr. Drobny knew of those circumstances, and with
that knowledge and his sophistication,
he can ot claim to
have relied upon the expertise of the law firm.
placement
memorandums
state
in
capital
Indeed, the
letters
that
investors should seek independent counsel concerning the tax
consequences of the programs.
Finally
we do not believe
that a person of Mr. Drobny's experience, including 4 years
at the IRS, could reasonably have relied upon lack of action
by
the
Commissioner
as
a
basis
for
determining
the
- 39 legitimacy of the programs when he had detailed knowledge of
the use of the proceeds of the bank loans.
Mr.
Drobny
states
that
based
experience with Isle and Mr. White,
on
past
business
he reasonably believed
that the contracts would be completed.
Such contention is
not
the
believable
development
FAL,
because
activities
he
knew
had
been
that
subcontracted
research
and
to
and
ARL
neither of which had a financial existence apart from
the programs, and that only $145,000 would be available for
such
activities.
Additionally,
product
development
would
not have changed the tax consequences of the circular flow
of the loan proceeds and would very likely not have produced
.
an economic profit to the investors.
Also,
of
Mr.
Drobny contends that he did not prepare any
the documents or financial
programs
and,
preparation
therefore,
of
such
did
documents
data
that were
used
not
commit
fraud.
is
not
required
in
the
The
to
prove
a
whole,
fraud; knowing participation is sufficient.
We
conclude
that
this
evidence,
taken
as
clearly and convincingly indicates that Mr. Drobny knew that
some or all of
the
research
and experimental
arising from the programs were not
intentionally
reported
losses
expenditures
deductible and
resulting
from
such
that he
claimed
- 40 deductions
on
his
1979
income
tax
return,
esulting
in
fraudulent underpayment of tax.
Decisions will be entered
for the respondent.
a
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.