# SERy I CE

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## Record

- **Collection:** Agency decision
- **Document type:** Agency decision

## 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

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A05c9e4b7e9fe7fe5. Public record. Not legal advice.