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T.C. Memo. 1996-206
UNITED STATES TAX COURT
STEPHEN H. GLASSLEY AND JUDITH GLASSLEY, ET AL.,1
Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 13431-89, 19140-89
24177-89.
Filed April 30, 1996.
John E. Williams and Eric W. Bloom, for petitioners.
Rodney J. Bartlett and Brian M. Harrington, for respondent.
1
The following cases were consolidated herewith for purposes
of trial, briefing, and opinion: Paul S. Mahoney, docket No.
19140-89; and Edward F. Houser, Jr. and Kathryn G. Houser, docket
No. 24177-89. There are presently at least four other cases
docketed in this Court which by stipulation are bound by the
outcome of these consolidated cases.
- 2 CONTENTS
Page
MEMORANDUM FINDINGS OF FACT AND OPINION........................2
OPINION OF THE SPECIAL TRIAL JUDGE.............................3
FINDINGS OF FACT...............................................4
A. Background...............................................4
1. The Jojoba Industry in General.......................4
2. Carole A. Whittaker..................................5
3. Joseph E. Berberich..................................7
4. Jojoba Development Partners, Ltd.....................9
a. The Private Offering Memorandum..................9
b. The Research and Development Agreement..........15
c. The Option and Joint Venture Agreement..........20
d. The Farm Lease..................................23
e. The Option and Farm Lease Agreement.............24
5. Petitioners.........................................25
a. Petitioners Stephen H. Glassley and Judith S.
Glassley........................................25
b. Petitioner Paul S. Mahoney......................28
c. Petitioners Edward F. Houser, Jr. and Kathryn G.
Houser..........................................29
B. The Jojoba Plantation...................................32
C. The Consequences of Petitioners' Initial Investment.....41
D. The Experts.............................................43
1. Paul H. Gross.......................................43
2. Dr. Eberhardt.......................................47
3. Marvin T. Parr......................................48
OPINION.......................................................51
A. The Criteria That Must Be Satisfied For Expense Treatment
Under Section 174.......................................51
1. The Expenditures Must Be For Research or
Experimentation.....................................52
2. The Expenditures Must Be Paid or Incurred on Behalf
of the Taxpayer.....................................64
3. The Expenditures Must Be Paid or Incurred in
Connection with the Taxpayer's Trade or Business....68
B. Negligence..............................................77
1. Petitioners Glassley and Houser.....................78
2. Dr. Mahoney.........................................82
C. Increased Interest......................................82
MEMORANDUM FINDINGS OF FACT AND OPINION
DAWSON, Judge:
These cases were assigned to Special Trial
Judge Norman H. Wolfe pursuant to the provisions of section
- 3 7443A(b)(4) and Rules 180, 181, and 183.2
The Court agrees with
and adopts the opinion of the Special Trial Judge, which is set
forth below.
OPINION OF THE SPECIAL TRIAL JUDGE
WOLFE, Special Trial Judge:
Respondent determined
deficiencies in and additions to petitioners' Federal income
taxes as follows:
Additions to Tax
Sec. 6653(a)(1) Sec. 6653(a)(1)
Petitioners
Year
Deficiency
Glassley
1981
$20,222.00
$1,011.00
1
-
Mahoney
1981
23,283.00
1,164.15
2
$6,984.90
Houser
1981
1982
19,476.06
160.00
1,337.12
277.35
3
4
Sec. 6659
-
1
50 percent of the interest due on $20,222.
50 percent of the interest due on $23,283.
3
50 percent of the interest due on $19,476.06.
4
50 percent of the interest due on $160.
2
In the statutory notices of deficiency for petitioners Stephen H.
Glassley and Judith S. Glassley (petitioners Glassley) and
petitioner Paul S. Mahoney (Dr. Mahoney), respondent also
determined that the provision for increased interest under
section 6621(c)3 applied.
Subsequently, respondent asserted by
first amendment to answer that petitioners Edward F. Houser, Jr.,
2
All section references are to the Internal Revenue Code in
effect for the tax years in issue, except as otherwise indicated.
All Rule references are to the Tax Court Rules of Practice and
Procedure.
3
Sec. 6621(c) was repealed by sec. 7721(b) of the Omnibus
Budget Reconciliation Act of 1989 (OBRA 89), Pub. L. 101-239, 103
Stat. 2106, 2399, effective for tax returns due after Dec. 31,
1989, OBRA 89 sec. 7721(d), 103 Stat. 2400. The repeal,
therefore, does not affect the instant cases.
- 4 and Kathryn G. Houser (petitioners Houser) were liable for
increased interest under section 6621(c).4
Respondent concedes
that there is no addition to tax due from Dr. Mahoney under
section 6659.
The issues remaining for decision are:
(1) Whether
petitioners are entitled to deduct losses relating to their
investments in a limited partnership, Jojoba Development
Partners, Ltd., which arose principally from that partnership's
deduction of purported research and development expenditures paid
or incurred during 1981; (2) whether petitioners are liable for
additions to tax for negligence; and (3) whether petitioners'
underpayments of tax are attributable to a tax-motivated
transaction for purposes of computing increased interest pursuant
to section 6621(c).
FINDINGS OF FACT
Some of the facts have been stipulated, and are so found.
The stipulation of facts and exhibits attached thereto are
incorporated herein by this reference.
A.
Background
1.
The Jojoba Industry in General
The jojoba plant is a shrub that is native to the Sonoran
Desert region in Arizona, California, and Mexico.
4
A jojoba plant
Respondent asserted also by first amendment to answer that
Dr. Mahoney was liable for increased interest under sec. 6621(c).
Respondent had determined in the statutory notice of deficiency
as well that the provision for increased interest under sec.
6621(c) applied.
- 5 may live well over 100 years.
The female jojoba plant produces a
seed, sometimes referred to as a bean, that contains
approximately 50 percent by weight of an unusual oil.
Jojoba oil
is actually a liquid wax ester, unlike the triglyceride oils
typically produced by plants, and is similar to sperm whale oil.
It takes 5 years or more for a jojoba plant to produce seeds
in a harvestable quantity.
Approximately 20 pounds of jojoba
seeds are needed to produce 1 gallon of jojoba oil.
Jojoba oil
is useful for a variety of purposes, ranging from cosmetics and
shampoos to industrial lubricants.
The ban in 1971 on the importation of sperm whale oil and
products using that oil stimulated an interest in the commercial
production of jojoba oil.
During the nineteen seventies and into
the early nineteen eighties, jojoba oil was available only from
native jojoba plants.
At that time in the United States, there
were only a few commercial-sized jojoba plantations, all of which
were in developmental stages.
Domestication studies were being
conducted in the United States during that time at the University
of California at Riverside and the University of Arizona, among
other places.
2.
Carole A. Whittaker
Prior to 1978, Carole A. Whittaker (Whittaker) taught
mathematics and science, primarily chemistry, at the high school
through college levels.
Whittaker became generally interested in
the jojoba plant and its seed during 1976 or 1977.
She left her
- 6 teaching position in 1978 to consider entering private business
and then took a sabbatical year, during which she investigated
jojoba more intensively.
By the end of 1978, she had decided to
plant and farm jojoba as a business.
From 1978 through 1980,
Whittaker read extensively on the subject, attended international
conferences on jojoba, and consulted various authorities in the
field, including Dr. Demetrios Yermanos (Yermanos)5 of the
University of California at Riverside and Dr. Lemoyne Hogan of
the University of Arizona.
From September 1978 through the spring of 1979, Whittaker
searched for a location on which to develop a commercial jojoba
plantation.
Whittaker had experience in science and project
management but she had no experience in economics or business.
She therefore also sought advice during that time from friends
and colleagues about how to develop a commercial jojoba
enterprise.
By June 1979, Whittaker identified a section of land in
Hyder, Arizona, on which to develop a commercial jojoba
plantation.
At that time, with some associates, she formed Hyder
Jojoba, Inc. (HJI), a subchapter S corporation organized under
the laws of Arizona.
Whittaker became HJI's president and
chairman and was its principal shareholder.
5
Dr. Demetrios Yermanos, a noted expert on the jojoba plant,
was recognized worldwide as a leader in the domestication of that
plant for commercial purposes.
- 7 During August 1979, HJI acquired a 640-acre parcel of
partially developed land in Hyder, Arizona, and began farm
development.
A small planting of jojoba undertaken in the fall
of 1979 failed.
Extensive planting of jojoba plants began in the
spring of 1980.
HJI had planted 400 acres of jojoba by the fall
of 1980.
Planting of the remaining 240 acres was completed in
1981 with the help of financing provided by Hyder Jojoba Partners
(HJP), a farming partnership.
HJI was the general partner of
HJP, provided farm management services to HJP, and leased land to
HJP.
3.
Joseph E. Berberich
Joseph E. Berberich (Berberich) is a partner in the law firm
of Manning, Leaver, Bruder, and Berberich, located in Los
Angeles, California.
He is involved primarily in a commercial
and business practice of law.
His law firm was not directly
involved in the transactions in issue in the instant cases.
Berberich became interested in jojoba in 1979 after reading
in World Market Perspective, an industrial newsletter, an article
entitled "Jojoba, Super Bean of the Future".
Berberich began
reading more about jojoba and decided to invest in jojoba with
three of his friends who shared an interest in such a project.
He traveled with those friends to a number of jojoba plantations
located in Southern California and in Arizona.
Berberich also
read a number of private offering memoranda relating to
- 8 investments in jojoba.
He attended an all-day seminar on jojoba
given by Yermanos at the University of California at Riverside.
Sometime during late 1980, Berberich met Whittaker in Los
Angeles, California.
He was impressed with her scientific
background and with the fact that her father was William
Whittaker, founder of the Whittaker Corp., which was a publicly
traded company.
Berberich traveled with his friends to Hyder,
Arizona, and examined the jojoba plantation planted by HJI there.
To invest in Whittaker's jojoba farming, Berberich and his
associates became the first limited partners in HJP.
At that
time, Berberich had no prior experience in agriculture or
agricultural investments.
Whittaker, Berberich, and others believed that the
successful commercialization of jojoba depended on the industry's
developing a significant and stable supply of jojoba seed.
Following discussions with Berberich, during late summer or early
fall of 1981, Whittaker developed a preliminary proposal relating
to research regarding plant selection and propagation, nutrient
applications, water requirements, and pollination requirements
that might be conducted in connection with a jojoba limited
partnership investment.
During 1981, Whittaker and Berberich
agreed that Berberich would form, and serve as the general
partner of, a new limited partnership named Jojoba Development
Partners, Ltd. (JDP).
The decision to form this partnership had
been made, at least in principle, by the time Whittaker prepared
- 9 her draft proposal concerning research possibilities.
To be
attractive to potential investors and raise the funds that HJI
needed to develop its jojoba plantation, the limited partnership
had to provide substantial tax benefits and had to be formed near
the end of 1981.
4.
Jojoba Development Partners, Ltd.
a.
The Private Offering Memorandum
With the assistance of counsel, Berberich prepared a private
offering memorandum (the offering) relating to JDP.
The offering
was dated November 19, 1981, and represented that a minimum of 22
and a maximum of 65 limited partnership units in JDP would be
sold.
According to the offering, JDP was to be "organized to
perform research and experimentation for the development of a
particular strain of jojoba plant and seeds which can be planted,
grown and harvested in a commercially feasible manner and which
will produce a commercial yield of jojoba beans or seeds."
The
offering identified HJI as the contractor selected to carry out
the research and development (R & D) program under an R & D
Agreement pursuant to which HJI would develop a so-called
experimental plantation.
This plantation (hereafter the "small
plantation") was to consist of a minimum of 160 acres and a
maximum of 464 acres, depending on whether the minimum or maximum
number of limited partnership units was sold on land located in
the Hyder Valley of Arizona.
Potential investors in JDP were
advised that the offering would be terminated and any payments
- 10 received, together with any accrued interest, would be refunded
if the minimum number of limited partnership units were not sold
on or before December 21, 1981, but that, if the minimum number
of units were so sold by December 21, 1981, JDP would be formed
and the offering would continue until the maximum number of such
units was sold or until March 31, 1982, whichever occurred first.
The offering further indicated that JDP intended to
determine, on or before December 31, 1986, whether to convert the
small plantation into a commercial plantation for the growing,
harvesting, processing, and marketing of jojoba plant material,
beans or seeds, oil, and products derived from the jojoba plants.
According to the offering, JDP would continue only if it decided
that growing the strain of jojoba developed under the R & D
program on a commercial basis was feasible, either for JDP alone
or in a joint venture with HJI.
The principal investment objectives of the Partnership
specified in the offering were as follows:
(1) To conduct a comprehensive research and
development program on the jojoba plants on the
experimental plantation with the objective of
developing a strain of jojoba which can be planted,
grown and harvested on a commercially feasible basis
and which will produce a commercial yield of jojoba
beans;
(2) If the R & D Program is successful, to convert
the experimental plantation to a commercial plantation
in 1987 and operate such plantation for profit;
(3) To provide cash distributions to the Limited
Partners commencing in 1987, or as early thereafter as
- 11 possible, through the operation of the commercial
plantation; and
(4) To generate tax losses in 1981 which can be
used to offset the taxable income from other sources.6
In the "Investor Suitability Standards" section of the
offering, potential investors were further advised that, because
of the risks and benefits involved, the offering was restricted
to persons who made a minimum purchase of one limited partnership
unit at a cost of $50,000 per unit, unless the general partner
permitted the purchase of a fraction of a unit, and who had
either a net worth, exclusive of home, furnishings, and
automobiles, of at least $200,000 and taxable income in 1980,
some portion of which was subject to Federal income tax at a rate
of 50 percent or more, or a net worth, exclusive of home,
furnishings, and automobiles, of at least $300,000.
Potential
investors were informed that investors in higher Federal income
tax brackets should be able to utilize more fully certain income
tax deductions generated by JDP.
Potential investors were advised that an investor
subscribing to one limited partnership unit would have to pay
$15,000 in cash at the time of subscription and the balance of
$35,000 by the execution and delivery of a promissory note,
bearing interest at the rate of 10 percent per year on the unpaid
6
In the text we have employed the term "small plantation" to
describe the initial operations of the JDP partnership instead of
the pejorative term "experimental plantation" employed in the
promotional literature.
- 12 principal balance, payable $15,000 on May 1, 1982, $10,000 on May
1, 1983, and $10,000 on May 1, 1984, plus any accrued interest on
the note.
Potential investors were informed that the note would
be on a full recourse basis to the limited partner and that, in
the event of default, a limited partner would be subject to
expulsion from the partnership, in the discretion of the general
partner, and to deferral of his rights to return of capital.
According to the offering, the limited partners would own a
collective capital percentage of 99 percent up to the point of
recoupment, defined as the point at which the total of the
cumulative net profits allocated to the limited partners equaled
50 percent of the total of the cumulative net losses allocated to
them, after which the limited partners would own a collective
capital percentage of 90 percent.
The general partner would own,
as consideration for his capital contribution of $1,000, a
partnership interest of 1 percent up to the point of recoupment
and an interest of 10 percent thereafter.
The offering advised potential investors that, in addition
to his profits interest, the general partner would receive a fee
for 1981 of $10,000 as compensation for his services rendered in
connection with the formation of JDP.
In addition, commencing in
1982, the general partner would receive a yearly fee as
compensation for his services in managing the day-to-day affairs
of JDP, in the respective amounts of $10,000 per year for 1982
through 1987, $15,000 per year for 1988 through 1992, $20,000 per
- 13 year for 1993 through 1998, and $25,000 per year thereafter until
termination of JDP.
Furthermore, the general partner would be
reimbursed for any costs he or his affiliates incurred on behalf
of the partnership, including organizational and offering
expenses, accounting and other services, and operational
expenses.
The offering further indicated that if the minimum number of
partnership units were sold and 160 acres were planted, HJI would
receive a fee of $960,000 ($250,000 in cash at execution of the
agreement and the balance payable in 1982 through 1985), while if
the maximum number of partnership units were sold and 464 acres
were planted, HJI would receive a fee of $2,784,000 ($764,000 in
cash in 1981 and the balance payable in 1982 through 1985).
offering, however, cautioned that:
The Partnership will be funded with contributions of
not less than $1,100,000 nor more than $3,250,000. The
size of the R & D Program will be affected by the
amount of funds at the Partnership's disposal. If the
Partnership receives only the minimum amount of
proceeds it will be able to develop a 160 acre
experimental jojoba plantation and will have a reduced
ability to conduct the degree of research and
experimentation respecting propagation, watering and
fertilizing techniques it otherwise would do and to
complete research and experimentation on a larger seed
population, all of which, consequently, may reduce the
Partnership's chances of developing a superior jojoba
plant strain. Such a result would increase the risks
associated with the venture. If only the minimum or
near minimum number of Units is sold, the Partnership
will have to pay higher Organization and Offering
Expenses per Unit than if it received the maximum or
near maximum amount of proceeds from the sale of Units.
* * * The number of acres under the R & D Program will
increase in accordance with the size of the offering
The
- 14 and dealing with a relatively fewer number of acres in
the R & D Program or any subsequent commercial venture
will entail additional risks of casualty, economic and
environmental problems and other matters, the risks of
which could be absorbed or compensated for in an R & D
Program or venture with a larger number of acres in
various locations.
Attached to the offering was a copy of a 33-page tax opinion
letter dated November 17, 1981, issued by Kaplan, Jacobowitz,
Hendricks & Bosse, P.A., a law firm located in Phoenix, Arizona,
which served at that time as counsel to HJI.
Projections
calculated by HJI also were attached to the offering.
These
projections concerned the tax impact and possible returns to
partners based on various estimates and assumptions derived from
HJI's "past experience in developing a jojoba plantation, the
relatively limited yield data available and its research
respecting the cultivation of jojoba."
Contrasting projections
were provided on the premise of the development of a 160-acre
plantation and sales of 22 partnership units and on the premise
of the development of a 464-acre jojoba plantation and sales of
60 partnership units.
Unexecuted copies of the certificate and
agreement of limited partnership and certificate of fictitious
name, subscription agreement, promissory note, offeree
questionnaire, offeree representative questionnaire, research and
development agreement, option and joint venture agreement, option
and farm lease agreement, and farm lease were attached to the
offering.
- 15 In addition to the claim of an immediate full tax deduction,
the promoters of JDP made a sales presentation concerning the
profit potential of the jojoba industry and the idea that the
purchase of a partnership unit was a good investment.
The
offering, however, did not attract as many investors as the
promoters had hoped.
By December 21, 1981, six limited partners
had each subscribed to one full partnership unit in JDP.
By
December 28, 1981, an additional two limited partners had each
subscribed to one full partnership unit in JDP and two limited
partners had each subscribed to a one-half partnership unit in
JDP.
No limited partner acquired a partnership unit in JDP after
December 28, 1981.
Berberich, in his capacity as general
partner, nonetheless executed the certificate and agreement of
limited partnership and certificate of fictitious name of JDP on
December 31, 1981.
Such certificate was recorded in the official
records of Yuma County, Arizona, on December 31, 1981.
Under the
limited partnership agreement, no limited partner was required to
make any capital contribution beyond the initial capital
contribution, and no limited partner was liable for the expenses,
liabilities, or obligations of JDP.
b.
The Research and Development Agreement
On December 31, 1981, Berberich, as general partner of JDP,
and Whittaker, as president of HJI, executed a research and
development agreement (R & D Agreement).
The R & D Agreement
represented that HJI was experienced in the planting and
- 16 cultivation of jojoba plants and could conduct research and
experimentation work relating to the scientific development of a
plant strain with fast, hardy growth characteristics and high,
stable seed yields, which could be planted, grown, and harvested
in a commercially feasible manner.
The R & D Agreement also
stated that JDP anticipated that HJI would conduct such research
and experimentation work.
In the R & D Agreement, HJI agreed to
use its best efforts to carry out the research and development
program (R & D Program) described below:
2. Description of Program. The R & D Program to
be conducted by HJI, on the terms and subject to the
conditions and payments set forth in this Agreement,
shall consist of the following:
2.1 Experimental Plantation. HJI will acquire
the ownership or use of such land, buildings,
machinery, equipment and other property, and will
provide all personnel and materials, necessary to
develop and establish an experimental jojoba plantation
(the "plantation"). The plantation shall consist of 60
acres and shall be located on a site selected by HJI in
the Hyder Valley area of Yuma County, Arizona. The
site of the plantation may be purchased or leased from
an affiliate of HJI.
2.2 Plant Strain. HJI will conduct original
research into a particular jojoba plant strain. It
will then select both propagating seeds and plant
cuttings for planting and cultivation in controlled
areas of the plantation. The growth characteristics of
the plants will be closely observed, and replacement
will be made if and when HJI determines that it is
appropriate to the experimentation process and
economically feasible.
2.3 Cultivation Techniques. The plantation will
be divided into separate areas, with each area
subjected to various forms of experimental husbandry.
The variations will include research and
experimentation in soil conditions, methods of
- 17 propagation, fertilization and watering. Each
experiment shall be conducted in a scientific manner
and closely monitored.
2.4 Results. The plant characteristics in each
area of the plantation and the progress of plant growth
will be recorded. The nature and results of each
experiment conducted in the plantation will likewise be
recorded.
2.5 Conclusion. The R & D Program will be
concluded, and HJI's obligations under this Agreement
fulfilled, on December 31, 1986.
Pursuant to the R & D Agreement, JDP agreed to pay HJI
$360,000 as full compensation for the conduct of the R & D
Program on the 60-acre jojoba plantation, of which amount $85,000
was due upon the signing of the R & D Agreement and the remaining
$275,000 was payable according to the terms of recourse notes to
be delivered to HJI upon the signing of the R & D Agreement.
The
R & D Agreement indicated that HJI had allocated $200 per acre of
the contract fee for the purchase of water and the installation
of a water delivery system for the small plantation but that JDP
would pay an additional sum, up to a maximum of $50,000, in the
event that the actual cost of providing water to the small
plantation exceeded $200 per acre.
The R & D Agreement stated
that all costs and expenses of the R & D Program were the sole
responsibility of HJI.
In addition, it stressed that all
payments due on the Notes were:
required by HJI to enable it to commence and carry out
the R & D Program, and are not in any way conditioned
on HJI's performance under this Agreement. If HJI has
received timely payment and then fails to perform as
agreed, the Partnership may bring suit for damages or
- 18 specific performance, but further payments due under
the Notes may not be withheld. No part of any sums
paid by the Partnership to HJI shall be refundable for
any reason, nor shall the Partnership be entitled to
withhold payment to HJI * * *.
The R & D Agreement stated that the parties did not
contemplate that the R & D Program would result in any inventions
or patents.
However, the agreement indicated further:
It is contemplated that the R & D Program will result
in discoveries, technology and other information which
may or may not be proprietary. In any case, either
party to this Agreement may use any information,
discovery or technology resulting from the R & D
Program in any manner and for any purpose desired.
The R & D Agreement also provided that it "is contemplated
by the parties that if the R & D Program produces successful
results, the small plantation will be converted into a commercial
jojoba farm and thereafter operated for profit by or on behalf of
* * * JDP" pursuant to certain option agreements entered into
simultaneously with the R & D Agreement.
The R & D Agreement
stated further that all property of any kind, real, personal, or
mixed, acquired by HJI in connection with the R & D Program would
be the property of HJI, and that JDP would have no interest in or
rights to such property arising from the R & D Agreement or
otherwise.
The R & D Agreement stated also that HJI made no
representation or guarantee of any kind with respect to the R & D
Program or the results thereof.
In addition, the R & D Agreement
provided that HJI had not agreed to conduct the R & D Program on
- 19 an exclusive basis for JDP and was free to engage in any other
activities, including other research and development, whether for
itself or for others.
JDP paid all of the $360,000 contract price required under
the R & D Agreement to HJI as follows.
By check dated December
30, 1981, JDP paid HJI $85,000 pursuant to the R & D Agreement.
On December 31, 1981, JDP issued to HJI five promissory notes
bearing interest at the rate of 10 percent per year.
The face
amounts of the notes, dates payable, and amounts and dates of
payment are as follows:
Face Amount
Payable
Date Payable
Amount Paid
Date Paid
$80,000
50,000
60,000
45,000
40,000
6/1/82
10/1/82
10/1/83
10/1/84
10/1/85
$82,933.33
53,750.30
70,500.00
57,375.00
5/12/82
9/29/82
9/29/83
9/26/84
1
1
1
Information not provided in the record.
The promissory notes contained no restrictions or nonrecourse
features.
When Whittaker and Berberich signed the R & D Agreement,
they both understood that HJI would not undertake for JDP all of
the activities specified in section 2 of the R & D Agreement
because the offering had not raised sufficient funds.
Having
failed to raise sufficient funds to carry out the program
described in the offering circular, on December 31, 1981,
- 20 Berberich intended to form another limited partnership that he
hoped would attract additional investors.
Whittaker and Berberich anticipated that any discoveries
resulting from research or experimentation activities on the
jojoba plants or from their domestication on the plantations
operated or managed by HJI or its affiliates (hereinafter
collectively referred to as Hyder Jojoba plantations) would be
shared with other jojoba plantation operators so that marketable
supplies of jojoba seed would be available.
Whittaker recognized
that any information gathered about jojoba grown in one
environment might have no relevance to jojoba grown in a
different environment.
c.
The Option and Joint Venture Agreement
On December 31, 1981, Berberich, as general partner of JDP,
and Whittaker, as president of HJI, additionally
option and joint venture agreement.7
executed an
Under that agreement, HJI
was given an option, exercisable by notice to JDP not later than
September 15, 1986, to undertake the conversion of the small
plantation to a commercial farming operation if, not later than
August 1, 1986, the parties had agreed in writing that the R & D
Program had produced a strain of jojoba plant that they wished to
grow on a commercial basis.
7
We use the term joint venture for convenience. Such
designation should not be taken as a determination of the legal
effect of the option and joint venture agreement or of the nature
of any farming operations undertaken pursuant to such agreement.
- 21 Under the option and joint venture agreement, if HJI
exercised the option, the resulting joint venture would commence
on January 1, 1987, and continue until December 31, 2011.
No
initial capital was to be contributed by the joint venturers.
Instead, the only capital of the joint venture would be
accumulated capital in the form of undistributed earnings of the
joint venture.
The working capital required by the joint venture
for the first fiscal year would be supplied either by loans from
HJI or from other lenders.
No property was to be acquired by the
joint venture except for cash and short term investment
securities and consumables, such as propagating seed, plant
cuttings, fertilizer, herbicide, and other miscellaneous
supplies, to be used within 1 year.
Any other property needed to
conduct the business of the joint venture was to be furnished by
HJI or third parties.
The joint venture however was to pay HJI
the fair rental value of all property furnished by HJI or its
affiliates, but in no event more than it would cost to rent
comparable property in the open market.
Pursuant to the option and joint venture agreement, the net
profits or net losses of the joint venture would be divided among
the joint venturers as follows:
90 percent to JDP until the date
upon which JDP had received distributions from the joint venture
in the amount equal to the principal sums (but not interest) paid
by JDP to HJI under the R & D Agreement (recoupment), and
thereafter 65 percent.
The corresponding allocation was 10
- 22 percent to HJI until recoupment and thereafter 35 percent.
Distributions were to be made to the joint venturers in the same
proportion as profits and losses were to be shared.
Under the option and joint venture agreement, HJI was given
sole and exclusive authority over all of the business and affairs
of the joint venture.
at any time.
The joint venture was to have no employees
Rather, all personnel required to conduct the
business of the joint venture were to be furnished by HJI and
would be the employees solely of HJI.
The joint venture,
however, was to pay HJI monthly for the direct cost of all
personnel employed in the business of the joint venture plus a
personnel administrative fee of 15 percent of such cost.
In
addition, as compensation for its services in managing the joint
venture, HJI was to receive a general administrative fee in a sum
equal to $150 for each acre of land devoted to the farming
operations of the joint venture, plus cost of living increases.
Under the option and joint venture agreement, HJI was given
the right and option any time on or after January 1, 1997, to
purchase for their fair market value all rights and interest of
JDP in the joint venture.
The option and joint venture provided
further that upon dissolution for any reason other than by such
purchase:
the affairs of the Joint Venture shall be liquidated
forthwith. The assets of the Joint Venture shall first
be used to pay or provide for all debts of the Joint
Venture, including all accrued and unpaid operating
expenses. If the assets are not sufficient to pay
- 23 these obligations, the Joint Venturers shall
contribute, in the same proportion as they share
profits and losses, the capital necessary to pay such
obligations in full. Thereafter, all moneys in the
capital accounts of the Joint Venturers shall be paid
to the Joint Venturers respectively entitled thereto.
Then the remaining assets shall be divided according to
the proportionate interests of the Joint Venturers on
the basis that they share in profits and losses on the
date of such dissolution * * *.
During March 1983, Berberich, as general partner of JDP, and
Whittaker, as president of HJI, executed an amendment to the
option and joint venture agreement that, among other things,
changed the distribution of profits after recoupment to 66-2/3
percent to JDP and 33-1/3 percent to HJI.
The amendment to the
option and joint venture agreement in addition gave JDP the right
and option between November 1, 2011, and December 31, 2011, to
require HJI to purchase all of JDP's interest and rights in the
joint venture.
For convenience, we shall use the name "Turtleback Jojoba
Venture" hereinafter to refer to the joint venture that HJI and
JDP agreed to form pursuant to the option and joint venture
agreement.
d.
The Farm Lease
On December 31, 1981, HJI entered into a farm lease with
Whittaker Jojoba Corporation (Whittaker Jojoba).8
8
Under the farm
Whittaker formed Whittaker Jojoba during 1981. Until it was
merged into HJI in 1982 or 1983, Whittaker Jojoba owned the land
and plants allocated to JDP pursuant to the various agreements
that the respective parties entered into on Dec. 31, 1981.
(continued...)
- 24 lease, Whittaker Jojoba agreed to lease to HJI certain property9
near Hyder, Arizona, for a period of 5 years commencing on
January 1, 1982, at a rental of $12,000 per year.
In addition,
if HJI and JDP agreed to form the Turtleback Jojoba Venture, HJI
was given the option under the farm lease to extend the lease
term until December 31, 2011, for a yearly rental of $12,000 plus
10 percent of gross income exceeding $12,000.
Gross income was
defined as all income of any kind derived by the lessee from
business conducted on or from the property.
e.
The Option and Farm Lease Agreement
On December 31, 1981, JDP and Whittaker Jojoba entered into
an option and farm lease agreement.
That agreement provided in
pertinent part that, if HJI decided not to enter into the
Turtleback Jojoba Venture, then, effective January 1, 1987, JDP
was given an option to lease the property described in the farm
lease on substantially the same terms and conditions as set forth
in the farm lease.
The option and farm lease agreement did not
transfer to JDP any ownership rights to land, plants, equipment,
or any real or personal property.
8
(...continued)
During 1981, shareholders of Whittaker Jojoba included, among
others, Whittaker and Berberich. As a result of the merger of
Whittaker Jojoba into HJI during 1982 or 1983, Berberich became a
shareholder of HJI.
9
The legal description attached to the lease describes the
property as: "The westerly 1,980 feet of the north half of the
northwest quarter of Section 22, Township 4 South, Range 11 West,
Gila and Salt River Base and Meridian."
- 25 5.
Petitioners
a.
Petitioners Stephen H. Glassley and Judith S. Glassley
Petitioners Glassley resided in Fort Wayne, Indiana, at the
time they filed their petition in the instant cases.
During
1981, petitioner Stephen H. Glassley (Dr. Glassley) worked as a
physician, and petitioner Judith S. Glassley (Mrs. Glassley)
worked as a medical assistant in Fort Wayne, Indiana.
Petitioners Glassley reported adjusted gross income of $72,323 on
their 1981 Federal income tax return.
Dr. Glassley became interested in jojoba after reading about
the plant in the Wall Street Digest, an investment newsletter
written by Donald Rowe (Rowe).
Dr. Glassley had a high regard
for Rowe's investment advice.
In September 1981, Dr. Glassley
read more about jojoba and decided that an investment in jojoba
might be a way to add to his retirement income.
Mrs. Glassley
then wrote to Rowe to ask about potential jojoba investment
opportunities.
In response, petitioners Glassley were provided
with the names of two individuals, one of whom was Whittaker.
Berberich telephoned petitioners Glassley in response to a letter
they had written to Whittaker.
Dr. Glassley was impressed by
what Berberich said about jojoba and Whittaker.
Following their telephone conversation, Berberich mailed a
copy of the offering circular to petitioners Glassley.
They
studied the offering, including the tax opinion, and discussed it
with their certified public accountant who had glanced at the tax
- 26 opinion.
Dr. Glassley was impressed with Whittaker's
credentials.
On December 15, 1981, petitioners Glassley subscribed to one
partnership unit of JDP at a cost of $50,000.
As a result of
their capital contribution to JDP, petitioners Glassley acquired
an 11.1-percent capital interest in JDP.
Also on December 15,
1981, they executed the signature page to the certificate and
agreement of limited partnership and certificate of fictitious
name, offeree questionnaire, and a promissory note in the amount
of $35,000 payable to JDP in installments of $15,000 on or before
May 1, 1982, $10,000 on or before May 1, 1983, and $10,000 on or
before May 1, 1984, together with interest of 10 percent per year
of the unpaid balance.
Petitioners paid to JDP or its escrow
agent $15,000 on December 15, 1981, $16,160 on April 26, 1982,
$12,000 on April 29, 1983, and $11,000 on April 30, 1984.
Dr. Glassley maintained his interest in the jojoba plant and
its commercialization.
He continued to read about jojoba and
together with Mrs. Glassley attended an international conference
on jojoba held in Tucson, Arizona, during 1982.
Petitioners
Glassley also traveled to Hyder, Arizona, and visited the jojoba
plantation during 1982, 1983, and 1985.
Dr. Glassley would not have invested in JDP if he had
thought the joint venture would not be formed.
He was interested
in making a profit from his investment and believed that there
could be no profits without the formation of the joint venture.
- 27 According to Dr. Glassley, he expected to recoup his investment
in JDP and earn a few thousand dollars each year for at least 20
years as a result of the commercialization of the jojoba
plantation.
He also was aware of and attracted by the potential
tax benefits outlined in the offering with respect to an
investment in JDP.
On their 1981 Federal income tax return, petitioners
Glassley claimed a net loss relating to JDP of $40,530, resulting
in a tax benefit of approximately $20,000.
By notice of
deficiency dated March 17, 1989, respondent disallowed the
partnership loss relating to JDP that petitioners Glassley had
claimed for 1981 on the grounds that they had not established:
(1) The claimed amounts arose from transactions that had a
bona fide business/economic purpose or substance, or intent to
make a profit apart from the intended tax consequences of such
transactions;
(2) The research and development expenses were
not [sic] incurred in connection with a trade or
business within the meaning of Internal Revenue Code
Section 174;
(3) The expenses claimed by the partnership were
incurred or paid by the partnership, or if incurred or
paid, the expenses were not [sic] ordinary and
necessary business expenses;
(4) Your basis in the partnership is sufficient
to entitle you to claim a partnership loss deduction,
or;
(5) The partners are "at risk" within the meaning
of Internal Revenue Code Section 465.
- 28 b.
Petitioner Paul S. Mahoney
Dr. Mahoney resided in Los Angeles, California, at the time
he filed his petition in the instant cases.
worked as a physician.
During 1981, he
Dr. Mahoney reported adjusted gross
income of $175,155 on his 1981 Federal income tax return.
On December 11, 1981, Dr. Mahoney subscribed to one
partnership unit in JDP for a price of $50,000.
As a result of
his capital contribution to JDP, Dr. Mahoney acquired an 11.1percent capital interest in JDP.
Also on December 11, 1981, he
executed the signature page to the certificate and agreement of
limited partnership and certificate of fictitious name, offeree
questionnaire, and a promissory note in the amount of $35,000
payable to JDP in installments of $15,000 on or before May 1,
1982, $10,000 on or before May 1, 1983, and $10,000 on or before
May 1, 1984, together with interest of 10 percent per year of the
unpaid balance.
Dr. Mahoney paid to JDP or its escrow agent
$15,000 on December 15, 1981, $16,160 on April 18, 1982, $12,000
on April 18, 1983, and $11,000 on May 1, 1984.
On his 1981 Federal income tax return, Dr. Mahoney claimed a
net loss relating to JDP of $40,529.
By notice of deficiency
dated June 21, 1989, respondent disallowed the partnership loss
relating to JDP that Dr. Mahoney had claimed for 1981 on the
grounds that he had not established:
any amount was paid pursuant to a research and
development agreement or, if paid, that such
expenditures were not preconceived shams lacking
economic substance.
- 29 Alternatively, the amount deducted by the partnership
as research and development expenses has been
disallowed because it has been determined that such
expenditures do not meet the requirements of I.R.C.
Section 174.
In the further alternative, the amount deducted by the
partnership as research and development expenses has
been disallowed because it has not been established
that a profit motive existed when such amounts were
paid and that the transaction was entered into other
than solely for tax purposes.
In the further alternative, the amount deducted by the
partnership as research and development expenses has
been disallowed because you have not established:
(1) That the accrual method is a proper method
for accounting for research and experimental
expenditures, or
(2) That the use of the accrual method by said
partnership clearly reflects partnership income.
In the further alternative, you have not established
that the portion of the amount deducted by the
partnership as research and experimental expenses that
is attributable to the note presented by said
partnership is not contingent or that all events have
occurred which fix the liability thereof. See I.R.C.
Section 465.
Dr. Mahoney also was a partner in HJP.
On his 1981 Federal
income tax return, he claimed a net loss relating to HJP of
$30,172.
Dr. Mahoney did not testify at trial.
c.
Petitioners Edward F. Houser, Jr. and Kathryn G. Houser
Petitioners Houser resided in Lubbock, Texas, at the time
they filed their petition in the instant cases.
During 1981 and
1982, petitioner Edward F. Houser, Jr. (Dr. Houser) worked as a
physician, and petitioner Kathryn G. Houser worked as a realtor.
- 30 Petitioners Houser reported adjusted gross income of $79,103.92
on their 1981 Federal income tax return and $142,708 on their
1982 Federal income tax return.
Dr. Houser retired from the
practice of medicine in 1991.
Dr. Houser first became interested in investing in jojoba
during 1978 or 1979 after reading articles about the plant in a
number of investment newsletters.
During 1981, he read Rowe's
jojoba-related articles in the Wall Street Digest.
wrote to Rowe, and was referred to Whittaker.
Dr. Houser
Dr. Houser was
impressed with her credentials and telephoned her.
She referred
him to Berberich, who subsequently sent Dr. Houser a copy of the
offering circular.
Dr. Houser studied the offering, including the tax opinion.
He discussed the offering with his certified public accountant,
who did not raise any concerns about the potential investment.
Dr. Houser also discussed the offering with his brother, an
attorney, who told Dr. Houser that the law firm issuing the tax
opinion was reputable and that, in the brother's opinion, the
offering looked promising.
On December 28, 1981, petitioners Houser subscribed to one
partnership unit of JDP at a total cost of $50,000.
As a result
of their capital contribution to JDP, petitioners Houser acquired
an 11.1-percent capital interest in JDP.
Also on December 28,
1981, they executed the signature page to the certificate and
agreement of limited partnership and certificate of fictitious
- 31 name, offeree questionnaire, and a promissory note in the amount
of $35,000 payable to JDP in installments of $15,000 on or before
May 1, 1982, $10,000 on or before May 1, 1983, and $10,000 on or
before May 1, 1984, together with interest of 10 percent per year
of the unpaid balance.
Petitioners Houser paid to JDP or its
escrow agent $15,000 on December 28, 1981, $16,160 on April 26,
1982, $12,000 on April 23, 1983, and $11,000 on April 27, 1984.
Dr. Houser was enthusiastic about the jojoba plant's
product development and profit potential.
Petitioners Houser
traveled to Hyder, Arizona, and visited the jojoba plantation
during 1984 or 1985.
Dr. Houser was interested in making a profit from his
investment in JDP.
According to Dr. Houser, he believed that,
after the jojoba plantation was commercialized and the crop
matured, income from his investment would supplement his
retirement income and help build an estate for the benefit of his
children and grandchildren.
Dr. Houser would not have invested
in JDP if he had not believed that the joint venture would be
formed and that it would be profitable.
He also was aware of and
attracted by the potential tax benefits outlined in the offering
of an investment in JDP.
On their 1981 Federal income tax return, petitioners Houser
claimed a net loss relating to JDP of $40,529, resulting in a tax
benefit of approximately $20,000.
On their 1982 Federal income
tax return, petitioners Houser claimed a net loss relating to JDP
- 32 of $320, resulting in a tax benefit of approximately $160.
By
notice of deficiency dated August 21, 1989, respondent disallowed
the partnership losses relating to JDP that petitioners Houser
had claimed for 1981 and 1982 on the grounds:
1. It has not been established that the
partnership is engaged in a trade or business or that
the partnership engaged in the activity with the
primary purpose of making a profit.
2. It has not been established that any claimed
deductions for research and development expenses
represent an expenditure for or related to research and
development actually undertaken.
3. It has not been established that the amount
proven to be expended, if any, in relation to alleged
research and development are currently deductible and
are not capital expenditures.
4. It has not been established that you had any
amount at risk, as defined by Section 465 of the
Internal Revenue Code.
5. It has not been established that purported
transactions contained any economic reality or
substance.
6. It has not been established that the accrual
method of accounting clearly reflects the partnership
income.
7. It has not been established that any amount
deducted for research and development expenses was paid
or incurred in connection with the partnership's trade
or business.
B.
The Jojoba Plantation
For convenience, we use the name "Turtleback I" hereafter to
refer to the 80-acre jojoba plantation for which the expenses at
issue in the instant cases ostensibly were incurred.
HJI
purportedly allocated 60 of those acres to JDP and the other 20
- 33 acres to Jojoba Development Partners, Ltd. II (JDP-II), a limited
partnership formed by Berberich in 1982.
HJI also developed an
additional adjacent 40-acre field of jojoba for JDP-II.10
Berberich spoke with Whittaker regularly by telephone and
visited the Hyder Jojoba plantations once or twice a year.
In
addition, he spoke with her at the international jojoba
conference held in Tucson, Arizona, in 1982, and at a seminar
held in Los Angeles, California, which was sponsored by the
Arizona Growers Association.
In addition, on occasion Whittaker
sent to Berberich written progress reports or other
correspondence related to jojoba and the jojoba plantations
purportedly allocated to JDP and JDP-II.
Berberich periodically
reported to the JDP limited partners on matters relating to the
partnership.
When acquired, Turtleback I was a raw parcel of land.
During January and February 1982, the field was surveyed, cleared
of brush, and laser graded.
A water delivery system was
installed and one-half mile of concrete ditch was laid.
During
March the field was prepared for planting by ripping, landplaning, listing (plowing), pre-irrigating, and relisting.
Turtleback I was planted with jojoba seed on March 19, 1982.
For
that purpose, HJI used seed only from native jojoba plants that
10
In addition to JDP and JDP-II, HJI managed jojoba
plantations, and served as research and development contractor,
for at least 3 other designated research and development
partnerships in Hyder, Ariz. The record does not reveal who
promoted or served as general partner of those partnerships.
- 34 were growing in Superior, Arizona.
HJI treated some of those
seeds with fungicide and/or germination hormones during the
planting period but observed no measurable differences in the
plants as a result of such treatment.
HJI undertook a program to vary the nutrients to be applied
to the jojoba plants on Turtleback I.
Whittaker and Berberich
anticipated that varying the nutrient applications would help HJI
discover how to use nutrient applications to increase seed
productivity of jojoba plants and thereby increase profits.
In the first written progress report to Berberich as general
partner of JDP, dated August 26, 1982, Whittaker advised JDP,
among other things:
Due to the limited size of the R & D program under
contract with Jojoba Development Partners, it will not
be possible to carry out all of the R & D projects
planned for a 454-acre project. The 80-acre planting
for JDP (and JDP II) will allow us to do an excellent
study on the effects of various nutrient applications.
Commencing this month we are dividing Turtleback I into
10 experimental plots and intend to apply the following
treatments:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Control: no treatment
Nitrosul: applied in irrigation water
Urea: applied directly to plant roots through
soil
Urea: foliar application
Ammonia: applied directly to plant roots
through soil
Micronutrients: applied foliarly
Numbers 6 and 2 combined
Numbers 6 and 3 combined
Numbers 6 and 4 combined
Numbers 6 and 5 combined
The foliar applications will not begin until at
least spring of 1983 when there is new growth on the
plants.
- 35 I expect that it will take at least three years
before we will be able to observe any measurable
differences from these various treatments. What we
will be looking for are differences in the rate of
plant growth, seed yield, leaf tissue analysis and oil
content of seeds.
In the second written progress report to Berberich as
general partner of JDP, dated May 24, 1983, Whittaker advised
JDP, among other things, that:
In recent months I have had the opportunity to discuss
Jojoba Development Partner's R & D program in detail
with Drs. Dave Palzkill and Bill Feldman at the
University of Arizona, with the technical
representatives of our agri-chemical supply company and
with our farm staff. Dave Palzkill commented on the
need for growers in various areas to carry out R & D
programs such as this and suggested that we compare
notes with Bob Roth of the U of A Extension Services
Station. Dr. Palzkill recommended that, rather than
than [sic] study response to different forms of
nitrogen (in ammonia vs. nitrate vs. urea) or methods
of application (in water, soil or foliarly), we would
do better to study varying amounts over a wider range
than we had anticipated and to include response to
phosphorus in the program. He also pointed out the
need to replicate all trials in the two separate plots.
Following Dr. Palzkill's recommendations, Whittaker revised
the nutrient application program planned for Turtleback I.
Consequently, the 80 acres of Turtleback I were divided into 14
plots of jojoba plants with 15 rows each.
Seven application
formulations were devised for those 14 plots, consisting of
varying amounts of nitrogen and phosphate and varying application
periods during the year.
Each application formulation was then
applied to 2 of the 14 plots.
The primary purpose of the seven
application formulations was to test how to use nutrient
- 36 applications to increase the yield and profitability of jojoba
production.
During 1983, Whittaker, on behalf of HJI, contracted with
Inter Ag Services, Inc. (IAS), headed by Dr. Paul J. Eberhardt
(Eberhardt), to conduct periodic leaf tissue analyses to measure
the effect of the nutrient applications on the jojoba plants.
The leaf analyses indicated that the nitrogen and/or phosphate
applications had no discernable effect on the jojoba plants
growing on Turtleback I.
Results from nutrient applications to
jojoba plants growing in other locations, such as in Desert
Center, California, and at the University of Arizona jojoba
research site, however, had indicated that those jojoba plants
responded positively to nitrogen and/or phosphate applications.
It is common for crops in different environments to respond
differently to nutrients.
Subsequently, HJI contracted with IAS in February 1985, for
a total contract price of $16,262, to conduct some nutrients
tests to try to determine, among other things, why the jojoba
plants on Turtleback I were not responding to the nitrogen and
phosphorous as had been expected.
Some of the services performed
by IAS for HJI related to the effects on the jojoba plants of
other nutrients, such as zinc, iron, magnesium, and copper, and
were associated with JDP-II.
One of the projects undertaken by
IAS for HJI was performed on jojoba plants that were not located
on Turtleback I.
The work performed by IAS confirmed that
- 37 additional nitrogen and phosphate applications did not benefit
the jojoba plants on Turtleback I.11
Consequently, HJI
discovered that it would not need to incur costs relating to the
application of those additional nutrients to jojoba grown on
Turtleback I.
As a result of the jojoba leaf tissue analyses,
HJI also learned that the appropriate nutrient levels for a
jojoba plant varied seasonally.
HJI continued the nutrient field
testing on the jojoba plants on Turtleback I beyond December 31,
1986, the expiration date for the R & D Agreement.
In July 1986, HJI and JDP executed an agreement regarding
the option and joint venture agreement in which both parties
expressed their consensus that the jojoba growing on Turtleback I
could be farmed on a commercial basis and that Turtleback I
should be converted to a commercial jojoba plantation.
Subsequently, on September 11, 1986, Whittaker notified JDP that
HJI had exercised its option to convert Turtleback I to a
commercial farm and form Turtleback Jojoba Venture with JDP
pursuant to the option and joint venture agreement.
During 1987
and 1988, HJI operated Turtleback I as a commercial jojoba
11
Dr. Eberhardt gave reports on the nutrient tests at various
meetings of the Jojoba Growers Assoc. In addition, during Jan.
1988, he presented an article at the seventh international
conference on jojoba, held in Phoenix, Ariz., in which he relied
on information gathered from the leaf analyses of jojoba plants
grown on the Hyder Jojoba plantations. As a result, that
information is now being used as a guide or baseline for
determining the health of jojoba plants grown in other parts of
the world.
- 38 plantation and sold jojoba seeds harvested from jojoba plants
growing there under the name Turtleback Jojoba Venture.
For 1987, Turtleback Jojoba Venture reported a net farm loss
of $43,929 on Schedule F of its U.S. Partnership Return of
Income, Form 1065.
For 1988, Turtleback Jojoba Venture reported
a net farm profit of $3,890 on Schedule F of its U.S. Partnership
Return of Income, Form 1065.12
At the same time that HJI exercised its option to enter into
Turtleback Jojoba Venture with JDP, HJI exercised an option to
convert the jojoba plantation purportedly allocated to JDP-II to
a commercial jojoba plantation and to enter into a joint venture
with JDP-II (Turtleback Jojoba Venture II).
Thereafter, HJI
treated Turtleback Jojoba Venture and Turtleback Jojoba Venture
II as one jojoba plantation (TJV).
During late 1987, Whittaker informed Berberich that the TJV
plantation was in good condition and had excellent prospects for
producing profitable yields of jojoba seeds, but that TJV was out
of funds.
She also indicated that harvesting efficiency was
unacceptably poor and that it would probably take several years
of continued development of machinery, equipment, and systems
before harvesting efficiency would be substantially improved.
12
In
In the Schedule F for 1988, Turtleback I Venture reported a
farm rent expenditure of only $3,500, rather than the minimum
$12,000 rental fee required under the farm lease. Had Turtleback
I Venture reported the full $12,000 rental fee, the Schedule F
would have reflected a net farm loss of $4,610.
- 39 addition, she indicated that, although the market price and
demand for jojoba oil were strong and were expected to remain so:
The jojoba industry in general is reflecting the same
kind of problems that are being experienced by HJI and
its affiliates. Virtually all jojoba producers are
experiencing cashflow problems. Several more years are
required than were originally predicted to reach
commercial production. The development of efficient
harvesting, although steady, has delayed cashflow even
further. In most cases, the capital required to attain
positive cashflow is exceeding the amount committed by
the original investors and the sources for obtaining
additional funding are severely limited.
Whittaker further suggested, as an alternative to the dissolution
of TJV or the provision by the JDP and JDP-II limited partners of
a working capital loan, a plan:
calls for the combination of up to 3,000 acres of
plantations in the Hyder area into a single company
(which, for want of a better name, we will currently
call "NUCORP"). A key objective of the plan is to
develop an entity which is capable of attracting new
investment capital while preserving the capital of the
original investors. Under this plan, HJI and all of
the Partnerships with which HJI is affiliated will be
invited to contribute their assets to NUCORP in
exchange for stock in the company. Cash will be raised
from both existing partnerships and new investors. All
partnerships will have the opportunity to preserve
their relative equity positions. However, in order to
attract new investment capital, the interests of all
previous capital will have to be subordinated to any
new contributions.
The formation of such an entity creates a viable
vehicle for funding and managing a number of
plantations which might otherwise fail. The Company
will attract new investment capital by offering a
preferred position and lower risk to potential new
investors. It will be capable of borrowing funds by
using certain personal guarantees of new key investors
as well as its assets as collateral for such loans.
NUCORP should post a profit by 1989 and show
significant cashflow within a 3- to 5-year period. By
then, the Company will have several alternatives
- 40 including being a favorable candidate for acquisition
by a larger company or of becoming publicly traded and
expanding rapidly to meet increasing demand for jojoba
oil.
Berberich notified the limited partners of JDP and JDP-II of
Hyder Jojoba plantations' cash flow problems by letters dated
December 21, 1987, and February 10, 1988.
In those letters he
endorsed Whittaker's plan to form a corporation that would
combine into one entity all of the entities then comprising the
Hyder Jojoba plantations.
Subsequently, effective June 30, 1988,
the partners of JDP exchanged their partnership interests for
stock in a new corporation, HJI Holdings, Inc. (Holdings).
Petitioners accordingly became shareholders in Holdings.
As a
result of the exchange, JDP realized ordinary income from
liabilities assumed on the exchange in the amount of $58,495,
which was reflected on its final partnership tax return, filed
for 1988.
In connection with the creation of Holdings, the
partners of JDP and JDP-II were credited with raising capital of
$116,355.49 from sale of the assets of the partnerships and
additional contributions made by partners.13
As a part of the
reorganization, Holdings owns all of the land and assets that HJI
or entities affiliated with HJI had owned.
Following the
reorganization, Holdings farmed approximately 1,300 acres of
jojoba in the Hyder Valley.
13
The record does not reveal whether any of the petitioners
made any additional capital contributions.
- 41 C.
The Consequences of Petitioners' Initial Investment
JDP used the calendar year and the accrual method of
accounting to report its income on its U.S. Partnership Return of
Income, Form 1065, for calendar year 1981 (1981 partnership
return).
On the 1981 partnership return, JDP deducted, among
other things, $360,000 for research and experimental
expenditures.
JDP reported a net loss of $368,45214 on the 1981
partnership return, a proportionate amount of which was passed
through to each partner of JDP.
From the inception of JDP, its partners intended and
expected HJI to farm jojoba commercially on Turtleback I.
For
the partners to realize a return of their investment in JDP,
commercial farming operations had to be conducted on Turtleback
I.
HJI had sole responsibility for the farming operations on
Turtleback I.
The $360,000 JDP agreed to pay HJI under the R & D
Agreement was based on a fixed contract price.
$360,000 in its general funds.
HJI placed the
HJI used the $360,000, among
other purposes, to pay the farm lease payments to Whittaker
Jojoba, to prepare the land for farming, including installing the
irrigation system, to purchase jojoba seeds, and to plant and
14
JDP reported no income on its 1981 partnership return. In
addition to the $360,000 it deducted for research and
experimentation expenditures, JDP deducted $6,250 for legal fees,
$2,000 for accounting fees, and $202 for amortization of
organization costs.
- 42 cultivate those seeds.
HJI activities did not result in any
patentable technology, nor was any patentable technology expected
to be developed from those activities.
JDP had no right under
any of the various agreements entered into during 1981, or
amendments thereto, to share in any profits from Turtleback I
before January 1, 1987, following the formation of Turtleback
Jojoba Venture.
During 1988 through 1992, the Hyder Jojoba plantations
produced substantial amounts of jojoba seed.
During 1987, HJI
harvested 76,848 pounds of jojoba seed from 942 acres of jojoba
plants.
During 1988, it harvested 354,615 pounds of jojoba seed
from 1,162 acres.
As of the date of trial, however, a stable market for jojoba
seed or oil had not evolved and demand for the jojoba seed did
not expand to the extent expected.
For some products, less
expensive synthetic substitutes for jojoba oil were developed
that adversely affected the demand for jojoba seeds.
Consequently, prices for jojoba seeds and oil have fallen.
In
May or June 1993, Holdings cut off irrigation to the jojoba
plants because it had insufficient cash flow to continue
operations.
As a result, as of the date of trial, the income
potential for Turtleback I was small.
None of the JDP limited partners ever have recovered their
initial investment in JDP.
As of the date of trial, the limited
partners continued to hold their interests in Holdings.
- 43 D.
The Experts
1.
Paul H. Gross
Paul H. Gross (Gross) testified for petitioners relating to
the value of any research or experimentation services that were
to be provided by HJI to JDP pursuant to the R & D Agreement.
Gross is employed by American Appraisal Associates, which is
located in Atlanta, Georgia.
He has professionally valued
fertilizer companies, formulations of fertilizer, application
methods of fertilizer, devices for the applications of
fertilizers, patents thereon, hybrid seed corn varietal strains,
germ plasm pools, and the like.
Gross is qualified to testify in
the instant cases as an expert on valuing research and
development contracts.
Gross concluded that as of December 31,
1981, the value of the R & D Agreement was $382,000.
According to Gross, the value of the contract at its
inception depended on the qualification of the contractor who
was to perform the services, the plan of activity incorporated in
the contract, and the reasonableness of the payments to be made
under the contract.
In his view, HJI was qualified to perform
the research or experimentation services, based on HJI's and
Whittaker's background, their experience in operating a
commercial jojoba plantation in the Hyder Valley of Arizona, and
their contacts with qualified technical experts.
Gross used a cost approach to assess the reasonableness of
the payments under the contract.
To estimate the reasonableness
- 44 of the costs to be performed under the R & D Agreement as of
December 31, 1981, Gross made an analysis of each aspect of the
costs to be incurred in fulfilling that agreement.
For that
purpose, Gross first noted that neither HJI nor Whittaker had
prepared a cost estimate at the time the project was first
entered into nor a project plan outlining what was going to be
done for the consideration.
He also established that at the
outset of the project there was no cost accounting system that
would specifically identify the costs allocated to JDP.
Gross
therefore used data that Whittaker had maintained for 1984
through 1989 to estimate for each activity15 the per acre
contract expenditures that would be required under the contract
on a year-by-year basis.
He quantified these costs on a 60-acre
15
Gross segmented the activities under the R & D Agreement for
1981 through 1984 as follows:
For 1981-82: Project planning; land acquisition; land
clearing and planing; installation of irrigation; construction of
the pilot model; initial planting.
For 1983-84: Cultivation; fertilization (including analysis
and tissue analysis); irrigation; plant growth analysis;
harvesting; yield analysis.
For 1985-86: Cultivation; irrigation; fertilization
analysis; tissue analysis; harvesting; yield analysis.
- 45 basis and accumulated those total costs throughout the 5year period of the contract.
Gross calculated the aggregate
amount of those costs to be about $382,000.16
In addition, to check the reasonableness of his cost method
analysis and in the absence of a demonstrable income stream,
16
Because of a poorly reproduced exhibit, we had considerable
difficulty in deciphering the schedule submitted by Gross in his
report in support of his calculation of aggregate costs of
$382,000. Our best approximation of the amounts reflected on
that exhibit are as follows:
Estimated Annual Contract Expenditures by HJI
(And Its Subcontractors) in Performing
Research and Experimentation Services
1982
Land Use Charge
$129.25
Hourly Labor
61.76
Equipment Use
20.30
Irrigation
125.76
Chemicals
16.80
Contract Labor
13.24
Harvesting Labor
Consulting (Modeling
Year 1 Only 5 Months effort)
1,466.67
General Farm
Maintenance
16.00
Farm Management
50.00
Sub-Total
1,899.78
Administrative
and Overhead
379.96
Sub-Total
2,279.74
Profit
455.96
Sub-Total
2,735.69
Total [for 60
acres (rounded)]
$164,141
5-year Total
$382,212
Per Acre Total
$6,370
1983
Year
1984
1985
1986
$129.25
123.51
40.59
126.76
33.50
25.48
-
$129.25
123.51
40.59
125.76
33.50
25.48
128.00
$129.25
123.51
40.59
125.76
33.50
25.48
128.00
$129.25
75.44
41.44
108.82
58.16
6.44
128.00
3.20
3.20
3.20
9.25
16.00
50.00
548.29
16.00
50.00
675.29
16.00
50.00
675.29
16.00
50.00
622.80
109.78
658.07
131.61
789.68
136.38
811.67
162.33
974.00
136.38
811.67
162.33
974.00
124.56
747.36
149.47
896.83
$47,381
$58,440
$58,440
$53,810
- 46 Gross used a cost savings approach; in other words, "the
calculation of the benefit derived from the research performed
and conversion of that savings into a value amount."
Gross
classifies this approach as in a broad category of an income
approach.
According to Gross, for the cost savings approach, he
valued as of December 31, 1986, the discoveries made from the
cost savings that he calculated.
For his cost savings approach, Gross relied on Eberhardt's
conclusion that the leaf tissue analyses performed by IAS for HJI
indicated that the amount of nitrogen and phosphate routinely
being applied to the jojoba plants on Turtleback I was not
justified.
Gross calculated the savings from not applying the
unneeded fertilizer to be $38 savings per acre, based on $26 of
savings per acre for nitrogen and $12 per acre for phosphate.
He
then used a 10-percent capitalization rate to determine a total
per acre savings value of $380 from not applying unnecessary
nitrogen and phosphate.
In his report, Gross opined that:
It is not customary to conduct expensive research and
experimentation on a pilot model, and then expect the
pilot operation to provide for recovery of such
expense. Rather, the discoveries derived from research
and experimentation performed at a relatively small
cost on a pilot model are thereafter utilized in largescale production to produce large-scale cost savings.
Gross consequently concluded that the value of the discoveries in
1986 from the nutrient tests were most applicable to a large
producer of jojoba.
He estimated that such a major jojoba
- 47 producer would save at least $380,000 from the nonpurchase of
nitrogen and phosphate as a result of the nutrient tests
conducted on Turtleback I, based on his calculated $380 savings
per acre times 1,000 acres.
The 1,000 acres represent his
estimate that a major jojoba producer such as HJI would have
1,000 acres or more of jojoba under cultivation.
In preparing his report, Gross did not consider any of the
various contractual relationships that existed between JDP and
HJI.
He did not attribute any value in preparing his report to
the fact that a contractual joint venture opportunity existed
between HJI and JDP.
2.
Paul J. Eberhardt
Eberhardt testified for petitioners as to the nature of any
research or experimentation activities that HJI may have
conducted on Turtleback I during the R & D period.
earlier, Eberhardt is the head of IAS.
As stated
Eberhardt has a bachelor
of science degree in agricultural research, with a minor in
chemistry; a master of science degree in soils, with a minor in
statistics and plant physiology; and a doctor of philosophy
degree in agricultural chemistry and soils, with a minor in plant
physiology.
He is qualified as an expert in agronomics and
agricultural research and experimentation.
Eberhardt concluded
that the totality of research or experimentation activities
performed by HJI (including activities allegedly performed for
JDP-II) was research in the experimental or laboratory sense, and
- 48 was activity to discover information that would eliminate
uncertainty regarding the commercialization of jojoba
plantations.
Eberhardt was not aware of the manner in which HJI
purportedly allocated different plots of jojoba plants to various
limited partnerships.
As far as he knew, IAS performed its
services for HJI.
3.
Marvin T. Parr
Marvin T. Parr (Parr) testified for respondent as to the
merits of any research or experimentation activities HJI may have
conducted for JDP.
Parr is an engineer employed by the Internal
Revenue Service in Montgomery, Alabama.
He visited the TJV
plantations and inspected the growing jojoba.
He is qualified to
testify as an expert in the instant cases as to the matters set
forth in his report.
Parr concluded that the activities performed on Turtleback I
between January 1, 1982, and December 31, 1986, were
predominately aimed at the creation of an existing mature jojoba
farm and were not simply directed at acquiring information about
jojoba that was unknown at the time.
He also concluded that the
activities would not have eliminated any uncertainty regarding
the commercialization of jojoba because during that period jojoba
was being grown in other locations both without and within the
United States, and there were conflicting results about the
benefits of nutrients, especially with respect to nitrogen.
The
conflict in the results was that in some locations the jojoba had
- 49 responded favorably to nitrogen in the growth of the plants and,
in some instances, in yield of seeds, while in other locations
the growers had found no effect from applying nitrogen.
Parr agreed, however, that some of the activities performed
on Turtleback I during the period in question would be research
activities.
He agreed that some of the fertilizer trials, such
as the original nutrient application program begun in the spring
of 1983, the revised nitrogen and phosphate application in mid1983, as well as the IAS nutrient study in 1985,17 were valid
research conducted under proper experimental procedures.
According to Parr, before any experimental activities
commenced, a number of capital improvements had to be undertaken,
including the clearing and removal of brush, the leveling and
grading of the land surface, the installing of irrigation supply
piping to and on the tract, and the installing of a concretelined irrigation ditch on the tract.
Other expenditures relating
to establishing the jojoba stand, such as planting the seed and
irrigating the field to cause the seed to germinate and the
plants to grow also were undertaken before any experimental
activities began.
Parr concluded that only a minor portion of
the expenditures on Turtleback I related to actual research.
17
The
However, Parr would disregard as irrelevant to JDP all but a
small part of the research conducted by IAS because that research
was not identified in the R & D Agreement, was not performed
using jojoba plants from Turtleback I, or was not carried out on
Turtleback I.
- 50 bulk of the such activities was related to the creation and
development of a commercial jojoba plantation.
Parr estimated that, without cost documentation, the
expenses actually related to research activities would be less
than 20 percent of the expenses that went into the acquisition
and creation of the jojoba plantation.
He would exclude from
research expenditures such as the land lease, planting,
irrigation, and other cultivation practices performed during the
5-year R & D period because those activities would be required
regardless of any research.
According to Parr, nutrient study
costs include only the actual application of the nutrients and
the recordkeeping of the period of time when those nutrient
applications were made and the dissemination of the results at
the end of that time.
They do not include the cost to create the
plantation, which includes among other things, the land, the
jojoba plants, and the irrigation system.
Parr also concluded that any research activities would not
have been proprietary because the results already were known and
such knowledge was widely disseminated among the growers since,
at that time in the development of the jojoba industry, the
growers were not keeping secrets from one another and they were
freely sharing information, including knowledge of irrigation,
fertilizer, and pruning.
- 51 OPINION
A. The Criteria That Must Be Satisfied for Expense Treatment
Under Section 174
Section 174(a)(1)18 states, as a general rule, that
"research or experimental expenditures which are paid or incurred
by * * * [a taxpayer] during the taxable year in connection with
his trade or business", may, at the election of the taxpayer, be
treated as expenses not chargeable to capital account.
expenditures so treated shall be allowed as a deduction.
The
174(a)(1).
Sec.
A taxpayer is entitled to a deduction for research
and experimental expenditures with respect to expenses paid or
incurred by the taxpayer directly as well as expenses paid or
18
Sec. 174 provides in pertinent part:
SEC. 174.
RESEARCH AND EXPERIMENTAL EXPENDITURES.
(a)
Treatment as Expenses.-(1) In general.--A taxpayer may treat research or
experimental expenditures which are paid or incurred by him
during the taxable year in connection with his trade or
business as expenses which are not chargeable to capital
account. The expenditures so treated shall be allowed as a
deduction.
*
*
*
*
*
*
*
(c) Land and Other Property.--This section shall not apply
to any expenditure for the acquisition or improvement of land, or
for the acquisition or improvement of property to be used in
connection with the research or experimentation and of a
character which is subject to the allowance under section 167
(relating to allowance for depreciation, etc.) or section 611
(relating to allowance for depletion); but for purposes of this
section allowances under section 167, and allowances under
section 611, shall be considered as expenditures.
- 52 incurred on the taxpayer's behalf by another person or
organization.
Stankevich v. Commissioner, T.C. Memo. 1992-458;
sec. 1.174-2(a), Income Tax Regs.
1.
The Expenditures Must Be for Research or Experimentation
The term "research or experimental expenditures" as used in
section 174 means expenditures incurred in connection with the
taxpayer's trade or business which represent research and
development costs in the experimental or laboratory sense.
1.174-2(a)(1), Income Tax Regs.
Sec.
This regulation further
provides:
The term [research or experimental expenditures]
includes generally all such costs incident to the
development of an experimental or pilot model, a plant
process, a product, a formula, an invention or similar
property, and the improvement of already existing
property of the type mentioned. The term does not
include expenditures such as those for the ordinary
testing or inspection of materials or products for
quality control or those for efficiency surveys,
management studies, consumer surveys, advertising, or
promotions. * * *
We have found the above definition "to be reasonable and
consistent with the intent of the statute to limit deductions to
those expenditures of an investigative nature expended in
developing the concept of a model or product."
Mayrath v.
Commissioner, 41 T.C. 582, 590 (1964) (emphasis in original),
affd. without discussion on this issue 357 F.2d 209 (5th Cir.
1966).
In the instant cases, petitioners contend that HJI was
conducting valid research or experimentation on behalf of JDP
- 53 and, consequently, under section 174 JDP is entitled to deduct
the contract fee it paid HJI for such research or
experimentation.
Respondent contends, on the other hand, that
HJI used the funds JDP paid it to create a valuable capital asset
in the form of a jojoba plantation, including expenditures for
lease payments, site preparation such as ripping the land,
plowing, discing, and purchasing and installing an irrigation
system, and for planting the jojoba seeds.
Respondent argues
that such expenditures were made for the improvement of land to
which JDP could gain a property interest and, hence, under
section 174(c) the expenditures are not allowable.
Petitioners counter, however, that JDP did not acquire an
ownership interest in the land, jojoba plants, or equipment used
on Turtleback I, or in any other property, as a result of the
disputed expenditures.
Petitioners assert that under section
1.174-2(a)(1), Income Tax Regs., any costs HJI incurred to build
the jojoba plantation on Turtleback I are deductible as costs
associated with building "a pilot model".
Petitioners assert
further that respondent's expert Parr acknowledged that HJI
- 54 performed at least some qualifying research on JDP's behalf that
was experimental in nature.19
Petitioners contend that, given
Parr's admission that the nutrient study had to occur on an
existing jojoba plantation, and that all of Turtleback I was used
for the qualifying research, under section 1.174-2(a)(1), Income
Tax Regs., the Commissioner must allow petitioners to deduct the
expenditures associated with the development of the purported
"model" jojoba plantation.
We do not agree.
Any business arrangement may be scrutinized to ascertain
whether its form comports with economic reality.
Estate of
Helliwell v. Commissioner, 77 T.C. 964, 983 (1981); see Frank
Lyon Co. v. United States, 435 U.S. 561, 573 (1978); Commissioner
v. Court Holding Co., 324 U.S. 331 (1945); Gregory v. Helvering,
19
On brief, respondent concedes that some of HJI's activities
connected with the jojoba plants, specifically relating to
nutrient studies, did constitute research and experimentation.
Respondent maintains, however, that less than 20 percent of HJI's
efforts on the property ostensibly allocated to JDP constituted
research and experimentation. Respondent does not concede that
the expenditures were incurred in connection with JDP's trade or
business. In light of respondent's concession, we make no
determination here as to whether HJI's activities on Turtleback I
rose to the level of research and experimentation as contemplated
under sec. 174. However, even if research and experimentation
did occur on Turtleback I, for the reasons discussed infra, we do
not agree that such activities were incurred on JDP's behalf. We
are not bound by conclusions or stipulations of law. E.g.,
Estate of Sanford v. Commissioner, 308 U.S. 39, 51 (1939); Swift
& Co. v. Hocking Valley Ry. Co., 243 U.S. 281, 289 (1917);
Saviano v. Commissioner, 765 F.2d 643, 645 (7th Cir. 1985) affg.
80 T.C. 955 (1983); Commissioner v. Ehrhart, 82 F.2d 338, 339
(5th Cir. 1936), revg. and remanding a Memorandum Opinion of the
Board of Tax Appeals; Yagoda v. Commissioner, 39 T.C. 170, 183
n.7 (1962), affd. 331 F.2d 485 (2d Cir. 1964).
- 55 293 U.S. 465 (1935).
The objective economic realities of a
transaction control the tax consequences of a given transaction
rather than the particular form the parties employed.
E.g.,
Frank Lyon Co. v. United States, supra at 572-573; Commissioner
v. Court Holding Co., supra at 334; Estate of Franklin v.
Commissioner, 64 T.C. 752 (1975), affd. on other grounds 544 F.2d
1045 (9th Cir. 1976).
As the Court of Appeals for the Seventh
Circuit has noted:
The freedom to arrange one's affairs to minimize taxes
does not include the right to engage in financial
fantasies with the expectation that the Internal
Revenue Service and the courts will play along. The
Commissioner and the courts are empowered, and in fact
duty-bound, to look beyond the contrived forms of
transactions to their economic substance and to apply
the tax laws accordingly. [Saviano v. Commissioner,
765 F.2d 643, 654 (7th Cir. 1985), affg. 80 T.C. 955
(1983).]
After reviewing the record in the instant cases, we agree in
substance with respondent that JDP did not pay the $360,000
contract fee for research or experimentation to be conducted by
HJI on JDP's behalf.
Rather, for the reasons discussed below, we
conclude that the moneys JDP remitted to HJI for the putative
research or experimentation, in actuality, were paid for the
limited partners' right to participate in the jojoba farming
enterprise being operated by HJI in Hyder, Arizona.
We are
convinced that, from the inception of JDP, rather than being a
stand-alone operation, Turtleback I functioned and was viewed as
part of one integrated jojoba farming operation conducted by HJI.
- 56 In our view the R & D Agreement was designed and entered into
solely to provide a mechanism to disguise the capital
contributions of the limited partners as currently deductible
expenditures and thus reduce the cost of their participation in
the farming venture.
As the transaction was structured, JDP could obtain no
economic benefit solely from the putative research or
experimentation apart from the potential tax benefits.
patents or inventions were expected to be developed.
No
In
addition, any "discoveries" obtained through HJI's efforts were
to be shared, without compensation, with other jojoba growers.
Consequently, JDP could receive no marketable asset from HJI's
putative research or experimentation activities.
Plainly, no
unrelated party would have paid HJI for a similar research and
development contract under circumstances like those presented in
this case.
Petitioners, nonetheless, contend that the R & D Agreement
had independent value.
They assert that, as of December 31,
1981, the R & D Agreement had a fair market value of $382,000,
and that the value of the anticipated benefits of the research
was greater than the $360,000 JDP paid HJI under the R & D
Agreement.
In addition, they contend that the value of the cost
savings to the jojoba industry as a whole resulting from the
nutrient studies exceeded the amount JDP paid HJI under the R & D
Agreement.
Petitioners contend further that the parties to the
- 57 agreements believed that JDP would profit from the anticipated
increased yield of jojoba seed resulting from the research and
development project.
They also contend that JDP benefitted from
the R & D Agreement by obtaining the right to use any
"discoveries" resulting from the research or experimentation and
by the joint venture TJV using those "discoveries" after the
research and development period ended.
We disagree.
We believe that JDP received no economic benefit from its
"right" to use "discoveries, technology, and other information"
resulting from the putative research or experimentation.
The
parties fully anticipated from the beginning that any such
results were to be used by HJI and disbursed widely and freely
throughout the jojoba industry.
We doubt that a disinterested
third party under similar circumstances would have been willing
to pay for the "right" to use any such "discoveries".
Furthermore, we do not agree with petitioners that the R & D
Agreement had a fair market value of $382,000, as estimated by
petitioners' expert.
The nutrient studies HJI conducted on
Turtleback I by their very nature were applicable primarily, if
not exclusively, to that site.
Gross, however, made no
adjustment in his valuation of the R & D Agreement for its
limited applicability.
In addition, Gross failed to take into consideration the
value of the additional rights arising from other agreements the
parties executed simultaneously with the R & D Agreement.
No one
- 58 denies that the only way anyone could possibly profit from the
putative research or experimentation was from harvesting the
seeds from the mature jojoba plants.
Indeed, Drs. Glassley and
Houser admitted in effect at the trial that they would never have
participated in JDP had they thought that farming activities
would not be conducted on Turtleback I.
Yet, no valuation was
made of the fair market value of any rights conveyed by the
option and joint venture agreement or the option and farm lease
agreement.
We believe that Gross did not value the other rights
purportedly conveyed to JDP, in particular through the option and
joint venture agreement, even after we suggested at the trial
that he do so, because such valuations would have shown that the
purported value of the R & D Agreement was overstated.
In our
view, in light of the manner in which the arrangement was
structured, JDP could not have found a willing buyer for the R &
D Agreement at any price, let alone the $360,000 it agreed to pay
HJI, because JDP received no substantive ownership rights to the
results of the putative research or experimentation.
Furthermore, we consider Gross' valuation of the purported
benefits of HJI's putative research and development as highly
exaggerated.
The only way he was able to arrive at his $380,000
cost-savings estimate was arbitrarily to apply the alleged per
acre savings to 1,000 acres.
As the transaction was structured
in 1981, however, JDP could only reap any profits from the 60
- 59 acres purportedly allocated to it.
Others had interests in the
large areas farmed by HJI in Hyder, so Gross' computation of the
valuation for JDP was simply contrary to fact.
Moreover, even
Eberhardt states that the results of the nutrient studies were
site specific.
Therefore, petitioners' argument that the jojoba
industry saved millions of dollars as a result of HJI's putative
research or experimentation is outlandish.
In addition, we view with much skepticism testimony that the
parties to these agreements anticipated that JDP would recoup the
cost of the R & D contract fee from the increased production of
the jojoba plants on Turtleback I resulting from a successful
research program.
The record reveals that no one made any
projections before the agreements were executed, or afterward,
relating to the profit potential of a 60-acre jojoba plantation.
The profit projections in the offering were based on a jojoba
plantation's containing a low of 160 acres and a high of 464
acres.
The offering, furthermore, cautioned that JDP would face
higher risks should only the projected minimum 160 acres be
planted.
Yet, nowhere is any attempt made to show that the
results of operations on the 60 acres purportedly allocated to
JDP could support the anticipated 5-year research and
experimentation project to which the parties seemingly bound
themselves in the R & D Agreement.
Indeed, Gross admitted in his
report that "It is not customary to conduct expensive research
and experimentation on a pilot model, and then expect the pilot
- 60 operation to provide for recovery of such expense."
Gross,
furthermore, in effect acknowledged that the only effective use
of any discoveries obtained would have been on a large-scale
operation much greater than the 60 acres allocated to JDP.
Even
Whittaker testified that JDP, as a 60-acre partnership, was "not
a self-sustaining unit".
Petitioners, however, would have us
believe that they expected not only to recover the full cost of
the putative research or experimentation but also to earn a
substantial profit from operations on the 60-acre plantation.
In
our view, given the structure of the putative research and
development program, such an expectation would be pure fantasy.
The self-serving nature of the claims, together with the absence
of any evidence to support them, makes such testimony
implausible.
Based on this record, we are convinced that the R & D
Agreement was without economic substance.
In our view, the R & D
Agreement was mere window dressing, devised to attract investors
for HJI's jojoba farming operation through the promise of a large
upfront deduction for what in actuality were capital
contributions.
We note that the parties paid scant attention to
the terms of the offering or the R & D Agreement.
For example,
the offering unequivocally states that, unless a minimum of 22
limited partnership units were sold by December 21, 1981, the
offering would be terminated and any subscription payments would
be returned.
Only six limited partners had subscribed by
- 61 December 21, 1981, yet the offering was not terminated.
Just
four more limited partnership units were sold between December 22
and December 28, 1981 (two full units and two one-half units),
for a total of nine full limited partnership units.
Nonetheless,
Berberich proceeded to close the offering and to execute the
limited partnership agreement on December 31, 1981.
The parties'
haste to close the offering and form the limited partnership by
yearend in contradiction to the express terms of the offering
circular leads us to conclude that the primary objective of the
transaction was to generate tax losses during the first year of
the partnership and thus reduce the cost of petitioners' capital
investment in a jojoba farming venture.
As for the R & D Agreement, Whittaker admitted at the trial
that there was no way HJI could undertake the research or
experimentation outlined in that agreement for $360,000.
It is
quite clear from the record, moreover, that as of December 31,
1981, no specific research and development plan had been
formulated for the jojoba expected to be planted on Turtleback I.
In fact, the research or experimentation plan devised for
Turtleback I was not designed until 1983.
Moreover, no cost
estimates were made for the putative research or experimentation
at the time the documents were executed, nor did an accounting
system exist to allocate costs to JDP for at least the first 2
years of the purported research and development period.
We
conclude that the $360,000 contract fee was driven by the need to
- 62 provide the promised tax benefits for JDP's investors and that it
was not based on the value of any anticipated services to be
rendered by HJI.
Under such circumstances, we agree with
respondent that the R & D Agreement did not delineate the
agreement of the parties as to any research and development to be
conducted, and it had no substance.
Petitioners contend, however, that the option and farm lease
agreement, which purportedly accorded JDP the right to operate
Turtleback I had HJI elected not to enter into a joint venture,
shows that JDP was independent from HJI and intended to use the
expected discoveries in a trade or business.
We do not agree.
First, as we have stated earlier, we believe that from its
inception Turtleback I was not an independent jojoba plantation
but functioned as a part of HJI's jojoba farming enterprise.
Second, we are not convinced from this record that JDP ever had a
realistic prospect of carrying on a jojoba farming operation.
For example, JDP had no experience in farming jojoba.
As far as
we can tell from the record, Berberich was not involved directly
in the farming of jojoba on Turtleback I or anywhere.
He was a
lawyer, not a farmer, and all of his activities concerned
administering JDP or monitoring his own investments in the Hyder
Jojoba plantations.
JDP, moreover, had no employees and no
equipment, and it did not own the jojoba plants.
The record is
devoid of any evidence that JDP could have operated a successful
- 63 jojoba plantation on 60 acres, or that if it could, that JDP
would have had sufficient funds20 to continue such operations.
Nor is there any evidence that any limited partner could or would
have stepped in to farm Turtleback I.
Although the parties took great care to clothe the
transaction in the garments of research or experimentation, when
we view the transaction closely, we are convinced that the
limited partners were not paying for research or experimentation
but for the right to share in the profits from HJI's jojoba
farming enterprise.
Under such circumstances, we conclude that
the disputed payments were in the nature of capital
contributions.
Section 174 does not permit a deduction for a
contribution to capital.
20
See Safstrom v. Commissioner, T.C.
The record does not reveal JDP's financial status as of Jan.
1, 1987, the purported commencement date of the Turtleback Jojoba
Venture. However, we note that the limited partners were not
obligated to contribute any funds to JDP beyond their initial
partnership unit costs. Eight full and two one-half units in JDP
were sold, resulting in total capital contributions from the
limited partners of $450,000. According to the offering, the
general partner was to contribute $1,000 to JDP. Therefore, at
the most, JDP would have contributed capital of $451,000. JDP's
partnership return for 1981 reflected the R & D Agreement
contract fee of $360,000, syndication costs of $28,714,
organizational costs of $12,125, and legal and accounting fees of
$8,250, which totaled $408,289. As the transaction was
structured, JDP could earn no income from its inception on Dec.
31, 1981, through Dec. 31, 1986. Accordingly, JDP's operating
expenses for that period of time had to be paid from the
remaining $41,711 contributed capital (unless advanced by the
general partner). According to the offering, the general partner
was to be paid $10,000 for each of 1981 through 1987. It appears
unlikely, therefore, that as of Dec. 31, 1986, JDP would have had
the financial resources to take over operations on Turtleback I
if HJI had decided not to continue operations on that plot.
- 64 Memo. 1992-587, affd. without published opinion 42 F.3d 1401 (9th
Cir. 1994); Reinke v. Commissioner, T.C. Memo. 1981-120.
In view of our conclusion that JDP did not pay HJI for
research or experimentation, we need not further address
petitioners' argument that during the alleged research and
development period Turtleback I was functioning solely as a pilot
or model, and therefore, the costs of its construction are
deductible under section 1.174-2(a)(1), Income Tax Regs.
We
note, however, that as the foregoing discussion suggests,
Turtleback I was not a model at all, and that, even if it had
been a model, it would not have been a model for operation by or
on behalf of JDP or its investors.
2. The Expenditures Must Be Paid or Incurred on Behalf of
the Taxpayer
In the instant cases, respondent has conceded that some of
HJI's activities on Turtleback I were research or experimentation
in the experimental or laboratory sense.
Petitioners contend
that respondent's concession is dispositive of the question of
the deductibility of the expenditures associated with the
development of Turtleback I.
19.
We do not agree.
See supra note
Such expenditures also must have been incurred on JDP's
behalf.
Section 1.174-2(a)(2), Income Tax Regs., states that the
provisions of section 174(a)(1) "apply not only to costs paid or
incurred by the taxpayer for research or experimentation
- 65 undertaken directly by him but also to expenditures paid or
incurred for research or experimentation carried on in his behalf
by another person or organization".
On this record, we are not
persuaded that any research or experimentation performed on
Turtleback I was conducted on JDP's behalf.
Rather, we are
convinced that HJI operated an integrated jojoba farming
operation in Hyder, Arizona, and that any research or
experimentation conducted on Turtleback I was designed and
implemented to aid HJI's entire jojoba enterprise.
As discussed above, there is no evidence that Turtleback I
functioned independently of HJI.
Moreover, it is clear that from
its inception JDP was viewed as a part of HJI's jojoba farming
enterprise.
Indeed, the interrelationship of HJI and JDP can be
seen in the following responses Whittaker made to questions posed
to her on direct examination (by which petitioners were trying to
establish that it was anticipated that the purported research and
development program would lead to valuable discoveries (emphasis
added)):
Q. [Counsel] What would be the nature of the
property interest, the intangible property interest
that the discoveries might constitute?
A. [Whittaker] I am sorry. By the end of the
program or through the program, I think the nature of
the property would be technological expertise,
information or knowledge. The question of
patentability and licensing I think is a twofold issue.
One is, is it proprietary or specific enough to be of
the nature of being patentable, but really, more
importantly or specific to our purposes, I did not, we
did not consider that it was to the benefit of our
- 66 associated group to compartmentalize our information
between one partnership and another, but rather it was
to the benefit of all the parties, Jojoba Development
parties, Hyder Jojoba, Inc., Hyder Jojoba Partners,
which were the entities then in existence, to apply
whatever knowledge we discovered to the benefit of all
of the parties and move forward as a leading and
profitable jojoba production company.
Q: So specifically with respect to JDP, did you
expect the discoveries would be beneficial to JDP?
A:
Absolutely.
Q:
And how would it be beneficial specifically to
JDP?
A: How would improving the - - it would be
beneficial - Q: In other words, how would the discoveries be
beneficial to JDP?
A: Assuming that we had discovered that a
specific amount or regime of nutrient application could
increase yield by a certain amount, that would not only
benefit JDP specifically with regard to its operation
under a joint venture, but would also benefit JDP,
which is a 60-acre partnership and not a selfsustaining unit, but rather a group related to Hyder
Jojoba, Inc. and all of its farm production, by
contribution towards the development of an economically
viable unit company/corporation that could produce
jojoba effectively and profitably.
The record shows that HJI did not serve solely as JDP's
agent.
JDP had no power to direct or control any aspect of the
research or experimentation process.
solely ministerial.
Berberich's activities were
There is no evidence that JDP, Berberich, or
any limited partner, was involved in, directed, or controlled any
phase of the alleged research or experimentation project.
Cf.
Everett v. Commissioner, T.C. Memo. 1990-65, (citing Diamond v.
- 67 Commissioner, 92 T.C. 423, 443 (1989), affd. 930 F.2d 372 (4th
Cir. 1991)).
At the time the R & D Agreement was executed, the costs of
any research or experimentation to be conducted on Turtleback I
had not been estimated.
Under that agreement, HJI was to be
responsible for all of the costs of operating Turtleback I.
HJI
would make all of the decisions relating to its operations and
the putative research or experimentation, including deciding
exactly what research or experimentation, if any, would be done.
Although JDP purportedly paid a fixed contract fee for the
putative research projects delineated in the R & D Agreement, at
the time that agreement was executed neither party to the
agreement expected HJI to carry out the described projects.
HJI, moreover, did not plan to make a profit from the
receipt of the R & D contract fee.
The fee was to provide HJI
with working capital and financial resources to develop the
jojoba plantation and conduct any research and development
projects.
Its profit would come only from operating the jojoba
plantation.
HJI, furthermore, expected to, and did, use the results of
its putative research or experimentation activities on all of the
Hyder Jojoba plantations.
HJI shared in the potential risks of
failure and rewards of successful research or experimentation.
Under such circumstances, we conclude that JDP did not pay
HJI $360,000 in consideration for obtaining ownership of the
- 68 discoveries resulting from the putative research or
experimentation.
Rather, we conclude that any research or
experimentation that HJI conducted on Turtleback I was for its
own benefit and on its own behalf.
3. The Expenditures Must Be Paid or Incurred in Connection
with the Taxpayer's Trade or Business
Petitioners contend that the putative research or
experimentation expenditures were paid or incurred in connection
with JDP's trade or business.
According to petitioners, the
research was done in contemplation that JDP and HJI would form a
joint venture with the express purpose of commercially and
profitably farming jojoba upon the expiration of the research
program if it was determined at that time that such venture would
be commercially feasible.
Furthermore, petitioners assert, the
joint venture subsequently was formed, and it operated a
commercial jojoba plantation on which the discoveries from the
research or experimentation were used.
Respondent contends, on the other hand, that JDP was only a
passive investor that never engaged in or planned to engage in
its own separate trade or business.
Respondent asserts that the
passive nature of the investment is reflected in JDP's
willingness to enter into the R & D Agreement without retaining
any proprietary rights to any technology developed and where any
discoveries obtained from the field testing would be available to
anyone in the jojoba industry.
Respondent contends that JDP's
- 69 actions following the execution of the R & D Agreement with HJI
were ministerial at most and that HJI enjoyed complete discretion
and control over any research or experimentation as well as the
farming activities that were pursued after January 1, 1987.
Respondent contends further that the second phase of JDP,
following the expiration of the R & D period, was highly
speculative since it was conditioned on HJI's exercising an
option to exploit the jojoba plantation that had been developed.
If HJI refused to exercise the option, however, JDP could only
realize profit from the arrangement by exercising its option to
lease the property from Whittaker Jojoba, in which JDP's general
partner held an interest.
Respondent argues that these highly
speculative and conditional arrangements could not rise to the
status of a business, realized or anticipated, on December 31,
1981, when the research and development fee was deducted.
Respondent asserts that JDP was only a vehicle "for the injecting
of risk capital".
Green v. Commissioner, 83 T.C. 667, 687
(1984); see also Levin v. Commissioner, 87 T.C. 698, 725 (1986),
affd. 832 F.2d 403 (7th Cir. 1987).
In Snow v. Commissioner, 416 U.S. 500 (1974), the Supreme
Court established that deductions under section 174 could be
claimed in connection with a trade or business even though the
taxpayer was not currently producing or selling any product.
In
following the Snow case, however, this Court has held that to be
entitled to a deduction the taxpayer must be engaged in a trade
- 70 or business at some time and the activities must be sufficiently
substantial and regular to constitute a trade or business.
v. Commissioner, supra at 687-689.
Green
Where a partnership is
claiming deductions under section 174, the controlling inquiry is
whether there is a realistic prospect that the technology to be
developed will be exploited in a trade or business of the entity
in question.
See Diamond v. Commissioner, 92 T.C. at 443; see
also Kantor v. Commissioner, 998 F.2d 1514 (9th Cir. 1993), affg.
on this issue T.C. Memo. 1990-380; Spellman v. Commissioner, 845
F.2d 148, 149 (7th Cir. 1988), affg. T.C. Memo. 1986-403; Harris
v. Commissioner, T.C. Memo. 1990-80, supplemented by 99 T.C. 121
(1992), affd. 16 F.3d 75 (5th Cir. 1994).
Mere legal entitlement
to enter into a trade or business does not satisfy this test.
Instead, "The legal entitlement must be backed by a probability
of the firm's going into business."
Levin v. Commissioner, 832
F.2d at 407; Kantor v. Commissioner, supra at 1520; LDL Research
& Dev. II, Ltd. v. Commissioner, T.C. Memo. 1995-172; Stankevich
v. Commissioner, T.C. Memo. 1992-458.
But cf. Scoggins v.
Commissioner, 46 F.3d 950 (9th Cir. 1995) revg. T.C. Memo. 1991263, (where the Court of Appeals for the Ninth Circuit concluded
that there was a realistic prospect that the partnership involved
in that case would be engaged in a trade or business).
In
Scoggins, the individual taxpayers had directed the research
themselves, had experience in marketing, and had the ability to
provide the partnership with sufficient capital to manufacture
- 71 and market the equipment in question if the corporation did not
do so.
The circumstances in Scoggins are wholly different from
those presented here.
See LDL Research & Dev. II, Ltd. v.
Commissioner, supra, also distinguishing the Scoggins case.
A facts and circumstances test has been employed by this
Court in determining whether there is a realistic prospect that a
partnership may enter into a trade or business with respect to
technology that is to be developed.
We have considered such
factors as the terms of the parties' contractual arrangements,
the intentions of the parties involved in the arrangement, the
amount of capitalization retained by the partnership during the
research and development contract period, the exercise of control
by the partnership over the person or organization doing the
research, the business activities of the partnership, the
capacity and incentive, if any, of the partnership to use the
products in its own trade or business, and the experience of the
partners.
E.g., Diamond v. Commissioner, supra at 438-440; Levin
v. Commissioner, 87 T.C. at 726-728; Mach-Tech, Ltd. Partnership
v. Commissioner, T.C. Memo. 1994-225, affd. 59 F.3d 1241 (5th
Cir. 1995); Stankevich v. Commissioner, supra; Double Bar Chain
Co. v. Commissioner, T.C. Memo. 1991-572.
The grant of an exclusive license to exploit technology
prior to commencement of research and development may preclude a
licensor from engaging in a trade or business with respect to the
technology.
See Levin v. Commissioner, 87 T.C. at 726-727; Green
- 72 v. Commissioner, supra.
In addition, this Court has also
disallowed deductions claimed for research and experimental
expenditures even though the licenses had not officially been
entered into upon execution of the research and development
agreements.
See Stauber v. Commissioner, T.C. Memo. 1992-128;
Double Bar Chain Co. v. Commissioner, supra.
In Stauber, we
found that the partnership never intended to enter into a trade
or business with respect to the technology, and that there was a
pre-existing understanding regarding a future license of the
technology.
In Double Bar Chain Co. v. Commissioner, supra, we
held that even though there was no written license agreement, the
partnership never intended to enter the trade or business of
manufacturing and marketing the technology.
The relevant factors
in this determination included the limited capital retained in
the partnership, the private offering memorandum stating that
none of the essential activities relating to the technology would
be conducted by the partnership, the lack of control over the
research activities, and the lack of experience of the investors.
In Stankevich v. Commissioner, supra, we looked to the
passive nature and limited activity of the partnerships, as well
as their lack of control over all aspects of the investment, in
holding that the general partner never intended that the
partnerships would enter into a trade or business.
We also held
that the contractual arrangements between the parties made the
prospects unrealistic that the partnerships would ever be capable
- 73 of entering into a trade or business with respect to any
technology that might be developed.
Consequently, we held that
"Everything that * * * [the taxpayers] did was wholly consistent
with investor activity, not the activity of a person engaged in
an active trade or business."
Id.
In determining whether research and development expenditures
were incurred in the taxpayer's trade or business, this Court has
considered a two-step inquiry:
(1) Whether the taxpayer's
activities in connection with the venture were sufficiently
substantial and regular to constitute a trade or business and (2)
whether the taxpayer had the requisite profit objective in
undertaking the activity.
See Green v. Commissioner, 83 T.C.
667, 687 (1984); Stankevich v. Commissioner, supra.
Petitioners
contend that such requirements have been satisfied in the present
cases because TJV's primary motive in farming jojoba was to
realize profit, and its farming operations were continual and
regular.
Petitioners contend that the present cases are
distinguishable from cases such as Green v. Commissioner, supra,
Levin v. Commissioner, supra, and Stankevich v. Commissioner,
supra, because JDP actually formed a joint venture with HJI in
1987 that commercially farmed jojoba.
Petitioners argue that the
formation and operation of that joint venture is determinative of
the trade or business question.
We do not agree.
The fact that
some enterprise, be it HJI or TJV, was conducting commercial
- 74 farming on Turtleback I is not determinative.
As we have stated
previously, "the mere presence of a valid business enterprise at
some levels of a transaction does not automatically entitle
passive investors distant from day-to-day operations of the
enterprise to the associated tax benefits."
Commissioner, 85 T.C. 557, 580 (1985).
Beck v.
Rather, to resolve the
trade or business question in the instant cases we must focus on
JDP, not TJV, as petitioners would have us do.
For the reasons
set forth above, we conclude that JDP did not intend to engage,
nor did it engage, in its own trade or business.
As stated previously, we have concluded that Turtleback I
was not operated as an independent jojoba plantation.21
JDP
functioned from the beginning as a part of HJI's farming
enterprise.
JDP's relationship with HJI did not change as of
January 1, 1987, when purportedly the research and development
period ended and the putative joint venture operation commenced.
HJI continued to have sole responsibility and control over the
jojoba farming operations.
JDP moreover was not called upon to
provide any additional contributions to fund the operations of
the joint venture.
The fact that JDP would begin to share in any
profits after formation of the joint venture is not determinative
since no profits could have been expected during the putative
21
We may take into account a taxpayer's actions in years
subsequent to the years in issue in evaluating the taxpayer's
prospects during the years in issue. Levin v. Commissioner, 832
F.2d, 403, 406 n.3 (7th Cir. 1987), affg. 87 T.C. 698 (1986).
- 75 research and development period because that period coincided
with the maturation period of the jojoba plants.
The only
ostensible difference in the relationship between JDP and HJI is
that allegedly after 1986, as general partners, both JDP and HJI
would be jointly liable for any debts and losses of a joint
venture.
In the present cases, however, we find that difference
to be without distinction.
We are guided by the maxim that "the
relevant inquiry is the actual manner, not the form, in which the
parties intended to structure their relationship."
Slappey Drive
Indus. Park v. United States, 561 F.2d 572, 583 (5th Cir. 1977),
affg. Cairo Developers, Inc. v. United States, 381 F. Supp. 431
(M.D. Ga. 1974); see also Saviano v. Commissioner, 765 F.2d 643,
650 (7th Cir. 1985), affg. 80 T.C. 955 (1983).
partnership.
JDP was a limited
Consequently, the potential liability of the
individual partners did not change as a result of the formation
of Turtleback Jojoba Venture.
The mere presence of a profit motive, moreover, is not
determinative of whether the section 174 deduction will be
allowed.
What is significant in the instant cases is that JDP
never actually managed or controlled the use or marketing of the
results of the research or experimentation.
See Harris v.
Commissioner, 16 F.3d 75 (5th Cir. 1994), affg. T.C. Memo. 199080.
JDP did not have a realistic prospect of carrying on its own
jojoba farming business.
Even though JDP had an option to farm
- 76 Turtleback I at the end of the R & D period, it would have the
opportunity to exercise that option only if HJI decided that it
would be uneconomical to enter into the Turtleback Jojoba Venture
with JDP.
As we stated previously, there is no evidence that JDP
would have had the technical expertise or financial resources to
operate a jojoba plantation had HJI not exercised its option to
enter into Turtleback Jojoba Venture.
There is no evidence that
Berberich or any limited partner could or would have stepped in
to operate a commercial jojoba plantation on Turtleback I
commencing in 1987.
Neither JDP nor any of its partners had any
experience in farming jojoba.
JDP, moreover, had no employees,
equipment, or any other physical assets, and apparently would not
have had sufficient funds to acquire the necessary assets to
operate a jojoba plantation after the 5 to 6 years needed for the
jojoba plants to become productive.
JDP, moreover, was allocated
only 60 acres on which to operate such plantation, which, from
the evidence in this case, was insufficient acreage on which to
conduct such an operation.
Under such circumstances, we conclude that at the time the R
& D Agreement was executed, JDP did not intend to engage in a
business of its own.
Because of this conclusion, we do not
address alternative arguments raised by the parties in support of
their various positions.
Accordingly, we hold that petitioners are not entitled to
deduct losses attributable to JDP's deduction for research or
- 77 experimentation expenditures under section 174.
Respondent is
sustained on this issue.
B.
Negligence
Respondent determined that petitioners are liable for
additions to tax for negligence or intentional disregard of rules
and regulations under section 6653(a)(1) and (2).
Section
6653(a)(1) provides for an addition to tax in an amount equal to
5 percent of the underpayment if any part of the underpayment is
due to negligence or intentional disregard of rules and
regulations.
Section 6653(a)(2) provides for an addition to tax
in an amount equal to 50 percent of the interest payable under
section 6601 with respect to that portion of an underpayment
attributable to negligence or intentional disregard of rules and
regulations.
Negligence is defined as the failure to exercise the due
care of a reasonable and ordinarily prudent person under like
circumstances.
E.g., Allen v. Commissioner, 925 F.2d 348, 353
(9th Cir. 1991), affg. 92 T.C. 1 (1989); Sandvall v.
Commissioner, 898 F.2d 455, 458 (5th Cir. 1990), affg. T.C. Memo.
1989-189 and T.C. Memo. 1989-56; Forseth v. Commissioner, 845
F.2d 746, 749 (7th Cir. 1988), affg. 85 T.C. 127 (1985); Neely v.
Commissioner, 85 T.C. 934, 947 (1985).
The question is whether a
particular taxpayer's actions in connection with the transaction
were reasonable in light of his experience and the nature of the
investment or business.
See Henry Schwartz Corp. v.
- 78 Commissioner, 60 T.C. 728, 740 (1973).
A taxpayer may not be
negligent but still violate section 6653(a)(1) and (2) by
intentionally disregarding respondent's rules and regulations.
Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967),
affg. in part and remanding in part 43 T.C. 168 (1964) and T.C.
Memo. 1964-299.
Petitioners have the burden of proving that the
underpayment of tax was not due to their negligence or
intentional disregard of rules and regulations.
Rule 142;
Sandvall v. Commissioner, supra at 459; Forseth v. Commissioner,
supra; Luman v. Commissioner, 79 T.C. 846, 860-861 (1982).
1.
Petitioners Glassley and Houser
Petitioners Glassley and Houser contend that the addition to
tax for negligence under section 6653(a)(1) and (2) is not
applicable to them because they relied in good faith on the
advice of competent professionals that the tax treatment for the
putative research and development expenditures was proper.
Respondent asserts, on the other hand, that petitioners have not
demonstrated that they were reasonable in relying upon their
accountants.
She contends further that petitioners have not
shown what advice, if any, they received from their accountants
or that the accountants had sufficient knowledge of the facts to
render a competent opinion.
We agree with respondent.
Reliance on the advice of competent professionals, even if
erroneous, may form the basis for a successful defense against
the imposition of an addition to tax for negligence.
E.g., Weis
- 79 v. Commissioner, 94 T.C. 473, 487 (1990); Ewing v. Commissioner,
91 T.C. 396, 423-424 (1988), affd. without published opinion 940
F.2d 1534 (9th Cir. 1991); Freytag v. Commissioner, 89 T.C. 849,
888 (1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S.
868 (1991); Jackson v. Commissioner, 86 T.C. 492, 539 (1986),
affd. 864 F.2d 1521 (10th Cir. 1989); Brown v. Commissioner, 47
T.C. 399, 410 (1967), affd. 398 F.2d. 832 (6th Cir. 1968).
However, reliance on professional advice, standing alone, is not
an absolute defense to negligence, but only one factor to be
considered.
Freytag v. Commissioner, supra; Reimann v.
Commissioner, T.C. Memo. 1996-84; Kaplan v. Commissioner, T.C.
Memo. 1994-81.
A taxpayer's reliance must be reasonable, in good
faith, and based on full disclosure.
Ewing v. Commissioner,
supra; Pritchett v. Commissioner, 63 T.C. 149, 174-175 (1974).
Further, reliance on a tax professional will not absolve
taxpayers where they are aware that the "facts" upon which they
predicate their deductions are not the facts of the transaction
in issue.
McCrary v. Commissioner, 92 T.C. 827, 847 (1989).
Dr. Glassley testified that he relied on his accountant in
claiming the disputed expenditures while Dr. Houser testified
that he relied on his accountant and his brother, an attorney.
To show good faith reliance, petitioners Glassley and Houser must
establish that these individuals were competent to render the
advice, that petitioners supplied them with all necessary
information, and that the incorrect return was a result of the
- 80 professional's mistakes.
Weis v. Commissioner, supra; Conlorez
Corp. v. Commissioner, 51 T.C. 467, 474 (1968).
Neither petitioners Glassley nor Houser have established
that their accountants (or brother) had specialized knowledge of
the jojoba industry or of agricultural research.
Nor have
petitioners Glassley or Houser established the extent or nature
of these individuals' tax expertise.
None of these alleged
professionals, moreover, made an independent investigation of the
JDP partnership or hired anyone to make such an investigation.
In evaluating the transaction, petitioners Glassley's accountant
and petitioners Houser's accountant and Dr. Houser's brother
relied solely on the offering circular.
See Vojticek v.
Commissioner, T.C. Memo. 1995-444, to the effect that advice from
persons with an interest in the transaction "is better classified
as sales promotion".
Furthermore, there is no reliable evidence in the record
suggesting the exact nature of the advice, if any, that was
given.
Neither of the accountants nor Dr. Houser's brother
testified.
We cannot assume that their testimony would have been
favorable to petitioners.
have been unfavorable.
The normal inference is that it would
Pollack v. Commissioner, 47 T.C. 92, 108
(1966), affd. 392 F.2d 409 (5th Cir. 1968); see also Tokarski v.
Commissioner, 87 T.C. 74, 77 (1986); Bresler v. Commissioner, 65
T.C. 182, 188 (1975); Wichita Terminal Elevator Co. v.
- 81 Commissioner, 6 T.C. 1158, 1165 (1946), affd. 162 F.2d 513 (10th
Cir. 1947).
On this record, we conclude that petitioners Glassley and
Houser did not act in good faith reliance on professional advice.
In each case, the record shows that they acted on their
fascination with the idea of participating in a jojoba farming
venture and their satisfaction with tax benefits of expensing
their investments, which were clear to them from the promoter's
presentation.
They passed the offering circular by their
accountants for a "glance", and Dr. Houser spoke with his
brother, an attorney, though apparently not a person
knowledgeable about tax matters or agriculture.
do not establish consultation with an expert.
The facts here
Cf. Durrett v.
Commissioner, 71 F.3d 515 (5th Cir. 1996), affg. in part, revg.
in part T.C. Memo. 1994-179.
Petitioners Glassley and Houser
have not established that their purported reliance on the advice
of their accountants (and brother) actually occurred or was
reasonable, in good faith, and based on full disclosure.
Hence,
such alleged reliance is not sufficient to shield them from
liability for the negligence additions to tax.
An addition to tax for negligence is correctly assessed in
cases where deductions claimed on returns are not supported by
the facts.
Sandvall v. Commissioner, supra; Marcello v.
Commissioner, supra. Petitioners claimed deductions for purported
research and experimental expenditures that we have found to have
- 82 been in actuality contributions to capital.
Based on the record,
we conclude that petitioners Glassley and Houser knew, or should
have known, that JDP's payments to HJI were not made for the
purposes stated in the R & D Agreement.
We conclude further that
they nonetheless deliberately disregarded respondent's rules and
regulations in claiming as research or experimentation
expenditures on their tax returns for the years in issue the bulk
of their capital contributions for the right to participate in
HJI's jojoba farming enterprise.
Accordingly, we hold that petitioners Glassley and Houser
are liable for the negligence additions to tax under the
provisions of section 6653(a)(1) and (2).
Respondent is
sustained on this issue.
2.
Dr. Mahoney
Dr. Mahoney did not testify at trial and he has presented no
evidence on this issue.
Consequently, Dr. Mahoney has failed to
carry his burden of showing that, in claiming the disputed
deductions, he was not negligent or did not intentionally
disregard respondent's rules and regulations.
Accordingly, he
also is liable for the negligence additions to tax under the
provisions of section 6653(a)(1) and (2).
Respondent is
sustained on this issue.
C.
Increased Interest
Respondent determined in the notices of deficiency that the
increased interest under section 6621(c) applied to petitioners
- 83 Glassley and petitioner Mahoney.
Respondent also asserted by
amended answer that the increased interest under section 6621(c)
applied to petitioners Houser.
Respondent has the burden of
proof with respect to the increased interest asserted in the
amendment to answer.
Rule 142(a); Zirker v. Commissioner, 87
T.C. 970, 981 (1986).
The increased rate of interest under section 6621(c) is 120
percent of the statutory rate imposed on underpayments under
section 6601 if the underpayment exceeds $1,000 and is
attributable to a tax-motivated transaction (as defined in
section 6621(c)(3)).
The increased interest is effective only
with respect to interest accruing after December 31, 1984,
notwithstanding that the transaction was entered into before that
date.
Solowiejczyk v. Commissioner, 85 T.C. 552 (1985), affd.
per curiam without published opinion 795 F.2d 1005 (2d Cir.
1986).
Respondent contends that the increased rate of interest
under section 6621(c) applies because the research and
development expense deductions that petitioners claimed resulted
in a "substantial underpayment" attributable to a tax-motivated
transaction.
Section 6621(c)(3)(A) enumerates types of transactions that
are considered "tax-motivated transactions".
Furthermore,
section 6621(c)(3)(B) gives the Secretary of the Treasury
authority, by regulation, to add to the categories of
- 84 transactions that will be treated as tax-motivated transactions.
The definition of a tax-motivated transaction includes "any use
of an accounting method specified in regulations prescribed by
the Secretary as a use which may result in a substantial
distortion of income for any period."
Sec. 6621(c)(3)(A)(iv).
In Bailey v. Commissioner, 90 T.C. 558, 628 (1988), affd. in part
and remanded on another issue 912 F.2d 44 (2d Cir. 1990), the
Court determined that the deduction from income of management
fees that should have been capitalized and amortized was a
distortion of income under section 6621(c)(3)(A)(iv); see also
Lieber v. Commissioner, T.C. Memo. 1993-391; Upham v.
Commissioner, T.C. Memo. 1989-253, affd. 923 F.2d 1328 (8th Cir.
1991); sec. 301.6621-2T, Temporary Admin. & Proced. Regs., 49
Fed. Reg. 50391, 50392 (Dec. 28, 1984), 1985-1 C.B. 368.22
22
Sec. 301.6621-2T, Temporary Proced. & Admin. Regs., in
pertinent part provides as follows in question and answer format:
Q-3: What accounting method may result in a
substantial distortion of income for any period under
[sec. 6621(c)(3)(A)(iv)]?
A-3: A deduction or credit disallowed, or income
included, in any of the circumstances listed below
shall be treated as attributable to the use of an
accounting method that may result in a substantial
distortion of income and shall thus be a tax motivated
transaction that results in a tax motivated
underpayment:
*
*
*
*
*
*
*
(9) In the case of a taxpayer who computes
taxable income using the cash receipts and
disbursements method of accounting, any deduction
(continued...)
- 85 JDP (and thus petitioners) claimed deductions for research
and development expenditures that we found were in actuality
nondeductible contributions to capital.
Such deductions caused a
material distortion of their income.
See Lieber v. Commissioner,
supra; Upham v. Commissioner, supra.
The underpayment resulting
from such disallowed deductions is therefore attributable to a
tax-motivated transaction.
Accordingly, petitioners are liable
for the additional interest determined in the notices of
deficiency or asserted by amendment to answer.
Respondent is
sustained on this issue.
To reflect the foregoing,
Decisions will be entered for
respondent in docket Nos. 13431-89
and 24177-89.
Decision will be entered under
Rule 155 in docket No. 19140-89.
22
(...continued)
disallowed for any period because (i) the expenditure
resulting in the deduction was a deposit rather than a
payment, (ii) the expenditure was prepaid for tax
avoidance purposes and not for a business purpose, or
(iii) the deduction resulted in a material distortion
of income (see, e.g., Rev. Rul. 79-229, 1979-2 C.B.
210).
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.