Appendix — Hildebrand v. Commissioner

FILED .

2)

9/94 741 OCT 19 1994

@EBICE OF THE CLERK

In the Supreme Court

OF THE

United States

OCTOBER TERM, 1994

R. A. HILDEBRAND and

DorROTHY A. HILDEBRAND WAHL,

Petitioners,

vs.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

On Petition for a Writ of Certiorari

to the United States

Court of Appeals for the Tenth Circuit

APPENDIX TO PETITION FOR A

WRIT OF CERTIORARI

MICHAEL R. MATTHIAS

Counsel of Record

JEFFREY P. BERG

STUART R. SINGER

MATTHIAS & BERG

515 South Flower Street

Seventh Floor

Los Angeles, California 90071

(213) 895-4200

Counsel for Petitioners

Bowne of Los Angeles, Inc., Law Printers (213) 627-2200

TABLE OF CONTENTS

United States Tax Court Opinion,

99 T.C. 132

United States Court of Appeals for

The Tenth Circuit Opinion,

28 F.3d 1024

Sections of the Internal Revenue Code

of 1986

145

165

APPENDIX

99 T. C. No. 7

UNITED STATES TAX COURT

GARY E. KRAUSE, TAX MATTERS PARTNER,

BARTON ENHANCED OIL PRODUCTION INCOME

FUND, Petitioner v. COMMISSIONER OF

INTERNAL REVENUE, Respondent

R.A. HILDEBRAND AND DOROTHY A. HILDEBRAND

WAHL, Petitioners y. COMMISSIONER OF

INTERNAL REVENUE, Respondent

Docket Nos. 16425-86, 33231-86. Filed

July 29, 1992.

Petitioners invested in limited

partnerships relating to, among other

things, enhanced oil recovery technology.

Held, on the primary issues: (1)

Activities of the partnerships were not

engaged in with actual and honest profit

objectives, and (2) debt obligations of

the partnerships were not genuine.

Kenneth M. Barish, for petitioner at

docket No. 16425-86.

Jeffrey P. Berg, for petitioners at

docket No. 33231-86.

Stephen M. Miller, Marion S. Friedman,

and Elizabeth Girafalco Chirich, for

respondent.

SWIFT, Judge: At docket No.

33231-86, with respect to petitione's

Dorothy A. Hildebrand Wahl and R.A.

Hildebrand, respondent determined

deficiencies in Federal income tax,

increased interest, and additions to tax

for 1980, 1981, and 1982, as follows:

(SEE TABLE ONE]

At docket No. 16425-86, with respect

to Barton Enhanced Oil Production Income

Fund, a Kansas limited partnership, and

petitioner Gary E. Krause as tax matters

| partner, and by notice of final

partnership administrative adjustment

(FPAA), respondent disallowed Barton’s

ordinary losses for 1982 and 1983 in the

respective amounts of $504,972 and

$500,341.

Respondent also determined increased

interest and additions to tax under

sections 6621(c),' 6659, and 6661 with

respect to petitioner Gary E. Krause’s

1982 and 1983 individual Federal income,

tax liabilities.

These consolidated cases are test

cases for over 2,000 related cases and

for a number of related TEFRA

partnerships. Alleged total tax

‘unless otherwise indicated, all section

references are to the Internal Revenue

Code in effect for the years in issue,

and all Rule references are to the Tax

Court Rules of Practice and Procedure.

3

shasicieeceiieilintaiaaaeeaiiieite tii ail

deficiencies at issue in connection with

this group of related cases and TEFRA

partnerships are in excess of $2 billion.

On May 11, 1989, prior to trial, we

issued an opinion in these consolidated

cases with respect to the parties’ cross

motions for partial summary judgment

which decided a number of legal issues.

See Krause v. Commissioner, 92 T.C. 1003

(1989).

The particular limited partnerships

that are involved in these test cases

(namely, Technology Oil and Gas

Associates 1980 (Technology-1980) and

Barton Enhanced Oil Production Income

Fund (Barton)) were part of two groups of

limited partnerships that are referred to

in this opinion at various times as the

"Manhattan Partnerships", the "Wichita

Partnerships", and occasionally as "the

eR tad Ante ce

partnerships". The partnerships had the

stated general objective of, among other

things, investing in enhanced oil

recovery (EOR) technology for the

recovery of oil and natural gas.

Respondent disallowed substantial

losses claimed by the limited partners of

the partnerships for 1980 and 1981, and

Claimed by the partnerships for 1982 and

1983. These test cases raise the

following primary issues: (1) Whether the

investments in and the activities of the

partnerships were entered into and

engaged in with actual and honest profit

objectives, and (2) whether the stated

debt obligations of the partnerships

constituted genuine debt obligations, or

whether they constituted contingent, sham

debt obligations, lacking in economic

substance.

Resolution of the issues in these

cases is complicated by the extensive

record. Trial of these cases lasted 15

weeks. The trial transcript consists of

8,361 pages. Over 1,500 multi-page

exhibits were admitted into evidence, and

a total of 46 fact witnesses and 28

expert witnesses testified.

FINDINGS OF FACT

Some of the relevant facts were

stipulated and are so found.

Petitioner R.A. Hildebrand

(Hildebrand) resided in Denver, Colorado,

and petitioner Dorothy A. Hildebrand Wahl

(Wahl) resided in Lakewood, Colorado, at

the time their joint petition was filed.

Barton’s principal place of business was

in Wichita, Kansas, at the time the

petition was filed.

Throughout the mid to late 1970s and

early 1980s, world oil markets were

destabilized by war in the Middle East, |

by the Iranian revolution, by production

and export quotas of oil exporting

countries, and by other actions of the

Organization of Petroleum Exporting

Countries (OPEC). During these years,

certain segments of the public, of the

oil industry, and of governmental

organizations responsible for energy

policy reflected a certain hysteria about

the worldwide energy crisis and about oil

prices.

From 1978 to 1979, the average

domestic crude oil price fluctuated from

$12.70 per barrel to $34.35 per barrel

and peaked in March of 1981 at $34.70 per

barrel. In August of 1980, spot oil

prices for Saudi light crude oil reached

approximately $46 per barrel, and as of

the end of 1980, the price of Saudi light

crude oil was $38 per barrel.

A 1980 report of the U.S. Department

of Energy (DOE) and various studies

published by oil industry representatives

indicated that oil prices by 1990 could

go as high as $123 per barrel. The table

befow indicates the mid-level crude oil

price projections for 1980 to 1995 that

were set forth in the 1980 DOE report, in

1979 dollars and in projected inflated

dollars, as follows:

[SEE TABLE TWO]

In the late 1970s, as a result of the

energy crisis of the 1970s, the Carter

Administration announced a new national

goal for the United States within a

decade to achieve energy independence.

See President James E. Carter, The Energy

os Kotte il Ria i, ROM Aare

a A eR ke ean sen a x wl tla

Problem, Address to the Nation, 13 Weekly

Comp. Pres. Doc. 560 (April 18, 1977);

President James E. Carter, Energy and

National Goals, Address to the Nation, 15

Weekly Comp. Pres. Doc. 1235 (July 15,

1979). This goal was to be achieved by

increasing the supply of domestic crude

oil, by developing new alternate sources

of energy, and by conserving existing

energy resources. Numerous energy

related research and development

facilities were established, funded, or

subsidized by the Government. Billions

of dollars were spent directly by the

Federal Government or indirectly through

tax incentives to accelerate the

development of synthetic fuels, fossil

energy research, and EOR technology.

Specifically, regarding the

development of EOR technology, in 1979 a

tertiary oil incentive program was

adopted by the DOE. Under this progran,

which effectively expired in early 1981,

qualified oil producers were allowed to

sell oil at market prices, which prices

were substantially higher than the

controlled prices of crude oil, in order

to offset up to the lesser of $20 million

or 75 percent of their expenses in

qualified EOR projects. 10 C.F.R. sec.

212.78(a)(2) (1979). For a discussion of

the tertiary oil incentive program, see

Union Oi] Co. of Cal. v. U.S. Dept. of

Energy, 688 F.2d 797, 800-804 (Temp.

Emer. Ct. of App. 1982). Under the Crude

Oil Windfall Profit Tax Act of 1980, Pub.

L. 96-223, secs. 23(a) and 201-251, 94

Stat. 229, 256-287, certain oil recovered

through EOR technology qualified for a

reduced Federal excise tax, and certain

10

tax credits were made available with

respect to the production of oil from tar

sands.

In 1980, the U.S. Synthetic Fuels

Corp. was established. Energy Security

Act, Pub. L. 96-294, sec. 115, 94 Stat.

611 (1980). This corporation was

authorized to operate for 12 years and to

spend $20 billion in 1981.

Tar sands deposits throughout the

United States, particularly in Utah, were

identified as potential sources for the

production of additional oil through

application of EOR technology that might

be developed, and a number of

governmental and privately sponsored

projects were undertaken in an effort to

make the recovery of oil from tar sands

commercially viable.

The application of primary and

11

secondary oil recovery methods to oil

fields typically results in the recovery

of 30 to 40 percent of oil reserves in

the fields. The application of EOR

technology to oil fields (that already

have been worked with primary and

secondary oil recovery methods) consists

of applying nontraditional, innovative

methods of recovering a portion of the

remaining oil reserves from the fields.

More specific findings concerning the

particular EOR technology at issue in

this case are set forth later in this

opinion.

Basic Structure of Technology-1980

In late 1978 or 1979, Winsor Savery,

Richard B. Basile, E. Barger Miller,

Werner Heim, Robert Shaftan, William

Conklin, and a number of other

individuals participated in the formation

12

of tax shelter limited partnerships with

the stated general investment objectives

of drilling for oil and natural gas and

of obtaining the rights to certain EOR

technology that might be developed and

become valuable if the price of oil

continued to rise dramatically in

subsequent years.

Petitioners Hildebrand and Wahl

invested in one of the Manhattan

Partnerships known as Technology~-1980.

Initially, the individual general partner

of Technology-1980 was Richard B. Basile

(Basile), and the corporate general

copartner was Glenda Exploration and

Development Corp. (GEDCO), a Texas

corporation. Basile had no experience

with oil and gas exploration, production,

or investments. Rather, his experience

was in selling tax shelters. Basile did

13

not personally investigate the merits of

the proposed partnership investments. He

did not prepare feasibility studies

relating to the partnership, nor did he

have such studies prepared.

A number of the individual organizers

and promoters of Technology~-1980,

however, did consult with various experts

and did obtain and study various reports

that had been prepared relating to, among

other things, projections of world oil

prices, the extent of oil deposits in

Utah and Wyoming tar sands properties,

the potential for the recovery of oil

from tar sands, and the potential for the

recovery of natural gas from the Monroe,

Louisiana, natural gas field.

Also, certain economic, financial,

accounting, and tax analyses and opinions

were obtained by the organizers and

14

promoters of the partnerships. These

analyses and these opinions were

available to Basile, and much of these

analyses and many of these opinions were

reflected or summarized in the

partnerships’ offering memoranda given to

prospective investors.

Two hundred and fifty limited

partnership units in Technology-1980 were

authorized, and 211.5 limited partnership

units in Technology-1980 were sold to 142

limited partners.

The total stated subscription price

for each limited partnership unit in

Technology-1980 was $230,000, payable by

each limited partner as follows: (1)

$10,000 in cash; (2) two short-term

recourse promissory notes, each in the

amount of $10,000 with simple interest at

10 percent due respectively on March l,

15

1981, and March 2, 1982; (3) a long-term

purportedly recourse debt obligation in

the amount of $120,000 due in each of

four $30,000 installments of principal on

December 31, 1992, 1993, 1994, and on May

31, 1995 (with nonrecourse interest at 7

percent); and (4) a nonrecourse,

noninterest-bearing long-term debt

obligation in the amount of $80,000 due

on December 31, 2005.

If all 250 units in Technology-1980

were subscribed to, the following total

stated subscription amounts would be owed

to Technology-1980:

Due Under Due Under

Cash Due Purportedly Recourse Nonrecourse

In First | Debt Obligations Promissory Notes

3 Years In 1992-1995 in 2005

$7.5 million $30 million $20 million

Similar total amounts were owed to the

other Manhattan Partnerships depending on

16

the number of partnership units sold in

each partnership.

In spite of the large current and

long-term debt obligations associated

with investments in Technology-1980, no

credit investigations were undertaken by

Technology-1980 with regard to the credit

worthiness of the limited partners who

invested in Technology-1980.

The stated investment objectives of

Technology-1980 (and the other Manhattan

Partnerships) were: (1) To drill

developmental wells for, and to sell, oil

and natural gas located in the Monroe,

Louisiana, natural gas field and in other

oil and gas producing fields (the

"drilling program"), and (2) to prove the

economic feasibility of recovering oil

from certain tar sands properties using

17

certain licensed EOR technology.

With regard to the first stated

objective (namely, the natural gas

drilling program), Technology-1980 (and

the other Manhattan Partnerships) entered

into an agreement with Glenda Petroleum

Corp. (Glenda Petroleum), an affiliate of

GEDCO, the corporate general partner of

Technology-1980. Under this agreement,

Technology-1980 was to acquire from

Glenda Petroleum working or operating

interests in developmental natural gas

drilling property in a natural gas field

in Monroe, Louisiana, a field that was

already 90 percent depleted. Owners of

working interests generally have the

right to develop and exploit oil and

natural gas on the leased property and

are responsible for the cost of

development and operation of wells that

18

—

are drilled on the property. For each of

the first 11 wells drilled, the

partnership was to pay Glenda Petroleum

approximately $65,000.

In 1980, Glenda Petroleum had

approximately 5,000 acres under lease in

the Monroe, Louisiana, natural gas field,

on a portion of which approximately 300

commercially productive natural gas wells

already had been drilled. Technology-1980

entered into a non arm’s-length agreement

with Glenda Petroleum under which Glenda

Petroleum was to drill 35 test wells on

the sites or acreage covered by the

leases obtained by the Manhattan

Partnerships. The acreage, however, that

was actually assigned to the partnerships

by Glenda Petroleum represented

exploratory acreage and had no value

based on natural gas reserves.

19

In the Technology-1980 offering

memorandum, projections of the amount of

natural gas to be recovered from the

property leased by the Manhattan

Partnerships from Glenda Petroleum were

based on developmental natural gas

producing property, which projections

were excessive based on the exploratory

nature of the property actually assigned

to the partnerships. The projections

were also excessive in light of the

number of wells Glenda Petroleum was to

Grill each year for all of the Manhattan

Partnerships.

In November of 1980, when the

exploratory nature of the property

assigned to the Manhattan Partnerships

was determined, an agreement was entered

into between the partnerships and Glenda

Petrolewm substituting new developmental

20

property for the original exploratory

property.

Costs and revenue from the operation

of the gas wells drilled by Glenda

Petroleum on behalf of the Manhattan

Partnerships were to be shared between

the partnerships, Glenda Petroleum, and

the owners of the underlying property, as

follows:

{SEE TABLE THREE]

In order to achieve its second stated

investment objective (namely, the EOR

technology program), Technology-1980

entered into certain agreements to lease

from Elektra Energy Corp. (Elektra)

limited rights to use certain EOR

technology to develop pilot projects for

the recovery of oil, and Technology-1980

leased from Texoil International Corp.

(TexOil) working interests in certain tar

21

sands and other heavy oil properties that

contained deposits of viscous and high

pour-point crude oil.

Elektra apparently was owned by

various Swiss, Dutch, Panamanian, and

Netherlands Antilles corporations, but

the identity of the underlying

shareholders of these corporations could

not be explained by any of petitioners’

witnesses and is not disclosed in the

record. TexOil was a Delaware

corporation owned by a Ron Ferguson.

OR Licens eements and t

Obligations to Elektra

Under a 5-year-license agreement,

Technology~1980 acquired from Elektra

limited rights to use certain purported

EOR technology on specified tar sands and

heavy oil properties. Under the license

22

agreement, Technology-1980 also acquired

the right to use additional EOR

technology, if developed and acquired by

Elektra during the term of the 5-year

license agreement. Any such additional

EOR technology could only be used by the

partnerships on the specific tar sands

and heavy oil properties leased from

TexOil in which the partnerships acquired

working interests.

In the late 1970s and early 1980s, the

established license fee in the oil

industry for the right to use EOR

technology was a 2-3 percent running

royalty based on the incremental

increased oil production, or the income

actually realized therefrom, that was

attributable to the particular EOR

technology being licensed. On the

contrary, the license fees

23

Technology-1980 agreed to pay Elektra

with respect to the EOR technology at

issue in this case were computed on the

basis of the number of limited

partnership units in Technology-1980 that

were sold. The license fees were not

computed on the basis of increased oil

production or on the basis of income

actually realized that was attributable

to any use or application of the EOR

technology. The license fees agreed to

by Technology-1980 were not arrived at

through arm’s-length bargaining.

More specifically, in consideration

for the 5-year license agreement with

respect to certain EOR technology,

Technology~1980 agreed to pay license

fees to Elektra of $35,000 per year for

each limited partnership unit -- a total

of $8,750,000 per year -- based on the

24

anticipated sale of all 250 authorized

limited partnership units in

Technology-1980. In each of the first 3

years, cash of $885,000 was due from

Technology-1980, and the balance of the

total annual license fee was to be paid

with a $7,865,000 promissory note. In

the fourth and fifth years, the total

annual license fees of $8,750,000 were to

be paid with promissory notes. Over the

course of the 5-year EOR technology

license, Technology-1980 would become

obligated to Elektra for total license

fees relating to the EOR technology of

$43,750,000 (a total of $2,655,000 in

cash and $41,095,000 in promissory

notes). Further, the total principal

amount of the promissory notes was not

due until the year 2005, plus interest at

12 percent, substantially below the

25

extant prime rate. Because, as stated,

only 211.5 of the 250 authorized

partnership units in Technology-1980 were

actually sold, the amount of the total

license fees due from Technology-1980 to

Elektra was reduced on a pro rata basis.

The partnerships’ promissory notes to

Elektra were to be prepaid from available

net cash flow, if any, of the

partnerships.

By executing the subscription

agreement and the limited partnership

agreement, each limited partner of

Technology-1980 nominally assumed

personal liability with respect to a pro

rata share of Technology-1980’s debt

obligations to Elektra and TexOil up to a

maximum of $120,000 (which $120,000

corresponded in amount to the portion of

each partner’s total liability under his

26

or her subscription agreement with

Technology-1980 that was not reflected by

promissory notes).

Technology-1980 gave Elektra a

security agreement to secure the payment

of the promissory notes relating to the

license of the EOR technology.

Thereunder, Elektra received a security

interest in all of the obligations of the

limited partners of Technology-1980

relating to their subscription agreements

with Technology-1980.

As indicated, the term of the license

of EOR technology that Technology~-1980

entered into with Elektra was 5 years,

beginning on the date the license

agreement was executed. Technology-1980,

however, had the option to acquire an

additional license if certain

requirements were met that, in effect,

27

would allow it to receive an exclusive

license from Elektra to continue to use

the EOR technology on the specified

properties beyond the original 5 -year

term of the license agreement.

It is significant that under the

license with Elektra, Technology-1980

(and the other Manhattan Partnerships)

had the right to use the EOR technology

on the specified properties only until a

pilot project was installed on the

property using the EOR technology. The

license did not include the right to

engage in any commercial oil production

or recovery with the EOR technology. In

order to engage in commercial oil

production using-any of the EOR

technology, Technology-1980 would have

had to enter into separate developmental

licenses with Elektra with respect to the

28

very same EOR technology and for which

developmental licenses additional

consideration or license fees would have

been necessary, and which additional

license fees were to be based on

incremental increased oil production or

on income attributable to the use of the

EOR technology.

The other 15 Manhattan Partnerships

agreed to pay Elektra fees ranging from

$12 million to $73 million for licenses

to use the identical EOR technology on

different properties, under which

licenses the partnerships were only

entitled to establish pilot projects on

the properties using the EOR technology.

The license fees agreed to by the other

partnerships consisted of a similar

combination of cash and long-term

promissory notes due in 20 to 25 years.

29

In vague and general language in the

license agreement, Elektra agreed to

develop and acquire new or additional EOR

technology, and, as indicated, any new or

additional EOR technology developed or

acquired by Elektra would be covered by

the various license agreements with the

various Manhattan Partnerships with

respect to the specified properties

covered by the licenses.

Technology-1980 could terminate

without cause the EOR license agreement

with Elektra and the heavy oil property

lease agreement with TexOil (described

below) by giving 120 days’ written notice

to Elektra (and to TexOil). Also,

Technology~1980 apparently could

terminate the license agreement with

Elektra (or the lease agreement with

TexOil) at any time if the partnership

30

Sicha

was prevented from establishing pilot EOR

projects on tar sands or heavy oil

properties due to a U.S. Bureau of Land

Management (BLM) wilderness order.

If Technology-1980 terminated the

license agreement with Elektra or the

lease agreement with TexOil, all of

Technology-1980’s debt obligations to

Elektra would be extinguished except that

portion of the obligations that had

accrued prior to termination.

Property Lease Agreements and Debt

bligati to Tex0i]

As stated, in addition to acquiring.

limited rights to use certain EOR

technology, Technology-1980 was to

acquire working interests in certain tar

sands properties on which the EOR

technology could be tested and on which

31

pilot projects were to be established.

In that regard, on December 31, 1980,

Technology-1980 acquired from TexOil

20-year working interests in three

separate tar sands properties, consisting

of a total of 665 acres. Tar sands,

generally, are properties that do not

contain oil reserves; rather they contain

deposits of tar-like hydrocarbons that

have limited transmissibility and that

generally are not regarded as oil

reserves. For a discussion of the

meaning of tar sands, see Note, What is

"Tar Sand": Examining the Section 29

Credit, 45 Tax Lawyer (1992).

One of the properties was located on

the tar sands triangle geologic formation

in Eastern Utah and was leased by Tex0Oil

from the Federal Government under leases

due to expire in 1984 but subject to

32

possible renewal. The tar sands triangle

is an arid, isolate? property located in

rugged terrain within a wilderness area.

The other two tar sands properties

covered by the lease with TexOil were

located in the Circle Cliffs geologic

formation in Utah and in the Burnt Hollow

geologic formation in Wyoming. The

Circle Cliffs property was an outcrop,

and any oil in the property was

recoverable only from mining, not

drilling.

The property in the Burnt Hollow

geologic formation had low oil saturation

and heavy water flow.

As of 1980, with or without the use of

EOR technology, there was no proven

method for recovery of commercial

quantities of oil from the Utah and

Wyoming tar sands properties. None of

33

the tar sands properties leased by the

Manhattan Partnerships from TexOil had

any proven or probable reserves of oil or

natural gas, and commercial exploitation

of these properties, even with the use of

EOR technology, was highly speculative.

Under the leases with Tex0Oil,

allotments of the acreage on these tar

sands properties to the various

partnerships were arbitrary and related

primarily to the number of partnership

units sold and to certain assumptions

made about the oil in place on the

properties. The allotment of the acreage

was not based on any professional tests

or estimates of economically recoverable

oil in place or of hydrocarbon deposits

on the properties.

For the working interests in the 665

acres of heavy oil properties that

34

Technology-1980 acquired from Tex0Oil,

Technology-1980 agreed to pay TexOil

minimum annual royalties of $1,250,000

based on the expected sale of 250

partnership units.

The minimum annual royalties owed to

TexOil by Technology-1980 for the first

year were to be paid $110,000 in cash and

$1,140,000 with a promissory note. Based

| on the 211.5 partnership units actually

sold in Technology-1980, if not canceled

prior to the end of the 20-year lease,

total royalties of $21,150,000 would be

owed by Technology-1980 to Tex0Oil,

payable $93,060 in cash per year for the

first 3 years and $964,440 per year for

the first 3 years in non-negotiable long-

term promissory notes due in the year

2005 and long-term notes of $1,057,500

per year for the next 17 years also due

35

in the year 2005. The amount of these

royalties was computed on the basis of

the number of partnership units sold

(namely, $5,000 per partnership unit each

year for 20 years).

Calculated on a per acreage basis, the

amount of the royalties Technology-1980

agreed to pay TexOil represented $31,804

per acre, even though TexOil was paying

to its lessors only $100 per acre per

year for the same working interests

leased to Technology-1980.

Technology-1980’s obligation to pay

minimum annual royalties to TexOil each

year for 20 years was not dependent on

the success of any of the EOR technology

that Technology-1980 leased from Elektra

and that might be tested on the property,

nor on the success of any of the EOR

technology pilot projects that might be

36

established. Technology-1980’s

obligation to pay the royalties was not

dependent on the amount of oil recovered

from the properties, nor on the amount of

oil reserves estimated to be (or actually

located) on the properties. The

royalties were not determined through

arm’s-length negotiations, but, instead,

were arbitrarily established.

Also, the royalties were agreed to in

apparent disregard of the fact that

TexOil’s leases with the Federal

Government with respect to the Utah tar

sands properties were due to expire in

just 1 to 2 years and that renewability

of the leases by TexOil was not certain.

Technology-1980 could terminate its

agreement with TexOil without cause on 30

days’ written notice, and Technology~-1980

could terminate the agreement immediately

if it was prevented from developing the

properties due to a BLM wilderness order.

If Technology-1980 terminated the tar

sands property lease agreement with

TexOil, all of Technology-1980’s debt

obligations (including the long-term

promissory notes) to TexOil would be

extinguished except for that portion of

the debt obligations that had accrued

prior to the termination.

Technology-1980 and TexOil entered

into a security agreement to secure

Technology~-1980’s debt obligations to

TexOil. TexOil, however, did not file

the security agreement with the

appropriate governmental entities to

perfect its interest therein.

In 1980, Basile, the individual

general partner of Technology-1980,

apparently disregarded advice of lawyers

38

and of a recognized oil geologist to the

effect that the oil in place estimates

relating to the tar sands properties

leased from TexOil, upon which the

partnerships purportedly were relying,

could not be supported and were not

reasonable, that the viability of the EOR

technology vis-a-vis the tar sands

properties was speculative, and that the

costs of achieving any successful pilot

projects and of any commercial oil

production using the EOR technology would

likely result in substantial losses to

the partnerships.

Basile, on behalf of Technology-1980,

did not visit any of the tar sands

properties. Basile did not inquire into

what TexOil was paying for its leases of

the properties leased to the

partnerships, nor did Basile attempt to

39

determine what Elektra was paying for the

EOR technology the partnerships were

licensing from Elektra, nor for what

price the same or similar EOR technology

could be licensed from others.

Basile did not obtain any independent

opinions concerning the fair market value

of the EOR technology license agreement

with Elektra, of the EOR technology

covered by the license agreement, nor of

the leases of the tar sands properties.

Rather, Basile was concerned primarily

with the reasonableness of the split of

potential profits as between

Technology~1980 and Elektra, assuming the

success of the EOR technology on the

properties, assuming substantial oil was

produced from the drilling program in the

Monroe, Louisiana, natural gas field, and

assuming numerous other risk factors all

40

worked out in favor of the partnerships.

The reasonableness of these assumptions

was never questioned or considered by

Basile.

The offering memorandum of

Technology-1980 set forth the following

schedule of tax losses investors could

expect to realize over the first 4 years

of their investment in Technology~-1980:

[SEE TABLE FOUR]

Summary estimates were set forth in

the Technology-1980 offering memorandum

of total estimated oil "reserves" in the

Utah tar sands properties leased by the

partnerships. Typically, the oil and gas

industry regards oil reserves as the

amount of barrels of oil that

realistically could be recovered from

particular properties using known and

proven technology. In the

41

Technology-1980 offering memorandun,

however, the term oil “reserves" was used

differently and in a misleading manner to

refer to the estimated total heavy oil or

hydrocarbon deposits on the properties,

regardless of the fact that no oil was,

likely recoverable from the tar sands

properties through known and existing

technology.

For example, with regard to the 250

partnership units in Technology-1980 that

were offered for sale, Technology~-1980

was to be assigned lease interests in 745

acres of tar sands properties, and the

offering memorandum estimated that

approximately 50 million barrels of oil

"reserves" were located thereon, and

thereby implicitly represented to

investors that a significant portion of

such estimated oil reserves could

42

realistically be recovered on behalf of

Technology-1980 through application of

EOR technology.

These projections were made by

Technology-1980 in the offering

memorandum in spite of the fact that as

of 1980 no existing EOR technology had

proven successful in the recovery of any

oil from the Utah and Wyoming tar sands

properties.

The offering memorandum of

Technology-1980 did not contain any

projections or estimates: (1) Of income

or profits relating to investments in

Technology~1980; (2) of income that might

be realized in connection with the

license of EOR technology for use on the

tar sands or heavy oil properties; (3) of

the value of the EOR technology licensed

from Elektra; nor (4) of the natural gas

43

production anticipated from the

partnerships’ leases of working interests

in the Monroe, Louisiana, natural gas

field.

Certain financial analyses relating to

various aspects of investments in

Technology-1980 were undertaken on behalf

of the promoters of the partnerships by

various companies and individuals

experienced in the oil and gas industry,

but much of the information so provided

was not included in the offering

memorandum given to investors. For

example, one document (for distribution

only to investment advisers, accountants,

and attorneys, and "not to be shown to

potential investors") estimated that the

tar sands or heavy oil properties leased

by Technology-1980 contained total

"reserves" of approximately 50 million

44

barrels of oil and that between "20

percent and 70 percent of this

oil-in-place is estimated to be

recoverable, utilizing the [EOR

technology] licensed by the Partnership."

The above referred-to document also

projected, for 1981 through 1995, natural

gas production and partnership net cash

flows from Technology~-1980’s interest in

the Monroe, Louisiana, natural gas field,

in part as follows:

45

Total Gas Cash

Year Production (mcf) Flow ($)

1981 101,068 182,749

1982 234,226 512,838

983 418,434 1,062,337

1984 529,572 1,549,239

1985 617,999 2,072,020

1986 702,210 2,618,885

1987 818,516 3,402,318

1988 954,422 4,417,317

1989 1,119,151 5,764,483

1990 1,323,938 7,596,238

1991 1,578,093 10,081,725

1992 1,890,611 13,441,456

1993 1,914,430 15,158,220

1994 1,862,455 16,382,794

1995 1,823,745 17,822,142

The projections set forth in the above

document, relating to the production from

the Monroe, Louisiana, natural gas field,

were based on, among other things, the

following assumptions for all 15 years

covered by the projections: (1) Inflation

will average 10 percent per year through

1985, and 7 percent per year thereafter;

(2) gas prices will rise each year at a

rate 4 percent above the general

inflation rate; (3) suitable

46

developmental oil and gas properties will

remain available during the developmental

Grilling program; and (4) each new well

will have the same average production

curve over its expected life. In various

Technology-1980 promotional material,

significant additional assumptions were

made by others who were involved in

promoting and opining on the economics of

the partnerships.

The validity and reasonableness of the

above assumptions, however, generally

were either not commented on in the

promotional material, or the individuals

involved commented evasively to the

effect that the assumptions "appear to be

reasonable", without giving specific

opinions as to whether the assumptions

were reasonable. Even where statements

of the of “apparent reasonableness" of

47

stated assumptions were made, the

individuals making such qualified

statements did not have the background or

qualifications to do so.

The failure of many of the individuals

who (on behalf of the partnerships)

opined on aspects of the EOR technology

license and lease agreements to expressly

and clearly address the reasonableness of

the assumptions on which their opinions

were based, and in many cases their lack

of experience to do so, renders their

opinions of little value and causes their

opinions to constitute little more than

mathematical calculations based on the

stated assumptions. Examples of such

opinions (based on assumptions and

therefore constituting little more than

mathematical computations) are found in

trial Exhibits 25 (part G), 1021, 1022,

48

and 1304. At least one of petitioners’

witnesses who authored such a

"non-opinion"” acknowledged at trial that

the word "assumption" was intentionally

used in his report because he did not

have enough data to make professional

estimates.

A significant number of the

individuals who opined on the legal,

economic, and technical aspects of the

partnerships’ activities received

compensation for their services based on

the number of partnership units sold, a

compensation arrangement inconsistent

with their professed position as

independent experts. Some of the same

individuals also invested in the

partnerships, and some actually sold

interests in the partnerships for

commissions, further undermining their

49

independence from the partnerships.

Effective January 1, 1981,

Technology-1980 and 15 other Manhattan

Partnerships formed a joint venture which

pooled the tar sands leases of all 16

partnerships, and the joint venture

interests of all of the partnerships were

then managed by GEDCO.

The partnerships hired William

Kirkwood, who had experience in drilling

on tar sands properties, to conduct

drilling operations on the tar sands

properties in connection with efforts to

establish EOR technology pilot projects

on the properties. Under Mr. Kirkwood’s

supervision and with the assistance of

Dr. Todd Doscher, a specialist in steam

injection technology, a test well was

drilled on the Burnt Hollow property of

the partnerships and a modularized steam

50

injection system was installed. The

initial test results did not produce

commercial quantities of oil, and the

pilot project was eventually suspended.

Of the total cash contributions

received by the Manhattan Partnerships

from limited partners, excessive amounts

thereof were paid to various promoters,

lawyers, accountants, and salesmen

working for or on behalf of Elektra, and

little was available for the development

of EOR technology. Expenses that were

paid apparently relating just to the

formation and organization of the

Manhattan Partnerships totaled

$1,806,672.

Basile received $500,000. Basile’s

wholly owned corporation and employees

thereof directly or indirectly received

an additional $750,000. An accounting

51

firm which performed no services for the

partnerships received $36,963.

Two law firms received $1,940,123 for

agreeing to defend, in subsequent years,

tax benefits that were to be claimed in

connection with the limited partnership

investments. The law firms later reneged

on their commitments but never returned

any portion of the $1,940,123.

An attorney who assisted in the

preparation of the offering memorandum,

who secured title opinions on property

leased from TexOil, and who sold

interests in the partnerships, received

$1,210,117. The amount of some of the

legal fees paid by the partnerships was

based not on legal services rendered but

rather on the number of partnership units

sold. Various salesmen received a total

of $5,152,615 in connection with the sale

52

aaa

of limited partnership units in the

Manhattan Partnerships.

Barton Enhanced Oi] Production

income Fund

Barton is one of three similar TEFRA

limited partnerships that constitute the

Wichita Partnerships that were formed in

1982. The corporate general partner of

Barton was American Excel, Inc. (American

Excel), a Utah corporation. In 1984,

American Excel resigned and was replaced

by Energy Associates, Inc. (Energy

Associates), a Kansas corporation.

Prior to the formation of Barton in

late 1982 and before agreeing to become

the individual general partner of Barton,

Krause, who had significant experience in

selling tax shelters, undertook to study

the oil and gas industry and EOR

technology.

The stated business plan of the

Wichita Partnerships that were formed in

1982 was as follows: (1) To purchase and

operate working interests in producing

oil and gas properties for recovery of

oil and natural gas using primary and

secondary recovery methods (the drilling

program); (2) to license and apply EOR

technology to establish pilot projects on

the above properties (the EOR technology

program); and (3) to fund continued

research and development of EOR

technology, and -- as the value of the

EOR technology increases -- to sublicense

or distribute the EOR technology to third

parties in certain specified geographic

areas for sublicense fees (the

distributorship program).

Oil price projections that were the

basis for certain financial analysis

54

relating to the Wichita Partnerships

used, among other things, price

projections set forth in the DOE’s 1980

report which -- by late 1981 and

certainly by the time Barton and the

other Wichita Partnerships were formed in

late 1982 were of questionable validity

due to the decline that had occurred by

that time in world oil prices.

In 1982, 27 limited partners purchased

a total of 50 limited partnership units

in Barton. The subscription fee for each

limited partnership unit was $34,400,

with $14,800 of each subscription fee

payable partly in cash and partly with

purportedly recourse 11.5-percent

short-term promissory notes as follows:

55

Cash Promissory Note _ Due Date

$5,000 == On subscription

=< $5,000 June 15, 1983

= 1,600 June 15, 1984

o- 1,600 June 15, 1985

-- 1,600 June 15, 1986

The $19,600 balance of each limited

partner’s subscription fee per

partnership unit that was not reflected

by the above cash and short-term

promissory notes was stated to be due in

15 years on September 30, 1997. No

written promissory notes were executed in

connection with this $19,600 balance of

the subscription fee.

As stated, under the limited

partnership agreement, Barton was

required to retain a specific percentage

of its cash flow and to reinvest the

retained cash flow in Barton. Reinvested

funds were to be treated as additional

capital contributions made by the limited

56

-

partners and thereby would operate to

reduce the limited partners’ debt

obligations under the subscription

agreements.

When Barton was first formed, Barton

did not acquire rights to any oil and gas

producing properties. Rather, Barton

contracted with Midco Drilling, Inc.

(Midco), to acquire on behalf of Barton

working interests in oil and gas

producing properties and to operate the

working interests. As compensation for

acquiring working interests for Barton,

Barton was to pay Midco a 5-percent

commission on the purchase price of the

working interests. The compensation

Midco was to receive for operating the

working interests on behalf of Barton is

not in the record.

Barton agreed to spend at least 25

S7

percent of the initial cash contributions

received from limited partners on the

acquisition of oil and gas properties.

As part of its EOR technology program,

and even though Barton did not then have

any lease rights with respect to any

particular property on which the

technology could be applied, Barton

obtained from Hemisphere Licensing Corp.

(Hemisphere), a Texas corporation and the

successor corporation to Elektra, a

license for the use of, and

distributorship rights to, a purported

"portfolio" of EOR technology. The

amount of the fees to be paid by Barton

to Hemisphere in exchange for the license

of the EOR technology portfolio was based

on the number of limited partnership

units sold. The license was to have a

term of 25 years.

58

Hemisphere’s sole shareholder was

Petrotec Systems, A.G., a Swiss

corporation owned by a series of

offshore, tax haven entities, the

ultimate ownership of which could not be

explained by any of petitioners’

witnesses and which is not established in

the record.

The portfolio of EOR technology

licensed by Hemisphere to Barton (and the

other Wichita Partnerships) contained

essentially the same EOR technology as

that licensed by Elektra to

Technology-1980 (and the other Manhattan

Partnerships), but it also contained

additional purported E£oR technology not

specifically mentioned in the license to

the Manhattan Partnerships.

The license fees were structured to

provide substantial tax write-offs to the

59

investors. Barton’s offering memorandum

represented that investors would receive

tax write-offs of 3 to 1 in the first and

second years, and 2 to 1 in the third,

fourth, and fifth years of their

investments in the partnerships.

With certain adjustments described

below, in consideration for the- license

agreement with Hemisphere regarding the

EOR technology (which included the

distribution and extended distribution

rights), Barton agreed to pay Hemisphere

license fees of $8,500 per partnership

unit per year. Barton’s obligation for

the license fees was not based on, nor

was it dependent on the realization of

any income attributable to the use or

application of the EOR technology, and

the fees were not established by

arm’s-length negotiations.

60

For each of the years 1982 through

1986, payment by Barton of the $8,500

annual EOR technology license fees due

with respect to each partnership unit was

to be made partly in cash and partly

with 12-percent promissory notes as

follows:

(SEE TABLE FIVE}

Minimum installment payments were due

on each of the promissory notes

outstanding with respect to each

partnership unit as follows:

Amount Per Unit Due Dates

$2,000 September 30, 1993

4,000 September 30, 1994

6,000 September 30, 1995

11,000 September 30, 1996

19,600 September 30, 1997

Otherwise, the only payments due on the

above promissory notes prior to the

61

maturity dates of the notes were

triggered by the cash flow of the

partnerships.

The total amount of all of the

promissory notes to be issued by Barton

was $4,550,000. Barton, however, only

executed promissory notes totaling

$1,580,500.

Other Wichita Partnerships, for a

license to use the same EOR technology on

other property, were to issue, promissory

notes to Hemisphere in total amounts as

high as $64 million.

The amount of Barton’s debt

obligations to Hemisphere with respect to

which each of the limited partners

purportedly assumed personal liability

was $19,600 (which $19,600 corresponds in

amount to the portion of each partner’s

total liability under his or her

62

subscription agreement with Barton that

was not reflected by promissory notes).

Each limited partner’s $19,600 liability,

however, was not effective immediately.

The schedule below reflects the dates on

which the limited partners’ liabilities

on Barton’s debt obligations to

Hemisphere were to become effective:

Amount of Effective Date

Liability 2 -

$5,000 On subscription

5,000 July 1, 1983

3,200 July 1, 1984

3,200 July 1, 1985

3,200 July 1, 1986

Total $19,600

In the event Barton fails to make the

payments due within 60 days, Hemisphere

has the right either to declare the full

principal amount of the outstanding notes

due and payable and to initiate

collection proceedings directly against

63

each limited partner who has not made the

required contributions, or to foreclose

on the limited partner’s interest in the

partnership.

Barton and Hemisphere entered into a

security agreement to secure Barton’s

debt obligations to Hemisphere.

Hemisphere, however, did not file the

security agreement with the appropriate

governmental entities to perfect its

interest therein.

At the end of any calendar year,

Barton could terminate without cause the

license agreement with Hemisphere by

giving Hemisphere 90 days’ written

notice. If Barton terminated the license

agreement, the balance due on Barton’s

promissory notes and other debt

obligations to Hemisphere would be

extinguished except for that portion of

64

ain eens!

such obligations that had come into

existence prior to the date of

termination.

The license agreement entered into

between Hemisphere and Barton (and the

other Wichita Partnerships) was not

signed by anyone with authority to sign

on behalf of Hemisphere. The license

agreement purported to give Barton (and

the other Wichita Partnerships) the right

to use for 25 years the EOR technology on

property in which the partnerships were

to lease working interests, and the right

to sublicense the EOR technology as

described below.

Krause, as general partner, did not

attempt to determine the fair market

value of the EOR technology, nor of the

license agreements. Krause did not

retain an independent expert to advise

65

wr

him with regard thereto. Rather, Krause

relied primarily on persons affiliated

with Hemisphere who had significant

conflicts of interest with the

partnerships. Further, Krause did not

corroborate or document that

Barton.actually received legal transfer

of the rights to any EOR technology.

A joint marketing organization was to

be established between Barton and

Hemisphere to distribute or sublicense

EOR technology in territories located

proximate to Barton’s territories.

Generally, Barton was entitled to receive

a percentage of any royalties actually

received by Hemisphere with respect to

such sublicenses. It is particularly

significant that under any such

sublicenses that would be established,

Hemisphere and Barton were to receive

66

payments from the sublicensees based not

on any fixed fee schedule, but rather

only on running royalties on incremental

increased oil production attributable to

the EOR technology. As indicated, the

fees due from Barton to Hemisphere siene

not contingent upon the success of the

distribution program. Barton (and the

other Wichita Partnerships) relinquished

to Hemisphere all control over the

marketing program.?

As part of Barton’s stated business

*Under an extended distribution

agreement, Barton had the exclusive right

to distribute or sublicense the FOR

technology within four miles of the

boundaries of any of the other properties

in which it acquired working, interests,

plus the nonexclusive right to distribute

or sublicense any of the EOR technology

in California, Colorado, Illinois,

Kansas, Ohio, Oklahoma, Pennsylvania,

Texas, Wyoming, Utah, and the Province of

Alberta, Canada.

67

plan, working developmental oil and gas

interests were acquired on behalf of the

Wichita Partnerships in producing oil and

gas properties in the Parker Field in

Pennsylvania, in the Illinois Basin in

Illinois, in the West Peck Prue Sand Unit

and in the Centerview Property in

Oklahoma, and in the Sunburst Field in

Montana.

The Parker Field had been producing

over 60 years and was one of the oldest

oil fields still in production in the

United States. It has been described as

"the antiquity of the oil industry * * *

The most ancient, crude, primary

mechanism of producing oil in probably

the most rundown dilapidated condition."

The Parker Field is 99 percent depleted.

As of December 31, 1981, no successful

EOR project had been conducted on the

68

Parker Field.

Despite its age and the extent to

which oil had already been produced from

the Parker Field, it was represented to

investors in the partnerships that the

field was a "virgin field". Acreage was

assigned to the various partnerships

based on the number of limited

partnership units sold and on the assumed

oil in place.

Although charges were billed as early

as 1981 to the Wichita Partnerships with

respect to the lease of property in the

Parker Field, no acreage within the

Parker Field was assigned to the specific

Wichita Partnerships until October of

1983, and the assignment documents were

then backdated to 1981.

The lease payments agreed to by the

Wichita Partnerships with regard to the

69

property leased in the Parker Field were

in excess of fair market lease rates.

One of the properties. eventually

assigned to Barton under the license of

EOR technology from Hemisphere was

located within one-half mile of the Kern

River Field in Southern California, one

of the five highest oil producing fields

in the continental United States.

Because of the proximity of this

partnership property to the Kern River

Field, the Kern River Field or a portion

thereof was itself within the exclusive

sublicensing or distribution territory of

Barton. As of 1982, however, no

successful EOR project had been tested in

the Kern River Field.

During 1983 and 1984, Petroleum

Sciences, Inc., and others on behalf of

the Wichita Partnerships, performed some

70

field tests and studies of some of the

EOR technology on properties in which the

partnerships had purchased working

interests. The Parker Field was studied

for its suitability for use of the slim

hole drill technology and of steam

stripping technology.

A test of certain microbial enhanced

oil recovery (MEOR) technology was

conducted on the Illinois Basin property.

Use of the carboxymethylated surfactant

technology was studied on the Centerview,

Oklahoma, field. A polymer pilot was

conducted on the West Peck Prue Sand Unit

in Oklahoma.

A number of studies were conducted by

others unrelated to the partnerships of

the biosurfactant and emulsion blocking

technology on the West Peck Prue Sand

Unit in Oklahoma and the Kern River Unit

71

in California.

With regard to the research and

development aspect of Barton’s stated

business plan, Krause negotiated with

Hemisphere a requirement that Hemisphere

would use a portion of the funds received

from the EOR license fees to fund

continuing research and development on

EOR technology. Krause obtained a

commitment from Hemisphere for Hemisphere

to invest in EOR research and development

over the subsequent 25 years a minimum of

$25 million and a maximum of $100

million. Further, Krause negotiated with

Hemisphere that at least one-half of the

research and development on EOR

technology that was to be conducted on

behalf of Hemisphere by Petroleum

Sciences, Inc., was to directly relate to

the use of EOR technology on properties

72

in which Barton owned working interests.

With regard to the EOR research and

development that Barton (and the other

Wichita Partnerships) were to pay for,

such research was to be conducted by

third parties. Barton was to have no

authority to conduct, direct, or control

the research and development, nor was

Barton to acquire any ownership interest

in any EOR technology that might be

established as a result of the research

and development.

With regard to the marketing and

distribution of EOR technology, Barton

relinquished all control to Hemisphere.

In 1983, Krause renegotiated the price

the Wichita Partnerships were to pay with

regard to the original oil production

rights they acquired in the Parker Field.

In 1986, Barton (and the other Wichita

73

Partnerships) and Hemisphere amended the

EOR technology license agreement and

reduced the annual EOR license fee owed

by Barton for 1987 and thereafter to a

total of $5,000 per year.

EOR Technology

In general, in the late 1970s and

early 1980s, EOR technology and the use

thereof was a relatively new but exciting

development in the oil industry.°

Certain limited EOR technology had

3Some of the significant publications

prior to 1980 that had been written about

EOR technology are the following:

Interstate Compact Commission,

Secondary and Tertiary Oil Recovery

Processes (1974).

The National Petroleum Council,

Enhanced Oil Recovery (1976).

U.S. Congress, Office of Technology

Assessment; Enhanced Oil Recovery

Potential in the United States

(1978).

74

been developed and was available from a

number of companies before and during the

years in issue. For example, directional

drilling, under-reaming, steam flooding,

fire flooding, foam blocking, solvent

flooding, gravity drainage, and RF

heating constituted EOR technology that

to a certain extent, had been developed,

and such EOR technology was available

from suppliers other than Elektra.

EOR technology is known to be site

specific (i.e., one type of EOR

technology may work well on one property

but not at all on another property) and

for that reason the probable or likely

usefulness and value of particular EOR

technology on particular property can

only be determined by elaborate,

expensive, and time consuming tests and

experimentation. For this reason, the

75

acquisition of a "portfolio" of EOR

technology for use on particular

properties typically does not occur in

the oil industry. Rights to use

particular EOR technology are generally

acquired only after the par*icular

technology is tested on the property, and

then rights are acquired only to the

particular EOR technology, if any, that

has tested successfully on the property.

The offering memorandum of

Technology-1980 described four types of

EOR technology that purportedly were

covered by the license with Elektra: (1)

TEC; (2) Carmel VaporTherm (Carmel); (3)

ElektraFlo; and (4) SME Oil Drive. The

offering memorandum inaccurately suggests

that the above EOR technology, in

general, was existing, developed

technology. In 1979, 1980, 1981, and

76

1982, however, only the TEC and the

Carmel processes were developed to any

significant extent.

Both the TEC and the Carmel technology

were available in the market place to the

partnerships directly from the companies

that had invented those processes for a

running royalty based on incremental

increased production (similar to the

royalties Elektra agreed to pay for the

technology). In general, for the right

to use and sublicense the TEC technology,

Elektra had agreed to pay The

Electrothermic Co. and Carmel Energy

Corp. only a 7.5 percent running royalty

on incremental oil production

attributable thereto. Elektra had no

obligation to pay fixed fees for the use

of either the TEC or the Carmel

technology.

77

As described in the offering

memorandum of Technology-1980, the TEC

technology was a process of carrying an

electrical current down an oil well

casing and into an oil reservoir where

the electrical current disperses into the

oil reservoir and heats “most heavy oils

to a temperature where they will flow

freely for less than $2 per barrel". In

fact, the TEC technology, developed by

The Electrothermic Co., does not increase

the overall recovery of oil from a

reservoir. Rather, by heating the oil in

a reservoir proximate to the well bore

opening, the TEC technology simply

increases the speed or flow of oil into

the well.

As of 1980, the TEC technology had

been field tested in Kansas and Texas,

and six patents had been obtained with

78

respect to the TEC technology. But prior

to the time Elektra and the Manhattan

Partnerships entered into their license

agreements with respect to TEC

technology, the TEC technology had not

been tested on the Utah or Wyoming tar

sands properties leased by the Manhattan

Partnerships. The Technology-1980

offering memorandum inaccurately

suggested that the TEC technology, as of

May 31, 1980, had advanced beyond the |

test stage and that it was being used for

commercial exploitation of oil.

The license Elektra obtained from The

Electrothermic Co. for use of the TEC

technology was not exclusive, and owners

of working interests in oil producing

properties could have licensed the TEC

technology directly from The

Electrothermic Co. if the TEC technology

79

turned out to be a viable process on tar

sands properties.

As described in the Technology-1980

offering memorandum, the Carmel

technology was a process for injecting

steam and high combustion gases into oil

reservoirs in order to increase the

pressure within the reservoirs and to

thereby reduce the viscosity of the oil

and to increase the overall recovery of

oil from the reservoirs. The Carmel

technology was an existing technology,

and it or similar steam injection

processes were available from a number of

companies.

The Carmel technology required

substantial amounts of water which was

not available at the tar sands properties

of the Manhattan Partnerships without

incurring very substantial additional

80

costs. Earlier successful tests of the

Carmel technology had taken place on

properties in Kansas and Missouri, but

not on properties that were‘ comparable

to the partnerships’ tar sands properties

in Utah and Wyoming. Even though the

Utah tar sands properties had

characteristics different from midwestern

heavy oil properties, prior to the time

Elektra and the Manhattan Partnerships

obtained a license to use the technology,

the Carmel technology was not tested on

the Utah tar sands property.

The DOE was interested in the Carmel

technology, and had provided some of the

funding for the tests of this technology

in Kansas.

The purported ElektraFlo technology

‘As amended pursuant to Order dated March

31, 1993.

81

consisted of the use of a particular

combination of EOR technology (namely,

radio frequency heating to preheat the

solid oil, injection of steam into the

reservoir as a drive fluid, ibattinn of

solvents, fire flooding for heat and

drive energy, and gravity drainage). The

offering memorandum of Technology~-1980

inaccurately described the ElektraFlo

technology as an existing oil recovery

process involving --

the use of enlarged boreholes to enter

a formation. After such entry has

been made, long electrodes are

inserted in small diameter holes which

have been drilled radially from the

borehole into the formation so as to

create an area around the borehole

which can be heated in such a way as

82

to recover most of the oil within the

radius of the electrodes. During and

after this phase of the process, the

area within the radius of the

electrodes can be used to heat

injected water and solvents so as to

further reduce the viscosity of the

oil in the formation and create the

steam pressure necessary to recover

oil from the surrounding formation.

As the size of the sweep area

increases, additional production

boreholes may be drilled around the

primary borehole.

In fact, as of the late 1970s and }

early 1980s, the ElektraFlo process was

merely an idea or concept on which some

Swiss based companies were doing research

83

and had obtained a Swiss patent.* The

Technology-1980 offering memorandum

elsewhere did acknowledge that the

ElektraFlo technology had not been tested

anywhere in the world.

The offering memorandum of

Technology-1980 inaccurately suggested

that the SME Oil Drive technology

consisted of a developed existing system

or technology, as follows:

The SME Oil Drive System * * * is

designed to eliminate the need for the

heavy, expensive sucker rod pumping

systems that are presently operating

in most oil fields in the country.

°The ElektraFlo process was patented in

Switzerland in 1980. A U.S. patent was

applied for in 1981, and a U.S. patent

was issued for the ElektraFlo technology

in 1984.

84

The SME Oil Drive System is a compact,

energy efficient pumping system that

is lowered to the bottom of an oil

well. This system eliminates the need

for sucker rods and above ground

equipment. The unit, which acts as

the entire pump system, has no moving

parts, other than the pump piston; it

is entirely solid-state, and requires

little or no maintenance. The key

element in the SME Oil Drive System is

a Shape Memory Alloy. This alloy can

be bent or stretched, and then

restored to its original shape by

simply raising the temperature of the

alloy by approximately 50 F.

The SME Oil Drive is based on

utilizing the difference between the

force necessary to stretch the memory

alloy and the restoring force

85

generated by the alloy when it is

heated. The alloy cables of the pump

system are elongated with a

pre-stressed load while the cables are

cool. When the temperature of the

alloy is raised, it contracts to its

original length. This elongation and

contraction cycle drives the pump

mechanism. An additional benefit of

this pump system is that any excess

heat will be absorbed by the oil in

the down hole flow string, thereby

reducing the viscosity of the oil in

place.

In fact, the SME Oil-Drive had not

been tested anywhere. It was merely an

idea or untested concept of Neil Rogen,

president of Elektra, that was being

tested in a laboratory in the late 1970s

and early 1980s. Elektra obtained rights

86

to the SME Oil Drive technology from

Elektra’s president. These rights cost

Elektra $13.32 for each limited

partnership unit.

As indicated earlier herein, the

offering memorandum of Barton set forth

what it referred to as a "comprehensive

package" or "portfolio" of EOR technology

that purportedly was developed and was to

be licensed from Hemisphere. Described

as the "fundamental components" of the

portfolio were: (1) Biosurfactant

production technology; (2) application

systems for biosurfactants; (3) downhole

coal-fired steam generator; and (4)

blocking agents. The offering memorandum

of Barton described these components in

general, vague and misleading language,

in part, as follows (quoting from a

promotional document published by

Hemisphere and Petrotec Systems, A.G.):

(1) Bio-Surfactant Production. A

bio-surfactant will be selected to

match the particular reservoir in

which it is to be used. A bio-reactor

will be developed for the field

operator. In a continuous

fermentation process occurring in the

bio-reactor, the microbes will convert

lease crude oil (or molasses and

agricultural wastes) to powerful but

inexpensive surfactants. Metabolic

by-products will also include

co-surfactants (alcohols) that are

needed to maximize the effectiveness

of the surfactants.

5 * * * x x *

(2) Application Systems for

Bio-Surfactants. When liquid

surfactants are injected as a slug in

a conventional chemical flood they

tend to escape through high

permeability channels. The resulting

inefficiency can make the flood

uneconomical or even completely

ineffective.

In the Petrotec System, surfactants

are injected throughout the field in

aerosol form. The resulting

surfactant dispersion should improve

the efficiency of water, gas and steam

floods.

* * * * *

To increase the effectiveness of the

aerosol surfactant flood, numerous

small diameter injection holes are

required throughout the flooded area.

This need led to the development of a

Slim-hole drill by Maurer Engineering,

89

a leader in the field of specialty

drilling and completion techniques.

Initial tests on this drill have been

successful.

(3) Downhole Coal-Fired Steam

Generator. This system, designed by

Hemisphere, uses a wet air oxidation

process. This will allow coal costing

$1.50 per million BTUs to be used in

place of oil costing $6.00 per million

BTUs. The developmental engineering

will be in conjunction with Zimpro,

the world’s leading manufacturer of

wet air oxidation systems. The goal

is to reduce the cost of supplying

steam to heavy oil production zones

deeper than 2000 feet by 50 percent or

more as compared to conventional

systems.

(4) Blocking Agents. Hemisphere is

90

developing a blocking cement that will

seal the high permeability channels

through which sweep gases and steam

tend to escape. This "override"

effect can result in leaving up to 70

percent of the oil ina reservoir

after the steam drive has to be shut

down. If the "overriding" can be

prevented and the sweep gas or steam

forced through oil saturated zones,

the economics of steam and gas

recovery systems can be greatly

improved.

Most of the above purported EOR

technology, however, was undeveloped,

untested, or still being tested, and in

1982, of very speculative usefulness and

value, and the offering memoranda and

promotional material used by Hemisphere

and the Wichita Partnerships exaggerated

91

the development of the technology and

obfuscated the speculative value thereof.

A few examples from one of the

promotional brochures (entitled "The

Hemisphere Technology Portfolio" dated

September 15, 1982) of this exaggeration

of the development of the EOR technology

are illustrative. MEOR technology is

described as follows:

In recent years, the enormous

potential inherent in the use of

microbes for EOR purposes has been

acknowledged by an increasing number

of scientists and engineers. Microbes

come in an endless variety and have

the capacity to synthesize a wide

range of chemicals and gases that can

favorably enhance the recovery of oil.

The exploitation of this microbial

92

potential has resulted in the

development of a new category of EOR

technology, known as Microbial

Enhanced Oil Recovery (MEOR). This

technology promises to become a cost

effective means for overcoming the

reservoir problems of low pressure,

high surface tension, and high

viscosity.

MEOR is a field of technology in

which Hemisphere believes that it has

the potential to improve

substantially, if not revolutionize,

the techniques and economics of

enhanced oil recovery. This belief is

based upon the stated opinions of the

world-renowned microbiologists who are

directing its research, and upon the

laboratory test results that these

scientists have ilready achieved with

93

the proprietary MEOR processes

described in this Portfolio.

The status of thermal-shock assisted

drilling is described as follows:

To increase the efficiency of the

water-jet drill bit, Schalcher &

Partners of Zurich, in cooperation

with I.E.T., are designing, and intend

to develop, a system to heat the

formation immediately ahead of the bit

so as to take advantage of the shock

effect, resulting from the water

flowing from the water jets adjacent

to the preheated rock.

A primary goal of the water-jet

drill bit and thermal-shock assisted

drilling programs is to reduce the

axial thrust, which causes the need

for ever increasing power in

94

horizontal drilling, as the drill

moves further into the bore. (In

horizontal drilling, drill stem and

pipe weight works against the driller,

instead of for him, as in conventional

vertical drilling.) If thrust is

reduced, more of the driving power is

applied to the drill bit; the strength

requirement (and the weight and cost)

of the drill stem is reduced and

directional control is more easily and

accurately accomplished.

The status of exploding wire assisted

drilling technology is described as

follows:

This invention is a hard-rock drill

bit that simultaneously fractures and

drills by generating shock waves using

a high energy electrical discharge.

The design goals are a doubling of

drilling rates and a 75 percent

reduction in hard rock drilling costs.

Laboratory tests have demonstrated

feasibility and the effort is well

into the preliminary drill bit design

phase. * * *

In light of the largely speculative,

undeveloped, and untested nature of most

of the EOR technology licensed to the

Manhattan and Wichita Partnerships, it

can only be concluded, as we do, that the

offering memoranda and promotional

material of both Technology-1980 and of

Barton were misleading and less than

candid in the overly optimistic manner by

which they described the EOR technology

to be licensed by the partnerships. No

96

EN IT PN IL a NE ee ae a

ae

Rayan gen

ESRC RM HE HEME Set

iGo ed LEAT BAR a A tar

110k ORR NEA ARE KIS NS lew Klar a

adequate explanation is found anywhere in

the record in this case to justify how

Elektra and Hemisphere and the "experts"

who associated themselves with Elektra

and Hemisphere could have been so

optimistic about the value of the EOR

technology licensed to the partnerships.

By 1981, some additional potential EOR

concepts or ideas had been identified,

but they had not reached any stage of

development. Some potential additional

EOR technology was in the process of

being experimented with. Only one

additional EOR technology -- namely, the

slim hole drill -- ever reached the

developmental stage.

Many of the undeveloped EOR concepts,

as conceived and if ever developed, would

be dependent upon successful development

of other undeveloped EOR concepts.

97

During the 2 months from September 3,

1979, through November 1, 1979, the

purported ElektraFlo technology, along

with other purported but undeveloped EOR

technology, was transferred or sold a

number of times between various

individuals and entities who were

involved in the early stages of the

formation of the Manhattan and Wichita

Partnerships. Those transactions

involving the eventual transfer to

Elektra of the EOR technology included in

the license to the Manhattan Partnerships

are summarized below:

[SEE TABLE SIX]

Werner Heim (Heim) could not remember

how the price for the rights to the

ElektraFlo and other purported EOR

technology increased in value from

$170,000 to $10 million in just 1 month.

98

PM D2 Be ge RP

atid Taras

big’) Coy ge eaatete iG exe

oily

2a E SER ARR ORAS A ARN HEMEL IGA MOEN SE UNOS TEI

OME SIEM PALA INE NATTA BSR OBOE A AS LS GOONIES

Heim stated:

It’s hard to explain, but it was done

like that [by the lawyers who) formed

this company, and they prepared all

these documents * * *. I think that

must have been for tax reasons that

the lawyers did put the $10 million

dollars down for further tax

consequences.

Three transactions occurring on

November 1, 1981, leading to the transfer

of EOR technology to Hemisphere are

summarized below:

{SEE TABLE SEVEN)

No apparent consideration was

associated with the November 1, 1981,

transfer from Heim to Shalelectric, S.A.

But on the same day, Shalelectric

transferred the EOR technology to

Columbus Valley for a stated $10 million.

Heim could not explain how the $10

million figure was arrived at other than

to explain that it was "done by the

lawyers".

99

spe Pe I gn Oe EE) Sa eS EO EE LEE POT CAE Se ES PEE Ee Ly

As indicated in the above two

schedules with regard to the November i,

1979, transfer from Mardyn, N.V. to

Elektra, and the November 1, 1981,

transfer from Columbus Valley to

Hemisphere, no fixed consideration or fee

of any kind was to be paid. All payments

or consideration for the EOR technology

that were due from Elektra and Hemisphere

were contingent on the "installation" of

the EOR technology on oil and/or gas

producing properties and on income

attributable to the use of the

technology. Because none of the relevant

EOR technology was ever installed,

neither Elektra nor Hemisphere was ever

obligated to pay Mardyn, N.V., or

Columbus Valley anything with regard to

the EOR technology.

No income was realized by

100

Technology-1980 or by Barton (or by any

of the other Manhattan and Wichita

partnerships) from the EOR technology.

None of the rights to the EOR

technology that Technology-1980, Barton,

and the other Manhattan and Wichita

Partnerships acquired had any significant

value. Further, the fair market value of

the EOR technology licenses which

Technology-1980 and Barton acquired and

for which they agreed to pay millions of

dollars had no significant economic

value.

Other Matters

Petitioner R.A. Hildebrand is a

geological and mining engineer and has

worked for Union Carbide on research and

development relating to the recovery of

oil and natural gas through secondary

recovery methods. Hildebrand reviewed

101

the offering memorandum and the various

reports and analysis attached to the

offering memorandun.

Hildebrand and two associates hired an

independent geologic engineer to review

Technology-1980’s offering material.

After the above review and after

discussing the proposed investment with

his tax accountant who recommended the

investment, Hildebrand invested in

Technology-1980.

Krause, in 1981, invested in Barton and

agreed to be a general partner of Barton

only after significant investigation and

review of the proposed investment. He

familiarized himself with existing EOR

technology and with various ongoing

research relating to the development of

new EOR technology. He read various

industry and government reports

102

concerning EOR technology. He was

instrumental in negotiating a number of

the provisions of the Wichita

Partnerships that are different from

those of the earlier Manhattan

Partnerships and that are more favorable

to the partnerships. |

The following receipts, expenses, and

losses were reported by Technology~-1980

on its Federal income tax returns for

1980 through 1984:

[SEE TABLE EIGHT]

Of the total cumulative losses of

$23,016,260 claimed by Technology-1980

for 1983 and 1984, $16,708,500 related to

the license fees due Elektra and the

minimum annual royalties due Hemisphere,

and the remaining $6,307,760 related to

interest accrued on the notes to Elektra

and TexOil and other miscellaneous

103

expenses.

Revenue or income earned by Barton (and

the other Wichita Partnerships) was

minimal. The following receipts,

expenses, and losses were reported by

Barton on its Federal income tax returns

for 1982 and 1983.

[SEE TABLE NINE]

Of the total cumulative $1,005,493 in

losses claimed by Barton in 1982 and

1983, $907,992 related to the license

fees owed to Hemisphere.

After license fees, marketing fees, and

lease obligations were paid, only 6

percent of Technology-1980’s and none of

Barton’s cash received from investors was

left for working capital.

In notices of deficiency issued to

petitioners R.A. Hildebrand and Dorothy

L. Hildebrand-Wahl, respondent disallowed

104

the net losses claimed on petitioners’

1980, 1981, and 1982 individual Federal

income tax returns arising from the

annual license fees owed by

Technology-1980 to Elektra, the minimum

annual royalties owed by Technology~-1980

} to TexOil, and the accrued interest and

| other expenses claimed by

Technology~-1980.

Respondent issued a timely FPAA to

petitioner Krause, as the tax matters

partner of Barton. In the FPAA,

respondent made adjustments to the 1982

and 1983 Federal partnership tax returns

of Barton disallowing the net losses

claimed by Barton arising from the annual

license fees owed by Barton to Hemisphere

and from the accrued interest and other

expenses claimed by Barton.

105

ae

OPINION

In general, the net losses of

Technology-1980 and of Barton are not

deductible unless the activities of the

partnerships were engaged in with actual

and honest profit objectives. Nickeson

v. Commissioner, 962 F.2d 973 (10th Cir.

1992), affg. Brock v. Commissioner, T.C.

Memo. 1989-641; Karr v. Commissioner, 924

F.2d 1018, 1023 (llth Cir. 1991), affg.

91 T.C. 733 (1988); Dreicer v.

Commissioner, 78 T.C. 642, 644-645

(1982), affd. without opinion 702.F.2d

1205 (D.C. Cir. 1983).

Whether activities of partnerships were

engaged in with actual and honest profit

objectives is analyzed at the partnership

level. Antonides v. Commissioner, 91

T.C. 686, 694-695 (1988) (Court

reviewed), affd. 893 F.2d 656 (4th Cir.

106

A

i

E

v

&

b

a

y

|

:

f

i

.

BR RONEN PROTEC! RU amt aptRe I BS

1990); Siege]_v. Commissioner, 78 T.C.

659, 699 (1982); Branness v.

Commissioner, 78 T.C. 471, 505 (1982),

affd. 722 F.2d 695 (llth Cir. 1984).

The factors set out in the Treasury

Regulations under section 183 generally

are utilized in determining whether the

requisite profit objectives are present

under section 162, section 174, and other

Internal Revenue Code sections. Sec.

1.183-2(b), Income Tax Regs. See also

Cannon v. Commissioner, 949 F.2d 345,

347-351 (10th Cir. 1991), affg. T.C.

Memo. 1990-148; Independent Elec.

Supply, Inc, v. Commissioner, 781 F.2d

724, 726-727 (9th Cir. 1986), affg. _Lahr

v. Commissioner, T.C. Memo. 1984-472

(deductibility determined under secs.

162, 167, and 174); Brannen v.

Commissioner, supra at 704 (deductibility

107

determined under sec. 183). Those

factors, however, are not exclusive, and

all of the unique and relevant factors

and circumstances of the particular

investments at issve are to be

considered. Nickeson v. Commissioner,

supra at 977.

Factors particularly relevant in cases

involving new or undeveloped technology,

and particularly relevant to our analysis

of the profit objective issue in this

case are the following: (1) Heavy

promotion and marketing on the basis of

projected tax benefits and inaccurate

information regarding the EOR technoloyy

(see, e.g., Karr v. Commissioner, supra

at 1023; Independent Elec. Supply. Inc.

vy. Commissioner, supra at 727); and (2)

the financial structure of the fees and

royalties that the partnerships agreed to

108

pay (see, e.g., Karr vy. Commissioner, at

1024; Polakof v. Commissioner, 820 F.2d

321; 324 (9th Cir. 1987) affg. per curiam

T.C. Memo. 1985-197).

Taking into account the factors set out

in section 1.183(b) (2), Income Tax Regs.,

the gactore emphasized above, and the

extensive testimony of the key

participants in these transactions and of

the many other witnesses in this case, we

conclude that the activities of

Technology~1980 and of Barton were not

engaged in with actual and honest profit

objectives. The stated consideration

agreed to by the partnerships for the

license of EOR technology and for the

lease of tar sands properties bore no

relation to the value of that which was

acquired, did not conform to industry

norms, and precluded any realistic

109

opportunity for profit. Independent

Elec, Supply, Inc, v. Commissioner, supra

at 727-728; West v. Commissioner, 88 T.C.

152, 160-161 (1987).

In spite of the fact that a portion of

the purported EOR technology licensed by

the partnerships in this case might have

reached some stage of development by the

years in issue (and that additional EOR

technology might in subsequent years be

developed and become valuable), the

estimates used by the partnerships for

projected oil recovery from the use and

application of the EOR technology

licensed by the partnerships are not

supported by credible expert testimony in

this case and were not reasonable.

The use by petitioners’ experts of

projections of tar sands hydrocarbons or

of oil in place, rather than projections

110

of oil reserves, and the failure to take

sufficiently into account in their

projections the undeveloped, untested

status of the EOR technology

significantly flaws the projections used

by petitioners’ experts. Tallal v.

Commissioner, T.C. Memo. 1984-486, affd.

778 F.2d 275 (5th Cir. 1985).

Projections based on oil reserves and

realistic projected oil recovery

therefrom using known and developed EOR

technology would have provided a much

more realistic basis on which to base the

fees in question and a legitimate,

acceptable business plan.

The economic projections of

Technology-1980 and of Barton, upon which

the investments allegedly were based,

reflect a series of assumptions and

conditions which were acknowledged to be

111

= - = . _ — -

ee ee ee ee eT, a) a a, oe ee ee SN ee ees any Se eee eee eer a eee

assumptions in the offering memoranda and

other material. The validity and

reasonableness of those assumptions,

however, were never ascertained, nor was

any meaningful or credible comment or

opinion as to the validity and

reasonableness of those assumptions set

forth in the offering memoranda or other

material.

The economic assumptions made in the

partnerships’ promotional material

apparently did not even take into account

or note the abnormal nature and high cost

of the license fees and royalties, nor

the significant costs of conducting tests

and of establishing commercial operations

using EOR technology.

Petitioners argue that the amount of

the license fees due from Technology-1980

was not based on the number of

112

partnership units sold, as respondent

contends and as we have found, but rather

that the amount of the license fees was

based on the total available barrels of

oil in place projected to exist on the

various properties and that there were to

be 200,000 barrels of oil in place on the

leased tar sands properties for each

partnership unit sold. Petitioners may

be correct that, in making initial

calculations of the amount at which the

technology license fees might be set,

certain projections were made of the

amount of hydrocarbon deposits or of the

total barrels of oil in place on the

properties leased by the partnerships and

that those projections were used in

estimating how much income conceivably

might be earned by the partnerships. In

actually structuring the license

113

agreements, however, the amount of the

license fee that was agreed to was not

_ made dependent upon the amount of

hydrocarbons or of oil in place on the

related properties, upon successful pilot

tests, upon the amount of oil recovered,

nor upon the income realized therefrom,

thereby undermining and eliminating, on

the facts of this case, any meaningful

connection that the amount of the fees

may originally have had to oil-in-place

projections, or to projections of oil

recovery.

With regard to the stated business plan

of Technology-1980, petitioners’ expert

witnesses rely on many of the erroneous

assumptions and projections reflected in

the partnerships’ offering memoranda.

Their projections of cash flow are based

on assumed production figures from the

114

Monroe, Louisiana, natural gas field as

set forth in the offering memorandun.

They make erroneous cost estimates in

concluding that the royalties Technology-

1980 reasonably would receive just from

the natural gas production on the

property leased from Glenda Petroleum

would be sufficient to pay the entire

license and royalty obligations due with

regard to the EOR technology and the tar

sands properties in Utah and Wyoming, and

still produce a reasonable rate of return

for the partnerships. Under the

agreement between the Manhattan

Partnerships and Glenda Petroleum,

however, an excessive number of wells was

to be drilled by Glenda in the Monroe,

Louisiana, natural gas field, and the

agreement did not reflect arm’s-length

terms. The projections of natural gas

115

production from the working interests in

the Monroe, Louisiana, natural gas field

were excessive.

One of petitioners’ expert witnesses

theorizes that it would take 10 years to

bring the tar sands properties into

commercial development using the

ElektraFlo technology, at which point in

time he speculates that the tar sands

property interests of the partnerships

would be sold to a major oil company for

a sale price of at least $30 million.

Another of petitioners’ expert witnesses

opines that the Barton business plan was

a reasonable investment with a high

income potential. He, however, bases his

report on inappropriate assumptions as to

the oil reserves on the property to be

leased by Barton, production levels

attributable to specific underdeveloped

116

EOR technology, and cash flows from joint

ventures that did not yet exist.

We found the testimony of respondent’s

expert witnesses concerning the EOR

technology and the structure and

reasonableness of the license fees and

royalties more credible. The fixed fees

to be paid by the partnerships for the

EOR technology licenses were not

competitive in the oil industry and were

contrary to industry norms. All but two

of the technologies were undeveloped,

untested processes for which no prudent

investor would pay any substantial fixed

fees, and the TEC and Carmel processes

that were developed likely could have

been licensed by the partnerships

directly from the inventors thereof for

running royalties based solely on income

realized therefron.

117

Petitioners’ expert witness regarding

the value of the EOR technology license

agreement with Elektra did not opine on

any specific or general dollar fair

market value thereof. The expert witness

admitted that the terms of the license

agreement were unreasonable but justified

in this case on the ground that the

unreasonableness of the license agreement

somehow could or should be overlooked

because of the large amount of money the

partnerships were assumed to make from

the natural gas drilling program in the

Monroe, Louisiana natural gas field.

This assumption, among other assumptions,

-is made in spite of the fact that the

original properties assigned to

Technology-1980° were outside the

‘As amended pursuant to Order dated

August 4, 1992.

118

producing area of the natural gas field

and were only exploratory in nature and

in spite of the fact that the terms of

the drilling agreement with Glenda

Petroleum were unfavorable to the

partnerships and not at arm’s length.

Petitioners did not offer an expert

witness regarding the fair market value

of the EOR technology licensed from

Hemisphere, nor did petitioners offer an

expert witness as to the reasonableness

of the license agreement with Hemisphere.

Rather, petitioners submitted the report

of the National Institute of Petroleum

Energy Research (NIPER) which merely

summarizes NIPER’s research with two

types of EOR technology and the status

generally of EOR technology in the early

1980s, and which provides very general

estimates of the amount of oil that might

119

some day be recoverable by someone

through the use of EOR technology.

The authors of the NIPER report

understood little concerning the terms of

the partnerships’ license agreements with

Elektra and Hemisphere, when the license

agreements were entered into, and what

technology was included. The NIPER

report relies significantly on data from

1980, even though the continuing

viability of that data in 1981 and

certainly by 1982 was questionable.

Petitioners argue that the business

plans of Barton and the other Wichita

Partnerships were carefully developed and

that the plans were unsuccessful only

because of the unexpected decline-in

world oil and gas prices. More

specifically regarding Barton,

petitioners argue that the amount of the

120

EOR license fees was based on the number

of barrels of oil that were projected to

be recovered using EOR technology from

the particular properties in which the

partnerships obtained working interests.

For example, petitioners note that under

Barton’s EOR license agreement the

properties to be acquired were to have

not more than 100,000 barrels of oil

resources in the ground per partnership

unit. Inexplicably, using this maximum

number of 100,000 barrels of oil, the

promoters of Barton then assumed a

20-percent oil recovery rate using EOR

technology, or a total of 20,000 barrels

of oil per partnership unit, spread

ratably over 10 years or 2,000 barrels of

oil a year. The EOR license fee for the

right to use the EOR technology acquired

by each partnership unit was then set at

121

a Ce

$2,000 each year or $1 a barrel of

projected oil in the ground. Petitioners

argue that the 20-percent recovery rate

was based on expert opinions, that it was

conservative and reasonable, and that $1

a barrel was "a bargain".

We disagree. The estimate of a

20-percent recovery rate using EOR

technology that had not been tested in

any significant manner on the particular

partnership properties was grossly

excessive. We believe that by making the

license fees due from the partnerships a

definite, fixed amount (that was due

independently of any successful test of

the technology in the properties and

independently of any income or oil

production from the properties using EOR

technology), the license fees were not

reasonable, nor realistic. The fixed,

122

a

definite nature of the license fees flies

in the face of the many assumptions and

risky, speculative projections on which

the stated business plans of the

partnerships were based.

If, as petitioners contend, the amount

of the license fees related so directly

to estimates of recoverable oil in the

properties leased by the partnerships and

to the utilization or projected

utilization of the EOR technology on

those properties (and not to the number

of partnership units sold), why was

accrual of the fees and the amount of the

fees not made dependent upon successful

pilot tests on the properties of the

technology and on actual income realized

therefrom or on incremental increased

production of oil attributable to the EOR

technology (as were the fees Elektra and

123

Hemisphere were to pay for the same

technology and as were the license fees

to be computed in connection with any

sublicenses of the technology by

Hemisphere or by the partnerships).

We reiterate that, with respect to the

Wichita Partnerships, the properties in

which the partnerships were to acquire

working interests were not required to

have "at least" 100,000 barrels of oil in

the ground (which is the basis on which

petitioners’ argument and computations on

this point seem to be made). Rather, the

properties were required to have no more

than, or not in excess of, 100,000

barrels of oil in the ground.

Petitioners’ argument and computations do

not take into account the possibility

that many of the working interests that

the Wichita Partnerships might have

124

acquired under this provision could have

had much less than 166,000 barrels of

estimated oil in the ground and still

would have been in compliance with the

provisions of the partnership’s business

plan.

A significant additional flaw in the

projections used by the promoters of both

the Manhattan and Wichita Partnerships,

in the analyses used by petitioners’

expert witnesses, and in petitioners’

arguments herein, is that world oil

prices would continue increasing from

1979 and 1980 prices on a continuing

upward spiral for the next 20 years.

With regard to price projections in the

1980 DOE report, we agree with and

reiterate what has already been said:

The 1980 Department of Energy Report

was based on mid-1979 and earlier price

figures and was prepared during the

world energy crisis of the late 1970’s.

That crisis was produced mainly by the

Iranian Revolution and the related oil

embargo. Ina sense, the report

presented a worst-case scenario as of

the period when it was in preparation.

The difference between the mid-1979 and

the nominal dollar figures shown in the

above table [set forth herein supra at

page 5] demonstrates the rapidly

escalating inflation rate during the

late 1970’s which, by 1981 and 1982,

was already being dealt with by the

Federal Reserve Board and other

Government agencies. The report was

neither used by, nor intended to be

used by, businessmen as a basis for

business decisions. [Ferrell v.

Commissioner, 90 T.C. 1154, 1194-1195

Pe ee

(1988) .]

In support of the value of the EOR

technology licenses and the amount of the

license fees and royalties, petitioners

refer to a transaction in early 1981 by

which the Manhattan Partnerships entered

into a type of joint venture agreement

with Pogo Producing Co., Inc. (Pogo), a

publicly traded company, to conduct test

drilling operations on the Burnt Hollow

tar sands property. Pogo agreed to pay

approximately $1.73 million in connection |

with test wells to be drilled on the

Burnt Hollow property in return for a

5-percent undivided interest in the

profits from the GEDCO heavy oil joint

venture project on the Burnt Hollow

property. No representative, however, of

Pogo testified at trial, and we know too

little about this transaction to give it

any credence in considering the value of

the EOR technology licenses.

In support of their argument that the

partnerships’ investments were

reasonable, petitioners also rely on

certain testimony in this case regarding

a number of other apparently large and

risky investments in EOR technology by

major oil producing companies, some of

which apparently involved fixed fees.

Such testimony, however, was of a very

general nature, was largely given by

individuals who were not personally or

sufficiently involved with the

investments, and does little to bolster

the credibility or economic substance of

the tax-oriented limited partnership

investments at issue in this case.

Petitioners argue that even though no

existing, traditional technology had been

tested successfully on the Utah and

Wyoming tar sands properties, the

"portfolio" of EOR technology licensed by

Barton and the Wichita Partnerships

constituted just the type of unusual,

creative combination of EOR technology

that might prove valuable on such

property. As we have found, however,

that portfolio consisted of a package of

vague, largely untested ideas, that, if

and to the extent ever developed, would

likely be available generally in the

market place and on much more favorable

terms than from the partnerships. We

reject petitioners’ argument that the

portfolio of EOR technology obtained by

the partnerships represented anything of

any substantial value. The EOR

technology license agreements entered

into by Technology-1980 with Elektra and

129

by Barton with Hemisphere were

essentially valueless.

The multi-million dollar license fees

and royalties that Technology-1980 and

that Barton (and the other Manhattan and

Wichita Partnerships) agreed to pay were

excessive. They did not reflect

arm’s-length obligations, and they are

not to be recognized as legitimate

obligations of the partnerships. The

debt obligations of the partnerships

associated therewith did not constitute

genuine debt obligations and are to be

disregarded. Estate of Franklin v.

Commissioner, 544 F.2d 1045 (9th Cir.

1976), affg. on different grounds 64 T.C.

752 (1975); Hulter v. Commissioner, 91

T.C. 371, 390 (1988).

In summary, presented to us in this

case is a chain or multi-layered series

130

of obligations, stacked or multiplied on

top of each other via the numerous

partnerships to produce debt obligations

in staggering dollar amounts, using a

largely undeveloped and untested product,

in a highly risky, very speculative, and

non arm’s-length manner in an attempt to

generate significant tax deductions for

investors. The transactions did not, and

do not, constitute legitimate for-profit

business transactions.

Losses of the partnerships are

disallowed under section 183, and accrued

interest deductions are disallowed due to

the nongenuine nature of the underlying

debt obligations.

As an alternative argument, petitioners

contend that $1,800 of the per unit

annual EOR license fees agreed to by the

Wichita Partnerships should be treated,

131

under section 174, as deductible research

or experimental expenditures. The

apparent basis for this argument is that

a portion of the license fees was used by

Hemisphere to pay for research on EOR

technology that, if successful, would ©

accrue to the benefit of the ‘

partnerships.

We reject petitioners’ argument. We

note that no portion of the license fees

was paid by the partnerships as research

or experimental expenses, and we reject

petitioners’ attempt now to

reds suis reeee a PMC ALE Pe RCH RENT “4

recharacterize the license fees and to

qualify the fees as research or

experimental expenses.

Further, although the regulations under 7

section 174 do provide that costs

incurred by taxpayers to hire others to

conduct research that relates to the

132

taxpayers’ businesses may be deductible

as research or experimental expenditures,

see sec. 1.174-2(a), Income Tax Regs.,

case law makes it clear that where

taxpayers are merely passive investors

with regard to the research, amounts paid

to others with regard to the research do

not qualify for a deduction under section

174. See Nickeson v. Commissioner, 962

F.2d 973 (10th Cir. 1992); Zink v. United

States, 929 F.2d 1015, 1021 (5th Cir.

1991); Diamond v. Commissioner, 92 T.C.

423 (1989), affd. 930 F.2d 372, 376 (4th

Cir. 1991); Levin v. Commissioner, 87

T.C. 698, 725-726 (1986), affd. 832 F.2d

403, 406 (7th Cir. 1987).

Under the above authority, even if a

portion of the license fees were allowed

to be recharacterized as research or

experimental expenses, Hemisphere was to

133

conduct the research totally

independently of the Wichita

Partnerships. The partnerships were not

in the business of conducting research on

EOR technology, and no portion of the EOR

license fees would qualify for a

deduction under section 174.

We also note that under section

174(a) (2), to currently deduct research

or experimental expenditures, such

expenditures must be identified on the

tax return representing the first taxable

year for which such expenses are incurred

or consent to make an election to

currently deduct the expenditures must be

obtained from the Secretary.

For the first time in their reply

brief, petitioners argue summarily that a

portion of the license fees that Barton

paid to Hemisphere in connection with the

134

4

k

'

t

E

a alin [ake

redistribution or sublicensing rights of

Barton with regard to the EOR technology

should be deductible under section 1253

as franchise fees. This is a new issue

and will not be considered. Rule 41(a);

Russo v. Commissioner, 98 T.C. 28, 31

(1992); DiLeo v. Commissioner, 96 T.C.

858, 891 (1991), affd. 959 F.2d 16 (2d

Cir. 1992).

In light of our resolution of the above

issues, it is not necessary to address

certain other substantive issues raised

by the parties.

Additions to Tax and Increased Interest

For the years before us, sections

6653(a) and 6653(a)(1) provide additions

to tax equal to 5 percent of the

underpayments if any part of the

underpayments are due to negligence or

433

intentional disregard of rules and

regulations. Section 6653(a)(2) provides

an addition of 50 percent of the interest

on the portion of the underpayment

attributable to negligence. Negligence

under sections 6653(a), 6653(a)(1) and

(2) is the failure to exercise due care

or the failure to do what a reasonable or

ordinarily prudent person would do under

the circumstances. Zmuda v.

Commissioner, 731 F.2d 1417, 1422 (9th

Cir. 1984), affg. 79 T.C. 714 (1982);

Neely v. Commissioner, 85 T.C. 934, 947

(1985).

With regard to our analysis of the

additions to tax in this case, it is

important to note that one of

respondent’s own expert witnesses

acknowledges that investors may have been

Significantly and reasonably influenced

136

by the energy price hysteria that existed

in the late 1970s and early 1980s to

invest in EOR technology. We have noted

in our findings of fact a number of

industry and governmental reports and

publications that encouraged investors to

invest in EOR technology. Various

governmental incentives, funding, and

subsidies were directed at development of

EOR technology. In the early 1980s, a

large amount of money was spent on the

development of technology for the

recovery of oil from shale and synthetic

fuels in spite of the fact that such

technology was not technically viable at

the time and that minimal oil was

produced therefrom.

In evaluating the imposition of the

additions to tax in this case, and in

light of the above facts (encouraging

investments in and the development of

tertiary oil recovery methods such as EOR

technology), we are somewhat

understanding of the individual

investments that were made in the

Manhattan and Wichita Partnerships. In

the context of the hysteria relating to

the energy crisis the oil price increases

of the late 1970s, the industry and

governmental interest in EOR technology,

the heavy and sophisticated promotion of

these investments, and the evidence in

these cases (and in spite of our findings

and conclusions sustaining respondent’s

substantive tax adjustments), we conclude

that petitioners are not liable for the

additions to tax and the additional

interest element for negligence under

sections 6653(a), 6653(a)(1) and (2).

For 1982 and 1983, section 6659

138

provides for an addition to tax for

underpayments of tax attributable to

valuation overstatements. Valuation

overstatements exist if the value or

adjusted basis of property claimed on tax

returns equals or exceeds 150 percent of

the correct amount of the value or basis

of the property. To the extent taxpayers

claim tax benefits that are disallowed on

grounds separately and independently from

alleged valuation overstatements, the

resulting underpayments of tax are not

regarded as attributable to valuation

overstatements. Todd v. Commissioner, 89

T.C. 912 (1987), affd. 862 F.2d 540 (5th

Cir. 1988).

In these cases, we have disallowed the

Claimed losses of the partnerships on the

ground that the activities of the

partnerships lacked actual and honest

profit objectives. Although our

conclusion was influenced by excessive

license fees and royalties charged to the

partnerships, our conclusion was not tied

directly or indirectly to any specific

overstatements of value per se that

appeared on petitioners’ tax returns.

Accordingly, section 66S9 additions to

tax would appear inappropriate. See

Rybak v. Commissioner, 91 T.C. 524,

566-567 (1988); Harness v. Commissioner,

T.C. Memo. 1991-321.

Further, section 6659(e) authorizes

respondent to waive all or part of

additions to tax for valuation

overstatements if taxpayers establish

that there was a reasonable basis for the

adjusted bases or valuations claimed on

the returns and that such claims were

made in good faith. Respondent’s refusal

140

to waive section 6659 additions to tax

is reviewable by this Court for abuse of

discretion. See Brand v. Commissioner,

T.C. Memo. 1988-194. In these cases, on

the record before us, and in our

discretion, we conclude and hold that

respondent’s refusal to waive the section

6659 additions to tax constitutes an

abuse of discretion.

For 1982 and 1983, respondent asserts

that petitioners are liable for additions

to tax for substantial understatements of

tax under section 6661, equal to 10

percent of their respective underpayments

of tax attributable to such

understatements of tax.’ In order for

7As originally enacted by the Tax Equity

and Fiscal Responsibility Act of 1982,

Pub. L. 97-248, sec. 323(a), 96 Stat.

324, 613, the amount of the addition to

tax under sec. 6661(a) was 10 percent of

the underpayment of tax attributable to

the substantial understatement. The

141

understatements of tax to be considered

substantial, the amounts of the

understatements must exceed the greater

of 10 percent of the taxes required to be

shown on the Federal income tax returns

or $5,000. Sec. 6661(b) (1) (A).

Respondent contends that the additions

under section 6661 should be imposed in

amount of the addition was increased to

25 percent of such underpayment by the

Omnibus Budget Reconciliation Act of

1986, Pub. L. 99-509, sec. 8002(a)., 100

Stat. 1874, 1951. The amendment made by

Pub L. 99-509, sec. 8002(a), increasing

the rate of sec. 6661 addition to 25

percent, applies to all additions

assessed after the date of enactment of

Pub. L. 99-509. Pallottini v.

Commissioner, 90 T.C. 498 (1988).

Respondent has in an Amendment to Answer

increased the sec. 6661(a) additions to

tax to 25 percent above the 10 percent

amount set forth in the notice of

deficiency issued to but respondent has

not sought to increase the sec. 6661(a)

additions to tax above the 10 percent

amount set forth in the amendment to

answer with respect to Krause.

142

)

|

these cases because there was no

substantial authority supporting the

claimed treatment of the disallowed

items. Petitioners argue that even if

they are otherwise determined to be

liable for the section 6661 additions to

tax, respondent should have waived the

additions.

Based on the record in these cases and

many of the factors set forth above, we

conclude that respondent’s refusal to

waive the section 6661 additions to tax

constitutes an abuse of discretion.

Mailman v. Commissioner, 91 T.C. 1079

(1988).

Section 6621(c), and its predecessor

section 6621(d), provided an increased

rate of interest for substantial

underpayments attributable to

tax-motivated transactions. Substantial

underpayments are defined as

underpayments in excess of $1,000. By

regulation, among the types of

transactions that are considered to be

ta - motivated transactions within the

meaning of section 6621(c) are those with

respect to which the related tax

deductions are disallowed under section

183 for lack of profit objective. Sec.

301.6621-2T, A-4(1), Temporary Proced. &

Admin. Regs., 49 Fed. Reg. 59394 (Dec.

28, 1984); Rybak v. Commissioner, 91 T.C.

524, 568 (1988). In light of our

findings as to the lack of profit

objective, petitioners are liable for

increased interest under section 6621(c).

ecisi wi b e .

144

TABLE ONE

Petitioners at Docket No. 33231-86

Dorothy A. Hildebrand Wahl

Increased Interest and Additions to Tax

Sec. Sec. Sec. Sec.

Year Deficiency 6621(c) 6653(a) 6653(a)(1) 6653(a)(2)

1980 $39,359 bd $1,968 -- --

1981 $49,027 ss -- $2,464 os

R. A. Hildebrand

Increased Interest and Additions to Tax

Sec. Sec. Sec. Sec. Sec.

Year Deficiency 6621(c) 6653(a)(1) 6653(a)(2) 6659 6661

1982 $71,463 bd $3,573 oe $15,731 $1,903

* 120 percent of the interest accruing after Dec. 31, 1984,

on the portion of the underpayment attributable to a

tax-motivated transaction.

** 50 percent of the interest due on the portion of the

underpayment attributable to negligence.

145

TABLE TWO

In Constant 1979 Dollars ($/bbl)

1980 1885 1990 1995

Low price 32.66 32 32 32

Midprice 32.66 37 41 50

High price 32.66 43 49 70

In Project Inflated Dollars ($/bbl)

1980 1885 1990 1995

Low price 37.24 53 77 106

Midprice 37.24 61 98 165

High price 37.24 71 117 231

146

TABLE THREE

Retained

Glenda Royalty

Parnerships’ Petroleum’s Owners’

Item Percentage Percentage Percentage

Production Revenues 65.625 9.375 25.000

Drilling Costs 100.000 None None

Operating Costs 87.500 12.500 None

Compression & Gas Gathering Costs 87.500 12.500 None

Maintenance 87.500 12.500 None

147

TABLE FOUR

Cash Estimated Losses as a Percent

Year Investment Tax Losses of Cash Invested

1980 $10,000 $40,000 400%

1981 10,000 40,000 400%

1082 10,000 40,000 400%

1983 0 30,000 --

Totals $30,000 $150,000 500%

148

Notes to Be

Issued In

1982

1983

1984

1985

1986

Totals

149

TABLE FIVE

Cash Due Face Amount of Notes’

Per Unit Notes Per Unit Maturity Dates

$1,100 $7,400 Sept. 30. 1997

1,100 7,400 Sept. 30. 1997

95 8,405 Sept. 30. 1997

95 8,405 Sept. 30. 1997

95 8,405 Sept. 30. 1997

$2,485 $40,015

TABLE SIX

Stated

Date Assignor Assignee Consideration

9/3/79 Helm Elektra Not specified

9/25/79 Helm Mardyn, N.V. Not In the record

10/1/79 Gehrig Heim $170,000

10/5/79 Heim Elektra Not in the record

11/1/79 Heim Shalelectric, S.A. Not specified

11/1/79 Shalelectric, S.A. Mardyn, N.V. $10 million

11/1/79 Mardyn, N.V. Elektra Contingent

150

TABLE SEVEN

Stated

Date Assignor Assignee Consideration

11/1/81 Heim Shalelectric, S.A. --

11/1/81 Shalelectric, S.A. Columbus Valiey $10 million

11/1/81 Columbus Valley Hemisphere Contingent

151

Gross Receipts/Sales

Interest Income

License Fees

Royalties

Interest Expenses

Total Losses

152

TABLE EIGHT

1980 1981 1982 1983 1984

$0 $7,178 $62,557 $68,156 $119,677

8,260 285,814 104,419 43,576 36,150

(7,402,500) (7,402,500) (7,402,500) (7,402,500) (7,402,500)

(1,057,500) (1,057,500) (1,057,500) (951,750) (951,750)

(76,200) (969,086) (1,904,558) (2,825,644) (3,749,666)

($8,527,940) ($3,136,094) ($10,197,582) ($11,068,162) ($11,948,089)

Gross Receipts/Sales

Expenses

Hemisphere License Fees

Loss from Joint Venture

Other Deductions

Loss from Sale/Exchange of

Property

Interest Expenses

Total Adjusted Losses

Less: Interest Income

Income from Joint Venture

Total Net Losses

153

TABLE NINE

a 1982 1983

($493,425) ($414,567)

($4,703)

($7,024) ($40,979)

($17,831)

a ($48,329)

($505,152) ($521,706)

$4,862

$16,503

($505,152) ($500,341)

R. A. HILDEBRAND and DOROTHY A HILDEBRAND

WAHL, Petitioners~-Appellants, v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent~-Appellee.

GARY E. KRAUSE, Tax Matters Partner,

Barton Enhanced Oil Production Income

Fund, Petitioner-Appellant, v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent~-Appellee.

No. 93-9010, No. 93-9011

UNITED STATES COURT OF APPEALS FOR THE

TENTH CIRCUIT

28 F. 3d 1024; 1994 U.S. App. LEXIS

15501; 94-2 U.S. Tax Cas. (CCH) @¢ 50,305

June 22, 1994

154

Appeals from the United States Tax Court.

(Tax Court Nos. 33231-86 & 16425-86).

COUNSEL: Michael R. Matthias (Jeffrey

P. Berg and Stuart R. Singer, of Matthias

& Berg, Los Angeles, California, with him

on the briefs), of Matthias & Berg, Los

Angeles, California, for the

Petitioners-Appellants R.A. Hildebrand

and Dorothy A. Hildebrand Wahl.

Kenneth M. Barish, of Reish & Luftman,

Los Angeles, California, for the

Petitioner-Appellant Gary E. Krause, Tax

Matters Partner, Barton Enhanced Oil

Production Income Fund.

Kenneth W. Rosenberg (Loretta Cc.

Argrett, Assistant Attorney General, and

Richard Farber, Attorney, Tax Division,

155

Department of Justice, Washington, D.C.,

with him on the brief), Attorney, Tax

Division, Department of Justice,

Washington, D.C., for the

Respondent-Appellee.

JUDGES: Before TACHA and BRORBY,

Circuit Judges, and BROWN,* District

Judge.

* The Honorable Wesley E. Brown, Senior

District Judge, United States District

Court for the District of Kansas, sitting

by designation.

TACHA, Circuit Judge.

The taxpayers in these consolidated

cases, R.A. Hildebrand and Dorothy A.

Hildebrand Wahl (the "Hildebrands") and

156

Gary E. Krause ("Krause"), tax matters

partner of Barton Enhanced Oil Production

Income Fund ("Barton Income Fund"),

appeal the Tax Court’s disallowance under

26 U.S.C. § 183 ® of deductions for

losses resulting from investments in

limited partnerships and the disallowance

of 26 U.S.C. § 163 interest deductions.

The taxpayers also appeal the Tax Court’s

imposition of an increased interest rate

on the tax underpayment attributable to

tax-motivated transactions under 26

U.S.C. §§ 6601 and 6621(c). Finally,

Barton Income Fund alleges the Tax Court

erred in rendering a consolidated opinion

grouping Barton with the Hildebrands and

in finding that certain license fee

obligations incurred by Barton were not

®Al]l citations to Internal Revenue Code

sections are to code sections in force

during the tax years in question.

157

deductible under 26 U.S.C. § 174 as

research and development expenditures or

under 26 U.S.C. § 1253 as franchise fees.

I. BACKGROUND

The facts in this case are fully set

forth in the Tax Court opinion, Krause v.

Commissioner, 99 T.C. 132 (1992). We

offer only a brief procedural summary for

purposes of this appeal.

On their federal income tax returns the

Hildebrands claimed losses resulting from

their investment as limited partners in

Technology Oil and Gas Associates 1980

("Technology-1980"). The Commissioner of

the Internal Revenue Service

("Commissioner") disallowed these losses

and the Hildebrands petitioned the Tax

158

Court for redetermination of resulting

deficiencies in tax and additions to tax.

The Commissioner issued Barton Income

Fund a notice of final partnership

administrative adjustment disallowing

losses and amounts claimed as eligible

for tax credits. Krause petitioned the

Tax Court for redetermination of the

adjustments. The Tax Court consolidated

these cases for trial treating them as

test cases for a number of related cases

involving tax deductions by limited

partnerships.

After a fifteen-week trial the Tax

Court issued an opinion upholding

substantially all of the Commissioner’s

determinations. The Tax Court disallowed

under 26 U.S.C. § 183 the taxpayers’

deductions for losses resulting from

investments in the limited partnerships

because the partnerships did not have the

requisite profit motive and imposed an

increased interest rate on tax

underpayment attributable to

tax-motivated transactions under 26

U.S.C. §§ 6601 and 6621(c). The Tax Court

also disallowed under 26 U.S.C. § 163

interest deductions because the

partnerships’ underlying debt obligations

were not genuine. The taxpayers now

appeal.

This court has jurisdiction to review

the Tax Court’s decision pursuant to 26

U.S.C. § 7482(a). We affirm.

160

II. DISCUSSION

Whether Technology-1980 and Barton

Income Fund had actual and honest profit

objectives is a question of fact. Cannon

v. Commissioner, 949 F.2d 345, 349 (10th

Cir. 1991), cert. denied, 120 L. Ed. 2a

904, 132 8. Ce. 3630 (1992). "The

applicable standard of review is a

stringent one: a finding of fact should

not be disturbed unless it is clearly

erroneous." Id. (citing Fed. R. Civ. P.

52(a)). "A finding is ‘clearly erroneous’

when although there is evidence to

Support it, the reviewing court on the

entire evidence is left with a definite

and firm conviction that a mistake has

been committed." United States v. United

States Gypsum Co., 333 U.S. 364, 395, 92

L. Ed. 746, 68 S. Ct. 525 (1948). "If the

district court’s account of the evidence

is plausible in light of the record

viewed in its entirety, the court of

appeals may not reverse it even though

convinced that had it been sitting as the

trier of fact, it would have weighed the

evidence differently." Anderson v.

Bessemer City, 470 U.S. 564, 573-74, 84

L. Ed. 2d 518, 105 S. Ct. 1504 (1985).

After carefully examining the pertinent

parts of the record, we conclude that the

Tax Court’s finding that no actual and

honest profit objective was present in

either limited partnership is plausible

and not clearly erroneous.

The Tax Court applied the proper test

in determining whether the activities in

question were "engaged in for profit"

under 26 U.S.C. § 183(a). All expenses

associated with a business transaction

162

are not necessarily deductible. For a

deduction to be allowed it must be shown

that the activity engaged in was operated

with an actual and honest profit

objective. 26 U.S.C. § 183. We look to

the economic motive of the partnership,

not the individual investor, to determine

whether the activity is engaged in for

profit. Cannon, 949 F.2d at 349.

The taxpayer has the burden to prove

the requisite profit objective. Id. at

350. "The test is whether profit was the

dominant or primary objective of the

venture." Id. The regulations set forth

nine nonexclusive factors to be examined

under § 183 in determining whether a

taxpayer engages in activities with the

objective of realizing a profit:

(1) the extent to which the taxpayer

carries on the activity in a businesslike

163

manner; (2) the taxpayer’s expertise or

his reliance on the advice of experts;

(3) the time and effort the taxpayer

expends in carrying on the activity; (4)

the expectation that the assets used in

the activity may appreciate in value; (5)

the taxpayer’s success in similar

activities; (6) the taxpayer’s history of

income or loss in the activity; (7) the

amount of occasional profits, if any; (8)

the taxpayer’s financial status; and (9)

the elements of personal pleasure or

recreation. Cannon, 949 F.2d at 350; see

Treas. Reg. § 1.183-2(b). The regulation

directs:

In determining whether an activity is

engaged in for profit, all facts and

circumstances with respect to the

activity are to be taken into account. No

one factor is determinative in making

164

this determination. In addition, it is

not intended that only the factors

described in this paragraph [listed

above] are to be taken into account in

making the determination, or that a

determination is to be made on the basis

that the number of factors...

indicating a lack of profit objective

exceeds the number of factors indicating

a profit objective, or vice versa. Treas.

Reg. § 1.183-2(b).

The Tax Court applied the relevant

factors and concluded that the

Technology-1980 and Barton Income Fund

partnerships were not motivated by profit

on the following bases: (1) the amounts

the partnerships agreed to pay for the

licenses for the Enhanced Oil Recovery

(EOR) technology and for the lease by

Technology-1980 for tar sands properties

“bore no relation to the value of that

which was acquired, did not conform to

industry norms, and precluded any

realistic opportunity for profit;" (2)

the partnerships’ estimates of oil to be

recovered through EOR technology are "not

supported by credible expert testimony. .

- and were not reasonable" based on the

undeveloped and untested status of the

EOR technology; (3) the partnerships’

economic projections in their offering

materials reflect a series of assumptions

which were not substantiated and did not

account for the abnormal practice and

high cost of the license fees and

royalties or the significant cost of

establishing commercial operations; (4)

all but two of the EOR technologies

licensed by the partnerships were

"undeveloped, untested processes for

166

which no prudent investor would pay any

substantial fixed fees" and the other two

technologies could have been licensed

based solely on the income realized

therefrom; (5) the partnerships relied on

unrealistic projections that "world oil

prices would continue increasing from

1979 and 1980 prices on a continuing

upward spiral for the next 20 years;" (6)

the licensing agreements for the EOR

technologies were not completed through

arms-length negotiations; and (7) the

partnerships marketed the investments in

part on the basis of projected tax

benefits and inaccurate information

regarding the EOR technology.

Additionally, the tax court noted that

the partnerships had a record of

substantial losses and never recorded a

profit in any year of their ventures,

167

another factor relevant to the "profit

motive" inquiry. Cannon, 949 F.2d at 352

("A record of such persistent and

substantial losses is persuasive evidence

that the partnerships did not possess the

requisite profit motive."); see also

Treas. Reg. § 1.183-2(b) (6).

Taxpayers point to the court’s

determination that the partnerships’

reliance on the energy price projections

was unreasonable and its determination

that partnership management lacked

expertise in the oil and gas business as

the most substantial basis for

challenging the Tax Court’s finding that

the partnerships did not have the

requisite profit motive. The taxpayers

also assert error in the court’s

treatment of the up-front, fixed

licensing fees for the EOR technology.

168

The Hildebrands point to a joint venture

agreement with an independent third party

to perform test drilling on the tar sands

property in return for an interest in the

partnership as independent evidence of

the value of the EOR technology

agreements. The taxpayers argue further

that, because other companies made large

and risky investments in enterprises

involving similar EOR technology at

similar times, these investments are

therefore validated.

After reviewing the record, however, we

do not find the conclusions of the tax

court to be clearly erroneous. The Tax

Court did a thorough job of considering

the profit motive issue. It applied the

relevant factors, considered all the

evidence and testimony presented and

rested its determination on a solid

foundation. It also ably addressed the

arguments made by the taxpayers outlined

in the above paragraph.

Taxpayers next assert that the Tax

Court erred in disallowing certain

partnership interest deductions under 26

U.S.C. § 163. The Tax Court found that

the debt obligations of the partnerships

were not based on arms-length

transactions, resulted from excessive

amounts paid for the licenses of the EOR

technology and otherwise did not

represent genuine debt obligations and,

therefore, should be disregarded. The Tax

Court’s findings in this regard are not

clearly erroneous.

Taxpayers also appeal the imposition of

an increased interest rate on the tax

underpayment attributable to

tax-motivated transactions under 26

170

U.S.C. §§ 6601 and 6621(c). Because we do

not find clearly erroneous the Tax

Court’s determination that the requisite

profit motive did not exist, we reject

taxpayers’ argument and affirm the Tax

Court’s imposition of the increased rate

of interest for substantially the reasons

stated in its opinion. We specifically

reject Krause’s assertion that the Tax

Court erred in finding Barton Income Fund

liable for an increased rate of interest

because a transaction which is determined

to lack a profit motive does not equal a

tax-motivated transaction under section

6621. Section 6621(c)(1) imposes an

increased rate of interest on "any

substantial underpayment attributable to

tax motivated transactions," which

include activities not engaged in for

profit. Wolf v. Commissioner, 4 F.3d 709,

171

715 (9th Cir. 1993).

Krause also argues that the Tax Court

erred in rendering a consolidated opinion

covering both Hildebrand and Barton

Income Fund. We disagree. After our own

study of the record we conclude that the

minor errors in the Tax Court opinion

confusing facts applying only to

Hildebrand with facts surrounding Barton

Income Fund were insignificant and did

not affect the substance or the legal

conclusions in the Tax Court’s opinion.

Krause also asserts that the Tax Court

erred in disallowing portions of its

licensing fees as research and

development expenses under 26 U.S.C. §

174. We disagree. The Tax Court’s finding

that Barton Income Fund had no profit

objective precludes it from taking

deductions under § 174. Independent Elec.

172

Supply, 781 F.2d 724, 726 (10th Cir.

1986); Agro Science Co. v. Commissioner,

934 F.2d 573, 576 (5th Cir.), cert.

denied, 116 L. Ed. 2d 243, 112 S. Ct. 300

(1991).

III. CONCLUSION

We find no merit in taxpayers’

remaining arguments and affirm the

decision of the Tax Court for

substantially the reasons stated in its

opinion.

173

SECTIONS OF THE INTERNAL REVENUE CODE OF

1986

Sec. 161 ALLOWANCE OF DEDUCTIONS

In\computing taxable income under

section 63, there shall be allowed as

deductions the items specified in this

part, subject to the exceptions provided

in part IX (sec. 261 and following,

relating to items not deductible).

Sec. 162 TRADE OR BUSINESS EXPENSES,

(a) IN GENERAL.--

There shall be allowed as a deduction

all the ordinary and necessary expenses

paid or incurred during the taxable year

in carrying on any trade or business,

including--

(1) a reasonable allowance for salaries

or other compensation for personal

174

services actually rendered;

(2) traveling expenses (including

amounts expended for meals and lodging

other than amounts which are lavish or

extravagant under the circumstances)

while away from home in the pursuit of a

trade or business;

and

(3) rentals or other payments required

to be made as a condition to the

continued use or possession, for purposes

of the trade or business, of property to

which the taxpayer has not taken or is

not taking title or in which he has no

equity.

For purposes of the preceding sentence,

the place of residence of a Member of

Congress (including any Delegate and

Resident Commissioner) within the State,

Congressional district, or possession

175

which he represents in Congress shall be

considered his home, but amounts expended

by such Members within each taxable year

for living expenses shall not be

deductible for income tax purposes in

excess of $3,000.

Sec. 163 INTEREST

(a) GENERAL RULE. There shall be

allowed as a deduction all interest paid

or accrued within the taxable year on

indebtedness.

Sec. 165 LOSSES

(a) GENERAL RULE -- There shall be

allowed as a deduction any loss sustained

during the taxable year and not

compensated for by insurance or

otherwise.

176

Sec., 183 ACTIVITIES NOT ENGAGED IN FOR

PROFIT

(a) GENERAL RULE.--

In the case of an activity engaged in

by an individual or an S corporation, if

such activity is not engaged in for

profit, no deduction attributable to such

activity shall be allowed under this

chapter except as provided in this

section.

(b) DEDUCTIONS ALLOWABLE. --

In the case of an activity not engaged

in for profit to which subsection (a)

applies, there shall be allowed--

(1) the deductions which would be

allowable under this chapter for the

taxable year without regard to whether or

not such activity is engaged in for

profit, and

177

(2) a deduction equal to the amount of

the deductions which would be allowable |

under this chapter for the taxable year

only if such activity were engaged in for

profit, but only to the extent that the

gross income derived from such activity

for the taxable year exceeds the

deductions allowable by reason of

paragraph (1).

(c) For purposes of this section, the

term "activity not engaged in for profit"

means any activity other than one with

respect to which deductions are allowable

for the taxable year under section 162 or

under paragraph (1) or (2) of section

212.

Sec. 211 ALLOWANCE OF DEDUCTIONS

In computing taxable income under

section 63, there shall be allowed as

178

deductions the items specified in this

part, subject to the exceptions provided

in part IX (section 261 and following,

relating to items not deductible).

Sec. 212 EXPENSES FOR PRODUCTION OF

INCOME

In the case of an individual, there

shall be allowed as a deduction all the

ordinary and necessary expenses paid or

incurred during the taxable year--

(1) for the production or collection of

income;

(2) for the management, conservation,

or maintenance of property held for the

production of income; or

(3) in connection with the

determination, collection, or refund of

any tax.

SEC. 6621. DETERMINATION OF RATE OF

INTEREST.

(c) [As added by Tax Reform Act of

1984, Pub. L. No. 98369, 98 Stat. 494, §

144, effective for interest accruing

after Dec. 31, 1984, and amended by Tax

Reform Act of 1986, Pub. L. No. 99-514,

100 Stat. 2085, §§ 1511(c)(1), 1535.)

Interest on Substantial Underpayments

Attributable to Tax Motivated

Transactions. ---

(1) In general.--In the case of

interest payable under section 6601

with respect to any substantial

underpayment attributable to tax

motivated transactions, the annual rate

of interest established under this

section shall be 120 percent of the

underpayment rate established under

180

this subsection.

(2) Substantial underpayment

attributable to tax motivated

transactions.--For purposes of this

subsection, the term "substantial

underpayment attributable to tax

motivated transactions" means any

underpayment of taxes imposed by

subtitle A for any taxable year which

is attributable to 1 or more tax

motivated transactions if the amount of

the underpayment for such year so

attributable exceeds $1,000.

(3) Tax motivated transactions. --

(A) In general.--For purposes

of this subsection, the term "tax

motivated transaction" means--

(i) any valuation

overstatement (within the

meaning of section 6659(c)),

181

ee

(ii) any loss disallowed

by reason of section 465(a) and

any credit disallowed under

section 46(c) (8),

(iii) any straddle (as

defined in section 1092(c)

without regard to subsections

(ad) and (e) of section 1092),

(iv) 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, and

(v) any sham or

fraudulent transaction.

(B) Regulatory authority.--

The Secretary may by regulations

specify other types of transactions

182

which will be treated as tax

motivated for purposes of this

subsection and may by regulations

provide that specified transactions

being treated as tax motivated will

no longer be so treated. In

prescribing regulations under the

preceding sentence, the Secretary

shall take into account--

(i) the ratio of tax

benefits to cash invested,

(ii) the methods of

promoting the use of this type

of transaction, and

(iii) other relevant

considerations.

(C) Effective date for

regulations.--Any regulations

prescribed under subparagraph

(A) (iv) or (B) shall apply only to

interest accruing after a date

(specified in such regulations)

which is after the date on which

such regulations are prescribed.

(4) Jurisdiction of Tax Court.--In

the case of any proceeding in the Tax

Court for a redetermination of

deficiency, the Tax Court shall also

have jurisdiction to determine the

portion (if any) of such deficiency

which is a substantial underpayment

attributable to tax motivated

transactions.

184