# Appendix — Hildebrand v. Commissioner

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40386012_0695%3A2

## Record

- **Collection:** Supreme Court brief
- **Document type:** Appendix
- **Published:** January 1, 1995
- **Citation:** 513 U.S. 1079

## Text

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 re

[Text truncated at 120,000 characters. The full text is on the page linked above.]

---

Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40386012_0695%3A2. Public record. Not legal advice.