Petition for Writ of Certiorari — Mach-Tech, Ltd. Partnership v. Commissioner

BB 436 sip 1 4 1995

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NO.

IN THE

Supreme Court of the Gnited States

OCTOBER TERM, 1995

MACH-TECH, LTD. PARTNERSHIP and SERV-TECH,

INC., Tax Matters Partner,

Petitioners,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

Petition For Writ Of Certiorari To

The United States Court Of Appeals

For The Fifth Circuit

PETITION FOR A WRIT OF CERTIORARI

LARRY E. JACOBS

NORTON, JACOBS, KUHN

& MCTOPY, L.L.P.

333 Clay Ave.

Suite 700

Houston, Texas 77002

(713) 652-8870

Attorney for Petitioners

Of Counsel:

RUTH E. SALEK

333 Clay Ave.

Suite 700

Houston, Texas 77002

Alpha Law Brief Company © Houston, Texas © (713) 981-9000 © 1-800-981-9001

i

QUESTION PRESENTED FOR REVIEW

The question presented for review is whether the Fifth

Circuit used the correct standard of control in determining if

the requirements of Section 174 of the Internal Revenue

Code were met. Section 174 allows a taxpayer to deduct

research and experimental expenditures incurred by the

taxpayer in connection with his trade or business. A

taxpayer can meet the “connection to business” test even

though the taxpayer did not produce or sell a product at the

time the expenditures were incurred, if the taxpayer has

“operational nexus” at any time to a trade or business

utilizing the product of the research. Snow v Commissioner,

416 U.S. 500, 94 S.Ct. 1876 (1974), rev’g. 482 F.2d 1029

(6th Cir.) and 58 T.C. 585 (1972); Harris v Commissioner,

16 F.3d 75 (Sth Cir. 1994), aff’g. 58 T.C.M. (CCH) 1441

(1990), supplemented by 99 T.C. 121 (1992).

In this case, the Partnership incurred research and

experimental expenditures in the development of the Fast

Clean System. Subsequently, the Partnership merged into a

corporation which used the fruits of the Partnership’s

research in its trade or business. The Fifth Circuit

determined that after such merger, the Partnership did not

have sufficient “control” over the Fast Clean System to have

“operational nexus” and allow the Section 174 deduction for

the research and experimental expenditures. The Partnership

requests the Supreme Court establish the standard of control

needed to have “operational nexus".

ee ee ee eee ee

il

PARTIES TO THE PROCEEDINGS

1. For the Petitioners:

Serv-Tech, Inc.

Calvin, Martha

Krajicek, Michael

Krajicek, Richard W.

Krajicek, Stephen

Miller, Max

Miller, Michael

Randall, Edward III

Stanley, Charles

2. For the Respondent:

The Commissioner of Internal Revenue

iii

TABLE OF CONTENTS

PAGE

QUESTION PRESENTED FOR REVIEW ........ i

PARTIES TO THE PROCEEDINGS .......... il

TABLE OF CONTENTS .......2-eeeeeee- iil

TABLE OF AUTHORITIES .............-.-. Vv

REFERENCE TO THE OPINION BELOW ....... |

GROUND FOR JURISDICTION ...........-. |

RULE INVOLVED 2.0 cc ccc ccc cece es ceeer 2

STATEMENT OF THE CASE ............-.-. 2

REASONS FOR GRANTING THE WRIT ........ 9

I. The opinion of the Fifth Circuit in this

case decides the control standard in a

way that conflicts with this Court’s

DPE bwaw hase eee se 10

Il. By denying business realities, the Fifth

Circuit’s opinion creates a conflict

between it and the Sixth and Ninth

ah aS ae 6 es ee ew wt 13

Ill. The standard of control to be used is

an important question of federal

|

iV

A. It impacts many business and

governmental economic

er ree eo ares 20

B. An adverse standard of control

causes serious damage to anti-

trust laws and concepts ..... 24

CORCE AISI 0s 6 se ERT A 25

APPEREM A Sisesicns SRIRAM la |

APIEMEON DR (O04 CORNED. ANT OF AQ 8a

APPR ee sn we POR A 30a

APP Erase BP OS 8 SSO 35a

Vv

TABLE OF AUTHORITIES

CASES PAGE

Harris v. Commissioner,

16 F3d 75 (Sth Cir. 1994), aff’g. 58 T.C.M.

(CCH) 1441 (1990), supplemented by 99 T.C.

RPE Tore ce 5 6 Si RAB CU eee tee ok 5-8, 20

Mach-Tech Ltd. Partnership v Commissioner

of Internal Revenue, 1995 U.S. App. Lexis

17112 aff’g. 67 T.C.M.(CCH) 2984

Scoggins v. Commissioner,

46 F.3d 950 (6th Cir. 1995), rev’g. 61 T.C.M.

(CUB) Zone CSF ae as 7-9, 13-15, 19

Smith v. Commissioner,

937 F.2d 1089 (6th Cir. 1991), rev’g. 91 T.C.

Were air ee a 5-7, 9, 13-16, 19

Snow v. Commissioner,

416 U.S. 500, 94 S. Ct. 1876 (1974), rev’g.

482 F.2d 1029 (6th Cir. 1972) and 58 T.C.

MN os aie d one SAS kk ck vo ee * OS 4-1]

6

UNITED STATES STATUES

An Pea Es 5g 6 ko 8 6 Ko ck le eS 2

ee ees ko hae ee Ba oe ee Oe Passim

vi

OTHER

William D. Bygrave and Jeffry A. Timmons, Venture

Capital at the Crossroads, Harvard Business School

Press (19942). oi is «sé eee wears PI 17, 18

Hearings on HR 8300 before the Senate Committee

on Finance, 83 Cong., 2nd sess, ptl, p.105, and 100

Cong. Rec. 3423: (1950. A 24. 28s. ew Devers 11

William A. Sahlman, The Structure and Governance of

Venture Capital Organizations, Journal of Financial

Economics 27 (1990) 473-521, North Holland... 15, 18

Hoover’s Company and Industry Profiles,

The Reference Press, Inc. (1994), available

electronically on America Online, Personal

Finance Secteas i 6 os. ers fi WS oH BBG 17, 20

———

NO.

IN THE

Supreme Court of the Gnited States

OCTOBER TERM, 1995

MACH-TECH, LTD. PARTNERSHIP and SERV-TECH,

INC., Tax Matters Partner,

Petitioners,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

Petition For Writ Of Certiorari To

The United States Court Of Appeals

For The Fifth Circuit

PETITION FOR A WRIT OF CERTIORARI

REFERENCE TO THE OPINION BELOW

The opinion of the Fifth Circuit was not formally

reported, but has been published electronically as Mach-Tech

Lid. Partnership v Commissioner of Internal Revenue, 1995

U.S. App. Lexis 17112, and unofficially at 95-2 U.S.T.C.

(CCH) P50,375, and 76 A.F.T.R.2d (P-H) 5439. The

opinion is reproduced in Appendix A to this Petition.

The opinion of the Tax Court can be found at 67

T.C.M. (CCH) 2984 (1994), and is reproduced in Appendix

B to this Petition.

GROUND FOR JURISDICTION

The judgement appealed from was rendered by the

Fifth Circuit on June 16, 1995. The jurisdiction of this

2

Court to review the judgement is contained in 28 U.S.C.

Section 1254(1).

RULE INVOLVED

This case involves 26 U.S.C. Section 174 (hereinafter

referred to as Section 174), which provides (and so provided

for the years at issue) in pertinent part as follows:

(a) Treatment as Expenses-

(1) In General-A taxpayer may

treat research or experimental expenditures

which are paid or incurred by him during the

taxable year in connection with his trade or

business as expenses which are not chargeable

to capital account. The expenditures so

treated shall be allowed as a

deduction.[emphasis added]

STATEMENT OF THE CASE

In 1983, Mach-Tech, Ltd., a Texas limited

partnership (the “Partnership”), was formed to research,

develop, reduce to commercial use, and operate and/or

license a fully enclosed mobile heat exchanger bundle

cleaning system (the “Fast Clean System”). Used in hydro

blast cleaning of oil and gas industry equipment, the Fast

Clean System is today an integral part of the trade or

business of a $200 million revenue company named Serv-

Tech, Inc., a publicly trade corporation engaged in the oil

refinery maintenance business (“Serv-Tech”).

Serv-Tech was the general partner of the Partnership,

and the principal limited partners were Richard W. Krajicek

and Ed Randall. Krajicek was also a principal shareholder,

3

president and chairman of Serv-Tech. He was also the co-

inventor of the Fast Clean System. Randall was an

investment banker, friend and business acquaintance of

Krajicek for over twenty years. Together, they had

previously been in a similar business.

Upon formation, the Partnership entered into several

agreements. Among them was a contract with an affiliate of

Serv-Tech for the research and development of the Fast

Clean System, and another was an option granted Serv-Tech

to acquire the Fast Clean System under certain conditions in

exchange for a royalty.

Research and development of the Fast Clean System

proceeded and by 1985 a successful prototype had been

developed. Serv-Tech then undertook the additional task of

field testing. Pleased with the results of the field testing,

Serv-Tech made the decision in the Fall, 1985 to attempt to

acquire the Fast Clean System. Although Serv-Tech had the

royalty option mentioned above, it chose not to exercise it.

Instead, it made an all or nothing offer to each limited

partner to acquire such limited partner’s partnership interest

in exchange for Serv-Tech stock; if successful effectively

merging the Partnership into Serv-Tech.

Serv-Tech’s offer was made through an Offering

Memorandum prepared in compliance with state and federal

securities laws. The offer was conditioned upon acceptance

by all the limited partners. The Offering Memorandum

described the choice for each limited partner as either

merging with Serv-Tech or having the Partnership “go

alone”. The Offering Memorandum did not mention the

royalty option. All limited partners accepted the offer, and

the Partnership merged with Serv-Tech in early Summer,

1986.

4

Upon audit, the Commissioner of Internal Revenue

disallowed the Partnership’s claimed 1983 and 1985

deduction for research and experimental expenditures. The

Commissioner’s theory for disallowance was that the Fast

Clean System was not used in connection with the

Partnership’s trade or business, and there had never been any

realistic prospect that it would be so used.

Relevant to the issue presented to this Court, the

Partnership contended in the Tax Court that it incurred the

research and experimental expenditures in connection with its

trade or business involving the Fast Clean System by virtue

of its subsequent use by Serv-Tech. Such subsequent use by

Serv-Tech, the Partnership contended, was to be “attributed”

to the Partnership under the opinion of this Court in Snow v.

Commissioner, 416 U.S. 500, 94 S. Ct. 1876 (1974), rev’g.

482 F.2d 1029 (6th Cir. 1972) and 58 T.C. 585 (1972). In

Snow, this Court allowed the Section 174 deduction to the

research and development partnership when the actual trade

or business involving the technology developed by that

partnership was conducted by a successor corporation which

acquired the technology from the partnership in exchange for

ownership in the corporation. Such a relationship to the

entity actually engaging in the trade or business was held by

the Supreme Court to be all that the “in connection with”

language of Section 174 required.

The Commissioner, on the other hand, contended

that the activities of Serv-Tech after the merger should not be

attributed to the Partnership because the limited partners’

interests in the Partnership were much greater than their

interests in Serv-Tech after the merger. The Commissioner

argued that Snow was not applicable because it involved a

mere change in form of business enterprise with no change

in ownership. This purported distinction - mere change in

form versus change in percentage of ownership - is not

5

discussed in the Snow opinion nor even suggested as an

issue.

The Tax Court agreed with the Commissioner on this

newly developed ownership issue, and held that the

Partnership was not entitled to its Section 174 deduction,

citing as additional authority the Fifth Circuit’s opinion of

Harris v. Commissioner, 16 F3d 75 (Sth Cir. 1994), aff’g.

58 T.C.M. (CCH) 1441 (1990), supplemented by 99 T.C.

121 (1992).' In Harris, the Fifth Circuit interpreted this

Court’s Snow opinion as leaving open the degree of

connection required between the expenditures and the

operation of the trade or business itself - the so called

“operational nexus”. Harris at 78. According to the Fifth

Circuit, the one dispositive factor on whether there is

operational nexus is whether “the entity that incurred the

research expenses actually managed and actually controlled

the use or marketing of the research results.” Harris at 80

(emphasis added). As an example of a situation where the

deduction was warranted, the Fifth Circuit cited with

approval the decision of the Sixth Circuit in Smith v.

Commissioner, 937 F.2d 1089 (6th Cir. 1991), rev’g. 91

T.C. 733 (1988). In Smith, the deduction was allowed even

though it was found that the partnership at issue in that case

would transfer its technology to a joint venture with a public

utility (and thus not be the entity engaging in the trade or

business), would suffer a substantial dilution of ownership

of its developed technology incident to its transfer and use in

a trade or business by such joint venture, and would not

' Although not relevant to the issue being presented in this Petition,

the Tax Court also found that there was no realistic prospect that the

Partnership could ever engage in a trade or business utilizing the Fast

Clean System.

6

likely control the ongoing business? The effect of the Smith

opinion is to allow attribution, and thus establish operational

nexus, regardless of the percentage of ownership or day to

day control of the successor entity.

Encouraged by the Fifth Circuit’s favorable comments

regarding Smith and the similarity of the Smith facts to its

case, the Partnership appealed the Tax Court’s decision to

the Fifth Circuit. Before the Fifth Circuit, the Partnership

argued that the Tax Court’s imposition of a substantial

identity of ownership requirement in the successor entity

(Serv-Tech) was an incorrect application of the law as

enunciated by this Court in Snow and the Fifth Circuit in

Harris. In support of its contention, the Partnership cited the

Fifth Circuit’s approval of Smith and compared its facts to

those of both Snow and Smith, establishing almost complete

factual identity.

In reply, the government countered the Partnership’s

challenge to the substantial identity of ownership requirement

as a precondition to attribution by abandoning its mere

change in form argument altogether. In its place, the

government stated in footnote nine of its Brief that the issue

of the degree of control had not been addressed by the

Supreme Court in Snow. The government went on to argue

that the Fifth Circuit had addressed “control” in Harris, and

it meant continuing “day to day” control. Further, the

government asserted that “Serv-Tech carefully structured the

acquisition of the Partnership interests to ensure the original

stockholders would remain in control.” Appellee’s Brief,

p.36.n.9. In effect, the government’s argument was that

control had to result from ownership in Serv-Tech received

in exchange for the Partnership interests. Pre-existing

2 In Smith, the partnership had not actually engaged in a trade or

business, so its prospects for doing so was established by experts.

7

ownership of Serv-Tech by individual partners did not count.

Under the government’s theory, control, and thus operational

nexus, requires no less than continual majority ownership,

since the only way to achieve day to day control is to own at

least 51%.

Subsequent to filing of the Partnership’s Opening

Fifth Circuit Brief and the government’s Fifth Circuit Brief,

the Ninth Circuit issued its opinion in Scoggins v.

Commissioner, 46 F.3d 950 (9th Cir. 1995), rev’g. 61

T.C.M. (CCH) 2859 (1991). Scoggins allowed the Section

174 deduction to a partnership that was obligated to sell its

technology to a corporation controlled by the members of the

partnership pursuant to a pre-arranged contract. The Ninth

Circuit thus attributed the control of the taxpayers as

stockholders of the acquiring corporation to their control as

partners of the selling partnership. Thus, through Scoggins.

the Ninth Circuit did exactly the opposite of what the

government was arguing for in this case.

Following the Scoggins opinion, the Fifth Circuit’s

approval of Smith and the controlling facts in Snow, the

Partnership argued in its Reply Brief that the “control”

referred to by the Fifth Circuit in Harris was “strategic”

control over the direction of the commercialization of the

technology and not continuing day to day control or

continuing majority ownership, because such a requirement

would emasculate Section 174 due to the economic

impossibility of compliance.

On the issue here presented, The Fifth Circuit opinion

in this case held that the Partnership, based upon its post

merger ownership interest in Serv-Tech, “could not exercise

the control over the exploitation of the technology as

required by Snow and Harris.” Mach-Tech v Commissioner,

8

1995 U.S. App. LEXIS 17112 at *8°. The Fifth Circuit

thus rejected the Partnership’s suggested legal standard of

“strategic control” and accepted the government’s

interpretation of “continuing day to day control” or

continuing majority ownership as the legal standard for

measuring the control needed for operational nexus‘. It

determined whether the requisite control existed solely by

reference to the stock received by the limited partners in

exchange for their partnership interests. The Fifth Circuit

did not attribute the existing ownership of certain of the

partners of the Partnership in Serv-Tech in determining

> In its Fifth Circuit Brief, the government argued that the moment

for testing the deductibility was at the time the expense was incurred. In

its Reply Brief, the Partnership refuted this contention and established

that the case law looks to the facts existing at the time of trial since the

operational nexus requirement can be satisfied at any time, not just at the

time the deduction is claimed. See, Appellants’ Reply Brief, 2-10. The

Fifth Circuit agreed and rested its decision on the Partnership’s lack of

resulting control after the merger. See, Mach-Tech v. Commissioner,

1995 U.S. App. LEXIS 17112 at *1, 2. (" Courts have determined that

a taxpayer can meet the ‘connection to business test’...if a taxpayer is

engaged in a trade or business at any time, and the deducted expenditures

were incurred with respect to that business." [Emphasis added])

* Giving credit where it is due, we commend the Fifth Circuit for

enunciating the “operational nexus” concept in Harris. It is in line with

what the Supreme Court intended in Snow. It is unfortunate the Fifth

Circuit deprived operational nexus of any legal significance by

establishing an unrealistic standard of control in this case. The Fifth

Circuit opinion establishes a required standard of control despite its

attempt to classify its decision on this issue as a factual matter see,

Mach-Tech v Commissioner, 1995 U.S. App. LEXIS 17112 at *8.

Further, the Fifth Circuit’s declaration that its opinion in this case has no

precedential value and therefore should not be formally published is

clearly erroneous. Jd, at *1, n.1. The question of the degree of control

required to meet the fifth Circuit’s operational nexus is a legal one which

the government acknowledged on Brief had not been previously

addressed. Appellee’s Brief, p. 36, n. 9.

9

whether the requisite control was present as was done in

Scoggins, and it offered no explanation why the standard

applied in Scoggins was not being applied in this case. In

fact, the Fifth Circuit did not mention the Scoggins decision

in any respect. It also did not discuss its prior approval of

Smith nor distinguish it from this case. Finally, the Fifth

Circuit completely ignored this case’s factual and legal

identity with Snow, simply stating that the Partnership was

stretching the meaning of Snow.

REASONS FOR GRANTING THE WRIT

Review on Writ of Certiorari should be granted for

the following reasons:

‘. The decision of the Fifth Circuit in this case

conflicts with the decision of this Court in Snow.

YF There is a conflict among the Fifth Circuit on

one hand, and the Sixth and Ninth Circuits on the other, as

to the standard of ownership and control an entity or its

owners must have over the developed technology in order to

be entitled to the Section 174 deduction.

3. The question of degree of “control” and

“operational nexus” represents an important question of

federal law which has not been, but should be, settled by this

Court.

The reason for granting the writ is obvious. Both the

Fifth Circuit and the government acknowledge this Court has

not established the degree of continuing control, if any, a

taxpayer must have over the technology it develops in order

to obtain the Section 174 deduction. The lack of a standard

has resulted in unequal treatment of the issue by the various

Courts of Appeal. The resulting chaos creates conflict

10

among the circuit courts, and between them and this Court’s

opinion in Snow. As discussed below, this is an important

question of federal law which impacts not only the taxing

arena, but also other federal laws and initiatives.

I. The opinion of the Fifth Circuit in this case decides

the control standard in a way that conflicts with this

Court’s Snow decision.

The country and the world in general is in the early

stages of a technological revolution. To know this is true

requires one only to look around. Advances in medicine,

telecommunications, computer science and other areas are

everywhere. Combined with the ever more complex global

economy we live in, it becomes easy to see that in order for

America to retain its pre-eminent position as economic leader

with its attendant higher standard of living for its citizens,

continued research and development of leading technologies

is a must. Congress has long recognized this need and

provided a subsidy in the form of the Section 174 deduction

for research and experimental expenditures.

Development of new technologies will not be limited

to existing companies; rather, it will be the entrepreneurs of

tomorrow that will pioneer their development. After all,

until a few years ago who heard of Microsoft Corporation.

The same can be said of Apple Computer, Genentech *and

a host of other companies that have sprung into existence and

prominence on the strength of new technologies developed by

their founders.

The Section 174 deduction figures prominently in this

quest for new and better technologies by these and yet to be

* None of these companies existed when this Court issued its Snow

opinion.

11

heard of entrepreneurs. The Section 174 deduction may well

be the deciding factor in whether a new technology should be

researched and developed by a start-up company, which is

usually nothing more at that point than one person’s idea.

Without the deduction, the cost of researching the new

technology is probably prohibitive. Congress specifically

recognized this probability when drafting Section 174, and

this Court acknowledged it citing both the Hearings on HR

8300 before the Senate Committee on Finance, 83d Cong.,

2d Sess, ptl, p.105, and 100 Cong. Rec. 3425 (1954), in

Snow v Commissioner, 416 U.S. 500 at 503, 504:

The legislative history makes fairly clear the

reasons. Established firms with ongoing

businesses had continuous programs of

research quite unlike small or pioneering

business enterprises. Mr. Reed of New York,

Chairman of the House Committee on Ways

and Means, made the point even more explicit

when he addressed the House on the bill:

“Present law contains no statutory provision

for dealing expressly with the deduction of

these expenses. The result has been confusion

and uncertainty. Very often, under present

law small businesses which are developing

new products and do not have established

research departments are not allowed to

deduct these expenses despite the fact that

their large and well-established competitors

can obtain the deduction... This provision

will greatly stimulate the search for new

products and new inventions upon which the

future economic and military strength of our

Nation depends. i/t will be particularly

12

valuable to small and growing businesses.

[emphasis added by the Supreme Court]

This Court made the above passage the centerpiece of its

Snow opinion, stating at 504:

Congress may at times in its wisdom

discriminate tax-wise between various kinds of

businesses, between old and oncoming

businesses and the like. But we would defeat

congressional purpose somewhat to equalize

the tax benefits of the ongoing companies and

those that are upcoming and about to reach the

market by perpetuating the discrimination

created below and urged upon us here.

Snow, following congressional intent and economic logic,

provides a liberal interpretation of the Section 174 trade or

business requirement which the courts below had refused to

follow. When Snow was rendered, taxpayers were looking

to this Court to set the record straight, and it did so in a

manner which was true to business realities, congressional

intent, and the meaning of Section 174.

The Fifth Circuit opinion, from which this Writ is

sought, ignores these business realities, congressional intent

and the meaning of Section 174 by establishing a control

standard contrary to the foregoing, and thus contrary to this

Court’s opinion in Snow. It is not a liberal interpretation, as

is the strategic control standard argued for by the

Partnership. Rather, it is a strict literal interpretation of the

term “control” which, contrary to congressional intent,

restricts, not broadens, the applicability of Section 174. The

Fifth Circuit opinion in this case totally contradicts this

Court’s interpretation of the “in connection with” language

of Section 174. Snow did not require a current trade or

13

business and attributed the activities of a successor to the

predecessor for purposes of qualifying for the deduction.

The effect of the current Fifth Circuit opinion is to make

Snow an aberration to allowance of the Section 174

deduction, rather than the standard it should be as an opinion

of this Court. Thus, this Court should grant this Writ to

remove the “cloud” placed on Snow by the Fifth Circuit and

to re-affirm the underlying principles for which Snow stands.

Il. By denying business realities, the Fifth Circuit’s

opinion creates a conflict between it and the Sixth and

Ninth Circuits.

At both the Tax Court and Fifth Circuit, the

Partnership explained it defies all business reality to think the

entity developing a product will continue to maintain the

control mandated by the Fifth Circuit. Unlike the Fifth

Circuit, the Sixth and Ninth Circuits’ opinions of Smith v

Commissioner, 937 F.2d 1089 (6th Cir. 1991), rev’g. 91

T.C. 733 (1988) and Scoggins v Commissioner, 46 F.3d 950

(9th Cir. 1995), rev’g. 61 T.C.M. (CCH) 2859 (1991) accept

and incorporate business reality in their interpretation of

Section 174. This Court likewise acknowledged business

realities in its Snow opinion. In Snow, the development

partnership ran out of money, and the development was

completed with funds borrowed from the general partner.

Thereafter, the technology was somehow transferred to a new

corporation and the actual trade or business begun.

“Somehow” is the correct description of the process because

the Snow record does not disclose the terms of the transfer

of the technology to the corporation. The Partnership argued

on brief that business reality dictated that in Snow additional

funds of some sort of funding would be needed to commence

commercial operations and that whoever provided those

funds did not do so gratuitously; that is, something was

received in return. Consequently, the Snow partners had to

os

have owned less than 100% of the technology when

commercialization began. What the Snow partners did have

was the right to decide which of several avenues would be

chosen for the commercialization of the developed

technology. i.e. “strategic control.”

Despite the Partnership repeatedly making this point,

the lower courts failed to grasp this basic business reality,

and in conflict with the Sixth’s Smith and Ninth’s Scoggins

made their decision in a legal vacuum.

The conflict among the Circuits concerning the

standard of “control” and thus operational nexus is as

follows. The Fifth Circuit looks only to ownership in the

developing entity and will not consider pre-existing

ownership in the successor entity, while the Ninth Circuit

does just the opposite and will consider pre-existing

ownership in the successor entity, not just ownership

received in exchange for ownership in the development

entity. The Fifth Circuit requires the owners of the

developing entity, as a result of ownership of the

developing entity, to own a majority in interest in the

successor entity so that they literally “control” the successor

entity. The Ninth Circuit requires no equity ownership in

the successor entity as a result of ownership in the

development entity. In line with the Ninth Circuit is the

Sixth Circuit which allows for substantial dilution of

ownership from the development entity versus the successor

entity and does not require the developing entity to be in

continuing day to day control. These latter two Circuits have

in essence adopted the strategic control approach argued for

15

by the Partnership in this case, and which makes more sense

as explained below.°

Dilution of ownership and loss of “day to day

control” is part of everyday life in the business community,

particularly in the venture capital arena which is the heart of

research and development. Thus, any interpretation of

Section 174 that fails to grasp this reality is flawed and

should not be allowed to stand. Evidence of this business

reality is found everywhere from current real life situations

to the classroom.

William A. Sahlman, Professor of Business

Administration at the Harvard Business School’ notes in his

article, The Structure and Governance of Venture-Capital

Organizations, Journal of Financial Economics 27 (1990)

473-521, North Holland, at 475:

Venture capitalists invest at reasonable well

defined stages... The seed stage typically

precedes formation of a complete management

team or completion of a product or service

design. Each successive stage is generally tied

to a significant development in the company,

such as completion of design, pilot

* For assistance in understanding the differences among the Circuits,

attached hereto as Appendix C-i through C-5 are diagrams of the pre

and post technology transfer ownership structure presented in this case,

Snow, Smith and Scoggins as well as a single diagram depicting all of the

post technology transfer ownership for ease of comparison.

” At Harvard Business School, Dr. Sahiman teaches a course on

Entrepreneurial Finance. His primary research interests are financial

contracting and risk capital, with major emphasis on venture capital,

initial public offerings, and leveraged buyouts.

16

production, first profitability, introduction of

a second product, or an initial public offering.

Reproduced as Appendix D is a detailed description of the

stages of venture capital investing referred to by Dr. Sahiman

in his article. Of particular relevance to the issue before this

Court is Dr. Sahlman’s definition of “seed investments” He

defines the term as a small amount of capital provided to an

inventor or entrepreneur to determine whether an idea

deserves further consideration and further investment. If it

is a technology, this stage may involve building a small

prototype. This stage does not involve production or sale.

See, Appendix D.

Dr. Sahlman’s definition of “seed investment” fits the

Snow partnership, the Scoggins partnership at issue before

the Ninth circuit, the Smith partnership at issue before the

Sixth Circuit, and most importantly the Mach-Tech

partnership at issue in this case. As defined, the seed stage

involves only a small investment and precedes formation of

a complete management team; thus, a seed stage company

lacks the financial wherewithal or the infrastructure to

“control” the ultimate use or marketing of the research which

the Fifth Circuit has required by its opinion in this case.

Dr. Sahiman goes on to note that the founders of

many of these seed investments were often diluted in

ownership well below 50% by the time the company made an

initial public offering of its stock. Examples of ownership

dilution of technology intensive companies mentioned at

pages 485 and 486 of his article were the following:

17

Name of Company Beginning Ownership Ending Ownership

(After Initial Public

Offering)

Apple Computer 100% 30.7%

Cray Research 100% 24.3%

Genentech 100% 41.4%

Lotus Development 100% 30.9%

Seagate 100% 64.1%

In all the examples save one, the founders’ ownership was

diluted through the successive rounds of funding until it was

substantially below 50%.

Genentech is a particularly interesting and relevant

example. Founded in 1976 to explore the commercial

possibilities of recombinant DNA, the first capital was

produced from the funds of one of its founders, Robert

Swanson. Several months later, outside funds were obtained

in return for 25% of the company. This dilution process

continued until the company went public in 1980, raising

$38.5 million, at which time the founders’ original ownership

had been reduced to 41.4%. At that time, the company had

not marketed a product, i.e., had not commenced its trade or

business. Its first product was ready for the market in 1982;

however, the cost of marketing the product was so substantial

that it licensed the product to Eli Lilly, a major drug

company. The reason for license at this stage was that the

company needed funds to develop new products, estimated to

run over $100 million per product, not to mention the eight

to ten years to bring a new drug to the market. Genentech

simply could not afford to do both even though public and

well capitalized.*

* For further discussion of Genentech, see William D. Bygrave and

Jeffry A. Timmons, Venture Capital at the Crossroads, Harvard Business

School Press (1992),p. and Hoover’s Company Profiles, The Reference

Press, Inc.(1994), available electronically on America Online, Personal

18

This enormous cost of developing new products is

forcing a change in the manner in which research and

development is being undertaken. Historically, research and

development was funded into a single company which

continued to sell additional ownership interests in itself to

finance the different stages of development outlined by Dr.

Sahlman with the ultimate goal being a public offering.

However, Professors William D. Bygrave and Jeffry A.

Timmons of Harvard Business School maintain in their book,

Venture Capital at the Crossroads, that the future will see

more and more seed stage companies (that is those companies

according to Sahlman’s description in Appendix that have

neither the capital nor the management or other infrastructure

in place to conduct commercial operations) built with the

intent of merging with giant corporations, and additionally

they predict that more and more mergers with strategic

partners’ -- exactly the course of action followed by the

Partnership in this case and which the Fifth Circuit held was

insufficient to qualify for the Section 174 deduction.

Obviously, the Fifth Circuit decision flies squarely in the

face of known and well recognized business practices and

represents an impediment to continued research and

development in this country because of the importance of the

Section 174 deduction to such development.

Strategic control, on the other hand, fits nicely within

the framework of accepted business practices as outlined

above. At the same time, such interpretation of control

maintains the integrity of Section 174 because it requires

freedom of decision on the part of the persons or entities

Finance, Section, Keyword Genentech. A 1990 Tufts University study

found the average cost of developing new drug was $231 million.

Bygrave and Timmons at 115.

°See, Bygrave and Timmons at p.292

19

undertaking the research and development. Freedom of

decision is the essential element missing in all of the cases in

which the Section 174 deduction was properly disallowed.

Strategic control does not limit a taxpayer’s freedom of

decision. It lets the market place dictate the course of events

and allows a small company to obtain the Section 174

deduction safe in the knowledge that at the proper time, it

can choose the best avenue for exploitation of its technology,

whether through a merger with a strategic partner as done in

this case, through a strategic alliance as was found in the

Sixth Circuit’s Smith case, through an outright sale as was

allowed in the Ninth Circuit’s Scoggins case, or otherwise.

In each of these cases, the pubic interest was served because

the free market system allowed individuals to make choices

for the best method of commercialization to everyone’s

benefit. In contrast, the majority ownership control standard

adopted by the Fifth Circuit creates artificial limitations on

a taxpayer’s freedom of decision, and thus interferes with the

free enterprise system.

The failure of the Fifth Circuit to take into account

business reality in applying Section 174 creates a conflict

with the reality based approaches of the Sixth and Ninth

Circuits. This conflict results in a lack of uniformity in

application of this most important statute. Thus, this Court

should grant this Writ to resolve the conflict.

20

Ill. The standard of control to be used is an important

question of federal law.

A. It impacts many business and governmental

economic initiatives.

As both the Fifth Circuit and the government have

acknowledged, the question of the degree of control has not

been addressed by this Court. The government argued

however that the question of the degree of control had been

resolved by the Fifth Circuit in Harris v Commissioner, 16

F.3d 75 (Sth Cir. 1994). See, Appellee’s Brief, p.36, n.9.

Agreeing with the government, the Fifth Circuit held that the

issue of control in this case was factual, not a legal issue.

Mach-Tech v Commissioner, 1995 U.S. App. LEXIS, 17112

at *8. However, a closer look at Harris reveals that it only

established “control” as the essential element of operational

nexus; it did not establish the standard of control test needed

to evaluate any particular circumstance. The Fifth Circuit

decided this issue in this case solely by reference to the

Mach-Tech partners’ resulting post merger ownership interest

in Serv-Tech, thereby adopting a literal interpretation of

control--51%. This standard of control represents an

important question of federal law which should be settled by

this Court.

If this Court refuses to grant this Writ, the erroneous

standard of control adopted by the Fifth Circuit will stand.

To assist in understanding the importance of this Court

establishing a correct standard of control, the computer

software industry is examined below. The computer

software example is given to allow this Court to contemplate

how a taxpayer seeking to develop a new software product

would fare under the present Fifth Circuit standard. The

industry source information set forth below was taken from

Hoover Industry and Company Profiles, The Reference

21

Press, Inc. (1994), available electronically on America

Online, Personal Finance Section, Keyword Computer

Software.

The computer software industry is worldwide in

scope. For the latest year shown in the Hoover Industry

Profile, worldwide revenue was almost $72 billion. The

United States is the largest single market, followed by Japan,

Germany, the United Kingdom and France. The top

suppliers of software in 1992 were household names, IBM

and Microsoft Corporation of the United States and Fujitsu

and NEC of Japan.

Governments are participating in this industry in order

to enable their economies to remain competitive. In Western

Europe, for example, governments there have undertaken

several long-term research and development projects.

Among them is the Eureka Software Factory. Created in

1986, it is a 10 year software engineering project with a

budget of $500 million. Its participating members include

most of the countries of Western Europe, including

Germany, France, Norway, Spain, Sweden, and the United

Kingdom.

Private industry is also at work in Western Europe.

In 1993, 15 European manufacturers formed an alliance

known as the European Software Institute. Its nonprofit

purpose is to promote and train European companies in

software development techniques.

Things have been just as active in this country, and

obviously need to continue if this country is to retain its

current dominance in this area. At the federal level,

Congress enacted the Stevenson-Wydler Technology

22

Innovation Act of 1980. 15 U.S.C. Section 3701 et. seq. In

its current form, one of its declared purposes is to promote

technology development through the establishment of

“cooperative research centers.” 15 U.S.C. Section 3702(2).

The objective of the centers is to enhance technological

innovation through, among other ways, the participation of

individuals from industry and universities in cooperative

technological innovation “activities,” and the development of

continuing financial support from other mission agencies,

from state and local government, and from industry and

universities through, among other means, fee licenses, and

royalties. Its “activities” include, among others, assistance

to individuals and small businesses in the generation,

evaluation, and development of technological ideas

supportive of industrial innovation and new business

ventures. 15 U.S.C. Section 3705.

In addition, the Clinton administration, in order to

maintain the competitiveness of U.S. high technology firms,

plans to create a national “information superhighway,”

known as the National Information Infrastructure. The plan

is to create an alliance between government and industry in

which the private sector builds, operates and improves the

infrastructure, and government creates an efficient, legal and

regulatory environment and funds specific interconnection

projects.

Private industry in this country is forming new

alliances to develop new technologies. Among the more

notable is Taligent, IBM’s and Apple Computer’s joint

venture to develop the next generation of computer software

operating systems employing an object oriented system.

These companies are not alone. Intel, the leading chip

manufacturer, and Microsoft have announced plans to form

Fiala

23

an alliance to develop Windows Telephony, a software

program that will make it easier for computers to work with

telephone equipment.

Multimedia is another emerging market. Multimedia

is the name given to computer software programs designed

to combine video, animation, still pictures, voice music,

graphics and text into a single system, blurring the lines

between several formerly distinct industries. Strategic

alliance dominate this area because these alliances reduce

risks, spread costs, and allow companies to acquire expertise

quickly. The alliances all involve well know American and

multinational companies such as Time Warner and U.S.

West; IBM, NBC television and NuMedia Corp.; IBM,

Apple Computer and Toshiba; and Microsoft Corporation,

Intel and General Instruments. These strategic alliances are

the future of research and development as predicted to come

into existence by Bygrave and Timmons in 1992 in their

book.

Given that the computer software industry example

can be applied today to all segments of industry, can any one

taxpayer maintain actual -- 51% -- control from the birth of

an idea through to its production and marketing? Obviously

no! Yet, that is the “control” standard adopted by the Fifth

Circuit. Such a standard will deter tomorrow’s entrepreneurs

and “seed investors” from pursuing the research and

development vitally important to our economy. The Section

174 deduction was enacted to encourage these “seed stage

investments.” Under the Fifth Circuit’ standard of control,

the economic reality is that it is impossible for these

entrepreneurs and “seed investors” to obtain the Section 174

deduction. The likely result will be less technology developed

by the very people Congress sought to encourage with

24

Section 174, the entrepreneurs and small businesses. In

effect, Section 174 will be void of its intended substance.

Accordingly, the question of the degree of control necessary

to establish operational nexus is far too important an issue of

federal law to be left to the lower courts and instead should

be decided by this Court.

B. An adverse standard of control causes serious

damage to anti-trust laws and concepts.

The burden being imposed by the Fifth Circuit in its

interpretation of Section 174 also does serious damage to the

companion anti-trust laws and hinders the type of

development envisioned by Congress and spoken of so

eloquently by Mr. Reed. Under the Fifth Circuit’s

interpretation, the cost to develop new product and obtain the

deduction becomes too much for smail companies to bear.

The result will be to create monopolies by default -- exactly

the opposite of what Section 174 was intended to accomplish

-- due to lack of competition, not from unreasonable

restraints by an industry leader, but from the economic

restraints of trying to compete without the benefit of the

Section 174 deduction. Competition is the heart of America’s

free market, free enterprise system, and fostering competition

is the core public policy of both Section 174 and companion

laws. The Fifth Circuit’s decision imposes artificial non free

market barriers stifling competition and placing Section 174

at odds with other laws. Accordingly, the threshold control

requirement of Section 174 is too important an issue of

federal law to be decided by the lower courts. The standard

should be established by this Court.

25

CONCLUSION

Petitioners request the Supreme Court to issue a Writ

of Certiorari to the Court of Appeals for the Fifth Circuit to

review the issues presented in this case.

Respectfully Submitted,

LARRY E. JACOBS

NORTON, JACOBS, KUHN

& MCTOPY, L.L.P.

333 Clay Ave.

Suite 700

Houston, Texas 77002

(713) 652-8870

Attorney for Petitioners

Of Counsel:

RUTH E. SALEK

333 Clay Ave.

Suite 700

Houston, Texas 77002

(713) 652-8844

la

APPENDIX A

IN THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

No. 94-40798

MACH-TECH, LTD. PARTNERSHIP

and SERV-TECH, INC.,

Petitioners-Appellants,

versus

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

Appeal from the Tax Court of the United States

(6529-92)

Before JOLLY and BARKSDALE, Circuit Judges, and

FELDMAN, District Judge.

E. GRADY JOLLY, Circuit Judge: **

*District Judge, of the Eastern District of Louisiana,

sitting by designation.

**Local Rule 47.5 provides: "The publication of

opinions that have no precedential value and merely decide

particular cases on the basis of well-settled principles of law

imposes needless expense on the public and burdens on the

legal profession." Pursuant to that Rule, the court has

determined that this opinion should not be published.

2a

Serv-Tech, Inc. ("Serv-Tech"), the tax matters partner

for Mach-Tech, Ltd. Partnership ("Mach-Tech"), appeals the

Tax Court’s disallowance of Mach-Tech’s deduction for

research and development expenses under 26 U.S.C. § 174

for the years 1983 and 1985. Because we hold that Mach-

Tech neither was engaged in a trade or business, nor had a

realistic prospect of engaging in a trade or business during

the years at issue, we affirm the Tax Court’s ruling.

I

The Internal Revenue Code, 26 U.S.C. § 174,

provides that "a taxpayer may treat research or experimental

expenditures which are paid or incurred by him during the

taxable year in connection with his trade or business as

expenses which are not chargeable to capital account. The

expenditures so treated shall be allowed as a deduction." 26

U.S.C. § 174(a)(1). The costs represent “research and

development costs in the experimental or laboratory sense."

26 C.F.R. § 1.174-2(a)(1).

A small body of case law has developed interpreting

§ 174. Courts have determined that a taxpayer can meet the

“connection to business" test even though the taxpayer did

not produce or sell a product at the time the expenditures

were incurred, if the taxpayer is engaged in trade or business

at any time and the deducted expenditures were incurred with

respect to that business. Snow v. Commissioner, 416 U.S.

500, 94 S.Ct. 1876 (1974). Furthermore, a deduction under

§ 174 also may be allowed if it is determined that there was

a “realistic prospect" that the technology developed will or

would have been exploited in the taxpayer’s trade or

business. See Zink v. United States, 929 F.2d 1015, 1022-23

(Sth Cir. 1991); Diamond v. Commissioner, 930 F.2d 372,

375 (4th Cir. 1991). The courts have closely scrutinized

claimed research and development expenditures, particularly

——

3a

those claimed by partnerships, to separate those that are

legitimate from those that are merely designed to shelter the

income of passive investors. See, e.g., Harris v.

Commissioner, 16 F.3d 75, 80-82 (Sth Cir. 1994).

We employ a de novo standard of review in

examining the Tax Court’s legal conclusions, including its

interpretations of the Internal Revenue Code. Harris, 16

F.3d at 81. We must, however, accept the Tax Court’s

findings of fact unless they are clearly erroneous. Jd. In

this. appeal, the question is whether the Tax Court was

clearly erroneous in finding that in 1983 and 1985 there was

no realistic prospect that Mach-Tech could use the

technology it had developed in connection with its trade or

business.

II

After considering the record, briefs, and arguments,

we have reached the conclusion that the Harris analysis

controls this case. Accordingly, we find that the Tax Court

was not clearly erroneous in its findings of fact, nor did it

commit reversible error in its legal reasoning. Our basis for

reaching this result is outlined below.

A

We first undertake Serv-Tech’s challenges to the Tax

Court’s findings of fact. Serv-Tech first argues that the Tax

Court erred in determining that Mach-Tech was not engaged

in a trade or business during the years at issue. Second,

Serv-Tech contends that the Tax Court erred in determining

that there was no “realistic prospect" that Mach-Tech would

engage in a trade or business relating to the cleaning system.

Despite Serv-Tech’s arguments to the contrary, we are

persuaded that when the Tax Court examined the “economic

4a

realities of the financial arrangement" in this case, it could

reach only the conclusion of nondeductibility. See, Harris,

16 F.3d at 79.

With respect to whether Mach-Tech was engaged in

a trade or business, the capital contributed by the partners

upon the formation of Mach-Tech was immediately funneled

to a research and development company, which was a

subsidiary of Serv-Tech. During the years in question,

Mach-Tech had no employees. Furthermore, it is not even

clear that Richard Krajicek, a major partner in Mach-Tech,

co-inventor of the technology, and president of Serv-Tech,

was acting on behalf of the partnership of Mach-Tech in his

business activities for the years in question, 1983 and 1985.

Considering these and other relevant facts reflected in its

thorough opinion, the Tax Court did not err in its

determination that Mach-Tech was not engaged in a trade or

business during 1983 and 1985.

Furthermore, the Tax Court was not clearly erroneous

in its finding that there was no "realistic prospect” that

Mach-Tech would engage in a trade or business relating to

the cleaning system. The existence of Serv-Tech’s right of

first refusal option, as well as the non-existence of a business

plan in the event that Serv-Tech did not exercise its option,

also serve to convince us that the Tax Court was correct in

its findings. Still further, the record is not convincing that

the partners, without Serv-Tech, realistically could nave

marketed the product. Thus, the Tax Court did not clearly

err when it found that Mach-Tech was not involved in a

wrade or business, that it did not have a "realistic prospect"

of eiigaging in one, and that the evidence demonstrated that

the research and development indeed would be exploited

through another’s business.

Sa

B

We next turn to Serv-Tech’s argument that the Tax

Court committed legal error by misinterpreting Snow v.

Commissioner, 416 U.S. 500 (1974). Serv-Tech argues that

the Tax Court erroneously imposed an additional restriction

on Mach-Tech by mandating that the partnership itself exploit

the technology in order to meet the requirements of § 174.

The Mach-Tech partnership sold their partnership interests to

Serv-Tech for 7.5% interest in Serv-Tech, which marketed

the technology. As was suggested at oral argument, Serv-

Tech’s argument stretches the meaning and intent of Snow,

while refusing to recognize the significance of Harris. In

Snow, which allowed the deduction under § 174, the

partnership that conducted the research and development

eventually incorporated so that it could market and exploit

the technology. Serv-Tech analogizes its situation to that in

Snow: Acknowledging that Mach-Tech’s partners have only

7.5% interest in Serv-Tech that they received when they sold

their partnership interests (and, thus, the technology) to Serv-

Tech, they argue that because the actions of Serv-Tech on

behalf of the product can be attributed to the former partners

of Mach-Tech, they are entitled to the deduction. This

argument ignores Harris’s requirement of an “operational

nexus"; that is, "the degree of ‘connection’ required between

the expenditures and the operation of the trade or business

itself." Harris, 16 F.3d at 78. In Harris’s broad spectrum

of financial arrangements,” Mach-Tech’s relationship with

Serv-Tech falls toward the end of the spectrum of financial

arrangements that function merely as “investment vehicle[s]

that cannot deduct the cash paid to the corporation under

section 174 even if the corporation used that very cash to

’ fund its research expenditures." Jd. According to Harris, a

dispositive factor in cases determining whether a § 174

deduction is warranted is whether "the entity that incurred

the research expenses actually managed and actually

6a

controlled the use or marketing of the research results." /d.

at 80. Despite Serv-Tech’s “attribution” arguments, it is

clear that the Tax Court did not err in finding that Mach-

Tech, with its 7.5% interest in Serv-Tech after the merger,

could not exercise the control over the exploitation of the

technology as required by Snow and Harris. Thus, even

though Serv-Tech characterizes this aspect of their appeal as

a legal issue, it was a determination of fact by the Tax

Court, which we do not find to be clearly erroneous.

III

In sum, the Tax Court was not clearly erroneous in

finding that Mach-Tech was not engaged in a trade or

business, and that it did not have a realistic prospect of

engaging in a trade or business during the years of 1983 and

1985. Furthermore, we find that the Tax Court did not err

in its determination that Mach-Tech did not maintain the

requisite control over the technology after the merger to

entitle it to the deduction under § 174. For the foregoing

reasons, the judgement of the Tax Court is

AFFIRMED.

Ta

IN THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

No. 94-40798

MACH-TECH, LTD. PARTNERSHIP and

SERV-TECH, INC.,

Petitioners-Appellants,

versus

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

Appeal from Decision of the

United States Tax Court

Before JOLLY, and BARKSDALE, Circuit Judges, and

FELDMAN’, District Judge.

BY THE COURT:

IT IS ORDERED that appellant’s motion

for judicial notice and use of substituted copy of expert

report is DENIED.

/s/ E. GRADY JOLLY

U. S. District Judge

*District Judge, of the Eastern District of Louisiana,

sitting by designation.

8a

APPENDIX B

T.C. Memo. 1994-225

UNITED STATES TAX COURT

MACH-TECH, LTD. PARTNERSHIP, SERV-TECH,

INC., TAX MATTERS PARTNER, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 6529-92. Filed May 23, 1994.

Larry E. Jacobs and Ruth E. Salek, for petitioner.

David B. Mora, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

FAY, Judge: As stipulated, the only issue for

consideration is whether, pursuant to section 174,' Mach-

Tech, Ltd. Partnership (Partnership) is “entitled * * * to

elect to deduct its research and experimental expenditures.”

FINDINGS OF FACT

Some of the facts have been stipulated and are so

found. The stipulations of fact and attached exhibits are

incorporated herein by reference.

From December 1983 through June 1986, Partnership

was a limited partnership formed under the laws of the State

of Texas. When the petition was filed, Partnership no longer

'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, unless otherwise indicated.

9a

had a principal place of business, but the principal place of

business of its general partner and tax matters partner,’

Serv-Tech, Inc.’ (Serv-Tech), was in Houston, Texas.‘

Serv-Tech is a corporation incorporated under the

laws of the State of Texas. As of 1983, the business of

Serv-Tech was industrial and chemical cleaning, plant

maintenance, and oilfield services.

Partnership was formed to engage in the research,

development, reduction to commercial use, and operation

and/or licensing of a fully enclosed mobile heat exchange

bundle cleaning system (the Fast Clean System), used in

hydroblast cleaning of equipment used in the oil and gas

industry.

Limited partnership interests in Partnership were

acquired pursuant to a private offering memorandum dated

December 8, 1983 (the 1983 memorandum). The limited

partners in Partnership were as follows:

*The term “tax matters partner" is defined in sec. 6231(a)(7).

*Serv-Tech, Inc. (Serv-Tech), was originally named Mac-Services,

Inc., but its name was changed in 1984. For simplicity, all references

herein are to Serv-Tech.

“Unless stipulated to the contrary, venue for appeal in petitions filed

under the TEFRA unified partnership provisions is the U.S. Court of

Appeals for the circuit in which the principal place of business of the

partnership is located at the time the petition is filed. Sec. 7482(b)(1)(E);

see Peat Oil & Gas Associates v. Commissioner, T.C. Memo. 1993-130,

in which one of the factors we considered in deciding appropriate venue

for appeal was the principal place of business of the tax matters partner.

10a

Name Ownership Interest

Richard W. Krajicek 29.7 %

(Richard Krajicek)

Edward Randall, III 39.6

(Mr. Randall)

Max Miller 4.95

Michael Miller 4.95

Martha Calvin 4.95

Michael Krajicek 4.95

Stephen Krajicek 4.95

Charles Stanley 4.95

From at least December 1983 through at least June

1986, Richard Krajicek, the co-inventor of the Fast Clean

System, was also president, chairman of the board of

directors, and a shareholder holding 34 to 40.5 percent of the

stock’ of Serv-Tech. Mr. Randall was an investment banker

who had known Richard Krajicek for over 20 years and been

involved with him regarding Cesco, a company engaged in

the chemical plant cleaning business. As of May 12, 1986,

Mr. Randall, Max Miller, Michael Miller, and Charles

Stanley each owned less than 2 percent of the Serv-Tech

stock.

On December 29, 1983, Partnership executed a

research and development agreement (the form of which was

attached as an exhibit to the 1983 memorandum) with Mac-

Tech, Inc. (Mach-Tech), a wholly owned subsidiary of Serv-

Tech. The research and development agreement provided

that Mach-Tech, through its own activities and subcontracts,

would use its best efforts to develop the technology and

equipment for the Fast Clean System and assist in obtaining

‘From Jan. 1, 1983, through June 30, 1986, no other single

shareholder owned more Serv-Tech stock than Richard W. Krajicek

(Richard Krajicek).

lla

patents therefor for a fixed fee of $347,500, payable

$250,000 on or before December 31, 1983, and $97,500

during 1984. The research and development agreement

terminated on the earliest of (1) reduction of the Fast Clean

System to commercial use, (2) expenditure of the $347,500,

or (3) December 31, 1985. Partnership paid Mach-Tech

$250,000 on December 31, 1983, and $118,713 in 1985.°

Also on December 29, 1983, Partnership executed a

grant of option to acquire exclusive license (license option

agreement) with Serv-Tech, which granted Serv-Tech a right

of first refusal to acquire a nonexclusive license and an

exclusive license. Under this agreement, the form of which

was also attached to the 1983 memorandum, Partnership

could not "sell, alienate, assign or otherwise transfer any

right, title, interest or license" to the Fast Clean System

without offering Serv-Tech the option under the two license

provisions.

The nonexclusive license option provided Serv-Tech

with the right to manufacture and use the Fast Clean System

in Serv-Tech’s service operations for the 18-month period

after the Fast Clean System was reduced to commercial

practice.’ If Serv-Tech exercised this option, Serv-Tech was

*The parties stipulated that: “The Partnership has substantiated, all

of its expenditures". There is no explicit explanation in the record for

why the second amount was not paid in 1984, or was greater than the

$97,500 provided in the research and development agreement. However,

the research and development agreement states that Mach-Tech, Ltd.

Partnership (Partnership) shall pay or reimburse Mach-Tech, Inc. (Mach-

Tech), for certain costs relating to obtaining patents.

"The license option agreement defines the term “reduction to

commercial practice” as the design and manufacture of a fully enclosed

mobile bundle cleaning system and a successful bundle cleaning operation

under normal commercial conditions, evidenced by a letter or other

12a

required to “purchase” the Fast Clean System from

Partnership for the greater of (1) the cost of reproduction

reduced by depreciation, if any, or (2) the fair market value.

At the end of the 18-month license term, if Serv-Tech did not

exercise the exclusive license option described below,

Partnership was required to repurchase the Fast Clean

System for the greater of (1) the price paid by Serv-Tech,

reduced by depreciation for tax purposes, or (2) fair market

value.

The exclusive license option granted Serv-Tech the

right to acquire an exclusive license “to manufacture, use,

market and otherwise commercially exploit" the Fast Clean

System for the period subsequent to the 18-month period.

Except in the event of failure by Serv-Tech to pay royalties

or make reasonable marketing efforts, this exclusive license

would continue until the expiration, including extensions,

reissues, or renewals, of any United States or foreign patents

of the Fast Clean System or improvements thereon.

If Serv-Tech exercised either option, Serv-Tech

agreed to pay Partnership a royalty of 12.5 percent for 1984

and 1985, and 2 percent thereafter, of gross revenues from

(1) sales and rentals of machines utilizing the Fast Clean

System, (2) sublicensing of tle Fast Clean System, and (3)

services using the Fast Clean System.

The unsigned certificate and agreement of limited

partnership of Partnership (the partnership agreement)

attached to the 1983 memorandum includes an option,

exercisable in 1985 through 1987, for Serv-Tech to exchange

its stock for all of the interests of the limited partners,

provided that for the 90 days preceding the notice to exercise

written instrument indicating satisfactory operation by the responsible

manager of the industrial facility where such bundles were cleaned.

13a

the option the Serv-Tech stock was listed on the New York

or American Stock Exchange or quoted on the NASDAQ

System.

The "Summary of the Business" section of the 1983

memorandum states in part: "The Partnership also will seek

to secure patent protection for * * * [The Fast Clean

System], and will grant to * * * [Serv-Tech], the General

Partner, an option to acquire an exclusive license to

commercially exploit * * * [the Fast Clean System]." The

"FEDERAL INCOME TAX ASPECTS" section of the 1983

memorandum states in part: "* * *[Serv-Tech] will acquire

* * * [the Fast Clean System], once developed, instead of the

Partnership retaining it for use in its own trade or business".

All of the "Financial Illustrations” in the 1983 memorandum

assume that Partnership revenues from the Fast Clean System

are 12.5-percent royalties for 1984 and 1985 and 2-percent

royalties thereafter.

On February 15, 1985, Mach-Tech, acting as research

and development contractor to Partnership, and Serv-Tech

executed a testing agreement, pursuant to which Serv-Tech

agreed to test the Fast Clean System in commercial jobs at

its expense and was entitled to all revenues. The testing

agreement did not provide for the sale of the Fast Clean

System by Serv-Tech. The testing agreement terminated

when the Fast Clean System was reduced to “optimum

expected commercial use", but no later than December 31,

1985.

During 1985, Serv-Tech sold four units of the Fast

Clean System to (1) Fast Clear, Inc., from which it leased

them back for a rental "incurred" of about $30,000 for 1985,

and (2) Nolo Bido, Inc., from which it received $48,883 for

managing and operating the related equipment for 1985. In

a report for the calendar year 1985, Serv-Tech stated that

l4a

five units of the Fast Clean System were in service during

1985 generating gross revenue of $985,105. Additionally,

the notes to the consolidated financial statements for Serv-

Tech and its subsidiaries for 1985 and 1986 state that the

sales of the four units of the Fast Clean System “resulted in

revenues of approximately $1,100,000 and manufacturing

costs of approximately $834,000." No part of the proceeds

from the sale of the Fast Clean System units nor royalties on

the revenues generated from operation of it by Serv-Tech

were paid to Partnership.

On September 9, 1985, an application for a United

States patent for the Fast Clean System was filed,’ and the

patent was subsequently issued. On November 11, 1985, an

application for a European patent for the Fast Clean System

was filed on behalf of Partnership, and that patent was also

subsequently issued.

The Fast Clean System was ready for commercial

exploitation on January 1, 1986. On January 2, 1986,

pursuant to the license option agreement, Serv-Tech executed

a temporary nonexclusive license agreement with Partnership

for the Fast Clean System for a period of 18 months, and

Serv-Tech agreed to purchase the Fast Clean System

equipment owned by Partnership for $121,208, payable with

a note.

A document entitled "ASSIGNMENT" dated February

21, 1986, provides that Richard Krajicek and Robert R.

Cradeur, as the joint inventors, assign Partnership all rights,

*The patent document in the record describes the product as a

"Mobile Articulatable Tube Bundle Cleaner", and reflects Serv-Tech as

the assignee from the inventors, Richard Krajicek and Robert R. Cradeur.

A confidential offering memorandum circulated in May 1986 (described

infra) states that Mach-Tech applied for patents on behalf of Partnership.

a

15a

title, and interest in the Fast Clean System and any related

U.S. and foreign Letters Patent granted.

In May 1986, a confidential offering memorandum

(the 1986 memorandum) pursuant to which Serv-Tech offered

to exchange shares of its common stock for the interests of

all of the limited partners in Partnership, was circulated to

the partners of Partnership.? The 1986 memorandum stated

in part:

Reason for Exchange Offer. * * *

[Partnership] was established to research, develop and

test the Fast Clean system as to its feasibility and

j applicability in refinery, petrochemical and industrial

applications. The general research objectives of * *

* [Partnership] have been met. * * * {[Mach-Tech],

the research and development contractor, completed

the research and development program at the end of

December, 1985.

In order to commercially exploit the

developments made through the research and

development program, it will be necessary to build

additional Fast Clean systems, to expand marketing

program [sic] and to coordinate the Fast Clean system

with other petrochemical plant maintenance activities.

* * * [Partnership] does not presently have the

financial resources or the skilled personnel necessary

to undertake such a program.

* * * [Serv-Tech] feels that combined with *

* * [Serv-Tech’s] other product lines, the acquisition

*The condition to the exercise of the option to exchange contained in

the partnership agreement (that Serv-Tech stock be listed or quoted on

one of the enumerated stock exchanges) was not met at that time.

16a

of * * * [Partnership] Interests will give * * * [Serv-

Tech] the technology necessary to provide the

petrochemical industry a totally integrated on-site heat

exchanger maintenance capability. * * * [Serv-

Tech’s] presence in the market will provide the basis

for introducing the Fast Clean system to its

established customers. * * * [Serv-Tech] feels that it

is positioned to undertake commercial exploitation of

the Fast Clean system. It is unlikely that * * *

[Partnership] could economically provide for its own

account, the experienced personnel, facilities and

other resources which will be necessary to market and

continue development of the Fast Clean system.

[Emphasis added.]

Pursuant to the 1986 memorandum, the exchange would only

be consummated if all partners accepted. The number of

shares to be exchanged was determined by the board of

directors of Serv-Tech.!° The 1986 memorandum stated

further:

Control. Assuming all of the Serv-Tech stock

offered hereby is acquired pursuant to the terms of

this Offering, the present shareholders of * * * [Serv-

Tech] will own 92.3% of the shares of the Serv-Tech

stock. Since * * * [Serv-Tech’s] Articles of

Incorporation do not provide for cumulative voting,

such ownership and their positions with * * * [Serv-

Tech] will enable such shareholders to continue to

control * * * [Serv-Tech’s] policies and affairs. * *

7”

The parties stipulated that the adequacy of the consideration in the

exchange is not disputed.

17a

Additionally, the 1986 memorandum provided that,

"Concurrent with the offer to exchange” the stock, Serv-Tech

requested that the limited partners of Partnership consent to

the 1985 sales of the Fast Clean System, which it stated were

sold to affiliates of Partnership at cost.

All of the limited partners in Partnership accepted the

offer. In June 1986, the limited partners of Partnership

received a total of 475,000 shares of Serv-Tech common

stock in exchange for their partnership interests.

Thereafter, Serv-Tech used the Fast Clean System in

its business. For the fiscal year ended December 31, 1992,

Serv-Tech reported gross revenues of about $148 million and

had net income of about $6 million. Regarding the 1986

exchange, the notes to the consolidated financial statements

for Serv-Tech and its subsidiaries for the fiscal year 1985

State that, because of the exchange, Serv-Tech was "relieved

of obligation to reimburse * * * [Partnership] for the

research and development advances of $250,000" and that

that amount would be recorded as income for the fiscal year

1986. ;

During the tax years 1983 and 1986, Partnership had

no employees, no activities other than those described herein,

and no office other than that of its general partner, Serv-

Tech.

On the Form 1065, U.S. Partnership Return of

Income for the short taxable year December 30 through

December 31, 1983, Partnership elected to use the cash

method of accounting and the current expense method for

reporting "research and experimental expenses” under section

174(a), and deducted $250,000 for research and development

expenses. An amended return was filed for that year to

reflect a tax preference item of $247,917 for research and

18a

development expenses.

On the return for Partnership for 1985, research and

development expenses deducted total $118,713, and the tax

preference item for research and development expenses is

$106,842.

In Notices of Final Partnership Administrative

Adjustment (FPAAs) for Partnership, respondent disallowed

the “Research & Development" deduction claimed, and

eliminated the tax preference item reported, for research and

development expenses for each of the years 1983 and 1985,

respectively.

OPINION

Section 174 allows a taxpayer to treat as deductible

research and experimental expenditures paid during the

taxable year "in connection with" the taxpayer’s trade or

business." Treasury regulations provide that the

expenditures may be paid for research or experimentation

carried on by the taxpayer or another on the taxpayer’s

behalf. Sec. 1.174-2(a)(2), Income Tax Regs. The issue in

this case is whether Partnership engaged in the requisite trade

or business to which the expenditures in question relate.

Petitioner contends first that Partnership engaged in

a trade or business by virtue of the operation of the Fast

Clean System by Serv-Tech after the "merger" of Partnership

with it. Second, petitioner argues that Partnership engaged

in a trade or business based on the marketing activities

during 1985 and 1986 of Richard Krajicek, who was

allegedly acting as a limited partner of Partnership and

"'The “taxpayer” for this purpose is the partnership. Cf. Campbell

v. United States, 813 F.2d 694, 695-696 (Sth Cir. 1987).

19a

officer of Serv-Tech, the general partner of Partnership.

Third, petitioner maintains that there was a "realistic

prospect" Partnership would have engaged in a trade or

business if the "merger" had not taken place because Richard

Krajicek and Mr. Randall, the two limited partners with the

greatest ownership interests, had the ability to do so given

their respective backgrounds as inventor and investment

banker.

Respondent contends that Partnership had no realistic

prospect of engaging in a trade or business relating to the

Fast Clean System but could at most act as a passive investor

because of the existence of the exclusive license option.

Additionally, respondent argues that activities of Serv-Tech

after June 1986 should not be attributed to Partnership

because the limited partners’ interests in Partnership were

much greater than their stockholdings in Serv-Tech after the

1986 exchange. Respondent also maintains that petitioner

has not shown that Richard Krajicek was acting on behalf of

Partnership in 1985 and 1986.

We agree with respondent.

In order to be entitled to deductions for research and

development expenditures, a taxpayer need not be engaged

in a trade or business currently. Snow vy. Commissioner, 416

U.S. 500, 503-504 (1974). However:

For section 174 to apply, the taxpayer must still be

engaged in a trade or business at some time, and we

must still determine, through an examination of the

facts of each case, whether the taxpayer’s activities in

connection with a product are sufficiently substantial

and regular to constitute a trade or business * * *

[Green y. Commissioner, 83 T.C. 667, 686-687

(1984). ]

The applicable test is whether the taxpayer has a "realistic

20a

prospect" of engaging in a trade or business. Harris v.

Commissioner, 16 F.3d 75, 81 (Sth Cir. 1994), affg. T.C.

Memo. 1990-80, supplemented by 99 T.C. 121 (1992);

Diamond v. Commissioner, 92 T.C. 423, 439 (1989), affd.

930 F.2d 372 (4th Cir. 1991); Spellman v. Commissioner,

845 F.2d 148, 149 (7th Cir. 1988), affg. T.C. Memo. 1986-

403. The factors considered are (1) the terms of the parties’

contractual arrangements, (2) the intentions of the parties to

the agreements, (3) business activities, if any, of the

partnership, (4) exercise of control by the partnership over

the entity doing the research, and (5) the capacity and

incentive, if any, of the partnership to use the product in its

own trade or business. See Kantor v. Commissioner, 998

F.2d 1514 (9th Cir. 1993), affg. this issue T.C. Memo,

1990-380; Double Bar Chain Co. v. Commissioner, T.C.

Memo. 1991-572.

The grant of an exclusive license to exploit

technology vefore beginning research and development has

been held to preclude a licensor from engaging in a trade or

business with respect to the technology. Spellman v.

Commissioner, supra; Green v. Commissioner, supra.

We concluded similarly as to an option to acquire an

exclusive license to exploit the product granted before the

beginning of the research and development work and sale of

limited partnership interests in Diamond v. Commissioner,

supra. In Diamond v. Commissioner, supra, the taxpayer

contended that there was merely an option to acquire an

exclusive license, and, if the option was not exercised, the

partnership could exploit the products resulting from the

research. We concluded that there was no realistic prospect

2la

that the partnership could do so.’2 Diamond yy.

Commissioner, supra at 439. In so concluding, we adopted

the rationale of the Court of Appeals for the Seventh Circuit

in Spellman v. Commissioner, 845 F.2d 148 (7th Cir. 1988),

that, if the option price is reasonable and sufficient profits

are anticipated to justify incurring the manufacturing and

marketing costs, the corporation would exercise the option in

its sound business judgment. Diamond y. Commissioner,

supra at 440.

Pursuant to the right of first refusal’? in the license

"Diamond v. Commissioner, 92 T.C. 423 (1989), affd. 930 F.2d 372

(4th Cir. 1991), has been repeatedly followed in other situations involving

grants of options to acquire exclusive licenses in exchange for royalties,

see, €.g., Harris v. Commissioner, 16 F.3d 75, 81 (5th Cir. 1994), affg.

T.C. Memo 1990-80, supplemented by 99 T.C. 121 ( 1992); Kantor v.

Commissioner, 998 F.2d 1514 (9th Cir. 1993), affg. this issue T.C.

Memo. 1990-380. We have also disallowed deductions claimed for

research and development expenditures in situations where the licenses

were not executed in writing contemporaneously with the research and

development agreements. See Stauber v. Commissioner, T.C. Memo.

1992-128 (facts indicated that a "pre-existing understanding" concerning

a future license existed); Double Bar Chain Co. v. Commissioner, T.C.

Memo. 1991-572 (there existed an “understanding” regarding a future

license of technology).

"Petitioner does not contend that the right of first refusal ( i.e., that

Partnership has to "sell, alienate, assign or otherwise transfer any right,

title, interest or license" to the Fast Clean System before the licensee can

exercise the option) distinguishes this case from Diamond v.

Commissioner, supra. Petitioner did not cite us to any case involving a

right of first refusal in this context. The only case found is Universal

Research & Development Partnership No. 1 v. Commissioner, T.C.

Memo. 1991-437, in which the deduction for research and development

expenses was aliowed. In Universal Research, respondent had the burden

of persuasion, and the licensee had no more experience relating to the

product resulting from the research than the partnership. Here, petitioner

bears the burden, and the licensee, the general partner of Partnership, had

22a

option agreement here, Partnership could not sell, alienate,

assign, or otherwise transfer any right, title, interest, or

license to the Fast Clean System, without offering Serv-Tech

the option to an exclusive license to manufacture, use,

market, and otherwise commercially exploit the Fast Clean

System. The exclusive license option lasted for the life of

the patents. In return, Partnership would receive royalties.

During the years 1983 through 1986, Partnership had

no employees. See Harris v. Commissioner, supra at 80

n.10. By contrast, Serv-Tech had established itself in the

relevant field and had products related and complementary to

the Fast Clean System.

There was marketing activity and some income in

1985 relating to the Fast Clean System. Petitioner has not

presented evidence that there was no income earned during

the first half of 1986, when royalties would be payable to

Partnership under the January 2, 1986, temporary,

nonexclusive license agreement, or that royalties were paid.

The record does not contain statements from Serv-Tech to

Partnership setting forth why royalties were not payable or

Serv-Tech’s activities on behalf of Partnership during the

first half of 1986."

The 1983 memorandum states that: "[Serv-Tech] will

acquire * * * [the Fast Clean System], once developed,

instead of the Partnership retaining it for use in its own trade

or business". See Double Bar Chain Co. v. Commissioner,

extensive experience in the industry.

We consider these facts in deciding whether subsequent events are

consistent with our conclusions regarding the prospects in 1983 and 1985

of Partnership’s engaging in a trade or business relating to the Fast Clean

System. See Levin v. Commissioner, 832 F.2d 403, 406 n.3 (7th Cir.

1987), affg. 87 T.C. 698 (1986).

Macs mn is ema ee Sa

23a

T.C. Memo. 1991-572, in which we considered statements

in the private offering memorandum in concluding that the

partnership there never intended to engage in a trade or

business. The 1986 memorandum states that "It is unlikely

that * * * [Partnership] could economically provide for its

own account, the experienced personnel, facilities and other

resources which will be necessary to market and continue

development of the Fast Clean System." Again, this

statement in the 1986 memorandum supports our conclusions

regarding the prospects in 1983 and 1985 of Partnership

engaging in a trade or business relating to the Fast Clean

System. See Levin v. Commissioner, supra at 406 n.3.

We have considered that Richard Krajicek, who was

the co-inventor, was a limited partner in Partnership with a

29.7 percent ownership interest. However, he was also the

largest single shareholder, president, and chairman of the

board of directors of Serv-Tech. We are unable to conclude

that, as a limited partner, he was acting on behalf of

Partnership.

Recently in concluding that a limited partner was not

entitled to deduct research and development expenditures by

a partnership which granted an option for a perpetual license

of the resulting technology to the corporation doing the

research, the Court of Appeals for the Fifth Circuit noted

that:

In analyzing the operational nexus facet of section

174, the courts have dealt with a broad spectrum of

financial arrangements. At one end of the spectrum

lie arrangements in which a partnership buys stock in

a corporation, which then uses the capital to fund

research activities, manages the research activities

itself, manufactures the resulting product, sells the

product in the marketplace, and returns a portion of

24a

the profits to the partnership as dividends. In these

situations, the partnership does not incur research

expenses in connection with its trade or business but,

instead, functions as an investment vehicle that cannot

deduct the cash paid to the corporation under section

174 even if the corporation used that very cash to

fund its research expenditures. At the other end of

the spectrum lie financial arrangements in which a

partnership uses its own funds to conduct research

activities, manufactures the product itself, and sells

that product in the marketplace. In this instance, the

partnership incurs research and development

expenditures in connection with its trade or business

and deduct them under section 174. * * * [Harris v.

Conumissioner, 16 F.3d 75, 78 (Sth Cir. 1994).]

The facts here place Partnership on the "spectrum" as

a passive investor used as a financing vehicle, without an

established realistic prospect of engaging in a trade or

business relating to the Fast Clean System. The expectations

were that Serv-Tech would do so, or if Serv-Tech could not

do so, an entity other than Partnership would do so. See

United Fibertech, Ltd. v. Commissioner, T.C. Memo. 1991-

445, affd. 976 F.2d 445 (8th Cir. 1992), in which we

concluded that, even after the licensee, a research and

development corporation, could not market the product

because of financial problems, the partnership searched for

a successor, and did not try to acquire a staff or "entertain

the idea of manufacturing or marketing the product” itself.

Relying on Snow v. Commissioner, 416 U.S. 500

(1974), petitioner contends that the activities of Serv-Tech

after the exchange of its stock for the limited partners’

interests in Partnership should be attributed to Partnership.

‘In Harris v. Commissioner, 16 F.3d at 78, the Court of

Appeals for the Fifth Circuit stated that:

|

25a

Snow settled that the temporal nexus of a research

project to the start of an active trade or business was

not dispositive of section 174’s applicability, it left

open the degree of "connection" required between the

expenditures and the operation of the trade or

business itself--the operational nexus * * *

Petitioner has not established "the operational nexus”

for Partnership here nor persuaded us that the facts here are

sufficiently analogous to Snow.

Petitioner argues further that (1) Partnership could

only act through its partners, and (2) Richard Krajicek, as a

limited partner and an officer of Serv-Tech, the general

partner, of Partnership, was doing significant marketing from

1983 through 1986, which should be attributed to

Partnership. Petitioner also maintains that advertising

brochures of Serv-Tech for services relating to the Fast

Clean System should be attributed to Partnership because

Serv-Tech was acting on Partnership’s behalf.'® Richard

Krajicek testified as follows regarding his activities:

Q When you were marketing Fast Clean,

who were you marketing on behalf of? Let’s take

first in 1985.

"The testing agreement provisions suggest that Serv-Tech was acting

for its own benefit in 1985 and had total control over Partnership.

Despite earning revenues from the use of the Fast Clean System, Serv-

Tech was not required to make any payment, and apparently not even

required to provide an accounting, to Partnership. The testing agreement

did not provide for sales of units of the Fast Clean System. Consent to

the sales of the units by Serv-Tech in 1985 was not sought or obtained

until 1986, nor was an accounting of prices and associated expenses

provided.

26a

A Oh, I guess I was probably marketing

on behalf of myself, you know, being I had -- but I

would say I was marketing it on behalf of Mach-Tech

and the general partners [sic], the people who put up

the money.

Both Richard Krajicek and Serv-Tech had many roles in the

entities and transactions relating to the Fast Clean System.

Petitioner has not persuaded us that either was clearly acting

for Partnership in engaging in the marketing activities in

1985. The facts described above indicate that all intended

for Serv-Tech to engage in the trade or business as to the

Fast Clean System. The party on whose behalf the

marketing activities were undertaken was left at best

vague’® so that Serv-Tech could do so. Because the

activities of Serv-Tech and Partnership were so intertwined,

we cannot conclude that Serv-Tech was acting in its capacity

as general partner rather than on its own behalf.

Petitioner also maintains that Partnership had the

realistic prospect of engaging in a trade or business relating

to the Fast Clean System because, based on their respective

experience, Richard Krajicek and Mr. Randall could have

marketed the Fast Clean System if the limited partners had

not agreed to the "merger" with Serv-Tech. In the reply

brief, petitioner argues that Serv-Tech was “near

bankruptcy”, could not "cram [the exclusive license option]

‘Petitioner presented testimony that "typical" marketing efforts for

limited partnerships owning real estate and video rental franchises,

respectively, are made under the name of entities other than the

partnerships. Petitioner relies on the testimony in support of its

arguments. We do not find the testimony or these arguments persuasive.

The businesses are totally different from that of Partnership, section 174

does not appear to apply, and there is no indication that the courts have

concluded the other partnerships engage in a trade or business for tax

purposes.

27a

down . . . on" the limited partners, and never intended to

exercise it. Additionally in the reply brief, petitioner

contends that Mr. Randall would have stopped the exercise

of the exclusive license option by Serv-Tech and marketed

the Fast Clean System elsewhere.

We rejected a similar argument in Diamond y.

Commissioner, 92 T.C. 423, 441 (1989), affd. 930 F.2d 372

(4th Cir. 1991), stating as follows:

Robotics’ general partners had an abundance of

relevant experience, which they could presumably

employ to assemble a staff. However, the Seventh

Circuit found in Spellman that the lack of such

resources was not the factor that was fatal to the

taxpayer’s case, but that “whatever Sci-Med’s

desires," it would have the opportunity to engage in

a trade or business with respect to the byproducts

only if it was uneconomical to do so [and the option

was not exercised]. Taxpayer there, as petitioner

here, is prevented from engaging in the particular

trade or business either by the law of contracts or the

laws of economics.

Petitioner has not demonstrated that Serv-Tech would not

exercise the option under its right of first refusal, how it

could be stopped from doing so, or why the option existed if

Serv-Tech did not intend to exercise it. Petitioner has not

sufficiently shown that Serv-Tech was “near bankruptcy" (the

limited partners who exchanged their interests in Partnership

for Serv-Tech stock apparently did not think so), or that

there was a realistic prospect that Partnership would engage

in a trade or business even if Serv-Tech did not exercise the

option or otherwise acquire rights to the Fast Clean System.

28a

Petitioner relies on testimony of Mr. Randall in

response to a hypothetical question assuming that the limited

partners rejected the exchange of Serv-Tech stock for their

partnership interests as follows:

Q * * *

My question to you is, sir, at that time if

Serv-Tech had come back to you and said, Well, we

are now going to exercise our permanent royalty, and

take the technology from you, what would have been

your reaction?

* * « sd baad baad *

THE WITNESS: I would have seriously

objected and sought remedies to stop that.

* x * * * mm *

Q And why is that, sir?

A Well, if I had said no to the Serv-Tech

offer, after it was improved, it would have been

because I lacked confidence in the future of the

company. And I would have wanted to take the

product that we had developed and market it

elsewhere. And marketing such a thing like that is

something that I was familiar with.

However, on cross-examination, Mr. Randall testified that

this reference to marketing the Fast Clean System assumed

that Mr. Krajicek would also be involved in that effort and

was, at best, vague as to whether he would have gone

forward without Mr. Krajicek. This testimony does not

persuade us that Mr. Randall could have stopped Serv-Tech

from exercising the option or had a realistic plan for

29a

Partnership to engage in a trade or business, rather than to

license the Fast Clean System for royalties.

Although petitioner implies in the reply brief that

testimony of the vice president, chief financial officer, and

a director of Serv-Tech as of January 1986 was to the effect

that Serv-Tech would never exercise the exclusive license

option, the testimony does not say this clearly and is

insufficient to establish this point.

In the reply brief, petitioner repeatedly characterizes

respondent’s contentions as based not on the substance of the

transactions but on "magic words", referring to the term used

in describing the taxpayers’ arguments in Levin vy.

Commissioner, 832 F.2d 403, 406 (7th Cir. 1987), affg. 87

T.C. 698 (1986), to the effect that: "if the partnership’s

documents contain the right language, then all is well."

Unfortunately, this characterization does not do the trick,

because neither the form (the documents) nor the substance

of the transaction supports petitioner’s position.

To reflect the foregoing,

Decision will be entered for respondent.

30a

APPENDIX C-1

DIAGRAM OF TRANSFER OF TECHNOLOGY IN

SNOW V COMMISSIONER

a

SUCCESSOR TECHNOLOGY TRANSFERRED BE rch i

=

OWNERSHIP IN SUCCESSOR

CORPORATION

POST TRANSFER OWNERSHIP

a SNOW PARTNERSHIP

THE SNOW RECORD DOES

? aa NOT DISCLOSE HOW THE

SUCCESSOR CORPORATION

. WAS OWNED ALL THAT IS

scaitaiibiacgigaeil ae ti Fa | KNOWN IS THAT THE SNOW

SUCCESSOR CORPORATION _ PARTNERSHIP HAD NO

| FUNDS REMAINING AFTER

| THE COMPLETION OF THE

| RESEARCH. SEE. SNOW V

| COMMISHONER, 58 T.C. at 501

TECHNOLOGY

3la

APPENDIX C-2

DIAGRAM OF TRANSFER OF

TECHNOLOGY IN

SMITH V COMMISSIONER

PUBLIC UTILITY SMITH PARTNERSHIP

7

enna TRANSFER

TECHNOLOGY

MONEY IN EXCHANGE

EXCHANGE FOR

FOR JONT

JOINT VENTURE

INTEREST VENTURE

INTEREST

3

Pitas: Ae

NEWCO JOINT VENTURE

POST TRANSFER OWNERSHIP

|

PUBLIC UTILITY | SMITH PARTNERSHIP

eunanee OWNERSHIP

INTEREST INTEREST

ae ai

SUCCESSOR NEWCO JOINT VENTURE

32a

APPENDIX C-3

DIAGRAM OF TRANSFER OF

TECHNOLOGY IN

SCOGGINS V COMMISSIONER

SCOGGINS [|

PARTNERS |

%

By

Y ESS 9S: -

LR:

OWNERSHIP OWNERSHIP

OPTION TO PURCHASE

PERE ES See. SEE TECHNOLOGY a

IN EXCHANGE FOR

$5 MILLION

(AT LEAST $1 MILLION CASH)

OO ec ciliecrastenttiet 3 mwah SCOGGINS

PARTNERSHIP

POST TRANSFER OWNERSHIP

(ASSUMING EXERCISE OF OPTION)

——_——

| SCOGGINS

| PARTNERS

EPITAXY SYSTEMS, INC

( . $1 MILLION CASH (

| TECHNOLOGY| > ss PARTNERSHIP

| }

| aii

Se a

a PRS 2679 sj

33a

APPENDIX C-4

DIAGRAM OF TRANSFER OF TECHNOLOGY IN

MACH-TECH V COMMISSIONER

MACH IN

TECH OTHERS | |

4 Es LIMITED

PARTNERS | | <s°?-” PARTNERS

oer

OWNERSHIP OWNERSHIP ht ope

OFF eo ”

ese. <i ge

so

ae

MACH TECH

SERV-TECH LIMITED PARTNERSHIP

POST TRANSFER OWNERSHIP

| MCH TECH | >

| OWNRSHP | |

| RECVDIN [7%

——- OW NER SHIP

OWNERSHIP

34a

APPENDIX C-5

SINGLE DIAGRAM DEPICTING POST

TECHNOLOGY TRANSFER OWNERSHIP IN

SNOW, SMITH, SCOGGINS AND MACH-TECH

SNOW V COMMISSIONER

| mw . The record in Snow does not

j SNOW disclose how the successor

ee : PARTNRSHP corporation was owned. Alli that is

NZ } known is that the Snow

? . partnership had no remaining

_ OWNERSHIP Soeste sient a

Peed completed See, Snow v

NEWCO a | TECHNOLGY |

pn

| Commessioner, 58 TC. at 591

\ | es

SCOGGINS V COMMISSIONER

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35a

APPENDIX D

The Stages of Venture-Capital Investing'

1. Seed Investments

Aithough the term is sometimes used more broadly, the strict

meaning of “seed investment" is a small amount of capital

provided to an inventor or entrepreneur to determine whether

an idea deserves further consideration and further investment.

The idea may involve a technology, or it may be an idea for

a new marketing approach. If it is a technology, this stage

may involve building a small prototype. This stage does not

involve production for sale.

2. Startup

Startup investments usually go to companies that are less than

one year old. The company uses the money for product

development, prototype testing, and test marketing (in

experimental quantities to selected customers). This stage

involves further study of market-penetration potential,

bringing together a management team, and refining the

business plan.

3. First Stage- early development

Investment proceeds through the first stage only if the

prototypes look good enough that further technical risk is

considered minimal. Likewise, the market studies must look

good enough so that management is comfortable setting up a

modest manufacturing process and shipping in commercial

quantities. First stage companies are unlikely to be

profitable.

'‘Sahlman, The Structure and Governance of Venture-Capital

Organizations, Journal of Financial Econemics 27 (1990) 473-521, 479

36a

4. Second stage-expansion

A company in the second stage has shipped enough product

to enough customers so that it has real feedback from the

market. It may not know quantitatively what speed of

market penetration will occur later, or what the ultimate

penetration will be, but it may know the qualitative factors

that will determine the speed and limits of penetration. The

company is probably still unprofitable, or only marginally

profitable. It probably needs more capital for equipment

purchases, inventory and receivable financing.

5. Third Stage-profitable but cash poor

For third stage companies, sales growth is probably fast, and

positive profit margins have taken away most of the

downside investment risk. But, the rapid expansion requires

more working capital than can be generated from internal

cash flow. New VC capital may be used for further

expansion of manufacturing facilities, expanded marketing,

or product enhancement. At this stage, banks may be willing

to supply some credit it is can be secured by fixed assets or

receivables.

6. Fourth Stage-rapid growth toward liquidity point

Companies at the fourth stage of development may still

outside cash to sustain growth, but they are stable enough so

that the risk to outside investors is much reduced. The

company may prefer to use more debt financing to limit

equity dilution. Commercial bank credit can play a more

important role. Although the cash-out point for VC investors

is thought to be within a couple of years, the form (IPO,

acquisition, or LBO) and timing of cash out are still

uncertain.

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7. Bridge Stage- mezzanine investment

In bridge or mezzanine investment situations, the company

may have some idea which form of exit is most likely, and

even know the approximate timing, but it still needs more

capital to sustain rapid growth in the interim. Depending on

how the general stock market is doing, and how the given

types of high tech stocks are doing within the stock market,

"IPO windows" can open and close in very unpredictable

ways. Likewise, the level of interest rates and the

availability of commercial credit can influence the timing and

feasibility of acquisitions or leveraged buyouts. A bridge

financing may also correspond to a limited cash-out of early

investors Or management, or a restructuring of positions

among VC investors.

8. Liquidity stage- cash out or exit

A literal interpretation of "cash-out" would seem to imply

trading the VC held shares in a portfolio company for cash.

In practice, it has come to mean the point at which the VC

investors can gain liquidity for a substantial portion of their

holdings in a company. The liquidity may come in the form

of an initial public offering. If it does, liquidity is still

restricted by the holding periods and other restrictions that

are part of SEC Rule 144, or by "stand-off" commitments

made to the IPO underwriter, in which the insiders agree not

to sell their shares for some period of time after the offering

(for example, 90 or 180 days). If the acquisition is the form

of cash-out, the liquidity may be in the form of cash, shares

in a publicly traded company, or short term debt. If the

acquisition if paid for in the shares of a nonpublic company,

such shares may be no more liquid than the shares of the

Original company. Likewise, if the sellers take back debt in

a leveraged buyout, they may wind up in a less liquid

position than before, depending upon the liquidity features of

the debt.