Respondents Brief — Snow v. Commissioner

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Lo Supreme — .. 8.

“Our pl u> Ne 73-641 APR 6 1974

MICHAEL RODAK, JR. CLE

In the Supreme Court of the United States

OCTOBER TERM, 1973

* EDWIN A, SNOW AND HELEN B. SNOW, PETITIONERS

Vv.

COMMISSIONER OF INTERNAL REVENUE

ON WRIT OF CERTIORARI TO THE UNITED STATES

COURT OF APPEALS FOR THE SIXTH CIRCUIT

BRIEF FOR THE RESPONDENT _

Rosert H. Bork,

Solicitor General,

Scort P. CRAMPTON,

Assistant Attorney General,

STUART A. SMITH, :

Assistant to the Solicitor General,

BENNET N. HOLLANDER,

JANE M. EDMISTEN,

_ Attorneys,

Department of Justice,

Washington, D.C. 20530.

INDEX

Opinions below _.. .. recalls

Jurisdiction

Question presented .

Statute involved es

Statement - ia Sh scsi car iciicenas a a

Summary of semeties saints te genie

Argument

Both courts below correctly held that peti-

tioner could not deduct his pro rata share

of expenditures incurred by a partnership

for the development of an invention as re-

search and experimental expenditures un-

der Section 174 of the Code, because they

were not incurred in connection with a

trade or business .

Introduction: The background and

scope of Section 174 ve

The federal tax concept of “trade | or

business” requires engaging in the

selling of goods or services and there-

by precludes deductions under Section

174 for expenditures incurred simply

in the hope of realizing a profit -

The expenditures paid by the partner-

ship to develop the invention prior to

the time it was marketed were not in-

curred in connection with a trade or

I cisiccntaitencta mending

mtn aa a has :

CITATIONS

Cases: Page

Abegg v. Commissioner, 50 T.C. 145, af-

firmed, 429 F. 2d 1209,. certiorari de-

nied, sub nom. Cresta Corp., S.A. v.

Commission, 400 U.S. 1008 —..----- 32

Addressograph-Multigraph Co. Vv. Com-

missioner, 4 T.C.M. 147 —---------------- 17

Austin v. Commissioner, 298 F. 2d 583-... 25

Beaumont Co. v. Commissioner; 3 B.T.A.

822 % 16

Bessenyey v. Commissioner, 379 F. 2d 252,

certiorari denied, 389 U.S. 931 -....... 27

Best Universal Lock Co. v. Commissioner,

45 T.C. 1, acg., 1966-2 Cum. Bull. 4... 35, 37

Canning v. Commissioner, 29 B.T.A. 99... 16

Claude Neon Lights, Inc. v. Commissioner,

RTA. oC __._—___— 16-17

Cleveland v. Commissioner, 297 F. 2d

Commissioner v. Lincoln Savings & Loan

Assn., 403 U.S. 345 _.....-....-----------~-- 14

Commissioner v. Tellier, 383 U.S. 7... 14

Cooper Tire & Rubber Co. Employees’ Re-

tirement Fund v. Commissioner, 36 T.C.

96, affirmed per curiam, 306 F. 2d 20. 29

Cunningham v. Commissioner, 27 T.C.M.

i 36

Daily Journal Co. v. Commissioner, 135 F.

a 24

Darlington-Hartsville Coca-Cola B. Co. v.

United States, 273 F. Supp. 229, af-

firmed, 393 F. 2d 494, certiorari de-

nied, 398 U.S. 962 __....---.-------—----------- 15

Dean v. Commissioner, 56 T.C. 895 __...... 32

—"

‘

i .

Cases—Continued Page

Dempster Mill Mfg. Co. v. Burnet, 46 F.

ee eee 17

Deputy v. du Pont, 308 U.S. 488. 11, 14, 20, 24

Downs v. Commissioner, 49 T.C. 533 36

Flint v. Stone Tracy Co., 220 U.S. 107. 25

Frank v. Commissioner, 20 T.C. 511 32

Gilliam Manwfacturing Co. v. Commis-

sioner, 1 B.T.A. 967 ._....-----------—----- 16

Goodell-Pratt Co. v. Commissioner, 3

ty ene 16

Hart-Bartlett-Sturtevant Grain “Co. v.

Commissioner, 12 T.C. 760, affirmed,

2 3) fee 17

Hazeltine Corp. v. Commissioner, 32

2 A ee seen 16

Helvering v. Highland, 124 F. 2d 556 24

Higgins v. Commissioner, 312 U.S. 212 25, 26, 29

Hirsch v. Commissioner, 315 F. 2d 731 _. 27

Kilroy v. Commissioner, 32 T.C.M. 27 _. 36

Koons v. Commissioner, 35 T.C. 1092 21, 36

Lamont v. Commissioner, 339 F. 2d 377 27

Mayrath v. Commissioner, 357 F. 2d 209,

affirming, 41 T.C. 582 ....... 21, 35, 36

McDonald v. (Commissioner, 323 U.S. 57. . 26, 31

McDowell v. Ribicoff, 292 F. 2d 174, cer-

tiorari demied, 368 U.S. 919 24

Miller v. Commissioner, 102 F. 2d 476 25

Porter v. Commissioner, 437 F. 2d 39, af-

firming pei curiam, 28 T.C.M. 1489 27

Red Star Yeast & Products Co. v. Com-

missioner, 25 T.C. 321... 16-17

Richmond Television Corp. v. United

States, 34!5 F. 2d 901, vacated and re-

manded jer curiam on other grounds,

ta. eo... 24, 32, 33, 38, 39

: IV

+ Cases—Continued Page

i Schafer v. Commissioner, 23 T.C.M. 927. 36

. | Scull v. Commissioner, 23 T.C.M. 1353. 36

Stanton v. Commissioner, 399 F. 2d 326 _ 21, 24,

32, 35, 36

Teitelbaum v. Commissioner, 294 F. 2d

541, certiorari denied, 368 U.S. 987 15

Trent v. Commissioner, 291 F. 2d 669 _ . 24

; United States v. Akin, 248 F. 2d 742 _ 15

{ United States v. Gilmore, 372 U.S. 39 ___ 27

; United States v. Pyne, 313 U.S. 127. 26

Walet v. Commissioner, 31 T.C.461. 82

i Weinstein v. United States, 420 F. 2d

i 700 ~ os 32

} Welch v. ,. Helvering, 290 U. s. 111 14

: Wells-Lee v. Commissioner, 360 F. 2d

> a ee ee 15

; Westervelt v. Commissioner, 8 T.C. 1248 - 32

Whipple v. Commissioner, 373 U.S. 193 22, 28,

j 29

3 White’s Will v. Commissioner, 119 F. 2d

; EER caer SESS en Os 24

: Woodward v. Commissioner, 397 U.S. 572. 15

; Wright v. Commissioner, 274 F. 2d 883. 25

: Yanow v. Commissioner, 358 F. 2d 743, :

: affirming per curiam, 44 T.C. 444. 27

' Statutes:

Revenue Act of 1913, c. 16, Sections II(G)

(b) and II(B), 38 Stat. 166, et seq. 13, 15

_ Revenue Act of 1916, c. 463, Section 5(a)

(8), 39 Stat. 759 . os 15, 23

_ Revenue Act of 1918, ¢. y"% “Section 214

(a)(1), 4 Sik. 1006 .____.... 13

“Revenue Act of 1921, c. 136, Section 215

(a)(2), CU. Oe 15

Cases—Continued Page

Revenue Act of 1924, c. 234, Section 215

(a) (2), 43 Stat. 271 - 15

Revenue Act of 1926, c. 27, Section 215

(a) (2), este. 3... 15

Revenue Act of 1928, c. 852, Section 24

(a) (2), 45 Stat. 802 - 15

Revenue Act of 1932, c. 209, Section 24

(a) (2), 47 Stat. 183 . ae 15

Revenue Act of 1934, c. 277, “Section 24

(a) (2), 48 Stat. 691 - : 15

Revenue Act of 1936, c. 690, “Section 24

CoS Eas. Ge ee FOE 2... 15

Revenue Act of 1942, c. 619, Section 121

(a), 56 Stat. 819 - 26

Internal Revenue Code of 1939:

Section 23(a) (2) - cp alc

Section 23(k) (4) ~ ae 22

Internal Revenue Code of 1954:

Section 162 ~ i : 18, 27

Section 162 (a) . 10, . 13, 29, 30, $3, 35

FE i. _. passim

Section 174 (a) __________._1, 8, 9, 17, 37,

| pe atS.: 9,17, 18, 41

I 27

Section 212 . penne >) ke

Section 263 . Soc eee

Section 263 (a) (1) . ee

eee ee ee 8

ee ee 8

Section 1016 (a) isin 19

eee 8

ee eg 8

pees Tre. (0)() 23

Ss es gp GE DAE AN tian A MRI sahas

‘csctbabcaibeiee

Cases—Continued Page

Miscellaneous:

CCH Standard Federal Tax Reports, Vol.

5, 7 6170 (1952 ed.) —--...-------------- 17

100 Cong. Rec. 3425, 3553 -..... — ---- 21

100 Cong. Rec. 8998 -............---------------- 21

97 Cong. Rec. A4326 —_-...... akon oan : 33

H.R. 4775, 82d Cong., Ist Sess. 33

H. Rep. No. 1337, 83d Cong., 2d Sess.....19, 20, 21

H. Rep. No. 2333, 77th Cong., 2d Sess... 26, 30

H. Rep. No. 767, 65th Cong., 2d Sess... 13

4A Mertens, Law of Federal Income Tax-

ation (1972 ed.), §§ 25.33 —....... - 36

4 Merten, Law of Federal Income Taxa-

tion, § 25.01 (1960 Rev.) -........-.-- 13

Rev. Rul. 71-162, 1971-1 Cum. Bull. 97. 37

75 Reports of the American Bar Associa-

tion 1960 (1960) —__._..______---—- 33

1 Senate Hearings before the Committee

on Finance on the Internal Revenue

Code of 1954, 83d Cong., 2d Sess. 21

S. Rep. No. 1631, 77th Cong., 2d Sess.,

S. Rep. No. 1622, 83d Cong., 2d Sess. ...... 19, 21

Treasury Regulations 45, Art. 168... 16

Treasury Regulations 62, Art. 168... 16

Treasury Regulations 65, Art. 168... 16

Treasury Regulations on Income Tax (26

C.F.R.) :

§ 1.162-1(a) a ee 30

§ 1.162-17 (a) Rane Meant een 30

'iLAi-i(a) 15

Ju the Supreme Court of the United States

OCTOBER TERM, 1973

No. 73-641

EDWIN A. AND HELEN B, SNOW, PETITIONERS

COMMISSIONER OF INTERNAL REVENUE

ON WRIT OF CERTIORARI TO THE UNITED STATES

COURT OF APPEALS FOR THE SIXTH CIRCUIT

BRIEF FOR THE RESPONDENT

OPINIONS BELOW

The findings of fact and opinion of the Tax Court

(Pet. App. 13-34) are reported at 58 T.C. 585. The

opinion of the court of appeals (Pet. App. 35-44) is

reported at 482 F.2d 1029.

(1)

Side

wR Ci tts al Ala ROME 8 IA NRE ARE RRR ES ALIA

;

JURISDICTION

The judgment of the court of appeals was entered

on July 17, 1973 (I-A. 1).’ The petition for a writ of

certiorari was filed on October 12, 1973, and was

granted on January 7, 1974 (I-A. 104). The juris-

diction of this Court rests on 28 U.S.C. 1254(1).

QUESTION PRESENTED

Whether both courts below correctly held that pe-

titioner could not deduct his pro rata share of ex-

penditures incurred by a partnership for the develop-

ment of an invention as research or experimental

expenditures under Section 174 of the Internal Reve-

nue Code of 1954, because they were not incurred in

connection with a trade or business.

STATUTE INVOLVED

Section 174 of the Internal Revenue Code of 1954

is set forth in Appendix A, infra, pp. 40-42.

STATEMENT

Petitioner? is an officer of Procter & Gamble

Company, where he has been employed since 1933.

His work for that corporation was initially in ad-

1“A ” vreferences are to the record appendix which is sep-

arately bound in two volumes. References “I” and “II” are

to the volume of the record appendix.

2 References to petitioner are to Edwin A. Snow; Helen B.

Snow is a party solely by reason of having filed a joint re-

turn with her husband for 1966, the year at issue.

vertising and marketing. Subsequently, petitioner’s

employment duties were in management, and in 1966,

he became executive vice-president of Procter & Gam-

ble and a member of its board of directors. Petitioner

never had any training in engineering nor had he

ever applied for a patent (Pet. App. 14).

Since 1942, petitioner has known David H. Trott,

a fellow Procter & Gamble employee, who also worked

in advertising, marketing, and general management

activities. Like petitioner, Trott had no engineering

training or background. In 1963, Trott retired from

Procter & Gamble after 2214 years of service. Upon

his retirement, Trott purchased a 25 percent interest

in Crossbow, Inc. (“Crossbow”), a corporation which

performed machine and fabricating work. In 1965,

Trott became sole owner of Crossbow (Pet. App.

14-15).

At the time Trott first acquired an interest in

Crossbow, the primary activity of the corporation

was the manufacture and sale of a novelty item un-

der the trade name “Drinklight’” and the performance

of job shop work for customers in the fabricating

business (I-A. 55). The staff of that corporation was

also experimenting with a telephone answering serv-

ice. Thereafter, Trott conceived the idea of a tape

recording device and a leaf or trash burner, both of

which the Crossbow employees began developing.

Models of the leaf or trash burner were constructed

for the purpose of experimentation and development

(Pet. App. 15).

In December 1965, Trott’s patent counsel advised

him that the leaf burner might have certain patent-

able features but suggested that the preparation of

any patent application be delayed until after the com-

pletion of a prototype model. Two prototype models

were thereafter constructed and tests performed upon

them. In February 1966, the patent counsel advised

petitioner that the tests performed upon the two ex-

isting models and his examination of them demon-

strated that neither model performed satisfactorily

enough to be marketable. He stated that the device

would have to be modified before it could achieve an

adequate level of performance. As a result, the patent

counsel concluded at that time that “the leaf burner

invention has not yet been reduced to practice” (Pet.

App. 18-20; I-A. 103).

In February or March 1966, petitioner orally

agreed to join in a limited partnership venture to

assist Trott in financing the development of the de-

vice. On July 8, 1966, an agreement to form a limited

partnership known as Burns Investment Company

was executed. Under the partnership agreement, pe-

titioner contributed $10,000 for a four percent limited

partnership interest, and two other investors con-

tributed $20,000 and $10,000 for eight and four per-

cent limited partnership interests, respectively. Trott

received a 50 percent interest as the sole general

partner and a 34 percent interest as a limited part-

ner, in’exchange for which he contributed “[a]ll

right, title and interest to a product concept” of the

proposed device (Pet. App. 20-21).

As the general partner, Trott had the sole right

to manage and conduct the partnership business (Pet.

App. 21). Unless authorized by Trott, no limited

partner could transact partnership business or act

as agent for the partnership. The general partner

had complete control of the funds of the partner-

ship and their disbursement (I-A. 85). The limited

partners’ liability for partnership debts could not

exceed their capital contribution (Pet. App. 21-22;

I-A. 85).

During 1966, the Burns Investment Company part-

nership expended $36,780.44 for engineering services

performed primarily by Crossbow employees and for

management services performed exclusively by Trott.

There was no written contract between Crossbow and

Burns Investment Company for these services (Pet.

App. 22-23; I-A. 56-57).

“The office of Burns Investment Company was desig-

nated to be at the premises of Crossbow. In 1966, the

Burns partnership had no manufacturing plant of

its own, and had no office or separate facility. At the

Crossbow shop, the Burns partnership had no tele-

phone and there was no sign on the building denoting

its presence. Neither petitioner Trott nor anyone else

made any marketing efforts on behalf of the Burns

partnership in 1966 (Pet. App. 23; I-A. 61).

After the $40,000 cash contribution by the limited

partners had been exhausted, Trott financed the

project on his own and radically changed the mechani-

cal approach of the device. On June 10, 1968, Trott

filed an application for a patent which was issued

to him on March 3, 1970. Prior to that time, a cor-

AOL EP EET RE TERI WE MENTED, RSTO sanerescnngrwin

ee.

poration was organized under the name Burns In-

vestment Corporation to produce and market the de-

vice (Pet. App. 23; I-A. 68).

Burns Investment Company was not the only

limited partnership formed by Trott for the financing

of a potential invention. In 1965, Trott had formed

two different limited partnerships, Echo Develop-

ment Company and Courier Enterprises, for the re-

spective development of the telephone answering de-

vice and the tape repording device (Pet. App. 15-18).

As in the case of Burns Investment Company, the site

of both Echo and Courier was the premises occupied

by Crossbow (Pet. App. 15, 21). In 1965, petitioner

contributed $21,325 and $5,000 respectively to Echo

and Courier in exchange for 10 percent limited part-

nership, interests (Pet. App. 16; II-A. 141, 146, 150,

155).

During the years 1965 through 1967, neither Echo

nor Courier earned any income from operations. For

1965, their first year of existence, Echo and Courier

elected to deduct their expenditures for research and

development as current expenses under Section 174

of the Code. As a result, Echo and Courier reported

losses for 1965 of $79,167.60 and $19,677.11, respec-

tively (II-A. 138, 152). Unlike Crossbow’s relation-

ship with the Burns partnership, which was not re-

duced to a written understanding, the amounts Echo

and Courier paid to Crossbow were pursuant to writ-

ten contracts (I-A. 57).

Petitioner’s pro rata share of the Echo and Courier

partnership losses was $7,916.76 and $1,967.71, re-

spectively (II-A. 141, 155). For 1966, Echo and Cour-

ier reported smaller losses of $5,628.94 and $15.44

respectively (II-A. 143, 157). Petitioner’s pro rata

shares of these losses was $562.89 and $1.54, respec-

tively (II-A. 146, 159). For 1967, Echo and Courier

reported no income and no expenses (II-A. 148, 161).

Burns Investment Company’s income and expendi-

tures followed much the same pattern as that of Echo

and Courier except that the principal amount of its

expenditures were incurred in 1966, one year later.

For the period August 1, 1966 to December 31, 1966,

Burns Investment. Company reported no income and

$36,780.44 of research and development expenditures.

As a result of this expense, the partnership’s opening

capital of $40,000 was reduced to $3,219.56 as of

December 31, 1966. The partnership return stated

that the company “elects to expense in the current

taxable year * * * research and development expenses

pursuant to Section 174(a)” (Pet. App. 24; II-A.

124-125, 127-128). For the year 1967, Burns In-

vestment Company reported no income and no ex-

penses (Pet. App. 24; II-A. 129). Finally, for the

year 1968, it reported no income, research and de-

velopment expenses of $3,217.64, and a bank ‘service

expense of $1.92, thereby leaving no remaining assets

(Pet. App.\24; II-A. 183-134).

During 1966, petitioner devoted a minimum of 50

hours per week to his duties as vice president of Proc-

ter & Gamble; three hours a week to a thoroughbred .

race horse operation which he owned; and one hour a

week to a joint venture oi! operation. He spent ap-

BAW crm: eh aa le teen ae Patera

NEESER TED RNAS ERIE RTS PE Wt SO ra

at So

saleable

proximately one hour per week in meetings and con-

versations with respect to the project of each part-

nership—the telephone answering device, the tape

recorder, and the trash or leaf burner. Some of the

conversations took place by telephone, some at the

premises of Crossbow, some at restaurants, and some

at Trott’s or petitioner’s home. Petitioner witnessed

tests of various models of the leaf burner and gave

advice regarding marketing if it ever developéd to

the stage of being marketable (Pet. App. 26).

Petitioner deducted his pro rata share of Burns

Investment Company’s 1966 loss of $9,195.11 on his

individual income tax return for 1966* (II-A. 116).

On audit, the Commissioner of Internal Revenue dis-

allowed the deduction on the ground that the research

the development expenditures were not “incurred by

him during the taxable year in connection with his

trade or business” as required by Section 174(a) (1)

(Pet. App. 27). The Tax Court found that Burns

Investment Company was not engaged in a trade or

’In general, Section 704(a) of the Code permits a partner’s |

distributive share of gains and losses to be determined by the

partnership agreement. Mithough petitioner only had a 4

percent interest in profits, he deducted 25 percent of the part-

nership loss for 1966, pursuant to an amendment of the part-

nership agreement executed on April 3, 1967. The amend-

ment provided that the limited partners were to share net

partnership losses in proportion to their capital contribu-

tions (I-A. 87-89). Pursuant to Section 761(c) of the Code,

the April 3, 1967 amendment to the partnership agreement

was timely because it was made prior to April 15, 1967, the

prescribed time for filing the 1966 partnership return. See

Sections 6031 and 6072 of the Code.

business in 1966. It thereby upheld the Commis-

sioner’s determination that the expenses for research

and experimentation upon the trash burning device

paid by Burns Investment Company were not paid or

incurred in connection with the trade or business of

the partnership or of petitioner within the meaning

of Section 174 (Pet. App. 26).

The court of appeals unanimously affirmed. It

found that neither petitioner nor any other member

of the Burns Investment Company held themselves

out as engaging in the activity of selling the device

in 1966. That court emphasized the fact that the part-

nership had nothing to sell during that year because

the device did mot even function properly at that

time. As a result, it concluded that the partnership’s

activities did not meet the classic definition of a

“trade or business” and that its expenditures in-

curred in 1966 could not be deductible under Section

174 (Pet. App. 35-44).

SUMMARY OF ARGUMENT

Section 174(a) of the Internal Revenue Code of

1954 allows a taxpayer to “treat research or experi-

mental expenditures which are paid or incurred by

him during the taxable year in connection with his.

trade or business as expenses which are not charge-

able to capital account.” Section 174(b) provides

an option to amortize such expenditures over a

period of not less than 60 months. Prior to the en-

actment of this statute in 1954, the courts had uni-

Pa EPR RE CRI ON OR ELIMI AGRON RR RA AEE

OPA NA I~ NEE an WR MG NI SEINE =

OLDER LAD DAT SII OED

formly held that research or experimental expendi-

tures were nondeductible capital outlays because the

benefits derived from them extended beyond the tax-

able year. As a result, they could not, be deducted

under the longstanding provision, now contained in

Section 162(a), allowing deductions for “all the

ordinary and necessary expenses paid * iA * in carry-

ing on any trade or business.” .

The elimination in Section 174 of the requirement

that research or experimental expenditures be “ordi-

nary” insured their deductibility even if they were

unusual or otherwise were deemed to be a capital ex-

penditure. However, the statute retained the require-

ment, present in the business expense provision as

well, that such expenditures be incurred in connection

with a “trade or business.” By incorporating in Sec-

tion 174 a term which this Court has described as

“not new to the tax laws,’’ Congress made clear that

not all research or experimental expenditures would

be deductible, regardless of the context in which they

were incurred. |

The issue in this case is whether petitioner’s part-

nership incurred research or experimental expendi-

tures in 1966 “in connection with [its] trade or busi-

ness” so as to be deductible under Section 174. Both

courts below denied the claimed Section 174 deduc-

tion on the ground that no trade or business existed

during that year. Their conclusion is in conformity

with the classic definition of “trade or business,” which

is restricted to “holding one’s self out to others as en-

as a Re EN BRED LT OR ote INI

gaged in the selling of goods or services.” Deputy V.

duPont, 308 U.S. 488, 499. Since that definition was

formulated more than three decades ago, it has been

applied by the courts in a wide variety of factual

and statutory contexts. A necessary corollary of this

definition of “trade or business” is that expenditures

incurred in preparation for the possibility of entering

a new trade or business are not deductible as “trade

or business” expenses.

Although petitioner acknowledges that his partner-

ship was not engaged in a “trade or business” as that

term has been defined by the courts, he argues that

all Section 174 requires is the existence of a profit

motive. But if Congress had intended to allow the

deduction of all research or experimental expenditures

incurred in the hopes of realizing a profit, it surely

would have employed the broader test in Section 212

permitting deduction of expenses incurred for the

“production of income” rather than the narrow-

er “trade or business” formulation. Moreover, this

Court arid others have recognized that the term

“trade or business” has a uniform meaning through-

out the Code. Petitioner’s attempt to insulate the

phrase “trade or business” in Section 174 from its

use in other sections of the Code ignores both the

decisions of this Court and the legislative history of

that provision, which links it with the general “trade

or business” expense deduction provision of Section

162(a).

. Cc

Application of the foregoing principles to the facts

of this case shows that the expenditures incurred by

itll CEG AOE LERNER SLD RP! APES

had eM DB

Bit kth DaE se Ae LAND Fi ta:

EERE MN DER

petitioner’s partnership in 1966 to develop a trash

burner invention were not “incurred in connection

with a trade or business” within the meaning of

Section 174. During that year, neither petitioner nor

any other member of the partnership held themselves

out as engaging in the activity of selling anything.

Indeed, the partnership had nothing whatever to sell

because the invention was still in the development

stage and did not even function properly. Under these

circumstances, the activities of petitioner and his

partnership did not satisfy the elements of the well-

established “trade or business” definition. They were

at best an investigation into the future marketing

of a trash burning device. Since the expenditures

were not incurred in connection with an existing trade

or business, they were therefore not deductible under

Section 174.

With one possible exception, the decision below is

consistent with all the reported cases under Section

174. The courts have construed the “trade or busi-

ness” nexus of Section 174 to require a showing of

an existing trade or business, which is completely

lacking in this case. To the extent that Cleveland Vv.

Commissioner, 297 F.2d 169 (C.A. 4), is regarded

as holding that the simple execution of a partner-

ship agreement is sufficient to establish a “trade

or business” for purposes of Section 174, we believe

that its conclusion was properly rejected as erroneous

by the court of appeals.

oun eA al

ON VON AIRE AE NN AR LATTEM TE » Beek ia TD et meh

ARGUMENT

BOTH COURTS BELOW CORRECTLY HELD THAT

PETITIONER COULD NOT DEDUCT HIS PRO RATA

SHARE OF EXPENDITURES INCURRED BY A

PARTNERSHIP FOR THE DEVELOPMENT OF AN

INVENTION AS RESEARCH AND EXPERIMENTAL

EXPENDITURES UNDER SECTION 174 OF THE

CODE, BECAUSE THEY WERE NOT INCURRED IN

CONNECTION WITH A TRADE OR BUSINESS

A. Introduction: The Background and Scope of Section 174

1. Prior to the enactment in 1954 of Section 174

of the Internal Revenue Code, the tax treatment

of research or experiinental expenditures incurred

by a business was uncertain. Under the longstanding

general business expense provision now in Section

162(a) of the Code, a deduction is allowed for “all

the ordinary and necessary expenses paid or in-

curred during the taxable year in carrying on any

trade or business * * *.”’‘ While research or experi-

mental expenditures might qualify as “necessary” in

that they are “appropriate and helpful’ for “the

+The Revenue Act of 1913 allowed a deduction for the

“ordinary and necessary” business expenses of a corporation

and the “necessary” business expenses of an individual. Rev-

enue Act of 1913, c. 16, 38 Stat. 114, 166, Secs. II (G) (b)

(corporation) and Sec. II (B) (individuals). Five years later,

the word “ordimary” was added to the section covering in-

dividuals’ deductions. Revenue Act of 1918, c. 18, 40 Stat.

1057, Section 214(a) (1). It appears that this change was

designed merely to make the language of the two sections con-

sistent. H. Rep. No. 767, 65th Cong., 2d Sess, p. 10; 4 Mer-

tens, Law of Federal Income Taxation, § 25.01, n. 2 (1960

Rev.).

wn DELS CAE EMRE

;

5 |

development of the [taxpayer’s] business,” Welch Vv.

Helvering, 290 U.S. 111, 118, it was less clear that

they would be deemed “ordinary.”

Decisions of this Court have indicated that the

statutory term “ordinary” serves two distinct pur-

poses. In construing that term, the Court first ob-

served that the word has the connotation of “normal,

usual, or customary.” Deputy v. duPont, 308 U.S.

488, 495. While noting that “an expense may be

ordinary though it happen but once in the tax-

payer’s lifetime,” the Court has defined “ordinary”

to require that “the transaction which gives rise to

[the expenditure] * * * be of common or frequent

occurrence in the type of business involved.” (Ibid.)

See also Welch v. Helvering, supra, at 114. More

recently, in Commissioner v. Tellier, 383 U.S. 687,

the Court stated (383 U.S. at 689-690) :

The principal function of the term “ordinary”

in $162(a) is to clarify the distinction, often

difficult, between those expenses that are cur-

rently deductible and those that are in the nature

of capital expenditures, which, if deductible at

all, must be amortized over the useful life of the

asset.

See also Commissioner v. Lincoln Savings & Loan

Assn., 403 U.S. 345, 353.

The essence of an “ordinary” business expense as

that term is used in Commissioner V. Tellier, supra, is

that the benefit from the expense is derived and ex-

hausted within the taxable year. In contrast, Section

263(a)(1) prohibits a deduction for “[a]ny amount

paid out for new buildings or for permanent im-

provements or betterments made to increase the value

of any property or estate.”

While the principle embodied in this statutory pro-

vision is most frequently applied to costs incurred in

the acquisition of a capital asset, Woodward v. Com-

missioner, 397 U.S. 572, 575, a cost that “results in

the creation of an asset having a useful life which ex-

tends substantially beyond the close of the taxable

year * * *” is also a nondeductible capital outlay.

Treasury Regulations, Section 1.461-1(a)(1) and

(2). See also United States v. Akin, 248 F.2d 742,

744 (C.A. 10); Wells-Lee v. Commissioner, 360 F.2d

665 (C.A. 8); Teitelbaum v. Commissioner, 294 F.2d

541 (C.A. 7), certiorari denied, 368 U.S. 987; Dar-

lington-Hartsville Coca-Cola B. Co. v. United States,

273 F. Supp. 229, 231 (D.S.C.), affirmed, 393 F.2d

494, 496 (C.A. 4), certiorari denied, 393 U.S. 962.

The nondeductibility of so-called capital expendi-

tures has been well established in the federal tax sys-

tem from its very beginnings.* As a result, research

5 The language of Section 263 of the 1954 Code was first

used in Section I1(B) of the Revenue Act of 1913, c. 16, 38

Stat. 114, 167, and has been included in each successive in-

come tax statute. See Sec. 5(a) (8), Revenue Act of 1916, c.

463, 39 Stat. 756, 759; Sec. 215(a) (2), Revenue Act of 1921, c.

136, 42 Stat. 227, 242; Sec. 215(a) (2), Revenue Act of 1924, c.

234, 43 Stat. 253, 271; Sec. 215 (a) (2), Revenue Act of 1926, c.

27, 44 Stat. 9, 28; Sec. 24 (a) (2), Revenue Act of 1928, c. 852,

45 Stat. 791, 802; Sec. 24(a) (2), Revenue Act of 1932, c. 209,

47 Stat. 169, 183; Sec. 24(a) (2), Revenue Act of 1934, c. 277,

48 Stat. 680, 691; Sec. 24(a) (2), Revenue Act of 1936, c. 690,

49 Stat. 1648, 1662; Internal Revenue Code of 1939, Sec. 24 (a)

sponse S VGA a Totaa oa Dens SAO PPO ES ate

‘hia ache om

‘

or experimental costs incurred in the development

of a new process, formula, or invention, the benefits

of which would be derived beyond the year of the

expenditure, were first regarded as nondeductibe cap-

ital outlays. Such costs could be only recovered by de-

preciation or amortization. Because of the difficulty

in determining the useful life of such an asset or

when a research project was abandoned so that a

loss could be claimed, the Commissioner issued regu-

lations in 1919 under the depreciation provisions al-

lowing a taxpayer the option of either currently de-

ducting or of depreciating “expenses in his business

for designs, drawings, patterns, models, or work of

an experimental nature calculated to result in im-

provement of his facilities or his product * * *.”

Regulations 45, 62 and 65, Article 168.

The Regulation, however, was apparently deemed

not to apply to the costs of acquiring a patent, which

were early held to be nondeductible capital expendi-

tures.° In 1926, the Regulation was withdrawn and

the courts continued to hold a wide variety of re-

search or experimental expenditure to be nondeduc-

tible.’ Indeed, in Red Star Yeast & Products Co. V.

(2) (26 U.S.C. 1952 ed.). An application of the bar against

deduction of capital expenditures is at issue and is awaiting

decision this Term in Commissioner v. Idaho, Power Co., No.

73-263.

6 Gilliam Manufacturing Co. v. Commissioner, 1 B.T.A.

967; Goodell-Pratt Co. v. Commissioner, 3 B.T.A. 30; Beau-

mont Co. v. Commissioner, 3 B.T.A. 822.

™ Canning v. Commissioner, 29 B.T.A. 99; Hazeltine Corp.

v. Commissioner, 32 B.T.A. 110; Claude Neon Lights, Ince. Vv.

to tate od rine

Commissioner, 25 T.C. 321, the Tax Court adhered to

its prior decisions holding research and experimental

expenditures nondeductible under the 1939 Code,

notwithstanding the statement of the Commissioner

of Internal Revenue before the Joint Committee on

Internal Revenue Taxation on April 4, 1952, that

such costs were deductible if the taxpayer had adopted

the practice of charging them to expenses under its

established method of accounting (25 T.C. at 341-342;

CCH Standard Federal Tax Reports, Vol. 5, {6170

(1952 ed.)).

2. It was against this background that Section

174 was added to the statute as part of the 1954

codification. The parallels to the earlier short-lived

Regulation outstanding from 1919 to 1926 are strik-

ing. Both provide the option of either currently de-

ducting research or experimental expenditures or

amortizing them. The Regulation’s requirement that

such expenditures be “in [the taxpayer’s] business”

was carried over in the statutory phrase in Section

174(a) (1) that the outlays be “research or experi-

mental expenditures which are paid or incurred by [the

taxpayer] during the taxable year in connection with

his trade or business.” Section 174 (b), which pro-

vides an option to amortize such expenditures ratably

over no less than a 60-month period, likewise requires

Commissioner, 35 B.T.A. 424; Addressograph-Multigraph

Corp. Vv. Commissioner, 4 T.C.M. 147; Dempster Mill Mfg. Co.

v. Burnet, 46 F. 2d 604 (C.A. D.C.); Hart-Bartlett-Sturtevant

Grain Co. v. Commissioner, 12 T.C. 760, affirmed, 182 F. 2d

158 (C.A. 8).

indy 2 pce AIAN dries SGU Ni NAIR ONE a 1 6 ow Maret AOSD BHO

ithe dar vk

that they be paid “‘in connection with [the taxpayer’s ]

trade or business.”” Section 174 (b) (1) (A).°

The common requirement in the early Regulation

and Section 174 that deductible research or experi-

mental expenditures be incurred in connection with

the taxpayer’s trade or business indicates that Sec-

tion 174 was not intended to allow the deduction of

all research or experimental expenditures. To the

contrary, it has a far more limited scope. The trade

or business nexus of Section 174 must be viewed in

the context of two other provisions: (1) the general

business expense provision of Section 162(a), which

allows a deduction for “ordinary and necessary ex-

penises paid * * * in carrying on any trade or busi-

ness”; and (2) the general bar in Section 263 against

the deduction of capital expenditures.

Formulation of the “trade or business” standard in

Section 174 without the requirement that the ex-

penditure be “ordinary” demonstrates that the provi-

sion was simply intended to permit current deduction

of research or experimental expenditures incurred by

a business without a showing that the benefits from

8 The only difference between the earlier Regulation and

Section 174 is the latter’s elimination of the necessity to de-

termine useful life under the amortization option. Because

the Regulation permitted depreciation of such costs, such

treatment was available only if the research resulted in the

creation of an asset with an ascertainable useful life. Sec-

tion 174(b), however, specifically rests upon the unavailability

of the deduction for depreciation. Section 174(b) (1) (C). It

is thereby available to the class of research expenditures

which do not result in the creation of specific assets with de-

terminable useful lives.

SNE mt ERE OIL

them were derived and exhausted within a single

taxable year. That Section 174 was intended to pro-

tect such costs expended by a business from classifi-

cation as nondeductible capital expenditures is dem-

onstrated by the statement in the statute that such

outlays be treated as “expenses which are not charge-

able to capital account.” Furthermore, the simultane-

ous enactment in 1954 of an exception to the rule of

Section 263 for “research and experimental expendi-

tures deductible under section 174” confirms that

this was the legislative purpose. Section 263(a) (1)

(B). See also H. Rep. No. 1337, 83d Cong., 2d Sess.,

p. A65; S. Rep. No. 1622, 83d Cong., 2d Sess., p. 225."

This interpretation of the limited scope of the stat-

ute is supported by the legislative history. As the

Senate Finance Committee observed with respect to

this provision (S. Rep. No. 1622, 83d Cong., 2d Sess.,

p. 33):

No specific treatment is authorized by present

law for research and experimental expenditures.

To the extent that they are ordinary and neces-

sary they are deductible; to the extent that they

are capital in nature they are to be capitalized

and amortized over useful life. Losses are per-

mitted where amounts have been capitalized in

° To the extent that the election is made to amortize such

expenditures, there would be an upward basis adjustment

for an expenditure properly chargeable to capital account

under Section 1016(a)(1). As the deferred expenses ‘are

deducted, there would be corresponding downward basis ad-

justments under Section 1016(a) (14). See S. Rep. No. 1622,

83d Cong., 2d Sess., p. 215.

— wi same a RS a ty A Pt Ri EE ae ty Rl A

ee =

connection with abandoned projects, and recovery

through amortization is provided where the use-

ful life of these capital items is determinable,

as in the case of a patent. However, where

projects are not abandoned and where a useful

life cannot be definitely determined, taxpayers

have had no means of amortizing research ex-

penditures.

To eliminate uncertainty and to encourage

taxpayers to carry on research and experimen-

tation the House and your committee’s bill pro-

vide that these expenditures, incurred subsequent

to December 31, 1953, may, at the option of the

taxpayer, be treated as deductible expenses. It

also provides that a taxpayer may elect to cap-

italize such expenditures and if no other means

of amortization is provided, may write them off

over a period of not less than 60 months, be-

ginning with the month in which benefits are

first realized.

* * * *

See also H. Rep. No. 1337, 83d Cong., 2d Sess., p. 28.

Moreover, the elimination of the word “ordinary”

in Section 174 also removed the necessity of a show-

ing that a research or experimental expenditure was

“of common or frequent occurrence in the type of

business involved” under the first definition of that

term adopted by the Court in Deputy v. du Pont,

supra, 308 U.S. at 495. As a result, deductibility un-

der Section 174 was not defendent upon the existence

of a continuous program of research or experimenta-

tion under a regular budget which might be main-

tained only by large businesses. The provision there-

by insures that small businesses as well can take ad-

vantage of the option to deduct or amortize such ex-

penditures even if the outlays are infrequent or un-

usual.”

Under the statute, however, the expenditure must

be incurred in connection with an existing “trade or

business” of the taxpayer, whether large or small.

This requirement—at issue in this case—is reaf-

firmed in the detailed discussion in the committee

reports of the technical provisions of the statute,

H. Rep. No. 1337, supra, pp. A57-A59; S. Rep. No.

1622, supra, pp. 214-216, as well as the case law.

See, e.g., Stanton v. Commissioner, 399 F. 2d 326

(C.A. 5); Mayrath v. Commissioner, 357 F. 2d 209

(C.A. 5), affirming 41 T.C. 582; and Koons v.

Commissioner, 35 T.C. 1092.

3. The foregoing discussion of the terms and back-

ground of Section 174 demonstrates that Congress did

not intend to allow deductions for research or experi-

mental expenditures regardless of the context in

which they were incurred. Such expenditures are de-

ductible only if they arise in connection with the tax-

payer’s “trade or business.” Contrary to the position

of petitioner and the amici, this phrase—‘“trade or

business”—cannot be interpreted in a vacuum with-

out references to the other statutory provisions em-

ploying the “trade or business” standard.

B. Folsom, 1 Senate Hearings Before the Committee on Fi-

nance on the Internal Revenue Code of 1954, 83d Cong., 2d

Sess., p. 123; Statement of Congressman Reed, 100 Cong. Rec.

3425; Statement of Congressman Knox, 100 Cong. Rec. 3553;

and Statement of Senator Millikin, 100 Cong. Rec. 8998.

Se ioe AL REMORL G nY ERNE GREET may - —

le Ce. Aha She

ye eee Te

Thus, for example, in Whipple v. Commissioner,

373 U.S. 198, the question presented was whether a

loss was sustained from the worthlessness of a debt

“incurred in the taxpayer’s trade or business” within

the meaning of Section 23(k) (4) of the 1939 Code.

Nevertheless, the starting point of the Court’s analy-

sis was a detailed review of its prior decisions inter-

preting the phrase “trade or business” as it appeared

in the general business expense deduction provision.

It noted that “[t]he concept of engaging in a trade

or business as distinguished from other activities

pursued for profit is not new to the tax laws” (373

U.S. at 197).

Similarly, here, both courts below appraised the

facts of this case in the light of the long-standing

judicial definition of the statutory term “trade or

business.” They concluded that neither petitioner nor

the Burns Investment Company partnership were en-

gaged in a trade or business with respect to the trash

burning device because neither petitioner nor any oth-

er member of the partnership held themselves out as

engaged in the activity of selling. An examination

of the scope of the statutory term “trade or business,”

to which we now turn, confirms the correctness of

that ruling.

23 : 7

B. The federal tax concept of “trade re-

quires engaging in the selling of goods or services and

thereby precludes deductions under Section 174 for

expenditures incurred simply in the hope of realizing

a profit

1(a). From almost the very inception of the fed-

eral income tax, the statute has drawn a distinction

between the broad range of income or profit produc-

ing activities and those which fit within the narrow

category of trade or business. Thus, in the Revenue

Act of 1916, Section 5(a) provided a deduction for

those losses incurred in “business and trade’ and

those sustained “[i]n transactions entered into for

profit but not connected with * * * business or trade.”

The distinction continues to exist in the present Code,

which variously employs the terms “trade or busi-

ness,” “‘transaction entered into for profit,” and “pro-

duction of income” in a variety of contexts. See Ap-

pendix B, infra, pp. 43-44."

The longstanding statutory distinction between a

“trade or business” and other activities simply under-

taken for the purpose of profit has been viewed by

this Court as a fundamental differentiation between

“business” activities and “investment”’ activities. Al-

though the term “trade or business” is used through-

out the Code, it is nowhere defined, either in the

statute or the regulations, other than to include the

performance of the functions of a public office. See

Section 7701(a) (26) of the Code.

1 A list of the provisions of the Code employing these three

phrases are set forth in Appendix B, infra, pp. 43-44.

ne re ee ene ARE ES, Sop LOHR ME SARE NET

Sie? pole EE tt, vy Ue he eee “-

Significantly, for purposes of this case, a “trade

or business” has been defined by members of this

Court as activity which ‘involves holding one’s self

out to others as engaged in the selling of goods or

services.” Deputy v. du Pont, supra, 308 U.S. at 499

(concurring opinion of Justice Frankfurter in which

Justice Reed joined). Since the formulation of this

classic definition more than three decades ago, it has

been applied by the courts in considering ‘whether a

wide variety of activities constitutes a “trade or busi-

ness” under several different provisions of the reve-

nue statutes. E.g., White’s Will v. Commissioner, 119

F. 2d 619, 621 (C.A. 8) (trustee’s activities of su-

pervising investments) ; Helvering v. Highland, 124

F. 2d 556, 561 (C.A. 4) (executor’s estate manage-

ment activities) ; Daily Journal Co. v. Commissioner,

135 F. 2d 687, 688 (C.A. 9) (management of news-

paper); Trent v. Commissioner, 291 F. 2d 669, 670-

671 (C.A. 2) (services to employer) ; McDowell v.

Ribicoff, 292 F. 2d 174, 176-177 (C.A. 3), certiorari

denied, 368 U.S. 919 (fiduciary’s estate management

activities); Richmond Television Corp. v. United

States, 345 F. 2d 901, 907 n. 7 (C.A. 4), vacated

and remanded per curiam on other grounds, 382 U.S.

68 (pre-operating expenses to train prospective

staff); and Stanton v. Commissioner, 399 F. 2d

326, 329 (C.A. 5) (development of invention).

This accepted definition of the term “trade or busi-

ness” contains two separate elements. First, it re-

quires that the taxpayer hold himself out to others

as so engaged. Second, it is essential that the par-

ticular activity involve “selling,” either of goods or

services. Thus conceived, the category of “trade or

business” may embrace such diverse enterprises as

the sale of services by a lawyer or an employee, the

sale of a novel, or even of an idea. The point we

emphasize is that the element of “sale” is an indis-

pensable feature of all of these transactions and the

means by which profit is realized.”

(b). Consistent with this definition, the Court sub-

sequently held in Higgins v. Commissioner, 312 U.S.

212, that a taxpayer’s handling and oversight of his

own extensive stock and bond investments was not a

“trade or business” for purposes of the business ex-

pense deduction. Such personal investment activities

did not involve the taxpayer’s holding himself out as

engaged in the selling of goods or services. This was

the case even though the taxpayer was engaged in

continuous personal activity with respect to his invest-

ments which involved the full time operation of an

office and staff. In Higgins, the Court expressly re-

jected a broad interpretation of the term “trade or

business” which would embrace everything about

which a person can be employed. Cf. Flint v. Stone

Tracy Co., 220 U.S. 107, 171. Instead, it held that

the existence of a “trade or business” would depend

12 The case law has developed other criteria for the existence

of a “trade or business.” For example, the activity must be

frequent, continuous, and regular and the participants must

devote a substantial part of their time to its pursuit. See,

e.g., Austin v. Commissioner, 298 F. 2d 583 (C.A. 2); Wright

v. Commissioner, 274 F. 2d 883 (C.A. 6); Miller V. Commis-

sioner, 102 F. 2d 476 (C.A. 9).

upon the facts of each case as found by the trial court

(312 U.S. at 217-218). See also United States v.

Pyne, 313 U.S. 127, 129-131.

In response to the Higgins decision, Congress en-

acted Section 121(a) of the Revenue Act of 1942,

c. 619, 56 Stat. 798, 819, which added Section 23(a)

(2) to the 1939 Code (Section 212 of the 1954 Code).

This provision authorized for the first time the deduc-

tion of “non-trade” or “non-business” expenses, 7.€.,

those incurred in the “production or collection of in-

come, or for the management, conservation, or main-

tenance of property held for the production of in-

come.” It is significant that in making such expenses

deductible, Congress did not see fit to broaden the ex-

isting concept of trade or business, which had been re-

strictively interpreted in Higgins and which continued

to be an important concept for purposes such as Sec-

tion 174, the provision involved here.

Instead, it created a new category of income-pro-

ducing activity. Indeed, the committee reports under-

score the lack of any intent to alter the trade-or-busi-

ness concept by pointing out that the amendment

would allow deductions “whether or not such expenses

are paid or incurred in carrying on a trade or busi-

ness.” See S. Rep. No. 1631, 77th Cong., 2d Sess., p.

87; H. Rep. No. 2333, 77th Cong., 2d Sess., p. 74. As

Justice Frankfurter noted in his plurality opinion in

McDonald v. Commissioner, 323 U.S. 57, 62 (in which

Chief Justice Stone and Justices Roberts and Jackson

joined), “The amendment of 1942 merely enlarged the

category of incomes with reference to which expenses

were deductible. It did not enlarge the range of al-

lowable deductions of ‘business’ expenses.” See also

United States v. Gilmore, 372 U.S. 39, 45.

2. In view of the “trade or business” requirement

in Section 174, deductibility under that provision does

not simply depend, as petitioner argues (Br. 12-15),

upon the existence of a profit motive. To be sure, the

absence of a profit motive may defeat a claim that an

activity is a trade or business.’ But, as the Court

13'The absence of a profit motive is especially significant

in disallowing so-called “hobby losses.” See, e.g., Porter V.

Commissioner, 437 F. 2d 89 (C.A. 2), affirming per curiam,

28 T.C.M. 1489; Bessenyey v. Commissioner, 379 F. 2d 252

(C.A. 2), certiorari denied, 389 U.S. 931; Yanow v. Com-

missioner, 358 F. 2d 748 (C.A. 3), affirming per curiam, 44

T.C. 444; Lamont v. Commissioner, 339 F. 2d 377 (C.A. 2);

Hirsch v. Commissioner, 315.F. 2d 731 (C.A. 9).

The amici curiae argue (Br. 8-9) that the purpose of Sec-

tion 174 would be better served if the criteria under Section

183 were employed. That provision sets forth rules relat-

ing to the allowance of deductions for activities “not engaged

in for profit” and essentially codifies the court-made law with

respect to hobby losses. Unlike Section 174, the purpose of

Section 183 is to provide rules for the disallowance of deduc-

tions with respect to expenses which are not allowable as

trade or business expenses (Section 162) or as expenses in-

curred for the production of income (Section 212). The

thrust of Section 183 is to provide objective rules for the de-

termination whether an activity is engaged in for profit. It

does not, however, purport to eliminate the bar against the

deduction of the type of capital expenditures incurred by

petitioner. If such expenditures are to be deductible, they

must qualify under Section 174. Any importation of the cri-

teria of Section 183 into Section 174, which is adressed to an

entirely different problem, must be accomplished, if at all, by

Congress.

reaffirmed in Whipple v. Commissioner, supra, a profit

motive cannot of itself establish a trade or business.

If Congress had intended that all research or ex-

perimental expenditures were to be deductible when-

ever they were incurred in the hope of realizing a

profit, Section 174 would have employed the.broader

“production of income” test of Section 212 rather

than the more restrictive “trade or business” stand-

ard. Indeed, had Congress done so, research or ex-

perimental expenditures would be deductible with

little regard to the seriousness of purpose with which

they were incurred. Petitioner’s argument simply

ignores the plainly stated requirement of Section 174

that the expense be incurred “in connection with [the

taxpayer’s] trade or business.”

Faced with the language of the statute and the

well-established definition of the phrase “trade or

business,” petitioner concedes (Br. 13) that his part-

nership was not engaged in a “trade or business’’ as

that term has been defined by the courts. He con-

tends, however, that this term as used in Section 174

connotes a broader range of profitmaking activities,

urging that the judicial definition of “trade or busi-

ness” is relevant only with respect to those statu-

tory provisions previously construed by the courts.

This argument, as we have noted, is contrary to the

Court’s analysis in Whipple v. Commissioner, supra,

which looked not only to the Court’s own prior de-

cisions under the business expense provisions but

also to the Congressional response in 1942 to Higgins.

In Whipple, the Court held that the meaning of “trade

or business” under the bad debt provisions was iden-

tical to its meaning under the statutory allowance of

a deduction for general “trade or business” expenses.

The uniform meaning of the term throughout the

Code is underscored by the Court’s rejection of the

taxpayer’s claim in Whipple “against the background

of the 1942 amendments and the decisions of this

Court in the Dalton, Burnet, du Pont and Higgins

eases * * *” (373 U.S. at 202). See also Cooper

Tire & Rubber Co. Employees’ Retirement Fund v.

Commissioner, 36 T.C. 96, 100, affirmed per curiam,

306 F. 2d 20 (C.A. 6).*

Finally, petitioner’s attempt to accord a unique

definition to the phrase “trade or business” in Section

174 is expressly refuted by the legislative history

(supra, pp. 19-20), which makes specific reference

to the “ordinary and necessary” standard of the gen-

eral business expense deduction provision of Section

162(a). The elimination of the “ordinary and neces-

sary” requirement and the retention of the “trade or

business” standard further demonstrates that the

meaning of “trade or business” in the two statutes

14 Petitioner suggests (Br. 16) that if the term “trade or

business” in Section 174 had the same meaning as in Section

162(a), the former provision would have an explicit cross-

reference to the latter. But the absence of such a cross-

reference in the bad debt deduction provision involved in

Whipple did not prevent the Court from invoking the mean-

ing of “trade or business” as used in the predecessor of Sec-

tion 162(a).

$8 TMS IG AL YOR DATS AE NRE RI POET RRL

BAR ASA ATA Tie RARE iar ee Ee. a

sa nate ai

was intended to be identical.” To conclude otherwise

would be to suggest that the congressional retention

of the “trade or business” requirement in Section 174

was either inadvertent or that a phrase with a long-

standing definition was to have a wholly different

meaning in that provision. Neither possibility, we

submit, offers a realistic interpretation of the statu-

tory language. As Justice Frankfurter observed in

15In support of his argument that Sections 162(a) and

174 have different standards, petitioner points (Br. 15-16)

to the differing terminology of the two provisions. He notes

that Section 162(a) uses the term “in carrying on any trade

or business” while Section 174 speaks of expenses incurred

“in connection with [the taxpayer’s] trade or business.” Peti-

tioner thereby draws the conclusion that the language of the

former provision is more consonant with the requirement of

an existing business. Suffice it to say that there is no sup-

port in the legislative history to indicate that the phrases are

to be accorded such a variant reading. Moreover, the Treas-

ury Regulations under Section 162 frequently use the terms

“connected with or pertaining to” and “in connection with”—

phrases similar or identical to that of Section 174. See Treas-

ury Regulations, Sections 1.162-1(a) and 1.162-17 (a).

Finally, in reporting out the bill which added Section 28

(a) (2) to the 1939 Code (now Section 212 of the 1954 Code),

the House Ways and Means Committee Report used the terms

“in connection with” and “in carrying on” interchangeably.

Thus, it stated (H. Rep. No. 2338, 77th Cong., 2d Sess., p.

16)+

A deduction under this section is subject, except for the

requirement of being incurred in connection with a trade

or business, to all the restrictions and limitations that ap-

ply in the case of the deduction under section 23 (a) (1)

(A) of an expense paid or incurred in carrying on any

trade or business. [Emphasis added.]

See also S. Rep. No. 1631, 77th Cong., 2d Sess., p. 88.

a similar context in McDonald v. Commissioner,

supra, 323 U.S. at 64—

[A]sa system, tax legislation is not to be treated

as though it were loose talk or presented isolated

abstract questions of law casting upon the federal

courts the task of independent construction. Tax

language normally has an enclosed meaning or

has legitimately acquired such by the authority

of those specially skilled in its application.

3. Since the accepted definition of the term “trade

or business” requires holding one’s self out as en-

gaging in the activity of selling either goods or

services, there is necessarily a time in the history of

any enterprise organized for profit when that test

may be satisfied. Conversely, the period of time in

which preparations are made for the commencement

of the business do not constitute engaging in a trade

or business. This is a necessary corollary of the

definition which requires a sufficient degree of af-

firmative action so that it can readily and objec-

tively be ascertained that the enterprise has begun

to function.

While the making of sales and the flow of gross

receipts is a persuasive indicium of the existence of

a trade or business, the absence of sales and gross

receipts need not be determinative. For example, the

opening of an office by a young lawyer and his hold-

ing himself out as ready to perform the services of

his profession would presumably constitute engaging

in a trade or business even though he may not re-

ceive any fees for a substantial period of time. The

4 SG rersceancenenesay

2055 ENED CM TAS TR SITE ISA TELE ae NERY

costs incurred for overhead during this period would

be deductible as trade or business expenses. How-

ever, the pre-operating expenses borne by the young

lawyer in deciding where to locate his office would

not be deductible. The dividing line is the point in

time when the taxpayer begins to hold himself out

as engaged in selling of goods or services.

Thus, the courts have uniformly held that outlays

incurred in investigating a new trade or business or

preparing for the possibility of entering it are non-

deductible. See, e.g., Richmond Television Corp. v.

United States, 345 F. 2d 901, 907 (C.A. 4), vacated

and remanded per curiam on other grounds, 382 U.S.

68; Weinstein v. United States, 420 F. 2d 700, 701

(Ct. Cl.) ; Stanton v. Commissioner, 399 F. 2d 326,

329 (C.A. 5); Dean v. Commissioner, 56 T.C. 895,

902-903; Abegg v. Commissioner, 50 T.C. 145, 154,

affirmed on other grounds, 429 F. 2d 1209 (C.A. 2),

certiorari denied sub nom. Cresta Corp. S.A. v. Com-

missioner, 400 U.S. 1008; Walet v. Commissioner,

31 T.C. 461, 471; Frank v. Commissioner, 20 T.C.

511, 514; Westervelt v. Commissioner, 8 T.C. 1248,

1254-1255. As the Fourth Circuit stated in Rich-

mond Television Corp. v. United States, supra, 345

F, 2d at 907:

[E]ven though a taxpayer has made a firm

decision to enter into business and over a con-

siderable period of time spent money’ in prepa-

ration for entering that business, he still has

not “engaged in carrying on any trade or busi-

ness” within the intendment of section 162 (a)

until such time as the business has begun to

da Ser he PSEA ARIIE 2 Ma, HAE PNRM IER IRA SL IA nye . a

PRORATED

function as a going concern and performed those

activities for which it was organized.

The Fourth Circuit indicated that this rule was

equally applicable to claimed research or experimental

expenditures under Section 174 by citing the cases

in which Section 174 deductions were disallowed for

lack of an existing trade or business. See 345 F. 2d

at 907, n. 7.°° Under both Sections 162 (a) and 174,

therefore, preparatory expenditures incurred prior to

the commencement of the taxpayer’s holding himself

out as engaged in selling activities—the sine qua non

of a “trade or business”—are not currently deducti-

ble. Their costs may be recovered, if at all, only

through capitalization and depreciation.

We turn now to an examination of the facts of

this case, which demonstrate that the activities of

petitioner’s partnership during 1966 were at most in

1° In arguing that he is entitled to current deductions under

Section 174 in advance of the commencement of a trade or

business by the Burns partnership, petitioner cites (Br. 8)

the statement of Representative Camp in support of the argu-

ment that the provision was designed to help “small or be-

ginning business enterprises.” 97 Cong. Rec. A4326. Petitioner

presumably infers that the settled line of decisions disallowing

trade or business expense deductions have no application to

outlays for research or experimental purposes. But the re-

marks of Representative Camp were made with respect to a

wholly different bill introduced three years before the enact-

ment of Section 174. Unlike the statute, that bill, which was

proposed by the American Bar Association, had no require-

ment that such expenditures be incurred in connection with a

trade or business. See H.R. 4775, 82d Cong., Ist Sess.; 75 Re-

ports of the American Bar Association 130-132 (1950).

EP LAAT L ET IAT PIU A Be OE SLO TEST IIE

ations ”

preparation for the possibility of entering a trade

or business in the future.

C. The expenditures paid by the partnership to develop

the invention prior to the time it was marketed were

not incurred in connection with a trade or business

When the foregoing principles governing the defi-

nition of “trade or business” are applied to the facts

of this case, it is plain that the expenditures paid

by the partnership in 1966 were not deductible under

Section 174. During that year, neither petitioner nor

any other member of the partnership held themselves

out as engaging in the activity of selling anything.

In fact, the existence of the Burns partnership was

unknown to the public (Pet. App. 23). Under no

stretch of the imagination was there a going busi-

ness in the accepted sense of that term.

Indeed, in 1966 the partnership had nothing what-

soever to sell because the invention was still in the

development stage and did not even function prop-

erly."’ In the opinion of the partnership’s own patent

* Disputing the relevance of the fact that the partnership

had no product to offer during the taxable year at issue, the

amici curiae argued (Br. 12-18) that it is unjust to limit the

availability of the benefits of Section 174 to those enter-

prises engaged in marketing of a product. It contends that

the effect of such an interpretation would be to deny the de-

duction for pre-marketing research costs to an enterprise de-

veloping an initial product while allowing it to an enterprise

which is engaged in marketing another product, no matter

how tenuous the connection may be between the developed

product and the marketed product. Disallowance of a Section

174 deduction for the development of an initial product is

simply a consequence of the statutory requirement of an

counsel, the device “ha[d] not yet been reduced to

practice” (I-A. 103). No patent was issued until

1970, four years later (Pet. App. 23). Under these

circumstances, the activities of petitioner and _ his

partnership were at most an investigation into the

future possibility of marketing a trash burning de-

vice. .

As such, the expenditures incurred prior to the

marketing of the device fall into the category of pre-

operating investigatory outlays which the courts have

consistently held nondeductible as “trade or business”

expenses. There can therefore be no allowable deduc-

tion under a provision such as Section 174, which

requires that the experimental expenditures be in-

curred “in connection with his trade or business.”

Consistent with our view that Section 174 was in-

tended simply to relieve research or experimental ex-

penditures from the need to qualify under the “ordi-

nary” standard of Section 162(a), the courts have

construed the “trade or business” nexus of Section

174 to require a showing of an existing trade or

business, which is completely lacking in this case.

Thus, for example, in Stanton v. Commissioner, 399

F. 2d 326 (C.A. 5), the court held that the phrase

existing “trade or business.” However, the existence of a

marketed product does not guarantee the availability of Sec-

tion 174 treatment with respect to the development of another

product. If the connection between the marketed product

and the developed product is sufficiently tenuous, the Com-

missioner will disallow the claimed deduction. Compare May-

rath v. Commissioner, 41 T.C. 582, affirmed, 357 F. 2d 209

(C.A. 5), discussed infra, p. 36, with Best Universal Lock

Co. V. Commissioner, 45 T.C. 1, discussed infra, p. 37 n. 18.

“trade or business” in Section 174 presupposes an

existing trade or business of so as to exclude de-

ductions for expenses incurred in the hope of realiz-

ing a profit or in preparation for the possibility of

entering a new trade or business (399 F. 2d at 329).

The court therefore denied a deduction under Section

174 for expenses incurred in attempting to invent a

storm proof boat. See also Koons v. Commissioner, 35

T.C. 1092, 1100-1101.

Similarly, Mayrath v. Commissioner, 41 T.C. 582,

affirmed, 357 F. 2d 209 (C.A. 5), denied a claimed

Section 174 deduction for expenditures incurred in

connection with the development of an experimental

home. Despite the fact that the taxpayer was an

inventor of farm implements, both courts found that

the home was not built in the course of a trade or

business. The Tax Court observed, in terms most

appropriate to this case: “We think the statute was

intended to be used in the realistic and practical

sense of a going trade or business—a condition which

does not exist here” (41 T.C. at 590) (Emphasis

in original) .*

18 To the same effect are Downs v. Commissioner, 49 T.C.

533; Kilroy v. Commissioner, 32 T.C.M. 27; Cunningham V. |

Commissioner, 27 T.C.M. 1219; Scull v. Commissioner, 23

T.C.M. 1358; and Schafer v. Commissioner, 23 T.C.M. 927.

See also 4A Mertens, Law of Federal Income Taxation, Sec.

25.38, p. 169 (1972 ed.), which states: “It is clear that the

statutory phrase ‘trade or business’ presupposes an existing

business with which the taxpayer is directly connected. Ex-

penditures made in investigating a potential new trade or

Indeed, the only reported decision relied upon by

petitioner (Br. 16-17) that arguably supports his

position is Cleveland v. Commissioner, 297 F. 2d 169

(C.A. 4). There, the taxpayer, a lawyer, had made

extensive loans over a long period of time to an in-

ventor who, for more than 10 years, had experi-

mented with the invention of an inorganic liquid

binding material and had applied for patents. After

having made a number of advances, taxpayer entered

into a trust agreement with the inventor regarding

their respective interests in the compound. The Tax

Court disallowed a deduction for the advances claimed

under Section 174, holding that the arrangement con-

stituted at most a sale by the inventor to the lawyer

of a one-half interest in the invention in considera-

tion of past monies advanced, and that the expendi-

business, or preparatory to entering into such business, do not

qualify for the application of Section 174(a) (1) of the Code.”

Although petitioner (Br. 11) relies upon Best Universal

Lock Co. v. Commissioner, 45 T.C. 1, acq. 1966-2 Cum. Bull.

¢&, that case is distinguishable. There, the taxpayer, an exist-

ing business engaged in the manufacture and sale of locks,

was permitted to deduct research and experimental expendi-

tures incurred in the development of an isothermal air com-

pressor. Based upon the corporation’s long history of experi-

mentation and efforts to develop new products, the Tax Court

held that the expenditures at issue were “incurred in connec-

tion with [its] trade or business.” Here, however, the Burns

partnership’s expenditures to develop the trash burner could

not be linked to an existing trade or business because the

partnership was not engaged in any trade or business. It

was simply experimenting with a potential product that might

become part of a future trade or business. Cf. Rev. Rul. 71-

162, 1971-1 Cum. Bull. 97.

38 .

tures were not made in taxpayer’s trade or business.

The court of appeals, however, reversed and allowed

the Section 174 deduction with respect to the post-

agreement advances, characterizing the agreement as

creating a joint venture which it held to be a “trade

or business” of the taxpayer and the inventor.

The length of time over which the experimentation

was conducted in Cleveland is significantly longer

than in this case. But more importantly, unlike the

subsequent decision of the Fourth Circuit in Rich-

mond Television Corp. v. United States, supra,” the

earlier Cleveland opinion of that court did not focus

on the “trade or business” issue. It is therefore un-

clear what considerations led the Cleveland court to

rule that a “trade or business” existed after the exe-

cution of the partnership agreement. As we have

demonstrated, however, it is the performance of the

specific activity of holding oneself out as selling which

constitutes engaging in a trade or business. That

factor was absent both here and in Cleveland.

Thus, to the extent that Cleveland is regarded as

holding that the simple execution of a partnership

agreement, without more, transforms non-deductible

research and development expenditures into qualify-

ing outlays under Section 174, we believe that such a

conclusion was properly rejected as erroneous by the

1” As we have pointed out supra, p. 33, while Richmond

Television Corp. dealt with a claimed deduction under Section

162(a), it correctly recognized that the “trade or business”

standard under Section 174 is identical. See 345 F. 2d at 907

ni. 7,

court of appeals (Pet. App. 40). Indeed, in the light

of the Fourth Circuit’s subsequent ruling in Rich-

mond Television Corp. v. United States, supra, it is

doubtful whether that court would follow its prior

Cleveland decision.

CONCLUSION

For the reasons stated, the judgment of the court

of appeals should be affirmed. :

Respectfully submitted.

RoBERT H. Bork,

Solicitor General.

Scott P. CRAMPTON,

Assistant Attorney General.

STUART A. SMITH,

Assistant to the Solicitor General.

BENNET N. HOLLANDER,

JANE M. EDMISTEN,

Attorneys.

APRIL 1974.

APPENDIX A

Internal Revenue Code of 1954 (26 U.S.C.):

Sec. 174. RESEARCH AND EXPERIMENTAL Ex-

PENDITURES.

(a) Treatment As Expenses.—

(1) In general—A taxpayer may treat re-

search or experimental expenditures which are

paid or incurred by him during the taxable year

in connection with his trade or business as ex-

penses which are not chargeable to capital ac-

count. The expenditures so treated shall be al-

lowed as a deduction.

(2) When method may be adopted.—

(A) Without consent.—A taxpayer may,

without the consent of the Secretary or his

delegate, adopt the method provided in this

subsection for his first taxable year—

(i) which begins after December 31,

1953, and ends after the date on which this

title is enacted, and

(ii) for which expenditures described in

paragraph (1) are paid or incurred.

(B) With consent.—A taxpayer may, with |

the consent of the Secretary or his delegate,

adopt at any time the method provided in this

subsection.

(3) Scope-—The method adopted under this

subsection shall apply to all expenditures describ-

ed in paragraph (1). The method adopted shall

be adhered to in computing taxable income for

the taxable year and for all subsequent taxable

years unless, with the approval of the Secretary

or his delegate, a change to a different method

is authorized with respect to part or all of such

expenditures.

(b) Amortization of Certain Research and Ex-

perimental Expenditures.—

(1) In general—At the election of the tax-

payer, made in accordance with regulations pre-

scribed by the Secretary or his delegate, research

or experimental expenditures which are—

(A) paid or inturred by the taxpayer in

connection with his trade or business,

(B) not treated as expenses under subsec-

tion (a), and

chargeable to property of a charcter which is

subject to the allowance under section 167 (re-

lating to allowance for depreciation, etc.) or

section 611 (relating to allowance for deple-

tion),

may be treated as deferred expenses. In comput-

ing taxable income, such deferred expenses shall

be allowed as a deduction ratably over such period

of not less than 60 months as may be selected

by the taxpayer (beginning with the month in

which the taxpayer first realizes benefits from

such expenditures). Such deferred expenses are

expenditures properly chargeable to capital ac-

count for purposes of section 1016(a)(1) (relat-

ing to adjustments to basis of property).

(2) Time for and scope of election.—The elec-

tion provided by paragraph (1) may be made for

any taxable year beginning after December 31,

1953, but only if made not later than the time

prescribed by law for filing the return for such

taxable year (including extensions thereof). The

method so elected, and the period selected by the

taxpayer, shall be adhered to in computing tax-

able income for the taxable year for which

the election is made and for all subsequent tax-

able years unless, with the approval of the Sec-

retary or his delegate, a change to a different

method (or to a different period) is authorized

with respect to part or all of such expenditures.

The election shall not apply to any expenditure

paid or incurred during any taxable year before

the taxable year for which the taxpayer makes

the election.

* x = *

APPENDIX B

I. Substantive Provisions of the Internal Revenue

Code Using the Phrase “Trade or Business”

Sections 46(c)(3), 47(b), 48(i), 50A(c)

(2)(B), 50B(c)(1), 57(b) (2), 62(1), 75(a),

103(c) (2), 108(a), 114(a), 116(d), 162(a),

163(d), 164(a), 165(c)1, 166(d)(2), 167(a)

(1), 170(e) (1), 171(d), 172(d) (4), 174, 179

(d)(1)(B), 182(d)(2)(A), 216(c), 217(f)

(1)(B), 245(a), 264(a)(1), 268, 274(a) (1),

301(b) (1) (C), 311(d) (2) (B), 312(b) (2), 337

(b) (1) (A), 341(b)(3)(B), 346(b), 355(b),

382(a)(1)(C), 401(c) (1), 404(a), 407(a), 421

(a), 446(d), 455(c)(1), 456(c)(1), 471, 481

(b) (4) (C), 502, 509(a) (2) ((A) (ii), 512(a),

513, 514(b) (1), 543(a) (3), 545(b) (8), 556(b)

(5), 702(a)(3), 707(c), 804(b)(3), 805(b)

(4), 817(a), 822(b) (2), 832(c) (1), 842, 856(a)

(4), 861(a)(1)(C) and (D), 864(b), 871(b),

872(a), 873, 875, 877(b), 881(a), 882(b), 884

(2), 894(b), 904(f), 906, 911(b), 921, 931(a)

(2), 9384(b) (2), 952(b), 954(c) (3), 956(b) (2)

(C), 957(c), 981(b) (2), 993(c), 996(g), 1031

(a), 1033(g), 1054, 1221, 1231, 1236(a) (2),

1237(a), 1244(d) (3), 1253(d) (1), 1341(b) (2),

1402(c), 1441(c), 1442(b), 1451(a) and (b),

and 3401(d) (2).

II. Substantive Provisions of the Internal Revenue

Code Using the Phrase “Production of Income”

Sections 57(b) (2) (C), 62(5), 163(d) (3) (C), 164

(a), 167(a) (2), 212(1) and (2), 216(c), 265(1)

and 404(a).

III. Substantive Provisions of the Internal Reve-

nue Code Using the Term “Entered into for

Profit”

Sections 165(c) (2), 877(b), and 931(d) (2) (A).

W ov. S. GOVERNMENT PRINTING OFFICE; 1974 336395 220

i LOONEY CANE: MANY Maerviery 2 ro

TEES INP RBI PY SUEY NALIN TY ME San Sl

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.