T.C. Memo. 1998-6
UNITED STATES TAX COURT
UTAH JOJOBA I RESEARCH, WILLIAM G. KELLEN,
TAX MATTERS PARTNER,1 Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 7619-90. Filed January 5, 1998.
Frederick R. Schumacher, for petitioner.
Rodney J. Bartlett and Brian M. Harrington, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
DAWSON, Judge: This case was assigned to Special Trial
Judge Norman H. Wolfe pursuant to the provisions of section
1
There are at present 18 other docketed cases that are bound
by stipulation by the outcome of this case.
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7443A(b)(4) and Rules 180, 181, and 183.2 The Court agrees with
and adopts the opinion of the Special Trial Judge, which is set
forth below.
OPINION OF THE SPECIAL TRIAL JUDGE
WOLFE, Special Trial Judge: Utah Jojoba I Research (Utah I)
is a limited partnership organized under the laws of California.
The provisions of sections 6221-6233 (the TEFRA partnership
provisions)3 are applicable to Utah I. By notice of final
partnership administrative adjustment (FPAA) respondent
determined the following adjustments to the partnership return of
income of Utah I: (1) Disallowance of a claimed loss for 1982 in
the amount of $1,304,819, including $1,298,627 claimed as
qualified research and experimental expenditures under section
174; and (2) disallowance of a claimed loss of $50,482 for 1983.
William G. Kellen (Kellen), as tax matters partner (TMP), timely
filed a petition with this Court.
We must decide whether the Utah I partnership is entitled to
the claimed deductions for losses for 1982 and 1983 and
particularly whether Utah I is entitled to treat amounts
2
All section references are to the Internal Revenue Code in
effect for the tax years in issue, except as otherwise indicated.
All Rule references are to the Tax Court Rules of Practice and
Procedure.
3
The so-called TEFRA partnership provisions, secs. 6221-6233,
were added to the Code by the Tax Equity and Fiscal
Responsibility Act of 1982 (TEFRA), Pub. L. 97-248, sec. 402(a),
96 Stat. 648.
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allegedly paid or incurred for research and experimental
expenditures as deductible trade or business expenses.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the exhibits attached thereto are
incorporated herein by this reference.
The jojoba plant is a shrub that is generally found on the
periphery of the Sonora Desert. While classified as a member of
the boxwood family, it is not closely related to any other plant.
. The jojoba plant produces a seed, sometimes referred to as a
bean, that contains approximately 50 percent by weight of an
unusual oil. Jojoba oil is actually a liquid wax ester, unlike
the triglyceride oils typically produced by plants, and is
similar to sperm whale oil.
It takes 5 years or more for a jojoba plant to produce seeds
in a harvestable quantity. Jojoba oil is useful for a variety of
products, ranging from cosmetics to industrial lubricants.
The ban in 1971 on the importation of sperm whale oil
stimulated an interest in the commercial production of jojoba
oil. In 1978, an estimated 2,200 acres of jojoba were planted in
Arizona and California. At that time, it had been estimated that
25,000 acres of jojoba would be sufficient to replace the sperm
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whale oil requirements of the United States. By 1982, the
planted jojoba acreage had increased more than 10 times to an
estimated 25,000 acres, and by 1986 an estimated 40,000 acres of
jojoba had been planted in Arizona, California, and Texas.
Utah I entered into an agreement with U.S. Agri Research and
Development Corp. (U.S. Agri) that purported to provide for U.S.
Agri to furnish agricultural research and development services
with respect to the growing of jojoba on land in Desert Center,
California (the plantation). Utah I engaged in no activity other
than to enter into the agreements described herein and transmit
payments to U.S. Agri.
1. Utah Jojoba I Research
When the petition was filed, the principal place of business
of Utah I was Cora, Wyoming.
On December 27, 1982, Utah I was organized as a limited
partnership with a described purpose of conducting research and
development involving the jojoba plant. Kellen served as both
the general partner and TMP of Utah I. Under the accrual method
of accounting and pursuant to a claimed election under section
174, Utah I claimed losses of $1,304,819 for 1982, largely from
the deduction of $1,298,627 as research and experimental
expenses for the taxable year ending on December 31, 1982, and
also claimed losses of $50,482 for the taxable year ending
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December 31, 1983. However, no activity under the research and
development (R&D) agreement occurred prior to December 31, 1982.
In 1982, Kellen worked primarily as an attorney and a bank
executive in the Fontana and Riverside areas of California. In
October 1982, Kellen was introduced by Eugene Pace (Pace), a
former neighbor and casual business acquaintance, to Coordinated
Financial Services (CFS) of Salt Lake City, Utah. CFS and Pace
represented a group of investors who were seeking someone to
serve as the general partner for a limited partnership with a
described purpose of conducting research and development of the
jojoba plant and its product, the jojoba nut (or bean). Pace
suggested to CFS that Kellen would be a suitable general partner
for the jojoba limited partnership.
Prior to his formation of U.S. Agri, discussed infra, Pace
was a financial planner. In 1968 Pace simultaneously formed
Gemini Financial Corp. (Gemini) and a brokerage/dealership called
GFCS, Inc. Through Gemini, Pace marketed life insurance and
securities in various forms. Gemini was also involved in the
promotion of syndications as tax-advantaged investments in the
form of limited partnerships. Among the many syndications
organized by Gemini were those involving investments in an orange
grove, apartment units, shopping centers, and egg-laying hens.
At Pace's suggestion, Kellen traveled to Salt Lake City,
Utah, to interview with members of CFS regarding the general
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partner position. In November 1982, CFS notified Kellen that he
had been selected to serve as the general partner of Utah I.
Shortly thereafter, CFS notified Kellen that the investing group
intended to form three additional jojoba limited partnerships and
asked Kellen if he would serve as the general partner for these
additional limited partnerships. Kellen agreed and became the
general partner of four jojoba research and development limited
partnerships, including Utah I. When he became general partner
in 1982, Kellen had no prior experience in the growing of jojoba.
At that time, Kellen's knowledge of jojoba was limited to
articles he read in National Geographic and his familiarity to
some extent with the experimental jojoba plantations located at
the University of California at Riverside.
Kellen and Pace had known each other since 1975. Then Pace
owned a 96-acre orange grove located across the street from
Kellen's residence in Riverside, California. Pace wished to
develop the orange grove through a syndication. After learning
that Kellen was a civil engineer as well as an attorney, Pace
engaged Kellen to assist him in subdividing the land. Kellen
successfully completed the subdivision of Pace's land in
approximately 1979. Pleased with Kellen's handling of the sale
of the orange grove, Pace remained in contact with Kellen after
the sale was completed.
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The next joint business activity by Kellen and Pace occurred
either in late 1979 or early 1980 when Pace asked Kellen for
assistance in locating desert property with a good water supply
that would be suitable for growing jojoba. Kellen directed Pace
to land located in Desert Center and Blythe, California, which
had an unlimited water supply for agricultural purposes. Since
1974 Kellen had been actively involved in efforts to develop the
land in this area agriculturally. According to Kellen, he was
actively involved in the development of alfalfa, citrus, jojoba,
grapes, and asparagus. Nevertheless, the private placement
memorandum used to promote Utah I characterized Kellen as having
"no previous experience" with respect to jojoba beans. The
maximum amount of land that Kellen owned at any one time in the
Desert Center and Blythe areas was 4,000 to 6,000 acres.
Pace was pleased with the characteristics of the land Kellen
showed him in Desert Center, California, and thought it would be
a good location for growing jojoba. In 1980, the Sterling Trust,
which had been established by Pace, purchased 400 acres of
property in Desert Center, California. The Sterling Trust was an
inter vivos trust in which Pace was both the grantor and the
beneficiary. At trial, Pace was not able to recall the name of
the individual who sold the property to the Sterling Trust.
Kellen served and continues to serve as trustee of the Sterling
Trust. Kellen also served as a director of U.S. Agri before he
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became general partner of jojoba farming partnerships. In 1981,
the Sterling Trust leased the 400 acres it owned to U.S. Agri
(described infra) for jojoba farming operations. The 80 acres
later allocated to Utah I were included in the 400 acres leased
to U.S. Agri.
Utah I was financed through a private placement, as
described infra. The operation was conducted by U.S. Agri,
purportedly with management and supervision by Agri Futures, Inc.
Kellen frequently made the 120-mile trip from his office to
Desert Center to inspect the land allocated to Utah I. As
general partner, Kellen received quarterly progress reports in
the form of correspondence from Pace on behalf of U.S. Agri
regarding the progress on the jojoba plantation. On October 23,
1983, Kellen forwarded one of the progress reports he received
from U.S. Agri regarding the growth of the jojoba plants to Utah
I's limited partners. Although Kellen received additional
progress reports from Pace on behalf of U.S. Agri during 1984, he
did not forward any of these reports to the limited partners of
Utah I. On February 14, 1985, Kellen forwarded two additional
progress reports from Pace on behalf of U.S. Agri to the limited
partners of Utah I.
Pace believed that Utah I's research contract with U.S. Agri
terminated after 4 years, on approximately December 31, 1986.
However, by its literal terms, the R&D agreement expired upon
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Utah I's execution of the license agreement described in
paragraph 10.a of the R&D agreement. This license agreement was
executed by Kellen on December 31, 1982, concurrently with
Kellen's execution of the R&D agreement. Kellen testified at
trial that he did not read the private placement memorandum for
Utah I, which included the R&D agreement and the license
agreement, before signing them on December 31, 1982, and that
after signing the documents he gave "No thought to the license
agreement whatsoever."
By 1986, U.S. Agri had not been successful in developing a
method to "harden off" the jojoba plants cultured in the
laboratory and grown in a greenhouse test tube. According to
Pace, the process of hardening off jojoba plants refers to the
technique of taking a jojoba plant grown in a greenhouse test
tube and successfully planting it in the ground. As a result, a
high percentage of the cultured jojoba plants died after they
were planted in the ground. In 1987, when Pace decided to close
U.S. Agri's laboratory and greenhouse and stop all research
activity, U.S. Agri was still experiencing a 90-percent failure
rate for the cultured jojoba plants transferred to the field.
Soon after, in late 1987, U.S. Agri integrated the 80 acres
allocated to Utah I with the rest of its commercial jojoba
farming operation.
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Kellen testified that passage of the Tax Reform Act of 1986,
which required passive investors to capitalize all preproduction
costs, ultimately contributed to the failure of Utah I. Kellen
explained that "with the collapse, basically, of the tax
incentive for doing jojoba, we had to then go into some type of
other mode of operation to see if we couldn't make the venture
profitable." In October 1991, Utah I was consolidated with 36
other limited partnerships under contract with U.S. Agri into one
large limited partnership, Jojoba Plantation Ltd. The general
partners of the 37 limited partnerships believed that by
combining resources they could reduce costs and enable their
jojoba farming ventures to become profitable. At the time of the
trial of this case, Jojoba Plantation Ltd. was in chapter 7
bankruptcy.
a. The Private Placement Memorandum
Coordinated Financial Services (CFS) prepared the private
placement memorandum (the offering) and all other organizational
and contractual documents for Utah I, including the R&D agreement
and the license agreement. Although Kellen, as general partner
of Utah I, properly executed the documents, he claims that he did
not carefully review any of the documents prepared by CFS before
subscriptions were taken for Utah I. The offering, dated
November 10, 1982, provided for a maximum capitalization of
$2,968,000 consisting of 350 limited partnership units, at $8,480
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per unit. Each unit consisted of a cash downpayment of $2,500
and a non-interest-bearing promissory note in the principal
amount of $5,980 payable in 10 annual installments with an
acceleration provision in case of default. Subscription
agreements, which included the promissory note, were signed by
each limited partner and obliged him to make these payments.
Kellen never took any action in a State or Federal court to
enforce the promissory notes against the limited partners of Utah
I who defaulted. The offering was limited to investors with a
net worth (exclusive of home, furnishings, and automobiles) of
$150,000, or investors whose net worth was $50,000 (exclusive of
home, furnishings, and automobiles) and who anticipated that for
the taxable year of the investment they would have gross income
equal to $65,000, or taxable income, a portion of which, but for
tax-advantaged investments, would be subject to a Federal income
tax rate of 50 percent. Each limited partner also was required
to execute a limited guaranty agreement in which he guaranteed a
proportionate share of partnership debt to U.S. Agri. The Utah I
partnership was formed with subscriptions for 247 units for a
total capitalization of $2,094,560, which facilitated farming
operations on 80 acres of real property located in the environs
of Desert Center, California, for a period of approximately 4
years.
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According to the offering circular, Utah I was to be "formed
to undertake a comprehensive research and development program on
the plant Simmondsia Chinensis (Jojoba)," and, ultimately obtain
production from the plantation property allocated to Utah I.
The offering identified U.S. Agri as the contractor selected to
carry out the research and development program under an R&D
agreement.
b. U.S. Agri
U.S. Agri was a Nevada corporation established by Pace on
November 7, 1979. Prior to 1979, Pace was not familiar with
jojoba. Pace was the sole shareholder of U.S. Agri and also
served as the chief executive officer. Pace delayed activating
U.S. Agri until the summer of 1981 so he could learn more about
the jojoba business before committing to participation in the
business. For 4 or 5 months in 1981, Kellen served as an officer
and director of U.S. Agri.
U.S. Agri leased, with an option to buy, 1,306 acres of land
in Desert Center and Blythe, California. U.S. Agri allocated 400
of those acres located in Desert Center to research and
development partnerships. The other 906 acres were utilized for
U.S. Agri's commercial jojoba farming operations. The 400 acres
that U.S. Agri allocated to research and development partnerships
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were leased from the Sterling Trust.4 In 1981, U.S. Agri began
making leasehold payments to the Sterling Trust for this land,
including the 80 acres that Utah I would later comprise.
U.S. Agri was only nominally capitalized before the summer
of 1981, and thereafter was capitalized with $200,000 cash
invested by Pace. As part of the capitalization of U.S. Agri,
Pace also became obligated on a $150,000 note and deed of trust
for the initial 400 acres that had been purchased by the Sterling
Trust and leased to U.S. Agri. Funds paid for subscriptions to
Utah I subsequently were used to pay for or reimburse U.S. Agri
for costs associated with tilling and leveling the land, planting
jojoba, purchasing and installing the irrigation system, and
otherwise developing Utah I's 80-acre jojoba plantation.
In March 1982, U.S. Agri opened a laboratory and a
greenhouse in Riverside, California. Pace alleges that the day-
to-day management of the greenhouse was handled by Pace's
parents. Pace claims to have hired Dr. Prem Jauhar and Dr. Joyce
Clark to set up and run the laboratory. Other technical
personnel Pace claims to have employed to perform research for
U.S. Agri in the lab and greenhouse include Dr. Meena Moses, Dr.
Fen Lin, Dr. Duncan Williams, and Dr. Steven Koenisberg. None of
the above-named technical personnel from U.S. Agri testified at
4
There is no information in the record regarding the
ownership of the remaining 906 acres of land leased by U.S. Agri.
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the trial. Additionally, no evidence was introduced at the trial
to substantiate Pace's testimony regarding their actual
employment by U.S. Agri.
Sometime between 1979 and 1981, U.S. Agri allegedly entered
into a management contract with Agri Futures, Inc. (Agri
Futures), a California company. Under this contract, Agri
Futures purportedly was to develop the 400 acres U.S. Agri leased
from the Sterling Trust, including the land allocated to Utah I,
into jojoba plantations. Agri Futures was also known as American
Jojoba Industries. U.S. Agri's management contract with Agri
Futures is not part of the record in this case.
The sole shareholders of Agri Futures, Gordon Fisher and
Bill Rivers, also served as officers and directors of U.S. Agri.
As U.S. Agri's subcontractor, Agri Futures provided the physical
labor involved in the preparation of the land for farming jojoba
and the maintenance of the jojoba plantations. Pursuant to its
management contract with U.S. Agri, Agri Futures purportedly
planted, maintained, and irrigated the jojoba on the land
allocated to Utah I. Pace testified that employees of Agri
Futures performed all of the work for Utah I that was necessary
to follow the plan he developed for Utah I. Funding for these
activities was provided by U.S. Agri pursuant to its arrangements
with Utah I, described infra. No one from Agri Futures testified
at the trial.
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Throughout the entire time that Pace operated U.S. Agri, he
was a member of the International Jojoba Association. As a
member of the International Jojoba Association, Pace participated
in the association's drive to increase the overall annual size of
the jojoba crop in order to have a readily available source of
supply at a reasonable yet profitable price. These efforts may
have included the sharing of information regarding field tests
among growers of jojoba.
In the late summer or early fall of 1982, U.S. Agri produced
a videotape primarily aimed at potential general partners for
jojoba limited partnerships that described jojoba as "liquid
gold" and "the industrial crop of the future". Pace testified
that this videotape was distributed to 400-500 people in the
financial planning community. Additionally, each general partner
of the 12 jojoba research and development limited partnerships
serviced by U.S. Agri received a copy of the videotape.
According to Pace, his ultimate objective in establishing
U.S. Agri, the laboratory, and the greenhouse, in addition to
acquiring the 400 acres in Desert Center, was "to develop two or
three dozen super hybrid jojoba plants that could be cloned
and/or xeroxed, if you will, by virtue of the techniques
developed in the lab, for sale to other growers." According to
Pace, the land in Desert Center was necessary in order to be able
to identify which of the jojoba plants cultured in the lab would
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actually grow into superior plants that then could be sold to
other growers. However, none of the work done in the laboratory
or greenhouse was specifically designated for Utah I. U.S. Agri
did not allocate any of its losses from its laboratory and
greenhouse operations to Utah I.
U.S. Agri's failure to develop a successful technique for
hardening off the jojoba plants cultured in the laboratory and
passage of the Tax Reform Act of 1986 forced Pace to close U.S.
Agri's laboratory and greenhouse in October or November 1987.
As a result, the 400 acres of land that U.S. Agri allegedly had
allocated to research and development, including the land
allocated to Utah I, was added to the 906 acres that U.S. Agri
already was operating as a commercial jojoba farming operation.
By 1991, U.S. Agri serviced 37 different limited
partnerships that eventually merged into Jojoba Plantation Ltd.
Twelve of these limited partnerships were being serviced pursuant
to agreements similar to the agreement between Utah I and U.S.
Agri.
c. The Research and Development Agreement
U.S. Agri executed an exclusive R&D agreement with Utah I on
December 31, 1982, for the stated purpose of "conducting research
and experimentation on the jojoba plant and developing the
technology resulting in the commercial cultivation of the jojoba
plant." No other bids were considered for the role of prime
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research contractor. The R&D agreement, along with other
documents, was sent by CFS to Kellen at his law office on
December 31, 1982, in a last minute rush to execute and file the
documents before the end of the year. Pursuant to directions
Kellen received from CFS, he notified the notary at his law
office to be on "standby" and waited for the courier to arrive
with the documents. Upon the arrival of the courier, Kellen
quickly signed the documents and had them notarized before
returning them to the courier.
The terms of the R&D agreement entered into between U.S.
Agri and Utah I specified that U.S. Agri was "to use its best
efforts to develop a jojoba plantation in the vicinity of Desert
Center, California, at a specific location to be selected by * *
* [U.S. Agri] to be used to conduct research on the
domestication, commercial cultivation, planting and irrigation
techniques, weed, disease and insect management, and harvesting
of the jojoba plant. Said plantation to be eighty (80) acres."
The 80 acres was further described in the R&D agreement as
follows:
The plantation will be located within the larger tract
of land described as follows: the Southeast quarter of
the Northwest quarter and the Southwest quarter of
Section 16, Township 5 South, Range 16 East, San
Bernardino Base and Meridan.
Under the R&D agreement, Utah I agreed to pay U.S. Agri a
total of $1,298,627, plus interest, $423,428.52 of which was to
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be paid with the execution of the R&D agreement. Subsequent
installments of nine payments of $121,941 each, including
interest on the unpaid balance at the rate of 7 percent, were to
be paid annually starting on July 31, 1983. The final sum of
$232,921 representing the balance of the payments at 7 percent
and 2 percent of deferred interest not previously paid was to be
paid on July 31, 1992. The record does not include evidence
concerning actual payment of any of these amounts except for Utah
I's 1982 and 1983 tax returns and Pace's testimony that he
recovered the amounts he advanced to start U.S. Agri from Utah I
funds.
The R&D agreement also specified that U.S. Agri was entitled
to "retain any and all amounts paid to it by the Partnership * *
* [Utah I], whether or not the R&D Program is successful and
accomplishes the results contemplated hereunder. * * * [U.S.
Agri] does not guarantee that its work will be successful and the
Partnership * * * [Utah I] shall have no rights of refund." The
R&D agreement further provided that "Any real property and
tangible personal property acquired or improved" by U.S. Agri in
connection with the research and development program was to
remain U.S. Agri's sole property and that "no ownership rights in
such property will be transferred to the partnership * * * [Utah
I]." The R&D agreement also stated that no income from the
jojoba plantation was anticipated during the research and
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development period. If any income were generated during the R&D
period, it would "be divided eighty-five percent (85%) to the
Partnership * * * [Utah I] and fifteen percent (15%) to the
Contractor * * * [U.S. Agri]."
As part of the R&D agreement, Utah I also had the option of
requiring U.S. Agri to enter into a license agreement that would
include the commercial exploitation of the jojoba plantation
assigned to it. The option, which referred to U.S. Agri as the
contractor and Utah I as the partnership, was described as
follows:
At such time as the Jojoba plantation on which the
research and development is being conducted has reached
a stage of commercial development, the Contractor * * *
shall give the Partnership a written report to that
effect and the Partnership will have the option to
require the Contractor to enter into a License
Agreement for the purpose of commercially exploiting
the technology developed pursuant to this Agreement. *
* * This option shall be solely at the discretion of
the Partnership.
Execution of the license agreement by Utah I, pursuant to this
option, would result in the automatic termination of the R&D
agreement between Utah I and U.S. Agri according to the terms of
the R&D agreement.
The R&D agreement gave Utah I the ownership of "any
inventions, discoveries, improvements, devices, designs,
apparatus, practices, processes, methods or products, * * *
whether patentable or not, made, developed, perfected, devised,
conceived" in the course of U.S. Agri's work for Utah I. U.S.
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Agri did not develop any proprietary technology with respect to
or for Utah I. U.S. Agri did present four pages of an incomplete
patent application that had been prepared with respect to a
tissue culture process. However, this application was never
filed or completed, nor did it concern Utah I.
d. The License Agreement
Concurrently with the execution of the R&D agreement between
Utah I and U.S. Agri, on December 31, 1982, Kellen, on behalf of
Utah I, executed an exclusive license agreement with U.S. Agri.
The license agreement granted U.S. Agri for 40 years "the
exclusive right to utilize the technology developed for the
account of the Licensor * * * [Utah I]," in exchange for which "a
royalty shall be paid by Licensee * * * [U.S. Agri] to Licensor *
* * [Utah I]." The amount of the royalty "shall be eighty-five
percent (85%) of all products produced on the Plantation and
intended to be sold or moved from the Plantation by the Licensee
* * * [U.S. Agri]."
e. The Amended Research and Development Agreement
On February 4, 1983, Kellen on behalf of Utah I, and Pace on
behalf of U.S. Agri, executed an addendum to the original R&D
agreement that set forth a "Research Plan" regarding the 80-acre
plantation allocated to Utah I. The stated objectives of the
amended research plan were:
(1) to develop cultural information on how to manage
Jojoba plantations in semi-arid regions of Southern
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California in terms of irrigation, fertilization and
weed control treatment; (2) to compare the productivity
of plots established with different genetic materials;
(3) determine the variations, if any, as to plant
response of different genetic materials in relation to
#1 above and; (4) to develop sections of Jojoba with
maturation, and above average seed size.
A chart containing a configuration of the field testing to be
completed on Utah I's plantation pursuant to the amended research
plan was attached. Pursuant to the amended research plan, all of
Utah I's land was to be planted at one time. In addition, the
amended research plan contained no provision for the repetition
of any of the purported experiments to average out the influence
of any uncontrollable factors such as the weather.
To carry out the objectives of the amended research plan, 3
plots of 10 rows of jojoba seed each were to be divided for
purposes of comparing the use of "Roundup" and "Princep" as
herbicide treatments. In 1983, both "Roundup" and "Princep" were
herbicides or weed killers generally available to the public for
farming purposes. The amended research plan also provided for 6
subplots of 20 rows each, which would be subjected to various
irrigation and fertilization techniques. The first two subplots
were to be irrigated at various levels throughout the growing
season, and no fertilizer would be applied to the subplots. The
third and fourth subplots were to be irrigated in the same
fashion but fertilized with "Uran 32". The fifth and sixth
subplots also were to be irrigated in the same fashion but
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fertilized with "10340". "Uran 32" and "10340" were fertilizers
generally available to the farming community in 1983. The final
part of the amended research plan specified that 5 acres of the
80-acre parcel allocated to Utah I was to be divided into 4
subplots. Each of the four subplots was to be planted with seed
collected and cataloged by U.S. Agri as to specific geographic
origin. Once the jojoba plants had emerged, they were to be
irrigated at a specific rate.
The record does not establish that the above-described
procedures ever were carried out. Petitioner's business records
contain no formal compilation of research data or scientific
analysis completed for Utah I. U.S. Agri's only records of the
work allegedly carried out on behalf of Utah I are 16 pages of
handwritten notes reflecting Pace's personal observations on the
growth of the jojoba plants from April 1983 through December
1985. Pace's notes were made at irregular intervals and contain
no scientific data. For example, in July 1983 Pace states in his
notes "Emergence is very good. Continue everything exactly as it
is." One year later in July 1984, Pace noted "1, 2 & 3 [a]ll
look good but weeds in one are quite a problem. No observable
damage or losses in 2 or 3 but probably too soon to tell." There
is no evidence that Agri Futures, as the farm manager for U.S.
Agri, prepared any reports regarding the status of the jojoba
being grown on land allocated to Utah I.
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2. The Expert--Levi Chen
Levi Chen (Chen) testified for respondent as to whether any
research or experimentation activities were conducted pursuant to
the exclusive R&D agreement entered into between Utah I and U.S.
Agri, and as to the extent and nature of any such research
activities. Chen is an engineer employed by the Internal Revenue
Service in Los Angeles, California. He visited the site of the
jojoba plantation in Desert Center, California, and inspected the
growing jojoba in May 1986. Chen also visited U.S. Agri's
laboratory and greenhouse in Riverside, California. He is
qualified to testify as an expert in the instant case as to the
matters set forth in his report. Petitioner did not call an
expert witness to testify.
In the report he prepared with respect to the Utah I
partnership, Chen concluded that the activities conducted on the
80 acres controlled by Utah I between December 31, 1982, and
December 31, 1986, were irrigation, fertilization, and herbicide
field tests combined with efforts to select superior jojoba
plants for propagation. The field tests were carried out using
commercially available herbicides, such as "Roundup" and
"Princep", and commercially available fertilizers, such as "Uran
32", and a "10-34-0"5 mixture in different combinations, which is
5
The amended research plan refers to the fertilizer as simply
"10340".
- 24 -
a common farming practice. Chen concluded that the activities
conducted by U.S. Agri on the land allocated to Utah I did not
constitute research and development and were merely farming
activities. The field tests were not designed or carried out for
the purpose of acquiring information about jojoba that was
unknown at the time. Chen found no substantial evidence that any
research was conducted.
Chen found that few, if any, scientific procedures were
established for the conduct of the proposed research. In Chen's
view, for the conclusion of a research project to be valid, the
experiment must be able to produce repeatable results, and Utah
I's research project produced no repeatable results. Chen's
report elaborated:
Experiments are planned to minimize the effects of
uncontrollable factors such as weather. In botany this
means that an experiment would have to be carried out
on the same age plants over several years to average
out the influence of the weather. Otherwise it would
not be possible to determine if results were due to the
experiment.
The Partnership's Project was planted without any
provision for the repetition of the experiments. The
land was planted at once.
Staggered planting of the land is necessary so that the same age
plants from different years could be compared and conclusions
could be formed about the effectiveness of the various
procedures. There is no evidence that staggered planting
occurred on Utah I.
- 25 -
In preparing his expert report, Chen reviewed copies of the
quarterly progress reports Pace, on behalf of U.S. Agri,
submitted to Kellen, as general partner of Utah I, as required by
the original R&D agreement. Although Chen found that the
progress reports contained some general statements about starting
an "experimental procedure", by mid-1986 the progress reports
contained no references to any possible research activities.
Generally, however, Chen concluded that the progress reports
submitted by U.S. Agri were written in the manner of general
farming reports containing information on the progress of Utah
I's jojoba crop. The progress reports contained no discussion of
the different experiments as set forth in the amended research
plan, nor any description of how each plot was progressing
relative to others or a control plot.
The handwritten notes Pace submitted were determined by Chen
to be inadequate for research purposes. They contained no record
of weather conditions or growth measurements of the jojoba
plants. Furthermore, the time intervals between Pace's written
observations were irregular and too far apart for Pace's notes to
be of any scientific value.
Chen also determined that the plant selection portion of the
amended research plan was merely an application of existing
processes and techniques used to cull the best plants and was not
selective breeding. Chen's report stated that U.S. Agri's
- 26 -
purported plan to breed the seeds from only one generation of
jojoba plants in an attempt to produce a jojoba plant with
superior attributes was nothing more than U.S. Agri practicing
culling. Chen's report explained that U.S. Agri's activities
were not plant breeding. Producing plants with consistently
superior attributes takes many generations in order to assure
that "the progenies would breed true."
After touring U.S. Agri's laboratory and greenhouse in
Riverside, California, Chen concluded that the activities carried
out in the laboratory and greenhouse had not been contracted for
by Utah I. The amended research plan of Utah I contains no
references to U.S. Agri's laboratory or greenhouse. U.S. Agri
did not provide Chen with any of its expense records regarding
the contract fee it received from Utah I.
On the basis of the foregoing, Chen concluded that in his
expert opinion "the partnership has not shown that it has done
anything but farming."
OPINION
This partnership proceeding is governed by the procedural
rules of the Tax Equity and Fiscal Responsibility Act of 1982
(TEFRA), Pub. L. 97-248, sec. 402(a), 96 Stat. 648, codified as
secs. 6221-6233. Under section 6221, the tax treatment of
partnership items is determined at the partnership level. We
conclude that Utah I is not entitled to a section 174(a) research
- 27 -
and experimental expense deduction for 1982 because it did not
directly or indirectly engage in research or experimentation. In
addition, we hold that Utah I was not actively involved in a
trade or business and also lacked a realistic prospect of
entering a trade or business. Nickeson v. Commissioner, 962 F.2d
973, 978 (10th Cir. 1992), affg. Brock v. Commissioner, T.C.
Memo. 1989-641; Zink v. United States, 929 F.2d 1015, 1021 (5th
Cir. 1991). Therefore, Utah I is not entitled to any additional
deductions for 1982 and 1983 under section 162(a).
This Court previously has addressed the deductibility of
purported research and development expenditures under section 174
by limited partnerships formed for the purported purpose of
engaging in agricultural research and development of the jojoba
plant. Cactus Wren Jojoba, Ltd. v. Commissioner, T.C. Memo.
1997-504; Glassley v. Commissioner, T.C. Memo. 1996-206;
Stankevich v. Commissioner, T.C. Memo. 1992-458. In the Cactus
Wren Jojoba Ltd., Glassley, and Stankevich cases, we held that
the taxpayers were not entitled to deductions for research and
experimental expenditures under circumstances similar to those
presented in this case.
The evidence presented in this case persuades us that the
R&D agreement before us was mere window dressing, designed and
entered into solely to decrease the cost of participation in the
jojoba farming venture for the limited partners through the
- 28 -
mechanism of a large up-front deduction for expenditures that in
actuality were capital contributions. Cactus Wren Jojoba, Ltd.
v. Commissioner, supra; Glassley v. Commissioner, supra;
Stankevich v. Commissioner, supra. Additionally, Utah I was
involved in neither the business of jojoba technology research
nor jojoba production. At most, Utah I was a passive investor in
a farming venture from which it might have received a share of
any profits in the future. Kellen, the general partner of Utah
I, admitted that he did not even read the private placement
memorandum for Utah I, which included the R&D agreement and the
license agreement, until preparing this case for trial.
A. Research and Experimental Expenditures for 1982
Section 174 allows a taxpayer6 to elect to treat research
and experimental expenditures paid or incurred during the taxable
year "in connection with" the taxpayer's trade or business as
expenses that are not chargeable to capital account. The
expenditures so treated are allowed as a deduction. Treasury
regulations provide that the expenditures may be paid or incurred
for research or experimentation carried on by the taxpayer or by
another on the taxpayer's behalf. Sec. 1.174-2(a), Income Tax
Regs.
6
The "taxpayer" for this purpose is the partnership. Cf.
Campbell v. United States, 813 F.2d 694, 695-696 (5th Cir. 1987).
- 29 -
Petitioner contends that the expenditures here in issue
qualify under the statutory standard. Respondent argues, first,
that the expenditures in issue were not "research and
experimental expenditures" and, secondly, that Utah I did not
exercise sufficient direction or control over U.S. Agri to be
actively involved in a trade or business in connection with
jojoba production or jojoba technology research. Respondent also
argues that Utah I had no realistic prospect of engaging in a
trade or business related to jojoba farming and could at most act
as a passive investor because of the existence of the exclusive
license. Accordingly, respondent concludes that petitioner did
not pay or incur "research or experimental expenditures" in
connection with a "trade or business". We agree with respondent.
The term "research or experimental expenditures" as used in
section 174 means "expenditures incurred in connection with the
taxpayer's trade or business which represent research and
development costs in the experimental or laboratory sense." Sec.
1.174-2(a)(1), Income Tax Regs. This regulation further
provides:
The term [research or experimental expenditures]
includes generally all such costs incident to the
development of an experimental or pilot model, a plant
process, a product, a formula, an invention, or similar
property, and the improvement of already existing
property of the type mentioned. The term does not
include expenditures such as those for the ordinary
testing or inspection of materials or products for
quality control or those for efficiency surveys,
- 30 -
management studies, consumer surveys, advertising or
promotions. * * *
Respondent claims that the amounts paid to U.S. Agri by Utah
I in 1982 do not fall within the purview of the quoted regulation
and are not deductible under section 174. Respondent contends
that the amounts expended by Utah I were payments in connection
with U.S. Agri's farming enterprise that had the commercial
production of jojoba as the sole or primary objective.
Furthermore, most of the amounts paid by Utah I to U.S. Agri were
allocable to land development or improvement. Respondent argues
that the activities of U.S. Agri were, at most, field testing and
more likely were simply farming activities directed toward
maximizing the potential production of the jojoba plantations.
Moreover, respondent contends that no research whatsoever was
performed by U.S. Agri on behalf of Utah I. Petitioner contends
that U.S. Agri conducted valid research or experimentation
regarding cultivation of the jojoba plant on behalf of Utah I
and, consequently, under section 174(a)(1), Utah I is entitled to
deduct the contract fees paid to U.S. Agri for such research or
experimentation. The record in this case supports our conclusion
that respondent's determinations are correct, and that
petitioner's arguments to the contrary are without merit.
Attempts to farm jojoba commercially do not represent
research and development in the experimental or laboratory sense.
Cactus Wren Jojoba, Ltd. v. Commissioner, supra; Glassley v.
- 31 -
Commissioner, supra; Stankevich v. Commissioner, supra. U.S.
Agri attempted to develop a jojoba plantation that would be
farmed for the oil seed. The limited partners of Utah I would
have realized income only through the sale of the jojoba oil if
the plantation had been successful. The correspondence of Pace
to Kellen, introduced at trial as progress reports from U.S.
Agri, did not reflect any proprietary technology but contained
only a general description of the growth of the jojoba plants and
was replete with optimistic comments regarding future jojoba
production. Before 1983, Pace had only limited knowledge of and
minimal background in jojoba. Despite Pace's inexperience with
the jojoba plant, 16 pages of Pace's handwritten notes reflecting
his personal observations on the growth of the jojoba plants from
April 1983 through December 1985 were the only reports on the
purported jojoba field research introduced by petitioner at
trial. U.S. Agri's laboratory and greenhouse were located in
Riverside, California, and not at the site of Utah I's plantation
in Desert Center, California. Additionally, petitioner failed to
provide documentation of U.S. Agri's purported research and
development costs.
We agree with respondent's expert witness that U.S. Agri's
actions were no more than what any farmer would do in the
ordinary course of preparing to grow a crop for commercial
harvesting. The amended research plan of Utah I primarily
- 32 -
involved the application of commercially available herbicides,
such as Roundup and Princep, and commercially available
fertilizers such as Uran 32 and a 10-34-0 mixture applied with
varying levels of irrigation to the jojoba plants. Application
of these commercial products to a large-scale production endeavor
as was attempted on the land allocated to Utah I is merely
testing of the sort normally conducted as part of agricultural
operations. See sec. 1.174-2(a), Income Tax Regs. Evidence
presented at trial, including the testimony of both Kellen and
Pace, indicates that they interpreted the activities being
performed on Utah I's plantation as field testing or field
trials.
The record does not show that U.S. Agri's efforts on behalf
of Utah I would lead to patentable technology or even know-how.
Moreover, the record does not include proof that the partially
completed patent application prepared by U.S. Agri concerned work
performed as part of its R&D agreement with Utah I. We note that
none of the allegedly highly qualified individuals supposedly
employed by U.S. Agri to conduct the purported research and
experimentation on behalf of petitioner testified at trial.
Additionally, we note that no one from Agri Futures testified at
trial regarding the nature of the work performed by their
employees on Utah I's plantation. The record shows that this
case is another example of efforts by promoters and investors in
- 33 -
the early 1980's to reduce the cost of commencing and engaging in
the farming of jojoba by claiming, inaccurately, that capital
expenditures in jojoba plantations might be treated as research
or experimental expenditures for purposes of claiming deductions
under section 174. Cactus Wren Jojoba, Ltd. v. Commissioner,
T.C. Memo. 1997-504; Glassley v. Commissioner, T.C. Memo. 1996-
206; Stankevich v. Commissioner, T.C. Memo. 1992-458.
Furthermore, in this case, it is questionable whether Utah
I's liability under its R&D agreement with U.S. Agri ever became
fixed. According to its terms, the R&D agreement Utah I entered
into with U.S. Agri on December 31, 1982, expired upon Utah I's
execution of the license agreement.7 Kellen, as general partner
of Utah I, extinguished Utah I's liability under the R&D
agreement by contemporaneously executing the license agreement
with the R&D agreement. As an experienced attorney and bank
executive, Kellen was capable of reading and understanding the
details of the R&D agreement and the license agreement he
executed on behalf of Utah I. Kellen showed a lack of concern
7
Paragraph 11 of the R&D agreement states:
11. Terms of this Agreement
This Agreement shall be effective as of the date
hereof, and shall terminate upon the first to occur of
the following:
a. Upon the execution of the License Agreement
referred to in Paragraph 10.a hereof;
- 34 -
about the details of the two agreements that he hastily signed on
December 31, 1982. Utah I's liability under the R&D agreement
was extinguished by Kellen's concurrent execution of the license
agreement between Utah I and U.S. Agri. Therefore, the record
here indicates that the amounts paid to U.S. Agri by Utah I were
not even paid pursuant to a valid R&D agreement but were passive
investments in a farming venture under which the investors'
potential return was to be in the form of royalty pursuant to a
licensing agreement.
Since Utah I did not directly or indirectly engage in
research or experimentation, we hold that petitioner is not
entitled to a deduction for these expenditures under section 174.
B. Requirement of a Trade or Business
In addition, we hold that the activities of Utah I did not
constitute a trade or business. To be entitled to deductions for
research and development expenditures, a taxpayer need not be
currently producing or selling any product. Snow v.
Commissioner, 416 U.S. 500, 503-504 (1974); LDL Research & Dev.
II, Ltd. v. Commissioner, 124 F.3d 1338 (10th Cir. 1997), affg.
T.C. Memo. 1995-172. However, "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
- 35 -
are sufficiently substantial and regular to constitute a trade or
business" for purposes of section 174. Green v. Commissioner, 83
T.C. 667, 686-687 (1984); see also Levin v. Commissioner, 87 T.C.
698, 725 (1986), affd. 832 F.2d 403 (7th Cir. 1987).
The controlling inquiry in determining whether an
expenditure under section 174 was made "in connection with" the
partnership's trade or business is whether the taxpayer is
"'actively involved in the * * * [research project] as a trade or
business.'" LDL Research & Dev. II, Ltd. v. Commissioner, supra
at 1342 (quoting Nickeson v. Commissioner, 962 F.2d at 978). On
the record of this case, Utah I has not satisfied the "active
involvement" test set forth above.
To be actively involved in the research project as a trade
or business, Utah I must be more than a passive investor in the
activities of U.S. Agri. Id. To establish that expenses under
section 174 were in connection with their trade or business,
"taxpayers must show * * * that their activities were substantial
and regular enough to establish that they were actively involved
in the trade or business." Nickeson v. Commissioner, supra at
978. Even if this Court had found that Utah I had a fixed
liability under the R&D agreement, the activities of Kellen and
U.S. Agri on behalf of Utah I did not establish that Utah I was
actively involved in a trade or business involving jojoba
technology or jojoba production. See, e.g., Zink v. United
- 36 -
States, 929 F.2d at 1021; see also Higgins v. Commissioner, 312
U.S. 212, 218 (1941). Kellen testified that he did not even read
the private placement memorandum for Utah I until preparing for
the trial of this case. Utah I's role was only to serve as a
vehicle for the injection of risk capital into U.S. Agri's jojoba
farming operation. Utah I was a passive investor in a farming
venture.
Utah I's actions following the execution of the R&D
agreement were ministerial only. As general partner, Kellen was
not active in pursuing the affairs of Utah I. CFS and Pace
identified the investors for Utah I. Kellen testified that CFS
prepared the private placement memorandum and all related
documents for Utah I. Kellen simply signed all of the documents
placed before him without any analysis or independent evaluation.
Kellen did not regularly relay U.S. Agri's quarterly progress
reports, in the form of correspondence from Pace, to Utah I's
limited partners. Kellen never met with the limited partners and
made no effort to enforce the obligations of the limited partners
who defaulted on their promissory notes. Although Kellen claims
to have "frequently" visited Utah I's plantation, the actual
number of times he visited the plantation was never established.
Additionally, under both the original R&D agreement and the
amended research plan, as well as the licensing agreement, U.S.
Agri enjoyed complete discretion and control over any research
- 37 -
and development as well as farming activities on the 80 acres
allocated to Utah I.
We also hold that Utah I had no realistic prospect of
entering into a trade or business with regard to the technology
that was to be developed by U.S. Agri. The Supreme Court's
decision in Snow v. Commissioner, supra, "makes it important to
determine whether the prospects for developing a new product that
will be exploited in a business of the taxpayer are realistic".
Spellman v. Commissioner, 845 F.2d 148, 149 (7th Cir. 1988),
affg. T.C. Memo. 1986-403. Unless the taxpayer can show that
there is a realistic prospect that he will ultimately engage in a
trade or business that exploits the developed technology, a
research and experimental expenditure cannot be said to have been
paid or incurred "in connection with" a trade or business.
Harris v. Commissioner, 16 F.3d 75, 81 (5th Cir. 1994), affg.
T.C. Memo. 1990-80, supplemented by 99 T.C. 121 (1992); Zink v.
United States, supra at 1023; Spellman v. Commissioner, supra at
148-149; Diamond v. Commissioner, 92 T.C. 423, 439 (1989), affd.
930 F.2d 372 (4th Cir. 1991).
The management of investments, however, is not a trade or
business, regardless of how extensive or complete the portfolio
or how much time is required to manage the investments. Green v.
Commissioner, supra at 688-689. This Court and other courts have
scrutinized claimed research and development expenditures to
- 38 -
differentiate those that are legitimate from those that are
merely designed to shelter the income of passive investors. See,
e.g., Spellman v. Commissioner, supra; Diamond v. Commissioner,
supra; Levin v. Commissioner, supra; Green v. Commissioner,
supra. For an investing partnership successfully to claim
research and experimental deductions, there must be a realistic
prospect that the technology to be developed will be exploited in
a trade or business of the partnership claiming deductions under
section 174. See Diamond v. Commissioner, supra. Mere legal
entitlement to enter into a trade or business does not satisfy
this test. Instead, "The legal entitlement must be backed by a
probability of the firm's going into business." Levin v.
Commissioner, 832 F.2d at 407.
In making this determination, we consider such facts and
circumstances as the intentions of the parties to the research
and development contract, the amount of capitalization retained
by the partnership during the research and development contract
period, the exercise of control by the partnership over the
person or organization conducting the research and development,
the existence of an option to acquire the technology developed by
the organization conducting the research and development and the
likelihood of its exercise, the business activities of the
partnership during the years in question, and the business
experience of the partners. See Cactus Wren Jojoba, Ltd. v.
- 39 -
Commissioner, T.C. Memo. 1997-504; Glassley v. Commissioner, T.C.
Memo. 1996-206; Mach-Tech, Ltd. Partnership v. Commissioner, T.C.
Memo. 1994-225, affd. without published opinion 59 F.3d 1241 (5th
Cir. 1995); Stankevich v. Commissioner, T.C. Memo. 1992-458;
Stauber v. Commissioner, T.C. Memo. 1992-128.
The grant of an exclusive license to exploit technology
prior to commencement of research and development may preclude a
licensor from engaging in a trade or business with respect to the
technology. Spellman v. Commissioner, supra; Levin v.
Commissioner, 87 T.C. at 725-728; Green v. Commissioner, 83 T.C.
667 (1984).
It is the licensee, rather than the licensor, who earns
profits from the sale of the product; the licensor merely
collects royalties from the licensee. Thus, by granting an
exclusive license, the licensor is deprived of control over
the manufacture, use, and sale of the product, and the
licensee is the one engaged in the trade or business of
exploiting the developed technology. [Medical Mobility Ltd.
Partnership I v. Commissioner, T.C. Memo. 1993-428.]
As a mere passive investor, the licensor will not be entitled to
a deduction under section 174(a) for research and experimental
expenditures. Nickeson v. Commissioner, 962 F.2d at 978; Zink v.
United States, 929 F.2d at 1022-1023; Diamond v. Commissioner,
supra at 443.
In Green v. Commissioner, supra, a partnership entered into
a research and development agreement under which it divested
itself of all ownership rights in the technology to be produced
under the agreement. We held that the taxpayer's partnership
- 40 -
could not have engaged in a trade or business as it had disposed
of all of the incidents of ownership by assigning all its rights
in the technology to a third party. Id. at 689. "Following this
assignment, the partnership's activities were purely ministerial;
the taxpayers were no more than mere investors." Diamond v.
Commissioner, supra at 438.
In Levin v. Commissioner, 87 T.C. at 727-728, we held that
the grant of an exclusive license foreclosed the possibility that
the licensor could be engaged in a trade or business in
connection with the licensed product, as the licensor was
deprived of control over the product. "An entity with no control
over activities in which it invests is more properly classified
as an investor and cannot be engaged in a trade or business in
connection with those activities." Diamond v. Commissioner,
supra at 443.
In Diamond v. Commissioner, supra, the partnership granted
an option to a research contractor to acquire an exclusive
license to the new technology at some future time. Because the
option could have been exercised for a relatively nominal amount,
we concluded that there was no realistic prospect that the
partnership would ever enter any trade or business relating to
the technology. Id. at 440-441.
In Cactus Wren Jojoba, Ltd. v. Commissioner, supra, and
Stankevich v. Commissioner, supra, the limited partnership in
- 41 -
each case entered into an exclusive license agreement whereby the
limited partnership granted the prime contractor licenses to any
technology resulting from the prime contractor's research and
development efforts. As a royalty, the limited partnerships each
received specified percentages of the profit interests in the
jojoba crops grown on the acreage allocated to the limited
partnerships for research purposes. We held that the limited
partnerships were not entitled to a deduction for research and
experimental expenditures under section 174(a) because the
limited partnerships were not engaged directly or indirectly in a
trade or business because of the granting of the exclusive
licenses. We see no difference between the situations in Cactus
Wren Jojoba, Ltd. v. Commissioner, supra, and Stankevich v.
Commissioner, supra, and the facts presented in the case at bar.
See also Glassley v. Commissioner, supra.
The case before us now involves the simultaneous execution
by the limited partnership of an R&D agreement and an exclusive
license agreement with a term of 40 years. Additionally, the R&D
agreement terminated upon execution of the license agreement.
Section 5 of the R&D agreement entered into between Utah I
and U.S. Agri provides in part:
The property rights in and to all inventions,
discoveries, improvements, devices, designs, apparatus,
practices, processes, methods, or products (herein
individually or collectively called "Inventions"),
whether patentable or not, made, developed, perfected,
devised, conceived, either solely or jointly with
- 42 -
others, under the terms of this Agreement in the course
of its Contractor's * * * [U.S. Agri's] work for the
Partnership, * * * [Utah I] or any Inventions so made
at any time which is an improvement on any invention
covered by a patent application or patent acquired by
the Partnership * * * [Utah I] shall be the sole and
exclusive property of the Partnership * * * [Utah I].
Section 10 of the R&D agreement granted Utah I an option,
exercisable after receipt of a written report from U.S. Agri,
that the plantation was ready for commercial development:
At such time as the Jojoba plantation on which the
research and development is being conducted has reached
a stage of commercial development, the Contractor * * *
[U.S. Agri] * * * shall give the Partnership * * *
[Utah I] a written report to that effect and the
Partnership * * * [Utah I] will have the option to
require the Contractor * * * [U.S. Agri] to enter into
a License Agreement for the purpose of commercially
exploiting the technology developed pursuant to this
Agreement. The License Agreement, if the Partnership *
* * [Utah I] so elects, shall be in the form of the
License Agreement attached hereto and made a part of
this Agreement. This option shall be solely at the
discretion of the Partnership * * * [Utah I].
In section A, paragraph 3 of the license agreement attached to
the R&D agreement, the "technology" is described as "written
reports delivered by the Licensee * * * [U.S. Agri] to Licensor *
* * [Utah I] during the term of the Research and Development
Agreement, all of which, taken together in the aggregate, will
comprise the technology and shall remain the sole property of the
Licensor * * * [Utah I]."
Section B, paragraph 1 of the license agreement granted U.S.
Agri the exclusive right to utilize the technology:
- 43 -
During the term hereof, Licensee * * * [U.S. Agri]
shall have the exclusive right to utilize the
technology developed for the account of the Licensor *
* * [Utah I], and said technology shall be applied to
the benefit of the parties on the Jojoba plantation * *
* upon which the research and development has been
conducted for the purpose of developing said
technology.
Section B, paragraph 2 of the license agreement provides that
"The license granted hereby shall be exclusive." Utah I
relinquished all of its rights to the plantation, retaining only
its nominal ownership of the technology, subject to the license,
in section B, paragraph 4 of the license agreement:
Licensor * * * [Utah I] specifically disclaims any
right, title, or interest in or to the Jojoba
plantation on which the said technology will be
developed and its sole asset is and shall be the
technology for which the * * * royalty shall be paid.
Section B, paragraph 5 of the license agreement granted U.S. Agri
the exclusive license for a period of 40 years.
According to the terms of the license agreement, Utah I
granted U.S. Agri the exclusive right to utilize the technology
developed for Utah I for 40 years in return for payments from
U.S. Agri of royalties of "eighty-five percent (85%) of all
products produced on the Plantation and intended to be sold or
moved from the Plantation by Licensee * * * [U.S. Agri]."
Section B, paragraph 6 of the licensing agreement also states
"that this Agreement in no way constitutes a partnership or a
joint venture between Licensor * * * [Utah I] and Licensee * * *
[U.S. Agri]."
- 44 -
Kellen exercised Utah I's option under the R&D agreement on
December 31, 1982, when he signed the license agreement. There
is no evidence in the record that any useful technology ever was
developed by U.S. Agri for Utah I under the terms of the R&D
agreement. However, even if any technology had been developed,
under the terms of the license agreement, the licensor, Utah I,
relinquished any control over the technology for a 40-year
period.
Utah I's election, contemporaneous with its execution of the
R&D agreement, to convey the "right to utilize the technology
developed" to U.S. Agri exclusively for a 40-year period reflects
the passive nature of Utah I's investment. Additionally, it is
evident from the words of the R&D agreement that Utah I was not
going to be actively involved in the development of the jojoba
plantation. As section 2 of the R&D agreement states:
The Partnership * * * [Utah I] hereby engages
Contractor * * * [U.S. Agri] to conduct the R&D Program
and Contractor * * * [U.S. Agri] accepts such
engagement hereunder and agrees to use its best efforts
to develop a Jojoba plantation in the vicinity of
Desert Center, California, at a specific location to be
selected by Contractor * * * [U.S. Agri] to be used to
conduct research on the domestication, commercial
cultivation, planting and irrigation techniques, weed,
disease and insect management and harvesting of the
Jojoba plant. Said plantation to be eighty (80)acres.
It is unlikely that Kellen ever intended Utah I to enter into a
trade or business. The contractual arrangements between Utah I
and U.S. Agri made the prospects unrealistic that Utah I would
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ever be capable of entering into a trade or business with respect
to any technology that might be developed. Under the terms of
the license agreement, Utah I was deprived of control over any
technology U.S. Agri might have developed.8 Kellen's actions
were consistent with investor activity and not the activity of a
person engaged in a trade or business.
"A taxpayer that funds research by another party in return
for royalties is clearly no more than an investor making a
capital contribution to the trade or business of another." LDL
Research & Dev. II, Ltd. v. Commissioner, 124 F.3d at 1346. It
is clear that Utah I funded alleged "research activities" of U.S.
Agri with the expectation of royalties from the sale of the
jojoba beans. The promotional videotape prepared by Pace, and
distributed to potential investors in jojoba limited partnerships
serviced by U.S. Agri, heavily emphasized the potential for a
high rate of return from an investment in "liquid gold" or
jojoba.
As the contractor for Utah I, U.S. Agri was the only entity
engaged in a trade or business related to jojoba farming. Pace
8
As the Court of Appeals for the Fifth Circuit noted in
Harris v. Commissioner, 16 F.3d 75,79 (5th Cir. 1994), affg. T.C.
Memo. 1990-80, supplemented by 99 T.C. 121 (1992): "those cases
in which a section 174 deduction was upheld may be distinguished
by one dispositive factor: In each of the cases allowing the
deduction, the entity that incurred the research expenses
actually managed and actually controlled the use or marketing of
the research".
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testified at trial that U.S. Agri was operating commercial jojoba
farms on 906 acres of land in Desert Center and Blythe,
California, in addition to the 400 acres U.S. Agri had allegedly
set aside for R&D partnerships focused on jojoba. Respondent's
expert witness, Chen, visited U.S. Agri's greenhouse and
laboratory in Riverside, California. The actions of Kellen,
including irregular visits to the plantation site and forwarding
three of U.S. Agri's progress reports on the status of the
maturing jojoba plants to the limited partners of Utah I, were
merely the actions of an interested investor keeping up with his
investment. There is no evidence that Kellen ever inspected U.S.
Agri's laboratory or greenhouse.
There is no evidence before this Court regarding the details
of U.S. Agri's operating budget other than testimony from Pace
that none of U.S. Agri's losses were allocated to Utah I.
Utah I had no employees. See Harris v. Commissioner, 16
F.3d at 80 n.10. Petitioner presented no evidence that Utah I
exercised any control over the activity on the jojoba plantation.
The evidence before us establishes that Utah I's role was to
distribute the money invested by the limited partners to U.S.
Agri pursuant to agreement. U.S. Agri then used these funds to
finance activities on the 80-acre plantation site, including
planting the jojoba, tilling and leveling the land, and
installing the irrigation system. These funds were also used by
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U.S. Agri to make lease payments to the Sterling Trust.
Additionally, funds from investor subscriptions in Utah I went to
reimburse Pace or U.S. Agri for any developmental expenses
incurred on the plantation prior to the incorporation of Utah I.
Utah I was not adequately capitalized for operation as a
business in the long term, as evidenced by Kellen's decision in
1991 to consolidate Utah I with 36 other jojoba limited
partnerships under contract with U.S. Agri into 1 large limited
partnership, Jojoba Plantation Ltd. Kellen and the other general
partners hoped that the creation of one large limited partnership
would enable them to reduce the costs of farming jojoba. By
1991, Jojoba Plantation was in chapter 7 bankruptcy. Kellen made
no attempt to pursue any of the limited partners who defaulted on
their promissory notes to Utah I.
On the record in the instant case, we agree with respondent
that Utah I did not pay the contract fees for research or
experimentation to be conducted by U.S. Agri on behalf of the
limited partnership. Rather, for the reasons discussed above, we
conclude that the moneys the limited partnership remitted to Utah
I for the putative research or experimentation, in actuality,
were paid for the limited partners' right to participate as
passive investors in the jojoba farming enterprise being operated
by U.S. Agri in Desert Center, California. In our view, the R&D
agreement was designed and entered into solely to provide a
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mechanism to disguise the capital contributions of the limited
partners as currently deductible expenditures and thus reduce the
cost of their participation in the farming venture.
Accordingly, we hold that Utah I is not entitled to deduct
its losses for research or experimentation expenditures under
section 174. Additionally, because the activities of Utah I did
not constitute a trade or business, Utah I is not entitled to
deduct its losses in 1982 and 1983 as ordinary and necessary
business expenses under section 162(a). Respondent is sustained
on these issues.
To reflect the foregoing,
Decision will be entered
for respondent.