T.C. Memo. 1998-183
UNITED STATES TAX COURT
PATRICK F. AND ARLENE G. SHEEHY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 22034-96. Filed May 18, 1998.
Ralph C. Larsen, for petitioners.
Christine V. Olsen, for respondent.
MEMORANDUM OPINION
RAUM, Judge: The Commissioner determined deficiencies of
$31,643 and $1,605 in petitioners' 1992 and 1993 Federal income
taxes, respectively. At issue is whether petitioners are
entitled to deduct an expenditure of $50,000 in connection with
their investment in Recyclable Containers Company. This case was
submitted on the basis of a stipulation of facts.
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Petitioners, Patrick and Arlene Sheehy, resided in
California when the petition in this case was filed. References
to petitioner in the singular are to petitioner husband.
In 1992, petitioner made $50,000 in capital contributions to
Recyclable Containers Company (RCC).1 His investment resulted in
his ownership of a 1-percent profit-share.
According to an undated private placement memorandum, there
was $400,000 worth of limited partnership interests available in
RCC. The private placement memorandum explains:
Recyclable Containers Company * * * intends to offer
privately to a limited number of sophisticated
investors the opportunity to invest in [RCC], a
California limited partnership organized to further
research and development of the technology involved
relating to the high volume manufacturing of a
fabricated all-plastic, reusable and recyclable
shipping and storage container and pallet * * * which
has various proven produce and industrial applications;
to build the production tooling and equipment to
manufacture and sell the Product; and to license the
technology to manufacture the Product on a world-wide
basis.
For taxable year 1992, petitioners deducted $50,000 as a
"Product Development" expense on a Schedule C, Profit or Loss
From Business, attached to their 1992 Federal income tax return.
On the Schedule C, petitioners listed "Recyclable Container
Company" as the business name, and characterized the business as
1
Petitioners contend that the $50,000 is not a capital
contribution. However, RCC characterized investments as either
"loan" or "capital", and we use the capital contribution
designation for the sake of convenience.
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"Manufacturing Recyclable containers". They also indicated that
petitioner materially participated in the operation of the
business. Petitioners reported no income on the Schedule C, nor
did they deduct any expenses other than the $50,000 "Product
Development" expense.
The Commissioner's notice of deficiency disallowed two
different research and development deductions, each for $50,000.
The first, taken in 1992 in connection with horse-breeding
activities, was conceded by respondent. The second, taken in
1992 in connection with the investment in RCC, is still in
contention. The remaining items contained in the notice of
deficiency have been conceded by the parties or are statutory
adjustments dependent upon the outcome of the RCC issue.
Petitioners contend they are entitled to deduct the $50,000
they paid to RCC in 1992 under section 174(a).2 Section 174(a)
allows a taxpayer to "treat research or experimental expenditures
which are paid or incurred * * * in connection with his trade or
business as expenses which are not chargeable to capital account.
The expenditures so treated shall be allowed as a deduction."
Section 1.174-2(a)(2), Income Tax Regs., indicates that section
174 applies "not only to costs paid or incurred by the taxpayer
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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for research or experimentation undertaken directly by him but
also to expenditures paid or incurred for research or
experimentation carried on in his behalf by another person or
organization".
Deductions are a matter of legislative grace, and the
taxpayer has the burden of demonstrating that he is entitled to a
deduction. New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440
(1934). The burden of proof remains on the taxpayer even when
the case is submitted fully stipulated. Borchers v.
Commissioner, 95 T.C. 82, 91 (1990), affd. 943 F.2d 22 (8th Cir.
1991). Petitioners have adequately substantiated that they paid
$50,000 to RCC in 1992. To be entitled to the deduction,
however, they must demonstrate that the amount was actually spent
for research or experimentation conducted by them or on their
behalf in connection with their trade or business. See Grindle
v. Commissioner, T.C. Memo. 1993-297.
Petitioners' evidence consists of two documents. First, on
the Schedule C of their 1992 Federal income tax return, they list
RCC as petitioner's business. They describe its function as
"Manufacturing Recyclable containers" and indicate that
petitioner "materially participated". Plainly, petitioners'
Schedule C is self-serving, and hardly represents convincing
evidence on their behalf.
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Second, petitioners provide the first page of RCC's private
placement memorandum. That document describes RCC as
a California limited partnership organized to further
research and development of the technology involved
relating to the high volume manufacturing of a
fabricated all-plastic, reusable and recyclable
shipping and storage container and pallet * * * which
has various proven produce and industrial applications;
to build the production tooling and equipment to
manufacture and sell the Product; and to license the
technology to manufacture the Product on a world-wide
basis.
The Amended Certificate of Limited Partnership for RCC was
entered into on December 30, 1983. Petitioner's checks to RCC
are dated June 12, 1992. It is unclear when the private
placement memorandum was issued. It is possible that during the
9 years between RCC's formation and petitioner's investment, RCC
started to manufacture and sell its product. If that is the
case, petitioners would need to demonstrate that their $50,000
was spent on research or experimentation as opposed to
manufacturing. This they have not done. It is also possible
that RCC licensed the technology to another organization on an
exclusive basis. In that event, RCC's research is not being
conducted in connection with a trade or business of its own or
petitioners' of developing recyclable plastic containers. As a
result, petitioners, on whose behalf the research is being
conducted, have not met the requirements of section 174(a).
The above situations are merely hypothetical. The record
does not provide enough evidence for more than speculation. It
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might be, as petitioners argue, that RCC is involved in the
business of developing recyclable containers with the intention
of manufacturing them. Then again, it might not. It is up to
petitioners to prove that they engaged indirectly through RCC in
research or experimentation. This they have not done. It is
also up to petitioners to prove that their expenditure was paid
or spent in connection with their own trade or business. The
controlling inquiry in determining whether an expenditure under
section 174 was made "in connection with" a taxpayer'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, 124 F.3d 1338, 1342 (10th Cir.
1997) (quoting Nickeson v. Commissioner, 962 F.2d 973, 978 (10th
Cir. 1992), affg. Brock v. Commissioner, T.C. Memo. 1989-641),
affg. T.C. Memo. 1995-172. As stated by the Court of Appeals for
the Ninth Circuit:
The language of * * * [section 1.174-2(a)(2), Income
Tax Regs.] makes clear that a taxpayer may enjoy the
section 174 deduction for research conducted by another
entity. Read in isolation, the regulation might
suggest that the * * * [taxpayer] is entitled to the
deduction even though it engaged the research firm to
conduct its research. The regulation, however, does
not eliminate the trade or business requirement of
section 174. If a * * * [taxpayer] engages another
firm to conduct its research, it must satisfy the trade
or business requirement in some other way, such as by
manufacturing or marketing the resulting technology.
* * *
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Kantor v. Commissioner, 998 F.2d 1514, 1521 (9th Cir. 1993),
affg. in part and revg. in part T.C. Memo. 1990-380.
Petitioners rely on Cleveland v. Commissioner, 297 F.2d 169
(4th Cir. 1961), affg. in part, revg. in part and remanding 34
T.C. 517 (1960), and Green v. Commissioner, 83 T.C. 667 (1984),
to support their contention that petitioner was an active
participant in RCC.
In Cleveland, Mr. Cleveland, an attorney, formed an informal
partnership with Hans Kerla, an inventor and chemist. Kerla was
working on the development and commercialization of an inorganic
binding material. Cleveland provided the funding, and Kerla
performed the experiments. Id. at 170. Cleveland also used his
business contacts to market Kerla's invention. Id. at 171. The
Court of Appeals concluded that Cleveland and Kerla were involved
in a joint venture:
Each of the parties was to participate in the
enterprise, Kerla giving his time and effort and
Cleveland providing the necessary funds, and they were
to share equally in the avails thereof. * * *
Cleveland was thereafter engaging with Kerla in the
trade or business of promoting the commercial
development of the invention in which Cleveland was the
owner of a participating one-half interest.
Id. at 173-174.
According to petitioners, petitioner was as active a
participant in RCC as Mr. Cleveland was in his joint venture.
However, they have not shown that petitioner's contribution to
RCC was comparable to Mr. Cleveland's efforts on behalf of his
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partnership. Their characterizations about petitioner's
participation in RCC are not supported by the record. According
to the exhibits, petitioner's only contribution to the running of
RCC was checks totaling $50,000. Moreover, petitioners
misconstrue Mr. Cleveland's contribution to his partnership,
characterizing it as "cash invested and attending to some
paperwork." Cleveland has been interpreted to mean that an
active role is necessary to qualify as being in a trade or
business:
Furthermore, the court in Cleveland did not hold that
the act of financing research in itself constitutes the
trade or business of promoting an invention. The
combined activities of both participants in the joint
venture formed the basis for the court's finding of a
trade or business. * * *
Green v. Commissioner, supra at 691. Petitioners have not shown
that petitioner did any more than provide financing.
Neither does Green v. Commissioner, supra, support
petitioners' entitlement to a deduction. The taxpayers in Green
were limited partners in a partnership called LaSala. LaSala was
organized to acquire, improve, and develop four inventions. Id.
at 668-669. On the day LaSala acquired the inventions, it
entered into an agreement with NPDC, a patent development
company. Under the agreement, NPDC was to research and develop
the inventions. Id. at 671. LaSala had no authority to direct
NPDC's efforts. Id. at 672. This Court held that LaSala
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functioned only as an investor, id. at 687, and denied the
taxpayers the deduction under section 174(a):
LaSala's "royalty" interest in the development and
commercialization of the four inventions was analogous
to that of an investor in securities. After the
transactions of December 24, 1979, LaSala had no
ownership interest in the inventions and no control
over their actual development, production, or
marketing. * * *
Id. at 689.
The factual situation in Green is similar to that of
petitioners'. In both, a limited partnership rather than the
taxpayers themselves was in charge of conducting the research and
development. The Court in Green analyzed the agreements between
LaSala and NPDC to determine whether LaSala was actually
controlling the research and development. That analysis is
impossible here, because petitioners have not submitted any
substantive information on RCC and how it plans to develop the
recyclable plastic containers. Lacking such evidence here, we
cannot find that petitioner or RCC was actively involved in a
trade or business involving the development or manufacture of
recyclable plastic containers. Nor can we find that petitioner
or RCC had a realistic prospect of entering into a trade or
business with regard to the products that were to be developed by
RCC. See Snow v. Commissioner, 416 U.S. 500, 503-504 (1974);
Kantor v. Commissioner, supra at 1518. Based on the record, we
cannot say that petitioner was any more than an investor in RCC.
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Petitioners have not shown that the $50,000 paid to RCC in
1992 was spent on research or experimentation activities. Nor
have they shown a connection between any research or
experimentation activities and a trade or business conducted by
petitioner. Accordingly, we hold that petitioners are not
entitled to deduct their $50,000 payment to RCC in 1992 under
section 174. Additionally, because the activities of petitioner
did not constitute a trade or business, petitioners are not
entitled to deduct the expenditure as an ordinary and necessary
business expense under section 162(a).
Decision will be entered
under Rule 155.