T.C. Memo. 2000-259
UNITED STATES TAX COURT
RESEARCH TWO LIMITED PARTNERSHIP, DENNIS W. TOWNSEND,
TAX MATTERS PARTNER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 25445-88. Filed August 16, 2000.
Daniel S. Goldberg, for petitioner.
Clare J. Brooks and Linda E. Chan, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WELLS, Chief Judge: By notice of final partnership
administrative adjustment dated July 8, 1988, respondent
increased the taxable income of Research Two Limited Partnership
(Research II) as follows:
- 2 -
Year Amount
1982 $2,806,250
1983 233,061
1984 148,897
Unless otherwise noted, 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. The issue we must decide is whether Research II was
entitled to deduct for its 1982 taxable year certain amounts owed
to CemCom Research Associates, Inc. (CemCom), for research and
development services.1
FINDINGS OF FACT
Some of the facts and certain exhibits have been stipulated
for trial pursuant to Rule 91. The parties' stipulations of fact
are incorporated herein by reference and are found as facts in
the instant case.
1
In their briefs the parties appear to pose a second issue of
whether Research II is entitled to miscellaneous deductions of
$56,250, $233,061, and $174,828 for taxable years 1982, 1983, and
1984, respectively. Petitioner, however, presented almost no
argument on that issue. Rather, petitioner states that, if the
Court finds that Research II is not engaged in a trade or
business, the Court should allow Research II to amortize those
expenses as organizational expenses under sec. 709(b).
Respondent argues that Research II is not engaged in a trade or
business but also states that Research II is entitled to amortize
the organizational expenses under sec. 709(b). As there appears
to be no dispute over the issue, we will address only the sec.
174 research and development deduction.
- 3 -
At the time the petition in this case was filed, Research II
was a limited partnership with its principal place of business in
Towson, Maryland. Petitioner, Dennis W. Townsend, Research II's
tax matter partner, resides in Towson, Maryland.
Research II was formed on December 29, 1982. The general
partners of Research II are Dennis W. Townsend and Townsend &
Co., Inc. They collectively own a 1.01-percent interest in
Research II. The remaining interests in Research II are owned by
32 limited partners. Research II maintains its books and records
and files its Federal income tax returns on the accrual method of
accounting. Research II has a calendar year.
Before its formation as a limited partnership and in
connection with obtaining funds, Research II issued a
confidential memorandum which described Research II's proposed
purpose as the development of advanced cementitious composite
technology for application in the heat treatment and ceramic
industries (new technology). The confidential memorandum
explained that Research II would attempt to achieve its purpose
by engaging CemCom2 to perform research and development work on
behalf of the partnership. The confidential memorandum states
that, in engaging CemCom, the promoters of Research II
anticipated that the new technology could be used in
2
Cemcom was a research corporation formed in 1981 to research
further development and applications of cementitious composites.
- 4 -
constructing a room-temperature castable ceramic cement that
would maintain exact tolerances and physical integrity in the
2,000 degree Fahrenheit range. Promoters of Research II also
foresaw application of the new technology in making a high-
temperature cementitious ceramic.
Pursuant to the limited partnership agreement dated
December 29, 1982, each limited partner was required to make
capital contributions to Research II of the following amounts:
(1) A cash payment of $24,500 for each unit held, for an
aggregate amount of $1,225,000, due upon formation of Research
II; (2) a cash payment of $6,500 for each unit held, for an
aggregate amount of $325,000, on October 15, 1983; (3) a cash
payment of $5,500 per unit held, for an aggregate amount of
$275,000, on December 15, 1983; and (4) an additional cash
contribution of up to $24,000, plus recourse interest for each
unit held, up to an aggregate of $1,200,000, plus recourse
interest for all partners, at the call of the general partners,
to the extent that Research II had insufficient funds to pay the
deferred obligation under the research and development agreement
with CemCom.
On December 29, 1982, Research II and CemCom entered into a
research and development agreement. Pursuant to the terms of
the research and development agreement, CemCom undertook to
perform certain research tasks and experimental services on
- 5 -
behalf of Research II for the purpose of developing and
perfecting the new technology and associated patentable and
nonpatentable inventions, know-how, and trade secrets.
All property rights in the new technology and all items of new
technology were to be the sole and exclusive property of
Research II.
In consideration of CemCom's performing research and
experimental services on behalf of Research II, the research and
development agreement provided that Research II was obligated to
pay CemCom $2,750,000, plus interest at an annual rate of 10
percent of the unpaid balance. Payments were to be made as
follows: (1) $950,000 in cash upon execution of the research
and development agreement; and (b) $1,800,000 in a promissory
note. Payments under the promissory note were to be made as
follows: (1) $325,000 of principal payable on November 1, 1983;
(2) $275,000 of principal payable on January 3, 1984; and (3)
$1,200,000 plus all accrued and unpaid interest at the annual
rate of 10 percent (totaling $294,583.33) payable on December
31, 1984. All such payments were with recourse to Research II
and its partners.
The research and development agreement also provided that
Research II could notify CemCom on or before December 31, 1984,
and the $1,494,583.33 could be restated as principal and
amortized at 14 percent per year in nine consecutive semiannual
- 6 -
payments of $229,398.32 each, with the first payment due on June
30, 1985. If Research II elected that option, any interest
accrued on the unpaid balance after December 31, 1984, was
without recourse to any partner. Moreover, if there were
insufficient funds within Research II to make the semiannual
payments, payment could be deferred until June 30, 1989. If
Research II failed to pay by June 30, 1989, Research II would be
in default under the research and development agreement, and
CemCom could exercise its rights as a creditor against Research
II and its limited partners.
On December 29, 1982, Research II and CemCom entered into a
technology transfer agreement. Pursuant to the terms of the
technology transfer agreement, Research II licensed, on a
nonexclusive basis, the rights to certain technology from
CemCom. Research II also entered into a license agreement with
Research I Limited Partnership (Research I).3 The CemCom
licenses enabled Research II to use all proprietary information
of CemCom and Research I necessary to proceed with the research
and development activities required under the research and
development agreement.
The technology transfer agreement also granted CemCom the
option, exercisable between June 30 and July 31, 1984, to enter
3
Research I Limited Partnership is also a Maryland limited
partnership in which Dennis Townsend and Townsend & Co., Inc.,
are general partners.
- 7 -
into an exclusive perpetual license of the new technology if the
new technology was patentable. If CemCom chose to exercise that
option, it would be obligated to make a series of annual royalty
payments (minimum royalty payments) based upon a percentage of
CemCom's cumulative gross revenues but at least $10,950,000.
The payments were due at the following intervals:
Date Minimum Payment
12/31/84 $430,000
6/30/85 430,000
12/31/85 430,000
6/30/86 455,000
12/31/86 455,000
6/30/87 480,000
12/31/87 480,000
6/30/88 505,000
12/31/88 505,000
6/30/89 300,000
12/31/89 300,000
6/30/90 325,000
12/31/90 325,000
6/30/91 350,000
12/31/91 350,000
6/30/92 375,000
12/31/92 375,000
6/30/93 400,000
12/31/93 400,000
6/30/94 425,000
12/31/94 425,000
6/30/95 450,000
12/31/95 450,000
6/30/96 475,000
12/31/96 475,000
6/30/97 500,000
12/31/97 500,000
If the actual computation of the royalty was greater than
the minimum royalty payments, CemCom would be obligated to make
greater royalty payments. If the new technology was not
- 8 -
patentable, the due dates for the minimum royalty payments owed
to Research II by CemCom would be adjusted to reflect the date
of the exercise of the exclusive license. In order for CemCom
to ascertain the applicability of the new technology to CemCom's
product line and to facilitate its decision as to whether to
exercise the option, the technology transfer agreement provided
CemCom with a "review license" from December 29, 1982, through
June 30, 1984, to use, review, and evaluate each item of new
technology.
If CemCom exercised its option for the exclusive license,
the royalty arrangement would provide Research II with a profit
equal to the difference between the minimum royalty payments and
its deferred obligation to CemCom. CemCom, however, was under
no obligation to exercise its option while Research II was
unconditionally liable to CemCom for the payment of its deferred
obligation.
If CemCom chose not to exercise its option, the technology
transfer agreement obligated CemCom to grant Research II a
nonexclusive perpetual license of the old technology and the
Research I technology necessary and useful in the further
development, manufacture, use, or marketing of the new
technology. In return for the license, Research II would pay
- 9 -
CemCom a 5-percent annual royalty on all gross revenues from the
sales or licensing of the new technology.
Before the formation of Research II during 1982, Mr.
Townsend and Townsend & Co., Inc., were the general partners of
Research I limited partnership. Research I was organized on
December 31, 1981, and was likewise engaged in research and
development in the area of cementitious composites. Research I
also engaged CemCom to provide the actual research and
development services. Pursuant to an agreement between Research
I and CemCom, CemCom was granted the option to license the
technology it developed on behalf of Research I provided that it
paid Research I minimum royalty payments. Deductions taken by
the various limited partners of Research I were the subject of
Harris v. Commissioner, T.C. Memo. 1990-80, affd. 16 F.3d 75
(5th Cir. 1994), affd. without published opinion sub nom.
Travers v. Commissioner, 21 F.3d 424 (4th Cir. 1994), which
denied Research I a deduction pursuant to section 174(a)(1) for
amounts paid to CemCom for research and development services.
During 1982, CemCom approached Mr. Townsend with a proposal
for a new research venture. Mr. Townsend was reluctant to
organize a second partnership absent assurance by CemCom that it
would exercise its option under its agreement with Research I.
On December 29, 1982, the same day as the formation of Research
II, CemCom and Research I entered into an agreement whereby
- 10 -
CemCom agreed to exercise its option to license the technology
being developed by Research I. Consequently, on December 29,
1982, Mr. Townsend believed that CemCom had bound itself to make
substantial minimum royalty payments to Research I.
Accordingly, as of December 29, 1982, it was not certain
that CemCom would exercise its option under the technology
transfer agreement with Research II to license the new
technology. Additionally, the exercise of the option was
unlikely, given the amount of minimum royalties that CemCom owed
under the Research I agreement. Even if CemCom were to exercise
its option, CemCom would not be able to continue making the
minimum royalty payments for any sustained period.
During 1983 and 1984, research and development work was
performed by CemCom in creating and developing the new
technology on behalf of Research II. During that time, CemCom
provided Mr. Townsend with financial statements and progress
reports detailing CemCom's research and experimental projects
and activities. The Research II limited partners were kept
advised on CemCom's progress by a series of bulletins. The
research performed by CemCom during 1983 and 1984 resulted in
the creation and development of "Jetfix".
On July 31, 1984, CemCom's option to license the new
technology pursuant to the technology transfer agreement lapsed.
On September 27, 1984, Research II and CemCom entered into a
- 11 -
licensing agreement (1984 licensing agreement) which granted
CemCom the exclusive right and perpetual worldwide license to
the new technology. The 1984 licensing agreement provided a
royalty rate to Research II at less than the rate provided in
the technology transfer agreement and provided for minimum
royalties as follows:
Within 90 days $12,000
6/30/85 285,000
1/01/86 285,000
6/30/86 285,000
1/01/87 285,000
6/30/87 285,000
1/01/88 285,000
6/30/88 285,000
1/01/89 285,000
6/30/89 285,000
The revised royalty arrangement enabled Research II to
maintain a profit potential, at a minimum, equal to the
difference between the minimum royalties and the deferred
obligation to CemCom.
Also, on September 27, 1984, Research II and CemCom entered
into a first amendment to the research and development agreement
which provided that both parties had fully complied with all
requirements of the research and development agreement and that
the new technology had reached the stage where further
development would no longer qualify as research and development
under section 174. The first amendment further canceled
CemCom's agreement not to do research within the specific scope
and definition of the research program for other parties.
- 12 -
Additionally, the first amendment altered the amortized payments
if Research II exercised its option to restate principal as
follows:
6/30/85 $229,398.32
1/01/86 229,398.32
6/30/86 229,398.32
1/01/87 229,398.32
6/30/87 229,398.32
1/01/88 229,398.32
6/30/88 229,398.32
1/01/89 229,398.32
6/30/89 229,398.32
On the next day, September 28, 1984, Research II entered
into an exercise of stock agreement to purchase and purchased 7
percent of the stock of CemCom for $13,000. The stock purchase
was part of an overall series of stock purchases pursuant to
which Research I, Research II, Mr. Townsend, and another partner
in both Research I and Research II acquired over 50 percent of
the stock and voting control of CemCom.
On December 31, 1984, Research II elected to restate the
amount due under the research and development agreement as
principal. On February 6, 1985, Research II and CemCom entered
into a second amendment to the research and development
agreement reflecting Research II's election to restate the
principal amount due.
On its Federal income tax return for 1982, Research II
claimed a $2,806,250 loss consisting of a research and
development expense of $2,750,000 and miscellaneous expenses of
- 13 -
$56,250. On its Federal income tax return for 1983, Research II
claimed a $231,432.45 loss consisting of $1,628.83 of dividend
income and miscellaneous expenses of $233,061.28. On its
Federal income tax return for 1984, Research II claimed a
$174,571.15 loss consisting of $257.18 of dividend income and
miscellaneous expenses of $174,828.33. By notice of final
partnership administrative adjustment dated July 8, 1988,
respondent denied Research II's deductions for the years in
issue but allowed Research II a deduction of $25,931 for
amortization of patents in 1984. Respondent has stipulated that
Research II was entitled pursuant to section 709(b) to deduct
amortization of organizational fees of $1,250 for 1982.
OPINION
The issue we must decide is whether Research II is entitled
to a deduction, pursuant to section 174(a)(1), for the
$2,750,000 debt it incurred to CemCom during 1982. Section
174(a)(1) provides:
SEC. 174(a). Treatment as Expenses.–-
(1) In general.--A taxpayer may treat research or
experimental expenditures which are paid or incurred by him
during the taxable year in connection with his trade or
business as expenses which are not chargeable to capital
account. The expenditures so treated shall be allowed as a
deduction.
The parties agree that the $2,750,000 debt related to
research or experimentation falls within the scope of section
174. Respondent contends, however, that the debt was not
- 14 -
incurred by Research II in connection with its trade or
business.
In Snow v. Commissioner, 416 U.S. 500, 502 (1974), the
Supreme Court compared the "in connection" language of section
174 with the "in carrying on" language of section 1624 and
established that a business need not currently produce or sell
any product in order to obtain a deduction for research or
experimental expenditures. Rather, the Supreme Court reasoned
that the policy behind section 174, which is to aid "small or
pioneering business enterprises" as well as more established
ones, calls for a more relaxed "trade or business requirement"
than applies to section 162. Id. at 503-504.
In Green v. Commissioner, 83 T.C. 667, 671-672 (1984), a
deduction pursuant to section 174 was claimed by a partnership
that entered into a research and development agreement with a
research corporation and on the same day, through the grant of
an exclusive license, divested itself of all ownership rights to
the inventions to be produced. We held that Snow "did not
eliminate the 'trade or business' requirement of section 174
altogether" and denied the partnership the deduction. Id. at
4
Sec. 162(a) provides:
SEC. 174(a). In General.--There shall be allowed
as a deduction all the ordinary and necessary expenses
paid or incurred during the taxable year in carrying on
any trade or business, * * *.
- 15 -
686-687. We explained that the partnership was acting merely as
an investor and not as the type of business that section 174
intended to promote. See id. at 687.
In Diamond v. Commissioner, 92 T.C. 423, 424 (1989), affd.
930 F.2d 372 (4th Cir. 1991), the taxpayer was a limited partner
in a limited partnership that became a limited partner in
another limited partnership (project partnership). The general
partner in the project partnership was a publicly held
corporation that was involved in robotics technology. See id.
Pursuant to the project partnership agreement, the corporation
was required to contribute the rights to its technology to the
project partnership and to pursue further research activities on
behalf of the project partnership. See id. at 427-428. In
return, the partners in the project partnership were to
contribute certain sums of money. See id. at 428. The
corporation was granted an option, exercisable in its sole
discretion at any time, to acquire an exclusive and irrevocable
license to carry out all production, manufacturing, and
marketing of any product developed under the agreement. See id.
at 428-429. This Court held that there was no realistic
prospect, during the year in issue, that the technology to be
developed "would ever be exploited in any trade or business
carried on by anyone other than * * * [the corporation]." Id.
at 439. In that regard, we reasoned that, if the technology
- 16 -
appeared commercially promising, the corporation would
definitely exercise its option, and, if the corporation declined
to exercise the option, the project partnership and the limited
partnership would be left with the right to develop an asset
whose costs would not appear to justify additional investment.
See id. at 440-441.
The Court of Appeals for the Fourth Circuit affirmed our
opinion, stating:
The question is not whether it is possible in
principle, or by further contract, for these
partnerships to engage in a trade or business, but
whether, in reality, the project partnership * * *
possessed the capability in the years before the court
to enter into a new trade or business in connection
with the proposed * * * [technology]. The answer to
the question of reality must be found in economic
reality, which is revealed more by the direction of
the money than by the complexion of the principle.
[Diamond v. Commissioner, 930 F.2d at 375.]
In Harris v. Commissioner, T.C. Memo. 1990-80, we held that
Research I, a partnership of which Mr. Townsend was a general
partner, was not entitled to deductions under section 174 for
amounts paid to CemCom for research and development services
which are similar to the research and development services
provided by CemCom to Research II under the terms of the
research and development agreement. Research I and CemCom had
also entered into an agreement, similar to the technology
transfer agreement between Research II and CemCom, under which
CemCom was granted the option to license the technology it
- 17 -
developed for Research I subject to high minimum royalty
payments. We found that, at the time Research I entered into an
agreement with CemCom in 1981, Mr. Townsend, as Research I's
general partner, did not intend ever to enter into any business
regarding the technology. Rather, we found that it was Mr.
Townsend's intention that CemCom would exercise the option as
written or the parties would renegotiate the amount of the
minimum royalties. In reaching that conclusion, we relied on
the fact that the Research I offering memorandum made no mention
of any other options except CemCom's exercise of the option. We
also relied on the testimony of Mr. Townsend and others that the
intent of the partners in Research I was that CemCom would
exercise its option.
Petitioner has not shown that the facts surrounding
Research II are materially different from those surrounding
Research I. Like the confidential memorandum issued to
prospective limited partners in Research I, the confidential
memorandum issued to the Research II partners contains neither
specific plans nor economic forecasts related to the possibility
that Research II might itself engage in the marketing of the new
technology. Similarly, no mention is made in the Research II
memorandum of hiring a staff experienced in the area or of
acquiring real or personal property for such purposes. Finally,
as in Research I, virtually all of the funds of Research II were
- 18 -
to be disbursed in payment of the licensing agreement to CemCom,
and the limited partners of Research II were under no obligation
to contribute additional funds for that purpose. These facts
indicate that Research II never intended to enter a trade or
business in connection with the new technology.
Petitioner argues that the instant case is distinguishable
from Harris v. Commissioner, supra, because the high minimum
royalties required by the technology transfer agreement in
addition to the royalties which CemCom owed under the Research I
agreement made it virtually certain that CemCom would never
exercise its option under the Research II agreement to license
the new technology. However, as we said in Harris: "the amount
of the royalties does not supply the required prospect of a
'trade or business' to be carried out by the Partnership."
Petitioner further argues that the fact that Research I,
Research II, Mr. Townsend, and another partner in both Research
I and Research II ultimately acquired control of CemCom is
evidence of the Research II's intent to engage in a trade or
business. To the contrary, such evidence convinces us that,
even when CemCom was unable to license the new technology,
Research II did not take advantage of the opportunity to enter
into a trade or business with the new technology. Instead, the
minimum royalties were reduced, and CemCom, with its new owners,
remained the vehicle through which the actual trade or business
involving the new technology was operated.
- 19 -
In sum, we hold that the research and developmental
expenses incurred by Research II during December 1982 were not
made in connection with its trade or business within the meaning
of section 174(a). We have considered the parties' remaining
arguments and find them without merit, irrelevant, or
unnecessary to reach.
To reflect the foregoing and the concessions of the
parties,
Decision will be entered
under Rule 155.