Peat Oil & Gas Assocs. v. Commissioner

PEAT OIL AND GAS ASSOCIATES, JAMES KARR, A PARTNER OTHER THAN THE TAX MATTERS PARTNER, ET AL., ¹ Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Peat Oil & Gas Assocs. v. Commissioner

Docket Nos. 30296-87, 20081-88, 20130-88, 820-91, 24514-91, 30440-91

United States Tax Court

100 T.C. 271; 1993 U.S. Tax Ct. LEXIS 18; 100 T.C. No. 17;

March 31, 1993, Filed

---

In Smith v. Commissioner, 91 T.C. 733">91 T.C. 733 (1988), the synthetic fuel activities of petitioners were held to lack economic substance, and deductions for license fees, interest expense, and research and development expenses relating to those activities were denied. Held, the deductions claimed by petitioners in subsequent years are denied. Held, further: Smith v. Commissioner, 937 F.2d 1089">937 F.2d 1089 (6th Cir. 1991), revg. 91 T.C. 733">91 T.C. 733 (1988), is not followed. Karr v. Commissioner, 924 F.2d 1018">924 F.2d 1018 (11th Cir. 1991), affg. Smith v. Commissioner, 91 T.C. 733">91 T.C. 733 (1988), is followed.

For petitioners: Dennis N. Brager and Jackson D. Hamilton.

For respondent: Debra K. Estrem.

COHEN, SHIELDS, CLAPP, SWIFT, JACOBS, WRIGHT, PARR, COLVIN, HALPERN, BEGHE, CHIECHI, LARO, HAMBLEN, PARKER, RUWE, CHABOT, GERBER

---

COHEN

COHEN, Judge: Respondent sent Notices of Final Partnership Administrative Adjustments (FPAA) disallowing certain deductions claimed on partnership returns of three partnerships. Petitions were filed for the years in issue as follows:

Docket		Tax
Number	Petitioner	Year
30296-87	Peat Oil and	1983
	Gas Associates
	(POGA)
20081-88	Syn-Fuel	1982
	Associates	1983
	1982 (SFA-1982)	1984
		1985
20130-88	POGA	1984
820-91	POGA	1986
24514-91	Syn-Fuel	1983
	Associates	1984
	(SFA)	1985
		1986
		1987
30440-91	POGA	1987

The disputed items deducted on the partnership tax returns are as follows:

			Amount of	Research and
	Return	Amount of	Interest	Development
Partnership	Year	License Fee	Payment	Expenses
POGA	1983	$ 7,752,875	$ 943,086	-
	1984	5,825,219	1,334,470	-
	1986	-	1,569,093	-
	1987	-	1,570,124	-
SFA-1982	1982	5,961,600	2,492	-
	1983	5,779,000	399,938	$ 658,000
	1984	5,783,400	721,367	162,000
	1985	4,467,150	1,021,951	-
SFA	1983	2,660,750	323,666	-
	1984	5,783,400	721,367	-
	1985	-	538,719	-
	1986	-	538,584	-

These deductions were claimed in addition to expenses relating to the oil and gas activities of the partnerships, which are not disputed by respondent.

The parties have stipulated:

15. If a final determination of the Tax Court holds that venue on appeal in these cases lies to the Sixth Circuit, then decisions should be entered which reflect that the Partnerships' tax returns were correct as filed for each of the years at issue, pursuant to Golsen v. Commissioner, 54 T.C. 742 (1970), aff'd445 F.2d 985">445 F.2d 985 (10th Cir. 1971),cert. denied, 404 U.S. 940 (1971).

16. If a final determination of the Tax Court holds that venue on appeal lies anywhere but the Sixth Circuit, then decisions should be entered as shown on the following Exhibits, which reflect certain government concessions:

Partnership	Tax Year	Exhibit No.
"SFA, 192"	1982	30-AD
	1983	31-AE
	1984	32-AF
	1985	33-AG
"POGA"	1983	34-AH
	1984	35-AI
	1985	36-AJ
	1986	37-AK
"SFA"	1983	38-AL
	1984	39-AM
	1985	40-AN
	1986	41-AO
	1987	42-AP

In addition, the Court's decision should reflect its determination of the deductibility of the unagreed adjustments, as defined in paragraph 17, following.

17. Except as detailed in Exhibits 30-AD through 42-AP above, no adjustments are to be made to any items on any of the Partnerships' income tax returns for the years at issue, except as determined by the Court with respect to unagreed adjustments. Unagreed adjustments are those items disallowed in the FPAA's and not conceded by the government in Exhibits 30-AD through 42-AP above. Neither the petitioners nor the respondent concedes the unagreed adjustments.

* * *

20. The parties incorporate herein by reference the entire record of the proceeding in the cases of Karr v. Commissioner, Docket No. 309-87, and Smith v. Commissioner, Docket No. 48306-86, including the transcripts of the proceeding before the United States Tax Court, the Stipulation of Facts in those cases, and the Exhibits, as if they had been presented to the Tax Court in the cases captioned herein.

21. The events surrounding the formation and operation of "SFA, 1982" were so similar to the facts presented with respect to "SFA" and "POGA" at the Smith and Karr trials that the Court shall determine, except as specifically agreed herein, the issues in this case based upon the record in the Smith and Karr cases. To amplify, it is the belief of the parties that due to the similarity of factual circumstances no purpose would be served by presenting additional evidence (other than evidence presented herein) to the Court, and the Court may decide this case as if the evidence presented in the Smith and Karr cases were presented with regard to "SFA, 1982."



In T.C. Memo. 1993-130, filed this date, it has been found that the principal place of business of the three partnerships at the times the petitions were filed was in New York. Given that factual determination, appeal will lie to the Court of Appeals for the Second Circuit. Sec. 7482(b)(1)(E). The stipulation of the parties, therefore, requires that we again resolve the disputed deductions set forth above.

Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue and when the petitions were filed, and all Rule references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated facts are incorporated in our findings by this reference. The stipulation also incorporates the entire record in the cases of Smith v. Commissioner, 91 T.C. 733 (1988) (Smith and Karr), affd. sub nom. Karr v. Commissioner, 924 F.2d 1018 (11th Cir. 1991) (Karr), and revd. by the Sixth Circuit in Smith v. Commissioner, 937 F.2d 1089 (6th Cir. 1991) (Smith). The findings of fact in our prior opinion, 91 T.C. at 734-754, are attached to this opinion as an appendix and are hereby reaffirmed and incorporated in haec verba.

ULTIMATE FINDINGS OF FACT

The synthetic fuel activities of the partnerships lacked economic substance. The partnerships did not engage in those activities for the purpose of or with an actual and honest objective of making a profit.

OPINION

We "follow a Court of Appeals decision which is squarely in point where appeal from our decision lies to that Court of Appeals and to that court alone." Golsen v. Commissioner, 54 T.C. 742">54 T.C. 742, 757 (1970), affd. 445 F.2d 985">445 F.2d 985 (10th Cir. 1971). On the other hand, if appeal from our decision lies to a Court of Appeals that does not have a decision squarely in point, we, as a court of national jurisdiction, must thoroughly reconsider an issue in light of the reasoning of a reversing appellate court and, if still of the opinion that our original result was right, follow our own beliefs until the Supreme Court decides the point. Lawrence v. Commissioner, 27 T.C. 713">27 T.C. 713, 716-717 (1957), revd. on other grounds 258 F.2d 562">258 F.2d 562 (9th Cir. 1958). Here, of course, we also consider the opinion of the Court of Appeals for the Eleventh Circuit in Karr v. Commissioner, 924 F.2d 1018 (11th Cir. 1991), affg. Smith v. Commissioner, 91 T.C. 733">91 T.C. 733 (1988).

In our opinion in Smith and Karr, 91 T.C. at 753, we discussed profit objective and economic substance under the unified approach adopted by this Court in Rose v. Commissioner, 88 T.C. 386">88 T.C. 386, 414 (1987), affd. 868 F.2d 851">868 F.2d 851 (6th Cir. 1989). Subsequent to our opinion in Smith and Karr, the Court of Appeals for the Sixth Circuit affirmed our decision in Rose but did not adopt the generic tax shelter analysis reflected in our opinion in that case. Rose v. Commissioner, 868 F.2d at 853.

In reversing our opinion, the Court of Appeals for the Sixth Circuit in Smith stated:

In its factual aspect, the Tax Court's conclusion that the transactions in question lacked economic substance leaves us "with the definite and firm conviction that a mistake has been committed." Anderson v. Bessemer City, 470 U.S. 564">470 U.S. 564, 573 (1985) (quoting United States v. United States Gypsum Co., 333 U.S. 364">333 U.S. 364, 395, 68 S. Ct. 525">68 S.Ct. 525, 542, 92 L. Ed. 746">92 L.Ed. 746 (1948)). We recognize that this result is at odds with the Eleventh Circuit's decision in Karr (see note 1, supra), but under the law of this circuit the proper test is "whether the transaction has any practicable effects other than the creation of income tax losses." Rose, 868 F.2d at 853 (emphasis supplied). It is crucial, moreover, that this inquiry be conducted from the vantage point of the taxpayer at the time the transactions occurred, rather than with the benefit of hindsight. Hayden [v. Commissioner], 889 F.2d [1548] at 1554-56 [(6th Cir. 1989)] (Nelson, J., dissenting); Treas. Reg. sec. 1.183-2(a). [Smith v. Commissioner, 937 F.2d at 1096.]



The Court of Appeals, relying on its opinion in Bryant v. Commissioner, 928 F.2d 745">928 F.2d 745 (6th Cir. 1991), affg. in part and revg. in part T.C. Memo. 1989-527, continued:

The conclusion in Bryant was similar to the one we reach in this case --" a reasonable expectation of profit [subjectively] is not to be required;" rather we look to whether "the taxpayer entered the activity, or continued the activity, with the objective of making a profit . . . even though the expectation of profit might be considered unreasonable." Id. at 750 (emphasis added) quoting S. Rep. No. 552, supra. Here, as in Bryant, we conclude that the Tax Court was in error in questioning the transaction on the basis of whether it "was likely to be profitable." Id. [Smith v. Commissioner, 937 F.2d at 1097.]

In our view, "Rose did not depart from the principle that a reasonable expectation of profit (as contrasted to an actual and honest profit objective) is not required. See Rose v. Commissioner, 88 T.C. at 411, quoting Jasionowski v. Commissioner, 66 T.C. 312">66 T.C. 312, 321 (1976)." McCrary v. Commissioner, 92 T.C. 827">92 T.C. 827, 846 (1989). We stated in McCrary: "A transaction that has a business purpose or profit objective will survive the Rose analysis of economic substance. Rose simply reformulated a two-pronged test into a unified approach in certain types of cases." McCrary v. Commissioner, 92 T.C. at 845.

Thus we did not reach our conclusion in Smith and Karr on the basis of whether the transaction was "likely to be profitable." The features of the arrangement were discussed by us as a predicate to determining the purpose of the partnerships in which the taxpayers invested. At 91 T.C. at 756, we stated:

respondent has conceded deductions and credits relating to * * * [the oil and gas] activities. Thus we cannot conclude that the partnerships totally lacked economic substance. The question remains: What, if anything, was the economic substance of the Koppelman Process activity of the partnerships? Specifically, were these partnerships engaged in the trade or business of developing energy sources from the Koppelman Process or were they in the business of financing the operations of other entities in exchange for tax benefits? The business activities of other entities directly involved in exploiting the Koppelman Process will not necessarily be attributed to the limited partnerships in which petitioners invested. See Beck v. Commissioner, 85 T.C. 557">85 T.C. 557, 580 (1985).

Whether we are determining the existence of a profit objective or the status of an activity as a trade or business, we examine the appropriate factors at the partnership level. Brannen v. Commissioner, supra [78 T.C. 471 (1982), affd. 722 F.2d 695">722 F.2d 695 (11th Cir. 1984)]; Madison Gas & Electric Co. v. Commissioner, 72 T.C. 521">72 T.C. 521, 564-565 (1979), affd. 633 F.2d 512">633 F.2d 512 (7th Cir. 1980). Citing Surloff v. Commissioner, 81 T.C. 210">81 T.C. 210, 233 (1983), petitioners specify that "in determining whether the Partnerships had the requisite profit motive it is necessary to look at the motive and objectives of the promoters and managers of the Partnerships." * * * [Fn. ref. omitted.]

Our opinion in Smith and Karr examined in detail the motive and objectives of the promoters and managers of the partnerships and concluded that the structure precluded any economic benefit to the limited partners -- the petitioner taxpayers. Smith and Karr, 91 T.C. at 764-765.The Court of Appeals for the Sixth Circuit seemed to give the limited partners the benefit of the possibility that some "practicable effects other than the creation of tax losses" might be realized by other persons associated with the venture. Smith, 937 F.2d at 1096.

We need not here decide whether we will follow the Rose approach in the future in view of its failure to gain acceptance by the Court of Appeals for the Sixth Circuit and others. See Hunt v. Commissioner, 938 F.2d 466">938 F.2d 466, 471 n.5 (4th Cir. 1991), affg. T.C. Memo. 1989-660; Collins v. Commissioner, 857 F.2d 1383">857 F.2d 1383, 1386 (9th Cir. 1988), affg. Dister v. Commissioner, T.C. Memo 1987-217">T.C. Memo. 1987-217. Further, it is not our place here to decide whether the test stated by the Sixth Circuit in Smith and in Bryant v. Commissioner, 928 F.2d 745">928 F.2d 745 (6th Cir. 1991), revg. T.C. Memo. 1989-527, is consistent with the Supreme Court's statement in Commissioner v. Groetzinger, 480 U.S. 23">480 U.S. 23, 35 (1987), that, in order for a taxpayer to be in a trade or business, within the meaning of section 162, the "primary purpose" for engaging in the activity must be for profit. Using the traditional subjective and objective analyses that preceded Rose, the Court of Appeals for the Eleventh Circuit in Karr and the dissenting judge in Smith reach the same conclusion as that reached by us in Smith and Karr.

The Court of Appeals for the Eleventh Circuit in Karr, 924 F.2d at 1024, stated:

Although the Commissioner presented no expert witnesses, the record contains substantial evidence from which one may conclude that POGA's Koppelman process activity lacked economic substance and had no business purpose other than the creation of tax benefits. The offering memorandum emphasized the tax benefits of the partnership, including anticipated tax write-offs for the limited partners of four times their cash investment over the first four years of the partnership. The purchasers of partnership units did not negotiate for the price of their shares and knew of conflicting business interests. ⁷POGA held no tangible assets, and the limited rights to exploit the Koppelman process that POGA did possess were difficult to value. Moreover, the fees paid by POGA to Sci-Teck and FTRD were not the result of arm's-length negotiations.

The amount and structure of the fees paid by the partnerships also lend support to the Tax Court's conclusion that the transactions lacked economic substance. POGA and SFA incurred a fixed obligation to pay an amount potentially 56 to 112 times greater than the price paid by Ronodo; yet, the partnerships received fewer rights than did Ronodo to exploit the Koppelman process. Another noteworthy difference between Ronodo's payments to Koppelman and POGA's payments to Ronodo is that Ronodo's payments were contingent on the completion and testing of the system's construction and on the commercial success of the Koppelman process technology and exploitation. In contrast, POGA's payments to Sci-Teck and FTRD were based on a multiple of the number of partnership units sold. Furthermore, the bulk of POGA's payment consisted of promissory notes due in twenty-five years. Although they were recourse notes, the Tax Court found that the substantive liability that they represented was significantly less than the face amount of the notes.

The Court of Appeals for the Eleventh Circuit also affirmed our use of the testimony of Michael Zukerman (Zukerman), an attorney involved in structuring the transactions.

The majority of the Court of Appeals for the Sixth Circuit, in contrast, differed in its interpretation of Zukerman's testimony. Smith v. Commissioner, 937 F.2d at 1094. After analyzing that testimony and other evidence in the record, the court concluded that, "On the basis of the evidence presented, it seems obvious to us that the investment was not a sham." Id. at 1096.

Circuit Judge Charles W. Joiner, dissenting in Smith, discussed at length the application of regulations under section 183 and concluded:

It was perfectly apparent to purchasers of partnership units that the partnerships dealt only with corporations controlled by the promoters, that none of the web of commitments of the partnership had been negotiated at arms' length, that the principals and contractors to the partnership had no experience in relevant endeavors, and other facts communicating the insubstantial nature of the enterprise. These partnerships were not business ventures, they were paper montages of likely Tax Court arguments.

It does not controvert the significance of the other facts at issue to say that the income from the oil and gas activities of the partnership might have covered the expenses of the Koppelman process activities. It may be that the Koppelman process itself is commercially feasible. However, as the Tax Court clearly pointed out, it was the structure of this venture, the conflicts of interest, and other factors separate from the economic viability of the processes at issue, which demonstrate that the investors had no profit motive. The experts offered by the taxpayers who found the oil and gas projections reasonable, addressed merely the surface question of the economic potential of the partnerships' activities. However, there was no serious intent to pursue those activities, and the purchasers of the partnership units, to whom the partnerships were marketed as tax-oriented investments, had no expectation that the partnerships would be commercially successful. The principals of this venture had no incentive to make it a success, the venture had inadequate funding to make it a success, and there is no evidence of attempts to make the venture a success after the failure of the activities originally planned, despite the fact that the partners had an obligation to fund the partnerships for the next twenty years. Viewing the above circumstances as a whole, I would affirm the Tax Court's finding that there was no profit motive under section 183, and that SFA was engaged in a sham transaction rather than a "trade or business" entitling it to deductions under section 174. [Smith v. Commissioner, 937 F.2d at 1102-1103.]

Obviously, this is a case where judges disagree in their interpretation of the facts. The unanimous opinion of the Court of Appeals for the Eleventh Circuit and the dissenting judge sitting on the Court of Appeals for the Sixth Circuit agreed with us. Judge Joiner's dissenting opinion concisely states our position.

We have given consideration to the reasoning of the Court of Appeals for the Sixth Circuit. We believe that the majority opinion failed to differentiate between the potential economic benefits that might be realized by persons other than the partners and the losses certain to be realized by the taxpayers before the Court. With due respect to their opinion, and in view of the support for our position from the Court of Appeals for the Eleventh Circuit and from the dissent in Smith, we respectfully conclude that our original result was correct. Cf. Bayer v. Commissioner, 98 T.C. 19">98 T.C. 19, 22-23 (1992). Petitioners have not included in their briefs any new or additional argument that must be addressed. Accordingly,

Decisions will be entered under Rule 155.

Reviewed by the Court.

SHIELDS, CLAPP, SWIFT, JACOBS, WRIGHT, PARR, COLVIN, HALPERN, BEGHE, CHIECHI, and LARO, JJ., agree with the majority opinion.

HAMBLEN and PARKER, JJ., concur in the result only.

APPENDIX -- Findings of Fact from Smith v. Commissioner, 91 T.C. 733">91 T.C. 733, 734-753 (1988)

COHEN, Judge: Respondent determined deficiencies in and additions to petitioners' income tax as follows:

				Addition to tax
Docket No.	Petitioner	Year	Deficiency	1 sec. 6661
48306-86	Smith	1981	$ 19,505.00	--
		1982	13,059.64	$ 1,303.00
309-87	Karr	1981	8,907.77	--
		1982	7,972.84	797.28

After concessions, the issues for decision are as follows:

(1) Whether petitioners are entitled to deduct their pro rata share of the losses of certain limited partnerships on their 1981 and 1982 income tax returns;

(2) Whether petitioners are liable for additions to tax under section 6659;

(3) Whether petitioners are liable for additions to tax under section 6661 for 1982; and

(4) Whether petitioners are required to pay additional interest under section 6621(c) on any underpayment.

FINDINGS OF FACT

I. Background

Many of the facts have been stipulated, and the facts set forth in the stipulation are incorporated in our findings by this reference. Petitioners Karr and Smith resided in Georgia and Michigan, respectively, when their petitions were filed. In each of the years in issue, petitioner James Karr was a limited partner in Peat Oil & Gas Associates, Ltd. (POGA); petitioners Smith were limited partners in Syn-Fuel Associates, Ltd. (SFA). POGA and SFA were putatively formed to exploit a technique known as the Koppelman Process.

The Koppelman Process refines wood, peat, lignite, and other low-grade biomass or fossil fuel into a dry, stable, higher-heating-value solid fuel, physically resembling coal, known as K-Fuel. In general, K-Fuel is produced by placing raw material, known as feedstock, into a Koppelman reactor, where it is dried and carbonized at high temperature and pressure.

This technique was developed by Edward Koppelman (Koppelman). In 1980, the U.S. Department of Energy (the DOE) awarded to Koppelman a $ 727,882 grant to study the feasibility of the Koppelman Process. Pursuant to the 1980 grant, Koppelman, SRI International (SRI), the University of Maine, Lehman Brothers Kuhn Loeb Inc., Ekono Inc., Central Maine Power Co., and Stone & Webster Engineering Corp. (Stone & Webster) prepared a report (the 1981 report). The 1981 report concluded that the Koppelman Process was technically, environmentally, and economically feasible.

SRI was formed in 1948 as Stanford Research Institute and is a leading research and development organization that provides research and consulting for business and government clients worldwide. Stone & Webster has a reputation as a leader in the engineering field with respect to the construction of large-scale plants.

In 1981, the DOE awarded to A.T. Kearney, an international consulting firm, a $ 1,603,480 grant for an alternative fuels feasibility study for K-Fuel. Koppelman received a subcontract from A.T. Kearney under the 1981 grant in the amount of $ 425,000.

By the summer of 1981, Koppelman, with the assistance of SRI and others, had built a model plant capable of producing K-Fuel in small quantities. The model plant was built at SRI's 70-acre research facility in Menlo Park, California. By this time, the Koppelman Process was covered by various U.S. and foreign patents.

On March 21, 1984, Koppelman sold a 20-percent undivided interest in the Koppelman Process to DSC Holdings, Inc., a wholly owned subsidiary of Diamond Shamrock Corp. (the Diamond Shamrock agreement) for $ 10 million. On the same date Koppelman sold an 80-percent undivided interest in the Koppelman Process to Theodore Venners for $ 90 million (the Venners agreement). The rights transferred by Koppelman pursuant to the Diamond Shamrock agreement and the Venners agreement were transferred subject to the rights held by POGA and SFA.

II. The Network

In early 1981, Richard B. Basile (Basile) learned of Koppelman and the Koppelman Process. In March or April of 1981, Basile met with Koppelman. Shortly thereafter, an elaborate network of interrelated entities was formed to exploit the Koppelman Process. POGA and SFA were elements of this network.

Intro-Continental Investment, B.V. (Intro-Continental), owned all of the stock of Ronodo Corp., N.V. (Ronodo), which, in turn, owned all of the stock of Sci-Teck Licensing Corp. (Sci-Teck). In August 1981, Koppelman signed a document in which he purported to license Ronodo to produce K-Fuel. Ronodo sublicensed its rights to Sci-Teck, which, in turn, sublicensed its rights to POGA and SFA. On December 31, 1981, POGA and SFA entered into a joint venture to own, operate, and manage a pilot K-Fuel plant. On that date, POGA and SFA entered into separate research and development agreements with Fuel-Teck Research & Development, Inc. (FTRD), under which FTRD agreed to conduct and coordinate the research and development efforts of Koppelman, A.T. Kearney, and others for the benefit of SFA and POGA. FTRD was a wholly owned subsidiary of Petro-Syn Corp. (Petro-Syn).

SFA and POGA also entered into agreements with Chronometer Management & Consultants, Inc. (Chronometer), pursuant to which Chronometer was to render administrative services to the partnerships. The partnerships' attempt to develop the Koppelman Process was to be partially subsidized by investments in certain oil and gas wells. The partnerships' oil and gas activities were to be conducted by Fuel-Teck Oil & Gas, Inc. (FTOG), another wholly owned subsidiary of Petro-Syn.

A. Koppelman's License to Ronodo

The August 1981 license agreement purportedly granted Ronodo the exclusive right to use the Koppelman Process in the State of North Carolina to refine wood and peat into K-Fuel. The agreement also purportedly granted Ronodo the exclusive right to use the Koppelman Process in the United States and certain other countries to refine bagasse into K-Fuel. The agreement explicitly did not grant Ronodo the right to use the process to produce charcoal briquettes for cooking purposes.

In exchange for its rights under the agreement, Ronodo promised to pay a one-time license fee of $ 4 per estimated annual output ton for each Koppelman Reactor. No fee was payable for the first such reactor to be operated by Ronodo. Ronodo also agreed to pay, with certain restrictions and modifications, a 5-percent net royalty on substances produced through the Koppelman Process. Finally, Ronodo agreed to pay additional consideration of $ 1 million, contingent on the commercial viability of the first Koppelman Reactor. One-third of this amount was allocated to the "Peat License" and two-thirds to the "Bagasse License." The first of two addenda to the license stated that Ronodo would pay $ 1,600,000 for a Koppelman Reactor to be assembled by Koppelman in North Carolina. The addendum stated that a "down payment" of $ 640,000 would be paid by December 1, 1981, with a second "down payment" of equal amount to be paid on "April 30, 1981" [sic] and the balance on completion of the reactor's installation.

The license agreement consisted of 19 typewritten pages and (inserted between pages 9 and 10) 3 handwritten pages. Each typewritten page contained handwritten changes, additions, and deletions, none of which were initialed or otherwise validated. The 3 handwritten pages, which referred to the additional consideration of $ 1 million, were unsigned, uninitialed, and not referred to in the typewritten pages. The agreement bore Koppelman's undated, unwitnessed signature and no other. The first typewritten addendum to the agreement contained uninitialed handwritten alterations and was not signed or dated. The second typewritten addendum was dated and signed by Koppelman, and by an "attorney in fact," of Ronodo, whose name was illegible.

B. Sci-Teck's License to SFA and POGA

Ronodo sublicensed its rights under the 1981 license agreement to Sci-Teck, its wholly owned subsidiary. On December 31, 1981, Sci-Teck entered into separate agreements in which it sublicensed certain rights to SFA and POGA. Sci-Teck's agreement with SFA granted SFA (i) the exclusive right to use the Koppelman Process with respect to peat and wood in certain counties of North Carolina (the SFA exclusive area); (ii) the nonexclusive right to use the process at the North Carolina plant with respect to peat; (iii) the nonexclusive right to use the process with respect to peat and wood in the States and Territories of the United States (except the counties of North Carolina not within the SFA exclusive area); and (iv) the nonexclusive right to use the process with respect to any material other than bagasse in the States and Territories of the United States. Sci-Teck's agreement with POGA granted POGA the exclusive right to use the Koppelman Process with respect to wood and peat in all North Carolina counties not within the SFA exclusive area (the POGA exclusive area) and other nonexclusive rights identical to those conferred in Sci-Teck's agreement with SFA.

In their respective agreements with Sci-Teck, SFA and POGA each represented that it was a partnership in the process of making a private offering of between 125 and 250 partnership units. Each partnership agreed to pay Sci-Teck $ 112,175 for each SFA or POGA partnership unit sold, as follows:

Date	Form	Amount per unit
Upon commencement	Cash	$ 3,800
	Partnership note
	due Oct. 1, 2006	16,500
Oct. 1, 1982	Cash	2,700
	Partnership note
	due Oct. 1, 2007	24,900
Oct. 1, 1983	Cash	3,700
	Partnership note
	due Oct. 1, 2008	33,000
Oct. 1, 1984	Cash	2,775
	Partnership note
	due Oct. 1, 2009	24,800
		112,175

Each partnership thus agreed to pay between $ 14,021,875 and $ 28,043,750 for the rights licensed by Sci-Teck.

In October of 1982, SFA executed a full recourse promissory note payable to Sci-Teck in the amount of $ 1,805,250 due October 1, 2007. In October 1982, POGA executed a full recourse 25-year promissory note in the amount of $ 5,260,125 payable to Sci-Teck.

On its income tax return for 1981, SFA deducted $ 1,492,050 as a license fee to be paid to Sci-Teck. The amount represented accrual of the note and cash payments due to Sci-Teck on 73.5 units, determined as of the date the 1981 income tax return was prepared. On its income tax return for 1981, POGA deducted $ 4,288,375 as a license fee to be paid to Sci-Teck. The amount represented accrual of the note and cash payments due to Sci-Teck on 211.25 units, determined as of the date the 1981 income tax return was prepared.

On its 1982 income tax return, SFA deducted $ 1,980,700 as a license fee. On its 1982 income tax return, POGA deducted $ 5,830,500 as a license fee. These amounts represented the accrual of the cash and note payments due to Sci-Teck during 1982. For 1982, POGA also deducted $ 505,897 as interest expense and reported $ 428,455 as interest income on notes receivable.

C. FTRD

FTRD was created for the purpose of overseeing the construction by Stone & Webster of a Koppelman Process plant. On December 31, 1981, SFA and POGA separately entered into identical research and development agreements with FTRD. In its agreements with the partnerships, FTRD promised to coordinate the activities of Koppelman, A.T. Kearney, and others for the benefit of SFA and POGA. SFA and POGA each agreed to pay FTRD $ 29,800 for each SFA or POGA partnership unit sold, as follows:

Date	Form	Amount per unit
Upon commencement	Cash	$ 4,000
	Partnership note
	due Oct. 1, 2006	16,500
Oct. 1, 1982	Cash	1,000
	Partnership note
	due Oct. 1, 2007	8,300
		29,800

On its 1981 income tax return, SFA deducted $ 1,506,750 as a research and development fee to be paid to FTRD. This amount represented the accrual of the note and cash payments due to FTRD on 73.5 units. On its 1981 income tax return, POGA deducted $ 4,288,375 as a research and development fee to be paid to FTRD. This amount represented the accrual of the note and cash payments due to FTRD on 211.25 units, determined as of the date the 1981 tax return was prepared.

On its 1982 income tax return, POGA deducted $ 1,964,625 as a research and development fee. On its 1982 income tax return, SFA deducted $ 653,750 as a research and development fee.

D. Chronometer

SFA and POGA each entered into agreements with Chronometer pursuant to which Chronometer agreed to provide management and financial consulting services to the partnerships. For its services, Chronometer was to receive from the partnerships (i) 2 percent of the limited partners' 1981, 1982, 1983, and 1984 capital contributions, (ii) 2 percent of the partnerships' gross income from operations, and (iii) a fixed annual fee of $ 17,500, adjusted for inflation, plus expenses.

E. SFA and POGA

SFA and POGA issued substantially identical offering memoranda. According to the memoranda, SFA and POGA each offered from 125 to 250 limited partnership interests. The subscription price of $ 161,500 per interest was payable in cash and promissory notes as follows:

Form	Due	Amount
Cash	On subscription	$ 10,000
Note in the principal amount of	Mar. 1, 1982	10,000
$ 27,500 (payable in three	Mar. 1, 1983	10,000
installments)	Mar. 1, 1984	7,500
Note in the principal amount of	Mar. 1, 1993	24,000
$ 124,000 (payable in five	Mar. 1, 1994	30,000
installments)	Mar. 1, 1995	30,000
	Mar. 1, 1996	30,000
	Mar. 1, 2007	10,000
Total		161,500

Investors in SFA and POGA also agreed to assume personally a proportionate share of the partnerships' liabilities to FTRD under the research and development agreements and the liabilities to Sci-Teck under the license agreements. The assumption agreement signed by petitioners was limited to the principal amounts of these liabilities.

The memoranda stated that the partnerships were organized for the following purposes:

To devote a significant portion of initial cash proceeds to a program of developmental oil and gas drilling.

To reinvest a major portion of the early cash flow from initial drilling operations in order to maximize the number of partnership wells.

To exploit new technology by the construction and development of an experimental pilot plant (partially funded by the Department of Energy) to convert peat, wood, and other cellulosic materials into a new and theoretically clean and efficient synthetic fuel.

Each memorandum set forth tax losses anticipated for the first 4 years of the partnerships' operations. The memoranda contained a complete tax analysis and opinion, assurances of tax representation by Baskin & Sears, and the following caveat:

If an Investor does not, or is not able to, utilize such tax savings profitably, such Investor will not be able to derive the full intended benefit of investment in the Partnership.

The POGA memorandum identified Arthur Goldman (Goldman) as POGA's general partner and described him as follows:

Arthur Goldman. Mr. Goldman is a certified public accountant licensed in the State of New Jersey. Mr. Goldman has been a financial consultant since March 1980 to World Video Corporation, which is engaged in the business of producing video tapes for the medical field. He also is General Partner of Opthalmology Associates, a limited partnership which manufactures and distributes video cassettes and disks for use by the medical profession. From 1975 to 1980, Mr. Goldman was General Manager and Treasurer of Princeton Electronic Products Inc., which manufactures medical components. During 1974 Mr. Goldman acted as financial consultant to corporations in the telecommunications industry. Prior to 1974 Mr. Goldman was, among other things, General Manager of Plessey Communication Systems Corp., which manufactured and distributed telephone equipment, and Assistant Controller of Majestic Specialties Inc., a manufacturer of women's clothing.

The SFA memorandum identified Martin Kaye (Kaye) as SFA's general partner and described him as follows:

Martin Kaye. Mr. Kaye is an independent tax and financial consultant. Since January 1979 he has been a consultant to VAS in connection with tax oriented investments. Mr. Kaye is also a consultant to Reliable. During 1978 he served as Vice President and Chief Financial Officer of Dia-Chem International, Ltd., a broker of plasma (human) chemistry control products. Mr. Kaye was a partner of Henry Warner & Company, a New York certified public accounting firm from 1968 through 1977. Mr. Kaye is a licensed certified public accountant in the States of New York and Illinois and is a member of the New York State Society of Public Accountants and the American Institute of Certified Public Accountants. In addition, Mr. Kaye is Vice President -- Finance and a director of BIS Communications Corporation, which is engaged in providing business information at airport terminals. He also serves as Vice President -- Finance of Goldtex Foods Corporation, a holding company that is engaged through its subsidiaries in retail baking and franchising. Mr. Kaye is a director of Sands Minerals Corporation (Canada) which invests in oil and gas programs.

The memoranda emphasized the difficulties of oil and gas development and the risks associated with research and development. The offering memoranda contained the following caveat:

The value of the Licensed Technology to the Partnership cannot be conclusively demonstrated. The license fee was not negotiated in an arm's-length transaction and it is possible that the Licensed Technology will prove not to have a value to the Partnership commensurate with its cost. Finally, were the title of Ronodo to any of the technology found to be invalid or were any of the patents found to be invalid or unenforceable or found to infringe technology of others, the Partnership would have to seek redress against Sci-Teck which has no significant assets or Ronodo, which is a foreign corporation with very limited assets and against whom suit might be difficult.

Only 10 percent of the funds contributed to the partnerships was to be allocated to working capital. Almost 70 percent was to be paid to promoters, attorneys, or network entities. According to the memoranda, the proceeds of the offering were to be applied as follows:

	Per unit	Total
		Percent	Percent	Percent	Total	Total
		age	age	age
		of	Out of	of	of	for	for
	During	1981-84	long-	long-	total	minimum	maximum
			term	term
Item	1981-84	pay	notes	notes	unit	offering	offering
		ments
Cash commis-
sions and
marketing	$ 5,625	15.00%	--	--	3.49%	$ 703,125	$ 1,406,250
fees
Management
fee to
general
partner	375	1.00	--	--	0.23	46,875	93,750
Organiza
tional
expenses in-
cluding
legal and
accounting
fees	1,125	3.00	--	--	0.70	$ 140,625	$ 281,250
Fees to	5,000	13.33	$ 24,800	20.00%	18.45	3,725,000	7,450,000
R & D
License fee
to Sci-Teck	12,975	34.60	99,200	80.00	69.46	14,021,875	28,043,750
Oil and gas
operations	11,275	30.07	--	--	6.98	1,409,375	2,818,750
Management
fee to
consultants	750	2.00	--	--	0.46	93,750	187,500
Working	375	1.00	--	--	0.23	46,875	93,750
1 capital
	37,500	100.00	124,000	100.00	100.00	20,187,500	40,375,000

The memoranda stated that up to 85 percent of the net cash-flow generated by the oil and gas activities would be utilized to increase oil and gas holdings and to pay off the partnerships' notes to FTRD and Sci-Teck.

SFA prepared an analysis of expected revenues from the partnerships from gas and oil well drilling operations. POGA prepared a similar analysis of the projected revenues from its gas and oil well drilling operations. The projected revenues from gas and oil well drilling would have been sufficient to completely retire the partnerships' notes to Sci-Teck and FTRD both as to principal and interest.

The partnerships did not include financial projections as to the Koppelman Process in the offering materials because of concerns about applicable securities laws. The memorandum clearly warned, however, that financial success, in terms of K-Fuel development, was highly unlikely. Reasons cited included (1) commercially unproven technology; (2) lack of experience; (3) conflict of interests; (4) large obligations incurred without arm's-length negotiations; (5) environmental and health problems; (6) severe competition; and (7) inadequate capital (after payments to the promoters and their associates).

III. The Promoters and Their Agents

A. Basile

Basile was a promoter of energy-related limited partnerships. At some point in 1981, Basile discussed a possible K-Fuel project with Werner Heim of Zurich, Switzerland, with whom Basile had an ongoing relationship. Heim had placed well in excess of $ 1 million at Basile's disposal for various projects. Thereafter, Intro-Continental was formed, and for services rendered by Basile, he received a 15-percent interest in Intro-Continental and in its wholly owned subsidiary, Ronodo. In August 1981, Basile became chairman, chief executive officer, and president of Petro-Syn, in which he owned 35 percent of the outstanding stock as of both August 31, 1981, and December 31, 1981. For services to Petro-Syn, Basile was to receive $ 25,000 annually for 3 years. Basile also was secretary-treasurer and director of FTRD and of FTOG.

According to the partnership memoranda, Basile's personal interests conflicted with the interests of SFA, POGA, and the limited partners. Basile was president and chief executive officer of Genoco Industries, Inc. (Genoco), and a promoter of Petrogene Oil & Gas Associates (Petrogene). The partnership memoranda stated that Genoco would engage in oil and gas activities similar to those engaged in by FTOG, and that Genoco would convert bagasse into synthetic fuel. Petro-Syn, Sci-Teck, Ronodo, Genoco, and Petrogene were all entities in which Basile had a proprietary interest and which stood to profit at the expense of the partnerships. In approximately May 1982, Basile sold his interests in Intro-Continental and Petro-Syn to Ronodo for $ 650,000.

B. Gaskell

Keith R. Gaskell (Gaskell) was one of the three principals of Chronometer. In early 1981, as general partner of Petrogene, Gaskell became familiar with the Koppelman Process. Gaskell devoted most of 1981 to the Petrogene project. Gaskell's interest in using the Koppelman Process for his Petrogene project involved bagasse as a fuel stock.

Gaskell had a background in engineering and management. In 1981, Gaskell discussed the Koppelman Process with Koppelman, SRI, Stone & Webster, and the DOE. Gaskell was attracted to the Koppelman Process by its low ash and sulfur content. During 1981, Gaskell believed that energy prices would continue to rise at a "real rate" of 4 percent. He believed that K-Fuel would be a cost-effective alternative to nuclear power, coal, and wood.

Gaskell employed Compunetics, Inc. (Compunetics), to review the profitability of the Koppelman Process. Compunetics prepared a report (the Compunetics report), in December of 1981, that concluded that the license fees to be paid to Sci-Teck were "well within the range of normal commercial practice." The Compunetics report was prepared by Dr. Samuel Hanna, a professor of mathematics and business at Boston University.

The Compunetics report concluded that, assuming that only one K-Fuel reactor tube were built, all of the notes due to Sci-Teck and FTRD would be fully paid by 1992. Assuming that on K-Fuel reactor tube were built the Compunetics report concluded that the rate of return to a limited partner on a present value basis would be not less than 17 percent. The Compunetics report concluded that if a four-reactor tube plant were built, and 250 limited partnership units were sold, the rate of return to the limited partners would be over 55 percent. The report did not examine the validity of its underlying assumptions, i.e., it did not determine whether the construction of a K-Fuel reactor was financially or technically possible. (The Compunetics report was admitted for nonhearsay purposes only. Petitioners rely on the report to demonstrate that Gaskell took steps consonant with a bona fide profit objective.)

In 1981, Gaskell requested that Lawrence Kurland (Kurland) of Hubbell, Cohen, Stiefel, and Gross review all of Koppelman's patents. Kurland was a patent attorney. Kurland reviewed the patents and the file histories of the patents with respect to the K-Fuel process. He concluded that the scope of Koppelman's patents was fairly broad and not restricted in any meaningful way. Kurland advised the partnership that, of the various technologies that he had investigated, the Koppelman Process had the best technological underpinnings. He concluded on the basis of his investigation that investing in the Koppelman Process involved a reasonable technical risk and that it was a sound investment. (Kurland did not testify as an expert witness. Petitioners rely on his testimony only to demonstrate that Gaskell took steps consonant with a bona fide profit objective.)

C. Rosenthal

According to the partnership memoranda, Peter B. Rosenthal (Rosenthal) was president of World Medical Marketing Corp. which used limited partnerships to produce and market medical video tapes. Rosenthal also was a promoter and a consultant to Genoco. According to the partnership memoranda, in 1975, Rosenthal was convicted under 18 U.S.C. sec. 371 of conspiracy to commit securities fraud. He was fined $ 10,000, served 4 months and 23 days at Allenwood, Pennsylvania, and was placed on 1-year's probation. Rosenthal was to be employed by Petro-Syn as a consultant. For services to Petro-Syn, Rosenthal was to receive $ 25,000 annually. At the time the partnerships were formed, Rosenthal owned 35 percent of the outstanding capital stock of Petro-Syn. Rosenthal also owned 15 percent of the stock of Intro-Continental and Ronodo, the parent company of Sci-Teck.

D. Aronson

Sometime in 1980, James M. Aronson (Aronson) placed in the Wall Street Journal a situation-wanted ad which came to the attention of Rosenthal. In August 1980, Rosenthal hired Aronson as a full-time employee of World Medical Marketing Corp. Aronson worked for Gaskell, searching for technology usable by Petrogene. At the same time, Aronson worked for Basile, searching out potential energy projects using the Koppelman Process. Aronson was attracted to the Koppelman Process because it could be used with a variety of feedstocks, as well as by the involvement of A.T. Kearney, SRI, the DOE, and Koppelman. Aronson recommended to the partnerships that North Carolina be chosen as the site to build the K-Fuel demonstration plant based upon North Carolina's favorable climate, the availability of raw materials, and its proximity to coal burning utilities that were regulated by the "Clean Air Act." Ultimately, as the result of "consensus decision" by Basile and others, Aronson was sent to the site of a K-Fuel plant to be constructed in North Carolina "to be in visual contact with what was going on" and to report back to Basile.

In early 1982, Aronson arranged for a site to locate the North Carolina plant and negotiated an agreement to obtain a supply of peat for the operation of the plant. When the plant was under construction, Aronson briefly lived in a tent adjacent to the North Carolina construction site. From 1982 through 1984, Aronson engaged in a variety of projects related to coordinating the construction of the North Carolina plant. The North Carolina plant opened in early 1984.

Aronson had discussions with various potential purchasers of K-Fuel including Carolina Power & Light. When the price of energy leveled off, Aronson refocused his sales efforts away from the high demand, low margin electric utility market, to the low demand, high profit charcoal briquette market with the hope of obtaining a profit under changed economic conditions. On July 27, 1983, SFA and POGA were granted the exclusive right to use the Koppelman Process in the State of North Carolina to produce char for use in the manufacture of charcoal briquettes.

Aronson was a stockholder of Petro-Syn. The partnership offering memoranda stated that Aronson was to receive $ 35,000 annually for services to Petro-Syn. He was also president of FTRD. His annual salary from FTRD initially was $ 35,000; later it was increased to $ 50,000. He also received a bonus of between $ 10,000 and $ 15,000.

E. Zukerman

In 1981, Michael Zukerman (Zukerman) was a partner in Baskin & Sears, a New York law firm, specializing in corporate law. Basile, as promoter of the K-Fuel project and a client of Baskin & Sears, brought Zukerman into the project as legal counsel. Zukerman, in turn, brought in Kurland. Zukerman, who had done legal work in a number of similar transactions, regarded himself as being in "the deal business." As such, Zukerman was brought into transactions by a promoter, such as Basile, with whom Zukerman had had a previous relationship. If the deal were not consummated, Zukerman would be paid by the promoter. If it succeeded, Zukerman would become counsel to the partnership and would be paid by the partnership.

Baskin & Sears prepared all promissory notes, contracts, and assumption agreements to be entered into by SFA, POGA, and their respective limited partners. None of these agreements was entered into at arm's length. Baskin & Sears owned 40 shares, or 4 percent, of the outstanding stock of Petro-Syn. The firm received payment for its services in the SFA/POGA project both from Intro-Continental and from Basile. Although Baskin & Sears looked upon Basile as "the client," the firm also represented Petro-Syn and the partnerships; the limited partners (investors) were not separately represented.

The "tax group" of Baskin & Sears rendered a tax opinion examining the SFA and POGA offerings and reviewed all pertinent documents to ensure that the transaction complied with section 465. Zukerman's understanding of the network was as follows:

It had to do with the tax structure, in order to accomplish the desired tax results, you have to have an independent licensor from a contract, and the partnership, in effect -- there was a diagram in the private placement memorandum which directed the cash and knowledge, and the whole concept was to establish an independent contractor, that's where Petro-Syn fell in, and you needed an independent licensor. The various other parties around it, Verrilli, Altschuler & Schwartz was the broker-dealer, Chronometer was the management company, and you had outside contractors, A.T. Kearny, Stone & Webster, Celas and Peatco. And the structure was really a tax structure to accomplish the desired tax end.

IV. The Investors

A. Petitioners Smith

The Smiths became limited partners in SFA in December of 1981 by purchase of one unit. The Smiths invested in their limited partnership interest in SFA, pursuant to a schedule calling for payment as follows:

Per unit
$ 10,000	Payable upon subscription to SFA
10,000	Due on Mar. 1, 1982
10,000	Due on Mar. 1, 1983
7,500	Due on Mar. 1, 1984
24,000	Due on Mar. 1, 1993
30,000	Due on Mar. 1, 1994
30,000	Due on Mar. 1, 1995
30,000	Due on Mar. 1, 1996
10,000	Due on Mar. 1, 2007
161,500

The Smiths' obligations to SFA were embodied in full recourse promissory notes. The Smiths made timely payments of principal for 1981, 1982, and 1983. Their 1984 principal payment was made in 1985. With Kaye's consent, the Smiths delayed until 1986 the interest payments due in 1982, 1983, and 1984.

On December 30, 1981, the Smiths entered into an agreement withSci-Teck pursuant to which they agreed to assume personal liability for SFA's obligations to Sci-Teck in the total amount of $ 99,200. On December 30, 1981, the Smiths entered into an agreement with FTRD pursuant to which they assumed SFA's liability to FTRD in the total amount of $ 24,800.

In the statutory notice sent to the Smiths, respondent explained his disallowance of their share of partnership losses as follows:

It is determined that the amounts of $ 40,392.00 and $ 38,316.00 shown on your returns for the taxable years 1981 and 1982 as your distributive share of losses from the SYN-FUEL ASSOCIATES partnership are not allowable since it has not been established that the losses were incurred in connection with an activity engaged in for profit or in connection with a trade or business.

It is further determined that your investment in the SYN-FUEL ASSOCIATES partnership is lacking in economic substance other than the avoidance of tax.

It is further determined that no portion of the claimed losses from the SYN-FUEL ASSOCIATES partnership represents expenditures for research and development under the provisions of section 174 of the Internal Revenue Code of 1954.

Accordingly, your taxable income is increased $ 40,392.00 and $ 38,316.00 for the taxable years 1981 and 1982 respectively.

In the alternative, it is determined that -- should any portion of the claimed losses from the SYN-FUEL ASSOCIATES partnership be deemed allowable -- said allowable portion is limited to the amount which was at risk under the provisions of section 465 of the Internal Revenue Code of 1954 during the taxable year; and that the amount which was at risk does not exceed the amount of your net cash investment in the SYN-FUEL ASSOCIATES partnership which was paid during the taxable year.

B. Petitioner Karr

Karr and Robert H. Bluhm (Bluhm) became limited partners of POGA in December of 1981 by purchasing one unit as tenants in common. For purposes of this case, Karr will be deemed to have purchased a one-half unit of POGA. Bluhm is not a party to this proceeding. Because Karr purchased only a one-half unit of POGA, his liability was as follows:

Per one-half unit
$ 5,000	Payable upon subscription to POGA
5,000	Due on Mar. 1, 1982
5,000	Due on Mar. 1, 1983
3,750	Due on Mar. 1, 1984
12,000	Due on Mar. 1, 1993
15,000	Due on Mar. 1, 1994
15,000	Due on Mar. 1, 1995
15,000	Due on Mar. 1, 1996
5,000	Due on Mar. 1, 2007
80,750

Karr's obligations to POGA were embodied in full recourse promissory notes. Karr timely made all of the payments due to POGA between 1981 and 1984, including interest.

On December 29, 1981, Karr entered into an agreement with Sci-Teck whereby he agreed to assume personal liability for POGA's obligations to Sci-Teck in the total amount of $ 49,600. On December 29, 1981, Karr entered into an agreement with FTRD whereby he assumed POGA's liability to FTRD in the total amount of $ 12,400.

In the statutory notice sent to the Karrs, respondent explained his disallowance of their share of partnership losses as follows:

It is determined that the activity in which the partnership was engaged was not entered into for a profit. Accordingly, the income shown on the returns is adjusted in accordance with IRS section 183.

It is determined that the amount of $ 505,897 shown on your return for 1982 as interest expense is not allowed because the liability on which it is based is contingent in nature and the notes lack economic substance.

It is determined that the amounts shown are disallowed in full because it has been determined that the partnership activity was not entered into for a profit within the meaning of IRS section 183.

It has been determined that the partnership activity was not engaged in for profit, and accordingly, no investment credit is allowable with respect to any property acquired by the partnership.

V. The Experts

A. Lam

Jeffrey Lam (Lam), petitioners' first expert witness, submitted a report examining the oil and gas investments of SFA and POGA. Lam is an engineer registered in Texas. He holds a bachelor of science degree in petroleum engineering from the University of Texas, and he is president of Newington Petroleum Consultants, Inc., a firm that appraises oil and gas properties.

In his report, Lam examined the assumptions used by SFA and POGA to calculate the projected production, revenues, and cash-flow set forth in the offering memoranda. Lam concluded that the assumptions used by the partnerships were reasonable and consistent with industry practice. He opined that the projections of production and net revenue set forth in the memoranda were acceptable and reasonable.

B. Pomerantz

Martin L. Pomerantz (Pomerantz), petitioners' second expert witness, submitted a report examining the market potential of K-Fuel slurries. Pomerantz is an engineer registered in Pennsylvania. He holds a Ph.D. degree in mechanical engineering from the University of Pittsburgh, and he is executive vice president of Fuels Utilization Research Institute, a firm that develops co-generation and fuel conversion programs.

In his report, Pomerantz examined slurry fuel technology and boiler retro-fit information available in 1981. Based on this information, and in light of 1981 oil price forecasts, Pomerantz concluded that in 1981 it would have been reasonable to predict a 1985 K-Fuel market of 520,000 tons of K-Fuel per year in North Carolina alone.

C. Plummer and Thomas

James L. Plummer (Plummer) and Thomas C. Thomas (Thomas) prepared the final expert witness report submitted by petitioners. Plummer holds a Ph.D. degree in econometrics from Cornell University and is the author of numerous books concerning the economics of energy and venture capital formation. Thomas holds a Ph.D. degree in economics from the Massachusetts Institute of Technology. In their report, Plummer and Thomas examined whether SFA and POGA had reasonable prospects for profitability in 1981. The report also discussed whether the price paid by the partnerships for licensing the Koppelman Process corresponded to reasonable fair market value.

In determining whether SFA and POGA had reasonable prospects for profitability in 1981, Plummer and Thomas drew upon a wide variety of sources to estimate the capital and operating costs of commercial K-Fuel plants. Plummer and Thomas assumed that the partnerships would not internally finance full-scale commercial operations, but would instead form a joint venture with an electric utility in the region. Relying on a variety of assumptions concerning the division of profits between the partnerships and their joint venture partner, Plummer and Thomas concluded that the partnerships could achieve a pre-tax internal rate of return in excess of 25 percent. If the K-Fuel were marketed as a component of an oil slurry, the partnerships' rate of return could have exceeded 40 percent. Plummer and Thomas concluded that SFA and POGA had reasonable prospects of profitability in 1981.

In determining whether the price paid by the partnerships for licensing the technology was reasonable, Plummer and Thomas compared the rate of return sought by the partnerships to that sought by Occidental Petroleum in a much larger and riskier shale oil project in Colorado. The report then compared the price paid by the partnerships with that paid by Diamond Shamrock Corp. and Theodore Venners in 1984. Finally, the report compared the price paid by the partnerships to that paid by Ronodo to Koppelman. The report concluded that the two to one step-up in price from the Ronodo purchase to the purchase by the partnerships was a reasonable cost for the syndication of risk among a large pool of investors. Plummer and Thomas opined that "the agreement between the Limited Partnerships and Sci-Teck was within the range of fair market values."

OPINION

Respondent has conceded that petitioners may deduct their distributive shares of partnership losses attributable to oil and gas investments and may use their distributive shares of any credits attributable to those oil and gas investments. The only deductions in issue, therefore, are the partners' distributive shares of losses represented by payments to Sci-Teck for license fees and to FTRD for research and development, including interest claimed by POGA and disallowed in the statutory notice sent to the Karrs. The parties agree that the claimed losses are deductible only if incurred in an activity engaged in for profit and, specifically with respect to the research and development expenses, in connection with a trade or business. Respondent also asserts other grounds for disallowing the deductions to the extent that they are based on notes, rather than cash. The parties disagree about who has the burden of proof on respondent's alternative arguments in the Karrs' case. If, however, we decide that the partnerships, and consequently petitioners, are not entitled to any deductions, we need not reach the grounds for disallowing deductions not represented by cash payments.

Profit Objective and Economic Substance

Determination of whether an activity is undertaken for profit is generally referred to as involving a "section 183 issue." Section 183 initially served to distinguish between business objectives and personal objectives, but in recent years has been used frequently to compare business objectives with tax objectives. See generally Brannen v. Commissioner, 78 T.C. 471">78 T.C. 471, 506-507 (1982), affd. 722 F.2d 695">722 F.2d 695 (11th Cir. 1984); Jasionowski v. Commissioner, 66 T.C. 312">66 T.C. 312, 321 (1976). In Rose v. Commissioner, 88 T.C. 386">88 T.C. 386, 414 (1987), on

SWIFT; RUWE

SWIFT, J., concurring: Neither of the two U.S. Courts of Appeals that have already analyzed the precise investment herein, nor any of the other Courts of Appeals, have adopted and applied the "unified" generic tax-shelter test of Rose v. Commissioner, 88 T.C. 386 (1987), affd. 868 F.2d 851">868 F.2d 851 (6th Cir. 1989).¹ Even the majority's opinion in this case indicates that "in the future" (majority op. p. 9) the Tax Court may decide not to follow the unified generic tax-shelter test of Rose.

I would make that decision now. I would no longer follow Rose, and I would conclude that the test that should be utilized to evaluate the profit-objective element of passive tax-sheltered investments is the "actual and honest" profit-objective test reflected in so many of our recent opinions. As discussed below, I believe a "primary" profit-objective test, as suggested by Judge Ruwe in his concurring opinion -- that is not found in the relevant statutory or regulatory scheme, that is in my opinion contrary to commercial and financial reality, and that has been utilized by the Supreme Court only in the context of evaluating whether an activity is in the nature of a hobby activity as distinguished from a trade or business activity -- is too strict.

Over the years, in the context of analyzing passive, tax-sheltered investments, the courts have not been consistent in the language used to describe the quantity or level of profit objective that must be established: (1) Under section 183; (2) under the profit-objective aspect of the sham-transaction doctrine; and (3) under the profit-objective aspect of the economic-substance doctrine. The inconsistent profit-objective language that has been used has included, among other language, the following: "Basic", "dominant", "primary", "predominant", "substantial", "reasonable", "bona fide", and "actual and honest". As one court commented, we have been "glutted with tests. Many such tests proliferate because they give the comforting illusion of consistency and precision. They often obscure rather than clarify." Collins v. Commissioner, 857 F.2d 1383">857 F.2d 1383, 1386 (9th Cir. 1988), affg. Dister v. Commissioner, T.C. Memo. 1987-217.

Some courts have used different, inconsistent language in the same opinion. For example, one recent opinion suggested that investors have to establish that they had a "dominant" profit objective, but also that "the determination crucial to the instant case [was] whether the taxpayers had an actual and honest profit objective." Nickeson v. Commissioner, 962 F.2d 973">962 F.2d 973, 976 (10th Cir. 1992), affg. Brock v. Commissioner, T.C. Memo 1989-641">T.C. Memo. 1989-641. Another opinion suggested that investors must show a "primary" profit objective, but then suggested that the test for sham-transaction purposes was whether "the transaction has any practicable economic effects other than" tax benefits. Bryant v. Commissioner, 928 F.2d 745">928 F.2d 745, 748 (6th Cir. 1991), affg. in part, revg. in part, and remanding T.C. Memo. 1989-527. (Emphasis added.)

The Tax Court, however, in the last 5 years and with few exceptions -- in evaluating passive, tax-sheltered investments and in an attempt to bring some uniformity to the language and the analysis associated with the determination of profit objective -- has consistently stated the test relating to profit objective to be whether the investors had an "actual and honest" profit objective (or whether the investors had a "bona fide", "good faith", or "any" profit objective -- language, in my opinion, synonymous with "actual and honest"). Generally, no particular attempt has been made by the Tax Court to quantify the amount of profit objective required (i.e., to disallow claimed tax benefits where the investors' profit objective was actual and honest but not primary).

According to my research, in over 123 of the 131 Tax Court division and memorandum opinions issued since 1987 in which profit objective was at issue in the context of passive, tax-sheltered investments, we applied the "actual and honest" profit-objective test, or a synonymous test, in evaluating whether passive investors had the requisite profit objective. See, e.g., Krause v. Commissioner, 99 T.C. 132">99 T.C. 132 (1992); Marine v. Commissioner, 92 T.C. 958">92 T.C. 958 (1989), affd. without published opinion 921 F.2d 280">921 F.2d 280 (9th Cir. 1991); McCrary v. Commissioner, 92 T.C. 827">92 T.C. 827 (1989); Levy v. Commissioner, 91 T.C. 838">91 T.C. 838 (1988); Antonides v. Commissioner, 91 T.C. 686 (1988), affd. 893 F.2d 656">893 F.2d 656 (4th Cir. 1990); Soriano v. Commissioner, 90 T.C. 44">90 T.C. 44 (1988); Fielding v. Commissioner, T.C. Memo. 1992-553; Universal Research and Development Partnership No. 1 v. Commissioner, T.C. Memo. 1991-437; Schwartz v. Commissioner, T.C. Memo. 1991-380; Berry v. Commissioner, T.C. Memo. 1991-145;Charlton v. Commissioner, T.C. Memo. 1990-402; Bukove v. Commissioner, T.C. Memo. 1989-588;Golden v. Commissioner, T.C. Memo. 1989-514; Keenan v. Commissioner, T.C. Memo. 1989-300; Brown v. Commissioner, T.C. Memo. 1988-527.

The U.S. Courts of Appeals have been less consistent. Nearly every circuit, however, in at least one opinion, has utilized the "actual and honest" profit objective-test (or a synonymous non-quantitative test) without any reference to a "primary" or "dominant" profit-objective requirement. See, for example --

1st Circuit:

Estate of Power v. Commissioner, 736 F.2d 826">736 F.2d 826 (1st Cir. 1984), affg. T.C. Memo 1983-552">T.C. Memo. 1983-552;

2d Circuit:

Schley v. Commissioner, 375 F.2d 747">375 F.2d 747 (2d Cir. 1967), affg. T.C. Memo. 1965-111;

3d Circuit:

Weir v. Commissioner, 109 F.2d 996 (3d Cir. 1940), affg. in part and revg. in part 39 B.T.A. 400">39 B.T.A. 400 (1939);

4th Circuit:

Faulconer v. Commissioner, 748 F.2d 890">748 F.2d 890 (4th Cir. 1984), revg. and remanding T.C. Memo 1983-165">T.C. Memo. 1983-165; Malmstedt v. Commissioner, 578 F.2d 520">578 F.2d 520, 527 (4th Cir. 1978), revg. T.C. Memo 1976-46">T.C. Memo. 1976-46;

6th Circuit:

Smith v. Commissioner, 937 F.2d 1089">937 F.2d 1089 (6th Cir. 1991), revg. 91 T.C. 733">91 T.C. 733 (1988); Campbell v. Commissioner, 833">868 F.2d 833 (6th Cir. 1989), affg. in part, revg. in part and remanding T.C. Memo 1986-569">T.C. Memo. 1986-569;

7th Circuit:

Burger v. Commissioner, 809 F.2d 355">809 F.2d 355 (7th Cir. 1987), affg. T.C. Memo. 1985-523; Glimco v. Commissioner, 397 F.2d 537">397 F.2d 537, 540 (7th Cir. 1968), affg. T.C. Memo. 1967-119;

8th Circuit:

Evans v. Commissioner, 908 F.2d 369">908 F.2d 369 (8th Cir. 1990), revg. T.C. Memo. 1988-468;

9th Circuit:

Hillendahl v. Commissioner, 976 F.2d 737">976 F.2d 737 (9th Cir. 1992), affg. without published opinion Noonan v. Commissioner, T.C. Memo. 1986-449; Sochin v. Commissioner, 843 F.2d 351 (9th Cir. 1988), affg. Brown v. Commissioner, 85 T.C. 968">85 T.C. 968 (1985);

10th Circuit:

Clark v. Commissioner, 951 F.2d 1258">951 F.2d 1258 (10th Cir. 1991), affg. without published opinion T.C. Memo 1989-598">T.C. Memo. 1989-598;

D.C. Circuit:

Cornfeld v. Commissioner, 797 F.2d 1049">797 F.2d 1049 (D.C. Cir. 1986), revg. and remanding T.C. Memo. 1984-105; Dreicer v. Commissioner, 665 F.2d 1292">665 F.2d 1292 (D.C. Cir. 1981), revg. and remanding T.C. Memo 1979-395">T.C. Memo. 1979-395.

I submit that the "primary" profit-objective test suggested by Judge Ruwe ignores the commercial and business reality that the tax laws affect the shape of most business transactions. Frank Lyon Co. v. United States, 435 U.S. 561">435 U.S. 561, 580 (1978). The underlying activity on which a passive, tax-sheltered investment is typically structured generally constitutes an activity that carries with it (assuming it is not a sham) significant tax benefits. The availability of the tax benefits, or tax shelter, is often the reason the particular activity (e.g., equipment leasing) is selected in preference to an activity that does not carry with it significant tax benefits (e.g., undeveloped land). The presence, therefore, of significant tax benefits (that may even represent the investor's primary objective for entering into the transaction) should not result in the loss of the associated tax benefits if the investor, in fact, has an actual and honest profit objective apart from the tax benefits (and assuming the transaction is not a sham).

We have expressly recognized the above proposition in a number of situations where Congress has made available particular tax benefits with the specific intent of providing investors special incentives to enter into investments that they might not otherwise enter into. See, e.g., Levy v. Commissioner, 91 T.C. 838">91 T.C. 838, 853, 871-872 (1988); Friendship Dairies, Inc. v. Commissioner, 90 T.C. 1054">90 T.C. 1054, 1064 (1988); Estate of Thomas v. Commissioner, 84 T.C. 412">84 T.C. 412, 432 (1985);Fox v. Commissioner, 82 T.C. 1001">82 T.C. 1001, 1021 (1984).

Respondent's own "bible" on leveraged, equipment-leasing transactions recognizes this proposition and requires only a nominal profit objective. See Rev. Proc. 75-21, 1 C.B. 715">1975-1 C.B. 715, 716; see also Macan & Umbrecht, "Tax Aspects of Equipment; Leasing", in Equipment Leasing -- Leveraged Leasing, 313, 430-436 (Fritch et al. eds., 3d ed. 1988).

Similarly, in the instant case, which involves research and development activities, by enactment of section 174 and by making available certain tax benefits thereunder, Congress sought to "stimulate the search for new products and new inventions upon which the future economic and military strength of our Nation depends." Snow v. Commissioner, 416 U.S. 500">416 U.S. 500, 503 (1974). In reversing our opinion in Smith v. Commissioner, 937 F.2d 1089 (6th Cir. 1991), the Sixth Circuit explicitly recognized that the exact same investment activity as the activity at issue in the instant case is a tax-favored investment under section 174, as follows:

Snow made it clear that "section 174 was enacted in 1954 to dilute some of the conception of 'ordinary and necessary' business expenses under section 162(a)." * * * We deem the kind of enterprise to develop the Koppelman process and K-Fuel reactors as a type of "small" and "upcoming" partnership enterprise encouraged in Snow. [Smith v. Commissioner, 937 F.2d 1089">937 F.2d 1089, 1097-1098 (6th Cir. 1991); citations omitted.]



See also Diamond v. Commissioner, 930 F.2d 372">930 F.2d 372, 374 (4th Cir. 1991), affg. 92 T.C. 423">92 T.C. 423 (1989); Green v. Commissioner, 83 T.C. 667">83 T.C. 667, 686 (1984).

Judge Ruwe's concurring opinion cites the Supreme Court's opinion in Commissioner v. Groetzinger, 480 U.S. 23 (1987), as support for his suggestion that we should require taxpayers to prove a "primary" profit objective in analyzing the allowability of tax benefits associated with passive, tax-sheltered investments. In Commissioner v. Groetzinger, supra at 35, the Supreme Court utilized a "primary" profit-objective test to ascertain whether a taxpayer was engaged in the active conduct of a gambling trade or business activity or whether the taxpayer's gambling activity was merely a hobby. As stated by the Supreme Court, "the taxpayer's primary purpose for engaging in the activity must be for income or for profit. A sporadic activity, a hobby, or an amusement diversion does not qualify." Id.²

The hobby-loss issue in Groetzinger is distinguishable from issues arising in the context of tax-sheltered investments, and as suggested in Snyder v. United States, 674 F.2d 1359">674 F.2d 1359, 1363 (10th Cir. 1982), the primary profit-objective test should only apply when distinguishing between a hobby and a trade or business activity. See also Carkhuff v. Commissioner, 425 F.2d 1400">425 F.2d 1400, 1404 (6th Cir. 1970), affg. T.C. Memo. 1969-66; Schley v. Commissioner, supra at 750. As noted in Johnson v. United States, 11 Cl. Ct. 17">11 Cl. Ct. 17, 27, 58 AFTR 2d 86-5893, at 86-5901, 86-2 USTC par. 9705, at 85,705, (1986), "the predominant profit motive cases under section 162 have importance only in the 'hobby loss' context, and do not control in a business situation" and a primary profit-objective test is not supported by relevant statutory language or legislative history.

Continuing, the Johnson court explained --

Economic and tax motives regularly operate side by side to influence business transactions, and it would be unfair and contrary to the realities of the marketplace to apply a "primary or dominant" test to them. * * * [Johnson v. United States, 11 Cl.Ct. at 27.]

As observed by the Court of Appeals for the Fourth Circuit in Faulconer v. Commissioner, 748 F.2d 890">748 F.2d 890, 895-896 n.10 (4th Cir. 1984), neither section 183 nor the regulations thereunder require a "primary" or "dominant" profit objective. All that is required is "a profit" objective.

In summary, in my opinion, Judge Ruwe's suggested "primary" profit-objective test should not apply in this case (involving tax benefits claimed under section 174), and such a test should not apply generally to typical passive, tax-sheltered investments that are structured largely on the basis of the extensive tax benefits that Congress has made available.

If a tax-sheltered investment is a sham, if it has no economic substance, if the investor had no actual and honest profit objective, or so negligible a profit objective that it should be ignored, let the courts so find, and let the courts reject the claimed tax benefits. But I would spare us, other courts, the IRS, and the tax bar, the task of evaluating whether, for example, a $ 5,000 before-tax profit when compared to $ 20,000 of tax benefits provides a sufficient non-tax profit for one investor but not for another.

WELLS and WHALEN, JJ., agree with this concurring opinion.

RUWE, J., concurring: I agree with the result reached by the majority; however, because the Court of Appeals for the Sixth Circuit reversed our holding in Smith v. Commissioner, 91 T.C. 733">91 T.C. 733 (1988), revd. 937 F.2d 1089">937 F.2d 1089 (6th Cir. 1991), and disagreed with our "generic tax-shelter analysis", I wish to express my views on the utility of continuing to use that analysis and on the profit-objective requirement of section 183.

The Generic Tax-Shelter Analysis

The generic tax-shelter analysis was first articulated in Rose v. Commissioner, 88 T.C. 386 (1987), affd. 868 F.2d 851">868 F.2d 851 (6th Cir. 1989). It attempted to combine the test for determining whether there was profit objective with the test for determining whether a transaction had economic substance. The goals of the unified test were to "emphasize objective factors", "not require weighing the objective facts against a taxpayer's statement of his intent," "be more understandable to taxpayers who doubt our ability to determine their subjective state of mind", and treat similarly situated taxpayers the same. Rose v. Commissioner, 88 T.C. at 414.

While these goals were laudable, a close look at the analysis in Rose leads me to the conclusion that the unified approach required findings with respect to the same subjective and objective factors that the separate tests required. ¹ That being the case, the results produced by the unified analysis will be the same as those produced by the separate tests. However, since many tax shelter-type cases can be totally disposed of by using either the subjective profit-objective test, see Hayden v. Commissioner, 889 F.2d 1548 (6th Cir. 1989), affg. T.C. Memo. 1988-310; Thomas v. Commissioner, 792 F.2d 1256">792 F.2d 1256 (4th Cir. 1986), affg. 84 T.C. 1244">84 T.C. 1244 (1985); Seaman v. Commissioner, 84 T.C. 564 (1985), or the economic substance test, see Illes v. Commissioner, 982 F.2d 163">982 F.2d 163 (6th Cir. 1992); ²Cherin v. Commissioner, 89 T.C. 986">89 T.C. 986 (1987); ³James v. Commissioner, 87 T.C. 905 (1986), affd. 899 F.2d 905">899 F.2d 905 (10th Cir. 1990), there is no apparent benefit to be gained by continuing to apply a unified approach requiring both tests.

The unified approach, if properly used, does not lead to erroneous results. See Collins v. Commissioner, 857 F.2d 1383">857 F.2d 1383, 1386 (9th Cir. 1988), affg. T.C. Memo. 1987-217. However, there has been some misunderstanding of what we intended. For example, the Court of Appeals for the Sixth Circuit in Smith v. Commissioner, 937 F.2d 1089">937 F.2d 1089 (6th Cir. 1991), concluded that we had used a profit-motive test that focused on whether the taxpayer's subjective expectation of profit was "reasonable" rather than focusing on whether the profit objective was actual and honest. This was not our intention. (See majority op. p. 8.) Nevertheless, because the unified approach has been misunderstood, has been rejected by several Courts of Appeals, ⁴ and is not particularly helpful, I would discontinue using it.

The Profit-Objective Test

The Court of Appeals for the Sixth Circuit in Smith, believed that we were clearly erroneous in finding that there was no actual and honest profit objective.

We find it error to have concluded on the facts and record that the Smiths were motivated by "no business purposes" * * *. [Smith v. Commissioner, 937 F.2d at 1098-1099; emphasis in original.]



If our finding that the taxpayers had no profit objective was erroneous, our holding that the transaction was a sham under the unified generic tax-shelter test would have been error. See McCrary v. Commissioner, 92 T.C. 827">92 T.C. 827, 845 (1989). ⁵ However, the mere existence of a profit objective will not necessarily result in the allowance of deductions. A taxpayer still must meet the separate subjective test inherent in sections 162 and 183 requiring that the taxpayer's primary purpose for engaging in the activity was to make a profit. See Cato v. Commissioner, 99 T.C.    ,     (1992) (slip op. p. 21). ⁶

The requirement that the activity be engaged in primarily for profit is the test used by the Court of Appeals for the Sixth Circuit. Hayden v. Commissioner, 889 F.2d 1548">889 F.2d 1548, 1552 (6th Cir. 1989), affg. T.C. Memo 1988-310">T.C. Memo. 1988-310. In Bryant v. Commissioner, 928 F.2d 745">928 F.2d 745, 748 (6th Cir. 1991), affg. in part and revg. in part T.C. Memo 1989-527">T.C. Memo. 1989-527, the court stated:

A taxpayer may deduct development costs only if the primary objective of the mining venture was to make a profit. Collins v. Commissioner, 857 F.2d 1383">857 F.2d 1383, 1385 (9th Cir. 1988); sec. 183. However, the court shall not inquire into a transaction's primary objective until it determines that the transaction is not a sham. Collins, 857 F.2d at 1385; Rose v. Commissioner, 868 F.2d 851">868 F.2d 851, 853 (6th Cir. 1989).

In Bryant, as in Smith, the Court of Appeals reversed the Tax Court's finding that the mining venture was a sham without economic substance. In Bryant, the Court of Appeals remanded the case to the Tax Court for a finding of whether the requisite profit objective was present. However, in Smith, the Court of Appeals did not remand the case in order for us to determine whether the requisite profit objective was present, nor did it make an independent finding that profit was the taxpayers' primary objective. ⁷

The distinction between finding that the taxpayers had a profit objective and finding that profit was their primary objective cannot be dismissed as mere semantics. Section 183 provides that, except as otherwise allowed in that section, no deduction is allowable that is attributable to an activity which is "not engaged in for profit".⁸Section 183(c) states that the term "activity not engaged in for profit" should be defined by standards used in sections 162 and 212. The profit standards applicable to section 212 are the same as those used in section 162. See Agro Science Co. v. Commissioner, 934 F.2d 573">934 F.2d 573 (5th Cir. 1991), affg. T.C. Memo 1989-687">T.C. Memo. 1989-687; Antonides v. Commissioner, 893 F.2d 656 (4th Cir. 1990), affg. 91 T.C. 686">91 T.C. 686 (1988). In order for expenses to be deductible under section 162, the activity in which they are incurred must meet the profit-objective standard necessary to be a "trade or business" within the meaning of section 162. As explained by the Supreme Court:

Section 162(a) provides a deduction for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Although the statute does not expressly require that a "trade or business" must be carried on with an intent to profit, this Court has ruled that a taxpayer's activities fall within the scope of § 162 only if an intent to profit has been shown. See Commissioner v. Groetzinger, 480 U.S. 23">480 U.S. 23, 35 (1987) * * * [Portland Golf Club v. Commissioner, 497 U.S. 154">497 U.S. 154, 164 (1990).]



In Commissioner v. Groetzinger, 480 U.S. 23">480 U.S. 23 (1987), the Supreme Court made clear that in order for a taxpayer to be in a trade or business, within the meaning of section 162, the "primary purpose" for engaging in the activity must be for profit. The Supreme Court stated that:

the taxpayer must be involved in the activity with continuity and regularity and * * * the taxpayer's primary purpose for engaging in the activity must be for income or profit. * * * [Commissioner v. Groetzinger, 480 U.S. at 35; accord Portland Golf Club v. Commissioner, supra.] ⁹

Accord Portland Golf Club v. Commissioner, supra.

Even before Groetzinger was decided, the Tax Court had held that deductibility under section 162 required that the taxpayer's "primary purpose" for engaging in the activity be for profit.

In order to find that the partnership's coal venture constituted the carrying on of a trade or business, we must first find that the partnership engaged in the activity with the primary and predominant purpose and objective of making a profit. Brannen v. Commissioner, 722 F.2d 695">722 F.2d 695, 704 (11th Cir. 1984), affg. 78 T.C. 471">78 T.C. 471 (1982); Ramsay v. Commissioner, supra at 810; Surloff v. Commissioner, supra at 232-233. As used in this context, "primary" means "of first importance" or "principally," and "profit" means economic profit, independent of tax savings. Surloff v. Commissioner, supra at 233. While a reasonable expectation is not required, the profit objective must be bona fide. Fox v. Commissioner, 80 T.C. 972">80 T.C. 972, 1006 (1983), affd. without published opinion 742 F.2d 1441">742 F.2d 1441 (2d Cir. 1984), affd. sub nom. Barnard v. Commissioner, 731 F.2d 230 (4th Cir. 1984), affd. without published opinion sub nom. Krasta v. Commissioner, 734 F.2d 6">734 F.2d 6 (3d Cir. 1984), affd. without published opinion sub nom. Hook v. Commissioner, 734 F.2d 5">734 F.2d 5 (3d Cir. 1984).[Seaman v. Commissioner, 84 T.C. 564">84 T.C. 564, 588 (1985); accord Thomas v. Commissioner, 84 T.C. 1244">84 T.C. 1244, 1269 (1985), affd. 792 F.2d 1256">792 F.2d 1256 (4th Cir. 1986).] ¹⁰

This same requirement has been described by the Court of Appeals for the Sixth Circuit in the following terms:

The threshold inquiry in determining whether an activity is a trade or business or is carried on for the production of income is whether the activity is engaged in for the primary purpose and dominant hope and intent of realizing a profit. Godfrey v. Commissioner, 335 F.2d 82">335 F.2d 82, 84 (6th Cir. 1964), cert. denied, 379 U.S. 966">379 U.S. 966, 85 S. Ct. 660">85 S.Ct. 660, 13 L. Ed. 2d 560">13 L.Ed.2d 560 (1965). In this context, "profit" means economic profit, independent of tax savings. Campell, 868 F.2d at 836. The burden of proving the requisite profit motive is on the taxpayer. Rules of Practice and Procedure of the United States Tax Court, Rule 142(a) (Jan. 1, 1984). A finding regarding a taxpayer's motivation is purely one of fact, and as such may not be disturbed on appeal unless shown to be clearly erroneous. * * * [Hayden v. Commissioner, 889 F.2d 1548">889 F.2d 1548, 1552 (6th Cir. 1989), affg. T.C. Memo. 1988-310; fn. ref. omitted.] ¹¹

"Primary" means first; principal; chief; leading; and first in rank or importance. Black's Law Dictionary 1190 (6th ed. 1990); Webster's Third New International Dictionary (1971), and we have previously held that "primary" means "of first importance" or "principally". Fox v. Commissioner, 82 T.C. 1001">82 T.C. 1001, 1022 (1984), Seaman v. Commissioner, supra at 588; Thomas v. Commissioner, supra at 1269. See Malat v. Riddell, 383 U.S. 569">383 U.S. 569, 572 (1966); Surloff v. Commissioner, 81 T.C. 210">81 T.C. 210, 233 (1983). If two or more objectives or purposes motivated a taxpayer to engage in an activity, courts must determine which one was "primary". Thus, if a taxpayer was motivated by both profit and tax objectives, we must determine if profit was the "primary" objective. Seaman v. Commissioner, supra at 588, 590; ¹² see Estate of Baron v. Commissioner, 83 T.C. 542">83 T.C. 542, 558 (1984), affd. 798 F.2d 65">798 F.2d 65 (2d Cir. 1986); cf. Commissioner v. Soliman, 506 U.S.    , 113 S. Ct. 701, 702 (1993) (determining whether an office in a taxpayer's home qualifies as his "principal" place of business requires a comparative analysis of the various business locations used by the taxpayer).

In applying the appropriate profit-motive standard, it must be recognized that tax considerations play a part in most, if not all, business decisions. Comparison of a taxpayer's profit motive with other motives will sometimes be difficult. At times, it will be necessary to reconcile the profit-motive requirement with statutory tax incentives intended to promote certain types of activities. We have recognized that there are certain situations where deductions and credits are congressionally authorized even though an economic profit, independent of tax considerations, is not the primary objective. Fox v. Commissioner, supra, at 1021. However, the deductions in the instant case do not fall within such an exception. It is true that some of the partnership deductions were for research and development expenditures, and that Congress provided some relief for research and development expenses in section 174 by allowing such expenses to be deducted if incurred "in connection with" a trade or business. That relief simply allowed deductions to be taken before the commencement of the trade or business operations as opposed to the normal section 162 requirement that deductions be limited to expenses incurred "in carrying on" a trade or business. See Snow v. Commissioner, 416 U.S. 500">416 U.S. 500 (1974); Zink v. United States, 929 F.2d 1015 (5th Cir. 1991). Section 174 provided no relief from the requirement that the taxpayer must be engaged in a trade or business at some time, see Green v. Commissioner, 83 T.C. 667">83 T.C. 667 (1984), nor did it provide relief from the requirement that in order to be a trade or business, the "primary" objective for engaging in the activity must be for profit. Nickeson v. Commissioner, 962 F.2d 973">962 F.2d 973, 976 (10th Cir. 1992); Agro Science Co. v. Commissioner, 934 F.2d 573">934 F.2d 573, 576, (5th Cir. 1991), affg. T.C. Memo. 1989-687. ¹³

The generic tax-shelter analysis used by us in Smith v. Commissioner, supra, did not require us to determine whether the taxpayers engaged in the activity with the primary purpose of making a profit. However, based on our opinion in Smith and the majority opinion in this case, it is clear that Judge Cohen believed that profit was not the primary objective. In reversing our holding in Smith, the Court of Appeals for the Sixth Circuit did not find that the taxpayers engaged in their Koppleman-process activities with the primary objective of making a profit. Had that requirement been considered by the Court of Appeals, the result may well have been different. See Thomas v. Commissioner, 792 F.2d 1256">792 F.2d 1256, 1258, 1259 (4th Cir. 1986), affg. 84 T.C. 1244">84 T.C. 1244 (1985). ¹⁴

Respondent disallowed deductions for both lack of economic substance and lack of the requisite profit objective. Petitioners cannot prevail by simply proving that the activity had economic substance and that they had a profit objective. They must also prove that profit was their "primary" purpose for engaging in the activity. This, they have not done.

CHABOT, JACOBS, GERBER, and PARR, JJ., agree with this concurring opinion.

---

Footnotes

• 1. Cases of the following petitioners are consolidated herewith: Syn-Fuel Associates, 1982, John McCurdy, A Partner Other Than the Tax Matter Partner, docket No. 20081-88; Peat Oil and Gas Associates, James Karr, A Partner Other Than the Tax Matters Partner, docket No. 20130-88; Peat Oil and Gas Associates, A Limited Partnership, Joseph Yadgaroff, A Partner Other Than the Tax Matters Partner, docket No. 820-91; Syn-Fuel Associates, A Limited Partnership, Keith Gaskell, A Partner Other Than the Tax Matters Partner, docket No. 24514-91; and Peat Oil and Gas Associates, A Limited Partnership, Robert Ferguson, A Partner Other Than the Tax Matters Partner, docket No. 30440-91.↩

• 7. For example, Basile's personal interests conflicted with the interests of POGA and SFA. Basile was President and Chief Executive Officer of Genoco Industries, Inc. (Genoco), and a promoter of Petrogene Oil and Gas Associates (Petrogene). The partnership memorandum warned that Genoco would engage in oil and gas activities similar to those engaged in by FTOG, and that Genoco planned to convert bagasse into synthetic fuel. Basile had a proprietary interest in Petro-Syn, Sci-Teck, Ronodo, Genoco, and Petrogene, all entities which stood to profit at the expense of the partnerships.↩

• 1. Unless otherwise indicated, all section references are to the Internal Revenue Code as amended and in effect during the years in issue.↩

• 1. Interest on the limited partners' short-term notes will be added to working capital. This interest is estimated at approximately $ 28,125 in 1982, $ 140,625 in 1983, and 189,845 in 1984 if 125 units are sold and $ 56,250 in 1982, $ 281,250 in 1983, and $ 379,690 in 1984 if all 250 units are sold. The general partner will seek to maintain working capital at $ 150,000 and will retain funds whenever it falls below that level in order to replenish it.↩

• 1. See Nickeson v. Commissioner, 962 F.2d 973">962 F.2d 973, 976 (10th Cir. 1992), affg. Brock v. Commissioner, T.C. Memo. 1989-641; Hunt v. Commissioner, 938 F.2d 466">938 F.2d 466, 471 n.5 (4th Cir. 1991), affg. T.C. Memo 1989-660">T.C. Memo. 1989-660; Smith v. Commissioner, 937 F.2d 1089">937 F.2d 1089 (6th Cir. 1991); revg. 91 T.C. 733">91 T.C. 733 (1988); Karr v. Commissioner, 924 F.2d 1018">924 F.2d 1018, 1023 (11th Cir. 1991), affg. Smith v. Commissioner, 91 T.C. 733">91 T.C. 733 (1988); Rose v. Commissioner, 868 F.2d 851">868 F.2d 851, 853 (6th Cir. 1989), affg. 88 T.C. 386">88 T.C. 386 (1987) (Court reviewed); Collins v. Commissioner, 857 F.2d 1383">857 F.2d 1383, 1386 (9th Cir. 1988), affg. Dister v. Commissioner, T.C. Memo. 1987-217↩.

• 2. It has been noted that "The primary standard first appeared as a judicial gloss on the statutory language of section 165(c)(2) in Helvering v. National Grocery Co., 304 U.S. 282 (1938), * * * [a] case unrelated to section 165(c)(2) and the reference to section 23(e) (predecessor to section 165(c)(2)) was made in order to support the proposition that 'The instances are many in which purpose or state of mind determines the incidence of an income tax'." Fox v. Commissioner, 82 T.C. 1001">82 T.C. 1001, 1018 (1984) (citations omitted); see also Dewees v. Commissioner, 870 F.2d 21">870 F.2d 21, 33 (1st Cir. 1989), affg. Glass v. Commissioner, 87 T.C. 1087 (1986); Miller v. Commissioner, 84 T.C. 827">84 T.C. 827, 851-852 (1985) (Simpson, J., dissenting), revd. 836 F.2d 1274">836 F.2d 1274 (10th Cir. 1988); Thurner v. Commissioner, T.C. Memo. 1990-529↩.

• 1. In Rose v. Commissioner, 88 T.C. 386">88 T.C. 386 (1987), affd. 868 F.2d 851">868 F.2d 851 (6th Cir. 1989), we found that the taxpayers did not have an actual and honest profit objective. 88 T.C. at 405, 415. This finding alone would have been dispositive of the deductions and credits to which the unified generic tax-shelter analysis was applied. We went on to find that there was no reasonable possibility that the transactions in issue would generate sales sufficient to recoup the taxpayer's investment in order to produce a profit and that the transactions lacked economic substance. Id. at 405. This second finding would have independently led to the conclusion that the activities in question should not be recognized for tax purposes even if the taxpayer had a profit objective. See Cherin v. Commissioner, 89 T.C. 986">89 T.C. 986 (1987); James v. Commissioner, 87 T.C. 905">87 T.C. 905, 924 (1986), affd. 899 F.2d 905">899 F.2d 905↩ (10th Cir. 1990).

• 2. In Illes v. Commissioner, 982 F.2d 163">982 F.2d 163, 165 (6th Cir. 1992), the court stated:

  If the transaction lacks economic substance, then the deduction must be disallowed without regard to the "niceties" of the taxpayer's intent. * * * [Citations omitted.]↩

• 3. In Cherin v. Commissioner, supra at 994, we stated:

  Subjective intent cannot supply economic substance to a business transaction. Where, as in the case at bar, we examine the transaction and conclude as we do in this case that Southern Star's herd investment packages lack any realistic potential for profit, we need not examine the investor's state of mind. This analysis, where it can be used, avoids the difficult task of weighing dual motives, such as we were forced to undertake in Fox v. Commissioner, 82 T.C. 1001">82 T.C. 1001↩ (1984). * * *

• 4. See Hunt v. Commissioner, 938 F.2d 466 (4th Cir. 1991), affg. T.C. Memo. 1989-660; Smith v. Commissioner, 937 F.2d 1089">937 F.2d 1089 (6th Cir. 1991), revg. 91 T.C. 733">91 T.C. 733 (1988); Rose v. Commissioner, 868 F.2d 851">868 F.2d 851 (6th Cir. 1989), affg. 88 T.C. 386">88 T.C. 386 (1987); see also Collins v. Commissioner, 857 F.2d 1383">857 F.2d 1383, 1386 (9th Cir. 1988), affg. T.C. Memo. 1987-217↩.

• 5. A transaction that has a business purpose or profit objective will survive the Rose analysis of economic substance. * * * [McCrary v. Commissioner, 92 T.C. 827">92 T.C. 827, 845↩ (1989); emphasis added.]

• 6. If we were correct in Smith v. Commissioner, 91 T.C. 733">91 T.C. 733 (1988), revd. 937 F.2d 1089">937 F.2d 1089 (6th Cir. 1991), in finding that there was no profit objective, it was not necessary to determine whether profit was the "primary" objective. See Estate of Baron v. Commissioner, 798 F.2d 65">798 F.2d 65, 72 (2d Cir. 1986), affg. 83 T.C. 542">83 T.C. 542↩ (1984). However, the often-stated requirement that there be an "actual and honest profit objective" does not replace the requirement that profit be the "primary purpose" for engaging in the activity.

• 7. The two-judge majority in the Court of Appeals in Smith acknowledged that whether the taxpayers had any profit objective was a close question and noted that four of the six appellate court judges who reviewed the facts agreed with the trial judge that the taxpayers had no profit objective. Smith v. Commissioner, 937 F.2d at 1089. While the majority in Smith found that there was a profit objective, they did not decide whether the taxpayers had proven the more difficult requirement, i.e., that profit was their primary↩ objective.

• 8. One of the reasons for respondent's disallowance of the deductions in the instant case, and in Smith↩, was that the partnerships' involvement in the Koppelman process was an activity not engaged in for profit.

• 9. Prior to Commissioner v. Groetzinger, 480 U.S. 23">480 U.S. 23 (1987), the Supreme Court described the profit-motive requirement in the following words:

  Section 162 permits a taxpayer to deduct "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Undoubtedly due to the desirability of tax deductions, § 162 has spawned a rich and voluminous jurisprudence. The standard test for the existence of a trade or business for purposes of § 162 is whether the activity "was entered into with the dominant hope and intent of realizing a profit." Brannen v. Commissioner, 722 F.2d 695">722 F.2d 695, 704 (CA11 1984). * * * [United States v. American Bar Endowment, 477 U.S. 105">477 U.S. 105, 110↩ n.1 (1986); emphasis added.]

• 10. In Levy v. Commissioner, 91 T.C. 838">91 T.C. 838, 871 (1988), we stated that the existence of an "actual and honest profit objective" was sufficient and that the taxpayer need not show that profit was the primary purpose for the activity. Levy does not purport to overrule the "primary purpose" test adopted by the Tax Court, nor does it discuss or attempt to reconcile the opinions of the Supreme Court, Circuit Courts, and this Court dealing with the "primary purpose" test. It appears that the statement in Levy regarding the profit-objective requirement was intended to be limited to the unique circumstances of that case. See Levy v. Commissioner, supra at 871, 872. We have recognized that there are certain situations where deductions and credits are congressionally authorized even though profit is not the primary purpose for engaging in the activity. See Fox v. Commissioner, 82 T.C. 1001">82 T.C. 1001, 1021↩ (1984).

• 11. Most of the Courts of Appeals have expressly held that the primary or dominant purpose for engaging in the activity must be for profit. Simon v. Commissioner, 830 F.2d 499">830 F.2d 499, 500 (3d Cir. 1987); Antonides v. Commissioner, 893 F.2d 656">893 F.2d 656, 659 (4th Cir. 1990); Agro Science Co. v. Commissioner, 934 F.2d 573">934 F.2d 573, 576 (5th Cir. 1991); Bryant v. Commissioner, 928 F.2d 745">928 F.2d 745, 749 (6th Cir. 1991); Nickerson v. Commissioner, 700 F.2d 402">700 F.2d 402, 404 (7th Cir. 1983); Vorsheck v. Commissioner, 933 F.2d 757">933 F.2d 757, 758 (9th Cir. 1991); Nickeson v. Commissioner, 962 F.2d 973">962 F.2d 973, 976 (10th Cir. 1992); Brannen v. Commissioner, 722 F.2d 695">722 F.2d 695, 704↩ (11th Cir. 1984).

• 12. In Seaman v. Commissioner, 84 T.C. 564">84 T.C. 564, 590 (1985), we stated:

  Petitioners contend that the partnership is permitted to take advantage of tax deductions provided by law without destroying the validity of its profit objective. Of course, in so contending, petitioners miss the mark. The point is that the actions of the general partners, in elevating the importance of securing tax advantages over the importance of investigating the economic viability of the venture, belie a primary economic profit objective.↩

• 13. Congress allows deductions under 26 U.S.C. sec. 162 for expenses of carrying on activities that constitute a taxpayer's trade or business, under 26 U.S.C. sec. 174 for research and development expenses in connection with a trade or business, and under 26 U.S.C. sec. 212 for expenses incurred in connection with activities undertaken to produce or collect income. Expenditures may only be deducted under sections 162, 174, and 212 if the facts and circumstances indicate that the taxpayer made them primarily in furtherance of a bona fide profit objective independent of tax consequences. 26 C.F.R. sec. 1.183-2(a) (1990); Mayrath v. Commissioner, 357 F.2d 209">357 F.2d 209, 214 (5th Cir. 1966); Drobny v. Commissioner, 86 T.C. 1326">86 T.C. 1326, 1340 (1986). [Agro Science Co. v. Commissioner, supra↩ at 576.]

• 14. In Thomas v. Commissioner, 792 F.2d 1256">792 F.2d 1256, 1258-1259 (4th Cir. 1986), affg. 84 T.C. 1244">84 T.C. 1244 (1985), the court explained that the determination of whether the activity was engaged in primarily for profit, is a test that is separate and apart from whether the transaction was a sham.

  The taxpayers contend that the court should have applied the "sham transaction" test. * * *

  We reject this argument. The Commissioner did not disallow the taxpayers' deductions on the ground that the program was a sham. Instead, the Commissioner asserted that the program lacked the primary objective of making a profit. These are different grounds for invalidating deductions. See Sanderson v. Commissioner, 1985 T.C.M. (P-H) par. 85,477 at 210 n. 15. If a business has the primary objective of making a profit, deductions pertaining to a specific transaction may or may not be allowed depending on whether the transaction is a sham. See, e.g., Rice's Toyota World↩, 752 F.2d at 91-92. The issue in this case is more fundamental. It is whether the mining venture itself has the primary objective of making a profit.