United States Court of Appeals,
Fifth Circuit.
No. 92-5097.
Joseph R. HARRIS, Petitioner-Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
March 10, 1994.
Appeal from a Decision of the United States Tax Court.
Before POLITZ, Chief Judge, REYNALDO G. GARZA, and JOLLY, Circuit
Judges.
E. GRADY JOLLY, Circuit Judge:
The taxpayer appeals from the Tax Court's denial of his
deduction of his distributive share of payments made by his
partnership to a corporation as a research and development expense
under 26 U.S.C. § 174(a)(1). Because we find the partnership did
not pay for research and development "in connection with" its own
trade or business, we affirm the Tax Court.
I
In 1981, Jake Bauer and Howard Leith carried out a plan to
attract capital for continued funding of their research and
development of cementitious composites for use as tooling in the
aerospace industry and of glass-reinforced cement for use in a
substitute for wood in shipping pallets. First, Bauer and Leith
formed CemCom Research Associates, Inc. ("CemCom") to own the
technology and conduct research. Bauer and Leith anticipated that
CemCom would license the finalized technology to other entities
that would manufacture and sell the resulting cement products.
1
Second, the two men retained an investment advisor, Mr. Townsend,
to form Research One Limited Partnership (the "Partnership") to
attract capital by selling limited partnership interests to the
public. Third, the Partnership executed a Research and Development
Agreement (the "R & D Agreement") under which the Partnership
contracted out all of the research work to CemCom. The R & D
Agreement provided that all property rights arising from CemCom's
research would vest in the Partnership, and the Partnership would
pay installments totalling $5,050,000 to CemCom for the research
services. Fourth, the Partnership and CemCom executed a Technology
Transfer Agreement (the "Transfer Agreement") under which CemCom
received the option of obtaining a perpetual exclusive license of
the resulting technology. CemCom would have to pay substantial
royalties to the Partnership if it exercised the option. If it did
not exercise the option, however, CemCom, Bauer, and Leith could
not engage in any research, development, or business activity
involving the cement technology for a period of five years.
Under the R & D Agreement, the first two installments payable
to CemCom, totalling $2,250,000, would be funded with capital paid
into the Partnership by the partners. The final installment of
$2,800,000 would be paid over an eight-year period beginning in
1984. The investment prospectus indicated that the promoters
anticipated the final installment to be offset by royalties paid by
CemCom to the Partnership after the exercise of the licensing
option. In the event these royalties were insufficient to provide
additional research funds to CemCom, the limited partners would be
2
personally liable for their proportionate share of the final
installment. Townsend told potential limited partners that
although it was not highly probable that CemCom would exercise its
current option with high royalty payments, it was highly probable
that CemCom would renegotiate the licensing option to provide for
lower royalty payments.
When the research and development did not produce results as
quickly as hoped, Mr. Townsend became involved in assisting CemCom
in negotiating sublicensing agreements with third parties and in
obtaining capital from outside sources. In September 1984, CemCom
negotiated a new licensing agreement with the Partnership that
provided for royalty payments that were lower than those projected
in the original option, but were still sufficient to avoid
requiring the limited partners to fund the third installment under
the R & D Agreement. Between 1984 and 1986, the Partnership, as
CemCom's assignee, received six patents on the cement technology.
In March 1986, CemCom granted an exclusive sublicense to a chemical
company to commercialize all of CemCom's technology and products
for twenty-five years.1 Four months later, the Partnership
1
On page 24 of his brief, Harris states:
Eventually, the Partnership did license the patented
technology, after further arm's length negotiations.
In the interim, CemCom's option had expired.
The record (Volume II, Exhibit 46-AT), however, shows that
it was CemCom—not the Partnership—that sublicensed the
patented technology to the chemical company. Although
CemCom's option to license the technology expired in March
1984 (Volume II, Ex. 39-AM), CemCom nevertheless entered
into a licensing agreement with the Partnership on September
22, 1984 (Volume II, Ex. 45-AS) and, thus, had the exclusive
3
renegotiated its licensing agreement with CemCom to provide for
lower minimum royalty payments, but higher maximum royalty
payments.
In 1981, the Partnership accrued a deduction of $5,050,000 for
research expenses under section 174(a)(1) of the Internal Revenue
Code. As a limited partner, Mr. Harris deducted his distributive
share of this amount, and the Commissioner disallowed the
deduction.
II
The Tax Court agreed with the Commissioner and disallowed the
deduction because it held that the Partnership did not expend the
funds "in connection with [its] trade or business." Specifically,
the Tax Court held that there was no "realistic prospect" that the
Partnership would develop and exploit the cement technology,
through manufacture of a product or licensing of technology, in a
trade or business of its own. Instead, the Partnership was a
passive investment vehicle. The Tax Court also found that the
transfer of the cement technology to CemCom via the licensing
agreement did not constitute a trade or business of the
Partnership. Further, the Tax Court held that the clause in the R
& D Agreement that stated that CemCom undertook the research
activities "on behalf" of the Partnership did not attribute the
trade or business of CemCom to the Partnership.
III
A
rights to sublicense the technology in the marketplace.
4
Before the enactment of section 174, the treatment of research
expenditures depended on whether the taxpayer incurring the
expenses was an ongoing business or a start-up business. Ongoing
businesses could deduct research expenditures as ordinary and
necessary expenses incurred in "carrying on a trade or business."
See 26 U.S.C. § 162 (1988). Start-up companies, however, were
prevented from deducting research expenses by the general rule that
companies that had not yet begun business could not deduct expenses
because they did not incur the expenses in "carrying on" a trade or
business.2 Accordingly, start-up companies had to capitalize these
expenditures and their future ability to recover the costs depended
on the ultimate and sometimes unpredictable results of the
research. If the research effort was ultimately unsuccessful, the
start-up company could deduct the cost incurred as an abandonment
loss.3 If the expenditures were successful and produced a result
that had a determinable useful life, such as a patent, the start-up
company could amortize the cost over the relevant useful life.4 If
2
Professor Willis states:
A principle of federal tax law that is axiomatic
is that costs incurred by a taxpayer prior to entering
into a business are not deductible currently. Although
disagreements may exist over whether business in fact
has begun, there no longer are viable grounds for
challenging the basic legal principle.
Willis, et al., Partnership Taxation § 41.08, p. 41-13 (4th
ed. 1993).
3
S.Rep. No. 1622, 83d Cong., 2d Sess. 1, 33 (1954),
reprinted in 1954 U.S.C.C.A.N. 4621, 4663.
4
Id. at 33, 1954 U.S.C.C.A.N. at 4663.
5
the successful effort produced a result without a determinable
useful life, the start-up company had no means of recovering the
cost of research results short of selling the project in toto to a
third party.5
In designing section 174, Congress intended to: (1) eliminate
the tax treatment uncertainty faced by start-up companies beginning
a research project where they could not anticipate whether their
efforts would result in patentable or nonpatentable results; and
(2) encourage research and experimentation.6 To this end, Congress
mollified the harsh effects of section 162's beginning business
requirement by drafting section 174 to allow a deduction of
research expenditures incurred "in connection with," instead of in
"carrying on," a trade or business language. Section 174(a)(1)
provides:
A taxpayer may treat research or experimental expenditures
which are paid or incurred by him during the taxable year in
connection with his trade or business as expenses which are
not chargeable to [the] capital account. The expenditures so
treated shall be allowed as a deduction.
(Emphasis added).
There has since been one Supreme Court case interpreting this
section. In Snow v. Commissioner, 416 U.S. 500, 94 S.Ct. 1876, 40
L.Ed.2d 336 (1974), the Supreme Court allowed a partnership to
deduct research expenses under section 174 for the development of
an incinerator even though the device had not been marketed at the
end of the relevant tax year. The Court viewed section 174's "in
5
Id. at 33, 1954 U.S.C.C.A.N. at 4664.
6
Id.
6
connection with" language—unlike section 162's "carrying on"
language—as allowing the partnership to deduct the research
expenses even though the expenditures were connected with a future
business of the partnership rather than its current business. Id.
at 504, 94 S.Ct. at 1878-79.
B
Although Snow settled that the temporal nexus of a research
project to the start of an active trade or business was not
dispositive of section 174's applicability, it left open the degree
of "connection" required between the expenditures and the operation
of the trade or business itself—the operational nexus—in order to
trigger section 174's exception to the general rule of
nondeductibility of pre-operation expenditures. In analyzing the
operational nexus facet of section 174, the courts have dealt with
a broad spectrum of financial arrangements. At one end of the
spectrum lie arrangements in which a partnership buys stock in a
corporation, which then uses the capital to fund research
activities, manages the research activities itself, manufactures
the resulting product, sells the product in the marketplace, and
returns a portion of the profits to the partnership as dividends.
In these situations, the partnership does not incur research
expenses in connection with its trade or business but, instead,
functions as an investment vehicle that cannot deduct the cash paid
to the corporation under section 174 even if the corporation used
that very cash to fund its research expenditures. At the other end
of the spectrum lie financial arrangements in which a partnership
7
uses its own funds to conduct research activities, manufactures the
product itself, and sells that product in the marketplace. In this
instance, the partnership incurs research and development
expenditures in connection with its trade or business and can
deduct them under section 174. It is between these clearly defined
ends of the spectrum that the cases that guide our decision today
lie.
In Snow, 416 U.S. at 502, 94 S.Ct. at 1878, the partnership
actually conducted research activities. The general partner was an
inventor and devoted a significant amount of time to the research
and development of the incinerator. Id. at 502, 94 S.Ct. at 1877-
78. The partnership also contracted out some of the research work
to an engineering firm. Id. at 502, 94 S.Ct. at 1878. Eventually,
the research was successful, the partnership incorporated and sold
the incinerators to the public. Id. at 502 & n. 3, 94 S.Ct. at
1878 & n. 3. Thus, the partnership incurred the research
expenditures "in connection with" its trade or business of
developing, manufacturing, and selling incinerators, and the court
allowed the section 174 deduction. Id. at 504, 94 S.Ct. at 1879.
In Smith v. Commissioner, 937 F.2d 1089, 1091 (6th Cir.1991),
the partnership obtained a license to use certain energy
technology. In order to construct and operate an energy plant, the
partnership contracted out all the research and the construction
oversight to an outside research firm. Id. After the plant was
completed, however, the partnership owned, operated, and managed
the plant to produce "synthetic fuel for marketing purposes." Id.
8
Because, the research fees paid to the outside firm were "in
connection with" the partnership's trade or business of developing,
owning, and operating an energy plant, and section 174 applied to
allow the deduction of research expenses. Id. at 1097-98.
In Zink v. United States, 929 F.2d 1015, 1017 (5th Cir.1991),
this court dealt with a financial arrangement in which individuals
owned plans for component airplane parts instead of partnership
interests. The taxpayers contracted out both the research work and
the manufacturing and marketing activities. Under the relevant
agreements, the individuals paid cash to an aircraft design company
to conduct the research on the airplane parts. Id. at 1017.
Although the individuals would own the resulting plans, these plans
had no market value because they were only for the components of an
overall design. Id. Further, as part of the initial agreements,
the individuals immediately licensed the right to use, sublicense,
and otherwise exploit the results of the research. Id. Thus,
there was no "realistic prospect" that the investors who admittedly
knew nothing about the airplane business would ever engage in
developing or marketing airplanes or airplane parts. Id. at 1022-
23. Accordingly, we denied the deduction under section 174. Id.
at 1023.
Spellman v. Commissioner, 845 F.2d 148 (7th Cir.1988) (Posner,
J.), is illustrative of cases the circuit courts have dealt with in
which a partnership did not immediately grant a license to the
research company to manufacture and market the results of the
research, but in which the economic realities of the arrangement
9
insured that the partnership would grant such a license instead of
exploiting the research results itself.7 In Spellman, 845 F.2d at
150, a limited partnership paid a pharmaceutical company to engage
in research to develop penicillins and granted the pharmaceutical
company the exclusive right to "make, sell, license, etc." the new
penicillins and the option to purchase any byproducts of the
research for a small fee. The court found that there was no
realistic prospect that the partnership would engage in the
business of manufacturing or marketing the penicillins because,
despite the partnership's claimed reversionary rights to the
penicillins, it was not prepared to exploit the drugs itself. Id.
Furthermore, even though the partnership had the rights to the
byproducts of the research, the fact that the pharmaceutical
company could purchase the rights to exploit the research
byproducts for a small fee dimmed the prospects that the
partnership itself would manufacture or market the byproducts. Id.
at 150-51. Thus, the court affirmed the Tax Court's grant of
summary judgment denying deductibility under section 174 because
there was no realistic prospect the results of the expenditures
would be used "in connection with" the partnership's trade or
7
See Kantor v. Commissioner, 998 F.2d 1514 (9th Cir.1993)
(denying section 174 deduction where partnership contracted all
software research out to research corporation and, although the
partnership would "own" the resulting software, the corporation
had a low-cost option to market the resulting software); Diamond
v. Commissioner, 930 F.2d 372 (4th Cir.1991) (denying section 174
deduction to partnership where the economic reality was that a
research corporation would perform all robotics research and,
although the partnership would "own" the results of the research,
the corporation had a no-cost option to manufacture and market
the results of that research).
10
business. Id. at 149, 151-52.
C
As with the courts before us, we must sift through research
and development agreements, technology transfer agreements,
options, licenses, etc., in order to ascertain whether the economic
realities of the financial arrangement in this case warrant
allowance of the section 174 deduction.8 All of the above
cases—both those allowing and disallowing the section 174
deduction—involved a profit motive. See, e.g., Zink, 929 F.2d at
1021 (stating that section 174's trade or business requirement
necessitates a profit motive). Consequently, the mere presence of
a profit motive in the financial arrangement here is not
determinative of whether the section 174 deduction will be allowed.
In our view, those cases in which a section 174 deduction was
upheld may be distinguished by one dispositive factor: In each of
the cases allowing the deduction, the entity that incurred the
research expenses actually managed and actually controlled the use
or marketing of the research results. The question here is whether
the Tax Court was clearly erroneous in finding the nexus of those
activities was to CemCom instead of the Partnership.9
8
As the Seventh Circuit noted in Spellman, 845 F.2d at 151,
"[T]he Supreme Court's interpretation of section 174(a)(1) fairly
invited the creation of R & D tax shelters, and the bar quickly
took up the invitation." The financial arrangement in the
instant case evidences an unusual degree of sophistication in
attempting to secure the benefits of section 174 for the limited
partner-investors.
9
Harris also argues that the application of post-1981 case
law—essentially post-Snow cases—to this case constitutes an
unjustified retroactive application of a new rule in a civil
11
IV
A
On appeal, Harris focuses his argument on the marketing of the
research results.10 He contends that the Partnership was in the
trade or business of licensing—marketing the right to use—the
cement technology that CemCom developed. See Louw v. Commissioner,
30 T.C.M. (CCH) 1421 (1971) (holding that the exploitation of
inventions through royalties, sales of patents, or otherwise may
constitute a business). Harris points out that the Partnership did
in fact obtain patents, as CemCom's assignee. Harris argues that
the Partnership had a realistic prospect of licensing those patents
in either of two ways. First, because of the very high royalty
expenses CemCom would incur if it exercised the option to license
the patents back from the Partnership—in contrast to the small fee
to license the research results that the research company was
confronted with in Spellman, 845 F.2d at 150-51—there was a
case. This contention is meritless. As previously discussed,
Snow dealt with the temporal nexus to a trade of business. The
post-Snow cases that have dealt with the operational nexus
requirement of section 174, in effect, interpret the pre-1981 "in
connection with" language using the economic realities, or
substance over form, doctrine. This doctrine also predates 1981.
See Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed.
596 (1935) (holding that a transaction, although qualifying in
form, failed to qualify in substance as a reorganization because
"[t]o hold otherwise would be to exalt artifice above reality
..."). Accordingly, the post-Snow cases did not develop or apply
a new rule.
10
This approach is Harris's only claim to the deduction
because CemCom performed all of the research and development
activities without significant oversight by the Partnership.
Further, evidence showed that the Partnership was interested in
"results only" and not the actual performance of research
activities as it had no plans to hire any staff.
12
significant possibility that CemCom would not license the
technology and, thus, the Partnership would have to license it in
the marketplace. Second, even if the Partnership did plan only to
license the patents to CemCom, the licensing of those patents alone
would constitute the trade or business of licensing the technology.
The Partnership did in fact license those patents to CemCom,
and the Partnership's general partner, Townsend, helped CemCom in
negotiating the ultimate sublicense to the chemical company. Thus,
Harris contends, the monies that the Partnership paid CemCom to
develop the patentable technology were in connection with the
Partnership's trade or business of licensing that technology. The
Commissioner asserts to the contrary that the Partnership was
merely an investor, and that the parties always intended that
CemCom would conduct all of the research and perform all of the
marketing activities with third parties which, in fact, it did.
We review de novo the Tax Court's legal conclusions,
including its interpretations of the Internal Revenue Code. Lukens
v. Commissioner, 945 F.2d 92, 97 (5th Cir.1991). We must, however,
accept the Tax Court's findings of fact unless they are clearly
erroneous. Commissioner v. Duberstein, 363 U.S. 278, 291, 80 S.Ct.
1190, 1200, 4 L.Ed.2d 1218 (1960). We must determine whether the
Tax Court was clearly erroneous in finding that, in 1981, there was
a realistic prospect that the Partnership, instead of CemCom, would
engage in the licensing of the cement technology. See Spellman,
845 F.2d at 149.
B
13
Harris's first contention—that there was a realistic prospect
that the Partnership would market the technology because CemCom
would not exercise its option—fails because the economic realities
of the instant financial arrangement do not support his contention.
From the face of the documents, it might appear that unlike the
research company in Spellman, 845 F.2d at 150, and similar cases
where the section 174 deduction was denied, CemCom would not
exercise its option because of the extraordinarily large royalty
payments. Thus, the documents might suggest that the Partnership
was going to license the technology in the marketplace itself.
When we look beyond the face of the documents, however, we cannot
characterize as clearly erroneous the Tax Court's finding that, in
1981, the parties actually intended to renegotiate the option at a
lower level of royalty payments, which would allow CemCom to
license the technology from the Partnership at a reasonable price.
This intent was evidenced by the covenant not to compete agreement
that would have put CemCom, Bauer, and Leith out of the cement
business for five years if they did not license the technology back
from the Partnership. Further, the partnership had no expertise in
the cement industry and no remaining capital to fund any marketing
efforts. Still further, Townsend told potential investors in the
Partnership that the licensing agreement would probably be
renegotiated to provide for lower royalty payments. The ultimate
disposition of the technology reflects the intent the parties had
in 1981: CemCom sublicensed the technology it developed to a third
party, the chemical company, that paid royalties to CemCom, and
14
CemCom forwarded a portion of these royalties to the Partnership
under a renegotiated licensing agreement. Thus, we hold that the
Tax Court was not clearly erroneous in finding that there was no
realistic prospect that the Partnership would market the technology
itself.11
Harris's second contention—that the intended licensing of the
patents to CemCom constituted the trade or business of marketing
the technology—fails because the Partnership's licensing of the
patents to CemCom did not possess the indicia of continuity and
regularity necessary to endow an activity with trade or business
status. The Partnership's prearranged license of the inventions
11
The various agreements simply do not attribute CemCom's
trade or business of licensing the technology to the Partnership.
Although the regulations provide that another entity may perform
research on behalf of the taxpayer, Treas.Reg. § 1.174-2(a)(2)
(1957), they do not provide that the other entity may conduct a
trade or business on behalf of the taxpayer. See Zink, 929 F.2d
at 1022 ("[T]he mere presence of a valid business purpose at one
level of a transaction does not automatically entitle passive
investors distant from the day-to-day operations of the
enterprise to the associated tax benefits") (internal citations
omitted). As Judge Posner hypothesized in Spellman, 845 F.2d at
150:
[I]t does not follow that [the partnership] could
deduct these expenditures under the statute if it had
dealt away to [the research company] the right to
[exploit] the products resulting from the research and
development. Having contracted out both the research
and development and the production and marketing, [the
partnership's] involvement in the product cycle might
be viewed as that of an investor rather than that of an
entrepreneur....
Judge Posner then stated that the remote possibility that
the partnership in Spellman would actually exploit the
byproducts was insufficient to detract from the economic
realities and resulting tax effects of the above
hypothetical. Id. at 150-51.
15
that resulted from CemCom's research back to CemCom was in essence
a single prearranged deal. One prearranged deal does not evidence
the continuity and regularity found in trades or businesses. See
Commissioner v. Groetzinger, 480 U.S. 23, 35, 107 S.Ct. 980, 987,
94 L.Ed.2d 25 (1987) (stating that it has long been the law that
the phrase "trade or business" involves an activity conducted "with
continuity and regularity"); Green v. Commissioner, 83 T.C. 667,
689, 1984 WL 15626 (1984) (holding that although the regular
licensing and sale of inventions can amount to a trade or business,
the intent to dispose of all the inventions in one transaction,
instead of regularly licensing inventions for profit, indicates
that such activity did not rise to the level of a trade or
business).12 Thus, we hold that the Partnership was not in the
trade or business of marketing the technology.
In sum, the operational nexus of the trade or business in this
financial arrangement was to CemCom in 1981, because the economic
realities clearly show that CemCom would conduct all the research
activities and would market the results of those activities to
12
Further, the record fully supports the view that the
Partnership and Cemcom entered into the licensing transaction to
allow CemCom to obtain revenue from outside third parties from
which it then would pay the Partnership royalties. Indeed,
CemCom itself did not have the financial resources necessary to
pay the Partnership royalties; a sale to an independent third
party was a necessary prerequisite to the financial success of
the arrangement. This case is not similar to those cases in
which a single product sold in a prearranged deal to an
independent third party constituted a trade or business. See,
e.g., S & H, Inc. v. Commissioner, 78 T.C. 234, 244, 1982 WL
11190 (1982) (holding that the sale of property acquired for the
purpose of selling to an independent buyer in a single
transaction constituted the trade or business of selling real
estate).
16
third parties. Thus, the research expenditures made by the
Partnership were not "in connection with" its trade or business,
and section 174 does not apply.
V
For the foregoing reasons, we AFFIRM the Tax Court's denial of
Harris's deduction for research and development expenditures made
in connection with the Partnership's trade or business.
AFFIRMED.
17