T.C. Memo. 1996-122

UNITED STATES TAX COURT

INVESTMENT ENGINEERS, LTD., ROBERT S. McGLAMERY,

A PARTNER OTHER THAN THE TAX MATTERS PARTNER, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 9300-92. Filed March 12, 1996.

Robert S. McGlamery, pro se.

Robert L. Montelius, Jr., tax matters partner, pro se.

Sherri L. Munnerlyn, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge: In a Notice of Final Partnership

Administrative Adjustment (FPAA) sent December 3, 1991,

respondent increased the income of Investment Engineers, Ltd.

(the partnership), by $540,500 for 1982, $218,000 for 1983, and
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$123,000 for 1984. In Investment Engineers, Ltd. v.

Commissioner, T.C. Memo. 1994-255, we concluded that the statute

of limitations did not bar assessments pursuant to the FPAA. 

Remaining for decision is whether the partnership is entitled to 

deductions claimed under section 174 in the amounts adjusted by

respondent. Unless otherwise indicated, all section references

are to the Internal Revenue Code in effect for the years in

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference. The

history of management of the partnership is set forth in T.C.

Memo. 1994-255. Subsequent to that opinion, respondent filed a

Motion to Appoint a Tax Matters Partner. Robert L. Montelius,

Jr. (Montelius), was appointed tax matters partner solely for the

purpose of these proceedings. 

The partnership was formed in December 1982. The promoter

of the partnership was Gregory A. Knox (Knox). Knox had a juris

doctor degree, but was not admitted to any bar, and made his

living as a financial planner. 

The partnership was created by a Limited Partnership

Agreement dated December 14, 1982. The stated purpose of the

partnership was to engage in the business of research and

experimentation for the development of computer software in the
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field of financial planning. The partnership agreement stated “a

partnership unit” represented a capital contribution of $5,000 to

the partnership. After identifying the initial general partner

and one limited partner, the agreement provided in part:

Each additional person who (not to exceed thirty

four (34) in total, with spouses, and other close,

family related multiple investors counting together as

one investor) acquires any such Partnership Units shall

be eligible to become a Limited Partner in the

Partnership at such time as he has:

(1) Purchased three or more Partnership

Units,

(2) Contributed the sum of $5,000 cash and/or

notes for each Partnership Unit purchased,

In a Certificate of Limited Partnership executed

December 15, 1982, Timothy J. Curtis, the initial general

partner, and Debra Lee Jensen (Ms. Jensen), the initial limited

partner, stated that Ms. Jensen had contributed cash of $83.33

and a note for $416.67 to the partnership. 

In an Amendment to Certificate of Limited Partnership of

Investment Engineers, executed December 30, 1983, the cash and

other property contributed by the limited partners were listed. 

According to that certificate, as of December 30, 1983, eight

limited partners had contributed cash in the amount of $100 each

and notes in amounts varying from $9,900 to $59,900. Two limited

partners had contributed $500 in cash each and notes of $14,500

and $34,500. Montelius contributed $110 cash and notes totaling

$79,890. Robert S. McGlamery contributed cash of $4,010 and
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notes totaling $159,990. Two other limited partners contributed

cash of $2,500 and $4,000 and notes of $12,500 and $20,000,

respectively. 

The notes executed by the limited partners were due over a

period of approximately 11 years, with the first payment due on

May 1 of the year following the date on which the note was

executed and with additional annual payments commencing on

December 1 of the fifth year after the note was executed. 

In the prospectus for the partnership, the benefits to the

limited partners were described as follows:

(1) 6:1 Write Off - An investor may be able to deduct

from his taxable income in 198_ six times the

amount of his cash contribution made during the

first year of partnership operations.

(2) Capital Gains Treatment of Profits - Investors may

only have to report 40% of profits from the

partnership in their taxable incomes.

(3) High Profit Potential - If 4,100 customers are

obtained by year 5, and retained at a royalty of

$250 per year to the partnership, each investor

can expect an average annual after tax return of

up to 45% of his initial investment.

Nothing in the prospectus described how the software to be

developed by the partnership would be manufactured, distributed,

or marketed. Under the heading “Risk Factors”, the prospectus

stated, in part, the following:

The proposed researchers appear to have the

skills, experience and commitment to produce the

product ordered by the partnership. However, in the

Investment Engineers, LTD. project, there are no funds,

neither can there be funds (without loss of tax
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benefits) for marketing. Thus, even should a

successful product be delivered to the Partnership, it

would take a marketing company [to] make the

partnership successful. * * *

On December 31, 1982, a Research Agreement between Knox and

the partnership was executed. The partnership agreed to pay to

Knox a flat fee $600,500. Article I of the Research Agreement

specified the scope and definition of work as follows: 

Knox will carry on research and development work

at the order and risk of the Partnership on a research

program to develop new and unique computer software in

the field of financial planning. It is understood that

this software will cause computers to perform financial

planning tasks in contrast with other such software,

and/or real doubt exists as to the operational

feasibility of developing the software. The proposed

software should perform, at a minimum, the following

functions:

A. Convert the essential factors of qualitatively

“unlike” investments, including stocks, real estate,

fixed-interest investments (bonds, etc.), gold, foreign

currencies, silver, commodities, collectables, etc., to

a common “investment language” so that they can be

analyzed, compared, and contrasted as though they were

qualitatively identical;

B. Allow the software user to imput [sic] the

dissimilar investments, and receive back either the

computer’s translation into its own “language”, or an

analysis of the dissimilar investments which will allow

the user to analyze them as though they were

qualitatively similar; being then dissimilar only

quantitatively;

C. Cross reference, between apparently dissimilar

investment choices, areas that are actually similar,

such as where--

1. Two investments are similar because they

both are “leveraged”, such as real estate and

commodities, or
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2. Multiple investment media are actually

different ways of owning the same underlying

entity, such as gold versus gold stocks versus

gold commodity futures.

D. Allow user to imput [sic] current cyclical and

technical indicators, or experiment with any possible

indicators, and show their historical effect on any

particular investment, group of investments, or

portfolio combinations.

E. As to various types of investments, assuming

consistent quality among them, the user will be able to

design investment strategies to maximize the goals of a

particular client presenting a specific factual

situation, according to either historical performance

of the investments involved and the cyclical and

technical indicators imputed, or, according to the

users own theories and strategies.

F. The software will have a built in strategy for

preservation of capital in the face of disasters of

either deflation or runaway inflation, as well as

beating inflation in current circumstances. 

On December 30, 1983, the partnership and Knox executed an

Amendment to Research Contract. Under the amendment, the

partnership agreed that Knox would not perform, as part of the

consideration under the original Research Agreement, item F,

quoted above, and Knox agreed to a reduced fee of $540,500 for

the other work to be performed under the original Research

Agreement. In addition, Knox agreed to perform item F above and

two new items for a flat fee of $218,000. The new items were set

forth as follows:

G. Knox will attempt to make the software perform

as a type of “Video Game” that will allow the user to

take various roles, such as government, investor, and

voter, to teach and illustrate cause and effect

relationships between various dependent and independent
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variables in an economy, and how such relationships may

affect investment prices.

H. Knox will attempt to make the software include

an effective “Sales” type approach which will allow a

user who is a financial planner to introduce the

software’s (and his) abilities to a prospective client,

who must be “sold” in a very short presentation.

On July 9, 1984, the partnership and Knox executed another

Amendment to Research Contract. For an additional flat fee of

$241,500, Knox agreed to additional tasks specified as follows:

I. Knox will attempt to adapt the latest

techniques of educational psychology to make the

software a powerful teaching tool, to train the user in

each area of planning covered by the Research

Agreement. This training and teaching does not apply

to computer or software program use, but to financial

planning itself. Thus, it is hoped that the software

will teach financial planning as well as do financial

planning, both using software techniques which are new

and unique.

J. Knox will attempt to make the software, in its

functions as a planning, teaching, and sales tool

adaptable to the various primary distributors of

financial planning, such as banks, life insurance

companies, and securities brokers, so that their

particular products are emphasized and highlighted. 

On November 29, 1987, the partnership and Knox executed

another Amendment to Research Agreement. That amendment stated

in part: 

Whereas, Gregory A. Knox having agreed to do

research over an eleven year period, at the order and

specification of the partnership in exchange for

certain sums, to be paid entirely at the risk of the

partnership, and, such payments have been facilitated

by the previous assignment of partnership receivables

in the form of notes, the parties to such Research

Agreement hereby amend it according to the following

considerations:
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I. Inasmuch as Knox has substantially exceeded

original projections of the time in which a marketable

product was to be delivered to the Partnership, and,

while acknowledging that he made no warranties, other

than to perform in good faith, as to the fruits of his

efforts, he acknowledges his imput [sic] into the

projections which comprised a pertinent part of the

offering materials.

II. The Partnership acknowledges dramatic changes

in political, economic and engineering environments

which have all impacted the progress of the research

contemplated by the Research Agreements, and, certifies

that Knox has thus far performed his duties in good

faith. (Substantial progress having been made toward

all research goals).

III. Knox hereby makes the following concessions:

(a) To forgive all interest due on all

Partnership Notes assigned to him as payment for

the Research Agreements; (except those that have

been sold, optioned, or borrowed against)

acknowledging that interest was charged in the

first place in light of anticipated high, “1970's”

inflation rates, which have not materialized.

(b) To push back the due dates of said Notes

until either December 1, 1994, (approximately one

year after the conclusion of the original research

agreement), or, one year after a completed product

is delivered to the Partnership, whichever occurs

first. Payments on the Notes are to be made over

the same number of annual installments as stated

therein, and the amount of each installment shall

be the remaining balance on the Note, less

interest, divided by the number of payments

stated.

Knox determined the amounts of compensation that he was to

receive for his services under the Research Agreement. 

No companies were organized or contacted to market any

potential products created under the Research Agreement, and the

partnership did not enter into any contracts with third parties
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regarding the marketing of any potential product created pursuant

to the Research Agreement. There was no funding within the

partnership for the marketing of any computer software product

that might have been produced, and no marketing occurred. 

Knox never provided the partnership with the completed

computer software product. The partnership never maintained any

office. The partnership never operated a trade or business. The

partnership received no income from sales of computer software.

During the years in issue, Knox wrote checks to various

partners and related persons and entities for “research” or

“consulting”. For 1982, the partnership sent a Form 1099-MISC to

Knox, reporting $4,000 paid for research. Knox sent a

Form 1099-MISC to Montelius, reporting $500 paid for research. 

For 1983, the partnership sent a Form 1099-MISC to Knox,

reporting $71,136 paid for research, and Knox sent Forms

1099-MISC to Montelius and to Michael V. Jensen (Jensen),

reporting $17,804 and $17,691, respectively. For 1984, the

partnership sent to Knox a Form 1099-MISC, reporting payment of

$29,450. Knox issued Forms 1099-MISC to Wayne E. Brickey for

$5,453, Montelius for $6,000, and Jensen for $7,374.

In an undated report to limited partners, the following

accounting summary was set forth:
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A. 1983 (& before) Commitments - $26,000

B. 1983, etc. receipts - $10,333

C. 1983, etc. still owed - $12,667

D. 1984 Commitments - $20,500

E. 1984 Receipts - $4,000

F. 1984 still owed - $16,500

Note: Principals will finish for above cash, or unsold

Partnership equity, or a combination thereof.

G. Raisable funds - 1985 $48,647

H. 1984 Expenditures

 1. Greg Knox - Lab Research $8,733 (+1890)

 2. Wayne Brickey - Lab Research - $5,600

 3. Mike Jensen $7,374 [illegible] 

 4. Robert L. Montelius $6,700 programming

 for John

On U.S. Partnership Returns of Income, Forms 1065, filed for

1982, 1983, and 1984, the partnership reported as “Cost of goods

sold and/or operations” the amounts of $540,500, $218,000, and

$123,000, respectively. The amounts were claimed to be “cost of

labor” on the partnership returns. The balance sheets on the

returns reflected the following balances:

 1982 1983 1984 

Cash $ 5,057 $ 14,912 $ 1,426

Other current assets--

 notes receivable 85,860 19,723 14,500 

Other assets--

 notes receivable 454,583 175,833 102,500

Total assets $545,500 $210,468 $118,426

Accounts payable $540,500 $205,468 $113,426

Partners’ capital accounts 5,000 5,000 5,000

Total liabilities and 

 capital $545,500 $210,468 $118,426

 
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Respondent disallowed the deductions claimed for costs of

goods sold on each of the returns in issue, with the following

explanation:

It is determined that the losses reported on your 1982,

1983, and 1984 schedule K, Form 1065, U.S. Partnership

Return of Income are disallowed for the alternative

reasons listed below:

1. It has not been established that the

partnership is engaged in a trade or business

or that the partnership engaged in the

activity with the primary purpose of making a

profit.

2. It has not been established that the claimed

deductions represent an expenditure for a

related [sic] to research and development

actually undertaken.

3. It has not been established that the amounts

proven to be expended, if any, in relation to

alleged research and development are

currently deductible, and are not capital

expenditures.

4. It has not been established that you had any

amount at risk, as defined by section 465 of

the Internal Revenue Code.

5. It has not been established that the

purported transactions contained any economic

reality or substance.

In 1995, in relation to settlement negotiations with

respondent’s Appeals Division, Montelius created diskettes

supposedly demonstrating the software produced under the Research

Agreement.

ULTIMATE FINDINGS OF FACT

The research activities of the partnership lacked economic

substance. The partnership did not engage in any activity for
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the primary purpose of or with an actual and honest objective of

making a profit. The partnership had neither the objective

intent nor the capability of entering into a computer software

business. 

OPINION

Petitioner has the burden of proving that respondent’s

determination is erroneous. Rule 142(a); INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992); Rockwell v. Commissioner,

512 F.2d 882 (9th Cir. 1975), affg. T.C. Memo. 1972-133. 

Petitioner contends that, even though the partnership was never

in a trade or business, it is entitled to deduct research

expenses under section 174. Section 174(a)(1) provides:

(1) In general.--A taxpayer may treat

research or experimental expenditures which are

paid or incurred by him during the taxable year in

connection with his trade or business as expenses

which are not chargeable to capital account. The

expenditures so treated shall be allowed as a

deduction.

The language “in connection with * * * [the taxpayer’s] trade or

business” has been interpreted to allow deduction of research

expenses in a business that is only prospective. Snow v.

Commissioner, 416 U.S. 500 (1974). In Kantor v. Commissioner,

998 F.2d 1514, 1518-1519 (9th Cir. 1993), affg. T.C. Memo. 1990-

380, the Court of Appeals for the Ninth Circuit stated: 

Although a taxpayer need not be conducting a trade or

business at the time it incurs the research

expenditure, the taxpayer must demonstrate a “realistic

prospect” of subsequently entering its own business in

connection with the fruits of the research, assuming
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that the research is successful. See Zink v. United

States, 929 F.2d 1015, 1023 (5th Cir. 1991); Spellman

v. Commissioner, 845 F.2d 148, 149 (7th Cir. 1988). We

hold that a taxpayer demonstrates such a prospect by

manifesting both the objective intent to enter such a

business and the capability of doing so. See Spellman,

845 F.2d at 150-51; Levin v. Commissioner, 832 F.2d

403, 406-07 (7th Cir. 1987); see also United Fibertech,

Ltd. v. Commissioner, 976 F.2d 445, 446 (8th Cir. 1992)

(per curiam); Diamond v. Commissioner, 930 F.2d 372,

375 (4th Cir. 1991).

 

In Kantor v. Commissioner, supra, the Court of Appeals for the

Ninth Circuit affirmed our conclusion that the partnership

involved there had no realistic prospect of engaging in its own

trade or business in connection with the development of software

at the time it incurred the research expenditures in dispute. 

The Court of Appeals agreed that the evidence in that case

established that the partnership “had neither the objective

intent nor the capability of entering such a business.” Id. at

1519. We reach the same conclusion here. 

In Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987), the

Supreme Court reviewed prior cases, including Snow v.

Commissioner, supra, and stated that “to be engaged in a trade or

business, 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. A sporadic activity, a hobby, or an amusement diversion

does not qualify.” It is established that tax deductions cannot

be based on “the expedient of drawing up papers to characterize

the transactions in question as something contrary to the
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economic realities thereof, solely to obtain unallowable tax

benefits.” Falsetti v. Commissioner, 85 T.C. 332, 355 (1985). 

We conclude here that the partnership lacked the required profit

objective and that the partnership activity had no substance

beyond the attempted creation of tax benefits. 

Nothing in the record of this case explains who did what and

when to justify the deductions totaling $881,500 over a 3-year

period. It cannot be determined reliably from the record how

much cash actually changed hands, because the exhibits reflect

inconsistent representations by the partnership. The

contributions reported on the limited partnership certificates do

not reconcile with the terms of the partnership agreement. The

Forms 1099-MISC submitted to the Internal Revenue Service do not

reconcile with the reports to the partners. Payments in evidence

primarily went from the partnership to Knox and back to the

partners. The cash payments are a small fraction of the

deductions claimed. The size of the payments belies the

allegation that much work was actually performed. The only

indication that anything tangible was done are the diskettes

produced by Montelius in 1995 expressly for the purpose of being

presented to the Appeals Division in an attempt to settle this

case. 

By contrast, the record contains various exhibits and

testimony suggesting that the partnership’s primary purpose was

to promote the political and economic views of Knox and,
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acccordingly, to deny tax revenues to the Federal Government. 

Petitioner’s trial memorandum states, in part:

the product sought to be developed by the partnership

here dealt simultaneously with politically driven

investment economics, and the computer software and

hardware industries which both underwent watershed

revolutions in the years since the product development

began. In spite of delays, the product has been

managed to professional engineering specifications,

and, a working prototype thereof attempts to solve at a

personal level what at this moment is the biggest

political issue of all, how to deal with government’s

relationship with the economy without depending on the

politicians, who may not be able to perform. 

 

Knox testified:

Q. Could you explain to us how * * * [the

computer software] was supposed to work?

A. I had a background in political science and

financial planning, as well as law, and I had worked as

a financial planning rather--planner rather than as a

lawyer. And I was interested in the nexus between

government action and economics and investments, and I

had studied the--I’d done some reading and studying in

the--I’d become converted to some economic philosophies

that are founded in what’s called the Austrian School

of Economics, and became convinced that the government

deficit and spending problem was out of control at that

time and would eventually wreak serious consequences on

the economy, and that there existed investment

strategies that individuals could use to counter coming

distortions or upheavals that would affect their

investment portfolios.

Q. So what was the purpose of this product?

A. The purpose of the product was to give

people--the purpose of the product was to discover and

apply proprietary ways of measuring governmental and

political influence on the economy and use these

measurements to develop investment strategies that

would be used through the--through computer software,

so that people could use the computer software to

design investment strategies to counter political and

governmental influences in the economy. 
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Neither Knox nor anyone else provided any specific explanation,

examples, or research product that showed how the product would

or could work, or how the research would lead to an actual

business activity. Petitioner and Knox merely offered hearsay

materials that allegedly corroborated their view of the problems

in the national economy. 

Petitioner introduced expert testimony and a report that

analyzed the diskettes created in 1995. The expert report

specifically stated, however, that the expert was not an

economist and did not “fully understand the economic projections

and usefulness of the goals of this software and furthermore

cannot comment on the algorithms used in the software.” 

The record is devoid of any plan for production of the

software for sale to the public, and petitioner stipulated to the

absence of arrangements for marketing any product. Knox and

Montelius made a few self-serving reports to investors, some of

which were prepared after audit of the partnership’s returns

commenced, but the reports are not corroborated by any nonhearsay

evidence, and they lack credibility. 

The record supports various inferences about the

tax-avoidance purpose of the partnership and the motivation of

Knox and the other partners; it negates economic substance or

profit objective. The evidence does not support a finding that

the partnership had either the objective intent or the capability

of entering into any business. Petitioner has failed to satisfy
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his burden of proving that respondent’s determination is

erroneous in any respect. Upon due consideration of the entire

record, 

Decision will be entered

for respondent.