F I L E D

United States Court of Appeals

Tenth Circuit

SEP 8 1997

PATRICK FISHER

Clerk

PUBLISH

UNITED STATES COURT OF APPEALS

TENTH CIRCUIT

LDL RESEARCH & DEVELOPMENT

II, LTD., a limited partnership;

ENSIGN MANAGEMENT GROUP,

INC. And TAX MATTERS

PARTNER,

Petitioners - Appellants,

v.

COMMISSIONER OF INTERNAL

REVENUE,

Respondent - Appellee.

No. 95-9014

Appeal from the United States Tax Court

for the Commissioner of Internal Revenue

(D.C. No. 19566-91)

David C. Wright of Kruse, Landa & Maycock, L.L.C., Salt Lake City, Utah for

the Petitioner - Appellant LDL Research & Development.

Annette M. Wietecha (Ann B. Durney with her on the brief), Department of

Justice, Washington, D.C. for the Respondent - Appellee.

Before SEYMOUR, LOGAN and LUCERO, Circuit Judges.

LUCERO, Circuit Judge.
1

In the absence of § 174(a)(1), research expenditures would not be deductible as

current expenses because they are capital in nature, i.e. they yield benefits over a period

of time rather than when incurred. See Spellman v. Commissioner, 845 F.2d 148, 149

(7th Cir. 1988). See also William Natbony, The Tax Incentives for Research and

Development: An Analysis and a Proposal, 76 Geo. L.J. 347, 348 (1987) (“Without

section 174, research and experimental expenditures would be capitalized into the cost of

the resulting developed technology and recovered for tax purposes only as the developed

technology was depreciated or amortized.”).

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Section 174(a) of the Internal Revenue Code allows “[a] taxpayer [to] 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.” In this case we are required to determine when a partnership’s

expenditures made to third parties to engage in research are “in connection with

[the partnership’s] trade or business” and consequently deductible as current

expenses pursuant to 26 U.S.C. § 174(a).1

I

At issue in the present case are three claimed deductions made by a Utah

limited partnership, LDL Research and Development II (“LDL II”), for research

and development expenditures paid to a Utah corporation, Larson-Davis

Laboratories (“Larson-Davis”). The deductions were claimed on LDL II’s tax

returns for 1983, 1984, and 1985, and total some $1,111,210. Larson-Davis was

founded in 1981 by two engineers, Brian Larson and Larry Davis, to research,
2Originally, the managing general partner of LDL II was CFS Properties, Inc., a

Utah corporation that specialized in sponsoring real estate limited partnerships. In 1986,

CFS Properties was replaced as managing general partner by Ensign Management Group,

Inc. 

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develop, manufacture, and market acoustic and vibration testing electronic

equipment. Both Larson and Davis had extensive prior experience in these areas

of expertise. In contrast, the general partners of LDL II had only minimal

experience in researching, developing, manufacturing and marketing such

equipment.2

In November 1983, Larson-Davis concluded a number of written

agreements with LDL II, including a “Development Agreement,” “Cross-License

Option Agreement,” and “Purchase Option Agreement.” Under the terms of the

Development Agreement, LDL-II was to pay Larson-Davis $975,000 in three

annual installments in return for Larson-Davis developing various electronic

testing devices. Larson-Davis was to send LDL-II monthly and quarterly reports

regarding the status of research and development of the devices. Under the

Development Agreement, which was to terminate on the earlier of October 1,

1986 or the date the devices were ready for commercial production, LDL-II would

be the exclusive owner of the technology developed by Larson-Davis.

While the Development Agreement suggests LDL-II would own the

resulting technology, the other agreements indicate that its ownership was not
3LDL-II and Larson-Davis concluded two other written agreements: a

“Development License” and a “Use License Option Agreement.” Under the

Development License, LDL-II paid Larson-Davis $25,000 to use the latter’s existing

“base” technology in the research and development of the proposed devices. This

nonexclusive license was to terminate at the same time as the Development Agreement. 

Under the Use License Option Agreement, LDL-II held an option to acquire a

nonexclusive license to Larson-Davis’s base technology following the termination of the

Development License. If the option were exercised, LDL-II would pay Larson-Davis

0.25% of revenue from sales of products incorporating the base technology as a royalty

fee up to a total of $80,000.

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absolute. Under the terms of the Cross-License Option Agreement, Larson-Davis

held an option on a non-exclusive license to manufacture and market developed

devices for 14 months. If the option were exercised, LDL-II would receive a 12%

royalty fee. Finally, under the terms of the Purchase Option Agreement, LarsonDavis held an option to buy all rights in the technology outright from LDL-II. If

exercised, LDL-II would receive a 15% royalty fee up to a total of $6.35 million. 

At that point, Larson-Davis would transfer 5% of its stock to LDL-II.3 All rights

in the technology were to pass to Larson-Davis at the time the Purchase Option

was exercised. 

Simultaneous with these agreements, LDL-II published a “Private

Placement Memorandum” (or “PPM”) designed to attract investors to the

partnership. The PPM stated that Larson-Davis would research, develop,

manufacture and market two specific electronic devices. The PPM further stated

that the general partners of LDL-II were not significantly experienced in
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researching, developing, manufacturing, or marketing such devices, and that

LDL-II had done no study on the marketability of the proposed devices. By the

terms of the PPM, LDL’s limited partners would obtain tax benefits from 1983 to

1985 as § 174(a) deductions reported by LDL II were passed through to investors. 

Limited partners would also have the prospect of cash distributions from 1986

onward. The PPM anticipated that a total of $1,905,300 in capital would be

raised, principally from the sale of limited partnership units and promissory notes. 

Some $975,000 would be paid to Larson-Davis by the terms of the Development

Agreement, while $905,000 would go to LDL-II for salaries, administrative costs,

and interest payments on the promissory notes, and $139,149 would be held as a

cash reserve. The limited partnership shares sold would allow LDL II to raise a

further $224,000 from its limited partners as needed.

In 1985, Larson-Davis developed the “Series 3100 Real Time Analyzer”

(the “3100”), which performed the functions of both electronic devices described

in the PPM and Development Agreement. In April 1986, LDL-II exercised its

option under the Use License Option Agreement. In October of that same year,

Larson-Davis exercised its option under the Cross License Option Agreement to

market and manufacture the 3100. In November 1987, LDL-II and Larson-Davis

entered into a Memorandum of Agreement that extended the terms of the Cross

License Option Agreement for a further five months. Though it appears that
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Larson-Davis never formally exercised its rights under the Purchase Option

Agreement, Larson-Davis paid LDL-II the higher 15% royalty fee from June

1988. In total, Larson-Davis paid LDL-II some $236,196 in royalties between

1986 and 1989. Thereafter, sales of the 3100 declined. Because Larson-Davis

apparently never exercised its option under the Purchase Option Agreement, LDLII continues to hold the rights to market and manufacture the 3100. However, it

has never pursued these rights.

Following an audit, the Internal Revenue Service disallowed the deductions

on grounds that LDL-II was not engaged in a trade or business in connection with

the research and development expenditures made to Larson-Davis. LDL-II

challenged the Commissioner’s ruling in the United States Tax Court. When

judgment was entered for the Commissioner, LDL-II appealed to this court. We

exercise jurisdiction pursuant to 26 U.S.C. § 7482. We conclude that the tax

court properly denied the deductions claimed by the partnership.

II

A taxpayer’s research and development expenditures are deductible under §

174(a) only if they are incurred in connection with the taxpayer’s trade or

business. Nickeson v. Commissioner, 962 F.2d 973, 976 (10th Cir. 1992). The

taxpayer has the burden of proving that amounts deducted are spent for qualified

research and experimental expenditures. Lisa Fagan et al., Mertens Law of
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Federal Income Taxation, § 25.95, at 260. We determine the availability of a

deduction pursuant to § 174(a), first, by making “an initial inquiry into whether

the activity was undertaken or continued in good faith, with the dominant hope

and intent of realizing a profit, i.e., taxable income therefrom.” Nickeson, 962

F.2d at 976 (internal quotations omitted). In this case, the Commissioner has

conceded that LDL-II’s payment of research and development expenditures to

Larson-Davis had a bona fide profit motive and was not made merely to reap tax

benefits.

To claim a deduction, LDL-II need not carry out any actual research. The

Commissioner has interpreted § 174(a)(1) to allow deductions to be taken

not only [for] costs paid or incurred by the taxpayer for research and

experimentation undertaken directly by him but also for expenditures

paid or incurred for research or experimentation carried on in his

behalf by another person or organization (such as a research institute,

foundation, engineering company, or similar contractor).

Treas. Reg. § 1.174-2(a)(2). Neither the Internal Revenue Code nor Treasury

regulations defines “in connection with the taxpayer’s trade or business” more

specifically.

In this circuit, research expenditures are made “in connection with” the

partnership’s trade or business if the taxpayer is “actively involved in the

[research project] as a trade or business.” Nickeson, 962 F.2d at 978. Other

circuits also allow research expenditures to be deducted under § 174 if a taxpayer
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has a “realistic prospect” of such involvement. See Spellman, 845 F.2d at 149. 

LDL-II claims to satisfy either the “active involvement” or “realistic prospect”

tests. The Commissioner disputes both contentions.

In this case, the Tax Court ruled that LDL-II was neither actively engaged

in a trade or business nor had a realistic prospect of being so. Its basis for

concluding that LDL-II was not actively engaged in a trade or business was the

partnership’s lack of control over the activities of Larson-Davis. The former

could only insist that Larson-Davis spend the $975,000 on 3100 research, and

provide the partnership with progress reports. LDL-II’s actual activities were

limited to “ministerial” functions such as “filing tax returns, receiving status

reports from [Larson-Davis], and informing investors of the status of the research,

development, manufacture, and marketing of the electronic devices.” Tx. Ct. at

16.

The Tax Court also concluded that LDL-II lacked a realistic prospect of

engaging in a trade or business in connection with the 3100 technology. First,

compared to the principals of Larson-Davis, LDL-II had little or no experience in

the research, development, manufacture, and marketing of electronic devices. 

Second, the written documents made clear that LDL-II was in fact relying on

Larson-Davis to perform all these functions; whatever rights LDL-II retained to

manufacture or market the devices were purely theoretic. LDL-II had no plans in
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place to market and manufacture the devices should Larson-Davis not exercise its

options to do so. Thus, there was only a “mere possibility” that LDL-II would

enter the relevant trade or business. See Tx. Ct. at 19. Third, LDL-II lacked the

capital and employees necessary to market and manufacture the 3100. 

Accordingly, the Tax Court regarded LDL-II as a passive investor and unentitled

to the deductions claimed. 

LDL-II believes that the Tax Court erred in crediting the “form” of its

relationship with Larson-Davis over its actual “substance.” According to LDL-II,

the latter should control the tax consequences of their deal with Larson-Davis. 

LDL-II also contends that because the Commissioner conceded the partnership

had a profit motive, it must have been more than a passive investor in LarsonDavis. Both arguments fit within LDL-II’s contention that its day-to-day

activities in connection with the 3100 project demonstrate entitlement to the §

174(a)(1) deductions because LDL-II was actively engaged in a “trade or

business” as required by the statute.

We review the Tax Court’s factual findings under the clearly erroneous

standard and purely legal questions de novo. 26 U.S.C. § 7482(a); Hawkins v.

Commissioner, 86 F.3d 982, 986 (10th Cir. 1996). That court’s “ultimate

determination that the partnership’s expenditures were not ‘research or

experimental expenditures . . . in connection with [a] trade or business’ involves
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the application of law to fact, and calls for de novo review by this court.” 

Scoggins v. Commissioner, 46 F.3d 950, 952 (9th Cir. 1995). We therefore reject

the Commissioner’s contention that we should review the ultimate facts of this

case—whether the taxpayer satisfied either the active involvement or realistic

prospect tests—under a clear error standard.

III

A

To be actively involved in the 3100 project as a trade or business, LDL-II

must be more than a passive investor in the 3100 project. See Nickeson, 962 F.2d

at 978. We have not definitively established the boundary between passive

investment and active involvement. In Nickeson, we relied on Zink, 929 F.2d at

1021, Higgins, 312 U.S. at 218, Snyder v. United States, 674 F.2d 1359, 1364

(10th Cir. 1982), Levin v. Commissioner, 832 F.2d 403, 406 (7th Cir. 1987), and

Diamond v. Commissioner, 930 F.2d 372, 376 (4th Cir. 1991). See Nickeson, 962

F.2d at 978. In those cases, the primary determinant between involvement and

investment was the degree of taxpayer control over, or regular and substantial

participation in, the project in question. See id. (to claim § 174(a)(1) deduction,

taxpayer “must show . . . that their activities were substantial and regular enough

to establish that they were actively involved in the trade or business”); Zink, 929

F.2d at 1022 (“The lack of control over the activities in which [taxpayers]
4The partnership argues that accepting the Commissioner’s stipulation that the

R&D project was carried on with a profit motive is itself sufficient to prove that its

activities were in connection with an active engagement in a trade or business. It is true

that in determining whether a taxpayer has a profit motive, courts may consider a large

number of factors, including the question of whether the taxpayer is merely a passive

investor. See Nickeson, 972 F.2d at 973, citing Diamond v. Commissioner, 930 F.2d 372,

376 (4th Cir. 1991). But the presence of a profit motive cannot establish that LDL-II was

ever more than a passive investor. As Nickeson makes clear, the taxpayer must show a

profit motive and substantial activities demonstrating active engagement. There would be

no point to this two-step analysis if the latter step flowed from the former as a matter of

course. See Nickeson, 962 F.2d at 978; see also Zink, 929 F.2d at 1021 (“Obviously,

establishment of the requisite profit motive alone does not satisfy section 174); Harris v.

Commissioner, 16 F.3d 75, 80 (5th Cir. 1994) (same). Active engagement ensures that

the expenditures are made in connection with the taxpayer’s trade or business. See §

174(a).

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invested leads to the conclusion that they were merely investors.”); Diamond, 930

F.2d at 376 (taxpayer lacking control over project in which it invests, and without

“a say in [its] affairs,” properly classified as investor); Levin, 832 F.2d at 406

(where taxpayer “dominated” by researching entity and “had no independent

expertise in the . . . business,” Tax Court permissibly concluded investor only).

The Tax Court’s conclusion that LDL-II’s involvement in the project at the

time the deductions were claimed was insufficient to justify the deductions

claimed under the active involvement test is based on the factual finding that

LDL-II’s on-going activities toward the project during the years in question were

limited to “filing tax returns, receiving status reports from the Lab [i.e. LarsonDavis], and informing investors of the status of the research, development,

manufacture, and marketing of the electronic devices.”4 Tx. Ct. at 16. Noting the
Of course, where a taxpayer has not contracted out the research portion of a

production process, the concession of profit motive will a fortiori entitle it to deduct the

costs of its research expenditures pursuant to § 174(a)(1). So long as the resultant

technology is intended for commercial exploitation of some kind, then the taxpayer’s

research costs are presumptively expended in connection with its trade or business. In

such a case, the taxpayer’s “active involvement” in the research project will usually be

readily established. The present dispute, by contrast, involves a taxpayer who chose to

contract out the research work involved. In such a case, the question to be resolved is

whether the taxpayer’s other connections to the work performed are sufficient to establish

“active involvement.” 

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partnership’s agreements with Larson-Davis, the Tax Court found that the only

indicia of LDL-II’s control over the 3100 project were its “right . . . to receive

reports and the limitation on the Lab [Larson-Davis] in the use of the $ 975,000.” 

Id.

Unless these findings are clearly erroneous, we must affirm the tax court’s

determination that LDL-II was not actively engaged in the 3100 project. 

Appellant argues that many of the Tax Court’s factual findings proceed from

erroneously elevating the “form” of the relationship between LDL-II and LarsonDavis above its “substance.” Appellant views the written agreements between

itself and Larson-Davis as the “form” of their relationship. The true substance of

that relationship, appellant contends, is revealed in unrebutted oral testimony

given at trial by CFS employees who worked for LDL-II and by employees of

Larson-Davis who were familiar with the interactions between the two firms. 

This testimony allegedly indicates that LDL-II exercised a far greater degree of
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control over Larson-Davis and was far more actively engaged in connection with

the 3100 business than the Tax Court found on the basis of the formal relationship

between the two.

LDL-II incorrectly characterizes the basis of the Tax Court’s factual

findings. A close reading of the decision below reveals that the lower court

credited the “form” of the relationship over what appellants view as its substance

only inasmuch as it perceived the written agreements between Larson-Davis and

LDL-II to be more revealing of the true substance of the relationship than the oral

testimony presented at trial. The Tax Court explicitly recognized that to

determine the taxpayer’s entitlement to a deduction under § 174(a)(1), “all of the

surrounding facts and circumstances are relevant.” Tx. Ct. at 13. Moreover, it

expressly found the oral testimony offered by LDL-II at trial to be “vague,” and

concluded that the appellant had failed to produce “documentary evidence or

other credible testimony that would indicate that the general partners of LDL

exercised any significant direction or control over the Lab.” Id. at 17 (emphasis

added). 

“If the district court’s account of the evidence is plausible in light of the

record viewed in its entirety, the court of appeals may not reverse it even though

convinced that had it been sitting as the trier of fact, it would have weighed the

evidence differently. Where there are two permissible views of the evidence, the
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factfinder’s choice between them cannot be clearly erroneous.” Anderson v. City

of Bessemer City, 470 U.S. 564, 573-74 (1985); see also id. at 575 (“When

findings are based on determinations regarding the credibility of witnesses, Rule

52(a) demands even greater deference to the trial court’s findings.”). Reviewing

the testimony offered, we conclude that the tax court’s decision to credit the

substance of the relationship as established by the written agreements between

LDL-II and Larson-Davis, and by the PPM, was not clearly erroneous.

Applying the facts to the law, the right to receive reports and monitor the

use of the contributed funds cannot render LDL-II actively involved in the

electronic acoustic testing equipment business. To suppose otherwise would

mean that a “bond debenture entitling the debenture trustee to inspect the books

and plants of the corporation issuing the bonds would make the bondholders joint

venturers with the corporation.” Spellman, 845 F.2d at 151. At least as to a startup R&D partnership, the right to require contributed funds to be spent on a

specified research project cannot establish active involvement in a trade or

business. Such funding may constitute the R&D partnership’s initial steps into

the trade or business in question—but that will only be the case where the

partnership will ultimately control the commercial exploitation of the fruits of the

research. If the partnership will not exercise such control, then the initial

research funding will be merely a passive investment in a specific research
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project. Ear-marking funding cannot, without more, establish active involvement

in a trade or business. That is the case regardless of whether LDL-II expended

energy and resources in determining which research project should receive its

prospective investment. Managing investments, no matter how time-consuming

or lucrative, does not constitute a trade or business. See Higgins v.

Commissioner, 312 U.S. at 218; Zink v. United States, 929 F.2d 1015, 1021 (5th

Cir. 1991) (citing Higgins, 312 U.S. at 218; Whipple v. Commissioner, 373 U.S.

193, 202 (1963)); but see Commissioner v. Groetzinger, 480 U.S. 23, 35-36

(1987) (full time professional gambler engaged in trade or business).

Supreme Court precedent strongly suggests that any non-financial

contributions LDL-II may have provided Larson-Davis would not in and of

themselves establish LDL-II’s active involvement in the 3100 trade or business. 

In Whipple, the Supreme Court stated:

Devoting one's time and energies to the affairs of a corporation is not

of itself, and without more, a trade or business of the person so

engaged. Though such activities may produce income, profit or gain

in the form of dividends or enhancement in the value of an

investment, this return is distinctive to the process of investing and is

generated by the successful operation of the corporation's business as

distinguished from the trade or business of the taxpayer himself.

When the only return is that of an investor, the taxpayer has not

satisfied his burden of demonstrating that he is engaged in a trade or

business since investing is not a trade or business and the return to

the taxpayer, though substantially the product of his services, legally

arises not from his own trade or business but from that of the

corporation. 
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373 U.S. at 202. Of course, LDL-II might have provided certain services to

Larson-Davis for purposes other than protecting its pre-existing investment in the

3100 company. For instance, the two firms might have negotiated for LDL-II to

have provided such services for compensation separate from return on investment. 

If that were the case, then LDL-II might be able to establish its services were

provided in connection with a trade or business, see id. at 202-03, and leave open

the possibility that its research expenditures would be deductible. However, the

written agreements between Larson-Davis and LDL-II provide no indication

whatever that LDL-II was expected or required to provide anything more than

research funds. Even the oral testimony offered by LDL-II—discounted though it

was by the Tax Court—does not suggest that LDL-II’s legal, accounting, or other

business services were factored into the overall bargain negotiated between the

two concerns. Thus, even if Larson-Davis came to rely on LDL-II for such

services, there is no record to support a finding that the partnership was doing

more than promoting or protecting its investment. Such is not “active

involvement” for the purposes of § 174(a). See, e.g., Kantor, 998 F.2d at 1520

(noting that limited partner’s “activities with the research firm on behalf of the

partnership were consistent with those of an investor who applies his knowledge

and expertise to insure that an investment is successful”).
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B

Many start-up R&D partnerships that contract out research work will not

qualify for § 174(a)(1) deductions under the “active involvement” test. In the

years the deductions are claimed, such partnerships will often have too limited a

connection to a trade or business to establish the kind of proprietorial control that

can validate the deduction of research expenditures under § 174(a)(1). The

“realistic prospect” test, which is in effect a specific form of the active

engagement test, arises from the Supreme Court’s determination that, in order to

qualify for a deduction under § 174(a)(1), a taxpayer need not be actively engaged

in a trade or business at the time research expenditures are made. See Snow v.

Commissioner, 416 U.S. 500, 503-04 (1974). On the basis of legislative history,

the Snow Court held that § 174(a)(1) was partly intended to benefit start-up

research and development companies. Id. at 503. The Court upheld the

deductibility of research expenditures by a taxpayer who had reported no sales

during the year for which the deduction was claimed, but whose expectations of

entering the market with a developed product were at that time high and, indeed,

subsequently realized. Id. at 502-04.

Snow “fairly invited the creation of R&D tax shelters,” Spellman, 845 F.2d

at 151, and has been interpreted narrowly to require that deducted research and

development expenditures be directed at projects with “realistic prospects” of
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“developing a new product that will be exploited in a business of the taxpayer,”

id. at 149. “If those prospects are not realistic, the expenditure cannot be ‘in

connection with’ a business of the taxpayer,” who therefore remains merely a

passive investor. Id. In light of Snow, a taxpayer demonstrates a “realistic

prospect” of entering its own business in connection with the research project, by

“manifesting both the objective intent to enter such a business and the capability

of doing so.” Kantor v. Commissioner, 998 F.2d 1514, 1518 (9th Cir. 1993). 

Hence, the mere possibility of engaging in a project-connected trade or business

does not satisfy the requirements of § 174(a). Id. at 1520; Levin, 832 F.2d at

406-07. By the same token, the bare contractual right to enter such a business

does not entitle the taxpayer to a § 174(a)(1) deduction. Rather, the “right

question” is “whether the partnership[] reasonably anticipated availing [itself] of

the privileges [it] possessed on paper.” Levin, 832 F.2d at 406.

Snow does not question an investor’s lack of entitlement to § 174

deductions. See Nickeson, 962 F.2d at 978. “Tax law draws a fundamental

distinction between engaging in a business of one’s own and investing in the

business of another.” Kantor, 998 F.2d at 1519 (citing Whipple, 373 U.S. at 202;

Higgins, 312 U.S. at 218). By its plain language, § 174(a)(1) is limited to

expenditures made by the taxpayer in connection with his trade or business. 

Accordingly, the IRS has consistently and reasonably maintained that investors in
5Of course, if the taxpayer has no intention of exploiting for profit the fruits of the

research, the deductions claimed will not be in connection with its trade and business. 

See Boris I. Bittker & Lawrence Lokken, 1 Federal Taxation of Income, Estates and

Gifts, ¶ 26.3.1 (2d ed. 1989) (“A fortiori, § 174 does not embrace research conducted as a

hobby or any other project not engaged in for profit.”).

6 There remains, for instance, the question of how sustained or regular the

taxpayer’s commercial exploitation of the fruits of the research must be to constitute a

trade or business under § 174(a)(1). Interpreting 26 U.S.C. § 162(a), which allows

deductions for “ordinary and necessary business expenses . . . incurred in carrying on any

trade or business,” the Supreme Court has held that “to be engaged in a trade or business,

the taxpayer must be involved in the [income or profit producing] activity with continuity

and regularity . . . . A sporadic activity . . . does not qualify.” Commissioner v.

Groetzinger, 480 U.S. 23, 35 (1987); see also Snyder, 674 at 1364 (holding that taxpayer

must “devote[] sufficient time over a substantial enough period to be in a trade or

business under section 162”).

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R&D partnerships should receive the same tax treatment as investors in other

enterprises, and should not be able to avail themselves of §174(a)(1). Thus,

investment risk from a project’s potential failure is not enough to confer

entitlement to a research deduction under the “realistic prospect” test. Rather, the

taxpayer who funds research activities by another party can only claim such a

deduction if it will own the results of the research project at its completion, and

will thereby accede to the benefits and costs of proprietary control.5 By assuming

an expectation of ownership before the research has been conducted, the taxpayer

ensures that its research payments to another party are potentially in connection

with its own future trade or business. The question is not wholly determined by

ownership because the taxpayer’s intended commercial exploitation must still

meet the definition of a “trade or business.”6 But unless it assumes a realistic
We express no opinion as to whether this case law is applicable to § 174(a)(1)

deductions, and, if so, whether certain forms of commercially exploiting research

products might be too irregular or unsustained to constitute a trade or business. We note,

however, that the Groetzinger court was careful to observe that any effort to provide an

all-purpose definition for “trade or business” applicable to all Code contexts “would be

counterproductive, unhelpful, and even somewhat precarious for the overall integrity of

the Code.” 480 U.S. at 36. We further note that the § 174(a)(1) regulations state that the

term, “research . . . expenditures, . . . generally includes all . . . costs incident to the

development and improvement of a product,” § 1.174-2(a)(1), and that “the term product

includes any . . . invention, technique, patent, or similar property, and includes property to

be used in its trade or business as well as products to be held for sale, lease, or license,” §

1.174-2(a)(2) (emphasis added). 

7Similarly, a partnership that funds research by buying stock with a future

expectation of return in the form of dividends functions as an investment vehicle and is

consequently unentitled to § 174 deductions. See Harris, 16 F.3d at 78.

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expectation of owning the resulting technology for purposes of commercial

ownership, the taxpayer’s research expenditures will be made in connection with

another party’s trade or business, and will not be deductible.

The risks of investing in a research endeavor and of assuming its

ownership, including the risk associated in carrying on a trade or business from

any technology that it may produce, are not readily separable. At the extremes,

the differences are apparent. A taxpayer that funds research by another party in

return for royalties is clearly no more than an investor making a capital

contribution to the trade or business of another. See Spellman, 845 F.2d at 150

(comparing such contributions to the purchase of a share in an oil lease).7

Conversely, a profit-motivated taxpayer that funds research by another party in

return for full ownership of the research results assumes the risks associated with
8Appellant’s reliance on cases such as Smith v. Commissioner, 937 F.2d 1089 (6th

Cir. 1991) and Goldman v. Commissioner, 55 T.C.M. (CCH) 1490 (1988), is accordingly

misplaced. In both Smith and Goldman the partnerships anticipated owning the resulting

technology for their own commercial exploitation.

9

 In such circumstances, an R&D partnership can no longer rely on the language

of Treas. Reg. § 1.174-2(a)(8), which allows the taxpayer to deduct expenditures incurred

for research carried on “in his behalf.” See William Natbony, Tax Shelters and Section

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the expectation of ownership. It is accountable for any liabilities generated by the

research product, and stands to reap the entire financial benefit of the research

project proving successful. Assuming that the taxpayer objectively manifests its

intention to exploit the fruits of the research product in an adequately commercial

capacity, it presumptively makes the research expenditure in connection with its

trade or business. 

LDL-II clearly believes that as the stated “owner” of the results of the 3100

research venture, it is entitled to the deductions. Had the partnership simply

engaged Larson-Davis to perform certain research, LDL-II would have had an

entirely realistic expectation of assuming the full benefits and costs of ownership;

all the returns and liabilities of the final product would have been its own. But by

granting Larson-Davis the two options contained in the Cross-License and

Purchase Option Agreements, LDL-II’s expectations of ownership were far

different.8 In effect, the options show that it was Larson-Davis that bargained for

an expectation of ownership, thereby assuming the risks and rewards of

proprietary control.9
174: Research and Experimental Expenditures in the Tax Shelter Context, 4 Journal of

Taxation of Investments 19, 26-27 (1986) (§ 1.174-2(b)(8) “necessitates that the research

be at the taxpayer’s risk and for his reward, the principal attributes of ownership; that is,

for the taxpayer to be entitled to the Section 174 deduction when research is performed

‘in his behalf,’ he must be the owner in substance as well as form. Thus, under a tax

shelter R&D contract, the contractor must serve solely as agent of the taxpayer, not

sharing in any risks or rewards of successful research.”).

10The Purchase Option Agreement provides in pertinent part:

7. Indemnity; Prosecution of Actions

(a) The Corporation [Larson-Davis] will promptly give the

Partnership [LDL-II] written notice of and defend at the Corporation’s sole

expense any action or proceeding brought after the Purchase Option

Exercise Date by any third party against the Partnership or the Corporation

on account of manufacture, production, use or marketing of the Resulting

Technology by the Corporation and shall indemnify and save the

Partnership harmless against any and all losses, expenses and damages

(including reasonable fees of attorneys, accountants and similar advisors)

which may be incurred by the Partnership therein or settlement thereof.

Ex. 11-K, at 11-12. 

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Thus, should the completed research have proven marketable, Larson-Davis

would likely have exercised its option rights. In return for its earlier financial

contributions, LDL-II would have been left with the prospect of royalty returns, a

reduced exposure to products liability,10 and, for the fourteen month period of the

Cross-License Agreement, the opportunity to sell non-exclusive, short-term

licenses to parties other than Larson-Davis. These are not the indicia of

ownership that would indicate a realistic prospect of entering a business in

connection with the 3100. Royalty returns on funding a fortiori flow to investors. 

See Spellman, 845 F.2d at 150. Larson-Davis’s indemnification responsibilities
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under the Purchase Option Agreement were “not those of a licensee, but of the

owner of the ultimate product.” Property Growth Co. v. Commissioner, 55

T.C.M. (CCH) 1072 (1988), aff’d, 889 F.2d 1090 (8th Cir. 1989). At trial, LDLII provided no evidence that there was any market for non-exclusive 14-month

licenses to the technology, or that it intended to enter such a market, or that it

would be able to do so in and for such a short time frame. Cf. Zink, 929 F.3d

1023 (noting that legal entitlement to go into business retained by taxpayer’s

licensing technology “nonexclusively” not determinative when “totally lacking in

commercial reality.”); see also Martyr v. Commissioner, 60 T.C.M. (CCH) 1115

(1990) (holding that where R&D partnership granted researching entity before

completion of research 13-month non-exclusive license option and exclusive

license option exercisable thereafter, § 174(a)(1) deductions properly disallowed),

aff’d, 999 F.2d 543 (9th Cir. 1993); Everett v. Commissioner, 58 T.C.M. 1366

(1990) (same).

In the event Larson-Davis concluded that the results of the research were

not marketable, and accordingly chose not to exercise its options, LDL-II would

accede to ownership. But in such circumstances, LDL-II would be left with a

marginal asset and few prospects for entering a trade or business in connection

with the fruits of the research. Where Larson-Davis chose not to exploit the law
11LDL-II suggests that it might also have acceded to ownership because of the

“significant” option purchase price of $6.35 million. However, the Purchase Option

Agreement makes clear that this payment was to be made in the form of royalties, and that

the transfer in ownership would occur when the option was formally exercised, not when

the full “purchase price” had been paid, see Ex. 11-K, at 5, 7-8. Thus, unlike the situation

considered by the Ninth Circuit in Scoggins, 46 F.3d at 952, the purchase price in this

case represented little barrier to Larson-Davis’s assumption of ownership. In Scoggins, a

deduction of $500,000 in research expenditures was permitted where the sale price was

$5 million, with $1 million to be paid in cash and the remainder by an interest-bearing

promissory note. Scoggins, 46 F.3d at 951-52. In the present case, the deductions claimed

were for in excess of $1 million and the sale price was $0 up-front, plus specified

royalties up to specified total. Cf. Kantor, 998 F.2d at 1517 (disallowing deduction of

$3.15 million where sale price was $5,000 up-front, plus specified royalties).

12LDL-II intimates that the fourteen-month cross-license option was designed to

allow the partnership to exploit other avenues for marketing and manufacturing the 3100

technology should Larson-Davis’s sales performance prove disappointing. But LDL-II

remained obliged to yield all rights to the technology to Larson-Davis should the latter

simply choose to make a higher royalty payment under the terms of the Purchase Option

Agreement. Thus, LDL-II would never really have had the opportunity to “pull” LarsonDavis from the marketing and manufacturing ends of the project unless Larson-Davis

itself found its sales disappointing and chose to abandon the project. LDL-II nowhere

explains why it would try to enter a business with a product whose previous sellers, armed

with far greater marketing and manufacturing experience in the field, had concluded it

was not commercially viable. See Medical Mobility v. Commissioner, 66 T.C.M. (CCH)

741 (1993) (“Even if the grantor has sufficient resources to bring the product to market, it

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of contracts to assume ownership of the completed research, the laws of

economics would likely preclude commercial exploitation.

LDL-II claims its expectations of ownership were far broader.11 It tells us

it insisted on retaining ownership of the resultant technology so that had LarsonDavis failed as a commercial enterprise, the partnership would have been able to

enter the business of selling 3100 products itself—a proposition that amounts to

“putting in good money after the bad.”12 LDL-II has not shown that this retained
is unlikely that he will do so, in the face of the optionee’s appraisal that the project is not

commercially viable.”).

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interest was based on anything more than the possibility of Larson-Davis’s

failure. See Kantor, 998 F.2d at 1520; Levin, 832 F.2d at 406-07 (mere legal

possibility of entry into trade or business insufficient to satisfy § 174(a)(1)). The

partnership’s possible succession to an ownership interest it never intended to

exploit would not automatically put it in the 3100 trade or business any more than

“foreclosing on a real estate mortgage would make a bank a real estate company.” 

Spellman, 845 F.2d at 150. Tom Christopolous, who was an analyst at CFS

Properties during 1983-85, stated that “if Larson-Davis couldn’t make it,” the

firm contemplated “prop[ping] up Larson-Davis” and “hiring the existing

salespeople and bringing them inside CFS,” but admitted that the plans for this

“purely hypothetical” contingency were not “real finite.” See III R. at 127-29. 

Moreover, he stressed that plans were limited “because the project, basically, with

the exception of the initial period, hit its numbers.” Id. at 128-29.

As the tax court noted, the PPM suggests LDL-II intended from the outset

that the marketing and manufacturing of the resultant technology be performed by

Larson-Davis pursuant to the terms of the Cross-License and Purchase Option

agreements. The first documentary evidence of LDL-II’s actually evaluating the

potential for entering the 3100 business through potential licensees other than
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Larson-Davis dates from 1989, four years after the final deductions were claimed. 

See Ex. 28-0. Subsequent investigations confirmed the economic difficulties of

proceeding with any such operation, and concluded that LDL-II should continue

to allow Larson-Davis to market and manufacture the technology for a dwindling

royalty return despite Larson-Davis’s actual failure to purchase the technology

outright. See Ex. 52. These facts support the conclusion that LDL-II had sought

to deduct “a capital contribution to a company that was in the business of

developing new products,” and not “a development expense in connection with its

own . . . prospective business.” Spellman, 845 F.2d at 150. Such a deduction

must be disallowed.

At best, then, the record shows no more than that LDL-II briefly made

vague, worst-case plans. Even were we to find clear error in the Tax Court’s

refusal to credit the oral testimony offered, the partnership has not shown that it

ever had an objectively realistic prospect of entering the 3100 business. See

Estate of Cook v. Commissioner, T.C.M. (CCH) 1523 (1993) (recognizing that

taxpayers’ “understanding that contingency plans existed to exploit the research if

the license agreement . . . expired or was terminated,” insufficient to establish

necessary connection to taxpayers’ trade or business). Without a far stronger

evidentiary showing that the partnership regarded its takeover of the 3100
- 27 -

business as probable, and planned with serious intent for that probability, we

cannot conclude that the Tax Court erred in its “realistic prospect” analysis.

IV

Section 174(a)(1) was expressly intended to encourage businesses to carry

out research, and we are sympathetic to the view that “[w]ithout R&D

partnerships, many of today’s new technologies would still be on the drawing

board.” Robert L. Wolff, Tax Treatment of Research and Development Limited

Partnerships, 32 Prac. Law. 37, 43 (1986). Certainly, “[t]he uncertain contours of

‘trade and business’ create opportunities for fair debate.” Levin, 832 F.2d at 406. 

Ultimately, however, “[f]air debates about fact-bound matters of characterization

are resolved on appeal in favor of the solution the trier of facts reaches.” Id.

Before making any research expenditures, LDL-II negotiated a set of structured

agreements that undermined its proprietary control of the completed research, and

leave it now unable to overcome the obvious inference that it contractually

assumed the role of an investor. AFFIRMED.