Warren E. Burger: We will hear arguments next in 73-641, Snow against the Commissioner of Internal Revenue. Mr. Doan, you may proceed whenever you are ready.
Burgess L. Doan: Mr. Chief Justice, may it please the Court. This case involves the deficiency in federal income tax for the taxable year 1966. The issue is whether the petitioner is entitled to a deduction for his distributive share of a net operating loss resulting from research and experimental expenditures incurred and paid by Burns, a partnership during the taxable year 1966. Petitioner contends he is entitled to deduct his distributive share of the net operating loss of Burns since the expenses giving rise to this loss were incurred and paid during the taxable year 1966 as research and experimental expenses. These expenses are covered by Section 174 of the Internal Revenue Code of 1954. The Commission of Internal Revenue has disallowed these expenses upon audit of the partnership return on the grounds that neither Burns Investment Company nor the Petitioner Snow was engaged in a trade or business. The United States Tax Court sustained the Commissioner and the Court of Appeals of the Sixth Circuit sustained the Tax Court's decision holding that the expenditures sought to be deducted by Burns Investment Company in 1966 were pre-operating expenses and not deductible under Section 174. The facts of the case were fairly simple. In 1963, Mr. Trott who was the inventor of a trash-burning device and who was also the managing partner of Burns Investment Company resigned from his position with the Procter & Gamble Company and purchased an interest in a small, closely-held corporation doing business as Crossbow. In addition to his activity in Crossbow, Mr. Trott carried on research and development work on three different items: Number one, a telephone answering device; number two, a tape recorder; and number three, the item at issue, a trash burner or a leaf burner. Upon audit of the partnership return, the Internal Revenue Service held that Mr. Trott, the general partner was engaged in the business of an inventor by virtue of his activities in these various projects. The partnerships which were three, which were formed to carry on these various ventures, were doing business as Echo Development Company and that partnership was formed in March of 1965. The second partnership doing business as Courier Enterprises was formed to carry on the development of the tape recorder and that partnership was also formed in March of 1965. The partnership, Burns Investment Company which was formed to carry on the development of the trash burner was formed in 1966. All three partnerships was formed for the same purpose, and that was the development, securing patents on and finally either producing or licensing another manufacture to produce these various items. During 1966, Echo and Courier -- 1966 is the year at issue and during 1966, Echo and Courier had completed products -- that is the tape recorder, and the telephone answering device which was then held available for sale or licensing. Patents had been applied for, in the case of the telephone answering device as of August the 16th, 1966. Patents had been applied for, in the case of the tape recorder as of November 22, 1967. Patents for the trash burner was applied for as of June 10, 1968 and in each instance, patents were granted. And in the case of the trash burner, foreign patents have been granted in at least 14 foreign countries. The Internal Revenue Service held that Burns Investment Company was not engaged in a trade or business during the taxable year 1966. The Internal Revenue Service did not see fit to disturb the status of Echo or Courier, the two remaining partnerships. Mr. Trott, the inventor and the managing partner, testified that he worked on the development of the trash burner during the years 1964 and 1965, and during that time, he devoted at least one-third of his time to that venture. On December 10th 1965, the development of the trash burner had advanced to the stage that Mr. Trott had received an opinion from patent counsel, stating that "features of the trash burner were then patentable" in his opinion. However, he advised against filing an application for a patent in December of 1965 suggesting that the filing be held up until a prototype had been built. The --
Warren E. Burger: And what year was the prototype built?
Burgess L. Doan: Your Honor --
Warren E. Burger: When did the work start on the prototype?
Burgess L. Doan: Many prototypes had been built prior to that time.
Warren E. Burger: I see.
Burgess L. Doan: The prototype, to which we allude as existing in 1965, was a rather crude prototype model that admittedly did have some flaws in it. It did not work well. The second letter which was received from patent counsel in February of 1966, pointed out that the prototype that was then in existence needed further modification, again in the opinion of patent counsel. After receiving the letter from patent counsel advising of that fact in 1966, Mr. Trott proceeded to form the partnership Burns Investment Company to raise capital to further develop the trash burner. After forming the partnership, articles of partnership were drawn up and filed with the Hamilton County Reporter's Office. The partners paid in their capital contributions to the extent of $40,000.00. The partnership proceeded to secure its federal employer identification number. It proceeded to establish its bank accounts. It set up its books and records. It filed its Federal Income Tax Return.
Thurgood Marshall: You have skipped an important point, where was its office?
Burgess L. Doan: Your Honor, the office of Burns Investment Company was in the facilities of the closely-held corporation, Crossbow.
Thurgood Marshall: What? It has a name on the door?
Burgess L. Doan: No, Your Honor, it did not.
Thurgood Marshall: Let's all admit it, it didn't have a name on the door, it didn't have a telephone but where is the "business"?
Burgess L. Doan: The business --
Thurgood Marshall: Of that partnership, just the one, where was that business?
Burgess L. Doan: That business was located within the same building as Crossbow. It did not have a name on the door and it did not have a telephone.
Thurgood Marshall: And the difference between that and Crossbow was what?
Burgess L. Doan: One was a partnership --
Thurgood Marshall: How many employees did this one have?
Burgess L. Doan: It did not have any employees directly. Mr. Trott --
Thurgood Marshall: How do you run a business without employees?
Burgess L. Doan: Mr. Trott was --
Thurgood Marshall: Don't you have to show, you have a partnership business in order to qualify?
Burgess L. Doan: Yes Your Honor, we have to show we have a partnership business.
Thurgood Marshall: I am waiting for you to show me the business. The man is doing experiment on this, he making models and everything but where is his business?
Burgess L. Doan: Your Honor, we submit that his business is the research and the experimental activity carried on in perfecting the trash burner. The partnership Burns Investment Company did enter into a contractual relationship with Crossbow and with other suppliers obligating itself for goods and services. It conducted regular partnership meetings regarding the development work, regarding tests and experiments that were carried on, regarding the design of the trash burner, regarding the various marketing methods on how the trash burner could best be brought to the commercial market. The partnership Burns did not have a trash burner that was then available for sale to the market in 1966. Section 174 of the Internal Revenue Code provides that a taxpayer may deduct research and experimental expenditures paid or incurred by him during the taxable year in connection with his trade or business. There is no dispute as to these expenses involved in this case being a research and experimental expenses within the meaning of Section 174.
Speaker: I take it, there's no dispute about the integrity of these expenses?
Burgess L. Doan: No, Your Honor. There is not.
Speaker: And I take it you also concede that -- were you relegated to 162, your case would not be a good one?
Burgess L. Doan: We admit to that, Your Honor. The term trade or business is nowhere defined in Section 174 or in the Commissioner's regulations under Section 174. The respondent contends in this case that the term trade or business has the same meaning in Section 174 as it has in other sections of the Internal Revenue Code. However, the case law relied upon in support of this proposition in every instance goes back to a Section 162 standard. And 162 allows expenses incurred in carrying on a trade or business. Section 162 has other standards as well. Specifically, Section 162 provides that a taxpayer may deduct ordinary and necessary expenses incurred in carrying on a trade or business while Section 174 has a different standard. Section 174 says that the taxpayer may deduct research and experimental expenditures incurred or paid during the taxable year in connection with a trade or business.
Speaker: So, that you're still going into a trade or business category, you have to satisfy that, I take it.
Burgess L. Doan: Yes, Your Honor. We have to satisfy the standard trade or business.
Speaker: How many times does this Court concern itself with the 174?
Burgess L. Doan: Never, Your Honor to my knowledge.
Speaker: This is the first time?
Burgess L. Doan: Yes, Your Honor. The basis of the respondent's contention in this case goes back to an early decision written by this Court where the theory was advanced that before a taxpayer could be said to be sharing on a trade or business, he must be holding himself out as offering for sale goods or services. We submit that that standard was not intended to apply to Section 174 which was not written until 1954. We believe that this is borne out by the legislative history found in the committee reports in connection with the development of Section 174. We believe that Section 174 was intended to be a liberalizing provision to allow these expenditures which otherwise would have to be capitalized to be deductible in the year incurred. The legislative history of 174 indicates a broad purpose to provide an economic incentive especially for small and growing businesses to engage in the research for new products and new inventions. The measure was initially introduced in the Congress in 1951 and the purpose for its introduction was to clarify the existing confusion in respect to tax treatment of such expenditures and to prevent tax discriminations between large, existing, well-established businesses and their small beginning counterparts.
Speaker: Mr. Doan, if this had been done by IBM or 3M, do you think this service would have allowed the deduction?
Burgess L. Doan: Yes, Your Honor. The best illustration of that is Best Universal Lock Company. The case decided in 1966 by the Tax Court. Best Universal Lock Company involved a corporation, a successful large corporation based in the State of Indiana which had historically been in the business of manufacturing locks. During the 1960's, Best Lock Company decided to develop a new line of business and it as a result, commenced a research program on isothermal air compressors which was admittedly a completely unrelated line of business. The Commissioner of Internal Revenue disallowed it saying that research and development expenses claimed in this connection were not deductible. However, the Tax Court reversed or did not hold for the Commissioner of Internal Revenue in that case and said that these businesses were sufficiently or these expenditures were sufficiently connected with an ongoing business and therefore deductible. The Commissioner of Internal Revenue has acquiest in that decision and in 1973, the Commissioner has issued a revenue ruling directing the employees at the audit level and on up through the ranks of the Internal Revenue Service that this decision will be valid.
William H. Rehnquist: Do you think in that case, (Inaudible) that they were at least in an ongoing business of some other sort.
Burgess L. Doan: Yes, Your Honor and there lies the discrimination against my client. The remarks of Mr. Reed who was then Chairman of the House Committee on Ways and Means in the hearings on HR 8300, the Bill which embodied what was to become the Revenue Code of 1954, I believe makes this point very clear. He stated and I quote, "The present law contains no statutory provisions dealing with the deduction of these expenses". The result has been confusion and uncertainty. Very often under present law, small businesses which are developing new products and do not have established research departments are not allowed to deduct their expenses despite the fact that the large, well-established competitors can obtain the deduction. This provision will greatly stimulate the search for new products and new inventions upon which the future economic and military strength of a nation depends. It will be particularly valuable to small and growing businesses. Throughout the committee reports, the term pops up small and growing businesses. The Undersecretary of the Treasury when he appeared before that Ways and Means Committee testifying as to the present treatment of these expenses used the same analogy except that he used the term that this will help small pioneering businesses.
Speaker: Mr. Doan, if you lose this case, does Mr. Snow ever get any tax benefit for this? Is he allowed in some way to amortize or --
Burgess L. Doan: Your Honor, if a taxpayer cannot utilize Section 174, and the expenses are held to be in the category of pre-operating expenses or investigatory-type expenses, there is no provision for any relief for tax purposes except when the venture may be abandoned or when it might be sold. That is the venture itself not an item within the venture. There's no provision for these expenditures being capitalized and amortized over the useful life because it is and has been the position of the treasury that you cannot determine a useful life and therefore they are not subject to depreciation or amortization.
Warren E. Burger: And I suppose on the standpoint of a small-pioneering, I think you called it business, that kind of deferred tax benefit isn't very useful?
Burgess L. Doan: No, Your Honor, it is not especially if this is a genuine and bona fide business venture where the people are in there trying. They put it together and it does become an ongoing business. It grows up and it becomes a Polaroid, a Xerox, and IBM. That capital contribution would be locked in for any period of time.
Warren E. Burger: But if they become one of those three, they don't need that very much, do they?
Burgess L. Doan: No, Your Honor. Hopefully, it will. We believe however, the clear congressional intent, is that a small business like Burns whose entire energies are devoted to a product development effort would seem to be precisely the kind of taxpayer that Congress sought to bring within the reach of Section 174. The decision by the Sixth Circuit in Snow however makes that Section unavailable to Burns while preserving it to large and well-established competitors. The by-product of that decision, in my opinion, will foster monopoly. It will stifle research and development activity. It will continue the discrimination against small businesses that Section 174 was designed to eliminate.
Speaker: I take it that there wouldn't have been any problem here if there had been a patent issued and had been available for licensing.
Burgess L. Doan: The decisions are not clear, Your Honor. The test that respondent has suggested would require holding a product or a service --
Speaker: For sale.
Burgess L. Doan: For sale.
Speaker: Or for licensing, a patent for licensing.
Burgess L. Doan: Yes, Your Honor. I --
Speaker: There might be expenditures after that time that would be deductible then.
Burgess L. Doan: Yes, Your Honor.
Speaker: Not prior.
Burgess L. Doan: Not prior to that time.
William H. Rehnquist: Is it conceivable that 174 would have been some tax relief to small businesses by relieving them of the requirement for a business deduction that would be "ordinary and necessary" without necessarily going as far as you're asking us to go here?
Burgess L. Doan: That is the contention of the respondent, Your Honor. However, we feel that Section -- that is a Section 162 standard but that's only part of it. Section 162 says, ordinary and necessary in carrying on a trade or business. There are three elements involved in Section 162, the total standard. Now, in Section 174, Congress did not choose to include any of those. Respondent suggests that it was for the purpose of eliminating the two you mentioned, Your Honor, "ordinary and necessary". However, I contend that the carrying on standard was also eliminated.
William H. Rehnquist: Because 174 is in connection with rather --.
Burgess L. Doan: Yes, Your Honor. We, of course, rely heavily on Cleveland versus Commissioner which was decided by the Fourth Circuit. The respondent on the other hand, relies on a later Fourth Circuit decision, Richmond Television. Cleveland versus Commissioner was a Section 174 case, a Section 174 issue. Richmond Television was a Section 162 case, a 162 issue. In the case of Cleveland versus Commissioner, that Court found that the expenses involved in a case involving an attorney who financed an individual who was in a trade or business of --or who was involved in activities in working on a formula, a patented product which he had hoped to obtain the patent on. He had advanced funds to this inventor over a long period of time. There were no sales of this substance or this item. There was no patent as far as I can tell as of the year at issue in the Cleveland case. There is no evidence in the record that the patent was held -- was actively held for sale. However, the Court of Appeals held in that case that the expenses involved and incurred by a joint venture between Cleveland and the inventor in that case who was Courier were deductible under Section 174. Now, in Richmond Television case, we have a situation involving expenditures by a corporation before it obtained a license to start operating a television station. The expenses involved there were Section 162 expenses involved the training of the employees and getting organized and geared up, commonly known as "start-up expenses". We feel that the Fourth Circuit has grasped the fine line of distinction between Section 174 and Section 172 and we respectfully submit to this Court that a new standard should be fashioned within Section 174 to take care of 174 cases and leave the Section 162 standard that has already been fashioned intact as it is just today. Thank you.
Thurgood Marshall: (Inaudible)
Burgess L. Doan: Yes, Your Honor. They're --
Thurgood Marshall: (Inaudible)
Burgess L. Doan: Yes, Your Honor. I'm glad you asked that question.
Thurgood Marshall: (Inaudible)
Burgess L. Doan: One of the problems and this is not in the record.
Thurgood Marshall: (Inaudible)[Laughter]
Burgess L. Doan: Okay. One of the problems Burns Investment Company ran into in 1966 was pollution standard problem. Now, the device has been perfected at this point in time and it does meet pollution standards, thought it would get in the commercial --
Speaker: (Inaudible) specifying requirements --
Burgess L. Doan: Your Honor. And --
Speaker: And transferred what this has satisfied with the requirements of the county regulations (Inaudible)
Burgess L. Doan: I am informed that the trash burner in this case does now satisfy all of the ordinances that we know about to date.
Warren E. Burger: Very well, Mr. Doan. Mr. Smith.
Stuart A. Smith: Mr. Chief Justice and may it please the Court. I think I'd like to refer to the text of the statute just set forth in Appendix A of our brief. This statute provides that 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. Subsection B provides for an election to amortize such expenses over a period of time not less than 16 months. Now, this case focuses upon the statutory requirement which exists in both subsection A and subsection B that the expenditures be incurred in connection with the taxpayer's trade or businesses.
Warren E. Burger: Well, do you mean -- is your view of that that the trade or business will must already be an ongoing business?
Stuart A. Smith: Yes. In our view, the term trade or business has had a long and honored history under the Taxing Act as recognized by this Court that the tax law has long drawn the distinction between investment activities or income producing activities and that trade or business connotes something more than that. More than the hope of a profit, it connotes holding oneself out as selling -- available to selling goods or services. Now, this case involves only 1966 and the courts below I think properly confined their attention to the events of that year. Now, in that year, you had a situation where Trott, the purported inventor had this idea for a product, he needed some financing. He asked several of his friends to lend, to give him some money and ultimately, a limited partnership venture was formed of the petitioner here contributing $10,000.00, I think for 4% limited partnership interest. Now, the important thing in our view is, what exactly happened in 1966. And I think the findings of that of the Tax Court are not disputed in this regard that what happened simply was that a very crude prototype model was developed. Patent counsel examined it, looked at it and said simply that it wasn't reduced to practice, that it didn't work properly and that additional work would have to be done on it. Ultimately, the partnership spent the rest of its $40,000.00 initial capital I think in the next year 1967. And then ultimately, as both courts below adverted to more work had to be done on it that the device radically changed and before the ultimate patent was applied for in 1969 and received in 1970, the device became a very different device. Now, in our view --
Harry A. Blackmun: Has the service -- I assume this is outside the record. Has the service ever recognized that this particular taxpayer has now qualified under 174 in subsequent taxable years?
Stuart A. Smith: That Mr. Justice Blackmun is outside the record. What seems to be -- what seems to what can be pieced together essentially is that the partnership went out of existence in 1968 or 1969. A corporation was formed for the Burns Investment Corporation. That's in Tax Court findings of fact. Whether that corporation, whether the shareholders of that corporation are the same as the limited partners here, it's unclear from the record. I would just assume, speculate it probably is the case that the shareholders, that the partners contributed the partnership assets to the corporation in a tax free exchange. I think that probably would happen.
Harry A. Blackmun: And perhaps the other partnerships too would.
Stuart A. Smith: Perhaps Echo and Courier also went the same way as we had --
Harry A. Blackmun: So, you have to be an ongoing business agreement?
Stuart A. Smith: Yes. Essentially, there -- and Mr. Doan pointed out that the service did not disturb -- petitioners did claim deductions for 174 treatment for the other -- for the other partnerships in the year 1965. That's probably the case although I think it's quite irrelevant. It simply was -- it is simply an over side of, you know. The service has to set priorities for its audit work.
Lewis F. Powell, Jr.: Mr. Smith, you state that the Government position is that there must be an ongoing trade or business. Let's assume for the moment that Burns did have an ongoing business in the manufacture and sale of some other product and that at the same time, this inventor tried to commence work on the incinerator. Would that partnership have been entitled under your position here today, to deduct the expenses of that work?
Stuart A. Smith: I think it probably would, Mr. Justice Powell. I think from -- I think that that flows from the services acquiescence in the Best Lock Company case. There was a case where the company was clearly in the business of manufacturing locks. The Tax Court's findings -- the Internal Revenue Service however disallowed to claim the 174 deductions for the development of an isothermal air compressor. And the Tax Court in its opinion said simply that disallowance ignored that corporation's long history of experimentation and efforts to develop new products. I think once you have it, an ongoing trade or business, I think it's a statutory manner you have a trade or business in connection with which a research or experimental expenditures would be incurred. I think they would --
Lewis F. Powell, Jr.: Would it make any difference at all if the incinerator works totally dissimilar to the other product than being manufactured?
Stuart A. Smith: Well, apparently, there are instances. There is a case called Mayrath decided by the Fifth Circuit which involved the situation of a man who developed, who invented farm implements and then he spent a lot of money on an experimental home and the service disallowed that deduction. There was very little in the way of focusing on the question as to whether -- he was clearly an inventor having invented and manufactured, you know and sold farm products but the Fifth Circuit simply said that this was an experimental home in which he was living and then they will classify simply as personal expenses. I think that the service probably would like to reserve some leeway so to speak if the products are totally unrelated to each other. But because the Best Universal Lock Company case rested in part, I think on the corporation's long history of experimentation. But I think that it's a general matter, the acquiescence in that case, I think stands for the proposition that if you have an ongoing business, which was clearly not the case here in 1966, that research or experimental expenditures expended to develop a new product would come within 174 treatment.
Speaker: What would be heard if they are anymore unrelated than in the Lock case?
Stuart A. Smith: I suspect so. I mean, you have an isothermal air compressor, so this is so --
Speaker: Suppose a soap manufacturer, constantly, this one connect to the Procter & Gamble, one, they're constantly in research and development in various soap products and detergents, and all that kind of stuff. Suppose they had taken on the development of this incinerator.
Stuart A. Smith: Well, I think that we would have a more difficult case. I don't think --
Speaker: Would that not be a Lock?
Stuart A. Smith: It probably would be the Lock case. I don't think we have to worry about that here because I think under the Court's Whipple opinion and the long history of separating corporations from their employees, I think that, there's no suggestion here that we can attribute the business of Procter & Gamble to the petitioner in this case.
Speaker: But going back to my question to your opposing counsel about 3M or IBM having done precisely this which I take it in Mr. Brennan's question, do I detect from your answers that probably, they would've been given a deduction?
Stuart A. Smith: Probably, would've been given the deduction because they are in the -- they would be deemed to be engaged in a trade or business. I would like to address myself to another question that you asked during Mr. Doan's argument. And that is, what the ultimate effect would be -- what the ultimate tax benefit of these expenditures would be. I don't think that it's entirely clear that they are lost forever. I think that if the partnership had continued, I think that there's certainly an arguable case for saying that these things could have been -- that the election could have been made to amortized the expenditures. In fact, the amortization aspect of the statute is exactly designed to help the kind of small pioneering business that Mr. Doan has --
Speaker: That is triggered also by bringing the trade or business.
Stuart A. Smith: Yes, that is true. But the point is that the election to amortize -- assuming that the partnership went along for a few years and then ultimately satisfied the test of being in a trade or business, the amortization provisions provide that the election to amortize begins with the year -- the first year in which benefits from the expenditure are derived. So, assuming that a few years went on and then the partnership ultimately held these things out for sale, I think that the partnership would have a strong case then to say, we elect the amortization provision. We are in the trade or business.
Speaker: (Voice overlap)
Stuart A. Smith: Well, I don't think he would go back -- I don't think you could go back in this case. It would depend simply whether the year would be open in which the benefits were first derived.
Speaker: (Voice overlap) that in any event, they would be considered taxable expenditures?
Stuart A. Smith: In any -- yes but --
Speaker: So, they're not lost in that?
Stuart A. Smith: They're not lost in that respect. Now, this case is muddied further by the fact that apparently, the whole thing went into a corporation.
Thurgood Marshall: Mr. Smith, suppose Snow had set up the Snow Soap Company partnership and it had done the same thing?
Stuart A. Smith: Had done the same thing?
Thurgood Marshall: Yes.
Stuart A. Smith: Well, that would depend very much. See, Mr. Justice Marshall, in our view and we think this is really whether Fourth Circuit went raw in the Cleveland case. Simply the setting up of a partnership and the execution of a partnership agreement without more -- we don't think --
Thurgood Marshall: No. No, he's got it going --
Stuart A. Smith: It's got a going soap business.
Thurgood Marshall: Going soap business that he manufactured $2,000.00 worth of soap a year.
Stuart A. Smith: And then it began to --
Thurgood Marshall: And do what it did here to make trash burner?
Stuart A. Smith: Well, I suspect that --
Thurgood Marshall: But he's really got a going business?
Stuart A. Smith: He's got a going business and then there's a research --
Thurgood Marshall: But what else does he need beside to go on business.
Stuart A. Smith: Under the statute, that is really the critical thing that you need -- you need a --
Thurgood Marshall: So, that's all he needs to set up a little thousand dollar business to be qualified?
Stuart A. Smith: Well, I suspect -- Well, I wouldn't want to suggest that any kind of cosmetic establishment of a cosmetic business would suffice because I think when Congress --
Thurgood Marshall: If he changed it? He probably would change it from soap to shoes? [Laughter attempt]
Stuart A. Smith: Alright. Well, what I meant by cosmetic, I meant simply a façade. I think that what we're talking about here is a bonafide enterprise. I think when Congress inserted the term trade or business here, if this was done against the background of a long distinction between trade or business and investment activities. In fact, this Court in about 1940 had held in the Higgins case that the management of one's personal investment portfolio even if it required the hiring of several people and/or the leasing of an office was not a trade or business. And the expenses in connection there with were not deductible. What Congress did in 1942, I think is significant. It enacted Section 212. It didn't -- which did not enlarge the category of trade or business expenses. It simply created a new category a non-trade or business expenses. Now, I think that's really the key to this case. Congress could have --
Speaker: -- research, the expenditures didn't qualify for either.
Stuart A. Smith: Which is research expenses did not qualify for either. Right! Because research expenditures are somewhat different. Research expenditures prior to the enactment of the 54 Code were regarded as --
Speaker: Certainly, 174 was intended to do something for research and development expenditures that 212 and 162 was implementing.
Stuart A. Smith: Yes, I think it was intended to do something and I think what it was intended to do as we suggest in our brief was to relieve the necessity of qualifying under the ordinary "standard" of Section 162 because research and development expenditures are traditionally the kinds of things that relate to the creation of income and the benefits derived in the future year. That is the traditional kind of non-deductible capital expenditure. Taxpayers also had a problem because of the difficulty of determining if at all whether such expenditures could be depreciated because of the difficulty of tagging it to the useful life of the particular asset.
Speaker: Do you think 174 as read means that you may deduct those expenses which absent 174 would've been chargeable to capital?
Stuart A. Smith: Yes, and I think that that's -- that I think is confirmed by the fact that the statute --
Speaker: Well, let's put it the other way. All expenses that under 162 would be all research expenses that under 162 would be chargeable and capital are not deductible.
Stuart A. Smith: Right and could not qualify for depreciation either. In fact, that was one of the things that the statute was designed to cure because there was a regulation outstanding for seven years between 1919 and 1926. That came out under the depreciation provisions and --
Speaker: I'm --
Stuart A. Smith: I'm sorry.
Speaker: You're saying these expenses wouldn't qualify under 162?
Stuart A. Smith: These expenses wouldn't qualify under 162.
Speaker: And they would be chargeable as capital?
Stuart A. Smith: They would be chargeable as capital.
Speaker: Well, 174 says that they're chargeable of capital under 162, they're deductible here.
Stuart A. Smith: No, I think it says --
Speaker: That's what I asked you and you said yes.
Stuart A. Smith: Oh, I'm sorry.[Laughter attempt] I think it says that you can treat it if they incurred in connection with the trade or business, you can treat them as expenses which are not chargeable to capital account. I think that's the key. I think what Congress wanted to do was to take a class of capital expenditures and relieve them of the necessity of qualifying under the ordinary standard.
Warren E. Burger: Mr. Smith, -- go ahead, finish.
Stuart A. Smith: Oh, I'm sorry. Well, it's a slightly unrelated point.
Warren E. Burger: Well, let me ask you something else. I'd like to get to a homely hypothetical stuff like IBM or Xerox or 3M. There was a man that has a conception of how to handle, how to raise chickens and a new way to develop an incubator and so he puts whatever he's doing, teaching the Physics department in the university or whatnot. Eyes himself a piece of land in a house and then begins to build this new kind of gages in a private research and development and develops a bunch of sheds and barns with the incubators. Finally satisfied that it could probably work and buys himself a couple of thousand of eggs but he's in that business. He can't afford a telephone. He can't afford employees. He and his wife and his son do all these. Now, that he reaches a point where it's feasible. He organizes a corporation that carried on for the future. Under the framework of the Government's view of this case, would this year or work done in this taxable year on the development of these incubators, the sheds, all the things I have described and a lot that you can imagine filling in, deductible or not?
Stuart A. Smith: Well, I think his research or experimental expenditures --
Warren E. Burger: Yes, remind you he hasn't sold -- he's only bought eggs to turn into chickens. He hasn't sold the chicken. He hasn't advertised, hasn't done anything. He gets into business the next year.
Stuart A. Smith: I think under our view of the case that would be a problem. There would be a problem in deducting that. I think that curing the hypothetical in some respects might be if he had energetically sought to interest someone in purchasing or entering into a contract with him to provide the kinds of services that he ultimately hoped to provide from his idea. I think that under the statute, I think though that the amortization election would be best suited.
Warren E. Burger: Did he meant that when he -- if the business were a great success, he might get it when it was immaterial to him and if it was a failure, it would be academic, would it not?
Stuart A. Smith: Well, no. I don't think it would be -- I don't think that tax deductions would be immaterial. I think that would -- what would be done I think that instead of -- permit me to indulge in a moment of tax advice. I think what could be done in a situation like that is to continue operating as an individual for a while. Get some gross receipts, elect the amortization provisions and be able to write off those expenses over the 60-month period which 174 (Voice Overlap).
Warren E. Burger: The small businessman of the kind, I take it was Congressman Reed was talking about. It appears to be Congressman Reed's statement, wouldn't be helped much by an amortization extended over five years.
Stuart A. Smith: Well, I think that if he remains small, I think that, you know, essentially during some of that period, it would help.
Warren E. Burger: Isn't it the usual history of small businesses getting started like this that they put themselves completely in track as it were to get started?
Stuart A. Smith: I think that's right but I think though that, you know, we're faced really with a statute that uses the term "trade or business" and uses it in the way that -- I see the light.
Warren E. Burger: We'll resume there right after lunch, Mr. Smith. You may proceed.
Stuart A. Smith: Mr. Chief Justice, and may it please the Court. Resuming the Government's presentation of the Snow case, I think the best way to describe how the statute works. Section 174 of the Code is to simply suggest to the Court that there are two types of capital expenditures that could occur in any particular situation. Now, there's the capital expenditure that is incurred before one enters trade or business and then capital expenditures which are incurred after the commencement of a trade or business. Now, in our view, Section 174 is only designed to cover this second category of capital expenditures. It makes them subject to the option to either currently deduct or to amortize over five years. Thus, the insertion, in our view of the term "trade or business" in the statute requires that the research or experimental expenditures be incurred by an ongoing business in order to come within the purview of the Section. Petitioner's references in the legislative history to the fact that Congressman referred to the fact that small businesses that the statute was designed to benefit small businesses, I think it should be emphasized to the extent that those remarks have relevance. The important thing is that it was still a business that was designed to be benefited. That trade or business is a technical term under the Code. It appears in many provisions. It's been interpreted by the Courts to require the holding of one's self out as engaged in selling goods or services. And if Congress wanted to simply make all research or experimental expenditures deductible without regard to the context in which they were incurred, I think it could've easily employ the standard it used in 1942 when Section 212 came into the Code, that is expenditures incurred in connection with the production of income. The fact that it didn't do that and the fact that Congress created this special type of non-trade or business expenditures but yet, nevertheless used the term "trade or business" in Section 174 is to us dispositive of the matter in terms of requiring that a strict standard be employed in this case. And I think that the standard is important because the trade or business test provides in our view an objective criteria with which to measure, to separate out, so to speak, simple, personal activities that is someone tinkering in his basement with something that he thinks someday may amount to something and spending money on that, so to think. And someone who is seriously interested in developing a product and carries it through to the point in which income and benefits are derived from that expenditure. Now, I wanted also to point out to the Court that --
Thurgood Marshall: Now, I don't understand this carrying it through, if I understand you, if I'll be able to sets this up, he starts collecting the first year.
Stuart A. Smith: Well, the fact that IBM sets this up -- In the IBM example, Mr. Justice Marshall, I think the fact of the matter is that -- there is no quarrel about the fact that IBM is an ongoing trade or business and is engaged in a trade or business and it is holding itself out as engaged in the selling of goods or services. And as a result under the case, under the Commissioner's view of the statute --
Thurgood Marshall: But he does collect right away?
Stuart A. Smith: He can't -- that the statute is available for the election to amortize or deduct.
Thurgood Marshall: And so, it doesn't depend that they're actually working on this to sustain --
Stuart A. Smith: No, well, I was just addressing myself, I think to the beginning of business.
Thurgood Marshall: If IBM instead of Snow, right?
Stuart A. Smith: Yes.
Thurgood Marshall: It would apply.
Stuart A. Smith: The statute would apply in that case because IBM is engaged in a trade or business and the expenditures are incurred in connection with the trade or business.
Thurgood Marshall: Mr. Snow, went out of business in 67, IBM would still collect the 66.
Stuart A. Smith: That is correct. But the point to the matter is that that simply is non-volunteer. What we have here is no trade or business within the tax year under scrutiny 1966. Now, the petitioner focuses upon the fact that there is an alleged difference in terminology between Section 162 and 174. He says that you have the phrase "incurred in carrying on a trade or business" in Section 162 and you the have the phrase "incurred in connection with the trade or business" in Section 174. In our view, the terminology is equivalent. The committee reports for Section 212 used the phrases interchangeably. In fact, what was the Commissioner's regulation under Section 162 used the phrase in connection with "incurred in carrying on" interchangeably. I don't think that there's any difference between those two statutory expressions. The fact of the matter is both require the existence of an ongoing trade or business. Now, the connection between Section 162 and 174 is an --
Speaker: But IBM couldn't deduct these research expenditures under 162, could it, if it did what Snow did here?
Stuart A. Smith: That is correct because they would be regarded as -- they probably would not fit within the ordinary. They would not meet the ordinary standard necessary simply regarded as viewed. I don't think necessary term -- the word or term necessary is involved in this case. I think it's the term ordinary and the fact that the term ordinary was deleted from Section 174, in our view is the key to what this Section was designed to do. What would be otherwise capital expenditures incurred by an ongoing business currently deductible. Now, the connection between 162 and 174 was made by what we think is the more appropriate, is more current and correct rule of the Fourth Circuit in the Richmond Television Corporation case because while that case involved a corporation and involved a claim deduction for expenditures under 162, the Court nevertheless cited in a footnote not only the classic what we were going --
Speaker: Can I ask you this thing before I forget it. Assume that Snow here admitted an office and got a telephone and hired a secretary. They were really -- they needed the correspondence and whatnot, I take it that you would have the same decision with respect to the rent paid for the office?
Stuart A. Smith: I think we probably would have the same position with regards to the rent paid to the office. I think that the important thing here is that there was within the meaning of the test, there was no holding oneself out as engaged in selling goods or services because as a factual matter, they had nothing whatever --
Speaker: What happens to the expenses paid out for the rent of the office? They aren't just capitalized yearly.
Stuart A. Smith: Well -- (voice overlap)
Speaker: Are there losses?
Stuart A. Smith: I suspect that they (Voice Overlap). I think that they would go -- they would increase in a partnership context, I think they probably would have to increase the basis of each partner's partnership interest and to the extent that they might be subsequently amortized. At a later date they might be amortized. I see your point because the point is that it deals with rental for a particular year but I think that it -- essentially, I think the problem is the same problem that the Court is facing under consideration in Idaho Power (Voice Overlap).
Speaker: If they were deductible at all under 162, you'd be in great trouble here, I suppose?
Stuart A. Smith: I think our position is that they're not because they're in connection with -- I think that the issue in Idaho Power is the same. You're talking about depreciation of construction equipment and they're while it's in annual expense, it nevertheless has to go into the basis of the asset that's ultimately created.
Warren E. Burger: Let me answer Justice White's hypothetical and other but non-recurring item of expense. Suppose they call a professional employment agency and said, 'Here is the staff we think we'll need. We'll need X number of executives and some of the stenographers and a shop foreman and a whole list and engage them on a professional basis for hire. Now, have they got into business yet?
Stuart A. Smith: Well --
Warren E. Burger: Along with the office?
Stuart A. Smith: I think that the critical thing is really holding oneself out as engaged in -- if the product had gotten to the point where they could offer it for sale and make it enter into pecuniary arrangements with people who are willing to pay for something that they had third parties. I think then that they would be engaged into trade or business.
Speaker: So, you're saying that there has to be -- they have to be trading with somebody or actually doing business with somebody.
Stuart A. Smith: They have to be actually -- there has to be an ongoing business with someone pointing out exact -- you know, selling something that they have to offer.
Speaker: Or offering to them.
Stuart A. Smith: Or offering something. They may be ultimately unsuccessful.
Warren E. Burger: And that must relate to the product which is ultimately to be distributed, is that right?
Stuart A. Smith: It must be -- yes, it must relate to the product which -- I have one final point if I may, just for a moment.
Warren E. Burger: Very briefly.
Stuart A. Smith: The petitioner raises the hypothetical of what might be considered the usual type of investment in a real estate venture and says, Well, don't -- Isn't it clear that interest is deductible during the construction period of a project? And the simple answer to that is that, in Section 163, Congress provided for the deduction of interest without regard to any trade or business nexus or any production of income nexus whatever. It's simply interesting incurred on indebtedness and we think the analogy is false and we think that this case has to be viewed within the trade or business nexus of statute.
Speaker: Mr. Smith, I hold you for a moment but I have to quick ones. Suppose that in -- on December 1 and we're on the calendar you're based, Mr. Snow did get in to a trade or business within the services concept, would you permit the deduction of research and development expense incurred in the preceding 10 years, 10 months or that calendar year?
Stuart A. Smith: Well, I think that was -- since the system is an annual accounting system, I think, I'm not sure of the answer to this but I think probably, yes. Simply because we're talking about an incurred within, you know -- within or during the taxable year. And if we're talking about a calendar year, I think the answer to that would be yes.
Speaker: And secondly, I admittedly haven't gotten into the legislative history but what brought about 174? Was this brought into the code at the behest of a service or was it -- as it were imposed on the service by some group of taxpayers who are able to persuade the Congress to put it in? Do you know?
Stuart A. Smith: I am not sure I know the answer to that question. I think it was simply a general dissatisfaction with the fact that such expenditures were being disallowed as capital expenditures because they did not relate to production. They did not derive any benefit within the taxable year. I think that the Congress simply eliminated the ordinary requirement. I don't think that there's any feeling in the hearings. There were private people who testified and as Mr. Doan have pointed out that the Undersecretary of the Treasury testified also. I don't think I can give you a precise answer to that question.
Speaker: But many times, these things are imposed upon the service?
Stuart A. Smith: That is true but I don't -- I didn't find any suggestion of that in the legislative history.
Burgess L. Doan: If I may Mr. Chief Justice, I believe I have my two minutes remaining.
Warren E. Burger: You have four minutes now.
Burgess L. Doan: If I may respond to the last comment first. In 1951, Representative Kent indicated that the American Bar Association had urged Section 174. I would also like to point out that I believe the issue has really boiled down to whether or not the petitioner Snow was in a trade or business. That is whether or not there was a trade or business in existence. Not whether or not he was carrying on a trade or business. And in that regard, if I might draw from the regulations under a different Code Section, and that is Section 248. The regulations under that Section defines existence of a trade or business versus the beginning of a trade or business. I am sorry, not trade or business just business. And it has to do with the amortization of organization expenditures which is a type of expenditures that is very much akin to a Section 174 type of expenditure -- that is pre-operating type expenditure. The regulations as promulgated by the Commissioner say that. If the activities of the corporation have advanced to the extent necessary, to establish the nature of its business, the business operation. However, it will be deemed to have begun business.
Warren E. Burger: What's that section again, Mr. Doan?
Burgess L. Doan: That is Section 248, Your Honor. For example, the acquisition of operating assets which are necessary to the type of business contemplated may constitute the beginning of business. And may it please the Court, I submit to you that Burns Investment Company had acquired everything it needed to carry on the operation contemplated by Burns Investment Company. It had entered into a contract with a separate corporation to manufacture these prototype models and this is specifically permitted under the regulations under Section 174. It had contracted for these services. It had collected the capital from the partners. Mr. Trott devoted one-third of his time to this venture and he commenced devoting his time way back in 1964 not in 1966. This was a continuous activity through this period of time. It was not a sporadic venture that just popped up in 1966. It was a bonafide business venture. This man gave up a very good position and devoted his entire energies and efforts to the development of these products. It was certainly no play thing and it was a continuing endeavor on his part. And this is the kind of thing that Congress chose to encourage by implementing into law, Section 174. I am not sure that we're clear on one further point and that is amortization versus deductibility of expenses under Section 174. That I submit is a choice. If he can amortize these expenses, he can deduct these expenses under Section 174. The only remedy available to my client if it is held at Burns Investment Company is not engaged in a trade or business, is a capitalization of these expenditures without any depreciation available to him. Thank you.
Warren E. Burger: Thank you gentlemen. The case is submitted.