Opinion ID: 673854
Heading Depth: 2
Heading Rank: 1

Heading: Deductions for Licensing Fees and Research and Development Fees

Text: 8 An activity will not provide the basis for deductions if it lacks economic substance. See Gregory v. Helvering, 293 U.S. 465, 469, 55 S.Ct. 266, 267, 79 L.Ed. 596 (1935); Gardner v. Commissioner, 954 F.2d 836, 838 (2d Cir.), cert. denied, --- U.S. ----, 112 S.Ct. 1940, 118 L.Ed.2d 546 (1992). The question whether a transaction is devoid of economic substance is often analyzed in terms of its being 'sham.' A sham transaction analysis requires a determination 'whether the transaction has any practicable economic effects other than the creation of income tax losses.'  Jacobson v. Commissioner, 915 F.2d 832, 837 (2d Cir.1990) (quoting Rose v. Commissioner, 868 F.2d 851, 853 (6th Cir.1989)). We have also held that a business lacks economic substance if it is fictitious or if it has no business purpose ... other than the creation of tax deductions. DeMartino v. Commissioner, 862 F.2d 400, 406 (2d Cir.1988). Moreover, the Tax Code provisions, under which the partnerships' claimed deductions for licensing fees and research and development fees arguably fall, require that the expenses sought to be deducted be incurred in a trade or business. See 26 U.S.C. Sec. 162(a) (deduction for ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business); id. Sec. 174 (deduction for research or experimental expenditures which are paid or incurred ... in connection with [a] trade or business). An activity may not be characterized as a trade or business, however, if the activity is not undertaken with an intent to profit. See Portland Golf Club v. Commissioner, 497 U.S. 154, 164, 110 S.Ct. 2780, 2787, 111 L.Ed.2d 126 (1990); The Brook, Inc. v. Commissioner, 799 F.2d 833, 838 (2d Cir.1986). 9 In this case, therefore, the question whether the partnerships should be allowed deductions for the licensing fees and research and development fees turns first on whether the tax court correctly found that the partnerships' activities lacked economic substance and, second, if not, whether the court nonetheless properly found that those activities were not undertaken with an actual and honest profit objective. Economic Substance 10 We review the tax court's factual finding on the issue of economic substance only for clear error. Jacobson, 915 F.2d at 837. After reviewing the full record in this case, we conclude that the tax court's finding that the partnerships' Koppelman Process activities lacked economic substance is not clearly erroneous. 11 First, the amount and structure of the expenses at issue--fees paid by the partnerships to Sci-Teck Licensing Corp. (Sci-Teck) for their licenses to the Koppelman Process, and fees paid by the partnerships to Fuel-Teck Research and Development, Inc. (FTRD) for research and development services--suggested a lack of economic substance. The amount of all of the fees was based on the number of partnership units sold, not on the fair market value of the license or services rendered. 91 T.C. at 759. The licensing fees and research and development fees also were not negotiated at arms' length because the partnerships, Sci-Teck and FTRD were all part of the same network of interrelated entities. Id. In addition, payment of the fees was largely deferred, resulting, for example, in inadequate funding of the research and development activities in the early years of the partnerships. Id. at 761. 12 Second, the tax court's findings regarding the inexperience of and conflicts of interest among the partnerships' promoters were properly considered as indicia of the absence of economic substance. As the tax court found, [a]ctual control [of the partnerships] rested in persons whose compensation from these partnerships depended solely on capital contributions, while they had interests in the profitability of competing ventures. Id. at 764. For example, Richard B. Basile was a promoter of the partnerships but also held interests in Sci-Teck and other entities that stood to profit at the expense of the partnerships. Id. at 744. Moreover, the partnerships' general partners were all tax and financial professionals, having no technical experience that would be relevant to the Koppelman Process activities. See id. at 741-42, 756. 13 Third, as the tax court found, the partnerships' offering memoranda placed heavy emphasis on the tax benefits that would be gained by subscribers. The memoranda specifically stated that an Investor [who] does not, or is not able to, utilize such tax savings profitably ... will not be able to derive the full intended benefit of investment. Id. at 741. The memoranda also were replete with warnings about the partnerships' riskiness. For example, the memoranda disclosed that the value of the Koppelman Process license was uncertain and that, if Sci-Teck's license to the Koppelman Process should prove to be invalid, the partnerships would essentially have no recourse against it. See id. at 742. The memoranda also cautioned that the financial success of the Koppelman Process project was highly unlikely. Id. at 743. 14 Finally, the offering memoranda disclosed that almost seventy percent of the partnerships' capital contributions were to be paid to promoters, lawyers and other network entities, including Sci-Teck and FTRD. Only a small percentage, however, was reserved for working capital. Id. at 742. 15 In light of all of this evidence of the economics of the partnerships' Koppelman Process activities, we affirm the tax court's finding that the partnerships' Koppelman Process activities lacked economic substance and its decision to uphold the Commissioner's disallowance of the claimed deductions. We thus agree with the Eleventh Circuit's decision in Karr, 924 F.2d at 1024-25. Profit Motive 16 Having concluded that the partnerships' Koppelman Process activities lacked economic substance, those activities must be disregarded for tax purposes and cannot form the basis of any deductions. It is unnecessary, therefore, for us to analyze the tax court's findings with respect to the partnerships' profit motive. See Gilman v. Commissioner, 933 F.2d 143, 148 n. 5 (2d Cir.1991), cert. denied, --- U.S. ----, 112 S.Ct. 871, 116 L.Ed.2d 776 (1992); see also Karr, 924 F.2d at 1025 n. 8. Accordingly, we need not resolve the parties' dispute as to whether section 162 requires that the taxpayer's profit motive be primary or dominant or whether it may be only one of several objectives.