Green v. Commissioner

Harold J. and Marion F. Green v. Commissioner, 83 T.C. 667 (1984), decided by Judge Simpson of the United States Tax Court, addresses how far the Supreme Court's holding in Snow v. Commissioner extends the Section 174 research and experimental expenditure deduction to research funded through a passive investment vehicle. The case arose on the Commissioner's motion for partial summary judgment against a limited partner who had claimed a distributive share of a partnership's depreciation and research deductions.

The LaSala Transactions

Harold Green was a limited partner in LaSala, Ltd., an Illinois limited partnership reorganized in December 1979 for the stated purpose of acquiring, developing, and licensing four unpatented inventions: a wind power system and a contact lens system developed by Dr. John Troll, a set of hydrophilic gels developed by Dr. C.K. Kliment, and a cleansing bar developed by Mr. J. Barrows. On the same day, December 24, 1979, LaSala executed three sets of agreements for each invention: an acquisition agreement conveying all of the inventor's rights to the partnership; a research and development agreement under which LaSala agreed to pay National Patent Development Corp. (NPDC) a total of $650,000 over three years to develop the inventions into commercially viable products; and an exclusive worldwide license agreement granting NPDC the right to make, use, and sell the inventions in exchange for royalties running to LaSala.

LaSala claimed a depreciable cost basis of $8,801,000 in the inventions and took corresponding depreciation deductions, along with a $650,000 deduction under section 174(a) for its obligation under the research and development agreements. The Commissioner moved for partial summary judgment disallowing both the depreciation and the section 174 deductions.

The License Agreements Effected an Immediate Sale

The Tax Court first held that the exclusive license agreements were unambiguous and conveyed all of LaSala's substantial rights in the four inventions to NPDC immediately, on the same day LaSala acquired them from the inventors. The petitioners argued that development of the inventions into marketable products was intended as a condition precedent to the licenses taking effect, but the court found several provisions -- including NPDC's obligation to begin exerting its best efforts to commercialize the product "immediately upon the execution" of the agreement -- incompatible with that reading. Because the grant of an exclusive right to "manufacture, use, and sell" an invention for the life of the patent constitutes a sale under long-established patent-law principles, LaSala had sold, not licensed, the inventions on the day it acquired them.

No Depreciable Asset Retained

Because LaSala had transferred away all its substantial rights, the court held it retained no "license" or other asset of a depreciable character -- only a contractual right to future royalty payments based on NPDC's eventual sales. Having neither used the inventions in a trade or business nor held them for the production of income after the sale, LaSala was not entitled to any depreciation deduction under section 167(a).

The Section 174 Trade-or-Business Holding

The more significant holding concerned whether LaSala's $650,000 in research payments to NPDC were made "in connection with" a trade or business, as section 174(a)(1) requires. The court reviewed Snow v. Commissioner, 416 U.S. 500 (1974), in which the Supreme Court held that a taxpayer need not currently be producing or selling a product to claim the section 174 deduction, reversing the more restrictive pre-Snow rule that had treated research by not-yet-operating enterprises as nondeductible pre-operating expenses. But the court emphasized that Snow did not eliminate the trade-or-business requirement altogether -- the taxpayer must still be engaged in a trade or business at some point, determined from the facts and circumstances of the case.

Applying that standard, the court found that LaSala's activities never surpassed those of an investor. Reorganized only days before the transactions at issue, with a general partner that had no prior business history, LaSala's role after December 24, 1979 was purely ministerial: it collected capital contributions from its limited partners, made the recourse payments due the inventors, paid management, legal, and accounting fees, and would eventually collect royalties if NPDC succeeded in commercializing the inventions. It had no ownership interest in the inventions after the sale and no power to supervise, review, or direct NPDC's development work -- it was entitled only to progress reports. The court characterized LaSala's interest as "analogous to that of an investor in securities," and held, citing Higgins v. Commissioner and Whipple v. Commissioner, that "the management of investments is not a trade or business," no matter how much time or capital is devoted to it.

Distinguishing Cleveland v. Commissioner

The petitioners relied on Cleveland v. Commissioner, 297 F.2d 169 (4th Cir. 1961), in which the Fourth Circuit had allowed a section 174 deduction to an investor who financed an inventor's research through a joint venture. The Tax Court distinguished Cleveland on the ground that the investor there remained an owner of the joint venture's inventions and an active participant, alongside the inventor, in the trade or business of commercially developing them. LaSala, by contrast, had sold away all of its rights to NPDC before any development occurred, and -- unlike the joint venture in Cleveland -- would never itself be in a position to use, produce, or market the resulting inventions. The court noted that Cleveland did not hold that merely financing research is itself sufficient to constitute a trade or business; it was the combined, ongoing activity of both participants in the joint venture that supported that finding.

Significance

Green stands as an important limiting case in the line of authority running from Snow through Cleveland: it confirms that Snow's relaxation of the trade-or-business requirement does not extend section 174 to partnerships that function purely as passive conduits for research capital, with no ownership stake, no operational control, and no prospect of ever exploiting the research themselves. The decision belongs to the same body of case law -- Cleveland v. Commissioner and Kilroy v. Commissioner are both cited in its analysis -- that federal courts and the IRS continue to draw on when scrutinizing modern research-and-development tax shelter arrangements.