                        T.C. Memo. 1996-122



                      UNITED STATES TAX COURT



         INVESTMENT ENGINEERS, LTD., ROBERT S. McGLAMERY,
   A PARTNER OTHER THAN THE TAX MATTERS PARTNER, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



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



     Robert S. McGlamery, pro se.

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

     Sherri L. Munnerlyn, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     COHEN, Judge:   In a Notice of Final Partnership

Administrative Adjustment (FPAA) sent December 3, 1991,

respondent increased the income of Investment Engineers, Ltd.

(the partnership), by $540,500 for 1982, $218,000 for 1983, and
                                 - 2 -

$123,000 for 1984.   In Investment Engineers, Ltd. v.

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

of limitations did not bar assessments pursuant to the FPAA.

Remaining for decision is whether the partnership is entitled to

deductions claimed under section 174 in the amounts adjusted by

respondent.   Unless otherwise indicated, all section references

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

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

Practice and Procedure.

                          FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.       The

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

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

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

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

purpose of these proceedings.

     The partnership was formed in December 1982.       The promoter

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

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

living as a financial planner.

     The partnership was created by a Limited Partnership

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

partnership was to engage in the business of research and

experimentation for the development of computer software in the
                               - 3 -

field of financial planning.   The partnership agreement stated “a

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

the partnership.   After identifying the initial general partner

and one limited partner, the agreement provided in part:

          Each additional person who (not to exceed thirty
     four (34) in total, with spouses, and other close,
     family related multiple investors counting together as
     one investor) acquires any such Partnership Units shall
     be eligible to become a Limited Partner in the
     Partnership at such time as he has:

                (1) Purchased three or more Partnership
           Units,

                (2) Contributed the sum of $5,000 cash and/or
           notes for each Partnership Unit purchased,

     In a Certificate of Limited Partnership executed

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

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

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

and a note for $416.67 to the partnership.

     In an Amendment to Certificate of Limited Partnership of

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

other property contributed by the limited partners were listed.

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

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

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

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

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

$79,890.   Robert S. McGlamery contributed cash of $4,010 and
                                - 4 -

notes totaling $159,990.   Two other limited partners contributed

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

respectively.

     The notes executed by the limited partners were due over a

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

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

executed and with additional annual payments commencing on

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

     In the prospectus for the partnership, the benefits to the

limited partners were described as follows:

     (1)   6:1 Write Off - An investor may be able to deduct
           from his taxable income in 198_ six times the
           amount of his cash contribution made during the
           first year of partnership operations.

     (2)   Capital Gains Treatment of Profits - Investors may
           only have to report 40% of profits from the
           partnership in their taxable incomes.

     (3)   High Profit Potential - If 4,100 customers are
           obtained by year 5, and retained at a royalty of
           $250 per year to the partnership, each investor
           can expect an average annual after tax return of
           up to 45% of his initial investment.

Nothing in the prospectus described how the software to be

developed by the partnership would be manufactured, distributed,

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

stated, in part, the following:

          The proposed researchers appear to have the
     skills, experience and commitment to produce the
     product ordered by the partnership. However, in the
     Investment Engineers, LTD. project, there are no funds,
     neither can there be funds (without loss of tax
                                - 5 -

     benefits) for marketing. Thus, even should a
     successful product be delivered to the Partnership, it
     would take a marketing company [to] make the
     partnership successful. * * *

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

the partnership was executed.   The partnership agreed to pay to

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

specified the scope and definition of work as follows:

          Knox will carry on research and development work
     at the order and risk of the Partnership on a research
     program to develop new and unique computer software in
     the field of financial planning. It is understood that
     this software will cause computers to perform financial
     planning tasks in contrast with other such software,
     and/or real doubt exists as to the operational
     feasibility of developing the software. The proposed
     software should perform, at a minimum, the following
     functions:

          A. Convert the essential factors of qualitatively
     “unlike” investments, including stocks, real estate,
     fixed-interest investments (bonds, etc.), gold, foreign
     currencies, silver, commodities, collectables, etc., to
     a common “investment language” so that they can be
     analyzed, compared, and contrasted as though they were
     qualitatively identical;

          B. Allow the software user to imput [sic] the
     dissimilar investments, and receive back either the
     computer’s translation into its own “language”, or an
     analysis of the dissimilar investments which will allow
     the user to analyze them as though they were
     qualitatively similar; being then dissimilar only
     quantitatively;

          C. Cross reference, between apparently dissimilar
     investment choices, areas that are actually similar,
     such as where--

               1. Two investments are similar because they
          both are “leveraged”, such as real estate and
          commodities, or
                               - 6 -

               2. Multiple investment media are actually
          different ways of owning the same underlying
          entity, such as gold versus gold stocks versus
          gold commodity futures.

          D. Allow user to imput [sic] current cyclical and
     technical indicators, or experiment with any possible
     indicators, and show their historical effect on any
     particular investment, group of investments, or
     portfolio combinations.

          E. As to various types of investments, assuming
     consistent quality among them, the user will be able to
     design investment strategies to maximize the goals of a
     particular client presenting a specific factual
     situation, according to either historical performance
     of the investments involved and the cyclical and
     technical indicators imputed, or, according to the
     users own theories and strategies.

          F. The software will have a built in strategy for
     preservation of capital in the face of disasters of
     either deflation or runaway inflation, as well as
     beating inflation in current circumstances.

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

Amendment to Research Contract.   Under the amendment, the

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

consideration under the original Research Agreement, item F,

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

the other work to be performed under the original Research

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

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

forth as follows:

          G. Knox will attempt to make the software perform
     as a type of “Video Game” that will allow the user to
     take various roles, such as government, investor, and
     voter, to teach and illustrate cause and effect
     relationships between various dependent and independent
                              - 7 -

     variables in an economy, and how such relationships may
     affect investment prices.

          H. Knox will attempt to make the software include
     an effective “Sales” type approach which will allow a
     user who is a financial planner to introduce the
     software’s (and his) abilities to a prospective client,
     who must be “sold” in a very short presentation.

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

Amendment to Research Contract.   For an additional flat fee of

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

          I. Knox will attempt to adapt the latest
     techniques of educational psychology to make the
     software a powerful teaching tool, to train the user in
     each area of planning covered by the Research
     Agreement. This training and teaching does not apply
     to computer or software program use, but to financial
     planning itself. Thus, it is hoped that the software
     will teach financial planning as well as do financial
     planning, both using software techniques which are new
     and unique.

          J. Knox will attempt to make the software, in its
     functions as a planning, teaching, and sales tool
     adaptable to the various primary distributors of
     financial planning, such as banks, life insurance
     companies, and securities brokers, so that their
     particular products are emphasized and highlighted.

     On November 29, 1987, the partnership and Knox executed

another Amendment to Research Agreement.   That amendment stated

in part:

          Whereas, Gregory A. Knox having agreed to do
     research over an eleven year period, at the order and
     specification of the partnership in exchange for
     certain sums, to be paid entirely at the risk of the
     partnership, and, such payments have been facilitated
     by the previous assignment of partnership receivables
     in the form of notes, the parties to such Research
     Agreement hereby amend it according to the following
     considerations:
                               - 8 -

          I. Inasmuch as Knox has substantially exceeded
     original projections of the time in which a marketable
     product was to be delivered to the Partnership, and,
     while acknowledging that he made no warranties, other
     than to perform in good faith, as to the fruits of his
     efforts, he acknowledges his imput [sic] into the
     projections which comprised a pertinent part of the
     offering materials.

          II. The Partnership acknowledges dramatic changes
     in political, economic and engineering environments
     which have all impacted the progress of the research
     contemplated by the Research Agreements, and, certifies
     that Knox has thus far performed his duties in good
     faith. (Substantial progress having been made toward
     all research goals).

          III.   Knox hereby makes the following concessions:

               (a) To forgive all interest due on all
          Partnership Notes assigned to him as payment for
          the Research Agreements; (except those that have
          been sold, optioned, or borrowed against)
          acknowledging that interest was charged in the
          first place in light of anticipated high, “1970's”
          inflation rates, which have not materialized.

               (b) To push back the due dates of said Notes
          until either December 1, 1994, (approximately one
          year after the conclusion of the original research
          agreement), or, one year after a completed product
          is delivered to the Partnership, whichever occurs
          first. Payments on the Notes are to be made over
          the same number of annual installments as stated
          therein, and the amount of each installment shall
          be the remaining balance on the Note, less
          interest, divided by the number of payments
          stated.

     Knox determined the amounts of compensation that he was to

receive for his services under the Research Agreement.

     No companies were organized or contacted to market any

potential products created under the Research Agreement, and the

partnership did not enter into any contracts with third parties
                                - 9 -

regarding the marketing of any potential product created pursuant

to the Research Agreement.    There was no funding within the

partnership for the marketing of any computer software product

that might have been produced, and no marketing occurred.

     Knox never provided the partnership with the completed

computer software product.    The partnership never maintained any

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

partnership received no income from sales of computer software.

     During the years in issue, Knox wrote checks to various

partners and related persons and entities for “research” or

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

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

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

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

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

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

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

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

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

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

     In an undated report to limited partners, the following

accounting summary was set forth:
                               - 10 -

          A.   1983 (& before) Commitments -     $26,000
          B.   1983, etc. receipts -             $10,333
          C.   1983, etc. still owed -           $12,667

          D.   1984   Commitments -              $20,500
          E.   1984   Receipts -                  $4,000
          F.   1984   still owed -               $16,500

     Note: Principals will finish for above cash, or unsold
     Partnership equity, or a combination thereof.

          G.   Raisable funds - 1985         $48,647
          H.   1984 Expenditures
               1. Greg Knox - Lab Research    $8,733 (+1890)
               2. Wayne Brickey - Lab Research - $5,600
               3. Mike Jensen $7,374 [illegible]
               4. Robert L. Montelius $6,700 programming
                     for John

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

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

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

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

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

returns reflected the following balances:

                                    1982        1983           1984

Cash                            $     5,057   $ 14,912     $    1,426
Other current assets--
  notes receivable                  85,860      19,723         14,500
Other assets--
  notes receivable               454,583       175,833      102,500
Total assets                    $545,500      $210,468     $118,426

Accounts payable                $540,500      $205,468     $113,426
Partners’ capital accounts         5,000         5,000        5,000
Total liabilities and
  capital                       $545,500      $210,468     $118,426
                              - 11 -

     Respondent disallowed the deductions claimed for costs of

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

explanation:

     It is determined that the losses reported on your 1982,
     1983, and 1984 schedule K, Form 1065, U.S. Partnership
     Return of Income are disallowed for the alternative
     reasons listed below:

     1.   It has not been established that the
          partnership is engaged in a trade or business
          or that the partnership engaged in the
          activity with the primary purpose of making a
          profit.

     2.   It has not been established that the claimed
          deductions represent an expenditure for a
          related [sic] to research and development
          actually undertaken.

     3.   It has not been established that the amounts
          proven to be expended, if any, in relation to
          alleged research and development are
          currently deductible, and are not capital
          expenditures.

     4.   It has not been established that you had any
          amount at risk, as defined by section 465 of
          the Internal Revenue Code.

     5.   It has not been established that the
          purported transactions contained any economic
          reality or substance.

     In 1995, in relation to settlement negotiations with

respondent’s Appeals Division, Montelius created diskettes

supposedly demonstrating the software produced under the Research

Agreement.

                     ULTIMATE FINDINGS OF FACT

     The research activities of the partnership lacked economic

substance.   The partnership did not engage in any activity for
                               - 12 -

the primary purpose of or with an actual and honest objective of

making a profit.   The partnership had neither the objective

intent nor the capability of entering into a computer software

business.

                               OPINION

     Petitioner has the burden of proving that respondent’s

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

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

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

Petitioner contends that, even though the partnership was never

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

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

                 (1) In general.--A taxpayer may treat
            research or experimental expenditures which are
            paid or incurred by him during the taxable year in
            connection with his trade or business as expenses
            which are not chargeable to capital account. The
            expenditures so treated shall be allowed as a
            deduction.

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

business” has been interpreted to allow deduction of research

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

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

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

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

     Although a taxpayer need not be conducting a trade or
     business at the time it incurs the research
     expenditure, the taxpayer must demonstrate a “realistic
     prospect” of subsequently entering its own business in
     connection with the fruits of the research, assuming
                              - 13 -

     that the research is successful. See Zink v. United
     States, 929 F.2d 1015, 1023 (5th Cir. 1991); Spellman
     v. Commissioner, 845 F.2d 148, 149 (7th Cir. 1988). We
     hold that a taxpayer demonstrates such a prospect by
     manifesting both the objective intent to enter such a
     business and the capability of doing so. See Spellman,
     845 F.2d at 150-51; Levin v. Commissioner, 832 F.2d
     403, 406-07 (7th Cir. 1987); see also United Fibertech,
     Ltd. v. Commissioner, 976 F.2d 445, 446 (8th Cir. 1992)
     (per curiam); Diamond v. Commissioner, 930 F.2d 372,
     375 (4th Cir. 1991).

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

Ninth Circuit affirmed our conclusion that the partnership

involved there had no realistic prospect of engaging in its own

trade or business in connection with the development of software

at the time it incurred the research expenditures in dispute.

The Court of Appeals agreed that the evidence in that case

established that the partnership “had neither the objective

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

1519.   We reach the same conclusion here.

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

Supreme Court reviewed prior cases, including Snow v.

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

business, the taxpayer must be involved in the activity with

continuity and regularity and * * * the taxpayer’s primary

purpose for engaging in the activity must be for income or

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

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

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

the transactions in question as something contrary to the
                               - 14 -

economic realities thereof, solely to obtain unallowable tax

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

We conclude here that the partnership lacked the required profit

objective and that the partnership activity had no substance

beyond the attempted creation of tax benefits.

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

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

period.   It cannot be determined reliably from the record how

much cash actually changed hands, because the exhibits reflect

inconsistent representations by the partnership.    The

contributions reported on the limited partnership certificates do

not reconcile with the terms of the partnership agreement.      The

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

reconcile with the reports to the partners.    Payments in evidence

primarily went from the partnership to Knox and back to the

partners.    The cash payments are a small fraction of the

deductions claimed.    The size of the payments belies the

allegation that much work was actually performed.    The only

indication that anything tangible was done are the diskettes

produced by Montelius in 1995 expressly for the purpose of being

presented to the Appeals Division in an attempt to settle this

case.

     By contrast, the record contains various exhibits and

testimony suggesting that the partnership’s primary purpose was

to promote the political and economic views of Knox and,
                              - 15 -

acccordingly, to deny tax revenues to the Federal Government.

Petitioner’s trial memorandum states, in part:

     the product sought to be developed by the partnership
     here dealt simultaneously with politically driven
     investment economics, and the computer software and
     hardware industries which both underwent watershed
     revolutions in the years since the product development
     began. In spite of delays, the product has been
     managed to professional engineering specifications,
     and, a working prototype thereof attempts to solve at a
     personal level what at this moment is the biggest
     political issue of all, how to deal with government’s
     relationship with the economy without depending on the
     politicians, who may not be able to perform.

Knox testified:

          Q. Could you explain to us how * * * [the
     computer software] was supposed to work?

          A. I had a background in political science and
     financial planning, as well as law, and I had worked as
     a financial planning rather--planner rather than as a
     lawyer. And I was interested in the nexus between
     government action and economics and investments, and I
     had studied the--I’d done some reading and studying in
     the--I’d become converted to some economic philosophies
     that are founded in what’s called the Austrian School
     of Economics, and became convinced that the government
     deficit and spending problem was out of control at that
     time and would eventually wreak serious consequences on
     the economy, and that there existed investment
     strategies that individuals could use to counter coming
     distortions or upheavals that would affect their
     investment portfolios.

          Q.   So what was the purpose of this product?

          A. The purpose of the product was to give
     people--the purpose of the product was to discover and
     apply proprietary ways of measuring governmental and
     political influence on the economy and use these
     measurements to develop investment strategies that
     would be used through the--through computer software,
     so that people could use the computer software to
     design investment strategies to counter political and
     governmental influences in the economy.
                               - 16 -

Neither Knox nor anyone else provided any specific explanation,

examples, or research product that showed how the product would

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

business activity.   Petitioner and Knox merely offered hearsay

materials that allegedly corroborated their view of the problems

in the national economy.

     Petitioner introduced expert testimony and a report that

analyzed the diskettes created in 1995.   The expert report

specifically stated, however, that the expert was not an

economist and did not “fully understand the economic projections

and usefulness of the goals of this software and furthermore

cannot comment on the algorithms used in the software.”

     The record is devoid of any plan for production of the

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

absence of arrangements for marketing any product.   Knox and

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

which were prepared after audit of the partnership’s returns

commenced, but the reports are not corroborated by any nonhearsay

evidence, and they lack credibility.

     The record supports various inferences about the

tax-avoidance purpose of the partnership and the motivation of

Knox and the other partners; it negates economic substance or

profit objective.    The evidence does not support a finding that

the partnership had either the objective intent or the capability

of entering into any business.   Petitioner has failed to satisfy
                              - 17 -

his burden of proving that respondent’s determination is

erroneous in any respect.   Upon due consideration of the entire

record,

                                         Decision will be entered

                                    for respondent.
