                                 - 1 -




                          T.C. Memo. 1998-338



                        UNITED STATES TAX COURT



    ESTATE OF ROBERT L. WAGNER, DECEASED, RUTH R. WAGNER, PERSONAL
      REPRESENTATIVE, AND RUTH R. WAGNER, ET AL.,1 PETITIONERS v.
             COMMISSIONER OF INTERNAL REVENUE, RESPONDENT



       Docket Nos.   8581-96, 25799-96,    Filed September 23, 1998.
                     25800-96, 25801-96.



            RTA, an S corporation within the meaning of sec.
       1361(a), I.R.C., reported a loss to its shareholders on
       account of a failed investment in certain technology.
       The shareholders deducted their pro rata shares of that
       loss on their returns. Respondent disallowed those
       deductions on the ground that the loss was not
       evidenced by a closed and completed transaction in the
       year the loss was claimed on account of the reasonable
       prospect of a recovery under a lawsuit against the
       supplier of the technology.
            Held: Respondent’s determination is sustained
       because petitioners have failed to prove that RTA’s
       chances for success on the lawsuit were remote or

1
     Cases of the following petitioners are consolidated
herewith: Walter W. Manley II, docket No. 25799-96; Richard T.
Wagner and Margie S. Wagner, docket No. 25800-96; Charles E.
Lecroy II and Karen A. Lecroy, docket No. 25801-96.
                                - 2 -

     nebulous or, if not remote or nebulous, the financial
     condition of the defendant made unrealistic the
     possibility of an actual recovery.



     Stephen G. Salley and Anthony J. Scaletta, for petitioners.

     William R. McCants, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     HALPERN, Judge:    These cases have been consolidated for

trial, briefing, and opinion.   By separate notices of deficiency,

respondent determined deficiencies in Federal income taxes as

follows:

                                 Docket No.
             1
     Year     8581-96      25799-96    25800-96      25801-96
     1991        --        $88,523     $236,376      $12,491
     1990     $2,199         --           --            --
     1989     16,758         --           --            --
     1988     36,716         --           --            --
1
   Respondent made adjustments for 1991, which decreased
petitioners’ net operating loss for 1991 and, consequently,
petitioners’ loss carrybacks to 1988, 1989, and 1990, which
created deficiencies in tax for those earlier years.

     Except as otherwise noted, all section references are to the

Internal Revenue Code in effect for the years in issue.    All Rule

references are to the Tax Court Rules of Practice and Procedure.

     The common denominator in these consolidated cases is

Resource Technology Associates, Inc. (RTA), a small business

corporation within the meaning of section 1361(b).    Petitioners

Ruth R. Wagner, Richard T. Wagner, Walter W. Manley II, and

Charles Lecroy were shareholders in RTA during 1991 (the
                               - 3 -

shareholders).   RTA reported a loss to the shareholders for 1991,

and, on account thereof, each claimed a loss deduction in

determining his or her 1991 Federal income tax liability.

Respondent disallowed those loss deductions, and the sole issue

remaining for decision is whether RTA sustained the loss that

gave rise to the shareholders’ claimed deductions.

                         FINDINGS OF FACT

Introduction

     Some of the facts have been stipulated and are so found.

The stipulation of facts, with accompanying exhibits, is

incorporated herein by this reference.   At the time of the filing

of the petitions in these cases, all petitioners resided in

Florida.

Resource Technology Associates, Inc. (RTA)

     RTA, a Florida corporation, was organized on July 26, 1989.

RTA was organized for the purpose of investing in a new and

speculative technology for the safe and efficient disposal of

used truck and automobile tires.   Shortly after it was organized,

RTA elected pursuant to section 1362(a) to be an S corporation

within the meaning of section 1361(a).   RTA’s taxable year is the

calender year.

Environmental Disposal Systems, Inc., and the Tire Transformation
System

     Prior to organizing RTA, the shareholders had researched and

investigated an opportunity for investing in a product that would
                                - 4 -

dispose of old tires.    That product, the tire transformation

system (TTS), was being marketed and promoted by Environmental

Disposal Systems, Inc. (EDS), a Georgia corporation.    The TTS was

designed both to transform used truck and automobile tires into

marketable byproducts, such as oil, steel, ash, and carbon black,

and to comply with the environmental requirements of the Federal

Clean Air Act.    EDS, which held patent rights to the design of

the TTS, had successfully obtained the necessary State regulatory

permits and had instituted an experimental prototype of the TTS

in Georgia in 1988.

Master Asset Acquisition Agreement

       On August 29, 1989, RTA and EDS entered into an agreement,

the Master Asset Acquisition Agreement (the agreement).    The

agreement provides for the acquisition of the TTS by RTA from

EDS.    The Agreement was amended in June 1990 to grant RTA

nationwide developmental and marketing rights in the technology

underlying the TTS (the marketing rights).

       The Agreement provides that EDS will deliver the TTS to RTA

“on a completely installed, ‘turn key’ basis for the sum of

$2,500,000.00" (the purchase price).    The agreement further

provides that the purchase price is to be paid in installments,

upon completion of specified construction benchmarks.    Because

EDS possessed neither the experience nor the equipment necessary

to manufacture the TTS, the agreement identifies a third-party

fabricating company, Miles Fabricating & Machine Co., Inc. (Miles
                               - 5 -

Fabricating), which the parties agreed would manufacture the TTS.

The agreement also requires EDS to provide RTA with all

assistance and advice necessary for obtaining the regulatory

permits required for operation of the TTS.   EDS's principal

shareholders guaranteed the performance of EDS's obligations

under the agreement.

Construction and Permitting of the TTS

     Subsequent to entering into the agreement, RTA began

searching in Polk County, Florida, for a site on which to locate

the TTS.   Manufacture of the TTS began in the fall of 1989.   On

May 11, 1990, RTA applied for a permit from the Florida

Department of Environmental Regulation (FDER).   Obtaining the

FDER permit was key to RTA's success, because, without it, RTA

could not legally operate the TTS in Florida.    On June 5, 1990,

the FDER sent RTA's president, Robert L. Wagner (deceased husband

of petitioner Ruth R. Wagner) a letter detailing certain

deficiencies in RTA's permit application and identifying

substantial additional information that RTA was required to

submit before the FDER could fully consider the permit

application.

The Lawsuit

     In June 1990, Miles Fabricating stopped manufacturing the

TTS because RTA had terminated its periodic payments to EDS and

EDS lacked the financial resources necessary to pay Miles

Fabricating.   EDS considered RTA's cessation of payments a breach
                               - 6 -

of the agreement and, in August 1990, sent RTA a notice of

default, asserting that the agreement was canceled.    RTA

reciprocated by sending EDS its own notice of default, asserting

that (1) EDS had failed to provide the technical reports and

information concerning the TTS that were necessary to obtain the

FDER permit and (2) RTA intended to hold EDS and its officers

responsible for this and other alleged breaches of the agreement.

At that time, RTA had paid in excess of $1.6 million towards the

development of the TTS, the TTS was approximately 55 percent

complete, and the underlying TTS technology remained unproven.

     Initial attempts at salvaging the business relationship

between RTA and EDS failed, and, in September 1990, RTA filed a

complaint (the complaint) in a lawsuit (the lawsuit) against EDS

and its principal shareholders in the Circuit Court of the Ninth

Judicial Circuit, in and for Orange County, Florida (the Circuit

Court).   The complaint contains three counts.   The first count

relates to the TTS and alleges breach of contract.    Among the

remedies sought are (1) specific performance of the agreement by

EDS, (2) delivery of the TTS, (3) damages, and (4) injunctive

relief against EDS selling or using the TTS.     Alternatively, the

complaint asks for a return of moneys paid to EDS and damages.

The second count relates to the marketing rights; it alleges

breach of contact and asks for injunctive relief.    The third

count relates to certain medical technology, alleges breach of

contract, and asks for injunctive relief.   EDS answered the
                              - 7 -

complaint, mostly denying the allegations, and counterclaimed.

The counterclaim alleges that RTA breached the agreement and asks

for damages.

The Injunction

     In December 1990, in pursuit of the lawsuit, RTA petitioned

the Circuit Court for an injunction preventing EDS from selling

the TTS equipment to other investors.   RTA successfully persuaded

the Circuit Court of the merits of its claim for an injunction,

but it did not post the required bond, and the Circuit Court did

not issue the injunction.

Permit Denial

     On March 19, 1991, the FDER issued RTA a notice of permit

denial, formally denying approval of RTA’s application to operate

the TTS in Polk County, Florida.   The FDER denied the permit

because, among other things, RTA had failed to provide much of

the technical information requested by the FDER.   RTA did not

pursue its rights under Florida law to appeal the denial.

The FDER Invitation

     Although it had denied RTA's permit application, on

April 17, 1991, the FDER invited RTA to participate in oral

discussions with the FDER and five other firms concerning

innovative technologies for the disposal of waste tires.

Participants selected by the FDER would receive State contracts

for the disposal of waste tires.   RTA prepared an information

package on the TTS and made an oral presentation to the FDER.
                               - 8 -

Despite its efforts, the FDER did not award RTA a waste tire

disposal contract.

Cessation of RTA’s Business Operations

     Following RTA’s failure to obtain a FDER waste tire disposal

contract, the shareholders collectively determined that RTA would

cease all further business activities.   In May 1991, RTA

discharged its employees and ceased operations.   RTA did not

further pursue obtaining a FDER permit, attracting additional

investors, or marketing or promoting the TTS technology.

EDS’s Agreement with Tire Recyclers, Inc.

     At the time RTA discontinued payments to EDS in mid-1990,

EDS began marketing the TTS and underlying technology to new

investors.   On November 6, 1991, EDS entered into an agreement to

sell the equipment to an unrelated company, Asset Holding Co.,

which assigned its rights to Tire Recyclers, Inc. (the TRI

agreement and TRI, respectively).   Pursuant to the TRI agreement,

TRI agreed to purchase the TTS (i.e., the partially constructed

TTS that EDS originally had been constructing for RTA) for a

purchase price of $3 million plus costs incurred in transporting

the TTS to TRI's business location in Virginia.   One-fourth of

the purchase price ($750,000) was payable to EDS prior to

shipment of the TTS, and the balance was due to EDS once the TTS

had been successfully constructed and, among other things, had

satisfied all governmental requirements for continued operation.
                                - 9 -

RTA had been aware of EDS’s efforts to sell the TTS as early as

January 1991, when RTA sent a memorandum to Charles White, a

principal shareholder of TRI, warning of its interest in the TTS.

Conclusion of the Lawsuit

     The lawsuit continued until the fall of 1992, when

negotiations between RTA and EDS produced a settlement agreement

(the settlement agreement), which the parties executed on

December 24, 1992.    The settlement agreement terminated the

lawsuit and provided that EDS would pay RTA $2.1 million (the

settlement amount).    Payment of approximately one-half of the

settlement amount was dependant upon successful completion of the

TRI agreement.   The remainder of the settlement payment was

dependent on EDS' making future sales of products, equipment, or

intangible rights.    The parties executed an addendum to the

settlement agreement in February 1993, which granted RTA an

option to purchase all products or services of EDS at the lowest

prices offered by EDS to other purchasers, as well as a territory

in which RTA would have marketing rights for future sales of the

tire transformation system technology.

Continued Development of the TTS

     EDS and TRI continued to develop the TTS over the next

several years (1993-95).    Nevertheless, as of the date of trial

of this case, the TTS had not been placed into service, and,

consequently, RTA had received no reimbursement as a result of

the settlement agreement.
                                - 10 -

Tax Returns

      On RTA’s Federal income tax return for 1991, RTA claimed a

loss of $1,692,000 with respect to its investment in the TTS (the

TTS loss).    RTA characterized the TTS loss as resulting from the

disposition of section 1231 property and reported to each

shareholder his or her (her) pro rata share of the TTS loss.

Each shareholder is a calender-year taxpayer.    Each reported her

pro rata share of the TTS loss on her 1991 Federal income tax

return.    Respondent denied the shareholders’ deductions for the

TTS loss, explaining that there was insufficient evidence of a

loss.

                                OPINION

I.   Introduction

      Resources Technology Associates, Inc. (RTA), is an

S corporation within the meaning of section 1361(a).    As such, it

is not generally subject to Federal income tax.    See sec.

1363(a).    Instead, RTA’s items of income, loss, deduction, and

credit are passed through to its shareholders and taxed directly

to them.    See sec. 1366.   RTA determined that it suffered a loss

in 1991 on its investment in certain technology and reported that

loss to its shareholders (the shareholders), each of whom claimed

his or her (her) pro rata share on her 1991 Federal income tax

return.    Respondent does not question RTA’s investment in the

technology; respondent questions only whether RTA sustained any

loss in 1991 because RTA had pending at the end of 1991 a lawsuit
                                - 11 -

that respondent believes afforded RTA a reasonable prospect for

recovering its investment.     The sole issue we must decide is

whether RTA failed to sustain a loss in 1991 because the lawsuit

afforded RTA a reasonable prospect of recovery.      That presents a

question of fact, and petitioners bear the burden of proof.       Rule

142(a).     Petitioners have failed to carry that burden.

II.    Summary of Facts

       In 1989, RTA and Environmental Disposal Systems, Inc. (EDS),

entered into an agreement (the agreement) for the acquisition by

RTA from EDS of the tire transformation system (TTS).

Difficulties ensued, and, in September 1990, RTA sued EDS for

breach of contract (the lawsuit), its principal requests being

specific performance, delivery of the TTS, and injunctive relief.

In May 1991, RTA discharged its employees and ceased business

operations.     It claimed a loss on its 1991 Federal income tax

return on account of abandonment of the TTS (the TTS loss) and

reported the TTS loss to the shareholders.     The lawsuit was

concluded in 1992, when EDS agreed to pay RTA $2.1 million, none

of which, however, has been paid.

III.    Law Applicable to Deductions of Losses

       A.   Allowance for Losses Sustained During the Taxable Year

       With limitations not here pertinent, section 165 "[allows]

as a deduction any loss sustained during the taxable year and not

compensated for by insurance or otherwise."      Sec. 165(a).

Section 1.165-1(b), Income Tax Regs., provides:      “To be allowable
                              - 12 -

as a deduction under section 165(a), a loss must be evidenced by

closed and completed transactions, fixed by identifiable events,

and * * * actually sustained during the taxable year.”     An

essential inquiry under the “closed transaction” concept is

whether, in the year the deduction is sought, there exists a

substantial possibility that the alleged losses could be recouped

by actions against responsible third parties or otherwise.       E.g.,

Ramsay Scarlett & Co. v. Commissioner, 61 T.C. 795, 807 (1974),

affd. 521 F.2d 786 (4th Cir. 1975).    When such a claim exists, no

portion of the loss with respect to which reimbursement might be

received is sustained until it becomes reasonably certain that

reimbursement will not be received.    Sec. 1.165-1(d)(2)(i),

Income Tax Regs.

     B.   Reasonable Prospect of Recovery

     The existence of a reasonable prospect of recovering from

litigation is determined by the facts and circumstances of each

case.   Boehm v. Commissioner, 326 U.S. 287, 292-293 (1945).      The

determination is based primarily on objective evidence, Ramsay

Scarlett & Co. v. Commissioner, supra at 812, but the taxpayer's

subjective belief as of the close of the taxable year also is a

relevant factor, Boehm v. Commissioner, supra at 292-293.        The

loss deduction need not be postponed if the potential for success

of a claim is remote or nebulous.     Ramsay Scarlett & Co. v.

Commissioner, supra at 811.   Also, where the financial condition

of the person against whom a claim is filed is such that actual
                                - 13 -

recovery cannot realistically be expected, the loss deduction

need not be postponed.    Gottlieb Realty Co. v. Commissioner, 28

B.T.A. 418, 420-421 (1933).    Alternatively, if the taxpayer’s

claim is not speculative or wholly without merit, and if the

taxpayer believes that the chance of recovering the loss is

sufficiently probable to warrant bringing a lawsuit and

prosecuting it with reasonable diligence to a conclusion, the

taxpayer may have to wait until the conclusion of the lawsuit to

claim the loss deduction.     Estate of Scofield v. Commissioner,

266 F.2d 154, 159 (6th Cir. 1959) (regarding a theft loss), affg.

in part and revg. in part 25 T.C. 774 (1956).

IV.   Analysis

      A.   Introduction

      RTA, which was formed to exploit the TTS, discharged its

employees and ceased business in 1991.    At that time, all it had

to show for its investment in the TTS were its unfulfilled

contract rights under the agreement, the possibility of success

under the lawsuit (which was much the same thing), and a

potential liability under the counterclaim.    The principal relief

RTA sought in the lawsuit was not money damages but completion of

the agreement, delivery of the TTS, and the protection of RTA’s

nationwide developmental rights.    We must determine not only

whether RTA’s claim had some minimal chance of success but also

whether such success would ring hollow because of EDS’s lack of

resources.
                                 - 14 -

     B.   The Lawsuit

     We have examined the agreement and the complaint, and, on

their faces, the agreement is valid and the complaint properly

drawn.    J.P. Carolan III, is an attorney who represented RTA in

the lawsuit.    At trial, he opined that EDS would not be

successful in terminating the agreement in its entirety and that

RTA “had a claim”.      He described RTA’s initial efforts to

prosecute the lawsuit, including RTA’s success on the merits in

December 1990 in asking for an injunction to prevent EDS from

selling the TTS equipment to other investors.      He stated that,

even after RTA failed to post the bond necessary to have the

injunction issued, RTA’s activity on the lawsuit (primarily

discovery) continued for a few months, until the lawsuit became

dormant for economic reasons in early 1991.      Walter W. Manley II,

one of the shareholders, a director of RTA, an attorney, and a

professor of business administration at Florida State University,

College of Business, testified credibly that there was merit to

the breach of contract claim that gave rise to the lawsuit.

Messrs. Carolan's and Manley’s testimony convinces us that the

breach of contract claim in the lawsuit had merit.      The second

count of the lawsuit related to the marketing rights obtained by

RTA from EDS.    We presume that, in some part, the injunctive

relief that RTA successfully argued for related to that count,

and that success convinces us that the marketing rights claim of

the lawsuit had merit.      Petitioners have presented no evidence
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that EDS would have been successful in its defenses to the

lawsuit or with respect to the counterclaim.     We are, thus,

satisfied that the lawsuit had merit--that RTA’s chance of

success in the lawsuit was not remote or nebulous--and we so

find.

       C.   Realistic Possibility of Enforcing a Judgment

       Having found that the lawsuit had merit, we now inquire

whether there was a realistic possibility that RTA could actually

have enforced a judgment against EDS.     The principal remedies

sought by RTA were specific performance, delivery of the TTS, and

injunctive relief.     Alternatively, RTA asked for the return of

moneys paid by RTA and unspecified damages.     Petitioners'

principal argument is that EDS had no financial ability to

provide either performance under the agreement or any money to

RTA.    Petitioners point to EDS's dire financial condition as

objective evidence that performance or payment was not reasonably

foreseeable at the end of RTA's 1991 tax year.     Petitioners

overlook two things, however.     First, EDS's principal

shareholders were named in the complaint and had guaranteed the

performance of EDS's obligations under the agreement.

Petitioners have failed to prove the inability of those principal

shareholders to satisfy any judgment against them.     Second, EDS

had patent and other rights with respect to the TTS technology,

along with certain TTS equipment.     RTA has failed to prove those

rights and equipment were valueless.     Indeed, during 1991 the
                               - 16 -

shareholders were aware that EDS was seeking new investors for

the TTS.    In the counterclaim, EDS alleges that, on or about

January 16, 1991, RTA interfered with an advantageous business

relationship between EDS and one Charles White.    A memorandum

attached to the counterclaim from “Bob Wagner, Resources

Technology Associates, Inc.” to “Mr. Charles White” mentions the

lawsuit and claims an interest in, among other things, the TTS

equipment.    On November 6, 1991, EDS entered into a contract to

sell the TTS equipment for $3 million ($750,000 before delivery)

to a company of which Mr. White was the controlling shareholder

(Asset Holding Co., which assigned its rights to Tire Recyclers

Inc.).    Petitioners have failed to prove that, as of the end of

1991, there was no realistic possibility of an actual recovery

from EDS or its guarantors.

     D.    Subjective Belief

     We have taken into account the testimony of the two

shareholders who testified:    Walter W. Manley II, and Richard T.

Wagner.    It is clear that, at some point, both of those

shareholders lost confidence in the TTS investment.    Mr. Manley

testified about his refusal in late 1990 or early 1991 to post

the necessary $50,000 bond following the successful effort to

persuade a court to issue an injunction:    “Because at that

particular time, I was the person providing the money, and I had

determined considerably before then that it was a worthless

project, and * * * I wasn’t about to put good money after bad
                               - 17 -

money.”   Apparently, Mr. Manley had become disenchanted with the

project even before it began, when the fabricator of the TTS

equipment, Miles Fabricating & Machine Co., Inc., would not

become “a participant” in the agreement between RTA and EDS.

Mr. Manley testified that he proceeded with his investment

because he had given his word that he would do so to his close

friends Richard T. Wagner and Robert L. Wagner (husband of

shareholder Ruth R. Wagner).   Richard T. Wagner testified that

the decision not to post the $50,000 bond was not recommended by

all those with an interest in the matter.    He testified that,

although he did not agree, his father, Robert L. Wagner, was

hopeful that the TTS technology could be proven or that EDS could

be successful at some point.   Mr. Manley testified: “[Robert L.

Wagner] had a different risk profile then I did.”

     Apparently, the shareholders had different beliefs on the

probable success of RTA’s investment in the TTS.    However,

Mr. Manley, the man with the money, was in control.    He decided

not “to put good money after bad money”.    That was a business

judgment, which was different not only from the business judgment

of Robert L. Wagner, but also from the business judgment of

Charles White, who, in 1991, agreed to pay $3 million for a TTS,

$750,000 to be paid before delivery.

     We have considered the testimony of Messrs. Manley and

Richard T. Wagner, and we conclude that it does not establish

that there was no reasonable prospect for recovery on the lawsuit
                              - 18 -

at the end of 1991 but only that they did not wish to bear the

risk associated with any further investment.

     E.   Conclusion

      Petitioners have failed to prove that RTA’s claim against

EDS and its shareholders was speculative or wholly without merit.

RTA instigated a lawsuit, which, at least initially, it

prosecuted diligently and, in any event, eventually settled on

favorable terms.   We believe that the evidence does not establish

a closed and completed transaction with respect to the TTS

investment in 1991 because there was a reasonable prospect of

recovery on the lawsuit at the end of 1991.    Accordingly, no loss

deduction is allowable to RTA for 1991.

V.   Conclusion

      We have concluded that RTA did not suffer a deductible loss

with respect to the TTS during 1991.   Therefore, no deductible

loss may be passed through to the shareholders in that year.

Respondent’s determinations of deficiencies in the shareholders’

Federal income tax liabilities are sustained.


                                          Decisions will be entered

                                    for respondent.
