                       T.C. Memo. 2002-107



                     UNITED STATES TAX COURT



 IMPACT RESEARCH CORPORATION, JOAN C. BENZ, TAX MATTERS PERSON,
   Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

 RESEARCH IMPACT CORPORATION, JOAN C. BENZ, TAX MATTERS PERSON,
   Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 14872-98, 14873-98.1   Filed April 29, 2002.



          S-1 and S-2 were S corporations formed to finance the
     research and development activities of A, a nonpublicly
     traded C corporation engaged in the business of developing
     educational videodiscs. In a series of written agreements
     between S-1, S-2, and A, (1) S-1 and S-2 acquired
     proprietary rights in the results of the research which A
     was to perform on their behalf, (2) A was obligated to pay
     royalties to S-1 and S-2, and (3) A was given the option to


     1
      The petition in each docket was filed by Frank Colenda, the
tax matters person of each of the named corporations. After
trial and the filing of all briefs, the Court was notified that
Frank Colenda died. After appropriate representations, we
granted petitioners’ counsel’s motion in both dockets to (1)
substitute Joan C. Benz for Frank Colenda as tax matters person
and (2) change captions to reflect this substitution.
                              - 2 -

     buy all the assets of S-1 and S-2 in exchange for stock in
     A. S-1 and S-2 each deducted under sec. 174, I.R.C. 1954,
     the amounts each assertedly paid to A to conduct the
     research and development activities.

          Held: Neither S-1 nor S-2 is entitled to a deduction
     under sec. 174, I.R.C. 1954, because the amounts S-1 and S-2
     allegedly paid to A were not paid in connection with S-1's
     and S-2's respective trades or businesses.



     Cheryl R. Frank and Gerald W. Kelly, Jr., for petitioners.

     Lindsey D. Stellwagen, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     CHABOT, Judge: By separate notices of final S corporation

administrative adjustment (hereinafter sometimes referred to as

FSAA) respondent determined adjustments to the 1984 S corporation

income tax returns of Impact Research Corporation (hereinafter

sometimes referred to as IRC) and Research Impact Corporation

(hereinafter sometimes referred to as RIC).2   For IRC, respondent




     2
      This method of resolving disputes regarding subchapter S
items was enacted by sec. 4 of the Subchapter S Revision Act of
1982, Pub. L. 97-354, 96 Stat. 1669, 1691, 1697, effective for
taxable years beginning after Dec. 31, 1982. It was repealed by
sec. 1307(c)(1) of the Small Business Job Protection Act of 1996,
Pub. L. 104-188, 110 Stat. 1755, 1781, 1787, effective for
taxable years beginning after Dec. 31, 1996. The year in issue
in the instant cases is 1984, a year to which this method
continues to apply. Thus, even though both of the FSAAs here
involved were issued after the 1996 repeal, we concur with the
parties’ position that this Court has jurisdiction to resolve the
parties’ disputes in the instant cases. See New York Football
Giants, Inc. v. Commissioner, 117 T.C. 152, 154 n.3 (2001).
                              - 3 -

determined (1) a $241,700 adjustment3 resulting from the

disallowance of a deduction for research or experimental

expenditures under section 1744 and (2) an $80,000 adjustment

eliminating IRC’s reported short-term capital gain.   Petitioner

in docket No. 14872-98 does not dispute the $80,000 adjustment.

For RIC, respondent determined a $631,289 adjustment resulting

from the disallowance of a deduction for research or experimental

expenditures under section 174.5


     3
      Under the heading of “Detail of Adjustments To Ordinary
Income”, the FSAA for IRC shows a $241,700 adjustment to research
and development expense. Under the heading of “Other
Adjustments”, the FSAA shows a $221,558 adjustment to research
and development expense and a $20,142 adjustment to qualified
investment expenses, paralleling the treatment on Schedule K,
Shareholders’ Share of Income, Credits, Deductions, etc., of
IRC’s 1984 S corporation tax return; the sum of these adjustments
is $241,700. On brief, the parties treat this as one $241,700
adjustment. For convenience, we follow the parties’ one-
adjustment terminology. This does not affect our substantive
analysis or our conclusions.
     4
      Unless indicated otherwise, all section references are to
sections of the Internal Revenue Code of 1954 as in effect for
1984.
     5
      Under the heading of “Detail of Adjustments To Ordinary
Income”, the FSAA for RIC shows a $631,289 adjustment to research
and development expense. Under the heading of “Other
Adjustments”, the FSAA shows a $594,192 adjustment to research
and development expense and a $37,097 adjustment to qualified
investment expenses, paralleling the treatment on Schedule K,
Shareholders’ Share of Income, Credits, Deductions, etc., of
RIC’s 1984 S corporation tax return; the sum of these adjustments
is $631,289. However, on a “STATEMENT I” of RIC’s 1984 S
corporation tax return, the deduction is broken down as follows:
(1) “research-development exp”--631,000, and (2) “other exp”--
289. The parties do not appear to focus on the differences
between these two breakdowns of the $631,289 total. Because the
                                                   (continued...)
                               - 4 -

     These cases have been consolidated for trial, briefs, and

opinion.   After a concession by respondent,6 the issues for

decision as to each of the S corporations are as follows:

           (1) Whether the S corporation made research or

     experimental expenditures (within the meaning of

     section 174) in 1984 and, if so, then in what amount.

           (2) Whether any such expenditures by the S

     corporation were made in connection with that

     corporation’s trade or business.

                        FINDINGS OF FACT

     Some of the facts have been stipulated; the stipulations and

the stipulated exhibits are incorporated herein by this

reference.7




     5
      (...continued)
differences between these breakdowns do not affect our
substantive analysis or our conclusions, for convenience, we
treat respondent’s determinations as one adjustment.
     6
      Shortly before trial, respondent raised the question of
whether IRC had a valid S corporation election under sec. 1362(a)
in effect for 1984. Two months after the trial, the parties
stipulated the document that constituted the election form and
showed on its face that it had been timely received and accepted
by respondent. Respondent thereupon conceded that IRC had a
valid S corporation election in effect for 1984.
     7
      Six of the stipulated exhibits were offered for limited
purposes only and (as was made clear in the trial transcript)
were received subject to those limitations. We have carefully
observed those limitations in making our findings and arriving at
our conclusions. See Fed. R. Evid. 105.
                               - 5 -

     IRC and RIC had their respective principal places of

business in Sterling, Virginia, when the respective petitions

were filed in the instant cases.   Both IRC and RIC were cash

basis taxpayers; each reported on its respective 1984 information

return that it had no income but claimed a deduction for research

and development expenses (IRC--$241,700; RIC--$631,000).    RIC

claimed a $289 deduction for other expenses.

A.   Systems Impact, Inc.

     In 1984, Systems Impact, Inc. (hereinafter sometimes

referred to as Systems), was a nonpublicly traded C corporation

seeking to develop interactive educational videodiscs, a

relatively new technology at the time.   Videodiscs are discs

which contain information which users may access with a videodisc

player.   The videodisc player transmits the information contained

in the videodisc to a computer monitor for display.

     Systems sought to exploit the videodisc technology as an

educational aid.   Systems’ videodiscs were about the size of a

78-rpm phonograph record; they contained information about

various subjects including fractions, algebra, and earth science.

As used in an educational setting, teachers could monitor student

learning while the videodiscs presented the information to the

students.   Based on their observations, teachers could tailor the

presentation of the information to what they perceived to be the

needs of the students.   For instance, if the class did not appear
                               - 6 -

to grasp a portion of a lesson, then the teacher could replay the

unclear portion of the lesson in a step-by-step process to

reinforce or clarify key principles; conversely, if the class

appeared to understand the lesson, then the teacher could

continue with the lesson.   The videodiscs also enabled teachers

to present the information contained in the videodiscs in more

than one manner.

     By 1984, Systems had developed early prototypes of the

videodiscs, but it needed an additional $5-8 million to bring

them to market.

B.   Creation and Operation of IRC and RIC

     In 1984, Gordon Gould (hereinafter sometimes referred to as

Gould) was the president of Heritage Financial Corp. (hereinafter

sometimes referred to as Heritage Financial).   Heritage Financial

was a securities firm; a broker-dealer, it sold stocks, bonds,

and other forms of investments.

     In 1984, Gould met with Systems’ representatives about

raising the financial support Systems needed in order to expand

its research and development activities.   Gould considered the

videodisc technology to be a “valid potential product for

investors”.   After consulting with securities attorneys, Gould

and Systems agreed that the formation of two S corporations

represented the best way to (1) provide to Systems the additional

financing it needed, and (2) secure an equity investment in the
                                 - 7 -

videodisc technology for shareholders in the to-be-formed S

corporations.

     Once Gould and Systems agreed to form the two S

corporations, Gould began to locate potential shareholders in

what would become IRC and RIC.    Gould tried to locate

shareholders who would qualify under the private placement rules

of the Securities Act of 1933.    To ensure qualification,

prospective shareholders completed "investor qualification forms"

which solicited the information necessary to determine whether

potential shareholders satisfied the Securities and Exchange

Commission’s rules regarding private placement offerings.        The

investor qualification forms provided information about the

potential shareholder’s balance sheets, income statements, tax

returns, and experience with investing in private placements.

Potential shareholders in IRC and RIC had to have a minimum net

worth of $200,000.   Gould reviewed the investor qualification

form of each potential shareholder.      Shareholders in the S

corporations were not selected on the basis of education and

experience in manufacturing or in marketing.

     A majority of the shareholders of IRC and RIC were

professionals and had some managerial and business expertise.

Frank Colenda (supra note 1) participated in the U.S. Navy’s

development of the “Sparrow” missile program.      Among the

shareholders of RIC were the following:      Joan C. Benz, a Ph.D.,
                               - 8 -

who later became a high school principal; Francis E. Rundell, a

retired U.S. Air Force colonel who managed missile research and

development programs for the U.S. Air Force; and William A.

Fleming, a former supervisor in the lunar lander program of the

National Aeronautics and Space Administration and former

supervisor in the Federal Aviation Administration.

     On February 28, 1984, IRC was incorporated in Delaware.     IRC

elected S corporation status for its first taxable year (the

short period from Mar. 1 through Dec. 31, 1984); it reported its

income using the cash method of accounting.

     On March 5, 1984, IRC opened a checking account with

Maryland National Bank.   IRC wrote four checks on that account:

Two checks totaling $7,412 for legal fees and two checks totaling

$20,900 to Heritage Financial for fees and commissions associated

with the private placement of IRC stock.

     On June 5, 1984, RIC was incorporated in Delaware.    RIC

elected S corporation status for its first taxable year (the

short period from June 5 through Dec. 31, 1984); it reported its

income using the cash method of accounting.

     In June of 1984, RIC opened a checking account with

Maryland National Bank.   RIC wrote eight checks on that

account:   Two checks totaling $32,588 for legal fees, one

$80,000 check for the repayment of a loan, two checks totaling

$12,069 for refunds of investments in RIC stock, one $10,000
                                - 9 -

check to Systems as a transfer of funds, and two checks

totaling $91,960 to Heritage Financial for sales commissions

and legal fees associated with the private placement of RIC

stock.   RIC transferred an additional $100,000 to Systems by

debit memorandum and Systems transferred $20,000 to RIC.     RIC

also transferred to Systems $331,092 by means of seven debit

memoranda.   RIC closed its checking account with Maryland

National Bank and transferred the remaining balance of the

account, $5,086.80, to Systems by debit memorandum on or about

December 10, 1984.   RIC transferred a net of $426,178.80 to

Systems from its Maryland National Bank checking account

($100,000 + 10,000 - 20,000 + 331,092 + 5,086.80).

     On or about July 10, 1984, RIC opened a checking account

with McLachlen National Bank.    RIC did not write any checks on

the account.   RIC closed the account and transferred the

remaining balance, $205,137.20, to Systems on August 24, 1984.

RIC transferred $631,316 to Systems from its two checking

accounts ($426,178.80 (Maryland National Account) + $205,137.20

(McLachlen National Account)).

     Neither IRC nor RIC performed educational videodisc research

or development activities through its own employees.    For that

matter, neither S corporation had any employees.    IRC and RIC did

not prepare any written marketing or business plans.    Neither IRC

nor RIC held corporate board meetings, owned physical assets,
                               - 10 -

owned or leased physical premises, or maintained inventory.

Neither IRC nor RIC was adequately capitalized to market and

license products, nor did either corporation make any provisions

to raise additional capital.   There are not any written documents

reflecting that either IRC or RIC intended to enter the market

for educational videodiscs.

C.   Agreements Among Systems, IRC, and RIC8

     IRC entered into three agreements with Systems: (1) A

research and development agreement (hereinafter sometimes

referred to as the R & D Agreement), (2) an exclusive license

agreement, and (3) an option agreement.   On June 13, 1984, IRC

and Systems amended the R & D Agreement to make RIC a party

thereto.9   At some point, IRC and Systems also amended the

exclusive license agreement to make RIC a party thereto.      See

supra note 9.   Also, at some point RIC became a party to an

option agreement with Systems, but the record does not indicate


     8
      In many instances, the entire agreements are physically in
the record. Nevertheless, as explained supra note 7, our
findings with respect to these agreements do not go beyond the
stipulated limitations on the purposes for which the agreements
were offered and received in evidence, except to the extent the
findings are based on other evidence of record or on the parties’
unobjected-to proposed findings.
     9
      So stipulated. However, neither the parties’ stipulations
nor any other evidence in the record herein shows what RIC’s
obligations and benefits were under the R & D Agreement as so
amended. For example, we cannot tell from the record whether it
is more likely than not that RIC shared all or any of IRC’s
obligations and benefits under the R & D Agreement. But see
infra note 10.
                               - 11 -

whether this was accomplished by an IRC-Systems amendment to the

original option agreement or a separate RIC-Systems agreement.

     1.   Research and Development Agreement

     The R & D Agreement obligated IRC to pay to Systems a fixed

fee of $875,000 in consideration of Systems’ performance of

research activities.10   In this connection, section 2.02 of the

R & D Agreement provides as follows:

          2.02. Payments. In consideration for the
     performance of the Funded Research Effort, SII
     [Systems] shall receive a fixed fee of $875,000.00.
     Such fee shall be paid in seven (7) installments in
     accordance with the payment schedule set forth on
     Exhibit B, which hereby is incorporated herein and made
     a part hereof. The obligation of IRC to make payments
     to SII pursuant to this Section 2.02 shall be
     contingent upon the delivery to IRC by SII of the
     monthly reports required pursuant to Section 4.01
     hereof, and the absence of any default under Section
     7.03 hereof. In consideration of such fixed fee, SII
     shall complete the entire Funded Research Effort
     irrespective of the actual cost thereof. Regardless of
     whether a commercially marketable technology or product
     results from the Funded Research Effort, no part of any


     10
      We note that the FSAAs disallowed research or experimental
expenditures deductions in the amounts of $241,700 (IRC) and
$631,289 (RIC), for a total of $872,989. This is very close to
the $875,000 fixed fee provided for in the R & D Agreement.
Also, this is almost exactly the $873,000 that petitioners ask us
to find as IRC’s and RIC’s payment obligation under the R & D
Agreement. However, the parties have not enlightened us as to
whether this is an indication that the June 13, 1984, amendment
involved RIC’s taking over some specified portion of IRC’s
original obligations under the R & D Agreement. In light of the
lack of record evidence as to what was involved in the June 13,
1984, amendment to the R & D Agreement, we cannot tell whether
(1) petitioners intend to suggest that the June 13, 1984,
amendment slightly reduced the contractual fee obligation, or (2)
the $873,000 statement is merely petitioners’ typographical error
that went unnoticed by respondent.
                                  - 12 -

     such fixed fee shall be refundable to IRC except as
     provided in Section 8 hereof.

     The Exhibit B payment schedule referred to in section 2.02

of the R & D Agreement provides as follows:

                                 EXHIBIT B
                                     to
                    RESEARCH AND DEVELOPMENT AGREEMENT

          Impact Research Corporation shall make payments to
     Systems Impact, Inc. pursuant to the Research and
     Development Agreement according to the following schedule:

             Date                      Amount of payment

     No later than
     Mar. 19, 1984                         $151,000

     Apr. 1, 1984                           149,000

     May 1, 1984                            143,000

     June 1, 1984                           137,000

     July 1, 1984                           102,000

     Aug. 1, 1984                            97,000

     Sept. 1, 1984                           96,000

          TOTAL                             875,000

     Any payments that IRC made to Systems were not made in

accordance with the Exhibit B payment schedule.11        Systems did

not provide to IRC the monthly reports referenced in par. 2.02 of

the R & D Agreement or any other written periodic reports, nor



     11
      So stipulated. See supra note 10, as to our lack of
information as to RIC’s obligations. Also, the record does not
indicate whether RIC made payments in accordance with any such
obligations.
                                - 13 -

did Systems provide written periodic reports to RIC; however,

Systems did provide a final report to both IRC and RIC.   Systems

conducted frequent meetings with Gould and invited shareholders

of IRC and RIC to discuss the progress of the research.   None of

IRC’s or RIC’s shareholders became actively involved in, or

monitored the substance of, Systems’ research.   However, one

shareholder, Paul Smith, traveled once to Utah where the actual

research was being performed.

     The R & D Agreement further provides that IRC and RIC

acquired proprietary rights in the results of Systems’ research

activities as follows:

          6.01. Ownership in IRC [and RIC]. IRC [and RIC]
     shall have the full exclusive right, title and interest
     in and to all knowledge, developments, techniques,
     processes, discoveries, inventions, improvements,
     devices, designs, apparatuses, practices, methods,
     products and trade secrets of whatever nature, whether
     or not patentable, that are perfected, devised,
     conceived, developed, acquired or reduced to practice
     in performance of the [R & D] Agreement; provided,
     however, IRC’s [and RIC’s] rights in Preexisting
     Research shall be as provided in Section 3 hereof.[12]

The research under the R & D Agreement was not intended to, and

did not result in, any commercially viable product.13




     12
      Sec. 3 of the R & D Agreement was not offered and received
into evidence.
     13
      Petitioners ask us to make this finding. Respondent does
not object. We treat this as the equivalent of a supplemental
stipulation.
                               - 14 -

     The R & D Agreement provides that it would terminate at the

later of (1) the passage of 1 year, or (2) when Systems delivered

a final report “acceptable to IRC”.14

     2.   Exclusive License Agreement

     Under the exclusive license agreement, IRC transferred to

Systems certain rights in exchange for a royalty interest.

The exclusive license agreement obligated Systems to remit to IRC

royalty payments equal to 10 percent of the gross revenues

Systems derived from the sale of “Demonstration Discs” and “Core

Concepts in Science and Mathematics” for the term of the

exclusive license agreement, discussed below.   Systems was

further obligated to remit to IRC royalties of 10 percent of the

gross revenues Systems derived “from the sale of any other

products based upon or embodying the Demonstration Discs”, for a

period of 5 years.   At some point, RIC became a party to the

exclusive license agreement.

     The term of the exclusive license agreement is set forth in

section 2.04 thereof, which provides as follows:

          2.04.   Duration.

                 (a) The Exclusive License shall continue in
     effect until such date (the “Date of Termination”) as
     it is terminated, in whole or in part, in accordance
     with the following provisions. Royalty Payments (as


     14
      The record herein does not indicate whether the final
report was acceptable to IRC (or, for that matter to RIC, supra
note 9) or even whether Systems’ delivery was late enough so that
the R & D Agreement lasted longer than 1 year.
                                - 15 -

     hereinafter defined in Section 5) accrued as of the
     Date of Termination shall remain due and payable
     notwithstanding termination.

                 (b) Subject to the provisions of paragraph
     (c) of this Section 2.04, the Exclusive License shall
     terminate as to the Demonstration Discs upon the
     occurrence of any of the following events: (i) * * *
     [Systems] or an assignee pursuant to the terms hereof
     is adjudicated a bankrupt and ceases operations; (ii)
     there shall be a failure to make a Royalty Payment in
     accordance with Section 5 hereof for a period of at
     least twenty (20) days after the date on which the same
     is due and payable; (iii) * * * [Systems] fails to
     complete the Funded Research Effort (as defined in the
     R&D Agreement) within one (1) year from the date
     hereof; (iv) * * * [Systems] fails to complete the
     development of and to offer for sale to the public at
     least five (5) of the courses to be included in the
     Core Concepts in Science and Mathematics series on or
     before January 1, 1987; or (v) * * * [Systems] fails to
     develop and maintain in good faith policies and a
     program to protect the confidentiality of the
     Demonstration Discs and the technology relating
     thereto, pursuant to section 8 hereof.

                 (c) If the Exclusive License has not
     terminated pursuant to the preceding provisions of this
     Section 2.04, it shall terminate on March 31, 1994 (the
     “Date of Termination”).

     Systems did not remit to either IRC or RIC any royalties in

1984.

     3.     Option Agreement

        On or about March 19, 1984, IRC and Systems entered into an

agreement under which Systems had the option to buy IRC’s assets

in exchange for Systems’ stock, but only if all of certain

specified conditions were met.    One of these specified conditions

was that Systems’ notice of election to exercise the option

“shall provide for the consummation of the sale of the assets of
                              - 16 -

IRC to * * * [Systems] on or before March 31, 1985.”    At some

point, RIC became a party to an option agreement with Systems.

      Under an agreement dated March 2, 1984, among IRC and its

shareholders, if Systems satisfied each of certain specified

conditions, then IRC’s shareholders were obligated to vote their

shares to approve the proposed merger or assets acquisition.      The

specified conditions in the March 2, 1984, IRC shareholders

agreement are almost exactly the same as the specified conditions

in the above-described option agreement    If Systems did not

satisfy the foregoing conditions, then the terms of any agreement

to merge or sell assets would be subject to negotiations.

      On or about March 26, 1985, Systems’ president asked that

the option expiration date be extended from March 31, 1985, to

May 31, 1985.   On or about March 29, 1985, the boards of

directors of IRC and RIC refused the request for extension.

D.   Mergers of IRC and RIC Into Systems

      Contentious merger negotiations between Systems, IRC, and

RIC ensued after Systems’ option to buy the stock of IRC and RIC

expired on March 31, 1985.   The negotiations ultimately proved

successful and a merger occurred.

           _____________________________________________

      Both IRC and RIC were formed and operated primarily to

furnish investment capital to Systems.     Neither IRC nor RIC spent

money in 1984 for the purpose of research or development in a
                             - 17 -

trade or business that the respective S corporation was

conducting in 1984 or that the respective S corporation expected

or intended to conduct at any time after 1984.

                             OPINION

     Respondent contends that neither IRC nor RIC is entitled to

the section 174 deduction each claimed because petitioners have

failed to carry their burdens of proving the following: (1)

Either IRC or RIC paid research expenses in 1984,15 (2) any

expenses paid for by IRC or RIC in 1984 constitute research or

experimental expenditures under section 174, and (3) any such

expenditures were paid in connection with the respective S

corporation’s trade or business.   Respondent contends that

     To meet the “in connection with” requirement, petitioners
     must establish that * * * [the S corporations] had * * *
     realistic [prospects] of going into business [, and they
     must do so] by demonstrating both an objective intent and
     the current ability to enter the marketplace.

Respondent views petitioners’ burdens as a series of “hurdles”,

every one of which must be surmounted by a petitioner in order

for that petitioner to establish that that petitioner’s S

corporation is entitled to any part of its claimed deduction.

     Petitioners contend that (1) the work that Systems performed

on behalf of IRC and RIC qualifies under section 174 and should



     15
      At one point on brief, respondent seems to contend that
the failure of proof of 1984 expenditures applies to both IRC and
RIC; at another point respondent applies this contention only to
IRC.
                                 - 18 -

be treated as having been performed by IRC and RIC; (2) IRC and

RIC could have and would have entered the marketplace with the

technology so developed, but for Systems’ acquisition of IRC and

RIC; and (3) IRC and RIC spent the necessary funds in 1984.

     We agree with respondent that IRC and RIC did not pay the

research expenses in connection with their respective trades or

businesses, and so neither S corporation is entitled to its

claimed section 174 deduction (see supra notes 3 and 5).

     Section 174(a)(1)16 permits a taxpayer to currently deduct

research or experimental expenditures which the taxpayer pays or

incurs during the taxable year in connection with the taxpayer’s

trade or business.     (For these purposes, the taxpayers in the

instant cases are IRC and RIC, even though they are pass-through

entities.)

     For IRC and RIC to be entitled to their claimed section 174

deductions, the record must show that (1) IRC and RIC made

payments to Systems, (2) these payments were made in order to


     16
          Sec. 174(a)(1) provides as follows:

      SEC. 174.     RESEARCH AND EXPERIMENTAL EXPENDITURES.

             (a) Treatment As Expenses.--

                  (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.
                                - 19 -

have Systems conduct research or experiments on behalf of IRC and

RIC, and (3) this research or these experiments are in connection

with IRC’s or RIC’s trade or business.    Failure to satisfy any of

these requirements would lead to a conclusion that IRC and RIC

are not entitled to their claimed section 174 deductions.    See

Green v. Commissioner, 83 T.C. 667, 691 (1984).

       We consider first the question of whether the expenditures

were “paid or incurred * * * in connection with * * * [IRC’s or

RIC’s] trade or business”.    Sec. 174(a)(1).

       In Snow v. Commissioner, 416 U.S. 500, 503 (1974), the

Supreme Court contrasted the “in connection with” language of

section 174 with the “in carrying on” language of section 162.

The Supreme Court concluded that the difference in language meant

that the requirements of section 174 were different from the

requirements of section 162.     The Supreme Court examined the

legislative history of section 174 in order to determine what

were the relevant differences between section 174 and section

162.    Id. at 503-504.   The Supreme Court then concluded that the

different statutory language meant that deductions under section

174 are to be available to companies “that are upcoming and about

to reach the market”, as well as to “ongoing companies”.     Id. at

504.

       Although the taxpayer need not be conducting a trade or

business at the time of the research or experimental expenditure,
                               - 20 -

in order to satisfy the trade or business requirement of section

174, the record must demonstrate that the taxpayer’s prospects of

entering that trade or business are realistic.    Zink v. United

States, 929 F.2d 1015, 1023 (5th Cir. 1991); Spellman v.

Commissioner, 845 F.2d 148, 149 (7th Cir. 1988), affg. T.C. Memo.

1986-403.   Demonstrating a realistic prospect of entering a trade

or business requires proof of (1) the objective intent to enter

such trade or business, and (2) the capability of doing so.

Kantor v. Commissioner, 998 F.2d 1514, 1518-1519 (9th Cir. 1993)

(and cases cited therein), affg. on this issue and revg. on

another issue T.C. Memo. 1990-380.

     “In order to qualify for the section 174 deduction, a

taxpayer’s existing or prospective business must be its own and

not that of another entity.”   Id. at 1519.   Putting it

differently, the record must show that the taxpayer is not merely

an investor in someone else’s trade or business but is (or is to

be) the conductor of its own trade or business.    Harris v.

Commissioner, 16 F.3d 75, 78 (5th Cir. 1994), affg. T.C. Memo.

1990-80; Diamond v. Commissioner, 930 F.2d 372, 375-376 (4th Cir.

1991), affg. 92 T.C. 423 (1989); Green v. Commissioner, 83 T.C.

at 687; see Travers v. Commissioner, 21 F.3d 424, 73 AFTR 2d 1798

(4th Cir. 1994), affg. without published opinion Harris v.

Commissioner, T.C. Memo. 1990-80.
                              - 21 -

     We view the record in the instant case in light of the

foregoing.

     As 1984 began, Systems existed; IRC and RIC had not yet been

created.

     Systems was developing interactive educational videodiscs

and seeking to exploit the technology.   Systems needed an

additional $5-8 million to bring its videodiscs to market.     IRC

and RIC were created in 1984 through the efforts of Systems and

Gould (Systems’ financial adviser); these efforts were motivated

by Systems’ need for additional financing.

     Gould’s testimony makes it plain that IRC and RIC were

created to meet Systems’ need for financing research that Systems

wanted to do so that Systems could exploit interactive videodisc

technology.   Gould selected IRC’s and RIC’s potential

shareholders in order to have these individuals contribute funds

to IRC and RIC, in order to have IRC and RIC satisfy a portion of

Systems’ financial needs.   Gould was petitioners’ witness.

Gould’s testimony completely negates any thought that IRC and RIC

had the trade or business ideas and merely sought out Systems to

do research in order to enable IRC and RIC to exploit new

technology.   A February 27, 1984, letter from John P. Clark

(hereinafter sometimes referred to as Clark) to Systems’

president shows that Clark, too, understood that Systems was

looking for a source of funds that Systems could use to advance
                                - 22 -

Systems’ prospects to enter the “videodisc instructional systems”

market.   Clark understood that “Funds are to be raised in a tax

advantaged Subchapter S investment vehicle” and these funds would

be used by Systems to further Systems’ business efforts.       In this

letter, Clark, as vice president of Scott & Stringfellow, Inc.,

was offering the services of his firm “to act as investment

bankers for Systems”.

     Systems and IRC entered into three agreements.      RIC got

folded into these agreements in some manner not clearly disclosed

in the record.   The R & D Agreement required IRC (and RIC?) to

make payments to Systems on a specified schedule in consideration

of Systems’ performing research, and required Systems to provide

monthly reports to IRC (and RIC?).       The R & D Agreement was

respected only in part by the parties thereto.       The parties

herein have stipulated that the payments were not made in

accordance with the R & D Agreement schedule.       The parties herein

have stipulated that Systems did not provide any written periodic

reports to IRC or RIC, much less the monthly reports mandated by

the R & D Agreement.    The R & D Agreement gave to IRC and RIC

exclusive ownership of whatever Systems’ research developed.

However, the parties herein agree that “The research under the

R & D Agreement was not intended to and did not result in any

commercially viable product.”    Although Systems failed to provide

written monthly reports, it did conduct frequent meetings with
                              - 23 -

Gould and invited shareholders of IRC and RIC to discuss the

progress of the research.   However, the parties herein have

stipulated that “No shareholder of * * * [IRC or RIC] monitored

the substance of the research being performed by Systems”.     The

record does not disclose how many, if any, of the shareholders

attended the meetings of Systems and Gould.

     Under the exclusive license agreement, IRC transferred to

Systems certain rights in exchange for royalty payments.   Because

of the limitations on use of various stipulated documents (supra

note 7), we cannot determine on the basis of the record herein

whether these rights are the rights given to IRC (and RIC?) under

the R & D Agreement.   Systems did not remit to either IRC or RIC

any royalties in 1984.   In light of the parties’ herein agreeing

that “The research under the R & D Agreement was not intended to

and did not result in any commercially viable product”, it is not

clear whether the parties to the exclusive license agreement

contemplated that Systems would ever be obligated, in a real-

world sense, to make any royalty payments under the exclusive

license agreement.

     Under the option agreement, Systems had the option to buy

all of IRC’s and RIC’s assets in exchange for Systems’ common

stock which would be (1) worth at least twice the aggregate

contributed capital of IRC and RIC, and (2) at least 10 percent

of Systems’ outstanding common stock immediately after the
                              - 24 -

transaction.   The option expired.   There were negotiations.   The

exchange of stock for assets occurred, apparently in 1985, and

perhaps on terms more favorable to IRC’s and RIC’s shareholders

than were provided for in the option agreement.

     From the foregoing, it is clear that (1) the “upcoming

business” was Systems’, (2) IRC and RIC were created to provide

investment capital for Systems’ trade or business, and (3), if

things worked well, then IRC and RIC would end up with Systems

stock and not with their own trade or business.

     Although the R & D Agreement appeared to provide IRC and RIC

with rights that theoretically they might be able to exploit in

their own trades or businesses, (1) neither party to the R & D

Agreement bothered to comply with some of the Agreement’s

specific obligations, and (2) if the rights really turned out to

be valuable, then Systems had an absolute right to acquire them.

In fact, even though Systems let the option agreement expire,

that merely resulted in a negotiated merger into Systems and not

trades or businesses for IRC and RIC.    Thus, although the 1985

events deviated from the 1984 option agreement, the 1985 events

confirmed17 that element of the 1984 option agreement that

controls for our purposes--Systems bought out IRC’s and RIC’s



     17
      See Levin v. Commissioner, 832 F.2d 403, 406 n.3 (7th Cir.
1987), affg. 87 T.C. 698 (1986); MedChem (P.R.), Inc. v.
Commissioner, 116 T.C. 308, 310 n.2 (2001), on appeal (1st Cir.,
Aug. 24, 2001).
                                - 25 -

assets so that if trade or business use would be made of any

research or experimental expenditures, then it would be made in

Systems’ trade or business, and not in IRC’s or RIC’s.

       Because of our determination, based on our findings of fact

(see Levin v. Commissioner, 832 F.2d 403, 405 (7th Cir. 1987),

affg. 87 T.C. 698 (1986)), that any research or experimental

expenditures by IRC and RIC were not paid in connection with

IRC’s or RIC’s trade or business within the meaning of section

174(a)(1), it is unnecessary for us to determine whether IRC or

RIC made relevant expenditures in 1984 in at least the amounts of

their respective claimed deductions, or in any amounts, and

whether the expenditures that IRC or RIC made qualify as research

or experimental expenditures.    Green v. Commissioner, 83 T.C. at

691.



                                          Decisions will be entered

                                     for respondent.
