                       T.C. Memo. 2000-259



                     UNITED STATES TAX COURT



     RESEARCH TWO LIMITED PARTNERSHIP, DENNIS W. TOWNSEND,
               TAX MATTERS PARTNER, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 25445-88.                    Filed August 16, 2000.



     Daniel S. Goldberg, for petitioner.

     Clare J. Brooks and Linda E. Chan, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     WELLS, Chief Judge:    By notice of final partnership

administrative adjustment dated July 8, 1988, respondent

increased the taxable income of Research Two Limited Partnership

(Research II) as follows:
                                 - 2 -

                     Year           Amount

                     1982        $2,806,250
                     1983           233,061
                     1984           148,897


     Unless otherwise noted, 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.   The issue we must decide is whether Research II was

entitled to deduct for its 1982 taxable year certain amounts owed

to CemCom Research Associates, Inc. (CemCom), for research and

development services.1

                            FINDINGS OF FACT

     Some of the facts and certain exhibits have been stipulated

for trial pursuant to Rule 91.     The parties' stipulations of fact

are incorporated herein by reference and are found as facts in

the instant case.




1
     In their briefs the parties appear to pose a second issue of
whether Research II is entitled to miscellaneous deductions of
$56,250, $233,061, and $174,828 for taxable years 1982, 1983, and
1984, respectively. Petitioner, however, presented almost no
argument on that issue. Rather, petitioner states that, if the
Court finds that Research II is not engaged in a trade or
business, the Court should allow Research II to amortize those
expenses as organizational expenses under sec. 709(b).
Respondent argues that Research II is not engaged in a trade or
business but also states that Research II is entitled to amortize
the organizational expenses under sec. 709(b). As there appears
to be no dispute over the issue, we will address only the sec.
174 research and development deduction.
                                - 3 -

     At the time the petition in this case was filed, Research II

was a limited partnership with its principal place of business in

Towson, Maryland.    Petitioner, Dennis W. Townsend, Research II's

tax matter partner, resides in Towson, Maryland.

     Research II was formed on December 29, 1982.   The general

partners of Research II are Dennis W. Townsend and Townsend &

Co., Inc.   They collectively own a 1.01-percent interest in

Research II.    The remaining interests in Research II are owned by

32 limited partners.    Research II maintains its books and records

and files its Federal income tax returns on the accrual method of

accounting.    Research II has a calendar year.

      Before its formation as a limited partnership and in

 connection with obtaining funds, Research II issued a

 confidential memorandum which described Research II's proposed

 purpose as the development of advanced cementitious composite

 technology for application in the heat treatment and ceramic

 industries (new technology).   The confidential memorandum

 explained that Research II would attempt to achieve its purpose

 by engaging CemCom2 to perform research and development work on

behalf of the partnership.    The confidential memorandum states

that, in engaging CemCom, the promoters of Research II

anticipated that the new technology could be used in



2
     Cemcom was a research corporation formed in 1981 to research
further development and applications of cementitious composites.
                             - 4 -

constructing a room-temperature castable ceramic cement that

would maintain exact tolerances and physical integrity in the

2,000 degree Fahrenheit range.   Promoters of Research II also

foresaw application of the new technology in making a high-

temperature cementitious ceramic.

     Pursuant to the limited partnership agreement dated

December 29, 1982, each limited partner was required to make

capital contributions to Research II of the following amounts:

(1) A cash payment of $24,500 for each unit held, for an

aggregate amount of $1,225,000, due upon formation of Research

II; (2) a cash payment of $6,500 for each unit held, for an

aggregate amount of $325,000, on October 15, 1983; (3) a cash

payment of $5,500 per unit held, for an aggregate amount of

$275,000, on December 15, 1983; and (4) an additional cash

contribution of up to $24,000, plus recourse interest for each

unit held, up to an aggregate of $1,200,000, plus recourse

interest for all partners, at the call of the general partners,

to the extent that Research II had insufficient funds to pay the

deferred obligation under the research and development agreement

with CemCom.

     On December 29, 1982, Research II and CemCom entered into a

research and development agreement.   Pursuant to the terms of

the research and development agreement, CemCom undertook to

perform certain research tasks and experimental services on
                               - 5 -

behalf of Research II for the purpose of developing and

perfecting the new technology and associated patentable and

nonpatentable inventions, know-how, and trade secrets.

All property rights in the new technology and all items of new

technology were to be the sole and exclusive property of

Research II.

     In consideration of CemCom's performing research and

experimental services on behalf of Research II, the research and

development agreement provided that Research II was obligated to

pay CemCom $2,750,000, plus interest at an annual rate of 10

percent of the unpaid balance.    Payments were to be made as

follows:    (1) $950,000 in cash upon execution of the research

and development agreement; and (b) $1,800,000 in a promissory

note.   Payments under the promissory note were to be made as

follows:    (1) $325,000 of principal payable on November 1, 1983;

(2) $275,000 of principal payable on January 3, 1984; and (3)

$1,200,000 plus all accrued and unpaid interest at the annual

rate of 10 percent (totaling $294,583.33) payable on December

31, 1984.   All such payments were with recourse to Research II

and its partners.

     The research and development agreement also provided that

Research II could notify CemCom on or before December 31, 1984,

and the $1,494,583.33 could be restated as principal and

amortized at 14 percent per year in nine consecutive semiannual
                                - 6 -

 payments of $229,398.32 each, with the first payment due on June

 30, 1985.   If Research II elected that option, any interest

 accrued on the unpaid balance after December 31, 1984, was

 without recourse to any partner.   Moreover, if there were

 insufficient funds within Research II to make the semiannual

 payments, payment could be deferred until June 30, 1989.     If

 Research II failed to pay by June 30, 1989, Research II would be

 in default under the research and development agreement, and

 CemCom could exercise its rights as a creditor against Research

 II and its limited partners.

      On December 29, 1982, Research II and CemCom entered into a

 technology transfer agreement.   Pursuant to the terms of the

 technology transfer agreement, Research II licensed, on a

 nonexclusive basis, the rights to certain technology from

 CemCom. Research II also entered into a license agreement with

 Research I Limited Partnership (Research I).3   The CemCom

 licenses enabled Research II to use all proprietary information

 of CemCom and Research I necessary to proceed with the research

 and development activities required under the research and

 development agreement.

      The technology transfer agreement also granted CemCom the

 option, exercisable between June 30 and July 31, 1984, to enter


3
     Research I Limited Partnership is also a Maryland limited
partnership in which Dennis Townsend and Townsend & Co., Inc.,
are general partners.
                              - 7 -

into an exclusive perpetual license of the new technology if the

new technology was patentable.   If CemCom chose to exercise that

option, it would be obligated to make a series of annual royalty

payments (minimum royalty payments) based upon a percentage of

CemCom's cumulative gross revenues but at least $10,950,000.

The payments were due at the following intervals:

            Date                      Minimum Payment

          12/31/84                        $430,000
          6/30/85                          430,000
          12/31/85                         430,000
          6/30/86                          455,000
          12/31/86                         455,000
          6/30/87                          480,000
          12/31/87                         480,000
          6/30/88                          505,000
          12/31/88                         505,000
          6/30/89                          300,000
          12/31/89                         300,000
          6/30/90                          325,000
          12/31/90                         325,000
          6/30/91                          350,000
          12/31/91                         350,000
          6/30/92                          375,000
          12/31/92                         375,000
          6/30/93                          400,000
          12/31/93                         400,000
          6/30/94                          425,000
          12/31/94                         425,000
          6/30/95                          450,000
          12/31/95                         450,000
          6/30/96                          475,000
          12/31/96                         475,000
          6/30/97                          500,000
          12/31/97                         500,000

     If the actual computation of the royalty was greater than

the minimum royalty payments, CemCom would be obligated to make

greater royalty payments.   If the new technology was not
                              - 8 -

patentable, the due dates for the minimum royalty payments owed

to Research II by CemCom would be adjusted to reflect the date

of the exercise of the exclusive license.   In order for CemCom

to ascertain the applicability of the new technology to CemCom's

product line and to facilitate its decision as to whether to

exercise the option, the technology transfer agreement provided

CemCom with a "review license" from December 29, 1982, through

June 30, 1984, to use, review, and evaluate each item of new

technology.

     If CemCom exercised its option for the exclusive license,

the royalty arrangement would provide Research II with a profit

equal to the difference between the minimum royalty payments and

its deferred obligation to CemCom.    CemCom, however, was under

no obligation to exercise its option while Research II was

unconditionally liable to CemCom for the payment of its deferred

obligation.

     If CemCom chose not to exercise its option, the technology

transfer agreement obligated CemCom to grant Research II a

nonexclusive perpetual license of the old technology and the

Research I technology necessary and useful in the further

development, manufacture, use, or marketing of the new

technology.   In return for the license, Research II would pay
                              - 9 -

CemCom a 5-percent annual royalty on all gross revenues from the

sales or licensing of the new technology.

     Before the formation of Research II during 1982, Mr.

Townsend and Townsend & Co., Inc., were the general partners of

Research I limited partnership.   Research I was organized on

December 31, 1981, and was likewise engaged in research and

development in the area of cementitious composites.   Research I

also engaged CemCom to provide the actual research and

development services.   Pursuant to an agreement between Research

I and CemCom, CemCom was granted the option to license the

technology it developed on behalf of Research I provided that it

paid Research I minimum royalty payments.   Deductions taken by

the various limited partners of Research I were the subject of

Harris v. Commissioner, T.C. Memo. 1990-80, affd. 16 F.3d 75

(5th Cir. 1994), affd. without published opinion sub nom.

Travers v. Commissioner, 21 F.3d 424 (4th Cir. 1994), which

denied Research I a deduction pursuant to section 174(a)(1) for

amounts paid to CemCom for research and development services.

     During 1982, CemCom approached Mr. Townsend with a proposal

for a new research venture.   Mr. Townsend was reluctant to

organize a second partnership absent assurance by CemCom that it

would exercise its option under its agreement with Research I.

On December 29, 1982, the same day as the formation of Research

II, CemCom and Research I entered into an agreement whereby
                              - 10 -

CemCom agreed to exercise its option to license the technology

being developed by Research I.    Consequently, on December 29,

1982, Mr. Townsend believed that CemCom had bound itself to make

substantial minimum royalty payments to Research I.

     Accordingly, as of December 29, 1982, it was not certain

that CemCom would exercise its option under the technology

transfer agreement with Research II to license the new

technology.   Additionally, the exercise of the option was

unlikely, given the amount of minimum royalties that CemCom owed

under the Research I agreement.   Even if CemCom were to exercise

its option, CemCom would not be able to continue making the

minimum royalty payments for any sustained period.

     During 1983 and 1984, research and development work was

performed by CemCom in creating and developing the new

technology on behalf of Research II.   During that time, CemCom

provided Mr. Townsend with financial statements and progress

reports detailing CemCom's research and experimental projects

and activities.   The Research II limited partners were kept

advised on CemCom's progress by a series of bulletins.   The

research performed by CemCom during 1983 and 1984 resulted in

the creation and development of "Jetfix".

     On July 31, 1984, CemCom's option to license the new

technology pursuant to the technology transfer agreement lapsed.

On September 27, 1984, Research II and CemCom entered into a
                                - 11 -

licensing agreement (1984 licensing agreement) which granted

CemCom the exclusive right and perpetual worldwide license to

the new technology.   The 1984 licensing agreement provided a

royalty rate to Research II at less than the rate provided in

the technology transfer agreement and provided for minimum

royalties as follows:

               Within 90 days              $12,000
               6/30/85                     285,000
               1/01/86                     285,000
               6/30/86                     285,000
               1/01/87                     285,000
               6/30/87                     285,000
               1/01/88                     285,000
               6/30/88                     285,000
               1/01/89                     285,000
               6/30/89                     285,000

     The revised royalty arrangement enabled Research II to

maintain a profit potential, at a minimum, equal to the

difference between the minimum royalties and the deferred

obligation to CemCom.

     Also, on September 27, 1984, Research II and CemCom entered

into a first amendment to the research and development agreement

which provided that both parties had fully complied with all

requirements of the research and development agreement and that

the new technology had reached the stage where further

development would no longer qualify as research and development

under section 174.    The first amendment further canceled

CemCom's agreement not to do research within the specific scope

and definition of the research program for other parties.
                              - 12 -

Additionally, the first amendment altered the amortized payments

if Research II exercised its option to restate principal as

follows:

                6/30/85             $229,398.32
                1/01/86              229,398.32
                6/30/86              229,398.32
                1/01/87              229,398.32
                6/30/87              229,398.32
                1/01/88              229,398.32
                6/30/88              229,398.32
                1/01/89              229,398.32
                6/30/89              229,398.32

     On the next day, September 28, 1984, Research II entered

into an exercise of stock agreement to purchase and purchased 7

percent of the stock of CemCom for $13,000.   The stock purchase

was part of an overall series of stock purchases pursuant to

which Research I, Research II, Mr. Townsend, and another partner

in both Research I and Research II acquired over 50 percent of

the stock and voting control of CemCom.

     On December 31, 1984, Research II elected to restate the

amount due under the research and development agreement as

principal.   On February 6, 1985, Research II and CemCom entered

into a second amendment to the research and development

agreement reflecting Research II's election to restate the

principal amount due.

     On its Federal income tax return for 1982, Research II

claimed a $2,806,250 loss consisting of a research and

development expense of $2,750,000 and miscellaneous expenses of
                                - 13 -

$56,250.    On its Federal income tax return for 1983, Research II

claimed a $231,432.45 loss consisting of $1,628.83 of dividend

income and miscellaneous expenses of $233,061.28.     On its

Federal income tax return for 1984, Research II claimed a

$174,571.15 loss consisting of $257.18 of dividend income and

miscellaneous expenses of $174,828.33.     By notice of final

partnership administrative adjustment dated July 8, 1988,

respondent denied Research II's deductions for the years in

issue but allowed Research II a deduction of $25,931 for

amortization of patents in 1984.     Respondent has stipulated that

Research II was entitled pursuant to section 709(b) to deduct

amortization of organizational fees of $1,250 for 1982.

                               OPINION

       The issue we must decide is whether Research II is entitled

to a deduction, pursuant to section 174(a)(1), for the

$2,750,000 debt it incurred to CemCom during 1982.     Section

174(a)(1) provides:

       SEC. 174(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.

       The parties agree that the $2,750,000 debt related to

research or experimentation falls within the scope of section

174.    Respondent contends, however, that the debt was not
                                - 14 -

 incurred by Research II in connection with its trade or

 business.

      In Snow v. Commissioner, 416 U.S. 500, 502 (1974), the

Supreme Court compared the "in connection" language of section

174 with the "in carrying on" language of section 1624 and

 established that a business need not currently produce or sell

 any product in order to obtain a deduction for research or

 experimental expenditures.   Rather, the Supreme Court reasoned

 that the policy behind section 174, which is to aid "small or

 pioneering business enterprises" as well as more established

 ones, calls for a more relaxed "trade or business requirement"

 than applies to section 162.     Id. at 503-504.

      In Green v. Commissioner, 83 T.C. 667, 671-672 (1984), a

 deduction pursuant to section 174 was claimed by a partnership

 that entered into a research and development agreement with a

 research corporation and on the same day, through the grant of

 an exclusive license, divested itself of all ownership rights to

 the inventions to be produced.    We held that Snow "did not

 eliminate the 'trade or business' requirement of section 174

 altogether" and denied the partnership the deduction.     Id. at


4
     Sec. 162(a) provides:

          SEC. 174(a). In General.--There shall be allowed
     as a deduction all the ordinary and necessary expenses
     paid or incurred during the taxable year in carrying on
     any trade or business, * * *.
                               - 15 -

686-687.    We explained that the partnership was acting merely as

an investor and not as the type of business that section 174

intended to promote.    See id. at 687.

     In Diamond v. Commissioner, 92 T.C. 423, 424 (1989), affd.

930 F.2d 372 (4th Cir. 1991), the taxpayer was a limited partner

in a limited partnership that became a limited partner in

another limited partnership (project partnership).     The general

partner in the project partnership was a publicly held

corporation that was involved in robotics technology.     See id.

Pursuant to the project partnership agreement, the corporation

was required to contribute the rights to its technology to the

project partnership and to pursue further research activities on

behalf of the project partnership.      See id. at 427-428.   In

return, the partners in the project partnership were to

contribute certain sums of money.    See id. at 428.    The

corporation was granted an option, exercisable in its sole

discretion at any time, to acquire an exclusive and irrevocable

license to carry out all production, manufacturing, and

marketing of any product developed under the agreement.       See id.

at 428-429.    This Court held that there was no realistic

prospect, during the year in issue, that the technology to be

developed "would ever be exploited in any trade or business

carried on by anyone other than * * * [the corporation]."          Id.

at 439.    In that regard, we reasoned that, if the technology
                             - 16 -

appeared commercially promising, the corporation would

definitely exercise its option, and, if the corporation declined

to exercise the option, the project partnership and the limited

partnership would be left with the right to develop an asset

whose costs would not appear to justify additional investment.

See id. at 440-441.

     The Court of Appeals for the Fourth Circuit affirmed our

opinion, stating:

     The question is not whether it is possible in
     principle, or by further contract, for these
     partnerships to engage in a trade or business, but
     whether, in reality, the project partnership * * *
     possessed the capability in the years before the court
     to enter into a new trade or business in connection
     with the proposed * * * [technology]. The answer to
     the question of reality must be found in economic
     reality, which is revealed more by the direction of
     the money than by the complexion of the principle.
     [Diamond v. Commissioner, 930 F.2d at 375.]

     In Harris v. Commissioner, T.C. Memo. 1990-80, we held that

Research I, a partnership of which Mr. Townsend was a general

partner, was not entitled to deductions under section 174 for

amounts paid to CemCom for research and development services

which are similar to the research and development services

provided by CemCom to Research II under the terms of the

research and development agreement.   Research I and CemCom had

also entered into an agreement, similar to the technology

transfer agreement between Research II and CemCom, under which

CemCom was granted the option to license the technology it
                              - 17 -

developed for Research I subject to high minimum royalty

payments.   We found that, at the time Research I entered into an

agreement with CemCom in 1981, Mr. Townsend, as Research I's

general partner, did not intend ever to enter into any business

regarding the technology.   Rather, we found that it was Mr.

Townsend's intention that CemCom would exercise the option as

written or the parties would renegotiate the amount of the

minimum royalties.   In reaching that conclusion, we relied on

the fact that the Research I offering memorandum made no mention

of any other options except CemCom's exercise of the option.     We

also relied on the testimony of Mr. Townsend and others that the

intent of the partners in Research I was that CemCom would

exercise its option.

     Petitioner has not shown that the facts surrounding

Research II are materially different from those surrounding

Research I.   Like the confidential memorandum issued to

prospective limited partners in Research I, the confidential

memorandum issued to the Research II partners contains neither

specific plans nor economic forecasts related to the possibility

that Research II might itself engage in the marketing of the new

technology.   Similarly, no mention is made in the Research II

memorandum of hiring a staff experienced in the area or of

acquiring real or personal property for such purposes.     Finally,

as in Research I, virtually all of the funds of Research II were
                              - 18 -

to be disbursed in payment of the licensing agreement to CemCom,

and the limited partners of Research II were under no obligation

to contribute additional funds for that purpose.    These facts

indicate that Research II never intended to enter a trade or

business in connection with the new technology.

     Petitioner argues that the instant case is distinguishable

from Harris v. Commissioner, supra, because the high minimum

royalties required by the technology transfer agreement in

addition to the royalties which CemCom owed under the Research I

agreement made it virtually certain that CemCom would never

exercise its option under the Research II agreement to license

the new technology.   However, as we said in Harris:   "the amount

of the royalties does not supply the required prospect of a

'trade or business' to be carried out by the Partnership."

     Petitioner further argues that the fact that Research I,

Research II, Mr. Townsend, and another partner in both Research

I and Research II ultimately acquired control of CemCom is

evidence of the Research II's intent to engage in a trade or

business.   To the contrary, such evidence convinces us that,

even when CemCom was unable to license the new technology,

Research II did not take advantage of the opportunity to enter

into a trade or business with the new technology.   Instead, the

minimum royalties were reduced, and CemCom, with its new owners,

remained the vehicle through which the actual trade or business

involving the new technology was operated.
                              - 19 -

     In sum, we hold that the research and developmental

expenses incurred by Research II during December 1982 were not

made in connection with its trade or business within the meaning

of section 174(a).   We have considered the parties' remaining

arguments and find them without merit, irrelevant, or

unnecessary to reach.

     To reflect the foregoing and the concessions of the

parties,


                                    Decision will be entered

                               under Rule 155.
