Dean B. Smith and Irma Smith v. Commissioner of Internal Revenue ( 1991 )

WELLFORD, Senior Circuit Judge.

Appellants, Dean B. Smith and Irma Smith, appeal from the decision of the United States Tax Court concerning deficiencies and penalties imposed upon their federal income tax for 1981 and 1982 by the Commissioner of Internal Revenue. The Tax Court determined that the 1981 and 1982 deficiencies constituted substantial underpayments attributed to a tax-motivated transaction under I.R.C. § 6621 and that petitioners were liable for an additional assessment (in addition to § 6661). Smith v. Commissioner, 91 T.C. 733 (1988). On this appeal, we must decide: (1) whether the Tax Court correctly determined the taxpayers were not entitled to deduct their alloca-ble shares of partnership losses from the Koppelman Process activities; and (2) whether the Tax Court correctly sustained an addition to petitioners’ tax under I.R.C. § 6661 for a substantial understatement of tax and imposed additional interest under § 6621(c) for substantial underpayments attributable to tax-motivated transactions.

The Tax Court decided that appellants were not entitled to deduct a pro rata share of the losses incurred by Syn-Field Associates, Ltd. (SFA).¹ The Tax Court determined that the taxpayers were not liable for an addition to tax pursuant to § 6659. In 1989, the Tax Court issued a supplemental opinion concerning the calculation of the amount of the underpayment subject to the addition to tax under I.R.C. § 6661. We have jurisdiction to hear this appeal under 26 U.S.C. § 7482.

In 1981, the Smiths became limited partners in SFA. In 1981, James Karr became a limited partner in Peat Oil and Gas Associates, Ltd. (POGA). SFA and POGA (collectively the “partnerships”) were formed for the purpose of (1) engaging in the exploration and development of oil and gas prospects and the acquisition and ownership of gas and oil interests; (2) owning, licensing or otherwise exploiting technology relating to the production of synthetic fuel (K-Fuel) (K-Fuel is a high heating value solid fuel, physically resembling coal, produced by placing wood, peat, lignite and other low grade fossil fuel into a Koppel-man Reactor at temperatures and pressures) from peat and other materials; and (3) experimenting with, using, and licensing technology to try to demonstrate the commercial feasibility of producing synthetic fuel from peat and other cellulosic materials. The idea included the construction, operation, and management of a pilot plant that would attempt to convert peat and other cellulosic material into synthetic fuel for marketing purposes. We set out facts that are found essentially undisputed by the Tax Court. The partnerships entered into a joint venture agreement to own, operate, and manage a North Carolina pilot K-Fuel plant. This is known as the “Kop-pelman process.”

The Koppelman process, reviewed and extensively written about in various technical and industry journals, was developed by Edward Koppelman. In 1980, the United States Department of Energy awarded Koppelman a substantial grant to study the feasibility of his process. Pursuant to this grant, Koppelman, SRI International (SRI), the University of Maine, a large investment banker, and others, including Ekono, Inc. and Central Maine Power Company, a utility and a large engineering firm, prepared a report concluding that the Koppelman process was “technically, environmentally, and economically feasible.” 91 T.C. at 735. SRI is a research and development organization that provides research and consulting for business and government clients worldwide.

In the summer of 1981, Koppelman, together with SRI, completed a model plant capable of producing K-Fuel in small quantities. At the end of 1981, it was believed that the chances of completing successful construction of a K-Fuel plant were high.

In August 1981, Ronodo Corporation, N.V. (Ronodo) sublicensed from Koppelman the exclusive right to use the Koppelman process within the State of North Carolina to refine and convert peat and wood into K-Fuel. Koppelman also granted Ronodo certain additional rights, all of which were sublicensed by Ronodo to its wholly owned subsidiary Sci-Teck Licensing Corp. (Sci-Teck).

At the end of 1981, the partnerships involving Smith and Karr licensed from Sci-Teck the exclusive rights within the State of North Carolina to use the Koppelman process with respect to peat and wood, as well as the nonexclusive rights to use the Koppelman process in the remainder of the United States with respect to any material other than bagasse. The partnerships agreed to pay a license fee to Sci-Teck including payment by both cash and notes.

The partnerships also entered into research and development agreements with Fuel-Tech Research and Development (FTRD), which was to conduct and coordinate the research and development efforts of Koppelman, A.T. Kearney, and others, and to oversee the construction by Stone & Webster of a Koppelman process plant. The partnerships agreed to pay FTRD a fee for its services, again through cash and partnership notes. By 1984, a Koppelman process plant had been built in North Carolina.

Taxpayers purchased their one unit partnership interest for $161,500, pursuant to the following schedule of principal amounts:

$10,000 payable upon subscription to SFA

10,000 due Mar. 1, 1982

10,000 due Mar. 1, 1983

7,500 due Mar. 1, 1984

24,000 due Mar. 1, 1993

30,000 due Mar. 1, 1994

30,000 due Mar. 1, 1995

30,000 due Mar. 1, 1996

10,000 due Mar. 1, 2007

Taxpayers’ obligations to SFA were in the form of full recourse promissory notes, and they made timely payments of principal through 1983. Their 1984 principal payment was not made until 1985. With Martin Kaye’s² consent, taxpayers delayed until 1986 the interest payments due in 1982, 1983, and 1984. On December 30, 1981, the taxpayers entered into the described agreements with Sci-Teck and FTRD whereby they agreed to assume personal liability for SFA’s obligations in the total amounts of $99,200 and $24,800, respectively.

On their disputed income tax returns for 1981 and 1982, taxpayers deducted $40,392 and $38,316, respectively, representing their distributive share of partnership losses. The Commissioner disallowed these deductions on the ground that it had not been established that the losses were actually incurred in connection with an activity in which the partnership was engaged for profit or with respect to a trade or business. The Commissioner also determined that taxpayers’ investment in the partnership lacked economic substance other than the avoidance of tax.

The taxpayers then petitioned the Tax Court to redetermine the proposed tax deficiency. Their case was selected as one of two test cases involving the SFA and POGA partnerships. Following a week-long trial, the Commissioner conceded that the taxpayers could deduct their distributive shares of partnership losses attributable to oil and gas investments. The Tax Court opinion, which we review, addressed the partners’ distributive shares of losses represented by payments to Sci-Teck for license fees and to FTRD for research and development. The Tax Court held that the partnerships were not entitled to the claimed deductions. Citing Rose v. Commissioner, 88 T.C. 386, 414 (1987), aff'd, 868 F.2d 851 (6th Cir.1989), the Tax Court determined that tax motivations shaped the limited partnership transactions in question and that Koppelman Process activities lacked economic substance apart from the anticipated tax benefits.³ The Tax Court, moreover, determined that such activities were not “in connection” with the partnerships’ trade or business under I.R.C. § 174.

The Commissioner conceded that taxpayers may deduct their distributive shares of partnership losses attributable to oil and gas investments and may use their distributive shares of any credits attributable thereto. The only deductions in issue, then, are the distributive shares of losses represented by partnership payments to Sci-Teck for license fees and to FTRD for research and development. There is no dispute but that the claimed losses to be deducted must have been incurred in an activity in which taxpayers engaged for profit, and with respect to the research and development expenses, the losses must have been incurred in connection with a trade or business.

The Tax Court noted that ten percent of contributed funds to the various related partnerships was to go to working capital while seventy percent was to go to “promotions, attorneys, or network entities.” The offering memorandum, however, provided that interest on the limited partners’ short-term notes was to be added to working capital, estimated at $28,125 in 1982, $140,625 in 1983, and about $190,000 in 1984. Only 125 units (one-half of the total proposed) were sold. Working capital was to be maintained at $150,000. The opinion also noted that “up to 85 percent of the net cash flow generated by the oil and gas activities would be utilized to increase oil and gas holdings and to pay off the partnerships notes to FTRD (the entity created to oversee construction) and Sci-Teck.” Analyses prepared by SFA and POGA, the Tax Court conceded, indicated that “projected revenues from oil and gas drilling would have been sufficient to completely retire the partnerships notes to Sci-Teck and FTRD.” The same offering memorandum warned that financial success of K-Fuel development was “highly unlikely” for a number of particularized reasons, including “inadequate capital,” “conflict of interests,” and “commercially improved technology.”

An outside firm found the significant amount of license fees to be paid to Sci-Teck to be “well within the range of normal commercial practice.” This conclusion was based upon a report by a purported academic expert, which also indicated a profit to investors if one K-Fuel reactor tube was successfully constructed and became operable. A patent attorney gave an opinion that Koppelman's patents seemed valid and that the Koppelman process had better “technological underpinnings” than others he had investigated. This attorney, Lawrence Kurland, concluded that this potential process “involved a reasonable technical risk” and was a “sound investment.” One of the promoters or supervisors of the North Carolina plant, James Oronson, secured rights to use the Koppelman process “to produce char for ... charcoal briquettes.” A New York law firm, purportedly involved in legal work in “a number of similar transactions” rendered a tax opinion on the organizational structure of the partnership involved and described it as “a tax structure to accomplish the desired tax end.”

An expert witness in the oil and gas field, Jeffrey Lau, concluded that the assumptions used by the partnerships were reasonable and consistent with industry practice “with respect to projections and assumptions” of oil revenues and cash flows. Dr. Martin Pomerantz, an engineer expert, and an executive in a fuel conversion business, concluded “that in 1981 it would have been reasonable to predict a 1985 K-Fuel market of 520,000 tons.” Two other economist academic experts, were of the opinion that the partnerships might achieve a reasonable return on investment “and had reasonable prospects of profitability in 1981,” and that the price to be paid to Sci-Teck “was within the range of fair market value.”

I.R.C. Section 183 Considerations

The “general rule” as to actions covered by this section of the Internal Revenue Code dealing with “activities not engaged in for profit” is that “no deduction attributable to such activity shall be allowed” unless otherwise allowable under § 162⁴ or § 212(1) or (2).⁵ Under § 183, an activity is engaged in for profit if the taxpayer entertained an actual and honest, even though “unreasonable” or “unrealistic”, profit objective by engaging in the activity. Treas. Reg. § 1-183-2(a) cited in Campbell v. Commissioner, 868 F.2d 833, 836 (6th Cir.1989). Campbell instructs that nine relevant factors are to be examined in making this determination.⁶ In disallowing expenses or deductions relating to the Koppelman process or K-Fuel development under this section, the Tax Court relied heavily upon Rose v. Commissioner, 88 T.C. 386 (1987), aff'd, 868 F.2d 851 (6th Cir.1989) (decided by this court after the Tax Court decision in controversy). Rose involved a purchase by taxpayers of “reproduction masters” of Picasso originals while operating as Lecea Arts and claims by taxpayers of investment tax credits, depreciation, interest expense attributable to the disputed purchase. In Rose, the taxpayers made the purchase “[wjithout investigation of the highly sophisticated art market,” and without “any independent appraisals” of value, and the “reproductions ... had no proven market or marketability.” 868 F.2d at 852. (The court noted that the “fair market value” in the tax years at issue “was negligible.” Id.). There was no income realized from any claimed trade or business in the years in question. Admittedly, tax considerations played a “substantial role” in the purchases of what was treated as a “tax shelter” in Rose. Id.

Taxpayers in Rose plunged into an unknown area, “and neither sought nor received information on how to exploit commercially” the reproductions obtained for an inflated price of more than one million dollars. Id. Accordingly, the Tax Court in Rose held that “[t]he [taxpayers] did not have an actual and honest profit objective in acquiring the Picasso packages, and the transactions were devoid of economic substance.” Id. at 854. We upheld the Tax Court findings that the activity in question did not constitute a “trade or business” under I.R.C. § 162. We adopted the test in Rose of “whether the transaction had any practicable economic effect other than the creation of tax losses.” Id. Since the Tax Court findings in Rose were not clearly erroneous, and its “analysis” was “correct,” we affirmed the holding that the transaction was essentially a “sham” with “no honest profit motive.” Id. citing Mahoney v. Commissioner, 808 F.2d 1219, 1220 (6th Cir.1987).

In Rose, however, we did not adopt the “generic tax shelter test,” which was discussed at considerable length by the Tax Court in the instant case. Id. at 853. The concerns of the Tax Court were (1) emphasis upon tax benefits; (2) no price negotiation; (3) difficulty of valuation; (4) payment of twice the price paid by the seller licensor for limited Koppelman process rights; and (5) deferral of payment. In addition to Rose, the Tax Court emphasized the testimony of Michael Zukerman, tax counsel involved. The Tax Court conceded that the business partnership here, unlike the purported Rose business entity, did not lack economic substance, at least in part.

Zukerman testified that the complex financial structure was utilized to accomplish favorable tax ends. European investors committed over one million dollars for a Petrogene project and for “the Peat project” and another that did not go forward. These investors, who had a conflict of interest, to some extent, with the partnerships involved, were, according to Zuk-erman, “buying the [Koppelman] license.” In connection with their risk, (and, coincidentally, that of the taxpayers and the limited partnerships) “it was anticipated that the down side would be covered by reactively safe investments in oil and gas ... [and] almost eliminate the risks that would take place in the research and development area.”⁷ In sum, the Tax Court concluded from the Zukerman testimony “that the limited partners were to provide cash to finance the activities of the promoters for their various projects, including notably Petrogene.”

The Tax Court was struck by the fact that the amount of fees in this arrangement for services (for license and for research and development) were dependent upon the number of partnership units sold, “a very strange way to run a trade or business.” The experts produced by the Smiths justified this practice, and the increase in price paid for the Koppelman process license, because the carrying out of the K-Fuel project “was exceedingly risk-oriented.”

We are not as impressed as the Tax Court judge was with this purportedly unusual method of procedure, or contingent arrangement, because many times promoters, salespersons, or professionals, such as attorneys or brokers or engineers, may receive a greater or lesser fee based upon success of the venture or undertaking involved. We interpret Zukerman’s testimony, on the other hand, as indicating that European investors or promoters put up front end money or “pure risk capital” to acquire the license and to do initial research on feasibility “before a sale of a single unit took place,” and that a sale of the license or process to the partnerships would call for an amount “to make the project economically viable” for the initial promoters and developers of the Koppel-man process, who invested original substantial sums at risk in the hope it would produce a satisfactory return.

The Tax Court conceded in its opinion that, despite the complex and unusual nature of the over-all transaction, the structuring was not necessarily detrimental to the partnership, because it was not required to pay out any more than it took in, therefore characterizing the partnership in controversy as a “capital investment partnership rather than an active business to which the license fees and research and development fees were committed.” We do not agree that this is a correct characterization; we conclude, rather, that the partnerships were risk venture operations carrying on a trade or business within the meaning of the tax laws.

The Tax Court challenged the substance of the fee and license payments because the payments were contingent in size or amount and because the obligation to pay involved a long term obligation. The Tax Court cited Ferrell v. Commissioner, 90 T.C. 1154 (1988) in support of its holding that such an extended payment did “not make sense from a business standpoint.” Ferrell, however, involved very large mul-ti-million notes, not installment notes, due in approximately twenty years to an entity which had “no capital or other funds with which to finance the acquisition of leases” needed purportedly to put the oil and gas venture into operation. The notes involved in Ferrell were many times more in amount than the actual cash value of leases to be acquired, and a substantial proportion were executed in Ferrell, when much of the program of leases for which it represented payment had already been abandoned. Also, the notes were interpreted to provide for non-recourse simple interest payable in some twenty years, and there was a “prearranged” release of individual taxpayer investors from their personal assumption of liability. 90 T.C. at 1188. Ferrell did indeed involve “bizarre behavior” in a “tax shelter facade ... [with] never any intention to enforce [the notes] and assumption agreements.” Id. at 1189.

We are mindful of the considerable differences between the Ferrell and Smith arrangements. Two promoters in Ferrell, “neither one of whom had any oil and gas business experience,” siphoned off 65% of the anticipated gross receipts of the entity involved in the face amount of $118,000,000 in long term non-recourse notes. 90 T.C. at 1188. The notes “almost certainly would not be paid” in Ferrell, whereas here the recourse installment notes were, in fact, paid by investors over a course of years. Id. at 1186. In Ferrell, the leases assigned to the taxpayer partnership were not only paid for, but, in addition, the Ferrell investors agreed to pay “multi-million-dollar notes” “having no relationship to economic reality.” Id. at 1186, 1187 (emphasis added). Like the situation in Ferrell, the amount of the notes at issue were keyed to the amount of cash to be invested by the limited partners rather than the value of the leases, but approximately $80,-000,000 of notes were executed in Ferrell after 62% of the proposed oil and gas program had been abandoned, and interest on the notes was deferred for some 20 years. The entity to be paid the huge amount of money in Ferrell clearly had no experience or means to give practical assistance in oil operations. We are persuaded that while there were some similarities between Ferrell and the instant controversy concerning tax shelter arrangements, the substantial differences in the cases render Ferrell distinguishable.

We deem the situation here to be more akin to that in Pritchett v. Commissioner, 827 F.2d 644 (9th Cir.1987) where the limited partner’s proportionate share of liability on recourse notes on an oil and gas venture were held to be deductible for tax purposes. See Melvin v. Commissioner, 88 T.C. 63, 75 (1987) (limited partners who remain in “chain of liability” and have ultimate economic responsibility for the loan, payable in future years, may deduct payments), aff'd, 894 F.2d 1072 (9th Cir.1990). It should be noted also that oil and gas revenues from the partnerships in this case were expected to retire the partnership notes to Sci-Teck and FTRD so that not all of the taxpayers’ payments were expected to be needed at the outset. We thus view the arrangement as not devoid of any business rationale or economic reality. We conclude, therefore, that the payments at issue were part of a transaction engaged in for ultimate hope of profit, and were incurred in carrying on a partnership trade or business within the meaning of I.R.C. §§ 183 and 162. We also conclude that principal and interest payments by the Smiths were intended as expenditures for production of income within the meaning of I.R.C. § 212.⁸ The transaction and investment, including execution of recourse notes, had “practicable income effects other than the creation of income tax losses.” Rose v. Commissioner, 868 F.2d 851, 853 (6th Cir.1989).

The standard of review to be applied in review of findings of fact of the Tax Court is whether such findings are clearly erroneous. Ratliff v. Commissioner, 865 F.2d 97, 98 (6th Cir.1989); Ohio Teamsters Educational and Safety Training Trust Fund v. Commissioner, 692 F.2d 432, 435 (6th Cir.1982). On the other hand, the legal standard applied by the Tax Court and its legal conclusions based upon its findings of fact are reviewed de novo. Ratliff, 865 F.2d at 98.

In its factual aspect, the Tax Court’s conclusion that the transactions in question lacked economic substance leaves us “with the definite and firm conviction that a mistake has been committed.” Anderson v. Bessemer City, 470 U.S. 564, 573 (1985) (quoting United States v. United States Gypsum Co., 333 U.S. 364, 395, 68 S.Ct. 525, 542, 92 L.Ed. 746 (1948)). We recognize that this result is at odds with the Eleventh Circuit’s decision in Karr (see note 1, supra), but under the law of this circuit the proper test is “whether the transaction has any practicable effects other than the creation of income tax losses.” Rose, 868 F.2d at 853 (emphasis supplied). It is crucial, moreover, that this inquiry be conducted from the vantage point of the taxpayer at the time the transactions occurred, rather than with the benefit of hindsight. Hayden, 889 F.2d at 1554-56 (Nelson, J., dissenting); Treas Reg. § 1.183-2(a).

The evidence presented at trial included the following: a report concluding that the Koppelman process was “technically, environmentally, and economically feasible;” a showing that the taxpayers’ obligations to SFA took the form of full recourse notes; financial analyses indicating that projected revenues would be sufficient to retire the partnership’s notes to FTRD and Sci-Teck; and uncontradicted expert testimony stating that the Koppelman process did have a reasonable chance of generating profits. These investments were risky, to be sure, and the taxpayers were predictably concerned about saving taxes — but the question is whether, apart from the anticipated tax advantages, the taxpayers’ investment was a sham. On the basis of the evidence presented, it seems obvious to us that the investment was not a sham.

We are supported in our conclusion by our recent decision in Bryant v. Commissioner, 928 F.2d 745, (6th Cir., 1991), in which we reversed the Tax Court under circumstances similar in many respects to those present here. Bryant also involved a speculative venture which produced a claim of large tax losses by the investors, the Commissioner disallowing on the basis of a § 183 determination that it was a sham transaction. First we considered in Bryant the question as to whether a fully enforceable recourse note not contingent on the profitability of the venture was a legitimate basis for deduction under § 616(a) of the Code. (It was.) We next concluded in Bryant that “we review de novo the legal standard applied in determining whether or not a transaction is a sham.” Id. at 748, citing Rose v. Commissioner, supra.

The standard to apply was then set out

[I]n determining whether a transaction was a sham, the court should not address whether, in the light of hindsight, the taxpayer made a wise investment, as did the trial court here. Instead, the court must address whether the taxpayer made a bona fide investment at all or whether he merely purchased tax deductions.

Id. at 749.

We reversed the Tax Court on the sham inquiry citing legislative history to § 183:

[1]n determining whether losses from an activity are to be allowed, the focus is to be on whether the activity is engaged in for profit rather than whether it is carried on with a reasonable expectation of profit. This will prevent the rule from being applicable to situations where many would consider that it is not reasonable to expect an activity to result in a profit even though the evidence available indicates that the activity is actually engaged in for profit. For example, it might be argued that there was not a “reasonable” expectation of profit in the case of a bona fide inventor or a person who invests in a wildcat oil well.

Id., quoting S.Rep. No. 552, 91st Cong., 1st Sess., reprinted in 1969 U.S.Code Cong. & Admin.News 1645, 2027, 2133-34.

The conclusion in Bryant was similar to the one we reach in this case — “a reasonable expectation of profit [subjectively] is not to be required;” rather we look to whether “the taxpayer entered the activity, or continued the activity, with the objective of making a profit ... even though the expectation of profit might be considered unreasonable.” Id. at 750 (emphasis added) quoting S.Rep. No. 552, supra. Here, as in Bryant, we conclude that the Tax Court was in error in questioning the transaction on the basis of whether it “was likely to be profitable.” Id.

I.R.C. Section 174.

For expenses to be deductible under this section providing deductions for research and experimental expenditures, they must be incurred also “in connection with” the partnership trade or business, a less stringent requirement than “carrying on” a trade or business. Because expenses under section 174 are intended to stimulate new products and processes, such as energy development, taxpayers argue that they fulfill this requirement of this section.

The provisions of section 174(a)(1) “apply not only to costs paid or incurred by the taxpayer for research or experimentation undertaken directly by him but also to expenditures paid or incurred for research or experimentation carried on in his behalf by another person or organization (such as a research institute, foundation, engineering company, or similar contractor).” Sec. 1.174-2(a)(2), Income Tax Regs.

Green v. Commissioner, 83 T.C. 667, 684 (1984).

In Snow v. Commissioner, 416 U.S. 500, 94 S.Ct. 1876, 40 L.Ed.2d 336 (1974), the Supreme Court, construing § 174, held that a partnership formed to develop an unpat-ented trash-burning device, even though no sales of product were made in the years in question, could deduct expenses for developing the new product under § 174. “The taxpayer must still be engaged in a trade or business at some time,” however, to qualify for § 174 treatment. Green, 83 T.C. at 686. We conclude that the claimed deductions (and those of the partnership) do qualify under § 174 since they “are sufficiently substantial and regular to constitute a trade or business.” Id. at 687. See also Levin v. Commissioner, 87 T.C. 698 (1986), aff'd, 832 F.2d 403 (7th Cir.1987). We cannot say that the Koppelman process activity lacked economic substance or that it was not an effort in research and experimentation within the intention of § 174.

Snow made it clear that “[sjection 174 was enacted in 1954 to dilute some of the conception of ‘ordinary and necessary’ business expenses under § 162(a).” Id., 416 U.S. at 502, 94 S.Ct. at 1878. Snow interpreted “in connection with” as used in §174 to be broader than the term “in carrying on any trade or business” as used in § 162. Id. at 503, 94 S.Ct. at 1878.⁹ We deem the kind of enterprise to develop the Koppelman process and K-Fuel reactors as a type of “small” and “upcoming” partnership enterprise encouraged in Snow. Id. at 504. Since we find evidence of a profit motive in the development of the Koppelman process at issue, we conclude that Snow is applicable here.¹⁰ The Tax Court found that the partnership in question, SFA, was making an “attempt to develop the Koppelman process.” 91 T.C. at 736. SFA had an “exclusive right” in its limited development in North Carolina. It also purported to engage in “oil and gas drilling” and “to exploit new technology ... to convert peat [and] wood ... into a new ... clean and efficient synthetic fuel.” Id. at 741. Kaye was engaged as consultant, a CPA, with varied business experience and a director in another oil and gas investor entity, and the K-Fuel development was described as “commercially unproven technology [with potential] environmental and health problems [and] inadequate capital.” Id. at 743. Zukerman, who was paid as counsel in arranging the transaction by outside promoters not connected with SFA, formulated the agreements and tax structure designed to maximize tax deductions to SFA and investors such as Smith.

We conclude, despite the deferred nature of license and partnership payments, despite the high percentage of receipts going to promoters, attorneys, and developers, and despite the contingent and problematical nature of the operation, and the high risks involved, that the partnership activities, through a number of agents and outside managers and consultants, were sufficiently “substantial and regular” to constitute a trade or business for purposes of § 174. See Green, 83 T.C. at 687. The activities involved a risk-filled hope and design to develop a new energy source or process. Experts testified that oil and gas assumptions and projections of SFA were reasonable. Other experts pronounced it reasonable to expect substantial production and sale of K-Fuel in North Carolina and that SFA “had reasonable prospects of profitability.” Smith, 91 T.C. at 752.

The issues in this case are close as evidenced by the position of the dissent and the differing views of another circuit on similar facts. We readily recognize that such issues may invite different viewpoints on deductibility of the losses here involved especially as to the project’s commercial feasibility. We must simply disagree with the characterization of the dissent that taxpayer’s experts’ testimony about “commercial viability” were of “negligible value” in distinction to what was “centered” on “technical viability of the Koppelman process.” ¹¹ We must also respectfully disagree that the “taxpayers’ outlay for this venture was minimal.”

We conclude, in any event, that the taxpayers’ claimed interest paid on the notes to FTRD and Sci-Teck are deductible. Rice’s Toyota World v. Commissioner of Internal Revenue, 752 F.2d 89 (4th Cir.1985), held that even in the case of a sham transaction entered into primarily for tax benefit purposes, a taxpayers’ payment of interest on a recourse note made in connection with a no profit motive arrangement was deductible. The recourse note in the instant case, as in Rice’s Toyota World, was a “genuine” obligation, and involved “something of economic value.” Such recourse notes interest is deductible even in the face of the sham nature of the underlying agreement.

To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of a profit exists.

Id. at 91.

We find it error to have concluded on the facts and record that the Smiths were motivated by “no business purposes” and that the transaction in controversy had “no economic substance” nor any “reasonable possibility of a profit.”

The Commissioner and the Tax Court were correct in examining the complex arrangement in this case carefully and with skepticism given the totality of circumstances. We believe, however, that the claimed deductions, including interest, considered under each of the code sections analyzed, do authorize a deduction as claimed subject to further examination and limitation under I.R.C. § 465. We, accordingly, REVERSE the Tax Court’s disallowance under the above sections and its decision that SPA was a “generic tax shelter” rather than a “statutory tax shelter.” Id. at 754.

Section 6661 Considerations

Section 6661(b)(1) defines a substantial understatement of income tax as an understatement exceeding the greater of 10 percent of the tax required to be shown on the return for the year or $5,000.00.

As of its effective date, section 661(b)(2)(C) creates one category of “statutory tax shelters” referred to in Rose v. Commissioner, 88 T.C. at 407 n. 2

Smith, 91 T.C. 733, 766, 767.

The Tax Court found that, based primarily on the Zukerman testimony, “the principal purpose of the Koppelman Process arrangements between the limited partnerships and the other entities in the network was the avoidance of Federal income tax.” Id. at 767-68. Taxpayers claim that they acted in good faith, although taking substantial tax deductions was, no doubt, a part of the anticipated arrangement. Based on our conclusion that the deductions were improperly disallowed, we need not pause further to discuss the § 6661 penalty. Our conclusion on the basic de-ductibility of the partnership claims settles it that no § 6661 penalty may attach. Our decision requires the same result as to the added § 6621(e) assessment.

We REVERSE the decision of the Tax Court, accordingly, and REMAND for consideration of the alternative I.R.C. § 465 contention of the Commissioner in this case.

1 . The Tax Court consolidated this case with a related case in which an appeal was taken to the United States Court of Appeals for the Eleventh Circuit; that court recently affirmed the Tax Court’s decision. Karr v. Commissioner, 924 F.2d 1018 (11th Cir.1991). The Tax Court's opinion refers to both the Smiths and the Karrs, the latter being Georgia residents.

2 . Martin Kaye, the general partner of SFA, is an independent tax and financial consultant.

3 . Because the Tax Court found that the partnerships’ Koppelman process activities lacked economic substance, it did not reach the other grounds for disallowance of a portion of the deduction as asserted by the Commissioner based on I.R.C. § 465. 91 T.C. at 750, 753.

4 . Section 162 deals with "trade or business expenses", which are limited to “ordinary and necessary expenses paid or incurred ... in carrying on any trade of business."

5 . Section 212 deals with "expenses for production of income” or "management, conservation or maintenance of property held for the production of income."

6 . The factors are:

(1) the manner in which the taxpayer carried on the activity;

(2) the expertise of the taxpayer or his advis-ors;

(3) the time and effort expended by the taxpayer in carrying on the activity;

(4) the expectation that assets used in the activity may appreciate in value;

(5) the success of the taxpayer in carrying on similar or dissimilar activities;

(6) the taxpayer’s history of income or loss with respect to the activity;

(7) the amount of occasional profit, if any, which is earned;

(8) the financial status of the taxpayer; and

(9) whether the elements of personal pleasure or recreation are involved.

Treas.Reg. § 1 — 183—2(b).

7 . Zukerman added that “you had a high risk with a high reward.... [T]he K-Fuel project, although not as revolutionary [as the Petrogene project] had some very, very exciting potential."

8 . "Section 162(a) allows deductions for professional and consulting fees, and travel and other miscellaneous expenses only if they are ordinary and necessary expenses incurred in carrying on a trade or business." Hayden v. Commissioner, 889 F.2d 1548, 1552 (6th Cir.1989). "Section 212 allows a deduction for such expenses only if they are paid or incurred for the production of income." Id.

9 . "[S]ince the decision in Snow, a taxpayer need not be engaged in a trade or business at the time of expenditure in order to qualify for a deduction under section 174(a)(1), because that provision was intended to encourage high technology start-up ventures ... 'the taxpayer must still be engaged in a trade or business at some time Green v. Commissioner, 83 T.C. 667, 686 (1984) (emphasis in original).” Diamond v. Commissioner of Int. Rev., 930 F.2d 372 (4th Cir.1991).

10 . Our court affirmed the Tax Court in Snow in disallowing the claimed deductions as not "in connection with a trade or business.” The Supreme Court reversed for the reasons indicated.

11 . The dissent seems to concede that such testimony did address "the surface question of the economic potential of the partnerships’ activities.” (Emphasis added).