86 T.C. 848">*849 Respondent determined a deficiency of $ 4,833 in petitioners' 1980 Federal income 1986 U.S. Tax Ct. LEXIS 115">*118 tax and an addition to tax of $ 1,208 under section 6651(a). ¹ At issue in this case are various deductions and an investment tax credit claimed by petitioners in regard to their acquisition of four electrocardiogram (ECG) analysis computer terminals pursuant to franchise agreements with Comp-U-Med, the equipment's manufacturer. The issues for decision are:

(1) Whether petitioners' computerized ECG terminal franchise venture was an activity engaged in for profit;

(2) Whether, and if so to what extent, certain payments petitioners made to Comp-U-Med in 1980, denominated as royalties, are deductible expenses;

(3) Whether for purposes of depreciation and the investment tax credit, petitioners' computerized ECG terminals were placed in service during 1980;

(4) Whether, and if so to what extent, petitioners' purchase money note, allocated to the computerized ECG terminals, was a "true debt" for Federal tax purposes;

(5) Whether, and if so to what extent, petitioners were "at risk" with respect to their computerized ECG terminal venture, within the meaning of section 465; and

86 T.C. 848">*850 (6) Whether petitioners' failure timely to file their 1980 Federal income tax return was due to reasonable cause and 1986 U.S. Tax Ct. LEXIS 115">*119 not due to willful neglect within the meaning of section 6651(a)(1).

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulations of fact and exhibits attached thereto are incorporated herein by this reference.

Petitioners, husband and wife, resided in Portland, Oregon, at the time they filed their petition in this case. Petitioners filed a joint Federal income tax return (Form 1040) for 1980. Their return preparer, an accountant, signed the return on April 13, 1981; Warner R. Waddell signed the return on May 5, 1981; ² and the return was filed in respondent's Ogden, Utah, Service Center on May 7, 1981.

Electrocardiography is a diagnostic process for studying the functioning of the heart. A device known as an electrocardiograph is used to measure the electrical activity of the heart, and this measurement is reported on a tracing or strip chart, called an electrocardiogram (ECG). First 1986 U.S. Tax Ct. LEXIS 115">*120 developed in the late 19th century, electrocardiography had by 1940 become an accepted diagnostic technique within the medical profession.

During the 1960's, several medical institutions (including the U.S. Public Health Service, the Veterans' Administration, and the Mayo Clinic) developed systems for using computers to receive and analyze electrocardiograms. After the Public Health Service had made public its program for "computerized" electrocardiography in 1969, many private companies began developing and marketing computerized ECG systems. The early 1970's saw a gradual increase in the accuracy of the computer analyses, due to improvements in the software (programming). By the middle to late 1970's, computerized electrocardiography was well accepted in the medical community, and there were several established companies offering computerized ECG systems to various segments of the health care industry. The basic technology for the ECG equipment that performs the electrocardiogram 86 T.C. 848">*851 has remained essentially unchanged for the past 50 years. As noted above, the development has been in computerized analysis or interpretation of the electrocardiogram. Although there have been continuing 1986 U.S. Tax Ct. LEXIS 115">*121 improvements in the computer software to perform this analysis, no fundamental, radical changes in the hardware for computer ECG analysis was anticipated in the period of the early 1980's. Changes in the ECG machines and computer terminals usually related to improvements to make them easier for the doctor or technician to use.

Comp-U-Med, Inc., is a company specializing in technology for medical diagnostic systems. Comp-U-Med, Inc., designs, develops, and manufactures computer-based electronic systems for use by physicians, clinics, hospitals, health-maintenance organizations (HMO's), and industrial and corporate health care facilities. Comp-U-Med Systems, a wholly owned subsidiary of Comp-U-Med, Inc., was formed to facilitate sales of Comp-U-Med's product by offering franchises to individual investors. For simplicity, we shall treat Comp-U-Med, Inc., and Comp-U-Med Systems as a single company (Comp-U-Med). ³

Comp-U-Med's principal product is its System 107 1986 U.S. Tax Ct. LEXIS 115">*122 Computer ECG Terminal, a device used to administer an electrocardiogram, transmit the data to a mainframe computer for analysis, and then receive back the computer's analysis or interpretation. This model, essentially an updated, mass-produced version of its earlier prototype Model 103, was first sold in 1978. ⁴ From 1978 through 1982, Comp-U-Med marketed its System 107 exclusively through its franchise program, as described below. Comp-U-Med has sold no franchises since the early spring of 1982.

During the middle to late 1970's, when Comp-U-Med was formulating its marketing plans for its System 107 terminals, venture capital was scarce. Comp-U-Med was unable to obtain ordinary equity financing. The computer industry had traditionally used third-party lessors as a technique for 86 T.C. 848">*852 financing computers. However, because it was new to the computerized ECG industry and had no track record, Comp-U-Med believed it could not use conventional third-party financing (i.e., sale and leaseback). Comp-U-Med wanted quickly to capture as large a market share as possible, which meant making the ECG 1986 U.S. Tax Ct. LEXIS 115">*123 terminals available with a minimal financial commitment by the various users. As an innovative financing method and to facilitate its ambitious marketing goals, Comp-U-Med devised its franchise system: Comp-U-Med would sell its terminals to individual investors (largely on credit), giving a right of access to its central processing (mainframe) computers on a fee-for-use basis. The individual investors would be primarily responsible for placement of their terminals with actual users (physicians, clinics, hospitals, etc.), which was to be done through independent medical equipment distributors. The franchise contemplated that the users would pay a modest up-front charge and then pay for ECG's administered and analyzed through the Comp-U-Med terminals and computers on a fee-for-use basis. Comp-U-Med would directly bill and receive the payments from the users. Comp-U-Med would then distribute the proceeds as follows: to itself for shipping, processing and billing fees, to the distributors for their commissions, and to the investors for their net income. After all expenses were paid by Comp-U-Med, 50 percent of any net income to an investor was retained by Comp-U-Med and credited against 1986 U.S. Tax Ct. LEXIS 115">*124 the investor's purchase obligation.

In the latter half of 1980, petitioners contacted Michael O. Murphy, a tax attorney, regarding a notice of deficiency they had received for their taxable year 1977. Petitioners also sought estate planning and investment advice from Mr. Murphy. Petitioners had been operating a business called Western Business Builders, Inc., for more than 30 years. Petitioners' 1979 income was about $ 80,000. Petitioners had a net worth of about $ 750,000 (exclusive of home, automobiles, and furnishings), including extensive holdings of rental real estate. Petitioners wanted to diversify their holdings; they were also interested in the tax shelter aspects of various potential investments.

Mr. Murphy first became aware of Comp-U-Med in September of 1980, when he received a telephone solicitation 86 T.C. 848">*853 from Control Financial Group (CFG), an investment firm. He subsequently received and reviewed a copy of Comp-U-Med's franchise offering circular. Mr. Murphy had an associate investigate the literature and representations Comp-U-Med provided with its offering circular. Specifically, the associate contacted various doctors and hospitals to confirm the potential market for 1986 U.S. Tax Ct. LEXIS 115">*125 Comp-U-Med's computerized ECG terminals on the fee-for-use basis contemplated in its offering and to attempt to corroborate Comp-U-Med's usage projections. The associate found many physicians who were interested in ECG terminals under the terms of Comp-U-Med's marketing arrangements, including several doctors who specifically had heard of Comp-U-Med. Mr. Murphy and his associate thought that an outpatient clinic would make maximum use of the terminals; they also recognized that use levels by private physicians were dependent upon the nature of their practices. Neither Mr. Murphy nor his associate was aware of Comp-U-Med's actual marketing strategy -- focusing on low volume users -- until after petitioners had acquired their franchises and terminals.

Mr. Murphy and petitioners considered various other investments but settled on Comp-U-Med franchises. Mr. Murphy recommended and petitioners chose Comp-U-Med because they all felt that it represented a realistic profit potential independent of the expected tax benefits. Petitioners also thought that equipment leasing would diversify their investments; moreover, they were attracted to the Comp-U-Med terminals because of their aura of "high 1986 U.S. Tax Ct. LEXIS 115">*126 technology."

In late December of 1980, petitioners purchased four Comp-U-Med franchises. On December 22, 1980, in accordance with the instructions in Comp-U-Med's Franchise Offering Circular, petitioners executed an application for franchise, a personal financial statement, a franchise agreement for four franchises, a purchase order for four terminals, and a promissory note. On the same day, petitioners executed an equipment distribution agreement and a form "Equipment Delivery Instructions" for each of the four terminals. Pursuant to the offering circular, petitioners paid Comp-U-Med a total of $ 24,000, $ 6,000 per franchise, by a 86 T.C. 848">*854 check drawn on December 23, 1980. The stated allocation of the $ 6,000 advance payment per franchise was a "franchise fee" of $ 500, a downpayment on the terminal of $ 2,500, and a "first year royalty fee" of $ 3,000. Comp-U-Med approved petitioners' franchise application on December 30, 1980. ^{51986 U.S. Tax Ct. LEXIS 115">*127}

Each of petitioners' Comp-U-Med franchises included the purchase of a System 107 Computer ECG Terminal for a stated purchase price of $ 27,500, with $ 2,500 paid upon execution of the franchise agreement and the balance of the purchase price ($ 25,000) payable in accordance with the terms and conditions of the franchise agreement and promissory note. Petitioners' promissory note was in the aggregate amount of $ 100,000 (four terminals). The note, denominated as "Recourse," was for an initial term of 7 years and called for interest at 6 percent per annum on the unpaid principal balance. At the end of the initial term, the note called for payment of any accrued, unpaid interest and all unpaid principal, but if payments were then current, petitioners could extend the note for an additional 7-year term (the extension term). Moreover, the note provided that at any time during the extension term, petitioners could convert the note from "full-recourse" to nonrecourse by paying $ 1,000 (per franchise/terminal) to be applied against principal.

The note called for a minimum payment of $ 1,500 per year (per franchise/terminal), due 1986 U.S. Tax Ct. LEXIS 115">*128 within 30 days of the note's anniversary date, to be applied against accrued, unpaid interest. Any other payment under the note was to come only from net exploitation receipts. Petitioners were obligated to pay Comp-U-Med out of the net receipts (gross receipts less expenses) from their exploitation of the terminal (a) any accrued, unpaid interest and (b) 50 percent of their additional net receipts, if any, which was to be credited against principal. ⁶ If during the extension term petitioners converted the note to nonrecourse, there were no minimum payments due. Instead, petitioners were required 86 T.C. 848">*855 to pay all their net receipts against accrued interest and 75 percent of any additional net receipts against principal. It is not clear that the $ 1,500 minimum payments would be due during the extension term even if petitioners did not elect to convert the note to nonrecourse. The minimum payment requirement in the note seems to be limited to just the initial term of 7 years.

Comp-U-Med could accelerate payment of all principal and unpaid accrued 1986 U.S. Tax Ct. LEXIS 115">*129 interest if petitioners failed to make the required payments (from net exploitation proceeds) on the note. Moreover, if petitioners defaulted on any of their obligations under the franchise agreement, Comp-U-Med could also accelerate payment of principal and unpaid, accrued interest. If petitioners defaulted while the note was recourse, Comp-U-Med could proceed against the security or petitioners' personal assets to collect any amount due. If petitioners defaulted while the note was nonrecourse, Comp-U-Med could only proceed against the security to collect any amount due. The offering circular represented that after the initial 7-year term, the terminal would be worth approximately 10 percent of its initial "purchase price," or $ 2,750.

Petitioners' franchise agreement with Comp-U-Med provided for an initial term of 7 years, with an option to renew for an additional 7 years upon proper notice and payment of a $ 200 renewal fee (per franchise), but only if petitioners were not in default under the franchise agreement. Under the agreement, petitioners were to purchase one System 107 Computer ECG Terminal for each franchise. ⁷ The franchise agreement gave petitioners a nonexclusive 1986 U.S. Tax Ct. LEXIS 115">*130 right to use Comp-U-Med's name, logo, methods, systems, and techniques in operating their franchises, i.e., maintaining and operating the terminals to generate lease revenues from physicians, clinics, or other health care organizations. Comp-U-Med provided petitioners with suggested lease forms, rates, and commissions. Comp-U-Med also furnished petitioners the accounting standards, manuals, and procedures 86 T.C. 848">*856 they were required to maintain and follow in keeping records for their ECG terminal and franchise.

Under the franchise agreement, Comp-U-Med agreed to provide unlimited use of its mainframe computer facilities via telephone for petitioners or users of their equipment at a royalty charge of 50 cents for each ECG processed by Comp-U-Med's computers. However, this fee was waived for the first year in favor of a flat "royalty" of $ 3,000 per franchise prepaid at the time the agreement was executed. During the renewal term, if the promissory note had 1986 U.S. Tax Ct. LEXIS 115">*131 been paid, Comp-U-Med was to charge petitioners its then-current ECG computer processing rates. Comp-U-Med also agreed to provide up-to-date computer programs for interpreting electrocardiograms on its computers for use by petitioners or their customers. At some time subsequent, Comp-U-Med obtained a WATS long-distance telephone line, for which it charged a fee of $ 1 for each ECG interpretation performed.

Comp-U-Med also agreed to provide billing services, sending out monthly statements to users, receiving payments, and distributing cash received. For this service, Comp-U-Med charged $ 5 per franchise per month plus 5 cents per ECG. Comp-U-Med's computers provided the information concerning the number of uses per month, and the billing rates used were those recommended by Comp-U-Med unless petitioners directed otherwise. Unless petitioners requested in writing another disbursement schedule, receipts were to be credited in the following order of priority: (1) Shipping and delivery charges; ⁸ (2) Comp-U-Med's ongoing franchise fees, consisting of royalty fees and billing service fees; (3) commissions (if any) for the distributor; (4) interest on the purchase money note (retained 1986 U.S. Tax Ct. LEXIS 115">*132 by Comp-U-Med); (5) principal on purchase money note of one-half of the balance of the net monthly receipts (also retained by Comp-U-Med); and (6) the other half of the balance of the net monthly receipts to petitioners.

Under the agreement, Comp-U-Med undertook various other obligations. Comp-U-Med agreed to train any person (whom it approved) designated by petitioners in operating 86 T.C. 848">*857 and handling the terminal and in supervising the use of the machine and system to administer and interpret an ECG. Comp-U-Med also agreed to allow petitioners or their designees to review and update their training and to avail themselves of new procedures and practices developed by Comp-U-Med. Comp-U-Med warranted that the computer ECG terminal would be free from all defects in workmanship and materials for a period of 5 years after the original purchase and that no charge would be made for parts and labor during the warranty period. Petitioners were required to return defective equipment to Comp-U-Med at their own expense. Comp-U-Med agreed to return the serviced 1986 U.S. Tax Ct. LEXIS 115">*133 equipment to petitioners or their customers at its own expense. Comp-U-Med agreed to provide $ 1 million product liability coverage naming petitioners and providing them with a Certificate of Insurance, to insure petitioners against product liability from use of the terminal purchased from Comp-U-Med. Finally, Comp-U-Med agreed to replace the terminal at a cost of 15 percent of the original "purchase price" of $ 27,500 (e.g., $ 4,200) in the event the terminal was stolen, lost, destroyed, or damaged.

Petitioners also undertook other obligations under the franchise agreement in addition to their purchase obligation under the promissory note. Petitioners agreed to operate their franchises according to Comp-U-Med's plans, systems, and methods, which Comp-U-Med might periodically establish, revise, and improve. Petitioners agreed to indemnify Comp-U-Med against any claim or liability arising from the operation of their franchises, including any of petitioners' third-party agreements, and from their use or disclosure of Comp-U-Med's intangibles (company name, trademark, information, etc.). Petitioners acknowledged Comp-U-Med's exclusive right, title, and interest in and to its intangible 1986 U.S. Tax Ct. LEXIS 115">*134 assets and promised not to impair any part of these rights. Petitioners promised to pay all taxes and all other governmental fees arising from their franchises and to otherwise comply with all applicable laws and regulations. Petitioners agreed to obtain a policy of liability insurance covering their franchises and to provide their own workmen's compensation insurance or similar coverage to protect themselves and their employees. Finally, petitioners agreed to 86 T.C. 848">*858 maintain accurate books and records of their franchise revenues, which Comp-U-Med had a right (at its own expense) to have audited.

The franchise agreement listed various acts that would constitute a default by petitioners, including: (1) A continuing failure to make any required payment or to perform any required act 15 days after notice from Comp-U-Med of such failure; (2) the attachment of any involuntary lien, not promptly removed, of $ 500 or more upon any of petitioners' business assets or property; (3) various acts of insolvency by petitioners, commencement by petitioners of an insolvency proceeding (including bankruptcy or receivership), or their failure to obtain dismissal of an involuntary proceeding within 60 days 1986 U.S. Tax Ct. LEXIS 115">*135 after its filing; (4) conduct of their franchise that adversely affects the goodwill and reputation of Comp-U-Med or its product; (5) any transfer of any portion of the franchise rights without Comp-U-Med's prior written consent; and (6) failure to comply with all the terms of the franchise agreement and all other agreements, whether oral or written, between them and Comp-U-Med. Although the franchise agreement provided no express remedy upon default (as defined therein), the promissory note allowed Comp-U-Med at its option to accelerate all principal and interest in the event of petitioners' default under the franchise agreement.

To secure performance of their obligations under the promissory note, petitioners granted Comp-U-Med a security interest in the terminals and in any leases petitioners obtained. The security interest attached on the later of the execution of the agreement or petitioners' acquisition of rights to the collateral (terminals and leases). Petitioners agreed to execute a Form UCC-1 Financing Statement for filing with the California secretary of state to evidence the security interest granted to Comp-U-Med and to execute and deliver to Comp-U-Med any other documents 1986 U.S. Tax Ct. LEXIS 115">*136 it deemed necessary to protect its security interest. Petitioners executed the Form UCC-1 Financing Statement on January 26, 1981. Prior execution of the financing statement was not a condition precedent to petitioners' right to direct delivery by Comp-U-Med of their terminals. ⁹

86 T.C. 848">*859 On December 22, 1980, petitioners 1986 U.S. Tax Ct. LEXIS 115">*137 executed equipment distribution agreements for each of their terminals, with the following medical equipment distributors: ¹⁰ Dr. Medical (David Rousett) (Terminal No. 72146); Cobb Bennett (Terminal No. 72147); Cardiac Systems (Pamela Fyffe) (Terminal No. 72148); and A/C Medical (Bill Carroll) (Terminal No. 72149). Petitioners agreed to consign a terminal to each distributor, each of whom promised to use his or her best efforts to place the terminal with a user. Petitioners agreed to have the terminal drop shipped to the distributor, and the distributor agreed to accept consignment of the equipment and to examine it upon receipt to ensure that it was free from defects and suitable for immediate use. Petitioners agreed to pay each distributor a commission for placing the terminal with a user in the amount of the first and last months' minimum use fee plus 10 percent of gross revenues from the user during the term of the equipment distribution agreement. Also on December 22, 1980, petitioners executed forms entitled "Equipment Delivery Instructions" for each of their terminals, informing Comp-U-Med of the identity of the distributors, listed above, and directing Comp-U-Med to retain 1986 U.S. Tax Ct. LEXIS 115">*138 the terminals until it received a request for shipment.

On December 22, 1980, petitioners entered into a management agreement with Medical Management Group (MMG) to obtain management services in connection with the operation of their Comp-U-Med franchises. These management services included: (1) Securing and publishing a fictitious business name statement; (2) securing various necessary bank accounts; (3) securing stationery and business cards relating to franchise operations; (4) securing any applicable resale permits from the Board of Equalization or other applicable Government agencies; (5) establishing a book keeping system relating to operations of the franchise; (6) 86 T.C. 848">*860 assisting in the supervision of equipment placement; and (7) corresponding with Comp-U-Med. Petitioners chose to contract with MMG rather than directly manage their franchises because they had no experience in leasing medical equipment and because they were busy managing their business and their investment real estate. MMG was independent of Comp-U-Med, although it appears that it was affiliated 1986 U.S. Tax Ct. LEXIS 115">*139 with CFG, the investment firm that sold many of Comp-U-Med's franchises. CFG was also independent of Comp-U-Med.

The term of petitioners' management agreement with MMG was 1 year, commencing December 24, 1980. Petitioners paid MMG its management fee of $ 750 per franchise, or a total of $ 3,000, by a check dated December 23, 1980. The management agreement was renewable annually at MMG's then-applicable renewal fee ($ 150 in 1980).

Petitioners subsequently changed distributors for their terminals on several occasions, as follows:

In each case, MMG initiated the change of distributors; petitioners merely signed the necessary documents.

To generate sufficient net revenues even to meet the minimum annual payments of $ 1,500 (per franchise/terminal), much less to make any reduction of the stated $ 25,000 principal, petitioners had to place their terminals with users. ^{111986 U.S. Tax Ct. LEXIS 115">*140} Petitioners' terminals were first placed with users in 1982, as follows: 86 T.C. 848">*861

Petitioners' terminals generated the following revenues and expenditures:

As of the end of 1982, none of petitioners' franchises had generated enough net revenues to reduce any of the stated principal amount on the purchase money notes for their four terminals. None had earned enough even to meet the required minimum payments. At the end of 1982, Comp-U-Med's records showed that of 1,272 terminals/franchises sold, there had been no reduction in principal for 870 or 68 percent of 1986 U.S. Tax Ct. LEXIS 115">*141 that number. As to the 402 terminals/franchises for which Comp-U-Med's records showed some reduction in principal, the reduction was less than $ 1,000 in most instances.

In its offering circular, dated February 1, 1980, Comp-U-Med recommended that its franchisees charge their users a 86 T.C. 848">*862 minimum monthly rental (including 14 free ECG's) of $ 98 and the following additional ECG processing fees:

Petitioners' user agreements called for the following ECG fees:

Citing the 1979 revisions of a report on computerized electrocardiography prepared by Arthur D. Little, Inc., for the U.S. Department of Health, Education and Welfare, Comp-U-Med's offering circular claimed a nationwide average of 1,500 ECG's per year per user. The 1979 revisions of the Little report, which Comp-U-Med used in preparing its offering circular, showed, however, the following information:

86 T.C. 848">*863 The original Little report and its 1979 revision also report the following data for earlier years:

In its offering circular, Comp-U-Med also claimed substantial use experience of its own, identified as extrapolations of Comp-U-Med's average monthly volumes through December 31, 1979, as follows: 86 T.C. 848">*864

During the relevant periods, Comp-U-Med's franchise program resulted in the sales, placements, and ECG activities shown in the table on page 866.

Comp-U-Med's franchise program contemplated that Comp-U-Med would not be actively involved in the actual placement of its franchisees' terminals, limiting its efforts to providing franchisees with a list of existing medical equipment distributors. Comp-U-Med soon discovered that this arrangement did not work 1986 U.S. Tax Ct. LEXIS 115">*144 too well, so it began training people to act as independent contractors to be compensated strictly on a commission basis. In March of 1983, Comp-U-Med began making placements directly through company employees, hiring eight of its most successful independent distributors for this purpose. Although Comp-U-Med still uses some independent distributors, it plans to eliminate them and use a direct sales force of company employees.

As of March 15, 1982, Comp-U-Med claimed that on the average its terminals had been placed with users within 12 months after sale. Comp-U-Med, however, expected the time interval between sales to the investor and placement with a user to increase significantly due to its successful sales program. The Comp-U-Med placement and usage data for the month ending November 22, 1982, indicated the following:

86 T.C. 848">*865 This most recent data also showed the following average (annualized) number of ECG's per terminal:

Comp-U-Med generally followed a practice of sequential placement of the terminals, i.e., in the order in which the 86 T.C. 848">*866

86 T.C. 848">*867 terminals were sold to investors. Based on such sequential placement and based on total placements as of November 22, 1982, it would have taken Comp-U-Med approximately another 28 months, or until around March of 1984, to place all of the terminals which had already been sold as of December 31, 1981. As of March 1983, approximately 45 percent of the terminals Comp-U-Med had sold to franchisees had not yet been placed with a user.

To pay the promissory note according to its terms, including the 7-year extension period, a Comp-U-Med ECG terminal purchased and placed pursuant to its franchise program would have to reach an average use of at least 520 ECG's per year. See appendix, tables 1 and 2. Even to meet the $ 1,500 minimum annual payments, denominated as "interest," a terminal would have to average at least 215 ECG's per year for 14 years. See appendix, tables 3 and 4. For petitioners' terminals placed with Alcoa and General Foods at more favorable terms than Comp-U-Med's suggested rental rates, the required average usage rates are higher, as follows:

See 1986 U.S. Tax Ct. LEXIS 115">*147 appendix, tables 5 through 7.

As of March 1982, approximately 60 percent of Comp-U-Med franchisees whose terminals had been placed with users in excess of 1 year were experiencing negative cash flows (apart from the claimed tax benefits). Comp-U-Med was concerned about the slow placements and low usage because its own long-term success depended upon the placement of the terminals with physicians and the level of ECG usage. A successful placement rate was necessary to enable Comp-U-Med to continue to market its terminals/franchises to investors. Also Comp-U-Med recognized that if its marketing method became impracticable because of changes in the tax laws or otherwise, its ability to place its terminals with physicians and thus directly derive revenues from their use would become even more important to the company's economic well-being.

86 T.C. 848">*868 The Comp-U-Med System 107 Computer ECG Terminal is designed for use principally by primary health care providers, generally individual doctors who do not specialize in cardiology. Comp-U-Med has directed its marketing efforts at primary care physicians, industrial clinics, and nursing homes. Comp-U-Med's principal market is generally physicians who 1986 U.S. Tax Ct. LEXIS 115">*148 perform low volumes of ECG's.

On its books, Comp-U-Med treats the $ 25,000 promissory note executed by each franchisee as a contingent liability. On its balance sheets, Comp-U-Med records the notes as long-term notes receivable, assigning as their value the discounted present value of the minimum annual payments of $ 1,500 for 7 years plus the $ 1,000 to convert the note to nonrecourse. Moreover, Comp-U-Med records accrued revenues upon a sale of a franchise in an amount equal to the cash downpayment received plus the present value of the future payments to which it is unconditionally entitled (i.e., the minimum annual payments and the conversion payment).

Comp-U-Med uses and applies the $ 3,000 first year prepayment, denominated as a "royalty fee," received from the sale of each Comp-U-Med franchise as follows:

Comp-U-Med 1986 U.S. Tax Ct. LEXIS 115">*149 broke down the elements of its stated purchase price of $ 27,500 for a terminal as follows:

86 T.C. 848">*869 When Comp-U-Med introduced its System 107 Computer ECG Terminal in 1978, there 1986 U.S. Tax Ct. LEXIS 115">*150 were already several companies competing in the market for computerized ECG's. There were approximately 11 other companies that manufactured automatic electrocardiograph terminals that took an electrocardiogram from a patient and transmitted it over a phone line to a computer center. There were approximately six companies that sold integrated computer systems with hardware and software to hospitals and to service bureau companies selling computer time. Many companies sold computers and computer programs; there were also approximately 12 service bureau companies. Companies like Hewlett-Packard (and shortly thereafter, IBM), ¹² which had been among the first to use and improve the U.S. Public Health Service program, attempted to sell ECG terminals and mainframe computers to large hospitals processing large numbers of ECG's. Smaller companies, like Phone-A-Gram and Telemed, manufactured simpler, less sophisticated terminals for use in connection with their central data bases for processing ECG's; these companies concentrated on lower volume users such as small hospitals, clinics, corporate and industrial health units, and individual physicians. Other prominent companies in the 1986 U.S. Tax Ct. LEXIS 115">*151 field of computer-interpreted 86 T.C. 848">*870 ECG's included American Optical, Burdick, Cambridge, and Marquette. Phone-A-Gram and Telemed were most comparable to Comp-U-Med and were its primary competitors.

There were some differences among the various ECG terminals and computer analysis systems offered in the market. The simplest terminal was a device that merely transmitted the electrical data provided by a basic electrocardiograph to a computer for analysis. Such a device might or might not have a strip chart to give the administering physician or technician an immediate reading. A more advanced terminal would also have the capability to receive and print out the computer's interpretation of the ECG; these terminals would also usually have a strip chart, so that the reading and computer interpretation could be maintained together. The most sophisticated system would have its own internal computer for interpreting the ECG so that no data transmission to or receipt from 1986 U.S. Tax Ct. LEXIS 115">*152 a separate computer (teleprocessing) center would be required.

All of the terminals, however simple or sophisticated, required "patient cables," the electric cables that convey the electrical data to the terminals. These cables had to be replaced after approximately 5,000 ECG's. To attach the patient to the electrode at the end of the cables also required use of suction cups for each of the electrodes and a special gel on each suction cup to improve electrical conductivity. Those terminals with strip charts and printers also had to have strip-chart paper.

There were other technical differences among the various terminals. First, there were differences in the method of transmitting the ECG data. Most of the equipment had 12 leads receiving electrical data from the patient, but some equipment transmitted or received information in three channels and some in one channel. Each lead or group of leads transmitted so many seconds of data, so a single-channel system required more time than a three-channel system to send and to receive. Similarly, strip charts incorporated in terminals could print one or three channels of data; single-channel strip charts were more common, even in terminals 1986 U.S. Tax Ct. LEXIS 115">*153 transmitting three channels of data. Because more data was transmitted at once, three-channel terminals 86 T.C. 848">*871 transmitted the data faster than single-channel terminals, but single-channel terminals actually transmitted more data as to the heart's rhythms over a longer period of time. The interpretation of an ECG, computerized or manual, essentially required a three-channel presentation; with single-channel strip charts, this essentially required cutting the information into three strips and mounting them to show the three strips together. The three-channel presentation gave the cardiologist a look at a single complex from three different views at the same time. Thus, a cardiologist could look at an abnormal beat from three different directions, and for that reason some cardiologists favored the three-channel system. However, the disadvantage was that there was only 10 seconds of data available for analysis. With the older machines with single-channel transmission, it took a longer period to perform the ECG, but the ECG resulted in more data and more total length of time in which the cardiologist could detect abnormal rhythms in the heart.

The ECG data was encoded for transmission 1986 U.S. Tax Ct. LEXIS 115">*154 in two different modes -- digital and analog. Much of the reason for the different transmission modes related to the sophistication of the telephone equipment. Analog transmission was a little slower than digital because it would have to be converted into digital for use by the computer; presumably, the computer's interpretation would also have to be reconverted for transmission back to an analog terminal. While the matter is not wholly free of doubt, digital transmission may be somewhat more reliable than analog and may represent some slight improvement over analog machines.

Of the terminals capable of receiving back the computer interpretation, some received it on the same telephone call. These terminals, acoustically coupled or using standard telephone jacks, were portable. Other terminals required a separate call-back from the computer facility; because these terminals required "hard wiring" and a dedicated telephone line for the computer callback, these terminals were not portable.

All but the most sophisticated of the computerized ECG systems required access to a central mainframe computer for analysis of the ECG's. High volume users, primarily hospitals, could afford to acquire 1986 U.S. Tax Ct. LEXIS 115">*155 their own mainframes or 86 T.C. 848">*872 sophisticated systems containing their own internal computers. Lower volume users who could not afford their own mainframes were required instead to use private service bureaus offering central mainframes for multiple users. The compatibility of a particular terminal and mainframe (whether owned or accessed through a service bureau) depends upon the software (programming) used in the mainframe. ¹³ Comp-U-Med maintains a central service bureau using Hewlett-Packard HP-1000 mainframe computers to which its franchisees (and their users) have an unlimited right of access under the franchise agreements.

Comp-U-Med's System 107 Computer ECG Terminal (terminal) is a three-channel ECG terminal containing a single-channel writer (strip chart) and a printer. The terminal must be connected to a telephone line for transmission of the patient information to a computer processing center and for receipt of the analysis from the computer center. The 1986 U.S. Tax Ct. LEXIS 115">*156 terminal, however, is fully portable, plugging into any standard telephone jack. The terminal has a key pad for entering patient identifying and diagnostic data. After a technician taking the ECG enters the patient data, the terminal automatically dials and transmits the data and the ECG readings via telephone lines to the computer center. ¹⁴ On the same telephone call, the interpretation is transmitted to the terminal, which produces the ECG traces in a strip graph and a printout of the computerized analysis, which are then mounted by the technician on a form provided by Comp-U-Med. Comp-U-Med offered (at additional cost to users) review by a cardiologist of the computerized ECG interpretation (cardiologist overreading), both immediate and delayed.

Initially, Comp-U-Med manufactured terminals that used the analog mode of transmission but switched in 1981 to digital. All four of petitioners' terminals are analog. Comp-U-Med 1986 U.S. Tax Ct. LEXIS 115">*157 included a 5-year factory service or replacement warranty for its terminals. It appears that Comp-U-Med 86 T.C. 848">*873 provided the patient cables and suction cups at no cost. Comp-U-Med also sold the electrodes, gel, and paper necessary to use the terminal.

The Telemed SR-200 ECG terminal is similar to Comp-U-Med's Model 107. The Telemed SR-200 transmits three channels of ECG data to a central computer; it has a single-channel strip chart writer. Like the Comp-U-Med Model 107, the SR-200 has a key pad for entry of the patient data, which is transmitted along with the ECG data directly to Telemed's computer service bureau. Unlike Comp-U-Med's terminals, the SR-200 receives the computer interpretation by a separate telephone call rather than on line; consequently, the SR-200 must be hard wired to a telephone line and is not portable.

Telemed's primary market was individual physicians and small hospitals (200 beds or less); in 1978, its customers averaged about 1,000 ECG's per year. Telemed tried to secure long-term leases for its terminals, up to 5 years. In 1983, Telemed sold its SR-200 ECG terminal for approximately $ 4,750, which was complete (terminal, strip chart graph, and printer) except 1986 U.S. Tax Ct. LEXIS 115">*158 for the stand. The record contains no information regarding any warranties, service policies, patient cables, or the related supplies for Telemed's SR-200.

Phone-A-Gram, Comp-U-Med's other primary competitor in the lower volume user market, manufactured various relatively simple ECG terminals. Its basic unit was a terminal that transmitted the ECG data to Phone-A-Gram's central computer. The basic unit had no strip chart and no printer. Phone-A-Gram also offered a unit with a strip chart. Beginning in 1980, Phone-A-Gram also offered a remote printer (separate from the terminal), initially an off-the-shelf model manufactured by another company and subsequently a printer it manufactured itself.

All of Phone-A-Gram's ECG units used a single-channel ECG transmission. Compared to Comp-U-Med's 20-second data epoch, Phone-A-Gram's data epoch was 72 seconds, which can be important in the rhythm analysis of an ECG. Phone-A-Gram's units were acoustically coupled to the telephone lines, allowing greater portability. There was no automatic access to the Phone-A-Gram computers; instead, 86 T.C. 848">*874 an operator would orally take the patient data from the physician or ECG technician and enter it into the 1986 U.S. Tax Ct. LEXIS 115">*159 Phone-A-Gram computer and then direct that the ECG trace be commenced. The operator could observe the quality of the ECG trace and, if it was not good, direct that another trace be sent. Phone-A-Gram's usual practice was to mail back a report and strip chart of the tracing. Those customers with optional printers could receive back the computer interpretation. Phone-A-Gram also provided (at additional cost) for oral callback of reports, with or without separate review by a Phone-A-Gram staff cardiologist, ¹⁵ similar to that offered by Comp-U-Med.

Phone-A-Gram's principal market was lower volume users, primarily individual physicians. Phone-A-Gram also targeted small clinics, corporate and governmental health units, and small hospitals. From the late 1970's through 1982, Phone-A-Gram's users averaged approximately 150 to 200 ECG's per year. Phone-A-Gram sold few of its ECG units directly to users, preferring to place them with rental users on a fee-for-use basis. Like Comp-U-Med, Phone-A-Gram's minimum monthly rentals entitled the users to a certain number of ECG interpretations. Phone-A-Gram's rates 1986 U.S. Tax Ct. LEXIS 115">*160 were comparable to those suggested by Comp-U-Med. Most sales of Phone-A-Gram units were sale-and-leasebacks for financing purposes, primarily with its shareholders and other related persons. Phone-A-Gram did offer its units for sale to users. In 1980, its basic unit without a printer sold for about $ 2,000, and in 1983 its strip chart unit with a remote printer sold for about $ 3,400. Its prices reflected a markup of about 50 percent over its manufacturing costs. Sales included a 1-year warranty; rental users were entitled to full maintenance (repair or replace) for as long as they remained users. To rental users, Phone-A-Gram supplied the patient cables and initial supplies (electrodes, contact gel, and strip chart paper); additional supplies it sold to its users. The record does not indicate the terms upon which user-purchasers of a Phone-A-Gram unit obtained patient cables and related supplies. Phone-A-Gram maintained a bank of central computers for analyzing ECG's to which its users had access; like Comp-U-Med, Phone-A-Gram maintained a 86 T.C. 848">*875 WATS telephone line for its long-distance customers, for which it charged them.

Hewlett-Packard manufactured and sold terminals for computer 1986 U.S. Tax Ct. LEXIS 115">*161 ECG interpretation as well as the mainframe computers. Hewlett-Packard concentrated its sales efforts on large hospitals and similar high volume users processing 5,000 or more ECG's per year. In 1980, Hewlett-Packard sold its Model 1517A ECG Terminal. The Model 1517A was a three-channel transmission unit with a single-channel strip chart. The Model 1517A included (at extra cost), a transmitter to send the ECG data to a computer and a printer to print out the interpretation. In 1980, a Model 1517A that included a transmitter and printer sold for about $ 14,500.

In 1981, Hewlett-Packard discontinued the Model 1517A, replacing it with the Model 4700A. Like the 1517A, the 4700A was a three-channel unit; its strip chart, though, produced a three-channel report on an 8 1/2 inch by 11 inch sheet by a special device that involved new technology. In 1983, a Hewlett-Packard 4700A, including transmitter and printer, sold for about $ 12,000.

Both the 1517A and 4700A included a 1-year warranty upon sale. Hewlett-Packard offered a service contract for the terminals, calling for on-site servicing. In 1980, the cost was about $ 106 per month; in 1983, it was about $ 166 a month, but in both years 1986 U.S. Tax Ct. LEXIS 115">*162 the cost could have been more depending on the customer's geographical location. Hewlett-Packard also offered a less expensive service contract for maintenance at its service centers rather than on site. Hewlett-Packard also sold patient cables and at least some of the related supplies.

Hewlett-Packard sold its terminals directly to users; any leasing was arranged by the purchasers, not by Hewlett-Packard. There was an active market for used Hewlett-Packard terminals; prices depended on the age and condition of the particular terminal, but generally ranged between 50 and 70 percent of the initial (new) selling price. Because Hewlett-Packard was a leader in the industry, it could (and did) charge higher prices for its terminals, supplies, and services.

IBM introduced its Model 5880 ECG System in 1979. Unlike the other ECG terminals discussed above, the IBM 86 T.C. 848">*876 5880 contained its own internal microcomputer, eliminating the need for a central mainframe computer system. This unit was a three-channel terminal with an integrated printer and three-channel strip chart. The 5880 could store up to 21 ECG's, or up to 70 with an optional second disk unit. In 1980, an IBM 5880 cost about $ 35,600 1986 U.S. Tax Ct. LEXIS 115">*163 -- $ 21,600 for the unit and a one-time licensing fee of $ 14,000 for IBM's software (including updates). The IBM service contract was about $ 105 per month in 1980. By 1983, the IBM 5880 sold for about $ 14,500 -- $ 10,000 for the terminal and a $ 4,500 fee for the software. By 1983, the service contract was $ 150 a month.

In 1981, IBM introduced its Model 5885 Terminal featuring a three-channel mode with a single-channel printout. The IBM 5885 had to be used with a remote computer, either an IBM 5880 system or a central mainframe computer. IBM does not have a central computer processing bureau for ECG analysis. The IBM 5885, equipped with a transmitter for teleprocessing, sold for $ 17,600 both in 1981 and in 1983. The service contract for the IBM 5885 was about $ 157 per month.

Like Hewlett-Packard, IBM's primary market was large hospitals and similar high volume users. IBM's high prices effectively excluded it from competing in the lower volume user market. Only a small percentage of IBM's Model 5880 and Model 5885 units was sold to individual physicians.

On Schedule C of their 1980 joint individual income tax return, petitioners reported gross receipts, deductions, and losses 1986 U.S. Tax Ct. LEXIS 115">*164 from their Comp-U-Med franchise equipment leasing venture as follows:

The depreciation deduction was based on a cost basis for the four terminals of $ 110,000, using double declining balance depreciation and a useful life of 7 years. Petitioners elected the Class Life Asset Depreciation Range (CLADR) 86 T.C. 848">*877 System of depreciation and the half-year convention. Petitioners claimed $ 4,000 additional first-year depreciation plus $ 15,143 of depreciation using the double declining balance method. In addition, petitioners claimed a tentative regular investment credit for the terminals of $ 11,000. The deduction for legal and professional fees represents the management fee of $ 750 per franchise that petitioners paid to MMG. The deduction for royalty fees represents the payment of $ 3,000 per franchise denominated as first-year royalty fees. Petitioners' 1980 taxable income, excluding all items relating to Comp-U-Med, was $ 34,038.

In his statutory notice of deficiency, respondent allowed the entire claimed deduction of $ 3,000 for legal and professional fees (the 1986 U.S. Tax Ct. LEXIS 115">*165 management fee, $ 750 per franchise, that petitioners paid to MMG). Respondent also allowed $ 2,400 ($ 600 per franchise) of the royalty fee as the maximum potential royalty based on Comp-U-Med's highest projected use (1200 ECG's per year at $ 0.50 royalty per ECG). Respondent disallowed the remaining $ 9,600 of $ 12,000 first-year "royalty" fee ($ 2,400 per franchise) as nondeductible startup costs. Respondent determined that no depreciation or amortization of these "capitalized" startup costs was allowable. With respect to petitioners' claimed depreciation and investment credit, respondent made alternative determinations. Respondent's primary position is that neither depreciation nor investment credit is allowable because petitioners did not place their terminals in service during 1980, the taxable year in issue. Alternatively, respondent determined that petitioners' purchase money indebtedness for their terminals was effectively nonrecourse and too contingent and speculative to be a true debt for Federal tax purposes. Accordingly, respondent limited petitioners' basis for depreciation and the investment credit to $ 10,000, the cash downpayment of $ 2,500 per terminal. Because 1986 U.S. Tax Ct. LEXIS 115">*166 he determined the note was effectively nonrecourse, respondent also concluded that petitioners' "investment" in the terminals attributable to the note was not at risk, within the meaning of section 465. Finally, respondent determined that petitioners had not shown that their untimely return was due to reasonable cause and accordingly determined the section 6651(a) delinquency addition to 86 T.C. 848">*878 tax. Although the statutory notice determined the addition to be the maximum of 25 percent of the tax, respondent now concedes that this is a mathematical error and that since their return was less than 1 month late, petitioners are liable for an addition of only 5 percent of the tax. See sec. 6651(a)(1), (b)(1).

Neither party presented any probative expert valuation testimony or reports. Petitioners offered an appraisal report Comp-U-Med had obtained; the Court excluded it since the appraiser had died before the trial and the appraisal report was not admissible as a business record under Federal Rules of Evidence 803(6), as petitioners contended. Petitioners' expert, Dr. James M. Stancill, accepted the purchase price stated by Comp-U-Med as the fair market value and 1986 U.S. Tax Ct. LEXIS 115">*167 simply addressed what he regarded as the economics of the investment. The Court struck both the testimony and the reports of respondent's expert for reasons set out in the Court's order of August 31, 1983, which is here incorporated by reference. See note 16, infra. However, respondent's expert merely purported to show errors in Dr. Stancill's report and did not address any valuation issues. Most of the materials respondent's expert relied upon and discussed were already matters of record. There is, without expert valuation reports, ample evidence in the record to support the Court's determination of fair market value. As to petitioners' expert, the Court relied upon his testimony, with modifications, for the economics of the proposed investment as viewed by petitioners in entering into the investment, and hence to show petitioners had an actual and honest profit objective, although not a reasonable one.

The tables on pages 880-884 project income and expense from the operation of a Comp-U-Med ECG terminal and franchise to determine the usage levels necessary for minimum payment and for full payment of the purchase money "indebtedness." Our methodology in making these projections 1986 U.S. Tax Ct. LEXIS 115">*168 is based on that of petitioners' expert witness, Dr. James M. Stancill, with various modifications. ^{161986 U.S. Tax Ct. LEXIS 115">*169}

86 T.C. 848">*879 Each table will identify its various individual assumptions that depart in any way from our general assumptions.

General Assumptions:

1. Revenues are based on the per-ECG rates suggested by Comp-U-Med in its offering circular.

2. The royalties, billing fees, and 1986 U.S. Tax Ct. LEXIS 115">*170 placement commissions are those called for in Comp-U-Med's offering circular. ¹⁷

3. We have excluded the first-year advance payment of $ 3,000, denominated as a "royalty." This item was prepaid, and, consequently, does not affect the allocation of a franchisee's first-year 1986 U.S. Tax Ct. LEXIS 115">*171 net revenues, if any.

4. Dr. Stancill's projections did not include any expense for maintenance. Our projection also includes none for the first 5 years, while the terminal is under warranty. We believe, however, that a maintenance expense should be included for subsequent years. The Hewlett-Packard and IBM service contracts, available for the duration of the use of those terminals, suggest that maintenance expenses are a regular cost that should be included in the projection and 86 T.C. 848">*880

ASSUMPTIONS: Payoff in year 14

12-month delay in placement

10% inflation

Income and expense projections rounded to even dollars

86 T.C. 848">*885 undermine Comp-U-Med's "bathtub curve" view of maintenance expenses, which they see as occurring only in the early and late years of the franchises. We have used an initial figure of $ 200, which is one-fifth of what Comp-U-Med determined to be the cost of its initial 5-year warranty.

5. Dr. Stancill's projections contemplated that inflation would increase the gross revenues over the 14-year period, and yet his projections 1986 U.S. Tax Ct. LEXIS 115">*189 used constant, uninflated expense figures. We see no basis for employing inflation considerations for revenues but not for expenses, and petitioners have not presented any convincing argument why the effect of inflation on the expenses should be ignored. Accordingly, those projections that contemplate the effect of inflation on revenues likewise reflect inflation of the expenses for WATS long-distance telephone charges, maintenance, and the additional commission for subsequent replacement by the distributor. The distributor's general commission, 10 percent of gross revenues, will necessarily reflect the inflation element of gross revenue projections. The royalties and billing fees due Comp-U-Med, however, are not adjusted; the franchise agreement sets flat rates for these items until the note is paid in full.

6. For those projections employing inflation considerations, we have used Dr. Stancill's figure of 10 percent. Although experience shows a lower rate in recent years, we think that 10 percent was reasonable as of the time petitioners acquired their franchises (December 1980). A lower inflation rate would require higher average use for full payment; consequently, our ultimate 1986 U.S. Tax Ct. LEXIS 115">*190 conclusions would not be affected by using a lower inflation rate that respondent seems to suggest.

7. Amounts paid to principal contemplate that 50 percent of the net revenues above the minimum annual payment goes to Comp-U-Med for the entire 14-year period; thus, none of the projections that contemplate full repayment assume that a franchisee will convert the note from recourse to nonrecourse after the initial 7-year term. If a franchisee renewed the note but left it "recourse," he would remain entitled to 50 percent of the net franchise revenues; if he elected to convert to nonrecourse, he would only be entitled to 25 percent of the net revenues. A franchisee in the 86 T.C. 848">*886 50-percent tax bracket (as contemplated in Comp-U-Med's offering circular) who elected to convert to nonrecourse would have to pay part of his taxes on his revenues out-of-pocket rather than out of his share of the revenues. A franchisee in the 50-percent tax bracket who chose not to convert would be able to pay all his taxes out of his share of the revenues. Consequently, where usage levels generate net revenues approaching the level required to pay off the note under the franchise as structured, a franchisee would 1986 U.S. Tax Ct. LEXIS 115">*191 normally choose not to convert the note.

8. Dr. Stancill's projections contemplate several years before peak usage levels are met. We have not accepted this approach for Comp-U-Med's own experience negates this assumption. See note 40 infra. Moreover, the effect of our use of a uniform average usage beginning in the first year of placement is to petitioners' benefit because it results in a lower peak use than if an increase over several years is posited.

TABLE 1

Comp-U-Med's offering circular contemplated depreciation under the CLADR System, using $ 4,000 first-year (bonus) depreciation and the 200-percent double declining balance method, resulting in the following claimed tax deductions:

These projections contemplate a full year's depreciation during the first year. In addition, the circular contemplated an investment credit of $ 2,750 in year one, computed on 7-year property with a cost of $ 27,500. The 1986 U.S. Tax Ct. LEXIS 115">*192 circular also used a 50-percent effective marginal rate; petitioners were in the 54-percent bracket the year before they acquired their 86 T.C. 848">*887 franchises and were in the 37-percent bracket the year they acquired them. The following projections assume a 50-percent marginal tax rate.

The projected tax benefits of a Comp-U-Med franchise, without discounting for the time value of money, were as follows:

This projection assumes that no ECG's are performed and that a franchisee converts the note to nonrecourse.

The projected economic profits, based on Comp-U-Med's claimed average usage of 550 ECG's per year, were $ 29,104 (undiscounted). See table 10 supra. Subtracting a franchisee's $ 6,000 cash investment and $ 200 franchise renewal fee (the minimum payment is largely met from franchise operations (see table 10 supra)), leaves a net pretax return of $ 22,904.

The present value of the projected tax benefits of a Comp-U-Med franchise, assuming a 10-percent discount rate (see sec. 20.2031-7(f), 1986 U.S. Tax Ct. LEXIS 115">*193 table B, Estate Tax Regs.), was as follows:

The present value of the projected net income stream, also assuming a 10-percent discount rate, was approximately $ 10,700. Subtracting a franchisee's $ 6,000 cash investment in year one and his franchise renewal fee in year 8 (present cost $ 103) leaves a net pretax return with a present value of $ 4,597.

86 T.C. 848">*888 The present value of the tax benefits of the investment would be somewhat lower to investors (like petitioners) who acquired their franchises at the end of the year and thus would be unable to obtain the full first-year's depreciation. Moreover, investors (like petitioners) who acquired several terminals would have to spread their additional first-year depreciation among all of their terminals, rather than claiming the full bonus depreciation for each terminal as Comp-U-Med's offering circular seems to contemplate.

ULTIMATE FINDINGS OF FACT

1. Petitioners engaged in their Comp-U-Med ECG terminal franchise activity with the 1986 U.S. Tax Ct. LEXIS 115">*194 actual and honest objective of deriving an economic profit.

2. Petitioners' computerized ECG terminals were placed in service during 1980.

3. The fair market value of a new Comp-U-Med Model 107 ECG Terminal during 1980 was no more than $ 6,500.

4. Petitioners' purchase money note in the principal amount of $ 25,000 is too contingent and speculative to be treated as a true indebtedness for Federal tax purposes.

5. The recourse obligation represented by the minimum annual payment, the franchise renewal fee, and the payment for conversion to nonrecourse is a bona fide debt for Federal tax purposes.

6. The portion of petitioners' purchase money note for the terminals that constitutes bona fide debt and that exceeds the fair market value of the terminals themselves represents part of the costs of petitioners' Comp-U-Med franchises.

7. Comp-U-Med has an interest in the net profits of petitioners' ECG terminal leasing activity other than as a creditor.

OPINION

This is a test case, involving one of about 2,000 investors in Comp-U-Med's ECG terminal franchises. The case raises a number of tax issues. Although the investment was obviously structured to try to get around the "at risk" limitations of 1986 U.S. Tax Ct. LEXIS 115">*195 section 465, it is hardly the typical abusive tax shelter scenario.

86 T.C. 848">*889 Petitioners purchased four of Comp-U-Med's franchises, each of which included the purchase of one of Comp-U-Med's computerized electrocardiogram (ECG) terminals. For each franchise and terminal, petitioners paid $ 6,000 in cash and executed a promissory note of $ 25,000. Comp-U-Med labeled $ 500 of the $ 6,000 as a "franchise fee" and $ 3,000 as a "first year royalty." Comp-U-Med allocated the remaining $ 2,500 of cash and all of the $ 25,000 note to the ECG terminal, for a purported purchase price of $ 27,500 per terminal. The term of the franchise was 7 years (initial term) but upon payment of a $ 200 fee, petitioners could renew the franchise for an additional term of 7 years (extension term). The promissory note was labeled as "recourse" and was also for a 7-year term. During the initial term, petitioners' only obligation under the note was to make a minimum payment of $ 1,500 per year, which was denominated as interest at the stated rate of 6 percent of the stated principal of $ 25,000. Any payment of principal was due only out of net exploitation revenues from petitioners' leasing of the ECG terminals to 1986 U.S. Tax Ct. LEXIS 115">*196 users such as primary care physicians or clinics. At the end of the initial 7-year term, if petitioners renewed the franchise they could also renew the note for the extension term of the franchise and, upon payment of $ 1,000, could convert the note to nonrecourse. On its books, Comp-U-Med treated the $ 25,000 promissory note as a contingent liability. On its balance sheets, Comp-U-Med recorded the notes as long-term notes receivable, assigning as their value the discounted present value of the minimum annual payments of $ 1,500 for 7 years, plus the $ 1,000 to convert the note to nonrecourse. On their tax return for 1980, the year of purchase, petitioners claimed depreciation and an investment tax credit computed on the full amount of $ 27,500 per terminal. Petitioners also deducted royalty expenses and other expenses relating to their Comp-U-Med ECG terminal franchises.

Respondent's broad assault on petitioners' tax-advantaged investment includes several overlapping and alternative arguments. Since respondent's profit-motive arguments, 86 T.C. 848">*890 if accepted, would be wholly or largely dispositive of the case before us, we will first address those issues.

Although in his statutory notice of deficiency respondent allowed a portion of petitioners' claimed deduction for the first-year royalty, he now contends that none of the claimed royalty and depreciation deductions, nor the investment credit, are allowable. ^{181986 U.S. Tax Ct. LEXIS 115">*198} Respondent argues that petitioners' acquisition or operation of their franchises was not an activity engaged in for profit. Alternatively, with respect to the claimed royalty deduction, respondent contends that it was a nondeductible startup expense because petitioners were not engaged in a "trade or business" during the taxable year in issue.

Petitioners' claimed deductions and credit hinge upon whether petitioners entered into their Comp-U-Med franchise venture for the predominant purpose of deriving a profit. ^{191986 U.S. Tax Ct. LEXIS 115">*200} Although petitioners' profit motive need not be reasonable, nonetheless, they must have had an actual and honest profit objective. Sec. 1.183-2(a), Income Tax Regs.; 86 T.C. 848">*891 Fox v. Commissioner, 80 T.C. 972">80 T.C. 972, 80 T.C. 972">1006 (1983), affd. without published opinion 742 F.2d 1441">742 F.2d 1441 (2d Cir. 1984), affd. sub nom. Barnard v. Commissioner, 731 F.2d 230">731 F.2d 230 (4th Cir. 1984), affd. without published opinion sub nom. Hook v. Commissioner, 634 F.2d 5">634 F.2d 5 (3d Cir. 1984), Leffel v. Commissioner, 734 F.2d 6">734 F.2d 6 (3d Cir. 1984), Rosenblatt v. Commissioner, 734 F.2d 7">734 F.2d 7 (3d Cir. 1984), Zemel v. Commissioner, 734 F.2d 9">734 F.2d 9 (3d Cir. 1984); Flowers v. Commissioner, 80 T.C. 914">80 T.C. 914, 80 T.C. 914">931 (1983); Dreicer v. Commissioner, 78 T.C. 642">78 T.C. 642 (1982), affd. without opinion 702 F.2d 1205">702 F.2d 1205 (D.C. Cir. 1983). In this context, the requisite element is economic profit, independent of tax savings. Ramsay v. Commissioner, 83 T.C. 793">83 T.C. 793, 83 T.C. 793">810 (1984); 1986 U.S. Tax Ct. LEXIS 115">*199 Surloff v. Commissioner, 81 T.C. 210">81 T.C. 210, 81 T.C. 210">233 (1983).

Section 1.183-2(b), Income Tax Regs., lists some of the relevant factors to be considered in determining whether an activity is engaged in for profit. ^{201986 U.S. Tax Ct. LEXIS 115">*202} These factors include: (1) The manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisors; (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 losses with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation are involved. Case law provides other relevant factors. See, e.g., Estate of Baron v. Commissioner, 83 T.C. 542">83 T.C. 542, 83 T.C. 542">558-559 (1984); Flowers v. Commissioner, 80 T.C. 914">80 T.C. 937. No single factor is determinative; rather, the issue is one of fact to be resolved by examining all of the 1986 U.S. Tax Ct. LEXIS 115">*201 circumstances. Fuchs v. Commissioner, 83 T.C. 79">83 T.C. 79, 83 T.C. 79">98 (1984); Dean v. Commissioner, 83 T.C. 56">83 T.C. 56, 83 T.C. 56">74 (1984); Fox v. Commissioner, 80 T.C. 972">80 T.C. 1007; 86 T.C. 848">*892 Flowers v. Commissioner, 80 T.C. 914">80 T.C. 931-932; Dunn v. Commissioner, 70 T.C. 715">70 T.C. 715, 70 T.C. 715">720 (1978), affd. 615 F.2d 578 (2d Cir. 1980). In making this factual determination, we give greater weight to objective factors than to the taxpayers' mere statements of their intent. Sec. 1.183-2(a), Income Tax Regs.; 83 T.C. 79">Fuchs v. Commissioner, supra;83 T.C. 56">Dean v. Commissioner, supra;Siegel v. Commissioner, 78 T.C. 659">78 T.C. 659, 78 T.C. 659">699 (1982); Engdahl v. Commissioner, 72 T.C. 659">72 T.C. 659, 72 T.C. 659">666 (1979).

There are a few factors mentioned in the regulations that tend to indicate the absence of a profit objective, such as petitioners' losses during the years in evidence (1980-82), their acquisition and use of assets that will depreciate rather than appreciate in value over time, and their relatively high income ($ 80,000 taxable income in 1979, placing them in the 54-percent marginal rate bracket, based on a joint return). The existence of losses (both cash and tax), however, is not determinative, particularly where, as here, they arise in the early years of an investment when losses may often be expected. See sec. 1.183-2(b)(6), Income Tax Regs. Similarly, the concurrent existence of other income against which any losses from the activity may be used is not conclusive; it merely serves to pose the question. ^{211986 U.S. Tax Ct. LEXIS 115">*204} As we stated in Engdahl v. Commissioner, supra (72 T.C. 659">72 T.C. 670):

As long as tax rates are less than 100 percent, there is no "benefit" in losing 1986 U.S. Tax Ct. LEXIS 115">*203 money. * * * The essential question remains as to whether there was a genuine hope of economic profit. * * *

These negative factors do not outweigh the strong inference of profit motive created by the reasoned, businesslike acquisition and operation of ECG terminal franchises by experienced business persons and investors like petitioners. Based on all of the evidence of record, we are convinced 86 T.C. 848">*893 that petitioners acquired and exploited their Comp-U-Med franchises with the requisite profit objective.

Petitioners, already successful in managing their business and their investment real estate, chose an equipment leasing venture to diversify their holdings; they were also attracted to the Comp-U-Med franchise because they viewed it as modern "high tech." Petitioners acquired their Comp-U-Med franchises upon the recommendation of their attorney and investment advisor; the advisor recommended the franchise investment only after an independent investigation he had directed to be performed appeared to corroborate the market description and usage projections in Comp-U-Med's offering circular. Although petitioners were interested in the prospective tax benefits from the Comp-U-Med franchises, they chose the Comp-U-Med investment over other potential investments because they and their advisor believed that the ECG terminal franchise offered a realistic profit potential.

Having acquired their franchises, petitioners immediately retained Medical Management Group (MMG) to perform management services and contracted with medical equipment distributors 1986 U.S. Tax Ct. LEXIS 115">*205 to place their terminals with actual users. Although both MMG and the equipment distributors apparently were identified to petitioners (and other franchisees) by Comp-U-Med, these firms were independent of Comp-U-Med. Several of petitioners' terminals were first placed with users shortly after petitioners had changed distributors (at MMG's recommendation). This indicates that MMG took seriously its task as management consultant and that MMG and the distributors were also independent of each other. Since petitioners had no experience in medical equipment leasing, their profit objective in operating their franchises is corroborated, not undermined, by their use of a retained consultant and hired distributors. Indeed, their profit objective might well be suspect had they, inexperienced as they were in computerized ECG equipment, purported to try to manage their franchises and place the terminals themselves.

As stated in our ultimate findings, supra, and explained in Part IIB, infra, we have determined that a substantial portion of petitioners' purchase money note is not a true indebtedness for Federal tax purposes. However, while we have considered that factor here, it is not determinative 1986 U.S. Tax Ct. LEXIS 115">*206 as to 86 T.C. 848">*894 petitioners' profit objective. Cases such as 83 T.C. 542">Estate of Baron v. Commissioner, supra, and 80 T.C. 914">Flowers v. Commissioner, supra, involved far more grossly inflated purchase prices, attributable to nonrecourse purchase money notes, which indicated that those taxpayers were just buying tax deductions, not entering into economically motivated investments. ²² From the conclusion that a portion of the purchase money indebtedness is too speculative and contingent to be treated as a true debt for tax purposes, it does not necessarily follow that petitioners' overall investment was not profit motivated. Of course some inflation of the purchase price and note occurred in this case as will be discussed in Part IIB infra.

Finally, we note that unlike 83 T.C. 542">Estate of Baron v. Commissioner, supra, there is no substantial disparity between the projected net tax benefits and projected economic profits over the 14-year period. Quite to the contrary, on both a gross dollar basis and present value basis, here the projected economic profits exceeded expected net tax benefits. See appendix to findings of fact, table 11, supra. ^{231986 U.S. Tax Ct. LEXIS 115">*208} On a per terminal 1986 U.S. Tax Ct. LEXIS 115">*207 basis, revenues at the usage levels claimed in Comp-U-Med's offering circular could, depending on the actual effect of inflation, repay the entire $ 25,000 purchase money note over its effective 14-year term, while returning substantial before-tax income to petitioners. Although these projections were, on the whole, far too optimistic, they appeared reasonable to petitioners and their advisor at the time they acquired their franchises. The apparent economic viability of the Comp-U-Med franchise, based on the information known to petitioners and their advisor at the time of the franchise acquisition, indicates that petitioners' investment was profit motivated. Based on the entire record, we are persuaded that petitioners acquired and operated their ECG terminal franchises with the actual and honest objective of earning real monetary profits. ²⁴

86 T.C. 848">*895 B. Deductibility of first-year "royalty"

Ordinary and necessary expenses generally are deductible, whether incurred in a trade or business (sec. 162(a)), or in a profit-motivated activity not rising to the level of a trade or business. Sec. 212(1), (2). No current deduction is allowed, however, for an expenditure that results in the acquisition of an asset with a useful life extending substantially beyond the close of the taxable year. Secs. 1.212-1(n), 1.263(a)-2(a), Income Tax Regs.; Commissioner v. Idaho Power Co., 418 U.S. 1">418 U.S. 1 (1974); Woodward v. Commissioner, 410 F.2d 313">410 F.2d 313, 410 F.2d 313">318 (8th Cir. 1969), affd. 397 U.S. 572">397 U.S. 572 (1970). Such capital expenditures must be recovered 1986 U.S. Tax Ct. LEXIS 115">*209 through depreciation or amortization over the asset's useful life, or taken into account in the determination of gain or loss upon taxable disposition of the asset. Woodward v. Commissioner, 397 U.S. at 575-576; Southern Pacific Transportation Co. v. Commissioner, 75 T.C. 497">75 T.C. 497, 75 T.C. 497">577-578 (1980). Moreover, no current business expense deduction (sec. 162(a)) is allowed for expenditures incurred prior to the beginning of actual business operations. Richmond Television Corp. v. United States, 345 F.2d 901">345 F.2d 901 (4th Cir. 1965), vacated and remanded on other issues 382 U.S. 68">382 U.S. 68 (1965); Goodwin v. Commissioner, 75 T.C. 424">75 T.C. 424, 75 T.C. 424">433 (1980), affd. without published opinion 691 F.2d 490">691 F.2d 490 (3d Cir. 1982); Madison Gas & Electric Co. v. Commissioner, 72 T.C. 521">72 T.C. 521, 72 T.C. 521">566-567 (1979), affd. 633 F.2d 512">633 F.2d 512 (7th Cir. 1980). See also Todd v. Commissioner, 77 T.C. 246">77 T.C. 246, 77 T.C. 246">249-250 (1981), affd. per curiam 682 F.2d 207">682 F.2d 207 (9th Cir. 1982). ²⁵ We have held, however, that the preopening expense doctrine does not apply to amounts deductible under section 212(2), paid or incurred for the management, conservation, or maintenance of property held for the production of income. Hoopengarner v. Commissioner, 80 T.C. 538">80 T.C. 538 (1983), affd. 1986 U.S. Tax Ct. LEXIS 115">*210 without published opinion 745 F.2d 66 (9th Cir. 1984). ²⁶

Respondent allowed $ 600 per terminal of petitioners' claimed "first-year royalty," which he determined was the highest allowable ECG processing royalty as based on 86 T.C. 848">*896 projected and actual use. Respondent disallowed the remaining $ 2,400 per terminal as nondeductible "startup" costs, and now argues that none of the claimed $ 3,000 "first-year royalty" per terminal should be allowed. We agree that none of the prepaid "first-year royalty" is deductible but for a different reason.

The startup costs for which deductions are disallowed under the preopening expense doctrine are expenses that would have been deductible had they been paid or incurred in a trade or business. Deductions for startup costs are disallowed because the taxpayer has not yet commenced his trade or business. 345 F.2d 901">Richmond Television Corp. v. United States, supra;1986 U.S. Tax Ct. LEXIS 115">*211 Hoopengarner v. Commissioner, supra, 80 T.C. 538">80 T.C. 540; 75 T.C. 424">Goodwin v. Commissioner, supra.Capital expenditures, however, are nondeductible regardless of whether the taxpayer has begun a trade or business.

Petitioners paid a "franchise fee" of $ 500 per franchise; the franchise rights were clearly more valuable than that nominal sum. Petitioners' franchise rights included ECG processing and billing at nominal rates, use of Comp-U-Med's goodwill and other intangibles (enhanced by Comp-U-Med's advertising), training users in operating the terminals, and liability insurance. On its books, Comp-U-Med allocated the $ 3,000 per terminal "first-year royalty" to these various categories of franchise rights. The manner in which Comp-U-Med allocated its franchisees' first-year royalty fees on its books thus tracks the bundle of franchise rights almost exactly. These intangible rights, acquired for the term of the franchise, are quintessentially capital expenditures and thus are nondeductible. See Seligman v. Commissioner, 84 T.C. 191">84 T.C. 191, 84 T.C. 191">201-203 (1985).

Respondent disallowed all of petitioners' depreciation deductions and the investment tax credit claimed 1986 U.S. Tax Ct. LEXIS 115">*212 for their Comp-U-Med ECG terminals. Respondent's primary position is that the terminals were not placed in service during the taxable year in issue. ²⁷ Alternatively, respondent's remaining 86 T.C. 848">*897 arguments are that petitioners' purchase money note should not be included in basis because it was not a "true debt for Federal tax purposes, and that in any event, petitioners' losses are limited to their cash investment because that is the extent to which they are "at risk" under section 465.

Depreciation and the investment credit are allowed in the year in which the qualifying property is placed in service by the 1986 U.S. Tax Ct. LEXIS 115">*213 taxpayer. Secs. 38(a), 46(a)(1), 46(a)(2), 46(c)(1); secs. 1.46-3(a)(1), 1.167(a)-10(b), 1.167(a)-11(e)(1)(i), Income Tax Regs. Property is placed in service when it is "placed in a condition or state of readiness and availability for a specifically assigned function, whether in a trade or business, in the production of income, in a tax-exempt activity, or in a personal activity." Secs. 1.46-3(d)(1)(ii), 1.167(a)-11(e)(1)(i), Income Tax Regs.

Respondent's sole argument in support of his position that petitioners' terminals were not placed in service is that petitioners had not acquired the terminals (e.g., had no possessory interest in the terminals) during the taxable year in issue. Respondent reads the franchise agreement as requiring petitioners to execute a UCC-1 financing statement as a condition precedent to delivery of the terminals; he concludes that petitioners had no possessory interest in 1980 because they did not sign the UCC-1 until 1981. We have rejected respondent's construction of the agreement (see note 9 supra ), and we conclude that petitioners had the right to direct delivery of the terminals (whether to themselves, to their distributors, or to their ultimate 1986 U.S. Tax Ct. LEXIS 115">*214 users) as of December 30, 1980, the day Comp-U-Med approved their franchise application.

For an asset to be "placed in service" for purposes of depreciation and the investment credit, it is not necessary that the property actually be used during the taxable year in the taxpayer's profit-motivated venture. It is sufficient that the property be available for use. Sears Oil Co. v. 86 T.C. 848">*898 Commissioner, 359 F.2d 191, 198 (2d Cir. 1966); SMC Corp. v. United States, an unreported case ( E.D. Tenn. 1980, 80-2 USTC par. 9642, 46 AFTR 2d 80-5827), affd. per curiam 675 F.2d 113 (6th Cir. 1982). ²⁸ See also Grow v. Commissioner, 80 T.C. 314">80 T.C. 314, 80 T.C. 314">326-327 (1983). Property held for leasing to others is placed in service when it is first held out for lease. ^{291986 U.S. Tax Ct. LEXIS 115">*215} That petitioners executed distribution agreements for their terminals simultaneously with their purchase clearly shows that the terminals were available to be used in petitioners' profit-motivated leasing venture from the date of purchase. ³⁰ We conclude that petitioners' terminals were placed in service in 1980.

For purposes of depreciation (and amortization), a taxpayer's basis in purchased property is his cost, and his cost includes valid liabilities incurred in acquiring the property. Crane v. Commissioner, 331 U.S. 1">331 U.S. 1 (1947); Parker v. Delaney, 186 F.2d 455 (1st Cir. 1950); Blackstone Theatre Co. v. Commissioner, 12 T.C. 801">12 T.C. 801, 12 T.C. 801">804 (1949). The same basis rules apply for determining the taxpayer's qualified investment for purposes of the investment credit. Sec. 1.46-3(c), Income Tax Regs.; Denver & Rio Grande Western R.R. Co. v. United States, 205 Ct. Cl. 597">205 Ct. Cl. 597, 205 Ct. Cl. 597">601-602, 505 F.2d 1266, 1269 (1974).

Recourse liabilities generally pose no difficulty because of the taxpayer's fixed, unconditional obligation to pay, with interest, ³¹ a specific sum of money. A nonrecourse liability, however, is more problematical because it lacks the personal obligation to pay. Nonetheless, a nonrecourse liability is a lien that the taxpayer must satisfy according to its terms to retain possession and use of the encumbered property. A nonrecourse liability 1986 U.S. Tax Ct. LEXIS 115">*216 can be a true loan that will be included in a taxpayer's cost basis; the finding that a nonrecourse debt is a true loan is "predicated on the assumption that the mortgage will be repaid in full." Commissioner v. Tufts, 461 U.S. 300">461 U.S. 300, 461 U.S. 300">308 (1983). See 331 U.S. 1">Crane v. Commissioner, 331 86 T.C. 848">*899 U.S. at 14 (fn. ref. omitted), where the Supreme Court was concerned with "the reality that an owner of property, mortgaged at a figure less than that at which the property will sell, must and will treat the conditions of the [nonrecourse] mortgage exactly as if they were his personal obligations." See also Mayerson v. Commissioner, 47 T.C. 340">47 T.C. 340, 47 T.C. 340">352 (1966), where we said "It can be assumed that a capital investment in the amount of the mortgage will eventually occur despite the absence of personal liability." See also Odend'hal v. Commissioner, 748 F.2d 908">748 F.2d 908, 748 F.2d 908">913 (4th Cir. 1984), affg. 80 T.C. 588">80 T.C. 588 (1983).

Because of the potential abuse that inheres in the allowance of deductions in excess of the cash investment, the courts have endeavored to test the validity of the repayment assumption and have excluded from basis nonrecourse obligations that were not likely to be paid. See and compare Gibson Products Co. v. United States, 637 F.2d 1041, 1047-1048 (5th Cir. 1981); 1986 U.S. Tax Ct. LEXIS 115">*217 Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir. 1976), affg. 64 T.C. 752">64 T.C. 752 (1975); Fox v. Commissioner, 80 T.C. 972">80 T.C. 1020-1023; Brannen v. Commissioner, 78 T.C. 471">78 T.C. 493-499. Contrary to petitioners' arguments, these judicial doctrines for evaluating nonrecourse obligations as part of cost basis vel non were not vitiated by the Supreme Court's decision in 461 U.S. 300">Commissioner v. Tufts, supra. See Herrick v. Commissioner, 85 T.C. 237">85 T.C. 237, 85 T.C. 237">261-262 (1985). ³²

We also reject petitioners' argument that the at risk rules of section 465 supersede these judicial doctrines for testing the inclusion of purported nonrecourse debt in basis. The at risk rules do not replace the rules for basis determination. See S. Rept. 94-938 (1976), 1976-3 C.B. (Vol. 3) 49, 86. ³³ First, the at risk rules do not apply to all transactions that can give rise to tax losses. See sec. 465(c)(1), (3). Second, until 1986 U.S. Tax Ct. LEXIS 115">*218 1981, there was no at risk limitation applicable to the investment credit; a taxpayer's qualified investment thus depended upon traditional basis principles. See sec. 46(c); sec. 1.46-3(c)(1), Income Tax Regs.Section 46(c)(8), which 86 T.C. 848">*900 limited a taxpayer's basis for investment credit purposes to his amounts at risk, applies only to property placed in service after February 18, 1981, and thus does not apply to this case. See sec. 211(i)(5), Economic Recovery Tax Act of 1981, Pub. L. 97-34, 95 Stat. 172, 235, 1981-2 C.B. 256, 291. Section 46(c)(8) has since been amended. See sec. 431(a), Tax Reform Act of 1984, Pub. L. 98-369, 98 Stat. 494, 805-807, 1984-3 C.B. (Vol. 1) 1, 313, 315. Finally, the validity of the purported nonrecourse loan affects the characterization of Comp-U-Med's interest in applying the at risk rules. See part IIC of this opinion infra. Thus, we must consider whether the purported nonrecourse liability (the $ 25,000 note) in this case is true debt for basis purposes.

In determining whether a purported nonrecourse liability is to be treated as a true debt for Federal tax purposes, 1986 U.S. Tax Ct. LEXIS 115">*219 the courts have used various approaches. One line of cases looks at the fair market value of the property in relation to the stated purchase price and/or the principal amount of the indebtedness. This line of cases treats a nonrecourse obligation as a true debt only if the acquired property reasonably secures payment of the obligation; where the nonrecourse obligation is not adequately secured, a purchaser would acquire no equity in the property and therefore would have no economic incentive to repay the note. Put differently, as stated by the Ninth Circuit in the leading case of Estate of Franklin v. Commissioner, 544 F. 2d at 1048:

An acquisition * * * at a price approximately equal to the fair market value of the property under ordinary circumstances would rather quickly yield an equity in the property which the purchaser could not prudently abandon. This is the stuff of substance. It meshes with the form of the transaction and constitutes a sale.

No such meshing occurs when the purchase price exceeds a demonstrably reasonable estimate of the fair market value. Payments on the principal of the purchase price yield no equity so long as the unpaid balance of the purchase price exceeds 1986 U.S. Tax Ct. LEXIS 115">*220 the then existing fair market value. Under these circumstances the purchaser by abandoning the transaction can lose no more than a mere chance to acquire an equity in the future should the value of the acquired property increase. * * *

See also Odend'hal v. Commissioner, 80 T.C. 588">80 T.C. 588, 80 T.C. 588">604-605 (1983), affd. 748 F.2d 908">748 F.2d 908 (4th Cir. 1984); Hager v. Commissioner, 76 T.C. 759">76 T.C. 759, 76 T.C. 759">773-774 (1981); Narver v. Commissioner, 75 T.C. 53">75 T.C. 53, 75 T.C. 53">98-100 (1980), affd. per curiam 86 T.C. 848">*901 670 F.2d 855">670 F.2d 855 (9th Cir. 1982); Beck v. Commissioner, 74 T.C. 1534">74 T.C. 1534, 74 T.C. 1534">1552 (1980), affd. 678 F.2d 818 (9th Cir. 1982). ³⁴

The other major approach holds that an obligation, even if 1986 U.S. Tax Ct. LEXIS 115">*221 recourse, will not be treated as a true debt where payment, according to its terms, is too contingent. See 205 Ct. Cl. 597">Denver & Rio Grande Western R.R. Co. v. United States, supra, (obligation payable at rate of 32 percent of carload freight traffic revenue after movement of 100,000 net tons per year); Lemery v. Commissioner, 52 T.C. 367">52 T.C. 367 (1969), affd. per curiam on another issue 451 F.2d 173">451 F.2d 173 (9th Cir. 1971) (obligation contingent upon business sold showing net profit); Columbus & Greenville Railway Co. v. Commissioner, 42 T.C. 834">42 T.C. 834 (1964), affd. per curiam 358 F.2d 294">358 F.2d 294 (5th Cir. 1966), cert. denied 385 U.S. 827">385 U.S. 827 (1966) (obligation to pay based on mileage of railroad lines); Albany Car Wheel Co. v. Commissioner, 40 T.C. 831">40 T.C. 831 (1963), affd. per curiam 333 F.2d 653">333 F.2d 653 (2d Cir. 1964) (obligation for severance pay -- incurred as part of acquisition of assets of predecessor corporation -- contingent upon failure to give employees notice prior to closing plant). This "contingent obligation" approach has been applied recently in tax shelter cases involving nonrecourse loans where the principal was payable out of exploitation proceeds. See, e.g., CRC Corp. v. Commissioner, 693 F.2d 281 (3d Cir. 1982), affg. 1986 U.S. Tax Ct. LEXIS 115">*222 in relevant part, revg. and remanding on other grounds Brountas v. Commissioner, 73 T.C. 491">73 T.C. 491 (1979) (payment of note contingent upon discovery of recoverable amounts of oil or gas); Brountas v. Commissioner, 692 F.2d 152">692 F.2d 152 (1st Cir. 1982), vacating and remanding on other grounds 73 T.C. 491">73 T.C. 491 (1979) (same); Gibson Products Co. v. United States, 637 F.2d 1041 (5th Cir. 1981) (same); ^{351986 U.S. Tax Ct. LEXIS 115">*224} Estate of Baron v. 86 T.C. 848">*902 Commissioner, 83 T.C. 542">83 T.C. 550-553 (note payable solely out of proceeds of record sales); Fox v. Commissioner, 80 T.C. 972">80 T.C. 1022-1023 (note payable solely out of book sale proceeds); Saviano v. Commissioner, 80 T.C. 955">80 T.C. 955 (1983), affd. 765 F.2d 643">765 F.2d 643 (7th Cir. 1985) (note payable solely out of sales proceeds of mined gold); Graf v. Commissioner, 80 T.C. 944">80 T.C. 944 (1983) (note payable solely out of profits from foreign dredging operation). The contingent liability theory is in many ways complimentary to Estate of Franklin's reasonable security approach. Fox v. Commissioner, 80 T.C. 972">80 T.C. 1020. ³⁶ Both theories represent efforts by the courts to validate from objective criteria the assumption upon which a valid nonrecourse debt (for tax purposes) is predicated -- the assumption that the obligation will 1986 U.S. Tax Ct. LEXIS 115">*223 be paid. A nonrecourse debt will be recognized for tax purposes only if it appears likely from all the facts and circumstances that the obligation will be paid.