All of the interests in leases acquired by Western Reserve were subject to landowner's royalties and overriding royalties retained by the assignors and retained in previous transactions. Where the acquisition transactions were sufficiently documented to permit a determination, the record shows that the percentage interest acquired by Western Reserve varied from 1 percent to approximately 75 percent of the working interest. As a general rule, the property covered by the leases was adjacent to or near property on which there were producing oil or gas wells.

In connection with the lease assignments, Magna and Western Reserve entered into joint agreements with the assignors ⁶ who were also drilling companies. The joint agreements committed Western Reserve to advance a stated sum of money to cover the cost of drilling one or more wells on each property. Most of the joint agreements, except1988 U.S. Tax Ct. LEXIS 78">*110 the agreement covering the Lauridson prospect, contained, among other provisions, agreements along the lines of the following between Magna, designated as purchaser, and Western Reserve, designated as nonoperator:

8.1 The lease acquired by NON-OPERATOR from PURCHASER by virtue of this Agreement shall in no case exceed twelve (12) months; and,

90 T.C. 1154">*1172 8.2 Should production be obtained by NON-OPERATOR, NON-OPERATOR shall retain solely mineral rights to those minerals so produced, for the economic life of those minerals; and,

8.3 Upon expiration of the twelve (12) months, without renewal, extension or exception, all lease rights and all privileges thereunder shall revert to PURCHASER.

At the time Western Reserve acquired its interests in the leases, no wells had been drilled on any of the properties except one. A gas well had1988 U.S. Tax Ct. LEXIS 78">*111 been drilled in the southwest corner of the Lauridson prospect in Colorado.

As noted, the Lauridson prospect was the only one acquired in 1981 and it cost $ 4,000.

By August 1, 1983, thirty-nine wells ⁷ had been drilled on properties covered by the leases in which Western Reserve acquired interests in which some oil or gas was found. The record does not show which ones, if any, of the wells possessed commercially exploitable quantities of oil or gas. At least five dry holes had been drilled by that date.

12. Relationship Between the Investors-to-Western Reserve Notes and the Western Reserve-to-Magna Notes

As stated above, each investor in Western Reserve was required to sign three long-term purportedly recourse notes1988 U.S. Tax Ct. LEXIS 78">*112 payable to Western Reserve 20, 21, and 22 years later (or 19, 20, and 21 years later, depending on the year of the investment) in the total amount of 12 times his cash investment, i.e., three $ 40,000 notes for each $ 10,000 invested. Also, it was originally contemplated that, for each year's program, Western Reserve would sign three 20-year notes payable to Magna. Each note would be in an amount equal to 4 times the amount of cash invested for the year, i.e., notes in the total amount of 12 times the year's cash investment, and would be assumed proportionately by the investors. The long-term investors-to-Western Reserve notes were purportedly used as collateral for the payment of the Western Reserve-to-Magna notes. These series of investors-to-Western Reserve and Western Reserve-to-Magna notes provided the foundation for the 12-for-1 tax deductions 90 T.C. 1154">*1173 promised investors in the promotional material described above.

Thus, it was originally contemplated that for the partnership units sold in 1981, Western Reserve would give Magna its note dated December 31, 1981, for $ 20,584,000 and would incur an obligation in the same amount for each of the 2 succeeding years. Similarly, 1988 U.S. Tax Ct. LEXIS 78">*113 for the partnership units sold during 1982, Western Reserve would have incurred an obligation of $ 38,760,000 for 1982 and each of the 2 succeeding years.

Under date of May 31, 1983, however, Phillips sent a letter to all investors modifying the tax shelter program by canceling all 24-month notes and one set of the long-term notes. The letter contained the following:

Crude oil prices have declined and the marketplace for natural gas is still unstable. (In fact very little of our gas is being purchased). These factors, coupled with the fact that we had anticipated a 4% inflation rate tied to both crude oil and natural gas prices (which did not occur) has necessitated a modification of our program in order to deliver our intended economic goals. ALL 24-MONTH NOTES HAVE BEEN CANCELLED (those notes paid solely from distributions) ALONG WITH THE LONG-TERM NOTES WHICH ACCOMPANY THEM. The CANCELLED COPIES ARE ENCLOSED for your files. By applying this technique, the equilibrium of our program will remain in balance. To adjust the rate of expected return for a $ 10,000.00 initial investment, just reduce all figures exhibited in your initial pro-forma by one-third (because the total 1988 U.S. Tax Ct. LEXIS 78">*114 investment has been reduced by one-third). The adjusted result indicates the new anticipated rate of return.

How does this affect you -- a 1981 INVESTOR. You will not receive a 4 to 1 tax write-off for 1983. You will receive ITC's; IDC's; ACRS; WINDFALL PROFITS CREDITS; and, DEPLETION PASS-THROUGHS. The significant portions of your tax benefits have been exhausted. We suggest you contact your tax advisor now.

How does this affect you -- a 1982 INVESTOR. You will receive your expected 4 to 1 tax write off for 1983. You will not receive a 4 to 1 tax write off for 1984. You will receive all other benefits available to the 1981 investor.

Notwithstanding the purported mortgage interest given to Magna by Western Reserve as security for the payment of these notes, there is no evidence of record to show that Magna agreed to the cancellation of the notes referred to in Phillips' letter of May 31, 1983.

As a result of this action, Western Reserve did not incur the purported minimum royalties obligation to Magna for 90 T.C. 1154">*1174 the third year of the 1981 and 1982 programs. The $ 59,344,000 note dated December 31, 1982, includes the second year's obligation of $ 20,584,0001988 U.S. Tax Ct. LEXIS 78">*115 with respect to the partnership units sold in 1981, plus the first year's obligation of $ 38,760,000 with respect to the partnership's units sold in 1982. The note for $ 38,760,000 represents the second year's obligation with respect to the 1982 sales of partnership units.

Consistent with those note obligations, Western Reserve claimed a deduction on its partnership returns for advance royalties of $ 20,584,000 for 1981, $ 59,344,000 for 1982, and $ 38,760,000 for 1983. Also, on the partnership return balance sheet for 1982, there are shown liabilities on mortgages and notes of $ 20,584,000 at the beginning of the year and $ 79,664,000 at the end of the year. ⁸1988 U.S. Tax Ct. LEXIS 78">*116 On the partnership return balance sheet for 1983 are shown liabilities on notes and mortgages of $ 79,644,000 at the beginning of the year and $ 118,336,000 at the end of the year. ⁹

13. Conversion of Certain Long-Term Notes to Nonrecourse Notes and Release of Related Assumption Agreements

On July 29, 1983, Brannan (on behalf of Magna), Pimco, and Phillips (on behalf of Western Reserve) signed and distributed the following agreement releasing the 1981 and 1982 limited partners from personal liability under the assumption agreement with respect to Western Reserve's notes to Magna:

By powers granted the General Partners under the Western Reserve Oil and Gas Company's Limited Partnership Agreement dated December 2, 1981, paragraph 15.4, the General Partners with the consent of Magna Energy Corporation, for good business reasons, namely: the mineral properties of the Partnership have developed to the point that they have sufficient value to support the Partnership's debt obligation to Magna Energy Corporation, and, by authority of IRS Rev. Rul. 81-283, 12/7/81 and other competent1988 U.S. Tax Ct. LEXIS 78">*117 authorities do hereby convert the twenty (20) year long-term full-recourse note obligations of the 1981 Limited Partners to 90 T.C. 1154">*1175 non-recourse; and, hereby convert the nineteen (19) year long-term full-recourse note obligations of the 1982 Limited Partners to non-recourse.

Further, Magna Energy Corporation agrees that the personal liability of the Limited Partners are [sic] no longer essential to protect Magna from loss from these obligations based upon information supplied to Magna from an independent reserve analysis report completed by the international consulting firm of R.E.M.I. on or about July 1, 1983 and MAGNA hereby releases same Limited Partners from that portion of their Assumption Agreement obligations only to the extent of the obligations caused to be converted by virtue of this notice.

By this document, Brannan released the 1981 investors from their assumption of the 1981 note in the amount of $ 20,584,000 and released the 1982 investors from their assumption of $ 38,760,000 of the 1982 note of $ 59,344,000. He did not rely upon a report dated August 1, 1983, by REMI, Petroleum Consultants, Inc. (hereinafter the REMI report), referred to in the document, to any1988 U.S. Tax Ct. LEXIS 78">*118 degree in deciding to release the investors. The REMI report referred to the total reserves underlying the listed properties, not Western Reserve's fractional interest therein. Brannan had no idea at that time whether the note would ever be satisfied out of oil and gas production from Western Reserve's then-existing leases. He signed the releases only because Mabile or Phillips or both told him the releases were needed to satisfy the "requirements" of the partnership. The record does not show expressly what he meant by "requirements" of the partnership.

At the time the releases were executed, Phillips and Mabile were not aware that the release of the assumption agreements would have adverse tax consequences for the limited partners. When Phillips learned of a Revenue Ruling which indicated that the releases would cause adverse tax consequences, Phillips attempted to withdraw the releases.

Then, under date of April 4, 1984, Phillips sent a letter to the investors which included the following:

your General Partner strongly recommends that you do not accept conversion of your 19 or 20 year long term full-recourse note even though Western Reserve has the assets to comply with Revenue Ruling 81-283.1988 U.S. Tax Ct. LEXIS 78">*119 Though only a small chance may exist that an adverse position may be taken by the Internal Revenue Service, again, we feel it is not worth the risk of recapture under Revenue Ruling 465(e). The conversion process began last year but was not completed because the assumption agreements 90 T.C. 1154">*1176 were never returned to the Partnership by Magna Energy Corporation. We currently are in the final conversion process and need you to be aware of your rights in addition to the possible tax implications of this transaction.

As always, we suggest you contact your tax advisor for guidance regarding your possible tax consequences. If you are advised to accept the risk of losing your "at risk" status under the Code, just send us a notarized letter stating you understand the possible adverse tax consequences under Revenue Ruling 465(e) and desire to retain your conversion under Revenue Ruling 81-283. No notification is required if you do not wish to take the risk of losing your deduction. You have thirty (30) days to make this election or we will take the position that you agree with your General Partner's recommendation1988 U.S. Tax Ct. LEXIS 78">*120 not to accept the conversion.

14. Abandonment Loss Claims

In amendments to the petitions, petitioners claim abandonment losses with respect to five leases on which dry holes were drilled in 1982. The claim is based on the allegation that the leases acquired in the "1981 program" ¹⁰ had an aggregate value and cost basis of $ 17,267,428 and a portion of that basis is allocable to the leases on which the dry holes were drilled. The five leases, the percentage of each lease of the "1981 program," the asserted value of the lease, and the abandonment loss claimed in 1982 are as follows:

1988 U.S. Tax Ct. LEXIS 78">*121 15. Partnership Returns

Western Reserve prepared and filed its partnership returns for 1981, 1982, and 1983 on the accrual basis using a calendar year. For 1981, the partnership return showed income of $ 6,494 (none from the production of oil and gas), total deductions of $ 20,763,397, and an overall loss of $ 20,756,903.

90 T.C. 1154">*1177 The following is a list of the deductions claimed by the partnership:

Western Reserve's partnership return for 1982 reported income of $ 5,972,074, $ 121,321 of which was gross receipts from the production of oil and gas; the cost of goods sold, shown as $ 56,488, was subtracted from the gross receipts, leaving gross profit of $ 64,833. Most of the remainder of the income was accrued interest on the limited partners' notes to Western Reserve. The return showed total1988 U.S. Tax Ct. LEXIS 78">*122 deductions of $ 65,680,899 for an overall loss of $ 59,708,825.

The deductions claimed for 1982 by the partnership on an accrual basis were as follows:

90 T.C. 1154">*1178 The return shows the partners' share of deductions included intangible drilling costs of $ 3,221,482.

Western Reserve's partnership return for 1983 shows gross receipts of $ 1,338,670 from oil and gas production, cost of goods sold of $ 1,285,018, and a gross profit from that source of $ 53,652. The cost of goods sold consisted of the following:

1988 U.S. Tax Ct. LEXIS 78">*123 The return shows total deductions of $ 47,261,096 consisting of the following:

The "Other deductions" included an item of $ 38,760,000 for "advance royalties."

At the time of the trial, Western Reserve was in the hands of a receiver, Richard Shaffer, appointed in February 1986 by Judge Consuelo Marshall of the U.S. District Court for the Central District of California. ¹¹

1988 U.S. Tax Ct. LEXIS 78">*124 In the notices of deficiency, respondent determined that the deductions claimed by petitioners were not allowable for the following reasons:

90 T.C. 1154">*1179 It is determined that the alleged losses claimed by you in your income tax return with respect to an alleged partnership known as Western Reserve Oil & Gas Company, Ltd., are not allowable because you have not established that the transactions in which the partnership was involved or in which you were involved with respect to such partnership were bona fide arm's length transactions at fair market value, that such transactions were entered into for profit, or that such transactions had any economic substance other than the avoidance of taxes.

The notices of deficiency, in addition, set forth a series of alternative grounds for disallowing the losses. Also, the notices determine that petitioners are liable for the additions to tax set forth above.

OPINION

In our findings, we have set forth a list of the deductions claimed on Western Reserve's partnership returns for 1981 and 1982, the years before the Court, and the amounts of the claimed losses. The losses were passed through the partnership to petitioners and the other limited1988 U.S. Tax Ct. LEXIS 78">*125 partners who claimed them as deductions. In addition, the partners apparently claimed as deductions their distributive share of other items. See sec. 1.702-1(a)(8), Income Tax Regs. We must decide whether the deductions are allowable. ¹²

Respondent contends that Western1988 U.S. Tax Ct. LEXIS 78">*126 Reserve was neither organized nor operated with the objective of making a profit and that the arrangement pursuant to which its activities were carried out lacked economic substance. Respondent argues that Magna was created to act as a "strawman" to provide a facade in which Western Reserve "obligated" itself to pay the "minimum royalties" in the form of promissory notes so that the limited partners, through their "assumption" of the notes, would have a basis for claiming $ 12 (or $ 8) in deductions for each $ 1 of cash they invested. See secs. 722, 752(a). The possibility that the promissory notes would be paid, respondent maintains, was so speculative 90 T.C. 1154">*1180 as to be illusory and there was never any intention that Magna would enforce either the limited partners' long-term notes to Western Reserve or the partners' alleged assumption of the Western Reserve-to-Magna notes. Consequently, respondent argues, the disputed deductions are not allowable.

Petitioners concede that the deductions of $ 20,484,000 for 1981 and $ 59,344,000 for 1982 taken by Western Reserve for advance royalties are not deductible as such because the note obligations do not meet the advance minimum royalty1988 U.S. Tax Ct. LEXIS 78">*127 requirements of section 1.612-3(b)(3), Income Tax Regs.¹³ Petitioners contend, however, that Western Reserve and its general partners acquired and developed the mineral leases with a profit objective and that there was a reasonable prospect in 1981 and 1982 that the notes would be paid and a profit would be realized. On this ground, petitioners maintain that Western Reserve was carrying on a trade or business, that petitioners' assumption of a proportionate part of the Western Reserve-to-Magna notes gave them a basis in their partnership interests sufficient to support the deductions they claimed, and that petitioners are entitled to the benefit of the claimed deductions (with the exception of the advance royalties).

1988 U.S. Tax Ct. LEXIS 78">*128 Petitioners presented their case without the testimony of Phillips and Mabile who promoted and managed this tax shelter arrangement. The Court was informed that Mabile was in Canada and refused to come to the United States and that the whereabouts of Phillips was unknown. Brannan was the only principal who testified, but his participation in Western Reserve was limited mainly to locating potentially productive mineral leases that could be acquired. 90 T.C. 1154">*1181 Petitioners attempted to fill the gap by calling as witnesses some of the individuals who marketed the partnership interests; their testimony was about as credible as some of the representations made in the promotion of the sale of Western Reserve partnership interests. Accordingly, we must decide the case, in the light of the objective facts, without the benefit of any first-hand explanation of the machinations in which Western Reserve engaged.

As we view the facts before us, we must hold for respondent. We do not think that the testimony of Phillips and Mabile would have materially aided petitioners' cause.

With the exception of the1988 U.S. Tax Ct. LEXIS 78">*129 $ 1,852,560 interest and the $ 10,952,730 abandonment loss deductions claimed in this proceeding for 1982, which will be discussed separately, each of the deductions and credits claimed by the partnership for 1981 and 1982 must meet the requirements of section 162(a) or section 167(a). Section 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a "trade or business." ¹⁴Section 167(a) allows depreciation deductions only if it is shown that the depreciable property was "used in the trade or business." Section 48(a)(1) allows investment tax credits only for property for which depreciation (or amortization) deductions are allowable. Thus, petitioner has the burden of demonstrating that Western Reserve was a "trade or business" within the meaning of sections 162(a) and 167(a). Rose v. Commissioner, 88 T.C. 386">88 T.C. 386, 88 T.C. 386">406 (1987); Beck v. Commissioner, 85 T.C. 557">85 T.C. 557, 85 T.C. 557">569 (1985).

1988 U.S. Tax Ct. LEXIS 78">*130 To demonstrate that Western Reserve's operations were a trade or business under section 162(a) and 167(a), petitioners must show that its activities were undertaken with "the actual and honest objective of making a profit." Dreicer v. Commissioner, 78 T.C. 642">78 T.C. 642, 78 T.C. 642">645 (1982), affd. without opinion 702 F.2d 1205">702 F.2d 1205 (D.C. Cir. 1983). "Profit" in this context means economic profit, independent of tax savings. Beck v. 90 T.C. 1154">*1182 , 85 T.C. 557">85 T.C. 570; Surloff v. Commissioner, 81 T.C. 210">81 T.C. 210, 81 T.C. 210">233 (1983). The determination of whether a profit objective existed must be made at the partnership level. Polakof v. Commissioner, 820 F.2d 321">820 F.2d 321, 820 F.2d 321">323 (9th Cir. 1987), affg. a Memorandum Opinion of this Court; Tallal v. Commissioner, 778 F.2d 275">778 F.2d 275, 778 F.2d 275">276 (5th Cir. 1985), affg. a Memorandum Opinion of this Court; Brannen v. Commissioner, 78 T.C. 471">78 T.C. 471, 78 T.C. 471">505 (1982), affd. 722 F.2d 695">722 F.2d 695 (11th Cir. 1984); see also Independent Electric Supply, Inc. v. Commissioner, 781 F.2d 724">781 F.2d 724, 781 F.2d 724">726 (9th Cir. 1986),1988 U.S. Tax Ct. LEXIS 78">*131 affg. a Memorandum Opinion of this Court; DePinto v. United States, 585 F.2d 405">585 F.2d 405, 585 F.2d 405">408 (9th Cir. 1978).

As we view the evidence before us, the principal objectives of the Western Reserve program were to help the investors avoid taxes and to enrich the promoters. The arrangement lacked economic substance. There was never any realistic opportunity for Western Reserve to make a profit for its investors, and we do not think there was any bona fide hope that it would do so.

(a) Emphasis of Tax Benefits

The objective of providing the investors with substantial tax benefits is shown by the promotional materials used to sell investments in Western Reserve. Those materials emphasized the tax benefits that were to be obtained by the limited partners. See Rose v. Commissioner, 88 T.C. 386">88 T.C. 386, 88 T.C. 386">415-416 (1987). Our findings contain some examples of this emphasis. The materials called attention to Mabile's former employment with the IRS and promised deductions for "minimum annual royalties" equal to $ 12 (later reduced to $ 8) for each $ 1 of cash invested as well as other deductions and credits. ¹⁵

1988 U.S. Tax Ct. LEXIS 78">*132 Because the partnership planned to adopt the accrual accounting method, the promotional materials emphasized that the partnership would not await exploration for, or production of, oil and gas to take advance minimum royalty deductions. Under the Western Reserve plan, the investors would get the promised deductions even if no oil or gas was 90 T.C. 1154">*1183 produced. The investors, who were required to be in the 50-percent income tax bracket, were thus assured by the promotional material they would save $ 6 (later reduced to $ 4) in income taxes for every $ 1 paid to Western Reserve. This was a paradigmatic case of how an investor could win even by losing. Barnard v. Commissioner, 731 F.2d 230">731 F.2d 230, 731 F.2d 230">231 (4th Cir. 1984), affg. Fox v. Commissioner, 80 T.C. 972">80 T.C. 972 (1983). "Where, as here, the promised tax benefits are suspiciously excessive and the transaction as a whole is entered into and carried out with a complete indifference to profit, it is clear what the parties intended to accomplish." Flowers v. Commissioner, 80 T.C. 914">80 T.C. 914, 80 T.C. 914">941 (1983); Patin v. Commissioner, 88 T.C. 1086">88 T.C. 1086, 88 T.C. 1086">1112 (1987),1988 U.S. Tax Ct. LEXIS 78">*133 on appeal (4th, 5th, 6th, and 9th Cirs., Jan. 25, 1988).

(b) Payments to the Promoters

The complete indifference to profit for Western Reserve is demonstrated by the provisions the promoters made for themselves. Those provisions left Western Reserve with only a fraction of any potential income from production of oil and gas with which to operate the business and deprived it of any realistic opportunity for survival.

The promoters spent a substantial amount on legal expenses, preparing and printing the promotional materials and other syndication expenses, and Western Reserve bore these expenses from the invested cash. Fifteen percent of the invested cash paid in by the limited partners and 15 percent of any payments on the 12- and 24-month notes were to go to Mabile and his associates as commissions for marketing the limited partnership interests. Also, Western Reserve was to pay Magna $ 100,000 per annum as advance royalties; this payment was used to cover Brannan's salary and expenses. Another 5 1/2 percent of the cash investments by limited partners and a similar percentage of any payments on the 12- and 24-month notes were to go to Phillips and PIMCO, purportedly as a1988 U.S. Tax Ct. LEXIS 78">*134 management fee. Pending actual use of the invested cash, it was to be placed in money market accounts, certificates of deposit, or the like, and the interest earned thereon was also to go to Phillips and Pimco.

90 T.C. 1154">*1184 In addition, if any oil or gas was produced, 30 percent of the gross receipts, not just net income, was, in addition, to go to Phillips and PIMCO. The 12- and 24-month investors-to-Western Reserve notes were to be paid from 100 percent of Western Reserve's "net cash flow" which was first to be "distributed" to the limited partners as a bookkeeping entry and then applied on their notes to Western Reserve. After the 12- and 24-month notes were paid, 50 percent of the 70 percent of all gross receipts remaining after the 30 percent distribution to Phillips, i.e., 35 percent of all gross receipts was to go to Magna as "obligatory" payments on the Western Reserve-to-Magna notes. ¹⁶ Mabile and Brannan would benefit from this 35 percent of the gross receipts because they owned Magna's stock. This arrangement gave Mabile, as owner of 95 percent of Magna's stock, a share of the gross receipts approximating $ 118 million (i.e., the total amount of the Western Reserve-to-Magna1988 U.S. Tax Ct. LEXIS 78">*135 notes). The May 31, 1983, cancellation of the 24-month notes merely hastened the day when the "obligatory" payment of 35 percent of the gross receipts to Magna would begin.

Thus, Phillips and Mabile, neither one of whom had any oil and gas business experience, took more than 20 percent (15 percent to Mabile as 1988 U.S. Tax Ct. LEXIS 78">*136 sales commissions and 5 1/2 percent to Phillips and PIMCO as fees) of the total investments by Western Reserve's limited partners, leaving less than 80 percent available for use in the business. In addition, they created a mechanism for siphoning 65 percent of the gross receipts to themselves, 30 percent to Phillips and 35 percent to Magna, until the Western Reserve-to-Magna notes in the face amount of $ 118 million were paid. This leaves only 35 percent of the gross receipts for the payment of severance taxes, all overhead, production, operating and other expenses, and any subsequent lease acquisitions and drilling expenses. Western Reserve's partnership returns for 1982 and 1983, the only years for which there was any operating 90 T.C. 1154">*1185 experience, show that the cost of goods sold alone ($ 56,488 for 1982 and $ 1,285,018 ¹⁷ for 1983) far exceeded 35 percent of the gross receipts ($ 121,321 for 1982 and $ 1,338,670 for 1983) from oil and gas production. These cost of goods sold figures do not include the long list of deductions shown in our findings.

1988 U.S. Tax Ct. LEXIS 78">*137 We think it inconceivable that any organizers of a new oil and gas business with a bona fide profit objective would begin by taking out for themselves more than 20 percent of the capital and arranging to siphon off for themselves 65 percent of the gross receipts for their own benefit. See Polakof v. Commissioner, 820 F.2d 321">820 F.2d at 324. This arrangement, leaving Western Reserve with only 35 percent of its gross receipts with which to pay all future operational and capital costs, deprived the venture of any reasonable prospects of realizing a profit for the investors.

(c) Western Reserve's Notes to Magna

Petitioners point to Western Reserve's multi-million-dollar notes to Magna to show that the partners had a cost basis evidenced by bona fide obligations to support the claimed deductions. Petitioners assert that these recourse notes, purportedly assumed by the investors, were given in good faith to Magna as consideration for both the assignment of the oil and gas leases and Magna's expert assistance and counsel in the management and operation of Western Reserve's business. Under this theory, petitioners contend that the notes reflect Western Reserve's1988 U.S. Tax Ct. LEXIS 78">*138 cost of the leases and that, if we understand their position, the limited partners' assumption of their respective shares of the notes establish a basis for the partners' claimed losses. See secs. 722, 752(a). ¹⁸ We do not agree.

90 T.C. 1154">*1186 1988 U.S. Tax Ct. LEXIS 78">*139 We are fully aware of the long line of decisions of this Court and other courts that have dealt with bona fide long-term recourse notes assumed by limited partners. In those cases, the courts have given credence to recourse notes as a basis for supporting claimed losses or establishing section 465 "at risk" amounts. See, e.g., Pritchett v. Commissioner, 827 F.2d 644">827 F.2d 644 (9th Cir. 1987), revg. and remanding 85 T.C. 580">85 T.C. 580 (1985) (at risk under sec. 465); Follender v. Commissioner, 89 T.C. 943">89 T.C. 943 (1987) (at risk under sec. 465; partnership's basis); Melvin v. Commissioner, 88 T.C. 63">88 T.C. 63, 88 T.C. 63">75 (1987) (at risk under sec. 465); Abramson v. Commissioner, 86 T.C. 360">86 T.C. 360 (1986) (partnership's basis; at risk under sec. 465).

In all of those cases, however, the recourse notes were given to independent third parties whose interests did not necessarily coincide with those of the note makers. Those cases did not involve, as does the instant case, transactions between two organizations created to carry out a tax shelter scheme, notes given for amounts having no1988 U.S. Tax Ct. LEXIS 78">*140 relationship to economic reality, or notes which almost certainly would not be paid. See Goldstein v. Commissioner, 364 F.2d 734">364 F.2d 734, 364 F.2d 734">740-741 (2d Cir. 1966), affg. 44 T.C. 284">44 T.C. 284 (1965); Durkin v. Commissioner, 87 T.C. 1329">87 T.C. 1329, 87 T.C. 1329">1376-1377 (1986); Waddell v. Commissioner, 86 T.C. 848">86 T.C. 848, 86 T.C. 848">902 (1986), affd. 841 F.2d 264">841 F.2d 264 (9th Cir. 1988); Houchins v. Commissioner, 79 T.C. 570">79 T.C. 570, 79 T.C. 570">589-590 (1982).

In the instant case, we are convinced, as stated above, that the purportedly recourse Western Reserve-to-Magna notes served merely as a facade for the support of the tax benefits promised the investors and as a vehicle for the transfer of 35 percent of Western Reserve's gross receipts to Magna. The possibility that the notes would be repaid was illusory. We base our findings on the totality of several factors.

First, Magna was not an independent unrelated third party but was an essential element of the tax shelter team. The notes to Magna were needed to provide part of the predicate for the promised $ 12 (later $ 8) in tax deductions1988 U.S. Tax Ct. LEXIS 78">*141 for each $ 1 invested by the limited partners. Without the 90 T.C. 1154">*1187 Western Reserve-to-Magna notes or the related notes of the investors, there would have been no ground for claiming such dramatic tax benefits.

Brannan testified that he suggested to Mabile that the leases be acquired in a "one-to-one oil and gas setup" but Mabile explained to him, in substance, that the leases had to go through a second company in order to meet the "requirements" of the partnership. The clear inference is that by "requirements" Mabile meant requirements for the tax benefits.

Second, the amounts of the notes bore no relationship to the value of the leases Western Reserve acquired. Brannan testified, in substance, that the leases cost an average of $ 10,000 to $ 12,000 each. During the 3 years, 1981, 1982, and 1983, Magna acquired interests in 25 leases for an amount, computed under Brannan's estimate, of some $ 250,000 to $ 300,000 and then assigned them to Western Reserve. Yet Western Reserve not only paid the drilling company-sublessors for the leases but then at the end of the year gave Magna its multi-million-dollar notes. Magna paid the assignor-sublessors nothing. In fact, on December1988 U.S. Tax Ct. LEXIS 78">*142 31, 1981, when Western Reserve signed the first $ 20,584,000 note, Western Reserve had acquired only one lease, the Lauridson lease in Colorado, and it cost only $ 4,000.

The amounts of the notes were not negotiated in relation to the value of the leases. The first offering memorandum issued nearly 6 months before any leases were acquired stated that the amounts of the notes were to be keyed to the amounts of the cash invested by the limited partners, not to the value of the leases. See Rose v. Commissioner, 88 T.C. 386">88 T.C. 386, 88 T.C. 386">417-419 (1987). The amount of the notes thus could not be fixed until Mabile and his sales force turned in their reports on the total amounts invested at the end of each year. See Independent Electric Supply Co. v. Commissioner, 781 F.2d 724">781 F.2d 724, 781 F.2d 724">728 (9th Cir. 1986), affg. a Memorandum Opinion of this Court. In fact, when the 1982 $ 59,344,000 note was executed, which included the second $ 20,584,000 obligation for the 1981 program, petitioners now allege that more than 62 percent of the 1981 program, as discussed below, had allegedly been abandoned.

90 T.C. 1154">*1188 Third, the form of the three Western Reserve-to-Magna1988 U.S. Tax Ct. LEXIS 78">*143 long-term notes is foreign to the business world. The principal of each of the three notes is due and payable within 20, 20, and 18 years, respectively. ¹⁹ The notes provide for the payment of simple interest on the principal amount "at nine (9%) percent per annum, non-cumulative, payable on December 31, 2001," 2002, and 2002, respectively. The term "non-cumulative" is not explained in the record. As we interpret the notes, however, the interest portion is nonrecourse except for the interest in the year in which payment is made.

Fourth, the agreements whereby each limited partner assumed his proportionate share of the Western Reserve-to-Magna notes recites that the agreement was made "to induce MAGNA to finance1988 U.S. Tax Ct. LEXIS 78">*144 the acquisition price" of the leases to be acquired. The undisputed facts are that Magna had no capital or other funds with which to finance the acquisition of leases and, as stated above, all the leases were paid for directly by Western Reserve, not Magna. This stated justification for the notes thus has no factual basis.

Finally, the release on July 29, 1983, by Magna and Western Reserve of the investors from their assumptions of proportionate shares of Western Reserve's notes to Magna was prearranged and engineered by Phillips and Mabile. In promotional material distributed by Mabile and his associates in December 1981, quoted in part in our findings, it was explained that "the ONLY way you may get a larger deduction than your cash invested is if you combine CASH & RECOURSE NOTES," pointing out that the offering memorandum clearly states that "the notes will be liquidated FROM PRODUCTION ONLY." The assumption agreements themselves expressly authorize Magna "to release or substitute any one or more endorsers or guarantors without affecting the liability of the Partnership."

In keeping with the foregoing authorization, Western Reserve and Magna on July 29, 1983, released the limited1988 U.S. Tax Ct. LEXIS 78">*145 partners from their personal liability on their assumption agreements and converted the 20-year notes for 1981 and 90 T.C. 1154">*1189 the 19-year notes for 1982 to nonrecourse notes. The release stated that it was given because the partnership's reserves "had sufficient value to support the partnership's debt obligations." Yet less than 2 months previously, on May 31, 1983, Phillips canceled the 24-month investors-to-Western Reserve notes and the accompanying long-term notes, one-third of the whole program, because, he stated, crude oil prices had declined and the natural gas could not be sold. Brannan testified that he agreed on behalf of Magna to release the partners from liability under their assumption agreements because Mabile or Phillips or both assured him this was the thing to do under the requirements of the partnership. Brannan admitted that the REMI report, cited as justification for the release, contained estimates of all the reserves underlying the leases, not the fractional interests acquired by Western Reserve. On learning that the limited partners' release could cause them to suffer adverse tax consequences, Phillips attempted unilaterally to rescind the releases and reinstate1988 U.S. Tax Ct. LEXIS 78">*146 the assumption agreements. ²⁰ He later sent a letter dated April 4, 1984, to the investors informing them of the adverse consequences and suggesting that, for tax reasons, they decline to accept the releases.

1988 U.S. Tax Ct. LEXIS 78">*147 This kind of bizarre behavior is not characteristic of the business world. It serves only to emphasize that the notes were a tax shelter facade and that there was never any intention to enforce them or the assumption agreements. The notes and assumption agreements had no practical economic effect other than the creation of tax losses. Sochin v. Commissioner, 843 F.2d 351">843 F.2d 351 (9th Cir. 1988), affg. Brown 90 T.C. 1154">*1190 , 85 T.C. 968">85 T.C. 968 (1985); Neely v. United States, 775 F.2d 1092">775 F.2d 1092, 775 F.2d 1092">1094 (9th Cir. 1985); Thompson v. Commissioner, 631 F.2d 642">631 F.2d 642, 631 F.2d 642">646 (9th Cir. 1980), affg. 66 T.C. 1024">66 T.C. 1024 (1976). Western Reserve and Magna, the payor and payee of the notes, moved in lock step to attempt to enrich Phillips and Mabile and to attempt to provide the investors with the tax benefits Phillips and Mabile had promised. The Western Reserve-to-Magna notes do not establish a basis for supporting the disputed deductions.

As to petitioners' contention that Magna was to provide assistance and counsel on Western Reserve's operations, Magna had no resources1988 U.S. Tax Ct. LEXIS 78">*148 with which to do that. The oil and gas business requires the exercise of judgments on geophysical, production, engineering, transportation, and a host of other specialized business considerations. Magna had only two regular employees, Brannan and a secretary. The record does not show that Brannan had any experience that qualified him to provide Phillips with needed guidance. He had a degree in geology but he had operated a land title business for 25 years. His work gave him access to drillers who had promising leases, and he helped Western Reserve acquire such leases from several drilling companies. He obviously knew more about the oil and gas business than Phillips, but the record does not show that he was qualified to provide any substantial advice on operations or that it was intended that he do so.

(d) The Excessiveness of the Western Reserve-to-Magna Notes

Despite the facts that the amounts of the Western Reserve-to-Magna multi-million-dollar notes were determined pursuant to a formula announced in the offering memorandum, petitioners make a valiant effort to show that Western Reserve somehow came up with leases with underlying reserves of oil and gas sufficient to1988 U.S. Tax Ct. LEXIS 78">*149 produce enough income over the productive life of the leases to pay the Western Reserve-to-Magna notes in full and give the limited partners a large profit on their investments. Petitioners' computations indicate profit of $ 70 million on the 1981 investments and $ 162 million on their 1982 investments.

90 T.C. 1154">*1191 After discounting the potential income figures, petitioners contend that the values of the leases when acquired were $ 17,267,428 for the 1981 program and $ 57,079,448 for the 1982 program. These values are only a few million dollars less than the face amounts of the 1981 and 1982 Western Reserve-to-Magna notes. Compare Milbrew, Inc. v. Commissioner, 710 F.2d 1302">710 F.2d 1302, 710 F.2d 1302">1307 (7th Cir. 1983), affg. a Memorandum Opinion of this Court. We agree with respondent that petitioners' valuation and projected income figures are unrelated to reality.

Petitioners' valuation of the leases based on estimated reserves and a discounted cash-flow overlooks the fact that fair market value even "for a producing [oil and gas] property is not a unique value that may be derived by solving equations. It is rather a subjective estimate reflecting the expectations of1988 U.S. Tax Ct. LEXIS 78">*150 the buyer and seller at the time of any trade." ²¹ Accordingly, "when two parties dealing at arm's length assign a certain value to property being sold, and when that value has economic significance to each of the parties, the value assigned by the parties is very persuasive evidence of its fair market value." Narver v. Commissioner, 75 T.C. 53">75 T.C. 53, 75 T.C. 53">97 (1980), affd. 670 F.2d 855">670 F.2d 855 (9th Cir. 1982); Elmhurst Cemetery Co. v. Commissioner, 300 U.S. 37">300 U.S. 37, 300 U.S. 37">39 (1937).

Beginning in December 1981 and continuing through at least part of 1983, Brannan on behalf of Magna negotiated the acquisition of Western Reserve's leases1988 U.S. Tax Ct. LEXIS 78">*151 from third-party owners. He negotiated the acquisitions in arm's-length transactions with drilling companies that had no previous business connection with Western Reserve. According to Brannan, the leases cost an average of $ 10,000 to $ 12,000; ²² on this basis, the total amount paid for the leases would fall between $ 250,000 to $ 300,000, a tiny fraction of the total 90 T.C. 1154">*1192 amount of the Western Reserve-to-Magna notes. We find that these lease costs approximate the value of the leases.

We are aware that Magna, Western Reserve, and the drilling company-assignors entered into joint agreements or exploration agreements when the lease assignments were made. In these agreements, Western Reserve1988 U.S. Tax Ct. LEXIS 78">*152 obligated itself to advance money needed for drilling wells on the leases. Because the assignors obtained drilling contracts as parts of the deals, petitioners argue that the assignors may have been willing to part with the leases at a lower price than the assignors would have demanded in transactions not coupled with drilling contracts. The record contains no information whatever on how much the accompanying drilling contracts influenced the lease prices if they did so at all. Nonetheless, the direct cost of the lease assignments plus the full amount of Western Reserve's intangible drilling costs ²³ during 1982 and 1983 still represent only a small fraction of the lease values now advocated by petitioners. ²⁴

1988 U.S. Tax Ct. LEXIS 78">*153 Even if we disregard the contemporaneous transactions in which Western Reserve acquired the leases, we think petitioners' valuations are grossly excessive. In making their projections of the potential cash-flow from the leases, petitioners used (a) the amounts of the reserves underlying the leases set forth in a report prepared by an IRS petroleum engineer, (b) the future prices of oil and gas shown in an Annual Report to Congress issued by the U.S. Department of Energy, Energy Information Administration, in 1980 (hereinafter the 1980 Department of Energy report), and (c) the projected drilling and production costs used by the IRS petroleum engineer. After applying various discounts, 90 T.C. 1154">*1193 petitioners treat the discounted revenue figure as the value of the leases.

Using this formula, petitioners, as noted above, arrive at the values of $ 17,267,428 for the 1981 program leases and $ 57,079,448 for the 1982 program leases. These figures compare with values computed by the IRS petroleum engineer, using prices of $ 30 to $ 34 per barrel for oil, of $ 1,418,000 and $ 3,552,000 for the 1981 and 1982 program leases, respectively.

We are far from convinced that the IRS petroleum engineer's1988 U.S. Tax Ct. LEXIS 78">*154 cost figures are reliable. They do not appear to take into full account the eventual necessity for reworking wells when production lags, for replacing depreciated or obsolete equipment over the years, paying overhead and other expenses, and the like. It must be remembered that all of those costs would have to be paid from the 35 percent of gross receipts to be retained by Western Reserve after the 12- and 24-month (later only the 12-month) notes were paid.

Nor are we convinced that the estimates of reserves of oil and gas underlying the leases have much validity. As we understand the estimates, the engineer resolved every doubt in favor of the maximum possible reserves and assumed every possible well would be drilled. He based his estimates not on a reasoned analysis of available geologic and geophysical data but largely on oral conversations with drilling company representatives without any apparent consideration of their motives, the reliability of their judgments, or their possible perennial optimism. Further, it is not clear whether those conversations distinguished between estimated reserves and estimated recoverable and marketable reserves.

In other words, we have1988 U.S. Tax Ct. LEXIS 78">*155 before us no knowledgeable analysis of the available geologic and geophysical data on the oil and gas recoverable and marketable ²⁵ from the leases. Nonetheless, respondent accepts the engineer's report, and we fully understand why petitioners eagerly embrace the report's cost and reserve figures. In these 90 T.C. 1154">*1194 circumstances, notwithstanding our own reservations, we proceed to examine the income projections on the assumption that the reserve estimates and cost figures have some factual foundation.

Even making that assumption, we think petitioners' estimates of projected income are grossly flawed. Apart from the absence of any objective analysis of recoverable and marketable reserves or any realistic consideration of costs of future production, 1988 U.S. Tax Ct. LEXIS 78">*156 we do not think the 1980 Department of Energy report can appropriately be used to project the reasonably expected income from Western Reserve's leases. The following table taken from that report shows the oil price "forecasts" for 1980 to 1995 in mid-1979 dollars and in nominal dollars:

Stated generally, petitioners' experts applied these price "forecasts" to the reserves and costs determined by the IRS petroleum engineer and then made various discounts on a variety of assumptions in reams and reams of computation tables.

The 1980 Department of Energy report was based on mid-1979 and earlier price figures and was prepared during the world energy crisis of the late 1970's. That crisis was produced mainly by the Iranian Revolution and the related oil embargo. In a sense, the report presented a worst-case scenario as of the period when it was in preparation. The difference between1988 U.S. Tax Ct. LEXIS 78">*157 the mid-1979 and the nominal dollar figures shown in the above table demonstrates the rapidly escalating inflation rate during the late 1970's which, by 1981 and 1982, was already being dealt with by the Federal Reserve Board and other Government agencies. The report 90 T.C. 1154">*1195 was neither used by, nor intended to be used by, businessmen as a basis for business decisions. ²⁶

1988 U.S. Tax Ct. LEXIS 78">*158 The first of Western Reserve's lease acquisitions occurred in December 1981; thirteen of the 25 lease acquisitions occurred as late as March 1, 1983. By these dates, the price of oil had already fallen from its 1980 price of $ 37.24 per barrel and it continued to fall. ²⁷ The Department of Energy representative, called by petitioners to explain the report, admitted that by the time the Department's next report, the 1981 report, which was published in March 1982, before most of Western Reserve's lease acquisitions occurred, the assumptions underlying the 1980 report were "somewhat dated." Asked how much difference there was in the price forecasts in the 1980 and 1981 report, the representative replied:

It was probably several dollars a barrel difference. * * * The world was starting to change by then, and these reports, like everybody else's reports, tend to reflect some of those changes that are going on on a year-to-year basis.

1988 U.S. Tax Ct. LEXIS 78">*159 The record is abundantly clear, moreover, that Western Reserve's representatives either did not know of, or did not rely on, the 1980 Department of Energy report in planning Western Reserve's lease acquisitions. The report was not considered in making any business judgments for Western Reserve. Several items of promotional material in evidence 90 T.C. 1154">*1196 computed projected income from Western Reserve's proposed operations by using a price of $ 34 per barrel and assuming that oil prices would increase 4 percent annually. The letter to investors transmitting petitioner Ferrell's canceled 24-month and the related long-term notes, dated May 31, 1983, quoted in part in our findings, stated that "Crude oil prices have declined and the marketplace for natural gas is still unstable. (In fact very little of our gas is being purchased.)" That May 31, 1983, letter was written only a few weeks after Western Reserve made 13 of the 25 lease acquisitions on March 1, 1983.

Finally, we have the anomalous situation of petitioners' claiming, as an alternative to their now-conceded advance minimum royalties deductions, abandonment losses for 1982 with respect to five leases, the E. Miller, LeBlanc, 1988 U.S. Tax Ct. LEXIS 78">*160 DuPont #1, H. Thompson, and Cavasos prospects. All of these prospects were acquired on June 1, 1982, and allegedly abandoned before the end of that year. According to petitioners, these leases constituted more than 62 percent (or approximately $ 10,950,000) of the alleged $ 17,267,428 value of the so-called 1981 program, i.e., the leases acquired with cash invested in 1981 by the limited partners. We think this position on the amount of the abandonment losses alone demonstrates that the values advocated by petitioners are in no way related to reality. The value of the leases approximated what Western Reserve paid the assignor-drillers for them.

(e) The Limited Partners' Notes to Western Reserve

Petitioners rely to some extent on the purportedly recourse notes the investors were required to sign on entering Western Reserve to show the investments had economic substance. ²⁸ To become a Western Reserve limited partner, an investor was required, as a minimum, to pay Western Reserve $ 10,000 in cash, execute 12- and 24-month nonrecourse notes for $ 10,000 each, and execute three long-term recourse notes of $ 40,000 each payable no later 90 T.C. 1154">*1197 than 19, 20, and 21 years 1988 U.S. Tax Ct. LEXIS 78">*161 (or 20, 21, and 22 years, depending on the year of the investment) after they were signed. The nonrecourse notes were to be paid from production income. The long-term notes, purportedly recourse on their face, could, petitioners argue, have been enforced. As security for the Western Reserve-to-Magna notes, Western Reserve purportedly gave Magna something in the nature of a mortgage on all of the investors-to-Western Reserve notes along with its other assets.

We do not think, however, that there was any intention to enforce the payment of any of the long-term, purportedly recourse notes. The promotional material, quoted in our findings, repeatedly explains that1988 U.S. Tax Ct. LEXIS 78">*162 the notes were required to be recourse obligations for tax reasons. Those same materials also repeatedly state that the notes will be paid from production income.

Moreover, as stated in our findings, under date of May 31, 1983, Phillips unilaterally canceled the 24-month notes "along with the long-term notes which accompany them." The only justification for the cancellation was the decline in crude oil prices and difficulties in selling natural gas. Even accepting petitioners' argument that the cancellation related only to one set of the long-term notes, this unilateral recision of at least one-third of the anticipated capital contributions is further evidence that there was no intention to enforce the notes.

Finally, article 10.5 of the partnership agreements, quoted in our findings, authorizes limited partners, after paying $ 10,000 cash contributions and giving long-term notes, to elect to terminate future obligations due in 1982, 1983, and 1984 and 21 and 22 years after formation of the partnership. All the partner needed to do was to notify the general partner no later than November 1 of the year of the election.

Petitioners argue that this cancellation provision applies only1988 U.S. Tax Ct. LEXIS 78">*163 if the limited partner first files for bankruptcy. We do not agree. It is true that the first part of article 10.5 gives each limited partner an option to require the general partner to purchase his interest in the partnership "if the Limited Partner files for bankruptcy." As we read the article as a whole, however, that option and the procedure for the 90 T.C. 1154">*1198 partners' withdrawal by termination of a partner's future obligations on the note are separate provisions. In our findings, we have quoted Phillips' understanding of the provision, and he was a party to the agreement. In substance, his view, consistent with our own, was that the provision authorized the cancellation of the notes if notice was given before November 1 of the year of the cancellation. A note that can be renounced in this manner obviously has no economic substance.

(f) Conclusion

In summary, Western Reserve's machinations were carried out for the purposes of enriching Phillips and Mabile, the promoters, who had no oil and gas business experience, and providing tax deductions for petitioners and the other investor-limited partners. The Western Reserve activities served no other substantial commercial, 1988 U.S. Tax Ct. LEXIS 78">*164 legal, or profit objectives. We recognize that oil and gas exploration is speculative and large profits can be realized from a bona fide oil and gas venture, that Congress has enacted various tax measures (e.g., intangible drilling costs and percentage depletion provisions) to encourage oil and gas exploration, and that the Western Reserve promotional material included representations on potential profits. The manner in which the Western Reserve transactions were structured and carried out, however, demonstrates that any profit motive was subordinate or incidental. The investors merely bought tax shelters. Because it has not been shown that the promoters' and the general partners' objective was to make a profit, Western Reserve was not engaged in a trade or business, and the claimed deductions turning on section 162(a) and 167(a) are not allowable. Polakof v. Commissioner, 820 F.2d 321">820 F.2d 321, 820 F.2d 321">323 (9th Cir. 1987), affg. a Memorandum Opinion of this Court; Independent Electric Supply, Inc. v. Commissioner, 781 F.2d 724">781 F.2d 724, 781 F.2d 724">726 (9th Cir. 1986), affg. a Memorandum Opinion of this Court; DePinto v. United States, 585 F.2d 405">585 F.2d 405, 585 F.2d 405">408 (9th Cir. 1978).1988 U.S. Tax Ct. LEXIS 78">*165

We have reached the foregoing conclusion that the general partners and promoters of Western Reserve did not have a bona fide profit purpose in the light of objective facts. Basically, those same objective facts show that the 90 T.C. 1154">*1199 Western Reserve transactions "are devoid of economic substance consonant with their intended tax effects." Rose v. Commissioner, 88 T.C. 386">88 T.C. 415. That the Western Reserve and Magna activities had no practical economic effect other than the creation of tax losses is demonstrated by Western Reserve's gratuitous execution of the multi-million-dollar notes to Magna at the end of each year, purportedly as consideration for leases it had already bought and paid for; the absence of any relationship between the amounts of those notes, fixed in advance, and the value of the leases; the practical fact that the Western Reserve-to-Magna notes, the key to the tax benefits, would never be paid; the arrangements for siphoning off to Phillips and Mabile, directly or indirectly, all except 35 percent, up to $ 118 million, of the gross receipts (not just net income) from oil and gas production which, the experience for 1982 and 1983 shows, 1988 U.S. Tax Ct. LEXIS 78">*166 would not have permitted the long-term economic survival of Western Reserve; and the on-again-off-again treatment of the investors' assumptions of the multi-million-dollar notes as well as the investors' notes to Western Reserve. A transaction entered into for tax benefits without any objective prospect of producing a profit apart from those benefits will not be given effect for tax purposes. Frank Lyon Co. v. United States, 435 U.S. 561">435 U.S. 561, 435 U.S. 561">573 (1978); Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89">752 F.2d 89, 752 F.2d 89">91-92 (4th Cir. 1985), affg. in part, revg. in part, and remanding 81 T.C. 184">81 T.C. 184 (1983); Patin v. Commissioner, 88 T.C. 1086">88 T.C. 1086, 88 T.C. 1086">1116 (1987), on appeal (4th, 5th, 6th, and 9th Cirs., Jan. 25, 1988); Beck v. Commissioner, 85 T.C. 557">85 T.C. 557, 85 T.C. 557">569 (1985). Petitioners are not entitled to the claimed deductions.

Western Reserve deducted under section 163(a), ²⁹ for 1982, $ 1,852,560 as an accrued interest expense. The deduction was based on the 1981 Western Reserve-to-Magna1988 U.S. Tax Ct. LEXIS 78">*167 90 T.C. 1154">*1200 note of $ 20,584,000. That note calls for simple, noncumulative interest of 9 percent per annum.

An interest deduction is allowable only with respect to genuine indebtedness. Estate of Franklin v. Commissioner, 544 F.2d 1045">544 F.2d 1045, 544 F.2d 1045">1049 (9th Cir. 1976), affg. 64 T.C. 752">64 T.C. 752 (1975); Odend'hal v. Commissioner, 80 T.C. 588">80 T.C. 588, 80 T.C. 588">604-605 (1983), affd. on this issue 748 F.2d 908">748 F.2d 908 (4th Cir. 1984). In our foregoing discussion, we have found that the Western Reserve-to-Magna notes were not genuine indebtedness but were a facade to provide support for tax deductions. The interest deduction is not, therefore, allowable.

Petitioners argue that the five leases listed in our findings, with respect to which abandonment1988 U.S. Tax Ct. LEXIS 78">*168 losses are claimed, became worthless in 1982. Petitioners compute the total value of the "1981 program" to be $ 17,267,428. The five leases claimed to have been abandoned, according to petitioners, constituted approximately 63 percent of the value of the 1981 program. On that ground petitioners claim an abandonment loss of over $ 10,952,730.

This deduction is not allowable for several reasons. All five leases on which petitioners base their claim were acquired on June 1, 1982. The agreements between Magna and Western Reserve authorized Western Reserve to drill at any time within 1 year. True, a dry hole was struck on each of these leases in 1982, but that did not prevent further drilling until June 1, 1983, five months after the close of the year. To be entitled to an abandonment loss, a taxpayer must show "an intention to abandon the property, coupled with an act of abandonment." Massey-Ferguson, Inc. v. Commissioner, 59 T.C. 220">59 T.C. 220, 59 T.C. 220">225 (1972); see also Brountas v. Commissioner, 692 F.2d 152">692 F.2d 152, 692 F.2d 152">162 (1st Cir. 1982), and CRS Corp. v. Commissioner, 693 F.2d 281">693 F.2d 281, 693 F.2d 281">283-284 (3d Cir. 1982), both1988 U.S. Tax Ct. LEXIS 78">*169 revg. on other grounds Brountas v. Commissioner, 73 T.C. 491">73 T.C. 491 (1979). There is no showing that Western Reserve released any of its rights in 1982, that any leases expired in 1982, or that any judgment was made that the leases on which the dry holes were drilled were worthless and would be abandoned. Therefore, petitioner has failed to show that 90 T.C. 1154">*1201 the leases were abandoned during the tax year for which the loss is claimed.

Further, in the foregoing discussion, the Court has held that the Western Reserve-to-Magna notes were not genuine indebtedness but were executed for tax purposes. The arrangement in which the leases were acquired lacked economic substance. The transactions do not, therefore, establish that Western Reserve had any basis in the properties which would support the claimed abandonment losses.

Section 6653(a)(1) provides for the imposition of a 5-percent addition to tax if any part of any underpayment of tax is due to negligence or intentional disregard of the revenue1988 U.S. Tax Ct. LEXIS 78">*170 laws. Section 6653(a)(2) provides for a further addition to tax in the form of additional interest with respect to the portion of any such underpayment attributable to negligence or disregard of the laws. Negligence under the section is defined as a lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances. Neely v. Commissioner, 85 T.C. 934">85 T.C. 934, 85 T.C. 934">937 (1985).

Any tax scheme promising tax savings equal to 12 times the amount invested, as did this one, would raise doubts in the mind of any prudent investor intending to comply with the tax laws. Cf. Hanson v. Commissioner, 696 F.2d 1232">696 F.2d 1232, 696 F.2d 1232">1234 (9th Cir. 1983), affg. per curiam a Memorandum Opinion of this Court. Yet there is no evidence that petitioners sought the unbiased advice of competent tax lawyers or accountants before making their Western Reserve investments and claiming the deductions.

Petitioner Ferrell admitted that he invested in Western Reserve at least in part for its income tax advantages at the suggestion of his tax return preparer, Henry Vierregger. Although Vierregger denied he received a commission1988 U.S. Tax Ct. LEXIS 78">*171 for placing Western Reserve investments, he admitted that he suggested it as an investment for a number of his clients. In his testimony, he denied that he had advised Ferrell to 90 T.C. 1154">*1202 make the investment. He attempted to leave the impression that he had analyzed the Western Reserve prospectus. His testimony showed that he was, in general, familiar with the broad outlines of the Western Reserve scheme. However, his tax research apparently consisted of a telephone call to Mabile who assured him "he had taken pains to make sure that Western Reserve complied with all interpretations of the law at that time." Vierregger knew little, if anything, about the economics of the precise arrangements for the Western Reserve operations.

Petitioner Crowder did not testify at the trial. Mr. Crowder's business manager, Clark Lilly, sold Mr. Crowder the Western Reserve units. Lily testified that he learned of Western Reserve from Mabile who described himself as a "tax shelter specialist." He testified that Mabile "marched me through the Code and showed me why it was good, legitimate." Lily admitted that he did nothing to verify the accuracy of Mabile's representations. Lily placed Western1988 U.S. Tax Ct. LEXIS 78">*172 Reserve investments with other clients of his as well as Mr. Crowder and received compensation from "Terry Mabile & Associates" for the investments he placed.

Petitioners Woltman made their Western Reserve investment through Garry Gorman who placed similar investments with other clients. In 1981, Gorman sold Western Reserve investments to approximately 50 clients (earning $ 50,000 to $ 75,000 in commissions) and from 75 to 100 clients in 1982 (earning commissions of approximately $ 200,000). He also sold 100 to 125 interests in the 1983 Western Reserve Oil & Gas Co., Ltd., another Phillips-sponsored tax shelter, earning "in the neighborhood of a couple hundred thousand, approximately." There is no evidence that the Woltmans consulted any reputable advisor on the tax consequences or economics of their investments or took any other reasonable steps to determine whether the Western Reserve deductions were allowable.

Petitioners have not carried their burden of showing that, within the meaning of section 6653(a)(1) and (2), they were not negligent or did not intentionally disregard the revenue laws in claiming the deductions in dispute.

90 T.C. 1154">*1203 5. Petitioners' Understatements of1988 U.S. Tax Ct. LEXIS 78">*173 Tax Were Not Attributable to a Valuation Overstatement Within the Meaning of Section 6659

Respondent determined that petitioners' underpayment of tax was attributable to a "valuation overstatement" within the meaning of section 6659. ³⁰ That section provides for an addition to tax up to 30 percent of the tax underpayment where there is an underpayment of income tax that is attributable to a valuation overstatement with respect to property or the adjusted basis of property on any return. Under section 6659(c), a valuation overstatement occurs where the claimed value of property or its adjusted basis is 150 percent or more of the value or adjusted basis that is "determined to be correct." The section applies with respect to returns filed after December 31, 1981. Nielsen v. Commissioner, 87 T.C. 779">87 T.C. 779 (1986). The section, therefore, covers both 1981 and 1982, the years before the Court.

1988 U.S. Tax Ct. LEXIS 78">*174 To support the addition to tax, respondent relies upon the advance minimum royalty deductions, now conceded by petitioners, claimed on the 1981 and 1982 partnership returns in the amounts of $ 20,484,000 and $ 59,344,000, respectively. Respondent argues that minimum royalty expenditures are capital in nature and that absent Western Reserve's election pursuant to section 1.612-3(b)(3), Income Tax Regs., the partnership would have been required to capitalize the minimum royalty notes. The cost of acquiring the leases shown in this capital account, according to 90 T.C. 1154">*1204 respondent, would have been its stated basis for the lease. Because the face amount of the royalty notes exceeded the value of the property by more than 150 percent, respondent argues the section 6659 addition to tax must be imposed.

We think respondent's argument misconceives the nature of an advance minimum royalty interest. "A royalty interest, for Federal tax purposes, is a right to oil and gas or minerals in place that entitles its owner to a specified fraction, in kind or in value, of the total production from the property, free of expense of development and operation." C. Russell & R. Bowhay, Income Taxation1988 U.S. Tax Ct. LEXIS 78">*175 of Natural Resources, sec. 2.03 (1988); Getty Oil Co. v. United States, 185 Ct. Cl. 244">185 Ct. Cl. 244, 185 Ct. Cl. 244">249-250, 399 F.2d 222">399 F.2d 222, 399 F.2d 222">225 (1968). "An advance or minimum royalty represents a production royalty paid in advance. It usually takes the form of advance minimum royalties to encourage the lessee to begin production as quickly as possible." See C. Russell & R. Bowhay, supra, sec. 18.22. An advance minimum royalty is recoupable out of future royalties. Sec. 1.612-3(a) and (b), Income Tax Regs.

As we have discussed above, the amounts of the Western Reserve-to-Magna notes, which purported to be payments of advance minimum royalties, were four times the amounts of the cash paid to Western Reserve by the limited partners. The amounts of the notes thus were not dependent on the value of the leases. Western Reserve's minimum royalty deductions were subject to disallowance on a variety of grounds including the absence of a trade or business, the lack of economic substance in the whole transaction, and the failure of Magna to retain an economic interest in the minerals in place. None of these grounds, however, turned on the value or overvaluation of1988 U.S. Tax Ct. LEXIS 78">*176 the leases. We think the value or basis of the leases is too tangentially related to the now conceded advance minimum royalty deductions to support the imposition of the section 6659 additions to tax.

Section 6661(a) ³¹ imposes an addition to tax equal to 25 percent of any underpayment attributable to a substantial 90 T.C. 1154">*1205 understatement. For purposes of the section, there is a substantial understatement of tax if the amount of the understatement of tax exceeds the greater of 10 percent of the tax shown on the return or $ 5,000. Sec. 6661(b)(1). The amount of the understatement, in the case of a tax shelter, may be reduced by an amount for which there was substantial authority for the treatment adopted by petitioners on their return. This reduction is not available in the case of a tax shelter unless the taxpayer reasonably believed that the claimed tax treatment was "more likely than not" the proper treatment. Sec. 6661(b)(2)(C)(i)(II).

1988 U.S. Tax Ct. LEXIS 78">*177 The amounts of the understatements in each case before the Court exceeded 10 percent of the tax shown on the returns. From the testimony of petitioners and their tax return preparers or advisors, it is clear that they did not make the kind of legal or factual analysis of the Western Reserve arrangement that would enable them to formulate any reasonable belief one way or another as to whether the tax treatment they gave to their claimed Western Reserve 90 T.C. 1154">*1206 deductions was more likely than not the proper treatment. We hold that the addition to tax is applicable. ³²

Section 6621(c) (formerly section 6621(d)) provides for an elevated interest rate where there is a substantial underpayment (at least $ 1,000) in any taxable year attributable to one or more tax-motivated transactions. The additional interest accrues after December 31, 1984, even though the transaction was entered into prior to the date of the enactment of the section. Solowiejczyk v. Commissioner, 85 T.C. 552">85 T.C. 552 (1985), affd. without published opinion 795 F.2d 1005">795 F.2d 1005 (2d Cir. 1986). The term "tax motivated transaction" includes any "sham or fraudulent transaction." Sec. 6621(c)(3)(A)(v).

For the reasons stated at some length above, the whole Western Reserve scheme lacked economic substance. There was no reasonable prospect that it would produce profits apart from the tax benefits. The underpayments in these cases were thus attributable to a "sham or fraudulent transaction." 88 T.C. 1086">Patin v. Commissioner, supra at 1128. The key element of the transaction was the multi-million-dollar Western1988 U.S. Tax Ct. LEXIS 78">*179 Reserve-to-Magna notes the amounts of which were deducted by Western Reserve as advance minimum royalties. The amounts were not related to any anticipated production from the leases but to the cash payments made by the investors. Western Reserve gave the notes to Magna at the end of each year even though Western Reserve itself had already paid the assignor-drilling companies the full cost of the leases; Magna incurred no costs in connection with the leases except Brannan's salary and expenses, all of 90 T.C. 1154">*1207 which were paid with funds transferred by Western Reserve to Magna. The whole Western Reserve scheme, we reiterate, served only to enrich Phillips and Mabile and his associates and to create a facade for the 12-for-1 (or 8-for-1) deductions to be claimed by the limited partners. We hold that the addition to tax is applicable.

To reflect the foregoing,

Decisions will be entered under Rule 155.