T.C. Memo. 1997-148



                      UNITED STATES TAX COURT



3-KOAM COMPANY, A PARTNERSHIP, MY HAT, INC., TAX MATTERS PARTNER,
 Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4232-95.                 Filed March 20, 1997.



     David M. Kirsch, for petitioner.

     Kimberley J. Peterson, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     PARR, Judge:   3-Koam Company partnership (3-Koam), My Hat,

Inc. (My Hat or petitioner), Tax Matters Partner, petitioned the

Court under section 6226 to readjust respondent's adjustments of

partnership items flowing from the partnership.   By notice of

final partnership administrative adjustment (FPAA) dated February

16, 1995, respondent determined adjustments to items claimed on
                                - 2 -

3-Koam's 1990 U.S. Partnership Return of Income (Form 1065) of

$111,962.

       After concessions by the parties,1 the issues for decision

are:    (1) Whether pursuant to section 174, 3-Koam may deduct

research and development expenses allegedly incurred in 1990.2

We hold it may not, except to the extent allowed by respondent.3

(2) Whether pursuant to section 166, 3-Koam may claim a $30,000

bad debt deduction in 1990.    We hold it may not.

                          FINDINGS OF FACT

       Some of the facts have been stipulated and are so found.

The stipulated facts and the accompanying exhibits are

incorporated into our findings by this reference.    At the time

the petition in this case was filed, 3-Koam's principal place of

business was in Fremont, California.    During the year in issue,

3-Koam used the accrual method of accounting and filed its

returns on a calendar year basis.



1
     For 1990, petitioner concedes the following amounts: (1)
($3,629) for meals and entertainment, (2) $2,658 for automobile
expenses, (3) $194 for insurance, (4) $399 for depreciation, and
(5) $340 for interest. These concessions will be reflected in
the parties' Rule 155 computation.
2
     All section references are to the Internal Revenue Code in
effect for the taxable year in issue, and all Rule references are
to the Tax Court Rules of Practice and Procedure, unless
otherwise indicated. All dollar amounts are rounded to the
nearest dollar, unless otherwise indicated.
3
     On its 1990 Form 1065, 3-Koam deducted $90,000 for research
and development; in her notice of deficiency respondent
disallowed $82,000 of such amount.
                               - 3 -

     My Hat, the tax matters partner for 3-Koam, is a California

corporation with its principal place of business in Cupertino,

California.

     From the time of its inception in 1987 through the year in

issue, the partners of 3-Koam, and their respective interests in

partnership capital, profits, and losses were as follows:   My

Hat, of which Edward Houston (Houston) is the sole shareholder

(25 percent), Unpo Paik (Paik) (25 percent), and Nae Yeal Lee

(Lee) (50 percent).   The initial capital of the partnership was a

$50,000 line of credit extended by Lee; Paik and Houston

contributed a new product and technical know-how.   Houston is a

metallurgical and component engineer and Paik has a college

degree in computer science.

Research and Development Deduction

     3-Koam is primarily engaged in the business of sub-

contracting, packaging, and assembling electronics products,

including video games.   When customers would return defective

game cartridges, such as Nintendo type games to a retailer, the

retailer would send the cartridges to the manufacturer, who, in

turn, would ship them to 3-Koam for testing.   If possible, 3-Koam

would repair the product, repackage it, and send it back to the

manufacturer for resale.   If 3-Koam could not repair a product it

would return it to the manufacturer.   A substantial part of 3-

Koam's business also included assembling arcade game cabinets for

its customers who manufactured video game boards.
                               - 4 -

     In September of 1990, Houston and Paik formed a second

partnership named Inkax.   Thereafter, Inkax, contacted Dooyong

Industries Co., Ltd., (Dooyong), a Korean video game designer,

for the purpose of determining whether Dooyong could develop two

prototype video games for Inkax.   Sometime between May and

September of 1990, Dooyong began developing video game boards for

Inkax.   Inkax and Dooyong did not execute a formal contract

memorializing their arrangement.   From the time of its formation

until the date of trial, the only business that Inkax had ever

engaged in was the research and development transaction with

Dooyong.

     In October of 1990, 3-Koam issued a purchase order to Inkax

for the research and development of two video games.   In November

and December of 1990, Inkax sent three invoices to 3-Koam

totaling $90,000 for the cost of video game development.

Thereafter, 3-Koam paid Inkax $90,000, consisting of two checks

in December of 1990 for $30,000 and $40,000, and one check in

March of 1991 for $20,000.   On its 1990 Form 1065, 3-Koam

deducted $90,000 in research and development expenses.   Sometime

after March 21, 1991, Inkax returned the $90,000 to 3-Koam in one

or more payments.

     On December 3, 1990, Dooyong sent Inkax an invoice for

$82,000, reflecting the charge for video game development.     On

March 17, 1991, in exchange for the two video games, Inkax issued
                                - 5 -

a 0 percent interest promissory note to Dooyong for $82,000.    The

maturity date of the note was March 17, 1993.

     On March 29, 1991, Dooyong shipped two video games4 to

3-Koam.   For U.S. Customs' purposes, Dooyong declared $4,500 as

the total value of the games.   This was the only import

transaction between Dooyong and 3-Koam.    Thereafter, 3-Koam test

marketed its product by placing one of the games in an arcade in

Santa Clara, California, and the other in Santa Cruz.    After 4

weeks, 3-Koam determined that the games did not attract

sufficient customers and had no residual value, and therefore

decided to abandon the idea of distributing arcade video games.

3-Koam never attempted to sell the games to any other person or

entity.

     Neither Inkax nor 3-Koam ever paid Dooyong for its

development efforts.   Moreover, at the time of trial, Inkax had

closed its bank account and dissolved.    Dooyong has never taken

any legal recourse against 3-Koam or Inkax to enforce the $82,000

promissory note issued by Inkax.

     On its 1990 U.S. Partnership Return of Income (Form 1065),

the only transactions Inkax reported were the accrual of $90,000

of income from 3-Koam, and an accrual of $82,000 as cost of goods

sold, reflecting the promissory note issued to Dooyong, which

produced an $8,000 operating profit.    Houston and Paik each

4
     Dooyong actually shipped 3-Koam video game circuit boards,
which 3-Koam then assembled into two video game arcade cabinets.
                                - 6 -

reported their $4,000 distributive shares of such profit on their

1990 individual Federal income tax returns (Forms 1040).



Bad Debt Deduction

       Sometime around 1989, Paik was introduced to Sung Ok Sue

(Sue) by family friends.    Thereafter, Paik met with Sue on

several occasions.    Sue was engaged in a variety of businesses,

including a video arcade and rental establishment.

       In November of 1989, Paik personally applied for, and

received, a $30,000 loan from Union Bank (Bank).    The loan was

secured with a certificate of deposit (CD) belonging to 3-Koam.

Upon receiving the loan proceeds Paik transferred the funds to

Sue.    In exchange, Sue signed a promissory note for the $30,000,

which was made payable to 3-Koam.    The note was unsecured, it had

a 0 percent interest rate, and no maturity date.    Sue never paid

the $30,000 to 3-Koam, and 3-Koam has never made any formal

demand for the funds.    3-Koam has not hired a collection agency,

nor has it taken any other legal action against Sue to obtain the

money.

       The bank used 3-Koam's CD to satisfy the $30,000 outstanding

loan.    3-Koam deducted the $30,000 as a bad debt on its 1990 Form

1065.
                               - 7 -

                              OPINION

Issue 1. Research and Development Expenditures

     Respondent determined that 3-Koam may not claim an $82,000

research and development deduction for 1990, because the alleged

agreement entered into by 3-Koam with Inkax was a sham

transaction, lacking both a business purpose and economic

substance.   Petitioner asserts that 3-Koam properly incurred and

accrued a research and development expense in 1990, and therefore

may deduct such amount pursuant to section 174 and the

regulations thereunder.

     Respondent's determinations are presumptively correct, and

petitioner bears the burden of proving otherwise.   Rule 142(a),

Welch v. Helvering, 

, 115 (1933); Durando v. United

States, 

, 550 (9th Cir. 1995).

     As a general rule, a taxpayer may deduct research or

experimental expenditures paid or incurred during the taxable

year in connection with its trade or business.   Sec. 174(a); Snow

v. Commissioner, 

, 504 (1974).   Section 174 not only

applies to expenses paid or incurred directly by the taxpayer,

but it also includes expenditures paid or incurred for research

and development carried on in the taxpayer's behalf by another

person or organization.   Sec. 1.174-2(a)(2), Income Tax Regs.

     A taxpayer is generally free to structure its business

transactions as it pleases, though motivated by tax reduction

considerations.   Gregory v. Helvering, 

(1935);
                               - 8 -

Casebeer v. Commissioner, 

(9th Cir. 1990), affg.

T.C. Memo. 1987-628, affg. Larsen v. Commissioner, 

(1987), affg. Sturm v. Commissioner, T.C. Memo. 1987-625, affg.

Moore v. Commissioner, T.C. Memo. 1987-626; Rice's Toyota World,

Inc. v. Commissioner, 

, 196 (1983), affd. in part on

this issue, revd. in part 

(4th Cir. 1985).    However,

it is well settled that the substance of a transaction and not

the form will control its tax consequences. Frank Lyon Co. v.

United States, 

, 573 (1978).   A transaction entered

into solely for the purpose of tax reduction, which is devoid of

economic, commercial, or legal purpose other than the expected

tax benefits, is a sham without effect for Federal income tax

purposes.   Id.; Rice's Toyota World, Inc. v. 

at 196.   In Rice, we stressed that where "a taxpayer, cognizant

of potential tax benefits, enters into a transaction of

questionable economic worth, the tests developed under the sham

transaction doctrine are applied to determine whether a threshold

level of business purpose and economic substance is present."

of all the facts in this case,

we conclude that the transfer of the $90,000 from 3-Koam to Inkax

is not a bona fide outlay for research and development, because

the transaction lacks sufficient economic substance.   The record

shows that there is little, apart from tax considerations, to

justify 3-Koam's entry into the purported research and
                               - 9 -

development transaction with Inkax.    Although no single fact is

determinative of this conclusion, numerous factors taken

collectively, as discussed herein, demonstrate that such

transaction was a sham.

     The agreement between 3-Koam and Inkax consists of a vague,

one-page letter, which lacks any discussion of the respective

rights of the parties, a detailed description of the product

configuration, performance criteria by which to measure the

product's suitability for its intended use, or the price to be

charged for its development.   As such, we find the purported

research and development contract to be a letter between related

partnerships, intended merely to lend credence to Inkax's

existence, as a shell partnership created by 3-Koam solely for

tax avoidance purposes.   See Frank Lyon Co. v. United States,

supra at 581.

     3-Koam was haphazard in its efforts to enter into the video

game distribution market.   3-Koam had no prior experience in

developing and marketing video games.   Its knowledge of the video

game business was limited to testing existing products and

assembling video game cabinets for its customers.   No market

projection or appraisal was performed to determine whether the

video games had any potential of producing a profit, or had an

economic value approximating the $90,000 that 3-Koam ostensibly

paid for them.   The extent of 3-Koam's marketing efforts was to

place one video game in an arcade in Santa Clara and another in
                              - 10 -

Santa Cruz.   After 4 weeks, 3-Koam determined that the games did

not attract sufficient customers and had no residual value; it

then abandoned the purported plan to distribute the games.

Finally, 3-Koam never attempted to sell the games in an effort to

recoup some of its alleged $90,000 investment.

     The absence of arm's-length dealings among the parties, for

example, where two entities under common ownership are involved

in a "money movement transaction" is a factor often present in

sham transactions.   Karme v. Commissioner, 

, 1186

(1980), affd. 

(9th Cir. 1982).   In Karme, taking

into account the relationship between the two parties, we found

that the taxpayer was not genuinely at risk for any money,

despite purported indebtedness between the entities.

  Two of 3-Koam's partners formed Inkax for the alleged

purpose of marketing video games for 3-Koam; plainly the

partnerships are closely related.

     On its 1990 Form 1065, 3-Koam deducted a $90,000 research

and development expense; however, neither 3-Koam nor Inkax ever

paid Dooyong for its development efforts.5   More importantly,

5
     At trial and on brief, 3-Koam claims that Inkax's failure to
pay Dooyong has absolutely no bearing on the propriety of the
accrual by 3-Koam of the $90,000 research and development
expenditure, because the taxpayer here is 3-Koam, not Inkax. As
such, petitioner argues that 3-Koam properly "paid or accrued"
the amount claimed as a deduction pursuant to sec. 461(a).
However, accounting methods or descriptions, without more, do not
lend substance to that which has no substance. Frank Lyon Co. v.
United States, 

, 577 (1978) (citing Commissioner v.
                                                   (continued...)
                               - 11 -

3-Koam concedes that sometime after March of 1991, it received

the $90,000 back from Inkax, purportedly in the form of a loan.

     Respondent argues, however, that the $90,000 transferred

back to 3-Koam fails to exhibit any indicia of a loan, and in

substance is actually a repayment of the proceeds originally

disbursed by 3-Koam to Inkax pursuant to the alleged research and

development agreement.   See Frierdich v. Commissioner, T.C. Memo.

1989-393, affd. 

(7th Cir. 1991) (factors to consider

in deciding whether a bona fide loan exists between related

parties).

     On brief, petitioner argues that we need not decide this

point, because whether or not Inkax lent the $90,000 to 3-Koam in

1991 has no bearing on whether 3-Koam actually incurred the

research and development expenses; and therefore it may properly

deduct the expense in 1990.   See sec. 461(a) (all events test).

For the reasons just 

at note 5, we disagree.

     The record shows that at the time 3-Koam and Inkax entered

into the purported loan transaction, 3-Koam never intended to

repay Inkax, and Inkax never intended to enforce monetary

payment.    See Karme v. 

.   3-Koam did not issue



5
 (...continued)
Lincoln Sav. & Loan Association, 

, 355 (1971)). The
question of the appropriate accounting treatment may be answered
only when the transaction is determined to be legitimate. A sham
transaction is not entitled to favorable tax treatment; therefore
3-Koam's accounting method is irrelevant.
                              - 12 -

Inkax a promissory note for the $90,000, nor did Inkax require

any security on the purported loan.

     Moreover, 3-Koam never paid, nor will it ever pay Inkax,

because Inkax was dissolved immediately after engaging in the

alleged research and development transaction.    In fact, the only

business that Inkax ever engaged in was the one transaction with

Dooyong, and once Inkax's "limited function had been exercised,

it was immediately put to death."     Gregory v. Helvering, 

, 470 (1935).

     Thus, the circular movement of money in 3-Koam's case and

the use of Inkax, a partnership created and controlled by Houston

and Paik, as a conduit for such funds, establish that 3-Koam did

not in substance incur the $90,000 expense it claimed for

research and development.   Karme v. Commissioner, 

.

     Another key factor we consider in analyzing a sham

transaction is a grossly inflated purchase price.    Falsetti v.

Commissioner, 

, 349 (1985); Grodt & McKay Realty, Inc.

v. Commissioner, 

, 1240-1241 (1981).    In Grodt, we

analyzed whether a transaction was a true sale and found that a

normal attribute of an arm's-length sale is a purchase price "at

least approximately equal to [the item's] fair market value".

Grodt & McKay Realty, Inc. v. 

at 1240-1241.

A "totally disproportionate" purchase price belies a taxpayer's

contention that a true sale occurred.

stipulated that $4,500 was the value of the video

games declared for U.S. Customs' purposes.    At trial, Houston

testified that 3-Koam later determined the video games to have no

residual value.   Thus, it appears that the $90,000 was a grossly

inflated amount compared to the video games' actual value.

     In sum, based on the entire record and the facts discussed

herein, petitioner has failed to meet its burden of proving that

the alleged research and development transaction entered into by

3-Koam with Inkax had economic substance.    Accordingly, we

sustain respondent's determination with respect to this issue.

Issue 2. Bad Debt Deduction

     Respondent determined that 3-Koam may not deduct $30,000 as

a bad debt on its 1990 Form 1065, because petitioner failed to

establish that 3-Koam made a bona fide business loan.6

Petitioner asserts that 3-Koam properly deducted on its 1990 Form

1065, a business bad debt that was owed to 3-Koam by Sue and

became worthless in 1990.

     Section 166(a) and the regulations thereunder allow a

taxpayer to deduct all or part of any "bona fide" debt that

becomes worthless during the taxable year.    See Calumet Indus.,

Inc. v. Commissioner, 

, 284 (1990).    For purposes of


6
     In the alternative, respondent argues that 3-Koam has not
shown worthlessness during 1990 as required by sec. 166(a)(1).
We find, as discussed in the opinion herein, that 3-Koam did not
make a bona fide business loan. Thus, we do not find it
necessary to address the issue of worthlessness.
                               - 14 -

section 166(a), a "bona fide debt is a debt which arises from a

debtor-creditor relationship based upon a valid and enforceable

obligation to pay a fixed or determinable sum of money."   Sec.

1.166-1(c), Income Tax Regs.   Whether a bona fide debtor-creditor

relationship exists is a question of fact to be determined upon

consideration of all the pertinent facts in a particular case.

Fisher v. Commissioner, 

, 909 (1970).

     In the case at bar, we must determine whether the advances

to Sue were made in exchange for a bona fide debt.   Petitioner

bears the burden of proof on this issue.   Rule 142(a); Welch v.

Helvering, 

, 115 (1933); Durando v. United States, 

, 550 (9th Cir. 1995).

     At trial, Paik testified that he has known Sue since 1989

when they were introduced through family and friends.

Thereafter, the two met on several occasions.   In November of

1989, Paik personally applied for and received a $30,000 loan

from the bank, and according to petitioner's argument, advanced

the proceeds to Sue on behalf of 3-Koam.   In February of 1990,

Sue signed a $30,000 promissory note, made payable to 3-Koam.

     We note that we closely scrutinize the form of an alleged

business arrangement to determine its true substance where

parties have a personal relationship, such as the one between

Paik and Sue.

      At trial, Paik and Houston claimed that Sue received the

$30,000 as a loan from 3-Koam for the purpose of enabling Sue to
                              - 15 -

open an arcade, where 3-Koam could place its video games.       On

brief, petitioner argues that the loan application supports

Paik's and Houston's contention, because it lists "partial cash

needs for a business investment" as the purpose for obtaining the

loan proceeds.

     We disagree.   Petitioner's reliance on the loan application

is self-serving, because Paik supplied the bank officer with the

information found on such document.     Furthermore, petitioner has

failed to prove that the advance of $30,000 created a bona fide

debtor-creditor relationship between Sue and 3-Koam.       3-Koam

failed to perform a credit check on Sue, nor did it obtain

collateral from Sue to secure the alleged loan.    Furthermore, the

$30,000 promissory note that Sue signed had a 0 percent interest

rate, no maturity date, and no fixed schedule of repayments.

     Moreover, not only did Sue fail to repay the $30,000, but

3-Koam never made any demand for the funds, nor did it take legal

action against her.   These are the types of reasonable actions a

creditor would institute against a debtor.     Newman v.

Commissioner, T.C. Memo. 1982-61.     Thus, we note that a taxpayer

cannot justify a bad debt deduction merely because it elects not

to enforce the obligation.   See Southwestern Life Ins. Co. v.

United States, 

, 644 (5th Cir. 1977).

     In sum, we find that petitioner failed to sustain its burden

of proving that 3-Koam made a bona fide loan of $30,000 to Sue.
                             - 16 -

Accordingly, we sustain respondent's determination with respect

to this issue.

     To reflect the foregoing,



                                     Decision will be entered

                                 under Rule 155.