Unpublished Disposition, 878 F.2d 1438 (9th Cir. 1988)

MEMORANDUM^* 

OVERVIEW

Barton and Constant Bunting filed a petition with the United States Tax Court, challenging the Commissioner's disallowance of certain depreciation deductions and investment tax credits on their 1979 and 1980 income tax returns. The deductions and credits arose in connection with the Buntings' investment in the promotion of an educational film and slide program. After a two-day trial, the Tax Court entered judgment in favor of the Commissioner. We affirm. The Tax Court's finding that the Buntings had no expectation of profit in the investment, apart from tax aspects, is not clearly erroneous. The petitioners failed to come forward with sufficient evidence establishing that they were motivated by profit. Furthermore, the Tax Court did not err in assessing a negligence penalty against the Buntings.

FACTUAL AND PROCEDURAL BACKGROUND

The deductions and credits at issue in this case arose in connection with petitioners' investment in the promotion of certain "master films." The master films consist of a set of slides and accompanying scripts from which educational slide presentations and filmstrips can be produced. The idea to market the master films was originally conceived by two brothers, Donald and William Clark. William had had previous experience in the production of slide shows, having made several for various Fortune 500 companies. The Clark brothers decided to explore the idea of producing a set of slide shows concerning astronomy, copies of which they hoped to sell to various educational institutions.

William worked together with a photographer, Ralph Heigl, in creating the master films. The master films included original artwork and photography, as well as NASA photographs that were in the public domain. The scripts accompanying the slides were prepared by various experts in astronomy, including the author of a popular textbook on the subject. Three different scripts were written for use at different educational levels (elementary school, high school, and college).

After producing the master films, William sold them for between $2500 and $3000 to Clark Financial Corporation ("CFC"), a company controlled by his brother Donald. William testified that this amount was not quite sufficient to cover all his costs, and that he used his own money to cover any cost overruns. CFC in turn offered the master films to investors in the general public by way of a prospectus entitled "Proposal for educational audio/visual aids." The prospectus indicated that the purchase price of the master films would be $10,000, and that a master film should only be purchased by someone who could afford a high risk investment. Indeed, the prospectus stated that buyers should be aware that "there is only a relatively small possibility that any film will be a financial success."

The bulk of the prospectus, however, was devoted to the potential tax benefits of investment in the master films.¹  Although the prospectus prominently stated that each buyer should consult his or her own tax adviser, it nonetheless extensively described the tax implications of the master films program. Among other things, the prospectus indicated that investors might obtain a tax write-off of as much as $7,082 over the first three years of the investment. The prospectus also indicated that the sale of master films would be limited to those investors who were in at least the 25% tax bracket.

The prospectus mentioned that in a recent revenue ruling, the IRS had disallowed certain depreciation deductions in connection with the purchase of motion picture films. The prospectus went on to state, however, that the facts in the ruling differed significantly from those involved in the purchase of the master films. First, unlike the case in the earlier ruling, the fair market value of the films would approximate or exceed the total selling price. Indeed, CFC would provide each purchaser with two appraisals indicating this fact. Second, the notes involved in the sale of the master films would be full-recourse notes, whereas in the earlier ruling the notes were nonrecourse. The prospectus did note, however, that there remained risks that depreciation deductions and investment tax credits might be disallowed by the IRS.

The "full-recourse" financing involved in the sale of the master films was described in the prospectus as follows. The buyer would be required to pay 10% of the purchase price ($1,000) in cash on or before the closing of the sale. The remainder would be financed by a full-recourse promissory note, which would bear an interest rate of 6% per annum and which would mature after seven years. The interest would be permitted to accrue during the seven year period. The only payments that had to be made annually were payments representing a portion of the net proceeds from the exploitation of the films. However, if there were no such proceeds, a minimum payment of $100 would be required. At the end of the seven years, if any principal or interest remained unpaid, the buyer had the right to renew the note, rather than to pay it. The new renewal note would be on the same terms as the prior one, with one important difference--it would be a nonrecourse note. At the end of the second seven year period, the buyer had the option of renewing the note, under the same conditions, for a third seven year period.

In late 1979, appellant Barton Bunting decided to purchase one of the master films.²  He testified that there were several factors that led to this decision. First, he knew Donald Clark both personally and professionally (having once been Donald's business partner), and he therefore trusted Donald's integrity and business judgment. Second, Bunting stated that he was aware of William's experience in the development of slide shows and that this gave him confidence that the master films would be a successful venture. Third, Bunting testified that he reviewed a number of pamphlets, brochures, and other information provided by Donald Clark. However, the only such materials that Bunting specifically produced at trial were a copy of the master film purchase and security agreement itself, and the distribution agreement for the master film. On cross-examination, however, the Commissioner established that he had also read and relied upon the following materials: the prospectus, a report from an attorney to CFC outlining the tax implications of the purchase, and two appraisal letters provided by CFC.³ 

Although the appraisal letters were from two different appraisers, they were form letters that were identical in all other respects except for the dollar value they placed on the films. One letter listed the film's value as $33,000, while the other stated that it was worth $38,500. However, neither letter indicated any basis for the appraisal, described the method by which the value was determined, or indicated the qualifications of the appraisers. Furthermore, Bunting did not introduce any evidence at trial that would have indicated any of these three things.

Bunting also testified that he never viewed any of the master films (including the one he bought, "Viewpoint Earth") before he decided to invest. He also stated that he and his wife did not consult anyone other than Donald Clark before they decided to purchase a master film. In arranging the purchase, Bunting did not attempt to reduce the purchase price of $25,000, despite the fact that this price was $15,000 higher than the price listed in the prospectus. Bunting stated that he did not attempt to do so because he thought that, all things considered, the price was a reasonable one.⁴ 

The appellants also point out that there was considerable evidence indicating that the master films would be a worthwhile investment. First, a number of prominent and well-qualified people were involved in their production. Second, William Clark had conducted "extensive market research" to determine whether the master films would be a viable and profitable project. However, there is no evidence in the record to indicate that Bunting was aware of this information or that he relied upon it in making his decision to invest.⁵ 

On October 16, 1979, Bunting signed a purchase agreement with CFC. Under the terms of the agreement, Bunting would pay a total of $25,000 for the master film. Five hundred dollars of the purchase price was paid at the signing, $2,000 more would be payable on or before November 15, 1979, and the remainder would be financed by a promissory note. The agreement also stated that CFC would provide Bunting, at no additional cost, audit protection for three years.

Bunting did not pay the $2,000 by the November 15 deadline. Instead, when the sale was consummated on December 28, 1979, he borrowed $2,000 from Donald Clark.⁶  Several additional documents were completed and signed as part of the closing of the deal. First, Bunting completed a "Purchaser qualification questionnaire." One of the seven questions on the questionnaire was the following: "Will any portion of your present annual gross income be subject to Federal Income Tax at a rate of 25% or higher?" Bunting responded: "Very possibly that or higher."

Bunting also completed a "Master film purchase and security agreement." The financing terms were in all material respects the same as those described in the prospectus with only two exceptions: (1) the purchase price was $25,000 instead of $10,000, and (2) the percentage of net proceeds that had to be paid to CFC during the life of the note was set at 70% (in the prospectus this figure had been left unspecified).⁷  Bunting signed a separate agreement and promissory note embodying these terms.

The purchase and security agreement also specified that Bunting would be "solely responsible for the selection of a distributor and any other persons who will assist the buyer in the expoitation of the Master Film." On the same date, December 28, 1979, Bunting signed an agreement naming Summit Distributors as the distributor of his master film. Summit was owned by Donald's brother, William Clark.

On appeal, Bunting argues that his choice of Summit was "freely" made and that he selected Summit because he was aware of William's experience in this area. Indeed, Bunting testified on direct examination that he had relied on William's "expertise in the marketing and distribution" of such film programs. However, Bunting conceded on cross-examination that he had not attempted to find out about any other potential distributors for his master film. Furthermore, Bunting admitted that Summit had been recommended to him by Donald Clark, and that he followed Donald's recommendation. He also admitted that he had not inquired into the prior gross receipts of Summit. He felt that this was unnecessary since it was a new company.

Bunting's master film produced no income for the years 1979, 1980, 1981, 1982 or 1983.⁸  Despite the lack of income, there is no indication in the record that Bunting consulted William about the problem or that he sought to switch distributors. Bunting testified that William sent him letters several times each year, detailing the progress that was being made in the attempts to market the master films. However, only two of these letters were introduced at trial, and both appear to be fairly brief form letters. Bunting stated that he was satisfied with the performance and the level of effort that William had been putting into the project.

During this period of time, Bunting failed to make any of the required $100 payments on his promissory note. Although CFC could have called the note because of this failure, Bunting testified that the only action taken was that Donald Clark contacted him sometime in 1984 and asked him to pay the $400 that was then due on the note. Bunting paid the $400 without objection.

In connection with his investment in the master film, Bunting claimed a depreciation deduction for 1979 of $10,000 and an investment tax credit of $434. For tax year 1980, Bunting claimed a depreciation deduction of $4,236 and an investment tax credit of $2,066. These deductions and credits produced tax savings for the Buntings of over $5,000.

In 1981, William Clark developed and patented technology that would allow him to put thousands of slides onto laser videodiscs. In order to market these new videodiscs, William set up a new corporation, Video Vision. Video Vision subsequently acquired the distribution rights for the master films from Summit. William testified that the CFC master films (including those of petitioners other than the Buntings) make up only about 10% of the material contained on the Video Vision "Astronomy" videodisc. Although Video Vision lost money and had trouble marketing its products from 1981 to 1984, William testified that he expected the company to show a profit of $60,000 to $70,000 in 1985. William testified that, with the use of mass marketing techniques, the prospects for the videodiscs are promising. He also stated that he was involved in negotiations with Apple Computer to make the videodiscs available on a larger scale.⁹  However, at the time of trial in 1985, Bunting had received only about $27 in earnings from his master film.

On February 7, 1983, the Commissioner sent the Buntings a notice of deficiency. The Commissioner indicated that he was disallowing the deductions and credits taken for the master films in 1979 and 1980. Among the reasons stated for the action was that the Buntings had failed to establish that they were motivated by profit in deciding to invest in the master films. The total tax deficiency was $2,451 for 1979 and $3,250 for 1980. Pursuant to 26 U.S.C. § 6653(a), the Commissioner also assessed negligence penalties of $122.55 and $162.50 for each tax year, respectively.

The petitioners filed a petition in the Tax Court on April 18, 1983, challenging the Commissioner's determination. A two day trial was held on December 3-4, 1985. In an opinion filed November 23, 1987, Judge Gerber ruled in favor of the Commissioner. The Tax Court concluded that Bunting did not have a profit motive, apart from tax considerations, in purchasing the master film. Accordingly, under 26 U.S.C. § 167(a), the Buntings were not entitled to a depreciation deduction. The Tax Court also concluded that they were not entitled to an investment tax credit under 26 U.S.C. § 48(a) (1), and that negligence penalties were properly assessed under 26 U.S.C. § 6653(a). The Tax Court entered judgment to this effect on February 2, 1988. A timely notice of appeal was filed on February 29, 1988. See Fed. R. App. P. 13(a).

DISCUSSION

The Tax Court's determination that Bunting lacked a profit motive is reviewed under the clearly erroneous standard. Polakof v. Commissioner, 820 F.2d 321, 323 (9th Cir. 1987), cert. denied, 108 S. Ct. 748 (1988).

Section 167(a) of the Internal Revenue Code, 26 U.S.C. § 167(a), permits

as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)--

(1) of property used in the trade or business, or

(2) of property held for the production of income.

The Tax Court correctly ruled that Bunting was not entitled to a depreciation deduction under Sec. 167(a) (1), since it is undisputed that the master film is not used in the trade or business of Bunting. Bunting has had no personal involvement in the development or marketing of his master film; indeed he has never even seen it in its entirety. Accordingly, Bunting is entitled to a depreciation deduction only if he can establish that he held the master film "for the production of income." Bunting bears the burden of proof on this issue. Independent Electric Supply, Inc. v. Commissioner, 781 F.2d 724, 727 (9th Cir. 1986).

In order to show that he held the property "for the production of income," Bunting must show that he acquired the master film with an expectation that it would be profitable. Polakof, 820 F.2d at 323 n. 1; Hirsch v. Commissioner, 315 F.2d 731, 736 (9th Cir. 1963); Beck v. Commissioner, 85 T.C. 557, 569 (1985); see also 26 U.S.C. § 183(a) (" [I]f such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed under this chapter except as provided in this section."). Although the petitioner must show that he had an actual, good-faith profit motive, he is not required to show that the expectation of profit was a reasonable one. Flowers v. Commissioner, 80 T.C. 914, 931 (1983); Fox v. Commissioner, 80 T.C. 972, 1007 (1983), aff'd 742 F.2d 1441 (2d Cir. 1984); 26 C.F.R. Sec. 1.183-2(a). The determination as to whether Bunting had a profit motive is to be made on the basis of all the facts and circumstances. Flowers, 80 T.C. at 931-32; Wildman v. Commissioner, 78 T.C. 943, 953 (1982); 26 C.F.R. Sec. 1.183-2(a). However, greater weight is generally given to objective facts than to the parties' potentially self-serving statements of intent. Flowers, 80 T.C. at 932; Fox, 80 T.C. at 1007; 26 C.F.R. Sec. 1.183-2(a).

The Treasury Department has promulated regulations that list several factors that may be relevant to determining whether a particular activity has been carried on for profit. 26 C.F.R. Sec. 1.183-2(b). The regulations emphasize that " [n]o one factor is determinative," that other factors not listed may be relevant, and that the determination of profit motivation should not be made by simply examining whether the number of factors indicating a profit objective exceeds the number of factors indicating a lack of such an objective. Id. The factors listed are:

(1) " [T]he [m]anner in which the taxpayer carries on the activity";

(2) "The expertise of the taxpayer or his advisors";

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

(4) " [The] [e]xpectation that assets used in [the] activity may appreciate in value";

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

(6) "The taxpayer's history of income or losses with respect to the activity";

(7) "The amount of occasional profits, if any, which are earned";

(8) "The financial status of the taxpayer"; and

(9) " [Any] [e]lements of personal pleasure or recreation."

26 C.F.R. Sec. 1.183-2(b) (1)-(9).

The Tax Court concluded that most of these factors were not relevant in this case because Bunting was a passive investor, whereas most of the factors listed presume that the taxpayer is himself actively engaged in the activity in question. Barkley v. Commissioner, 54 T.C.M. (CCH) 1126, 1129-30 (1987). Bunting challenges this conclusion on appeal, arguing that the Tax Court should have considered how the factors applied to the advisors to whom he had delegated responsibility for exploiting the master film. In support of this proposition, Bunting quotes the following language from Flowers:

[T]hose parties possessing resources sufficient to acquire and exploit investment property are not always blessed with corresponding expertise. In such case, [taxpayers] can rely upon the expertise of third parties by contractually assigning most of the normal duties and responsibilities associated with the income-generating operations to such parties. The scope of the relevant inquiry therefore expands to encompass the entirety of such multi-layered transactions.

80 T.C. at 932.

Bunting is correct in his assertion that, in a situation involving a passive investor, the court should consider whether applying the listed factors to the persons actually managing the investment is relevant to determining the motive of the taxpayer. The above-quoted portion of Flowers squarely stands for this proposition. However, this is only part of the inquiry. Bunting omitted the following language from Flowers, which immediately follows the above quotation, and which qualifies it in important respects:

However, the profit motive issue must still be assessed from the perspective of the [taxpayer]. Thus, where the [taxpayer] is virtually passive in [his] operations, the prudence [he] exercises in acquiring property and in assigning duties to third parties, and the care with which [he] oversees the performance of such duties are of heightened importance.

80 T.C. at 932.

The Tax Court's analysis of Bunting's motivation fully satisfied the requirements of Flowers. Contrary to Bunting's suggestion, the Tax Court considered several of the listed factors in its analysis, see, e.g., 54 T.C.M. (CCH) at 1131, and, indeed, the court even concluded that William Clark was motivated by profit in conducting the project, id. Thus, while it may be true that applying the first three Treasury factors to William Clark indicates that he was motivated by profit, the fact that Bunting knew very little about William's activities and made little, if any, effort to find out about them suggests that William's motives cannot be imputed in this case to Bunting. Indeed, after examining the additional factors that Flowers states should be considered in the passive investor context, the Tax Court concluded that Bunting had failed to show that he was motivated by profit in deciding to invest in the master films.

The first Flowers factor is the "prudence [the taxpayer] exercises in acquiring [the] property." 80 T.C. at 932. The Tax Court concluded that Bunting's conduct in deciding to invest demonstrated "at least a lack of prudence on [Bunting's] part in acquiring the property, and at most a total disregard for any legitimate profit motive." 54 T.C.M. (CCH) at 1131. The court based its conclusion on the following facts: The prospectus indicated that few educational films made any profit; an overwhelming proportion of the prospectus was devoted to tax considerations; Bunting received from CFC a legal opinion on the tax consequences of the investment; the appraisals supplied by CFC were bare-bones form letters that did not indicate the manner in which the film had been valued or the qualifications of the persons valuing it; Bunting's almost complete reliance on Donald Clark was unreasonable, given that the petitioners had failed to show Donald knew anything about the filmstrip industry, and given that Donald did not testify at the trial; Bunting did not speak to William before investing, and did not show that he was aware of any of the work or research that William had done with respect to the master films; Bunting did not produce any of the many brochures upon which he claims to have relied; Bunting never viewed his master film in its entirety; and Bunting did not request any sort of forecast as to the possible return on his investment, projected sales, or the probability of success.¹⁰  Each of these facts is amply supported in the record. The Tax Court did not clearly err in concluding that they indicate an almost complete lack of prudence on Bunting's part (apart from tax considerations) in deciding to acquire the master film.¹¹ 

In this regard, the Tax Court noted that the facts of this case were closely analogous to those involved in its recent decision in Beck v. Commissioner, 85 T.C. 557 (1985). See 54 T.C.M. (CCH) at 1130. In Beck, the taxpayers claimed deductions for losses and depreciation arising out of their purchase of rights to a children's book. The offering memorandum sent to potential investors indicated that the offer was only available to persons who were in at least the 50% tax bracket, and also indicated that the investment involved a high degree of risk. Accompanying the memorandum was an opinion letter analyzing the tax implications of investment in the books. In the chart outlining the tax benefits, it was assumed that the book would produce no income in the first two years. Rosen, an accountant and tax advisor for the company that was offering the books ("Contemporary Perspectives, Inc." or "CPI"), contacted Beck to encourage him to invest. Rosen sent Beck a copy of the offering memorandum and the accompanying documents. Although Rosen's letter to Beck does state that he thought the investment had merits, the predominant focus of the letter was on the favorable tax consequences. Beck relied heavily upon Rosen's advice, and indeed, he contacted no one else about the matter before deciding to invest. However, neither Beck nor Rosen knew anything about the publishing industry. In addition to the above mentioned documents, CPI sent Beck a letter of appraisal indicating that the book would produce total returns of $243,700 over 12 years. Beck received no other information concerning the expected performance of his book. Beck never read the book that he purchased before deciding to invest.

Based on this evidence, the Tax Court concluded that Beck was not motivated by an expectation of profit, but rather by the hope of significant tax benefits. 85 T.C. at 573. In an argument similar to that made by Bunting, Beck argued that Flowers and other cases allowed him to establish his profit motive by relying in part on the efforts of CPI and the distributors of the book. While the court agreed that this was true, the court also pointed out that Flowers states that, in such a passive investor situation, the court should focus on the prudence exercised in acquiring the property and the care with which the investor supervises those who manage the investment. 85 T.C. at 574 (quoting Flowers, 80 T.C. at 932). The court concluded that, given Beck's ignorance and neglect of the nontax aspects of his investment, he could not establish that he had a profit motive by pointing to the activities of those attempting to market the book. Id.

Bunting claims that Beck is "unmistakably distinguishable" and that the Tax Court erred in relying upon it. Bunting raises three grounds for distinguishing Beck. First, Bunting points out that whereas he relied upon a business associate whom he knew well and whom he trusted considerably (Donald Clark), Beck relied exclusively on a tax adviser who was personally unknown to him. Second, whereas in Beck there was no communication between the investor and the marketers concerning the lack of performance, here "Bunting received regular updates and correspondence from William Clark explaining the marketing approach, results of market surveys and modifications planned to address adjustments in the market and technology developments." Third, Bunting claims that whereas the Tax Court questioned the validity of the appraisal in Beck, this was not true in the present case.

These arguments are unavailing. First, the fact that Bunting knew Donald Clark well is of no significance. Like Rosen, Donald Clark knew very little about the industry in which he was recommending that the taxpayer invest. Like Beck, Bunting has not shown that he knew very much about the nontax aspects of his investment, nor has he shown that he inquired about such aspects. Like Beck, he did not consult others before deciding to invest. Under these circumstances, it is not clear that anything significant is added by the fact that Donald Clark was a trusted business associate.

Second, the only evidence that Bunting introduced concerning the "regular updates" he received from William Clark consisted of two brief form letters that gave only sketchy details concerning the efforts being made to market the master film. Although Bunting testified that he received more information than this from William, he failed to present this material at trial.¹² 

Third, Bunting is incorrect in asserting that the Tax Court did not question the validity of the appraisals. Although the Tax Court did not pick apart the appraisal in the way the court did in Beck, see 85 T.C. at 577-79, this was due to the fact that the appraisals in this case--unlike the one in Beck--failed to specify how the appraised value was determined. In this case, there simply was nothing to pick apart. The Tax Court did, however, indicate that, given the bare-bones nature of the appraisals in this case, the court was doubtful of their worth:

The appraisals furnished by CFC were bare conclusions as to the worth of the films. The facts upon which such appraisals were based and the qualifications of the persons who prepared them were not furnished at trial, and apparently not furnished to petitioners at the time of sale. It was unreasonable for petitioners to rely on such information....

54 T.C.M. (CCH) at 1130; see also id. at 1131 ("... the lack of trustworthiness of the appraisals has already been discussed."). Thus, contrary to Bunting's suggestions, Beck provides strong support for the Tax Court's conclusion that Bunting lack a legitimate profit motive. See also Baigent v. Commissioner, 53 T.C.M. (CCH) 1221, 1228 (1987) (no profit motive where, inter alia, purchasers of videotape relied on adviser with no experience in industry, did not investigate company, did not negotiate concerning price, did not obtain their own appraisals, and did not view the tape).

The second Flowers factor is the care that the investor exercises in "assigning duties to third parties" and in "oversee [ing] the performance of such duties." Flowers, 80 T.C. at 932. The Tax Court concluded that Bunting exhibited a "lack of care in supervising duties [that had been] entrusted to others," and that this lack of care indicated "a disregard for any economic profit objective." 54 T.C.M. (CCH) at 1132. The Tax Court based this conclusion on several facts. First, as noted earlier, Bunting failed to show that he had received the type of regular and detailed reports from William that he had claimed to receive. Second, Bunting chose Summit as his distributor without conducting any research into the matter. Third, despite the fact that the master film produced no profit for several years, Bunting did not exercise his right to terminate his distribution agreement with Summit. Indeed, he did not even consider or explore the possibility of obtaining a new distributor. Furthermore, although the Tax Court did not rely upon this fact, Bunting so neglected the nontax aspects of his investment in the master film that for four years he neglected to make the required $100 payments on the promissory note. Taken together, all of these facts indicate that the Tax Court did not clearly err in concluding that Bunting had been so careless in supervising his investment as to suggest that he was not motivated by a profit objective.

Any remaining doubt that Bunting was not motivated by profit is dispelled when one considers the Tax Court's conclusion that the purchase price of the master film was grossly inflated by the use of a nonrecourse note. The Tax Court gave several reasons for concluding that the parties had inflated the value of the films. First, the court rejected all of Bunting's evidence concerning the value of the master film. As noted earlier, the court did not trust the appraisals, given that they were obtained by the seller and did not explain how the appraised value was determined. Furthermore, the court did not believe that the CFC master films were comparable to the custom made films that William had made earlier. Accordingly, the court concluded that these earlier slide shows did not provide much guidance in determining the value of the master films. While it is a close question whether the Tax Court clearly erred in concluding that the master films were "much shorter" than the earlier slide shows, we conclude that, in light of the fact the earlier slides were "custom made" for corporate clients, the court was not clearly incorrect in its overall conclusion that the two sets of films were too dissimilar. Lastly, the court concluded that William's testimony that he sold the master films to CFC for $2,000 to $3,000 apiece--which William testified was just under his costs in producing the master films--supported the conclusion that the price was overinflated. 54 T.C.M. (CCH) at 1131.¹³ 

Second, the Tax Court noted that the interest rate on the promissory note with which the master film was purchased was well below market rate. Id. The court noted that the use of a below market rate had the effect of reducing the discounted present value of the note to only about half of its face value. Id. A similar argument was made by the court in Goldstein v. Commissioner, 1987 Tax Ct.Rep. (CCH) 3609, 3615-16. In Goldstein, the court rejected the petitioners' claim that the property in question was worth $20,000, concluding that the fact that the purchase was financed at an interest rate that was below the market rate reduced the present value of the notes by more than 50%. The Tax Court correctly recognized that the use of below market rate financing helped to inflate the face value of the notes above their actual economic value.

Third, although the promissory note that Bunting signed was technically a full-recourse note, the Tax Court correctly concluded that a close examination of the substance of the transaction indicated that the note was in effect a nonrecourse note. 54 T.C.M. (CCH) at 1132. The court pointed out that the promissory note only obligated Bunting to pay $100 per year until the note matured seven years later.¹⁴  At the end of seven years, Bunting had the option of converting the note from recourse to nonrecourse. Thus, Bunting would only have to pay $600 on the note before it would become nonrecourse. Once the note was converted, the only risk that Bunting faced was the risk of forfeiting the master film. Under these circumstances, the Tax Court correctly concluded that the balance of the note was illusory and that it was worth substantially less than its face value. See Baigent, 53 T.C.M. (CCH) at 1228 (although notes were characterized as "full-recourse," they were in essence "contingent, nonrecourse obligations" except to the extent of the required minimum payments).

Taken together, all of these facts indicate that the Tax Court did not commit clear error in concluding that the purchase price was grossly inflated for tax reasons. This fact further supports the court's conclusion that Bunting lacked a legitimate nontax profit motive. See Flowers, 80 T.C. at 937 (the existence of an inflated purchase price financed by a nonrecourse note can indicate that the property was not acquired with an expectation of producing profit). Accordingly, the Tax Court correctly concluded that Bunting's investment in the master films was not depreciable under 26 U.S.C. § 167(a). Furthermore, since investment tax credits may only be taken for depreciable property, see Polakof, 820 F.2d at 323 n. 1; 26 U.S.C. §§ 38 & 48(a) (1), Bunting's lack of a profit motive disqualifies him from receiving an investment tax credit as well.

Finally, Bunting has provided no basis for challenging the propriety of the negligence penalty other than to argue that there was no deficiency in the first place. Since Bunting is incorrect in that assertion, there is no reason to overturn the Tax Court's assessment of a negligence penalty. See Zmuda v. Commissioner, 731 F.2d 1417, 1422 (9th Cir. 1984) (taxpayer bears the burden of establishing that the penalty was erroneous).

CONCLUSION

The judgment of the Tax Court is AFFIRMED.