LDL Research & Development II, Ltd. v. Commissioner of Internal Revenue

LDL Research & Development II, Ltd. (LDL) (plaintiff) set up a business arrangement through a series of agreements. Under one agreement, LDL would pay Larson-Davis Laboratories (the lab) to engage in research and development (R&D) of acoustic and vibration testing devices. The lab was required to send periodic status reports to LDL, and LDL would own the technology developed by the lab. However, the lab negotiated and obtained from LDL option-to-license and option-to-purchase agreements. At the option of the lab, it could obtain a nonexclusive license to manufacture and market any developed devices, in which case LDL would collect royalties. Also, at its option, the lab could purchase all the rights in developed devices, in which case LDL would collect royalties. LDL published a private placement memorandum to attract investors, stating that LDL was not experienced in R&D but that investors could expect to benefit from tax deductions taken by LDL. LDL performed administrative tasks with respect to raising funds and reviewing the lab’s reports. Eventually, the lab developed a device (the 3100), exercised its licensing option, and began marketing and manufacturing the device. Before the lab could exercise its purchase option, sales of the 3100 declined. On its tax returns, LDL deducted R&D expenditures for three taxable years, consisting of over $1.1 million in payments to the lab. The Internal Revenue Service (IRS) (defendant) disallowed the deductions on the grounds that LDL was not engaged in a trade or business in connection with the R&D expenditures. LDL challenged the IRS determination, and the tax court entered judgment for the IRS. LDL appealed.