## Facts

- LDL Research & Development II, Ltd. (LDL II), a Utah limited partnership, claimed current research or experimental expense deductions under I.R.C. § 174(a) for tax years 1983–1985 totaling about $1.11 million.
- The claimed deductions reflected installment payments to Larson-Davis Laboratories, a Utah corporation, under agreements executed in November 1983.
- Under a “Development Agreement,” LDL II agreed to pay $975,000 over three annual installments for the development of specified acoustic and vibration testing devices; Larson-Davis was to provide periodic progress reports; the agreement ended by October 1, 1986 or earlier commercial readiness.
- The agreements provided that LDL II would be the exclusive owner of developed technology, but related option agreements gave Larson-Davis (1) a nonexclusive license option to manufacture and market products for royalties and (2) an option to purchase all rights, also with royalties to LDL II.
- Larson-Davis’s founders had significant experience in developing and marketing the relevant equipment; LDL II’s general partners had minimal experience in that field.
- LDL II’s own activities were primarily raising investor funds, handling administrative matters, and reviewing Larson-Davis reports; LDL II conducted no meaningful technical research.
- A private placement memorandum emphasized anticipated tax deductions and acknowledged limited R&D experience among the partners.
- Larson-Davis developed a product (the “3100”) and exercised the license option to manufacture and market it; LDL II’s expected return was largely royalty-based.

## Issues

1. Whether LDL II’s payments to Larson-Davis qualified as research or experimental expenditures “paid or incurred … in connection with [LDL II’s] trade or business” under I.R.C. § 174(a).
2. Whether a partnership that mainly finances third-party development and holds contractual rights (including royalty and option rights) is “carrying on” a trade or business for § 174 purposes.

## Decision

- The Tenth Circuit affirmed the Tax Court’s decision for the Commissioner.
- LDL II was not engaged in a trade or business to which the research expenditures related within the meaning of § 174(a).
- Because the expenditures were not incurred in connection with LDL II’s trade or business, they were not currently deductible under § 174(a).

## Legal Principles

- I.R.C. § 174(a) allows current deduction of research or experimental expenditures only when paid or incurred in connection with the taxpayer’s own trade or business.
- A general profit motive, ownership of development rights, or an expectation of royalties does not by itself establish that the payor is carrying on the relevant trade or business.
- Financing another entity’s research, coupled with largely administrative oversight and lack of operational activity, is consistent with investment activity rather than the conduct of a trade or business for § 174(a).
- Whether a taxpayer is carrying on a trade or business is a fact-intensive inquiry; findings that the taxpayer lacked personnel, facilities, and operational involvement support denial of § 174 deductions.

## Conclusion

The court held that LDL II functioned primarily as a financing and rights-holding entity while Larson-Davis performed the actual development and commercialization; because LDL II was not carrying on a trade or business connected to the claimed research expenses, § 174(a) did not permit current deductions for the payments.


LDL Rsch. & Dev. II, Ltd. v. Comm’r of Internal Revenue, 124 F.3d 1338 (10th Cir. 1997)