MEMORANDUM FINDINGS OF FACT AND OPINION

TANNENWALD, Judge: Respondent determined the following deficiencies in, and additions to, petitioners' Federal income taxes:

The issue for decision is whether the Boone County Coal Properties partnership is entitled to various deductions with respect to its mining activities, and in turn, whether petitioners are entitled to their distributive share of such deductions.

Some of the facts have been stipulated and are so found. This reference incorporates the stipulation of facts and attached exhibits. For reasons of convenience, we have combined our findings of fact and opinion.

Petitioners resided in Alexandria, 1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="4" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*592 Virginia, at the time they filed their petitions. They timely filed joint Federal income tax returns on a cash basis for the 1976, 1977 and 1981 taxable years.

In the summer of 1974, George Neilan ("Neilan"), a patent attorney, was approached by a mining engineer client regarding the disposition of certain coal property in West Virginia. While in West Virginia on behalf of his client, Neilan became aware of another tract of land, constituting approximately 1,420 acres, which was available for sale. Neilan expressed interest in purchasing the tract, provided that what he considered adequate coal reserves existed on the land. However, there was no existing coal reserve estimate on the tract, so upon his return from West Virginia, Neilan engaged the services of Wilfred Lunding ("Lunding"), a geology Ph.D. candidate at George Washington University, to prospect the land. Although Lunking had no prior working experience with respect to estimating coal reserves, he prepared a geological report, dated February, 1975, on the 1,420-acre tract for Neilan. At some point subsequent to Neilan's initial contact with Lunding, Neilan's fee for service arrangement with Lunding evolved into1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="5" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*593 a partnership relationship and Neilan and Lunking formed L & N Associates.

In February, 1975, Neilan hired the firm of Robinson and Robinson, a division of NUS Corporation, as a coal mining consultant. Neilan and Lunking dealt primarily with Ernest D. Conaway ("Conaway"), chief engineer of mine development for Robinson and Robinson. Neilan furnished Conaway with the Lunking report. In February, 1976, Conaway provided Neilan with a report of the estimated recoverable coal reserves on the 1,420-acre tract. Conaway calculated the reserves in three seams, the Cedar Grove, Alma and Peerless.

Neilan and Lunking were looking for a third party to provide financial backing for the mining of the coal. They were flexible as to the structure of the financing and had been considering the possibilities of leasing the coal for a percentage or entering into a joint venture to syndicate it.

In June, 1976, Neilan met with Mark Jones ("Jones"), an investment banker, in Jones' office in New York. Jones represented to Neilan that he was looking for coal properties to develop. With respect to the transaction involved herein, Jones was introduced to Jay Landesman ("Landesman"), a New York attorney, 1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="6" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*594 investor and financial consultant, through a mutual friend and business associate of Lanesman, Douglas Palermo ("Palermo"). Neilan, in turn, met Landesman in July, 1976. During the summer of 1976, Jones and Landesman each visited the 1,420-acre tract with Neilan. As of 1976, neither Jones, Palermo nor Landesman had any experience in operating a coal mine.

Landesman and Jones reviewed the Conaway report, and Landesman met with Conaway during the summer of 1976. During that summer, Jones contacted the West Virginia engineering firm of J. W. Miller and Associates. Landesman also met with Messrs. Miller and Laird of J. W. Miller and Associates ("Miller") to discuss the project.

In July, 1976, Jones and Neilan entered into a letter of intent (dated July 21, 1976) written by Jones. Jones proposed to sell, on a best-effort basis, limited partnership interests enabling him to lease from Neilan and his associates (presumably L & N Associates) the Peerless seam on a royalty basis. Jones would in turn sublease the seam to the limited partnership. The letter also provided that Neilan was to arrange for the mining, and obtain a contract, or purchase order, for the sale of not less1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="7" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*595 than 100,000 tons per year, at a minimum contract price of $ 26 per ton delivered.

Between July 21, 1976 and August 3, 1976, a deed dated April 1, 1976 was executed by various parties, granting to Neilan the coal in place and underlying three great tracts of land in Boone County and Logan County, West Virginia. The deed was filed in the Boone County Commission Clerk's Office on October 13, 1976. Under the terms of the deed, Neilan acquired for the stated consideration of $ 336,400 all the coal in place in and underlying the land, and the mining rights and privileges associated thereto with respect to all three tracts. He did not acquire surface mining rights by the deed, other than the right to use the surface of the land normally associated with deep mining operations. ²

Of the total $ 336,400 consideration, $ 300,000 was attributable to the parcel of land defined in the deed as "GREAT TRACT NUMBER ONE (1)," which constituted the approximately 1,420-acre tract along Hurricane Branch (Fork) which was the subject of discussion between Neilan and Jones. Of the $ 1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="8" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*596 300,000, $ 25,000 was paid in cash and $ 275,000 was in the form of a negotiable promissory note, bearing interest at 8 percent per annum, from Neilan, his wife, and Lunking to the grantors of the coal in place.

The $ 275,000 note was secured by a deed of trust dated April 1, 1976 from Neilan and his wife. The deed of trust was executed by Neilan and his wife on October 5, 1976, and filed in the Boone County Commission Clerk's Office on October 13, 1976. Under the terms of the $ 275,000 note, semi-annual installments of $ 25,000 were payable on October 1 and April 1 of each year until April 1, 1981, when the entire remaining amount became due. The semi-annual installment payments were made from 1976 through 1979.

Jones selected the western half of the tract to lease from Neilan and a division was made up the hollow (Hurricane Branch) so that one road up the hollow could service both western and eastern halves. The mine at issue herein (Hereinafter referred to as the "Boone mine") was opened north of Hurricane Branch. In a revised report, dated October 15, 1976, Conaway estimated the portion of the reserves set forth in his February, 1976 report which were located on the1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="9" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*597 western half of the total tract, but limited his estimates to the Peerless and Cedar Grove seams. Neilan retained the eastern half of the 1,420-acre tract and leased it in 1977 to an entity known as the Alma Coal Properties Partnership which, in the summer of 1978, opened a mine approximately 500 feet from the Boone mine south of Hurricane Branch (hereinafter referred to as the "Manila mine"). Of the $ 300,000 stated purchase price to be paid by Neilan for the coal in the entire 1,420-acre tract, $ 150,000 was attributable to the western half.

Prior to entering into a final lease, Landesman asked the Miller firm for an economic feasibility study on the property. On August 11, 1976, Miller Management Co., Inc., a Miller subsidiary (hereinafter the parent and its subsidiary will collectively be referred to as "Miller"), rendered a preliminary report which concluded that the property was mineable. Miller also undertook in its report to manage the property. On October 1, 1976, Miller submitted a final report to Neilan, with copies to Jones and Landesman. Miller estimated the cost of mining coal and delivering it to the ground outside the mine at $ 15 to $ 16 per ton, with an assumed1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="10" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*598 production at 200,000 tons per year. The assumption that 200,000 tons per year was recoverable was based on Conaway's report. Miller estimated that $ 550,000 would initially be required to capitalize the mining operation.

In September, 1976, the Blair Mott Drilling Corporation performed one core drilling on the western half of the 1,420-acre tract (hereinafter the "Blair Mott core drilling"). The core drilling was performed for United Equity Corporation, an investment syndication group that was considering leasing some of the reserves. The group had access to the Conaway report, but wanted further confirmation of the report. Neilan had access to the results of the core drilling, and made the results known to Conaway and to LJP.

On October 27, 1976, Neilan (individually) and LJP Partners ("LJP"), a Connecticut general partnership comprised of Landesman, Jones, and Palermo, executed a 10-year lease of the coal in the Peerless and Cedar Grove seams underlying the western half of the 1,420-acre tract (hereinafter, this document will be referred to as the "lease"). Under the terms of the lease, LJP was to pay Neilan a tonnage royalty of $ 1.62 per ton of merchantable coal mined, 1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="11" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*599 removed and sold and LJP agreed to pay to Neilan an $ 800,000 advanced royalty on or before December 31, 1976, subject to recoupment against the tonnage royalty on the first 1,290,323 tons of coal mined at the rate of $ .62 per ton. LJP paid $ 675,000 to Neilan in cash on December 31, 1976, and executed a $ 125,000 note for the remainder of the $ 800,000 advanced royalty. The note was not paid. Neilan also agreed that, simultaneously with payment of the advanced royalty, he would contribute $ 500,000 to initially capitalize Boone Resources Inc. ("Boone Resources"), a West Virginia corporation to be formed for the purpose of conducting mining operations on the property. ³ Boone Resources was subsequently formed on November 29, 1976, and Neilan was its president. The $ 500,000 used to capitalize Boone Resources came from the proceeds of the $ 675,000 cash portion of the advanced royalty. Neilan also deposited $ 50,000 from these proceeds into an escrow account to assure one year's payment on the $ 275,000 note to the grantors of the coal in place.

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="12" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*600 The advanced royalty payment was conditioned on Neilan delivering to LJP, on or before December 31, 1976, at LJP's option, either a counterpart of the lease signed by Neilan's wife or an instrument executed by Neilan's wife subordinating her dower right in the leased property to the lien of the lease. If a subordination agreement or lease counterpart was not delivered to LJP on or before December 31, 1976, LJP would be released from its obligation to pay the advanced royalty.

On October 27, 1976, a Certificate of Limited Partnership for Boone County Coal Properties ("Boone"), a West Virginia limited partnership, was executed by Richard Guthrie ("Guthrie") as general partner and Landesman as limited partner. The stated purpose of Boone was to acquire the right to mine certain coal properties in West Virginia pursuant to a sublease agreement (dated as of October 27, 1976) entered into by LJP and Boone, and to mine the coal. Additional limited partners could be admitted upon the consent of Guthrie and Landesman.

LJP and its individual partners (Landesman, Jones and Palmermo) were the promoters and "parents" of Boone. Guthrie was selected and requested to serve as the general partner1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="13" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*601 of Boone by LJP. As of 1976, Guthrie had no experience in operating a coal mine or had ever been responsible for extracting coal from the ground. Prior to 1976, Guthrie had served as a mining specialist with Manufacturer Hanover Trust Company and as a securities analyst with Irving Trust Company.

On October 27, 1976, LJP and Boone executed a 10-year sublease (hereinafter the "sublease") of the coal in the Peerless and Cedar Grove seams on and underlying the same lands described in the Neilan-LJP lease. The sublease was signed by Landesman, Jones and Palermo for LJP, and Guthrie for Boone.

Under the sublease, Boone was to pay LJP a tonnage royalty of $ 2.70 per ton of merchantable coal mined, removed and sold and Boone agreed to pay to LJP a $ 5,025,000 advanced royalty on or before December 31, 1976, subject to recoupment against the tonnage royalty on the first 2,010,000 tons of coal mined at the rate of $ 2.50 per ton. Furthermore, the sublease provided that a minimum annual royalty of $ 10,000 per year for each year during the term of the sublease was to be paid to LJP "whether or not the tonnage royalty on coal actually mined, removed and sold from the Property during each1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="14" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*602 such year shall produce a sum equal to said Minimum Annual Royalty." Pursuant to the sublease, the $ 5,025,000 advanced royalty was payable to LJP in cash of $ 1,525,000 and by a $ 3,500,000 promissory note.

The $ 3,500,000 note was dated December 31, 1976, matured on December 31, 1987, was nonnegotiable and bore interest at 6 percent per annum. Interest was due on December 31, 1977. Thereafter, the outstanding principal, together with interest, was payable in quarterly installments of $ 115,000, with a final installment of $ 223,258 due on the maturity date. Boone had the right, upon a minimum payment of $ 2,500 of any installment ("mandatory minimum payment"), to defer until the maturity date the payment of the remainder of the installment. In any event, the minimum amount to be paid per quarter was $ 2,500, or $ 10,000 per year. If the mandatory minimum payment was not made, LJP had the right to declare the balance due. Boone was obligated to prepay the note in the amount of $ 2.30 per each ton mined and sold from the property, which prepayments would be applied to the quarterly payments. The note was without recourse to Boone, its general partners or any limited partners,1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="15" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*603 and was secured by a mortgage and security interest in all Boone's interest in the property that was the subject of the sublease. LJP's sole remedy in event of default was to terminate the sublease and foreclose.

The terms and provisions of the sublease, the note and the mortgage were determined by LJP. The simultaneous lease of the property by Neilan to LJP for an advanced royalty of $ 800,000 was structured by LJP. Neilan, Landesman, LJP and Boone relied on Conaway's estimated reserves with respect to the decisions to purchase the western half of the 1,420-acre tract for $ 150,000, lease it for an advanced royalty of $ 800,000 and sublease it for an advanced royalty of $ 5,025,000, and on the Miller report in determining the feasibility of the mining operation.

Neither the lease nor sublease included a metes and bounds description of the property subject thereto. On November 24, 1976, George T. Ikner, Jr. ("Ikner") rendered a title opinion to Boone upon Neilan's request. The title opinion pertained to the property described in the lease, i.e., the western half of the tract, which in fact consisted of nine smaller tracts. The title opinion provided that the actual likelihood1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="16" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*604 of failure of title in the properties was small, except for two of the nine tracts (John T. Ellis and Robert Ellis). The private placement memorandum (see p. 13 et seq., infra) stated that Boone's title with respect to these excepted portions of Boone's leasehold interest (affecting approximately 515,000 recoverable tons of coal) was highly questionable. Because of the defects in title, Neilan leased the Alma seam to LJP as security in the event of any title problems which would impare LJP's mining capabilities. LJP, in turn, leased the Alma seam to Boone. No additional royalty was required for the Alma seam.

Various documents were executed on or about November 22, 1976, whereby Neilan's wife agreed to the various transactions to which Neilan was a party and released any dower interest.

On October 27, 1976, Boone Resources and Boone entered into a contract mining agreement. Pursuant to the agreement Boone was to pay Boone Resources $ 17.00 per ton for coal production (mining, processing, transportation, marketing) of the Peerless and Cedar Grove seams covered by the sublease. Boone Resources agreed to the supervision of the management of all phases of the mining operations1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="17" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*605 by Miller. In addition to all mining operations, Boone Resources was responsible for the procurement of purchase orders or long-term contracts. The contract mining agreement could be terminated by Boone without cause upon 30 days written notice, and by Boone Resources upon the lawful termination of the sublease.

By a management agreement dated as of October 27, 1976, between Boone, Boone Resources and Miller, Miller agreed to manage the mining operations of Boone in return for its engineering costs and ordinary and necessary expenses, plus 20 percent above the total costs, and $ .50 per ton of coal shipped and sold. All compensation required to be paid to Miller by the terms of the agreement was payable by Boone Resources. Under the management agreement, Miller was to supervise Boone Resources in the performance of its obligations under the mining agreement. Miller, for example, was to recruit, hire, supervise and discharge all mining personnel, represent Boone Resources in contract negotiations for the sale of coal, and develop additional markets for coal produced.

Neilan had a two-thirds interest in Boone Resources; Lunking had a one-third interest. By pledge agreements, 1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="18" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*606 the stock of Boone Resources was pledged to Boone to secure performance by Boone Resources on the contract mining agreement.

In November, 1976, by four agreements (base leases), Neilan acquired the right to surface mine certain portions of the 1,420-acre tract, and assigned his rights to LJP.

On November 26, 1976, Boone issued its private placement memorandum. At the outset, the private placement memorandum warned that:

THE INVESTMENT DESCRIBED HEREIN IS HIGHLY SPECULATIVE. INITIAL DEVELOPMENT OF A COAL MINING PROPERTY MUST BE CONSIDERED A HIGH RISK UNDERTAKING AND SHOULD BE CONSIDERED ONLY BY SOPHISTICATED INVESTORS WHO HAVE SUBSTANTIAL NET WORTH AND CAN FULLY AFFORD A COMPLETE LOSS OF THEIR INVESTMENT.

Furthermore, it was provided that:

Prospective investors reading this memorandum should be aware that one of the most important potential benefits of an investment in the Partnership is a Partner's ability to deduct on his personal Federal income tax return his proportionate share of the Partnership's losses. However, the deductibility by the Partnership in 1976 of its $ 5,025,000 advance royalty payment involves substantial questions; particular attention should therefore1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="19" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*607 be paid to the tax aspects of this Memorandum. [Emphasis supplied.]

The private placement memorandum went on to detail specifically the mining and business risks inherent in an investment in Boone. For example, prospective investors were made aware that:

1. The Partnership has not received title insurance or an unqualified opinion of counsel with respect to title to its leasehold interest in the Property, although the Partnership has received an opinion of special counsel to the effect that with respect to the major portion of the Property, the actual likelihood of a failure of title is small. However, its title with respect to a portion of its leasehold interest is highly questionable. Consequently, no assurances can be given that the Partnership will not encounter title problems with respect to all or a portion of its leasehold interest which may affect its ability to profitably mine and sell coal from the Seams on the Property. (See Description of the Property -- Title, below)

2. The exploration for and the mining of coal is presently being pursued by many companies substantially larger in size and with greater resources than the Partnership and the General Partner.1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="20" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*608 Such companies will be competitors of the Partnership, will be in a better position than the Partnership to withstand temporarily depressed markets and other adverse economic conditions and may be able to supply larger quantities of coal to their customers and to potential customers of the Partnership than can be supplied by the Partnership. (See Competition and Regulation, below)

4. [sic] Coal competes with oil and gas, atomic energy, hydro-electric power and other forms of energy, both domestic and imported, the availability and cost of which affects the demand for coal. Governmental regulations exist with respect to the mining and use of coal, including, without limitation, minimum safety and health standards and environmental considerations. In addition, legislation is continuously being proposed and considered by Federal, state and local legislative bodies which would impose certain requirements on companies engaged in the coal business. Any of the foregoing, together with any other present or future regulations or restrictions, may have an adverse effect on the ability of the Partnership to mine, sell and/or dispose of coal on a commercially profitable basis. (See Competition1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="21" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*609 and Regulation, below)

4. No assurances can be given that purchasers for the Partnership's coal can be found or that transportation on commercially reasonable terms or the permits necessary therefor will be available for the delivery of such coal. In addition, the possibility exists that there may be difficulty in selling at favorable prices coal that the Partnership mines from the Property. Unless a market is available for coal at the anticipated production rate, the cost of production per ton may be adversely affected by a lower production rate. Mining companies often seek to reduce these risks by contracting in advance to sell a major portion of their anticipated output at predetermined prices to coal users. Although the General Partner has conducted preliminary discussions with coal users, no such contracts have been entered into or are likely to be entered into prior to the Closing Date.

5. Although the reports of the Robinson & Robinson Division of NUS Corporation ("Robinson & Robinson"), dated as of February 5, 1976, and October 15, 1976, attached hereto as Exhibit B. (collectively the "Robinson & Robinson Report") indicate the existence of substantial recoverable1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="22" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*610 coal reserves under the Property based upon the prospecting techniques employed, there is no assurance as to the actual amount of such coal reserves or that such reserves are physically or economically recoverable.

6. The Partnership and Resources intend to mine and develop the Seams in accordance with the program set forth in a letter, dated October 1, 1976, from J. W. Miller & Associates, an affiliate of Miller, a copy of which is attached hereto as Exhibit C (the "Miller Letter"). However, while such study projects a rate of production of marketable coal from the Seams on the Property of approximately 200,000 tons per annum by January 1978, there is no assurance that such rate of production will be achieved by that date or at any other time.

7. Coal samples obtained on the Property have been analyzed for moisture, ash, B.T.U. and sulphur content. The results of these analyses are set forth at page 11 of the February 5, 1976 segment of the Robinson & Robinson Report. Although the General Partner believes that such tests indicate a marketable metallurgical coal, there is no assurance that such will be the case.

8. Market prices of coal are subject to wide fluctuations. 1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="23" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*611 Principal factors affecting market prices include the manner in which the coal is sold (spot or long-term contracts) and changes in quantity and quality demands of users. In the event that the prices at which the Partnership is able to sell its coal are not in excess of the sum of its mining costs, taxes, commissioners, royalties, fees, required payments of principal and interest on its Note to LJP and other obligations and other costs, the Partnership may be unable to meet all of its obligations and may stop mining operations. In either event, it runs the risk that because of its inability to pay its fixed obligations on the Note to LJP, it may forfeit the Property. (See Description of the Sublease, The Note and The Mortgage, below) In such event, the Limited Partners may lose their entire investment and suffer adverse tax consequences. In addition, any stoppage of mining activities by the Partnership may cause it to terminate the Contract Mining Agreement which would then require the Partnership to purchase or otherwise acquire the machinery and equipment owned or used by Resources. (See Description of the Contract Mining Agreement, below) The Partnership would be adversely1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="24" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*612 affected by its inability to replace Resources or by its being required to pay a contract miner amounts in excess of the amounts provided for in the Contract Mining Agreement. The Partnership may also be adversely affected by variations in the quality of the coal which it mines, causing it to be unable to meet the specifications of any purchasers of its coal. Accordingly, as indicated above, there can be no assurance as to the prices, if any, which the Partnership will be able to obtain for a substantial portion of its anticipated coal production or that such prices will be sufficient to warrant the Partnership's continuing mining operations. Also, to the extent the Partnership obtains long-term contracts for the sale of coal at a specified price per ton and the market price for coal subsequently rises, the Partnership's sales made pursuant to said contracts might be required to be made at a price less than the then current market price.

9. Under and subject to the terms of the Contract Mining Agreement, Resources is required to furnish contract mining, sales, processing and transportation services for the Partnership at a base price of $ 17.00 per ton, inclusive of sums paid1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="25" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*613 to Miller under the Management Agreement. That base price of $ 17.00 per ton will increase on a dollar for dollar basis to reflect any increased costs incurred by Resources with respect to miners' wages or benefits or other direct labor costs. In addition, the Partnership is required under the Contract Mining Agreement to absorb cost increases incurred by Resources in performing its services thereunder to the extent such increases cause Resource's [sic] costs to exceed $ 17.50 per ton. Furthermore, after 200,000 tons of coal have been mined or after two years, whichever occurs first, Resources may request that the price paid by the Partnership to Resources for its services under the Contract Mining Agreement be on a cost plus basis, which would increase the price paid by the Partnership for Resources' services. (See Description of Contract Mining Agreement and Description of Management Agreement, below) Labor, trucking, explosives and other expenses may increase beyond present levels due to inflation, labor conditions, material shortages, the impact of a national energy crisis and other factors. Variations in levels of productivity and the need for additional equipment may also1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="26" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*614 affect costs. In addition, costs may increase as a result of the enactment and enforcement of laws and regulations regulating business activities affecting the environment and/or health and safety. It is unlikely that the Partnership will be able to absorb such cost increases since it will have minimal working capital; consequently, unless the Partnership can pass such cost increases to its customers by selling coal at increased prices, the Partnership will probably be forced to cease operations.

10. The Contract Mining Agreement extends for the life of the Sublease but it may be terminated for any reason by the Partnership upon 30 days' written notice. In the event that Resources either defaults in any of its obligations under the Contract Mining Agreement or is unable or is unwilling to perform satisfactorily, the Partnership may be required to find one or more persons, other than Resources, to perform the mining services. There can be no assurances that the Partnership will be able, if necessary, to find one or more satisfactory replacements for or additions to Resources or, even if it can, that it will be able to do so without thereby increasing the costs of the Partnership's1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="27" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*615 operations to an unprofitable level. In addition, among the principal factors affecting the Partnership's ability to mine 200,000 tons of coal in any year is the availability of mining services at cost levels which would permit the Partnership to mine such coal profitably. The failure of Resources to perform its obligations under the Contract Mining Agreement, unless it were satisfactorily replaced, may result in the Partnership being unable to mine and sell enough coal to generate revenues sufficient to fulfill its payment obligations under the Note or to pay the Annual Royalty, which nonpayment would constitute a default under the Sublease and the Note and could cause the Partnership to forfeit the Sublease. (See Description of the Sublease, below)

11. The success of the Partnership's mining operations will be dependent to a great extent on the ability of Resources to market coal mined from the Property. To the extent that Resources is unsuccesful in its marketing activities, the Partnership may have to use other marketing services or create its own marketing staff at a significant cost. Such additional costs could increase the Partnership's operating expenses to an unprofitable1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="28" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*616 level. The failure of Resources to provide the Partnership with orders for coal which Resources is required to mine, unless alternative satisfactory orders were obtained, may result in the Partnership being unable to mine and sell enough coal to generate revenues sufficient to fulfill its payment obligation under the Note or to pay the Annual Royalty, which non-payment would constitute a default under the Sublease and the Note and could cause the Partnership to forfeit the Sublease. (See Description of the Sublease, below) The Partnership has no prior experience in the management of coal development ventures and thus will be dependent to a significant degree on Miller and Resources.

12. The possible imposition of mandatory price controls or allocations of various energy sources, including coal, or other similar measures could have an adverse effect on the Partnership's operations. It is also possible that a reduction in oil or gas prices or increasing use of other energy sources may reduce the demand for and the price of coal, thereby making the Partnership's proposed mining activities either less profitable or unprofitable. A reduction in the price of coal could also result1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="29" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*617 at any time that available coal supplies exceeded the demand for coal. Since a significant portion of the coal mined in the United States is exported, any adverse economic conditions abroad could have an adverse effect on the ability of coal producers, especially smaller entities such as the Partnership, to market their coal domestically.

13. Coal mining activities involve hazards such as possible high wall slides, roof callapses, blast related damages and the leakage of dangerous gases into mining tunnels. The Partnership may incur losses due to hazards against which it cannot insure or against which it elects not to insure because of high premium costs or other reasons. While the General Partner intends to have Resources and any other contract miner used by the Partnership maintain insurance for the Partnership against risks and in amounts which are customary for coal mining operations in the vicinity of the Property, substantial uninsured liabilities to third parties may arise, the satisfaction of which could reduce or eliminate the funds available for further operations and thereby cause the curtailment or termination of mining operations by the Partnership.

Similarly, 1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="30" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*618 the private placement memorandum specifically set forth certain tax risks attendant upon an investment in Boone, most notably that:

The Partnership intends to deduct on its 1976 Federal income tax return the Advanced Royalty. Although there is authority for deducting advance royalty payments in the year paid, the matter is not free from doubt and the Partnership has not received, and will not be receiving, an opinion of counsel with respect thereto. Also, any subsequent sale or sublease of the Sublease by the Partnership could have an adverse effect on the deduction of the Advanced Royalty. Potential investors are strongly urged to review the deductibility of the Advanced Royalty with their own tax advisor prior to investing. Particular attention should be paid to the October 29, 1976, Information Release 1687 of the Internal Revenue Service with respect to the deductibility of advanced royalty payments, a copy of which is annexed hereto as Exhibit D, and potential investors are cautioned that there is a substantial risk of disallowance of such deduction and a substantial risk that the Partnership would not prevail if the matter were litigated.

Attached to the private1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="31" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*619 placement memorandum were copies of the Conaway and Miller reports and two sets of unaudited financial statements derived therefrom, prepared by the certified public accounting firm of Elmer Fox, Westheimer & Co. These statements included projected cash flow and income statements for the years 1976 through 1985 for Boone as an entity, as well as individual projections of "cash flow and tax savings (cost)" per whole unit investment (i.e. $ 50,000) in the partnership assuming a 50, 60 or 70 percent tax bracket.

As the notes to the first set of statements explain, for purposes of deriving the projections found therein, it was anticipated that the Boone mine would commence operations in December, 1976, and it was assumed that production in that month would aggregate 2,000 tons; in 1977 at the annual rate of 80,000 tons, and thereafter at the annual rate of 200,000 tons (i.e., 1,682,000 tons through 1985). It was also assumed that the net selling price, after deduction of a 15-percent shrinkage factor, would be $ 23.375 per ton, and that the amount to be paid to Resources as contract miner was $ 17.00 per ton. Moreover, the projections assumed that Boone would be entitled to deduct1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="32" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*620 the full amount of the advanced royalty of $ 5,025,000 in 1976, and explained that depletion would be computed on the percentage method. The following is the "Statement of Projected Cash Flow and Tax Savings (Cost)," assuming a 50-percent tax bracket and a $ 50,000 investment in the partnership:

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="33" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*621 The accompanying information and assumptions relating to projections are an integral part of this statement.

The private placement memorandum also provided a second set of projections based on the assumption that the Internal Revenue Service would take the position that the advanced royalty was not fully deductible from gross income in the year paid (1976), but instead allowable as a deduction ratably over the period the coal was to be mined and sold. In all other respects, these alternative projections were based on the same assumptions as discussed 86 T.C. 14">supra at p. 19-20. ⁴ The following is the "Statement of Projected Cash Flow and Tax Savings (Cost)," assuming a 50-percent tax bracket and a $ 50,000 investment in the partnership, as modified in the private placement memorandum for the change in treatment of the advanced royalty:

The accompanying information and assumptions relating to the projections are an integral part of the projected statement. (Assuming the advanced royalty1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="35" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*623 paid during 1976 is deducted ratably over the period the coal is mined and sold.)

On December 31, 1976, a first amendment to certificate of limited partnership was executed and dated as of November 1, 1976, by Guthrie, as general partner and acting on behalf of later limited partners, and Landesman. The cash contributions were stated to be:

There were 18 later limited partners, including:

Highboro Associates was also one of the later limited partners, with a stated cash capital contribution of $ 65,000. Petitioner Jim Zegeer ("Zegeer") was a reported partner of Highboro Associates in 1976, and contributed $ 5,000 to the capital of Boone on December 30, 1976. Zegeer had the right to .3014 percent of the profits and losses of Boone, through Highboro Associates in 1976 and individually in subsequent years.

The proceeds of the Boone offering were to be used as follows:

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="36" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*624

To the extent the legal and accounting fees exceeded $ 45,000, the excess was to be paid by LJP. LJP intended to use the $ 1,525,000 cash portion of the advanced royalty as follows:

The $ 665,000 "working capital," less certain commissions and fees in excess of the $ 45,000 in organization expenses, was to be profit to LJP.

The Boone offering was on an all or nothing basis. Under the terms of the offering, Landesman had to sell all of the Boone units or return the money. As the promoter of Boone, Landesman did not sell all the units to outside investors by the end of December, 1976. Accordingly, Landesman and Palermo formed Wickam Partners ("Wickam") and contributed $ 775,000 to Boone. Landesman had a 47 percent interest in Wickam, whose reported proportionate loss from Boone for 1976 was $ 2,374,319. Landesman and Palermo borrowed the $ 775,000 they contributed to Boone from the Chemical Bank in late December, 1976, and paid the $ 775,000 back to Chemical Bank in January, 1976, out of the $ 1,525,000 proceeds1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="37" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*625 that went from Boone to LJP for cash portion of the advanced royalty.

Neilan received $ 675,000 in cash from LJP for the advanced royalty. Of this amount, $ 500,000 was used to capitalize Boone Resources; $ 50,000 was put into escrow to assure one year's payment on the $ 275,000 note to the third parties under the deed; and $ 125,000 was treated as L & N's capital contribution to Boone. After the first year's payments on the $ 275,000 note to the third-party grantors of the coal in place ($ 50,000), default on the note was prevented for one year by using funds from the Alma Coal Properties Partnership associated with the eastern half of the 1,420-acre tract.

Under Miller, mining operations (road construction, mine site) were to commence in November, 1976. Mining permits were to be obtained by November, 1976, and there was to be production in 1976. As of the end of 1976, Boone obtained no permits, conducted no mining operations and sold no coal. On its 1976 return (1065), Boone claimed a $ 5,025,000 deduction for the advanced royalty. Boone also claimed a deduction of $ 30,000 for the general partner's management fee and $ 25,000 for professional fees for tax advice. The total1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="38" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*626 loss claimed by Boone was $ 5,080,000. Petitioners claimed a $ 15,318 loss from Boone (through Highboro Associates) in 1976.

Post-1976 Events

In the spring of 1977, Landesman became involved in the Boone mining operations. Landesman was not satisfied with Guthrie's performance as a general partner with respect to his non-administrative duties in operating Boone. On July 6, 1977, Boone Resources obtained a certificate of approval for mine openings for the Peerless seam. In August, 1977, Landesman asked Miller for the termination of the management agreement, and Miller, upon securing consent from Boone, cancelled the agreement. Miller's proposed schedule for mining called for the completion of the road, pond and face up, and a single shift operation on a single section of mining by June - July, 1977, which, at the time of termination, had not been met.

Landesman contacted Robert Wolfe ("Wolfe") of Kelley, Gidley, Blair and Wolfe, Inc. ("Kelley, Gidley") to perform engineering and management services for Boone and Boone Resources entered into a management agreement with that firm. Under the agreement, Kelley, Gidley was to supervise the mining, represent Boone Resources1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="39" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*627 in contract negotiations for the sale of coal, and, to the best of its ability, develop additional markets for the coal produced from the property. Boone Resources was to pay 2.6 times Kelley, Gidley's actual payroll costs, plus out-of-pocket disbursements reasonably incurred, plus, as additional compensation, 25 cents per ton for the first 100,000 tons of coal shipped and sold monthly from the property per year, and 50 cents per ton for each ton shipped and sold in excess thereof. Wolfe's day-to-day contracts were with Landesman. Wolfe had signature authority with Guthrie on all Boone Resources' checks.

On September 7, 1977, Boone Resources and Jerry Thompson, d/b/a Carrie Lynn Coal Company ("Carrie Lynn") entered into a subcontract to mine the Peerless seam. Prior to mining, Carrie Lynn was to build a road to the mine site, a pond and face up the seam. Carrie Lynn would be paid $ 45,212 for the road and pond work, and 12 percent above cost for the face up, estimated at $ 60,000. Carrie Lynn could retain the resulting coal from the face-up operation. Boone Resources agreed it would spend up to $ 30,000 to bring electricity to the mine site, and up to $ 5,000 for site work1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="40" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*628 needed in preparation for moving a coal processing facility onto the site. Carrie Lynn was responsible for selling the coal it mined, and for procuring a coal cleaning plant to be moved on the property within 6 months. Under the subcontract, Carrie Lynn was to commit $ 300,000 worth of machinery and document that it had $ 100,000 available in operating capital. It was contemplated that Boone Resources would expend approximately $ 140,000 in preparation of mining (road, pond, electricity and face up). As of September 28, 1977, Carrie Lynn had not documented its operating capital or its commitment of machinery. On that date, Landesman and Jerry Thompson, d/b/a Carrie Lynn, entered into an agreement appointing Landesman receiver of Carrie Lynn. ⁵

As of September, 1977, Boone Resources had $ 390,000 in funds left from the $ 500,000 initial capital, having spent $ 110,000. 1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="41" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*629 By that time, work had not commenced on the road. On October 3, 1977, Carrie Lynn moved onto the site to commence the preliminary work (road, pond and face up). On October 26, 1977, Boone Resources obtained a permit to upgrade a road to the mine site.

By the end of 1977, no coal had been produced or sold by Boone. On its partnership return for 1977, Boone claimed an ordinary loss of $ 227,063. Of this amount, $ 210,000 was attributable to accrued interest on the $ 3.5 million note, and the remaining $ 17,063 to operating expenses consisting of rent and mine supervision and office costs. The minimum mandatory payments ($ 2,500 quarterly) required by the $ 3.5 million nonrecourse note were not made by Boone in 1977. Through Highboro, petitioners claimed a loss of $ 685 from Boone in 1977.

From December, 1977, to March, 1978, there was a coal miners' strike. The preliminary work at the Boone mine (road, pond and face up) took place during the strike. By April, 1978, the haul road, pond and face up had been completed. All but approximately $ 16,000 of the remaining $ 390,000 of Boone Resource capital (see p. 29, supra) had been expended and mining had not commenced. 1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="42" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*630 Of the capital that was expended, $ 64,127 was paid to Kelley, Gidley for management services.

Wolfe was disappointed with Thompson's performance, and accordingly, upon his suggestion, Carrie Lynn was terminated sometime after March, 1978.

On April 7, 1978, Boone notified Boone Resources and Neilan of the termination of the October 27, 1976, contract mining agreement. Boone Resources was terminated because it had expended the entire $ 500,000 in capital without mining. On March 24, 1978, Guthrie sold 50 percent of his general partnership interest to Lanni Mining Enterprises, Inc. ("Lanni") and Lanni became the co-managing general partner of Boone. The president of Lanni was Morris Silver ("Silver"), an accountant from New York.

On January 17, 1978, a preliminary draft report was prepared for Landesman by Kelley, Gidley evaluating various mining systems to be used in mining the Peerless seam. On March 31, 1978, Hurricane Branch Coal Company ("Hurricane") was formed as a wholly-owned subsidiary of Madison Resources, Inc. ("Madison Resources") which was owned by Landesman. Kelley, Gidley presented to Madison Resources and Hurricane a feasibility report for the Peerless seam.1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="43" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*631 On April 7, 1978, Madison Resources and Boone executed a contract mining agreement for the mining of the Alma and Peerless seams. Hurricane completed the preliminary work.

Madison Resources was the contract miner for Madison Associates ("Madison"), a mining co-ownership formed in 1977. Madison Resources had $ 500,000 in capital as a result of the Madison syndication in 1977 covering a proposed Madison mine which was to be close to the Boone mine. Madison Resources and Hurricane drafted a proposal for the mining of the Peerless seam. The proposal called for the borrowing of $ 600,000 to be used for equipment ($ 500,000) and working capital ($ 100,000). The Conaway reports were part of the proposal. The Madison mine never operated, and the Madison investors received no return on their capital investment. Instead, the $ 500,000 of Madison Resources capital from the Madison syndication was used for the Boone mining operation in 1978, upon consent of the Madison investors. Madison Resources sold 1,100 tons of face up coal in May, 1978, for $ 21,000. Madison Resources received the proceeds of the sale.

By mid-1978, Landesman believed that, if the mining was not consummated in1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="44" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*632 a timely manner, the Boone investors would realize income as a result of recapture measured by the amount of $ 3.5 million nonrecourse note from default on the property. Landesman believed that since the investors would realize unearned income at 70 percent levels, it would be a "major disaster" if the property were not mined. One of Landesman's objectives was to mine the property in order to preserve the $ 5 million plus tax deduction. Neilan was concerned in August, 1978 that, if Boone did not commence mining, his tax deductions would be in jeopardy.

On September 1, 1978, the Boone investors were advised by letter that mining was about to commence, and that Boone had "succeeded in fulfilling the obligations to face-up the mine and, in fact, put it in a state of readiness for actual mining." Boone did not know at what price it would sell its coal, or what income, if any, could be expected out of the mine in 1978. Mining at the Boone site commenced in the fall of 1978 under the name of Hurricane. Hurricane expended approximately $ 500,000 on the mining operation, which $ 500,000 came from the Madison syndication. On October 31, 1978 a load operator was killed at the mine site.1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="45" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*633 As a result of the accident, the mine was closed down for a short period of time by the Mine Health and Safety Administration; after a full investigation, it was allowed to reopen. The accidental death led to a highly regulated environment at the mine, consisting of ongoing inspections, which increased the cost, and adversely affected the efficiency, of the mining operations. The mine did not operate after January 2, 1979. In 1978, the mine produced 4,466 tons of coal, but Boone sold none of this production.

On November 7, 1979, Hurricane filed a petition in bankruptcy. On June 29, 1981, notice of a trustee sale of the 1,420-acre tract was given as a result of Neilan's default on the $ 275,000 note to the grantors under the deed of trust dated April 1, 1976. The foreclosure sale was conducted on July 3, 1981, and the 1,420-acre tract reverted to the grantors. No minimum mandatory payments as required by the nonrecourse note were ever made during or after 1978.

On its 1981 partnership return, Boone claimed a $ 140,068 ordinary loss. Of this amount, $ 140,000 was attributable to accrued interest in the $ 3.5 million nonrecourse note. Boone also reported on that return a1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="46" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*634 $ 4,482,500 capital gain under section 1231. Boone reported the gain as arising from the sale of a "coal lease" acquired in October, 1976 and sold in July, 1981. The $ 4,482,500 gain equalled the discharged liabilities, calculated as follows:

Zegeer's distributable claimed loss from Boone for 1981 was $ 422, and his share of the reported gain was $ 13,511. Petitioners did not report the $ 422 loss of the $ 13,511 gain on their 1981 return.

The initial issue for decision is whether the partnership, and through it petitioners, is entitled to the claimed deductions for an advanced royalty and management and professional fees in 1976, and for operating expenses in 1977. See pp. 26, 29, supra. The extent of petitioners' additional income for 1981 depends, at least in part, on resolution of this issue.

Respondent does not dispute that "Royalties traditionally have been described as akin to rent and are deductible by the payor as a trade or business expense under section 162(a)(3)." Seaman v. Commissioner,84 T.C. 564">84 T.C. 564, 84 T.C. 564">588 (1985)1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="47" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*635 (Citations omitted). Nor does he suggest that the fees and operating expenses are not of a character which would normally qualify them as ordinary and necessary business expenses deductible under section 162. Rather, respondent argues that Boone is not entitled to the claimed deductions because the partnership's operations did not constitute an activity entered into for profit within the meaning of section 183, ⁶ and therefore Boone cannot be considered as being engaged in a trade or business within the meaning of section 162.⁷

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="48" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*636 Hence, the relevant inquiry herein is whether the Boone mining venture was entered into 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). This determination must be made at the partnership level, Taube v. Commissioner,88 T.C. 464">88 T.C. 464, 88 T.C. 464">478 (1987); 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); Siegel v. Commissioner,78 T.C. 659">78 T.C. 659, 78 T.C. 659">698 (1982), and although a reasonable expectation of profit is not required, it must be shown that a bona fide objective of making a profit did exist. 88 T.C. 464">Taube v. Commissioner, supra at 478-479; 78 T.C. 642">Dreicer v. Commissioner, supra at 643-645; see also Estate of Baron v. Commissioner,83 T.C. 542">83 T.C. 542, 83 T.C. 542">553 (1984), affd. 798 F.2d 65">798 F.2d 65 (2d Cir. 1986). The burden of proving such objective is on petitioners. 88 T.C. 464">Taube v. Commissioner, supra at 480.

The regulations promulgated under section 183 list nine relevant factors which should be taken into account1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="49" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*637 in determining whether an activity is engaged into for profit. See section 1.183-2(b)(1)-(9), Income Tax Regs. However, as the regulations clearly provide, this is only intended as a partial list of the factors relevant to making such a determination and no single factor is considered determinative. Section 1.183-2(b), Income Tax Regs. Our decision as to whether Boone possessed the requisite profit objective is a question of fact which must be determined in light of all the facts and circumstances, 88 T.C. 464">Taube v. Commissioner, supra at 480; 83 T.C. 542">Estate of Baron v. Commissioner, supra at 553, section 1.183-2(b), Income Tax Regs., and not arrived at "by merely counting the factors which support each party's position." Dunn v. Commissioner,70 T.C. 715">70 T.C. 715, 70 T.C. 715">720 (1978), affd. 615 F.2d 578">615 F.2d 578 (2d Cir. 1980). Accordingly, rather than analyzing each of the individual factors set forth in the regulations, "we will deal with the totality of the circumstances revealed by the record herein in the context of the factors asserted by the parties in favor of their positions." 88 T.C. 464">Taube v. Commissioner, supra at 480-481. See also 83 T.C. 542">Estate of Baron v. Commissioner, supra at 554.1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="50" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*638

Before proceeding with our analysis, certain preliminary observations are in order. To begin with, respondent makes much of the fact that Guthrie, Boone's general partner, was not called to testify at trial. Citing to Wichita Terminal Elevator Co. v. Commissioner,6 T.C. 1158">6 T.C. 1158 (1946), affd. 162 F.2d 513">162 F.2d 513 (10th Cir. 1947), he argues that Guthrie's absence gives rise to the inference that his testimony would not have supported petitioners' position. We disagree. In determining profit objective at the partnership level, focus is "on the intent of the general partner and the promoters of [the partnership] since it is these individuals who actually controlled the partnership's activities." Fuchs v. Commissioners,83 T.C. 79">83 T.C. 79, 83 T.C. 79">98 (1984) (emphasis added). See also 88 T.C. 464">Taube v. Commissioner, supra at 480. We were favored at trial with extensive testimony by Landesman, the chief promoter of the syndication, whom respondent himself refers to as "the driving force of the Boone promotion." We found such testimony not only convincing and forthright, but generally supported by the other evidence we saw and heard. Accordingly, 1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="51" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*639 while Guthrie's testimony would most certainly have been welcomed, not only do we decline to draw any adverse inference from his absence at trial, but we do not think it was incumbent on petitioners to call him as a witness in order to carry their burden of proof.

Moreover, we emphasize at the outset, especially in view of the large amount of evidence submitted in this case which deals with events surrounding the partnership's activities after Boone's syndication in 1976, that "the focal point with respect to our analysis should be at the beginning of the transaction and that our decision should not be based on objective hindsight." 88 T.C. 464">Taube v. Commissioner, supra at 480. See also Smith v. Commissioner,78 T.C. 350">78 T.C. 350, 78 T.C. 350">392 n.32 (1982), affd. without opinion 820 F.2d 1220">820 F.2d 1220 (4th Cir. 1987). Hence, we have formulated our conclusions herein as to whether the partnership possessed the requisite profit objective under section 183 by evaluating the facts and circumstances as they existed during the latter part of 1976.

Respondent argues that "the Boone promotion was entirely tax motivated and economically doomed from the outset" and is thus but1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="52" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*640 the latest in a long line of cases decided by this Court dealing with "artificial, inflated deductions arising from unsound tax avoidance coal mining schemes circa 1976." See, e.g., Capek v. Commissioner,86 T.C. 14">86 T.C. 14 (1986); 84 T.C. 564">Seaman v. Commissioner, supra;Thomas v. Commissioner,84 T.C. 1244">84 T.C. 1244 (1985), affd. 792 F.2d 1256">792 F.2d 1256 (4th Cir. 1986); Ramsay v. Commissioner,83 T.C. 793">83 T.C. 793 (1984). We disagree. While the matter is not entirely free from doubt, we think the record reveals sufficient evidence for us to conclude that, although the Boone promotion was a risky venture which failed to live up to its economic expectations, it was entered into with a bona fide objective to make a profit.

Respondent sets forth numerous arguments in support of his position. However, the primary consequences upon which he has based his case is that it was unreasonable for the partnership to have relied on the Conaway and Miller reports in formulating its decision to go ahead with the investment. Respondent essentially argues that Conaway's efforts in investigating the property were inadequate and, as a result, his reports, which1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="53" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*641 were used as a basis for the tonnage projections found in the private placement memorandum and for the Miller economic feasibility study, were incomplete and misleading. Respondent also takes issue with the cost per ton estimates found in the Miller report as well as with Miller's estimate of the amount of initial capital required to get the Boone operation off the ground.

Conaway's revised report, dated October 15, 1976, estimated that there were 2,597,000 proved recoverable tons of coal ⁸ located in the western portion of the Cedar Grove and Peerless seams. ⁹ To arrive at these figures Conaway ¹⁰ made 6 measured outcrop exposures of each of the seams, ¹¹ from which he concluded that Cedar Grove seam averaged between 40 and 50 inches in thickness and that the Peerless seam's average thickness was from 34 to 35 inches. ¹² In turn, he derived the gross tons-in-place for each of the seams by multiplying the total coal acres per seam by an average of each seam's thickness. ¹³

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="54" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*642 Respondent's expert, Thomas Howard ("Howard"), both in his report and through his oral testimony, calls into question Conaway's methods and conclusions. Initially, he criticizes Conaway's reliance on information supplied to him by Lunking and Neilan in formulating his reports, and concludes, "as a result, the report has no substantiation. And as far as I'm concerned, it's meaningless. He has taken information that the owners' supplied him with and made a report from it." While we recognize that Conaway did rely to a certain extent on the preliminary investigations and continued help of Lunking and Neilan in putting together his study, we think it abundantly clear from the record that, in carrying out the assignment, he carefully supervised all facets of the project (see, e.g., note 10, supra) and that his conclusions were based on well-reasoned analysis. Contrary to the inference Howard seems to suggest, we are convinced that Conaway did not merely regurgitate information provided to him by Neiland and Lunking, but instead digested this information, evaluated it, supplemented it with additional data, and, by drawing on what became apparent at trial was his vast amount of1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="55" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*643 experience with respect to the coal reserve in the geographic area involved herein, formulated his own independent basis for the results found in his reports. ¹⁴ We find the situation herein quite different from that which existed in 84 T.C. 1244">Thomas v. Commissioner, supra at 1273. In the same vein, we disagree with Howard's criticism that the Conaway reports were unacceptable and his results were unsubstantiated and should therefore be disregarded before they contained no pictures or sketches of the outcrop exposures or details as to where these exposures were made. While we agree that his reports might have been more illustrative, we think Conaway's testimony leaves no doubt that the estimates found therein were supported by the results of his investigation.

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="56" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*644 From a more technical standpoint, Howard questions the reliability of Conaway's estimates because Conaway took no core drilling samples of the seams. A core drilling, as its name implies, is a process by which a diamond drill head is used to bore deep into a mountain to take a core sample of the mountain. Howard argues that, in order to assure that proven reserves exist throughout a coal seam, such core drillings must be made in addition to making outcrop exposures. In the case of the Boone property, he concludes that three such drillings should have been made by Conaway in order to confirm his findings. Conaway, on the other hand, defends his decision not to make any such drillings and claims that given the number of outcrop measurements he made, core drillings were not needed to establish that proven reserves existed in the Peerless and Cedar Grove coal seams. Similarly, Thomas Gales ("Gales)", another West Virginian mining engineer who testified as an expert at trial, buttressed Conaway's opinion and command that, given the small acreage of the property at issue, core drilling was not required and that "there were enough outcrop measurements for me to make a determination of1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="57" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*645 the coal reserve on the area effected." Gales also testified that the standards utilized by Conaway in evaluating the property were almost identical to those used by his company in 1976 and complied with the general standard set forth in Geological Survey Bulletin 1450-B: Coal Reserve Classification System of the U.S. Bureau of Mines and U.S. Geological Survey (hereinafter referred to as "Bulletin 1450-B"), a report published jointly by the U.S. Bureau of Mines and the U.S. Geological Survey, which sets out general guidelines for the industry for determining whether a given coal reserve is proven or not. Bulletin 1450-B does not list core drilling as an essential requirement in establishing a proven reserve. Accordingly, we attach no significance to the fact that no drill cores were made on the property. ¹⁵

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="58" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*646 Finally, with respect to the Conaway report, Howard also argues that Conaway failed to make enough outcrop exposures on each of the seams. For example, Howard opined that 90 outcroppings, in contrast to the six made by Conaway, were necessary to establish that proven reserves existed in the Peerless seam. He reasoned that to establish that a reserve is proven an outcropping must be made every 500 feet along a seam, and, since Conaway's reports indicated that the Peerless seam was approximately nine miles long (i.e., about 45,000 feet), 90 exposures were required. We disagree, and find that the six exposures made by Conaway ¹⁶ were sufficient to support his estimates.

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="59" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*647 To begin with, under the guidelines set out in Bulletin 1450-B, to establish that a reserve be classified as proven (the actual terminology used in the Bulletin is "Measured") points of observation must be no greater than 1/2 mile apart (i.e., approximately 2600 feet), not the 500 feet suggested by Howard in his report, and measured coal is projected to extend as a 1/4 mile (i.e., approximately 1300 feet) wide belt from the outcropping. Thus, according to these general guidelines, only 17 outcroppings would be required to establish that the reserves in the Peerless seam fell into the measured or proven category (45,000/2600). However, as we think Conaway correctly suggested at trial, this number could be even further reduced to account for the fact that coal seams do not simply lie in a straight line extending from point A to point B. To the contrary, they tend to snake in and around the hillside, so although a given point in a seam may, for example, lie linearly five miles from another point in that same seam, it may only lie a couple thousand feet as the the crow flies. Moreover, while Bulletin 1450-B sets out general guidelines to be followed by the industry, it recognizes1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="60" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*648 that consistency of coal seams varies from region to region, and we think the experience of the mining engineer with respect to a given region cannot be overlooked in determining the correct number of outcroppings necessary to establish proven reserves. Accordingly, we decline to substitute our knowledge of estimating coal reserves as gleaned from reading Bulletin 1450-B for that of Conaway, a seasoned mining veteran well versed in West Virginan coal, whose testimony we found most convincing and who testified that "I feel I know that seam. I've only seen that seam but about 45 locations in an area of about 100 square miles around there," or for that of Gales who testified that the number of outcroppings made by Conaway was sufficient to estimate the amount of proven reserves on the western tract. See p. 41, supra. We are satisfied that Conaway was not, as respondent suggests, merely the handmaiden of Neilan who gave him and through him the partnership the figure that they wanted for the estimated coal reserves. Compare Thomas v. Commissioner,84 T.C. 1244">84 T.C. 1276. With respect to Howard's conclusions which argue against adopting such a view, we comment that

We1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="61" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*649 are not bound by the opinion of any expert witness when that opinion is contrary to our judgment. * * * We may embrace or reject expert testimony, whichever, in our best judgment, is appropriate. * * * [Parker v. Commissioner,86 T.C. 547">86 T.C. 547, 86 T.C. 547">561 (1986). Citations omitted.] ¹⁷

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="62" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*650 Accordingly, we conclude that the reserve estimate figures found in the Conaway reports provided a reliable reflection of the amount of proven, recoverable reserves on the Boone property and that Boone was justified in relying on them. ¹⁸

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="63" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*651 We are also satisfied that the cost-per-ton figures contained in the Miller report were, as of the end of 1976, a reasonable estimate of the cost of extracting coal from the Boone mine, and, in turn, that the $ 17.00 per ton figure the partnership agreed to pay to Boone Resources pursuant to their contract mining agreement, was reasonably relied upon by the partnership in making its projections. In arriving at this conclusion, we have not attempted to peg with exactitude the precise cost per ton of coal. Rather, we have endeavored, given the plethora of expert testimony with which we were presented, to estimate a reasonable range of cost and decide whether profit projections based upon such a range were reasonable.

The Miller report estimated $ 16.00 as the cost per raw ton of mining the Boone coal based on an annual production of 200,000 tons. This amount reflected not only the out-of-pocket cost of extracting the coal from the ground, but also included a $ 2.50 per ton allowance for depreciation. Thus, to arrive at a proper estimate of the out-of-pocket cost of extracting the coal we subtract out this $ 2.50, for a net cash cost of $ 13.50 per raw ton. Moreover, we note that1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="64" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*652 since the Miller report focused only on the cost of extraction it made no provision for the transportation or washing of the coal. ¹⁹

We also heard testimony from Conaway and Gales with respect to the out-of-pocket cost of extracting coal from the Boone mine. ²⁰ Conaway estimated the cost of extraction to be $ 14.59 per ton. To this figure Conaway added a 10 percent addition for unexpected contingencies to arrive at an out-of-pocket cost, net of transportation, of $ 16.05 per ton. ²¹ However, Conaway's estimates,1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="65" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*653 which were extrapolated at trial from the Howard report, were calculated on a clean ton, as opposed to a raw ton, basis. The Boone promotion, however, was based on the assumption that Boone would sell raw tonnage, and that the purchaser would be responsible for cleaning the coal, i.e., separating out from the coal any rock or other extraneous material which also gets mined during the excavating process -- a process to be distinguished from washing, see note 19, supra. Thus, in computing cost per ton for purposes of our analysis herein we divide total cost by 200,000 raw tons, not the 180,000 clean tons used by Howard and relied upon by Conaway in deriving his estimates. Accordingly, Conaway's clean ton estimate, as adjusted, reflects a cost per raw ton of $ 14.15 ($ 16.05 x .9). Gales estimated the out-of-pocket cost per raw ton of coal, net of transportation, to be $ 17.58. ²² While Gales provided for no contingency amount as stated as a fixed percentage of total cost, he explained at trial that he indeed had provided for contingencies by reducing the efficiency of the labor force by a factor of 25 percent in making his calculations. Accordingly, if we summarize the results1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="66" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*654 reached by the Miller report and by petitioners' experts, we derive a range of cost, net of transportation, between $ 13.50 and $ 17.58 per raw ton. Moreover, although not an expert, Roger Ball ("Ball"), a coal miner and mining equipment dealer, who as of the time of trial had been involved in coal mining for over 18 years, and who in 1976 had been the mine superintendent of the Manila mine on the eastern portion of the 1420 acre tract (see p. 6, supra), testified that looking back to 1976 he considered $ 16 per ton to be a sufficient price for a mining company to profitably extract coal from the Boone site.

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="67" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*655 With this range in mind, we now turn to Howard's estimate of cost per ton. Howard's report estimated the cost per clean ton of coal to be $ 21.88, ²³ plus a contingency factor of five percent, bringing the total of $ 22.97 per clean ton, or $ 20.67 per raw ton ($ 22.97 x .9). The record reveals that Howard's higher cost estimate is attributable primarily to his higher estimates of the cost of labor and supplies. With respect to his estimate of the cost of labor, we are convinced, based on the testimony of Conaway, Gales and Ball, that many of the assumptions on which Howard relied, such as the number of laborers needed to run the mine, were incorrect and that he overestimated the total cost attributable to labor at the mine. Similarly, with respect to Howard's estimate of the cost of supplies attributable to the operation and maintenance of the mine, we think Conaway's estimates, which were substantially lower than Howard's and were based on Conaway's comparison of actual costs of similar mines operating in the same general area, were more realistic.

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="68" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*656 Accordingly, we think the $ 17.00 cost per ton agreed to by Boone and Boone Resources under the terms of the contract mining agreement, which was based upon the Miller estimate, fell within a reasonable range of cost given the facts and circumstances that existed in 1976. While we recognize that the range discussed above does not include any amount attributable to transporting the coal, it does not seem that the addition of hauling costs would have adversely affected Boone's or Boone Resources' profit potential. Neilan testified that it was initially estimated that hauling charges would cost Boone Resources somewhere between $ .60 and $ 1.00 per ton, based upon the standards in the industry at the time. We see no reason to question Neilan's figures, especially in the absence of any conflicting evidence put forth by respondent as to the going rate for hauling coal during the time frame herein at issue. ²⁴ Thus, we conclude that, in 1976, the total cost of mining a raw ton of coal, including a $ 1.00 charge per ton for transportation, lay in a range between $ 14.50 and $ 18.58, which embraces the $ 17.00 figure agreed to in the contract mining agreement. Accordingly, we find that1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="69" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*657 the cost assumptions relied upon by the partnership in this respect, in preparing the projections found in the private placement memorandum, were reasonble and accurately reflected the potential actual costs of the project. See also note 21, supra.

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="70" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*658 Finally, we address, and reject, respondent's contention that Boone Resources was undercapitalized. The Miller report estimated that the total initial capital required to get the Boone mine underway would be $ 550,000, comprised of $ 145,000 for equipment and the balance for working capital. The $ 145,000 attributable to equipment reflected the full purchase price in cash of certain equipment and the payment of a 20 percent down payment on other equipment with the balance of payments to be made on a monthly lease-purchase rate. The report also provided that in July, 1978, an additional section of equipment would be needed that would require the infusion of another $ 420,000 of capital funds. Based on these estimates, Boone Resources was initially capitalized with $ 500,000.

Howard, in contrast, estimated that the capital cost of opening the Boone mine was $ 2,480,775, and respondent, seizing upon this estimate, claims that Boone Resources was grossly undercapitalized. We disagree. To begin with, Howard, in arriving at his estimates, incorrectly assumed that Boone Resources would purchase all its equipment for cash and not acquire any of it by lease. Accordingly, it is necessary, 1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="71" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*659 as Gales did at trial, to recalculate Howard's capital estimates assuming that a portion of the mine equipment was leased under terms similar to those found in the Miller report. Gales concluded that, after such an adjustment, the total capital required to start up the mine was $ 1,167,400. ²⁵ Moreover, Howard's total assumed that capital would initially be required for equipment for both sections of the mine. Miller, on the other hand, was only concerned with the capital required to start up the first section of the mine. We agree with Miller's approach. We accept Ball's explanation that, in determining Boone Resources' capital needs, it should have been assumed that the company would be "rolling on its own capital" in order to come up with the additional $ 420,000 necessary for the second section of equipment, i.e., the cash flow generated from the coal mined and sold through July, 1978, (projected at over 200,000 tons) would serve as the source of the additional capital. ²⁶ We think it was unrealistic from an economic standpoint for Howard to assume that up-front capital was necessary to finance the second section of the mine which was not contemplated to come on line until1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="72" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*660 some 18 months later. As a result, assuming, as the Miller report did, that approximately 43 percent of the total costs for the two sections are attributable to the second section only ($ 420,000/970,000), we are left with approximately $ 665,000 of capital costs attributable to the start up of the mine. While we recognize that this number still exceeds the $ 550,000 provided for in the Miller report, we think it is too close to support a finding that the Miller estimate was so unrealistic that it should not have been relied upon by the partnership. In this regard, we found it significant that Ball, who was superintendent of the Manila mine on the eastern tract, which was a similar type of mining operation, testified that he considered $ 450,000 to $ 600,000 to be the amount of capital necessary to get the Boone mine operation underway.

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="73" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*661 Accordingly, in view of our acceptance of the estimates contained in the Conaway and Miller reports, we proceed with our profit-objective analysis by focusing on the financial projections found in the Boone private placement memorandum which were derived therefrom. As the table on p. 21, supra, reflects, assuming a 50 percent tax bracket ²⁷ and that the partnership would be entitled to deduct the entire advanced royalty in 1976, a limited partner investor stood to receive in before-tax dollars $ 88,464 over a ten-year period ($ 138,464 minus $ 50,000) above his cash investment of $ 50,000. Moreover, as the table on p. 21, supra, also reveals, the cash flow produced by the tax savings would have amounted to only $ 22,629 ($ 161,093 minus $ 138,464). Thus, in the instant case, there is not the substantial disparity between the projected net tax benefits and the cash-on-cash return which existed in Estate of Baron v. Commissioner (see 83 T.C. 542">83 T.C. 558-559). In fact, the situation herein is quite different from that which existed in Estate of Baron, where the tax benefit was substantially in excess of the cash invested. In the instant case, the reverse1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="74" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*662 situation exists in that the $ 50,000 cash invested by each partner is in excess of the tax benefit of $ 22,629. This excess is a further indication that tax benefits were not a primary objective of the partnership. If we take the analysis one step further and assume, as the partnership did in the table on p. 23, supra, that the advanced royalty deductions would have to be taken pro rata over the term of the investment, then the 50-percent taxpayer would find himself in an even less favorable position.

Another comparison reveals that, the $ 76,544 cash flow from the deduction of the advanced royalty in 1976 is less than one-half of the cumulative cash flow and net after-tax savings of $ 161,093 ($ 138,464 plus $ 22,629).²⁸ Even if we1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="75" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*663 focus our attention on the $ 26,544 profit accruing in the first year from the anticipated deduction of the advanced royalty ($ 76,544 minus $ 50,000), we cannot find a significant disparity since this amount is far less than the anticipated profit of $ 84,549 after taxes during the years 1977 through 1985 ($ 161,093 minus $ 76,544).²⁹ In short, the bulk of the anticipated profit was expected to come from the mining operations rather than the tax savings. Compared 83 T.C. 542">Estate of Baron v. Commissioner, supra at 558-559. See also Taube v. Commissioner,88 T.C. 464">88 T.C. 483-484; Waddell v. Commissioner,86 T.C. 848">86 T.C. 848, 86 T.C. 848">894 (1986). ³⁰

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="76" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*664 We have no doubt that tax considerations were an element -- perhaps a significant element, particularly in respect to the immediate savings from the write-off of the $ 5,025,000 advance royalty in 1976 -- in the partnership's decision to engage in the transaction involved herein, but, based upon our evaluation of the entire record, we are satisfied that such considerations were not the primary objective of any such investment decision.

Moreover, as might be gleaned from our favorable analysis with respect to the Miller and Conaway reports, we are satisfied that the Boone promoters, despite their lack of expertise with respect to mining domestic coal, "produced sufficient advice and made sufficient inquiries to make a reasonable determination as to whether the [Boone promotion] would be a profitable venture." 88 T.C. 464">Taube v. Commissioner, supra at 481. Furthermore, unlike the situation in Seaman v. Commissioner,84 T.C. 564">84 T.C. 590-591, not only had the services of Miller and Conaway already been engaged prior to the signing of the sublease agreement, but their reports had been completed, reviewed and relied upon by Guthrie and the Boone promoters precedent1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="77" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*665 to entering into the transaction. This was not, as it was found to be in Seaman, a case of "putting the horse before the cart." 84 T.C. 564">84 T.C. 590. ³¹

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="78" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*666 Finally, we do not consider the differential in the amounts paid by LJP ($ 800,000) and Boone ($ 5,025,000) as advanced royalties to require a conclusion that a profit objective did not exist. The situation herein is unlike that which existed in 84 T.C. 564">Seaman v. Commissioner, supra, or 84 T.C. 1244">Thomas v. Commissioner, supra, in which we concluded that a disproportionately large advanced royalty required to be paid by a sublessor partnership to a lessor akin to LJP could only be explained under the facts of that case as a means of inflating the deductions for the limited partners (84 T.C. 564">84 T.C. 593-594 and 1280). To begin with, we are satisfied that the $ 5,025,000 advanced royalty amount agreed to in the sublease was reasonable determined and is supported by the record herein. Landesman testified that it was ascertained that the probable selling price of the coal would be between $ 25.00 and $ 30.00 per ton, ³² and that it was determined that an amount constituting slightly less than 10 percent of this price, i.e., $ 2.50 per ton, was considered to be commercially reasonable as a royalty. Accordingly, based on the assumption that 2,000,000 tons of coal1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="79" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*667 would be extracted and sold over the course of the investment, an assumption which we have already found is supported by Conaway's estimate, it was calculated that the amount of the advanced royalty could reasonably be estimated at approximately $ 5,000,000 ($ 2.50 x 2,000,000). We think this was a sound analysis. ³³ Furthermore, as Landesman explained at trial and, as the record reveals, Neilan's agreement to accept the $ 800,000 advance royalty was conditioned on, and must be viewed in light of, the fact that Neilan, through Boone Resources, expected to earn a per-ton profit as contract miner in addition to the per-ton royalty he expected to receive under the lease agreement. Thus, while at first glance it appears that LJP cut a better deal than Neilan due to the wide disparity between the amounts to be received by each in advanced royalties, we see that this was simply not the case when the venture is viewed in its entirety since the contract mining agreement reveals that Boone Resources expected that as contract miner it would reap an additional profit of $ 3.00 per ton.

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="80" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*668 The long and the short of the matter is that we are convinced that Boone initially entered into the venture with a bona fide objective to make a profit, only to be undone by subsequent and changing circumstances, many of which were not within its control, and which transformed the project into an unprofitable investment. Most notably, unforeseen difficulties were encountered in constructing the hauling road which prematurely exhausted the majority of Boone Resources' initial capital and delayed the opening of the mine. Moreover, while it appears that the mine workers' strike did not have a measurable effect on the mine's development, we think it clear from the record that the fatality at the mine had a deleterious effect on the mine's operations. Furthermore, by the time the mine was finally producing, the great demand for coal, which had been spurred on by the onset of the energy crisis in 1973, had begun to decline as the crisis subsided, causing the price of coal to fall. At the same time, the cost of production increased because, as the need for coal as an energy source declined, environmental standards became much stricter necessitating the washing of the coal so that it1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="81" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*669 could be merchantable. Thus, Boone's profit picture had become quite bleak by 1978. As the private placement memorandum had made quite clear, investment in Boone was a venture frought with risk, conceived with only a small financial margin of error. Unfortunately for its investors, the Boone offering became a self-fulfilling prophecy. Nonetheless, no matter how risky the investment was and despite its eventual failure, we think the underlying objective of the venture was, from its inception, to make a profit.

In view of the foregoing, we hold that petitioners have carried their burden of proving that the partnership had a bona fide profit objective aside from the tax benefits which inured from the project. ³⁴

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="82" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*670 We now turn to the question of the amount of the the advanced royalty deduction to which Boone is entitled. Prior to October 29, 1976, section 1.612-3(b)(3), Income Tax Regs., provided in pertinent part, that

The payor, at his option, may treat the advanced royalties so paid or accrued in connection with mineral property as follows:

(i) As deductions from gross income for the year the advanced royalties are paid or accrued * * * [Emphasis added.]

However, on October 29, 1976, the Internal Revenue Service published News Release IR-1687 announcing proposed amendments to section 1.612-3(b), Income Tax Regs., effective as of such date. The effect of these amendments, as it concerns this case, was henceforth to preclude the deduction of advanced royalty payments in years in which no minerals are actually sold, or produced in the case of minerals sold prior to production. See section 1.612-3(b)(3), Income Tax Regs., as amended. ³⁵

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="83" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*671 However, the amended regulation provided, in pertinent part, that

the amendment will not apply if prior to October 29, 1976 (i) the payment of the advanced royalties was required pursuant to a mineral lease which was binding upon the party who in fact pays or accrues such royalties, * * * [T.D. 7523, 1 C.B. 192">1978-1 C.B. 192, 193.]

In Zegeer v. Commissioner,T.C. Memo. 1984-587, we held that the sublease agreement entered into between Boone and LJP constituted such a binding obligation. As a result, we concluded that the amended regulation was not applicable to the Boone deduction. Respondent, in turn, filed a motion for us to reconsider our decision therein, which we subsequently denied pursuant to an order and memorandum sur order dated January 3, 1985. Respondent asks us to reconsider our prior stance in light of the evidence adduced at trial and find that no binding objection existed between Boone and LJP as a result of the October 27, 1976 sublease. Unfortunately for respondent, and after careful review of such evidence, our view remains unchanged; we consider the October 27, 1976 sublease to constitute a binding obligation between LJP and1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="84" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*672 Boone. Accordingly, the allowable amount of Boone's deduction with respect to the advanced royalty payments must be determined pursuant to the regulation as it existed prior to amendment (the "old" regulation). It is from this point that we now proceed. ³⁶

Notwithstanding the fact that the partnership qualifies for treatment under the old regulation, we conclude that it is not entitled to the full amount of the deduction claimed on its 1976 partnership return. To begin with, we consider the payment by Boone of the nonrecourse note as being so speculative and contingent as to preclude the accrual by the partnership of the $ 3,500,000 portion of the advanced royalty which was secured by it. As we stated in Vastola v. Commissioner,84 T.C. 969">84 T.C. 969, 84 T.C. 969">977 (1985),

It is well established that the proper year of deduction for an accrual-method taxpayer is "the1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="85" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*673 taxable year in which all the events have occurred which determine the fact of the liability and the amount thereof can be determined with reasonable accuracy." Sec. 1.461-1(a)(2), Income Tax Regs.; see Thor Power Tool Co. v. Commissioner,439 U.S. 522">439 U.S. 522, 439 U.S. 522">543 (1979); Burlington Northern Railroad Co. v. Commissioner,82 T.C. 143">82 T.C. 143, 82 T.C. 143">146-147 (1984); see also Pub. L. 98-369, sec. 91(a), 98 Stat. 598-600 (1984) (adding Code section 461(h)(4), effective as to deductions allowable after July 18, 1984). It is also well established that contingent liabilities may not be accrued and deducted while they are still contingent. Security Flour Mills Co. v. Commissioner,321 U.S. 281">321 U.S. 281, 321 U.S. 281">284 (1944); Bennett Paper Corp. v. Commissioner,78 T.C. 458">78 T.C. 458, 78 T.C. 458">470 (1982) affd. 699 F.2d 450">699 F.2d 450 (8th Cir. 1983).

Just as nonrecourse notes upon which payment is wholly contingent on production are so illusory as to be "inherently inconsistent with the regulatory definition of a minimum royalty provision" (84 T.C. 564">Maddrix v. Commissioner, supra at 623), such notes are also so illusory as to fail to establish all the events necessary to determine1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="86" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*674 the fact of liability. Brountas v. Commissioner,692 F.2d 152">692 F.2d 152, 692 F.2d 152">161 (1st Cir. 1982), and CRC Corp. v. Commissioner,693 F.2d 281">693 F.2d 281, 693 F.2d 281">283 (3d Cir. 1982, vacating and remanding on other grounds 73 T.C. 491">73 T.C. 491 (1979); Gibson Products Co. v. United States,637 F.2d 1041">637 F.2d 1041, 637 F.2d 1041">1047-1049 (5th Cir. 1981). In the words of the Court of Appeals for the Fifth Circuit, a "true lending transaction," and thus a true liability, requires "'a reasonable basis for the prediction that the ability of the borrower to repay will not be wholly or substantially contingent upon the success or failure of the business venture.'" 637 F.2d 1041">Gibson Products Co. v. United States, supra at 1047; citation omitted. [Footnote reference omitted.]

In the instant case, as in Vastola, it is clear that payment of the nonrecourse note was wholly contingent on production. Simply put, review of the record herein leaves no doubt that the note would, and could, be paid only if the mine was productive and generated a sufficient cash flow. Moreover, while we have determined that, for purposes of ascertaining whether the partnership had a bona fide objective of1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="87" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*675 making profit, recoverable reserves existed on the land and that it was indeed possible that they could be economically recovered and sold by the partnership, we think payment of the note must be considered too speculative and contingent to justify accrual of the advanced royalty liability, given the fact that the inherent risks in the project were so great that the actual extraction and sale of these reserves so as to pay of the note were far from certain. See 84 T.C. 969">Vastola v. Commissioner, supra at 978. Accordingly, under such circumstances, we hold that accrual by the partnership of the portion of the advanced royalty secured by the nonrecourse note would be improper since "as a matter of law * * * all the events necessary to establish liability on the notes * * * did not occur during the years in issue." 84 T.C. 969">Vastola v. Commissioner, supra at 979. Thus, the partnership's deduction, to the extent we determine it to be allowable, may not exceed the cash portion of the advanced royalty.

Furthermore, we conclude that, even under the old regulation, ³⁷ the partnership is not entitled to deduct as an advanced royalty in 1976 the full amount of the cash1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="88" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*676 paid to LJP. As we commented in Seaman v. Commissioner,84 T.C. 564">84 T.C. 587,

We think it also important to note that it is exceedingly doubtful that the old regulation permitted the deduction of lump-sum advanced royalty payments. See Redhouse v. Commissioner,728 F.2d 1249">728 F.2d 1249, 728 F.2d 1249">1251 (9th Cir. 1984); Wendland v. Commissioner,79 T.C. 355">79 T.C. 355, 79 T.C. 355">385 (1982), affd. 739 F.2d 580">739 F.2d 580 (11th Cir. 1984), affd. sub nom. 728 F.2d 1249">Redhouse v. Commissioner, supra. Such a deduction would be not only inconsistent with the language of the old regulation, specifying that the advance royalties were required to be paid, "annually," but also contrary to the well-entrenched principle of tax accounting that a payment that creates an asset having a useful life that extends substantially beyond the close of the taxable year must be deducted over the years to which the payments relates. See, e.g., sec. 1.461-1(a)(2), Income Tax Regs.; Commissioner v. Bolyston Market Association,131 F.2d 966">131 F.2d 966 (1st Cir. 1942); Baton Coal Co. v. Commissioner,51 F.2d 469">51 F.2d 469 (3d Cir. 1931), cert denied 284 U.S. 674">284 U.S. 674 (1931);1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="89" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*677 University Properties, Inc. v. Commissioner,45 T.C. 416">45 T.C. 416 (1966), affd. 378 F.2d 83">378 F.2d 83 (9th Cir. 1967). * * * [Footnote reference omitted.] ³⁸

In line with this reasoning, ³⁹ we hold that Boone must amortize the cash portion of the advanced royalty payment over the term of the sublease,1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="90" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*678 i.e., 10 years. See section 1.167(a)-1 and (a)-3, Income Tax Regs. Thus, we find that Boone is entitled to a claimed annual deduction of $ 152,500 ($ 1,525,000/10). Accordingly, since the sublease was not entered into until October 27, 1976, Boone's deduction for the 1976 taxable year is limited to approximately $ 25,000 -- the exact amount to be determined pursuant to a computation under Rule 155. See section 1.167(a)-10(b), Income Tax Regs.⁴⁰

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="91" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*679 The next issue for decision is whether Boone is entitled to the $ 210,000 interest deduction taken with respect to the nonrecourse note, which was accrued by the partnership but not paid in 1977. Under the same rationale which led us to the conclusion that payment of the nonrecourse note was too speculative and contingent to justify accrual of the non-cash portion of the advanced royalty liability, see pp. 64-66, supra, we hold that the partnership is not entitled to the accrued interest deduction it claimed in 1977 which flowed therefrom. Moreover, we note that, by the end of 1977, payment of the note had become even more speculative, given the facts that mining had still not commenced, that Boone's capital base was quickly eroding and that the partnership had failed to make even the required minimum quarterly payments on the note during the year. See p. 29, supra.

We next address whether in 1981 Boone should recognize gain as a result of the foreclosure on the deed of trust, see p. 32, supra, and, if so, whether such gain should be categorized as ordinary or capital in nature. On its 1981 return, Boone reported a $ 4,482,500 capital gain, attributable to the discharge1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="92" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*680 of its liabilities with respect to the venture, calculated as follows:

As noted at p. 33, supra, petitioners did not report their distributive share of such income on their 1981 return. ⁴¹ Respondent argues only that Boone must include in income gain with respect to the discharge of these liabilities to the extent that we determine that the partnership is allowed deductions with respect to these amounts in 1976 and 1977. ⁴² Since we have determined that Boone is not entitled to its claimed deductions with respect to the non-cash portion of its accrued advance royalty obligation or the interest it accrued on the nonrecourse note, we hold that Boone recognized no gain as a result of the events that occurred in 1981. ⁴³ Accordingly, we hold, that petitioners are not liable for any taxes on their distributive share of such amounts, or for the additions to tax under section 6653(a)(1) and (2) for their failure to report this income in 1981. ⁴⁴

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="93" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*681 Finally, we hold that, in view of our finding that the partnership's activities constituted an activity engaged in for profit under section 183, there is not substantial underpayment in this case arising from a tax-motivated transaction. Accordingly, with respect to interest on the underpayments which has accrued after December 31, 1984, we find that petitioners are not liable for the increased rate of interest under section 6621.

To reflect the foregoing,

Decisions will be entered under Rule 155.

APPENDIX A

Lists of checks drawn on Southwest Enterprises' accounts which were used for the personal benefit of petitioners.

Total withdrawn (embezzled) during 1974 from Southwest Enterprises for nonbusiness payments made on behalf of petitioners:

$ 15,637.50

21,369.26

1,250.00

438.98

40.00

41,351.98

400.00

7,532.00

11,150.00

1,019.37

853.01

2,103.99

4,424.67

$ 107,570.76

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="98" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*686 Total withdrawn (embezzled) during 1975 from Southwest Enterprises for nonbusiness payments made on behalf of petitioners:

$ 4,179.38

750.00

405.65

1,573.35

1,714.00

5,420.4

$ 14,043.32

APPENDIX B

List of checks embezzled directly fron the Matankys and deposited into an account controlled by petitioner.

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="99" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*687 APPENDIX C

List of checks embezzled by petitioner from M & O Enterprises in 1974 and 1975.

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="101" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*689 APPENDIX D

Listing of rental payments due to M & O Enterprises from tenants in the Encino Medical Towers which were diverted from the partnership and deposited into petitioner's 16200 Building account.

1987 Tax Ct. Memo LEXIS 589" label="1987 Tax Ct. Memo LEXIS 589" no-link"="" number="102" pagescheme="<span class=">1987 Tax Ct. Memo LEXIS 589">*690 APPENDIX E

List of checks drawn on either VLA, UWIM of GNA accounts to fictitious payees or people or companies doing business with VLA, UWIM or GNA which were deposited into either petitioner's personal account or Mrs. Olken's personal account.

(Deposited in Esther Olken's account at Security Pacific Bank).

APPENDIX F

List of checks paid by some unrelated entity to either V. R. Lundin, one of his companies, or an insured individual, but deposited into petitioners' accounts.