energy costs were forecast to increase, on the average, 3.8 percent (electricity-2.0 percent, gas-9.1 percent, oil-4.3 percent). This is a weighted average for the typical industrial/commercial fuel combination. Considering a 7percent inflation rate, the annual rate of energy cost increase would be 10.8 percent. DOE reports for earlier periods had projected cost increases of some 20 percent.

Actual energy savings to a particular end-user may vary significantly, depending on physical characteristics of the facility and energy conservation measures which may already have been taken. Industry reports predicted 5- to 12-percent savings with a maximum of approximately 20 percent. Actual savings are often less than projected.

We must also evaluate the useful physical and economic life of the devices. Optimistic estimates of the engineering useful life of these units is 20 to 25 years. Engineering or physical useful life is the length of time the unit may remain operational with normal repairs. The units in question were warranted for only 1 year. Electronic equipment is also subject to obsolescence (economic useful life); while the unit is still operative, it may nonetheless be more cost effective to replace it with newer, more efficient technology. These units are also subject to obsolescence or failure of the underlying climate control units (central heating or airconditioning units). When these are replaced, the new units often incorporate internal energy-management control systems. Thus, these devices have a useful life somewhere between 10 and 20 years.

OPINION

8

We pursue here the now familiar process of testing the economic substance of a transaction involving an otherwise normal business product or concept. Respondent, in his notice of deficiency, disallowed all the deductions and credits related to petitioners' OEC investment. Petitioners bear the burden of proof on all pertinent items-profit objective, useful life, fair market value, placement in service, and others. See Welch v. Helvering, 290 U.S. 111 (1933); Rule 142(a).

The product here involved could be useful as a means of energy and cost conservation, and the marketing approach, on its face, seems unique and effective.

All claimed deductions and credits are a matter of legislative grace, and must have a basis in the statute. New Colonial Ice Co. v. Helvering, 292 U.S. 435 (1934). Section 162 allows a deduction for ordinary and necessary expenses incurred in carrying on a trade or business. Similarly, section 212 allows a deduction for expenses incurred in transactions entered into for profit. The claimed advanced rental, installation, and other expenses must come within these statutory provisions to be deductible.

Section 38 allows a credit for investment in certain depreciable property. The credit is allowable on "section 38 property"-generally tangible personal property which is subject to the allowance for depreciation. Sec. 48(a)(1). Depreciation is allowable on property subject to wear and tear or obsolescence and used in a trade or business or for the production of income. Sec. 167(a). The amount of this credit is limited to the percentage of a taxpayer's qualified investment in section 38 property. Sec. 46(a)(2)(A)(i).° Qualified investment is a percentage of basis, and basis is generally cost. Secs. 46(c) and 1011. Under section 48(d), the lessor of property, here OEC, may elect to pass through the credit to the lessee, here Carolina-the lessee is treated as having acquired the property for its fair market value. The claimed investment tax credits on the EMS units must fit. within these provisions.

Section 46(a)(2)(A)(ii)10 allows an additional percentage credit for energy property.11 Energy property is specifically defined as, among other things, an automatic energy control system designed to reduce the amount of energy consumed in an industrial or commercial process. Sec. 48(1)(2)(A)(iii), (1)(5). Section 48(d), the credit pass-through provision, also specifically applies to the energy credit. The claimed energy credits on the EMS units must fit within these provisions.

A common threshold for the claimed tax benefits is that the taxpayer must be engaged in a trade or business, or in a transaction entered into for profit. Otherwise, no credits

"This section was redesignated as sec. 46(a)(1) by sec. 474(o)(1), Tax Reform Act of 1984, Pub. L. 98-369, 98 Stat. 494, 834.

10The Tax Reform Act of 1984 redesignated this section as 46(a)(2). See note 9 supra. 11For the years at issue, both the regular and energy percentages are 10 percent. Sec. 46(a)(2)(B)-(C). For the units at issue, the energy credit expired Dec. 31, 1982. Sec. 46(a)(2)(C)(i)(I).

are allowed, and deductions may be allowed only to the extent there is income from the activity. Sec. 183. This Court and others have commented on the "profit objective" requirement in many "tax shelter" cases. A representative sample of these cases was summarized in our opinion in Beck v. Commissioner, 85 T.C. 557, 569-570 (1985):

Essential to such a showing is a demonstration that petitioner had “an actual and honest objective of making a profit." Dreicer v. Commissioner, 78 T.C. 642, 646 (1982), affd. without opinion 702 F.2d 1205 (D.C. Cir. 1983); Fuchs v. Commissioner, 83 T.C. 79, 98 (1984); Dean v. Commissioner, 83 T.C. 56, 74 (1984). While a reasonable expectation of profit is not required, petitioner's objective of making a profit must be bona fide. Fox v. Commissioner, 80 T.C. 972, 1006 (1983), affd. "Profit" in this context means economic profit, independent of tax savings. Herrick v. Commissioner, [85 T.C. 237, 254 (1985)]; Surloff v. Commissioner, 81 T.C. 210, 233 (1983).

Whether petitioner possessed the requisite profit objective is a question of fact to be resolved on the basis of all the facts and circumstances. Elliott v. Commissioner, 84 T.C. 227, 236 (1985) [affd. 782 F.2d 1027 (3d Cir. 1986)], and cases cited therein. Although no one factor is determinative, greater weight must be given to objective facts than to petitioner's mere statement of his intent. Siegel v. Commissioner, 78 T.C. 659, 699 (1982); Engdahl v. Commissioner, 72 T.C. 659, 666 (1979); sec. 1.183-2, Income Tax Regs. [Fn. ref. omitted.]

We have used objective factors in determining profit motive. See cases summarized in Rose v. Commissioner, 88 T.C. 386, 412-414 (1987).

Profit motive is determined at the partnership level, not at the individual partner level. Goodwin v. Commissioner, 75 T.C. 424, 437 (1980), affd. without published opinion 691 F.2d 490 (3d Cir. 1982); Siegel v. Commissioner, 78 T.C. 659, 698 (1982); Brannen v. Commissioner, 78 T.C. 471, 501-504 (1982), affd. 722 F.2d 695 (11th Cir. 1984). In addition, since the general partners did not actively operate the partnership but gave a power of attorney to Security, the actions and motives of the individual partners are irrelevant, in any event.12

12Even if examined from petitioner's standpoint, the result would not be different. The initial material received from Carolina, though not related to OEC, was primarily tax related. Petitioner clearly understood the effect of tax credits. One of the settled issues in this case involves the "Mid South Music Tax Shelter." After learning of the OEC investment, petitioner merely looked at the appraisals briefly and made no other independent investigation. Petitioner's inexperience does not excuse him from exercising care in assigning duties to others. Flowers v. Commissioner, 80 T.C. 914, 932 (1983).

One of the hallmarks of economically distorted tax shelters is a purported transfer of ownership at a grossly inflated sales price. Generally, the "purchaser" executes nonrecourse notes for a large portion of the purchase price. In these instances, the transaction is so economically unfeasible or lacking in economic substance that the investor's primary or sole motivation in entering into the transaction is for the tax benefits (artificially bloated depreciation deductions and investment tax credits). The fair market value of the underlying asset could not conceivably support the purchase price, and the nonrecourse and/or contingent debt virtually assures that the price will not be paid. Thus, our opinions have focused upon fair market value of the property and the character of financing in an attempt to evaluate profit objective. See cases summarized in Rose v. Commissioner, supra.

This case is somewhat different from the "typical" tax shelter because benefits may be acquired under section 48(d) where no ownership interest is transferred.13 Because the transactions in the present case involve leasing, fair market value of the energy-management devices is not, in and of itself, a good indicator of the economic feasibility of the project. However, the cash-flow analysis applied herein to judge profitability essentially determines the fair market value of the leases. Further, we must consider the economic reality of the entire transaction.

Profit means economic profit, independent of tax savings. Herrick v. Commissioner, 85 T.C. 237 (1985); Surloff v. Commissioner, 81 T.C. 210 (1983). Respondent's expert's discounted cash-flow approach, which disregards tax consequences, is an appropriate measure of this investment.

The lessee's profitability is based on a number of factors. We assume, for this purpose only, that Carolina could find end-users throughout the useful life of the energymanagement systems-an assumption most favorable to petitioners. The proposed cash-flow to the lessee is based on six factors, namely: (1) Carolina's initial cash expenditure"advanced rental" and installation expenses; (2) the end

13While the lessee need not independently qualify for investment tax credits under sections other than 48(d), i.e., secs. 46(e)(3), 46(c)(8), Faulkner v. Commissioner, 88 T.C. 623 (1987), it is clear that shortcomings or defects in the lessor's qualifications under sec. 48(d) would limit the lessor's ability to pass through the credits to the lessee.

user's annual energy bill; (3) useful life of the devices; (4) anticipated savings; (5) inflation in energy costs; and (6) an appropriate discount rate. We find as ultimate facts the assumptions used by respondent's expert.

(1) Initial cash expenditures-$25,000 "advanced rental" plus $2,150 installation. The "advanced rental" figure was in the lease agreements and the installation figure was provided by the original seller.

(2) End-user's annual energy bill-$90,000. This is the minimum bill justifying use of the EMS III as provided to respondent's expert by OEC.

(3) Useful life-10 years. This is based on a combination of two factors, equipment failure and obsolescence, of both the EMS unit and the underlying air-conditioning or heating unit.14

(4) Anticipated savings-10 percent. While savings vary between facilities, the average is projected between 5 percent and 12 percent, with a maximum of 20 percent. In addition, in many instances the actual savings percentage is less than projected.

(5) Energy inflation-10.8 percent. This is a weighted average based on a July 1982 Department of Energy report. This report was available to the partnership prior to its December 1982 investment.

(6) Discount rate-20 percent. This is the rate at which the future cash-flow stream is discounted. It reflects risk of the venture and expected return. The prime rate in 1982 was approximately 15 percent. This is a considerably riskier venture, due to chances of equipment failure, energy cost variability, and failure to achieve savings. Twenty percent is the minimum rate of return. In the industry, a return of investment in 1 to 3 years is typical-an approximate 30-percent return.

Using these assumptions respondent's expert projected a negative discounted cash-flow of $13,959.15 This finding is

14" Obsolescence may render an asset economically useless to the taxpayer regardless of its physical condition. Obsolescence is attributable to many causes, including technological improvements and reasonably foreseeable economic changes." Sec. 1.167(a)-9, Income Tax Regs.

15 We will briefly explain the methodology used by respondent's expert in reaching his conclusions. Discounted cash-flow equals lessee's discounted percentage of energy savings minus advanced rental and installation expenses. The starting point for total energy savings is the minimum annual bill. This is projected into the future using the anticipated energy