Ofria v. Comm'r of Internal Revenue
| Decision Date | 31 August 1981 |
| Docket Number | 12306-77,12305-77,4671-78.,Docket Nos. 12304-77 |
| Citation | 29 Cont.Cas.Fed. (CCH) P 81854,77 T.C. 524 |
| Parties | CARMELO V. OFRIA and MARJORIE P. OFRIA, et al.,1 PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Ts are shareholders of Contract Machining Corp. (CMC), an electing small business corporation. CMC produced a fuze bomb coupler for the Air Force under several defense procurement contracts. Each of these contracts contained a “value engineering incentive” clause under which a contractor could submit proposals for modifying the contract specifications, thereby producing cost savings for the Air Force; the acceptance of such proposals would entitle the contractor to share in the cost savings. Pursuant to the value engineering incentive clause, CMC submitted four value engineering proposals to the Air Force. Each of these proposals incorporated data describing improvements to the coupler. The proposed modifications were secretly developed by CMC at its own expense. The Air Force accepted each of CMC's value engineering proposals, and, pursuant to the value engineering incentive clause, CMC granted the Air Force “all rights to use, duplicate or disclose” the data incorporated in the proposals. In accordance with the value engineering clause, the Air Force paid CMC substantial sums as its share of the cost savings realized from use of the data in the proposals. CMC and its shareholders reported these payments as capital gains. Held, the payments received pursuant to the value engineering incentive clause were payments for the sale of trade secrets, know-how, or unpatented technology qualifying as capital assets under sec. 1221, I.R.C. 1954. Burton L. Williams, for the petitioners.
Charles W. Maurer, Jr., for the respondent.
The Commissioner determined the following deficiencies with respect to petitioners' 1972, 1973, and 1974 income taxes:
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¦Docket No. ¦Petitioner ¦Year ¦Deficiency ¦
+------------+--------------------------------+------+------------¦
¦ ¦ ¦ ¦ ¦
+------------+--------------------------------+------+------------¦
¦12304-77 ¦Carmelo V. and Marjorie P. Ofria¦1972 ¦$18,074.05 ¦
+------------+--------------------------------+------+------------¦
¦4671-78 ¦do ¦1973 ¦47,567.43 ¦
+------------+--------------------------------+------+------------¦
¦ ¦ ¦1974 ¦27,355.28 ¦
+------------+--------------------------------+------+------------¦
¦12305-77 ¦James M. and Grace C. Ofria ¦1972 ¦22,182.47 ¦
+------------+--------------------------------+------+------------¦
¦ ¦ ¦1973 ¦43,760.36 ¦
+------------+--------------------------------+------+------------¦
¦ ¦ ¦1974 ¦29,556.18 ¦
+------------+--------------------------------+------+------------¦
¦12306-77 ¦Constance Ofria2 ¦1972 ¦18,168.03 ¦
+------------+--------------------------------+------+------------¦
¦ ¦ ¦1973 ¦51,678.00 ¦
+------------+--------------------------------+------+------------¦
¦ ¦ ¦1974 ¦30,532.25 ¦
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The husband-petitioners and Constance Ofria are three of the four equal shareholders of Contract Machining Corp. (CMC), an electing small business corporation. At issue is whether payments received by CMC pursuant to the value engineering incentive clause in a production contract with the Air Force are gain from the sale of capital assets or ordinary income.
Some of the facts have been stipulated and the stipulation of facts and related exhibits are incorporated herein by reference.
At the time of the filing of their petitions herein, petitioners resided in Massachusetts.
Petitioners Carmelo Ofria, James Ofria, and Constance Ofria, are three of the four equal shareholders of Contract Machining Corp. (CMC), a Massachusetts corporation organized in 1961 with principal offices in Burlington, Mass. It elected in 1966 to be taxed as a small business corporation pursuant to section 1371, I.R.C. 1954, and this election had not been revoked as of the time of the trial of this case.
CMC engages in the business of machining metal parts for both Government and commercial enterprises. It does not manufacture a product as such but produces items pursuant to subcontract or contract specifications.
Petitioner Carmelo V. Ofria, president of CMC, manages the production aspects of its business. Upon graduating from high school, he became a toolmaker's apprentice with the General Electric Co. After serving in the Air Force during World War II, he returned to General Electric. In 1952, he and his brothers formed a partnership and began a machining business which was subsequently incorporated as CMC. This business expanded from a total of three employees in 1952 to approximately 70 employees during the years 1972 through 1974.
Petitioner James M. Ofria, treasurer of CMC, manages the financial aspects of the business, including sales.
On February 16, 1969, CMC was awarded a contract by the Department of Defense to manufacture a fuze bomb coupler. CMC had never manufactured such devices before, and Government investigators in finance, productivity, and quality control examined CMC's operations prior to the award of the contract to CMC. CMC completed the contract in February 1970.
On January 16, 1970, the Department of the Air Force made a public solicitation for bids for the manufacture and supply of 238,854 additional fuze bomb couplers. Specifications for the coupler were publicly available as part of the solicitation for bids and were not subject to any security classification. CMC made a formal offer to produce the coupler, and on April 13, 1970, the Department of the Air Force awarded CMC a contract to produce 238,854 couplers at a unit price of $1.95. This contract was modified on July 22, 1970, to require an additional 4,080 couplers at the same unit price. CMC and the Department of the Air Force subsequently entered into three additional contracts for the manufacture and supply of couplers.
A coupler of the type covered by the contract of April 13, 1970, is in evidence. It is a cylindrical device approximately 2 inches high and 23;8 inches in diameter.3 The external structure of the coupler is composed of a cylindrical aluminum housing. An input shaft projects from the top of the housing; an output shaft at the bottom of the housing attaches to the fuze of the bomb. Each shaft passes through the housing. The input shaft and the output shaft are linked by the governor subassembly and the governor drum, which are inside the housing. The governor subassembly is composed of a flat steel disc called a governor plate, four movable wedge-shaped aluminum weights, each covering one-quarter of the governor plate, eight rivets holding the weights to the governor plate, and a coil spring wrapped around the outer edge of the weights.
The function of the coupler is to “arm” the fuze of the bomb. The bomb is initially unarmed and thus will not explode in the airplane. As the bomb is dropped from the airplane, the input shaft begins to spin. The input shaft drives the output shaft, which is attached to the fuze of the bomb. However, the number of revolutions per minute (rpm) of the output shaft is controlled by the governor mechanism. As the rpm of the input shaft increases, centrifugal force causes the weights on the governor plate to slide out from the center of the governor plate, thus disengaging the governor drum and breaking the link between the input shaft and the output shaft. The output shaft thus stops turning and engages the fuze.
The contract between CMC and the Air Force contains a “value engineering incentive” clause. This clause applies to cost reduction proposals voluntarily initiated and developed by the contractor for changing the drawings, designs, specifications, or other requirements of the contract. The clause provides, in part, that if a cost reduction proposal is accepted by the Government, the contractor is entitled to share in the savings under the contract and to receive a royalty for savings in existing and future contracts between the Government and any other parties.4 The clause also provides that if a proposal is accepted, “the Contractor * * * grants to the Government all rights to use, duplicate or disclose, in whole or in part, in any manner and for any purpose whatsoever, and to have or permit others to do so, any data reasonably necessary to fully utilize such proposal.” See generally 32 C.F.R. sec. 1.1707-1(a) (1970). The contract also incorporates by reference certain contract clauses set forth in the Armed Services Procurement Regulations, including a rights in technical data clause. See 32 C.F.R. secs. 7.104-9(a), 9.203(b) (1970).
Shortly after receiving word that CMC was the low bidder for the 1970 contract to supply 238,854 additional fuze bomb couplers, Carmelo Ofria began work in improving the fuze bomb coupler. His efforts ultimately resulted in four separate improvements.
The first improvement involved the elimination of the eight rivets and their corresponding holes in the weights of the governor plate assembly. As a consequence, the coupler would be easier and less costly to manufacture. Moreover, there would be a definite improvement in the coupler by reducing the possibility that the weights on the governor plate assembly would stick and prevent the coupler from functioning properly. Working primarily at night or on Saturdays when other employees were off duty, petitioner Carmelo Ofria redesigned the governor plate assembly,...
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