Reid v. Comm'r of Internal Revenue

• Decision Date: 21 June 1956
• Docket Number: Docket No. 51225.
• Parties: ROSE MARIE REID, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: U.S. Tax Court

110 U.S.P.Q. 145

26 T.C. 622

ROSE MARIE REID, PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket No. 51225.

Tax Court of the United States.

Filed June 21, 1956.

Arthur McGregor, Esq., Charles J. Higson, Esq., and Stafford R. Grady, Esq., for the petitioner.

John J. Burke, Esq., for the respondent.

In 1946, petitioner and one Kessler formed a corporation to manufacture and sell swimsuits, orally agreeing that petitioner would transfer to it her trade name and inventions, and Kessler cash in the amount of $50,000, each to receive 50 per cent of the stock. Petitioner performed what was required of her, but Kessler later denied such arrangement and insisted that he and petitioner were each to contribute $25,000 in cash. Various differences arose between the parties and petitioner was advised by counsel and believed that she could rescind and recover her name and patents. An agreement of settlement was entered into in 1949 between petitioner and the corporation, whereby it was provided, inter alia, that petitioner was to receive 1 per cent of the corporation's net sales for her name and patents. Held: (1) On the facts, the 1 per cent of net sales was consideration for petitioner's name and inventions, and not compensation for personal services. (2) The transaction respecting petitioner's name and patents constituted a sale, not a mere license. (3) The payments in question are taxable as capital gains.

Respondent has determined deficiencies and additions to tax in petitioner's income tax as follows:

+----------------------------------------------------+
                ¦    ¦          ¦Additions to tax                    ¦
                +----+----------+------------------------------------¦
                ¦Year¦Deficiency¦        ¦               ¦           ¦
                +----+----------+--------+---------------+-----------¦
                ¦    ¦          ¦Sec. 291¦Sec.           ¦Sec.       ¦
                +----+----------+--------+---------------+-----------¦
                ¦    ¦          ¦        ¦294 (d) (1) (A)¦294 (d) (2)¦
                +----+----------+--------+---------------+-----------¦
                ¦    ¦          ¦        ¦               ¦           ¦
                +----+----------+--------+---------------+-----------¦
                ¦1948¦$202.22   ¦$50.56  ¦               ¦           ¦
                +----+----------+--------+---------------+-----------¦
                ¦1949¦10,597.05 ¦        ¦$1,688.69      ¦$1,013.22  ¦
                +----+----------+--------+---------------+-----------¦
                ¦1950¦23,652.56 ¦        ¦               ¦1,379.86   ¦
                +----+----------+--------+---------------+-----------¦
                ¦    ¦          ¦        ¦               ¦           ¦
                +----------------------------------------------------+
                

All but one issue have been settled by the parties. The sole issue remaining is whether certain payments to petitioner in the above taxable years were taxable as ordinary income, as determined by respondent, or as capital gain, as contended by petitioner.

FINDINGS OF FACT.

A stipulation filed by the parties is incorporated by this reference as a part of our findings.

Petitioner is an individual who has resided at all times material subsequent to June 23, 1949, at Los Angeles, California. Prior thereto she was a resident of Canada. She filed individual income tax returns for the calendar years 1948, 1949, and 1950 with the then collector of internal revenue at Los Angeles, California.

During the 1930's petitioner became convinced that swimsuits then available lacked proper style and structural support for the female figure and were generally unsatisfactory. In 1937 she began designing and making swimsuits for her friends. She was urged to make them commercially, and thereafter designed several swimsuits and employed 16 women to make swimsuits in their homes.

The suits so made were sold in Canada under petitioner's name. Gross sales were made in 1937 in the amount of approximately $10,000, upon which petitioner realized a profit of approximately $2,500. During 1937, she also received national and international publicity as a result of the use of her products by female participants in the British Empire Games in Australia.

The swimsuits manufactured and sold by petitioner contained structural innovations which petitioner later patented in Canada. Some were also patented in the United States. These innovations made petitioner's swimsuits different from and superior to other available products.

In 1938 petitioner formed a Canadian corporation to manufacture and sell her swimsuits. Its original name was Reid's Holiday Togs, Limited. (but the name was thereafter changed to Rose Marie Reid, Limited (hereinafter called Canadian).

Canadian met with immediate and growing success. Annual sales grew from $32,000 in 1938 to $834,000 in 1946. Its products were sold throughout Canada by more than 500 retail outlets. All of its swimsuits bore the name Rose Marie Reid or Rose Marie Reid Originals, and contained one or more of petitioner's patented features. By 1946 Canadian had captured about 50 per cent of the swimsuit market in Canada. Its competitors for that market included many leading United States firms.

In 1938 petitioner entered into a licensing agreement with a large sportswear manufacturer in the United States located in Baltimore, Maryland, which sold its products nationally and internationally. The agreement provided that the licensee would manufacture and sell swimsuits in the United States for 1 year using petitioner's name and patents. Petitioner was to receive a royalty of 10 per cent of sales. Accordingly, swimsuits utilizing petitioner's patents were manufactured and sold throughout the United States during 1938 under the name Rose Marie Reid. The suits were advertised in magazines of national circulation and in newspapers, throughout the country. Sales were made in the amount of $110,000, and petitioner received royalties in the amount of $11,000. This arrangement was not continued because of the difficulties and inconveniences experienced by petitioner in traveling between Vancouver, Canada, and Baltimore, Maryland, and because the licensee wanted her to leave Canada and come to the United States. Petitioner did not feel free to do so because of her enterprise in Canada.

During the period 1938 through 1945 petitioner also sold to United States retailers a relatively small number of swimsuits manufactured by Canadian. There were many inquiries from others in the United States in the industry wishing to purchase her product. Wherever sold, her suits were met with general consumer acceptance and were highly successful. They were highly regarded by many large United States retailers, including recognized leaders in the fashion world. Petitioner was unable, however, to meet the full demand in the United States because of tariff restrictions and wartime scarcities. By 1946 her name had a distinct value and advantage in the industry in the United States. Her patents were valuable at all times.

The foregoing convinced petitioner that a great opportunity existed in the United States, and she decided to come to this country to manufacture swimsuits soon after the end of the war. With that idea in mind she kept in touch with suppliers of fabrics and sewing machine manufacturers, so as to be better able to secure her expected future needs.

In order to protect her inventions in the United States petitioner applied for five patents, all of which were ultimately granted. She also filed an application for registration of the name Rose Marie Reid.

About 1938 in the course of her business in Canada petitioner met Jack Kessler (hereinafter called Kessler) and his wife, Nina, both of whom then resided in Seattle, Washington. Kessler was interested in buying petitioner's swimsuits, and his wife encouraged her to come to the United States and enter the market in a larger way. During the war years the Kesslers visited petitioner several times, and purchased swimsuits for Nina and many of her friends.

In 1946 petitioner felt ready to come to the United States, and so advised Kessler. He evinced a desire to go into business with her, and informal discussions were had with that end in mind. They decided to form a California corporation.

Accordingly, in the spring of 1946, petitioner and Kessler met in Los Angeles, California, in the office of a man named Mitchell, Kessler's attorney. They orally agreed to form a California corporation to be called Rose Marie Reid (hereinafter called Californian). Petitioner and Kessler were each to received 50 percent of its stock.

The agreement so made was never reduced to writing. The only written evidence thereof consisted of notes made by Mitchell, which are no longer available. Petitioner's understanding of the substance of the agreement was that Kessler was to pay $50,000 in cash for his stock, and was also to provide a sufficient line of credit to finance the operations of the company. Petitioner, as consideration for her stock, was to surrender to Californian United States rights to her patents, patent applications, and trade name. Kessler was to act as business manager and petitioner was to act as designer. No salaries were to be paid to either of them until the corporation should begin to show a profit.

Petitioner was not at that time represented by counsel. She assumed that she would be dealt with honestly and fairly by Kessler and Mitchell. She was unfamiliar with legally complicated matters. She in fact turned over all documents relating to her patents and applications at that time.

Subsequently, Kessler claimed that the foregoing oral agreement was to the effect that each party was to supply Californian with cash in the amount of $25,000, and that he, in putting up $50,000, was lending petitioner $25,000, to be repaid by her out of earnings to be realized from the business. No consideration was provided for, in respect for petitioner's trade name, patents, and patent applications.

Petitioner at no time had such understanding of their arrangement. Her conception was at all times as above stated. She accordingly refused to sign a...