27 T.C. 200 (1956), 52506, Potter v. C.I.R.

Docket Nº:52506.
Citation:27 T.C. 200
Opinion Judge:ARUNDELL, Judge:
Attorney:John E. McClure, Esq., and Reuben Clark, Esq., for the petitioner. Richard G. Maloney, Esq., and Emil Sebetic, Esq., for the respondent.
Case Date:October 31, 1956
Court:United States Tax Court

Page 200

27 T.C. 200 (1956)




No. 52506.

United States Tax Court.

October 31, 1956

Page 201

John E. McClure, Esq., and Reuben Clark, Esq., for the petitioner.

Richard G. Maloney, Esq., and Emil Sebetic, Esq., for the respondent.

1. Petitioner by one instrument created irrevocable trusts for his wife and two minor children. He transferred to the trusts the full and exclusive right, title, and interest in and to a certain patent application and any and all patents issued thereon. Coincidentally with the creation of the trusts, the trustees entered into a nonexclusive license agreement with petitioner to make, use, and sell the article covered in the application at a graduated royalty rate. The trusts were to continue until the children reached their majority. One child was born about the time the trusts were created. Held, the income from the trusts for the years 1944, 1945, and 1946 was not taxable to petitioner under section 22(a), Internal Revenue Code of 1939, and petitioner was entitled, under section 23(a)(1)(A), 1939 Code, to deduct from his sole proprietorship business income the royalties he had agreed to pay under the license agreement with the trustees.

2. During the taxable years, petitioner borrowed from his children some of the income paid to them by the trustees and agreed to pay interest thereon. During the years 1945 and 1946, petitioner advanced funds to pay his children's income taxes. At the close of each year, he offset against such expenses the accrued interest on the loans from his children. Held, petitioner was entitled to deduct as interest ‘ paid’ under section 23(b), 1939 Code, the amount offset against the advances at the end of the years 1945 and 1946.

3. In 1945, petitioner purchased certain Government bonds and delivered the bonds to the trustees in payment of royalties accrued under the license agreement with the trustees. Held, the respondent erred in taxing the interest on the bonds to petitioner during the years 1945 and 1946.

4. Petitioner failed to file a declaration of estimated tax for the year 1946. Held, respondent did not err in determining additions to the tax under section 294(d)(1)(A) and (d)(2) of the 1939 Code.

Respondent determined deficiencies in income tax and additions to income tax under section 294 of the Internal Revenue Code of 1939 for the calendar years 1944, 1945, and 1946 as follows:

Additions under sec.-
Year Deficiency ____________________ ____________________
294(d)(1)(A) 294(d)(2)
1944 $18,201.66
1945 40,008.59
1946 37,701.39 $4,598.46 $3,065.65

The issues are:

1. For the years 1944, 1945, and 1946, was the income from the Potter Trusts taxable to petitioner under section 22(a) of the Internal Revenue Code of 1939 or, in the alternative, was the Potter Instrument Company (a sole proprietorship) entitled to deduct royalties accrued under a license agreement with the said trusts under section 23(a)(1)(A) of the 1939 Code? 2. For the years 1945 and 1946, was petitioner entitled to deduct as interest certain payments made on behalf of his children which were taken as offsets on their books of account? 3. For the years 1945 and 1946, was the interest on certain Government bonds properly taxable to petitioner? 4. For the year 1946, did respondent err in determining additions to the tax under section 294(d)(1)(A) and (d)(2) of the 1939 Code?

FINDINGS OF FACT. The stipulation of facts is incorporated herein by this reference. Petitioner is an individual residing at Oyster Bay, New York. The returns for the years here involved were filed with the then collector of internal revenue for the first district of New York. During the taxable years here involved, petitioner operated a sole proprietorship known as the Potter Instrument Company, hereinafter sometimes referred to as the Company. The Company employed the accrual method of accounting and kept its books of account on a calendar year basis. The Company was engaged, among other things, in the manufacture and sale of high-speed electronic counting, timing, and control instruments. Page 202 Petitioner attended the Rensselaer Polytechnic Institute and early became interested in science. On leaving Rensselaer, he went to work for John V. Hogan, a consulting engineer, for whom he did engineering work in high fidelity sound, facsimile, and television. Upon leaving Hogan, petitioner worked for various employers until 1939 when he went with the General Electric Company as an engineer in its engineering laboratory. While with General Electric, petitioner gave thought to developing a cheap and simple counter chronograph. Petitioner had contacts with the Army at the Aberdeen Proving Grounds in Maryland and, on receiving from the Army a promise that if he could produce such a counter chronograph for $4,000, which at that time was costing the Government about $25,000, the Army would purchase 5 of them, petitioner left General Electric to set up business for himself. In 1942 petitioner set up a business in Flushing, New York, in a small room and produced a counter chronograph which he sold to the Government for $4,000. Then he was given an order by the Army for additional units. During the years 1942 and 1943, petitioner engaged in personal effort that culminated in his inventing a basic electronic counter chronograph, also known as a 4-tube counter decade assembly. On November 13, 1943, petitioner filed application bearing serial number 510,229 for a patent with the United States Patent Office covering this device. On January 16, 1951, a patent bearing number 2,538,122 was issued to petitioner with respect to this application. The counter chronograph was immediately valuable commercially because all such counters until this time had at least 12 vacuum tubes in each decade. The counter invented and developed by petitioner used only 4 vacuum tubes and was at the same time a very dependable and economic counter. During the year 1943, as a result of this counter and other things it was doing, the Company did about $30,000 worth of business and at the beginning of 1944 it looked like it was going to be a good year and a profitable one. Among other things, the Company at this time was producing amplifiers, power supplies, and specialty items for the various proving grounds. The backlog of orders at this time was quite large. Petitioner has taken out over 20 patents during his working lifetime and has had considerable experience in negotiating license agreements in connection with such patents. In the latter part of 1943 and the early part of 1944, petitioner had conferences with Robert H. Horn, with respect to the creation of a trust for his wife, Doris T. Potter, and two minor children, Lois Trimble Potter, born July 1, 1940, and John Taft Potter, Jr., born January 28, 1944. Horn was a certified public accountant who did the supervisory auditing work for the Company and was responsible for the maintenance of its books. He also handled its financial affairs. Page 203 Petitioner was motivated to establish these trusts because the business of the Company was doing quite well in 1943 and petitioner felt that this would be a good opportunity to set something up for his wife and two children that would protect them if reverses should occur later. Paragraph 4 of the stipulation is as follows:

4. At an undisclosed date, petitioner established under a single trust instrument three trusts for the benefit of his wife, Doris T. Potter, and two minor children, Lois Tremble Potter and John Taft Potter, Jr. A copy of the trust instrument, which by its terms states that it was effective January 1, 1944, is attached hereto as Exhibit 3-C. The trusts created by this trust agreement are hereinafter referred to as the ‘ Potter Trusts.’

The trust instrument begins with these words and date: ‘ AGREEMENT, dated this 1st day of January, 1944, between’ petitioner as grantor and his wife, father (Harold T. Potter), and Horn, as the three trustees. The instrument was signed and separately acknowledged, before a notary, by petitioner and the three trustees. The four acknowledgments were identical except for the name of the person appearing before the notary. Petitioner's acknowledgment was as follows:


On the 1st day of February, nineteen hundred and forty-four, before me came JOHN T. POTTER, to me known and known to me to the the individual described in, and who executed, the foregoing instrument, and acknowledged to me that he executed the same. (Signed) Julie M. Valley #2233 Notary Public, Nassau County, New York, #2233. Under the trust instrument, petitioner irrevocably assigned all right, title, and interest in the patent application relating to the counter chronograph to the trusts. The trust agreement provided, in part, as follows:

FIRST: The grantor hereby assigns, transfers, gives and sets over to the Trustees, their successors or assigns, the full and exclusive right, title and interest in and to a certain application made for letters patents of the United States of America, which application has been duly filed in the patent office in the City of Washington, District of Columbia, and bears the number 510229, and any and all patents issued thereon; and any and all income, royalty, profit or proceeds of any nature and description whatsoever, that may be derived from the ownership of the invention covered by such application and described in the specifications filed therewith, (which, together with any and all property which may hereafter be added thereto or...

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