Lohrke v. Comm'r of Internal Revenue, Docket No. 5279-65.
| Decision Date | 10 August 1967 |
| Docket Number | Docket No. 5279-65. |
| Citation | 48 T.C. 679 |
| Parties | JAMES L. LOHRKE AND JUNE M. LOHRKE, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Gordon W. Gerber, for the petitioners.
Edward L. Newberger and Dennis C. DeBerry, for the respondent.
Petitioner was receiving a substantial amount of royalty income from the licensing of a patent on a process used in the synthetic fiber industry. Petitioner also had a substantial interest in a corporation that used this process in the conversion of synthetic fibers into fabrics. In 1961, the corporation made a shipment of defective fiber to a British corporation. Petitioner agreed to assume personally any loss to the British corporation resulting from this shipment and in 1962 sent his personal check in the amount of $30,000 to cover the loss. Held, under the circumstances, petitioner's payment to the British corporation was an ordinary and necessary expense of carrying on his licensing business.
The respondent determined a deficiency in the petitioner's income tax in the amount of $24,559.91 for the taxable year 1962. The only issue for decision is whether a payment made by the petitioner to a customer of a corporation in which the petitioner had a substantial interest was an ordinary and necessary expense of a trade or business operated by the petitioner as a proprietorship.
Some of the facts were stipulated, and those facts are so found.
The petitioners, James L. Lohrke and June M. Lohrke, are husband and wife who resided in West Chester, Pa., at the time the petition was filed in this case. They filed their joint Federal income tax return for the calendar year 1962 with the district director of internal revenue, Philadelphia, Pa. James L. Lohrke will be referred to as the petitioner.
The petitioner's father, James L. Lohrke, Sr., was an inventor, and during his lifetime, he developed several new ideas for processes in the textile-manufacturing field. Lohrke, Sr., was the owner of several patents, including one on the ‘Perlok’ process for converting synthetic fibers in continuous filament form (tow) into fibers of short length in strand form (top) comparable to natural fibers such as wool.
A few large chemical companies produce tow, which is sold to textile mills, where the tow is converted into top. The top is processed into yard, and the yarn is then made into fabrics such a rayon, nylon, orlon, and dacron.
In the 1940's Lohrke, Sr., became associated with the Garth Manufacturing Co., a sole proprietorship owned by H. L. Garth. This relationship continued until the death of Lohrke, Sr., in 1949. Lohrke, Sr., used the Garth plant to develop and demonstrate the Perlok process. H. L. Garth operated the plant, and Lohrke, Sr., provided the necessary capital and handled sales. Profits were equally divided between the two.
Lohrke, Sr., died on July 27, 1949. Under the terms of his will, a trust was established, and his share of the royalty income from the licensing of the Perlok process was to be paid 50 percent to his surviving wife, later known as Mary M. Simpler, 25 percent to his daughter Lois L. Read, now known as Lois L. Ellison, and 25 percent to the petitioner, as income beneficiaries. The surviving wife and the petitioner were named executors and trustees under the will.
From 1949 until 1964, when the Perlok process patent expired, the petitioner licensed companies in the United States and elsewhere to use the Perlok process. He conducted this activity as an executor and trustee under the will of Lohrke, Sr., between 1949 and 1959. In 1959 and 1960, he acted as the only general partner in a limited partnership known as the J. L. Lohrke Estate, to which the Perlok process patent had been assigned. At the dissolution of the limited partnership in 1960, the petitioner agreed to pay 55 percent of the gross royalty income to the former limited partners in return for their assignment to him of their interests in the patent, and he then conducted this activity in his individual capacity from 1960 to 1964. After paying such percentage to the former limited partners and the expenses of promoting the patent, the petitioner was entitled to the remaining royalty income.
The total royalty income produced annually by the licensing of the Perlok process during the period 1960 to 1964 was $233,751.04 for 1960, $469,543.62 for 1961, $463,461.80 for 1962, $448,831.11 for 1963, and $279,437.23 for 1964. Computed without regard to the payment which is the subject of this controversy, the petitioner's share of such income during these years was $74,170.52 for 1960, $156,323.90 for 1961, $172,648.28 for 1962, $145,778.36 for 1963, and $69,850.69 for 1964.
The petitioner has also been interested in a business using the Perlok process to manufacture top for sale. Between 1949 and 1955, the petitioner continued the same arrangements with H. L. Garth that his father had prior to 1949. This informal partnership was known as the J. L. Lohrke Co. and was formalized by the execution of a written partnership agreement on January 1, 1955. In March 1961, Lohrke Textiles, Inc.(Textiles), purchased the assets of the J. L. Lohrke Co. and took over all manufacturing and selling functions, which it has carried on to the date of the trial of this case. After March 1961, all of the outstanding shares of Textiles were owned by the J. L. Lohrke Co. The net profits and losses of the J. L. Lohrke Co. were distributable 61.3 percent to the petitioner, 25.8 percent to Mary M. Simpler, and 12.9 percent to Lois L. Read. A corporation was considered by the petitioner to be a better means of handling the manufactured business since, among other advantages, a corporation has unlimited life.
Textiles showed a net loss in the amount of $32,707.82 for its fiscal year ending in 1961, $80,045.57 for its fiscal year ending in 1962, $52,260.15 for its fiscal year ending in 1963, $5,903.23 for its fiscal year ending in 1964, and $15,174.05 for its fiscal year ending in 1965. The petitioner received income from Textiles in the amount of $6,202.42 in 1960 and no income in any of the years 1961 through 1965.
The petitioner has also invented new processes for use in the synthetic fiber industry. He now owns two new patents, one of which is a further invention relating to the basic Perlok process patented by Lohrke, Sr.
In 1961, Textiles entered into a business relationship with Francis Willey (Synthetics) Ltd. (Willey), for the purpose of promoting the sale of top in England. At that time, the sale of top by Textiles in both foreign and domestic markets had decreased from sales in prior years because many foreign and domestic mills had become licensees of the Perlok process, transforming them from customers into competitors of Textiles.
As part of the business relationship between Willey and Textiles, Willey ordered top from DuPont United Kingdom, specifying Textiles as the processor. DuPont United Kingdom transmitted the orders to DuPont in Wilmington, Del., which then advised Textiles of such orders. After manufacturing an order of top, Textiles billed DuPont in Wilmington, which paid Textiles the amount due it. Ultimately, DuPont United Kingdom billed Willey for the order.
A shipment of defective top was made to Willey in the early summer of 1961. The defect was the result of a failure by Textiles to make normal quality-control checks, and the responsibility for the defective top rested upon Textiles. In a telephone conversation with A. W. J. Massam, a director of Willey, in the middle of July 1961, the petitioner was advised by Massam that Willey preferred to ship the top back to Textiles, but that Willey would accept both the top already delivered and the top still in transit and would pay DuPont if the petitioner would agree to be personally responsible for any loss Willey might suffer. Massam, at that time, was aware of the poor financial condition of Textiles inasmuch as in earlier discussions in England, the petitioner had told Massam and others at Willey that Textiles needed to make sales in England because the success of the petitioner in licensing the Perlok process had made it difficult for Textiles to do a profitable business elsewhere. In that telephone conversation, the petitioner agreed to assume personal liability for any loss and later confirmed the agreement in a letter dated July 20, 1961.
The petitioner believed that if he did not agree to be personally liable for whatever losses Willey might sustain by accepting the top, his personal business future would be harmed. This belief was based in part on the realization that if Willey did not pay DuPont for the top, DuPont would have sought repayment from Textiles, which did not have sufficient cash. The petitioner feared that Textiles's involvement with DuPont over a defective shipment of top might become known to the entire synthetic fiber industry. The petitioner further did not want to lose the benefits that he, as a licensor and inventor, derived from having access to the manufacturing facilities of Textiles.
The petitioner did not attempt to distinguish his activities as licensor and inventor from his activities as president of Textiles to any members of the synthetic fibers industry. He described and used Textiles as a pilot plant and earlier advertised the J. L. Lohrke Co. as owner of the Perlok process patent. This was done partly to make clear to prospective licensees that Textile's evaluation of the Perlok process was not being given as an independent company. The petitioner regularly offered samples of top processed by Textiles to prospective licensees. A total of 80 companies became licensees of the Perlok process, and 58 of this number had purchased top from Textiles or the J. L. Lohrke Co. before becoming licensees. Forty-six of the 80 licensees visited the Textiles plant to see the machinery needed for using the Perlok process in operation...
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