W.B. Davis & Son, Inc. v. Comm'r of Internal Revenue

• Citation: 5 T.C. 1195
• Decision Date: 10 December 1945
• Docket Number: Docket No. 21.
• Parties: W. B. DAVIS & SON, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: United States Tax Court

5 T.C. 1195

W. B. DAVIS & SON, INC., PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket No. 21.

Tax Court of the United States.

Promulgated December 10, 1945.

1. Amounts agreed by the petitioner corporation to be paid to its president out of royalties received under a patent license granted by it to another corporation, held to be expenditures made for the acquisition of the president's interest in the inventions and patent applications, and not deductible as ordinary and necessary business expenses.

2. After acquiring the inventor's rights in inventions and patent applications in 1935, the petitioner paid the cost of defending the patent applications in interference proceedings and obtained letters patent in 1942. In 1935 the petitioner granted a license to use the patents, under which it received royalties during each of the years 1935 to 1942, the royalties received in 1940 being in excess of 125 percent of the average amount of royalties received for the years 1936 to 1939. Held, under section 721, Internal Revenue Code, that the royalty income received in 1940 was income resulting from the development of patents and was abnormal income, and that, in accordance with section 30.721-8, Regulations 109, the net abnormal income should be attributed to the years during which expenditures were made on account of the interference proceedings and in the proportion which the amount expended during each such year bears to the total of such expenditures: held, further, that the petitioner is entitled to exclude from its excess profits net income of 1940 that portion of its net abnormal income which is attributable to the years 1936 to 1939 and 1941 and 1942.

3. The depreciated cost of machinery which was removed and stored in the basement of petitioner's factory in 1940 held not deductible as a reasonable allowance for obsolescence or as a loss sustained by reason of abandonment of the machinery, on the ground that the proof does not establish a period of obsolescence or permanent abandonment of the machinery in 1940. Charles A. Noone, Esq., for the petitioner.

Charles P. Bagley, Esq., for the respondent.

This is a proceeding involving deficiencies of $1,582.50 in income tax for 1939, $2,070.85 in income and income defense taxes for 1940, and $1,970.68 in excess profits tax for 1940. The issues are whether the petitioner is entitled (1) to deduct $6,692.51 in 1939 and $7,449.65 in 1940 as ordinary and necessary business expenses; (2) to exclude $8,511.44 from its excess profits net income of the year 1940 under the provisions of section 721 of the Internal Revenue Code; and (3) to deduct $8,049.55 in the year 1940 for obsolescence, or as a loss from abandonment, of certain hosiery manufacturing machines.

FINDINGS OF FACT.

The petitioner is an Alabama corporation, with its office and place of business in Fort Payne, of that state. It was organized in 1913 by W. B. Davis and has been engaged since its organization in the business of manufacturing and selling misses' and children's hosiery. It filed its returns for the taxable years 1939 and 1940 with the collector at Birmingham, Alabama.

W. B. Davis and his son, Robert E. Davis, were the principal stockholders of the petitioner and were president and vice president, respectively, from 1913 to July 29, 1934. W. B. Davis died on July 29, 1934, and Robert E. Davis succeeded him as president and has since held that office and actively managed the petitioner's business. W. B. Davis left no estate other than his shares of stock in the petitioner, which he bequeathed to his widow. At the death of W. B. Davis the shares of petitioner owned by him and by Robert E. Davis were held by their creditors as security for personal loans of approximately $300,000.

Robert E. Davis was a textile engineer, and when he entered the employ of the petitioner he was placed in charge of its manufacturing operations. He devoted most of his time and attention to the petitioner's plant and machinery and to their improvement. In 1934 he invented certain processes and machines for the manufacture of hosiery having self-supporting, or elastic tops, known as ‘automatic tops‘; and in 1934 and 1935 he applied for letters patent. The applications and dates on which the applications were filed are as follows:

Self Supporting Garments, filed December 31, 1934, Serial No. 759,831.

Knitted Wear (a continuation in part of the above application, S.N. 759,831), filed June 26, 1935, Serial No. 28,463.

Knitting Machine, filed August 2, 1935, Serial No. 34,328.

Method of Producing Elastic Top Sock, filed September 24, 1935, Serial No. 41,840.

As hereinafter shown, Davis assigned the inventions and patent applications to the petitioner in 1935. The applications were contested in interference proceedings in the Patent Office for a period of eight years, and the patents were finally issued to the petitioner on December 22, 1942.

Davis received a substantial salary for his services in part of 1934 as vice president and subsequently for his services as president of the petitioner. He received $8,500 in 1934; $7,549 in 1935; $7,440 in 1939; and $8,440 in 1940. He devoted a large part of his time to the development of the inventions and the prosecution of the applications for patent. In the experimental work on the inventions he used the mechanical facilities of the petitioner and the services of its hired mechanics. He did not at any time prior to his assignment in 1935 have a contract or other understanding with the petitioner obligating him to make the inventions or to assign to petitioner his rights in the inventions or in the patent applications.

In 1935 the petitioner paid the preliminary fees for filing the applications in the Patent Office, in the amount of $334.60, and in the years 1936 to 1942 it paid the cost of defending the applications in the interference proceedings, in the amount of $51,322.51, which cost consisted principally of attorney fees. The amount paid in each of the said years is as follows:

+----------------+
                ¦1935 ¦$334.60   ¦
                +-----+----------¦
                ¦1936 ¦4,326.99  ¦
                +-----+----------¦
                ¦1937 ¦5,548.09  ¦
                +-----+----------¦
                ¦1938 ¦7,101.53  ¦
                +-----+----------¦
                ¦1939 ¦10,238.56 ¦
                +-----+----------¦
                ¦1940 ¦7,408.42  ¦
                +-----+----------¦
                ¦1941 ¦7,851.64  ¦
                +-----+----------¦
                ¦1942 ¦8,847.28  ¦
                +-----+----------¦
                ¦Total¦51,657.11 ¦
                +----------------+
                

The petitioner charged the foregoing amounts to patent application costs on its books. In 1936 the petitioner charged off $2,541.47 of such costs as an expense, and it deducted that amount on its income tax return. The remainder of the foregoing amounts was reflected in the assets shown on the balance sheets attached to petitioner's income tax returns for later years.

In 1935, soon after Davis had filed his first application for patent, the Interwoven Stocking Co., of New Brunswick, New Jersey (hereinafter sometimes called Interwoven) became interested in his inventions and began negotiating with Davis and the petitioner's attorney, who was also one of its directors, for a license to use the automatic top inventions in the manufacture of men's seamless hose. In the course of the negotiations Davis signed an instrument transferring to the petitioner his ‘whole right, title and interest‘ in the inventions and in the four applications hereinabove described, in consideration ‘of the sum of One Dollar to me paid and other valuable considerations.‘ The assignment bears date of June 29, 1935. Davis acknowledged the assignment on September 25, 1935, the day following the filing of the fourth of his patent applications, and the assignment was recorded in the Patent Office on September 27, 1935.

The parties prepared a license agreement between the petitioner and Interwoven by the terms of which the petitioner granted to Interwoven an exclusive license to use the Davis inventions in the manufacture of men's seamless hose. The license agreement was dated July 1, 1935. It was signed by Davis as president of the petitioner, pursuant to authority of the petitioner's executive committee, and was approved by the petitioner's directors at a meeting held on November 8, 1935. The pertinent parts of the license agreement are as follows:

2. LICENSOR gives, grants and conveys to LICENSEE the exclusive right and license to manufacture and/or to have manufactured for it, and to sell and use men's seamless hose * * * embodying the said inventions, owned or controlled by the LICENSOR during the continuance of this agreement, including the inventions covered by the said (Davis) applications for Letters Patent of the United States hereinbefore referred to, and under the Letters Patent to be granted therefor, * * *

4. LICENSEE agrees to pay to LICENSOR the sum of One Thousand ($1,000.00) Dollars on the day when these presents are duly executed by LICENSOR and delivered to LICENSEE; LICENSEE agrees to pay further to LICENSOR the sum of Five Thousand Two Hundred and Fifty ($5,250.00) Dollars within thirty (30) days after the execution and delivery of these presents.

5. LICENSOR agrees that it will expend sums paid to it as recited in the foregoing paragraph, or so much thereof as is necessary to secure adequate patent protection for the inventions herein licensed in the United States, and that it will well and truly prosecute the aforesaid applications, and will promptly take appeals to the Board of Appeals and to the Court of Customs and Patent Appeals if necessary, and will file and prosecute such divisions, continuing or substitute application or applications for Letters Patent of the United States as may be hereafter deemed necessary or desirable to more perfectly secure protection for the inventions under which this license is given.

6. LICENSOR shall file and prosecute such other applications for Letters Patent of the United States as may be or become necessary for all improvements on said men's seamless hose, and processes and apparatus...