Dreymann v. Comm'r of Internal Revenue, Docket No. 12707.

• Decision Date: 09 August 1948
• Docket Number: Docket No. 12707.
• Citation: Dreymann v. Comm'r of Internal Revenue, 11 T.C. 153, 78 U.S.P.Q. 302 (T.C. 1948)
• Parties: CARL G. DREYMANN, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: U.S. Tax Court

11 T.C. 153

78 U.S.P.Q. 302

CARL G. DREYMANN, PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket No. 12707.

Tax Court of the United States.

Promulgated August 9, 1948.

1. In September 1932 petitioner orally promised to give his daughter a one-half interest in a process for moisture-proofing paper and paper board if she would devote her full time in helping him produce the process. Petitioner's daughter agreed and complied with the terms of the agreement by rendering substantial and vital services to petitioner from September 1932 to 1942 in the invention, development and improvement of the process. The process was invented sometime in the period between April 1933 and August 30, 1933. Held, as of the moment the moisture-proofing process was reduced to practice, petitioner's daughter, by virtue of the agreement of September 1932, acquired an undivided one-half equitable interest in petitioner's property and the ‘royalty‘ income which was realized from such interest is not includible in petitioner's gross income.

2. Upon the evidence, held, the gain which petitioner realized in the involved taxable years for the sale of the invention is taxable at capital gain rates provided for in section 117, Internal Revenue Code, and not as ordinary income. Sidney B. Gambill, Esq., for the petitioner.

Homer F. Benson, Esq., for the respondent.

Respondent determined deficiencies in petitioner's income and victory taxes as follows:

+--------------------------------------+
                ¦1941, income tax            ¦$4,245.41¦
                +----------------------------+---------¦
                ¦1943, income and victory tax¦16,538.21¦
                +----------------------------+---------¦
                ¦1944, income tax            ¦12,385.84¦
                +--------------------------------------+
                

Due to the forgiveness feature of the Current Tax Payment Act of 1943, no deficiency was determined for the year 1942. The questions are:

(1) Is all of the ‘royalty‘ income realized from the sale of the process for moisture-proofing paper and cardboard for the years here involved includible in petitioner's gross income?

(2) Is the ‘royalty‘ income realized by petitioner from the sale of the invention for the years involved taxable as ordinary income or as capital gain?

Petitioner reported the ‘royalty‘ income which he received as ordinary income, but he contends here that such income was capital gain.

The returns were filed with the collector of internal revenue for the twenty-third district of Pennsylvania at Pittsburgh.

FINDINGS OF FACT.

Petitioner resides in Pittsburgh, Pennsylvania. He was born in Germany in 1875. He came to the United States during July 1913 for the purpose of becoming a permanent resident. He brought with him his wife and his only child, Annie L. Dreymann, who was born in Germany in 1913. Previously, he had come to the United States in 1906 and 1912 to study manufacturing.

After his arrival in the United States in 1913 petitioner constructed a plant in Baltimore, Maryland, to manufacture certain products out of fish oil. This business was discontinued in 1918, due to the increase in the price of the basic ingredient needed to manufacture his products.

While petitioner was engaged in operating the processing plant in Baltimore, he devised a process for substituting fish oil in the manufacture of steel. The process was patented and made available to United States Steel Corporation free of charge. While petitioner was in Europe, after World War I, he was contacted by one Dewey, formerly research director of United States Steel Corporation, who wanted to purchase petitioner's patent. Petitioner sold that patent to him for $3,000. Petitioner developed no other inventions until he discovered the process for moisture-proofing paper herein involved.

During 1924, principally through financing by citizens of the United States, petitioner built a rayon factory in Utica, New York. He operated that plant until 1928, at which time he left Utica to go to Chicago as a consulting chemist. He stayed there approximately six months and then went to New York City to become a consulting engineer.

During 1929 petitioner's wife died in New York, leaving petitioner and his daughter Annie without relatives in this country. Annie (now Mrs. Wilson) inherited property from her mother.

During 1930 a New York firm employed petitioner to go to the Mellon Institute at Pittsburgh, Pennsylvania, to test laminating materials for manufacturing shirt collars.

During 1931, while at the Mellon Institute, petitioner heard of the need for moisture-proof paper and paper board. Since he wanted to return to manufacturing, petitioner became interested in developing the desired materials and process therefor. During 1931 and 1932 he did considerable research in connection with this moisture-proofing problem in a laboratory in his home.

In June 1932 Annie, then 19 years old, was graduated from Madeira Preparatory School in Washington, D.C. She majored in scientific subjects. She had hoped to go to college and specialize in chemistry, but she felt that, due to the depression, she should get a job. She talked about this problem with petitioner shortly after her graduation, but they decided to postpone further discussion until she returned from her employment as counselor in a summer camp. In September 1932 petitioner asked Annie to work with him on the development of the process for moisture-proofing paper and paper board. During this discussion he agreed to give her a one-half interest in any process for moisture-proofing paper and paper board their efforts might produce. He pointed out to her that he would rather have her associated with him than anyone else. She previously had helped him while she was a senior at Madeira during the Christmas and Easter vacations. Annie accepted that offer and they immediately commenced work. They did their work at first in petitioner's home laboratory, which was set up in his kitchen.

During a conversation with a man in Pittsburgh, Pennsylvania, petitioner learned of the Grant Paper Box Co. (hereinafter referred to as Grant), which had a manufacturing plant in Pittsburgh. Petitioner and Annie conferred with Grant, the president of the company, in April 1933. Grant felt they were proceeding on the wrong course and suggested that his company install a laboratory so they could continue further research along the lines he suggested. At this time petitioner entered into a contract with Grant dated April 1933. It contained, among others, the following provisions:

WHEREAS, the second party claims he has a formula for making paper, or paper board, moisture proof to the extent that the paper or paper board after being treated with the preparation will prevent moisture from penetrating the paper or paper board to the extent of— milligrams, or better, and,

WHEREAS, the first party desires to assist the second party in the development of the said formula.

NOW, THEREFORE, THIS INDENTURE WITNESSETH that the first party shall pay the second party the sum of $200.00 per month for period of two months.

During the said period the second party agrees to devote his time and attention to the development of any ideas in the manufacture of paper boxes and cartons, as well as water proof board and water proof paper.

In the event that the second party is successful in developing anything new along the lines above set forth, then the first party is to have the sole, exclusive right of manufacturing and selling the same in the United States and Canada and the first party agrees to pay the second party, five (5%) per cent of the gross sales.

Soon after the execution of the above contract petitioner and Annie continued their experiments and research in the laboratory set up by Grant. Sometime after the execution of the April 1933 contract, the exact date was not shown, while they were testing certain material, petitioner spilled some wax which he found to be sticky. It occurred to him that this substance was the water-proofing material for which they had been searching. Tests with this substance developed the desired process and demonstrated its practical application. The results of these tests were communicated to Grant and thereupon another contract between petitioner and Grant was executed on August 30, 1933. That contract provided as follows:

AGREEMENT, made this 30th day of August, 1933, by and between GRANT PAPER BOX COMPANY, a corporation of the State of Pennsylvania (hereinafter referred to as the ‘Company‘), and CARL DREYMANN, of Pittsburgh, Allegheny County, Pennsylvania.

WHEREAS, Carl Dreymann has developed a process for making moisture proof cardboard and has conducted his work of development at the plant of the Company under a preliminary agreement, dated April, 1933; and

WHEREAS, the parties have decided to commence production of moisture proof cardboard and marketing of cartons made therefrom (which cartons are hereinafter referred to as the Product);

NOW, THEREFORE, in consideration of the premises and the mutual covenants herein contained, the parties hereto agree as follows:

1. The agreement of April 1933, is hereby rescinded.

2. It is agreed between the parties that Carl Dreymann shall forthwith make applications for United States and Canadian patents, protecting the manufacture of moisture proof paper, moisture proof cardboard and moisture proof cartons and paper boxes. The Company agrees to pay all fees and expenses necessary for the procuring of patent rights.

3. Carl Dreymann hereby agrees on the issuance of said patents, or either of them, to assign them to the Company.

4. Carl Dreymann agrees to devote all the time necessary to the perfecting and developing of his manufacturing process.

5. The Company agrees to pay Carl Dreymann as compensation for his time and ordinary services the sum of $200.00 per month, less any royalties due and payable under this contract. When the royalties payable according to the terms hereof shall amount to more than $200.00 per month then the...