Lan Jen Chu v. CIR, 73-1132.

• Decision Date: 02 November 1973
• Docket Number: No. 73-1132.,73-1132.
• Citation: 486 F.2d 696
• Parties: LAN JEN CHU and Grace Y. P. Chu, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.
• Court: U.S. Court of Appeals — First Circuit

486 F.2d 696 (1973)

LAN JEN CHU and Grace Y. P. Chu, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.

No. 73-1132.

United States Court of Appeals, First Circuit.

Argued September 6, 1973.

Decided November 2, 1973.

William S. Estabrook, III, Atty., Tax Div., Dept. of Justice, with whom Scott P. Crampton, Asst. Atty. Gen., Ernest J. Brown, and Grant W. Wiprud, Attys., Tax Div., Dept. of Justice, were on brief, for appellant.

Paul J. Foley, Washington, D. C., with whom Robert H. Rines and Rines & Rines, Boston, Mass., were on brief, for appellees.

Before McENTEE and CAMPBELL, Circuit Judges, and KILKENNY, Senior Circuit Judge.^*

McENTEE, Circuit Judge.

In this case we are faced with the question of whether the transfer by a taxpayer of a patent application to his controlled corporation may properly be considered the transfer of "property of a character which is subject to the allowance for depreciation" within the meaning of Internal Revenue Code § 1239(b), so as to treat the gain realized from such transaction as ordinary income rather than capital gain. Section 1239 provides in relevant part as follows:

"§ 1239. Gain from sale of certain property between spouses or between an individual and a controlled corporation

(a) Treatment of gain as ordinary income.—In the case of a sale or exchange, directly or indirectly, of property described in subsection (b)—

* * * * * *

(2) between an individual and a corporation more than 80 percent in value of the outstanding stock of which is owned by such individual, . . .; any gain recognized to the transferor from the sale or exchange of such property shall be considered as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231.

(b) Section applicable only to sales or exchanges of depreciable property. —This section shall apply only in the case of a sale or exchange by a transferor of property which in the hands of the transferee is property of a character which is subject to the allowance for depreciation provided in section 167."

The taxpayer in the instant action, Lan Jen Chu, is an eminent authority on electromagnetic theory and antenna systems. In the course of a long and distinguished academic career, he has written numerous articles on these subjects, and has been granted approximately twenty-five different patents relating to antennas. On June 26, 1956, Chu and an associate, Ivan Faigen, filed an application with the United States Patent Office seeking the issuance of letters patent on a new, completely enclosed antenna in which would be housed a transmission-line system consisting of a balanced and unbalanced line. In their application, Chu and Faigen maintained that because of its novel design, the system would be substantially less cumbersome and costly than existing antenna systems, and additionally would be less subject to atmospheric interference. The application contained eighteen separate claims, the first thirteen of which can be characterized as pertaining to the principal antenna structure. Claims 14-18 involved an alternative structure, preferable only if more than two antenna units were "stacked" one on top of another. On July 5, 1957, the Patent Office informed Chu that claims 1-13 had been disallowed because of prior existing patents. However, it indicated that claims 14-18 "appeared allowable."

Still confident about the eventual patentability of their invention, Chu and Faigen, on December 9, 1957, filed an amendment A to the initial application. Although the amendment took strong issue with the determination made by the Patent Office and sought to clarify and explain more fully the design of the antenna system, the application was once again denied. This time, however, the Patent Office indicated that, in addition to claims 14-18, claim 12 also appeared allowable. Subsequently, a further clarifying statement, Amendment B, was filed, and on September 14, 1959, the Patent Office issued a notice adhering to its previous position.

Several months later, on December 18, 1959, Chu assigned his 11/12 interest in the patent application to Chu Associates, Inc. At the same time, Rines (Faigen's assignee) made a similar assignment with respect to his 11/12 interest. Pursuant to these assignments, Chu and Rines were to receive, in respective 11/12 and 1/12 proportions, a minimum purchase price of $317,000, to be paid over the life of the patent that both expected would be ultimately granted.¹ Chu Associates, Inc. was incorporated under the laws of the Commonwealth of Massachusetts in August 1959 for the purpose of manufacturing antennas. The Articles of Organization provided for an authorized capital stock of 1,000 shares of no-par common. At incorporation, however, only ninety shares were issued and paid for. Chu received eighty shares and Faigen received ten shares. The purchase price to each was $200 per share resulting in a paid-in capital of $18,000.

On December 15, 1959, just three days before the assignments of the patent application in question, the corporation held a special joint shareholders and directors meeting. At that meeting, a resolution was adopted declaring a 100% stock split on the ninety existing shares. In addition, a second resolution was adopted, which provided:

"VOTED: To issue in addition to the shares of no par common stock already outstanding, 110 additional shares so as to make the number issued and outstanding 200 shares of no par common stock, of which 90 shares shall be issued to accomplish the stock split in accordance with the preceding vote, and the balance shall be issued to subscribers for $100.00 per share."

At the conclusion of the stock transactions contemplated by the approved resolutions, Chu was to own 160 of the outstanding 200 shares of the corporation, or exactly eighty percent of its voting strength. Thus, the stock transfer book indicated that on December 15, 1959, eighty additional shares had been issued to Chu so as to effectuate the stock split, ten additional shares had similarly been issued to Faigen, and the twenty remaining newly issued shares had been sold to certain other individuals.

However, the transfers suggested by the stock transfer book may not have been fully completed by December 18, 1959, the crucial date on which the patent application was assigned to Chu Associates, Inc. The corporate balance sheet for the taxable year ending September 30, 1960, revealed a paid-in capital of $19,800, thus indicating that only eighteen of the twenty shares to be sold to others pursuant to the December 15 resolutions had been actually issued and paid for.²

Sometime after the transfer of the application, on March 8, 1960, an Amendment C was filed with the Patent Office, once more attempting to clarify certain disputed aspects of the antenna's design. This time the effort was successful, and on September 7, 1960, the Patent Office informed Chu that a "Notice of Allowance" on all 18 claims had been approved. Subsequently, on May 30, 1961, letters patent were issued.

Since the patent was granted, Chu Associates, Inc. has sold numerous antennas systems under patented claims 1-13. However, none of the systems merchandised by the corporation has yet to involve application of the alternative design embodied in claims 14-18. Pursuant to the December 18, 1959, assignments, Chu has received substantial sums of money, all of which he reported as long term capital gain. The Commissioner, deeming § 1239 applicable under the facts of this case, sought to assess a deficiency by requiring that those sums be taxed at ordinary income rates.

In a lengthy opinion, the Tax Court explicitly rejected the government's contention that a patent application could be considered property "of a character subject to depreciation" within the intendment of § 1239(b), and thus concluded that § 1239 had no application. 58 T.C. 598, 609 (1972). The Tax Court also considered, and rejected, the argument that under the recent Seventh Circuit holding in Estate of Stahl v. Commissioner, 442 F.2d 324 (1971), the patent application at issue here had sufficiently "matured" so as to be viewed, at the time of transfer, as a depreciable patent governable by § 1239. By predicating its opinion on the "depreciable property" aspect of § 1239(b), the Tax Court found it unnecessary to decide whether the "control" test of § 1239(a) had been satisfied, though it intimated a belief that the government's position on this issue was strong. Because we feel constrained to agree with the Tax Court that the patent application transferred here was not "property of a character" subject to the depreciation allowance, we similarly find it inappropriate to pass upon the questions regarding control which are presented by these facts.³

The government argues strongly that the broad language of § 1239(b) (property of a character subject to depreciation) justifies the conclusion that the limitations on capital gain treatment imposed by that section apply not only to the sale or exchange of depreciable property, but also to the transfer of property of the type which might ultimately become depreciable. Thus, while the government is apparently willing to concede that a mere patent application should not be considered depreciable property in the strictest sense, it nevertheless contends that since the application, if eventually approved, would then become depreciable, American Chemical Paint Co. v. Commissioner, 66 F.2d 381 (3d Cir. 1933); Kershaw v. United States, 180 F.Supp. 415, 148 Ct.Cl. 693 (1960), § 1239 should govern transactions involving the application itself. If we could consider the question strictly from the vantage point of developing a sound federal tax policy, this approach would indeed have some merit. Unless § 1239 is interpreted as the government suggests, a significant loophole could be created in the application of that section. It would be a simple matter for a tax conscious...