NATIONAL UTILITY PRODUCTS CO. v. Commissioner

• Decision Date: 13 December 1978
• Docket Number: Docket No. 275-75,276-75.
• Citation: 37 TCM (CCH) 1851,1978 TC Memo 494
• Parties: National Utility Products Company v. Commissioner. Harold M. and Ann T. Bowman v. Commissioner.
• Court: U.S. Tax Court

37 T.C.M. (CCH) 1851-18 (1978)

T.C. Memo. 1978-494.

National Utility Products Company v. Commissioner.

Harold M. and Ann T. Bowman v. Commissioner.

Docket Nos. 275-75, 276-75.

United States Tax Court.

Filed December 13, 1978.

Larry Crystal and Daniel R. McCarthy, 962 Illuminating Bldg., Cleveland, Ohio, for the petitioners. Larry L. Nameroff, for the respondent.

Memorandum Findings of Fact and Opinion

WILBUR, Judge:

Respondent determined deficiencies in petitioners' Federal income taxes and additions to tax as follows:

                                                                                                 Addition to
                                                                                               Tax1 Under
                          Petitioner                                       Year    Deficiency    Sec. 6651(a)
                          National Utility Products Company2 .....    1969      $ 3,266
                                                                           1970       58,386
                          Harold M. and Ann T. Bowman3 ...........    1970       10,967
                                                                           1971       12,891         $683
                

Concessions having been made, the following four issues remain for our decision:

(1) Whether NUPCO is limited in its deduction for depreciation of a patent acquired on January 5, 1970, to 8 percent of the sales of items sold under the patent.

(2) Whether NUPCO's obligation to pay Bowman under a patent assignment qualifies as an "indebtedness" upon which accrued interest may be deducted under section 163(a).

(3) If such obligation is found to qualify under that section, whether and to what extent interest was actually paid on the obligation in accordance with section 267(a)(2)(A).

(4) Whether petitioners, Harold M. and Ann T. Bowman, timely filed their joint Federal income tax return for the taxable year ended December 31, 1971.

Findings of Fact

Some of the facts have been stipulated. The stipulation of facts and attached exhibits are incorporated herein by this reference.

Petitioner National Utility Products Company (NUPCO) is an Ohio corporation incorporated on May 31, 1962. At all times relevant to this matter, it had its principal place of business in Cleveland, Ohio. NUPCO maintained its books and records and filed its Federal income tax returns using an accrual method of accounting and a calendar year. For calendar years beginning January 1, 1971, NUPCO filed a timely election to be taxed as a "Subchapter S" corporation under section 1371.

Harold M. Bowman (Bowman) and Ann T. Bowman are husband and wife who reside in Cleveland, Ohio. They filed joint Federal income tax returns for the calendar years 1970 and 1971 which were prepared and filed on the cash basis method of accounting.

During all the years in issue, Bowman owned all of the issued and outstanding capital stock of NUPCO, which consisted of 100 shares of no par value common stock. At the time of its incorporation, Bowman's adjusted cost basis of NUPCO's stock was $1,250.

On November 23, 1965, Letters Patent (hereinafter referred to as "the patent" or as "patent 1") were granted to Bowman by the United States Patent Office in connection with a device which permits the raising of the level of manholes when roads are being repaved. On January 5, 1970, Bowman sold this patent to NUPCO. In connection with this sale, two documents were executed on this date. One document, entitled "assignment of Patent," was entered into by and between Harold M. Bowman as assignor and NUPCO as assignee. The pertinent provisions of this document provided as follows:

NOW, THEREFORE, the parties hereto agree as follows:

1. Assignor hereby sells, assigns and transfers to Assignee his entire right title and interest in and to the Manhole Cover Support Patent Number 3,218,943 bearing the date November 23, 1965, same to be held and enjoyed by the said Assignee for its own use to the full end of the term for which said letters patent are granted as fully and entirely as the same would have been held by Assignor had this assignment and sale not been made.

2. The purchase price shall be Seven Million Eight Hundred Thousand Dollars ($7,800,000.00) and shall be payable as follows:

a. Assignee shall pay Assignor eight per cent (8%) of gross sales made by Assignee resulting from the utilization of the subject patent until such time as the purchase price of Seven Million Eight Hundred Thousand Dollars ($7,800,000.00) has been fully remitted to Assignor.

b. There shall be no principal payments made by Assignee to Assignor during the first twelve (12) months from the date of assignment of the subject patent.

c. The first principal payment shall be due by no later than December 31, 1971 and shall consist of principal payments due for the year 1970 together with principal payments due for the year 1971, said payments to be computed in accordance with Paragraph 2. a. above.

d. Each and every year thereafter, Assignee shall remit to Assignor a principal payment based on eight per cent (8%) of gross sales which amount shall be due by no later than December 31, of each respective year.

e. The unpaid balance of the purchase price beginning with the date of assignment of the subject patent shall bear simple interest at the annual rate of four per cent (4%) and same shall be due and payable by no later than March 15th of each year.

The other document, executed by NUPCO in favor of Bowman, was entitled "Promissory Note." It started, in pertinent part:

On demand, the Undersigned, National Utility Products Company by its President and Secretary, Harold Bowman promises to pay to the order of Harold Bowman, the principal sum of Seven Million Eight Hundred Thousand Dollars ($7,800,000.00) for value received bearing simple annual interest at the rate of four per cent (4%). Principal and interest shall be paid in installments in accordance with the terms and provisions of a certain Patent Assignment entered into by and between National Utility Products Company and Harold Bowman dated the 5th day of January, 1970.

The undersigned shall have the right to prepay any part or all of this note at any time or times without penalty and the interest computed only to the date of prepayment.

The $7,800,000 figure was determined in 1969 in this way: Bowman first estimated what NUPCO's total unit sales of products manufactured under the patent would be for 1969. Then he estimated the probable percent by which sales could be expected to increase each year over the remaining useful life of the patent, 13 years, and thereby determined the probable total unit sales for the patent's remaining life. An estimate was next made of the selling price of patented products over the 13-year period. The expected unit sales for each year were multiplied by the expected selling price to arrive at the estimated total dollar sales for each year. Bowman's estimates, which are summarized below, indicated that $105,601,828 worth of patented products would be sold over the next 13 years.

                                 Estimated  Estimated   Estimated    Estimated
                  Calendar        % Sales     Units      Selling       Total
                    Year         Increase      Sold       Price        Sales
                    1970 .......    20%       10,400     $39 ea.  $    405,600
                    1971 .......    20%       12,480      40           499,200
                    1972 .......    30%       16,224      42           681,408
                    1973 .......    30%       21,091      44           928,004
                    1974 .......    40%       29,527      46         1,358,242
                    1975 .......    40%       41,338      48         1,984,224
                    1976 .......    50%       62,007      50         3,100,350
                    1977 .......    50%       93,011      50         4,650,550
                    1978 .......    50%      139,517      50         6,975,850
                    1979 .......    50%      209,276      50        10,463,800
                    1980 .......    50%      313,914      50        15,695,700
                    1981 .......    50%      470,871      50        23,543,550
                    1982 .......    50%      706,307      50        35,315,350
                                                                  ____________
                                                                  $105,601.828
                

It was then determined that between 7 percent and 8 percent of the total dollar sales would be a reasonable sales price for the patent. The $7,800,000 sales price resulted from this process.

In arriving at these projected figures, Bowman compared the estimated unit sales for each year with the total potential municipal market in being. Using 1968 statistics prepared by the Federal Bureau of Roads he found that there were over 532,000 miles of municipal roads and streets in the United States. Estimating that between 8 percent and 10 percent of these roads would be resurfaced each year and that each mile of road surface contained an average of 50 manholes, he determined that over 2,000,000 manholes would be raised each year. This was the product's potential yearly market used. The estimated yearly sales range from about .5 percent to approximately 30 percent of this figure. In making this estimate of the potential market, Bowman did not consider all of the potential markets for the product such as public utilities, military bases, and foreign markets.

The per unit selling price of the patented product since its acquisition by NUPCO has been greater than the estimated price used by Bowman in 1969 when he computed the $7,800,000 figure. Additionally dollar sales for the years before the Court have been in the projected range, and for the last year (1972) substantially exceeded projections.

In addition to patent 1, Bowman applied for another patent (patent 2) in 1972 or 1973 which was granted in 1974. Application for a third patent (patent 3) was pending at the time of trial. These patents cover devices for raising the level of manhole covers for street repaving purposes, although patent 2 permits a more finite vertical height adjustment than patent 1. Bowman sold patent 2 and the application to patent 3 to NUPCO for...