U.S. v. Van Dyke

• Decision Date: 23 December 1982
• Docket Number: No. 255-79T,255-79T
• Citation: 696 F.2d 957
• Parties: 83-1 USTC P 9127 The UNITED STATES, Appellant, v. L.J. and Marjorie VAN DYKE, Appellees. Appeal
• Court: U.S. Court of Appeals — Federal Circuit

Page 957

696 F.2d 957

83-1 USTC P 9127

The UNITED STATES, Appellant, v. L.J. and Marjorie VAN DYKE, Appellees.

Appeal No. 255-79T.

United States Court of Appeals Federal Circuit.

Dec. 23, 1982.

David C. Hickman, Washington, D.C., argued for the United States. With him on the briefs were Asst. Atty. Gen. Glenn L. Archer, Jr., Theodore D. Peyser, and Donald H. Olson, Washington, D.C.

Edward W. Rothe, Chicago, Ill., argued for appellees. With him on the briefs were Freeman, Rothe, Freeman & Salzman, P.C., Chicago, Ill.

Before MARKEY, Chief Judge, and DAVIS and NICHOLS, Circuit Judges.

NICHOLS, Circuit Judge.

This is a suit brought in the former United States Court of Claims seeking a refund of additional federal income taxes assessed and collected by the Internal Revenue Service (IRS) for 1972 and 1973 plus accrued interest and costs. The IRS refused to allow more than 30 percent of the net profits of appellees' business, Van Dyke Supply Company, to qualify for the 50 percent maximum tax rate on "earned income" established by section 1348 of the Internal Revenue Code of 1954. The United States Claims Court ^* held that appellees were entitled to a refund of the additional federal income taxes assessed for 1972 and 1973, together with assessed and accrued interest.

The main issue on appeal is whether the trial court was correct in concluding that capital was not a material income-producing factor in appellees' business and that the 30 percent limitation on net profits qualifying for the maximum tax rate on "earned income" would therefore not apply. For reasons set forth below, we agree with the trial court's conclusion and affirm.

The relevant facts are not in dispute. Mr. L.J. Van Dyke (Van Dyke) owns and operates, as a sole proprietorship, a taxidermy supply business in Woonsocket, South Dakota. Marjorie Van Dyke, wife of L.J. Van Dyke, also works in the business, without salary. She filed a joint return with her husband for the tax years in question, and is co-appellee in this case. They design and produce artificial eyes, forms, wood panels, and other materials and supplies, and sell them to commercial and museum taxidermists and competitive taxidermist supply dealers. The items are sold through an annual catalog and unlisted items may be purchased by special order.

Van Dyke began practicing taxidermy in 1946 after having had only a few weeks of experience helping an Army captain restore damaged bird specimens in an overseas university museum. After reading all available material on taxidermy, Van Dyke concluded that the state of the art was unsatisfactory. He thus began experimenting with different designs and materials to produce his own forms, artificial eyes, and adhesive materials. The forms are the interior parts of exhibits, to be covered by skins or feathers.

In 1949, Van Dyke distributed a one page mimeographed sheet to the taxidermy trade offering a limited selection of deer head and bird body forms and several special order items.

Van Dyke continued experimenting, developing, and improving different taxidermy materials such as glass eyes and form designs for different specimens. By 1973, Van Dyke's catalog offered approximately 600 different types and sizes of forms and 1,200 types and sizes of eyes. At that point his business supplied about 70 percent of the United States market and about 60 percent of the world market for glass eyes.

In addition, Van Dyke began designing and producing a line of wood panels and plaques for mounting. To aid taxidermists, he also sold miscellaneous supplies, which included chemical compounds and tools which he either developed, bought wholesale and repackaged for resale, or bought wholesale and altered and improved before resale.

The Van Dykes employed approximately 24 people in 1972, and 20 people in 1973, full or part-time, to produce the forms, eyes, and panels. These employees were previously unskilled and paid slightly above minimum wage. Each new employee received his or her training by observing the work of a seasoned employee. Van Dyke closely supervised the work of the new employee until that employee began making an acceptable product.

Van Dyke continued to research and experiment with taxidermy materials. He also supervised employees, spot-checked finished products, determined production quantity, and personally designed and supervised the production of special order items.

The machinery and equipment necessary for production of the taxidermy supplies were not extensive. The major items included two kilns, a number of artist brushes, foam machines, a shaper for panels, form casts, and devices used to make eyes that were designed and made by Van Dyke himself. The business was located in a former creamery and locker plant. The costs of the physical assets of the business during the years 1972 and 1973 totaled $40,861 and $105,237, respectively. These costs included buildings and additions, machinery and equipment, office equipment, vehicles, and an airplane purchased in 1973 for $55,423 to enable Van Dyke to attend taxidermy association functions and to call on major clients.

A fact that might appear conclusive at first blush is that there was no passive debt or equity capital investment by others in the appellees' business during the tax years in issue. We cannot, however, end the analysis there.

Appellees purchased raw materials for use in their year-round production of taxidermy supplies. During the hunting season in autumn and winter, the stock generated by the employees was depleted. After the first of the year, demand for taxidermy supplies would fall off and the employees would concentrate on rebuilding the inventory. Appellees sold the merchandise primarily through the catalog, and they required full remittance with the order or one-third down and the balance C.O.D. This arrangement allowed Van Dyke to operate his business without borrowing operating capital or having to invest substantial amounts of money in inventory at any given time of the year.

During the tax years in question, the maximum marginal tax rate on earned income was limited to 50 percent. 26 U.S.C. Sec. 1348(a). For purposes of section 1348, the Internal Revenue Code defines earned income as any income which is earned income within the meaning of section 401(c)(2)(C) or section 911(b). The trial court thought that appellees did not meet the criterion in section 401, for that section was designed to allow an individual author or inventor to treat royalty and licensing payments as earned income. Neither appellant nor appellees have raised any objection to this conclusion. Rather, the issue on appeal is whether the trial court properly held that appellees' net profits were "earned income" within the meaning of section 911. The trial court found that, in appellees' taxidermy business, capital did not constitute a material income-producing factor, and thus the net profits must be considered earned income as defined in section 911(b).

Section 911(b) provides:

For purposes of this section, the term "earned income" means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered. In the case of a taxpayer engaged in a trade or business in which both personal services and capital are material income-producing factors, under regulations prescribed by the Secretary or his delegate, a reasonable allowance as compensation for the personal services rendered by the taxpayer, not in excess of 30 percent of his share of the net profits of such trade or business, shall be considered as earned income.

The applicable IRS regulation, although promulgated after the tax years in question, provides guidance in determining this issue. Section 1.134-3(a)(3)(ii), Income Tax Regs., states:

Whether capital is a material income-producing factor must be determined by reference to all the facts of each case. Capital is a material income-producing factor if a substantial portion of the gross income of the business is attributable to the employment of capital in the business, as...