Wernentin v. United States

• Decision Date: 30 April 1963
• Docket Number: Civ. No. 1-528.
• Citation: 218 F. Supp. 465
• Parties: Fred C. WERNENTIN, Esther Wernentin, Robert L. Jester and Bobette Jester, Plaintiffs, v. The UNITED STATES of America, Defendant.
• Court: U.S. District Court — Southern District of Iowa

218 F. Supp. 465

Fred C. WERNENTIN, Esther Wernentin, Robert L. Jester and Bobette Jester, Plaintiffs, v. The UNITED STATES of America, Defendant.

Civ. No. 1-528.

United States District Court S. D. Iowa, Davenport Division.

April 30, 1963.

John C. Owen, Washington, Iowa, for plaintiffs.

John Hammerman, Tax Division, U. S. Dept. of Justice, Washington, D. C., for defendant.

VAN PELT, District Judge.

This is a suit to recover federal income taxes alleged to have been erroneously paid and collected for the calendar years 1951, 1952 and 1953. Plaintiffs are members of a partnership known as Wernentin and Jester.

The central issue presented is the same as was involved in a series of cases to be discussed herein, namely, whether payments made to the taxpayers pursuant to an agreement whereby they granted to another rights to the use of a patented machine and a trade name in described territories constituted ordinary income resulting from licenses or capital gain resulting from sales. The product involved in these cases is Dairy Queen, a soft-serve dairy product drawn from a machine and served directly to the customer. The machine produces the product and serves it in a semi-frozen condition.

Robert L. Jester, hereinafter referred to as Jester, was the only witness at the trial. He is a member of the partnership mentioned above. His testimony reveals much of the background of the controversy. Jester during 1948 contracted for certain patent and trade name rights for the State of New Jersey from H. A. McCullough and J. F. McCullough. This contract (Exhibit A attached to the complaint) granted Jester the right to the use of patented freezers and the name Dairy Queen within New Jersey, and the right to subdivide the state among sub-contractors. Although this contract did not specify that Jester's rights were exclusive, Jester testified that it was understood by the parties that they were to be exclusive, and since the date of the contract, Jester has had these rights exclusively except for the rights of Robert U. Dinkins, the individual who obtained the New Jersey rights from Jester and those to whom Dinkins has granted such rights.

By a contract entered into May 5, 1949 (Exhibit B attached to complaint) and further contracts of Feb. 1, 1950, Aug. 1, 1950, Feb. 1, 1951, July 16, 1951 and May 5, 1951 (Exhibits C, D, E, F, and G attached to the complaint) Jester conveyed certain rights to develop all of New Jersey to Dinkins.

These contracts conveyed certain rights and imposed certain duties and restrictions on each of the parties. The rights conveyed to Dinkins included the right:

1) to purchase and operate the patented freezers,

2) to establish Dairy Queen stores,

3) to use the Dairy Queen name,

4) to subcontract areas within the territory, subject to the primary contract between Jester and Dinkins and to Jester's prior written approval. In the subcontracts Dinkins could "charge a maximum of $2000 for the rights to operate under a subcontract and a maximum of 29 cents per gallon on all mix used" 5) to require that Jester refrain from granting any New Jersey rights to anyone else,

6) to require Jester to take up the matter of adjustments with respect to defective freezers.

Obligations assumed by Dinkins included covenants:

1) not to move freezers outside the territory,

2) to order freezers through Jester at a cost not exceeding the manufacturer's price f. o. b. the factory,

3) to pay Jester $333.33 on the starting date of the first three stores and $1,000.00 on the starting date of each additional store, and 19 cents per gallon on all mix used in the stores within the territory,

4) to keep records of all mix used or sold within the territory and of the freezers in which the mix was used; the seller, the patentee (Ar-Tik Systems, Inc.) and H. A. McCullough are given free access to the records to determine sums owed them,

5) to sell only Dairy Queen unless written permission from Jester to sell other products was obtained, and to use no other types of freezers without Jester's approval; Dinkins also agreed not to sell any freezers without Jester's written consent,

6) to purchase only high grade mix and supplies,

7) to make every effort to have at least three stores operating in the territory by Oct. 1, 1949; if he failed to do this, then, at Jester's option, Dinkins would lose his rights to further develop the territory. Dinkins complied with this requirement. It was also provided that the rights of the buyer to operate under the agreement continue only for areas under subcontract and areas within a two mile radius of a store operated by Dinkins.

Another freezer and territory agreement entered into on May 5, 1951 is like the 1949 agreement except that the royalty per gallon is increased to 21½¢ and the following provision is substituted for original paragraph 10, the substance of which is above set forth as paragraph 7.

"10. THAT the buyer shall make every effort to secure the establishment of Dairy Queen stores within the above described territory at desirable locations until said territory has been fully developed. In the event the Buyer defaults in his performance of the terms, conditions and provisions of this agreement, and the Seller desires to exercise his right to extinguish the Buyer's rights to further develop the above described territory, the Seller shall furnish the Buyer with NINETY (90) DAYS written notice by registered mail to the address herein given, notifying the Buyer of the termination of said rights."

This agreement granted to Dinkins rights to all portions of New Jersey not theretofore granted.

The examination of Jester, both on direct and cross, attempted to establish his actions in connection with the New Jersey operation after the contracts with Dinkins had been entered into. On direct examination Jester also explained the reasons for inserting various provisions in the contract. From the direct examination it appears that after the contract with Dinkins, Jester had nothing to do with negotiation of the subcontracts, nor did he thereafter convey any Dairy Queen rights in New Jersey to anyone. Jester provided Dinkins with a formula for the mix, at Dinkins' request, but never required him to use that formula. Jester did not exercise the right of audit which the contract provided for. Nor did he ever refuse to approve a subcontract submitted by Dinkins. Contrary to the terms of the contract, Dinkins would execute subcontracts before obtaining Jester's approval, and Jester would approve them after they had been so executed. Jester's approval was neither asked nor given when an individual operator wanted to sell his Dairy Queen store and rights. In all such cases it was Dinkins who gave the approval. Jester furnished, at Dinkins' request, blueprints for Dinkins' first store, but never required Dinkins to use the blueprints.

Jester's explanation of paragraph 12 of the contract requiring the purchase of high grade mix was that such provision was intended to protect Dairy Queen rights by keeping quality high, and that standards were necessary to obtain uniformity. Similarly, the provision preventing freezers from being sold or moved out of the territory was to protect other operators. The explanation of that part of the contract which provided that only Dairy Queen could be sold was that Dairy Queen was a specialty product and as such, other items had to be restricted so as not to detract from the specialty. The provision requiring Jester's approval of subcontracts was included to insure that there would be no conflict of territorial rights. The requirement that gallonage payments made by the individual operators should not exceed 29¢ a gallon was inserted to insure that these operators would make a profit, and this method is used around the country.

On cross-examination Jester testified that he never gave Dinkins permission to take any patented freezers outside New Jersey. He never allowed Dinkins to collect more than $2,000 or 29¢ per gallon nor did he excuse him from keeping records and submitting reports. On two occasions he allowed Dinkins to sell products other than Dairy Queen or to authorize such sales. Dinkins was never allowed to use any other type of freezer or to use a mix that was not high grade. The only right Jester had under the contract which he did not exercise was the right to approve subcontracts before they were entered.

Jester's testimony on cross-examination also revealed that he was somewhat active in the operation of the New Jersey enterprise. He sent a newsletter to the individual operators, attended statewide meetings there, and made a couple of trips a year to New Jersey. Jester insisted that most of his New Jersey activity was done at Dinkins' request, and that it was done mainly to help Dinkins out, although Jester did admit that he hoped that his efforts resulted in additional sales in New Jersey, and that such additional sales helped him financially. Jester testified that he had practically no contact with the individual operators at their stores, but did meet them at statewide meetings. During the period 1951-1953 Jester spent about five hours a week on the average on the New Jersey operation in addition to his trips there, but explained that the collection of money under the contract took some time. Jester says Dinkins requested his presence at the statewide meetings. He says that the items he inserted in the newsletter were materials which Dinkins requested him to include, and statewide included items in the area of exercise of control over the New Jersey stores. On trips made to New Jersey Jester would stay about four or five days, and usually went to Dinkins' house where they would confer on various items and problems, work out programs for the state meetings and discuss generally how things were going. It was also developed that Jester acted as master of ceremonies at the statewide meetings.

The government introduced copies of...