Danskin, Inc. v. Comm'r

Danskin, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent Danskin, Inc. v. Comm'r Docket No. 92048 United States Tax Court 40 T.C. 318; 1963 U.S. Tax Ct. LEXIS 125; 137 U.S.P.Q. (BNA) 688; May 15, 1963, Filed *125 Decision will be entered under Rule 50. Held, (1) legal expenses incurred by reason of a trademark infringement action brought by petitioner where an agreement of settlement was entered into with the alleged infringer are capital expenditures; (2) petitioner cannot now elect to amortize these expenses under the provisions of section 177, I.R.C. 1954*126 , as amended; and (3) petitioner has failed to establish that certain claimed bargain sales made to two stockholders were compensation for services rendered. Sidney Gelfand, for the petitioner. Henry G. Nagel, for the respondent. Black, Judge. BLACK *690 *318 The respondent determined a deficiency in income tax in the amount of $ 2,787.72 for the year 1959 as a result of the disallowance of a deduction of $ 5,361 for legal expenses. The following explanation of the adjustment was set forth in the notice of deficiency: *319 (a) Your claimed deduction for other deductions (legal fees) has been disallowed to the extent indicated inasmuch as you have not established same as allowable under any of the sections of the Internal Revenue*127 Code. The Commissioner now concedes that petitioner should be allowed expense items which total $ 595 as a deduction which the Commissioner has disallowed in his determination of the deficiency. The petitioner concedes that $ 100 of the amount which it claimed on its return to be deductible should be disallowed as a deduction. This leaves $ 4,666 legal expenses which petitioner claims is a deductible business expense in the year 1959. Petitioner also claims a deduction of $ 5,450 as additional compensation paid to certain parties in 1959 in the form of a bargain sale of its stock. This latter amount was not originally claimed as a deduction on its return for 1959. The issues presented for our determination, therefore, are: (1) Whether legal expenses in the amount of $ 4,666 incurred by reason of a trademark infringement suit brought by petitioner were capital expenditures as the Commissioner has determined or ordinary and necessary business expenses as the petitioner contends; (2) if we should find that the expenses were capital expenditures, whether petitioner may elect to amortize the expenditures under the provisions of sec. 177 of the 1954 Code, as amended; and (3) whether*128 sales of stock to two individuals in 1959 at a price which petitioner contends was less than their fair market value entitle petitioner to a deduction for compensation paid in the form of bargain sales. FINDINGS OF FACT A stipulation of facts, together with exhibits attached thereto, was filed by the parties and is incorporated herein by this reference. Petitioner, sometimes hereinafter called Danskin, is a corporation which was duly incorporated under the laws of the State of New York in December 1955, with its principal office at New York, N.Y. It filed its income tax return for 1959 with the district director of internal revenue, District of Manhattan. Issues 1 and 2 Petitioner engaged in the business of manufacturing ladies' and children's leotards, tights, and related items. The products made by petitioner were sold and nationally advertised under "Danskin," a trademark registered in the United States Patent Office, Reg. No. 584,683 issued January 12, 1954, for women's hosiery and stockings and opera hose, stockings and tights in class 39 clothing. In 1958, a competing firm marketed related products under the trademark "Gamskin" and petitioner filed a complaint and brought*129 suit on April 28, 1959, against the user of "Gamskin" for treble damages aggregating $ 75,000 and to have the user desist from using "Gamskin" *320 as a trademark in association with leotards, tights, and similar products. Petitioner's complaint alleged, among other things, that "the acts of defendant constitute trade mark infringement, unfair competition and deceptive acts and practices contrary to law, and will result in substantial and irreparable injury to plaintiff." After the hearing, the United States District Court, Eastern District of Pennsylvania, filed its opinion and issued an order granting a temporary injunction against Standard Merchandising Co., hereinafter sometimes referred to as Standard, enjoining it from using the trademark "Gamskin" in the sale of tights, leotards, or similar goods. In July 1959, petitioner and Standard entered into a settlement agreement under which the latter company agreed to the entry of a final decree perpetually enjoining it and its successors from manufacturing, distributing, or selling, directly or indirectly, tights, leotards, or similar goods bearing the trademark "Gamskin." Standard agreed to pay all court costs and further *130 agreed to have a judgment entered against it in the sum of $ 7,000 should any of the provisions of the stipulated agreement be breached or violated in any manner. Petitioner expended the sum of $ 4,666 with respect to this litigation and a deduction on petitioner's 1959 corporate income tax return was disallowed. Issue 3 Irving Lewis, hereinafter referred to as Lewis, is the sales manager of Triumph Hosiery Mills, Inc., hereinafter referred to as Triumph, and he received a salary of $ 31,500 from Triumph in 1959. Robert Erdos, hereinafter referred to as Robert, is the assistant plant manager of Triumph and he received a salary of $ 12,650 from Triumph in 1959. Neither received any compensation from Danskin in 1959. Danskin is a closely held corporation controlled by Peter and Norman Goodman. Triumph is a closely held corporation controlled by the father of Peter and Norman Goodman. There is a large degree of duplication in the stockholders of Danskin and Triumph. Danskin is located at the same address as Triumph and Triumph is the sole manufacturer, supplier, and distributor of Danskin products. Prior to 1959, Peter and Norman Goodman owned 3,000 shares each of class A voting*131 stock of Danskin. Prior to December 23, 1958, Bertha Rappaport owned 3,000 shares of class B voting stock of Danskin. On December 23, 1958, Bertha made a bona fide arm's-length sale of her Danskin stock to Triumph for approximately $ 15,000. On January 9, 1959, Triumph sold to Peter and Norman Goodman 1,500 shares each of class B voting stock of Danskin for approximately $ 5 per share or $ 7,500 each. This sale of stock increased their stockholdings in Danskin by exactly 50 percent. Prior to 1958, Lewis owned 240 shares and Robert owned 850 shares of class C nonvoting stock of Danskin. At the annual meeting *321 of Danskin stockholders held on December 24, 1958, Robert and Lewis offered to purchase 425 and 120 additional shares of class C stock, respectively. At the meeting of the board of directors of Danskin following the stockholders' meeting it was reported that the corporation had accepted the offer of Robert and Lewis to purchase the additional stock, and a motion was made, seconded, and passed to issue the shares requested. On January 13, 1959, Danskin sold 120 and 425 shares of its authorized, but unissued, class C nonvoting stock to Lewis and Robert, respectively, *132 at a price of $ 5 per share. No portion of the deduction on Danskin's 1959 income tax return for salary and wages paid during that year represents salary and wages paid to Lewis and Robert. Lewis entered into an agreement with Triumph on December 7, 1959, in which Lewis agreed that, at his option as to time, he would sell his entire 360 shares of class C Danskin stock exclusively to Triumph. Under this agreement the parties, on December 7, 1959, retroactively agreed that the valuation of the 360 shares of Danskin class C stock as of December 31, 1958, was $ 2,808, or $ 7.80 a share. Robert entered into an agreement with Triumph on November 6, 1959, in which Robert agreed that, at his option as to time, he would sell his entire 1,275 shares of class C Danskin stock exclusively to Triumph. Under this agreement the parties, on November 6, 1959, retroactively agreed that the valuation of the 1,275 shares of class C Danskin stock as of December 31, 1958, was $ 9,945, or $ 7.80 a share. The sale of Bertha Rappaport's class B voting stock was not subject to any restrictive agreement. Henry Erdos, hereinafter called Henry, the father of Robert, acquired 850 shares of class C nonvoting *133 stock on December 13, 1955. These 850 shares of class C stock owned by Henry were subject to a restrictive sales agreement. On December 19, 1957, these 850 shares were nevertheless transferred to Henry's son, Robert, subject to this restrictive agreement. The 240 shares of class C nonvoting stock which Lewis had acquired prior to 1958 were also subject to a restrictive sales agreement. The restrictive agreement entered into between Robert and Triumph on November 6, 1959, includes not only the 425 shares of class C nonvoting stock sold to Robert on January 13, 1959, but also covers the 850 shares which previously had been included in a restrictive agreement with Henry. Petitioner has failed to prove the value of any services which may have been rendered to it by Robert and Lewis during the calendar year 1959. The stock sold to Robert and Lewis in 1959 was sold to them in their capacity of shareholders of petitioner and had no connection with any compensation paid them for services rendered Danskin in that year. *322 OPINION Issue 1. Trademark Infringement Litigation Expenses Petitioner claimed as an ordinary and necessary business expense legal fees paid in connection with*134 a trademark litigation in 1959. On April 28, 1959, petitioner, owner of the registered trademark "Danskin," 1 for hosiery and stockings, brought an action against the user of the trademark "Gamskin," used in association with similar goods, for damages and injunctive relief under the provisions of sections 22, 32(1), 34, 35, 36, and 43(a) of the Trademark Act of 1946. 2 In July 1959, the parties entered into a settlement agreement whereby the user of "Gamskin" agreed to entry of a final decree enjoining it from using "Gamskin" in association with goods related to petitioner's. Respondent contends that the legal expenses incurred by petitioner during this action were capital expenditures, and the claimed deduction was disallowed. Respondent concedes on brief that the legal fees were not incurred to protect petitioner's ownership of the trademark "Danskin." Respondent does contend, however, that the expenses resulted in a long-term benefit to petitioner by removing the possibility of future loss of income through the elimination of the alleged infringement of its trademark and, consequently, that it was a capital outlay. An examination of the record indicates that the question*135 of petitioner's title to the trademark "Danskin" was not involved in the litigation and that the sole question was whether or not the alleged infringing "Gamskin" was so similar to petitioner's trademark when used in association with the respective goods so as to be likely to cause confusion or to deceive purchasers. By the terms of the settlement agreement, petitioner dropped its claim for damages but it did obtain the injunctive relief it originally sought prohibiting the use of the trademark "Gamskin." The question presented here is whether or not the legal fees in the amount of $ 4,666 paid by petitioner in the litigation were a capital expenditure where petitioner's title to its trademark was not involved in the litigation. As a general rule, litigation expenses incurred in establishing or defending title to property are capital outlays, Harris v. United States, 275 F. 2d 238*136 (C.A. 9, 1960), and it is well established that a trademark is property. 3 On the other hand, litigation expenses incurred in recovering lost income or protecting the right to retain income are deductible as ordinary expenses. The recovery of damages would, of course, be regarded as the recovery of lost income rather than as restitution for impaired capital. *137 In the instant case, however, neither *323 of these principles is involved. When petitioner settled its action with the alleged infringer of its trademark, *691 it did not obtain any restitution of profits and, as we said earlier, the validity or title to petitioner's own trademark was not challenged. The registration of the trademark was valid and subsisting and the certificate of registration is prima facie evidence of petitioner's ownership of the trademark "Danskin." 4 The agreement of settlement assured petitioner of an unmolested use of its trademark by the permanent elimination of competition from a confusingly similar trademark. We have previously found that such an expenditure is in the nature of a capital outlay. In Aluminum Products Co., 24 B.T.A. 420 (1931), we held that an amount expended by the taxpayer in settlement with a competitor concerning rights to the trademark "Lifetime" was an expenditure of a capital nature. We concluded therein: By obtaining the promise of Doty to discontinue the use of the word "Lifetime" on aluminum cooking utensils the petitioner acquired the right to the unmolested use, so far as Doty was concerned, of the trade-mark "Lifetime" on the aluminum ware manufactured by it. Doty, by abandoning the use of this trade-mark, would no longer be in a position to claim any rights under it, and as for the sale of goods bearing the trade-mark the field was left entirely to the petitioner. Doty was permanently eliminated from the field so far as the use of the trade-mark "Lifetime" was involved. These constituted rights of a substantial value, the benefits from which*138 would be available to the petitioner not only throughout the remaining 20-year period for which the trade-mark was registered, but to any renewal thereof. The acquisition of these rights by the petitioner constituted the perfection of its right to the free use of the trade-mark without interference of any kind from Doty. In a later case in the District Court, Sanymetal Products Co., Inc. v. Carey, an unreported case, 52 A.F.T.R. 1735 (N.D. Ohio, 1957), 57-2 U.S.T.C. Par. 9865, the court considered a case closely related to the instant case. In that case the taxpayer, owner of the registered trademark "Sanymetal" for class 12 products, brought suit against the owner of the trademark "Sanimetal" for similar goods seeking an injunction, accounting, and invalidation of the Federal registration of "Sanimetal." The case had been settled by agreement and the question before the District Court was whether or not the legal expenses were capital expenditures. The court concluded: The issue here is whether that payment and the legal expenses connected with that suit must be considered business expenses or capital expenditures. * * * * In the Clark*139 case [100 F. 2d 257], the following statement appears: "The benefits derived from this right (the right to use the trade name 'Clark') cannot be confined to the year in which it was acquired and, therefore, the cost of acquiring it cannot be charged against income in that year." This is the true test to be applied in determining whether any given payment is a business expense or a capital expenditure. The rationale of the cases is *324 that if expenditures are made in a lawsuit which relates to the retention of or the right to income previously earned or soon to be earned, the expenditure is considered a business expense. If, however, the lawsuit involves the right to income over an indeterminate period, the expenditures must be treated as capital expenditures. * * * In applying the Clark test to the present case, it becomes apparent that the lack of confusion in the trade had the effect of enhancing the value of the trademark "Sanymetal" and this increased value will remain for an indeterminate period. Therefore, since these disbursements were made for the purpose of securing a right to increased income for an indeterminate period, they must*140 be considered capital expenditures. In view of the above-cited cases we hold that the trademark litigation expenses were capital outlays and that the deduction was properly disallowed by respondent. Issue 2. Time for Election for Amortization of Expenses In view of the above conclusion, it is necessary for us to consider petitioner's alternative contention. Petitioner contends that if we should hold that the litigation expenses are to be capitalized then it can elect to amortize the expenses under the provisions of section 177. 5*692 Section 177 of the 1954 Code, as amended, provides that the taxpayer may elect to amortize trademark costs and the election "shall be made within the time prescribed by law (including extensions thereof) for filing the return for the taxable year during which the expenditure is paid or incurred." It is apparent that Congress has set forth the specific terms by which an election to amortize trademark expenditures may be made, see Income Tax Regs., sec. 1.177. Petitioner did not make such an election with respect to the legal expenses incurred by it in 1959. Section 177(c) specifically requires the election to be made within the time prescribed by *141 law for filing the return *325 (including extensions thereof) for the taxable year during which the expenditure was paid or incurred. Petitioner made no such election when it filed its income tax return for 1959. *142 We hold for the respondent as to this issue. Issue 3. Bargain Sales In its income tax return petitioner did not claim any deduction for salaries or wages to Lewis or Robert. However, in its amended petition it has an assignment of error which reads: (b) The Commissioner has erroneously failed to allow as a deduction additional compensation paid to employees in the amount of $ 5,450.00. Petitioner alleges as facts to support its assignment of error (b) the following: (h) In 1959 the petitioner sold to two of its employees, Robert Erdos and Irving Lewis, 425 shares and 120 shares respectively of its Class "C" stock at a price of $ 5.00 per share. At the time of sale the value of each share of stock was not less than $ 15.00 a share. (i) The petitioner is entitled to deduct as additional compensation $ 5,450.00 representing the difference between the selling price of the stock, $ 5.00 per share, and the value of the stock, $ 15.00 per share, multiplied by 545 shares. Although petitioner did not claim such deduction on its income tax return for the taxable year 1959 it, of course, has a right to raise this assignment of error. However, it should be remembered that petitioner *143 has the burden of proof to establish that the alleged compensation paid to Lewis and Robert in the form of bargain sales of stock of the petitioner corporation was, in fact, compensation, that personal services were actually rendered by the parties, and that the payments were reasonable in amount. Both Lewis and Robert were employed by Triumph, a corporation closely related to petitioner, at substantial salaries. The facts also show that Triumph was the sole manufacturer, supplier, and distributor of petitioner. The employment of Lewis and Robert by Triumph obviously involved "Danskin" products but this does not establish that they worked for Danskin. Based on a close examination of the record, we do not believe that petitioner has established that either Lewis or Robert were employees of Danskin. In any event, petitioner has not shown that the alleged compensation in the form of bargain sales of stock was reasonable in amount for any work they may have performed nor has it shown that the stock had a fair market value of $ 15 per share at the time of sale. *693 It appears to us from the facts presented here that the sales were made to Lewis and Robert in their capacity as shareholders*144 of Danskin. The facts show that the other shareholders of Danskin had increased their holdings by 50 percent which was the exact percentage increase in stock made by Lewis and Robert, cf. Gould-Mersereau Co., 21 B.T.A. 1316 (1931), and Heil Beauty Supplies v. Commissioner, *326 199 F. 2d 193 (C.A. 8, 1952), affirming a Memorandum Opinion of this Court. We hold in favor of the Commissioner on this issue. Decision will be entered under Rule 50. Footnotes 1. Registr. No. 584, 683 dated Jan. 12, 1954.↩ 2. 15 U.S.C., secs. 1072, 1114(1), 1116, 1117, 1118, and 1125(a)↩. 3. Campbell Soup Co. v. Armour & Co., 175 F. 2d 795 (C.A. 3, 1949), certiorari denied 338 U.S. 847↩. 4. Sec. 7(b), Trademark Act of 1946, 15 U.S.C., sec. 1057(b)↩. 5. SEC. 177. TRADEMARK AND TRADE NAME EXPENDITURES. (a) Election To Amortize. -- Any trademark or trade name expenditure paid or incurred during a taxable year beginning after December 31, 1955, may, at the election of the taxpayer (made in accordance with regulations prescribed by the Secretary or his delegate), be treated as a deferred expense. In computing taxable income, all expenditures paid or incurred during the taxable year which are so treated shall be allowed as a deduction ratably over such period of not less than 60 months (beginning with the first month in such taxable year) as may be selected by the taxpayer in making such election. The expenditures so treated are expenditures properly chargeable to capital account for purposes of section 1016(a)(1) (relating to adjustments to basis of property). (b) Trademark and Trade Name Expenditures Defined. -- For purposes of subsection (a), the term "trademark or trade name expenditure" means any expenditure which -- (1) is directly connected with the acquisition, protection, expansion, registration (Federal, State, or foreign), or defense of a trademark or trade name; (2) is chargeable to capital account; and (3) is not part of the consideration paid for a trademark, trade name, or business. (c) Time for and Scope of Election. -- The election provided by subsection (a) shall be made within the time prescribed by law (including extensions thereof) for filing the return for the taxable year during which the expenditure is paid or incurred. The period selected by the taxpayer under subsection (a) with respect to the expenditures paid or incurred during the taxable year which are treated as deferred expenses shall be adhered to in computing his taxable income for the taxable year for which the election is made and all subsequent years.↩