Nolde & Horst Co. v. Commissioner

NOLDE & HORST CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Nolde & Horst Co. v. Commissioner Docket No. 9867. United States Board of Tax Appeals 12 B.T.A. 417; 1928 BTA LEXIS 3540; June 6, 1928, Promulgated *3540 March 1, 1913, value of certain patents determined. L. S. Ayers,1 B.T.A. 1135, and Russel Wheel & Foundry Co.,3 B.T.A. 1168, followed. Oscar C. Pogge, Esq., and H. F. Kantner, Esq., for the petitioner. Shelby S. Faulkner, Esq., for the respondent. MURDOCK *418 Income and profits taxes for the calendar years 1920, 1921, and 1922, in the respective amounts of $520.72, $19,897.61, and $503.61 are in controversy. The petition alleged that the Commissioner erred - (1) In computing invested capital for the years 1920 and 1921, by subtracting a tentative tax from earnings available for dividends and/or for the redemption of capital stock in each of the years 1917, 1919, 1920, and 1921; (2) In reducing invested capital for the years 1917, 1918, 1919, 1920, and 1921, by prior years' taxes prorated from the dates when the installments were due; (3) In failing to allow deductions for exhaustion of certain patents based on the March 1, 1913, value of $3,369,256.40, instead of on the cost of the patents; and (4) In failing to allow deductions of amounts set aside as a reserve for bad debts in the years 1921*3541 and 1922, or in lieu thereof, the amount of debts determined to have been worthless. FINDINGS OF FACT. The petitioner is a Pennsylvania corporation, with its principal office in Reading. The petitioner declared and paid dividends as shown in the following table: Date of declaration Per cent Date of payment Amount Jan. 13, 1917 [100] Jan. 22, 1917 $250,000 Mar. 3, 1917 125,000 Mar. 3, 1917 [100] Apr. 13, 1917 125,000 Mar. 6, 1919 500,000 Jan. 2, 1920 [6] Mar. 15, 1920 [200] Mar. 16, 1920 450,000 Jan. 3, 1921 [6] On March 16, 1920, the petitioner purchased or redeemed for $52,500 cash, $50,000 par value of its capital stock. On January 3, 1921, the petitioner purchased or redeemed for $52,500 cash, $50,000 par value of its capital stock. The petitioner's net income for several taxable years, after deducting a depreciation allowance based upon the cost of the patents owned by the petitioner on March 1, 1913, was as follows: [1917] $1,113,084.03 [1919] 2,654,201.62 [1920] 1,729,371.24 [1921] 2,704,396.47 In computing the petitioner's income and profits-tax liability for each of the several years, the Commissioner reduced*3542 the net income *419 available for dividend distribution or for the redemption of stock by a theoretical tentative tax and as a result reduced statutory invested capital as follows: Year Tentative tax Reduction of statutory invested capital [1917] $477,756.69 $291,131.30 [1919] 1,051,378.80 180,564.90 [1920] 578,995.74 207,568.42 [1921] 727,327.31 44,871.57 The Commissioner reduced the petitioner's invested capital for each of the several years by Federal income and profits taxes for the preceding year prorated from the date on which the installments were due, as shown by the following table: Year Amount of previous year's tax Reduction of invested capital [1917] $12,503.23 $6,807.30 [1918] 509,828.43 279,357.94 [1919] 1,096,928.48 463,564.97 [1920] 1,060,486.26 446,888.95 [1921] 589,457.19 249,004.61 The net income of the petitioner for each of the five accounting periods immediately preceding March 1, 1913, after deducting a depreciation allowance based upon cost of the patents owned by the petitioner on March 1, 1913, and the net amount of tangible assets employed by the petitioner in its business during those periods, *3543 are shown by the following table: Accounting period Net income Net tangible assets 12 months ending Mar. 31, 1909 $375,971.87 $825,000.00 9 months ending Dec. 31, 1909 302,915.63 1,075,000.00 12 months ending Dec. 31, 1910 479,700.00 1,125,000.00 12 months ending Dec. 31, 1911 454,450.00 1,456,049.51 12 months ending Dec. 31, 1912 454,450.00 1,664,881.36 Total 2,067,487.50 6,145,930.87 Average annual net income (12 months basis) 435,260.53 Average net tangible assets 1,229,186.17 The Commissioner after deducting a depreciation allowance based upon the cost of the patents owned by the petitioner on March 1, 1913, determined that the petitioner's net income and its net tangible assets for the several calendar years were as follows: Year Net income Net tangible assets [1913] $375,000.00 $1,750,000.00 [1914] 221,420.97 1,875,000.00 [1915] 425,858.00 1,825,000.00 [1916] 613,081.81 1,850,000.00 [1917] 1,113,084.03 1,831,601.00 [1918] $1,759,027.03 $2,433,305.97 [1919] 2,654,201.62 3,684,001.74 [1920] 1,729,371.24 4,818,181.00 [1921] 2,074,396.47 4,830,899.23 [1922] 2,637,549.35 5,308,073.79 *420 The petitioner's*3544 gross sales for the taxable years 1920, 1921, and 1922 were as follows: [1920] $11,636,353.45 [1921] 9,635,264.69 [1922] 10,796,969.20 For many years both prior and subsequent to March 1, 1913, the petitioner has been engaged in the manufacture of plain and fancy cotton, silk, and woolen men's and women's hosiery. At least 75 per cent of its output for each year consisted of fancy goods and the remainder consisted of plain or staple goods made on ordinary knitting machines. About 75 per cent of the net tangible assets of the petitioner were employed in the manufacture of fancy hosiery. The fancy hosiery contained patterns in the fabric produced by dropped stitches, stripes, or two-color effects. All of the fancy goods were knitted on machines and attachments specially invented by men employed by the petitioner for this very purpose. When the patents were applied for the inventor assigned the applications to the petitioner. Because of the patents no other manufacturer could produce goods of the same pattern as those produced by the petitioner. On March 1, 1913, the petitioner owned 11 patents which had cost it $21,371.50. Two of these patents were for knitting*3545 machines designed to accommodate certain attachments for knitting fancy hosiery. The other patents were for attachments to be used on these and other knitting machines for knitting fancy hosiery. The following is a list of the patents, the date when issued and the unexpired life as of March 1, 1913: Unexpired life Number Date of issue Years Months Days 733,964 July 21, 1903 [20] 749,933 Jan. 19, 1904 [18] 815,167 Mar. 13, 1906 [12] 817,775 Apr. 17, 1906 [16] 817,776 do [16] 853,015 May 7, 1907 [6] 904,204 Nov. 17, 1908 [7] 906,880 Dec. 15, 1908 [14] 1,008,751 Nov. 14, 1911 [13] 1,008,752 do [13] 1,021,799 Apr. 2, 1912 [17] Average unexpired life [15] *421 By the use of the machines and attachments covered by the above patents the petitioner was able to manufacture fancy hosiery which was in great demand. The demand at all times exceeded the quantity which the petitioner was able to supply. The petitioner had no competition in its particular field, due to its patents. It had no trade-marks, trade brands, or trade names of its*3546 own, never advertised, and never had any salesmen. It sold all of its product through one firm of brokers, who had several men whose duty it was to call on certain selected wholesalers, notify each of the amount of merchandise for sale, and arrange for the order. Each purchaser was required to take a certain amount of staple goods with the amount of fancy goods allowed. The purchasers always wanted more fancy goods than could be allotted to them. The petitioner then filled these orders, marking the goods only with the name, label, and trade-mark of the individual wholesaler. The petitioner usually had on hand orders for all the plain and fancy hosiery which it could manufacture during next half year or year. The following table shows the number of dozens of pairs sold as "firsts" and the amount of the gross sales for certain periods: Period Number of dozen "firsts" Amount of sales sold at list price Year ended - Apr. 1, 1909 738,400 $1,544,798.80 Dec. 31, 1909 478,540 1,136,934.31 Dec. 31, 1910 754,138 2,094,546.15 Dec. 31, 1911 837,369 2,373,322.77 Dec. 31, 1912 901,171 2,530,697.27 Dec. 31, 1913 790,900 2,388,620.30 Dec. 31, 1914 645,397 2,110,714.64 Dec. 31, 1915 794,006 2,697,259.08 Dec. 31, 1916 992,329 3,560,514.64 Dec. 31, 1917 918,552 4,507,288.67 Dec. 31, 1918 907,889 6,268,411.09 Average sales for above years 2,037,957.72 Average number of dozen pairs sold during above year as "firsts" 780,972 *3547 The patented machines and attachments used for the manufacture of fancy goods required but little more attention than did the machines used for the manufacture of staple goods. It cost the petitioner but a trifle more to manufacture its fancy goods than to manufacture its staple goods. The profit made by the petitioner on its fancy goods was from three to four times the profit made on staple goods. Because of the demand for the fancy goods it was able to demand a better price on its staple goods than it could have demanded had it not had the fancy goods. During the period from 1908 to 1922, both years inclusive, the petitioner used in the manufacture of its fancy goods knitting machines and attachments embodying the inventions covered by patents *422 which it owned on March 1, 1913, in so far as those patents were in existence and unexpired. In 1927, it was still using machines and attachments of the kind covered by its 1913 patents. After March 1, 1913, there were improvements and new patented attachments used by the petitioner. On March 1, 1913, there was reason to believe that the patents would be as valuable in the future as they had been in the past. On March 1, 1913, the*3548 eleven patents had as a group a value of $3,000,000. During the years 1917, 1918, 1919, and 1920, the petitioner charged off its books debts actually determined to have become worthless and uncollectible, as follows: [1917] None. [1918] None. [1919] $8,200.25 [1920] None. OPINION. MURDOCK: The petitioner has alleged and proven certain facts relating to its tax liability for years other than those which are before us. We are concerned with the tax liability of other years only in so far as it affects the tax liability for the years 1920, 1921, and 1922, and we have no jurisdiction to determine whether or not the tax for any other taxable year has been overpaid or underpaid. Section 274(g) of the Revenue Act of 1926. The Commissioner was in error in subtracting a theoretical tentative tax from current earnings available for the payment of dividends and for the redemption or retirement of capital stock in his computation of invested capital. . In so far as his action affects the tax liability of the years before us, this error must be corrected. The Commissioner is correct in his contention that when the stock*3549 was redeemed he should have reduced invested capital by $52,500. The reduction of invested capital of a given year by the amount of prior years' taxes prorated from the dates when the installments were due was proper. See section 1207, Revenue Act of 1926, and . The evidence is entirely inadequate to show that the Commissioner committed any error with respect to an allowance for worthless debts or an addition to a reserve for worthless debts. The Commissioner allowed deductions for exhaustion of the eleven patents owned by the petitioner on March 1, 1913, on the basis of the cost of those patents. The petitioner contends that a deduction *423 should have been allowed, based upon the value of those patents on March 1, 1913, which value was greatly in excess of cost. The evidence indicates that on March 1, 1913, the petitioner owned eleven patents which had a substantial value and which enabled the petitioner to realize profits on its product greatly in excess of the profits which it could have realized had it not owned these patents. One witness only expressed an opinion as to the value of these patents on*3550 March 1, 1913. He was an officer of the petitioner, but we have no reason to question the veracity of his testimony, or to doubt that he was giving us his honest opinion as to the value of the patents in question. We were favorably impressed by his qualifications to express an opinion as to the value of these patents and we attach considerable weight to that opinion. Data were also offered for certain mathematical calculations which, the petitioner claimed, supported the value contended for. We have no great confidence in these calculations. However, the respondent's cross-examination and direct evidence failed to weaken the petitioner's case and under the circumstances we are of the opinion that the value of the patents as a group on March 1, 1913, was $3,000,000. So far as we know, the parties are not in disagreement as to the method of computing the deductions for exhaustion of these patents. Judgment will be entered under Rule 50.