Bendix Eng'g Works, Inc. v. Commissioner

BENDIX ENGINEERING WORKS, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Bendix Eng'g Works, Inc. v. Commissioner Docket No. 24956. United States Board of Tax Appeals 23 B.T.A. 1049; 1931 BTA LEXIS 1781; July 3, 1931, Promulgated *1781 The value of patents acquired in exchange for stock determined for the purpose of exhaustion. Arthur R. Foss, Esq., and Arnold R. Baar, Esq., for the petitioner. John D. Kiley, Esq., and L. A. Luce, Esq., for the respondent. MATTHEWS *1049 This proceeding is for the redetermination of deficiencies in income taxes of $10,370.46 for 1922 and $5,613.09 for 1923. The errors alleged to have been committed by the respondent are (1) failure to allow petitioner any depreciation on patents for the years 1922 and 1923; and (2) failure to apply an alleged statutory net loss for the year 1921 in reduction of the petitioner's income for 1922 and 1923. At the hearing it was stipulated between the parties that there was a net income from operations for the year 1921 in the sum of $11,747.90, which amount does not include any allowance for depreciation on patents, and that the statutory net loss for the year 1921 should be redetermined on the basis of the net income determined by the respondent less any depreciation which may be held to be allowable under our decision in this case. FINDINGS OF FACT. The petitioner corporation was incorporated*1782 under the laws of the State of Illinois on December 16, 1920, to take over the business formerly conducted by Vincent Bendix under the name of Bendix Engineering Works. In the articles of incorporation the object for which the corporation was formed was stated as follows: * * * to manufacture, buy, sell, operate and/or generally to deal in machinery, mechanical, electrical and automotive devices and equipment; to experiment with, test, improve and/or develop such machinery, devices and *1050 equipment; to acquire, hold, license under, use, buy, lease, pledge, mortgage, sell and/or exchange United States and foreign patents, patent rights, formulae, processes, licenses, royalties, inventions, trade-marks, trade names and copyrights and to do all things incidental to the undertaking and carrying out of any of the aforementioned objects. The total authorized capital stock of the corporation was stated to be 1,000 shares of no par value, which was subscribed for as follows: Name Number of shares Amount subscribed and paid in Vincent Bendix [998] $4,990.00 Earnest O. Bendix [1] 5.00 Walter J. Buettner [1] 5.00 At the first meeting of the incorporators*1783 held December 14, 1920, a proposition was submitted to the corporation by Vincent Bendix, which was substantially as follows: IN CONSIDERATION of the agreement of the corporation to issue to him 998 shares of the capital stock of the corporation and to deliver to him certain notes aggregating $14,861.33, he would sell, assign, transfer and set over to Bendix Engineering Works, Inc., all his right, title and interest in and to all patents, patent rights, inventions, development work, licenses, license and royalty agreements, processes, trade-names, good-will and contracts, together with all machinery, models, apparatus, books, accounts and bills receivable, and all other property connected with said business subject to current accounts and notes payable which the corporation is to assume; notes payable in 90 days without interest are to be given in payment for the office furniture, furnishings and fixtures, the amount to be appraised and fixed by the Board of Directors; he would pay to the corporation the sum of $4990 in cash and transfer to it his entire private business conducted under the name of Bendix Engineering Works. This proposition was accepted and the following transfer*1784 and assignment, which was executed by Vincent Bendix on December 14, 1920, was approved and ordered to be attached to the minutes of the meeting: FOR AND IN CONSIDERATION of the issue and delivery to me of Nine Hundred Ninety (990) [should read 998] shares of the capital stock of Bendix Engineering Works, Inc., and the delivery to me of ninety (90) day notes of said corporation for $14,861.33 and for other good and valuable considerations I hereby sell, assign, transfer and set over to Bendix Engineering Works, Inc., all my right, title and interest in and to all my patents, patent rights, inventions, development work, licenses, license and royalty agreements, processes, trade-name, good-will and contracts, together with all machinery, models, apparatus, books, accounts and bills receivable and all other property connected with my business heretofore conducted as Bendix Engineering Works, subject only to current accounts and notes payable, which I guarantee not to exceed $20,000.00 and which the Grantee herein by the acceptance of this instrument of conveyance agrees to assume and pay; it being my intention by this *1051 instrument to sell, assign, transfer and set over*1785 to Bendix Engineering Works, Inc., my whole business as heretofore conducted by me under the name of Bendix Engineering Works. It is hereby understood that the property conveyed hereby for said shares of stock and said notes is in addition to the Four Thousand Nine Hundred Ninety ($4,990) Dollars that I have already paid into the Treasury of the corporation on account of the purchase price of said shares. I covenant and agree that I have good right and title (subject to my existing contracts, agreements and charges) and good right to convey the property hereinbefore described. I further covenant and agree at any time or from time to time on request of the corporation to execute any further or specific assignments conveying all or any part of any item of the property hereinbefore described to the corporation, such assignments or instruments of conveyance to be in such form as shall be approved by Counsel for the corporation. The first meeting of the board of directors of the corporation was held on January 8, 1921, at which time the action of the incorporators was approved and the president and secretary of the company were authorized and directed to issue 1,000 shares of*1786 the capital stock in accordance with the subscriptions thereto. There had been issued to Vincent Bendix five patents covering an invention known as the Bendix drive starter. George Brandenburg owned a one-fifth interest in the profits in these patents. Under date of January 10, 1914, Vincent Bendix and George Brandenburg executed a license agreement granting an exclusive license to the Eclipse Machine Company to manufacture and sell in the United States and its territories and possessions the starting device covered by the Bendix patents, the licensee agreeing to pay to the licensors a royalty for each device manufactured and sold. Under the assignment dated December 14, 1920, the petitioner corporation succeeded to the rights of Vincent Bendix in the Bendix patents and thereby became entitled to receive four-fifths of the royalties to be paid by the Eclipse Machine Company in accordance with the terms of the license agreement. The licensee, the Eclipse Machine Company, was principally engaged in the manufacture of accessories for automobiles, motorcycles and bicycles. Through a subsidiary company it also manufactured apparatus and devices for the textile industry. Upon*1787 acquiring the exclusive right to manufacture under the Bendix patents the Eclipse Machine Company immediately began the exploitation and manufacture of the device covered by these patents and the Bendix drive starter soon became the company's principal item of manufacture. Prior to 1914 there had been no standardization in the methods of starting automobiles. The "self-starter" was in the experimental stage and had made little headway. One type of starter had been put on the Cadillac car in 1911, which employed a manual or pedal shift pinion on a small gear. This starter has continued to be used *1052 to a certain extent but not extensively. The Bendix drive is radically different in that it is completely automatically connected and disconnected. It is very simple in construction and easily operated. The operator establishes electrical connection, the Bendix drive automatically takes hold and cranks the car and lets go after the engine has been started. The Bendix drive is advertised as "the mechanical hand that cranks your car." The Bendix drive lent itself very readily to the economic manufacture of the surrounding parts so that it found a field almost ready-made. *1788 Because of its simplicity and automatic action, however, it was greeted with some suspicion in 1914 as to whether it might prove to be a desirable commercial device. Only a little over 5,000 of the devices were sold in 1914, but in the following year a great deal of the skepticism had been overcome and approximately 250,000 were sold. In 1916 the production was more than doubled and there has been a steady increase in the manufacture and sale of the device, with a variation which may be explained by general business conditions throughout the country, until in 1929 more than 5,000,000 devices were manufactured and sold. There was a drop in production in 1918 on account of the fact that many automobile and automobile accessories plants were devoting their resources to the production of materials for prosecuting the war. By 1920 the automobile business had resumed its normal growth. Automobiles were no longer considered luxuries. Except for 1921, when there was a decided slump in business generally, the automobile industry was constantly growing and expanding at a remarkable rate. During the years 1914 to 1919, inclusive, the Bendix drive was in the process of being established*1789 in the industry. By 1920 the exploitation of the Bendix drive had reached the point where the relationship between automobile production and the Bendix drive production was a comparatively fixed ratio, and during all of the subsequent years its production has kept step very closely with the ups and downs in the total production of automobiles in this country. The Chevrolet car began the use of the Bendix drive in 1914 and has continued to use it, as has the Overland Company, later known as the Willys-Overland Company. Another large producer is the Ford Company, which began to use the Bendix drive starter in 1918. At first the Ford Company used the Bendix drive starter as a part of the regular equipment on closed cars only. About the middle of 1919 this starter became standard equipment on all models of Ford cars. The use of the device on Ford cars, which amounted to approximately one-half of the total number of cars being produced, was a material factor to be considered in estimating the future profits to be derived from the invention. *1053 The officers of the Eclipse Machine Company believed in the future of the automobile industry and in 1920 made preparations*1790 for increased production of accessories for automobiles, including the Bendix drive. By that time it was recognized on the part of the entire industry that the Bendix patents were basic. No suit has ever been brought against a customer of the Eclipse Machine Company for infringement of the Bendix patents. By 1920 the Bendix drive was being used on between 85 per cent and 95 per cent of all the cars produced. A list of the passenger car and motor truck production during the years 1914 to 1923 inclusive is as follows: Passenger cars Motor trucks Year Number Year Number [1914] 543,679 [1914] 25,375 [1915] 895,930 [1915] 74,000 [1916] 1,525,578 [1916] 92,130 [1917] 1,745,792 [1917] 128,157 [1918] 943,436 [1918] 227,250 [1919] 1,657,652 [1919] 275,943 [1920] 1,905,560 [1920] 321,789 [1921] 1,529,165 [1921] 153,200 [1922] 2,430,965 [1922] 259,662 [1923] 3,759,704 [1923] 407,751 The royalties received during the years 1914 to 1923, inclusive, from the Eclipse Machine Company under the license agreement are as follows: [1914] $1,212.29 [1915] 21,753.34 [1916] 64,355.74 [1917] 70,890.02 [1918] 50,465.80 [1919] $184,731.66 [1920] 289,184.14 [1921] 168,559.05 [1922] 210,978.23 [1923] 295,879.54 *1791 In the depreciation schedule which is a part of the petitioner's income and profits-tax return for the year 1921, patents are valued at $450,962.80. Attached to this return is the balance sheet as of January 1, 1921, which appears to be the balance sheet of the Bendix Engineering Works, the name under which the individual business of Vincent Bendix had been conducted. The patents are listed on this balance sheet in the amount of $265,272.26, which amount represented the balance of the March 1, 1913, value after the deduction of depreciation since that date. The patents were not believed to be very valuable in 1913, but after the Ford Company began to use the device on all models of Ford cars it became apparent that the right to receive royalties on the devices was exceedingly valuable. On December 16, 1920, the date Vincent Bendix assigned to the petitioner corporation his right to receive royalties under the license *1054 agreement with the Eclipse Machine Company, the value of the transferred interest in the patents, for the purpose of exhaustion, was $1,500,000. The average remaining life of the patents at December 16, 1920, was 11.1446 years. The respondent did*1792 not allow any depreciation on patents for any of the years under consideration. The respondent determined the petitioner's taxable net income for the years 1921, 1922 and 1923 to be in the respective sums of $11,747.90, $82,963.69 and $156,185.53. OPINION. MATTHEWS: A careful review of the facts hereinabove set forth leads us to the conclusion that the right to receive royalties under the license agreement to manufacture and sell the device covered by the patents in question was extremely valuable when acquired by the petitioner. The invention was a success from the first year of the use thereof. The device appears to be exceedingly simple. It operates automatically. Between 1914 and 1920 the Bendix drive starter had become established in the automobile industry and the production had grown from a little more than 5,000 units in 1914 to between 85 per cent and 95 per cent of all self-starter production. The automobile industry was growing very rapidly and the future of the invention was bound up with the future of the automobile industry. In 1929 over 5,000,000 devices were manufactured and sold. The petitioner corporation was organized in December, 1920, to take over*1793 the interest of Vincent Bendix in the several patents. He received 99.8 per cent of the total capital stock of the corporation in exchange for the property and rights which he transferred and assigned to the corporation. The value of patents at any given date is a question of fact which must be determined upon the evidence. There should be taken into consideration the history and volume of the profits produced by the use of the patents, together with the opinion testimony of men experienced in dealings in patents and in the products protected by the patent monopoly. See , and cases cited therein. The only witness called to testify in this case was W. L. McGrath, who is vice president and chief engineer of the Eclipse Machine Company, the licensee under the license agreement dated January 10, 1914, which company manufactures the Bendix drive starter and pays royalties thereon. He has had wide experience in passing upon the merits of inventions and is thoroughly familiar with the Bendix drive starter. He estimated the value to the petitioner of *1055 the patents in question as of December 16, 1920, subject to*1794 the license agreement with the Eclipse Machine Company, to be $1,870,000. He arrived at this figure by taking the sum of $289,000, which was the approximate amount of the royalties received in 1920, and treating that sum as a return of 10 per cent upon an investment of $2,890,000. Since nearly six years of the seventeen-year life of the patents had expired, he took eleven-seventeenths of $2,890,000, which gave him the result of $1,870,000. Although, looking backward from the vantage point gained from a knowledge of the development of the automobile industry, it may be said that McGrath's valuation was not necessarily excessive, we believe it is too high, in view of the history of the patents up to the date Bendix assigned his rights to the petitioner corporation. McGrath took the amount of the royalties received in 1920, or $289,000, as one of the factors to be used in estimating the worth of the patents. This sum was greatly in excess of the amount received in 1919, which was approximately $185,000, and there was a dropping off in the royalties for the two succeeding years. In 1921 royalties were received in the sum of $168,559.05 and in 1922 they amounted to $210,978.23. *1795 We have found the average remaining life of the patents at December 16, 1920, to be 11.1446 years. We believe the petitioner could have clearly foreseen the receipt from the royalties for that period of approximately $250,000 per year. After carefully studying and weighing all the evidence submitted, we have reached the conclusion that the petitioner is entitled to annual deductions for exhaustion of its patents based upon a value of $1,500,000 at the date of acquisition and an average life of 11.1446 years. The statutory net loss for the year 1921 should be determined on the basis of the net income determined by the respondent less the amount of depreciation which is properly allowable for 1921 under this decision, and such net loss should be applied in reduction of the petitioner's income for 1922 and 1923 in accordance with the provisions of section 204 of the Revenue Act of 1921. Judgment will be entered under Rule 50.