John A. Nelson Co. v. Commissioner

JOHN A. NELSON COMPANY (FORMERLY KNOWN AS ROCKFORD MILLING MACHINE COMPANY), PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. John A. Nelson Co. v. Commissioner Docket Nos. 32986, 44700. United States Board of Tax Appeals 24 B.T.A. 1031; 1931 BTA LEXIS 1554; November 30, 1931, Promulgated *1554 1. Distributions, as "special compensation," to two inventors who together owned approximately 7 1/2 per cent of petitioner's outstanding common stock, of "five per centum (5%) of the net profits" of petitioner, held to be capital expenditures. 2. For 1918 to 1923, inclusive, petitioner filed returns on accrual basis. Its return for 1924 was timely filed on installment basis. Respondent approved such change and made refunds for 1918 to 1923, inclusive. Returns for 1925 and 1926 also were made on installment basis. Held, that collections made in 1924, 1925 and 1926 on account of installment sales made prior to 1924 are not taxable as income in those years. 3. Held, under the circumstances here, that "unrealized profits" on installment sales are not taxable where in 1926 petitioner, as a party to a reorganization, transferred substantially all its assets for stock of the second party in the reorganization and $2,000,000 in cash, and such stock and cash were immediately disposed of by petitioner in accordance with the plan of reorganization. Charles F. Meagher,20 B.T.A. 68, followed. F. E. Seidman, C.P.A., and J. S. Seidman, Esq.*1555 , for the petitioner. Brooks Fullerton, Esq., and John D. Kiley, Esq., for the respondent. LOVE *1031 These proceedings are for the redetermination of deficiencies asserted by the Commissioner for the years 1924, 1925 and 1926, as follows: Docket No. Deficiency Year Amount notice dated 32986 October 19, 1927 [1924] $24,573.08 32986 October 19, 1927 [1925] 6,145.70 44700 March 25, 1929 [1926] 45,855.03 *1032 In June, 1926, the Rockford Milling Machine Company (Docket No. 32986) changed its name, without change of corporate identity, to Sundstrand Corporation; and in December, 1926, again changed its name, without change of corporate identity, to John A. Nelson Company. The Board holds, therefore, that the John A. Nelson Company is the same corporate identity as the Rockford Milling Machine Company, and has ordered that the name "John A. Nelson Company "be substituted in this proceeding for "Rockford Milling Machine Company," and that further proceedings be in accordance therewith. In its petitions, original and as amended, petitioner asserts that the Commissioner has erred as below: For 1924:*1556 1. By capitalizing a bonus paid to designers in the amount of $13,481.06. 2. By including as profit $294,452.65 from collections on installment contracts covering sales of prior years. For 1925: 3. By capitalizing a bonus paid to designers in the amount of $15,284.80. 4. By including $29,009.86 resulting from collections in 1925 on installment sales made prior to 1924. For 1926: 5. By capitalizing a bonus paid to designers in the amount of $16,686.57. 6. By including $6,864.68 resulting from collections in 1926 on installment sales made prior to 1924. 7. By including in income $322,980.29, which amount represents the reserve for unrealized profit on installment sales. From the Commissioner's determinations as shown by the deficiency notices, timely appeal was taken to the Board, and the cases were consolidated for hearing and decision. The cases thus consolidated were submitted upon stipulation and briefs. No witnesses were examined, nor was oral argument made. From the stipulation we make the following findings of fact. FINDINGS OF FACT. Petitioner is an Illinois corporation, with its principal office at Rockford, Ill. It is*1557 now inactive, but during the years 1924 to 1926, inclusive, it was engaged in the manufacture and sale of milling and adding machines under the name of Rockford Milling Machine Company. In June, 1926, the name of the corporation was changed from Rockford Milling Machine Company to Sundstrand Corporation. In December, 1926, its name was changed to John A. Nelson Company. *1033 Petitioner kept its books and prepared its returns on the accrual basis, except for the years prior to 1924, as will appear later. In December, 1923, petitioner entered into a contract with Gustaf David Sundstrand and Oscar J. Sundstrand, the material parts of which contract, stipulated in substance, are as follows: The document is captioned "Contract-General Agreement with Inventors" and is a memorandum of agreement between Gustaf David Sundstrand and Oscar J. Sundstrand, parties of the first part, and Rockford Milling Machine Company, a corporation, party of the second part. It stipulates that the company's entire product consists of machines invented by the parties of the first part, some of which inventions had been patented by letters patent, both domestic and foreign, and as to others, *1558 patents had been applied for in all of about twenty inventions, the latest being dated January 9, 1922. It is stipulated that parties of the first part may invent other devices and improvements on machines then in use, and provides that all such new inventions should be disclosed to and assigned to the party of the second part without further costs. The consideration named in the contract is one dollar, and the mutual promises in said contract set forth. It stipulates that the party of the second part agrees to pay to the parties of the first part, their legal representatives and assigns, 5 per cent of the net profits of the company from any and all sources, it being understood that if the company should add to its lines machines or articles not invented by the parties of the first part which contribute a substantial portion of the company's net profits, such portion shall be excluded in calculating the percentage due to the parties of the first part. Such 5 per cent payments are made payable on an annual basis. The term of the agreement is stipulated to run from January 1, 1923, to the end of the term of the last to expire of the United States letters patent granted to*1559 Rockford Milling Machine Company under this agreement, it being understood that, in the event the Rockford Milling Machine Company should assign its business to another, such assignee should assume the liabilities in favor of parties of the first part, and the term should be to the last expiring date of the patents granted to such assignee on inventions of the parties of the first part. As a part of the contract, there is a draft of a resolution to be passed by the petitioner's board of directors in connection with the contract, which draft was made a part of the contract. The resolution was passed in the same language as the draft at a meeting of petitioner's board of directors held on December 31, 1923. *1034 All the patents and applications for letters patent mentioned in the "Whereas" clauses had been issued to petitioner or acquired by assignment from Gustaf David Sundstrand and Oscar J. Sundstrand on or before the dates of the respective letters patent or applications. Both Sundstrands were in the employ of petitioner throughout all the years involved, and also throughout the taxable years in question. They worked on the inventions during business hours and conducted*1560 their experiments with petitioner's tools and materials. The petitioner had paid and borne all costs of developing, securing, prosecuting, and defending said patents and applications. On December 31, 1923, Gustaf David Sundstrand owned 351 shares and Oscar J. Sundstrand owned 260 shares of a total of 8,250 shares of outstanding common stock of petitioner, each share having a par value of $100 each. The amounts paid by petitioner under the contract for the years 1924 to 1926, inclusive, were $15,827.68, $19,371.18 and $23,030.83. Petitioner deducted said amounts in its returns for the years mentioned as compensation for services. The respondent considered each of these amounts as a capital expenditure, applicable equally to each of the United States patents set forth in the contract. The respondent allowed as a deduction by way of amortization of these amounts (and the amount of $11,516.56 paid by petitioner for the year 1923) $1,289.63 for 1924, $1,739.76 for 1925, and $6,344.26 for 1926, computed on the basis of the remaining life of each of these patents at the end of the years 1924 to 1926, inclusive. The respondent accordingly disallowed as deductions in this respect, *1561 $13,481.06 for 1924, $15,284.80 for 1925, and $16,686.57 for 1926. In its returns for the years prior to 1924 petitioner's net income was not computed on the installment method. In its original return for the year 1924, filed prior to February 26, 1926, it changed its method of reporting net income to the installment basis, and the respondent approved thereof. Respondent then recomputed petitioner's income for the years 1918 to 1923, and refunded to petitioner for the years 1918 to 1923, inclusive, the excess (of tax as returned and paid on the accrual basis) above the tax as shown by said recomputation on the installment basis. Petitioner likewise reported on the installment basis in its original returns for the years 1925 and 1926, and the respondent approved thereof. In such return for the year 1924 the petitioner excluded, in computing income, amounts received during 1924 on account of installment sales made prior to 1924. The respondent, in determining the present deficiency, added to petitioner's income the amount of $294,452.65, based on amounts received during 1924 on account of installment sales made prior to 1924. *1035 In such return for the year 1925*1562 petitioner excluded, in computing income, amounts received during 1925 on account of installment sales made prior to 1924. The respondent, in determining the present deficiency, added to petitioner's income the amount of $29,009.86 based on amounts received during 1925 on account of installment sales made prior to 1924. In the return for the year 1926, petitioner included, in computing income, $6,864.68 as profits received by petitioner during 1926 on account of installment sales made prior to 1924. Respondent made no change in petitioner's 1926 return in respect of profits received by petitioner during 1926 on account of installment sales made prior to 1924. On December 31, 1926, petitioner was a party to a reorganization, pursuant to the plan of which it transferred substantially all of its properties to the Sundstrand Corporation of Delaware in exchange for 14,060 shares of the preferred stock of the Delaware Corporation and $2,000,000 cash. Petitioner immediately used part of the cash so received to retire its own preferred stock and immediately distributed the preferred stock and the balance of the cash so received to its own stockholders, pursuant to the reorganization*1563 plan. The contract and corporate minutes relative to such reorganization provide in substance: Date of agreement November 18, 1926. The agreement was between Sundstrand Corporation and Elliott-Fisher Company, a Delaware corporation. The stipulated consideration is one dollar and mutual agreements. Sundstrand Corporation represents that it owns the entire adding machine business formerly operated under the corporate name of Rockford Milling Machine Company, and will presently acquire other designated property. The contract stipulates that the Elliott-Fisher Company shall cause a new corporation to be organized having a presently issued capital stock of: (a) 12,500 shares of $7 preferred stock, par value $100. (b) 30,000 shares of common stock, no par value. Additional preferred stock was authorized for specific purposes. The Sundstrand Corporation obligated itself to convey to the new corporation all its assets, including patent accounts and notes receivable, to the new corporation, reserving out, however, $100,000 in cash. The new corporation assumed all the ordinary obligations of the Sundstrand Corporation. The new corporation, in payment for the assets so*1564 transferred, issued and delivered to the transferor 14,060 shares of its preferred stock and $2,000,000 in cash. No gain or loss was recognized or reported by petitioner in its 1926 return with respect to amounts received by petitioner during 1926 on account of installment sales made prior to 1924. Petitioner's *1036 treatment was approved by the respondent, except as set forth next below. As of December 31, 1926, the books of petitioner showed a reserve for "Unrealized Profit" on installment sales in the amount of $322,980.29. The respondent added the $322,980.29 to petitioner's income in arriving at the deficiency here in question, on the ground that, when it exchanged its assets for stock and cash, the petitioner collected 100 per cent for the total outstanding installment accounts receivable. Included in the $322,980.29 is an amount of $1,640.49 representing uncollected profits on sales made prior to 1924. This amount of $1,640.49 is not included in the amount of $6,864.68 referred to above as profits received by petitioner during 1926 on account of installment sales made prior to 1924. OPINION. LOVE: The direct issues are three: 1. Whether the amounts*1565 paid to the Sundstrands (who were two inventors) for their work in the inception and development of patents, are deductible as expenses, or whether they should be capitalized as a part of the cost of such patents. 2. Whether collections from sales made prior to 1924 on the so-called accrual basis may be included in income for 1924, 1925 or 1926, when the collections were made, during which years petitioner was reporting on the installment basis. 3. Whether taxable gain was realized in 1926, when a reorganization occurred, from a transfer of installment accounts maturing in subsequent years. To these direct issues, respondent adds the query whether, for 1924 and 1925, the evidence in the record is sufficient to enable the Board to redetermine petitioner's correct tax liability for those years. Respondent contends in respect of the years 1924 and 1925, that petitioner has not adduced evidence showing its income for those years (a) as reported on returns, (b) with changes made by the Commissioner, and (c) as corrected by the Commissioner. Counsel for respondent asserts that the determination of the Commissioner is presumed to be correct, and that the burden of proof is*1566 on petitioner to show that the Commissioner is wrong, and that petitioner must show what its correct tax liability is. To clear the way for the consideration of the other issues, we will first dispose of these contentions as applied to this case by denying them. There is no dispute between the parties in regard to the above matters and they are not at issue. The only things that the Board is undertaking to determine in the first instance are the questions at issue. Those once determined by the Board, the "redetermination" *1037 of the deficiency and the settlement follow under Rule 50 of the Board's rules of practice, which rule, among other things, is intended to and does provide for just such situations as we have here. It would be supererogatory for the Board to consider matters about which the parties are not in dispute. We conceive that we shall have no difficulty, occasioned by lack of evidence, in reaching conclusions in regard to the issues which are before us. The first of these, as we have set them out above, is in regard to the amounts paid to the Sundstrands for their work on the patents. On December 31, 1923, a written agreement was entered into by*1567 and between Gustaf David Sundstrand and Oscar J. Sundstrand, parties of the first part, and petitioner (then known as the Rockford Milling Machine Company), party of the second part, by which provision was made in accordance with a preexisting "oral understanding," for the assignment to petitioner which had been made by them prior to the date of the written agreement, of "the entire right, title and interest" in eighteen applications for letters patent of the United States, the latest bearing date of January 9, 1922, and eight applications for foreign letters patent, the latest, according to the record, being dated January 8, 1921, the assignment "including foreign patent rights" not otherwise specified. In accordance with the provisions of this agreement and the other facts as we have found them, we hold that these disbursements in 1924, 1925 and 1926, of "five per centum (5%) of the net profits of the company" for each year immediately preceding that in which the distribution was made, were capital expenditures for property acquired, and as such property, subject to depreciation over the 17-year life of each patent concerned. *1568 This rule has been consistently followed by the Board. See Individual Towel & Cabinet Service Co.,5 B.T.A. 158, and cases therein cited. See also Stephens-Adamson Manufacturing Co.,16 B.T.A. 41; affd., 51 Fed.(2d) 681. On this issue the Commissioner is sustained. The second question for our determination is the inclusion in taxable income for the years 1924, 1925 and 1926, of collections on installments sales made prior to 1924. From 1918 to 1926, inclusive, petitioner sold personal property on the installment plan. For 1918 to 1923, inclusive, petitioner reported its income on the accrual basis. In its original return for 1924 petitioner changed its method of reporting income to the installment basis. For 1925 and 1926, also, its returns were prepared on the installment basis. There is no question raised as to the propriety of making the returns on the installment basis, the change from the accrual to the installment basis being authorized by *1038 section 212(d) of the Revenue Act of 1926, as that section was made retroactive by section 1208 of the same act. In accordance with the statute, and the regulations*1569 thereunder (article 42 of Regulations 69), petitioner made application for and obtained a refund, for the years 1918 to 1923, inclusive, for the excess tax as returned on the accrual basis and paid for those years, above the tax as shown by recomputation on the installment basis. In reporting income received for 1924 petitioner, in its return, excluded as being derived from installment sales made prior to January 1, 1924, receipts amounting to $294,452.65. The Commissioner increased petitioner's reported income by that amount. In reporting income received for 1925 petitioner, in its return, excluded as being derived from installment sales made prior to January 1, 1924, receipts amounting to $29,009.86. The Commissioner increased petitioner's reported income by that amount. In reporting income for 1926 petitioner, in its return, included receipts derived from installment sales made prior to January 1, 1924, in the amount of $6,864.68. The Commissioner has made no adjustment in connection with that amount. Petitioner contends that the Commissioner's action in thus increasing its reported income for 1924 and for 1925, and the Commissioner's failure to decrease its reported*1570 income for 1926, are in conflict with section 705 of the Revenue Act of 1928, which follows: SEC. 705. INSTALLMENT SALES - RETROACTIVE. (a) If any taxpayer by an original return made prior to February 26, 1926, changed the method of reporting his net income for the taxable year 1924 or any prior taxable year to the installment basis, then, if his income for such year is properly to be computed on the installment basis - (1) No refund or credit of income, war-profits, or excess-profits taxes for the year in respect of which the change is made or any subsequent year shall be made or allowed, unless the taxpayer has overpaid his taxes for such year, computed by including, in computing income, amounts received during such year on account of sales or other dispositions of property made in any prior year; and (2) No deficiency shall be determined or found in respect of any such taxes unless the taxpayer has underpaid his taxes for such year, computed by excluding, in computing income, amounts received during such year on account of sales or other dispositions of property made in any year prior to the year in respect of which the change was made. (b) Nothing in this section shall*1571 be construed as in any manner modifying section 607, 608, 609 or 610 of this Act, relating to the effect of the running of the statute of limitations. The provisions of this section apply to all the years in controversy. We are in substantial accord with the opinion of the General Counsel of the Bureau of Internal Revenue as it is expressed in his memorandum 8144 (recorded in C.B. IX-1, p. 173). *1039 In the course of his memorandum, the General Counsel analyzes the somewhat involved syntax of section 705, and expresses the opinion, in conclusion, that: * * * where a taxpayer properly qualifies under section 705 of the Revenue Act of 1928, in determining deficiencies against the taxpayer there should be excluded in computing income for the year of change to the installment basis and for all subsequent years, amounts received on account of sales or exchanges of property made in years prior to the year of change, and that such procedure should be followed not only for the years involved * * * but also for years covered by the Revenue Act of 1928. * * * Respondent does not apply this opinion of the General Counsel in the instant case. He contends that section 705, *1572 quoted, supra, was enacted solely as a relief measure from double taxation which might result from the operation of the law as construed by the Board in Blum's, Inc.,7 B.T.A. 737, and that petitioner, having received refunds for 1918 to 1923, inclusive, as provided in section 1208 of the Revenue Act of 1926, is not a taxpayer who "properly qualifies under section 705 of the Revenue Act of 1928." Quoting respondent, he says that: Since petitioner, on account of the refund, has not been taxed on the profits which are included in the installment payments on sales of prior years collected in 1924, 1925 and 1926, the action of the Commissioner in including those profits in income for those years does not subject the petitioner to double taxation. Petitioner is not within the purview of the relief provision of section 705 of the 1928 Act and the Commissioner's action in taxing the profits as received was correct. * * * The petitioner having two methods of relief available has taken full advantage of one, and has not been subjected to double taxation. Now the petitioner wishes to invoke the other method in his favor and to escape taxation on income which in equity*1573 and good conscience should be taxed. Such was not the intent of Congress * * *. That such is the precise result that will ensue, if we support petitioner's contentions, is obvious, and it may even be admitted that the entire probability supports respondent's contention that such was not the intent of Congress, but where the mandate of a statute is clear and free from ambiguity, there are no sufficient grounds for this Board to disregard the statutory provisions merely because in a particular case the application of the statute appears to result in an inequitable or incongruous situation. There is nothing in the statute to indicate that section 705 is purely a "relief measure" available only to those taxpayers who have not received refunds under the other provisions of earlier acts. We are not here concerned whether "in equity or good conscience" these amounts in question should be taxed. In our judgment the unmistakable mandate of the statute is that they shall not be taxed, and we so hold. The two preceding issues are raised in all three of the taxable years in question. The third issue applies only to the last of them, *1040 the year 1926. On December 31 of*1574 that year petitioner was a party to a reorganization and, pursuant to the reorganization plan, it transferred substantially all of its properties to the Sundstrand Corporation of Delaware in exchange for 14,060 shares of the preferred stock of the Delaware corporation and $2,000,000 cash. Petitioner immediately used part of the cash so received to retire its own preferred stock and, still pursuant to the reorganization plan, immediately distributed to its own stockholders the preferred stock of the Delaware corporation, and the remainder of the cash. As of the same date (December 31, 1926) petitioner's books of account showed a reserve for "Unrealized Profit" on installment sales in the amount of $322,980.29. In arriving at the proposed deficiency here in question, respondent added this amount to petitioner's income, on the ground that when petitioner exchanged its assets for stock and cash, it collected 100 per cent of the total outstanding installment accounts receivable. Included in the $322,980.29 is an amount of $1,640.49 representing uncollected profits on sales made prior to 1924, but such $1,640.49 is not included in the amount of $6,864.68 referred to above as profits*1575 received by petitioner during 1926 on account of installment sales made prior to 1924. The question raised is whether the amount of $322,980.29 or any part thereof is income to petitioner in 1926. In one form or another, this question has been before the Board upon earlier occasions, and we have considered it as it was presented in the several cases decided. See Packard Cleveland Motor Co.,14 B.T.A. 118; R. L. Brown,14 B.T.A. 609; Wallace Huntington,15 B.T.A. 851; M. A. Milan,16 B.T.A. 1112; Charles F. Meagher,20 B.T.A. 68; Lucius H. Elmer,22 B.T.A. 224; and Virginia Beach Golf Course Annex Corporation,23 B.T.A. 1169. The pertinent parts of the 1926 Act, which governs here, are: SEC. 203(b)(3) No gain or loss shall be recognized if a corporation a party to a reorganization exchanges property, in pursuance of the plan of reorganization, solely for stock or securities in another corporation a party to the reorganization * * * * * * (e) If an exchange would be within the provisions of paragraph (3) of subdivision (b) if it were not for the fact that*1576 the property received in exchange consists not only of stock or securities permitted by such paragraph to be received without the recognition of gain, but also of other property or money, then - (1) If the corporation receiving such other property or money distributes it in pursuance of the plan of reorganization, no gain to the corporation shall be recognized from the exchange, * * * We have closely scrutinized the facts in the case at bar, the act relating thereto, and the earlier decisions of the Board. The case most closely paralleling the one now before us is Charles F. Meagher,*1041 supra. The Meagher case fell under the provisions of the Revenue Act of 1921, but the Act of 1926, applicable here, though it differs from the earlier act in the phraseology of some of its provisions, differs in no material respect therefrom in the effect of the sections above quoted, as we read and apply them, nor does respondent contend that it does. The 1926 Act is even more definite and free from ambiguity than the Act of 1921. In the Meagher case we said: We can but conclude that the transfer by petitioner of these installment obligations in a transaction*1577 which, under existing law is held not to result in taxable gain, can not be considered as a present realization of income therefrom, and this conclusion is further strengthened by the fact that the determining of a taxable gain from such a transaction is first provided for by the Revenue Act of 1928 in section 44(d), * * * This section is not by its terms made retroactive and, as we pointed out in Wallace Huntington, supra, the insertion of this new provision in that act was clearly indicated by the report of the Committee on Finance of the Senate, and the Committee on Ways and Means of the House of Representatives, to be for the purpose of changing the condition existing under the prior revenue acts, including the Revenue Act of 1921 [and the Revenue Act of 1926] here involved, under which it was possible to dispose of installment obligations in a transfer not giving rise to loss or gain and thereby evade tax liability in respect to the income which would otherwise be represented by them. We are controlled by the Meagher case from which we have just quoted, and by *1578 Wallace Huntington, supra. Accordingly, we hold that no taxable profit was realized by petitioner when in 1926 it transferred to the Sundstrand Corporation of Delaware substantially all of its properties (including installment accounts receivable) in exchange for 14,060 shares of the preferred stock of the Delaware corporation, and $2,000,000 in cash. The amount of $1,640.49 representing uncollected profits on sales made prior to 1924, included in the total amount of $322,980.29, is exempt from taxation under our decision on the second issue herein considered. Judgment will be entered under Rule 50.