GREENAWALT v. COMMISSIONER

JOHN E. GREENAWALT, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. GREENAWALT v. COMMISSIONER Docket No. 50793. United States Board of Tax Appeals 27 B.T.A. 936; 1933 BTA LEXIS 1281; March 15, 1933, Promulgated *1281 The petitioner is not entitled to the maximum earned income credit provided for in section 31(a) of the Revenue Act of 1928 in respect of royalties, computed upon a per ton basis, received under certain contracts with licensees embodying the use of patents relating to the process of sintering. Kenneth W. Greenawalt, Esq., for the petitioner. R. N. McMillan, Esq., for the respondent. SMITH *937 The respondent has determined a deficiency for the calendar year 1928 in the amount of $467.09. In his return, the petitioner claimed a maximum earned income credit of $30,000, whereas the respondent has determined that the petitioner in that year was engaged in a trade or business in which both personal services and capital are material income producing factors, and that the petitioner is entitled to an earned income credit of only 20 per cent of his net income, or $9,121.56. FINDINGS OF FACT. The petitioner is an electrical engineer. After completing his professional education at Cornell University, he was employed by the Westinghouse Company for a number of years. Upon the termination of his employment with that company he installed an electric*1282 railway on the Pacific Coast. Thereafter, he became interested in mining and metallurgy and particularly the application of electric current to metallic ores. His research and experiments along that line led to the development of a new process for treating ores, known as "sintering." In this process the fine ore is first mixed with a certain percentage of fuel, then placed in a grate and ignited at the top. The fire is made to burn downward by suction, fusing the metal content of the ore, which assumes a clinker-like form. The combustion of a grate of the ore mixture is usually completed in 10 or 15 minutes. This process has proven very successful and has been used extensively in the United States and in Europe and Japan. The petitioner spent a number of years in developing the sintering process and the patents pertaining thereto. He maintained a plant at Denver, Colorado, and conducted experiments there for about 10 years at a cost of approximately $20,000. In his application for basic patents on his process the petitioner met with considerable delay and litigation expenses on account of interference proceedings involving the so-called Dwight & Lloyd process, which is the*1283 only other sintering process known to the trade. After obtaining basic patents, the petitioner devoted all of his time to securing contracts with licensees for the use of the process and in supervising the installation of the apparatus and the operations at the various plants where it had been installed, and making further improvements in the process. All contracts were let on a royalty basis, the petitioner usually receiving royalties of about 10 or 15 cents per ton on all sintered material. The contracts were to continue for the life of the patents. In each contract the petitioner was required to furnish a detailed *938 drawing of the apparatus and a general outline of the plant and to supervise personally the operations. The following typical provision appears in a contract between the petitioner and Witherbee, Sherman & Co., licensee: The party of the second part agrees to furnish to the party of the first part, free of all cost, detail working drawings of the apparatus, and a general outline drawing of a plant necessary for the successful carrying out of the inventions of the several letters patent aforesaid. It is expressly understood, however, that the party*1284 of the second part will neither furnish detail drawings for the construction of the plant, nor do any of the engineering work incident to the erection of such a plant. The party of the second part agrees to personally supervise, without cost to the party of the first part, the operation of the apparatus and plant under the inventions aforesaid installed by said party of the first part, at such times as in the judgment of the party of the second part his presence may be necessary at said plant; otherwise said party of the second part may furnish advice and directions through correspondence or other channels of communication; it being the intention of the party of the second part to furnish to the party of the first part without cost to it such personal advice and assistance as may be required to enable the party of the first part to maintain its said apparatus and plant in a satisfactory working condition and at the highest state of efficiency. * * * Each sintering plant had to be designed by the petitioner personally to meet the local conditions. Sometimes several preliminary plans or "layouts" would have to be submitted before a satisfactory one was designed. The industry*1285 generally was unfamiliar with the sintering process and problems were frequently arising at the various plants which required the petitioner's personal attention. The plans and drawings for a new plant were usually made at the petitioner's offices in New York. The petitioner employed one or two draftsmen to assist him in this matter. During 1928, the petitioner's offices were located in the Bowery Savings Bank Building, New York, City. He occupied two medium sized rooms, one of which was equipped with a desk and chairs and bookshelves, and the other with drafting tables and instruments. The petitioner used no other equipment of any consequence in his business. In 1928, the petitioner had outstanding eight contracts from which he received royalty payments in the following amounts: Inland Steel Co $5,031.75 Pittsburgh Steel Co 14,071.94 Pulaski Iron Co 27,242.97 Trumbull-Cliffs Furnace Co 2,225.43 Witherbee Sherman Co 8,000.00 Struthers Furnace Co $1,796.71 Hanna Furnace Co 8,029.68 Republic Iron & Steel Co 10,973.80 Total 77,372.28 The petitioner's business expenses for the year amounted to $31,764.49, and the net income from his business was*1286 $45,607.79. The *939 respondent in the determination of the deficiency has computed the earned income credit as being 20 per cent of this amount, or $9,121.56. The petitioner had no other income in 1928. In his income tax return he deducted $2,000 representing depreciation on 17 patents. The depreciation deduction was computed on the basis of the cost of the patents to the petitioner, including the cost of litigation incident to their issuance. OPINION. SMITH: The petitioner contends that he is entitled in the computation of his tax liability for 1928 to the maximum earned income credit of $30,000, as provided in section 31 of the Revenue Act of 1928. This section of the act reads in part as follows: SEC. 31. EARNED INCOME CREDIT. (a) Definitions. - For the purposes of this section - (1) "Earned income" means wages, salaries, professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation*1287 for the personal services actually rendered. In the case of a taxpayer engaged in a trade or business in which both personal services and capital are material income producing factors, a reasonable allowance as compensation for the personal services actually rendered by the taxpayer, not in excess of 20 per centum of his share of the net profits of such trade or business, shall be considered as earned income. * * * (3) * * * In no case shall the earned net income be considered to be more than $30,000. The respondent has determined that the petitioner was engaged in a business in which both personal services and capital were material income-producing factors and that the petitioner's earned income credit is therefore limited to 20 per cent of his net profits for that year. Our question is whether the income which the petitioner received in 1928 in the form of royalties from his contracts with licensees (he had no other income in that year) was in the nature of compensation for personal services actually rendered or whether it was, to any material extent, a gain from capital. The petitioner in his brief relies upon *1288 ; affd., . It was held in that case that a corporation whose sole business was the granting of licenses under its patents and collecting the income therefrom was taxable under section 209 of the Revenue Act of 1917 as a "corporation having only a nominal capital." In its opinion, the District Court said: Taking this last definition, which embodies the thought of all the others, it seems clear that patents do not fall within the term "capital"; and it also seems to be clear that this is what was in mind when Congress made the *940 distinction between "invested capital," which is defined under section 207 to include the actual cash value of patents paid for in stock or shares, and also such other intangible property, which had been paid for in money or stock, and also what was in mind when the word "capital" is used alone in section 209, preceded by the word "nominal"; that is, in the sense of something in name only employed in or available for production. * * * From this point, the petitioner argues, in effect, that since patents are not capital and since his income*1289 was all attributable to the use of his patents and his personal services combined, the entire amount of the income constitutes compensation for personal services or "earned income." We can not agree with this contention. It is the clear intent of the statute that the term "earned income" shall include only the compensation for services actually performed such as "wages," "salaries," and "professional fees." These terms are too well understood to require any exposition by way of legal interpretation. "Wages" commonly denotes the price paid for labor by the day or week, or other short intervals; "salary," a fixed compensation for labor or services for a longer period, such as a month or year; and "professional fees," the fixed compensation for specific services performed by a doctor or other professional person. In all cases these forms of compensation are impliedly based on the value of the services actually performed. It seems to us that royalties received from several licensees under contracts for the use of patents and computed upon the basis of the quantity rather than the value of personal services performed bear but little resemblance to either wages, salaries, or professional*1290 fees. In construing this section of the statute, we are not so much concerned with the technical definition of "capital" or "invested capital" as these terms are used elsewhere in the revenue acts. Granting, as held in the De Laski & Thropp case, that for some purposes patents may not be considered "capital," still the courts all recognize that patents do embody property rights of great potential value capable to producing unlimited income, and that they sometimes represent a substantial capital investment in the hands of their owner. There can be no doubt that in the instant case the patents were the principal source of the petitioner's income, notwithstanding that under the contracts with the licensees the petitioner was required to perform, and did perform, certain personal services. The only necessity for his services was to see that his patented devices functioned to the best advantage. Such part of the royalties as is attributable to their use is clearly not "compensation for personal services actually performed" by the petitioner. The record indicates, too, that the contracts under which the licensees agreed to use the patents may have had considerable *941 *1291 capital value in the hands of the petitioner. Such contracts, being intangible property, are subject to limitation in their inclusion in statutory invested capital but nevertheless may constitute the chief income-producing asset in the hands of their owner. See ; . We are of the opinion that the respondent has allowed the petitioner the full benefits to which he is entitled under the law. Judgment will be entered for the respondent.