Canning v. Commissioner

JOHN F. CANNING, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Canning v. Commissioner Docket No. 41482. United States Board of Tax Appeals 29 B.T.A. 99; 1933 BTA LEXIS 997; October 12, 1933, Promulgated *997 1. In consideration of certain monthly royalties to be paid, petitioner on December 4, 1922, granted a corporation the sole and exclusive right and license to make, use and sell forever, or until the end of the life of any patent and any renewal thereof taken out therefor, an oxidizing compound, invented by him to improve the efficiency of gasoline motors, the corporation, however, having the option to terminate the contract upon giving 90 days written notice. On June 8, 1923, petitioner made an absolute assignment to his wife of an undivided one half interest in his aforesaid invention. Held, the petitioner, after such assignment, was the owner of and taxable with only one half of the royalties or income arising from his invention. 2. The petitioner during several years immediately preceding 1924 and in 1924 incurred certain expenses in developing, improving and testing his invention, and claims such should be allowed as a deduction in 1924, either as an ordinary and necessary business expense or as a loss. Held, that the expenses were in the nature of capital expenditures and not deductible as ordinary and necessary expenses. Held, further, that they may not*998 be taken as a deductible loss in 1924, the evidence showing that the invention in that year was not worthless and was productive of substantial income. Hugh Satterlee, Esq., I. Herman Sher, Esq., and Henderson Mathews, Esq., for the petitioner. Frank Surine, Esq., for the respondent. SEAWELL *100 The deficiency in income tax as determined by the respondent for the year 1924 and in controversy amounts to $7,166.27. The petitioner alleges that the respondent, in determining net income for the year 1924, erroneously added to taxable income, as follows: (1) The sum of $30,646.17, as representing alleged royalties received by the petitioner in 1924. (2) The amount of $6,675.20, as representing alleged excessive deductions claimed by the petitioner for testing expenses, and properly deductible as ordinary and necessary expenses or as losses incurred in his trade or business in said year and not compensated for by insurance or otherwise. (3) The amount of $6,500 as representing alleged excessive deductions claimed by petitioner for the cost of developing patents which became worthless in 1924 and for which he was in no way compensated. *999 FINDINGS OF FACT. The petitioner is a chiropodist and chemist, with his principal office at Richmond Hill, New York. His wife, Cecilia Mary Canning, was familiar with his business ventures and at times rendered him financial assistance in their prosecution, although no accurate accounting thereof was ever kept. Prior to December 4, 1922, petitioner had developed a secret formula to improve the efficiency of gasoline engines. The oxidizing compound or secret formula was very difficult of analysis. Prior to December 4, 1922, the petitioner submitted samples of this compound to officials of the Boyce & Veeder Co., a New York Corporation, which became interested in the compound, and on the aforesaid date the petitioner entered into a contract (in which he was called Dr. Canning) with the company, reciting that he had submitted to the company a compound of certain liquids combined to remove carbon and generally improve operating conditions of an internal combustion motor, which compound was subject to letters patent, and that he was about to apply for United States letters patent and that the parties to the contract had agreed that Dr. Canning should upon conditions set forth*1000 in the contract "grant to said Company the sole and exclusive license and right to make, use and sell such inventions or secret compound and all modifications and improvements thereof under all patents," whether taken out in the United States or elsewhere. In consideration of the recited premises, the contract provided, in part, as follows: I. Dr. Canning hereby grants and sells to the Company the sole and exclusive right and license to make, use and sell, and to cause to be made, used and sold throughout the United States and its dependencies, and in all foreign *101 countries, all chemical compounds for the improvement of the operation of an internal combustion motor and the like heretofore invented by Dr. Canning, and every other invention which shall hereafter be made by Dr. Canning relative to such compounds, and also the sole and exclusive right and license to so make or cause to be made, used or sold, any and all goods or chemical compounds made under any secret process and every patent whether issued by the United States or its dependencies, or by any foreign country for any and all such inventions or modifications or improvements thereof. It is agreed that such*1001 right and license hereby granted to the Company shall continue forever providing said compound, or compounds, remain a secret process, or until the end of the life of any and every patent and renewal thereof taken out for such invention, modification or improvement. II. Dr. Canning shall, at the expense of the Company (upon the signing of this agreement), disclose to the Officers of the Company, the exact formula, or modifications thereof of his invention or discovery, and shall immediately, upon the signing of this agreement, and to the best of his ability, make and prosecute an application for Letters Patent of the United States already made by him of said compounds or formulas, and from time to time for such other Letters Patent as the Company shall think wise, and Dr. Canning shall prosecute to the best of his ability - but at the expense of the Company or its successors - any and every application which may be deemed wise by the Company or its successors, for the issuing, renewal or re-issue of such Letters Patent. Dr. Canning shall further prosecute such investigation and experiments for the discovery of making of such other inventions, modifications and improvements, with*1002 respect to the manufacturer of said chemical, as he may find himself reasonably able to do, with due regard to other engagements, providing, however, that he shall not be bound so to do unless upon its reasonable request in writing the Company, or its successors, will advance the amount of the expense necessary to such investigation and experiments, and provided further that the Company and its successors, shall not be made liable for any such expense except upon due notice in writing to the Company and its successors, of the intention to incur such expense, stating the maximum amount of the expense so to be incurred for such purpose, and unless the Company, or its successors, shall agree in writing to pay such expense not to exceed the maximum amount so stated. In case of any inability or failure of Dr. Canning to make or prosecute any application for Letters Patent of the United States, or elsewhere, the Company, or its successors, shall have the right to prosecute such application for any Letters Patent in Dr. Canning's name, and for that purpose, Dr. Canning hereby appoints the Company, and its successors, to be the attorney or attorneys irrevocable and attorneys in fact of the*1003 Dr. Canning, so as to prosecute at their option, any and every such application in the event that Dr. Canning shall not himself prosecute the same as aforesaid. III. For the right and license granted, or to be granted by Dr. Canning to the Company as hereinbefore provided, the Company, or its successors, shall make to Dr. Canning payments of royalties and moneys as follows: 1. The Company, or its successors, shall pay to Dr. Canning royalty at the rate of five (5%) percent of the net selling price of said chemical compound sold by it or its agents. 2. The Company, or its successors, shall pay Dr. Canning a minimum royalty of two-hundred and eight ($208.00) dollars, payable on the fifteenth day of each calendar month - first payment of said two-hundred and eight dollars to be made at the expiration of the first month in which the sale of said chemical *102 compound or formula is made, or not later than six months (6) after the date of this contract, whichever period is shorter. * * * The contract was to benefit and bind the heirs and successors of the respective parties, but might be terminated by the company on 90 days notice. Other provisions of the contract*1004 considered immaterial herein are not set out. During the spring of 1923 the petitioner furnished to the patent attorney of the Boyce & Veeder Co. all information necessary for an application for a patent on his invention and early in June of that year was led to believe, by a vice president of the company, that the patent had been applied for. The petitioner's wife was fully informed as to his contract with the company and knew that he intended to give her a half interest in the patent and proceeds arising from it. He discussed the subject with Anthony Ianuzzi, an accountant and an old friend. Ianuzzi assumed he could prepare a form of assignment suitable to effect the desired gift. He obtained a book containing legal forms of various instruments and used it in the preparation of a document in duplicate form, which was so signed by the petitioner and witnessed by Ianuzzi and Paul Guidetti, a notary public. One copy of the instrument was given to petitioner's wife, Cecilia Mary Canning, on June 8, 1923, the day the assignment was executed. The aforementioned instrument was captioned "Tentative Agreement until patents are actually granted. Deed of Assignment of patent for*1005 undivided interest." The assignment recited letters patent of the United States and foreign countries "for certain automobile carbon remover," commercially known as "Boycite", had been applied for and further stated: NOW, THIS INDENTURE WITNESSETH, That for and in consideration of the sum of One Dollar ($1,00) to me in hand paid, the receipt of which is hereby acknowledged, I have assigned, sold, and set over, and do hereby assign, sell and set over unto Mrs. Cecilia Mary Canning, her heirs, executors, administrators and assigns, an undivided one-half interest of all the right, title and interest which I have in the said invention, as will be secured to me by said letters patent for, to and in the United States of America and Foreign Countries; the same to be held and enjoyed by the said Mrs. Cecilia Mary Canning for her own use and behoof, and for the use and behoof of her assigns and letal representatives, to the full end of the term for which said letters patent will be granted, as fully and entirely as the same would have been held and enjoyed by me if this assignment and sale had not been made. In executing the aforesaid instrument petitioner was endeavoring to make a gift*1006 to his wife. There is no evidence that the cash consideration of one dollar mentioned in the assignment was ever actually paid. "Quite a while after" the assignment was signed there were inserted in blank spaces in one of the copies thereof the *103 number of the patent application, 645916, and the date thereof, June 16, 1923. The Boyce & Veeder Co. began making monthly payments under its contract with petitioner in June 1923, all payments being remitted by checks made payable to the petitioner, and none made payable to petitioner's wife. The payments made between June 1923 and March 1924, amounting to $9,167.24, were received by the petitioner, endorsed by him to his wife and thereafter deposited to her account in the Bank of the Manhattan Co. All the payments received under the Boyce & Veeder Co. contract from March 1924, to and including the payments received during the year 1926, were deposited in the bank to the credit of petitioner. Monthly payments or royalties received from the Boyce & Veeder Co. during the years 1923, 1924, 1925 and 1926, under the contract with the petitioner, were in the following amounts: [1926] January $2,216.97 $208.00 $624.00 February 2,248.78 208.00 624.00 March 2,428.79 208.00 April 5,595.33 208.00 May 6,321.65 208.00 June $208.00 11,077.51 July 208.00 14,473.00 August 208.00 16,098.28 September 208.00 208.00 October 477.54 208.00 November 1,180.01 208.00 December 2,211.94 208.00 624.00 Total 4,701.49 61,292.31 1,664.00 1,248.00 *1007 The petitioner's wife retained as her own the amount of royalties which were received from the Boyce & Veeder Co. and deposited to her credit in the aforesaid bank in 1923 and in January and February 1924, with the result that she received in all as her own, or there was appropriated to her benefit, about one half of the entire amount of royalties paid by the Boyce & Veeder Co. to petitioner during the years 1923 to 1926, inclusive. The petitioner and his wife filed joint returns for 1923, 1926 and 1926, separate returns being filed by them for 1924. Of the total sum of monthly payments, $61,292.31, received during the year 1924, the petitioner and his wife reported in equal proportions the amount of $59,283.34. Nothing of the $1248 received during the year 1926 was reported by either the petitioner or his wife. The payments of royalty dropped off after August 1924, because the Boyce & Veeder Co. ceased the use of petitioner's formula, substituting one of its own, but continuing to use the name "Boycite." After that date it only made payments of minimum royalties and subsequently, in 1925 or 1926, terminated its contract with petitioner, *104 by giving the 90 days*1008 notice required by the contract with petitioner in the event cancellation of the contract was desired. The substituted compound or formula of the Boyce & Veeder Co. was not a commercial success, was unsatisfactory and different from petitioner's, yet was held out to the trade as "Boycite", and on account thereof, petitioner asserts and testifies, rendered worthless in 1924 his compound, also known as "Boycite." Petitioner's compound, however, was essentially as valuable as ever for the purpose contemplated and for which invented. The petitioner prior to 1924 made various experiments regarding his formula and estimated the expenses of the same at approximately $6,000. During the year 1924 the petitioner incurred expenses for traveling, hotel bills, and entertaining members of the Boyce & Veeder Co. and their guests, etc., which amounted to $1,915.60 and which respondent has allowed as a deduction in determining the deficiency herein. In the same year, 1924, the petitioner purchased a Ford automobile and employed a Ford expert for experimental or testing purposes in connection with his formula. He and the expert would photograph internal parts of the engine of the automobile, *1009 after which samples of various materials which the petitioner "was constantly working on to improve" the formula were used in driving the automobile, in order to see the effect and test the efficiency of the formula. A Chalmers automobile was also purchased in 1924 and used to make like tests and several chauffeurs were employed in connection with the use of the automobile. There had been some dispute about the effect of the compound upon metal and the use of the automobile was to prove that after the compound had been used in the automobile for 10,000 miles the metal surfaces would be covered with a film and that film would prevent overheating of the valves and prevent free ignition, whereas, if you have a compound that creates oxidation, you create a lot of heat. The car was used principally for testing purposes. The entire cost of both automobiles, less salvage thereof, and the chauffeurs, gasoline, oil, licenses, garage rent and other expenses in connection with the use of the cars, amounted to $6,589.50. In determining the deficiency in tax for the year 1924, the respondent treated all the monthly payments received from the Boyce & Veeder Co. during the year 1924 as*1010 the income of the petitioner, and no part of the expenses incurred by the petitioner prior to 1924 as heretofore stated, amounting to $6,000, and the expenses incurred during the year 1924, amounting to $6,589.50, were allowed as deductions by the respondent. *105 OPINION. SEAWELL: The respondent contends that the entire monthly payments made by checks to the petitioner by the Boyce & Veeder Co. during the year 1924 represent taxable income of the petitioner for that year. The petitioner insists that only one half of the amount of such payments constitutes taxable income to him. Which contention is correct, is the main issue for our determination. The record shows that it was the intention and desire of petitioner that his wife should have an undivided one-half interest in his invention and receive one half of whatever was realized from it, which invention or formula would be secured to him through letters patent, and it also shows that she did in fact receive as her own or there was appropriated to her use and benefit about one half of the amount of money paid by the Boyce & Veeder Co. under the contract made by it with the petitioner on December 4, 1922. The*1011 assignment by the petitioner to his wife, dated June 8, 1923, was of "an undivided one-half interest of all the right, title and interest" which he had in an invention which was to be secured to him by letters patent and for which he, at the time of executing the assignment, thought application had been made, though application was not actually made until June 16, 1923. No notice of the assignment appears from the evidence to have been given to the Boyce & Veeder Co., with which petitioner had contracted as heretofore stated, and no notice taken of the same by that company. The assignment did not mention the contract made by the petitioner with the company nor any royalties or payments to be made to petitioner by the company by reason of the exclusive right and license granted it by the petitioner. Such failure or omission on the part of the petitioner to notify the company of the assignment or make any mention therein of the royalties and payments to be made in accordance with the contract is not in our opinion material. What was assigned was, in our opinion, clearly in the nature of property or property rights as the same existed in petitioner's invention, not an attempted assignment*1012 of the royalties or income to be derived from such property, though the assignment carried with it an undivided half interest in such income. . The record shows very plainly that all the parties concerned in the transaction, the assignment of June 8, 1923, were acting withoug transaction, the assignment of June 8, 1923, were acting without assignment being had to a book containing forms, with a view to adopting or adapting one found therein as suitable for the purpose desired. The instrument as drawn and executed in duplicate, taken *106 in connection with the conduct of the petitioner and his wife at the time and subsequent thereto, in our opinion, shows conclusively that it was the intent and desire of petitioner that his wife should receive as her own one half of the royalties or monthly payments made under the petitioner's contract with or license given to Boyce & Veeder Co., and it had that effect although such was not specifically stated in the assignment. The sale or transfer of an invention before the issuance of a patent is governed by the general principles of law relating to contracts and sales. *1013 ; , and authorities cited therein; ; affd., ; ; affd., ; certiorari denied, ; . The fact that letters patent had not at the date of the assignment by petitioner to his wife been granted or applied for is, in our opinion, in view of authorities cited, immaterial. The fact that the nominal consideration of $1 mentioned in the assignment is not shown by the record to have been actually paid is not important or material in the light of the circumstances and facts shown herein - the marital relation existing between the parties to the assignment and no question as to petitioner's creditors being involved. , and authorities therein cited; *1014 The respondent insists in his brief that the petitioner was, under his contract with the Boyce & Veeder Co., required to required to render certain services and that it must be assumed that the payments in question represented in part compensation for services so rendered and that, therefore, the monthly payments made by the company were taxable income to petitioner, regardless of any assignment. An inspection of the terms of the contract shows that petitioner was not "bound" to do the things referred to in respondent's brief except upon the company or its successors making a "reasonable request in writing" of him and advancing "the amount of the expense necessary to such investigation and experiments." The record does not disclose that petitioner received any such request from the company to do any of the things for which he incurred expenses shown in our findings of fact, or that any money was advanced by it to cover or pay the expenses incurred and claimed as a deduction by the petitioner. What was required of the petitioner, as above indicated in the contract, was merely incidental; such as he might "find himself reasonably able*1015 to do, with due regard to other engagements" and then only in the event necessary expenses were advanced him, What he actually did in incurring the expenses may have increased the income received, though to what extent, if at all, is not disclosed by the *107 record and in any event does not appear to have been required of him or necessary under the terms of the contract. After carefully considering all the facts and circumstances in connection with the assignment by the petitioner to his wife and the contract of petitioner with the company, as heretofore set forth in our findings of fact, we are of the opinion and hold that the assignment was valid and effective to transfer to petitioner's wife "an undivided one-half interest" in the invention or secret formula of the petitioner, which one-half interest was property or property rights, and only one half of the monthly payments or royalties derived from the formula or invention belonged to petitioner and was taxable income to him. The fact that the monthly payments were made to petitioner by checks which were endorsed, deposited in a bank and the proceeds appropriated as*1016 shown in our findings of fact does not affect our opinion or effect a different result as regards ownership of the invention or formula and income arising from it. The manner in which the checks were handled and their proceeds appropriated shows that the petitioner recognized the validity of the assignment to his wife and her right and title to one half of the income. Cf. . The petitioner's second assignment of error, that the respondent in determining net income for 1924 erroneously added to taxable income the amount of $6,675.20 as excessive deductions claimed by petitioner, is not in our opinion, and we so hold, sustained by evidence sufficient to overcome the presumption of the correctness of the respondent's determination in respect thereto. The amount is shown to have been merely an estimate of the petitioner and is so recognized in brief filed in his behalf, wherein it is said: "For six or seven years prior to 1924 the petitioner incurred expenses in developing his formula to the state it was in when he licensed it to the Boyce & Veeder Co. He estimated that he had expended for such purpose about $100 a month over that*1017 period, a minimum of $6,000." The estimated expense, if it were satisfactorily established by the petitioner, was to develop his secret formula and would be a capital expenditure and not deductible as an ordinary and necessary expense from the 1924 income of petitioner. ; ; . The claim that the aforesaid amount, if not allowable as a diductible ordinary and necessary expense, should be allowed as a loss incurred in trade or business in 1924 and not compensated for by insurance or otherwise, on the ground that the formula became worthless in that year, is not, in our opinion and we so hold, borne out by the record, which shows that the formula was a continued source of *108 revenue during each month of the year 1924, all of 1925, and part of 1926. The evidence shows that the manufacture of the compound under the formula was stopped during 1924, but the Boyce & Veeder Co. did not surrender the right to resume its manufacture until 1926, and during the entire time continued to pay the minimum royalties and petitioner's formula in fact remained*1018 unchanged. We are of the opinion and hold, therefore, that the respondent did not err in adding the amount of $6,675.20 to petitioner's taxable income for the year 1924. The third and last assignment of error is that respondent erroneously added to taxable income for 1924 the amount of $6,500, "as representing alleged excessive deductions claimed by the petitioner for the cost of developing patents which became worthless in 1924" and for which he was not compensated for by insurance or otherwise. The contention that the expenses incurred in 1924 in developing petitioner's formula are deductible because of the worthlessness of such formula during that year is not tenable, as the evidence shows the formula was still good and income or royalty was realized therefrom, pursuant to petitioner's contract with the Boyce & Veeder Co. We are also of the opinion and hold that such expenses disallowed as a deductible loss in 1924 are not deductible as ordinary and necessary expenses in that year, having been incurred for the purpose of testing petitioner's formula, to prove its efficiency and usefulness, and being in the nature of capital expenditures. Judgment will be entered under*1019 Rule 50.