W. N. Thornburgh Mfg. Co. v. Commissioner , 17 B.T.A. 29 ( 1929 )

W. N. THORNBURGH MANUFACTURING CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

W. N. Thornburgh Mfg. Co. v. Commissioner

Docket No. 17120.

United States Board of Tax Appeals

17 B.T.A. 29; 1929 BTA LEXIS 2366;

July 31, 1929, Promulgated

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">*2366 Evidence considered and held insufficient to sustain in petitioner's contention that the payments involved herein were royalties.

W. W. Spalding, Esq., for the petitioner.

Paul Peyton, Esq., and Hugh Brewster, Esq., for the respondent.

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MARQUETTE

">*29 This is a proceeding for the redetermination of deficiencies in income and excess-profits taxes, asserted by the respondent for the years 1920, 1921, 1922, and 1923. The deficiencies arise from the respondent's disallowance of deductions taken by the petitioner on account of alleged royalty payments. The amounts of the deficiencies are, for 1920, $3,257.58; for 1921, $148.59; for 1922, $7,159.70; for 1923, $3,760.89, a total of $14,326.77.

FINDINGS OF FACT.

The petitioner is a corporation, organized on August 28, 1920, under the laws of Illinois. During all of the taxable years it was engaged in the manufacture and sale of dust guards for use in the journal boxes of railway cars.

Early in 1920 W. N. Thornburgh, who was then conducting a sales agency under the name of the W. N. Thornburgh Co., conceived the idea of combining certain interests engaged in the manufacture and sale">*2367 of dust guards. As a part of this plan, the W. N. Thornburgh Manufacturing Co., the petitioner herein, was organized August 28, 1920, taking over the assets of the Drexel Sash & Door Co., and the sales agency known as the W. N. Thornburgh Co. The Drexel Sash & Door Co. was owned by one Meydrech and one Sindelar. One J. A. Smith, who was the owner of a small metal-stamping works in Cicero, Ill., was also a party to the organization of the petitioner.

At the date of incorporation the capital stock of the petitioner consisted of 1,000 shares of common stock of a par value of $50 a share. This stock was issued as follows:

	Shares
Mrs. M. B. Thornburgh (wife of W. N. Thornburgh)	425
F. Meydrech and Otto Sindelar	425
J. A. Smith	75
Byron C. Thorpe	75

By agreement of the stockholders, Mrs. M. B. Thornburgh, who held 45 per cent of the stock of the petitioner, was entitled to receive 55 per cent of the profits distributed.

">*30 On August 1, 1920, the petitioner entered into the following agreement with J. A. Smith:

This agreement, made and entered into this 1st day of August, 1920, by and between Jacob A. Smith of Chicago, Illinois party of the">*2368 first part, and W. N. Thornburgh Manufacturing Company, a corporation, organized and existing under and by virtue of the laws of the State of Illinois of the same place, party of the second part.

Witnesseth:

That, whereas, parties of the first and second part have on this day entered into a certain license agreement concerning an application for U.S. Letters Patent filed August 27, 1919, in the United States Patent Office, Serial Number 320100, wherein and whereby said first party licensed to said second party the right to manufacture dust guards containing said improvements and

Whereas, it is the desire of said parties to fix the royalty upon which said second party shall enjoy the privileges of manufacture aforesaid:

Now, Therefore, in consideration of the premises and the sum of One Dollar by each party to the other paid, it is mutually agreed as follows:

1st: Said second party shall pay to said first party a royalty of six (6??) cents per guard upon all guards manufactured under said license agreement of August 1, 1920.

2nd: Said second party shall make settlement and pay said royalty on the 31st day of December of each year, so long as said second party shall manufacture">*2369 said guards, for the number of guards manufactured and sold by said second party for the year immediately preceding said 31st day of December, and shall on said 31st day of December of each year render to said first party a statement showing the number of guards manufactured during said year.

(Signed) JACOB A. SMITH,

W. N. THORNBURGH MANUFACTURING CO.,

By W. N. THORNBURGH, President.

On August 1, 1920, the petitioner entered into a similar agreement with Otto Sindelar, except that the second paragraph thereof referred to the use of secret processes instead of letters patent.

On September 12, 1920, the petitioner entered into new written agreements with Smith and with Sindelar which were identical except that one covered dust guards and the other a secret process and formulae. The agreement with Sindelar was as follows:

THIS AGREEMENT made and entered into this 12th day of September, A.D. 1920, by and between OTTO SINDELAR, Chicago, party of the first part, and W. N. THORNBURGH MANUFACTURING COMPANY, a corporation, organized and existing under and by virtue of the laws of the State of Illinois, of the same place, party of the second part, witnesseth:

WHEREAS, the">*2370 party of the first part is the owner of a certain secret process and formulae pertaining to the manufacture of certain veneer dust guards of various types and designs, and

WHEREAS, party of the first part desires to grant a license privilege to manufacture and sell dust guards, manufactured under said secret process and formulae to the party of the second part:

NOW, THEREFORE, in consideration of the premises and the sum of ONE ($1.00) DOLLAR by each party to the other paid, it is mutually agreed as follows: That the party of the first part hereby grants to the party of the second ">*31 part the perpetual and exclusive right to manufacture and sell said dust guards and all other dust guards embodying same process, etc.

The party of the second part hereby agrees to pay to the party of the first part or his heirs, successors or assigns, a royalty of 6?? per guard for all Dust Guards manufactured and sold by party of the second part under this agreement so long only as manufacturing and market conditions shall justify. Any proposed modification or change in the amount of said royalty to be verified by statements of the corporation showing good and just cause and approved">*2371 by the majority of the Board of Directors of said second party. It is mutually understood and agreed that said royalty of 6?? is computed on the basis of conditions existing during the second half of the year 1920, and shall only be decreased as these conditions may later change. Further, that while no fixed royalty can be guaranteed indefinitely by said second party it shall not be diminished by reason of any undue increased fixed expense of said second partly but only upon proper showing on bona fide changed conditions of business. Therefore, if at any time hereafter the Board of Directors of the party of the second part should decide that the market value for said dust guards does not justify the payment of the royalty of six (6) cents per guard as heretofore provided, that said Board of Directors may, in its discretion by proper resolutions, decrease the amount of royalty to be paid under and by virtue of this agreement, and it is agreed that the decision of the said Board of Directors shall be final.

Party of the second part hereby agrees to make a settlement with the party of the first part on December 31st of each year, and pay any royalties due party of the first part">*2372 under and by virtue of this agreement, within reasonable time thereafter; said statement to show the number of guards manufactured and sold during the year.

This annuls and supersedes the License Agreement of like character made and entered into between the parties hereto as of August 1st, 1920, and shall cover on shipments of Dust Guards from August 17, 1920, inclusive.

IN WITNESS WHEREOF said party of the first part has hereunto set his hand and seal in duplicate original and said second party has caused these presents to be signed in its corporate name by its president, attested by its secretary, and its corporate seal to be hereunto affixed the day and year first above written.

(Signed) OTTO SINDELAR (seal).

W. N. THORNBURGH MANUFACTURING CO.

By W. N. THORNBURGH, President.

ATTEST:

(Signed) JOSEPH J. MEYDRECH,

Secretary.

On September 13, 1920, Sindelar executed the following assignment:

For and in consideration of One ($1.00) Dollar and other good and valuable considerations to me in hand paid, the receipt of which is hereby acknowledged, I, the undersigned, Otto Sindelar, of Chicago, Illinois, do hereby assign to Byron C. Thorpe, as Trustee, all">*2373 royalties due me under and by virtue of a certain license agreement, concerning the manufacturing and sales rights of an improved dust guard, under secret processes and formulae, and all rights, title and interest in and to said license agreement, concerning the manufacturing and sales rights of an improved dust guard, under secret processes and formulae.

Witness my hand and seal this the 13th day of September, A.D. 1920.

(Signed) OTTO SINDELAR.

">*32 On the same day Smith executed a similar assignment to Thorpe, as trustee.

Also, on September 13, 1920, the following trust agreement was executed by Thorpe and accepted by all the stockholders of the petitioner, except Mrs. Thornburgh:

DECLARATION OF TRUST.

Whereas Otto Sindelar has on this day assigned to the undersigned, as Trustee, all royalties due him under and by virtue of a certain license agreement, concerning the manufacturing and sales rights of an improved dust guard, under secret processes and formulae and all right, title and interest in and to said license agreement, concerning the manufacturing and sales rights of the same.

Whereas, Jacob A. Smith has on this day assigned to the undersigned all">*2374 royalties due him under and by virtue of a certain license agreement, concerning an application for the United States letters patent, filed August 27, 1919, in the United States Patent Office, Serial Number 320100, and all right, title and interest in and to said license agreement and application for said letters patent, all in trust, nevertheless as follows:

It is understood and agreed that all moneys paid to the undersigned by W. N. Thornburgh Manufacturing Company under and by virtue of the said assignments and license agreements, shall be held in trust for the persons named in the schedule attached hereto, and shall be distributed to such persons by the undersigned, in the following proportions, to-wit:

M. B. Thornburgh shall receive 55 per centum of all moneys received by virtue hereof, and the remaining 45 per centum thereof shall be distributed to the following named persons or their assigns in the same proportion as the number of shares of stock now held by them and stated opposite the name of each person, bears to 287 1/2 shares of stock:

Schedule.
J. A. Smith	37 1/2
J. J. Meydrech	1
B. C. Thorpe	27 1/2
Otto Sindelar	61
Frank Meydrech	140 67/100
Frank Meydrech	9 83/100
Jos. Vistian	2 1/2
Aug. Sabotka	2 1/2
H. B. Mitchell	2 1/2
Emil Wolney	2 1/2

">*2375 Accepted:

(Signed) J. A. SMITH.

OTTO SINDELAR.

B. C. THORPE.

EMIL WOLNEY.

AUGUST F. SABOTKA, Jr.

FRANK MEYDRECH.

JOS. J. MEYDRECH. JOS. VISTIAN. H. B. MITCHELL.

">*33 The number of dust guards manufactured by the petitioner during the taxable years is as follows:

Year	Sindelar type	Smith type	Others	Total
1920	115,501	110,305	220	226,026
1921	148,560	90,989	5,384	244,933
1922	692,316	187,770	17,620	897,706
1923	842,604	224,558	4,645	1,070,807

For 1920 the petitioner distributed to its stockholders under the trust agreement of September 13, 1920, the sum of $13,396.98, which was charged to profit and loss. The petitioner's net earnings for that year were $13,873.41, but no royalties were figured in the current operating or manufacturing expenses for that year, nor for any of the taxable years.

For 1921 the petitioner's net earnings were $6,564.16. The directors fixed the royalty at 2 cents per guard, an aggregate of $4,370.40. This amount was charged to surplus on the petitioner's books.

For 1922 petitioner's directors fixed the royalty rate of 5.7 cents on 977,229 guards (although only 897,706">*2376 guards were manufactured that year), amounting to $55,973.03. Of this amount, $10,000 was charged on petitioner's books to profit and loss and the balance to surplus.

For 1923 the directors fixed the royalty rate at "about 2 1/8 cents on 125,194 guards, or $24,000." The total number of guards manufactured in that year was 1,070,807.

The amounts of the so-called royalty payments were deducted by the petitioner in computing its net income for the years 1920, 1921, 1922, and 1923. The respondent disallowed the deductions.

OPINION.

MARQUETTE: The question here involved is one of fact, namely, whether certain disbursements made by the petitioner were payments of royalties, or whether they were distributions of dividends. The petitioner contends that they were royalties and were reasonable in amount, while the respondent takes the position that they were dividends in the guise of royalties.

Section 234(a)(1) of the Revenue Acts of 1918 and 1921, reads as follows:

SEC. 234(a) That in computing the net income of a corporation subject to tax imposed by section 230 there shall be allowed as deductions:

(1) All the ordinary and necessary expenses paid or incurred during">*2377 the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered, ">*34 and including rentals or other payments required to be made as a condition to the continued use or possession of property to which the corporation has not taken or is not taking title, or in which it has no equity.

Under this section royalty payments made in consideration of a right granted to use another's patented article or process of manufacture are undoubtedly to be classed as ordinary and necessary expenses of the business and, therefore, deductible.

A royalty is defined by Bouvier as "A payment reserved by the grantor of a patent, mining lease, etc., and payable proportionately to the use made of such right." And in 34 Cyc. 1817, we find the statement that: "A royalty is a tax or duty paid to the owner of a patent for the privilege of manufacturing or using the patented article; something proportionate to the use of a patented article, in other words, a kind of excise," and citing ">*2378 .

The test, then, is whether the payment made was based upon, and proportionate to, the use of another's article or process of manufacture.

Do the facts show that the payments here in question measure up to that test? In our opinion, they do not. The original contracts for payment of royalties at the rate of 6 cents for each Smith type and Sindelar type guard which the petitioner might manufacture, were annulled a few weeks later by agreements which left to petitioner's board of directors the full power to fix, at the end of each year, the royalty rate to be paid for that year. The net profits each year were ascertained without taking any account of royalties, and it is patent from the evidence that the so-called royalties were fixed each year with reference to the year's profits, rather than proportioned to the use made of the manufacturing rights granted by Smith and Sindelar. This is borne out by the evidence which shows that the so-called royalties, as fixed each year, always exhausted (or nearly exhausted) the profits for that year; that in computing the aggregate amount to be so paid there were included">*2379 types of guard which the petitioner was free to make without any royalty payment; that there was no allocation of these so-called royalties to Smith and Sindelar, but all the stockholders of the petitioner participated in the benefits of these payments, in proportion to their stockholders at an agreed ratio; that this ratio was exactly the same as that at which dividends were to be distributed; that little, if any, profits were distributed as dividends; that the right to participate in these distributions depended upon one's ownership of stock and not upon his ownership of a patented article or a special process for manufacturing.

From the evidence before us, it would severely tax one's credulity to believe that the petitioner was obliged to pay Smith or Sindelar ">*35 any sum at all, as royalties, for the right to manufacture their respective types of guards. Doubtless these gentlemen did, at the beginning, insist upon the royalty agreement of 6 cents per guard. But before the petitioner got its business well started. They waived their rights as to such royalties. A glance at the following table will show that these two men were not particularly insistent upon "royalties" ">*2380 for the use of their articles and processes of manufacture:

SINDELAR
Year	Number of guards	Royalty rate	Royalty earned	Actually received
				under trust agree
				ment
		Cents
1920	115,501	6	$6,930.06	$799.24
1921	148,560	2	2,971.20	438.47
1922	692,316	5.7	39,462.01	5,344.21
1923	842,604	2 1/8	17,905.34	2,291.47
SMITH
		Cents
1920	110,305	6	$6,618.30	$1,300.09
1921	90,989	2	1,819.78	269.55
1922	187,770	5.7	10,602.89	3,285.38
1923	224,558	2 1/8	4,771.86	1,408.69
MRS. THORNBURGH
		Cents
1920	226,026	6	None.	$7,368.34
1921	244,933	2	None.	2,403.72
1922	897,706	5.7	None.	30,785.17
1923	1,070,807	2 1/8	None.	13,200.00

The evidence also discloses that the petitioner manufactured in 1922 a total of 897,706 guards. The aggregate amount of royalties at the rate of 5.7 cents as fixed by petitioner's directors, would be $51,169.24. But the resolution of the directors directed the distribution of "royalties" on 977,229 guards, in the aggregate amount of $55,973.03. In other words, the petitioner would have us believe that it paid "royalties" amounting to $4,803.79">*2381 on 76,523 guards which it did not manufacture and on which, therefore, no royalty could possibly be due.

Again, in 1923, the petitioner manufactured a total of 1,070,807 guards. The directors fixed the "royalty" rate at 2 1/8 cents per guard, and the aggregate amount of so-called royalty would be $22,754.65. But the directors' resolution called for a payment of 2 1/8 cents "on 125,194 guards, or $24,000." On that number of guards, at the rate specified, the total amount would be only $2,660.37.

Again, in 1921, the total number of guards manufactured by the petitioner was 244,933, on which the aggregate "royalties" at the ">*36 2 cent rate fixed by the directors would amount to $4,898.66. Yet the directors, for some unknown reason, omitted 26,413 guards of the Sindelar type from their computation, and distributed only $4,370.40 on 218,520 guards.

These facts have but little probative value in support of the petitioner's claim. The burden rested upon the petitioner to prove that the respondent's determination of deficiencies was erroneous, and that it should be set aside. In our opinion, the petitioner has failed to sustain that burden, and the determination of the">*2382 respondent is, therefore, approved.

Judgment will be entered for the respondent.