T.C. Memo. 2000-58
UNITED STATES TAX COURT
CASCADE DESIGNS, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
JAMES M. AND JANE I. LEA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 11498-98, 12555-98. Filed February 23, 2000.
Carmen J. SantaMaria, for petitioner in docket
No. 11498-98.
Darrell D. Hallett and Scott A. Schumacher, for petitioners
in docket No. 12555-98.
William A. McCarthy and Sandra Veliz, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARR, Judge: Respondent determined deficiencies and
- 2 -
accuracy-related penalties in Cascade Designs, Inc.'s (Cascade or
the corporation) Federal income tax in the following amounts:
Accuracy-Related Penalty
Year Deficiency Sec. 6662(a)
1992 $592,921 $118,584
1993 162,240 32,448
1994 182,378 36,476
1995 196,621 39,324
1996 90,564 18,113
Respondent determined deficiencies and accuracy-related
penalties in James M. and Jane I. Lea's (the Leas) Federal income
tax in the following amounts:
Accuracy-Related Penalty
Year Deficiency Sec. 6662(a)
1993 $62,355 $12,471
1994 65,462 13,092
1995 56,326 11,265
1996 28,640 5,728
These cases were consolidated for trial, briefing, and
opinion by order of this Court dated November 18, 1998.
The issues for decision are: (1) Whether the payments
Cascade made to James M. Lea (Lea) during the years at issue were
expenditures for the purchase of certain patents and, therefore,
deductible as patent amortization expenses. We find they are.
(2) Whether the Leas may report the payments as capital gain
income under section 1235.1 Respondent's position on this issue
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
- 3 -
in Rev. Rul. 69-482, 1969-2 C.B. 164, is that these payments are
capital gains; we therefore treat respondent's position in Rev.
Rul. 69-482, supra, as a concession that the Leas are entitled to
report the payments as capital gains. (3) Whether Cascade or Lea
is liable for an accuracy-related penalty. Because of our
disposition of the preceding issues, we need not address this
issue.
FINDINGS OF FACT
Some of the facts in this case have been stipulated and are
so found. The stipulation of facts and the accompanying exhibits
are incorporated into our findings by this reference. Cascade is
a C corporation, whose principal place of business was in
Seattle, Washington, at the time it filed its petition in this
case. At the time they filed their petition in this case, the
Leas resided in Seattle, Washington.
Lea is a mechanical engineer and was continuously employed
by the Boeing Co. (Boeing) from 1948 to 1971. In mid-1971, Lea
was laid off from Boeing until late 1972. While he was laid off,
Lea began to investigate products that he could invent,
manufacture, and sell. Lea's friend and fellow engineer, John
Burroughs (Burroughs), suggested that there was a need for a
better sleeping pad for hikers and mountain climbers than was
being produced. Lea, with the help of another friend, Neil
Anderson (Anderson), designed a high-quality foam-filled self-
- 4 -
inflating air mattress (mattress) for use by backpacking and
mountain climbing enthusiasts.
The Patents
In January 1972, Lea and Anderson applied for a patent on
the design of the mattress, and U.S. Patent No. 3,872,525 (the
525 Patent) was issued on March 25, 1975. Later, on February 3,
1976, Lea and Burroughs were issued U.S. patent No. 3,935,690
(the 690 patent) for their method of packaging the mattresses.
On May 31, 1977, Lea and Anderson were issued U.S. patent No.
4,025,974 (the 974 patent) for their method of making the
mattresses.
The Incorporation
On April 24, 1972, Cascade was incorporated in the State of
Washington for the purpose of manufacturing and selling the
mattresses under the name "Therm-A-Rest". Cascade was
capitalized with $1,000, and its stock was owned as follows:
Ownership
Shareholder Percentage
Lea 60
Burroughs 20
John Lea1 20
Total 100
1.
John Lea is Lea's brother.
Lea returned to work for Boeing in November 1972, where he
continued to work until June 1978. During these years, Lea and
Burroughs were full-time employees of Boeing, and worked for
- 5 -
Cascade on a part-time basis, which included working evenings, on
weekends, and during vacations.
The Officers and Their Duties
Lea was the president of Cascade, Burroughs was the vice
president and treasurer, and John Lea was the secretary and
corporate counsel.
Lea supervised production and quality control of the
mattresses. Burroughs supervised Cascade's sales and marketing.
Burroughs' duties included developing cash-flow models that were
used to determine whether to purchase new equipment and when to
pay the corporate officers. John Lea's duties were to take notes
at the officer's meetings and attend to the corporation's legal
matters.
The Recapitalization
In 1978, Lea retired from Boeing and became the first full-
time employee at Cascade. In this year, Cascade was
recapitalized to reflect better the relative contributions of the
various shareholders. As a result of the recapitalization,
Cascade's stock was owned as follows:
Ownership
Shareholder Percentage
Lea 62
Burroughs 29
John Lea 8
Richard Brooks (Brooks) 1
Total 100
- 6 -
These shareholders were the only members of Cascade's board
of directors, and each retained his ownership percentage until
1991.
The 1979 Sales Agreement and Patent Assignment
On January 9, 1979, Lea entered into an agreement (the 1979
sales agreement) with Cascade to sell "his entire right, title
and interest in and to" the 525, the 690, and the 974 patents,
U.S. Patent Application S.N. 800,288 (the patent application for
the "Method of Making Self-Inflating Air Mattress"), and the
British and Japanese patent applications for the mattress.2 The
1979 sales agreement, in relevant part, provided the following:
a. The total sales price for such sale is three
hundred thousand dollars ($300,000). Since it is
recognized that Cascade Designs, Inc. does not at this
time have the resources to make a cash payment of
$300,000, it is agreed that payment can be made only
out of the money received by Cascade Designs for sales
of the air mattresses which it markets.
Payment shall be made as follows:
1. For each air mattress sold by Cascade Designs,
Inc., covered by any one of the patents or patent
applications noted above, James M. Lea shall receive an
amount of money equal to 5% of the gross selling price.
* * * * * * *
b. Payments shall continue to be paid as
2
Anderson sold his interests in the 525 and the 974 patents,
and the U.S., British, and Japanese patent applications, on Jan.
7, 1979, for 0.134 percent of the gross sales price of each air
mattress. Payments made to Anderson for these properties are not
at issue in this case.
- 7 -
specified in paragraphs (1) * * * until the total
amount of $300,000 is paid. In computing payment from
year to year, the amount remaining due at the end of
each year will be adjusted according to the inflation
rate so that it will reflect the dollar value in the
year 1977. * * *
* * * * * * *
3. This agreement shall remain in force until all
of said U.S. and foreign patents expire or until the
payments have been made in full, whichever occurs
first.
4. * * * Quarterly, within thirty days after the
first days of January, April, July, and October of each
year during the continuance of this agreement, Cascade
Designs, Inc. shall render writting [sic] reports to
James M. Lea, stating in each report the quantities and
net selling prices of all air mattresses sold by
Cascade Designs, Inc. during the preceding three
calendar months. Each such report shall be accompanied
by remittance in full covering the payments shown
thereby to be due James M. Lea.
* * * * * * *
6. If Cascade Designs, Inc. fails to pay James M.
Lea the moneys payable under the terms of this
agreement, or fails to keep or perform any other
obligation of the agreement, then James M. Lea may, at
his option terminate this agreement by giving sixty
days written notice, specifying the default complained
of; provided, however, that if Cascade Designs, Inc.
shall, within such sixty days, cure the default
complained of, then the notice shall cease to be
operative and this agreement shall continue on [sic]
full force and effect as though such default had not
occurred; and provided further, that if Cascade Designs
shall within such sixty days notify James M. Lea in
writing that it disputes the asserted default, the
matter shall be submitted to arbitration as hereinafter
provided.
The patent and patent applications covered by the 1979 sales
agreement, except the 690 patent, were officially assigned by Lea
- 8 -
to Cascade by an assignment document, which was recorded with the
U.S. Patent and Trademark Office on March 19, 1979. The
assignment conveyed to Cascade "all letters patent, domestic and
foreign, which have issued or may issue thereon, whether said
Letters Patent issued directly or by * * * division".
Selling Mattresses Is a Seasonal Business
The recreational mattress industry is a seasonal business;
most of Cascade's sales were made in late spring and early
summer, and most of its sales revenue was received between July
and November. Consequently, its cash-flow was also seasonal,
peaking in late fall and early winter. However, to meet the
demands of the market during the peak sales season and to retain
its experienced work force, Cascade had to manufacture mattresses
year-round.
Each year, the demand for Cascade's mattresses increased
dramatically. To keep pace with the market's increased demand,
each year Cascade manufactured more mattresses and increased its
inventory of goods available for sale. This practice resulted in
the exhaustion of its financial resources by late spring of every
year.
The Manufacturing Facilities
For a short while, the first mattresses were manufactured in
a grimy machine shop where the press to manufacture the
mattresses had been made. Cascade required larger facilities to
- 9 -
realize its growth potential, and it soon moved its manufacturing
operation to a training facility for handicapped workers.
However, this facility proved unsatisfactory because once the
handicapped workers were trained to manufacture the mattresses,
they were replaced by new workers who required training. As a
result, Cascade was manufacturing mattresses with an unskilled
workforce that it was constantly training.
After approximately 1 year at the training facility, Cascade
moved its manufacturing equipment to a building near the Kingdome
and contracted to have the mattresses manufactured. This
arrangement was unsatisfactory because much of the potential
profit on the manufacturing operation was paid to the
manufacturing contractor. Finally, in 1981, Cascade moved to its
present location by renting a small corner of the building that
it later purchased.
At the time of its final move, Cascade recognized that its
manufacturing equipment was inadequate to produce all the
mattresses that it could market. Therefore, while the mattresses
were being manufactured under contract, Cascade designed and
built larger and heavier equipment for its new location.
Cash-Flow Problems
Cascade was undercapitalized and had cash-flow problems.
Because the shareholders were uncertain of the success of the
corporation, they generally were unwilling to make personal loans
- 10 -
to Cascade and also refused to guarantee a bank loan to the
corporation.
Cascade obtained its first line of credit in 1981. The
credit limit was $100,000, which was further limited to the value
of, and secured by, Cascade's accounts receivable and its
inventory of finished goods. Amounts advanced under the line of
credit bore an annual interest rate of 22.5 percent. The
corporation was generally averse to incurring debt because the
high rate of interest made it difficult for Cascade to make a
profit on borrowed money. Instead of borrowing, the corporation
retained its earnings to self-finance its working capital
requirements.
The board of directors and the corporate officers considered
that the best use of the corporation's working capital was to pay
its labor force and the various materials suppliers and to
increase its manufacturing capability with larger facilities and
improved production equipment. Consequently, the officers'
salaries were often in arrears, and Cascade did not make all the
quarterly payments due Lea under the 1979 sales agreement. By
December 31, 1982, Cascade owed Lea $259,128 in delinquent
payments.
Lea's Demand for Payment and the 1982 Agreement
Lea did not make a written demand for payment; however, the
minutes of the officers' meetings on March 31 and September 23,
- 11 -
1982, report that Lea demanded payment of the delinquent amounts,
and that the corporate officers considered whether Cascade could
make the payments. Because the corporation required all its
working capital to build its inventory of goods available for
sale, Lea suggested that Cascade get a loan from a bank or that
the other officers make loans to the corporation so that Cascade
could pay the amounts owed to him. The other officers rejected
this proposal.
The minutes of the officers' meeting on December 1, 1982,
reported that $130,000 of the amount owed to Lea would be paid
during the month, but the balance due in April would not be paid
until July or August of 1983. These minutes also report that Lea
had consulted a lawyer about the patent payments and intended to
meet with him again. The minutes of the February 23, 1983,
meeting report that $250,000 was still due Lea and could not be
paid. At this meeting, the officers discussed setting up an
installment schedule to pay the outstanding balance over time.
After Lea's consultations with his lawyer, Lea and Cascade
agreed to renegotiate the 1979 sales agreement. The renegotiated
agreement (the 1982 agreement3 or the agreement), recognized that
Cascade was in breach of the 1979 sales agreement, and, in
3
Although we refer to the agreement as "the 1982 agreement",
the parties spent some time negotiating its terms, and the
agreement was not entered into until April or May 1983.
- 12 -
pertinent part, provided the following:
5. NEW PATENTS AND PATENTS PENDING
Since the original sales agreement was entered
into, Lea has been granted an additional patent as
follows
US Patent 4,261,776 [the 776 patent4]"Method of
making self-inflated air mattresses" issued April
14, 1981.
Lea has also applied for an additional patent
under:
SN 395,750 [the 750 patent application or the
750 technology5] "Method and apparatus for
making air mattresses" filed July 6, 1982.
The additional patent and patent pending are
improvements on the prior patent sold to Cascade by Lea
and are valuable to Cascade in the manufacturing of air
mattresses, pads and related products and methods.
* * * * * * *
7. NEW CONSIDERATION
In consideration for Lea waiving prior breaches of
the original sales agreement by Cascade, of waiving any
claim which Lea may have for interest on unpaid amounts
due,[6] and of Lea granting to Cascade his entire right,
title, and interest in and to the new patent and patent
4
The 776 patent was a division of U.S. Patent Application
S.N. 800,288, "Method of Making Self-Inflating Air Mattress".
5
No patent was ever granted on the 750 patent application;
the application was rejected by the U.S. Patent and Trademark
Office primarily because of its "obviousness". Cascade used the
750 technology in its manufacturing process and regarded it as a
trade secret.
6
At the time Cascade and Lea entered into the 1982
agreement, the interest on the delinquent payments totaled
approximately $39,102.
- 13 -
application described in paragraph 5 above, Cascade
enters into this agreement and makes the promises
contained hereinafter:
8. AFFIRMATION OF ORIGINAL SALE
Lea hereby affirms that he has and does hereby
sell all of his right, title and interest in and to the
patent and patent applications described in the
original sales agreement and to the new patent and
patent application described in paragraph 5 hereof.
9. SALES PRICE
Cascade hereby agrees to pay Lea as consideration
for the waiver, reconveyance and conveyance by Lea
contained herein $10,000,000.00 less $172,310.00
representing payments made under the original sales
agreement and less $259,128.03 representing amounts
earned but not paid by Cascade to Lea under the
original sales agreement or as otherwise mathematically
stated the remaining sum of $9,568,561.97.
* * * * * * *
11. PAYMENT
Payment shall be made on or before the thirtieth
(30th) day of January, April, July, and October of each
year as follows:
A. For each product sold by Cascade covered by
any one of the patents or patent applications
noted above Cascade shall pay Lea an amount of
money equal to five percent (5%) of the gross
selling price.
* * * * * * *
C. This agreement shall remain in force until all
of said U.S. and foreign patents expire or until
the payments have been made in full, whichever
occurs first.
12. ROYALTY REVIEW
* * * * * * *
- 14 -
It further [sic] recognized that, for Cascade to
market its products competitively, there needs to be a
reasonable limit as to percentage of the selling price
which can be allocated to royalty payments or the like.
Accordingly, Cascade shall have the right to review on
an annual basis the patents and patent applications
sold by Lea to Cascade along with such other
improvements which might be incorporated in its product
line, to determine if there should be any reallocation
of the five percent (5%) payments which are to be made
to Lea for the following calendar year. If Cascade
determines that such other improvements have
substantial merit and make a significant contribution
to the technology incorporated in Cascade's products or
in the process for making the products, then Cascade
may, in its discretion, make a reallocation of the five
percent (5%) payments to be made Lea, * * * .
On April 20, 1983, in accordance with the 1982 agreement,
Cascade delivered to Lea an installment note for $259,128.03, the
amount of the payments delinquent under the 1979 sales agreement.
The note required quarterly interest payments and two equal
principal payments on December 31, 1983 and 1984.
Improved Cash-flow and Prosperity
Cascade made several changes that improved its cash-flow.
First, instead of contracting out the manufacturing operation,
Cascade began to manufacture the mattresses itself. This change
allowed Cascade to retain the contractor's profit, which it
estimated was approximately $100,000. Cascade also improved the
manufacturing operation by changing from a cut-out method to a
peel-out method of removing the mattresses from the presses.
Once the workers became proficient at using the new method, each
mattress was manufactured more quickly and, therefore, at a lower
- 15 -
cost.
Second, in November 1982, Cascade hired a new controller,
Lee Fromson (Fromson), who implemented certain changes in
Cascade's financial operations that improved its cash-flow during
1983. For instance, Fromson introduced the corporation to
computers, which Cascade used to automate its system of
accounting for sales and receipts. To quickly improve the
corporation's cash-flow, Fromson hired a full-time credit manager
who expeditiously collected the accounts receivable and a
purchasing manager who negotiated more favorable prices and
payment terms with the corporation's vendors.
Most importantly, to fund Cascade's growth, Fromson
negotiated with the bank for an increased line of credit at a
lower rate of interest, and he convinced the corporate officers
to use it. The credit limit was increased to $125,000 in April
and to $150,000 in June 1983, and the initial interest rate was
fixed at 11.5 percent. For the years 1983 through 1986, the
credit limit was increased to $300,000, and in 1987 it was
increased to $500,000. These lines of credit were secured by,
and limited to the value of, Cascade's accounts receivable and
its finished goods inventory.
The improved cash-flow allowed Cascade to pay its officers
and to become current on its patent payment obligations under the
1982 agreement at the same time it improved its manufacturing
- 16 -
capability.
The parties stipulated that for the years 1973 through 1983,
Cascade reported gross and taxable income in the following
amounts:
Year Gross Income Taxable Income
1973 $203 ($415)
1974 6,704 254
1975 49,596 10,501
1976 115,296 15,232
1977 248,634 45,917
1978 519,683 42,687
1979 1,033,661 169,723
1980 1,546,781 165,743
1981 2,266,492 286,675
1982 2,791,299 356,902
1983 3,935,215 414,216
The parties stipulated that during the years at issue,
Cascade reported gross and taxable income in the following
amounts:
Year Gross Income Taxable Income
1992 $19,921,985 $2,077,284
1993 22,861,486 3,573,098
1994 26,547,637 3,285,003
1995 28,921,971 3,778,212
1996 31,989,268 5,423,024
Suspension and Reduction of Patent Payments
In 1987, Cascade determined that a competitor was selling a
self-inflating foam-filled mattress that infringed upon its
patents. The competitor's mattress was manufactured in Taiwan.
After the competitor agreed to discontinue importing and selling
the mattress in the United States, the Taiwanese manufacturer
- 17 -
brought an action in Federal District Court seeking a declaratory
judgment as to the validity of Cascade's patents. In 1989,
Cascade filed a counterclaim against the Taiwanese manufacturer
and its U.S. distributor, and a complaint with the International
Trade Commission, claiming that the Taiwanese version of the
mattress infringed upon Cascade's patents.
In 1990, Cascade and Lea agreed to suspend the corporation's
obligation to make payments to Lea pending the resolution of the
litigation with the Taiwanese manufacturer. In 1991, at the
request of Cascade, the litigation was dismissed. As a result of
the dismissal, the Taiwanese manufacturer was allowed to continue
manufacturing the mattresses and to sell them in the United
States, and Cascade's patents retained their presumption of
validity. In 1992, Cascade paid Lea the amounts that had been
suspended pending the outcome of the litigation.
The 1982 agreement was amended on three occasions to reduce
the amount payable to Lea. Recognizing that the litigation with
the Taiwanese manufacturer had weakened, but not invalidated, the
patents, Cascade and Lea agreed in November 1992 to reduce the
payments from 5 to 4 percent of the gross selling price of the
products using the technology covered by those patents. In
January 1993, upon reassessment of the value of the patents after
the settlement of the lawsuit, Cascade and Lea agreed to reduce
the payments from 4 to 2.5 percent of the gross selling price of
- 18 -
the products. Finally, on May 23, 1996, as a result of
expiration of some of the patents and the introduction of new
technology, Cascade and Lea agreed to reduce the payment
percentage to 1 percent of the sales of all products using the
technology covered by the patents.
On April 14, 1998, the 776 patent, the last patent included
in the 1982 agreement, expired, and no payments were made to Lea
under the agreement for products that were sold thereafter. The
total amount paid to Lea under the 1982 agreement was
approximately $6.5 million.
Petitioners' Reporting Positions and Respondent's Determinations
Cascade deducted the payments to Lea as patent amortization
expenses. The Leas reported the payments as capital gains from
the sale or exchange of the patents.
In the notice of deficiency issued to Cascade, respondent
disallowed the deductions claimed for patent amortization
expenses because Cascade had not established that the payments
were ordinary and necessary business expenses or were paid to
purchase the patents. In the notice of deficiency issued to the
Leas, respondent determined that the payments Lea received from
Cascade were ordinary income from dividends, rather than capital
gains.
- 19 -
OPINION
Issue 1. Whether the Payments Were for the Purchase of Patents
Cascade asserts that the 1982 agreement is a valid and
legally enforceable contract and the amount paid for the patents
was reasonable. Consequently, Cascade argues, the payments are
deductible under section 167 as allowances for depreciation of
intangible property.7
On brief, respondent contends that the 1982 agreement must
be disregarded as it was neither fair nor reasonable; rather, it
was a mere vehicle to disguise distributions of corporate profits
for favorable tax benefits. Consequently, respondent asserts,
any payments made to Lea in excess of the amount provided in the
1979 sales agreement are nondeductible disguised dividends.
7
Sec. 167(a) allows as a depreciation deduction "a
reasonable allowance for the exhaustion, wear and tear (including
* * * obsolescence) * * * of property used in the [taxpayer's]
trade or business". Patents constitute intangible property,
which may be the subject of a depreciation allowance
(amortization) under this section over their useful lives. See
sec. 1.167(a)-3, Income Tax Regs.
Sec. 167(c) (which was designated sec. 167(g) in 1979 and
1982), specifies the basis for depreciation of any property
"shall be the adjusted basis provided in section 1011, for the
purpose of determining the gain on the sale or other disposition
of such property." Sec. 1012, when read with sec. 1011, provides
that the adjusted basis of the property is its "cost".
If the purchase price of a patent is expressed by formula by
which a fixed dollar amount cannot be ascertained until future
years, such as a purchase price that is a fraction of sales, the
purchaser may deduct each year as depreciation only the amount of
the purchase price actually paid or payable. See Newton Insert
Co. v. Commissioner, 61 T.C. 570, 581 (1974), affd. per curiam
545 F.2d 1259 (9th Cir. 1976); Associated Patentees, Inc. v.
Commissioner, 4 T.C. 979 (1945).
- 20 -
We begin by noting that, as a general rule, respondent's
determinations of fact are presumptively correct, and petitioner
bears the burden of proving otherwise. See Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933).
Section 162(a) allows deductions for all the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business. An "ordinary" expense is one
that relates to a transaction "of common or frequent occurrence
in the type of business involved", Deputy v. du Pont, 308 U.S.
488, 495 (1940), and a "necessary" expense is one that is
"appropriate and helpful" for "the development of the
petitioner's business", Welch v. Helvering, supra at 113.
Taxpayers do not have an inherent right to take tax
deductions. Deductions are a matter of legislative grace, and a
taxpayer bears the burden of proving entitlement to any deduction
claimed. See Deputy v. du Pont, supra at 493; New Colonial Ice
Co. v. Helvering, 292 U.S. 435, 440 (1934). The determination of
whether an expenditure satisfies the requirements for
deductibility under section 162 is a question of fact. See
Commissioner v. Heininger, 320 U.S. 467, 475 (1943); Granberg
Equip., Inc. v. Commissioner, 11 T.C. 704, 715 (1948).
Cascade promised in the 1982 agreement to pay Lea more for
the patents initially transferred in 1979. We must decide
- 21 -
whether the 1982 agreement is a valid, enforceable modification
of the 1979 sales agreement, and if so, whether the amount paid
for all the patents was reasonable. See Champayne v.
Commissioner, 26 T.C. 634, 643 (1956) (Court's finding that 5-
percent royalty was reasonable did not make contract to pay 20-
percent royalty one made in bad faith, a fiction, or a sham).
The 1982 Agreement Is a Valid Enforceable Modification
Default
It is clear from the facts that in 1982 Cascade was in
default on its payment obligation to Lea. The facts do not
support respondent's argument on brief that Cascade intentionally
defaulted because Lea did not want to be paid. Lea made repeated
demands for payment. Cascade's failure to meet its contractual
obligation was due to excessive demands on its cash-flow from
operations and its inability to obtain cost-effective financing
to satisfy its unmet cash requirements.
Cascade's decision to use the corporation's available
financial resources primarily to build its finished goods
inventory and to expand its manufacturing capabilities was a
business judgment. The Court is very reluctant to substitute its
judgment for that of the persons operating a company, unless the
facts and circumstances require us to do so. See Malone & Hyde,
Inc. v. Commissioner, 49 T.C. 575, 578-579 (1968).
- 22 -
Cascade was an undercapitalized startup company at the time
it was delinquent in its payments to Lea. The officers'
decisions enabled the corporation to establish its presence in
and to secure a share of a rapidly expanding market at the cost
of paying more over time for the essential patents. Considering
all the facts and circumstances, we are not disposed to second
guess these decisions of Cascade's management. See id.
Written Notice
Furthermore, we find that Lea's failure to provide 60 days'
written notice, specifying the default complained of, is without
consequence. It is clear from the corporate minutes that the
officers had actual notice of the default, and that Lea allowed
Cascade many days more than 60 to cure its default, which it did
not do. It is also clear that the requirement that written
notice be provided was waived by the actions of both parties.
See Eggers v. Luster, 200 P.2d 520, 523 (Wash. 1948); Kelly
Springfield Tire Co. v. Faulkner, 71 P.2d 382, 384 (Wash. 1937);
Barbo v. Norris, 245 P. 414, 417 (Wash. 1926); Consolidated Elec.
Distrib., Inc. v. Gier, 602 P.2d 1206, 1210 (Wash. Ct. App.
1979).
New Consideration
Respondent contends that the 1982 agreement is not valid
because Lea provided no new consideration for the contract
- 23 -
modification. Specifically, respondent asserts that the 776
patent and 750 patent application provided no consideration
because the 776 patent was a division of patent application S.N.
800,288 ("Method of Making Self-Inflating Air Mattress"), which
was, therefore, assigned to Cascade in 1979, and the 750 patent
application was rejected by the U.S. Patent and Trademark Office.
"We recall the first lesson in contracts, the peppercorn
theory--that courts will not inquire into the adequacy of
consideration so long as it was true and valuable." Pope v.
Savings Bank, 850 F.2d 1345, 1356 (9th Cir. 1988). Here it was.
"Adequacy of consideration" is to be distinguished from the legal
"sufficiency" of any particular consideration. Legal sufficiency
of consideration is concerned not with comparative value but with
that which will support a promise. King County v. Taxpayers, 949
P.2d 1260, 1267 (Wash. 1997); Browning v. Johnson, 422 P.2d 314,
316, amended 430 P.2d 591 (Wash. 1967). The relative values of a
promise and the consideration for it, do not affect the
sufficiency of consideration. See Browning v. Johnson, supra;
Puget Mill Co. v. Kerry, 49 P.2d 57, 64 (Wash. 1935); 3
Williston, Treatise on the Law of Contracts, sec. 7:21, at 383-
386 (4th ed. 1992).
We agree that the 776 patent did not provide new
consideration. The 776 patent was a division of patent
- 24 -
application S.N. 800,288, which was assigned by Lea to Cascade in
1979. See Differential Steel Car Co. v. Commissioner, T.C. Memo.
1966-65 (resale of patents by shareholder to corporation provided
no new consideration). However, although the 750 patent
application did not result in a new patent, it did provide new
consideration. See 3 Williston, supra at 393-394 (anything of
present or potential intrinsic value, including a new and
original idea, can serve as consideration for a promise to pay).
Moreover, we find that Lea's waiver of Cascade's breach of the
1979 sales agreement and any claim that he may have had for
interest on the unpaid amounts provided legally sufficient
consideration for the contract modification. See State v. Brown,
965 P.2d 1102, 1106 (Wash. Ct. App. 1998).
Accordingly, we find that the 1982 agreement was a valid and
enforceable modification of the 1979 sales agreement.
Reasonable Payments
Ordinarily, the amounts that a corporation must pay under an
agreement for the use of a patent would be deductible in their
entirety as ordinary and necessary business expenses, and neither
the Commissioner nor the Court would have any authority to
rewrite the agreement of the parties. See Thomas Flexible
Coupling Co. v. Commissioner, 14 T.C. 802, 818 (1950), affd. 198
F.2d 350 (3d Cir. 1952). But where the party contracting with
- 25 -
the corporation is the majority shareholder, the terms of their
agreement may be examined to see whether the amounts to be paid
may fairly be regarded as compensation for the use of the patent
or represent, to some extent, dividends in disguise. See id.
Lea was the majority shareholder of Cascade at the time the
parties entered into the 1982 agreement. Transactions between
related parties invite close scrutiny. See Differential Steel
Car Co. v. Commissioner, 16 T.C. 413, 424 (1951). Lea's majority
interest alone, however, does not make the patent payments
unreasonable. The agreements under which they were paid will be
given effect "if the arrangement is fair and reasonable, judged
by the standards of a transaction entered into by parties dealing
at arm's length." Sterns Magnetic Manufacturing Co. v.
Commissioner, 208 F.2d 849, 852 (7th Cir. 1954); Differential
Steel Car Co. v. Commissioner, T.C. Memo. 1966-65. We must
assess the reasonableness of the agreement at the time it was
entered into without the benefit of hindsight. See Speer v.
Commissioner, T.C. Memo. 1996-323 (citing Brown Printing Co. v.
Commissioner, 255 F.2d 436, 440 (5th Cir. 1958), revg. T.C. Memo.
1957-37); see also sec. 1.482-2(d)(2)(ii), Income Tax Regs. ("In
determining the amount of an arm's length consideration, the
standard to be applied is the amount that would have been paid by
an unrelated party for the same intangible property under the
same circumstances.").
- 26 -
Expert Witness Reports
Cascade submitted an expert witness report that analyzed the
contract terms and amounts paid Lea and concluded that the 1982
agreement was reasonable. Respondent submitted an expert witness
report to rebut the conclusions of Cascade's expert witness.
Expert witness testimony is appropriate to help the Court
understand an area requiring specialized training, knowledge, or
judgment. See Fed. R. Evid. 702; Snyder v. Commissioner, 93 T.C.
529, 534 (1989). The Court, however, is not bound by an expert's
opinion. We weigh an expert's testimony in light of his or her
qualifications and with respect to all credible evidence in the
record. Depending on what we believe is appropriate under the
facts and circumstances of the case, we may either reject an
expert's opinion in its entirety, accept it in its entirety, or
accept selective portions of it. See Helvering v. National
Grocery Co., 304 U.S. 282, 294-295 (1938); Seagate Tech., Inc. &
Consol. Subs. v. Commissioner, 102 T.C. 149, 186 (1994).
Cascade's expert witness identified guideline transactions
comparable to the one between Cascade and Lea. Comparability of
the transactions was determined by either similarity of product,
similarity of manufacturing process, similarity of markets, or
similarity of components and/or technology. In these guideline
transactions, the amounts paid for the patent or process range
from 1 to 7 percent of sales, and the mode is 5 percent.
- 27 -
Cascade's expert witness also made certain conclusions
regarding the value of the 776 patent and the 750 technology,
which were based on an analysis of the cost savings provided by
each of their technologies. Petitioner's expert estimated that
for the years 1983 through 1996, Cascade's use of both
technologies saved direct costs of at least $4.1 million, and the
combined direct and indirect cost savings may have been as great
as $14.4 million.
Petitioner's expert concluded that comparative industry
returns, cost of equity calculations, and an analysis of the
guideline transactions indicate that the 1982 agreement was
reasonable.
Respondent's expert witness did not consider whether a
normal and reasonable rate of payment for the patents was 5
percent of the gross selling price of the covered products during
the life of the patent. Respondent's expert witness considered
only whether the 776 patent and the 750 technology provided value
to Cascade and would support a purchase price of $10 million less
the earned but unpaid amounts under the 1979 sales agreement.
In his report, respondent's expert valued the 750 technology
at no more than $900,000; however, at trial, he adjusted his
analysis and concluded the value was $1.4 million. Respondent's
witness did not analyze the value of the 776 patent, because it
was not quantified in petitioner's report separate from the 750
- 28 -
technology. Respondent's expert opined that the 1979 sales
agreement established the value of the patents at $300,000, and
that the only difference between the 1979 sales agreement and the
1982 agreement was the "addition of the '776 patent and '750
application." Accordingly, respondent's expert concluded that
"The valuation of the patent and patent application portfolio at
December 31, 1982 would, therefore, have differed from the
$300,000 valuation under the 1979 Agreement only by the passage
of time", and that the value of the patents and patent
applications transferred in the 1982 agreement was between
$300,000 and $2 million.
We do not find respondent's expert witness' rebuttal
persuasive. Respondent's expert relied heavily on a 1983
appraisal of Cascade's stock value to determine the value of the
patents. This appraisal was commissioned by Cascade and
performed by Management Advisory Services. The appraisal valued
Cascade's stock at $2,450,000, including a control premium.
Respondent's expert, therefore, concluded the maximum value of
the patents and patent applications sold by Lea to Cascade is $2
million; the value "established for the entire company, including
all of its technology, patents and applications", less the
control premium. Respondent's expert did not consider that the
appraised value of the stock was based in part on Cascade's
estimated net earnings: its earnings minus the patent payments.
- 29 -
It is clear from the facts that much more than the passage
of time entered into the parties' considerations in negotiating
the 1982 agreement. For the years 1973 through 1978, before the
parties entered into the 1979 sales agreement, Cascade reported
total gross income of $940,116 and total taxable income of
$114,176. For the years 1979 through 1982, the years after the
1979 sales agreement and before the 1982 agreement, Cascade
reported total gross income of $7,638,233 and total taxable
income of $979,043. Furthermore, the parties expected the growth
rate of the sales, and Cascade's earnings, would continue to
increase.
We have found that the 1982 agreement modified the 1979
sales agreement. Therefore, in deciding whether the 1982
agreement was reasonable, we consider the value of all the
transferred patents, not only the 776 patent and the 750
technology.
The market value of the patents and the manufacturing
technologies was greater in 1983 than in 1979 simply because the
demand for the mattresses had increased dramatically, the cost of
manufacturing the mattresses had decreased substantially, and any
doubts that the target market would accept a foam-filled self-
inflating air mattress were diminished greatly. In summary, the
mattress was a successful product, and the market value of the
patents was more evident to Cascade and Lea in 1982 than it was
- 30 -
in 1979. See Differential Steel Car Co. v. Commissioner, T.C.
Memo. 1966-65 (whether payments by a corporation to its
controlling shareholder for the purchase of a patent are
reasonable depends to a considerable degree on the value of the
invention or process and its salability in the open market).
Furthermore, Cascade was not required by the 1982 agreement
to pay $10 million for the patents. Rather, the terms were that
Cascade would pay 5 percent of the gross selling price of the
covered products, and the total payments could not exceed $10
million. Cascade was not obligated to pay $10 million unless
sales of the covered products totaled $200 million before the
patents expired or were supplanted by other patents or
technology. If Cascade had sold no products, it would have paid
Lea nothing, and if it had sold more than $200 million of
products, it would have paid Lea no more than $10 million. These
terms support a finding that the 1982 agreement was fair and
reasonable. Cf. Differential Steel Car Co. v. Commissioner, T.C.
Memo. 1966-65 (contracts that required payment of 80 percent of
net sales, which did not consider the possibility of avoidance by
competitors or invalidity, were not reasonable).
In fact, the parties adhered to the terms of the 1982
agreement; the payment percentage was adjusted to recognize the
decreased value of the patents to the corporation, and Cascade
paid Lea substantially less than $10 million.
- 31 -
Moreover, we find no evidence that Lea dominated Cascade's
board of directors or the other officers. Rather, the minutes
show that all the officers participated in making the corporate
decisions, that it was primarily Burroughs' decision as vice
president and treasurer whether to pay Lea and the amount to pay
him, and that Burroughs negotiated the terms of the 1982
agreement on behalf of Cascade.
The payment percentage, 5 percent of the selling price of
the covered products, negotiated by Burroughs is well within the
range paid for similar patents and technologies. Burroughs, as
vice president, signed the 1982 agreement and testified that at
the time the parties entered into the agreement, he thought the
agreement was fair and reasonable. We had an opportunity at
trial to observe Burroughs and to evaluate his demeanor as a
witness. We find Burroughs to be a credible witness, and we are
satisfied that his testimony is truthful.
Finally, the evidence shows that the payments to Lea bore no
relationship to the percentage of his stock ownership. Cf.
Granberg Equip., Inc. v. Commissioner, 11 T.C. 704, 714 (1948)
(so-called royalty was payable to the stockholders in almost the
same percentage that their stockholdings bore to the taxpayer's
total stock).
It is clear from the facts that the patents Lea sold to
Cascade in 1979 were very valuable to the corporation, and we
- 32 -
have found that the corporation defaulted on its obligation to
pay Lea for those patents. In exchange for Lea's waiving
Cascade's prior breaches of the original sales agreement and
other consideration, Cascade agreed to modify the terms of the
1979 sales agreement; that is, Cascade promised in the 1982
agreement to pay more for the patents.
In cases like this when the majority shareholder of a
corporation is also holder of the patents which are sold to the
corporation, "it is easy to say that the transactions were not at
arm's length and thus clothe the situation with an aura of
suspicion. But we cannot decide cases on suspicion."
Differential Steel Car Co. v. Commissioner, 16 T.C. at 424.
After closely scrutinizing the transactions at issue, we find the
1982 agreement fair and reasonable, and, therefore, the payments
to Lea are expenditures for the purchase of patents, which are
deductible as patent amortization expenses.
Issue 2. Whether the Leas May Report the Payments as Capital
Gain Income Under Section 1235
The Leas reported the payments Lea received from Cascade as
capital gains from the sale of the patents. Respondent contends
on brief that even if we find that the 1982 agreement is
reasonable, the payments to Lea are ordinary income, not long-
term capital gains under section 1235.
Section 1235(a) provides, in general, that a transfer of all
- 33 -
substantial rights to a patent by any holder8 shall be treated as
the sale or exchange of a capital asset held for more than 1
year, regardless of whether or not the payments in consideration
of such transfer are contingent on the productivity, use, or
disposition of the property transferred. However, section
1235(d), provides: "Subsection (a) shall not apply to any
transfer, directly or indirectly, between persons specified
within any one of the paragraphs of section 267(b)".
Lea and Cascade are persons specified under section
267(b)(2), as modified by section 1235(d)(1); thus, Lea's sale of
the patents to Cascade was a transaction between related persons,
and section 1235(a) does not apply to the transaction. See Poole
v. Commissioner, 46 T.C. 392, 401-402 (1966).
The Leas assert that even if they are not entitled to
capital gains treatment under section 1235, they are entitled
under other provisions of the law to capital gains treatment for
the payments received for the transfers of the patents to
Cascade. The Leas cite section 1.1235-1(b), Income Tax Regs.,9
8
The term "holder" includes any individual whose efforts
created such property. Sec. 1235(b)(1).
9
Sec. 1.1235-1(b), Income Tax Regs., provides that if a
transfer is not one described in sec. 1.1235-1(a), Income Tax
Regs. (transfer of all substantial rights to a patent by a holder
to a person other than a related person), then
section 1235 shall be disregarded in determining
(continued...)
- 34 -
and the legislative history of section 1235 in support of their
position.
Previously, in Poole v. Commissioner, supra at 404-405, we
addressed these same arguments and found them unsound, stating:
We also find unsound Poole's alternate contention
that if section 1235 does not apply to the * * *
transfers, he is entitled under other provisions of law
to capital gains treatment for the royalties paid in
connection with such transfers. The legislative
history with respect to section 1235 explains that a
holder's recourse to prior case law is proper only when
the transaction is not one described in section
1235(a). In other words, if the payments for a patent
are contingent upon productivity, use, or disposition,
or if they are payable periodically over a period
generally coterminous with the transferee's use of the
patent, section 1235 is the holder's exclusive
provision for qualifying for capital gains * * *.
Moreover, this interpretation of the effect of section
1235 is supported by an analysis of the effect of the
provisions of the section. If a holder transfers a
patent resulting in the payment of royalties in the
manner described in section 1235(a) to a related
person, and if we were to hold that such a transfer is
entitled to capital gains treatment under another
provision of law, we would be nullifying section
1235(d). Since section 1235(d) was included in the
law, it must have been done for a purpose--the purpose
of denying capital gains treatment to a holder's
transfer to related persons when the payments are of
the type described in section 1235(a). [Fn. ref.
omitted.]
9
(...continued)
whether or not such transfer is the sale or exchange of
a capital asset. For example, a transfer by a person
other than a holder or a transfer by a holder to a
related person is not governed by section 1235. The
tax consequences of such transaction shall be
determined under other provisions of the internal
revenue laws.
- 35 -
See also Newton Insert Co. v. Commissioner, 61 T.C. 570, 583
(1974) (Court reviewed), affd. per curiam 545 F.2d 1259 (9th Cir.
1976).
In addressing the provisions of section 1.1235-1(b), Income
Tax Regs., we stated:
We are aware that sec. 1.1235-1(b), Income Tax Regs.,
provides that if sec. 1235 does not apply because a
transfer is made to a related person, the tax
consequences of the transfer are to be determined under
other provisions of law. If that section of the
regulations is intended to imply that when a holder
transfers a patent and receives payments in the manner
described in sec. 1235(a), such payments may qualify
for capital gains treatment, the regulations must yield
to the contrary legislative purpose. [Poole v.
Commissioner, supra at 404 n.7.]
Were we to apply the foregoing case law to the facts of this
case, we would agree with respondent that the Leas are not
entitled to report the proceeds of the sale of the patents as
long-term capital gains. However, our inquiry cannot end here.
In Rev. Rul. 69-482, 1969-2 C.B. 164, the Commissioner
considered whether a taxpayer-holder who transferred a patent, in
whose hands it was a long-term capital asset, to a related party
for contingent amounts is precluded by reason of section 1235(d)
from obtaining long-term capital gains treatment of the proceeds
of such a transfer under provisions of law other than section
1235. In his consideration of this issue, the Commissioner
reviewed Poole v. Commissioner, supra, section 1.1235-1(b),
Income Tax Regs., and the legislative history pertaining to the
- 36 -
adoption of section 1235. The Commissioner concluded that
consistent with the legislative history and section 1.1235-1(b),
Income Tax Regs.:
it is the position of the Service that where holders
make transfers of patents that do not meet the
requirements for capital gains treatment under section
1235 of the Code, the tax consequences of such
transfers will be determined under other sections of
the Code.
* * * * * * *
Therefore, the mere fact that a patent transfer by
a holder for contingent amounts does not qualify for
long-term capital gains treatment under section 1235 of
the Code, will not prevent it from qualifying for such
treatment under other provisions of the Code if it
would qualify for such treatment in the absence of
section 1235. * * * To the extent that the rationale
of the court in the Poole case may be construed as
contrary to the conclusion in this Revenue Ruling it
will not be followed.
Accordingly, the taxpayer in the instant case is
entitled to treat the transfer of all substantial
rights in the patent as the sale or exchange of a
capital asset and the gain therefrom is reportable as
long-term capital gain. [Rev. Rul. 69-482, 1969-2 C.B.
at 164-165.]
In previous cases concerning the income characterization of
patent payments, the Commissioner has been consistent in adhering
to its position in Rev. Rul. 69-482, 1969-2 C.B. 164. See, e.g.,
Omholt v. Commissioner, 60 T.C. 541, 547 n.7 (1973) (consistent
with his position stated in Rev. Rul. 69-482, supra, the
Commissioner made no argument that capital gain treatment is
prohibited by section 1235; accordingly, the decision in this
opinion was not made on that basis); Chu v. Commissioner, 58 T.C.
- 37 -
598, 608 n.1 (1972) (Government made no argument that the amounts
in issue constituted ordinary income solely on the basis that
capital gain treatment is not permitted under section 1235
because the taxpayer's ownership of stock exceeded the limits set
out in section 1235(d)), affd. 486 F.2d 696 (1st Cir. 1973);
Busse v. Commissioner, 58 T.C. 389, 392 n.4 (1972) (Commissioner
conceded pursuant to Rev. Rul. 69-482, supra, that the taxpayer-
holder was entitled to capital gain treatment of his receipts
from the sale of a patent to a related party under sections of
the Code other than section 1235), affd. 479 F.2d 1147 (7th Cir.
1973); see also Rev. Rul. 78-328, 1978-2 C.B. 215 (citing Rev.
Rul. 69-482, supra); Priv. Ltr. Rul. 83-26-035 (Mar. 25, 1983)
(same); Tech. Adv. Mem. 84-21-006 (Jan. 31, 1984) (same).
Except for his argument that the facts of the instant case
are distinguishable from the facts in Poole v. Commissioner,
supra, respondent has made no argument that Rev. Rul. 69-482,
supra, has no application in this case. We find that the
essential facts of Poole v. Commissioner, supra, are present in
this case, that in the hands of Lea, the patents were long-term
capital assets as defined in section 1221, and that the Leas
satisfy the requirements of the ruling.10
10
We note that sec. 1239(a), I.R.C. 1954 (as amended),
requires ordinary income treatment of the gain recognized by the
sale or exchange of property to a related person, if the property
(continued...)
- 38 -
Previously, in similar situations, we have treated
respondent's position in a revenue ruling as a concession of the
issue. See Walker v. Commissioner, 101 T.C. 537, 550 (1993);
Norwood v. Commissioner, 66 T.C. 467, 469 (1976); Merritt v.
Commissioner, T.C. Memo. 1995-44; Stalcup v. Commissioner, T.C.
Memo. 1995-43; Burleson v. Commissioner, T.C. Memo. 1994-130;
Nikkila v. Commissioner, T.C. Memo. 1993-628; Boice v.
Commissioner, T.C. Memo. 1993-627; Callison v. Commissioner, T.C.
Memo. 1993-626; see also Alumax Inc. v. Commissioner, 109 T.C.
133, 163 n.12 (1997) (although revenue rulings are not regarded
as precedent in this Court, as they merely represent the position
of the Commissioner on a particular issue, the public generally
has the right to rely on positions taken by the Commissioner in
revenue rulings), affd. 165 F.3d 822 (11th Cir. 1999); American
Campaign Academy v. Commissioner, 92 T.C. 1053, 1070 (1989) (it
seems self-evident that in general a taxpayer may rely on a
revenue ruling where parallel facts place the ruling in the
posture of a concession by the Commissioner as to the analogous
taxpayer); Nissho Iwai Am. Corp. v. Commissioner, 89 T.C. 765,
778 (1987) ("The public has a right to rely on positions taken by
10
(...continued)
in the hands of the transferee is subject to the allowance for
depreciation. This section is not applicable in the instant case
because Cascade and Lea are not related persons as defined under
the applicable sections. See sec. 1239(b) and (c), I.R.C. 1954
(as amended).
- 39 -
the Internal Revenue Service in published revenue rulings.
Having made a concession in * * * [the revenue ruling], we
believe respondent should be so bound."); ZuHone v. Commissioner,
T.C. Memo. 1988-142 (revenue rulings are not authority binding on
this Court, but they may, in certain circumstances, constitute an
admission or concession by the Commissioner), affd. 883 F.2d 1317
(7th Cir. 1989); see also Rev. Proc. 89-14, sec. 7.01(5), 1989-1
C.B. 814 (taxpayers generally may rely upon published revenue
rulings in determining the tax treatment of their own
transactions).
It is clear from Rev. Rul. 69-482, supra, that it is
respondent's position that the tax consequences of transfers by
holders of patents to related persons that do not meet the
requirements for capital gains treatment under section 1235 will
be determined under other sections of the Code. The ruling has
not been revoked, modified, or obsoleted, nor has the law
changed. We, therefore, treat respondent's position in Rev. Rul.
69-482, 1969-2 C.B. 164, as a concession that the Leas are
entitled to treat the payments as long-term capital gains from
the sale or exchange of the patents if they can establish that
they meet the factual requirements of the ruling. Since we have
found that they meet those requirements, the Leas are entitled to
long-term capital gain treatment of all the patent payments in
issue.
- 40 -
To reflect the foregoing,
Decisions will be entered for
petitioners.