*124 Decision will be entered under Rule 50.
1. Upon the record, held, that payments made by petitioner to its two principal stockholders during 1942 and 1943 were for the use of a secret formula used by petitioner in its manufacturing business and are deductible for income tax purposes as ordinary and necessary business expense.
2. Held, that payments made to one of petitioner's officers and shareholders as salary for the years 1942 and 1943 were reasonable in amount and that such payments are deductible from its gross income.
*218 *51 The respondent determined deficiencies as follows:
| 1942, declared value excess profits tax | $ 265.55 |
| 1942, excess profits tax | 19,788.92 |
| 1943, income tax | 809.93 |
*125 Petitioner has appealed from respondent's determination of deficiencies in its excess profits tax for 1942 and its income tax for 1943.
*52 The issues are:
(1) Is petitioner entitled to claim as deductions from gross income during the taxable years 1942 and 1943 amounts paid to each of two of its three stockholders as royalties for the use of a formula for a concrete-curing product?
(2) Do the deductions claimed by petitioner in each of the taxable years 1942 and 1943 as salary to one of its officers represent reasonable allowances for compensation for personal services rendered?
Petitioner filed its income tax returns for the period here involved with the collector of internal revenue for the fifth district of New Jersey at Newark.
FINDINGS OF FACT.
Royalty issue. -- The petitioner is a corporation which was organized under the laws of the State of New Jersey on January 24, 1933.
During the taxable years 1942 and 1943 the issued and outstanding 1,000 shares of stock were owned as follows: Robert Strange, 600 shares; Carl Kastner, 300 shares, and Kaye McNamara, 100 shares.
Petitioner's officers during 1942 and 1943 were Carl Kastner, president; Robert Strange, vice president; *126 and Kaye McNamara, secretary-treasurer. Petitioner's board of directors was composed of the same three persons.
Petitioner was organized principally for the purpose of manufacturing and selling the patented wall products "Plastorene" and "Morene" under the terms of a license agreement executed between it and Plastorene, Inc., on January 31, 1933. All of petitioner's 1,000 shares of no par value stock were given to Plastorene, Inc., as part of the consideration for that license. In the agreement, petitioner also promised to pay Plastorene, Inc., "a royalty of $ .01 per pound on each pound of Plastorene, and $ .25 per gallon on each gallon of Morene manufactured and sold by the Licensee."
Shortly before December 31, 1937, Robert Strange, a licensed attorney and petitioner's principal stockholder, obtained a judgment in the Supreme Court of the State of New York against Plastorene, Inc. Execution under the judgment was returned unsatisfied. On December 31, 1937, Plastorene, Inc., executed an assignment to Strange of all its assets, including the above mentioned license agreement. Since that time Strange has been paid the royalties due under that agreement.
During 1934 petitioner*127 employed Carl Kastner, a licensed civil engineer, to install the equipment and machinery necessary for the manufacture of Morene and Plastorene. Kastner continued in the employ of petitioner on a part time basis from that time through the taxable years *53 here involved. During this period he assisted petitioner principally in the manufacturing and selling of its products.
During 1934 Johnson March Co. contacted Strange relative to whether petitioner would manufacture a concrete-curing material known as Ritecure. Petitioner agreed and a contract was executed (the date is not shown) providing that Johnson March Co. would supply the equipment and materials and that petitioner would manufacture the product. In a short time petitioner found that it could not continue manufacturing Ritecure, due to the highly explosive nature of one of the basic ingredients used in its production. It was then that Strange and Kastner first discussed the matter of developing their own formula for curing concrete. After Strange supplied Kastner with certain data concerning concrete-curing materials which he had obtained from chemists formerly employed by him, Kastner began experimenting in his*128 home laboratory in an effort to develop a formula.
Johnson March Co., shortly after petitioner discontinued manufacturing Ritecure, perfected another formula for this material and again asked petitioner to manufacture the product. Petitioner agreed and manufactured this product for Johnson March Co. until the latter part of 1940.
By this time Kastner, in the employ of Strange, had developed a formula which they felt would produce a satisfactory concrete-curing material. Kastner prepared a sizable quantity of this product, some of which was sold. These sales proved the product was commercially successful.
Strange and Kastner, during 1941, began negotiations with petitioner concerning the manufacturing and selling of the involved concrete-curing material. During this time the problem of naming the product arose. It was determined that the material would be called "Klearcure." Petitioner made application for the trade-mark "Klearcure" in the latter part of 1942. The trade-mark was granted two or three months later.
In early 1942 this material passed the Army moisture retention test. In a "Tentative Specification for Curing" published by the War Department on May 8, 1942, the following*129 is stated:
* * * A compound will be approved if, in the opinion of the Contracting Officer, laboratory tests and field performance demonstrate that the above characteristics are equal to those secured with Klearcure (No. 70), SealKure, TruCure (No. FX-199 or 203), or Aquastatic (1-C, 1 FMST, or black) as submitted for test at the Central Concrete Laboratory, Mount Vernon, N. Y. in June 1942.
Petitioner's facilities were never used in the development of the formula and petitioner never employed Kastner, or *219 any one else, to do *54 experimental work in connection with it. Kastner and Strange never applied for a patent for the formula, for they believed that to do so would have made a public record of the ingredients of the formula and also of the technique of the manufacturing process thereof. The formula was simple and a competent chemist could break it down into its constituent elements. Hence, it was feared that, if the technique of the manufacturing process were revealed through proceedings for a patent, a workable competing formula might be involved, thereby entailing trouble and expense to prevent infringement of their invention. Strange and Kastner believed that their*130 invention would be better protected without than with a patent.
On January 15, 1942, Kastner, Strange, and Kaye McNamara, acting in their capacities as directors of petitioner, accepted, on behalf of petitioner, Strange's and Kastner's offer to permit petitioner to manufacture and sell Klearcure. In exchange, Strange and Kastner were to receive payments from petitioner based upon a percentage of the proceeds from each gallon of the product sold from and after January 1, 1942. The board of directors passed a resolution at a special meeting held on June 24, 1942, which provided as follows:
Resolved, that the royalties to be paid Messrs. Strange and Kastner, under the license agreement made by this corporation on January 15th, 1942, be fixed at nine (9 cents) cents per gallon, payable five (5 cents) cents per gallon to Strange and four (4 cents) cents per gallon to Kastner, and that said agreement as herein supplemented, be ratified and confirmed by this corporation.
The formula for Klearcure was known to only Strange and Kastner. Kastner was the only person who measured and supervised the mixing and processing of the formula's ingredients. He, alone, knew the technique of the manufacture*131 of Klearcure. In such manufacturing operation Kastner acted exclusively in the capacity of an employee of petitioner. Without his services in the application of his knowledge of the formula and his technical skill in processing the ingredients thereof, petitioner could not have manufactured Klearcure.
For each of the years 1934 to 1941, inclusive, petitioner reported annually a net loss on its income tax returns. For the years 1939 through 1946, inclusive, petitioner's net sales were as follows:
| 1939 | $ 11,138.98 |
| 1940 | 16,023.59 |
| 1941 | 38,117.55 |
| 1942 | 145,340.32 |
| 1943 | 51,449.00 |
| 1944 | 18,891.00 |
| 1945 | 15,040.01 |
| 1946 | 29,715.53 |
During 1942 petitioner sold 213,718 gallons of Klearcure for the amount of $ 121,208.54. During 1943 petitioner sold 51,316 gallons of that product for $ 34,620.42. At the end of the taxable year 1942 petitioner had a deficit in earned surplus of $ 7,925.69.
*55 During the taxable years 1942 and 1943 petitioner made payments to Strange and Kastner as follows:
| Royalties for | ||||
| manufacture | Payments | |||
| Year | and sale of | for use of | Salary | |
| Plastorene | Klearcure | |||
| and Morene | formula | |||
| Strange | 1942 | $ 2,119.55 | $ 10,685.90 | |
| 1943 | 820.80 | 2,565.80 | ||
| Kastner | 1942 | 8,548.72 | $ 8,000 | |
| 1943 | 2,052.64 | 7,000 |
*132 During the taxable years 1942 and 1943 petitioner owed Strange $ 26,000. It reported a net income of $ 21,738.91 for the taxable year ended December 31, 1942, and paid Federal taxes in the amount of $ 15,217.46. It reported a net loss of $ 3,578.71 for the taxable year ended December 31, 1943.
In determining the deficiencies herein respondent disallowed as deductions the amounts paid to Strange and Kastner for the sale of Klearcure during the years 1942 and 1943.
Strange and Kastner, for a valuable consideration, gave exclusive permission to petitioner to use their formula in the manufacture and sale of Klearcure. The payments made by petitioner to Kastner and Strange during 1942 and 1943 for the manufacture and sale of Klearcure were ordinary and necessary expenses incurred in a business regularly carried on.
Compensation issue. -- Kaye McNamara has been employed by petitioner since 1933 and through the taxable years 1942 and 1943. Her salary from 1933 through 1946 was as follows:
| 1933 | $ 1,450 |
| 1934 | 1,820 |
| 1935 | 1,145 |
| 1936 | 1,187 |
| 1937 | 1,342 |
| 1938 | 1,430 |
| 1939 | 1,575 |
| 1940 | 1,772 |
| 1941 | 2,563 |
| 1942 | 6,700 |
| 1943 | 5,500 |
| 1944 | 3,500 |
| 1945 | 3,500 |
| 1946 | 3,500 |
During the early*133 part of 1942 Kaye indicated she wanted her salary to be *220 increased to $ 7,000 per year. Strange believed that petitioner should pay her only $ 5,000 per year. At a board of directors' meeting attended by Strange, Kastner, and Kaye, held January 15, 1942, a resolution was passed to the effect that final determination of the amount of salary to be paid to Kaye would be postponed until later in the year and that meanwhile she should receive $ 50.50 per week. Disagreement concerning her salary continued through the spring, summer, and fall of 1942. Kastner threatened to resign unless Kaye's salary was increased. The relationship between Strange and Kaye became very strained. Finally, Frank C. Myers, Strange's law partner, *56 was asked to help work out a satisfactory agreement. Myers recommended, after an investigation that $ 6,700 was reasonable compensation for Kaye's services. At a board of directors' meeting held December 15, 1942, a resolution was adopted providing that Kaye's salary should be $ 6,700 per year.
Another controversy concerning Kaye's wages arose in 1943. Myers again was asked to intervene. On the basis of his recommendation, it was agreed that she should*134 be paid $ 5,500 as salary during the year 1943.
During Kaye's employment with petitioner, she acted as its assistant manager and secretary-treasurer. She was concerned primarily with sales, contacting customers, ordering materials, and making shipping arrangements. In addition, she kept the company books, made out all the bills, and did collection work. In 1942 and 1943 her duties were much increased by reason of petitioner's greater volume of business in those years. Its net sales increased from $ 38,117.53 in 1941 to $ 145,340.32 in 1942 and $ 51,449 in 1943. The net sales decreased in the years 1944, 1945, and 1946 to $ 18,891, $ 15,040.01 and $ 29,715.53, respectively. By virtue of Kaye's long experience in buying materials for petitioner, she was able to procure certain scarce goods required for the manufacture of its products during 1942 and 1943.
In his determination of the deficiencies herein respondent disallowed as deductions $ 3,700 of the salary paid Kaye in 1942 and $ 2,000 of the salary paid her in 1943.
The compensation paid to Kaye by petitioner during 1942 and 1943 was reasonable. Petitioner is entitled to deduct from its gross income the full amount of the*135 compensation so paid to her during 1942 and 1943.
OPINION.
The first issue involves petitioner's claim that it has the right under section 23 (a) (1) (A) of the Internal Revenue Code1 to deduct from its gross income the payments made to Strange and Kastner for the use of their secret formula. The respondent contends that Strange and Kastner possessed no secret formula and, therefore, that they conveyed no property right to petitioner which could be the basis for payments of royalties. The evidence convinces us that they had such a formula during 1942 and 1943.
*136 *57 In Nimms, Unfair Competition and Trade Marks, 3d Ed. (1929), relied upon by respondent, it is stated in section 141:
* * * A secret may be property, just as land is property; for money and other value is often given in return for learning it. It somewhat resembles the property one has in an unpublished manuscript. The right to have exclusive knowledge of foreign financial news for fifteen minutes after its receipt by the Associated Press has been held property; so also the knowledge of secret processes of manufacture and formulae for making various articles. * * *
In Derenberg, Trademark Protection and Unfair Trading (1936), pp. 118 and 119, as quoted by respondent, it is stated:
Trade secrets were recognized as property rights at a comparatively early date by the Courts. Closer observation shows, however, that in most cases of this kind, even where the decision was based on the assumption of such a right, another concept of equity in fact turned the scales: the trust. That this consideration is paramount is at once obvious when it is recalled that the secret process or formula or whatever else the secret may consist of, ceases to be treated as a "property right" *137 as soon as a third party, through his own efforts or investigation or through any other fair means obtains knowledge of the other's secret. [Emphasis supplied.]
Respondent contends that Strange and Kastner had no property interest in *221 the formula. He points out that Kastner admitted the formula is simple and that a competent chemist could break Klearcure down into its constituent parts. He further states that the Army approved two other concrete-curing products which performed equally as well as Klearcure. There is no proof in the record, however, that those products were derived from the same formula as Klearcure, or that they consisted of the same material. So far as the evidence is concerned, at least through the years in question, the formula was secret. The property right of Strange and Kastner in the formula is not negatived by the fact that they had not applied for a patent. Respondent's argument on this point, therefore, is without merit.
Respondent cites two cases in support of his position. The first of these, Peterson & Pegau Baking Co., 2 B. T. A. 637, concerned payments made by a taxpayer to its two principal shareholders for the *138 use of an alleged secret process for baking bread. In rejecting the taxpayer's contention, we stated at page 639:
* * * We are not convinced that he is in possession of any particular method which could be the subject of a secret process for monopolistic use by either himself or the taxpayer. [Emphasis supplied.]
In other words, in that case the taxpayer did not prove the existence of a secret formula. In the instant case, on the other hand, petitioner has shown and we have found that such a secret formula did exist. In the second case, L. Schepp Co., 25 B. T. A. 419, we held that the idea of selling coconut to the retail trade in a container -- a mere method of distribution -- could not be the basis for the payment of *58 royalties. The secret formula here, however, is property and is a proper basis for the payments made.
There is no question of shop rights involved here, for Kastner was never employed by petitioner to develop the formula, nor did he use any of its facilities in his experiments.
Hence, in accordance with the authorities above cited, as we have found Kastner and Strange owned a secret formula for Klearcure, petitioner is*139 entitled to deduct as an ordinary and necessary expense the payments made to them for its use.
The second issue relates to petitioner's claim that the salaries of $ 6,700 and $ 5,500 paid to Kaye McNamara in the years 1942 and 1943, respectively, were reasonable compensation and therefore deductible from its gross income. The respondent urges that such compensation was unreasonable, and supports his argument by pointing out that the board of directors considered a salary of $ 5,000 per year for her services was reasonable in 1942 and that she was paid only $ 3,500 in the years 1944, 1945, and 1946. From the evidence, we believe the salaries paid to Kaye during 1942 and 1943 were reasonable. The amounts thereof were arrived at in arms' length negotiations and appear to have been necessary in order to retain in those years a character of service badly needed, if not indispensable.
Strange was the only member of the board of directors who maintained that $ 5,000 was a reasonable salary for Kaye's services. Of the other two members, Kastner indicated his belief that Kaye's demands should be met by threatening to resign if a satisfactory arrangement with respect to her wages could *140 not be made. And, of course, the remaining member, Kaye, was in favor of voting a substantial raise for herself. It is true that Kaye's wages were reduced in the three years immediately following 1943. However, petitioner's business declined considerably in those years and it is reasonable to assume, we believe, that her duties likewise decreased.
It is true that where, as here, payments are to a shareholder, the proof must show that the directors were not disguising distributions of profit in the form of salary. See L. Schepp Co., supra. The evidence, as above noted, shows that both in 1942 and 1943 there was sharp disagreement among Strange, Kastner, and Kaye concerning the latter's salary for those years. In fact, the conflict concerning her compensation became so prolonged and so detrimental to petitioner's operations that it was found necessary to call in an arbitrator to work out a compromise. These facts, we think, negative any argument that the board's agreement to increase Kaye's wages during 1942 and 1943 was an attempt to distribute profits in the guise of wages.
The record shows that during the years in question she took care of all *141 the billing, performed collection duties, did the bookkeeping and correspondence work, was in charge of traffic, and ordered the *59 materials needed for the manufacture of Klearcure and other products. Her duties were much increased over previous years because of the greater volume of business transacted by petitioner during 1942 and 1943. Due to her knowledge of where to buy materials, gained from her long experience in this work, she was particularly valuable during 1942 and 1943, when she was able to purchase for petitioner certain scarce materials required for the manufacture of its products.
*222 Accordingly, we hold that petitioner may deduct from its gross income the full amount of the salaries paid to Kaye during each of the involved taxable years.
Decision will be entered under Rule 50.
Turner, J., dissenting: In my opinion the facts in this case are not such as to justify the conclusion that petitioner's two stockholders, Strange and Kastner, were the owners of a secret formula used by petitioner which would supply a basis for the deduction under section 23 (a) (1) (A) of the Internal Revenue Code of amounts paid to them by petitioner as payments for*142 use of a secret formula. In my judgment the payments in question were nothing more than a distribution by petitioner of corporate profits to its principal stockholders.
Footnotes
1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
(a) Expenses. --
(1) Trade or business expense. --
(A) In General. -- All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including * * * rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property * * *.↩