On the basis of numerous adjustments respondent determined deficiencies in petitioner's income tax liability for the calendar years 1938 and 1939 in the respective amounts of $11,408.33 and $2,599.33. Petitioner claims a refund for the calendar year 1938. In his answer and by stipulation respondent has conceded error in computing depreciation allowable to petitioner in each of the calendar years here involved on buildings on a farm in Culpeper County, Virginia. Two issues remain for our consideration. The first is whether petitioner is taxable on certain royalty payments received by his wife in each of the calendar years. The second question is what basis, if any, petitioner had in certain common stock sold by him in 1938. The case was submitted upon a stipulation of facts. The facts stipulated are so found.
FINDINGS OF FACT.
Petitioner is an individual with his address at 52 Williams Street, New York, N.Y. Petitioner's income tax returns for the calendar years 1938 and 1939 were filed with the collector of internal revenue for the second district of New York at New York, N Y
Kodachrome royalty issue. — Prior to 1935 petitioner rendered certain services to the New York Foreign Development Corporation, a corporation formerly existing under the laws of the State of New York, in connection with the financing of a process known as "Kodachrome," used in the manufacture of colored film. For the rendition of such services, petitioner was entitled to receive a certain percentage of the royalties on the process. All royalties on such process (except certain flat royalties payable directly to the inventors, which are not here in question) were, pursuant to an assignment, dated November 1, 1930, by Mannes and Godowsky, the inventors of the process, payable by the Eastman Kodak Co. to Kuhn, Loeb Co., as trustees. Kuhn, Loeb Co. thereupon paid such royalties to those entitled to receive them.
The following is a copy of the assignment above mentioned:
NOVEMBER 1, 1930.
Messrs. KUHN, LOEB CO. 52 Williams Street, New York City.
DEAR SIRS: For a valuable consideration, receipt whereof is hereby acknowledged, we hereby assign to Kuhn, Loeb Co., their successors and assigns, as trustees, all royalties payable to us under a license agreement and an option agreement of even date between us and The Eastman Kodak Company, copies of which are hereto annexed, other than royalties payable under paragraph 5 of said license agreement. We hereby agree to give written notice of this assignment to The Eastman Kodak Company and from time to time at your request to execute and deliver such other or further instruments of assignment as you may deem necessary or appropriate.
This assignment shall bind our heirs, executors and assigns.
Yours very truly,
[Signed] LEOPOLD D. MANNES LEOPOLD GODOWSKY, JR.
It is alleged in the petition and admitted in the answer herein that "In 1935 the petitioner was the owner of an interest in the Kodachrome process of manufacturing color film."
On or about December 20, 1935, petitioner wrote and delivered the following letter to his wife:
This is to evidence that I have, as of today, assigned and transferred over to you, absolutely and irrevocably all my right, title and interest in Kodachrome, manufactured by the Eastman Kodak Company. I am sending a copy of this letter to Kuhn, Loeb Co. for their records.
I take great pleasure in making this gift to you.
On or about December 20, 1935, petitioner wrote a letter to Kuhn, Loeb Co. notifying them of the assignment of royalties to his wife.
During 1938 petitioner's wife received from Kuhn, Loeb Co., pursuant to the assignment, $10,209.50 in royalties paid upon the Kodachrome process, and during 1939 she received $14,183.94 in such royalties. All these royalties were paid for periods beginning after 1935. Petitioner's wife included such amounts in her Federal income tax returns for the years 1938 and 1939, respectively, and paid income tax thereon. She has timely filed protective claims for refund for those years in view of respondent's position that the royalties are properly taxable to petitioner.
In determining the deficiencies here involved respondent included the amounts of the above mentioned royalties in petitioner's income for the respective taxable years, explaining that such income "was received in payment for services rendered" by petitioner.
Polaroid stock basis issue. — On or about August 10, 1937, the petitioner, pursuant to an agreement dated that day, between Kuhn, Loeb Co. and Schroeder, Rockefeller Co., parties of the first part, and Edwin H. Land, Helen M. Land, and George W. Wheelwright, 3rd, parties of the second part, which agreement was entered into by Kuhn, Loeb Co., as agent for the petitioner and others, agreed to purchase 450 shares of 5 per cent cumulative class A stock, par value $100 per share (a first preferred stock, as described in the agreement) of Polaroid Corporation, a Delaware corporation to be later formed (hereinafter referred to as Polaroid) at a price of $100 per share, or an aggregate purchase price of $45,000. As a bonus in connection with the purchase of the class A stock, the petitioner, pursuant to paragraph 5 of the agreement, was to receive 1,350 shares of the common stock, par value $1 per share.
Polaroid was organized on September 13, 1937, with a capitalization of 7,500 shares of 5 per cent cumulative class A stock of the par value of $100 per share, 2,500 shares of $5 cumulative class B stock of the par value of $5 per share, and 100,000 shares of common stock of the par value of $1 per share, for the purpose of developing certain patents and patent applications relating to a process of light polarization, known as the "Polaroid" process. Polaroid, on September 20, 1937, acquired all the patent rights still held by Edwin H. Land and all the shares of stock of various companies then owned by the Lands and Wheelwright, which companies had been formed from time to time for research, manufacturing, patent-holding or other purposes. In consideration for the above mentioned patents, patent applications, and stock, Polaroid issued to the Lands and Wheelwright all (2,500 shares) of its authorized $5 cumulative class B stock, par value $5 per share (a second preferred stock, as described in the agreement of August 10, 1937) and all (100,000 shares) of its then authorized common stock.
The common stock of Polaroid, to the extent of 71,500 shares, was made subject to a voting trust agreement dated as of September 20, 1937, between Polaroid and Edwin H. Land, George W. Wheelwright 3rd, and Julius Silver, trustees, leaving a balance of 28,500 shares of common stock, which was disposed of as follows:
(a) 22,500 shares were delivered as a bonus in connection with the acquisition of the class A stock of Polaroid under the above mentioned agreement dated August 10, 1937.
(b) 5,000 shares were sold in units in connection with the class B stock of Polaroid, as will be described hereinafter.
(c) 1,000 shares were retained by the Lands and Wheelwright.
The 5,000 shares of free common stock of Polaroid which are referred to in (b) above were sold in units in connection with the class B stock, pursuant to agreements dated August 10, 1937, to 4 firms and individuals. Five units, each consisting of 250 shares of the $5 cumulative class B stock of Polaroid and 1,000 shares of common stock of Polaroid, were sold at the price of $50,000 per unit. Delivery of these units was made on or about September 24, 1937, and on or about October 18, 1937.
It was provided in paragraph 1 of the agreement of August 10, 1937, that the class A stock was preferred as to dividends and redemption under voluntary liquidation over the class B stock and the common stock, and that the class B stock was preferred as to dividends and redemption upon voluntary liquidation over the common stock. However, upon involuntary liquidation, the net assets were to be distributed pro rata, share and share alike, among the holders of the class A stock, of the class B stock, and of the common stock. The class A stock was redeemable in whole or in part at the option of the corporation on notice of not less than three months at the par value thereof, plus all accrued and unpaid dividends thereon, provided that a similar proportion of the outstanding class B stock should be redeemed at the same time at the redemption price of $100 per share, plus all accrued and unpaid dividends thereon. The agreement provided in paragraph 4 thereof that Kuhn, Loeb Co. and Schroeder, Rockefeller Co. jointly and severally agreed to purchase 7,500 shares of the class A stock at the price of $100 per share, as follows:
(a) On at least 3 days' notice of the performance of the agreement on the part of the corporation. The firms above named were to pay $375,000 for the delivery of stock certificates representing 3,750 shares of class A stock; and
(b) The corporation might call upon the firms above named from time to time prior to December 31, 1939, to take up and pay for all or any part of the remaining 3,750 shares of class A stock at the purchase price of $100 per share.
Paragraph 5 of the agreement provided that the corporation upon the purchase of the first 3,750 shares of class A stock would transfer and deliver to the purchasers as a bonus 22,500 shares of common stock.
In paragraph 7 of the agreement an option was granted to the purchasers above named to purchase voting trust certificates representing 5,000 shares of common stock during the following option periods at the following prices:
(a) $25 per share if delivery date shall be within the first year of the corporation's existence.
(b) $37.50 per share if delivery date shall be within the second year of the corporation's existence.
(c) $50 per share if delivery date shall be within the third year of the corporation's existence.
(d) $100 per share if delivery date shall be within the fourth year of the corporation's existence. Such option was to expire at the close of the fourth year.
It was provided further that if the purchasers should take up and pay for any part or all of the additional 3,750 shares of class A stock, the price per share of the voting trust certificates would be reduced by $5 per share.
The petitioner acquired 225 shares of the class A stock of Polaroid pursuant to the agreement of August 10, 1937, and paid $22,500 therefore on or about September 24, 1937. At the same time the petitioner received 1,350 shares of common stock as a bonus. During 1939 petitioner acquired an additional 225 shares of class A stock for which he paid $22,500.
During October and November 1938 the petitioner sold 500 shares of the common stock of Polaroid mentioned above for an aggregate net price of $23,461.65. In his income tax return for 1938 petitioner used as a cost basis the amount of $7,100 for the 500 shares sold in 1938 and reported a short term capital gain of $16,361.65. The Commissioner has determined that the petitioner's cost basis upon such 500 shares is zero and that the petitioner upon such sale realized a short term capital gain of $23,461.65. The petitioner retained the balance of the common stock and did not sell any of the class A stock of Polaroid during 1937 or 1938. No class of stock of Polaroid was listed on any securities exchange in 1937. There were no quotations available on any class of the stock of Polaroid in the over-the-counter market in 1937. With certain exceptions, the common stock carried exclusive voting privileges.
A condensed consolidated balance sheet of Polaroid and its subsidiaries as of December 31, 1937, follows:
ASSETS Current assets: Cash ..................................... $330,713.81 Accounts and notes receivable ............ 12,445.16 Net inventories .......................... 9,292.43 ----------- Total current assets ................... 352,451.40 Other assets: Deferred expenses ........................ $459.79 Organization expense ..................... 2,933.01 Advances to foreign company .............. 1,117.46 -------- Total other assets ..................... 4,510.26 Laboratory equipment, machinery and furniture — net .................. 23,153.25 Patents — net .......................... 142,220.46 Prepaid officer's life insurance ............. 4,258.17 ---------- Total assets ........................... 526,593.54 ---------- LIABILITIES Accounts payable ............................. 11,512.64 CAPITAL AND SURPLUS Capital stock .............................. $487,500.00 Capital surplus ............... $18,757.50 Earned surplus, Jan. 1, 1937 .. 145.51 Net income for year 1937 ...... 8,677.89 ---------- 27,580.90 Total capital and surplus .............. 515,080.90 ---------- Total liabilities and capital .......... 526,593.54 The figure of $487,500 appearing on the balance sheet as "capital stock" was computed as follows: 3,750 shares of 5 per cent cumulative class A stock issued and outstanding (par value $100 per share), $375,000; 2,500 shares of $5 cumulative class B stock issued and outstanding (par value $5 per share), $12,500; and 100,000 shares of common stock issued and outstanding (par value $1 per share, of which 71,500 shares were represented by voting trust certificates), $100,000.
The relative value per share of the common stock of Polaroid was one-fourth of the value per share of the class A stock at the time of acquisition thereof by petitioner. An allocation of the cost per share of the total cost of $22,500 for 225 shares of class A stock and 1,350 shares of common stock between such two classes of stock, in accordance with the above stated relative value per share value, is practicable and reasonable.
OPINION.
HILL, Judge:
Kodachrome royalty issue. — Petitioner contends that the amounts received by his wife as royalties under his assignment to her of his interest in "Kodachrome" were not compensation for services which he rendered to New York Foreign Development Corporation, but that he was fully paid for such services by the inventor's assignment to him of an interest in the Kodachrome process royalties. Petitioner contends that by such assignment he acquired the ownership of a property right in the Kodachrome process. Such ownership is admitted by respondent in his answer to the petition herein. Petitioner contends that the services which he rendered to the New York Foreign Development Corporation were the consideration for the vesting in him of such ownership and were fully paid thereby. He contends that the operation whereby he acquired such ownership was a closed transaction and that the royalties in question were income attributable to the ownership of such property right and were not compensation for services or earnings attributable to services. Petitioner contends that the assignment to his wife was, as the language thereof indicates, an assignment of his ownership in "Kodachrome" and that after such assignment he had no interest in the Kodachrome process, but that the royalties herein sought to be taxed to him were received by his wife as the income from property which she, herself, owned. Accordingly, petitioner claims that he is not taxable on the income represented by such royalties. He relies primarily upon Nelson v. Ferguson, 56 F.2d 121; certiorari denied, 286 U.S. 565; and Blair v. Commissioner, 300 U.S. 5.
Respondent's position is that this case is squarely within the rule of Helvering, v. Horst, 311 U.S. 112, and Helvering v. Eubank, 311 U.S. 122. On brief respondent does not mention the Ferguson case, but, notwithstanding his admission that petitioner owned an interest in the Kodachrome process at the time of the assignment which he made to his wife, attempts to distinguish the Blair case in the same way it was distiguished by the Supreme Court in the Horst opinion, that is, on the ground that the petitioner did not assign any income-producing property, but merely assigned the benefits of an obligation to pay compensation to petitioner. In other words, respondent's position, as we understand it, is that the royalties from the Kodachrome process were compensation to petitioner for his services to the New York Foreign Development Corporation, regardless of the admission in the pleadings that petitioner had ownership of an interest in such process.
We are unable to deduce from the record that petitioner could have acquired such ownership other than as compensation for his services to the New York Foreign Development Corporation. It is, therefore, beyond our conception that the compensation for such services was the receipt of the royalties.
Aside from respondent's admission that petitioner owned an interest in the Kodachrome process, we think it clearly appears from the facts herein that petitioner acquired ownership of such interest in consideration for and in full payment of his services to the New York Foreign Development Corporation.
There seems to be little doubt that prior to the Horst and Eubank decisions of the Supreme Court a contract right to a certain percentage of royalties on an invention was itself income-producing property and that the holder of such a right was taxable on the royalties paid thereunder. Numerous decisions to that effect were relied upon by the taxpayer in Estate of J. G. Dodson, 1 T.C. 416, where apparently for the first time we were asked to review the question here presented in the light of the Horst and Eubank cases. Contentions quite similar to those here advanced were made by the parties in the Dodson case and the respondent there requested that we reexamine the whole question of anticipatory arrangements. With respect to that request we commented as follows:
We have read carefully, and with respect, the opinions of the Supreme Court relied upon by respondent, and find nothing therein which directly and explictly contravenes the propositions advanced by the petitioner to the effect that the donee and not the donor of income-producing property is taxable on the income derived therefrom, and that a royalty contract is property.
It is true that in the Dodson case we held the decedent-assignor taxable on the royalty payments on the ground that for all substantial and practical purposes he had retained ownership of the royalty contract itself and that he had not effectively assigned to his wife any interest therein. The significant and controlling fact there was the assignor's control over the corporation which had contracted to pay him the royalties. Cf. Joseph Sunnen, 6 T.C. 431, which presents a similar degree and type of control over the royalty payments. While, therefore, the paragraph quoted above was not the basis of our decision in the Dodson case, we think the observations contained therein are correct and that it follows therefrom that petitioner should be sustained here.
The Horst case is obviously distinguishable in that the taxpayer there assigned interest payable on a bond, but retained the bond itself, and thus had not divested himself of the income-producing asset, but had merely given the right to the income to another. Lewis v. Rothensies, 61 Fed. Supp. 862; affd., 150 F.2d 959, is similarly distinguishable, for the taxpayer there did not assign his contract right to royalty payments, but merely assigned certain royalties. Under the terms of petitioner's letter of assignment to his wife there can be no doubt that he intended to and did transfer to her his entire interest in the Kodachrome process and in the royalty contract. He thus parted with the income-producing asset itself and met the requirement of Blair v. Commissioner, supra. Hence, the Horst case does not apply.
The facts of the Eubank case are not similar to those here. That decision extended the doctrine of Lucas v. Earl, 281 U.S. 111, to require that one performing services, rather than his assignee, be taxed on the compensation for such services even though the payments become certain in amount only subsequent to the completion of the services.
The basis for such holding is that the renewal commissions were compensation additional to the compensation received for services rendered in procuring initially policies of insurance on which renewal premiums were paid. The commissions in question were paid by the insurance companies which owned the insurance contracts in respect of which the renewal premiums were paid. Eubank had no interest or property right in such contracts. He had only the right to compensation from the insurance companies measured by a percentage of the renewal premiums paid on the insurance contracts which he had been instrumental in procuring under employment by the insurance companies. Eubank merely assigned his right to such compensation as and when realized. The Supreme Court said in its opinion therein:
No purpose of the assignments appears other than to confer on the assignees the power to collect the commissions, which they did in the taxable year. The Government and respondent have briefed and argued the case here on the assumption that the assignments were voluntary transfers to the assignees of the right to collect the commissions as and when they became payable, and the record affords no other basis.
In the instant case petitioner earned compensation for services rendered to the New York Foreign Development Corporation, for which he was paid by the vesting in him of ownership of an interest in the Kodachrome process. This process was an income-producing asset and produced income in the form of royalties. Such royalties were not the earnings of petitioner and were not compensation for services rendered by petitioner. They were the increment of an investment in income-producing property. He assigned this property to his wife and she received the royalties in question in the taxable years here involved by reason of her ownership of the property from which the royalties flowed.
We think it apparent that, because of the wide dissimilarity between the facts in the Eubank case and in the instant case, the principle announced by the Supreme Court on the facts of the former is not applicable here. We accordingly hold that respondent erred in taxing to petitioner the royalties received by his wife in 1938 and 1939.
Polaroid stock basis issue. — Both parties are agreed that the applicable method for determining the basis of the Polaroid common stock is prescribed by Regulations 101, art. 22 (a)-8, which provides in part:
* * * If common stock is received as a bonus with the purchase of preferred stock or bonds, the total purchase price shall be fairly apportioned between such common stock and the securities purchased for the purpose of determining the portion of the cost attributable to each class of stock or securities, but if that should be impracticable in any case, no profit on any subsequent sale of any part of the stock or securities will be realized until out of the proceeds of sales shall have been recovered the total cost.
Respondent contends that the cost to petitioner of acquiring the class A and the common stock should all be allocated to the class A stock. Petitioner claims that the common stock had some value when acquired, but that it is impracticable to make any allocation as between the class A and common stock and that therefore no profit should be considered as realized until total cost has been recovered.
We think the record indicates, and we have made findings of fact as to, the relative value per share of the common stock and of the class A stock of Polaroid at the time of acquisition thereof by petitioner, and that in accordance with the relative per share value as so found an allocation of the cost per share of the total cost to petitioner of 225 shares of class A stock and 1,350 shares of common stock is practicable and reasonable. We find warrant for these findings in the following underlying facts of record: (a) The redemption value of both the class A and the class B stock was $100 per share; (b) the minimum option price of the common stock was $25 per share; (c) the sale price of the class A stock was $100 per share; and (d) the sale price of a unit of 250 shares of B stock and 1,000 shares of common stock was $50,000.
The common stock, the sale of which is here involved, was part of a common stock bonus in the sale to petitioner of 225 shares of A stock at $100 per share. The sale price of the 1,000 shares of common stock sold in a unit with 250 shares of B stock for $50,000 was obviously not less than $25 per share, since the 250 shares of B stock in such unit were redeemable at $100 per share. Hence the portion of the $50,000 unit sale price allocable to the 1,000 shares of common stock in such unit was not less than $25,000.
We, therefore, hold that, for the purpose of determining the gain realized by petitioner on the sale of 500 shares of the common stock of Polaroid in 1938, the cost basis of such stock should be computed in accordance with our finding of the relative value per share as between the common stock and the class A stock, as hereinabove indicated.
Reviewed by the Court.
Decision will be entered under Rule 50.
TURNER, J., dissents.