William M. Bailey Co. v. Commissioner

*469 By this proceeding petitioner claims a refund, under Internal Revenue Code section 721 (a) (2) (C), of excess profits tax for 1942 and 1943, and challenges respondent's determination*71 of deficiencies in declared value excess profits tax and excess profits tax as follows:

Some adjustments are not contested, and the only questions, in addition to the 721 issue, are the deductibility of "royalties" paid in each year to petitioner's president, ¹ premiums paid in 1943 on an endowment policy insuring his life, and amounts entered on petitioner's books in 1943 as liabilities owing to subcontractors, where settlement was not made until 1945.

An issue raised by petitioner with respect to the disallowance of a claim for relief under section 722 was dismissed at the hearing for lack of jurisdiction.

The parties have filed stipulations of fact. Other evidence was adduced at the hearing.

FINDINGS OF FACT.

The stipulated facts are hereby found. Petitioner filed its returns for the years in question with the collector of internal*72 revenue for the twenty-third district of Pennsylvania at Pittsburgh.

Petitioner is a Pennsylvania corporation organized in 1920 as Bailey-Lewis, Incorporated. Its name was changed to William M. Bailey Co. in 1921. From 1921 to 1926 it was engaged in selling the products of New York Blower Co., Chicago, and Vulcan Iron Works, Wilkes-Barre, Pennsylvania. Since 1926 petitioner has specialized in designing and selling its own line of steel products used in and around blast furnaces and known as "blast furnace specialties." Petitioner does no manufacturing. All of its products are manufactured by other companies.

*470 Petitioner's principal products, their inventors, and the patents protecting each, are as follows:

*73 Facts Relating to Deduction of Royalties.

William M. Bailey, hereinafter called Bailey, has been president and a majority stockholder of petitioner since its organization. He is not an engineer or a college graduate. From 1900 to 1915 he was employed by Carnegie Steel Co. as office boy, stenographer, and secretary to the president, and from 1915 to 1919 by Midvale Steel Co. as secretary and assistant to the president.

Petitioner was authorized to issue 9,000 shares of $ 50 par value common stock. As of the dates indicated, its outstanding stock was held by the following persons:

A schedule comparing for each year in question the percentage of*74 royalties paid with the percentages of stock held and of compensation for services as employees paid to the recipients of the royalties is as follows: *471

*75 Of royalties paid by petitioner in the aggregate amounts of $ 74,187.09 and $ 114,140.77 in 1942 and 1943, respectively, Bailey received the following:

Royalties on the plate paid by petitioner to Bailey from 1934 through 1948 were as follows:

*472 Royalties have been regularly paid to McGee and Schulze on the thermal valve and to Bowland on the mechanical valve. The royalties on the thermal valve were paid*76 under a written agreement dated March 27, 1926, in which McGee and Schulze as "licensors" granted Bailey as "licensee" the "exclusive right to make, use and sell" the valves protected by three patents issued to the licensors. Bailey assigned the agreement to petitioner on November 5, 1927, in exchange for $ 25,000 worth of petitioner's stock.

The royalties on the mechanical valve were paid under a written agreement between petitioner and Bowland dated October 6, 1936, providing in part:

In lieu of the assignment of the Patent Application of Andrew Bowland and patent when it is granted on the design of our American Mechanical Goggle Valve, The William M. Bailey Company agrees to pay Andrew Bowland 3% on the net selling price of each and every valve of this design as long as it is necessary to pay F. E. Kling on his patent * * *. After this patent is run out in 1937, The Bailey Company agrees to pay Andrew Bowland 5% on the net selling price on this valve.

A written agreement of September 29, 1937, after the Kling patent had expired, repeated petitioner's undertaking to pay royalties of 5 per cent. The patent on the mechanical valve was issued to petitioner on July 26, 1938.

Petitioner*77 has never attempted to enforce "shop rights" to inventions of its employees. Petitioner has a mutual understanding with its employees that it will pay them royalties of 5 per cent on any inventions it markets.

Payment in the taxable years of royalties on the plate by petitioner to Bailey, the sums in dispute, were made under one oral and two written agreements. Royalties from 1934 to 1943 on plates installed in thermal valves were paid under the oral agreement reached at an undisclosed date subsequent to June 1933. Royalties on plates installed in mechanical valves were paid under a written agreement between petitioner and Bailey dated May 1, 1936, obligating petitioner

* * * to pay William M. Bailey Three (3%) per cent Royalty on the net selling price on each and every Mechanical Goggle Valve manufactured in which the Goggle Plate as covered by the above patent is used. This agreement to hold good during the life of the patent or as long as the plate is used on the Mechanical Goggle Valves and sold by the William M. Bailey Company.

A "Memorandum agreement" between the same parties dated April 8, 1943, provided:

The William M. Bailey Company agrees to pay William M. Bailey, Five*78 (5%) per cent Royalty on the net selling price of each and every Goggle Plate manufactured in accordance with his design as shown on above patent. This agreement *473 to hold good during the life of the patent or as long as this Plate is manufactured and is sold by The William M. Bailey Company. This royalty has been paid since the patent was issued but no formal agreement was ever signed. It is now felt that some form of agreement should be prepared and signed as a protection both to the Patentee and the Company.

By an agreement dated November 8, 1945, Bailey as "licensor" granted to petitioner as "licensee," in consideration of royalties,

* * * the sole and exclusive right and license to make, use and sell apparatus embodying the inventions described and claimed in the aforesaid letters patent to the full end of the terms for which such patents are granted.

Either party was authorized to terminate the 1945 agreement after 1 year on 60 days' notice "for sufficient cause, such as lack of development of designs of the Licensor to keep pace with competition, or improper conduct or neglect of business by the Licensee."

The three agreements between petitioner and Bailey dated*79 May 1, 1936, April 8, 1943, and November 8, 1945, were each signed twice by Bailey: as president of petitioner and in his individual capacity.

In his Federal income tax return for the year 1946, Bailey reported the royalties received in that year as long term capital gain on sale of the plate patent held for more than six months.

In its returns for 1942 and 1943, petitioner deducted in full the royalties paid, in the respective amounts of $ 74,187.09 and $ 114,140.77. Respondent allowed the deduction of royalties paid to Bailey on the checker; royalties paid to McGee, Schulze and Bowland on the valves; and all the other royalties except those paid to Bailey on the plate. In his notice of deficiency respondent determined that $ 5,580.72 and $ 11,443.59 in 1942 and 1943, respectively,

* * * allegedly representing royalty payments made to William M. Bailey, your President and principal stockholder, and taken as a deduction in your return under the caption "other deductions," * * * [are] not a proper deduction from your gross income.

Facts Relating to Deduction of Insurance Premiums.

In addition to Bailey, petitioner's officers during the years in question were as follows:

*80 Petitioner paid compensation to its officers and other employees in 1942 and 1943 as follows: *474

On December 17, 1941, petitioner entered into a trust agreement with its five officers, naming William Wallace Booth and Union Trust Co. of Pittsburgh (now Mellon National Bank and Trust Co.) as trustees. The agreement recited that petitioner was presently carrying insurance on the lives of Bailey, Bowland, Ferree, and Kusserow, with petitioner as beneficiary, for the joint purpose of providing petitioner with funds to purchase its stock upon their deaths and to compensate petitioner for loss caused thereby. Pursuant to the trust agreement, all insurance policies on the lives of the four officers, in the following aggregate face amounts, were deposited with the trustees:

*81 Premiums on the above policies were paid by the trustees with funds furnished by petitioner. No deduction for those premiums has been claimed in any year by petitioner.

The agreement further recited:

WHEREAS, the company [petitioner] now desires to apply for and will take out additional insurance of the endowment type * * * on the life of the said Bailey for the two-fold purpose of establishing a bonus plan for said employee beneficiaries and for the purpose of making further funds available for the purchase of the company's stock, which said policy shall be in the amount of $ 32,000.00 and the beneficiary thereof shall be the Trustees under this agreement * * *

On November 5, 1941, petitioner and Bailey had jointly applied for a 10-year endowment policy for $ 32,000 on Bailey's life, naming petitioner as beneficiary. The policy, being the $ 32,000 endowment policy referred to in the trust agreement, was issued on December 27, 1941, and was assigned by petitioner to the trustees under the agreement on January 30, 1942.

In connection with the $ 32,000 endowment policy on Bailey's life, the trust agreement further provided, in part:

Fourth: Upon the maturity of said endowment*82 policy otherwise than by the death of Bailey, the Trustees shall collect the proceeds of the policy and will *475 purchase from Bailey and/or his wife, Mrs. Viola M. Bailey, and Bailey and/or Mrs. Bailey will sell to the Trustees, the number of shares of stock of the company which the insurance proceeds, less payment of the Trustees' expenses of collection, will purchase at a price to be determined as hereinafter provided; provided, however, that Bailey shall not be required to sell more than 162 shares, it being the intent hereof that Bailey and his wife shall at all times during his life own more than 50% of the outstanding stock of the company. Should such proceeds of endowment insurance amount to more than the purchase price of said 162 shares of stock, then and in that event the Trustees shall hold the balance of such proceeds for the respective employee beneficiaries in the following proportions:

Andrew Bowland, 24/64ths or 37.5 per cent.

Jay W. Ferree, 13/64ths or 20.3125 per cent.

John C. Hopkins, 16/64ths or 25 per cent.

Fred W. Kusserow, 11/64ths or 17.1875 per cent;