Court Opinion

ID: 8975210
Source: CourtListenerOpinion
Date Created: 2022-11-27 10:53:13.467025+00
Date Added: 2024-06-11T17:10:32.202484
License: Public Domain

DAVID A. NELSON, Circuit Judge,
dissenting.
I do not believe that the Tax Court’s decision ought to be affirmed in its present form.
The basic question, as the Tax Court saw it, was whether the taxpayers proved that the Food Rethermalization partnership had the requisite profit objective in purchasing its license for the invention patented by Messrs. Souder and Waldorf. A major part of the consideration for the license consisted of the $2.9 million non-recourse seven-year promissory note payable out of the royalties that the partnership hoped to receive from Beatrice Foods Corporation’s Market Forge Division. The Tax Court found that the partnership had no reasonable basis for supposing that royalties paid in the first seven years would be sufficient to pay anything close to $2.9 million on the note — and this finding, as I read the Tax Court’s opinion, was the real underpinning for the court’s conclusion that the transaction lacked economic substance.
I have no quarrel with the finding that nothing approaching $2.9 million was likely to be paid on the note during the first seven years. But the patents (the validity of which is not questioned by the Internal Revenue Service) were good for 17 years, and the testimony showed that Beatrice Foods expected to have the exclusive use of the patents for the full 17 years. Beatrice Foods said, indeed, that it would not have gone forward without that understanding. Although the initial term of the partnership’s license was only seven years, the partnership had a fixed contractual right to extend the license for an additional ten years on payment of a fee in the amount of only three percent of the royalties received during the original seven-year term. Extension of the license would automatically extend the promissory note for ten years as well.
The record, as I shall attempt to show, demonstrates that exercise of the right to extend would have seemed a virtual certainty from the investors’ vantage point in 1976. That being so, I believe it was clearly erroneous for the Tax Court to use a seven-year time frame in analyzing the economics of the transaction. Had the Tax Court run the economics over a seventeen-year period, I think the court’s conclusion that the transaction lacked economic substance would have been quite different.
Before looking at the numbers, it might be well to say something about the invention itself, and the enthusiasm with which it was viewed by Beatrice Foods and others.
Hospitals and other institutions that have to feed large numbers of people can save significant amounts of money by operating their kitchens only five days a week, on a nine-to-five schedule, preparing meals that can be kept on ice until needed and then reheated. But the typical institutional meal includes some foods and beverages that ought to be served cold, others that ought to be served warm, and others that ought to be served piping hot — and the mix will vary from meal to meal. The invention that Souder and Waldorf came up with was designed to provide a simple and efficient method of seeing that each individual component of each individual meal receives exactly the right amount of heat just before the meal is served regardless of when the meal may have been prepared originally.
The inventors’ idea was to have the central kitchen put individual food portions in separate color-coded containers, the bottoms of which, in the case of containers intended to be heated, would be metalized. *1555The filled containers, fitted with insulated covers, would then be placed on serving trays, and the trays would be stacked on the shelves of a refrigerated transport cart. Shortly before mealtime, the flip of an electric switch on the transport cart would activate induction heating coils in each shelf, producing heat-generating currents in those containers made with metallic bases; the other containers would receive no heat at all. The metallic bases could be calibrated, at the time of manufacture, to transmit different amounts of heat — so as long as the kitchen staff put the right food in the right container, each serving tray would come out of the cart with the contents of each dish at just the right temperature.
Mr. Souder talked to several large companies that he thought might be interested in acquiring manufacturing rights for his invention, and he testified that he “got significant interest from virtually everybody who saw it.” Beatrice Foods was the first to indicate that it “would like to go head-long into developing and implementing this technology,” and in March of 1976 that company signed a memorandum of understanding with Souder and Waldorf under which the company took an option on the patent and agreed to finance the construction of a prototype unit with a view to marketing the product. The agreement was to remain in effect for the life of the patent.1
Gerald Duszynski, Director of New Product Development for Beatrice Foods’ Market Forge Division, testified that the technology used in this project was “unquestionably” more advanced than that used in the reheating systems that were then on the market. Mr. Duszynski “really liked the concept,” he testified, and he “took it on enthusiastically.” Everyone at Market Forge, including the chief engineer, was “very upbeat” about the project. They told the inventors’ lawyer, Mr. Schwartz, that they thought this was an “exciting” product. Two years later, when the company decided to terminate its involvement in the project, Marketing Vice-President Henry Coletti wrote Schwartz, Waldorf, et al. that
“Market Forge still strongly believes that once developed, this product will revolutionize the health care patient feeding market for years to come. Our marketing projections and market studies all indicate a large viable market eager for a simple, labor-saving product within a wide cost range.” Exhibit AA, Coletti letter of June 26, 1978 (emphasis supplied).
Mr. Robert Flynn, who helped put together the group that brought out Souder and Waldorf in 1976, testified that his contacts at Cornell University and in the military gave him to understand that this new technology was “far superior” to what was already in the marketplace. Mr. Flynn’s expertise was in marketing and food service, not engineering, and he relied on Mr. Waldorf — whom he considered a “brilliant” engineer — to see that the prototype was built correctly. Mr. Waldorf apparently fell down on the job, but there was no showing that he was not up to the task from a technical standpoint.
Mr. Flynn was not privy to Market Forge’s market projections, to be sure, but he knew of the company’s enthusiasm for the product, and he relied totally on Market Forge to handle the marketing; “without them,” he testified “we wouldn’t have done anything.”2
*1556At least one of the physicians who invested in the partnership testified that Trans-therm was “an excellent concept” for both hospitals and nursing homes, as well as for the meals-on-wheels method of feeding home-bound geriatric patients. There was no effective impeachment of this or other testimony that was given along the same lines.
After listening to all the testimony, the trial judge told counsel he was satisfied that the people involved in the project were, as the judge put it, “looking for big bucks.” What obviously troubled the judge was not whether the taxpayer-investors had a bona fide profit objective with respect to the half million dollars they were committed to paying up front, but whether that objective extended to the $2.9 million non-recourse note as well.3 The answer to this question turns on the market prospects, as seen from late 1976, over the probable life of the note.
The record contains ample evidence on this subject. Market Forge, as the trial judge recognized, was “an independent third party of national standing.” As a division of Beatrice Foods, it was hardly a fly-by-night operation. Its assessment of the market potential would obviously merit respect, and the testimony of Messrs. Co-letti and Duszynski gives a reasonably clear picture of how Market Forge saw the numbers shaping up.
Although Market Forge was more pessimistic than Souder and the investors were with regard to the near term, the sales that Market Forge projected once the product was finally developed were impressive enough. Mr. Coletti testified that it would take four years for “real marketing” to begin and “five years before you start to see any kind of money coming in on it.” Mr. Duszynski concurred; he thought that actual sales would not begin before 1980. By 1985, however, Duszynski thought sales would reach a rate of about $13 million a year. Total hospital sales for the five years ending with 1985 were projected to be in the range of $32 million or $33 million, according to Duszynski; Coletti thought that $35 million was a possibility.
Mr. Coletti believed, as he wrote in mid-1978 and as he confirmed from the stand, that the new product would “revolutionize the health care patient feeding market for years to come.” The growth potential after 1985 was not quantified, but Mr. Coletti insisted that Market Forge had to have exclusive use of the patents for the full 17 years, and there was no indication that he doubted there would be an increase in sales after 1985.
Against that background, and assuming, as I think one must, that Market Forge’s projections were not unreasonable, I find it inexplicable that the Tax Court should have thought there would be any doubt, as of 1976, about an extension of the license agreement and the non-recourse note in December of 1983, when the primary term of seven years was scheduled to expire. If Market Forge was right that sales would not begin until 1980, total sales through 1983 could hardly be expected to exceed $20 million. On that hypothesis, the total royalty income received through 1983 would be less than $1 million — and the cost of extension (three percent of royalties to date) would be less than $30,000.4
*1557If the partnership did not pay this modest $30,000 extension charge upon the expiration of the primary term (and if it did not pay off the non-recourse note in full at that time), the patents would revert to Patents Licensing International. That company and its backers, Souder, Waldorf and Schwartz, could then look forward to receiving 100 percent of the royalties generated by the product over the next ten years. Assuming average annual sales of only $13 million, the additional royalties would total $6.5 million. Seventy percent of that $6.5 million could be kept by the partnership, on the other hand, if it simply paid the $30,000 and extended its license and note. If the Market Forge numbers were at all indicative of how a reasonable person would view the market prospects in 1976, therefore, it is inconceivable that the partnership would not have been planning to exercise its right to extend. And the record clearly shows an intent to extend: “The reality of it,” Mr. Flynn testified without contradiction, “was we had seventeen years ... [to pay the] $2.9 million, and we thought it was a cakewalk.”
Assuming an extension, then, we come at last to the question of what the economics for the full 17 years would have looked like in 1976 to an investor with a bona fide profit objective. The Market Forge projections are highly relevant in this connection, for reasons already explained.
Under the Market Forge projections, sales to hospitals alone could have been expected to total around $150 million over the life of the patent. Royalties on these sales would be approximately $7.5 million. Thirty percent of that amount — $2.25 million — would have to be paid to Patents Licensing on the non-recourse note, in addition to payments of $500,000 outside that note. And approximately $4.75 million would be left for the taxpayer-investors.
The return to the investors would be even larger than $4.75 million, of course, to the extent that Market Forge succeeded in making sales to institutions other than hospitals — and such sales would also generate additional funds for the holder of the non-recourse note. (Whether the note would have been paid in full, with interest, may be somewhat problematical, but I take it that assurance of payment in full would not be essential to a demonstration that the investors had a reasonable profit objective.)
The Tax Court found as a fact that Flynn and his partner, whom the court viewed as stand-ins for all the investors, were, at best, “indifferent to the success of the venture as a business proposition.” That finding would make sense only if the investors’ interest in the patents were limited to seven years. Their interest was not so limited, as we have seen — and the investors could hardly have been “indifferent” to the multimillion dollar returns that seemed to be in the offing over the full 17-year period. The Tax Court’s finding to the contrary does the investors a grave injustice, in my opinion, and I consider the finding clearly erroneous.
Accordingly, I would remand this case for recalculation of the taxes owed, using a life of 17 years for the license and making a corresponding adjustment in the period over which the cost of the license was to be amortized. (The seven-year amortization period used by the taxpayers was unrealistic, of course, under my view of the case.) My colleagues having seen the matter differently, I respectfully dissent.

. Both the original memorandum of understanding and a confirmatory agreement signed early in 1977 gave Beatrice Foods exclusive manufacturing rights extending until the expiration of the patents. Souder and Waldorf were parties to both agreements, and the corporation they formed to hold the patent, Patents Licensing International, was a party to the confirmatory agreement also. The renewal option contained in the license granted to the Food Rether-malization partnership by Patents Licensing provided that the license would be "nonexclusive” during the ten-year renewal period, but as a practical matter this limitation was illusory as long as Beatrice Foods wanted to retain its exclusive rights for the full 17 years.

. The Tax Court noted that Mr. Flynn’s extensive experience in the institutional feeding area was "dated,” and notwithstanding his subsequent success in the financial area, the court questioned Flynn's ability to evaluate Souder’s market projections. The venture would have seemed economically viable even with much lower projections, however, and the Tax Court's opinion seems to me to evidence a lack of *1556understanding of how investors actually make decisions and how much technical expertise they typically bring to the task. "I’ve learned in the years of my life,” the judge remarked during trial, "that there are a lot of things that go on in business that I don’t understand." Investment analysis may be one of those things; under the Tax Court’s view of the world, one suspects, Queen Isabella ought not to have pawned her jewels to finance Christopher Columbus, and Warren Buffet ought not to exist.

. The judge may have had a conceptual problem with the idea that any taxpayer should ever be permitted to take deductions in respect of indebtedness for which the taxpayer was not personally at risk. The law permitted such deductions at the time with which we are concerned here, however. Congress changed the law later on, but the change did not apply retroactively to the time period involved in this case.

. The cost of extension would be greater than $30,000 under Mr. Souder’s more optimistic sales projections, of course, but the profit potential for the remaining ten years would be greater too, under those projections. The incentive to extend would have been even stronger under Souder's scenario than under Market Forge's.