Court Opinion

ID: 4618731
Source: CourtListenerOpinion
Date Created: 2020-11-21 02:39:14.347973+00
Date Added: 2024-06-11T07:55:31.222015
License: Public Domain

Thomas L. Fawick and Marie Fawick, Petitioners v. Commissioner of Internal Revenue, RespondentFawick v. Comm'rDocket No. 846-67United States Tax Court52 T.C. 104; 1969 U.S. Tax Ct. LEXIS 149; 162 U.S.P.Q. (BNA) 185; April 21, 1969, Filed *149 Decision will be entered under Rule 50.  One of petitioners assigned certain patents, together with improvements that may be owned, controlled, or subject to licensing by him, to Falk Corp.  After this assignment this petitioner assigned a part of his right under this contract to his wife, the other petitioner in this case.  The assignment provided for an exclusive license only with respect to uses for marine purposes.  The assignor together with the assignee worked on certain improvements and a number of improvements were patented by the petitioner-assignor.  After expiration of the original patents but while an improvement patent which was used by Falk Corp. was unexpired, that corporation made payments to the petitioner-wife here for the years 1961, 1962, and 1963 under the assignment made to her from the petitioner-husband.  Held: The exclusive right to make, to use, and to sell with respect to one industrial field, namely, marine purposes, is an assignment of all substantial rights under sec. 1235, I.R.C. 1954; the fact that the original patent had expired does not cause the payments made under the contract to be ordinary income instead of capital gain where an improvement*150  patent is still being used by the assignee; none of the payments was for services of the assignor, the evidence showing that the payments were all for the use of the improvement patent; the contract entered into providing for the exclusive right to use for marine purposes the inventions contained in the patent applications listed in the contract or any improvements thereon that may be owned, controlled, or subject to licenses by petitioner constituted an agreement to assign future improvements and when future improvement patents were obtained payments which continued to be made under the contract constituted capital gain within the provision of sec. 1235, I.R.C. 1954, even though no formal assignment of the improvement patent was made.  Edward C. Crouch, for the petitioners.John P. Graham, for the respondent.  Scott, Judge.  SCOTT *186 *105  Respondent determined deficiencies in petitioners' income taxes for the calendar years 1961, 1962, and 1963 in the amounts of $ 46,066.22, $ 36,873.26, and $ 45,389.87, respectively.Most of the issues raised by the pleadings have been disposed of by agreement of the parties, leaving for our decision *151 whether amounts received by one of petitioners from Falk Corp. with respect to the manufacture by that corporation of a flexible clutch are long-term capital gain or ordinary income.FINDINGS OF FACTSome of the facts have been stipulated and are found accordingly.Petitioners, husband and wife whose legal residence was Shaker Heights, Ohio, on the date of the filing of the petition in this case, filed joint Federal income tax returns with the district director of internal revenue at Cleveland, Ohio, for the calendar years 1961, 1962, and 1963.Thomas L. Fawick (hereinafter referred to as petitioner) has been an inventor since sometime before 1926 and has been issued approximately 200 patents on his inventions during his lifetime. *152  He has not made a practice of selling his inventions or granting licenses to others to manufacture under his patents but has generally used his patents in his own manufacturing business.  Around 1926 he sold a patent on a transmission which was of a type he was not equipped to make and made no other sales or assignments of patents until he entered into an agreement with Falk Corp. in 1937 with respect to a patent for a flexible clutch and coupling.Prior to 1928 petitioner was engaged in the business of manufacturing clutches in Racine, Wis.  He sold this business in late 1927 or *106  early 1928 and moved to Akron, Ohio.  While he was in Akron he visited various rubber plants and began to conceive the idea of a flexible brake, coupling, and clutch with certain of the moving parts made of rubber. About 1936 he completed these inventions and made test models of his flexible coupling and clutch utilizing the principle of a rubber gland inflated with air.  In 1936 petitioner filed patent applications with respect to these inventions which later became known as Airflex couplings and clutches. Petitioner's application No. 99,420 dated September 4, 1936, was filed with the U.S. Patent*153  Office and U.S. patent No. 2,111,422 was issued upon this application on March 15, 1938, for Assembly for Driving Clutches and the like.  Petitioner's application No. 99,421, dated September 4, 1936, was filed and U.S. patent No. 2,141,645 issued on this application on December 27, 1938, for Assembly for Universal Joints and the like.  Petitioner's application No. 101,638, dated September 19, 1936, was filed and U.S. patent No. 2,251,443 issued on this application on August 5, 1941, for Assembly for Clutches, Brakes, Universal Joints and the like.  Patent No. 2,111,422 refers to the claim that "the construction and arrangement is admirably suited for heavy drives such as are required in oil-well drilling equipment * * *."As of February 23, 1937, petitioner entered into an agreement with Falk Corp. of Milwaukee, Wis., the primary business of which is the manufacture of machinery for marine use, with regard to his patent applications Nos. 99,420, 99,421, and 101,638.This agreement contained the following provisions:Whereas Fawick is the owner of certain United States patent applications relating to assemblies suitable for use in flexible couplings, driving clutches and power transmissions, *154  the same being identified as follows:Serial No. 99420 filed September 4, 1936Serial No. 99421 filed September 4, 1936Serial No. 101638 filed September 19, 1936, andWhereas Falk desires to obtain the hereinafter specified license to employ the inventions of the said patent applications,Now, therefore, for and in consideration of the provisions hereof and other good and valuable considerations, the parties hereto Agree as Follows:(1) Fawick hereby grants to Falk an exclusive license to make, to use, and to sell in the United States, its territories and possessions, and in the Dominion of Canada, flexible couplings, as distinguished from driving clutches and other forms of power *187  transmissions, embodying any of the inventions of the above identified patent applications or any improvement thereon that may be owned, controlled, or subject to licensing by Fawick.(2) Fawick hereby grants to Falk an exclusive license to make, to use, and to sell in the United States, its territories and possessions, and in the Dominion of Canada, but only for marine service, one-to-one driving clutches embodying any invention of the above identified patent applications or any improvement thereon that*155  may be owned, controlled, or subject to licensing by Fawick; and also a nonexclusive license to make, to use, and to sell such embodiments in the *107 United States, its territories and possessions, and in the Dominion of Canada, but only as a part of complete geared power transmission units of Falk's manufacture.(3) Falk agrees to pay to Fawick Twenty-Five Thousand Dollars ($ 25,000) upon the signing hereof and, in addition thereto, on or before the 15th day of January, April, July, and October of each year, Falk shall pay to Fawick upon all flexible couplings made hereunder, and installed for use by Falk or delivered to the customer during the next preceding three calendar months, and embodying any invention of the above identified patent applications as defined by any pending claim thereof or by a claim or claims of letters patent issued upon any of them, a royalty of five percent (5%) of the amount of the net sales price of the couplings after trade discounts but before cash discounts; and upon all driving clutches made hereunder, and installed for use by Falk or delivery to the customer during the next preceding three calendar months, a royalty of seven percent (7%) of *156  the amount of the net sales price of the clutches after trade discounts but before cash discounts.As of January 2, 1941, October 15, 1941, and November 13, 1942, petitioner and Falk Corp. entered into supplemental agreements with respect to patent applications Nos. 99,420, 99,421, and 101,638 entitled, respectively, "Supplemental Agreement," "Second Supplemental Agreement," and "Third Supplemental Agreement." The supplemental agreement dealt with a license of a "disconnecting coupling" which license was never exercised by Falk Corp. and granted to Falk Corp. the right to terminate the original and supplemental agreements with 90 days' notice.  The second supplemental agreement suspended until October 15, 1946, the right granted to Falk Corp. in the supplemental agreement to terminate the agreements.  The third supplemental agreement changed the method of payment by Falk Corp. by providing that 15 percent of any moneys that became due under the agreements be paid to each of petitioner's two daughters and the balance to petitioner.  By various assignments dated between the years 1942 and 1956 petitioner transferred additional percentages of the amounts due under his agreements with *157 Falk Corp. to his daughters and transferred percentages of such amounts to his niece and to his wife, Marie Fawick.Petitioner filed gift tax returns with respect to each of these transfers in which he valued the gift made by using an expiration date for the payments under his agreement with Falk Corp. in the year 1958.The flexible clutch which was the subject of petitioner's patent applications worked from its first trials and petitioner in 1937 began to manufacture some of these clutches for industrial use.  In 1938 petitioner organized Fawick Corp., an Indiana corporation, to engage in the manufacture and sale of these clutches for other than marine use.  As of December 30, 1938, petitioner assigned to Fawick Corp. his rights in the patents which were the subject of applications Nos. 99,420, 99,421, and 101,638 excluding the rights previously assigned to Falk Corp. and certain rights which he reserved to himself.  In return for this *108  assignment petitioner was issued all the stock of Fawick Corp.  Later Fawick Corp. became publicly held with its stock listed on the New York Stock Exchange.  However, as of 1963 petitioner and his family owned slightly over 50 percent of *158  the stock of Fawick Corp.  Fawick Corp. from shortly after the conclusion of World War II began, and continued throughout the years here in issue, to manufacture the Airflex clutch for industrial use in substantial amounts.  Many thousands of flexible clutches were manufactured under petitioner's patents by Fawick Corp. for various industrial uses including oil field drilling equipment and heavy metal-stamping equipment.  Neither petitioner nor Fawick Corp. ever manufactured any flexible clutches for marine uses except that Fawick Corp. manufactured many such clutches by agreement with Falk Corp. during World War II when Falk Corp.*188  was unable to supply the defense demand for such clutches. However, Fawick Corp. has manufactured on order from Falk Corp. certain rubber parts for the flexible clutches manufactured by Falk Corp. for marine use.  However, Falk Corp. has also had other suppliers of such rubber parts.Subsequent to the execution of the original agreement between petitioner and Falk Corp., petitioner worked with personnel of Falk Corp. on testing and improving the Airflex coupling and clutch. Falk Corp. began manufacturing the Airflex coupling and clutch in the fall of 1938. *159  Petitioner continued to work with representatives of Falk Corp. on improvements to the Airflex coupling and clutch and as a result of this and other work, petitioner in years subsequent to 1938 obtained several patents for improvements on the Airflex coupling and clutch. Among the patents obtained by petitioner for improvements on the Airflex clutch was U.S. patent No. 2,662,625 issued December 15, 1953.  The improvements embodied in this patent were used by Falk Corp. in the Airflex clutches it manufactured during the years here in issue and for some year prior thereto.  Falk Corp. obtained in its name three improvement patents with respect to the Airflex couplings and clutches.From the fall of 1938 throughout the years here in issue Falk Corp. manufactured and sold many Airflex couplings using the inventions of petitioner's patents and sold many geared power-transmission units for marine use in which the Airflex clutch was used.  During the years here in issue Falk Corp. sold no Airflex clutches other than those it sold as a component part of a complete geared power-transmission unit for marine use.  During the years here in issue Falk Corp. did not incorporate the Airflex clutch*160  in any geared power-transmission unit sold for any purpose other than marine use.*109  During the years 1961, 1962, and 1963 Falk Corp. paid total royalties to assignees of petitioner and to Marie Fawick in the following amounts:Total Fawick Royalties PaidAirflexAirflexYearTotalcouplingsmarineclutches1961$ 34,336.66$ 9,851.76$ 24,484.90196235,502.6010,381.3425,121.26196330,359.6610,833.7719,525.89Royalties Paid to Marie L. FawickAirflexAirflexYearTotalcouplingsmarineclutches1961$ 7,554.06$ 2,167.40$ 5,386.6619627,810.572,283.905,526.6719636,679.122,383.434,295.69The amounts paid by Falk Corp. to petitioner's assignees with respect to Airflex marine clutches during the years 1961, 1962, and 1963 were allocated by Falk Corp. on its books to "class 3" which designation referred to its nonexclusive license from petitioner to make, to use, and to sell the Airflex clutch as a part of any complete geared power-transmission units of Falk Corp.'s manufacture. Falk Corp. on its records deducted the royalties paid as an expense.Petitioners on their joint Federal*161  income tax returns for the years 1961 and 1963 reported the Falk Corp.'s payments to Marie Fawick as ordinary income and on their joint Federal income tax return for the year 1962 reported the payments by Falk Corp. to Marie Fawick as long-term capital gain.For the year 1962 respondent determined that the portion of the payments by Falk Corp. to Marie Fawick which was with respect to the Airflex clutch constituted ordinary income but did not change petitioner's method of reporting the payments with respect to Airflex couplings.Petitioners in their pleadings allege that they erroneously reported the payments Marie Fawick received from Falk Corp. as ordinary income for the years 1961 and 1963 since these amounts in fact constituted long-term capital gain. Petitioners' allegations dealing with payments with respect to Airflex couplings are not in issue herein but respondent has denied petitioners' allegations insofar as they relate to payments with respect to the Airflex clutch.*110  OPINIONIt is petitioners' position that the payments by Falk Corp. to Marie Fawick constitute capital gain under the provisions of section 1235, I.R.C. 1954.  1*189  Petitioner states that the payments*162  by Falk Corp. to Marie Fawick were under the provisions of the original agreement between Falk Corp. and petitioner granting to Falk Corp. an exclusive license to make, to use, and to sell for marine service one-to-one driving clutches embodying the inventions of patent applications Nos. 99,420, 99,421, and 101,638 "or any improvements thereon that may be owned, controlled, or subject to licensing by Fawick." Petitioner points out that an "exclusive license to make, use and sell" has long been considered to constitute a "sale" of a patent. Vincent A. Marco, 25 T.C. 544">25 T.C. 544 (1955). Petitioner states that even though the patents issued pursuant to the applications specifically referred to in the agreement had expired, Falk Corp. was using improvements with respect to which a patent was issued to petitioner in 1953 and that because of use of these improvements was required to pay the amounts specified as royalties under the original license agreement and the supplemental agreements.  It is petitioner's position that the transfer of the exclusive right to make, to use, and to sell for marine use is a sale or transfer of all rights to the patents and improvements*163  thereon for the specified usage and the transfer falls squarely within the provisions of section 1235 so that had the payments here in issue been made to petitioner they would have been capital gains, citing Estate of Milton P. Laurent, Sr., 34 T.C. 385">34 T.C. 385 (1960). Petitioner says the income having been assigned by gift by petitioner to Marie Fawick, retains its characteristic as capital gain in her hands, citing Franklin A. Reece, 24 T.C. 187">24 T.C. 187 (1955), affd.  233 F. 2d 30 (C.A. 1, 1956).*164  Respondent contends that the facts here show that the payments made to Marie Fawick during the years here in issue were not with respect to Falk Corp.'s exclusive license to manufacture and sell for marine uses but with respect to its nonexclusive license to incorporate the inventions into any complete geared transmission unit of its own manufacture. In the alternative respondent states that section 1235 is inapplicable to the agreement between petitioner and Falk Corp. since the exclusive license was limited to marine use and therefore was *111  not a "transfer" of "all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights * * *." Respondent further contends that even if we hold against his alternative contention, section 1235 should not be considered to be applicable to a "transfer" of an improvement "patent" which was not in existence and for which no application had been prepared or filed at the date the agreement to transfer the basic patent was entered into.  Finally, respondent contends with respect to the applicability of section 1235 that the language of the original agreement between Falk Corp. and Fawick is not sufficiently*165  clear as to be properly interpreted as requiring the transfer of improvements for which no applications were pending at the time the agreement was entered into.Respondent apparently does not contend that the payments by Falk Corp. to Marie Fawick do not constitute capital gains if such payments would constitute capital gains had they been made to petitioner.  In any event we consider the law in this respect to be as petitioner contends.  See Franklin A. Reece, supra.Also, respondent does still contend that the payments made by Falk Corp. to Marie Fawick were for services rendered by petitioner to Falk Corp.  However, the evidence shows this not to be in fact the basis for the payments.  Fawick Corp. of which petitioner was president manufactured the rubber components for the Airflex clutches made by Falk Corp.  However, the arrangement for such purchases including petitioner's services in connection therewith was separate and apart from the agreement between petitioner and Falk Corp. as to Falk Corp.'s use of petitioner's patents. Fawick Corp. was compensated for the parts it manufactured for Falk Corp. and such payments are not involved in this case. *166  The evidence in this case shows that during the years here in issue Falk Corp. sold no Airflex clutches in any complete geared power-transmission unit of its own manufacture that was to be used for any purpose other than marine. The evidence shows that all Airflex clutches sold by Falk Corp. during the years here in issue were included in complete geared, power-transmission units for marine use.  The evidence shows that Falk Corp. deducted *190  the payments made to petitioner's assignees under its agreement with petitioner as expenses and designated these payments as under "class 3" which was a designation it used for its nonexclusive license to incorporate the Airflex clutch in its complete geared power-transmission units of its own manufacture for other than marine use.  Since all the units manufactured during the years here in issue were for marine use, the evidence shows that the payments here in issue were under the exclusive license given by petitioner to Falk Corp. to manufacture for marine use.  The *112  evidence in this case does not support respondent's contention that the payments made by Falk Corp. to petitioner's assignees were in fact payments under the nonexclusive*167  license. We conclude from the evidence that all the payments made by Falk Corp. to petitioner's assignees including Marie Fawick during the years here in issue were under the exclusive license granted by petitioner to Falk Corp. to manufacture for marine uses.  The allocation by Falk Corp. on its records of these payments to "class 3" was a mistake on the part of that company.Since we conclude from the evidence that all the payments made by Falk Corp. to Marie Fawick were with respect to the exclusive license granted by petitioner to Falk Corp. to manufacture Airflex clutches for marine use, it is necessary for us to consider respondent's remaining contentions with respect to the application of section 1235.  Respondent contends that "all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights" as used in section 1235 does not include a grant limited to use in a specific field within a trade or industry such as the exclusive license for marine use here involved.  Respondent relies on the provisions of section 1.1235-2(b)(1)(iii), Income Tax Regs., 2 in support of his position.  In William S. Rouverol, 42 T.C. 186">42 T.C. 186 (1964),*168  we held that under the provisions of section 1235 a patent may be separated by fields of application and that a transfer or assignment to another of only one such field amounted to an assignment or transfer of "property consisting of all substantial rights to a patent" as used in section 1235.  In William S. Rouverol, supra, which is relied upon by petitioner in this case, we concluded that a transfer to which section 1235 is applicable had taken place when the exclusive right to make, use, and sell in a limited area or in a limited field in the industry had been granted by a contract.  At the date of our decision in the Rouverol case, respondent's regulations did not contain the provision now contained in section 1.1235-2(b)(1)(iii).  However, in Vincent B. Rodgers, 51 T.C. 927">51 T.C. 927 (1969), we held that our decision in William S. Rouverol, supra, would be followed and that section 1.1235-2(b)(1) of respondent's regulations insofar as contrary to our conclusion in that case was invalid.  In accordance with our holding in Vincent B. Rodgers, supra, we conclude *169  that respondent's contention that the *113  transfer by petitioner to Falk Corp. of an exclusive license to make, use, and sell the Airflex one-to-one clutch for marine purposes is not within the scope of section 1235 is without merit.  We therefore conclude that had the payments here in issue been made while the patents referred to in the agreement of February 23, 1937, were unexpired, such payments would have constituted long-term capital gain under the provisions of section 1235.*170  Respondent points out that the patents issued under the applications listed in the agreement between petitioner and Falk Corp. made as of February 23, 1937, had all expired by the years here in issue, the last of such patents expiring in 1958.  Respondent states that agreements for continuing payments for a patent after its expiration are unenforceable and petitioner does not contest this statement.  Both parties agree that the payments made during the years here in issue would not come within the provision of section 1235 if they were made with respect to the expired patents. It is, however, petitioner's contention that the payments were made with respect to a specific improvement patent. Respondent recognizes that it is well established that an agreement to transfer future inventions is a valid contract to assign such inventions. The validity of contracts to assign future inventions has long been recognized.  See Carl G. Dreymann, 11 T.C. 153">11 T.C. 153 (1948)*191 . Respondent argues, however, that even if there were a contract to assign future inventions in the instant case no such assignment was actually made.  The ownership of an invention may be assigned prior*171  to the time a patent is issued and even prior to the time that an application for a patent is filed.  See Franklin S. Speicher, 28 T.C. 938">28 T.C. 938 (1957). In Heil Co., 38 T.C. 989">38 T.C. 989, 1002 (1962), we held that an amount paid "in consideration for the sale or exchange by petitioner to Harvester of capital assets and the right in Harvester upon the coming into existence of like assets in the future to have the ownership thereof promptly and immediately transferred to it by petitioner" constituted capital gain. We recognized in the Heil Co. case that the transfer of a patent with a provision for the transfer of improvements thereon was subject to capital gains treatment even though no formal assignment of an improvement had been made.  From this holding it logically follows that payments made to an assignor for use by the assignee of an unexpired improvement patent under an agreement which grants to the assignee an exclusive license to make, to use, and to sell an invention covered by the patent, and future improvements thereon, constitute capital gain under section 1235.  The fact that the only assignment of the improvement patent*172  is in the original agreement and that the original patent has expired does not cause the payments for use of the improvement patent to be other than capital gain. We therefore conclude that the *114  payments here in issue constitute capital gain if the contract between petitioner and Falk Corp. entered into as of February 23, 1937, is properly to be interpreted as requiring the transfer by petitioner to Falk Corp. of future improvements on the patents assigned by the agreement.Respondent contends that it is well established that an agreement to assign a patent and improvements thereon covers only existing improvements unless the language of the contract is plain and the evidence unmistakable that the parties had in mind the assignment by the inventor of future improvements, citing De Long Corporation v. Lucas, 176 F. Supp. 104">176 F. Supp. 104, 127 (S.D.N.Y. 1959), affd.  278 F. 2d 804 (C.A. 2, 1960), and New Britain Machine Co. v. Yeo, 358 F. 2d 397 (C.A. 6, 1966).  Both of those cases dealt with situations entirely different from the circumstances of the instant case.  In New Britain Machine Co. v. Yeo, supra,*173  there was no specific agreement to assign improvements with respect to the particular patent involved in the litigation but one of the parties was attempting to have the contract interpreted to imply such an agreement to assign because of provisions of the contract with respect to assignment of improvements on other patented inventions. The De Long Corporation case dealt with an employee of De Long Corporation who had become employed by another company.  The employee's contract with De Long Corporation prohibited his competing or assisting another in competing with De Long Corporation for a period of 2 years after he ceased to be employed by De Long Corporation.  That case concerned questions of patents obtained by the employee after he left the employment of De Long Corporation but prior to the expiration of the 2-year period.In our view, the language of the agreement of February 23, 1937, is clear that it was contemplated by the parties that the right of Falk Corp. to future improvements by petitioner on the patents assigned to Falk Corp. were covered by that agreement.  The words "any improvement thereon that may be owned, controlled, or subject to licenses by" petitioner*174  contemplate improvements to be made in the future.  The term, "may be" is reasonably interpreted to include such future improvement.  Furthermore, the testimony in this case is that both parties considered the contract to cover future improvements.  We therefore conclude that the improvement which was being used by Falk Corp. during the years here in issue and with respect to which the payments here involved were made to Marie Fawick was an invention to which Falk Corp. was granted an exclusive license by the agreement of February 23, 1937.  We therefore hold that the payments by Falk Corp. to Marie Fawick during the years here in issue constituted capital gains under section 1235.*115  It is unnecessary for us to consider the argument of the parties with respect to whether the amounts paid by Falk Corp. to Marie Fawick during the years here in issue would constitute capital gain under section 1221.  We hold for petitioner on the only issue litigated herein.  However, a recomputation of petitioners' tax liability is necessary because a number of issues have been disposed of by agreement of the parties.Decision will be entered under Rule 50.  Footnotes1. All references are to the Internal Revenue Code of 1954.  Sec. 1235 provides as follows:(a) General.  -- A transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 6 months, regardless of whether or not payments in consideration of such transfer are -- (1) payable periodically over a period generally coterminous with the transferee's use of the patent, or(2) contingent on the productivity, use, or disposition of the property transferred.↩2. Sec. 1.1235-2(b)All substantial rights to a patent.  (1) The term "all substantial rights to a patent" means all rights (whether or not then held by the grantor) which are of value at the time the rights to the patent (or an undivided interest therein) are transferred. The term "all substantial rights to a patent" does not include a grant of rights to a patent --* * * *(iii) Which grants rights to the grantee, in fields of use within trades or industries, which are less than all the rights covered by the patent, which exist and have value at the time of the grant; or↩