Court Opinion

ID: 4620745
Source: CourtListenerOpinion
Date Created: 2020-11-21 02:43:17.337523+00
Date Added: 2024-06-11T07:55:52.823022
License: Public Domain

Dairy Queen of Oklahoma, Inc., Dissolved, L. E. Copelin, Trustee, L. H. Nehring, Trustee, Priscilla Nehring, Trustee, et al., 1 Petitioners, v. Commissioner of Internal Revenue, RespondentDairy Queen of Oklahoma, Inc. v. CommissionerDocket Nos. 48220, 48221, 48222, 48237United States Tax Court26 T.C. 61; 1956 U.S. Tax Ct. LEXIS 219; April 11, 1956, Filed *219 Decisions will be entered under Rule 50.  1. In 1939 an individual obtained from a patentee of a freezing and dispensing machine "the exclusive right and license to the use, manufacture, sale and distribution of all machines built" under the patent within 24 States, including Oklahoma.  The individual invented a formula for an ice cream mix and registered the product under the trade name "Dairy Queen" in Oklahoma.  In 1946 petitioner Copelin obtained from the above individual and his then partner the sole and exclusive right and franchise for the manufacture, preparation, sale, and distribution of the product within the State of Oklahoma for $ 23,364 plus 4 cents per gallon of mix to be paid the then assignee of the patentee.  Copelin was to pay for and own his own machines with the only restriction that they were not to be used or moved out of Oklahoma.  Thereafter, in 1946, Copelin associated with him as partners petitioners L. H. and Priscilla Nehring.  The three individual petitioners operated their business as a partnership until January 24, 1948, when they organized petitioner corporation and transferred all the assets of the business to the corporation in exchange for the*220  latter's stock and the assumption by the corporation of all the liabilities of the business, including $ 18,314.30 still owing on the $ 23,364 obligation of Copelin.  Beginning January 1, 1949, petitioner corporation was to pay the three individuals the total sum of 20 cents per gallon on all mix used in stores operated by holders of subfranchises granted by petitioner corporation.  During the taxable years 1948 and 1949 petitioner corporation entered into 36 subfranchise agreements.  Under these agreements petitioner corporation granted to the second parties an exclusive territory within the State of Oklahoma (city or county) and agreed to furnish the second parties with a formula for an ice cream mix and the necessary freezers to prepare, sell, and distribute the product known as Dairy Queen.  For these rights and privileges the second parties agreed to pay a lump sum upon the signing of the agreement and a further sum of 35 cents for each gallon of mix used in the machines. Held, the 36 agreements were licensing agreements rather than sales of property and the payments received thereunder (both lump-sum and gallonage) were royalties taxable as ordinary income.2. Held,*221  petitioner corporation has failed to show that it is entitled to deduct from its gross income any part of the above-mentioned $ 18,314.30 assumed by it at the time of its incorporation.3. In view of our holding under (1) above, more than 80 per cent of petitioner corporation's gross income for 1949 was personal holding company income.  Held, petitioner corporation was a personal holding company for that year.4. Held, the individual petitioners are liable as transferees for any deficiencies owing by petitioner corporation to the extent of the stipulated value of the corporation's assets received by them upon dissolution.  Robert Ash, Esq., and Charles H. Burton, Esq., for the petitioners.Frank C. Allen, Esq., for the respondent.  Arundell, Judge.  ARUNDELL*62  These consolidated proceedings involve deficiencies in income tax, personal holding company surtax, 25 per cent addition to the tax for failure to file a personal holding company surtax return, and transferee liability, as follows: *63 Docket No.YearTaxDeficiencyAddition482201948Income$ 14,873.7519497,869.771949P. H. C. S.34,887.80$ 8,721.9548221TransfereeIncome10,961.03P. H. C. S.16,813.854,203.4748222TransfereeIncome10,961.03P. H. C. S.16,813.854,203.4748237TransfereeIncome21,922.06P. H. C. S.33,627.708,406.93In addition to the above amounts of determined transferee liability, the respondent has also determined that interest, as provided by law will be assessed against the transferees.The issues presented are: (1) Whether certain amounts received by Dairy Queen of Oklahoma, Inc., during*223  1948 and 1949 from 36 "Franchise" agreements represent proceeds from the sale of capital assets or royalties taxable as ordinary income; (2) whether Dairy Queen of Oklahoma, Inc., is entitled to exclude or deduct from the alleged selling price any part or all of $ 18,314.30 paid to a partnership known as McCullough's Dairy Queen; (3) whether Dairy Queen of Oklahoma, Inc., was a personal holding company for the year 1949 and therefore liable for the personal holding company surtax, plus a 25 per cent addition to the tax for failure to file a personal holding company surtax return; and (4) whether the individual petitioners are liable as transferees.In his brief the respondent concedes that petitioners are not liable for any addition to the tax for failure of Dairy Queen of Oklahoma, Inc., to file a personal holding company surtax return.  Effect will be given to this concession under Rule 50.FINDINGS OF FACT.The stipulation of facts in these consolidated proceedings is incorporated herein by this reference.Dairy Queen of Oklahoma, Inc. (sometimes referred to as petitioner corporation), was incorporated on January 24, 1948, under the laws of the State of Oklahoma.  Its office and*224  principal place of business during the years 1948 and 1949 was in Tulsa.  It filed its income tax returns for those years with the then collector of internal revenue for the district of Oklahoma.During the period here in question the individual petitioners, L. H. Nehring and Priscilla Nehring, resided in DeKalb, Illinois, and L. E. Copelin resided in Tulsa, Oklahoma.Harry M. Oltz, on May 18, 1937, secured Patent No. 2,080,971 on a "Freezing and Dispensing Machine" which later became known as the Dairy Queen machine.*64  In a contract dated and signed by H. A. McCullough July 29, 1939, and accepted and signed by Oltz July 31, 1939, McCullough obtained from Oltz the exclusive right to manufacture machines covered by Patent No. 2,080,971 in all the States west of the Mississippi River, plus Illinois and Wisconsin.  McCullough was to furnish the mix to make the product to be frozen and pay Oltz a per gallon "royalty" on all the mix that went through the machines. McCullough was to own the machines and have the right to furnish such machines to other parties in his territory and pay Oltz his regular royalty. Payments to Oltz were to be continued as long as the machines were used, *225  irrespective of the life of the patent.On June 11, 1940, Oltz for one dollar and other good and valuable considerations sold, assigned, and transferred the whole right, title, and interest in and to Patent No. 2,080,971 to Ar-Tik Systems, Inc., a corporation of the State of Indiana.On September 7, 1946, Ar-Tik Systems, Inc., and McCullough by written agreement amended and construed the above-mentioned July 1939 agreement between Oltz and McCullough in several respects, the principal amendment being paragraph 11 of the original agreement which was amended to read as follows:It is understood that I [McCullough] shall have the exclusive right and license to the use, manufacture, sale and distribution of all machines built under Patent No. 2080971 within the described territory. This shall include the right and privilege of granting sublicenses to others for territorial rights and also for the manufacture of said machines, provided however, where I grant to others the right to manufacture such machines it shall be with the understanding that the use of the machines so manufactured shall be limited to the territory of the sublicensee.On February 14, 1946, H. A. McCullough and J. F. *226  McCullough, doing business under the trade name "McCullough's Dairy Queen," as first party, and Copelin, as second party, entered into a written agreement providing that:Whereas, The party of the first part is possessed of a certain formula together with the production methods and machinery requirements for the preparation, sale and distribution of a certain product known as DAIRY QUEEN, and has agreed to grant to the party of the second part an exclusive franchise for the manufacture perparation, [sic] sale and distribution of DAIRY QUEEN, within the territory and upon the terms hereinafter fully set forth; therefore,Know All Men by These Presents:The party of the first part hereby grants to the party of the second part, the sole and exclusive right and franchise for the manufacture, perperation, [sic] sale and distribution of DAIRY QUEEN within the State of Oklahoma, subject to the following terms and condition [sic] * * *Under the said agreement of February 14, 1946, as amended on September 15, 1947, effective as of February 14, 1946, it was further provided:*65  That the total sum consideration to be paid for the rights and privileges of this agreement shall*227  be the amount of $ 23,634.00.  That this sum shall be retired in the following manner: that the amount of franchise and royalties previously paid under this agreement shall be credited against it; that beginning with the effective date of this agreement as amended, the royalty shall be on the basis of Ninteen Cents ($ .19) per gallon of mix of which Fifteen Cents ($ .15) shall be credited against this amount until the total has been paid, after which time the total amount of royalty to be paid shall be Four Cents ($ .04) per gallon of mix.The above amount of $ 23,364 was arrived at on the basis of 1 cent for each person in the State of Oklahoma according to the 1940 census which gave the population for the entire State as 2,336,434.  The 4 cents per gallon mentioned above was the amount payable to Ar-Tik Systems, Inc., through McCullough.Also under the said agreement of February 14, 1946, Copelin was to pay for the machines at the rate of about $ 1,600 each; and first party was to have the right to audit the records of the second party "in order to determine if royalties have been paid." The agreement also provided that "The said Dairy Queen product is a registered trade name, and*228  is registered in the state of Oklahoma" and "This machine, and register [sic] name is not to be used or moved out of the allotted territory."At some time during 1946 Copelin associated with him as partners L. H. Nehring and Priscilla Nehring.  The Nehrings put up the necessary cash, and profits were to be shared equally between Copelin and the Nehrings.On June 24, 1947, Copelin and the Nehrings entered into an agreement to form a corporation on or about January 1, 1948, "for the promotion of the Dairy Queen business within the State of Oklahoma." Among other things, the agreement recited that Copelin and Nehring "are the owners of a franchise for the distribution of Dairy Queen products" within the State of Oklahoma and "are now operating said business * * * by operating their own store and by selling franchises for certain specific territories" within the State of Oklahoma, and that they "desired to form a corporation for the purpose of conducting the said Dairy Queen business * * *." It was then agreed that this entire "business" would be transferred to a corporation to be known as Dairy Queen of Oklahoma, Inc., in exchange for $ 10,000 of capital stock to be issued to Copelin, *229  $ 5,000 to L. H. Nehring, and $ 5,000 to Priscilla Nehring; that the corporation was to "assume any and all of the indebtedness of the business" and beginning on January 1, 1949, was to pay Copelin and Nehring the total sum of 20 cents per gallon on all mix used in all stores authorized by the said corporation except any stores owned and operated directly by the corporation.Petitioner corporation was incorporated on January 24, 1948, in accordance with all of the provisions of the above-mentioned June 24, 1947, agreement.*66  During 1948 and 1949 petitioner corporation entered into 19 and 17 agreements, respectively, with certain other parties.  Each agreement was designated "DAIRY QUEEN FRANCHISE AGREEMENT." In each agreement petitioner corporation was known as "COMPANY" and the second party as "LICENSEE." Each agreement recited that "COMPANY is the holder and owner of an exclusive franchise for the preparation, sale and distribution of a certain product known as DAIRY QUEEN, and has agreed to grant to the LICENSEE an exclusive territory within the State of Oklahoma for the preparation, sale and distribution of this product, upon the terms and conditions as hereinafter set *230  forth, said territory being" a specific county or city in the State of Oklahoma.  Each agreement then provided:That COMPANY shall furnish for the use of the LICENSEE within the territory as above set out two (2) DAIRY QUEEN freezers, such freezers to be furnished at the sole cost and expense of COMPANY, F. O. B. point of manufacture. That said freezers shall be and remain the property of COMPANY and shall retain the character of personal property irrespective of the manner in which they may be joined or attached to the real property wherein they may be used.  LICENSEE shall bear all costs of installation and shall thereafter maintain said freezers in a state of good repair.  COMPANY shall furnish competent supervision for the installation of said freezers and shall be responsible for getting said machines into satisfactory production and shall assist LICENSEE in the opening of the first store.  That LICENSEE or one of his key personnel shall take training in one of COMPANY'S stores of sufficient length to understand methods of operation prior to the opening of said store.  That any additional store opened within said teritory by the LICENSEE shall be on similar terms and conditions*231  to those contained herein.That COMPANY shall furnish LICENSEE with the formula for DAIRY QUEEN and shall assist him in obtaining a source of supply for the mix used in said machines. That this said mix shall at all times be procured from a source of supply which is approved by COMPANY.That the LICENSEE shall pay to COMPANY for the rights and privileges of this agreement:The total sum of $ 3750.00 which shall be payable $ 1,875.00 upon the signing of this agreement and the balance of $ 1,875.00 when the Licensee desires delivery of the second freezer, there being only one freezer furnished for the opening of the store.  That any other store opened within this territory shall be on similar terms and conditions to those contained herein.  That the LICENSEE shall pay a continuing royalty of thirty-five cents (35 cents) per gallon of mix used in said machine. That COMPANY or the patent owner shall have the right to audit the records of LICENSEE to determine if royalties have been correctly paid.  That said audits shall occur after November 1st and shall be at the expense of the auditing party.  That said royalties shall be paid by the fifth day of the month following the period of*232  sales.That the LICENSEE shall furnish a suitable location subject to the approval of COMPANY which shall be similar in construction and appearance to standard DAIRY QUEEN stores.  That the LICENSEE shall participate in the fulfillment of this contract as an individual unit bearing all costs of equipment and production except the cost of the freezers. That the LICENSEE shall at all times maintain the standards and quality set up by COMPANY with respect to cones, cups, flavoring, and all miscellaneous supplies.  That the *67  same standards shall be maintained with respect to cleanliness and sanitation.  That no other products than DAIRY QUEEN shall be sold or dispensed from said store.That the terms and conditions of this contract shall be varied or modified only upon a subsequent agreement in writing by the parties hereto.  That this contract shall not be transferred or assigned without the prior permission of COMPANY.  That the rights, privileges and obligations of this contract shall be binding upon the heirs, successors and assigns of each of the parties hereto.  That in the event of the termination of this agreement for any cause the LICENSEE agrees not to be engaged in*233  the preparation, sale and distribution of a similar product for a period of five (5) years from the date of such termination.That in the event the LICENSEE violates any of the material obligations of this agreement, COMPANY is given the right to enter and remove his said machines free and clear of any damages for trespass in effecting such repossession.During the year 1948 petitioner corporation received $ 57,056.45 as representing the lump-sum payments provided for in the franchise agreements and $ 30,434.73 as representing the amounts paid for the continuing royalty of 35 cents per gallon. In its corporation income tax return for 1948 it reported the $ 30,434.73 as gross income from "Royalties," and the lump-sum payments were treated as the gross sales price of property sold and a net long-term capital gain of $ 19,371.07 was computed as follows:Description of propertyCity franchisesDate acquired1946Gross sales price$ 57,056.45Less cost or other basis 218,314.30Net long-term capital gain$ 38,742.15One-half19,371.07*234  The respondent in his determination did not disturb the manner in which petitioner corporation reported the amount of $ 30,434.73 but determined that "the aggregate amount of $ 57,056.45 represented ordinary income and not the proceeds of sale of a capital asset held for more than six months as reported in schedule C of your return" and "Accordingly net income is increased by $ 57,056.45 and decreased by $ 19,371.07 the amount of the net capital gain reported."During the year 1949 petitioner corporation received $ 62,916.89 as representing the lump-sum payments provided for in the franchise agreements and $ 74,575.70 as representing the amounts paid for the continuing royalty of 35 cents per gallon. In its corporation income tax return for 1949 it reported the $ 74,575.70 as gross income from "Royalties" and the $ 62,916.89 as a net long-term capital gain.*68  The respondent in his determination did not disturb the manner in which petitioner corporation reported the amount of $ 74,575.70 but determined that "the aggregate amount of $ 62,916.89 represented ordinary income and not the proceeds of sale of a capital asset" and "Accordingly your net income is increased by $ 62,916.89*235  and net long-term capital gains decreased by the same amount."The lump-sum payments of $ 57,056.45 and $ 62,916.89 received by petitioner corporation during the years ending December 31, 1948 and 1949, respectively, pursuant to the Dairy Queen franchise agreements, constitute advance royalties for the use of Dairy Queen rights in the various counties (or cities) covered in the said agreements, and such amounts are royalties taxable to petitioner corporation as ordinary income.The amounts of $ 30,434.73 and $ 74,575.70 reported by petitioner corporation on its income tax returns for the years ending December 31, 1948 and 1949, respectively, as gross income from royalties, were properly reported and are taxable as ordinary income.Throughout the calendar year 1949 the entire outstanding stock of petitioner corporation was owned by three stockholders. Petitioner corporation did not distribute any of its 1949 earnings as dividends to its stockholders.During the taxable year 1949 petitioner corporation operated two stores at which it sold the frozen product, Dairy Queen.  On its income tax return for that year, petitioner corporation reported a gross profit from sales due to the operation*236  of those two stores of $ 21,921.14.  The parties have stipulated that "for the purpose of determining the personal holding company income of the said corporation for the year 1949" the gross profit from the sales of these two stores should be $ 18,648.58 instead of $ 21,921.14.More than 80 per cent of petitioner corporation's 1949 income was personal holding company income, and the corporation was a personal holding company during the year 1949.On January 1, 1951, petitioner corporation was dissolved in a voluntary dissolution proceeding and at the time of the dissolution Copelin and the two Nehrings were the only stockholders and directors of the corporation.  The outstanding capital stock of the corporation was at all times material herein owned 50 per cent by Copelin and 25 per cent by each of the two Nehrings.  The assets of petitioner corporation were distributed to the stockholders in proportion to their stock ownership and in exchange for their stock in the corporation.On February 9, 1953, respondent determined that Copelin and the two Nehrings were liable as transferees to the extent of the value of the assets they received from petitioner corporation for the alleged deficiency*237  in Federal income tax for the years 1948 and 1949, personal *69  holding company surtax for the year 1949, and a 25 per cent addition to the tax for failure to file a personal holding company surtax return for the year 1949, together with interest as provided by law.The respondent determined the alleged deficiency against petitioner corporation on February 9, 1953, which was subsequent to the date the corporation transferred its assets to its stockholders. The transfer of its assets by petitioner corporation on January 1, 1951, left the corporation without any assets to pay the alleged deficiency in Federal income tax, personal holding company surtax, the 25 per cent addition to the tax for failure to file a personal holding company surtax return, and interest as provided by law.The assets transferred by petitioner corporation on January 1, 1951, to its three stockholders had a value of $ 107,293.74.  The value of the assets received by Copelin was $ 53,646.87; the value of the assets received by L. H. Nehring was $ 26,823.44; and the value of the assets received by Priscilla Nehring was $ 26,823.47.The individual petitioners in Docket Nos. 48221, 48222, and 48237 do not dispute*238  their liability as transferees but dispute only the liability determined by respondent against petitioner corporation.OPINION.1. The main question is whether the amounts (both the lump-sum and gallonage payments) petitioner corporation received during the years 1948 and 1949 from the second parties in the 36 franchise agreements represented proceeds from the sales of capital assets and are taxable as long-term capital gain under section 117 3 of the Internal Revenue Code of 1939, or whether such amounts were royalties taxable as ordinary income.*239  In its returns petitioner corporation reported the lump-sum payments as capital gain and the gallonage payments as royalties. It now contends, however, that both kinds of payments are part of the consideration for the sale of subfranchise rights and should be taxed as long-term capital gain under section 117.  The respondent contends that the said franchise agreements entered into during the taxable *70  years 1948 and 1949 were mere licensing agreements and that both kinds of payments were royalties taxable as ordinary income.In the alternative, the respondent contends that if it be held that the franchise agreements in question could be regarded as a "sale or exchange" within section 117 (a) (4), supra, such sale or exchange was not one of "capital assets" as that term is defined in subsection (a) of section 117 and, further, that for the year 1948 it has not been shown that the assets claimed to have been sold were "held for more than 6 months" as is required under section 117 (a) (4).  In this connection, see Kronner v. United States, 126 Ct. Cl. 156, 110 F. Supp. 730, wherein the court said:To avail themselves of *240  the benefits of section 117, the burden is upon the taxpayers to establish (1) that the property in question is a "capital asset" as defined in section 117, (2) that there has been a "sale or exchange" of that property, and (3) that it has been held for more than six months prior to the "sale or exchange."We are of the opinion that the 36 franchise agreements here in question did not constitute sales or exchanges but were mere licensing agreements, as respondent contends.  In so holding, it will not be necessary to consider the alternative contentions argued by the respondent.In determining whether or not the transactions here involved constitute sales or licensing agreements, we recognize that the terms used in the agreements such as "LICENSEE" and "continuing royalty" are not controlling or conclusive.  Waterman v. Mackenzie, 138 U.S. 252; Parke, Davis & Co., 31 B. T. A. 427; Edward C. Myers, 6 T. C. 258.We have set out in our findings practically an entire "DAIRY QUEEN FRANCHISE AGREEMENT" which the parties have stipulated represented a sample of the 36 written agreements entered *241  into by petitioner corporation during the taxable years.  We think there are too many restrictions in these agreements to justify a holding or a finding that any sale or exchange took place.  The agreements have some of the elements of a sale as for instance where the first party "has agreed to grant to the LICENSEE an exclusive territory within the State of Oklahoma." But this was "upon the terms and conditions as hereinafter set forth." These terms and conditions were such that other parts of the agreements, as for instance where the "COMPANY shall furnish for the use of the LICENSEE" the necessary freezers, which "freezers shall be and remain the property of COMPANY," bespeak of a licensing arrangement rather than a sale.  We do not, however, think it would be proper to attempt, as petitioner corporation did in filing its returns, to split the consideration as being partly for sales and partly for licensing. We think we are compelled to treat all the consideration as being for a single "bundle" of rights and privileges *71  for the reason that the territory, trade name, freezers, and formula all are necessary for the successful operation of a Dairy Queen store and one would*242  be valueless without the others.  When looked upon in this manner, we cannot say that petitioner corporation "sold" this bundle of rights to the second parties.  Specifically, the freezers were to "remain the property" of the first party.  The second parties could only procure its mix "from a source of supply which is approved by" the first party.  The first party and the patent owner had the right to audit the records of the second party "to determine if royalties have been correctly paid." The second parties were compelled at all times to "maintain the standards and quality set up by" the first party "with respect to cones, cups, flavoring, and all miscellaneous supplies." The second parties could sell no other products than Dairy Queen, and in the event of termination of the agreement could not engage in the preparation, sale, or distribution of a similar product for a period of 5 years.  If the second parties violated "any of the material obligations" of the agreement, the first party had the right to enter and remove the freezers free and clear of any damages.  We hold, therefore, that the 36 franchise agreements were licensing agreements and that all of the consideration received*243  by petitioner corporation (both lump-sum and gallonage payments) represented royalties taxable as ordinary income.  Federal Laboratories, Inc., 8 T. C. 1150; Cleveland Graphite Bronze Co., 10 T. C. 974, affd.  177 F. 2d 200; John Randolph Hopkins, 15 T. C. 160; Broderick v. Neale, 201 F. 2d 621; Lynne Gregg, 18 T. C. 291, affd.  203 F. 2d 954; Ernest E. Rollman, 25 T. C. 481. Cf.  Kimble Glass Co., 9 T. C. 183.2. In its return for 1948 petitioner corporation, in computing the gain on the $ 57,056.45 of lump-sum payments received in 1948, excluded from the gross sales price the entire amount of $ 18,314.30 which it had assumed at the time of incorporation as representing that part of the $ 23,364 Copelin had agreed to pay the McCulloughs.  See footnote 2 above.Petitioner corporation now concedes that it was in error in excluding from the gross sales price the entire amount of $ 18,314.30 in 1948 but contends that*244  some reasonable allocation of its basis should be made for the subfranchises which it contends it sold in 1948 and 1949.  The respondent contends that not only were there no sales of subfranchises in either 1948 or 1949 but that petitioner corporation is not entitled to deduct any part of the $ 18,314.30 in either year in any event.We held under the first issue that the 36 franchise agreements were not sales or exchanges.  Therefore, there would be no occasion to compute any "gain" by excluding or deducting from the selling price a portion of the basis of the property alleged to have been sold.  Petitioner *72  corporation does not contend nor has it shown that some part or all of the $ 18,314.30 is deductible from gross income on other grounds.  We, therefore, sustain the respondent's determination.3. The third issue is whether petitioner corporation was a "personal holding company" for the year 1949 within the meaning of that term and the term "personal holding company income" as defined in sections 5014*245  and 502, 5 respectively, of the 1939 Code.Any corporation is a "personal holding company" if it meets the two requirements of section 501.  The requirement as to stock ownership is not in dispute.  All the stock during 1949 was owned by three stockholders. In order to meet the gross income requirement under section 501 (a) (1), at least 80 per cent of its gross income must be "personal holding company income as defined in section 502." (Footnote 5, supra.) The gross income of petitioner corporation for the year 1949 consisted of the following amounts:1. Gross profit from sales$ 18,648.58(as stipulated)2. Long-term capital gain (auto)11.23(defic. notice)3. Lump-sum payments from licensees62,916.894. Gallonage payments from licensees74,575.70Total gross income$ 156,152.20*246  Under the first issue we held that items 3 and 4, which together amount to more than 80 per cent of the total gross income, were "royalties" taxable as ordinary income.  This, of course, brings petitioner within the gross income requirement of section 501 (a) (1).  Petitioner makes alternative contentions that item 3 should be regarded as "advance rental" for the use of the machines and item 4 should be reduced to $ 19,021.29 by reason of the deduction taken in the return and allowed of $ 55,554.41 of royalties which it was required to pay to prior owners or assignors.  There is no merit to the second part of that argument because the test in section 501 (a) (1) is based upon gross income which is before any deduction.  The first *73  part of the argument then becomes of no consequence either because even though item 3 were to be regarded in whole or in part as "advance rental" for the use of the machines it would not amount to 50 per cent of the gross income and, therefore, would not be eliminated from personal holding company income.  Sec. 502 (g).  The petitioner has not shown that less than 80 per cent of its gross income was personal holding company income as defined in *247 section 502.  Hugh Smith, Inc., 8 T. C. 660, affd.  173 F. 2d 224, certiorari denied 337 U.S. 918.4. The parties are in agreement that the individual petitioners are liable as transferees for any deficiencies owing by petitioner corporation to the extent of the stipulated value of the corporation's assets received by them upon dissolution.  The amount of any deficiencies owing by the corporation will be determined under Rule 50 and the individual petitioners' liability as transferees will be determined accordingly.Decisions will be entered under Rule 50.  Footnotes1. Transferee proceedings of the following petitioners are consolidated herewith: L. H. Nehring, Alleged Transferee, Docket No. 48221; Priscilla Nehring, Alleged Transferee, Docket No. 48222; and L. E. Copelin, Alleged Transferee, Docket No. 48237.↩2. This $ 18,314.30 represents that part of the $ 23,364 which Copelin had agreed to pay the McCulloughs in the February 14, 1946, agreement as amended on September 15, 1947, which had not been paid at the time petitioner corporation was organized and which liability was assumed by petitioner corporation.↩3. SEC. 117.  CAPITAL GAINS AND LOSSES.(a) Definitions.  -- As used in this chapter -- (1) Capital assets. -- The term "capital assets" means property held by the taxpayer (whether or not connected with his trade or business), but does not include stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, or property, used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 23 (l) * * ** * * *(4) Long-term capital gain. -- The term "long-term capital gain" means gain from the sale or exchange of a capital asset held for more than 6 months, if and to the extent such gain is taken into account in computing net income;↩4. SEC. 501.  DEFINITION OF PERSONAL HOLDING COMPANY.(a) General Rule.  -- For the purposes of this subchapter and chapter 1, the term "personal holding company" means any corporation if -- (1) Gross income requirement.  -- At least 80 per centum of its gross income for the taxable year is personal holding company income as defined in section 502; * * *(2) Stock ownership requirement.  -- At any time during the last half of the taxable year more than 50 per centum in value of its outstanding stock is owned, directly or indirectly, by or for not more than five individuals.↩5. SEC. 502.  PERSONAL HOLDING COMPANY INCOME.For the purposes of this subchapter the term "personal holding company income" means the portion of the gross income which consists of:(a) Dividends, interest (other than interest constituting rent as defined in subsection (g)), royalties (other than mineral, oil, or gas royalties), annuities.* * * *(g) Rents.  -- Rents, unless constituting 50 per centum or more of the gross income. For the purposes of this subsection the term "rents" means compensation, however designated, for the use of, or right to use, property * * *↩