Potter v. Comm'r , 27 T.C. 200 ( 1956 )

John T. Potter, Petitioner, v. Commissioner of Internal Revenue, Respondent

Potter v. Comm'r

Docket No. 52506

United States Tax Court

27 T.C. 200; 1956 U.S. Tax Ct. LEXIS 52;

October 31, 1956, Filed

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Decision will be entered under Rule 50.

1. Petitioner by one instrument created irrevocable trusts for his wife and two minor children. He transferred to the trusts the full and exclusive right, title, and interest in and to a certain patent application and any and all patents issued thereon. Coincidentally with the creation of the trusts, the trustees entered into a nonexclusive license agreement with petitioner to make, use, and sell the article covered in the application at a graduated royalty rate. The trusts were to continue until the children reached their majority. One child was born about the time the trusts were created. Held, the income from the trusts for the years 1944, 1945, and 1946 was not taxable to petitioner under section 22 (a), Internal Revenue Code of 1939, and petitioner was entitled, under section 23 (a) (1) (A), 1939 Code, to deduct from his sole proprietorship business income the royalties he had agreed to pay under the license agreement with the trustees.

2. During the taxable years, petitioner borrowed from his children some of the income paid to them by the trustees and agreed to pay interest thereon. During the years 1945 and 1946, petitioner advanced funds to pay his children's income taxes. At the close of each year, he offset against such advances the accrued interest on the loans from his children. Held, petitioner was entitled to deduct as interest "paid" under section 23 (b), 1939 Code, the amount offset against the advances at the end of the years 1945 and 1946.

3. In 1945, petitioner purchased certain Government bonds and delivered the bonds to the trustees in payment of royalties accrued under the license agreement with the trustees. Held, the respondent erred in taxing the interest on the bonds to petitioner during the years 1945 and 1946.

4. Petitioner failed to file a declaration of estimated tax for the year 1946. Held, respondent did not err in determining additions to the tax under section 294 (d) (1) (A) and (d) (2) of the 1939 Code.

John E. McClure, Esq., and Reuben Clark, Esq., for the petitioner.

Richard G. Maloney, Esq., and Emil Sebetic, Esq., for the respondent.

Arundell, Judge.

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ARUNDELL

Respondent determined deficiencies in income tax and additions to income tax under section 294 of the Internal Revenue Code of 1939 for the calendar years 1944, 1945, and 1946 as follows:

		Additions under sec. --
Year	Deficiency
		294 (d) (1) (A)	294 (d) (2)
1944	$ 18,201.66
1945	40,008.59
1946	37,701.39	$ 4,598.46	$ 3,065.65

The issues are:

1. For the years 1944, 1945, and 1946, was the income from the Potter Trusts taxable to petitioner under section 22 (a) of the Internal Revenue Code of 1939 or, in the alternative, was the Potter Instrument Company (a sole proprietorship) entitled to deduct royalties accrued under a license agreement with the said trusts under section 23 (a) (1) (A) of the 1939 Code?

2. For the years 1945 and 1946, was petitioner entitled to deduct as interest certain payments made on behalf of his children which were taken as offsets on their books of account?

3. For the years 1945 and 1946, was the interest on certain Government bonds properly taxable to petitioner?

4. For the year 1946, did respondent err in determining additions to the tax under section 294 (d) (1) (A) and (d) (2) of the 1939 Code?

FINDINGS OF FACT.

The stipulation of facts is incorporated herein by this reference.

Petitioner is an individual residing at Oyster Bay, New York. The returns for the years here involved were filed with the then collector of internal revenue for the first district of New York.

During the taxable years here involved, petitioner operated a sole proprietorship known as the Potter Instrument Company, hereinafter sometimes referred to as the Company. The Company employed the accrual method of accounting and kept its books of account on a calendar year basis. The Company was engaged, among other things, in the manufacture and sale of high-speed electronic counting, timing, and control instruments.

Petitioner attended the Rensselaer Polytechnic Institute and early became interested in science. On leaving Rensselaer, he went to work for John V. Hogan, a consulting engineer, for whom he did engineering work in high fidelity sound, facsimile, and television. Upon leaving Hogan, petitioner worked for various employers until 1939 when he went with the General Electric Company as an engineer in its engineering laboratory. While with General Electric, petitioner gave thought to developing a cheap and simple counter chronograph. Petitioner had contacts with the Army at the Aberdeen Proving Grounds in Maryland and, on receiving from the Army a promise that if he could produce such a counter chronograph for $ 4,000, which at that time was costing the Government about $ 25,000, the Army would purchase 5 of them, petitioner left General Electric to set up business for himself.

In 1942 petitioner set up a business in Flushing, New York, in a small room and produced a counter chronograph which he sold to the Government for $ 4,000. Then he was given an order by the Army for additional units. During the years 1942 and 1943, petitioner engaged in personal effort that culminated in his inventing a basic electronic counter chronograph, also known as a 4-tube counter decade assembly. On November 13, 1943, petitioner filed application bearing serial number 510,229 for a patent with the United States Patent Office covering this device. On January 16, 1951, a patent bearing number 2,538,122 was issued to petitioner with respect to this application.

The counter chronograph was immediately valuable commercially because all such counters until this time had at least 12 vacuum tubes in each decade. The counter invented and developed by petitioner used only 4 vacuum tubes and was at the same time a very dependable and economic counter. During the year 1943, as a result of this counter and other things it was doing, the Company did about $ 30,000 worth of business and at the beginning of 1944 it looked like it was going to be a good year and a profitable one. Among other things, the Company at this time was producing amplifiers, power supplies, and specialty items for the various proving grounds. The backlog of orders at this time was quite large. Petitioner has taken out over 20 patents during his working lifetime and has had considerable experience in negotiating license agreements in connection with such patents.

In the latter part of 1943 and the early part of 1944, petitioner had conferences with Robert H. Horn, with respect to the creation of a trust for his wife, Doris T. Potter, and two minor children, Lois Trimble Potter, born July 1, 1940, and John Taft Potter, Jr., born January 28, 1944. Horn was a certified public accountant who did the supervisory auditing work for the Company and was responsible for the maintenance of its books. He also handled its financial affairs. Petitioner was motivated to establish these trusts because the business of the Company was doing quite well in 1943 and petitioner felt that this would be a good opportunity to set something up for his wife and two children that would protect them if reverses should occur later.

Paragraph 4 of the stipulation is as follows:

4. At an undisclosed date, petitioner established under a single trust instrument three trusts for the benefit of his wife, Doris T. Potter, and two minor children, Lois Trimble Potter and John Taft Potter, Jr. A copy of the trust instrument, which by its terms states that it was effective January 1, 1944, is attached hereto as Exhibit 3-C. The trusts created by this trust agreement are hereinafter referred to as the "Potter Trusts."

The trust instrument begins with these words and date: "agreement, dated this 1st day of January, 1944, between" petitioner as grantor and his wife, father (Harold T. Potter), and Horn, as the three trustees. The instrument was signed and separately acknowledged, before a notary, by petitioner and the three trustees. The four acknowledgments were identical except for the name of the person appearing before the notary. Petitioner's acknowledgment was as follows:

State of New York

County of Nassau

ss:

On the 1st day of February, nineteen hundred and forty-four, before me came JOHN T. POTTER, to me known and known to me to be the individual described in, and who executed, the foregoing instrument, and acknowledged to me that he executed the same.

(Signed) Julie M. Valley #2233

Notary Public, Nassau County, New York, #2233.

Under the trust instrument, petitioner irrevocably assigned all right, title, and interest in the patent application relating to the counter chronograph to the trusts. The trust agreement provided, in part, as follows:

FIRST: The grantor hereby assigns, transfers, gives and sets over to the Trustees, their successors or assigns, the full and exclusive right, title and interest in and to a certain application made for letters patents of the United States of America, which application has been duly filed in the patent office in the City of Washington, District of Columbia, and bears the number 510229, and any and all patents issued thereon; and any and all income, royalty, profit or proceeds of any nature and description whatsoever, that may be derived from the ownership of the invention covered by such application and described in the specifications filed therewith, (which, together with any and all property which may hereafter be added thereto or exchanged therefor, as herein after provided, is herein after referred to as the "trust estate"), to have and to hold the same unto the said Trustees their successors and assigns.

* * * *

SIXTH: By the execution of this Indenture and by the delivery of the property constituting the trust estate, it shall be deemed that, subject to the provisions hereof, a valid gift inter vivos has been made and neither the grantor nor his legal representatives nor assigns shall have any right, title or interest in or to any of the property at any time held hereunder.

The Potter Trusts were irrevocable and were to continue in existence until the children reached their majority. Petitioner retained no power to alter the status of the beneficiaries, nor did he retain any power to direct the accumulation or withholding of income. He had no control over investment policy. He possessed no reversionary interest. He had no power to change trustees. The trust instrument specifically provided that the income therefrom could not be used to discharge his legal obligation to support his wife and children, nor was any such income in fact so used. The trusts were, and are today, valid trusts under the laws of New York State. Petitioner filed a gift tax return with respect to these trusts.

During the taxable years involved, books of account were kept by Horn for the Company, the Potter Trusts, and for John T. Potter, Jr., and Lois T. Potter. The Potter Trusts employed the accrual method of accounting and kept their books of account on a calendar year basis.

Before entering into the trust agreement with the trustees, petitioner on behalf of the Company discussed with them the Company's right to license the patent application back from the trustees and the question of the royalty rate that should be paid by the Company to the trusts if such a license arrangement were to be entered into. Petitioner had discussions with the trustees in the early part of 1944, or previously, in which he wanted to ascertain what the royalty rate would be before he would establish the trusts. Petitioner and the trustees first agreed upon a royalty rate and then entered into the trust agreement and the license agreement coincidentally. Until the royalty rate was agreed to, petitioner would not have transferred the patent application to the trusts as a matter of business judgment, since he had to know in what order of magnitude the royalty would fall before the Company could enter into it and the understanding had to be arrived at ahead of time as to what the royalties would be.

Under a license agreement dated January 10, 1944, the trustees of the Potter Trusts and the Company entered into a nonexclusive license agreement for the Company to "make, use and sell" the counter chronograph covered by the aforesaid patent application. This agreement provided for a graduated royalty to be paid to the Potter Trusts by the Company.

On October 31, 1944, the Potter trustees on behalf of the Potter Trusts entered into a nonexclusive, royalty-free license agreement with the United States Government for the Government to make, use, and sell the counter chronograph under the patent application which had been transferred to the trusts.

Beginning sometime in 1945, Sanford C. Nussenfeld represented petitioner from time to time in legal matters. At some time prior to January 3, 1945, he was consulted with reference to the trusts by petitioner's father, Harold T. Potter. As a result of this consultation, Nussenfeld wrote Harold a letter dated January 3, 1945, in which he stated that he had read the John T. Potter trust agreement and would suggest the addition of two paragraphs which he set out in his letter. These two paragraphs do not appear in the trust agreement mentioned in paragraph 4 of the stipulation.

On October 25, 1945, the Potter trustees on behalf of the Potter Trusts entered into an exclusive license agreement with the American Totalisator Company, under which that company was entitled to use the counter chronograph solely in connection with totalisator machines at racetrack betting and parimutuel machines. A royalty payment of $ 5,000 with respect to the first contract year was made by that company to the trusts on July 19, 1946. A second payment of $ 5,000 for the second contract year was made to the trusts on October 25, 1946. Further payments in the amount of $ 5,000 each were made by the American Totalisator Company to the trusts on October 31, 1947, and on December 10, 1949. Under the terms of this agreement, the Company was to manufacture and service the desired parimutuel machines employing the counter chronograph. One such parimutuel machine, involving 78 decades, was manufactured under this contract, for which the aforesaid royalties were paid. Also, under the terms of this agreement petitioner was employed by American Totalisator Company for 5 years, receiving a guaranteed minimum payment of $ 10,000 a year for his services.

The trust agreement mentioned in paragraph 4 of the stipulation was executed on February 1, 1944.

During the calendar year 1944, royalties accrued to the Potter Trusts under the aforesaid license agreement with the Company in the following amounts:

1st quarter	$ 1,650.00
2d quarter	3,600.00
3d quarter	16,387.50
4th quarter	8,402.50
Total	$ 30,040.00

On December 28, 1944, the Company paid $ 15,000 to the Potter Trusts on account of accrued royalties. On March 9, 1945, the Company paid $ 15,040 to the Potter Trusts on account of the balance of accrued royalties for 1944.

On December 29, 1944, the Potter Trusts distributed to the three beneficiaries the sum of $ 15,000. Of this amount, $ 5,000 was distributed to Doris and $ 5,000 was distributed to each child. The $ 5,000 distributed to John T. Potter, Jr., was deposited in a savings account entitled, "John T. Potter, Guardian of John T. Potter, Jr." in the Port Washington National Bank & Trust Company (savings account No. X1721). The $ 5,000 distributed to Lois was likewise deposited in a savings account entitled "John T. Potter, Guardian of Lois T. Potter," (savings account No. X1720). Each savings account passbook was inscribed by petitioner with these words: "I am guardian in charge of this."

In the calendar year 1945, royalties accrued to the Potter Trusts under the aforesaid license agreement with the Company in the following amounts:

1st quarter	$ 8,316
2d quarter	12,756
3d quarter	12,192
4th quarter	10,243
Total	$ 43,507

On April 10, 1945, the Potter Trusts distributed $ 10,500 to the three beneficiaries. Of this amount, $ 3,500 was distributed to Doris and $ 3,500 to each of the two children. The distributions to the children were deposited in their respective savings accounts on April 17, 1945.

On August 28, 1945, the Company purchased 2 1/2 per cent 1967-72 United States Treasury bonds dated June 1, 1945, in the face amount of $ 25,000 at a cost of $ 25,325.99. On August 28, 1945, the Company delivered these bonds to the trusts on account of accrued royalties. On August 31, 1945, a distribution of the bonds was made in the amount of $ 12,662.99 to Lois and $ 12,663 to John T. Potter, Jr. The bonds were bearer bonds and were kept by petitioner as natural guardian for his children in his own safe-deposit box. Petitioner informed Doris about the bonds.

On or about October 19, 1945, petitioner and Doris entered into a separation agreement. Under this agreement, custody of the children was shared between their parents, Doris having custody during the school year and petitioner during the summer months. This agreement provided in part as follows:

The Wife and Husband hereby mutually grant, release and forever quit claim unto the other all right, title, interest, property, claim and demand whatsoever in law and in equity in the real estate of which either is now seized or which either party may hereafter become seized of, and they hereby release any and all rights which either now has or which either may hereafter acquire in the personal estate of the other, whether such rights arise under any statute of distribution or by virtue of any right of election or otherwise, and hereby waive any right of administration upon the estate or any benefit under any existing will of the other in the event of the death of either. This paragraph is subject to all rights and claims which either party may have against the other party or against his or her Estate under and pursuant to the terms of this agreement.

On December 12, 1945, petitioner and Doris were divorced.

In accordance with the terms of the trust agreement, Doris ceased to act either as a beneficiary or as a trustee of the Potter Trusts on being separated from petitioner. The undistributed balance of the Doris T. Potter Trust was transferred equally to the children, John and Lois.

On January 10, 1946, the Company paid to the Potter Trusts the sum of $ 18,181.01 on account of royalties accrued through December 31, 1945. On January 15, 1946, the trustees distributed $ 18,000 to the children, $ 9,000 to each. The amounts distributed to the children were deposited in their respective savings accounts.

In the calendar year 1946, royalties accrued to the Potter Trusts under the license agreement with the Company in the following amounts:

1st quarter	$ 9,144
2d quarter	10,353
3d quarter	10,392
4th quarter	13,647
Total	$ 43,536

On April 17, 1946, the Company paid the Potter Trusts the sum of $ 5,000 on account of accrued royalties.

Between January 5, 1945, and April 19, 1945, the Company borrowed from Doris the total amount of $ 7,900 and gave demand notes therefor. The full amount of these loans was repaid by the Company during 1945.

Between January 16, 1945, and April 18, 1946, the Company borrowed from each child the total amount of $ 12,900 from each and gave demand notes therefor. The Company repaid $ 400 to each child on August 2, 1945.

These sums were borrowed by the Company because it was necessary to use the money in the business. The Company needed capital. At the time he entered into the trust agreement, petitioner did not contemplate that the Company would need this money. Before the money was borrowed from petitioner's wife and children, the Company made attempts to borrow funds elsewhere, in various places, including the Flushing National Bank, but the Company was unable to obtain loans without putting up sufficient collateral. Petitioner's personal assets were insufficient to provide adequate security for loans. The Company was doing considerable research and development and this required more working capital than petitioner had without borrowing. Petitioner was aware of his fiduciary responsibility to his children in withdrawing their money from their savings accounts and considered that in doing so he was acting in the children's best interests since, unless the Company could be supplied with capital, there would not be any additional royalties forthcoming for the children.

Petitioner had had experience in negotiating license agreements with respect to patents in previous years. The royalty rate negotiated between the Company and the Potter Trusts was a graduated rate running from $ 150 per decade for the first 100 decades completed to only $ 10 per decade for all decades completed in excess of 900. Based upon the facts and circumstances as they then existed, this rate was reasonable. It was negotiated on the expectation that production would be in the thousands annually and that the sales price would be $ 100 per decade. At this time, competing chronographs were selling at a price of about $ 200 to $ 300 per decade. The cost of production of each decade to the Company was in the neighborhood of $ 15.

Since 1944 the patent application relating to the counter chronograph has become no longer as valuable as it was in 1944. It has since been replaced by a new basic circuit element called a magnistor which replaces the vacuum tube that is used in the electronic counter chronograph.

The Potter Instrument Company, Inc., ¹ is a corporation organized in 1947 to take over the business and assume the liabilities of the Company as of June 30, 1947, and is now producing a new magnetic counter under a license agreement with Richard Snyder. Snyder is an engineer and inventor who developed this new magnetic counter and offered a patent covering it to the corporation.

In 1947, the Company first learned of a similar decade to that owned by the Potter Trusts, which was an R. C. A. invention which came into the field and sold for $ 40 or $ 45 per unit. Accordingly, the Company was forced to drop the sales price of its own decade from $ 100 to about $ 45. This reduced selling price did not permit the Company, or later the corporation, to pay the graduated royalty provided for in the 1944 license. Therefore, the corporation negotiated a reduction of the royalty rate with the trustees. Subsequent to June 30, 1948, the corporation and the Potter trustees entered into a royalty modification agreement which was placed in effect as of January 1, 1948, which agreement halved the existing royalty rate.

In 1946, cash was not available to the Company with which to pay royalties in excess of the $ 5,000 paid on April 17, 1946. In lieu of cash, the trustees wanted notes. Accordingly, notes were given by the Company, bearing interest at 6 per cent per annum to the Potter Trusts with respect to the balance of accrued royalties for the year 1946 in the total amount of $ 38,536.

The trustees were willing to accept the notes for the purpose of enabling the Company to retain working capital, which policy directly benefited the trusts by permitting the Company to expand its sales volume with a resulting increase in royalty income.

On June 17, 1947, the Company transferred the assets and liabilities of the Company to the corporation in exchange for all of the latter's common stock. Among the liabilities assumed by the corporation was the indebtedness owing to the children in the amount of $ 25,000 on account of the borrowings heretofore described, and $ 52,686 on account of notes given to the trusts for accrued royalties (including accrued royalties for the first half of 1947, less a payment made by the Company to the trustees on account of royalties in the amount of $ 11,600 on March 28, 1947), plus accrued interest on account of this indebtedness.

The corporation employed an accrual method of accounting and kept its books of account on a June 30 fiscal year basis.

In 1946 and 1947 the existence of the outstanding obligations owing to the Potter Trusts and to the children interfered with the ability of the Company, and later the corporation, to borrow money. In order to extend credit, the Flushing National Bank wanted these outstanding notes subordinated to their own obligations. Horn suggested in 1949 that the notes be capitalized and that preferred stock be issued to the trusts and to the children in place of the notes.

As a result of its bad credit position, the corporation, on July 1, 1949, issued 1,400 shares of preferred stock which it transferred proportionately to the trusts and the children (700 to the trusts and 350 shares to each of the children) in satisfaction of this indebtedness. Such preferred stock had a par value of $ 140,000.

The trustees were willing to exchange the existing notes, royalties, and interest due for preferred stock in order to enable the corporation to improve its financial condition and credit rating. They considered that this exchange could be effectuated without subjecting the interests of the trusts to unjustifiable risks.

As a condition for the trustees' accepting the preferred stock in place of the notes, the trustees and the corporation arrived at an agreement whereby petitioner, as the sole common stockholder, consented to donate to the corporation surplus at least 50 per cent of the amounts payable to him for patent rights acquired from him by the corporation, such contributions to be continued or resumed at any time that the total common stock equity became less than 50 per cent of the outstanding preferred stock.

At the present time, petitioner owns all the shares of common stock of the corporation; 1,390 shares of preferred stock are owned by the Potter Trusts and 840 shares are owned by each of the children, Lois T. and John, Jr. Four hundred shares of preferred stock are owned by petitioner.

The corporation paid regular dividends on its preferred stock for the earnings period from July 1, 1949, to June 30, 1953, on the following dates and in the following amounts:

Aug. 31, 1950	$ 8,400
Sept. 30, 1951	10,275
Sept. 30, 1952	12,900
Sept. 30, 1953	18,325

When these dividends were paid by check to Horn as trustee, he would deposit them in the trustee's account and, at the same time, give the corporation the trustee's checks for roughly the same amount for the purchase of additional preferred stock of the corporation. Sometimes a part of the cash was withheld in order to pay the income taxes on such dividends. In so reinvesting a part of the dividends for additional preferred stock, Horn, as trustee, considered he was acting for the best interests of the trusts.

On March 15, 1945, petitioner paid Federal income taxes for 1944 for each of his two children in the amount of $ 954, a total of $ 1,908. These payments were entered as "Advances -- J. T. Potter" on the books of account of the children. On April 15, 1945, petitioner paid New York State income taxes for 1944 for each of his children in the amount of $ 90, a total of $ 180. On December 31, 1945, accrued interest was owing from petitioner to the children in the amount of $ 726.83, on account of existing indebtedness, and such interest was paid by petitioner in that year by offsetting on the books the advances previously made by him in that year in payment of the children's State and Federal income taxes.

On April 13, 1946, petitioner paid New York State income taxes for 1945 for the children in the amount of $ 566.40 ($ 283.20 for each) and the balance of Federal income taxes for 1945 for the children in the amount of $ 1,803.66 ($ 901.83 for each). These payments were recorded on the books and records of the children as "Advances -- J. T. Potter." On December 31, 1946, accrued interest was owing from petitioner to the children on account of existing indebtedness in the amount of $ 1,323.33. This interest was paid by petitioner through offsetting on the books the advances previously made to the children by him in that year in payment of State and Federal income taxes.

Petitioner filed estimated tax returns and paid estimated taxes for each of the calendar years 1944 and 1945. He failed to file an estimated tax return or pay an estimated tax for the calendar year 1946. Petitioner left the responsibility of making out his returns entirely to Horn. Petitioner did file an individual income tax return on Form 1040 for 1946 with the collector of internal revenue on March 15, 1947. This return reported a net income of $ 32,915.48 and a tax liability of $ 13,392.72.

OPINION.

The respondent contends that his determination under the first and principal issue must be sustained on any one of several grounds, namely: (1) That petitioner has failed to prove that the trust instrument in question was executed prior to December 31, 1946; (2) that petitioner has failed to prove that he made a valid assignment and delivery of the patent application to the trusts; (3) that assuming a valid assignment and delivery, petitioner has still failed to prove that he made a valid inter vivos gift of the patent application to the trusts in that he continued to exercise such complete dominion and control over the property throughout the tax years for his own benefit, without any interference from friendly trustees, as to make such trust income taxable to him under section 22 (a) of the 1939 Code and the doctrine of Helvering v. Clifford, 309 U.S. 331">309 U.S. 331 (1940); and (4) that in any event petitioner is not entitled to deduct under section 23 (a) (1) (A) of the 1939 Code the royalties that accrued under the license agreement executed between petitioner and the trustees at the time the trusts were created.

Regarding respondent's contention that petitioner has failed to prove the trust instrument was executed prior to December 31, 1946, petitioner testified that, to the best of his memory, it was executed in the early part of 1944. He said he knew it occurred when his business began to look fairly good. This was in the latter part of 1943 and early in 1944. The instrument is dated January 1, 1944, but it names as one of the beneficiaries John Taft Potter, Jr., who was not born until January 28, 1944. Certainly it was in existence on October 31, 1944, when the trustees entered into a license agreement with the United States Government, and on October 25, 1945, when they entered into a license agreement with the American Totalisator Company. Both of these dates were before December 31, 1946. It would seem that the best evidence as to when the trust agreement was executed was when the grantor and the three trustees appeared before the notary and acknowledged that they had executed the "foregoing instrument." This was on February 1, 1944. The only evidence that would cast any doubt on the latter date is the letter from Nussenfeld dated January 3, 1945. But this was after October 31, 1944. Furthermore, the evidence relative to the letter from Nussenfeld is very meager. The record does not show what Nussenfeld had before him which prompted his suggestions with reference to the trust agreements. Harold T. Potter did not testify. In any event, the suggestions made by Nussenfeld do not appear in the trust agreement. We have found as an ultimate fact and so hold that the agreement mentioned in paragraph 4 of the stipulation was executed on February 1, 1944.

We do not agree with respondent that there was no valid assignment or delivery of the patent application to the trusts. Section 47 ² of Title 35 of the United States Code, as it existed in 1944, provides that "[every] application for patent or patent or any interest therein shall be assignable in law by an instrument in writing * * *" and that "[if] such assignment, grant or conveyance of any application for patent or patent shall be acknowledged before any notary public * * * the certificate of such acknowledgement * * * shall be prima facie evidence of the execution of such assignment, grant, or conveyance." Paragraph First of the trust instrument, together with petitioner's acknowledgement before the notary, all of which are set out in our findings, clearly show that there was a valid assignment in accordance with statutory law, both of the application itself and "any and all patents issued thereon." Respondent makes a point that there was no manual delivery of the application itself. This was impossible since, in 1944, this application was on file with the Patent Office in Washington, D. C. Respondent also makes the point that when the patent was issued in 1951 it was issued in petitioner's name and has never since been assigned to the trusts by petitioner. But this did not make petitioner the owner of the patent. As between petitioner and the trustees, the ownership of the patent after it was issued rested in the trustees by virtue of the assignment acknowledged on February 1, 1944.

Our next consideration is whether, under the Clifford doctrine, the income of the trusts is taxable to petitioner under section 22 (a). Control and the duration of the trusts are the important factors in determining this question. Stanback v. Robertson, (C. A. 4, 1950) 183 F.2d 889">183 F. 2d 889. Cf. T. M. Stanback, 27 T. C. 1.

Respondent contends that petitioner in substance never parted with control. He argues that the nonexclusive license granted to petitioner by the trustees at the time the trusts were created, together with the borrowings made by petitioner from the beneficiaries, makes it clear that the trusts were "mere conduits and shams, having no substance for tax purposes." We do not agree.

We have previously held herein that petitioner made a valid assignment and delivery of the patent application to the trustees. This assignment was irrevocable. The trustees were independent. The trusts were not short-term trusts but were to continue until the youngest child reached the age of 21 years, at which time the trusts could be terminated by any or all of the beneficiaries. Upon such termination, the trust estate, under paragraph Eleventh of the instrument, "shall be turned over to and become vested in the beneficiary thereof, to have and to hold the same in his own right, his heirs and assigns forever." Petitioner retained no power to change the beneficiaries or to direct the accumulation or withholding of income or to change trustees. He had no control over the investment policy and retained no reversionary interest. The trusts were and are today valid trusts under the laws of the State of New York. Petitioner, in creating the trusts, changed his economic status as far as patent application No. 510,229 was concerned. He was no longer the owner of such property and should not be taxed on the income thereafter derived therefrom. Jones v. Norris, (C. A. 10, 1941) 122 F. 2d 6; United States v. Morss, (C. A. 1, 1947) 159 F.2d 142">159 F. 2d 142; L. M. Fischer, 14 T.C. 792">14 T. C. 792.

This brings us to respondent's so-called alternative contention that petitioner is not entitled to deduct, under section 23 (a) (1) (A)³ the royalties that accrued under the 1944 license agreement with the trustees. He argues that the royalty payments were not ordinary and necessary; that they were not required as a condition to the continued use of the property; that they had no business purpose; that petitioner had title and equity in the property; and that the entire transaction was without substance. Much of this argument is repetitious of that made in connection with the three grounds already considered. The principal point here is whether the royalties petitioner agreed to pay were excessive for, as the court in Limericks, Inc. v. Commissioner, (C. A. 5, 1948) 165 F. 2d 483, said, "rentals or other payments for the use of property which are excessive in amount, taking into consideration all the facts of the particular case, do not constitute ordinary and necessary business expenses, or payments required to be made as a condition to the continued use of the property" under section 23 (a) (1) (A) of the 1939 Code. In our findings, we have found as a fact that, based upon the facts and circumstances which existed at the time the agreement was entered into, the rate agreed upon was reasonable and was not excessive. At that time it was expected that production of the decade would be in the thousands annually as petitioner was selling them at $ 100 per decade, whereas his competitors were selling at a price of between $ 200 and $ 300 a decade. The agreement which the trustees made with the American Totalisator Company on October 25, 1945, was even more favorable from the trustees' standpoint than the agreement with petitioner. There the effective rate of royalties for the production of each decade amounted to about $ 256 per decade. It is true that later in 1948 when the corporation was forced to reduce the selling price of the decade from $ 100 to about $ 45 the trustees were persuaded to reduce the royalty rate by about one-half. But this was under facts and circumstances which were entirely different from those that existed in January 1944. We hold that the payments were not excessive and that petitioner is entitled to the royalty deductions claimed under section 23 (a) (1) (A), supra. Skemp v. Commissioner, (C. A. 7, 1948) 168 F. 2d 598, reversing 8 T.C. 415">8 T. C. 415; Brown v. Commissioner, (C. A. 3, 1950) 180 F. 2d 926, reversing 12 T.C. 1095">12 T. C. 1095, certiorari denied 340 U.S. 814">340 U.S. 814; and Albert T. Felix, 21 T. C. 794, where this Court decided to follow the Skemp and Brown decisions.

At the trial, counsel for petitioner conceded "that the income of the trust accruing prior to whatever date is determined as being the date that this instrument was actually executed is properly taxable to Petitioner and not to the trust." We have held that the trust instrument was executed on February 1, 1944. The income accruing to the trusts for the first quarter of 1944 amounted to $ 1,650. We hold that one-third of this amount, or $ 550, is taxable to petitioner and not to the trusts.

2. Respondent in his deficiency notice disallowed deductions claimed by petitioner in his returns for 1945 and 1946 for "Interest on business indebtedness" in the respective amounts of $ 1,113.58 and $ 1,673.33, and gave as his reasons therefor the following:

(c) It is held that no deduction is allowable under section 23 (a) (1) (A) and section 24 (c) of the Internal Revenue Code for interest on alleged loans from Doris T. Potter, Lois T. Potter and John T. Potter, Jr.

Petitioner concedes he has not met his burden on interest owing to Doris but contends that he "paid" interest to his children in 1945 and 1946 in the respective amounts of $ 726.83 and $ 1,323.33 and that these amounts are deductible under section 23 (b) as "interest paid or accrued within the taxable year on indebtedness." Respondent contends that (1) the indebtedness was not bona fide, (2) that the interest was not "paid" within the taxable year, and (3) that "accrued" interest would not be deductible under section 24 (c). The material provisions of the 1939 Code are in the margin. ⁴

In view of our holding on the main issue, we hold that the indebtedness in question was a bona fide indebtedness incurred in petitioner's business.

During 1945 and 1946, petitioner paid on behalf of his children their Federal and State income taxes in the total amount of $ 2,088 for 1945 and $ 2,370.06 for 1946. These amounts were treated on the books of the children as "Advances -- J. T. Potter." At the end of each year, interest in the respective amounts of $ 726.83 and $ 1,323.33 had accrued on the existing indebtedness. These accrued amounts were at the close of each year then offset against the advances petitioner had made earlier in the year. We have found as a fact and so hold that the amounts of $ 726.83 and $ 1,323.33 were paid within the respective years 1945 and 1946, and are deductible under section 23 (b), supra. In view of this holding, we need not consider section 24 (c), relied upon by respondent, as that section deals only with "unpaid" items.

3. In the notice of deficiency, respondent included as additional income to petitioner in 1945 and 1946, under section 22 (a), interest on Government bonds in the amounts of $ 191 and $ 625, respectively. These were the bonds petitioner purchased in 1945 at a cost of $ 25,325.99 which he delivered to the trusts in payment of royalties. In view of our holding on the main issue, we hold that the respondent erred in including the above-mentioned interest in petitioner's income.

4. Under the fourth issue, petitioner testified that he left the responsibility of making out his tax returns entirely to Horn. We have found as a fact that he did, but we do not think this is sufficient proof to show that the failure to file a declaration of estimated tax for the year 1946 was "due to reasonable cause and not to willful neglect" as that phrase appears in section 294 (d) (1) (A) of the 1939 Code. Petitioner contends, however, that we should consider as additional proof the statements made in a protest which he filed with the respondent while the case was being considered by the respondent prior to the mailing of the deficiency notice. The protest was prepared by Horn and was sworn to by both petitioner and Horn. It was admitted in evidence before this Court for the purpose of showing that some of Horn's testimony before us regarding the trusts was contrary to what was said in the protest. It was not admitted in evidence for the purpose of proving any facts relating to the present issue. We hold, therefore, that the respondent did not err in determining the additions to the tax under section 294 (d) (1) (A) and (d) (2) of the 1939 Code. Rene R. Bouche, 18 T. C. 144, taxpayer's appeal to C. A. 2 dismissed (nolle pros.); Sidney V. LeVine, 24 T. C. 147, 157; Walter M. Joyce, 25 T. C. 13; Howard M. Fischer, 25 T. C. 102; John Adrian Cooper, 25 T. C. 894; G. E. Fuller, 20 T. C. 308, 316; and Harry Hartley, 23 T. C. 353, 360.

Decision will be entered under Rule 50.

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Footnotes

• 1. The Potter Instrument Company, Inc., is sometimes referred to herein as the corporation and is not to be confused with the sole proprietorship called Potter Instrument Company and often referred to herein as the Company.↩

• 2. Sec. 47. Assignments of patents and applications; evidence of execution.

  Every application for patent or patent or any interest therein shall be assignable in law by an instrument in writing, and the applicant or patentee or his assigns or legal representatives may in like manner grant and convey an exclusive right under his application for patent or patent to the whole or any specified part of the United States. An assignment, grant, or conveyance shall be void as against any subsequent purchaser or mortgagee for a valuable consideration, without notice unless it is recorded in the Patent Office within three months from the date thereof or prior to such subsequent purchase or mortgage.

  If any such assignment, grant, or conveyance of any application for patent or patent shall be acknowledged before any notary public of the several States or Territories or the District of Columbia, or any commissioner of any court of the United States for any district or Territory, or before any secretary of legation or consular officer authorized to administer oaths or perform notarial acts under section 1203 of Title 22, the certificate of such acknowledgment, under the hand and official seal of such notary or other officer, shall be prima facie evidence of the execution of such assignment, grant, or conveyance. R. S. § 4898; Mar. 3, 1897, c. 391, § 5, 29 Stat. 693; Feb. 18, 1922, c. 58, § 6, 42 Stat. 391; Aug. 18, 1941, c. 370, 55 Stat. 634.↩

• 3. SEC. 23. DEDUCTIONS FROM GROSS INCOME.

  In computing net income there shall be allowed as deductions:

  (a) Expenses. --

  (1) Trade or business expenses. --

  (A) In General. -- All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including * * * rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.↩

• 4. SEC. 23. DEDUCTIONS FROM GROSS INCOME.

  In computing net income there shall be allowed as deductions:

  * * * *

  (b) Interest. -- All interest paid or accrued within the taxable year on indebtedness * * *

  SEC. 24. ITEMS NOT DEDUCTIBLE.

  (b) Losses From Sales or Exchanges of Property. --

  (1) Losses Disallowed. -- In computing net income no deduction shall in any case be allowed in respect of losses from sales or exchanges of property, directly or indirectly --

  (A) Between members of a family, as defined in paragraph (2) (D);

  * * * *

  (2) Stock ownership, family, and partnership rule. -- For the purposes of determining, in applying paragraph (1), the ownership of stock --

  * * * *

  (D) The family of an individual shall include only his brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants; and

  * * * *

  (c) Unpaid Expenses and Interest. -- In computing net income no deduction shall be allowed under section 23(a), relating to expenses incurred, or under section 23(b), relating to interest accrued --

  (1) If such expenses or interest are not paid within the taxable year or within two and one-half months after the close thereof; and

  (2) If, by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not, unless paid, includible in the gross income of such person for the taxable year in which or with which the taxable year of the taxpayer ends; and

  (3) If, at the close of the taxable year of the taxpayer or at any time within two and one-half months thereafter, both the taxpayer and the person to whom the payment is to be made are persons between whom losses would be disallowed under section 24 (b)↩.