
    PAULSEN AND ELIZABETH SPENCE v. THE UNITED STATES
    [Nos. 292-54 and 111-55.
    Decided December 4, 1957]
    
      
      Mr. Clarence E. Dawson for tbe plaintiffs. Messrs. Weston Vernon, Jr., and Milbank, Tweed, Hope & Hadley were on the brief.
    
      Mr. Robert Livingston, with whom was Mr. Assistant Attorney General Charles K. Rice, for the defendant. Messrs. James P. Garland and Rufus E. Stetson, Jr., were on the brief.
   Jones, Chief Judge,

delivered the opinion of the court:

In these two cases, consolidated for trial and involving the same issues of law and fact, the plaintiffs, husband and wife, sue to recover from the defendant income taxes alleged to have been improperly assessed for the years 1949 (case No. 292-54) and 1950 (case No. 111-55) in the amounts of $3,693.56 and $4,718.46, respectively.

The sole issue presented is whether the Commissioner of Internal Eevenue has properly determined that three-eighths of the amount received by plaintiffs from Spence Engineering Company, Inc., during each of the years in question, was compensation subject to regular income tax rates or whether, as claimed by plaintiffs, the entire amount represented royalties, thus subject only to capital gains rates. Elizabeth Spence is joined in these suits only because a joint return was filed with the Commissioner; hence, the term plaintiff as hereinafter used will refer only to the husband, plaintiff Paulsen Spence.

Since its inception in 1926, plaintiff was the president of the Spence Engineering Company, Inc. (hereinafter referred to as Spence), a company built on the basis of certain discoveries made by plaintiff and patents held by him.

In 1939, a reorganization of Spence was undertaken in which Spence was to acquire the assets of the Eider Ericsson Engine Corporation (hereinafter referred to as Ericsson), with which it did much business; Mr. Dexter, treasurer, stockholder and creditor of Spence and principal owner of Ericsson, was to accept preferred stock in Spence in exchange for its indebtedness to him; and plaintiff was to. sell his patents to Spence. Since the company was not in a financial position to offer plaintiff a lump-sum payment for his patents, an arrangement to pay him a continuing percentage of net sales was contemplated.

Plaintiff at first demanded 10 percent bnt this was objected to by Mr. Dexter who thought 8 percent of the net sales, provided they exceeded $300,000, would be a better figure. In the event that net sales did not exceed $300,000, plaintiff’s compensation was to be fixed by the Board of Directors of Spence.

There is testimony to the effect that, upon the contingency that plaintiff might sell his interest in the company, Mr. Dexter suggested, and plaintiff agreed, a better sales price might be obtained by both of them (plaintiff and Dexter) for their stock if it were provided that the payments to plaintiff should be decreased from 8 percent to 5 percent of the net sales at such time as he might sell his stock.

Subsequently, an offer to sell his patents was made by the plaintiff to the corporation by letter of May 15, 1939. The offer also made the sale contingent upon Mr. Dexter’s exchanging the corporation’s indebtedness to him for a specified amount of no par value cumulative preferred stock.

This letter offer, however, did not condition the reduction of the payments to be made to plaintiff from 8 percent to 5 percent on the sale of stock, rather on plaintiff’s retiring as executive head of the company.

An agreement consistent with the offer was executed on May 26, 1939, the same day on which the company’s Board of Directors passed a resolution accepting the offer and embodying the terms thereof.

Plaintiff started receiving his 8 percent of net sales in 1941 which was the first year the net sales exceeded the $300,000 specified in the agreement. During all the previous years he had received a fixed compensation, in 1940 receiving $3,635.

For the years 1941-1948, inclusive, sales exceeded $300,000 and payments to plaintiff were considerable. Plaintiff treated all of his receipts under the plan as ordinary income for those years. However, after the Tax Court in 1949 decided Edward C. Myers v. Commissioner, 6 T. C. 258 (1946), and therein held that payments made for the sale of patents were payments for the sale of capital assets and the amount received was subject to capital gains tax rates by the recipient and not ordinary income tax rates, plaintiff listed all his receipts from Spence as royalties thus attempting to obtain the full advantage of capital gain tax rates.

The Commissioner of Internal Revenue rejected this listing. He treated only 5 percent of the total receipts as royalties entitled to capital gains treatment. Since the express agreement between plaintiff and Spence stipulated that should plaintiff retire as executive head of the company his payments would' be cut down to 5 percent, the Commissioner felt that the additional 8 percent necessarily constituted compensation for services rendered as president of the corporation; hence, subject to ordinary tax rates. He, therefore, assessed taxes accordingly for the years 1949 and 1950. Plaintiff paid the assessments and here sues for the refund thereof, his claims for refund having been denied by the Commissioner.

Initially, plaintiff, in arguing against the assessment of ordinary income tax rates on the 8 percent, asserts that in order for the higher tax rates to be assessed' it must first be shown that the parties intended that some part of the 8 percent was to be compensation for services as president rather than royalties as such. Plaintiff claims this cannot be shown since, he argues, the reduction was the result of plaintiff’s acceding to the suggestion of Mr. Dexter that his stock would sell at a higher price if the annual payments to him for the assignment of the patents were reduced from 8 percent to 5 percent of the net sales, and because of plaintiff’s belief that if his interest in Spence was acquired by a large manufacturing concern, sales of the products manufactured under the patents would be substantially increased with the result that he would not suffer a detriment by the reduction. Plaintiff thus contends that the reduction was not because of any intent on the part of the parties that a portion of the 8 percent was compensation to plaintiff for services to the corporation as its president.

Second, plaintiff asserts that no services were rendered the corporation by plaintiff during the years in question and in support thereof points to the fact that from 1941 to the present plaintiff has spent little or no time on company affairs and has, in fact, spent nearly all of his time in Louisiana, while the company is located in Walden, New York; that bis time was almost completely taken up by other interests; that, notwithstanding these facts, the payments, no matter in what percentages they were paid, were part of the sales price of the patents to Spence, and were not intended in any way to be compensation for services rendered; and that any assistance plaintiff may have rendered the company was technical in nature and rendered only in connection with the company’s use of the patents; that such assistance is ancillary and subsidiary to the sale of patents and does not justify holding any part of the purchase price to be compensation for services. For this latter proposition plaintiff cites the cases Raymond M. Hessert v. Commissioner, 6 T. C. M. 1190 (1947) and Arthur C. Ruge v. Commissioner, 26 T. C. 138 (1956), both of which do stand for the proposition for which cited.

The plaintiff presents a rather persuasive case with his allusions to the record to show the intent of the parties at the time the agreement was made, to wit, that it was intended that the payments represented only royalties paid to plaintiff for selling his patents to the company and that no part was intended to represent compensation as such. However, plaintiff relies chiefly on oral testimony to sustain his case when documentary evidence, at least in some respects, reflects a different picture. This testimony is based on recall by witnesses of what took place about 17 years previously and is not substantiated by the documentary evidence of record.

These documents, executed contemporaneously with the sale of the patents to Spence, must be given more weight in determining intent that can be obtained by a reference to the testimony relied on.

The percentage payments were to be reduced from 8 percent to 5 percent at the time plaintiff ceased to be executive head of the company, not when he sold his stock as contended by plaintiff. That is the express language of the plaintiff’s offer to the corporation, the resolution of the corporation and the contract between plaintiff and the corporation. See findings 10, 11, and 12. The oral testimony and plaintiff’s argument flies into the face of these documents which must be presumed to be correct. At least they must be given greater weight than testimony relating to events which require witnesses to go back some 17 years in memory.

Thus, common sense dictates our conclusion that the provision for the reduction in payments was not to be effectuated when plaintiff sold his stock; but that the provision was included, at least in part, and we firmly believe entirely, because of an intent to compensate plaintiff for his services to the corporation as president. It is entirely conceivable that plaintiff could have sold his stock and have been retained, because of his know-how and for other reasons, as president of the corporation.

That it was intended that at least part of the total payments was to represent compensation is borne out by the following excerpts from the documents referred to above. From the plaintiff’s offer to the company appears this language:

This offer is contingent upon * * * the agreement by the corporation to pay to me as annual compensation for the use of the aforementioned patents together with my services as executive head of the corporation, a royalty of 8% of the total annual net sales of the corporation whenever such total annual net sales equal or exceed the sum of $300,000 per annum. In the event that the total annual net sales of the corporation fall below the sum of $300,000 it is understood that my annual compensation for the use of the aforesaid patents together with my services shall be fixed annually by the Directors of the corporation * * *. (Italics supplied.)

The corporation resolution is of like effect:

* * * that so long as he shall remain the executive head of the corporation the compensation of Paulsen Spence shall be based upon a royalty of 8% of the total net sales of the corporation when such total annual net sales equal or exceed $300,000 and in the event that the total annual net sales of the corporation fall below the sum of $300,-000, the compensation of Paulsen Spence shall be fixed annually by the Board of Directors. (Italics supplied.)

Thus, the express language of plaintiff and the corporation indicates that the parties intended the nature of the payments to be twofold: (1) annual royalties for the use of the patents, (2) annual compensation as executive head of the company.

We conclude, therefore, that the payments to plaintiff were intended to be dual in nature — royalties and compensation for personal services as president of the corporation. Since the 3 percent reduction in the amount plaintiff is entitled to is contingent upon his status as executive head of the company, it must necessarily be concluded, also, that the 3 percent represents that part of the payments which was intended to be paid as compensation for services rendered, and we so hold.

Plaintiff’s other contentions, that he lived a long distance from the company’s plant, spent only about two weeks per year on company business and that the payments represented the selling price of the patents only, are without merit.

Notwithstanding the fact that plaintiff spent little time on the company premises and allegedly little time on company business, he was the principal stockholder and executive head of the company and if the policies of the company were not run in accord with plaintiff’s wishes by Mr. Dexter, the senior executive officer at the plant, plaintiff would surely have stepped in and seen that they were. At any rate, he was always available for consultation, the telephone being a handy instrument, and undoubtedly he was consulted on many occasions. The record shows that he received reports about twice per week. These reports indicate to us that he was not so completely divorced from the business as plaintiff’s counsel would have us believe. We feel certain that plaintiff did not receive two reports per week from his company and never reply or comment thereon to the company’s management personnel at the plant. We say this despite plaintiff’s argument that he received these reports so he could keep track of the sales and, correspondingly, the amount of royalties due him. The situation necessarily implies that if these twice-weekly reports had shown slackening of sales plaintiff would have wanted to know why and would have taken action to correct the situation. Otherwise, why would he keep such a close check? This, of course, is implicit in our observation above that plaintiff was always available for consultation, was not too divorced from company affairs and still influenced company policy. Payment for such is certainly payment for services within the contemplation of the revenue statutes, which compensation would necessarily be subject to ordinary income tax rates.

In addition, since plaintiff was the inventor of the patents which were the very lifeblood of the company’s existence, it is a natural conclusion that the mere fact of plaintiff’s name remaining attached to the company would add some value or prestige.

Also, the record shows plaintiff, as president, signed company bank notes during the years in question. This is certainly the rendition of services no matter how much plaintiff attempts to minimize it.

Plaintiff’s last argument is that any work plaintiff did for Spence was merely technical assistance rendered in connection with the proper use of the patents conveyed and thus ancillary and subsidiary to the sale thereof. He argues that such assistance does not justify the conclusion that it represents services for which compensation was paid. As noted, plaintiff cites Hessert, supra, and Ruge, supra, in support of this argument.

We agree with the principle of law stated by those two cases but feel that the cáse before us is distinguishable on the facts which caused the Tax Court to reach that particular conclusion.

It is indisputable in this case that compensable services were actually rendered and that compensation over and above royalties was intended to be paid. Since the payments to plaintiff were to be decreased by 3 percent when he ceased to be executive head of the company, we must presume that the 3 percent represented what was intended to be compensation for those services.

We hold, therefore, that the Commissioner of Internal Revenue acted properly in disallowing three-eighths of the payments from capital gains treatment.

Plaintiffs’ petitions will be dismissed.

It is so ordered.

Washington, Circuit Judge, sitting by designation; Madden, Judge; Whitaker, Judge; and Littleton, Judge, concur.

FINDINGS OF FACT

The. court having considered the evidence, the report of Commissioner Wilson Cowen, and the briefs and argument of counsel, makes the following findings of fact:

1. These cases were consolidated for trial because both involve the same issues of fact and law, although petitions were filed for separate taxable years. The issue presented is whether certain sums of money received by plaintiff Paul-sen Spence during the years 1949 and 1950 from Spence Engineering Company, Inc., constituted long-term capital gain, or whether three-eighths of the amount received was ordinary income.

2. Plaintiffs are husband and wife residing in Baton Rouge, Louisiana, where they filed joint income tax returns for the years 1949 and 1950.

3. Plaintiff Paulsen Spence, hereinafter called plaintiff, was born in Baton Rouge and lived there until he was 21 years of age. When he graduated from Louisiana State University with a degree in mechanical engineering in June 1916, he moved to Detroit, Michigan. Between his graduation and the year 1925 he was employed by the Chalmers Motor Company, the Hudson Motor Company, Crane and Company, A. W. Cash Company, and the United States Army. During this employment he became expert in the design and manufacture of valve fittings.

4. Upon leaving A. W. Cash Company in April 1925, plaintiff founded the Spence Engineering Company, an individual enterprise registered in the State of New York. At about the same time, plaintiff filed an application for a patent on a basic type of automatic valve or regulator to reduce and automatically control the pressure of fluids. It was his purpose to develop, manufacture and improve this basic patent through this newly founded enterprise. The original patent was numbered 1,814,530.

5. In February 1926, Spence Engineering Company was incorporated under the name of Spence Engineering Company, Inc., hereinafter referred to as the Company. Its capital stock was composed of 100 shares of voting common stock and 500 shares of nonvoting preferred stock. In exchange for the accounts receivable, inventory, plant assets and drawings owned by the individual enterprise, plaintiff acquired the 100 shares of common stock in the Company. Along with the 100 shares of common stock issued, there were issued 500 shares of 7 percent cumulative preferred stock. Pursuant to an agreement, plaintiff transferred 50 shares of common to the original purchasers of the preferred. At all times subsequent to 1926, plaintiff has been the owner of 50 shares of common stock in Spence Engineering Company, Inc.

6. Before August 1927, the Company’s product was manufactured in several different places, including Hampton, New Jersey, New York City, and Hyde Park, Massachusetts. In 1927, the Company arranged to have its manufacturing done by the Eider Ericsson Engine Corporation of Walden, New York, hereinafter referred to as Ericsson. Ericsson charged the Company for labor and factory overhead, plus 30 percent for its services.

7. Mr. Leon B. Dexter was the principal owner of Ericsson in 1927. At the time the Company arranged to have its manufacturing done by Ericsson, Mr. Dexter bought 45 shares of preferred stock in the Company. From time to time thereafter, Mr. Dexter purchased more stock and made numerous loans to the Company. By May 1, 1939, he had made loans of $31,500 and had a preferred stock investment of $6,000, making a total investment in the Company of $37,500. At the same time, his total investment in Ericsson amounted to $88,000. After the Company acquired the assets of Ericsson, Mr. Dexter’s investment in the Company in May 1939 was $125,000. Mr. Dexter was elected treasurer of Spence Engineering Company, Inc., in May 1928, and is now treasurer, a director and senior executive officer of the Company in Walden, New York.

8. In April 1935, Mr. Dexter decided to shut down the Ericsson plant and retire. The Company thereupon arranged to lease the Ericsson plant and take over the manufacturing part of the business. The monthly rental was $100, which in effect eliminated the 30 percent extra the Company had been paying Ericsson, and allowed its prices to be reduced to conform with competitors’ prices. Thereafter, sales began to increase.

9. Sometime prior to May 1939, plaintiff conducted negotiations with several large concerns in an effort to sell the assets of the Company. He considered that his patents were very valuable and that if the patents and the assets of the Company were acquired by a large organization with manufacturing experience and an extensive sales organization, its sales of the regulators invented by him would far exceed the number the Company had been able to market. However, the terms offered were not satisfactory to him.

In May 1939, plaintiff learned that Mr. Dexter could arrange for the Company to buy the assets of Ericsson at a very reasonable price. Thereupon, plaintiff and Mr. Dexter discussed a reorganization of the Company on the basis of its ownership and operation of the Ericsson manufacturing equipment and facilities. The reorganization plan also contemplated that plaintiff would assign'his patents to the Company and that Mr. Dexter would accept preferred stock in the Company in exchange for its indebtedness to him. At that time, Mr. Dexter wanted to discontinue active participation in the manufacturing business and to retire to a farm in Wisconsin. He was treasurer of the Company, and since he had $125,000 invested in it, it was to his interest for the Company to acquire ownership of plaintiff’s patents at as low a price as possible. The Company had operated at a deficit, and its financial condition was such that it could not have paid plaintiff a substantial lump sum for his patents at the time of these discussions. It was obvious, therefore, that any consideration which plaintiff received for the patents would have to be paid out of the proceeds of the sales of the Company’s manufactured products. In the discussions between the two men, plaintiff offered to sell his patents to the Company in return for payments equivalent to 10 percent of its net sales in excess of $300,000 per annum. When Mr. Dexter objected on the ground that plaintiff’s offer was too high, it was agreed that the payments made to plaintiff should be on the basis of 8 percent of the net sales in excess of $300,000 per year.

Before the agreement was formalized, plaintiff suggested to Mr. Dexter that it might be a good idea if plaintiff sold his interest in the Company. At that point, there is testimony to the effect that Mr. Dexter stated that since plaintiff could probably obtain a substantial cash payment for his stock in the Company, plaintiff should, in the event of such a sale, be willing to reduce the Company’s payments for the acquisition of plaintiff’s patents from 8 percent to 5 percent of the net sales. In that connection, the testimony alleges, Mr. Dexter pointed out that if the payments to plaintiff were based upon 5 percent of the net sales, both he and plaintiff could dispose of their stock in the Company at higher prices than if the payments to plaintiff were based upon 8 percent of sales.

10. On May 15,1939, plaintiff wrote the board of directors of the Company in pertinent part as follows:

In consideration of the agreement by Leon B. Dexter to exchange the corporation’s notes payable to him aggregating $31,500.00 for $5.00 cumulative preferred stock of the Spence Engineering Company, Inc. of a like amount, I hereby agree to transfer, assign and set over to the Spence Engineering Company, Inc. the following numbered U. S. Patents registered in my name:
[Here follows a list of the numbers of the patents] and I hereby further agree to transfer, assign and set over to the Spence Engineering Company, Inc. any and all patents that may be issued to me subsequent to the signing of this agreement and during the term of my employment by the Spence Engineering Company, Inc. covering valves or steam and fluid specialties of such a character as can be manufactured by the Spence Engineering Company, Inc..
This offer is contingent upon the surrender by Leon B. Dexter of the aforementioned notes aggregating $31,500.00 for $5.00 cumulative preferred stock and the agreement by the corporation to pay to me as annual compensation for the use of the aforementioned patents together with my services as executive head of the corporation, a royalty of 8% of the total annual net sales of the corporation whenever such total annual net sales equal or exceed the sum of $300,000.00 per annum. In the event that the total annual net sales of the corporation fall below the sum of $300,000.00 it is understood that my annual compensation for the use of the aforesaid patents together with my services shall be fixed annually by the Directors of the corporation and that in the event of my retirement from the employ of the corporation, inasmuch as the corporation’s business is built upon my patents and designs, it shall pay to me a royalty of 5% of the total annual net sales of the corporation during the rest of my natural life.
As a further consideration for the surrender of the above named patents, I am to be paid the sum of $1.00 for each patent surrendered.
It is further understood that commencing with this date the corporation is to bear all of the expenses in connection with patents together with the development costs of such patented devices.
I hereby further agree to transfer to the corporation all royalties that may become payable to me for the use of the foregoing patents.
If this agreement meets with your approval kindly sign one copy in the space provided therefor and return the same to me.
I am
Yours truly,
[s] Paulsen Spence Paulsen Spence.
Accepted :
[s] S. Kenvin,
8pence Engineering Oom/pany. Inc.
May 26, 1939.

11. A special meeting of the board of directors of the Company was held on May 26, 1939, when a resolution was adopted providing for the issuance of preferred stock to Mr. Dexter in consideration of his cancellation of the corporation’s indebtedness to him. The resolution also stated in pertinent part:

Kesolved FURTHER, that the Spence Engineering Co., Inc. is to receive by assignment, from Paulsen Spence in consideration of the payment of $1.00 each, coincident with the exchange of the corporation’s indebtedness to Leon B. Dexter for its $5.00 cumulative no par value preferred stock, the following numbered United States Patents:
[Here follows a list of the numbers of the patents] and an agreement from the said Paulsen Spence to assign to the corporation for $1.00 each, any patents covering valves or steam and fluid specialties that may subsequently be obtained by the said Paulsen Spence as long as he remains the executive head of the Spence Engineering Co., Inc., and provided further, that so long as he shall remain the executive head of the corporation the compensation of Paulsen Spence shall be based upon a royalty of 8% of the total net sales of the corporation when such total annual net sales equal or exceed $300,000.00 and in the event that the total annual net sales of the corporation fall below the sum of $300,000.00, the compensation of Paulsen Spence shall be fixed annually by the Board of Directors. In the event of the retirement of Paulsen Spence as executive head of the corporation, the royalty payments to him shall be reduced to 5% of the total annual net sales of the corporation during the remainder of his natural life.

12. On May 26,1939, a written agreement was entered into between plaintiff and the Company. After listing the twelve letters patent owned by plaintiff, the agreement provided in pertinent part as follows:

All patents now owned by Paulsen Spence or which may be hereafter acquired by him, are hereby, and shall be, assigned by the said Paulsen Spence to the Spence Engineering Company, Inc. under the following terms and conditions:
Spence Engineering Company, Inc., in consideration of the aforesaid exclusive license to make, use and sell the devices embodied in the letters patent enumerated herein and assigned to it by Paulsen Spence, hereby agrees to pay to Paulsen Spence a sum equal to 8% of the total annual net sales of the Spence Engineering Company, Inc., when, as and if such total net sales equal or exceed the sum of $800,000.00 per annum, and during such period of time as Paulsen Spence shall remain the executive head of the Spence Engineering Company, Inc. In the event of the retirement of Paulsen Spence as executive head of the Spence Engineering Company, Inc., the aforesaid payments to Paulsen Spence shall be reduced from 8% to 5% of such total annual net sales and in the event of the death of Paulsen Spence such royalty payments shall cease altogether.

13. By written assignment dated June 15,1939, and thereafter recorded in the United States Patent Office, plaintiff transferred all the right, title, and interest in his patents to the Company. Since the agreement of May 26, 1939, plaintiff has obtained other patents covering improvements to or variations in the devices covered by the twelve patents assigned to the Company on May 26, 1939. All patents obtained by plaintiff since 1939 have been assigned to the Company. All the patents so assigned were capital assets which had been owned and held by plaintiff for more than 18 months prior to the date of assignment. The expenses, including attorneys’ fees, that were incurred in connection with the applications for and issuance of all the patents were borne by the Company.

14. The letter which plaintiff sent the directors of the Company on May 15, 1939 (finding 10), was prepared by him without the assistance or advice of an attorney. The minutes of the board of directors (quoted in part in finding 11) were prepared by the Company’s stenographer without supervision or examination by an attorney. At that time, the Company did not have sufficient funds to have a regularly employed counsel.

15. At the time the reorganization of the Company was completed, plaintiff owned 50 shares of the common stock of the Company, Leon B. Dexter owned 20 shares, and 2y2 shares were owned by E. J. Ritchie. There were 100 shares of voting common stock outstanding. Plaintiff was also president of the Company. At the time the agreement of May 26,1939, was executed, plaintiff planned that he would continue as executive bead of the Company so long as he retained ownership of 50 shares of the Company’s stock.

16. Plaintiff’s salary was fixed at $4,800 in 1927, but he received less than that in 1937, 1938, and 1939. In 1937, he received $3,565; in the years 1938 and 1939, his salary was $3,730 and $4,240, respectively. In 1940, the last year in which the Company had net sales of less than $300,000, his salary was $3,635. Social security taxes were paid on his salary for these years. After the income tax withholding provisions of the Revenue Act of 1942 became effective, the corporation withheld taxes on the salary of its officers and employees, but there was no income tax withheld on the amounts paid to plaintiff under the agreement of May 26, 1939.

17. In 1941, when the net sales were $310,441.39, plaintiff received $24,835 under the agreement of May 26, 1939, exactly 8 percent of the net sales. In 1942, plaintiff received $40,156 under said agreement, or 8 percent of net sales of $501,952.14.

18. Beginning in 1941, the Company paid plaintiff every year under the agreement and treated the payments on its books as royalties. However, in its Federal income tax return for 1941, which has been prepared by the Company’s bookkeeper, $24,000 of the payments made in that year to plaintiff was reported as salary and the excess over that amount as royalties. A representative of the Bureau of Internal Revenue took the position that the amount reported as salary was excessive, whereupon the following protest was filed:

Paulsen Spence is an engineer of exceptional ability in the field of high-pressure reducing valves and heat control apparatus, which are the chief products of the Spence Engineering Company, Inc., practically all of whose products are manufactured under patents developed and obtained by Paulsen Spence. These patents, consisting of more than 25 in number, were developed by Paulsen Spence over a long period of years, but owing to the difficulties of placing his products on the market and a lack of sufficient capital, the Spence Engineering Company, Inc., did not reach a fair and normal operating capacity until the year 1941 and, for that reason, was unable to pay to Paulsen Spence adequate compensation for his services.
Moreover, at the time the Spence Engineering Company, Inc. acquired the plant and machinery of the Eider-Erickson [sic] Engine Company, June 8, 1939, Paulsen Spence agreed to and did surrender to the corporation all of his patents, with the understanding that his compensation would be based on a royalty of 8 percent of the corporation’s net sales resulting from the use of such patents. This condition was the subject of an agreement between the Spence Engineering Company, Inc. and Paulsen Spence and is a matter of record, and the salary of Paulsen Spence for the year 1941 was based on the aforementioned agreement.

At an informal conference between plaintiff and the agent, it was agreed that the amount the Company had paid plaintiff was royalty rather than salary, but the parties were unable to resolve a dispute about the valuation of the plant. The case was then transferred to the technical staff of the Bureau of Internal Eevenue, and the matter was disposed of by a determination that the payments made by the Company to plaintiff were deductible as royalties. In years subsequent to 1941, the Company reported all payments made to plaintiff under the agreement as royalties.

19. Throughout the years 1939 to 1949 inclusive, plaintiff reported all payments received from the Company under the agreement on Federal income tax returns as ordinary income. After the decision in the Myers case (6 T. C. 258), plaintiff reported payments received from the Company in his 1950 tax return as gain from the sale of capital assets.

20. Until about December 31, 1940, plaintiff lived in East Orange, New Jersey, and prior to the reorganization of the Company he devoted full time to the management of its affairs and the promotion of its sales. Accordingly, he employed a factory supervisor and a sales manager and began looking for a chief engineer. After World War II began, the factory supervisor and sales manager joined the armed services. Late in 1940, plaintiff hired another factory supervisor, and during the early part of 1941, he employed a sales manager to replace the individual wbo had left. About the same time, he obtained the services of a chief engineer for the Company. In 1942, Mr. Dexter returned from Wisconsin and became general manager of the Company.

21. In 1941, plaintiff moved to Louisiana with the intention of permanently residing there. Since 1943, he has been operating a large plantation in Louisiana, and in 1947 he was made president and general manager of the Gulf Sand and Gravel Corporation, a Louisiana corporation. He also owns and operates the Louisiana Eastern Eailroad.

22. Plaintiff testified that since December 31, 1940, he has devoted about two weeks of his time per year to the affairs of the Company. He has gone to Walden two or three times a year to attend stockholders’ and directors’ meetings. '

Aside from the two men he hired for the Company in 1941, the services performed by plaintiff for the Company since December 31, 1940, have been of a general supervisory character. He has assisted new employees in becoming acquainted with their jobs.

He has maintained interest in his patents, and gives technical assistance in connection with the use of such patents. As an example of such assistance, he made suggestions to the Company for adapting the regulators for use in the Nautilus when the submarine was designed.

During the fall of each year, he attends the power show in Walden. The show consists of an engineering exhibit. Plaintiff testified that his principal purpose in going there is to visit with old friends.

23. Plaintiff continued as president of the Company during the years 1949 and 1950. However, during those years he did not hire or fire any company personnel, supervise any employees, purchase supplies or property for the Company, direct sales activities, or supervise or manage the manufacture of its products. As president, he has signed notes executed in the name of the corporation. About twice a week, he receives a report from Mr. Dexter on the volume of the Company’s sales.

24. During the years 1949 and 1950, the only money which plaintiff received from the Company, aside from the payments made pursuant to the contract of May 26, 1939, was the sum of $90 paid him as dividends on preferred stock. The Company has paid his traveling expenses incurred on trips from Louisiana to New York on business matters.

25. In the calendar year 1949, plaintiff received $72,562.65 from the Company under the contract for the sale of the patents, and in 1950 he received $83,626 under the said agreement. As previously stated, the amount received in 1949 was reported as ordinary income, but the amount received for 1950 was reported as long-term capital gain. A claim for refund on Form 843 was filed for the year 1949 on February 13, 1952, on the ground that the amount paid plaintiff by the Company was long-term capital gain and not ordinary income. On October 27, 1952, the Commissioner of Internal Eevenue, in a thirty-day letter, took the position that the entire amount received from the sale of the patents for each of the years 1949 and 1950 constituted ordinary income. By agreement on Form 870-AD, accepted by the Commissioner April 23, 1954, plaintiffs consented to an overassessment for the year 1949 of $5,277.90 and to a deficiency for 1950 of $4,718.46, which was paid by applying part of the 1949 overassessment. These figures were arrived at by treating five-eighths of the amount received by plaintiff in each of the years 1949 and 1950, as long-term capital gain and the remaining three-eighths of the amount as ordinary income. Form 870-AD reserved to the plaintiffs “full right to commence suit or proceeding for the recovery of tax on the ground that no portion of the consideration received during the taxable years 1949 and 1950 from the sale of patents is properly taxable as other than long-term capital gain.” The claim for refund for the year 1949 was disallowed by the Commissioner of Internal Eevenue on May 21, 1954, and the claim for refund for the year 1950 was disallowed on September 15, 1954.

CONCLUSION OE LAW

Upon the foregoing findings of fact, which are made a part of the judgment herein, the court concludes that as a matter of law the plaintiffs are not entitled to recover, and their petitions are, therefore, dismissed.  