UNITED STATES TAX COURT

T.C. Memo. 2000-58

UNITED STATES TAX COURT

CASCADE DESIGNS, INC., Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

JAMES M. AND JANE I. LEA, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 11498-98, 12555-98.

Filed February 23, 2000.

Carmen J. SantaMaria, for petitioner in docket

No. 11498-98.

Darrell D. Hallett and Scott A. Schumacher, for petitioners

in docket No. 12555-98.

William A. McCarthy and Sandra Veliz, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

PARR, Judge:

Respondent determined deficiencies and

- 2 accuracy-related penalties in Cascade Designs, Inc.'s (Cascade or

the corporation) Federal income tax in the following amounts:

Year

Deficiency

Accuracy-Related Penalty

Sec. 6662(a)

1992

1993

1994

1995

1996

$592,921

162,240

182,378

196,621

90,564

$118,584

32,448

36,476

39,324

18,113

Respondent determined deficiencies and accuracy-related

penalties in James M. and Jane I. Lea's (the Leas) Federal income

tax in the following amounts:

Year

Deficiency

Accuracy-Related Penalty

Sec. 6662(a)

1993

1994

1995

1996

$62,355

65,462

56,326

28,640

$12,471

13,092

11,265

5,728

These cases were consolidated for trial, briefing, and

opinion by order of this Court dated November 18, 1998.

The issues for decision are:

(1) Whether the payments

Cascade made to James M. Lea (Lea) during the years at issue were

expenditures for the purchase of certain patents and, therefore,

deductible as patent amortization expenses.

We find they are.

(2) Whether the Leas may report the payments as capital gain

income under section 1235.1

1

Respondent's position on

this issue

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

- 3 in Rev. Rul. 69-482, 1969-2 C.B. 164, is that these payments are

capital gains; we therefore treat respondent's position in Rev.

Rul. 69-482, supra, as a concession that the Leas are entitled to

report the payments as capital gains.

(3) Whether Cascade or Lea

is liable for an accuracy-related penalty.

Because of our

disposition of the preceding issues, we need not address this

issue.

FINDINGS OF FACT

Some of the facts in this case have been stipulated and are

so found.

The stipulation of facts and the accompanying exhibits

are incorporated into our findings by this reference.

Cascade is

a C corporation, whose principal place of business was in

Seattle, Washington, at the time it filed its petition in this

case.

At the time they filed their petition in this case, the

Leas resided in Seattle, Washington.

Lea is a mechanical engineer and was continuously employed

by the Boeing Co. (Boeing) from 1948 to 1971.

was laid off from Boeing until late 1972.

In mid-1971, Lea

While he was laid off,

Lea began to investigate products that he could invent,

manufacture, and sell.

Lea's friend and fellow engineer, John

Burroughs (Burroughs), suggested that there was a need for a

better sleeping pad for hikers and mountain climbers than was

being produced.

Lea, with the help of another friend, Neil

Anderson (Anderson), designed a high-quality foam-filled self-

- 4 inflating air mattress (mattress) for use by backpacking and

mountain climbing enthusiasts.

The Patents

In January 1972, Lea and Anderson applied for a patent on

the design of the mattress, and U.S. Patent No. 3,872,525 (the

525 Patent) was issued on March 25, 1975.

Later, on February 3,

1976, Lea and Burroughs were issued U.S. patent No. 3,935,690

(the 690 patent) for their method of packaging the mattresses.

On May 31, 1977, Lea and Anderson were issued U.S. patent No.

4,025,974 (the 974 patent) for their method of making the

mattresses.

The Incorporation

On April 24, 1972, Cascade was incorporated in the State of

Washington for the purpose of manufacturing and selling the

mattresses under the name "Therm-A-Rest".

Cascade was

capitalized with $1,000, and its stock was owned as follows:

1.

Shareholder

Ownership

Percentage

Lea

Burroughs

John Lea1

Total

60

20

20

100

John Lea is Lea's brother.

Lea returned to work for Boeing in November 1972, where he

continued to work until June 1978.

During these years, Lea and

Burroughs were full-time employees of Boeing, and worked for

- 5 Cascade on a part-time basis, which included working evenings, on

weekends, and during vacations.

The Officers and Their Duties

Lea was the president of Cascade, Burroughs was the vice

president and treasurer, and John Lea was the secretary and

corporate counsel.

Lea supervised production and quality control of the

mattresses.

Burroughs supervised Cascade's sales and marketing.

Burroughs' duties included developing cash-flow models that were

used to determine whether to purchase new equipment and when to

pay the corporate officers.

John Lea's duties were to take notes

at the officer's meetings and attend to the corporation's legal

matters.

The Recapitalization

In 1978, Lea retired from Boeing and became the first fulltime employee at Cascade.

In this year, Cascade was

recapitalized to reflect better the relative contributions of the

various shareholders.

As a result of the recapitalization,

Cascade's stock was owned as follows:

Shareholder

Lea

Burroughs

John Lea

Richard Brooks (Brooks)

Total

Ownership

Percentage

62

29

8

1

100

- 6 These shareholders were the only members of Cascade's board

of directors, and each retained his ownership percentage until

1991.

The 1979 Sales Agreement and Patent Assignment

On January 9, 1979, Lea entered into an agreement (the 1979

sales agreement) with Cascade to sell "his entire right, title

and interest in and to" the 525, the 690, and the 974 patents,

U.S. Patent Application S.N. 800,288 (the patent application for

the "Method of Making Self-Inflating Air Mattress"), and the

British and Japanese patent applications for the mattress.2

The

1979 sales agreement, in relevant part, provided the following:

a. The total sales price for such sale is three

hundred thousand dollars ($300,000). Since it is

recognized that Cascade Designs, Inc. does not at this

time have the resources to make a cash payment of

$300,000, it is agreed that payment can be made only

out of the money received by Cascade Designs for sales

of the air mattresses which it markets.

Payment shall be made as follows:

1. For each air mattress sold by Cascade Designs,

Inc., covered by any one of the patents or patent

applications noted above, James M. Lea shall receive an

amount of money equal to 5% of the gross selling price.

*

b.

2

*

*

*

*

*

*

Payments shall continue to be paid as

Anderson sold his interests in the 525 and the 974 patents,

and the U.S., British, and Japanese patent applications, on Jan.

7, 1979, for 0.134 percent of the gross sales price of each air

mattress. Payments made to Anderson for these properties are not

at issue in this case.

- 7 specified in paragraphs (1) * * * until the total

amount of $300,000 is paid. In computing payment from

year to year, the amount remaining due at the end of

each year will be adjusted according to the inflation

rate so that it will reflect the dollar value in the

year 1977. * * *

*

*

*

*

*

*

*

3. This agreement shall remain in force until all

of said U.S. and foreign patents expire or until the

payments have been made in full, whichever occurs

first.

4. * * * Quarterly, within thirty days after the

first days of January, April, July, and October of each

year during the continuance of this agreement, Cascade

Designs, Inc. shall render writting [sic] reports to

James M. Lea, stating in each report the quantities and

net selling prices of all air mattresses sold by

Cascade Designs, Inc. during the preceding three

calendar months. Each such report shall be accompanied

by remittance in full covering the payments shown

thereby to be due James M. Lea.

*

*

*

*

*

*

*

6. If Cascade Designs, Inc. fails to pay James M.

Lea the moneys payable under the terms of this

agreement, or fails to keep or perform any other

obligation of the agreement, then James M. Lea may, at

his option terminate this agreement by giving sixty

days written notice, specifying the default complained

of; provided, however, that if Cascade Designs, Inc.

shall, within such sixty days, cure the default

complained of, then the notice shall cease to be

operative and this agreement shall continue on [sic]

full force and effect as though such default had not

occurred; and provided further, that if Cascade Designs

shall within such sixty days notify James M. Lea in

writing that it disputes the asserted default, the

matter shall be submitted to arbitration as hereinafter

provided.

The patent and patent applications covered by the 1979 sales

agreement, except the 690 patent, were officially assigned by Lea

- 8 to Cascade by an assignment document, which was recorded with the

U.S. Patent and Trademark Office on March 19, 1979.

The

assignment conveyed to Cascade "all letters patent, domestic and

foreign, which have issued or may issue thereon, whether said

Letters Patent issued directly or by * * * division".

Selling Mattresses Is a Seasonal Business

The recreational mattress industry is a seasonal business;

most of Cascade's sales were made in late spring and early

summer, and most of its sales revenue was received between July

and November.

Consequently, its cash-flow was also seasonal,

peaking in late fall and early winter.

However, to meet the

demands of the market during the peak sales season and to retain

its experienced work force, Cascade had to manufacture mattresses

year-round.

Each year, the demand for Cascade's mattresses increased

dramatically.

To keep pace with the market's increased demand,

each year Cascade manufactured more mattresses and increased its

inventory of goods available for sale.

This practice resulted in

the exhaustion of its financial resources by late spring of every

year.

The Manufacturing Facilities

For a short while, the first mattresses were manufactured in

a grimy machine shop where the press to manufacture the

mattresses had been made.

Cascade required larger facilities to

- 9 realize its growth potential, and it soon moved its manufacturing

operation to a training facility for handicapped workers.

However, this facility proved unsatisfactory because once the

handicapped workers were trained to manufacture the mattresses,

they were replaced by new workers who required training.

As a

result, Cascade was manufacturing mattresses with an unskilled

workforce that it was constantly training.

After approximately 1 year at the training facility, Cascade

moved its manufacturing equipment to a building near the Kingdome

and contracted to have the mattresses manufactured.

This

arrangement was unsatisfactory because much of the potential

profit on the manufacturing operation was paid to the

manufacturing contractor.

Finally, in 1981, Cascade moved to its

present location by renting a small corner of the building that

it later purchased.

At the time of its final move, Cascade recognized that its

manufacturing equipment was inadequate to produce all the

mattresses that it could market.

Therefore, while the mattresses

were being manufactured under contract, Cascade designed and

built larger and heavier equipment for its new location.

Cash-Flow Problems

Cascade was undercapitalized and had cash-flow problems.

Because the shareholders were uncertain of the success of the

corporation, they generally were unwilling to make personal loans

- 10 to Cascade and also refused to guarantee a bank loan to the

corporation.

Cascade obtained its first line of credit in 1981.

The

credit limit was $100,000, which was further limited to the value

of, and secured by, Cascade's accounts receivable and its

inventory of finished goods.

Amounts advanced under the line of

credit bore an annual interest rate of 22.5 percent.

The

corporation was generally averse to incurring debt because the

high rate of interest made it difficult for Cascade to make a

profit on borrowed money.

Instead of borrowing, the corporation

retained its earnings to self-finance its working capital

requirements.

The board of directors and the corporate officers considered

that the best use of the corporation's working capital was to pay

its labor force and the various materials suppliers and to

increase its manufacturing capability with larger facilities and

improved production equipment.

Consequently, the officers'

salaries were often in arrears, and Cascade did not make all the

quarterly payments due Lea under the 1979 sales agreement.

By

December 31, 1982, Cascade owed Lea $259,128 in delinquent

payments.

Lea's Demand for Payment and the 1982 Agreement

Lea did not make a written demand for payment; however, the

minutes of the officers' meetings on March 31 and September 23,

- 11 1982, report that Lea demanded payment of the delinquent amounts,

and that the corporate officers considered whether Cascade could

make the payments.

Because the corporation required all its

working capital to build its inventory of goods available for

sale, Lea suggested that Cascade get a loan from a bank or that

the other officers make loans to the corporation so that Cascade

could pay the amounts owed to him.

The other officers rejected

this proposal.

The minutes of the officers' meeting on December 1, 1982,

reported that $130,000 of the amount owed to Lea would be paid

during the month, but the balance due in April would not be paid

until July or August of 1983.

These minutes also report that Lea

had consulted a lawyer about the patent payments and intended to

meet with him again.

The minutes of the February 23, 1983,

meeting report that $250,000 was still due Lea and could not be

paid.

At this meeting, the officers discussed setting up an

installment schedule to pay the outstanding balance over time.

After Lea's consultations with his lawyer, Lea and Cascade

agreed to renegotiate the 1979 sales agreement.

The renegotiated

agreement (the 1982 agreement3 or the agreement), recognized that

Cascade was in breach of the 1979 sales agreement, and, in

3

Although we refer to the agreement as "the 1982 agreement",

the parties spent some time negotiating its terms, and the

agreement was not entered into until April or May 1983.

- 12 pertinent part, provided the following:

5.

NEW PATENTS AND PATENTS PENDING

Since the original sales agreement was entered

into, Lea has been granted an additional patent as

follows

US Patent 4,261,776 [the 776 patent4]"Method of

making self-inflated air mattresses" issued April

14, 1981.

Lea has also applied for an additional patent

under:

SN 395,750 [the 750 patent application or the

750 technology5] "Method and apparatus for

making air mattresses" filed July 6, 1982.

The additional patent and patent pending are

improvements on the prior patent sold to Cascade by Lea

and are valuable to Cascade in the manufacturing of air

mattresses, pads and related products and methods.

*

7.

*

*

*

*

*

*

NEW CONSIDERATION

In consideration for Lea waiving prior breaches of

the original sales agreement by Cascade, of waiving any

claim which Lea may have for interest on unpaid amounts

due,[6] and of Lea granting to Cascade his entire right,

title, and interest in and to the new patent and patent

4

The 776 patent was a division of U.S. Patent Application

S.N. 800,288, "Method of Making Self-Inflating Air Mattress".

5

No patent was ever granted on the 750 patent application;

the application was rejected by the U.S. Patent and Trademark

Office primarily because of its "obviousness". Cascade used the

750 technology in its manufacturing process and regarded it as a

trade secret.

6

At the time Cascade and Lea entered into the 1982

agreement, the interest on the delinquent payments totaled

approximately $39,102.

- 13 application described in paragraph 5 above, Cascade

enters into this agreement and makes the promises

contained hereinafter:

8.

AFFIRMATION OF ORIGINAL SALE

Lea hereby affirms that he has and does hereby

sell all of his right, title and interest in and to the

patent and patent applications described in the

original sales agreement and to the new patent and

patent application described in paragraph 5 hereof.

9.

SALES PRICE

Cascade hereby agrees to pay Lea as consideration

for the waiver, reconveyance and conveyance by Lea

contained herein $10,000,000.00 less $172,310.00

representing payments made under the original sales

agreement and less $259,128.03 representing amounts

earned but not paid by Cascade to Lea under the

original sales agreement or as otherwise mathematically

stated the remaining sum of $9,568,561.97.

*

11.

*

*

*

*

*

*

PAYMENT

Payment shall be made on or before the thirtieth

(30th) day of January, April, July, and October of each

year as follows:

A. For each product sold by Cascade covered by

any one of the patents or patent applications

noted above Cascade shall pay Lea an amount of

money equal to five percent (5%) of the gross

selling price.

*

*

*

*

*

*

*

C. This agreement shall remain in force until all

of said U.S. and foreign patents expire or until

the payments have been made in full, whichever

occurs first.

12.

ROYALTY REVIEW

*

*

*

*

*

*

*

- 14 It further [sic] recognized that, for Cascade to

market its products competitively, there needs to be a

reasonable limit as to percentage of the selling price

which can be allocated to royalty payments or the like.

Accordingly, Cascade shall have the right to review on

an annual basis the patents and patent applications

sold by Lea to Cascade along with such other

improvements which might be incorporated in its product

line, to determine if there should be any reallocation

of the five percent (5%) payments which are to be made

to Lea for the following calendar year. If Cascade

determines that such other improvements have

substantial merit and make a significant contribution

to the technology incorporated in Cascade's products or

in the process for making the products, then Cascade

may, in its discretion, make a reallocation of the five

percent (5%) payments to be made Lea, * * * .

On April 20, 1983, in accordance with the 1982 agreement,

Cascade delivered to Lea an installment note for $259,128.03, the

amount of the payments delinquent under the 1979 sales agreement.

The note required quarterly interest payments and two equal

principal payments on December 31, 1983 and 1984.

Improved Cash-flow and Prosperity

Cascade made several changes that improved its cash-flow.

First, instead of contracting out the manufacturing operation,

Cascade began to manufacture the mattresses itself.

This change

allowed Cascade to retain the contractor's profit, which it

estimated was approximately $100,000.

Cascade also improved the

manufacturing operation by changing from a cut-out method to a

peel-out method of removing the mattresses from the presses.

Once the workers became proficient at using the new method, each

mattress was manufactured more quickly and, therefore, at a lower

- 15 cost.

Second, in November 1982, Cascade hired a new controller,

Lee Fromson (Fromson), who implemented certain changes in

Cascade's financial operations that improved its cash-flow during

1983.

For instance, Fromson introduced the corporation to

computers, which Cascade used to automate its system of

accounting for sales and receipts.

To quickly improve the

corporation's cash-flow, Fromson hired a full-time credit manager

who expeditiously collected the accounts receivable and a

purchasing manager who negotiated more favorable prices and

payment terms with the corporation's vendors.

Most importantly, to fund Cascade's growth, Fromson

negotiated with the bank for an increased line of credit at a

lower rate of interest, and he convinced the corporate officers

to use it.

The credit limit was increased to $125,000 in April

and to $150,000 in June 1983, and the initial interest rate was

fixed at 11.5 percent.

For the years 1983 through 1986, the

credit limit was increased to $300,000, and in 1987 it was

increased to $500,000.

These lines of credit were secured by,

and limited to the value of, Cascade's accounts receivable and

its finished goods inventory.

The improved cash-flow allowed Cascade to pay its officers

and to become current on its patent payment obligations under the

1982 agreement at the same time it improved its manufacturing

- 16 capability.

The parties stipulated that for the years 1973 through 1983,

Cascade reported gross and taxable income in the following

amounts:

Year

Gross Income

Taxable Income

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

$203

6,704

49,596

115,296

248,634

519,683

1,033,661

1,546,781

2,266,492

2,791,299

3,935,215

($415)

254

10,501

15,232

45,917

42,687

169,723

165,743

286,675

356,902

414,216

The parties stipulated that during the years at issue,

Cascade reported gross and taxable income in the following

amounts:

Year

Gross Income

Taxable Income

1992

1993

1994

1995

1996

$19,921,985

22,861,486

26,547,637

28,921,971

31,989,268

$2,077,284

3,573,098

3,285,003

3,778,212

5,423,024

Suspension and Reduction of Patent Payments

In 1987, Cascade determined that a competitor was selling a

self-inflating foam-filled mattress that infringed upon its

patents.

The competitor's mattress was manufactured in Taiwan.

After the competitor agreed to discontinue importing and selling

the mattress in the United States, the Taiwanese manufacturer

- 17 brought an action in Federal District Court seeking a declaratory

judgment as to the validity of Cascade's patents.

In 1989,

Cascade filed a counterclaim against the Taiwanese manufacturer

and its U.S. distributor, and a complaint with the International

Trade Commission, claiming that the Taiwanese version of the

mattress infringed upon Cascade's patents.

In 1990, Cascade and Lea agreed to suspend the corporation's

obligation to make payments to Lea pending the resolution of the

litigation with the Taiwanese manufacturer.

In 1991, at the

request of Cascade, the litigation was dismissed.

As a result of

the dismissal, the Taiwanese manufacturer was allowed to continue

manufacturing the mattresses and to sell them in the United

States, and Cascade's patents retained their presumption of

validity.

In 1992, Cascade paid Lea the amounts that had been

suspended pending the outcome of the litigation.

The 1982 agreement was amended on three occasions to reduce

the amount payable to Lea.

Recognizing that the litigation with

the Taiwanese manufacturer had weakened, but not invalidated, the

patents, Cascade and Lea agreed in November 1992 to reduce the

payments from 5 to 4 percent of the gross selling price of the

products using the technology covered by those patents.

In

January 1993, upon reassessment of the value of the patents after

the settlement of the lawsuit, Cascade and Lea agreed to reduce

the payments from 4 to 2.5 percent of the gross selling price of

- 18 the products.

Finally, on May 23, 1996, as a result of

expiration of some of the patents and the introduction of new

technology, Cascade and Lea agreed to reduce the payment

percentage to 1 percent of the sales of all products using the

technology covered by the patents.

On April 14, 1998, the 776 patent, the last patent included

in the 1982 agreement, expired, and no payments were made to Lea

under the agreement for products that were sold thereafter.

The

total amount paid to Lea under the 1982 agreement was

approximately $6.5 million.

Petitioners' Reporting Positions and Respondent's Determinations

Cascade deducted the payments to Lea as patent amortization

expenses.

The Leas reported the payments as capital gains from

the sale or exchange of the patents.

In the notice of deficiency issued to Cascade, respondent

disallowed the deductions claimed for patent amortization

expenses because Cascade had not established that the payments

were ordinary and necessary business expenses or were paid to

purchase the patents.

In the notice of deficiency issued to the

Leas, respondent determined that the payments Lea received from

Cascade were ordinary income from dividends, rather than capital

gains.

- 19 OPINION

Issue 1.

Whether the Payments Were for the Purchase of Patents

Cascade asserts that the 1982 agreement is a valid and

legally enforceable contract and the amount paid for the patents

was reasonable.

Consequently, Cascade argues, the payments are

deductible under section 167 as allowances for depreciation of

intangible property.7

On brief, respondent contends that the 1982 agreement must

be disregarded as it was neither fair nor reasonable; rather, it

was a mere vehicle to disguise distributions of corporate profits

for favorable tax benefits.

Consequently, respondent asserts,

any payments made to Lea in excess of the amount provided in the

1979 sales agreement are nondeductible disguised dividends.

7

Sec. 167(a) allows as a depreciation deduction "a

reasonable allowance for the exhaustion, wear and tear (including

* * * obsolescence) * * * of property used in the [taxpayer's]

trade or business". Patents constitute intangible property,

which may be the subject of a depreciation allowance

(amortization) under this section over their useful lives. See

sec. 1.167(a)-3, Income Tax Regs.

Sec. 167(c) (which was designated sec. 167(g) in 1979 and

1982), specifies the basis for depreciation of any property

"shall be the adjusted basis provided in section 1011, for the

purpose of determining the gain on the sale or other disposition

of such property." Sec. 1012, when read with sec. 1011, provides

that the adjusted basis of the property is its "cost".

If the purchase price of a patent is expressed by formula by

which a fixed dollar amount cannot be ascertained until future

years, such as a purchase price that is a fraction of sales, the

purchaser may deduct each year as depreciation only the amount of

the purchase price actually paid or payable. See Newton Insert

Co. v. Commissioner, 61 T.C. 570, 581 (1974), affd. per curiam

545 F.2d 1259 (9th Cir. 1976); Associated Patentees, Inc. v.

Commissioner, 4 T.C. 979 (1945).

- 20 We begin by noting that, as a general rule, respondent's

determinations of fact are presumptively correct, and petitioner

bears the burden of proving otherwise.

See Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).

Section 162(a) allows deductions for all the ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business.

An "ordinary" expense is one

that relates to a transaction "of common or frequent occurrence

in the type of business involved", Deputy v. du Pont, 308 U.S.

488, 495 (1940), and a "necessary" expense is one that is

"appropriate and helpful" for "the development of the

petitioner's business", Welch v. Helvering, supra at 113.

Taxpayers do not have an inherent right to take tax

deductions.

Deductions are a matter of legislative grace, and a

taxpayer bears the burden of proving entitlement to any deduction

claimed.

See Deputy v. du Pont, supra at 493; New Colonial Ice

Co. v. Helvering, 292 U.S. 435, 440 (1934).

The determination of

whether an expenditure satisfies the requirements for

deductibility under section 162 is a question of fact.

See

Commissioner v. Heininger, 320 U.S. 467, 475 (1943); Granberg

Equip., Inc. v. Commissioner, 11 T.C. 704, 715 (1948).

Cascade promised in the 1982 agreement to pay Lea more for

the patents initially transferred in 1979.

We must decide

- 21 whether the 1982 agreement is a valid, enforceable modification

of the 1979 sales agreement, and if so, whether the amount paid

for all the patents was reasonable.

See Champayne v.

Commissioner, 26 T.C. 634, 643 (1956) (Court's finding that 5percent royalty was reasonable did not make contract to pay 20percent royalty one made in bad faith, a fiction, or a sham).

The 1982 Agreement Is a Valid Enforceable Modification

Default

It is clear from the facts that in 1982 Cascade was in

default on its payment obligation to Lea.

The facts do not

support respondent's argument on brief that Cascade intentionally

defaulted because Lea did not want to be paid.

demands for payment.

Lea made repeated

Cascade's failure to meet its contractual

obligation was due to excessive demands on its cash-flow from

operations and its inability to obtain cost-effective financing

to satisfy its unmet cash requirements.

Cascade's decision to use the corporation's available

financial resources primarily to build its finished goods

inventory and to expand its manufacturing capabilities was a

business judgment.

The Court is very reluctant to substitute its

judgment for that of the persons operating a company, unless the

facts and circumstances require us to do so.

See Malone & Hyde,

Inc. v. Commissioner, 49 T.C. 575, 578-579 (1968).

- 22 Cascade was an undercapitalized startup company at the time

it was delinquent in its payments to Lea.

The officers'

decisions enabled the corporation to establish its presence in

and to secure a share of a rapidly expanding market at the cost

of paying more over time for the essential patents.

Considering

all the facts and circumstances, we are not disposed to second

guess these decisions of Cascade's management.

See id.

Written Notice

Furthermore, we find that Lea's failure to provide 60 days'

written notice, specifying the default complained of, is without

consequence.

It is clear from the corporate minutes that the

officers had actual notice of the default, and that Lea allowed

Cascade many days more than 60 to cure its default, which it did

not do.

It is also clear that the requirement that written

notice be provided was waived by the actions of both parties.

See Eggers v. Luster, 200 P.2d 520, 523 (Wash. 1948); Kelly

Springfield Tire Co. v. Faulkner, 71 P.2d 382, 384 (Wash. 1937);

Barbo v. Norris, 245 P. 414, 417 (Wash. 1926); Consolidated Elec.

Distrib., Inc. v. Gier, 602 P.2d 1206, 1210 (Wash. Ct. App.

1979).

New Consideration

Respondent contends that the 1982 agreement is not valid

because Lea provided no new consideration for the contract

- 23 modification.

Specifically, respondent asserts that the 776

patent and 750 patent application provided no consideration

because the 776 patent was a division of patent application S.N.

800,288 ("Method of Making Self-Inflating Air Mattress"), which

was, therefore, assigned to Cascade in 1979, and the 750 patent

application was rejected by the U.S. Patent and Trademark Office.

"We recall the first lesson in contracts, the peppercorn

theory--that courts will not inquire into the adequacy of

consideration so long as it was true and valuable."

Pope v.

Savings Bank, 850 F.2d 1345, 1356 (9th Cir. 1988).

Here it was.

"Adequacy of consideration" is to be distinguished from the legal

"sufficiency" of any particular consideration.

Legal sufficiency

of consideration is concerned not with comparative value but with

that which will support a promise.

King County v. Taxpayers, 949

P.2d 1260, 1267 (Wash. 1997); Browning v. Johnson, 422 P.2d 314,

316, amended 430 P.2d 591 (Wash. 1967).

The relative values of a

promise and the consideration for it, do not affect the

sufficiency of consideration.

See Browning v. Johnson, supra;

Puget Mill Co. v. Kerry, 49 P.2d 57, 64 (Wash. 1935); 3

Williston, Treatise on the Law of Contracts, sec. 7:21, at 383386 (4th ed. 1992).

We agree that the 776 patent did not provide new

consideration.

The 776 patent was a division of patent

- 24 application S.N. 800,288, which was assigned by Lea to Cascade in

1979.

See Differential Steel Car Co. v. Commissioner, T.C. Memo.

1966-65 (resale of patents by shareholder to corporation provided

no new consideration).

However, although the 750 patent

application did not result in a new patent, it did provide new

consideration.

See 3 Williston, supra at 393-394 (anything of

present or potential intrinsic value, including a new and

original idea, can serve as consideration for a promise to pay).

Moreover, we find that Lea's waiver of Cascade's breach of the

1979 sales agreement and any claim that he may have had for

interest on the unpaid amounts provided legally sufficient

consideration for the contract modification.

See State v. Brown,

965 P.2d 1102, 1106 (Wash. Ct. App. 1998).

Accordingly, we find that the 1982 agreement was a valid and

enforceable modification of the 1979 sales agreement.

Reasonable Payments

Ordinarily, the amounts that a corporation must pay under an

agreement for the use of a patent would be deductible in their

entirety as ordinary and necessary business expenses, and neither

the Commissioner nor the Court would have any authority to

rewrite the agreement of the parties.

See Thomas Flexible

Coupling Co. v. Commissioner, 14 T.C. 802, 818 (1950), affd. 198

F.2d 350 (3d Cir. 1952).

But where the party contracting with

- 25 the corporation is the majority shareholder, the terms of their

agreement may be examined to see whether the amounts to be paid

may fairly be regarded as compensation for the use of the patent

or represent, to some extent, dividends in disguise.

See id.

Lea was the majority shareholder of Cascade at the time the

parties entered into the 1982 agreement.

related parties invite close scrutiny.

Transactions between

See Differential Steel

Car Co. v. Commissioner, 16 T.C. 413, 424 (1951).

Lea's majority

interest alone, however, does not make the patent payments

unreasonable.

The agreements under which they were paid will be

given effect "if the arrangement is fair and reasonable, judged

by the standards of a transaction entered into by parties dealing

at arm's length."

Sterns Magnetic Manufacturing Co. v.

Commissioner, 208 F.2d 849, 852 (7th Cir. 1954); Differential

Steel Car Co. v. Commissioner, T.C. Memo. 1966-65.

We must

assess the reasonableness of the agreement at the time it was

entered into without the benefit of hindsight. See Speer v.

Commissioner, T.C. Memo. 1996-323 (citing Brown Printing Co. v.

Commissioner, 255 F.2d 436, 440 (5th Cir. 1958), revg. T.C. Memo.

1957-37); see also sec. 1.482-2(d)(2)(ii), Income Tax Regs. ("In

determining the amount of an arm's length consideration, the

standard to be applied is the amount that would have been paid by

an unrelated party for the same intangible property under the

same circumstances.").

- 26 Expert Witness Reports

Cascade submitted an expert witness report that analyzed the

contract terms and amounts paid Lea and concluded that the 1982

agreement was reasonable.

Respondent submitted an expert witness

report to rebut the conclusions of Cascade's expert witness.

Expert witness testimony is appropriate to help the Court

understand an area requiring specialized training, knowledge, or

See Fed. R. Evid. 702; Snyder v. Commissioner, 93 T.C.

judgment.

529, 534 (1989).

opinion.

The Court, however, is not bound by an expert's

We weigh an expert's testimony in light of his or her

qualifications and with respect to all credible evidence in the

record.

Depending on what we believe is appropriate under the

facts and circumstances of the case, we may either reject an

expert's opinion in its entirety, accept it in its entirety, or

accept selective portions of it.

See Helvering v. National

Grocery Co., 304 U.S. 282, 294-295 (1938); Seagate Tech., Inc. &

Consol. Subs. v. Commissioner, 102 T.C. 149, 186 (1994).

Cascade's expert witness identified guideline transactions

comparable to the one between Cascade and Lea.

Comparability of

the transactions was determined by either similarity of product,

similarity of manufacturing process, similarity of markets, or

similarity of components and/or technology.

In these guideline

transactions, the amounts paid for the patent or process range

from 1 to 7 percent of sales, and the mode is 5 percent.

- 27 Cascade's expert witness also made certain conclusions

regarding the value of the 776 patent and the 750 technology,

which were based on an analysis of the cost savings provided by

each of their technologies.

Petitioner's expert estimated that

for the years 1983 through 1996, Cascade's use of both

technologies saved direct costs of at least $4.1 million, and the

combined direct and indirect cost savings may have been as great

as $14.4 million.

Petitioner's expert concluded that comparative industry

returns, cost of equity calculations, and an analysis of the

guideline transactions indicate that the 1982 agreement was

reasonable.

Respondent's expert witness did not consider whether a

normal and reasonable rate of payment for the patents was 5

percent of the gross selling price of the covered products during

the life of the patent.

Respondent's expert witness considered

only whether the 776 patent and the 750 technology provided value

to Cascade and would support a purchase price of $10 million less

the earned but unpaid amounts under the 1979 sales agreement.

In his report, respondent's expert valued the 750 technology

at no more than $900,000; however, at trial, he adjusted his

analysis and concluded the value was $1.4 million.

Respondent's

witness did not analyze the value of the 776 patent, because it

was not quantified in petitioner's report separate from the 750

- 28 technology.

Respondent's expert opined that the 1979 sales

agreement established the value of the patents at $300,000, and

that the only difference between the 1979 sales agreement and the

1982 agreement was the "addition of the '776 patent and '750

application."

Accordingly, respondent's expert concluded that

"The valuation of the patent and patent application portfolio at

December 31, 1982 would, therefore, have differed from the

$300,000 valuation under the 1979 Agreement only by the passage

of time", and that the value of the patents and patent

applications transferred in the 1982 agreement was between

$300,000 and $2 million.

We do not find respondent's expert witness' rebuttal

persuasive.

Respondent's expert relied heavily on a 1983

appraisal of Cascade's stock value to determine the value of the

patents.

This appraisal was commissioned by Cascade and

performed by Management Advisory Services.

The appraisal valued

Cascade's stock at $2,450,000, including a control premium.

Respondent's expert, therefore, concluded the maximum value of

the patents and patent applications sold by Lea to Cascade is $2

million; the value "established for the entire company, including

all of its technology, patents and applications", less the

control premium.

Respondent's expert did not consider that the

appraised value of the stock was based in part on Cascade's

estimated net earnings:

its earnings minus the patent payments.

- 29 It is clear from the facts that much more than the passage

of time entered into the parties' considerations in negotiating

the 1982 agreement.

For the years 1973 through 1978, before the

parties entered into the 1979 sales agreement, Cascade reported

total gross income of $940,116 and total taxable income of

$114,176.

For the years 1979 through 1982, the years after the

1979 sales agreement and before the 1982 agreement, Cascade

reported total gross income of $7,638,233 and total taxable

income of $979,043.

Furthermore, the parties expected the growth

rate of the sales, and Cascade's earnings, would continue to

increase.

We have found that the 1982 agreement modified the 1979

sales agreement.

Therefore, in deciding whether the 1982

agreement was reasonable, we consider the value of all the

transferred patents, not only the 776 patent and the 750

technology.

The market value of the patents and the manufacturing

technologies was greater in 1983 than in 1979 simply because the

demand for the mattresses had increased dramatically, the cost of

manufacturing the mattresses had decreased substantially, and any

doubts that the target market would accept a foam-filled selfinflating air mattress were diminished greatly.

In summary, the

mattress was a successful product, and the market value of the

patents was more evident to Cascade and Lea in 1982 than it was

- 30 in 1979.

See Differential Steel Car Co. v. Commissioner, T.C.

Memo. 1966-65 (whether payments by a corporation to its

controlling shareholder for the purchase of a patent are

reasonable depends to a considerable degree on the value of the

invention or process and its salability in the open market).

Furthermore, Cascade was not required by the 1982 agreement

to pay $10 million for the patents.

Rather, the terms were that

Cascade would pay 5 percent of the gross selling price of the

covered products, and the total payments could not exceed $10

million.

Cascade was not obligated to pay $10 million unless

sales of the covered products totaled $200 million before the

patents expired or were supplanted by other patents or

technology.

If Cascade had sold no products, it would have paid

Lea nothing, and if it had sold more than $200 million of

products, it would have paid Lea no more than $10 million.

These

terms support a finding that the 1982 agreement was fair and

reasonable.

Cf. Differential Steel Car Co. v. Commissioner, T.C.

Memo. 1966-65 (contracts that required payment of 80 percent of

net sales, which did not consider the possibility of avoidance by

competitors or invalidity, were not reasonable).

In fact, the parties adhered to the terms of the 1982

agreement; the payment percentage was adjusted to recognize the

decreased value of the patents to the corporation, and Cascade

paid Lea substantially less than $10 million.

- 31 Moreover, we find no evidence that Lea dominated Cascade's

board of directors or the other officers.

Rather, the minutes

show that all the officers participated in making the corporate

decisions, that it was primarily Burroughs' decision as vice

president and treasurer whether to pay Lea and the amount to pay

him, and that Burroughs negotiated the terms of the 1982

agreement on behalf of Cascade.

The payment percentage, 5 percent of the selling price of

the covered products, negotiated by Burroughs is well within the

range paid for similar patents and technologies.

Burroughs, as

vice president, signed the 1982 agreement and testified that at

the time the parties entered into the agreement, he thought the

agreement was fair and reasonable.

We had an opportunity at

trial to observe Burroughs and to evaluate his demeanor as a

witness.

We find Burroughs to be a credible witness, and we are

satisfied that his testimony is truthful.

Finally, the evidence shows that the payments to Lea bore no

relationship to the percentage of his stock ownership.

Cf.

Granberg Equip., Inc. v. Commissioner, 11 T.C. 704, 714 (1948)

(so-called royalty was payable to the stockholders in almost the

same percentage that their stockholdings bore to the taxpayer's

total stock).

It is clear from the facts that the patents Lea sold to

Cascade in 1979 were very valuable to the corporation, and we

- 32 have found that the corporation defaulted on its obligation to

pay Lea for those patents.

In exchange for Lea's waiving

Cascade's prior breaches of the original sales agreement and

other consideration, Cascade agreed to modify the terms of the

1979 sales agreement; that is, Cascade promised in the 1982

agreement to pay more for the patents.

In cases like this when the majority shareholder of a

corporation is also holder of the patents which are sold to the

corporation, "it is easy to say that the transactions were not at

arm's length and thus clothe the situation with an aura of

suspicion.

But we cannot decide cases on suspicion."

Differential Steel Car Co. v. Commissioner, 16 T.C. at 424.

After closely scrutinizing the transactions at issue, we find the

1982 agreement fair and reasonable, and, therefore, the payments

to Lea are expenditures for the purchase of patents, which are

deductible as patent amortization expenses.

Issue 2.

Whether the Leas May Report the Payments as Capital

Gain Income Under Section 1235

The Leas reported the payments Lea received from Cascade as

capital gains from the sale of the patents.

Respondent contends

on brief that even if we find that the 1982 agreement is

reasonable, the payments to Lea are ordinary income, not longterm capital gains under section 1235.

Section 1235(a) provides, in general, that a transfer of all

- 33 substantial rights to a patent by any holder8 shall be treated as

the sale or exchange of a capital asset held for more than 1

year, regardless of whether or not the payments in consideration

of such transfer are contingent on the productivity, use, or

disposition of the property transferred.

1235(d), provides:

However, section

"Subsection (a) shall not apply to any

transfer, directly or indirectly, between persons specified

within any one of the paragraphs of section 267(b)".

Lea and Cascade are persons specified under section

267(b)(2), as modified by section 1235(d)(1); thus, Lea's sale of

the patents to Cascade was a transaction between related persons,

and section 1235(a) does not apply to the transaction.

See Poole

v. Commissioner, 46 T.C. 392, 401-402 (1966).

The Leas assert that even if they are not entitled to

capital gains treatment under section 1235, they are entitled

under other provisions of the law to capital gains treatment for

the payments received for the transfers of the patents to

Cascade.

The Leas cite section 1.1235-1(b), Income Tax Regs.,9

8

The term "holder" includes any individual whose efforts

created such property. Sec. 1235(b)(1).

9

Sec. 1.1235-1(b), Income Tax Regs., provides that if a

transfer is not one described in sec. 1.1235-1(a), Income Tax

Regs. (transfer of all substantial rights to a patent by a holder

to a person other than a related person), then

section 1235 shall be disregarded in determining

(continued...)

- 34 and the legislative history of section 1235 in support of their

position.

Previously, in Poole v. Commissioner, supra at 404-405, we

addressed these same arguments and found them unsound, stating:

We also find unsound Poole's alternate contention

that if section 1235 does not apply to the * * *

transfers, he is entitled under other provisions of law

to capital gains treatment for the royalties paid in

connection with such transfers. The legislative

history with respect to section 1235 explains that a

holder's recourse to prior case law is proper only when

the transaction is not one described in section

1235(a). In other words, if the payments for a patent

are contingent upon productivity, use, or disposition,

or if they are payable periodically over a period

generally coterminous with the transferee's use of the

patent, section 1235 is the holder's exclusive

provision for qualifying for capital gains * * *.

Moreover, this interpretation of the effect of section

1235 is supported by an analysis of the effect of the

provisions of the section. If a holder transfers a

patent resulting in the payment of royalties in the

manner described in section 1235(a) to a related

person, and if we were to hold that such a transfer is

entitled to capital gains treatment under another

provision of law, we would be nullifying section

1235(d). Since section 1235(d) was included in the

law, it must have been done for a purpose--the purpose

of denying capital gains treatment to a holder's

transfer to related persons when the payments are of

the type described in section 1235(a). [Fn. ref.

omitted.]

9

(...continued)

whether or not such transfer is the sale or exchange of

a capital asset. For example, a transfer by a person

other than a holder or a transfer by a holder to a

related person is not governed by section 1235. The

tax consequences of such transaction shall be

determined under other provisions of the internal

revenue laws.

- 35 See also Newton Insert Co. v. Commissioner, 61 T.C. 570, 583

(1974) (Court reviewed), affd. per curiam 545 F.2d 1259 (9th Cir.

1976).

In addressing the provisions of section 1.1235-1(b), Income

Tax Regs., we stated:

We are aware that sec. 1.1235-1(b), Income Tax Regs.,

provides that if sec. 1235 does not apply because a

transfer is made to a related person, the tax

consequences of the transfer are to be determined under

other provisions of law. If that section of the

regulations is intended to imply that when a holder

transfers a patent and receives payments in the manner

described in sec. 1235(a), such payments may qualify

for capital gains treatment, the regulations must yield

to the contrary legislative purpose. [Poole v.

Commissioner, supra at 404 n.7.]

Were we to apply the foregoing case law to the facts of this

case, we would agree with respondent that the Leas are not

entitled to report the proceeds of the sale of the patents as

long-term capital gains.

However, our inquiry cannot end here.

In Rev. Rul. 69-482, 1969-2 C.B. 164, the Commissioner

considered whether a taxpayer-holder who transferred a patent, in

whose hands it was a long-term capital asset, to a related party

for contingent amounts is precluded by reason of section 1235(d)

from obtaining long-term capital gains treatment of the proceeds

of such a transfer under provisions of law other than section

1235.

In his consideration of this issue, the Commissioner

reviewed Poole v. Commissioner, supra, section 1.1235-1(b),

Income Tax Regs., and the legislative history pertaining to the

- 36 adoption of section 1235.

The Commissioner concluded that

consistent with the legislative history and section 1.1235-1(b),

Income Tax Regs.:

it is the position of the Service that where holders

make transfers of patents that do not meet the

requirements for capital gains treatment under section

1235 of the Code, the tax consequences of such

transfers will be determined under other sections of

the Code.

*

*

*

*

*

*

*

Therefore, the mere fact that a patent transfer by

a holder for contingent amounts does not qualify for

long-term capital gains treatment under section 1235 of

the Code, will not prevent it from qualifying for such

treatment under other provisions of the Code if it

would qualify for such treatment in the absence of

section 1235. * * * To the extent that the rationale

of the court in the Poole case may be construed as

contrary to the conclusion in this Revenue Ruling it

will not be followed.

Accordingly, the taxpayer in the instant case is

entitled to treat the transfer of all substantial

rights in the patent as the sale or exchange of a

capital asset and the gain therefrom is reportable as

long-term capital gain. [Rev. Rul. 69-482, 1969-2 C.B.

at 164-165.]

In previous cases concerning the income characterization of

patent payments, the Commissioner has been consistent in adhering

to its position in Rev. Rul. 69-482, 1969-2 C.B. 164.

See, e.g.,

Omholt v. Commissioner, 60 T.C. 541, 547 n.7 (1973) (consistent

with his position stated in Rev. Rul. 69-482, supra, the

Commissioner made no argument that capital gain treatment is

prohibited by section 1235; accordingly, the decision in this

opinion was not made on that basis); Chu v. Commissioner, 58 T.C.

- 37 598, 608 n.1 (1972) (Government made no argument that the amounts

in issue constituted ordinary income solely on the basis that

capital gain treatment is not permitted under section 1235

because the taxpayer's ownership of stock exceeded the limits set

out in section 1235(d)), affd. 486 F.2d 696 (1st Cir. 1973);

Busse v. Commissioner, 58 T.C. 389, 392 n.4 (1972) (Commissioner

conceded pursuant to Rev. Rul. 69-482, supra, that the taxpayerholder was entitled to capital gain treatment of his receipts

from the sale of a patent to a related party under sections of

the Code other than section 1235), affd. 479 F.2d 1147 (7th Cir.

1973); see also Rev. Rul. 78-328, 1978-2 C.B. 215 (citing Rev.

Rul. 69-482, supra); Priv. Ltr. Rul. 83-26-035 (Mar. 25, 1983)

(same); Tech. Adv. Mem. 84-21-006 (Jan. 31, 1984) (same).

Except for his argument that the facts of the instant case

are distinguishable from the facts in Poole v. Commissioner,

supra, respondent has made no argument that Rev. Rul. 69-482,

supra, has no application in this case.

We find that the

essential facts of Poole v. Commissioner, supra, are present in

this case, that in the hands of Lea, the patents were long-term

capital assets as defined in section 1221, and that the Leas

satisfy the requirements of the ruling.10

10

We note that sec. 1239(a), I.R.C. 1954 (as amended),

requires ordinary income treatment of the gain recognized by the

sale or exchange of property to a related person, if the property

(continued...)

- 38 Previously, in similar situations, we have treated

respondent's position in a revenue ruling as a concession of the

issue.

See Walker v. Commissioner, 101 T.C. 537, 550 (1993);

Norwood v. Commissioner, 66 T.C. 467, 469 (1976); Merritt v.

Commissioner, T.C. Memo. 1995-44; Stalcup v. Commissioner, T.C.

Memo. 1995-43; Burleson v. Commissioner, T.C. Memo. 1994-130;

Nikkila v. Commissioner, T.C. Memo. 1993-628; Boice v.

Commissioner, T.C. Memo. 1993-627; Callison v. Commissioner, T.C.

Memo. 1993-626; see also Alumax Inc. v. Commissioner, 109 T.C.

133, 163 n.12 (1997) (although revenue rulings are not regarded

as precedent in this Court, as they merely represent the position

of the Commissioner on a particular issue, the public generally

has the right to rely on positions taken by the Commissioner in

revenue rulings), affd. 165 F.3d 822 (11th Cir. 1999); American

Campaign Academy v. Commissioner, 92 T.C. 1053, 1070 (1989) (it

seems self-evident that in general a taxpayer may rely on a

revenue ruling where parallel facts place the ruling in the

posture of a concession by the Commissioner as to the analogous

taxpayer); Nissho Iwai Am. Corp. v. Commissioner, 89 T.C. 765,

778 (1987) ("The public has a right to rely on positions taken by

10

(...continued)

in the hands of the transferee is subject to the allowance for

depreciation. This section is not applicable in the instant case

because Cascade and Lea are not related persons as defined under

the applicable sections. See sec. 1239(b) and (c), I.R.C. 1954

(as amended).

- 39 the Internal Revenue Service in published revenue rulings.

Having made a concession in * * * [the revenue ruling], we

believe respondent should be so bound."); ZuHone v. Commissioner,

T.C. Memo. 1988-142 (revenue rulings are not authority binding on

this Court, but they may, in certain circumstances, constitute an

admission or concession by the Commissioner), affd. 883 F.2d 1317

(7th Cir. 1989); see also Rev. Proc. 89-14, sec. 7.01(5), 1989-1

C.B. 814 (taxpayers generally may rely upon published revenue

rulings in determining the tax treatment of their own

transactions).

It is clear from Rev. Rul. 69-482, supra, that it is

respondent's position that the tax consequences of transfers by

holders of patents to related persons that do not meet the

requirements for capital gains treatment under section 1235 will

be determined under other sections of the Code.

The ruling has

not been revoked, modified, or obsoleted, nor has the law

changed.

We, therefore, treat respondent's position in Rev. Rul.

69-482, 1969-2 C.B. 164, as a concession that the Leas are

entitled to treat the payments as long-term capital gains from

the sale or exchange of the patents if they can establish that

they meet the factual requirements of the ruling.

Since we have

found that they meet those requirements, the Leas are entitled to

long-term capital gain treatment of all the patent payments in

issue.

- 40 To reflect the foregoing,

Decisions will be entered for

petitioners.