I. J. McCullough and Virginia S. McCullough, Petitioners, v. Commissioner of Internal Revenue, RespondentMcCullough v. Comm'rDocket No. 66615United States Tax Court37 T.C. 1069; 1962 U.S. Tax Ct. LEXIS 174; 133 U.S.P.Q. (BNA) 422; March 14, 1962, Filed 1962 U.S. Tax Ct. LEXIS 174">*174 Decision will be entered under Rule 50.  Petitioner I. J. McCullough and his brother owned 80 and 20 percent, respectively, of the stock of Tool Company.  Subject to royalty rights of three other individuals, Sweetman and another were the owners of patent applications covering devices for the use of explosives for cutting and perforating pipe in wells, particularly oil and gas wells.  On October 1, 1947, Sweetman and his coowner granted an exclusive license to Tool Company to manufacture, sell, lease, rent, and use the devices covered in the patent applications and any and all patents which might be granted, subject, however, to the royalty rights of the three individuals.  On August 4, 1948, Sweetman, after acquiring the interest of his coowner and the royalty rights of two of the royalty owners, transferred the interests so acquired to the McCullough brothers personally, reserving his prior interest.  Petitioner treated the payments thereafter received by him under the exclusive license agreement as long-term capital gain. In 1950, upon advice of counsel, Sweetman, petitioner, his brother, and the remaining royalty owner entered into an agreement with Tool Company for payment1962 U.S. Tax Ct. LEXIS 174">*175  of the royalties on a lump-sum basis over the period of years specified in the exclusive license agreement in lieu of the percentage payments originally provided.  Petitioner continued to treat the payments thereafter received as long-term capital gain. Held, that the payments received by petitioner from Tool Company during the years 1951, 1952, and 1953 constituted ordinary income, and not long-term capital gain. Wilson B. Copes, Esq., James E. Harrington, Esq., and Wellman P. Thayer, Esq., for the petitioners.Marion Malone, Esq., for the respondent.  Turner, Judge.  TURNER 133 U.S.P.Q. (BNA) 422">*423 37 T.C. 1069">*1070  The respondent determined deficiencies in income tax against the petitioners for the 1962 U.S. Tax Ct. LEXIS 174">*176  calendar years 1951, 1952, and 1953 in the respective amounts of $ 96,618.24, $ 133,698.04, and $ 128,199.20.  The only question remaining is whether payments received by the petitioners in the aggregate amount of $ 42,000 for each of the taxable years 1951, 1952, and 1953 under a so-called modification agreement, pertaining to certain patents, applications for patents and rights, constituted ordinary income or long-term capital gains.FINDINGS OF FACT.Some of the facts have been stipulated and are found as stipulated.Petitioners are husband and wife and are residents of Los Angeles, California.  They filed joint income tax returns for the years involved with the collector of internal revenue for the sixth district of California at Los Angeles.I. J. McCullough, hereafter referred to as petitioner, is president of the McCullough Tool Company, hereafter referred to as Tool Company, a corporation organized under the laws of the State of Nevada, with its principal place of business at Los Angeles, California.  At all times pertinent herein 80 percent of the stock of Tool Company was owned by petitioner and 20 percent was owned by his brother, O. J. McCullough, who is vice president 1962 U.S. Tax Ct. LEXIS 174">*177  and general manager of the Houston, Texas, division of the corporation.Since its inception in 1941, Tool Company has been and is now engaged in the rendition of perforating and other highly specialized services to the oil-drilling industry.  The business is highly competitive and approximately 75 percent thereof is based on a number of patents which it either owns or is licensed to use.Prior to October 1, 1947, William G. Sweetman and Earl J. Robishaw, both of Houston, Texas, were doing business as a copartnership under the name of Robishaw Tool peterrobinson@example.net.  Sweetman had invented certain methods and apparatus employing explosives for cutting and perforating pipe and other objects in place in wells, such as oil, gas, and water wells, on which he had filed the following applications for patents, sometimes referred to hereafter as the jet perforator patents:Ser. No. 703,655For Cutting Method and Apparatus, filed October 16, 1946.Ser. No. 709,246For Method and Apparatus for Cutting Inside a Well, filedNovember 12, 1946.Ser. No. 721,443For Mechanism for Detonating Explosives, filed January10, 1947.37 T.C. 1069">*1071  By an assignment executed on March 24, 1947, Robishaw1962 U.S. Tax Ct. LEXIS 174">*178  had become coowner with Sweetman in the above applications.In addition to the above, Sweetman had conducted experimental work and was assembling material preparatory to the filing of further patent applications covering an apparatus for perforating a well and coming under the broad aspects of application No. 703,655.  Several other applications for patents were filed by Sweetman along this same principle.On October 1, 1947, an "agreement," hereafter referred to as the license agreement, was entered into by and between Robishaw and Sweetman, individually and as copartners, collectively referred to as "Licensors," and Tool Company, referred to as "Licensee." The licensors, jointly and severally, granted unto Tool Company the sole and exclusive right, privilege, and license to manufacture, sell, lease, rent, and use the devices, and to 133 U.S.P.Q. (BNA) 422">*424  employ the methods described and claimed in the patent applications and under any and all patents which might be granted and issued on the inventions throughout the United States, its territories and possessions, and in all foreign countries, for the entire term of the patents.The agreement was assented to and approved by three individuals who had theretofore1962 U.S. Tax Ct. LEXIS 174">*179  acquired royalty rights in the patents and applications for patents as follows:Margia Manning1/4William D. Dunnam1/8James G. Gratehouse1/8Under the terms of the license agreement, a 10-percent royalty was to be paid by Tool Company from moneys derived from the sale, lease, rental, or use of the devices, or employment of the methods described, as follows:PercentWilliam G. Sweetman2.5 Earl J. Robishaw2.5 Margia Manning2.5 William D. Dunnam1.25James G. Gratehouse1.25The license agreement provided that Tool Company could make such modifications in the design and construction of the devices as might be necessary to render them practical and salable.The licensors were required to furnish Tool Company all patent information, technical information, data, and know-how in their possession relating to the manufacture and use of the inventions, including all their subsequent inventions falling within the scope of the patent applications.There was a provision in the agreement under which Tool Company agreed to keep books of account and records showing the number of 37 T.C. 1069">*1072  devices manufactured and sold, their size and type, and the number of devices1962 U.S. Tax Ct. LEXIS 174">*180  leased or rented and service jobs performed with the devices or by methods embraced by the subject matter of the agreement.  It also agreed to transmit, with each royalty check, to the licensors and the royalty recipients, by the 20th day of each month during the life of the agreement, a written statement showing the number, size, and type of devices sold or leased and service jobs performed during the preceding month.Under the license agreement Tool Company had the sole right to terminate the license upon 60 days' prior written notice.  No other termination of the license agreement could occur, except through breach of contract.The license agreement contained no provision specifically granting to the licensee the right to grant sublicenses.  It did provide that Tool Company could not transfer or assign the license, as a whole, separately from a transfer or sale of its entire business, without the approval of the licensors.Under the provisions of the agreement and contemporaneously with its execution, the licensors irrevocably sold and delivered to Tool Company and Tool Company paid to the licensors the amount of $ 14,750 for certain tools and equipment, which the licensors had1962 U.S. Tax Ct. LEXIS 174">*181  acquired for use in connection with the inventions, and other assets used in the conduct of their business, such items being identified and valued on a designated schedule.Sweetman was employed by Tool Company on October 1, 1947, and at the present time is one of its employees.  1Prior to August 4, 1948, Sweetman acquired from Robishaw, Dunnam, and Gratehouse all of their respective interests in the jet perforator inventions, applications for patents, and in the license agreement of October 1, 1947.On August 4, 1948, by separate instruments covering the respective interests, Sweetman transferred to petitioner and his brother, jointly, all of the right, title, and interest in and to the jet perforator inventions, applications for patents, and the license agreement of October 1, 1947, which1962 U.S. Tax Ct. LEXIS 174">*182  he had acquired from Robishaw, Dunnam, and Gratehouse.Prior to December 28, 1950, petitioner, his brother, Sweetman, and Manning were advised by their tax attorneys that the Commissioner of Internal Revenue had issued an "order" whereby the royalties that were being paid to them by Tool Company under the license agreement of October 1, 1947, would not qualify after the year 1950 for capital gains treatment.37 T.C. 1069">*1073  On December 28, 1950, Sweetman, petitioner, O. J. McCullough, and Manning, who, with Tool Company, were all of the parties possessing interests in the inventions, patent applications, "and/or" 2 the license agreement of October 1, 1947, executed agreements designated "Modification [Agreements]," which agreements were identical except as to amounts and parties.The modification agreement executed 133 U.S.P.Q. (BNA) 422">*425  by petitioner and Tool Company contains the following provisions:This Agreement made and entered into on the 28th day of December, 1950, by and between1962 U.S. Tax Ct. LEXIS 174">*183  I. J. McCULLOUGH of Los Angeles, California, hereinafter called "I.J.M.", and McCULLOUGH TOOL COMPANY, a corporation, hereinafter called "CORPORATION".WITNESSETH:Whereas, under an Agreement designated "License Agreement," dated October 1, 1947, EARL J. ROBISHAW and WILLIAM G. SWEETMAN, doing business as ROBISHAW TOOL COMPANY, a co-partnership, of Houston, Texas, sold to the Corporation certain inventions and patent applications covering certain useful method and apparatus employing explosives for the cutting and perforating of pipe and other objects in place in wells; andWhereas, said Agreement provided that the Corporation would pay to the named individuals an amount equal to 10% of the moneys received by the Corporation from the sale, lease, rental or use of the devices or methods embodied in said inventions and patent applications; andWhereas, "I.J.M." is the assignee of an undivided 25% of the rights of the named individuals in said Agreement and is entitled to 25% of the payments to be made thereunder; andWhereas, the parties hereto are desirous of modifying the method of payment provided under said Agreement insofar as it relates to said parties and substituting therefor1962 U.S. Tax Ct. LEXIS 174">*184  a fixed, definite total price to be paid by the Corporation to "I.J.M." in consideration of the sale of said inventions and patent applications to the Corporation,Now, Therefore, in consideration of the mutual premises of the parties hereto, IT IS AGREED AS FOLLOWS:1. In lieu of the provisions for payment set forth in the said "License Agreement" of October 1, 1947, by which the said inventions and patent applications were sold to the Corporation, insofar as they relate to "I.J.M." under the said assignment, the Corporation agrees to pay to "I.J.M." the sum of $ 717,500.00.  Said amount shall be paid in equal monthly installments of $ 3,500.00, payable on the 28th day of each month, commencing on the 28th day of December, 1950 and ending with a payment on the 28th day of December, 1967.2. It is agreed by the parties hereto that any and all provisions of said Agreement of October 1, 1947 which are inconsistent with this Modification Agreement shall have no effect.  Said Agreement of October 1, 1947 has been considered by the parties thereto as an absolute assignment or sale of the subject matter thereof.  That Agreement together with this Modification thereof shall be similarly 1962 U.S. Tax Ct. LEXIS 174">*185  construed hereafter.In Witness Whereof, "I.J.M." has hereunto affixed his signature hereto, and the Corporation has caused its corporate seal to be affixed and its corporate name to be subscribed by its duly authorized officers, effective as of the day and year first above written in this Agreement.37 T.C. 1069">*1074  In the Sweetman modification agreement, it was provided that Tool Company would pay Sweetman the same amount, $ 717,500, in the same equal monthly installments of $ 3,500, as he also was owner of an undivided 25 percent of the same rights.In the modification agreement between O. J. McCullough and Tool Company, the interest of O. J. McCullough in the October 1, 1947, license agreement was shown as 20 percent, 3 and the total sum to be received by reason of the modification was $ 574,000, payable in monthly installments of $ 2,800 each.Immediately after the execution of the modification agreement1962 U.S. Tax Ct. LEXIS 174">*186 Tool Company recorded on its books of account the total amount of the liability in the aggregate sum of $ 2,870,000.On January 28, 1960, this Court filed its opinion in McCullough Tool Co., 33 T.C. 743">33 T.C. 743, which proceeding involved different aspects of the transactions involved herein.  The Court specifically found that the modification agreements of 1950 were entered into in good faith and were valid and enforcible contracts, and that in July 1948, petitioner and his brother had each acquired a 25-percent interest in the jet patents. It also found the following as a fact:[Tool Company's] gross sales of parts and services under the jet patents, the royalty payable thereon if such royalty payments had been made under the agreement of October 1, 1947, the actual payments made under the modification agreement, and the excess of what royalty payments would have been made under the contract of October 1, 1947, over actual payments for the years 1950 to 1958 are as follows:YearSalesRoyaltyActualExcesspayments1950 1.$ 14,000($ 14,000.00)1951$ 2,391,904,25$ 239,190.43168,00071,190.43 19522,953,871.53295,387.15168,000127,387.15 19533,323,230.48332,323.05168,000164,323.05 19543,478,612.41347,861.24168,000179,861.24 19554,012,038.67401,203.87168,000233,276-910-0444,490,768.51449,076.85168,000281,076.85 19573,799,971.39379,997.14168,000211,997.14 19583,569,073.75356,907.38168,000188,907.38 28,019,470.992,801,947.111,358,0001,443,947.111962 U.S. Tax Ct. LEXIS 174">*187 133 U.S.P.Q. (BNA) 422">*426  On their returns for the taxable years, petitioners reported the payments received from Tool Company pursuant to the modification agreement as long-term capital gains. Respondent determined that petitioners were not entitled to treat the payments as long-term capital gains.OPINIONIt is the position of the petitioner that he acquired an interest in the jet perforator patents from Sweetman on August 4, 37 T.C. 1069">*1075  1948; that he sold the interest so acquired to Tool Company on December 28, 1950; and that the payments received during the taxable years under the 1950 agreement constituted long-term capital gains from such sale.If, however, the license agreement of October 1, 1947, had effected a sale of the patents to Tool Company, as respondent contends, petitioner in 1948 acquired no ownership in the patents and could not and did not sell any interest therein to Tool Company under his modification agreement of December 28, 1950.Petitioner, on brief, admits that the Tax Court and other courts in a substantial number of cases have held that an exclusive license agreement, such as the October 1, 1947, agreement herein, was "tantamount to a sale for tax purposes." 1962 U.S. Tax Ct. LEXIS 174">*188  He contends, however, that notwithstanding the holdings in those cases, an exclusive license agreement does not constitute a sale "in the traditional sense," and argues that a licensor still retains ownership of interests in the patents themselves.  Based on that argument, he reasons that the licensors herein "retained certain of the interests which constitute a part of the bundle of rights normally referred to as complete ownership"; that, in the transaction of August 4, 1948, he became the owner of the interests so retained by the licensors under the 1947 license agreement, which interests he sold to Tool Company on December 28, 1950.The contention, in our opinion, is without merit.  The various provisions relied upon by petitioner as indicating retention of property rights by the licensors in the patents themselves are similar to those which have been considered in other cases, and it has been held that they did not represent reservations of interests so as to constitute the exclusive license agreement other than a sale.  Kronner v. United States, 110 F. Supp. 730">110 F. Supp. 730; Lamar v. Granger, 99 F. Supp. 17">99 F. Supp. 17; Kimble Glass Co., 9 T.C. 183">9 T.C. 183;1962 U.S. Tax Ct. LEXIS 174">*189 Commissioner v. Celanese Corporation, 140 F.2d 339.The first of the Tax Court cases referred to by petitioner as holding that exclusive license agreements, such as that herein, constituted sales of the patents, was Edward C. Myers, 6 T.C. 258">6 T.C. 258, promulgated February 6, 1946.  The Commissioner acquiesced in the Myers case on June 17, 1946.  On March 20, 1950, he abrogated his acquiescence, and ruled that royalties paid on a fixed percentage basis would thereafter be regarded as ordinary income.  Mim. 6490, 1950-1 C.B. 9. It was this ruling that precipitated the execution of the December 28, 1950, modification agreements herein.The Tax Court and the other courts adhered to the view that the rule of the Myers case properly reflected the law.  Not only did the rule in the Myers case continue to be settled law according to the decided cases, but in 1954 it became statute law with the enactment of section 1235 of the Internal Revenue Code of 1954.  Under Public Law 629, 37 T.C. 1069">*1076  enacted June 29, 1956, a similar section was added to the Internal Revenue Code of 1939, as subsection 1962 U.S. Tax Ct. LEXIS 174">*190  (q) of section 117.  4133 U.S.P.Q. (BNA) 422">*427  The Commissioner, in the meantime, had recognized the 1954 enactment as applying to 1954 and subsequent years, but had adhered to his ruling in Mim. 6490 with respect to taxable years beginning after May 1, 1950, and before January 1, 1954.  After the enactment of section 117(q) and the opinion in Leonard Coplan, 28 T.C. 1189">28 T.C. 1189, had been filed, the Commissioner reconsidered his position as stated in Mim. 6490, revoked the ruling, and again acquiesced in the Myers case, and likewise acquiesced in the Coplan case and in Roy J. Champayne, 26 T.C. 634">26 T.C. 634. Rev. Rul. 58-353, 1958-2 C.B. 408. In the Coplan case, it had been held that a patent assignment by the owner in exchange for payments based on net sales was a sale or exchange, following the Myers case.  In the Champayne case, it had been held that each of two agreements was an exclusive license agreement, under which the owner had transferred his "whole" right in each patent to a corporation; that the agreement amounted to a sale of the patent involved; that the payments by the corporation under1962 U.S. Tax Ct. LEXIS 174">*191  the agreement were payments of purchase price, and that such payments constituted long-term capital gains to the licensor.1962 U.S. Tax Ct. LEXIS 174">*192  Prior to August 4, 1948, petitioner's only interest in the patents, or relating to the patents in any respect, was as a stockholder of Tool Company, which owned the patents by reason of the exclusive license agreement of October 1, 1947.  Sweetman, in the meantime, had acquired the rights of Robishaw, Dunnam, and Gratehouse in the October 1, 1947, agreement, whereby they had the right to collect and receive the payments by Tool Company for its exclusive license to the patents. Petitioner and his brother, by the agreements of August 4, 1948, acquired from Sweetman the rights in the 1947 license agreement which theretofore belonged to Robishaw, Dunnam, and Gratehouse to collect that portion of the selling price of the patents covering the interests which had been owned and sold by them.By the modification agreement of December 28, 1950, petitioner made no sale of any interest in the patents, because he owned no interest.  The modification agreement, we think, was what the term implies, a modification or rearrangement, prospectively, of the payments 37 T.C. 1069">*1077  thereafter to be received from Tool Company under the license agreement. Monthly payments in fixed amounts were substituted1962 U.S. Tax Ct. LEXIS 174">*193  for payments based on the receipts by the Tool Company from the sale, lease, rental, or use of the devices covered by the patents. In the modification agreement, the petitioner, as did the other holders of interests in the October 1, 1947, agreement, and as did the Tool Company, recited that the patents had been sold to the Tool Company under the license agreement dated October 1, 1947.  It merely substituted fixed payments on a monthly basis for payments based on the receipts of Tool Company from the use of the patents.In substance, the situation here is the same as that dealt with in John W. Chamberlin, 32 T.C. 1098">32 T.C. 1098, affd.  286 F.2d 850. In that case, Marian Chamberlin, as did the petitioner here, had, by assignment from the licensors, acquired an interest in the payments to be made by the licensee under the exclusive license. Thereafter the licensor and Marian gave notice to the licensee of an intention to cancel the license for default in payment of royalties and rendering certain statements called for by the license agreement. The dispute was settled, it being agreed that the license was in full force and effect and1962 U.S. Tax Ct. LEXIS 174">*194  that notice of cancellation was premature and ineffective.  Marian contended that the settlement under which payments under the license agreement were resumed constituted a sale or exchange.  Overruling her contention, we said:It appears that both the licensor and licensee retained the same rights and obligations they had before the notice of cancellation and that payments thereafter made by Borg-Warner to Marian Chamberlin were based on the original agreement from Research to Borg-Warner and the assignment of the right to receive the royalties by Research to Chamberlin and Bassett, which rights were purchased from them by Marian.  Marian did not receive the payments as the result of a sale or exchange of a capital asset either by her or anyone else.  Don O. Scott, * * * [26 T.C. 869">26 T.C. 869]; Bratter v. United States, 161 F. Supp. 365">161 F. Supp. 365. The payments were received as collection of a claim for royalties due and to the extent they exceed her basis, are taxable as ordinary income. Osenbach v. Commissioner, * * * [198 F.2d 235, affirming 17 T.C. 797">17 T.C. 797].133 U.S.P.Q. (BNA) 422">*428  Similarly, in1962 U.S. Tax Ct. LEXIS 174">*195  this instance, petitioner in the August 4, 1948, transaction acquired no interest in the patents and applications for patents. That had already been sold by Sweetman and his associates on October 1, 1947.  What petitioner acquired in 1948 was an interest in Sweetman's right to collect payments under the 1947 agreement, and, as in the Chamberlin case, his receipts in excess of basis constituted ordinary income.Our decision in 33 T.C. 743">McCullough Tool Co., supra, does not require a holding to the contrary.  In that case, the taxpayer was the Tool Company and the years involved were, as in this instance, 1951, 1952, and 1953, and the question was as to the proper depreciation allowance to the Tool Company to cover the exhaustion of the patents, it being the 37 T.C. 1069">*1078  position of the respondent that the Tool Company had no fixed cost for the patents susceptible of depreciation.  It was the contention of the Tool Company, on the other hand, that its cost had become fixed by the provisions of the December 28, 1950, agreement.  In holding for the taxpayer, we pointed out that with the modification agreements the Tool Company's cost for the patents had become 1962 U.S. Tax Ct. LEXIS 174">*196  definitely fixed and determined, and for the purposes of the decision there, it made no difference whether, under the views expressed in the Myers case, the licensor-vendors had effected a sale of the patents under the agreement of October 1, 1947, or the sale had been effected by the modification agreement in 1950.  What was material, was that the modification agreement had substituted a fixed cost to the Tool Company for a prior cost determinable only through gross receipts over the life of the patents. In that case, our findings of fact did contain what was in the nature of a statement of mixed law and fact that petitioner and his brother had each acquired in 1948 a 25 percent interest in the jet patents, but the decision there would have been the same even if there had been no sale at all of the patents by the licensors to the Tool Company until the December 28, 1950, agreement.We conclude and hold that petitioner's gains from the payments received during the taxable years from Tool Company pursuant to the agreement of December 28, 1950, were ordinary income.Decision will be entered under Rule 50.  Footnotes1. This finding of fact is from a stipulation of the parties.  In the Tool Company's tax case, referred to hereafter, it was found as a fact that "Neither Robishaw nor Sweetman was an employee of petitioner on October 1, 1947."↩2. The quoted wording is from the stipulation of the parties.↩3. Presumably O. J. McCullough had previously disposed of one-fifth of his interest in the 1947 license agreement.↩1.. December only.↩4. (q) Transfer of Patent Rights.  -- (1) General rule.  -- A transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 6 months, regardless of whether or not payments in consideration of such transfer are -- (A) payable periodically over a period generally coterminous with the transferee's use of the patent, or(B) contingent on the productivity, use, or disposition of the property transferred.* * * *(4) Applicability.  -- This subsection shall apply with respect to any amount received, or payment made, pursuant to a transfer described in paragraph (1) in any taxable year beginning after May 31, 1950, regardless of the taxable year in which such transfer occurred.↩
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