Louw v. Commissioner

Johan A. Louw and Aleida G. Louw v. Commissioner, T.C. Memo. 1971-326, 30 T.C.M. (CCH) 1421 (1971), decided by Judge Featherston, addresses whether an individual's inventive activities -- pursued alongside full-time salaried employment -- can themselves constitute a trade or business for purposes of the section 174 research and experimental expenditure deduction.

Background

Johan Louw, a native of Holland with a degree in mechanical engineering, operated his own die casting business there before working as a mechanical engineer for several Dutch companies, developing mechanical inventions for his employers without receiving special remuneration or a proprietary interest. After immigrating to the United States in 1956, he worked as chief engineer for a Nebraska company and later as an engineer for the Townsend Company in California, where he developed machines for manufacturing aircraft fasteners that led his employer to file three patent applications. On his own initiative and in his individual capacity, Louw also invented a throw-away plastic paint bag and a friction welder for pipelines, which he attempted to market through his employers and a patent search service.

In mid-1965, Louw began work on a "Method and Apparatus for Saline Water Conversion," devoting an average of 25 hours per week to the project for two to three years, working evenings, weekends, and vacations. In 1966 he hired a patent attorney, filed a patent claim in May of that year (granted in 1969), and incurred $2,569 in related costs -- $2,473 in patent attorney's fees, $72 for technical books, and $24 for patent copies -- which he deducted on his 1966 return under section 174. He then attempted, unsuccessfully, to interest his employer Townsend and the Fluor Corporation in developing the apparatus commercially; both companies had it evaluated but declined to invest. The Commissioner disallowed the deduction on the ground that the expenses were not incurred in a trade or business.

The Tax Court's Holding

The Tax Court held that Louw's inventive activities constituted the trade or business of being an inventor and that the disputed expenses were deductible. Section 174(a)(1) permits a taxpayer to currently deduct research or experimental expenditures paid or incurred "in connection with his trade or business," and the Commissioner did not dispute that Louw's outlays qualified as research or experimental expenditures within the meaning of the section -- only whether they were connected to a trade or business. The court observed that a taxpayer may carry on more than one business at once, and that "the exploitation of inventions through royalties, sales of patents, or otherwise may constitute a business," citing Harold T. Avery, 47 B.T.A. 538 (1942).

The court found Louw's inventive activities to be of "sufficiently sustained character" to qualify: his entire career, in Holland and the United States, had involved inventive work, much of it as an employee but also regularly and continuously in his own individual capacity, including the paint bag and pipeline welder inventions that preceded the desalination project. His devotion of roughly 25 hours per week over several years was, in the court's words, "the kind of regular, continuous, and extensive activity which normally characterizes a business." The court was also satisfied that Louw pursued the work with an intention and expectation of profit, noting his efforts to market the desalination apparatus and his other inventions both through direct contact with prospective manufacturers and through a patent search service, even though he had not yet received any income from the project.

Distinguishing Koons v. Commissioner

The Commissioner relied on John F. Koons, 35 T.C. 1092 (1961), in which the court had found that the taxpayer was merely preparing to enter a business that would commercially exploit a patent, making the costs of developing that patent non-currently-deductible. The Tax Court found Koons inapposite: Louw's activities involved the making of inventions rather than putting them to commercial use, and his purpose was to sell, lease, or license his designs to others for production, not to manufacture the apparatus himself. As the court put it, Louw "is not merely preparing to enter a business; he is already engaged in it."

Significance

Louw is a leading illustration of how individual inventors, distinct from research-funding partnerships or corporations, can satisfy section 174's trade-or-business requirement through sustained personal inventive effort pursued alongside other employment, without regard to whether any particular project has yet produced income. It sits alongside Cleveland v. Commissioner and Kilroy v. Commissioner in the line of cases addressing an individual's status as an inventor engaged in a trade or business for section 174 purposes.