Comm'r of Internal Revenue

Tax Court of the United States.Feb 28, 1951
16 T.C. 491 (U.S.T.C. 1951)
16 T.C. 491T.C.

Docket No. 24685.



E. D. McCurdy, Esq., for the petitioner. A. J. Friedman, Esq., for the respondent.

E. D. McCurdy, Esq., for the petitioner. A. J. Friedman, Esq., for the respondent.

INCOME— ORDINARY OR CAPITAL GAIN.— Petitioner gave an option providing for the sale to an individual of stock in a corporation at a cash price, and also providing for a contract of employment by the corporation for 5 years for a salary plus a commission on the corporation's magnet sales. Held, that the contract of employment was not part of the consideration for the sale of stock and the commission as well as the salary received during 1947 was compensation for services rendered and taxable as ordinary income. Held, further, that a lump sum received from the corporation in 1947 in consideration of cancellation of the unexpired term of the employment contract and petitioner's agreement not to engage in magnet business, constituted ordinary income.

This proceeding involves an asserted income tax deficiency of $4,183.56 and a claimed overpayment of $4,640 for the calendar year 1947.

The petitioner assigns as errors: (1) the respondent's action in including in ordinary income the amount of $13,500 reported on the return as a capital gain realized on the cancellation of a certain contract in December 1947, and (2) the petitioner's action in reporting on his 1947 return as ordinary income instead of a capital gain the amount of $17,549.42 received during 1947 prior to the cancellation of the contract alleged to involve a sale of capital assets consisting of shares of stock. However, on brief, petitioner concedes that $9,000 and $12,000 of the above-mentioned amounts, respectively, are properly allocable as ordinary income for personal services and accordingly he abandons his assignments of error in respect thereto.


The stipulated facts, including exhibits attached to and made a part thereof, are so found and included herein by reference.

The petitioner, an individual residing in Cleveland Heights, Ohio, filed his income tax return for 1947, made on a cash receipts and disbursements basis, with the collector of internal revenue for the eighteenth district of Ohio.

The petitioner, now 76 years of age, has been interested in manufacturing and selling magnets since 1900 and has been an authority on magnets for many years. Prior to and on February 28, 1946, petitioner was the president and chairman of the board of directors and the owner of practically the entire capital stock of the Ohio Electric Manufacturing Company, an Ohio corporation (hereinafter sometimes referred to as Ohio Electric), which manufactured magnets and fractional electric motors.

Shortly prior to February 28, 1946, petitioner made known the fact that he was interested in selling his 30,300 shares of Ohio Electric stock which attracted a number of prospective buyers. Petitioner indicated to N. B. Hott a selling price of $10 per share on condition that he receive from Ohio Electric an employment contract for a period of 5 years at a salary of $1,000 per month plus a commission of 1 per cent on magnet sales by that company, and also, that certain other persons receive employment contracts with the company. N. B. Hott negotiated with petitioner for several days in an effort to acquire the stock without the attached condition of the employment contracts because in his opinion the company would not benefit thereby, but he accepted petitioner's terms in order to close the deal.

On February 28, 1946, petitioner executed a written option agreement which provided in part as follows:

In consideration of the sum of $10.00, receipt of which is hereby acknowledged, I hereby give and grant to M. B. Hott, or his nominee, the exclusive right and option to purchase from me 30,300 shares of the $1.00 par value Capital Stock of The Ohio Electric Manufacturing Co., an Ohio Corporation, now registered in my name for the sum of $303,000.00 on or before 12 o'clock noon March 9, 1946, upon the following terms and conditions.

1. On or before 12 o'clock noon, March 9, 1946, there shall be paid to me in Cleveland funds the sum of $10,000.00.

2. In the event of such payment as recited above, such payment shall thereupon constitute a binding Agreement on my part to sell and upon the part of M. B. Hott to buy the aforesaid mentioned shares at the price recited, the balance of said purchase price, namely $293,000.00, to be paid to me on or before 12 o'clock noon April 1, 1946 in Cleveland funds.

3. Upon payment to me the full amount of said purchase price, namely $303,000.00, I agree to deliver said 30,300 shares to M. B. Hott, or his order, registered in his name or in such other names as he may designate and in such denominations as he shall designate.

9. This Agreement is subject to the following further conditions:

(a) That employment agreements for a period of five years, from April 1, 1946, covering the employment of the following individuals, shall be made at the respective salaries and commissions hereafter set forth, provided however, that such salaries and commissions shall be subject to such uniform reduction as may be made effective by the management among the entire salaried employees of the Company: F. W. Jessop, $1,000.00 monthly plus 1% on Magnet sales. Vincent Smith, $400.00 monthly plus 3/4% on motor sales and 3/4 of 1% on magnet sales. George Duncan, $400.00 monthly plus 1/10 of 1% on Motor sales. C. Whittier, $600.00 monthly. Ray Wertz, $350.00 monthly. Irving Bartlett, $400.00 monthly.

(b) That at least throughout the period of the above mentioned employment Agreements, you will cause the Ohio Electric Manufacturing Co. to maintain the policy of paying to the salaried employees, who are eligible for the pension trust, upon their respective deaths in service during said period, one year's salary.

At the time petitioner executed the option agreement, M. B. Hott was neither an officer nor employee of Ohio Electric and he did not represent that company in his transaction with petitioner.

Pursuant to the option agreement M. B. Hott exercised his option rights and paid to petitioner the sums of $10,000 as the initial payment and $293,000 as the balance of the purchase price for the stocks. At sometime between the initial and final payments to petitioner, M. B. Hott arranged a resale of the stock at $14 a share, which transaction and the final payment to petitioner were completed through a bank as the escrow agent.

In further pursuance of the terms of the option and under date of March 18, 1946, the petitioner as employee and the Ohio Electric entered into an ‘Employment Agreement,‘ which provided, inter alia, that petitioner was presently the president and magnet sales manager of the company which desired to retain his services, that the company agreed to employ petitioner for a period of 5 years commencing April 1, 1946, and agreed to pay ‘for his services hereunder a salary‘ of $1,000 per month and ‘in addition to the above salary, * * * a commission‘ of 1 per cent on the gross sales price on all magnets and magnet parts manufactured and sold by the company throughout the period of petitioner's employment provided the company was allowed a deduction therefor from gross income as an expense of doing business; that petitioner agreed to perform the duties assigned him, to devote his full time to the company's business, to pursue no other business occupation either competing or noncompeting without prior written consent and, further, that his ‘right to employment hereunder shall be conditioned‘ upon his faithful performance of the provisions of the agreement and at all times being mentally and physically capable of performing all reasonable duties and authority assigned him; that during his employment the petitioner agreed to disclose and upon request assign to the company all inventions or improvements conceived and relating to the company's business; that the agreement be terminated upon petitioner's death within the period of employment except as to the right of petitioner's estate to receive commissions becoming payable after death on sales made prior to death, and further that ‘This contract is for personal services, and no part of the same is assignable on the part of Employee.‘

The five individuals, other than petitioner, named in the option agreement of February 28, 1946, as persons who were to receive employment contracts with Ohio Electric did not sell any shares of stock in that company to M. B. Hott in connection with the latter's purchase of petitioner's stock, but they were employees of the company at that time. Pursuant to the option agreement and with the possible exception of Vincent Smith, Ohio Electric executed employment agreements with those individuals.

On the day following the completion of the transaction involving petitioner's sale of his Ohio Electric stock, he was voted out of the offices theretofore held by him. Thereafter and until December 22, 1947, petitioner served the company as an employee in an advisory capacity in connection with the sale of magnets, worked daily from 9 to 5, made quotations on magnets, and entered orders on sales, but the actual selling was done by salesmen on a commission basis. From April 1, 1946, until December 22, 1947, the petitioner was paid, in accordance with his employment contract, $1,000 per month plus 1 per cent of the company's magnet sales, and during that period of time such percentage payments averaged $500 per month.

In connection with the affairs of Ohio Electric the petitioner became persona non grata and offered to sell his employment contract so as to terminate his relations with the company. The company refused petitioner's first offer to sell on the basis of a percentage of the remainder of the original contract period, but accepted his second offer in December 1947 on the basis of in effect reducing the contract period to 30 months of which approximately 21 months had been served with compensation and leaving 9 months to be compensated for at $1,500 per month, or a lump sum payment of $13,500, to sell and terminate his employment contract.

On December 22, 1947, petitioner and Ohio Electric entered into an ‘Agreement of Release‘ which provided, inter alia, that both parties desired to terminate the employment contract of March 18, 1946, and settle their respective claims against each other; that the company agreed to pay and petitioner agreed to accept $13,500 ‘in full and complete settlement of all obligations under said Agreement of Employment‘; that each party released the other from all claims, demands and causes of action by virtue of the employment agreement or the relationship of employer and employee which existed between the parties prior to that agreement; that petitioner was entitled to ‘full compensation‘ for the month of December 1947; and that petitioner agreed that for a period of 3 years he would not engage in the magnet business directly or indirectly either as employer, employee, agent, technical adviser, stockholder, partner, or otherwise.

On December 22, 1947, Ohio Electric issued its check for $13,500 payable to petitioner and the accompanying voucher stated ‘In full Settlement of Cancellation of Employment Contract dated March 18, 1946 between F. W. Jessop and The Ohio Electric Manufacturing Company.‘ On the company's books that payment was treated as a charge to the cost of sales and it did not withhold any portion thereof for income tax. With respect to the salary and commissions on magnet sales paid to petitioner under the employment contract during 1947, Ohio Electric segregated the amounts thereof on its books, but withheld income taxes on both amounts.

On his 1947 income tax return, under Item 2, petitioner reported the amount of $17,549.42 as compensation received from his employer, Ohio Electric. On the same return, under Schedule D, petitioner reported a long term capital gain of $13,500 as realized from ‘Sale of Employment Contract‘ acquired April 1, 1946, and sold December 22, 1947, with 50 per cent of such gain taken into account for tax purposes. Respondent taxed the entire amount of $13,500 as ordinary income.



The two assignments of error raise a similar question as to the character of income received and will be discussed together. Petitioner has conceded that of the $17,549.42 and $13,500 payments received in 1947, the amounts of $12,000 and $9,000, respectively, are properly allocable to compensation for personal services and as such taxable as ordinary income. This leaves for decision herein the question of whether the remaining amounts, namely, $5,549.42 received under the employment contract and actually attributable to a percentage on magnet sales during 1947, and $4,500 received under the release agreement and alleged to be attributable to a percentage on prospective magnet sales, constituted compensation taxable as ordinary income or constituted long term capital gains realized on a sale of capital assets consisting of shares of Ohio Electric stock.

Petitioner contends that the Ohio Electric stock at the time of petitioner's sale thereof had a market value greatly in excess of the cash consideration of $10 per share; that under the terms of the option agreement the 5-year employment contract, providing for a stated salary and in addition for a percentage of magnet sales by Ohio Electric, constituted an integral part of the consideration and sale price of petitioner's stock; that the amounts of the payments under the 5-year contract were not ascertainable until received and therefore the contract had no fair market value at the time of the sale, and, further, that the payment to petitioner of a salary for services under one provision of the employment contract does not preclude the percentage payments, on magnet sales under another provision of that contract, from being treated as amounts realized from a sale of property (i.e., stock), within section 111, Internal Revenue Code, taxable as capital gains under section 117, Internal Revenue Code.

SEC. 111. DETERMINATION OF AMOUNT OF, AND RECOGNITION OF, GAIN OR LOSS.(a) COMPUTATION OF GAIN OR LOSS.— The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 113 (b) for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.(b) AMOUNT REALIZED.— The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.

SEC. 117. CAPITAL GAINS AND LOSSES.(a) DEFINITIONS.— As used in this chapter—(1) CAPITAL ASSETS.— The term ‘capital assets‘ means property held by the taxpayer (whether or not connected with his trade or business), * * *(4) LONG-TERM CAPITAL GAIN.— The term ‘long-term capital gain‘ means gain from the sale or exchange of a capital asset held for more than 6 months, if and to the extent such gain is taken into account in computing net income;(b) PERCENTAGE TAKEN INTO ACCOUNT.— In the case of a taxpayer, other than a corporation, only the following percentages of the gain or loss recognized upon the sale or exchange of a capital asset shall be taken into account in computing net capital gain, net capital loss, and net income:100 per centum if the capital asset has been held for not more than 6 months;50 per centum if the capital asset has been held for more than 6 months.

Briefly stated, respondent contends that the 5-year employment contract provided merely for payments of salary and commission for a period of years as ‘compensation for personal services,‘ within section 22 (a), Internal Revenue Code and thus the receipt of ordinary income rather than gain from a sale or exchange of property; that the entire amount of $17,549.42 was received during 1947 solely as compensation for services actually rendered, and that the entire amount of $13,500 was received in December 1947 as a single payment for petitioner's relinquishment of a contract right to receive compensation for services over the period of the contract which had not expired at the time of the cancellation.

Petitioner testified that ‘my idea was that I was selling a company plus extra management, at least during the time until the company could get familiar with the product and the method of sales,‘ but that he did not particularly desire to remain in the employ of the company for 5 years after the sale. Petitioner further testified that the Ohio Electric shares were then selling on the market for about $12.50 per share and he wanted the equivalent of $13 per share for his stock, or approximately $393,000. In effect, petitioner assumes that at time of the sale it could be foreseen that his salary and commissions would average $1,500 per month for the 60-month employment contract period and that petitioner might anticipate receiving $90,000 under that contract in addition to the cash consideration of $303,000 for the stock. As opposed to that assumption petitioner makes the specific contention that the amounts of the payments under the 5-year contract were not ascertainable until received and therefore the contract had no fair market value to be taken into account in determining gain at the time of the sale of the stock. Also, it would seem that the import of the testimony above referred to is conflicting in that it implies first, that petitioner intended to sell his stock and his management services and second, that he intended to sell the stock for a total price measured by the cash plus anticipated payments under the 5-year contract which would mean that the management services would be rendered gratis. That testimony was designed to explain the petitioner's intention in granting the option agreement.

On the other hand, petitioner also testified that the terms of the option relate the substance of his agreement. In our opinion the terms of the option agreement of February 28, 1946, are clear and unequivocal in providing for two separate undertakings: first, the purchase by M. B. Hott of petitioner's 30,300 shares of stock for $10 per share in cash, and second, the execution by Ohio Electric, a separate party, of employment contracts for the personal services of six persons, three of whom including petitioner, were to receive compensation measured by commissions on sales in addition to stated salaries. The terms of petitioner's employment contract of March 18, 1946, relate only to compensation in salary and commission to be paid by the company and the character of services to be rendered by petitioner in exchange therefor, and specifically state that ‘This contract is for personal services, and no part of the same is assignable on the part of the Employee.‘ The agreement of release of December 22, 1947, provides for the payment of a lump sum of $13,500 to petitioner in consideration for the termination of petitioner's employment, the full and complete settlement of all obligations under the employment contract, and also the petitioner's agreement to refrain from engaging in the magnet business for a period of 3 years.

The facts herein do not sustain petitioner's contention that the payments received by him from Ohio Electric in 1947 are separable as constituting in part salary for personal services, which petitioner concedes is taxable as ordinary income, and in part a percentage on the company's magnet sales representing deferred payments on his sale price of shares of stock sold to M. B. Hott in 1946. The petitioner's personal services were prerequisite to the obligation of Ohio Electric to pay him compensation consisting of a stated monthly salary plus commissions on sales during the period of his employment. The principles announced in the cases cited and relied on by petitioner are not applicable to the facts herein.

Cases relied on by petitioner include:Burnet v. Logan, 283 U.S. 404;Commissioner v. Carter, 170 Fed.(2d) 911, affirming 9 T.C. 364;Westover et al. v. Smith, 173 Fed.(2d) 90;George James Nicholson, 3 T.C. 596, petition for review dismissed October 17, 1945;Helvering v. Ackerman, 71 Fed.(2d) 586, affirming 24 B.T.A. 512; andHofferbert v. Briggs, 178 Fed.(2d) 743.

While the employment contract with Ohio Electric was an inducement to petitioner to sell his stock to M. B. Hott, it was not part of the consideration for the sale, but instead was a contract for personal services which had to be rendered as a prerequisite before any payments of either salary or commission became due and payable to petitioner. The form and character of the compensation are immaterial. Commissioner v. Smith, 324 U.S. 177, rehearing denied and opinion modified, 324 U.S. 695. Since the $5,549.42 commissions on sales of magnets as well as the $12,000 salary received under the employment contract during 1947, constituted financial benefits conferred as ‘compensation for personal service‘ within section 22 (a), Internal Revenue Code, the entire amount of $17,549.42 so received was taxable as ordinary income and thus was correctly reported by petitioner on his 1947 return.

The petitioner, in December 1947, offered to sell his employment contract to Ohio Electric for $13,500 which figure was arrived at by petitioner on the basis of $1,000 per month salary and $500 per month commission for a total of 9 months. However the petitioner may have arrived at an amount acceptable to him, the fact is that the agreement of release provided only for a lump sum payment of $13,500 to petitioner in consideration of termination of the employment contract, the settlement of all claims of each party (which so far as we know related only to services rendered or to be rendered), and also petitioner's agreement not to engage in the magnet business for 3 years. We conclude that the cancellation of petitioner's contract right to receive compensation of salary plus commissions over a period of years and his agreement not to engage in the magnet business in consideration for a lump sum payment of $13,500 resulted in his receipt of ordinary income in that entire amount. George K. Gann, 41 B.T.A. 388; and Charles J. Williams, 5 T.C. 639. See also Hort v. Commissioner, 313 U.S. 28.

The respondent did not err in his determination.

Decision will be entered for the respondent.