Comm'r of Internal Revenue

Tax Court of the United States.Jun 30, 1947
8 T.C. 1327 (U.S.T.C. 1947)
8 T.C. 1327T.C.

Docket No. 10471.



Leslie Handler, Esq., and Elias Moss, C.P.A., for the petitioner. William B. Springer, Esq., for the respondent.

Petitioner's distributive share of income of partnership terminated upon his withdrawal and sale of his interest, held taxable to him as ordinary income in his taxable year of termination and payment, notwithstanding that parthership's fiscal year would not otherwise have terminated until following calendar year. Leslie Handler, Esq., and Elias Moss, C.P.A., for the petitioner. William B. Springer, Esq., for the respondent.

Involved in this proceeding is a deficiency in income tax for the year 1943 in the amount of $18,256.52.

Petitioner having conceded certain adjustments made by respondent, the principal issue that remains is whether respondent erred in treating a part of the net proceeds received by petitioner in 1943 on the sale by him of his interest in a partnership as his distributive share of the net income of the partnership for the period prior to the sale. Petitioner, on his 1943 tax return, treated the net proceeds as resulting in a long term capital gain.

If respondent prevails on this issue, two ancillary questions arise: The amount of petitioner's distributive share of the partnership's net income for the period February 1-July 31, 1943, and the proper year in which such share should have been reported as income.


Petitioner, an individual, is a resident of the city of New York; his return for the period involved, prepared on a calendar year and cash basis of accounting, was filed with the collector of internal revenue for the second district of New York.

Prior to August 1, 1943, petitioner was a member of a partnership known as Crown Thread Co., which manufactured sewing thread, of which the other partners were Herman Segal and Harry Meisel.

The partnership was organized pursuant to written agreement dated February 19, 1940, for ‘a term of three years from and after February 1st, 1940,‘ but ‘the term of this partnership shall be extended for an additional term of two (2) years by the consent in writing of all of the partners of the partnership business as the same may exist at the termination of the first term of the partnership.‘

Pursuant to the agreement, the net profits were to be divided equally among the three partners. The partnership has filed its returns of income on an accrual and fiscal year basis of accounting ending January 31.

Upon the expiration of the partnership agreement, the partnership term was not extended. Rather, Segal and Meisel expressed a desire to purchase petitioner's interest; and sometime in February 1943 negotiations were undertaken, which were completed on or about July 26, 1943, when a written agreement was entered into, whereby petitioner sold his one-third interest in the partnership.

During the period of negotiations, and after the expiration of the term of the partnership, the parties recognized their relationship as a ‘partnership at will,‘ in which petitioner considered himself as having a one-third interest and a one-third interest in the profits until July 31, 1943.

Pursuant to the terms of the agreement of July 26, 1943, the purchasers agreed to pay petitioner, in full payment of his interest, a sum equal to one-third of the partnership's net worth as of the close of business on July 31, 1943. In the determination of net worth, machinery and fixtures were to be calculated at $7,700, good will at $10, and expenses and prepayments were to be apportioned. In case of dispute as to the inventory, differences were to be the subject of arbitration. Provision was made for petitioner to select an accountant who could verify the audit and statements prepared by the partnership's accountants, which were to form the basis for computation of the amount to be paid petitioner.

The agreement also provided for an accounting to be had between the parties as to certain accounts receivable, discounts, allowances and uncollectible debts five months after August 4, 1943, which accounting, purportedly had on January 4, 1944, has become a matter of dispute between the parties.

After the execution of the agreement of July 26, 1943, and on August 4, 1943, petitioner completed documents transferring his interest in the partnership and received a check in the sum of $101,340.60. Thereupon his connection with and interest in the old partnership ceased, and the old partnership itself was dissolved, liquidated, and terminated.

The sum of $101,340.60 included petitioner's one-third distributive share of the partnership net income for the period February 1-July 31, 1943. For that period opening inventory ($100,681.85) of the partnership, its purchases, factory labor, and general overhead expense totaled $869,301. Closing inventory amounted to $84,607.52. The difference is $784,693.48. For the same period net sales were $885,347.88, which, after deducting net costs of $784,693.48, leaves a net profit for the period of $100,654.40, of which one-third is $33,551.47.

Prior to the closing on August 4, 1943, petitioner had access to the partnership's books and records, which his accountant examined as well as certain statements prepared by the partnerships's accountant, which were necessary to determine the value of petitioner's interest. The partnership's accountant prepared a balance sheet as of July 31, 1943, a copy of which was sent to petitioner. He also prepared a profit and loss statement, which was available to petitioner and formed the basis for determining the amount of petitioner's distributive share of the partnership net income from February 1-July 31, 1943, and of the value of his net worth, which included his share of the net income.

After petitioner sold his interest, the business was continued by his two former partners under the same name, i.e., Crown Thread Co. They filed, after July 31, 1943, a certificate of change of interest and published a notice of the change.

The books of the company were not closed as of July 31, 1943, but were kept open and continued by the remaining two partners until January 31, 1944, when closing entries were made. At that time an entry was made showing petitioner's share of the net income for the period February 1 to July 31, 1943, to be in the amount of $33,551.47.

No Federal return of income was filed by the company for the period February 1 to July 31, 1943. The two partners remaining after July 31, 1943, filed after January 31, 1944, a Federal return of income for the company for the period February 1, 1943, to January 31, 1944. That return showed petitioner's distributive share of the net income to be $33,551.47 and that of each of the two remaining partners to be $62,642.14. Other than the unequal ratio of the shares, there was no indication on the return that the petitioner's distributive share figure was for the period February 1 to July 31, 1943, whereas the distributive share figures for the two remaining partners were for the period February 1, 1943, to January 31, 1944.

Petitioner did not report in his Federal income tax returns for either 1943 or 1944 any distributive share of the net income of the company for the period February 1 to July 31, 1943.

On his 1943 Federal income tax return, petitioner reported the receipt of the $101,340.60 as follows:

+-------------------------------------------------------------+ ¦LONG-TERM CAPITAL GAINS: ¦ ¦ ¦ +---------------------------------------+---------+-----------¦ ¦* * * ** * * * * * * ¦ ¦ ¦ +-------------------------------------------------------------¦ ¦Sale of Interest in Partnership Crown Thread Company ¦ +-------------------------------------------------------------¦ ¦120 East 16th St., New York, N.Y. ¦ +-------------------------------------------------------------¦ ¦Sale, August 1943 ¦ ¦$101,340.60¦ +---------------------------------------+---------+-----------¦ ¦Less: Expenses in connection with sale:¦ ¦ ¦ +---------------------------------------+---------+-----------¦ ¦Legal ¦$2,500.00¦ ¦ +---------------------------------------+---------+-----------¦ ¦Accounting ¦700.00 ¦3,200.00 ¦ +---------------------------------------+---------+-----------¦ ¦Net Sale ¦ ¦$98,140.60 ¦ +---------------------------------------+---------+-----------¦ ¦Cost ¦ ¦ ¦ +---------------------------------------+---------+-----------¦ ¦Capital account--6/30/43 ¦ ¦58,624.33 ¦ +---------------------------------------+---------+-----------¦ ¦Profit ¦ ¦$39,516.27 ¦ +---------------------------------------+---------+-----------¦ ¦Total Long-Term Capital Gains ¦ ¦41,256.27 ¦ +---------------------------------------+---------+-----------¦ ¦50% reportable (see sch. B) ¦ ¦20,628.13 ¦ +-------------------------------------------------------------+

Petitioner now agrees that the basis of his interest in the partnership for the purpose of computing gain or loss on the sale thereof is $62,889.24.

In his deficiency notice respondent considered $33,551.47 of the net proceeds of $98,140.60 as petitioner's distributive share of the net income of the partnership for the period February 1, 1943, to July 31, 1943, thus reducing to $64,589.13 the net proceeds received for the sale of petitioner's interest in the partnership. He then computed a long term capital gain of $1,699.89 ($64,589.13 minus $62,889.24) on the sale by petitioner of his interest in the partnership.


OPPER, Judge:

Under section 182, Internal Revenue Code, a partner is required to include in his net income ‘whether or not distribution is made to him * * * his distributive share of the ordinary net income of the partnership.‘ As of July 31, 1943, when petitioner for the first time withdrew from the partnership at will of which he was then a member and sold out his interest to his two former associates, there had been a period of six months since the end of the last partnership fiscal year for the accumulation of earnings as to which petitioner was entitled, by virtue of his membership in the partnership, to his proportionate distribution. Omitting reference to the amount of such profits or to the year in which they are taxable, even petitioner does not contend that no profits were earned during the period described.

We have been referred to no authority indicating that the mere sale of a partnership interest converts a partner's distributive share in past earnings upon which no tax has been paid into a capital item or relieves him from the necessity of paying a tax thereon as ordinary income. The rule in fact appears to be to the contrary. ‘Except for the 'purchase’ and release, all his collections would have been income; the remaining partners would merely have turned over to him his existing interest in earnings already made * * * The 'purchase' of that future income did not turn it into capital, any more than the discount of a note received in consideration of personal services. ‘ Helvering v. Smith (C.C.A., 2d Cir.), 90 Fed.(2d) 590, 592; see Bull v. United States, 295 U.S. 247, 256. And it scarcely requires the citation of authority to demonstrate the commonly applicable principle that no anticipatory assignment of income already earned can relieve the assignor of tax thereon. E.g., Helvering v. Eubank, 311 U.S. 122. We think it must be concluded that petitioner was taxable on his share of the income actually earned by the partnership to the date of his withdrawal, not as capital gain, but as a part of his ordinary income.

‘ * * * Let us suppose Bull had, while living, assigned his interest in the firm, with his partners' consent, to a third person for a valuable consideration, and in making return of income had valued or capitalized the right to profits which he had thus sold, had deducted such valuation from the consideration received, and returned the difference only as gain. We think the Commissioner would rightly have insisted that the entire amount received was income.‘

If the partnership had continued, instead of being dissolved by petitioner's withdrawal, its fiscal year would not have ended until February of the following calendar year; and under the provisions of section 188, Internal Revenue Code, the partnership income of that fiscal year might have been subject to inclusion in petitioner's then current taxable year, which would have been 1944, rather than 1943. Indeed, it has been held that where a partnership is continued after dissolution for purposes of liquidation, and as to surviving partners who continue the business after withdrawal by death or resignation, the partnership's fiscal year may proceed without change from the previous periods. Mary D. Walsh, 7 T.C. 205.

SEC. 188. DIFFERENT TAXABLE YEARS OF PARTNER AND PARTNERSHIP.If the taxable year of a partner is different from that of the partnership, the inclusions with respect to the net income of the partnership, in computing the net income of the partner for his taxable year, shall be based upon the net income of the partnership for any taxable year of the partnership (whether beginning on, before, or after January 1, 1939) ending within or with the taxable year of the partner.

But here the old partnership was not only dissolved, but it was liquidated and terminated as of the date of petitioner's withdrawal. The business was continued, but not, even for purposes of liquidation, by the old partnership. As far as petitioner was concerned, the venture was terminated and he so regarded it. The few remaining details, which affected only the total selling price and not the earnings and profits already secured were to be handled by the continuing partners, not as members of the old firm, but as the purchasers and new proprietors of the old assets.

It may be that for that reason petitioner could have postponed until the following year the final report as to his capital gain. See Bull v. United States, supra. This is a question we need not consider, since petitioner did not then nor does he now so treat the transaction. But as to the partnership earnings to which petitioner was entitled as a partner, nothing remained to be done when the transaction was closed on August 4, 1943, and petitioner was paid in cash the amount found to be due. As to petitioner, the retiring member of a business entity which was then and there being closed, completed, and wound up, the time for a partnership accounting had arrived and the period for which the accounting was to be had had been brought to an end.

A close analogy to the present facts is to be found in Guaranty Trust Co. v. Commissioner, 303 U.S. 493. There the partnership was dissolved by the death of the partner, while here the same result ensued from petitioner's retirement from the firm. New York Partnership Law, secs. 60, 62, 73. But in each cash the partner's earnings and profits for an uncompleted partnership fiscal year were ascertained and credited during the calendar year for which the deficiency was determined. And in the present case they were actually paid during that year. Notwithstanding that if the partnership had continued its fiscal year would not have ended until the following calendar year, it was held in the Guaranty Trust case that the partner's distributive share of the income was taxable to him in the year in which the partnership terminated by his death. The opinion, to be sure, was not based squarely on the conclusion that ‘the partnership 'taxable year’ within the meaning of section 182(a) includes in the special circumstances of this case an accounting period of less than 12 months,‘ here from February 1, 1943, to the date of termination, July 31, 1943. But in Anne Jacobs, 7 T.C. 1481, it was expressly held that ‘such fractional period is a taxable year within the meaning of section 48(a), supra.‘ This furnished the distinction from such cases as C. A. Tooke, 17 B.T.A. 690, which was decided under an earlier and different revenue act. The result is that petitioner's distributive share of the income of a partnership which was dissolved and terminated in the calendar year 1943 is taxable to him as income of that year.

Finally, petitioner resists respondent's determination as to the amount of partnership profits for the period in issue. Laying to one side any question of burden of proof or of the presumptive correctness of respondent's determination, we are satisfied that the record— as made in part by petitioner's own witness— supports the amount of partnership income and of petitioner's one-third share thereof as determined by respondent. The figures appearing in our findings were given by petitioner's accountant. He failed to arrive at respondent's total only because of a refusal to give effect to any closing inventory.

But the partnership itself was obviously a business in which inventories were an income-computing factor. This appears from the tax return itself and inferentially from the method of computation employed by petitioner's accountant. Such a procedure for computing income requires that, from opening inventory and raw materials purchased, there be deducted the amount of closing inventory before the cost of goods sold can be arrived at. See, e.g., income tax Form 1065. Petitioner's share is to be determined from a computation of the partnership's own income, which it is required to make in the same way as though it were itself the taxpayer. Internal Revenue Code, secs. 181-183, 187. It follows that no accurate computation of the partnership income for the period in question, and hence of petitioner's distributive share thereof, could be made without taking account of the closing inventory for the period. For the reasons stated, we are satisfied that the amount of this income, as set forth in our findings, established by the record, and determined by the respondent, is correct.

Decision will be entered for the respondent.