Comm'r of Internal Revenue

This case is not covered by Casetext's citator
Tax Court of the United States.Apr 26, 1963
40 T.C. 157 (U.S.T.C. 1963)

Docket No. 92352.



Sidney Gelfand, for the petitioners. Henry G. Nagel, for the respondent.

LONG-TERM CAPITAL GAIN OR ORDINARY INCOME— SECS. 1222, 736(a)(1).— An amount received by one partner, the petitioner, from the only other partner under an agreement to terminate the partnership, represented long-term capital gain from the sale of the petitioner's interest in the partnership business rather than payment for past services, unrealized receivables, or partnership income under section 736 (a)(1).

The Commissioner determined a deficiency of $1,614.37 in income tax of the petitioners for 1958. The only issue for decision is whether an amount received by Charles from Harry C. Miller was long-term capital gain, as reported by the petitioners, or was ordinary income (a) as payment for past services and for ‘unrealized receivables,‘ as determined by the Commissioner, or (b) under sections 702, 736, and 1222 as claimed by the Commissioner in an amended answer filed on the day of trial. Sidney Gelfand, for the petitioners. Henry G. Nagel, for the respondent.


The petitioners, husband and wife, filed a joint return for 1958 with the director of internal revenue for the district of Manhattan, N.Y.

Charles and Harry C. Miller became partners under an oral agreement on or about April 10, 1947. The name used by the partnership was Harry C. Miller Co. Miller's interest was 60 percent and Charles' interest was 40 percent. The partnership used a cash basis of accounting as did the petitioners. The partnership acted as sales representative for sporting goods manufacturers. It had five or six accounts but its principal client at times material hereto was the Garcia Corp. This account was brought to the partnership prior to 1951 by a nonpartner salesman. Miller, Charles, and their employees all participated in handling the Garcia account. It represented 80 to 85 percent of the business of the partnership in 1957 and 1958. There was no contract, written or oral, between the partnership and Garcia and the continuance of the arrangement depended upon satisfaction on each side. The partnership represented Garcia in 21 Eastern States and caused it to be recognized as the leading factory in the fishing tackle industry.

Charles was stricken with a heart attack in October 1957 and was recuperating in a hospital, at home, and in Florida until early in February 1958. He returned to work in that month. Meanwhile Miller had decided to discontinue the partnership. He told Charles of this decision in the latter part of February 1958 at which meeting they discussed but did not agree upon what might be done for Charles.

Charles then went to Thomas T. Lenk, the president of Garcia, who was friendly to both Miller and Charles. Lenk knew that the partnership was not going to continue and had decided in his own mind that Garcia would continue with Miller as its sales representative, that Charles would not represent Garcia in any territory, but that Charles would have to be paid off in some way by Miller. Miller wanted to drop Charles without paying him anything and had no further negotiations with him.

Miller and Charles executed an agreement dated March 25, 1958, ‘to terminate the partnership’ as of the close of business on March 31, 1958. It provided, inter alia, that Miller should have all assets being used in the operation of the business which he intended to continue, other assets were to be divided 60 percent to Miller and 40 percent to Charles, no publicity was to be given the dissolution, except by mutual consent, and for the 3 years beginning April 1, 1958, while Miller continued to act as sales representative of Garcia he was to pay to Charles from commissions he received from Garcia 16 1/2 percent for each of the first 2 years and 8 1/4 percent for the third year.

Miller agreed to include in the agreement of March 25, 1958, the provisions requiring him to pay the percentages of his commissions from Garcia to Charles because Lenk urged him to do it.

Miller paid to Charles in 1958, $11,704.01 representing 16 1/2 percent of commissions received by Miller from Garcia during the last 9 months of 1958.

The petitioners reported the $11,704.01 on their 1958 return as gross sales price from the sale of Charles' 40-percent interest in the partnership, deducted $750 as expenses of the sale, showed a long-term capital gain of $10,954.01, and reported one-half of it as taxable income.

The Commissioner in determining the deficiency, included the entire $10,954.01 in taxable income and explained:

The sum of $11,704.01 paid to you by Harry C. Miller in 1958 and reported by you as a long term capital gain in the amount of $10,954.01 ($11,704.01 principal less expenses of $750.00) has been determined to be properly includible in its entirety in your gross income for 1958 as it represents payment for past services rendered and for ‘unrealized receivables' within the purview of Section 735(a) and 751(a) and (c) of the Internal Revenue Code of 1954. Accordingly, the addition of $5,477.01 to your taxable income for the year 1958 is computed as follows:

+---------------------------------------------------------------------+ ¦Amount of payment properly to be reported ($11,704.01 less¦ ¦ +----------------------------------------------------------+----------¦ ¦expenses of $750.00 ¦$10,954.01¦ +----------------------------------------------------------+----------¦ ¦Amount previously reported as long term capital gain (50% ¦ ¦ +----------------------------------------------------------+----------¦ ¦of $10,954.01) ¦5,477.00 ¦ +----------------------------------------------------------+----------¦ ¦Additional income ¦5,477.01 ¦ +---------------------------------------------------------------------+

The $11,704.01 did not represent ‘payment for past services rendered’ by Charles to anyone and did not represent payment ‘for ‘unrealized receivables' within the purview of Section 735(a) and 751(a) and (c) of the Internal Revenue Code of 1954.’

All stipulated facts are incorporated here by this reference.



The explanation of the determination states first that ‘$10,954.01 ($11,704.01 principal less expenses of $750.00)‘ was included in gross income because ‘it represents payment for past services rendered.’ The parties stipulated ‘that no part of the $11,704.01 received by petitioner in 1958 represents past services rendered to the Harry C. Miller Co. partnership’ but the Commissioner contends that the deficiency notice was intended to refer to past services rendered by Charles to Garcia and paid by Garcia through Miller. The evidence shows that there is no merit in that contention, if it could be fairly read into the deficiency notice. The only services rendered Garcia by Charles were rendered on behalf of the partnership and were paid for in full to the partnership. Garcia did not owe Charles for any past services, never agreed to pay him the $11,704.01 or any other amount for past services, and did not pay him anything for past services to it through Miller or in any other way.

The other reason given in the deficiency notice for including the $10,954.01 in gross income was that it represented payment ‘for ‘unrealized receivables' within the purview of Section 735(a) and 751(a) and (c).’ This reason also is refuted by the evidence which shows that the partnership collected and reported as income all amounts due it, which amounts were in turn reported by Miller and Charles and are not involved herein; there were no ‘unrealized receivables'; and no part of the $11,704.01 represented receivables of any kind. Furthermore, Miller, not the partnership, paid the $11,704.01 to Charles.

The $11,704.01 was an amount which Miller agreed to pay to Charles out of commissions which he (Miller) might earn subsequently by performing services for Garcia and which he paid from that source as he had agreed. It was never income or funds of the partnership. Thus the petitioners have overcome the presumption of correctness attached to the Commissioner's determination as explained in his notice of deficiency.

The Commissioner filed at the opening of the trial an amendment to his answer by which he added an allegation ‘That the amount of $11,704.01 received by the petitioners in 1958 from Harry C. Miller is taxable at ordinary income tax rates under the provisions of section 702, 736 and 1222 of the Internal Revenue Code of 1954.’ He did not plead any facts in his answer to support or explain that allegation. The Court tried unsuccessfully to learn what was meant by the amendment. The petitioners denied the allegation in a reply. The Commissioner argues in his brief that there was no sale to support a long-term capital gain and ‘The payments received by petitioner were made in liquidation of his interest in the Harry C. Miller Co. partnership and are taxable as ordinary income under the provisions of section 736(a)(1) of the Internal Revenue Code of 1954.’

This amendment and the argument made thereunder are contrary, in one respect at least, to the determination made in the notice of deficiency which is presumed to be correct. That determination was that only ‘$10,954.01 ($11,704.01 principal less expenses of $750.00)‘ was includable in gross income and the Commissioner, to reverse himself as to the $750, would have to allege and prove facts to show that the $750 should now be disallowed as expenses and taxed as income. He has done neither and his original treatment of the $750 may not be changed.

The argument made on the point raised in the amendment to the answer is quite different from the reasons expressly set out in the deficiency notice and the petitioners argue strenuously that the Commissioner must assume the burden of proof on this point. If he has that burden then his pleadings are inadequate since he alleges no facts. He definitely has the burden of proving any facts not properly a part of the petitioners' burden before the amendment.

The Commissioner argues that no sale took place and his determination was based upon the absence of a sale and so is his new contention. His amendment is based upon sections 702, 736, and 1222. Section 702 provides how income of a partnership is to be reported by a partner but the money here in question was never income of the partnership and there is no allegation in the pleadings that it was income of the partnership. Section 1222 defines long-term capital gain as the gain from the sale or exchange of a capital asset held for more than 6 months. Charles' interest in the partnership was a valuable capital asset which he had held for more than 6 months. It was not a partnership asset.

Section 736(a)(1), upon which the Commissioner relies in his brief, provides that ‘Payments made in liquidation of the interest of a retiring partner * * * shall, except as provided in subsection (b), be considered— (1) as a distributive share to the recipient of partnership income if the amount thereof is determined with regard to the income of the partnership* * * .’ The Commissioner concedes on page 22 of his brief that this section applies only ‘to payments made by the partnership and not to transactions between the partners. That would seem to end the matter since here the agreement was between the partners, the amounts to be paid Charles were not to be paid by the partnership but were to come only from future earnings of Miller, and were to be paid by him. The partnership earned nothing after March 31, 1958, and ceased to exist.

Furthermore, the amounts to be paid Charles by Miller pursuant to their agreement of March 25, 1958, were not determined by them with regard to the income of the partnership. Charles talked with Lenk about those amounts but Lenk was not a contracting party and had no authority to represent either contracting party. Charles never negotiated with Miller with respect to these payments. Miller, on the witness stand, was asked, ‘did you have any connection at all with the negotiations leading up to this provision?’ and he answered, ‘No, none whatever.’ He wanted to rid himself of an undesirable partner; he did not want the customers of the business to know of the change; Lenk urged him to agree to make the payments; he wanted the Garcia business all for himself; and to accomplish the desired result he bought out Charles' interest in the partnership business. Section 741 applies rather than section 736(a)(1) since it is reasonable to conclude from a fair preponderance of the evidence that the transaction was a sale resulting in a long-term capital gain as reported by Charles.

Decision will be entered under Rule 50.

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