Schulz
v.
Comm'r of Internal Revenue

Tax Court of the United States.May 19, 1960
34 T.C. 235 (U.S.T.C. 1960)
34 T.C. 235T.C.

Docket Nos. 67160-67162 67310.

1960-05-19

RAY H. SCHULZ AND DORIS L. SCHULZ, ET AL.,1 PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Arthur B. Willis, Esq., and John E. Scheifly, Esq., for the petitioners in Docket Nos. 67160, 67161, 67162. Hugh J. Ritchie, Esq., and John C. McCall, Esq., for the petitioners in Docket No. 67310.


Arthur B. Willis, Esq., and John E. Scheifly, Esq., for the petitioners in Docket Nos. 67160, 67161, 67162. Hugh J. Ritchie, Esq., and John C. McCall, Esq., for the petitioners in Docket No. 67310.

Jack E. Roberts, Esq., for the respondent.

Held: Monthly payments to a retiring partner, specifically allocated in the formal agreement of partnership dissolution as consideration for his separately stated covenant not to compete, in fact reflected partnership goodwill and were a ‘nonseverable’ portion of the consideration paid him for his capital interest in the partnership as a going business. Accordingly, the payments in question were capital gain to the retiring partner and unamortizable, nondeductible capital expenditures to the continuing partners. Held, further, that the continuing partners correctly reported in their individual 1953 returns their distributive shares of partnership income for the full 12-month period ending January 31, 1953, including the disputed income for the month of February 1952.

In these consolidated proceedings, petitioners contest the following deficiencies and allege the following overpayments in income taxes for the years indicated:

+----------------------------------+ ¦Docket¦Year¦Deficiency¦Overpayment¦ +------+----+----------+-----------¦ ¦No. ¦ ¦ ¦ ¦ +------+----+----------+-----------¦ ¦67160 ¦1953¦$6,914.60 ¦$8,889.50 ¦ +------+----+----------+-----------¦ ¦67161 ¦1953¦6,914.62 ¦8,917.62 ¦ +------+----+----------+-----------¦ ¦67162 ¦1953¦6,700.46 ¦9,099.34 ¦ +------+----+----------+-----------¦ ¦67310 ¦1952¦7,852.32 ¦ ¦ +----------------------------------+

The questions remaining for decisions are as follows:

1. (a) Whether a partnership, in which the male petitioners in Docket Nos. 67160, 67161, and 67162 were members, was entitled to deduct on its return for the fiscal year ending January 31, 1953, certain amounts paid to Stanley C. Landen (petitioner in Docket No. 67310), allegedly for his covenant not to compete.

(b) Conversely, whether Landen was entitled to treat that portion of such amounts received in 1952 as capital gain upon the sale of his interest in the partnership.

2. Whether petitioners in Docket Nos. 67160, 67161, and 67162 properly reported their distributive shares of partnership income for February 1952 on their individual returns for the calendar year 1953, or whether, as now alleged by petitioners, they should have reported this income on their returns for the calendar year 1952.

FINDINGS OF FACT.

Certain facts have been stipulated and are incorporated herein by reference.

Ray H. and Doris L. Schulz are husband and wife residing in Pasadena, California. John W. and Lucille Schulz are husband and wife residing in San Gabriel, California. Melvin F. and Pauline Klagues are husband and wife residing in Arcadia, California. The aforementioned husbands and wives, respectively, filed joint income tax returns for the calendar year 1953 with the district director of internal revenue, Los Angeles, California.

Stanley C. and Virginia M. Landen, husband and wife residing in San Marino, California, filed a joint income tax return for the calendar year 1952 with the district director of internal revenue, Los Angeles, California.

On or about November 1, 1946, Stanley C. Landen (hereinafter referred to as Landen), Ray H. Schulz (hereinafter referred to as Ray), John W.Schulz (hereinafter referred to as John), and Melvin F. Klagues (hereinafter referred to as Klagues) organized a partnership by oral agreement under the firm name of Schulz Tool and Manufacturing Company (hereinafter referred to as Old Tool). Each partner made an original investment in the approximate amount of $3,000 and each had an equal interest in the partnership. Subsequently, all additional capital employed in the business was obtained by the retention of earnings.

Old Tool operated continuously with the four original partners until March 31, 1950, when it was dissolved. On or about April 1, 1950, the business theretofore operated as Old Tool was transferred to Schulz Tool and Manufacturing Co., Inc. (hereinafter referred to as Corporation), which had been organized on November 29, 1949. The capital stock of Corporation was held equally by Landen, Ray, John, and Klagues.

Corporation, under the continuous ownership of Landen, Ray, John, and Klagues, operated the business until May 31, 1951, when its assets and liabilities were distributed in liquidation to the stockholders. On or about June 1, 1951, Landen, Ray, John, and Klagues organized a partnership under the firm name of Schulz Tool and Manufacturing Company (hereinafter referred to as Tool), and transferred to it the assets and liabilities which they had received in liquidation of Corporation.

In 1952, Landen's interest in Tool was sold to Ray, John, and Klagues, and Tool was dissolved. Thereafter, Ray, John, and Klagues continued the operation of the business as equal partners under the same firm name of Schulz Tool and Manufacturing Company (hereinafter referred to as Manufacturing). The business carried on continuously by Old Tool, Corporation, Tool, and Manufacturing is hereinafter referred to collectively as Schulz Tool.

The initial business of Schulz Tool had two branches: The manufacture and sale of aircraft system fuel valves, and the performance of ‘job machine work.’ The fuel valves were ‘proprietary items' of Schulz Tool, being designed and developed by it to meet the requirements of aircraft manufacturers. ‘Job machine work,‘ in contrast, consisted of custom machining parts on orders from manufacturers who provided the necessary blueprints and designs. As the valve manufacturing aspect of the business developed and became increasingly profitable, it required a greater percentage of the machine time and resources available to Schulz Tool. This resulted in decreasing emphasis on job machine work. By January 31, 1952, Schulz Tool had either wound up or terminated existing machine work orders, and had ceased soliciting further orders.

After the close of World War II, and prior to the formation of Old Tool, Ray had purchased from Public Service Brass Corporation, his then employer, the manufacturing and engineering specifications for a fuel level control valve and a fuel vent float valve which he had developed while an employee and which were of potential use in the aircraft industry. However, there were no production orders for these valves in late 1946. They were being used experimentally by Lockheed Aircraft Corporation on its F-80 jet fighter and its Constellation, but the rubber diaphragms used in their operation were subject to deterioration, and to bursting at high flow refueling speeds.

At the time Old Tool was formed, Ray had some of these valves in process in his garage where he was manufacturing them under the name Schulz Tool and Manufacturing Company; the partnership retained this name. The experimental use of these valves by Lockheed gave Schulz Tool an ‘in’ to that company. The partners devoted their combined efforts to developing an improved valve without the defects of the original rubber diaphragm type. In the early months, each partner worked an average of approximately 90 hours per week; thereafter, and as of January 31, 1952, each partner worked an average of approximately 60 hours per week.

After 2 years of developmental work, the partners succeeded in producing a piston type valve which, through extensive engineering tests and promotional efforts, was shown to be superior in quality and performance to valves produced by competitors, as well as being cheaper in price. The piston type valve received ‘most favorable acceptance’ from substantially all major aircraft manufacturers and by the Government for use by the Air Force and Navy.

Schulz Tool's customers included Convair, Lockheed Aircraft Corporation, Republic Aviation Corporation, Canadair, North American Aviation, Northrop Aircraft, Inc., Rohr Aircraft Corporation, and Boeing Aircraft Company. A letter received from Republic Aircraft Corporation in 1949 stated that the continued production and delivery of its F-84G airplane was contingent on the uninterrupted supply of Schulz Tool's valves, and that Schulz Tool was Republic's sole source of supply for these valves. Schulz Tool also held prime military contracts with the Air Force and Navy. As of January 31, 1952, Schulz Tool valves were being used on all types of jets and reciprocating engine aircraft for military use.

Sales and product acceptance were achieved by direct contact with the Air Force, Navy, and major aircraft companies, which entailed extensive travel and numerous conferences with prospective purchasers. All of the sales activities, including customer relations and customer engineering liaison, were handled by Ray. Klagues also handled ‘some’ contract work, but his responsibilities included plant administration and supervision of industrial relations and personnel. Landen and John were primarily concerned with internal operations. Both were machinists and toolmakers by trade, Landen being considerably more experienced. Landen had no duties in the sales, design, or engineering phase of the business, although he did have some sales contacts with respect to the job machine work which he supervised before it was discontinued.

Demand for Schulz Tool's valves for military use outstripped its own ability to supply, to the extent that the partners were obliged to subcontract a substantial portion of machine work on its proprietary items. Schulz Tool also experienced a considerable repeat order business, as was customary with aircraft suppliers. From 1948 through 1954, the same basic valves, with modifications, were manufactured by Schulz Tool for Lockheed's F-80 and Constellation. Orders for valves to be installed on aircraft were normally accompanied by orders for spare parts in the amount of ‘probably four times' the orders for installation.

Pursuant to specification requirements imposed by the Government, through the airframe manufacturers, each valve manufactured and sold by Schulz Tool was marked with an identification number and labeled with the name of Schulz Tool. The name was also stamped on valves produced for commercial aircraft as identification for possible replacements and for ‘good advertising.’ These markings were accomplished by affixing a metal name plate by screws or pins to the side of one of the main castings of the valve.

Schulz Tool developed numerous manufacturing techniques and machining operations of its own, resulting in cost reductions, improved products, and an overall conservation of labor and material. In instances where specialized machines were unavailable on the open market, Schulz Tool redesigned and reworked other machines to enable them to perform operations necessary to experimental work and production.

Whereas competitors usually sent their newly developed products to outside laboratories for testing, Schulz Tool built its own modern completely equipped laboratory. It was estimated that testing costs, when sent to outside laboratories, averaged approximately $4,000 to $5,000 per unit. With its own laboratory, Schulz Tool was able to perform the same tests at an approximate 25 per cent reduction in costs.

A ‘Quality Control Department,‘ staffed by experts of many years' experience, was maintained and rigid high quality control methods were employed at all stages of production, both in-plant as well as at subcontractors' plants. These control methods enabled Schulz Tool to stop production on units where defects developed in the early stages of production, thus keeping scrap costs to a minimum.

These efficiencies were reflected in the fact that during the fiscal year ended January 31, 1952, 95 per cent of Schulz Tool's deliveries were made on time, pursuant to the production schedules of customers. Similarly, Schulz Tool kept its product rejection rate by customers to less than 2 1/2 per cent of sales, whereas the generally accepted rejection rate for aircraft parts ranged from 5 to 7 per cent. The average earnings of Schulz Tool per employee per month (including partners) increased as follows during the periods noted:

+------------------------------------------+ ¦ ¦ ¦Average ¦ +-------------------+---------+------------¦ ¦ ¦Average ¦amount ¦ +-------------------+---------+------------¦ ¦Period ¦number of¦earned per ¦ +-------------------+---------+------------¦ ¦ ¦employees¦employee per¦ +-------------------+---------+------------¦ ¦ ¦ ¦month ¦ +-------------------+---------+------------¦ ¦11/1/46 to 12/31/46¦4 ¦$1,248.37 ¦ +-------------------+---------+------------¦ ¦1/1/47 to 12/31/47 ¦5 ¦1,647.33 ¦ +-------------------+---------+------------¦ ¦1/1/48 to 12/31/48 ¦7 ¦1,721.59 ¦ +-------------------+---------+------------¦ ¦1/1/49 to 12/31/49 ¦10 ¦1,652.19 ¦ +-------------------+---------+------------¦ ¦1/1/50 to 3/31/50 ¦13 ¦1,883.38 ¦ +-------------------+---------+------------¦ ¦4/1/50 to 6/30/50 ¦19 ¦1,823.03 ¦ +-------------------+---------+------------¦ ¦7/1/50 to 5/31/51 ¦25 ¦1,790.46 ¦ +-------------------+---------+------------¦ ¦6/1/51 to 1/31/52 ¦29 ¦4,168.40 ¦ +-------------------+---------+------------¦ ¦2/1/52 to 1/31/53 ¦63 ¦5,160.84 ¦ +------------------------------------------+

Based on industry standards, an average return of $1,000 per employee per month was considered satisfactory.

Average monthly sales, and average monthly net profits before partners' salaries, similarly increased, as shown by the following table:

+------------------------------------------+ ¦ ¦Average ¦Average ¦ +-------------------+----------+-----------¦ ¦Period ¦monthly ¦monthly ¦ +-------------------+----------+-----------¦ ¦ ¦sales ¦net profits¦ +-------------------+----------+-----------¦ ¦11/1/46 to 12/31/46¦$4,993.47 ¦$2,915.47 ¦ +-------------------+----------+-----------¦ ¦1/1/47 to 12/31/47 ¦8,236.63 ¦4,070.51 ¦ +-------------------+----------+-----------¦ ¦1/1/48 to 12/31/48 ¦12,048.81 ¦4,815.64 ¦ +-------------------+----------+-----------¦ ¦1/1/49 to 12/31/49 ¦16,521.90 ¦6,208.32 ¦ +-------------------+----------+-----------¦ ¦1/1/50 to 3/31/50 ¦24,484.02 ¦9,653.53 ¦ +-------------------+----------+-----------¦ ¦4/1/50 to 6/30/50 ¦34,637.48 ¦13,175.33 ¦ +-------------------+----------+-----------¦ ¦7/1/50 to 5/31/51 ¦44,761.45 ¦10,060.55 ¦ +-------------------+----------+-----------¦ ¦6/1/51 to 1/31/52 ¦120,883.69¦28,484.87 ¦ +-------------------+----------+-----------¦ ¦2/1/52 to 1/31/53 ¦325,132.85¦122,039.75 ¦ +------------------------------------------+

Schulz Tool's average per cent of profit to sales during the period November 1, 1946, to January 31, 1953, was 34.3, a ‘relatively high level.’

There were many risks inherent in proprietary items manufactured by Schulz Tool. If the design proved faulty, the expense of rerunning and redesigning the item was borne by Schulz Tool. For example, in 1950 or 1951, a fuel filter manufactured for Lockheed failed to meet specifications and the castings had to be reworked at substantial additional cost. In 1954, a latent defect was discovered in valves produced for Lockheed's P2V7, and ‘secondary charges' in excess of $20,000 were incurred by Schulz Tool in removing the valves from the airplane, reworking their castings, and reinstalling them.

The typical purchase order received by Schulz Tool included a provision for termination of the contract by the purchaser, and the business did experience some cancellation of Government contracts. In addition, delivery schedules material, workmanship and performance of designs were guaranteed, although many of the items represented ‘first time’ designs and developments. At one point, a decrease in the production requirements of airframe manufacturers resulted in Schulz Tool's servicing a greater percentage of units than they were producing.

In order to meet rapidly changing specifications and design requirements, Schulz Tool was under constant pressure to modify its proprietary items or develop new ones. Such modifications might be required even during the production of a single type of aircraft. For example, the company repeatedly modified its valve for Lockheed's F-80, to the extent that the valve produced today is ‘not even similar to the valve as it started out.’ Without such changes, the company would not have enjoyed continued orders for this valve. During its fiscal year ending January 31, 1953, Manufacturing produced and sold 57 units developed prior to that year; during the same year it developed 73 ‘new’ units, many of which represented modifications of previously existing designs.

Either while Landen was a partner ‘or shortly afterwards,‘ the partners attempted to procure product liability insurance, but found the cost of premiums to be ‘prohibitive’; it was therefore forced to assume the role of self-insurer. This experience reflects both the risks of Schulz Tool's products, and the fact that insurance companies had insufficient experience in such products on which to base a rate.

Schulz Tool's valves were not protected by patents. Other aircraft suppliers made valves which, while not identical to those produced by Schulz Tool, served the same purpose and were competitive therewith.

In their income tax returns for the calendar year 1951, each of the partners reported capital gain upon the liquidation of Corporation during that year. In computing such capital gain, the partners did not include any amount for the goodwill of Corporation.

On January 31, 1952, Schulz Tool had a backlog of orders on hand in the amount of $3,498,254, all of which were for valves and components thereof.

Landen disagreed with Ray, John, and Klagues as to Schulz Tool's emphasis on proprietary items. He was concerned about the risk factors, the amount of capital investment required, and the research and engineering problems involved in the development and manufacture of such items.

In the latter part of January 1952, the four partners held an all-day meeting to discuss the aforementioned disagreements as to company policy. During the meeting Landen suggested that it might be better if he sold his interest in the partnership, and the other partners concurred. It was orally agreed to purchase Landen's interest as of January 31, 1952, but no discussion was had of the price to be paid Landen for his interest, nor was any formula set by which the price would be determined. It was agreed that the partnership's fiscal year would be closed on January 31, 1952, that a physical inventory would be taken as of that date, and that negotiations as to the terms of sale would be postponed until these events occurred.

On or about January 30, 1952, Ray, John, and Klagues spent 3 3/4 hours conferring with Arthur B. Willis, an attorney, with respect to drawing up an agreement for the purchase of Landen's interest. Willis' law practice was primarily in the tax field. On January 31, 1952, Willis spent 4 1/4 hours drafting a dissolution agreement and discussing it with Landen on the telephone.

Landen rendered no services to the partnership, nor did he participate in its management, after January 31, 1952. His visits to the plant during February were only for the purpose of getting information (e.g., with respect to inventory) to be used in the negotiations for the sale of his interest. Inasmuch as Landen had no other income during February, the other partners agreed to pay him an equal ‘salary’ for that month, but Landen did not otherwise participate in partnership profits after January 31,1952. The business of Schulz Tool continued as a partnership after January 31, 1952, composed of three equal partners, namely, Ray, John, and Klagues.

In early February 1952, but prior to a final accounting for the partnership's fiscal year ended on January 31, 1952, Landen compiled figures for partnership assets and liabilities on a worksheet in order to arrive at an offering price for the sale of his interest. The worksheet figures for cash, receivables, deposits, prepaid insurance, and deferred charges were taken from the books of account. Landen obtained his figures for physical assets by reference to an appraisal made by Union Appraisal Company in 1951 in connection with the liquidation of Corporation and brought up to date by him to reflect assets subsequently acquired and his awareness of values. Inventory valuation was based on a physical inventory as of January 31, 1952, which was available early in February, and from figures which Landen had received from J. A. Kendall & Company, the firm of certified public accountants employed by the partnership. Landen also entered the amount of $18,000 as representing his estimated interest in ‘Customer Accts. & Good Will.’ In estimating goodwill, Landen was not aware that Schulz Tool's order backlog on January 31, 1952, was $3,498,254; the only purchase orders he saw were ‘just shy of $1,000,000.’

Prior to mid-February 1952, Landen submitted an offer to the other partners to sell his interest for $111,000. According to the worksheet, the $111,000 offering price included Landen's estimate of $18,000 for goodwill. The remaining $93,000 represented approximately the amounts ascribed by Landen to his interest in partnership assets other than goodwill, less his share of partnership liabilities. However, Landen did not furnish the other partners with a breakdown of his worksheet figures, nor did he inform them at this time of his $18,000 allocation to goodwill. In mid-February 1952 Landen consulted an attorney, Arthur Sullivan. Sullivan was a general practitioner; he was neither a ‘tax attorney’ nor engaged in tax matters.

On February 29, 1952, a meeting was held in Sullivan's office in Los Angeles to determine a mutually acceptable price for the sale and purchase of Landen's interest. Landen and Sullivan were present at this meeting, as were Ray, John, Klagues, and their attorney, Willis.

The basis of discussion was Landen's offer to sell for $111,000. Although Landen did not show his worksheet to the other partners, he did, at Willis' request, furnish them with the figures he had arrived at for various partnership assets, including the $18,000 for goodwill. This was the first time that the figure for goodwill was specifically mentioned to the other partners. The partners also had with them a copy of the 1951 appraisal report by the Union Appraisal Company.

The partners had a specific discussion as to the correct evaluation of inventory and depreciable assets, and as to the liability of the partners for renegotiation of profits on Government contracts. Agreement was reached with respect to each of these items.

When these items had been disposed of, Ray, John, and Klagues made a counter offer to purchase Landen's interest for an overall price of $105,000, later increasing their officer to $107,000. Sullivan, with Landen's approval, then suggested a compromise price of $109,000. Willis indicated that the $109,000 figure might be acceptable, but that he desired first to confer privately with his clients. In private conference, Willis advised Ray, John, and Klagues that payments for a covenant not to compete enjoyed the income tax advantage of being deductible whereas payments for goodwill did not. Considering the reduced net cost resulting from anticipated deductibility of payments for a covenant not to compete, Ray, John, and Klagues determined to accept the compromise price of $109,000, provided that $18,000 thereof would be designated as separate consideration for Landen's covenant not to compete, and that no amount would be designated as consideration for goodwill.

Accordingly, after their return to the meeting, Ray, John, and Klagues offered to pay Landen $18,000 for refraining for 1 year, from (a) hiring Schulz Tool's employees; (b) soliciting the active customer accounts of Schulz Tool; and (c) opening a machine shop within a radius of 5 miles from the then location of Schultz Tool's plant. Upon Landen's objection, the 5-mile limitation was reduced to 1 mile. Willis stated that he would draft the written agreement of sale, and that the $18,000 would be separately stated therein as consideration for the covenant. Sullivan informed Willis that he could see no reason for such separate statement since the parties were concerned ‘with only one lump sum,‘ but Willis replied that that was his customary procedure and that was the way he wanted to do it. He did not tell either Landen or Sullivan that the payments allocated to the covenant might be taxable as ordinary income. Landen thought the covenant unobjectionable, as modified, and accepted it.

Prior to the aforementioned offer, no suggestion had ever been made to Landen that the other partners were interested in his covenant not to compete. They knew that Landen intended to engage in job machine work rather than the manufacture of proprietary items. In conversation with Sullivan, Klagues stated that Schulz Tool would be willing to subcontract a portion of its job machine work to Landen. Equipment necessary to carry on an operation similar to that of Schulz Tool could not have been obtained by Landen in 1952, or within a year of his leaving Schulz Tool, because of a priority system in effect during the Korean conflict, and Landen was not qualified from an engineering standpoint, nor did he have the sales representation or contacts, to begin such a business.

The agreement reached on February 29, 1952, was subsequently reduced to writing by Willis. After certain changes in the draft, requested by Sullivan, including a specification of the dissolution date as January 31, 1952, the partners signed the agreement in final form.

Article I, dealing with dissolution of the partnership, provided that:

The partnership heretofore existing between the parties is dissolved as of January 31, 1952. Due notice of such dissolution shall be given forthwith by publication in a newspaper of general circulation.

Article II, dealing with the sale of Landen's interest, provided as follows:

A. The retiring partner, in consideration of the payment of the sum specified and in consideration of the covenants of the continuing partners, all as contained in this Article II, hereby sells, assigns, transfers and conveys unto the continuing partners, all of his part, share and interest in and to all and singular, the leasehold and premises and the machinery and equipment, leasehold improvements, stock in trade and other effects, and debts, credits, contracts, effects, profits and assets of every description of the partnership.

B. The price at which the interest of the retiring partner is sold to the continuing partners is Ninety-One Thousand Dollars ($91,000), payable as follows:

The remainder of article II provided for payment of the $91,000 in installments: $36,000 within 7 days after execution of the agreement; $36,000 within 45 days after execution of the agreement; and.$19,000 in the form of a promissory note, secured by a chattel mortgage and payable in 12 monthly installments beginning April 1, 1952, each of the first 4 installments to be in the amount of $1,584 and the succeeding 8 installments to be in the amount of $1,583. Interest on the unpaid balance of the note accrued at 4 per cent beginning March 1, 1952.

Manufacturing subsequently issued two checks to Landen, each in the amount of $36,000 and each bearing the legend, ‘Part payment of Stanley C. Landen's interest in partnership assets as per agreement of February 29, 1952.’ The remaining.$19,000 was paid by 12 checks, 11 of which bore the legend, ‘Monthly payment on note of.$19,000 as provided in Article II of agreement of February 29, 1952,‘ and the last of which bore the legend, ‘Final monthly payment on note of.$19,000 as provided in agreement of February 29, 1952.’ The chattel mortgage delivered as security for the remaining.$19,000 was released upon payment of the note in full.

The covenant not to compete was set forth in article IV, as follows:

A. The retiring partner agrees that for a period of twelve (12) months following the execution of this Agreement he will not compete with the continuing partners. For the purpose of this Article IV, only the following acts, or any of them, shall be considered as violating the agreement not to compete:

1. The employment by the retiring partner, or the soliciting for employment by him, either for himself or for another, of any of the employees of the continuing partners or of the business entity in which they do business.

2. The soliciting of customer accounts of the partnership which are active at date of this Agreement.

3. The opening by the retiring partner, either as a sole proprietor or in conjunction with others, of a machine shop within a radius of one (1) mile of the present location of the partnership plant.

B. In consideration of the faithful observance of the covenant not to complete, the continuing partners agree to pay to the retiring partner the amount of Fifteen Hundred Dollars ($1500) for each month that the retiring partner refrains from competitive acts * * * until a total of Eighteen Thousand Dollars ($18,000) has been paid.

It was further provided that should Landen engage in competitive acts within the 12-month period and refuse to desist upon written demand of the continuing partners, the liability of the continuing partners to make further payments would cease and they would be entitled to recover all amounts theretofore paid under article IV. In the event the continuing partners failed to make any one payment under article IV, that portion of the $18,000 remaining to be paid would become immediately due and payable at Landen's election, and upon written notice thereof to the continuing partners.

In payment of the $18,000, Manufacturing subsequently issued 12 checks to Landen, beginning March 31, 1952, each in the amount of $1,500. Eleven of these checks bore the legend ‘Payment under Article IV of agreement of February 29, 1952, for refraining from competition,‘ and the last bore the legend, ‘Final payment under Article IV of agreement of February 29, 1952, for refraining from competition.’ Of these payments, a total of $16,500 was made by Manufacturing during its fiscal year ended January 31, 1953, and a total of $15,000 was received by Landen during his taxable year ended December 31, 1952.

The following ‘Notice of Dissolution of Co-Partnership and Certificate of Business under Fictitious Name’ was published in the Los Angeles Daily Journal on April 10, 1952, and filed in the office of the county clerk of the County of Los Angeles:

NOTICE IS HEREBY GIVEN that the partnership heretofore existing between Ray H. Schulz, John W. Schulz, Melvin F. Klagues and Stanley C. Landen, doing business under the fictitious firm name and style of SCHULZ TOOL AND MANUFACTURING COMPANY, at 401 East Mission Drive, San Gabriel, has been dissolved by mutual consent of the partners as of January 31, 1952.

A new partnership composed of Ray H. Schulz, John W. Schulz and Melvin F. Klagues and doing business under the fictitious firm name and style of SCHULZ TOOL AND MANUFACTURING COMPANY will continue the operations formerly conducted by the dissolved partnership.

Subsequent to January 31, 1952, Stanley C. Landen has no connection with Schulz Tool and Manufacturing Company and will not be responsible for any debts or liabilities incurred under that firm name.

The undersigned do hereby certify that they are conducting a machine shop business commencing February 1, 1952, at 401 East Mission Drive, San Gabriel, California, under the fictitious firm name of SCHULZ TOOL AND MANUFACTURING COMPANY * * *

/Signed/ Ray H. Schulz John W. Schulz Melvin F. Klagues

Schulz Tool's income for the month of February 1952 was $33,086. Manufacturing reported this income in its return for its fiscal year ended January 31, 1953, and Ray, John, and Klagues each included in his taxable income for the calendar year 1953 one-third of the income reported by Manufacturing for its fiscal year ended January 31, 1953.

Landen opened his own machine shop ‘shortly after the middle of 1952’ for the purpose of engaging in job machine work. He obtained some machinery in March 1952, but he was unable to acquire any basic equipment for jobwork until the latter part of 1952. Landen did not enter the valve-manufacturing field, although it was more profitable than job machine work.

In the deficiency notices, respondent adopted inconsistent positions with respect to the payments allocated to Landen's covenant not to compete. In the notices sent to Ray, John, and Klagues, he disallowed the deductions claimed for these payments, whereas, in the notice sent to Landen, he treated these payments as ordinary income rather than capital gain.

OPINION.

RAUM, Judge:

1. Covenant not to compete.— The question presented requires determination of the nature of the payments ostensibly made for Landen's covenant not to compete. Ray, John, and Klagues contend that the $18,000 was in fact paid as consideration for Landen's covenant, having been separately negotiated for, separately stated in the dissolution agreement, and having an importance to the continuing partners over and above their acquisition of Landen's interest in the partnership. Landen, on the other hand, argues that his covenant was valueless to the continuing partners. He takes the position that he sold his interest in a going business which had experienced extraordinary growth and success, and that the $18,000 stated as consideration for his covenant in fact represented a ‘nonseverable’ portion of the consideration paid for his interest. We agree with Landen.

The record does not support the contention of the continuing partners that Landen's covenant was important, meaningful, and valuable to them for business reasons other than the prospect of tax deductibility. Ray, John, and Klagues knew that Landen had no intention of competing with them in the manufacture of proprietary items to which the business of Schulz Tool had become devoted. It was precisely because of Landen's disagreement as to the emphasis placed on this aspect of partnership business that he decided to sell out. His intention, disclosed to the other partners, was to open a machine shop to engage in job machine work, the same type of business that Schulz Tool had recently discontinued.

Ray, John, and Klagues admit that Landen did not have the necessary engineering background or sales contacts to begin a business competitive with Schulz Tool; to the contrary, his training as a machinist and toolmaker and his temperament were oriented toward job machine work rather than the design and development of proprietary items. Still more persuasive in this regard is the concession of the continuing partners on brief that the ‘equipment necessary to carry on an operation similar to that of Schulz Tool could not have been obtained by Landen in 1952 or within a year of his leaving the partnership, because of the priority system caused by the Korean conflict.’ Thus, the threat of competition from Landen during the year following dissolution was virtually nonexistent. In Aaron Michaels, 12 T.C.17, 20, we refused to allocate any portion of the purchase price to the covenant not to compete, having noted that ‘the purchase of good will and right to service existing customers attained more than ordinary value,‘ whereas ‘the ability of a new laundry to enter the field was apparently limited to newcomers arriving in the community— a factor tending to diminish not only the dollars and cents value of a covenant not to compete, but also its significance as an independent element of the sale of the business as a whole.’ Cf. Richard Ullman, 29 T.C. 129, 141, affirmed 264 F. 2d 305 (C.A. 2), where both the subsequent history and terms of the covenant demonstrated that competition from the covenantors was ‘a real menace.’ Furthermore, if the continuing partners really considered it important to protect Schulz Tool against competitive acts by Landen, it seems improbable that they would have agreed to pay $18,000 for a covenant limited to the period (12 months after February 29, 1952) when such competitive acts were least likely to occur. In view of these circumstances, it is difficult to discern what practical importance or value the covenant could have had to the continuing partners, other than the reduced net cost to them, after taxes, of purchasing Landen's interest. Cf. Commissioner v. Gazette Tel. Co., 209 F.2d 926, 928 (C.A. 10), affirming 19 T.C. 692, where the Court of Appeals relied in part on the fact that ‘the covenant created a new and valuable right in the hands of the purchasers for which they paid a separate consideration.’

The record, however, does support Landen's contention that Schulz Tool had built up considerable goodwill in its 5 years of operation prior to January 31, 1952, and that the $18,000 separately stated as consideration for his covenant in fact reflected such goodwill. See Copperhead Coal Company v. Commissioner, 272 F.2d 45 (C.A. 6), affirming a Memorandum Opinion of this Court. The expertise, know-how, and efficiency of Schulz Tool, which resulted in its ability to undersell competitors while at the same time realizing above-average earnings per employee, are fully supported by the evidence. It is equally clear that Schulz Tool's products were most favorably received by the aircraft industry, and that its ‘active’ customer accounts included substantially all major aircraft manufacturers, the Air Force, and the Navy. Cf. D. K. MacDonald, 3 T.C. 720, 726. Moreover, these customers were habitual in the sense that a basic design, once approved for use on a particular aircraft, would be reordered throughout the life of the aircraft, provided the supplier was able to make the necessary modifications. Although Schulz Tool had been in business for only 5 years and 3 months, it had proven its ability to develop basic designs and to keep pace with constantly changing design requirements. In Sidney V. LeVine, 24 T.C. 147, we held that substantial goodwill may be developed even during a relatively short period of operation, in that case 28 months; cf. Erwin D. Friedland, 26 T.C. 1005. All these factors contributed to the dynamic growth of the valve manufacturing business, evidenced by an average profit margin of 34.3 per cent, and greatly increased sales and earnings. The prospect of continued profits was confirmed by the impressive backlog of orders on hand as of January 31, 1952, whether that backlog be measured by the orders actually on hand or by the smaller amount known to Landen. While it is true, as the continuing partners allege, that the fluid nature of design requirements created substantial business risks, the presence of such risks merely discounts, rather than eliminates, the amount of goodwill which the partnership accumulated. In fact, the success and attendant goodwill of Schulz Tool were in large measure attributable to its ability to prosper in spite of these risks.

It was stated in Ullman v. Commissioner, 264 F.2d 305, 307, that ‘when the parties to a transaction such as this one have specifically set out the covenants in the contract and have there given them an assigned value, strong proof must be adduced by them in order to overcome that declaration.’ We think such proof has been adduced in the instant case to show that Landen's covenant was in fact of little or no value to the continuing partners, whereas Schulz Tool had considerable goodwill not otherwise accounted for in arriving at the value of Landen's interest.

It is agreed that what Landen sold and what the continuing partners acquired was Landen's interest in Schulz Tool as a going business, and not merely his interest in the physical assets of the partnership. Herbert A. Nieman, 33 T.C. 411. Ray, John, and Klagues allege, however, that Landen's covenant was intended to protect Schulz Tool's ‘existing pool of labor’ and its ‘active’ customer accounts, that the covenant was important to them for these reasons, and that it was therefore ‘severable’ from the overall interest transferred. As previously indicated, the importance attributed to the covenant by the continuing partners is not supported by the record. But even if we assume that the covenant was important for the reasons alleged, it is clear that a pool of skilled labor and active customer accounts are contributory elements to goodwill and to the value of a going concern. Sidney V. LeVine, supra; A. Rhett du Pont, 19 T.C. 377; D. K. MacDonald, supra. In this sense, the covenant was ‘nonseverable’ from the goodwill inherent in Schulz Tool as a going concern, and likewise nonseverable from the interest in Schulz Tool which Landen transferred. As stated in Harold J. Burke, 18 T.C. 77, 80:

This Court has held that where a covenant not to compete accompanies the transfer of good will in the sale of a going concern, and such covenant is essentially to assure the purchaser the beneficial enjoyment of the good will he has acquired, the covenant is nonseverable and may not be depreciated. Aaron Michaels, 12 T.C. 17 (1949).

This result has been reached in instances, such as the present case, where a separate value is assigned to the covenant in the agreement of sale. Toledo Blade Co., 11 T.C. 1079 (1948), affirmed per curiam 180 F.2d 357 (C.A. 6), certiorari denied 340 U.S. 811. And in Toledo Newspaper Co., 2 T.C. 794, involving the same transaction, we reached a similar conclusion with respect to the covenantor, even though the covenant was found to be customary in the purchase of a newspaper business and ‘necessary in order to prevent the seller from destroying the value of the good will of the business transferred.’

The companion cases of Hamlin's Trust v. Commissioner, 206 F.2d 761 (C.A. 10), affirming 19 T.C. 718, and Commissioner v. Gazette Tel. Co., supra, are distinguishable for the reasons stated in Richard Ullman, supra at 139. As noted by the Court of Appeals in Hamlin's Trust, supra at 765, the taxpayers ‘merely sold stock’; they ‘did not sell the property, assets, or good will of a going concern.’ In contrast, Landen sold a direct proprietary interest in a going business which had developed considerable goodwill, and this goodwill was a contributing and integral factor in the sale.

For these reasons, we hold that the $18,000 ostensibly paid for Landen's covenant was in fact paid as part of the consideration for Landen's partnership interest in Schulz Tool. Accordingly, the payments in question represented capital gain to Landen and unamortizable, nondeductible, capital expenditures to Ray, John, and Klagues.

2. Partnership income for February 1952.— Partnership income for February 1952, was reported by Manufacturing on its return for the fiscal year ending January 31, 1953. Ray, John, and Klagues reported their distributive shares of this income in their returns for the calendar year ending December 31, 1953, pursuant to the general rule embodied in section 188 I.R.C. 1939.

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 * * * ending within or with the taxable year of the partner.

Ray, John, and Klagues now contend, however, that Tool was not dissolved until February 29, 1952, and that partnership income for February 1952 should have been reported by Tool in a separate partnership return for the month ended February 29, 1952. Respondent, on the other hand, argues that Tool was dissolved on January 31, 1952, and that the business was thereafter carried on by Manufacturing. We think that this issue must be decided against petitioners.

In the first place, we are satisfied on the evidence that Landen was no longer a member of the partnership after January 31, 1952. To be sure, the terms relating to the purchase of his interest had not yet been worked out, and he would undoubtedly have been entitled to an accounting if agreement had subsequently not been reached. But the evidence satisfies us that, beginning February 1, 1952, Landen no longer participated in the management of the enterprise, was no longer entitled to share in the profits of the enterprise, and was not in fact a partner. That he was given a ‘salary’ for February 1952 reflects merely an act of decency by the remaining partners, knowing that he had no other source of income. In contrast to the ‘salaries' paid to Ray, John, and Klagues for February 1952, the evidence indicates that the ‘salary’ paid to Landen was not treated on the books of Schulz Tool as the drawings of a partner. And the subsequent ‘Notice of Dissolution of Co-Partnership and Certificate of Business under Fictitious Name,‘ published in April 1952, in respect of Schulz Tool, simply recognized as a fact that which already existed, namely, that Landen had no connection with the business after January 31, 1952, and that commencing February 1, 1952, the business was conducted by the three remaining partners. Accordingly, since the ‘successor’ partnership continued the business beginning February 1, 1952, with a fiscal year ending January 31, the income for the month of February 1952 was properly reported in the income of the partnership for its fiscal year ending January 31, 1953, and therefore the partners properly reported their distributive shares in their 1953 returns.

Moreover, the result reached above is required by approaching the problem from a different angle. The ‘dissolution’ of a partnership caused by the retirement of a partner does not terminate the partnership's existence, cf. Heiner v. Mellon, 304 U.S. 271, nor does it warrant the filing of a separate partnership return for the period between the end of the previous fiscal year and the date of ‘dissolution.’ Where, as in the present case, the continuing partners carry on the business of the partnership without interruption, and do not wind up or liquidate it, they have no authority for departing from the partnership's regular fiscal year basis. Mary D. Walsh, 7 T.C. 205; Rev. Rul. 144, 1953-2 C.B. 212; cf. Anne Jacobs, 7 T.C. 1481; Louis Karsch, 8 T.C. 1327, 1331.

We hold that Ray, John, and Klagues correctly reported in their 1953 returns their distributive shares of partnership income for the full 12-month period ending January 31, 1953, including the disputed income for the month of February 1952.

Decisions will be entered under Rule 50.