Opinion
Docket Nos. 6346-66 2418-67.
1970-01-19
DONALD L. AND JOAN EVANS, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Thomas G. Ragatz, for the petitioners. Lawrence G. Becker, for the respondent.
Thomas G. Ragatz, for the petitioners. Lawrence G. Becker, for the respondent.
Petitioner assigned to his wholly owned corporation his one-half interest in a partnership (and not merely the right to future income) in which capital was a material income-producing factor. Held, that despite the fact that petitioner did not advise his partner of the assignment, and despite the fact that for State purposes the petitioner remained a partner after the assignment, the petitioner was no longer a partner for Federal income tax purposes (secs. 708 and 704(e), I.R.C. 1954), and that therefore he was no longer subject to tax upon the income attributable to the interest assigned or upon the gain realized upon a subsequent sale of the partnership interest to the other partner.
ATKINS, Judge:
The respondent determined deficiencies in income tax for the taxable years 1961, 1962, 1963, 1964, and 1965 of $19,053.29, $24,889.78, $17,224.10, $16,664.45, and $24,083.80, respectively. The parties having reached agreement as to certain issues, the issues remaining for determination are (1) whether a purported assignment by petitioner of all his interest in a partnership to a corporation of which he was the sole stockholder was effective to relieve him of tax upon the distributive share of partnership income attributable to such interest and (2) whether gain derived on a subsequent sale of such partnership interest is taxable to petitioner.
FINDINGS OF FACT
Some of the facts were stipulated and are incorporated herein by this reference. The petitioner are husband and wife and were such during all the years in question. At the times of filing the petitions herein they were residents of Windsor, Wis. Petitioners filed their joint Federal income tax returns for the taxable years 1961, 1962, 1963, 1964, and 1965 with the district director of internal revenue at Milwaukee, Wis. Hereinafter Donald L. Evans will be referred to as the petitioner.
In 1949 the petitioner entered into an informal oral partnership agreement with his brother-in-law, Raymond Zeier, to operate a business known as Evans-Zeier Plastic Company. The business consisted of the manufacture of plastic products by a process of injection molding. The machinery involved in this process was quite elaborate. The labor involved consisted of putting material into the machinery and then removing the finished product. Prior to 1961 the most employees the partnership ever had were four, in addition to petitioner and his partner, Zeier.
At Jan. 1, 1961, the partnership's balance sheet showed total assets of $103,014.68, consisting of cash of $26,832.25, notes and accounts receivable of $9,042.58, inventories of $700, land in the amount of $12,000, and buildings and other fixed depreciable assets of a book value of $54,439.85. Included in the last item was machinery having an original cost of $58,390.70 and a depreciated cost of $34,397.27. The balance sheet showed no liabilities except partners' capital accounts equaling the amount of the assets.
Petitioner and Zeier each owned a one-half interest in the partnership and each was entitled to one-half of the profits. There was never any discussion or agreement between the partners concerning the admission of new members to the partnership and not until 1965 was there any discussion or agreement as to the conveyance, transfer, or assignment of either partner's interest in the partnership.
Decisions on how to conduct the business were reached as a result of discussions between petitioner and Zeier. Such decisions had to do with what products to manufacture and to whom to sell them, what prices to charge, and where to buy their raw materials.
The petitioner never did develop a close or friendly relationship with Zeier. Petitioner felt that he himself was outside the family circle and he and Zeier had very little conversation aside from their work. Petitioner sometimes felt that there were problems of communication between them and this was a drawback in their relationship. The relationship between them, while never good, deteriorated greatly over the years immediately preceding 1960. A major conflict arose because petitioner wanted to expand the business while Zeier did not. Since he did not think that there would be any expansion of the partnership business in the foreseeable future, petitioner wanted to make arrangements to accumulate capital so he could start his own business. Because of the strained nature of the relationship with Zeier, petitioner did not want him to know of his plans.
In 1960 petitioner decided to seek professional advice about his business problems from his accountant and from his attorney. Both the account and the attorney told petitioner that to accomplish his purpose it would be advisable to form a corporation and transfer his interest in the partnership to the corporation. Petitioner decided to use this means of starting his own business.
On December 30, 1960, petitioner caused to be incorporated, and became the sole shareholder of Don Evans, Inc., a Wisconsin corporation, which has continued to be a valid corporation in good standing. In order to qualify for doing business under the State law, there had to be $500 capital and therefore petitioner contributed $500 and had issued to himself two shares of stock.
On January 2, 1961, petitioner executed to the corporation an ‘Assignment of Partnership Interest,‘ which provided:
That the said first party for and in consideration of the sum of Fifty-one Thousand Five Hundred Eighteen and 46/100 Dollars ($51,518.46), receipt of which is hereby acknowledged, does hereby give, sell, assign, transfer and convey to Don Evans, Inc., all interest that he owns in the co-partnership of the Evans-Zeier Plastic Company in the stock of goods, wares. merchandise, equipment, furniture and fixtures thereunto appertaining and all of the books and other debts or accounts now due and owing to the Evans-Zeier Plastic Company with offices located at Highway 51 in the Town of Burke, Dane County, Wisconsin. The business interest hereby conveyed consists of an undivided one-half interest in the Evans-Zeier Plastic Company partnership and a one-half interest in all of the profits and losses of the Evans-Zeier Plastic Company to which the undersigned, Donald L. Evans, would be entitled in the continued operation of said partnership business.
The amount of $51,518.46 set forth in the assignment represented the amount at which petitioner's interest was then carried on the partnership books. The petitioner did not receive cash from the corporation but, rather, received 206 shares of its no-par-value stock, documentary stamps in the amount of $51.50 being affixed. The partnership interest was entered on the corporation's books as an asset at the amount of $51,518.46. After this transaction, the corporation issued no more stock, and petitioner continued to be its sole stockholder. In executing the assignment it was the intention of petitioner to transfer his entire partnership interest to the corporation in exchange for stock and thereby meet the nonrecognition of gain or loss provisions of section 351 of the Internal Revenue Code.
The partnership's books were kept on an accrual method of accounting and on the basis of the calendar year. At the time of the above assignment the partnership's books reflected all income accrued to that time and such income was reported for tax purposes by the partnership.
Petitioner executed the ‘Assignment of Partnership Interest’ without telling his partner Zeier or asking him about it. At that time, Zeier had no knowledge of the existence of the corporation or of such assignment. The first time that Zeier heard of the corporation and any purported transfer of an interest to it was in 1962 in connection with the filing of the 1961 partnership returns. The petitioner's wife prepared the returns of the partnership and the accountant advised her that, in preparing the partnership returns for 1961, she should list the corporation as a partner because of the above assignment. When this was done, Zeier questioned petitioner about it and petitioner told him that there had been no change. Zeier, before filing the returns, erased the word ‘Incorporated’ so that both the Federal and the State returns were filed listing the petitioner as a partner. About 2 or 3 months later he told the petitioners of the erasures. Zeier heard nothing further about the corporation insofar as the plastics business was concerned until he and petitioner were engaged in the dissolution of the partnership in 1965.
On all subsequent partnership returns petitioner was listed as Zeier's partner in the Evans-Zeier Plastic Co. The accountant told petitioner's wife that it would be all right to do this to avoid worsening the relationship with Zeier since the corporation would report the income attributable to the interest assigned to it. All of the partnership returns, except the final return for 1965, were prepared by petitioner's wife, who gave them to petitioner for examination. Petitioner then gave them to Zeier who, after examining them, signed them for the partnership.
The accountant had also initially advised petitioners that checks of the partnership representing distributions attributable to the one-half interest should be made payable to the corporation, but that if this would create additional tension with Zeier, the petitioner should be shown as payee but that the checks should be deposited directly in the corporation's bank account. The latter procedure was adopted. The checks were signed at times by petitioner's wife and at times by Zeier. The petitioner's name remained on the bank's signature card, enabling him to sign partnership checks. On one occasion, in 1965, the petitioner signed a partnership check representing a withdrawal of partnership funds for himself. Petitioner's wife, on the advice of the accountant, continued to carry the investment and drawing accounts on the books of the partnership in the names of the petitioner and Zeier.
The petitioner did not inform persons dealing with the partnership, including the credit-rating agency to which the partnership supplied information and the insurance company which wrote the partnership's liability coverage, of the assignment or represent to them that he was no longer a partner.
The petitioner was president of the corporation. His wife was its secretary-treasurer and did all the accounting and book work. The petitioner continued to perform about one-half of the work carried on by the partnership as he had done before the assignment.
After the incorporation of Don Evans, Inc., petitioner sought to implement his plans to enable him to start his own plastic business. In order for the corporation to accumulate capital, it purchased two apartment buildings. These were subsequently sold when the corporation purchased some machinery. Petitioner investigated thermal set molding, a process different from that used by the partnership. He did this work in his home with equipment owned by the corporation. In 1962 the corporation sold some of the products resulting from this experimental work. In 1963 and 1964 it began regularly to sell plastic products.
In March 1965, the Security State Bank of Madison, Wis., made loans totaling about $49,000 to the corporation. In connection with the requests for the loans, the corporation submitted a balance sheet, indicating a net worth of about $108,000. Listed among the assets was the one-half interest in the partnership, valued at $37,855.24. In making the loans, the bank relied upon the balance sheet and would not have loaned the corporation $49,000 if the assets shown had not included the partnership interest.
The corporation paid amounts to the petitioner and his wife as salaries. The amounts so paid to the petitioner were: 1961, $18,000; 1962, $19,250; 1963, $15,000; 1964, $12,000; and 1965, $15,000. The corporation withheld taxes on these amounts, filed the required employment tax returns reflecting the withholding of taxes, and complied with the depository receipts requirements.
By 1965, relations with Zeier had become so strained that petitioner decided that it was time to sever his business association with him. Negotiations were handled by their respective attorneys. On December 16, 1965, an agreement was executed between Zeier and petitioner which provides in part as follows:
WHEREAS, the parties have carried on the business known as Evans-Zeier Plastic Company, as partners, pursuant to an oral partnership agreement, (and Evans advises his partnership interest has been assigned by Evans to Don Evans, Inc., a Wisconsin corporation), and whereas it has been orally agreed between the parties that the Evans-Zeier Plastic Company partnership shall stand dissolved as of the end of business on June 15, 1965 on the terms hereinafter set forth and that thereafter the business shall belong to and be carried on by Zeier, the continuing partner, solely, and that the share of Evans in the real estate occupied by the partnership and owned by the parties as co-partners, doing business as Evans-Zeier Plastic Company, and in the machinery, (except two (2) machine tools listed on Exhibit A which Evans is to receive), equipment, tools, molds, inventories of materials and of molded products, accounts receivable, office furniture, books, records and generally all assets of the partnership shall be assigned and made over to Zeier who will take upon himself all of the debts and liabilities of the partnership which were outstanding on the date of dissolution and that Zeier will pay to Evans for Evans one-half interest in all of such items. It is agreed that the parties hereby declare that the partnership shall be considered as terminated and hence stand dissolved as of the end of business on June 15, 1965 and Evans agrees that he will convey his one-half interest in the real estate to Zeier by warranty deed, free and clear of all encumbrances upon being paid the amount for said real estate set forth in Exhibit A, and that he will by bill of sale, transfer and convey to Zeier, all of his interest in the partnership's machinery (except said two (2) machine tools) and equipment, tools, molds, inventories and all other tangible personal property of the partnership upon being paid the amounts therefor as set out in Exhibit A. Evans hereby assigns to Zeier all of his interest in the partnership's accounts receivables as of the termination date above set forth and agrees that he will, on demand, execute and deliver one or more Powers of Attorney that may be deemed necessary or desirable by Zeier to collect said receivables for the sole benefit of Zeier and at his sole risk.
The above agreement was signed by Zeier, the petitioner, and the petitioner's wife and by the corporation by the petitioner as president and his wife as secretary. The agreement explains the joinder of petitioner's wife and the corporation as follows:
Joan Evans, wife of Donald Evans, joins in this agreement and hereby agrees that she will, if required, execute the deed to the real estate along with her husband.
Don Evans, Inc., a Wisconsin corporation, joins in the execution of this agreement and agrees to effect all transfers of interest acquired by said corporation by reason of assignment of assets of the partnership by Donald Evans to Don Evans, Inc.
The corporation was made a party to the agreement because Zeier's attorney wanted to avoid any question of ownership of the partnership interest and because petitioner's attorney felt that it was a necessary party in view of the assignment to the corporation executed by petitioner on January 2, 1961.
The proceeds of the sale were deposited directly in the corporation's bank account. After the sale the two machine tools which Zeier did not receive were entered on the corporation's books and thereafter the corporation claimed depreciation deductions with respect thereto.
At no time did Zeier ever consent to have any individual or corporation, other than the petitioner, as his partner in the partnership. At no time did he ever recognize, or represent to anyone, that any person other than the petitioner was his partner in the partnership
In its Federal income tax returns for the taxable years 1961 through 1965 the corporation reported and paid tax on the distributive share of partnership income attributable to the one-half interest in the partnership, namely, the respective amounts of $39,277.21, $47,076.46, $37,197.79, $40,285.32, and $39,103.53. In their joint income tax returns for such years the petitioner and his wife did not report any income from the partnership. Rather, they reported as income the amounts paid to them by the corporation as salaries.
In its Federal income tax return for the taxable year 1965 the corporation reported a long-term capital gain of $26,041.23 on the sale of the partnership interest to Zeier and paid the tax thereon. In their return for 1965 the petitioners did not report any gain on such sale.
In preliminary statements dated December 4, 1964, and November 16, 1965, the respondent proposed adjustments based upon the view that petitioner remained taxable as a partner. Thereafter, in the notices of deficiency the respondent determined that the above amounts reported by the corporation as income derived from the partnership constituted income to the petitioner and increased his reported income by those amounts. The respondent also increased the petitioners' reported income for the taxable year 1965 by the amount of $16,728.80 as ‘Gain on Sale of Partnership’ with the following explanation:
It is determined that you realized a gain on the sale of the partnership known as Evans-Zeier Plastic Company, in the amount of $26,041.23, taxable to extent of $16,728.80. Accordingly your taxable income is increased in the amount of $16,728.80, computed as follows:
+-----------------------------------------------------+ ¦Gross sales price ¦$75,000.00¦ +------------------------------------------+----------¦ ¦Less: Basis in partnership ¦48,958.77 ¦ +------------------------------------------+----------¦ ¦ ¦ ¦ +------------------------------------------+----------¦ ¦Gain on sale ¦26,041.23 ¦ +------------------------------------------+----------¦ ¦Less: Ordinary gain on section 1245 assets¦7,416.37 ¦ +------------------------------------------+----------¦ ¦ ¦ ¦ +------------------------------------------+----------¦ ¦Long-term capital gain ¦18,624.86 ¦ +------------------------------------------+----------¦ ¦Less: Long-term capital gain deduction ¦9,312.43 ¦ +------------------------------------------+----------¦ ¦ ¦ ¦ +------------------------------------------+----------¦ ¦Net long-term capital gain ¦9,312.43 ¦ +------------------------------------------+----------¦ ¦Add: Ordinary gain on section 1245 assets ¦7,416.37 ¦ +------------------------------------------+----------¦ ¦ ¦ ¦ +------------------------------------------+----------¦ ¦Net taxable gain ¦16,728.80 ¦ +-----------------------------------------------------+
OPINION
The respondent does not question the separate identities of the petitioner and the corporation, nor does he contend that the execution of the ‘Assignment of Partnership Interest’ by petitioner on January 2, 1961, was a sham. However, he contends that since the petitioner did not obtain the consent of his partner, Zeier, to the assignment, such assignment did not effect a transfer to the corporation of petitioner's entire partnership interest, but effected no more than an assignment of the right to future income to which petitioner thus retained his partnership interest; and that he is taxable upon his distributive share of the partnership income under section 702(a) of the Internal Revenue Code of 1954.
He relies principally upon Burnet v. Leininger, 285 U.S. 136.
The Internal Revenue Code of 1954 contains the following provisions:SEC. 701. PARTNERS, NOT PARTNERSHIP, SUBJECT TO TAX.A partnership as such shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.SEC. 702. INCOME AND CREDITS OF PARTNER(a) GENERAL RULE.— In determining his income tax, each partner shall take into account separately his distributive share of the partnership's— (items of income, gains, losses, etc.)SEC. 704. PARTNER'S DISTRIBUTIVE SHARE.(a) EFFECT OF PARTNERSHIP AGREEMENT.— A partner's distributive share of income, gain, loss, deduction, or credit shall, except as otherwise provided in this section, be determined by the partnership agreement.(e) FAMILY PARTNERSHIPS.—(1) RECOGNITION OF INTEREST CREATED BY PURCHASE OF GIFT.— A person shall be recognized as a partner for purposes of this subtitle if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift from any other person.(2) DISTRIBUTIVE SHARE OF DONEE INCLUDIBLE IN GROSS INCOME.— In the case of any partnership interest created by gift, the distributive share of the donee under the partnership agreement shall be includible in his gross income, except to the extent that such share is determined without allowance of reasonable compensation for services rendered to the partnership by the donor, and except to the extent that the portion of such shareattributable to donated capital is proportionately greater than the share of the donor attributable to the donor's capital. * * *SEC. 708. CONTINUATION OF PARTNERSHIP.(a) GENERAL RULE.— For purposes of this subchapter, an existing partnership shall be considered as continuing if it is not terminated.(b) TERMINATION.—(1) GENERAL RULE.— For purposes of subsection (a), a partnership shall be considered as terminated only if— (A) no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership, or (B) within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.SEC. 761. TERMS DEFINED.(a) PARTNERSHIP.— For purposes of this subtitle, the term ‘partnership’ includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate. * * *(b) PARTNER.— For purposes of this subtitle, the term ‘partner’ means a member of a partnership.(c) PARTNERSHIP AGREEMENT.— For purposes of this subchapter, a partnership agreement includes any modifications of the partnership agreement made prior to, or at, the time prescribed by law for the filing of the partnership return for the taxable year (not including extensions) which are agreed to by all the partners, or which are adopted in such other manner as may be provided by the partnership agreement.
The petitioner, on the other hand, contends that under Wisconsin law the assignment of January 2, 1961, was effective to transfer his capital interest in the partnership to the corporation. He therefore contends that the corporation, as owner of such capital interest, is taxable on the income from such interest, regardless of whether the corporation technically became a partner under State law. He argues that for Federal income tax purposes the transfer terminated the old partnership between him and Zeier by virtue of the provisions of section 708(b)(1)(B) of the Code and the regulations thereunder; that thereafter, for Federal income tax purposes, he was no longer taxable as a partner; that the corporation became a coowner with Zeier of the company; that as coowners the corporation and Zeier continued to carry on a business, petitioner acting as agent for the corporation; that under section 761(a) of the Code the relationship between Zeier and the corporation, for Federal income tax purposes, must be considered as that of a partnership; and further that section 704(e)(1) of the Code provides that a person shall be recognized as a partner if he owns a capital interest in a partnership in which capital is a material income-producing factor.
Both parties refer to the Uniform Partnership Act as enacted by the State of Wisconsin,
the respondent contending that thereunder the assignment in question transferred to the corporation only a share of the future profits of the partnership and, as stated, the petitioner contending that thereunder the assignment effected a transfer of his capital interest in the partnership.
Wis. Stat. Ann., provides in part:178.21 Property rights of partner(1) The property rights of a partner are his rights in specific partnership property, his interest in the partnership, and his right to participate in the management.(2) A partner is co-owner with his partners of specific partnership property holding as a tenant in partnership.(3) The incidents of this tenancy are such that:(a) A partner, subject to the provisions of this chapter and to any agreement between the partners, has an equal right with his partners to possess specific partnership property for partnership purposes; but he has no right to possess such property for any other purpose without the consent of his partners.(b) A partner's right in specific partnership property is not assignable except in connection with the assignment of the rights of all the partners in the same property.(c) A partner's right in specific partnership property is not subject to attachment or execution, except on a claim against the partnership. When partnership property is attached for a partnership debt the partners, or any of them, or the representatives of a deceased partner, cannot claim any right under the homestead or exemption laws.(d) On the death of a partner his right in specific partnership property vests in the surviving partner or partners, except where the deceased was the last surviving partner, when his right in such property vests in his legal representative. Such surviving partner or partners, or the legal representative of the last surviving partner, had no right to possess the partnership property for any but a partnership purpose.(e) A partner's right in specific partnership property is not subject to dower, curtesy, or allowances to widows, heirs, or next of kin.178.22 Partner's interest in partnershipA partner's interest in the partnership is his share of the profits and surplus, and the same is personal property.178.23 Assignment of partner's interest(1) A conveyance by a partner of his interest in the partnership does not of itself dissolve the partnership, nor, as against the other partners in the absence of agreement, entitled the assignee, during the continuance of the partnership, to interfere in the management or administration of the partnership business or affairs, or to require any information or account of partnership transactions, or to inspect the partnership books; but it merely entitled the assignee to receive in accordance with his contract the profits to which the assigning partner would otherwise be entitled.(2) In the case of a dissolution of the partnership, the assignee is entitled to receive his assignor's interest and may require an account from the date only of the last account agreed to by all the partners.178.33 Application of partnership property on dissolution(1) When dissolution is caused in any way, except in contravention of the partnership agreement, each partner, as against his co-partners and all persons claiming through them in respect of their interests in the partnerships, unless otherwise agreed, may have the partnership property applied to discharge its liabilities, and the surplus applied to pay in cash the net amount owing to the respective partners. * * *
We think it clear that the assignment in question was intended to, and did, transfer all the petitioner's interest in the partnership to the corporation, and not merely the right to future income. Under Wisconsin law a partner's interest in the partnership is his share of the profits and surplus. This interest is personal property and is assignable. An assignment of a partnership interest entitles the assignee to receive the profits to which the assigning partner would otherwise be entitled and, in the case of a dissolution of the partnership, entitles the assignee to receive the assignor's interest. And it appears that there is no requirement that consent to the assignment be obtained from the other partners.
The Internal Revenue Code of 1954 recognizes that an interest in a partnership may be sold or exchanged and, with exceptions not here material, considers the gain or loss as being from the sale or exchange of a capital asset. Sec. 741, I.R.C. 1954.
In enacting section 741 Congress gave recognition to existing decisions which held that the sale of a partnership interest was generally considered to be a sale of a capital asset. H. Rept. No. 1337, 83d Cong., 2d Sess., p. 70, and S. Rept. No. 1622, 83d Cong., 2d Sess., p. 96. These cases also clearly established that a partner's interest in the partnership is his share of the profits and surplus, and that he individually has no interest in the partnership assets except as they might figure in his share of the profits and surplus. See, e.g., H. R. Smith, 10 T.C. 398, affd. (C.A. 5) 173 F.2d 470, certiorari denied 338 U.S. 818; Allan S. Lehman, 7 T.C. 1088, affd. 165 F.2d 383, certiorari denied 334 U.S. 819, and cases cited therein.
Sec. 741 provides in part as follows: ‘in the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset, * * * ’It should be noted that there is here no issue in regard to whether or not the nonrecognition of gain or loss provisions of sec. 351 of the Code are applicable to the transfer. Nor is there any issue in regard to income earned prior to the time of the assignment.
We therefore think it reasonable to conclude that Congress, in enacting the 1954 Code, used the term ‘partnership interest’ in that sense, namely, that a partnership interest is a partner's interest in profits and surplus. Accordingly, within the meaning of the Code, the petitioner did transfer to the corporation his partnership interest. He transferred all the interest he owned.
In affirming the Lehman case the Court of Appeals for the Second Circuit stated in part: ‘ * * * in equity and in bankruptcy the chancellors long ago imposed modifications upon the rights and liabilities of partners, as the common-law conceived them; and, while the firm never became a jural person, capable of being sued and of suing as such, in the administration of its affairs it did become for most purposes an entity; and it was upon this traditional structure that Congress fitted the taxation of partnerships, although it levied the income tax upon the separate distributive shares of the partners, whether they were distributed or not.‘The modifications imposed upon the common law were of two kinds: not only were the individual partners not allowed to withdraw firm assets from the firm while the firm business continued; but it was a corollary that individual creditors, unlike firm creditors, were not allowed to levy upon and sell in execution their debtor's— the individual partner's— interest in firm assets. * * * The practical effect of these interpolations into the common law was to impound firm assets and deprive the individual partners of any control over them except in so far as they were dealing with them on behalf of the firm as a unit. The individual partner's beneficial interests as a legal joint owner were trimmed down so that he had nothing left save that the firm assets should be devoted to the firm business, that he should share in any profits they produced and in the surplus upon winding up, whether voluntary or by legal process. We have discussed all this in several tax decisions, and need add nothing to what we said in them. The Uniform Partnership Law codified this congeries of rights and obligations as it had developed; and made no substantial change, when it declared in so many words that ‘a partner's interest in the partnership is his share of the profits and surplus.‘‘ /3/ (Citing in a footnote the New York Partnership Law.)
While it is true that the transfer of petitioner's partnership interest did not serve to terminate the partnership under State law, it is clear that, since the assignment did effect a transfer of 50 percent of the total interest in the partnership capital and profits, the assignment did effect a termination of the partnership for Federal tax purposes, pursuant to the provisions of section 708 of the Code and the regulations thereunder.
The regulations under section 708 further indicate that upon such a termination the transferee of the partnership interest is to be treated as a partner in a new partnership.
Sec. 1.708-1(b)(1)(ii), Income Tax Regs., provides in part as follows:(ii) A partnership shall terminate when 50 percent or more of the total interest in partnership capital and profits is sold or exchanged within a period of 12 consecutive months. * * *
It follows that the petitioner was, after the assignment, no longer to be regarded as a partner for Federal income tax purposes, even though for State purposes he remained a partner.
Sec. 1.708-1(b)(1)(iv), Income Tax Regs., provides as follows:(iv) If a partnership is terminated by a sale or exchange of an interest the following is deemed to occur: The partnership distributes its properties to the purchaser and the other remaining partners in proportion to their respective interests in the partnership properties; and, immediately thereafter, the purchaser and the other remaining partners contribute the properties to a new partnership, either for the continuation of the business or for its dissolution and winding up. * * *
This view finds support in the provisions of section 704(e) of the Code. Although directed primarily toward ‘family partnerships,‘ that section is broad in its scope and covers a situation such as the instant case which does not involve a ‘family partnership’ (there being involved no members of a family as defined in section 704(e)(3) of the Code). That section provides that a person shall be recognized as a partner if he owns a capital interest in a partnership in which capital is a material income-producing factor. In enacting the predecessor of section 704(e), Congress made it clear that, although ‘family partnership’ situations offer great potential for abuse, recognition must be given the general principle of income taxation that income produced by capital is taxed to the owner of such capital.
S. Rept. No. 781, 82d Cong., 1st Sess., pp. 38-40, states:‘Section 339 of your committee's bill is intended to harmonize the rules governing interests in the so-called family partnership with those generally applicable to other forms of property or business. Two principles governing attribution of income have long been accepted as basic: (1) income from property is attributable to the owner of the property; (2) income from personal services is attributable to the person rendering the services. There is no reason for applying different principles to partnership income. If an individual makes a bona fide gift of real estate, or of a share of corporate stock, the rent or dividend income is taxable to the donee. Your committee's amendment makes it clear that, however the owner of a partnership interest may have acquired such interest, the income is taxable to the owner, if he is the real owner. * * *‘The amendment leaves the Commissioner and the courts free to inquire in any case whether the donee or purchaser actually owns the interest in the partnership which the transferor purports to have given or sold him. Cases will arise where the gift or sale is a mere sham. Other cases will arise where the transferor retains so many of the incidents of ownership that he will continue to be recognized as a substantial owner of the interest which he purports to have given away, as was held by the Supreme Court in an analagous trust situation involved in the case of Helvering v. Clifford (309 U.S. 351). * * *‘Not every restriction upon the complete and unfettered control by the donee of the property donated will be indicative of sham in the transaction. Contractual restrictions may be of the character incident to the normal relationships among partners. Substantial powers may be retained by the transferor as a managing partner or in any other fiduciary capacity which, when considered in the light of all the circumstances, will not indicate any lack of true ownership in the transferee. In weighing the effect of a retention of any power upon the bona fides of a purported gift or sale, a power exercisable for the benefit of others must be distinguished from a power vested in the transferor for his own benefit.’
The regulations under section 704(e) /9/ define ‘capital interest in a partnership’ as an interest in the assets of the partnership which is distributable to the owner of the capital interest upon his withdrawal from the partnership or upon liquidation of the partnership, but states that the mere right to participate in the earnings and profits is not a capital interest in the partnership. As stated above, the assignment in question, under section 178.23 of the Wisconsin statutes, entitled the corporation to not only the earnings and profits, but also, upon dissolution, to the petitioner's share of surplus, that is, his share of the partnership assets after payment of partnership liabilities. There can be no doubt that capital was a material income-producing factor in the business.
Therefore, section 704(e) requires the recognition of the corporation, rather than the petitioner, as a partner for Federal income tax purposes.
9. Sec. 1.704-1(e)(1)(v), Income Tax Regs., provides as follows:(v) Capital interest in a partnership. For purposes of section 704(e), a capital interest in a partnership means an interest in the assets of the partnership, which is distributable to the owner of the capital interest upon his withdrawal from the partnership or upon liquidation of the partnership. The mere right to participate in the earnings and profits of a partnership is not a capital interest in the partnership.Sec. 1.704-1(e)(1)(iv), Income Tax Regs., provides in part that capital is ordinarily a material income-producing factor if the operation of the business requires substantial inventories or a substantial investment in plant, machinery, or other equipment. See also Fred J. Sperapani, 42 T.C. 308.
In view of the above provisions of the Internal Revenue Code of 1954, we are of the opinion that Burnet v. Leininger, supra, which arose under prior tax statutes, is not governing in the instant case. Furthermore, it appears that in the Leininger case there was not an assignment by the taxpayer of a capital interest in the partnership in which he was a member, as was true here. In Leininger it was found only that a written agreement confirmatory of a preexisting oral agreement was entered into between taxpayer and his wife wherein it was acknowledged that taxpayer's wife had been and was a full equal partner with him in his interest in the partnership, entitled to share equally in the profits and obligated to bear equally any losses. The court stated that upon the facts found the agreement amounted to no more than an equitable assignment of one-half of what the taxpayer should receive from the partnership.
The fact that the petitioner continued to be the nominal partner is not sufficient to subject him to tax on the income from the distributive share held in his name since, as stated above, he had assigned to the corporation his full beneficial interest. See United States v. Atkins, (C.A. 5) 191 F.2d 146, rehearing denied 191 F.2d 951, certiorari denied 343 U.S. 941, in which it was held that, where the taxpayer assigned capital interest in partnerships of which he was a member to a partnership consisting of himself and his son, the taxpayer was not liable for tax upon the income attributable to the interest which he transferred, even though the assignee did not become a member of the original partnerships. In that case the court stated in part:
This is not a case of the taxpayer assigning fees, wages, salaries, or other income, to be earned by him in the future from work to be performed by him in the future. Atco's income resulted from capital invested in operating partnerships, and from the services performed by managing partners. The taxpayer did not assign income from those operating partnerships: he assigned his share, his entire interest in those partnerships to a separate partnership (Atco Investment Company), the members of which firm were engaged in a joint venture. * * *
Appellee was required to make such individual return as to each partnership of which he was a member whether or not distribution was made to him, but not if he retained no beneficial interest in the operating partnerships and was a partner in name only. * * * Though not a member of the operating partnerships, the Atco Investment Company was equitably entitled to receive the entire net income from the appellee's share in said operating partnerships, because Atco was the beneficial owner thereof, since appellee had not simply assigned income but had assigned his entire equitable interest therein. After this assignment was made, appellee retained only a naked legal title to said share. * * * An equitable interest in a partnership is a vendible asset, the income from which is computable in the same manner and on the same basis as any other property, the legal title to which is in a naked trustee. The partnership return may state the nominal partners only, but the individual return of any such member may disclose additional facts, and if the income from a share in the partnership is ultimately received by the equitable owner thereof, and all income taxes paid thereon by the real beneficiary thereof, the nominal partner is not also liable. * * *
See also Rupple v. Kuhl, (C.A. 7) 177 F.2d 823, Harry Klein, 18 T.C. 804, and Wilson v. United States, (N.D. Cal.) 246 F.Supp. 613.
In view of the foregoing, we hold that the respondent erred in holding that the petitioner was taxable upon one-half of the partnership earnings for each of the taxable years 1961 through 1965, and in holding that the petitioner is taxable upon the gain realized upon the sale of the partnership interest in 1965.
Decisions will be entered under Rule 50.