Opinion
Docket No. 50338.
1956-04-17
B. HOWARD SPICKER AND EMILY SPICKER, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Leon B. Newman, Esq., and Charles B. King, Esq., for the petitioners. Paul J. Henry, Esq., for the respondent.
Leon B. Newman, Esq., and Charles B. King, Esq., for the petitioners. Paul J. Henry, Esq., for the respondent.
1. Petitioner, upon withdrawing from an accounting partnership, received $25,000 for his interest in the cash capital account (then overdrawn), the profits, the uncollected accounts receivable, and the unbilled work of the partnership. Held, petitioner received in substance an amount representing earnings of the partnership which is taxable as ordinary income. Helvering v. Smith, 90 F.2d 590 (C.A. 2), followed.
2. Petitioner had overdrawn his capital account by $1,101.33, which he was permitted to retain upon severing his connection with the firm. Held, such excess, in the circumstances of this case, was a distribution of partnership earnings to him.
The respondent determined a deficiency in income tax for the year 1948 in the amount of $3,604.86.
The sole question is whether $26,101.33, received by B. Howard Spicker in 1948, in connection with termination of his association with a partnership, represents ordinary income or income from the sale of a capital asset.
FINDINGS OF FACT.
The stipulation of facts filed by the parties is incorporated herein by reference.
Petitioners, husband and wife, are residents of Weston, Massachusetts. They filed a joint Federal income tax return for the year 1948, on the cash basis, with the then collector of internal revenue for the district of Massachusetts. B. Howard Spicker will hereinafter be referred to as the petitioner.
Petitioner is a certified public accountant and has engaged in the practice of public accounting for approximately 20 years. In July 1944 petitioner and John P. Darmody (hereinafter referred to as Darmody) formed a partnership for the practice of public accounting under the name of John P. Darmody & Co. in Boston, Massachusetts. Petitioner contributed neither capital nor physical assets to the firm. The firm commenced business with furniture and fixtures which belonged to Darmody. Petitioner and Darmody had an oral agreement that Darmody's distributive share of the partnership income was to be 75 per cent and petitioner's 25 per cent.
On October 1, 1945, a new partnership was formed under the name of Darmody, Todd & Co. (hereinafter referred to as the firm or partnership). The partners were Darmody, petitioner, and E. Murray Todd (hereinafter referred to as Todd). The partnership had offices in New York and Boston. Darmody and petitioner were in the Boston office and Todd was in the New York office.
After the formulation of Darmody, Todd & Co., new books were opened and were kept on the cash basis. Each partner contributed capital to the partnership. The approximate amount contributed by each was Darmody $12,000, Todd $7,500 and petitioner $6,000. In the Boston office the partnership used the furniture and fixtures which were the personal property of Darmody, and acquired some new furniture and fixtures. Furniture and fixtures belonging to Darmody were not recorded on the partnership books.
Petitioner did the accounting for the partnership and prepared its tax returns and financial statements. The partnership operated on a fiscal year ending September 30.
In preliminary discussions at the time the new partnership was formed it was orally agreed that the distributive shares of the profits would be Darmody seven-fifteenths, Todd four fifteenths, and petitioner four-fifteenths. These ratios were changed at the end of the first year to Darmody 40 per cent, Todd 40 per cent, and petitioner 20 per cent.
During the fiscal years ending September 30, 1946, and September 30, 1947, the partnership operated under an oral agreement. Some time prior to November 13, 1947, some discord developed between the partners. Petitioner wanted to have his name included in the firm name and wanted a larger share of the profits. At this time the partners discussed the question of payments to be made to any partner who should die, retire, or leave the firm for some other reason, and concluded that they should have an agreement in writing spelling out their respective rights and obligations in the event of such contingency. An agreement was drafted by Todd, and on November 13, 1947, each of the partners signed it. It provided as follows:
It is mutually agreed between John P. Darmody, E. Murray Todd, and B. Howard Spicker that in the event of the death, retirement or other termination of the partnership of Darmody, Todd & Co. the deceased or retiring partner shall be entitled to his cash capital and profits computed on a cash basis to the date of death or retirement, and to his proportionate interest in the accounts receivable which shall be payable only when and as collected, and his proportionate interest in the unbilled work at the date of the termination which shall be payable only when and as billed and collected.
Subsequent to the execution of this agreement, petitioner continued to be unhappy about the division of profits and failure to have his name included in the partnership name, and friction between him and Darmody increased. Early on the morning of January 1, 1948, Darmody, who had been drinking, called the petitioner on the telephone and told him, among other things, that he was ‘all done’ and that he was not to come back to the office again.
On January 1 or 2, petitioner called Todd on the telephone and told him that Darmody had tried to terminate the partnership and that Todd should come to Boston. On or about January 3 Todd came to Boston from New York and met with Darmody and petitioner. Todd tried to effect a reconciliation between them, and returned to New York thinking he had accomplished his objective. About 2 weeks later he was advised that discord still existed and that petitioner wanted to leave the firm.
After January 1, 1948, petitioner continued to participate in the conduct of affairs of the partnership and to deal with its clients in all respects as he had done prior to that date.
On February 9, 1948, an attorney employed by petitioner sent the following letter to Darmody and Todd:
B. Howard Spicker has asked me to represent him in connection with the partnership affairs of the firm of John P. Darmody, E. Murray Todd and B. Howard Spicker, which Mr. Darmody dissolved on January 1, 1948 and which has not been successfully reconstituted in any form by new agreement. Mr. Spicker has concluded that the negotiations looking toward the possible formation of a new partnership, which have been in progress during the interim, must be understood to be at an end and that winding up the dissolved partnership must now proceed without further delay. In the meantime, subject to your approval, it would seem that the policy of avoiding any outward appearance of partnership interruption should be continued pending an early meeting.
I therefore suggest that you or your attorney arrange to confer with me as soon as possible so that we may arrive at an amicable arrangement for a winding up and accounting of the firm. * * *
Negotiations started immediately after February 9, 1948, and most of them took place in the office of petitioner's attorney. While they were going on petitioner had an opportunity to go over the firm's books. Early in the negotiations Darmody furnished petitioner with a list of accounts receivable and work in process of the Boston office as of February 7, 1948. At petitioner's or his counsel's request Todd furnished petitioner with a list of accounts receivable and work in process of the New York office as of February 7, 1948. The lists given petitioner were as of February 7, 1948, because that was the nearest date to a periodic closing and the date when the negotiations commenced. The figures contained in the lists were taken from the books of the partnership.
The accounts receivable and work in process of the New York and Boston offices were as follows on February 7, 1948:
+-----------------------------------------------------+ ¦ ¦Boston ¦New York ¦Combined ¦ +-------------------+----------+----------+-----------¦ ¦Accounts receivable¦$50,578.53¦$2,710.00 ¦$53,288.53 ¦ +-------------------+----------+----------+-----------¦ ¦Work in process ¦43,161.21 ¦24,361.04 ¦67,522.25 ¦ +-------------------+----------+----------+-----------¦ ¦ ¦$93,739.74¦$27,071.04¦$120,810.78¦ +-----------------------------------------------------+
Using the figures contained in the lists furnished him by Darmody and Todd, together with the firm's trial balance received from the bookkeeper, the petitioner, at the request of Darmody and Todd, made a computation on an accrual basis of accounting on some work sheets of his interest in the cash capital balance, accounts receivable, and work in process of the partnership at February 7, 1948. His computation showed the following:
+---------------------------------------------------------+ ¦Balance capital account Oct. 1, 1947¦ ¦$4,271.86 ¦ +------------------------------------+---------+----------¦ ¦Drawings to Feb. 7, 1948 ¦ ¦5,073.19 ¦ +------------------------------------+---------+----------¦ ¦ ¦ ¦________ ¦ +------------------------------------+---------+----------¦ ¦Balance before profits Feb. 7, 1948 ¦ ¦($801.33) ¦ +------------------------------------+---------+----------¦ ¦Cash basis profit ¦$4,548.04¦ ¦ +------------------------------------+---------+----------¦ ¦Accrual basis profit ¦24,162.18¦28,710.22 ¦ +------------------------------------+---------+----------¦ ¦ ¦ ¦$27,908.89¦ +---------------------------------------------------------+
Thereafter the work sheets prepared by the petitioner played an important part in the negotiations. A disagreement arose because of petitioner's insistence that the provisions of the agreement of November 13, 1947, relating to payment of his interest in accounts receivable and unbilled work only when and as collected, should not be followed and that he should receive a lump-sum payment. Darmody and Todd took the position that these provisions should be followed and that petitioner be paid as the accounts were collected because of the probability that full payment for certain of these accounts and for work in process would not be received. Darmody and Todd yielded to petitioner's demand for a lump-sum payment, and to deviate from the November 1, 1947, agreement to this extent, when petitioner threatened to file a bill in equity for a receivership of the firm. The amount demanded by petitioner was, however, reduced to reflect uncollectible accounts, and Darmody and Todd agreed to make a lump-sum payment of $25,000.
On March 5, 1948, Darmody and Todd, as parties of the first part, and petitioner, as party of the second part, entered into an agreement. It provided in part as follows:
WHEREAS, all of the parties have heretofore been all of the partners of a partnership doing business under the name and style of Darmody, Todd & Co., and
WHEREAS, the parties are desirous of a termination of said partnership, and
WHEREAS, the parties of the first part are desirous of making a final and complete settlement and lump sum payment to the party of the second part in lieu of a final accounting of the partnership:
NOW, THEREFORE, in consideration of the mutual promises herein contained, the parties agree as follows:
1. The parties of the first part shall pay to the party of the second part the sum of Twenty-five Thousand Dollars ($25,000.00) for all of the interest of the party of the second part in the cash capital account, profits, unbilled work and uncollected accounts receivable of the said partnership, together with any and all interest which the party of the second part may have in uncollected accounts receivable being carried under the names of John P. Darmody & Co. or John P. Darmody as an individual.
2. Upon the payment of said sum to the party of the second part, the said party of the second part shall deliver executed assignments of such other documents or papers as may be necessary to release, transfer or assign to the parties of the first part the interests set forth in Paragraph 1.
3. Upon performance of the undertakings of the parties of the first part herein contained, the party of the second part shall release, transfer and assign to the parties of the first part all interest which he may have in the name, physical assets and capital contribution, if any, of Darmody, Todd & Co., the said partnership, and to John P. Darmody all such interests arising out of a prior partnership composed of the said John P. Darmody and the party of the second part under the firm name and style of John P. Darmody & Co. The party of the second part shall deliver executed assignments or such other documents or papers as may be necessary to the performance of the undertakings contained in this paragraph. The agreement also provided that petitioner could at any place engage in the practice of public accounting, compete with Darmody and Todd in any fashion, and solicit business or engage to do business with persons, firms, or corporations with which Darmody and Todd or the partnership had previously or should thereafter to business, and that petitioner could announce, in any fashion that he might select, his severance from the partnership and the termination thereof.
On March 11, 1948, the petitioner executed and delivered to Darmody and Todd the releases and other documents required by paragraphs 2 and 3 of the agreement of March 5, 1948.
The document executed by petitioner on March 11, 1948, pursuant to paragraph 2, provided in part as follows:
KNOW ALL MEN BY THESE PRESENTS, that I, B. HOWARD SPICKER * * * in consideration of the payment to me of Twenty-five Thousand Dollars ($25,000.00) by JOHN P. DARMODY * * * and E. MURRAY TODD * * * , the receipt whereof being hereby acknowledge, do hereby grant, sell, set over and assign to the said JOHN P. DARMODY and E. MURRAY TODD all of my right, title and interest in and to the cash capital account, the profits, the uncollected accounts receivable and the unbilled work of the partnership consisting of JOHN P. DARMODY, E. MURRAY TODD and B. HOWARD SPICKER doing business under the name and style of DARMODY, TODD & CO., with offices located in New York City, New York and Boston, Massachusetts.
A document executed by petitioner on March 11, 1948, pursuant to paragraph 3, provided as follows:
KNOW ALL MEN BY THESE PRESENTS, that I, B. HOWARD SPICKER of Newton, Middlesex County, Massachusetts, in consideration of One Dollar ($1.00) and other good and valuable consideration paid to me by JOHN P. DARMODY * * * and E. MURRAY TODD * * * , the receipt whereof being hereby acknowledged, do hereby grant, sell, release, set over and assign to the said JOHN P. DARMODY and E. MURRAY TODD, all my right, title and interest in the name, physical assets and capital contribution of the partnership consisting of JOHN P. DARMODY, E. MURRAY TODD and B. HOWARD SPICKER, doing business under the name and style of DARMODY, TODD & CO., with offices located in New York City, New York and Boston, Massachusetts.
The $25,000 payment was made by three checks signed by Darmody, Todd & Co., drawn on the National Shawmut Bank, as follows:
+--------------------------+ ¦Date of check ¦Amount ¦ +----------------+---------¦ ¦Mar. 3, 1948 ¦$4,656.91¦ +----------------+---------¦ ¦Mar. 4, 1948 ¦343.09 ¦ +----------------+---------¦ ¦Mar. 11, 1948 ¦20,000.00¦ +--------------------------+
The partnership books during the fiscal year beginning October 1, 1947, showed as an asset, a furniture and fixtures account in the amount of $1,014.99, which amount represented the cost of the equipment listed in the account. On March 11, 1948, the partnership also owned some other physical assets, the cost of which had been charged to expense, including a small tax library, a year's supply of stationery, work papers and supplies. Petitioner, as a copartner, contributed to the cost of the physical assets and the cost of such goodwill as may have been acquired.
When petitioner left the firm two of its employees resigned and went to work for him, and he took with him more clients than he brought to the firm during the life of the partnerships.
On October 1, 1947, the balance in petitioner's capital account was $4,271.86. Between October 1, 1947, and March 11, 1948, petitioner's drawings of cash from the partnership amounted to $5,373.19.
The books of the partnership were not closed when petitioner left the firm, and the business was continued by Darmody and Todd until October 1, 1948. Collections of accounts receivable and work in process as of February 7, 1948, were treated as income by the firm when collected. A partnership Federal income tax return was filed for the fiscal year beginning October 1, 1947, and ending September 30, 1948, and in schedule I of that return the payment to petitioner of $25,000 plus the amount by which his cash capital balance was overdrawn when he left the firm ($1,101.33) was reported as his distributive share of partnership income.
In the joint return filed by petitioner and his wife for the year 1948 petitioner reported the receipt of $25,000 as a long-term capital gain realized upon the sale of his interest in the partnership. The respondent determined that this amount, plus the amount of $1,101.33 by which petitioner's cash capital balance was overdrawn, represented a distribution of partnership income to petitioner during the year 1948 and was taxable as ordinary income.
OPINION.
RAUM, Judge:
The petitioner contends that the transactions consummated on March 11, 1948, was in form and substance a sale of his partnership interest in the firm of Darmody, Todd & Co., that he realized a gain of $26,101.33 as a result of this sale, and that under the provisions of section 117 of the Internal Revenue Code of 1939, he is entitled to report this gain as a long-term capital gain. He argues that the partnership continued to do business as usual until March 11, 1948, and that he had an interest in each and every asset of the partnership and in its past and future profits; that he did not retire or withdraw from the partnership and was not bound by the terms of the agreement of November 13, 1947; and that he sold his interest in the firm.
We are unable to agree with the petitioner. The evidence convinces us that he did retire as a partner, and that the lump-sum consideration ($25,000) that he received was for all his interest as a retiring partner ‘in the cash capital account (already fully recovered), profits, unbilled work and uncollected accounts receivable.'
The amount was computed in such manner as not to include any consideration for an interest in the partnership as such, petitioner having already overdrawn his capital account. Indeed, petitioner executed certain documents on March 11, 1948, to consummate the transaction, one of which recited that the $25,000 consideration was paid for petitioner's interest ‘in and to the cash capital account, the profits, the uncollected accounts receivable and the unbilled work of the partnership * * * .’ There was no showing that the uncollected accounts receivable represented anything other than ordinary income flowing from personal services rendered by the partnership, and, since petitioner had already recovered his interest in the capital account, it is all too plain that the entire $25,000 represented ordinary income rather than capital gain to petitioner. This conclusion is reinforced by examining a second document executed by petitioner on March 11, 1948, in which he released all his right, title, and interest in the name, physical assets and capital contribution of the partnership for a recited consideration of are satisfied from the evidence that petitioner received no consideration in connection with the second document; that the only consideration actually received by him was in connection with the first document; and that such consideration represented items all of which constituted ordinary income. There was no convincing evidence that the firm in fact had goodwill of any consequence, apart from the goodwill of the individual partners, and we conclude that neither goodwill nor petitioner's comparatively minor interest in the physical assets of the partnership played any part in determining the amount of the payment made to him. The parties did not appear to have attached any particular significance to petitioner's interest in the partnership as such, and nothing was paid to him for such interest; the $25,000 was simply a lump-sum distribution of earnings.
The agreement of March 5, 1948, also mentions accounts receivable of the predecessor partnership or John P. Darmody as an individual. However, if there were any such accounts receivable, they do not appear to play any important part in this controversy.
As a retiring partner he was entitled under the agreement entered into between him and the other members of the partnership on November 13, 1947, to his cash capital and profits computed on the cash basis to date of retirement, and to his proportionate interest in the accounts receivable and unbilled work at the date of termination payable when and as collected. The negotiations between him, Darmody and Todd, and their attorneys, subsequent to February 9, 1948, were directed to determining his interest in the foregoing items, which petitioner, as a retiring partner, was entitled to receive. Using figures taken from the books of the partnership petitioner made a computation which disclosed that his capital account was overdrawn and that he was entitled to receive $27,908.29 for his interest in profits computed on the cash basis and in unbilled work and uncollected accounts receivable. At his insistence Darmody and Todd agreed to deviate from the provisions of the November 13, 1947, agreement to the extent of making a lump-sum payment, and he agreed to accept less than $27,908.29 because of the possibility that some of the accounts would prove to be uncollectible. The figure finally agreed upon was $25,000, but, as noted above, the agreement of March 5, 1948, states merely that this amount was to be paid for all of the interest of petitioner ‘in the cash capital account, profits, unbilled work and uncollected accounts receivable of the partnership.’
The transaction resulting in this payment did not differ in any material respect from that in Helvering v. Smith, 90 F.2d 590 (C.A. 2). In that case the partnership articles of a law firm on the cash basis provided that a retiring partner would be entitled only to his proportionate share of the earnings of the firm actually collected and his share of earnings collected after retirement for services performed prior thereto. One of the members of the firm retired and the remaining partners agreed to pay him, in lieu of his interest in such earnings, the sum of $125,000. The Court of Appeals, speaking through Judge Learned Hand, held that the lump-sum payment was taxable as ordinary income, and, among other things, said (at p. 592):
The transaction was not a sale because he got nothing which was not his, and gave up nothing which was. Except for the ‘Purchase’ and release, all his collections would have been income; the remaining partners would merely have turned over to him his existing interest in earnings already made. As he kept his books on a cash basis, it is true that he would have been taxed only as he received the accounts in driblets, but he would have been taxed upon them as income. The ‘purchase’ of that future income did not turn it into capital, any more than the discount of a note received in consideration of personal services. The commuted payment merely replaced the future income with cash. Indeed, this very situation was suggested in Bull v. United States, supra, 295 U.S. 247, at pages 256, 257, 55 S.Ct. 695, 698, 79 L.Ed. 1421, and dealt with as we say.
Nobody would suggest that the sale of a declared dividend payable in the future turns the cash received into capital.
It is of course possible to sell a partnership interest, computing the purchase price in such manner as to take into account future earnings of the firm; and the opinion in the Smith case itself recognized that such a sale might qualify as a capital transaction. 90 F.2d at p. 592. But the essence of the Smith case was that the taxpayer was merely being paid for his interest in the firm's earnings, and that is all that is really involved in the present case.
There are some decisions, particularly in the Seventh Circuit, which place a different emphasis on the problem (Swiren v. Commissioner, 183 F.2d 656 (C.A. 7); Meyer v. United States, 213 F.2d 278 (C.A. 7); but cf. Whitworth v. Commissioner, 204 F.2d 779 (C.A. 7); cf. also United States v. Shapiro, 178 F.2d 459 (C.A. 8), and cases cited), but they are distinguishable on their facts. The court in the Swiren case started (183 F.2d at p. 660) that the Smith case ‘appears to have been overruled in McClellan v. Commissioner, 2 Cir., 117 F.2d 988, and Williams v. McGowan, 2 Cir., 152 F.2d 570 * * * .’ We do not so read those two decisions as overruling the Smith case, which was explicitly distinguished in both of them.
And since we regard the instant case as presenting substantially the same problem as was involved in the Smith case, we shall follow it here. Also in harmony with this disposition are the following: Richard S. Doyle, 37 B.T.A. 323, affirmed 102 F.2d 86 (C.A. 4); Paul W. Trousdale, 16 T.C. 1056, affirmed 219 F.2d 563 (C.A. 9); United States v. Snow, 223 F.2d 103 (C.A. 9); Karsch v. Commissioner, 8 T.C. 1327; James Wesley McAfee, 9 T.C. 720; George F. Johnson, 21 T.C. 733.
Moreover, the Court of Appeals for the Second Circuit subsequently cited the Smith case in Commissioner v. Whitney, 169 F.2d 562, 567, footnote 5, certiorari denied 335 U.S. 892, without any suggestion that it had been overruled.
It should be noted also that although it has been administratively recognized that a sale of a partnership interest is to be treated as a sale of a capital asset (G.C.M. 26379, 1950-1 C.B. 58), the ruling explicitly states that (p. 59) ‘payments made to a retiring partner which represent his distributive share of earnings for past services should be treated as ordinary income rather than the proceeds derived from a sale of his interest,‘ citing the Smith, Doyle, and McAfee cases.
In addition to the $25,000 which petitioner received for his interest in profits, unbilled work, and accounts receivable at the time of his retirement, he also received from the partnership between October 1, 1947, and March 11, 1948, the amount of $1,101.33, which represented cash withdrawals in excess of his cash capital balance at the beginning of the partnership earnings. We hold that the respondent did not err in his determination that the total of these two amounts, $26,101.33, was taxable as ordinary income of the petitioner for the year ended December 31, 1948.
Decision will be entered for the respondent.