Opinion
Docket No. 7463-70.
1973-02-5
GEORGE EISLER AND RIANE EISLER, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Bruce I. Hochman and Harvey D. Tack, for the petitioners. H. Lloyd Nearing, for the respondent.
Bruce I. Hochman and Harvey D. Tack, for the petitioners. H. Lloyd Nearing, for the respondent.
Held: An amount of $235,000 paid by T to a former employer in settlement of a lawsuit involving the employer's claim to reacquire certain of its stock from T was intended in addition to settle the employer's claim against T for negligent performance of his duties. An allocation is made herein whereby (a) $100,000 of that payment is held to relate to the stock and to represent a charge against the capital gain which T realized upon sale of the stock and (b) $135,000 of that payment is held to relate to the negligence claim and to be deductible as a business loss or expense. Held, further, legal fees of $55,094.85 paid by T in respect of the foregoing are to be allocated to the two claims in accordance with findings made herein.
The Commissioner determined a $50,738.75 deficiency in petitioners' income tax for the calendar year 1966. The only issue for decision is whether petitioner George Eisler's payment of $235,000 in settlement of a lawsuit, and legal fees of $55,094.85 incurred by Eisler in connection with that lawsuit, represented ordinary expenses or losses or capital outlays.
FINDINGS OF FACT
The parties have filed a stipulation of facts which, together with accompanying exhibits, is incorporated herein by this reference.
Petitioners were husband and wife during the calendar year 1966. They filed a joint Federal income tax return for that year with the district director of internal revenue at Los Angeles, Calif., and resided in Los Angeles at the time they filed their petition herein. ,
George Eisler (petitioner) has been trained as an engineer. He has held positions in the field of engineering on the staff of a major university and in private enterprise, and operated an engineering consulting firm of his own from 1958 through 1963.
Sometime during the fall of 1963, petitioner was approached by one Max Palevsky, the president and principal shareholder of Scientific Data Systems, Inc. (SDS), in regard to the possibility of petitioner's affiliating with that firm. SDS was then active in the computer field. Petitioner accepted Palevsky's offer of employment and went to work in November of 1963 as his staff assistant. Petitioner expected to be made a vice president of SDS within a short time, and he was also given to understand that he eventually would become president of the company.
During the negotiations preceding the commencement of petitioner's employment with SDS, petitioner told Palevsky that he would insist upon owning a substantial equity interest in the firm as a condition of his employment. Palevsky agreed to this demand on the condition that SDS be given a right to reacquire petitioner's stock in the event that petitioner left the company. Pursuant to these discussions, petitioner and SDS entered into a written ‘Employment and Stock Purchase Agreement’ on December 13, 1963. Such agreement set forth the terms of petitioner's employment and provided that SDS would issue and sell to petitioner 2,000 shares of its common stock at the price of $25 per share, subject to various conditions running in favor of SDS which restricted petitioner's right to dispose of such stock. Among these limitations was the following provision, which applied to 1,600 of the 2,000 shares covered by the contract:
11. Termination of Employment. In the event that Employee shall leave the employ of the Company for any reason other than death, the Company shall have the option within sixty (60) days after the date of such termination to purchase the Restricted Stock of Employee at the price per share paid for such stock by Employee (hereinafter referred to as the ‘Option Price’). * * *
The restrictions on petitioner's rights of disposition, including the purchase option provided for by paragraph 11, were gradually to lapse with respect to the remaining shares acquired by petitioner over a period of 54 months, pursuant to a schedule contained in the written agreement.
The 2,000 shares covered by the agreement of December 13, 1963, were delivered to petitioner and paid for by him in full within a few weeks of the time of execution of the written agreement. Those shares then represented less than 1 percent of the total number of outstanding shares of common stock in SDS. To accommodate further petitioner's desire to acquire a substantial equity interest in the company, he and SDS executed a second written agreement, wherein the company granted petitioner an option to purchase up to 1,000 additional shares of SDS common stock, also at $25 per share, at specified times during his anticipated period of employment. Such agreement, known as the Stock Option Agreement, was dated October 23, 1963. Petitioner left the employ of SDS, in circumstances described more fully hereinafter, before his right to purchase any stock had matured under the terms of the Stock Option Agreement, and the only purchases of SDS stock ever made by petitioner were the 2,000 shares he acquired pursuant to the Employment and Stock Purchase Agreement.
Petitioner's employment by SDS terminated after he had worked there for approximately 11 months. On or about October 19, 1964, Palevsky discharged petitioner following petitioner's refusal to tender a voluntary resignation at Palevsky's request. Less than 60 days after petitioner's dismissal, SDS demanded in writing that petitioner reconvey to it the stock to which it alleged it was entitled under the terms of paragraph 11 of the Employment and Stock Purchase Agreement. Between the time of the execution of such agreement and the time of the making of the written demand by SDS, public trading in the company's common stock had been initiated, and the stock had split 5-for-1. The company therefore asserted its right to repurchase 8,000 (5 x 1,600) of the 10,000 shares of SDS stock then held by petitioner, and in accordance with the terms of paragraph 11 it tendered him $40,000, the aggregate amount he had paid for the original 1,600 shares. The aggregate market price of such shares was then in excess of $200,000, and petitioner rejected the repurchase offer of SDS.
Sometime after petitioner had been discharged by SDS, his attorney asked that representatives of the company see to the removal of the restrictions on disposition which still attached to petitioner's stock pursuant to the Employment and Stock Purchase Agreement. Such request was denied, and the attorney was informed that SDS intended to pursue its alleged rights under the contract. Accordingly, on December 18, 1964, SDS filed a complaint in the Superior Court of the State of California for the County of Los Angeles, praying, in substance, for a declaratory judgment that would establish its right under the Employment and Stock Purchase Agreement to reacquire 8,000 shares of its stock form petitioner at the aggregate price of $40,000, or alternatively, to recover damages from petitioner measured by the excess of the fair market value of such stock over $40,000. In his ‘answer and counterclaim’ which was filed on January 14, 1965, petitioner denied many of the allegations made in the complaint, raised a number of affirmative defenses, and alleged his own right to compensatory damages and certain declaratory relief in respect of various aspects of his relationship with SDS.
The litigation involving petitioner and SDS never came to judgment, for the parties negotiated a settlement of the lawsuit on June 19, 1966. Before the case had been settled, counsel for SDS had made a distinctly negative assessment of his client's chances of obtaining a judgment that would declare its right to repurchase any of the specific shares of stock held by petitioner, but he still hoped that SDS would be able to recover pecuniary damages in respect of the value of the stock. Accordingly, on June 10, 1966, SDS, through counsel, authorized petitioner to sell the 8,000 shares of stock which constituted the subject matter of the aforementioned litigation on the condition, however, that the proceeds of the sale be held by petitioner's lawyers pending the final disposition of the lawsuit and that such proceeds be substituted for the 8,000 shares without prejudice to the rights of the parties. Petitioner thereupon sold the 8,000 shares for $475,080.80.
Prior to the settlement, counsel for petitioner had also come to the conclusion that SDS was unlikely to obtain specific performance for the return of the stock held by petitioner, and he had further concluded that the alternative relief sought by SDS, relating to monetary damages, would probably not be granted. As counsel put it to petitioner, petitioner had a ‘75 to 80 percent chance’ of successfully defending himself against the claims made by SDS in its complaint. On the other hand, counsel also told petitioner that the likelihood of his obtaining a favorable judgment in respect to any of his own counterclaims was negligible.
Petitioner's attorneys were considerably disturbed, however, by another possible claim that SDS was threatening to lodge, the foundation for which had been laid in the course of discovery proceedings in the lawsuit. It had become evident to the lawyers representing both parties that SDS might successfully have been able to prosecute a cause of action sounding in negligence against petitioner, stemming from petitioner's alleged mishandling of three contracts in the negotiation or administration of which he had participated on behalf of SDS. Certain defenses against such a claim might have been available to petitioner, but his lawyer evaluated the prospect of defeating a negligence claim by SDS as no better than even. Prior to the consummation of the settlement agreement between petitioner and SDS, counsel apprised petitioner fully of his assessment of the foregoing matters. The threat of a negligence claim was invoked by counsel to persuade petitioner that it would be prudent to settle the pending controversy with SDS, for it was thought that petitioner's contingent liability to SDS in respect of the negligence claim was substantial— greatly in excess, in fact, of his contingent liability for the value of the SDS stock in dispute.
Motions for summary judgment in respect of the pending litigation were submitted by each of the parties. SDS never amended its complaint to add a negligence count, but it was prepared to do so before the case came to trial. Counsel for SDS had informed petitioner's lawyer of SDS' intentions in this respect, and these plans were communicated in turn to petitioner. The motions for summary judgment were confined, however, to the issues raised by the original pleadings.
It was in these circumstances that the parties arrived at a basis for settlement. On June 29, 1966, shortly before arguments on the motions for summary judgment were to be heard, the parties executed a General and Mutual Release Agreement, which provided, in part, as follows:
WHEREAS, SDS filed a complaint against Eisler in that certain action entitled Scientific Data Systems, Inc. vs. George Eisler, being action No. 851 134 in the Los Angeles Superior Court; and
WHEREAS, Eisler filed an answer, counterclaims and cross-complaints in said action; and
WHEREAS, the parties hereto desire to terminate said lawsuits and resolve all of the obligations and liabilities between each other arising out of said lawsuits or otherwise;
NOW, THEREFORE, for and in consideration of the mutual covenants and agreements hereinafter expressed, the parties agree as follows:
1. Concurrently with the execution and delivery of this agreement;
(a) Eisler will pay to SDS by certified or cashier's check, the sum of $235,000.00; and
(b) SDS and Eisler, through their respective counsel, will execute a request for dismissal with prejudice of that certain action entitled Scientific Data Systems, Inc. vs. George Eisler, being action No. 851 134 in the Los Angeles Superior Court.
2. SDS does hereby release and discharge Eisler, his agents, employees, heirs and assigns, from any and all claims demands or causes-of action, known or unknown, which SDS now owns or holds or has at any time heretofore owned or held against Eisler, including specifically, but not exclusively, and without limitating the general ty of the foregoing, any and all claims, demands or causes of action arising out of or in any way connected with:
(a) That certain action entitled Scientific Data Systems, Inc. vs. George Eisler, being action No. 851 134 in the Los Angeles Superior Court;
(b) That certain Employment And Stock Purchase Agreement dated December 13, 1963, and executed by SDS and Eisler;
(c) That certain Stock Option Agreement dated October 23, 1963, and executed by SDS and Eisler;
(d) Any and all matters relating to the employment of Eisler by SDS.
3. Eisler does hereby release and discharge SDS, its agents, employees and assigns, from any and all claims, demands or causes of action, known or unknown, which Eisler now owns or holds or has at any time heretofore owned or held against SDS, including specifically, but not exclusively, and without limiting the generality of the foregoing, any and all claims, demands or causes of action arising out of or in any way connected with:
(a) That certain action entitled Scientific Data Systems, Inc. v. George Eisler, being action No. 851 134 in the Los Angeles Superior Court;
(b) That certain Employment And Stock Purchase Agreement dated December 13, 1963, and executed by SDS and Eisler;
(c) That certain Stock Option Agreement dated October 23, 1963 and executed by SDS and EISLER;
(d) Any and all matters relating to the employment of Eisler by SDS.
4. SDS and Eisler hereby expressly waive and relinquish any and all rights and benefits under Section 1542 of the California Civil Code which provides as follows:
‘Section 1542. (Certain claims not affected by general release.) A general release does not extend to claims which the creditor does not know or suspect to exist in his favor at the time of executing the release, which if known by him must have materially affected his settlement with the debtor.’
Pursuant to paragraph 1(a) of the release agreement, petitioner paid SDS the sum of $235,000 on June 29, 1966. A former financial officer of SDS, who had been instrumental in the development of evidence pertinent to the proposed negligence claim against petitioner, regarded the payment as having been made in consideration of petitioner's release from his contingent negligence liability, and SDS treated the settlement proceeds as ordinary income for tax purposes.
Petitioner incurred expenses in the amount of $55,094.85 for legal services performed in connection with the litigation with SDS. On his 1966 income tax return he claimed a deduction for such amount as ‘Legal and professional fees' and a deduction of $235,000 which was described as ‘Settlement of claim for breach of employment contract.’ Both items were treated as expenses or losses from petitioner's ‘Business or Profession’ and hence were deducted from ordinary income. The Commissioner determined that the two expenditures represented additions to the basis of the 8,000 shares of SDS stock petitioner had sold in 1966, that they therefore constituted capital outlays under section 263 of the 1954 Code, and that they consequently did not qualify as business expenses that were deductible from ordinary income. Petitioner reported the gain from his sale of the SDS stock as a long-term capital gain.
OPINION
RAUM, Judge:
1. The $235,000 settlement payment.— The tax character of a payment in settlement of litigation must be ascertained by reference to the nature of the claim in respect of which the payment is made. Anchor Coupling Co. v. United States, 427 F.2d 429, 433 (C.A. 7), certiorari denied 401 U.S. 908; Spangler v. Commissioner, 323 F.2d 913, 916 (C.A. 9), affirming a Memorandum Opinion of this Court; Arthur H. DuGrenier, Inc., 58 T.C. 931; Dudley G. Seay, 58 T.C. 32, 37, acq. 1972-2 C.B. 3. The Commissioner's position is that petitioner paid SDS $235,000 solely to secure a release from his contingent liability in respect of the 8,000 shares of SDS stock he had owned, that the payment therefore represented a cost of ‘defending or perfecting title to property,’ and that it should have been added to the basis of the 8,000 shares under sections 1.212-1(k) and 1.263(a)-2(c) of the Income Tax Regulations and thus applied as an offset to the capital gain petitioner realized upon the sale of those shares. Petitioner maintains that the entire $235,000 was paid in satisfaction of claims related, in one way or another, to his status as a former employee of SDS and that the full amount of the payment was thus deductible by him as a business loss or expense. We hold that the settlement payment was made to secure releases from both the stock claim and a negligence claim which SDS was threatening to lodge, and therefore that part of the payment was deductible only as a capital outlay and the remaining portion represented a business expenditure deductible in full from ordinary income.
Although the litigation between petitioner and SDS initially involved only a claim relating to the stock petitioner had purchased under the Employment and Stock Purchase Agreement of December 13, 1963, the character of the controversy was altered both by petitioner's counterclaims and the possibility that SDS would bring a negligence claim against petitioner, which materialized in the course of discovery proceedings. The parties to the aforementioned lawsuit regarded petitioner's counterclaims as being of little, if any, value, but we are satisfied by the testimony of a former officer of SDS, petitioner himself, and counsel for the respective litigants that both the stock claim and the threatened negligence claim had real value in the minds of the litigants on June 29, 1966, when they executed the General and Mutual Release Agreement. To be sure, SDS never amended its complaint to add a negligence count, but the litigants plainly undertook to settle this claim as well as the stock claim, and the terms of the release agreement were broad enough to accommodate the mutual understanding of the parties as we have found it to have been.
The release instrument made no apportionment of the $235,000 settlement payment among the compromised claims. In the circumstances, we must make an allocation ourselves. See Spangler v. Commissioner, 323 F.2d at 915-917; Harry A. Kinney, 58 T.C. 1038; 1044; Telefilm, Inc., 21 T.C. 688, 693-695;
cf. Dudley G. Seay, 58 T.C. at 37-39. Moreover, it is entirely proper to allocate a portion of the settlement payment to the negligence claim notwithstanding the fact that the pleadings were never amended to reflect that claim. Cf. Dudley G. Seay, 58 T.C. 32. It is our best judgment, based upon the entire record, that $100,000 of the settlement payment was attributable to petitioner's release from the stock claim and that the remaining portion of the payment ($135,000) was made in settlement of the threatened negligence claim, and we so find as a fact. Accordingly, petitioner is entitled to deduct $135,000 in respect of the settlement payment as a business expense or loss (cf. Old Town Corporation, 37 T.C. 845, acq. 1962-2 C.B. 5), and he must treat the remaining $100,000 of that payment as an offset to the capital gain he had realized upon the sale of the 8,000 shares of SDS stock.
Telefilm, Inc., was reversed (C.A. 9, 5 A.F.T.R. 2d 1804, 55-1 U.S.T.C. par. 9453), but only in respect of the treatment of one of the components of the allocation (punitive damages), to give effect to the Supreme Court decision in Commissioner v. Glenshaw Glass Co., 348 U.S. 426, which had meanwhile been rendered.
In making the foregoing allocation we are, of course, aware that the matter is not susceptible of any precisely accurate determination, and that the most that can be expected of us is the exercise of our best judgment based upon the entire record. This we have undertaken to do, and it would serve no useful purpose to discuss the various items of evidence that we took into account. Suffice it to say, we did endeavor to make as close as approximation as we could in regard to what we considered to be the respective weights that the parties in fact placed upon the relative values of their respective claims, making appropriate allowance for a certain amount of overstatement or understatement of the claims in the testimony before us as we evaluated such testimony.
Although petitioner recognizes that an allocation is appropriate in this case— indeed he has suggested several different possible allocations on brief— he has made the alternative argument that he is entitled to report the entire $235,000 payment as a business loss because all of the settled claims were somehow connected with his prior activities as an employee of SDS. We find that position to be without merit. To the extent that the payment is properly allocable to the stock, it represents in the context of this case nothing more than a charge against the capital gain that he realized upon sale of the stock, cf. Arrowsmith v. Commissioner, 344 U.S. 6, and not a business loss, cf. United States v. Generes, 405 U.S. 93.
2. The $55,094.85 expenditure for legal services.— The tax character of petitioner's legal expenses must be determined pursuant to the same principles that governed the nature of the settlement payment. See Woodward v. Commissioner, 397 U.S. 574; United States v. Gilmore, 372 U.S. 39; Spangler v. Commissioner, 323 F.2d 913; Stass Reed, 55 T.C. 32. Accordingly, an allocation of the legal expenses is in order. The apportionment of those expenditures among the two claims which petitioner and SDS were most interested in settling need not, however, correspond to the allocation of the settlement payment itself. The settlement payment was apportioned pursuant to our best understanding of of the bargain struck by the parties on the date of the execution of the release agreement. The legal fees, however, were paid for services performed over a considerable period of time, and the record plainly shows that the litigation took on a vastly different character as it developed. Whereas the lawsuit began with a claim by SDS relating to the 8,000 shares of stock (which we have held to be capital in nature), the negligence claim (which was ordinary in nature) was of primary importance to the litigants at the time the suit was settled. The possible impact of the latter claim apparently did not become manifest until the later stages of the litigation, and certain of the activities of petitioner's attorneys in connection with that claim were plainly related to the original cause of action as well.
It is stipulated only that petitioner incurred expenses in the amount of $55,094.85 for legal services performed ‘in connection with the lawsuit.’ Apart from the facts giving rise to the inferences we have drawn above, there is little other evidence that sheds light upon the precise nature of the services performed by petitioner's counsel. It is incumbent upon us, in the circumstances, to do the best we can with the materials at hand. Accordingly, we find as a fact that $20,000 of the legal expenditures were allocable to work performed in connection with the threatened negligence claim and hence were deductible as ordinary expenses and that the remaining legal fees of $35,094.85 constituted capital outlays
for work done in connection with petitioner's defense against the stock claim.
Numerous decisions cited by petitioner to support the proposition that even the legal expenses allocable to the stock claim might constitute ordinary deductions are either distinguishable from the present case on their facts or of dubious viability in the wake of United States v. Gilmore, 372 U.S. 39, and its progeny.
Decision will be entered under Rule 50.