Opinion
No. E-199.
October 20, 1930.
Suit by Isidor Hellman against the United States.
Judgment for plaintiff.
This suit is for the recovery of $44,194.79, with interest, income tax alleged to have been erroneously and illegally collected for 1919. The question concerns the amount of income upon which the plaintiff was taxable from a partnership known as Smith Kaufmann.
Special Findings of Fact.1. The firm of Smith Kaufmann was established as a partnership in 1881. In 1887 plaintiff became connected with it as an employee and was admitted as a partner in 1892. The firm was always prosperous, earning profits in every year except one. When plaintiff became a partner he was given an interest in the profits without contributing any capital, and through the accumulation of profits he gradually acquired a capital interest. From December 31, 1910, the partnership consisted of Julius Kaufmann, the plaintiff, John Roberts, Edward M.C. Tower, and Edward Wackerhagen. December 21, 1915, Kaufmann withdrew from the partnership and became a creditor, and the partnership was continued by the other members. The partnership thus continued until July 26, 1918, when John Roberts retired therefrom, and a new partnership contract was entered into evidenced in two new documents, which are annexed to the petition in this case as Plaintiff's Exhibits B and C, and by reference are made a part of this finding. Plaintiff's Exhibit C, which was an agreement between the new partners fixing their distributive shares in the partnership to continue from that time forward, was agreed upon and was executed or was intended to be executed immediately before the execution of Plaintiff's Exhibit B, which was a partnership agreement signed by the plaintiff, Edward M.C. Tower, Edward Wackerhagen, Fritz Kaufmann, and Ernst B. Kaufmann, the members composing the new partnership, and by Julius Kaufmann, who had retired but who was continued as a creditor. These two documents represented but a single agreement or understanding between the partners, which was fully arrived at before either was drawn. They were both drawn in the light of a complete understanding and were executed simultaneously.
2. The agreement, Exhibit B, provided that the partners were entitled to draw salaries and interest at 6 per cent. upon their capital contributed or accumulated. After payment of expenses and the salaries and interest, the net profits of the firm were to be credited to the partners but not paid out in specified percentages. In this agreement plaintiff's percentage was 20 per cent. By agreement, Exhibit C, which was made by and between plaintiff and all of the other partners, it was provided that each of the other partners should be entitled to 199/800 of plaintiff's 20 per cent. interest in the net profits provided in the agreement, Exhibit B, which was annexed to and made a part of agreement, Exhibit C; each of the other four partners assuming a similar proportion of any loss. The agreement above referred to as Exhibit C, which was between plaintiff as party of the first part and the other four partners as parties of the second, third, fourth, and fifth parts, provides so far as material here, as follows:
"Whereas the party of the first part desires the parties of the second, third, fourth, and fifth parts to become members of a new firm to be known as Smith Kaufmann, to be composed of the parties hereto; and
"Whereas the party of the first part desires the parties of the second, third, fourth, and fifth parts to execute simultaneously herewith articles of copartnership, a copy of which is hereto attached marked `Exhibit A,' and hereby made a part hereof; and
"Whereas the said articles of copartnership provide that the party of the first part is to receive twenty (20%) per cent of the net profits to be earned by the said firm and to bear twenty (20%) per cent of the losses that are to be sustained by the new firm:
"Now, therefore, in consideration of the premises and in consideration of the sum of one ($1.00) dollar by each of the parties duly in hand paid, the receipt whereof is hereby acknowledged, this agreement
"Witnesseth:
"First. The parties of the second, third, fourth, and fifth parts hereby promise and agree that they will simultaneously with the execution of this agreement duly execute the original of the articles of copartnership of which a copy is hereto annexed and marked `Exhibit A.'
"Second. The party of the first part agrees to and does hereby sell, assign, transfer, and set over to each of the parties of the second, third, fourth, and fifth parts one hundred ninety-nine eight hundredths (199/800) of the interest of twenty (20%) per cent of the party of the first part in all net profits which may hereafter be made by the firm of Smith Kaufmann under Schedule A hereto attached, and the parties of the second, third, fourth, and fifth parts, each for himself, hereby agrees to bear and assume such proportionate amount of any losses that may result under Schedule A during the term thereof which is to and including the 31st day of December, 1921.
"[It is expressly understood and agreed that this agreement shall only relate to such net profits as may be earned by the firm of Smith Kaufmann from the date hereof to December 31st, 1921, and that it does not affect the interest of the party of the first part, his legal representatives or assigns in the good will in the firm of Smith Kaufmann, the machinery account, nor the reserve of one hundred seventy-five thousand ($175,000) dollars at the store, nor the reserve of seventy-five thousand ($75,000) dollars at the mill, nor in the life insurance policies aggregating one hundred thousand ($100,000) dollars on the life of Mr. Julius Kaufmann, nor anything else except the actual profits which may be earned from the date hereof to December 31st, 1921. Upon the dissolution or termination of the firm of Smith Kaufmann as formed under Schedule A hereto attached, the party of the first part shall have the same share in the assets of the said firm as he would have had had this agreement not been executed, except that the parties of the second, third, fourth, and fifth parts are each entitled to be credited with one hundred ninety-nine eight hundredths (199/800) of the share of twenty (20%) per cent of the party of the first part in such net profits as may be earned by the said firm of Smith Kaufmann from the date hereof to December 31st, 1921, or until the date of such dissolution or termination, or until, such earlier date should said firm be dissolved or terminated before the day aforesaid.]
"It is further expressly understood and agreed that no profits shall actually be paid out during the term of Schedule A but shall merely be credited to the account of the parties entitled to receive same.
"The interests of the parties of the second, third, fourth, and fifth parts in the net profits provided for by Schedule A shall be in addition to those which may accrue to them or any of them under this agreement."
The agreement, Exhibit B, referred to in the aforementioned agreement and attached thereto as Exhibit A, provided that the partners should be entitled to yearly salaries payable monthly of $7,500 for plaintiff, Tower, and Wackerhagen, and $6,000 for Fritz and Ernst Kaufmann.
The sixth article of this agreement was as follows:
(6) The net annual profits of the said business after a deduction of all losses and of all proper charges and expenses shall be credited to the partners, but not paid out, as follows: Each of the said partners shall be entitled to such portion of the said net annual profits as may equal 6 per cent. per annum upon the capital contributed by such partner to the said business, as hereinbefore provided, and also upon such accrued capital as may at any time be placed to the credit of said partner upon the books. Net profits shall be credited to the partners, but not paid out, in the following proportions:
Isidor Hellman, 20 per cent.
Edward M.C. Tower, 25 per cent.
Edward Wackerhagen, 25 per cent.
Fritz Kaufmann, 15 per cent.
Ernst B. Kaufmann, 15 per cent.
3. There were no other agreements between the partners except the one of November 18, 1919, hereinafter mentioned. Under these two agreements plaintiff's interest in the profits until Wackerhagen's death was 1/10 of 1 per cent. over and above his salary and 6 per cent. on his capital. When the new partnership arrangement and the interests of the partnership were agreed upon, commencing July, 1918, plaintiff was contemplating retiring and desired only a small interest in the partnership sufficient to produce a nominal return in addition to his salary and the interest which he was receiving upon his capital. It was understood by all that his distributive share in addition to his salary and interest on his capital was to be 1/10 of 1 per cent. of the net earnings, and it was also understood by all that the partnership agreement would provide for this. The partnership agreements were prepared by attorneys for the partners and they deemed it best to embody the understanding of the partners with reference to their distributive share in the two instruments of July 26, 1918, Exhibits C and B.
4. Strained relations developed among the partners because of national antipathies brought about by the war. Negotiations looking toward a termination of plaintiff's interest in the partnership were had in July, 1919, but did not culminate in a definite agreement. Edward Wackerhagen died August 20, 1919, which automatically terminated the agreement of July 26, 1918, evidenced by Exhibit C, hereinafter quoted, leaving in force the part evidenced by Exhibit B.
5. The books of the partnership were customarily closed on June 30 and December 31 of each year. They were closed on June 30, 1919, but were not closed and no determination of profits was made upon the death of Wackerhagen. The books were next closed December 31, 1919.
6. After Wackerhagen's death, plaintiff expected to be able to work in harmony with the other partners, but it developed that this could not be done and negotiations continued looking to a separation of their business relations.
After many conferences it was agreed that plaintiff should immediately withdraw from the partnership; that the remaining partners would form a corporation to take over the entire business and assets; and that such corporation should issue to plaintiff $450,000, par value of first preferred stock, for his interest. For some time plaintiff placed a value in excess of $450,000 upon his interest, but it was finally decided that he would surrender his interest for $450,000. This figure was arrived at by bargaining and not by the computation of shares and profits. On the basis of a net worth at the beginning of 1919 of $1,142,844.80, the firm had a net income for 1919 of $531,141.26, a sum well in excess of a normal return on the investment. Similarly, in the year 1920, the same business operated by a corporation earned a net profit of $472,654.21 after paying salaries of $12,000 each to three officials on the same capital which the partnership had at the end of 1919. The plaintiff's tangible capital interest, as shown by the partnership books at January 1, 1919, was $329,189.81, made up of $255,891.06 shown on the capital account and $73,298.75 constituting his share of a reserve carried by the partnership to meet contingencies. This was reduced by a withdrawal by plaintiff during 1919 of $891.06, leaving him $328,298.75 tangible book capital to sell.
7. Plaintiff's distributive share in the profits of the firm for 1919 consisted of (a) a salary of $7,500; (b) interest at 6 per cent. on his share of the capital account; (c) from January 1 to Wackerhagen's death, August 20, 1/10 of 1 per cent. of the net profits after payment of salaries and interest; and (d) 20 per cent. of the net profits after salaries and interest from August 21 to November 18, the latter date being the date on which plaintiff withdrew from the business, as will hereinafter appear.
The interest on capital account, amounting to $15,300, was withdrawn by plaintiff, as was the salary of $7,500, and they were not among the items for which under the agreement hereinafter referred to he was to receive $450,000 of stock. The distributive share of income, as indicated under (c) and (d) above, amounting to $26,530.84, had not been withdrawn and was included. The partnership of Smith Kaufmann had a valuable good will, and plaintiff agreed to sell his interest therein as well as the tangible book capital.
8. After the plaintiff and the other partners through negotiations had arrived at an understanding their attorneys prepared an agreement, attached to the petition as Exhibit D and by reference made a part of this finding. This agreement was executed on November 18, 1919, by the plaintiff, as party of the first part, and Julius Kaufmann, who was a creditor of the partnership but not a partner, as party of the second part, the executors of the estate of Wackerhagen as party of the third part, and Tower, Fritz Kaufmann, and Ernst Kaufmann as parties of the fourth part. This agreement, so far as material here, provided:
"First. (a) The parties of the fourth part agree that they will on or about January 2d 1920, form and organize a corporation under the laws of the State of New York, or such other State as may be unanimously agreed upon in writing by all of the parties hereto, under the name and style of Smith Kaufmann, Inc., for the purpose of continuing and carrying on the business in which the firm of Smith Kaufmann, in dissolution, is now engaged, which corporation to be formed shall be hereinafter designated as `the corporation.'
"(b) The corporation shall have three classes of stock, to be known, respectively, as first preferred stock, second preferred stock, and common stock."
"(d) The amount of the capital with which the corporation will commence business shall be one million ($1,000,000) dollars or more."
"(g) The voting power of the corporation shall, so far as is permissible by law, be vested exclusively in the holders of the common stock.
"(h) The corporation is to take over from the said copartnership all of its assets of every kind, nature, and description, as well as the assumption and payment of all its debts and liabilities, as appear from the books of account of the copartnership, in consideration of which the corporation is to issue to the respective parties shares of stock and make such payments as hereinafter set forth in detail.
"Second. The parties of the fourth part hereby agree that on or before the 31st day of December, 1919, the firm of Smith Kaufmann, in dissolution, will pay to the party of the second part, his legal representatives, or assigns, the total amount of the then indebtedness of the said firm of Smith Kaufmann to the party of the second part, and the party of the second part hereby agrees that immediately upon receiving said payment he will subscribe at par to one thousand seven hundred and fifty (1,750) shares of the first preferred stock, class B of the corporation.
"Third. The parties of the fourth part agree that upon the execution of this agreement by the party of the first part, there will be advanced to him as a loan the sum of fifty thousand ($50,000) dollars due on January 2d 1920, without interest. The party of the first part hereby acknowledges the receipt of the said loan of fifty thousand ($50,000) dollars and agrees to repay the same at the time of the formation of the corporation, which shall be on or about January 2d 1920. The corporation shall issue to the party of the first part four thousand five hundred (4,500) shares of its first preferred stock, class A in full payment of his interest in said copartnership, and of all his claims against said copartnership, it being understood and agreed that the party of the first part shall not be entitled to any other shares of stock of the corporation. The parties of the fourth part agree that they or the corporation will on or about the 2nd day of January, 1920, purchase for cash from the party of the first part fifteen hundred (1,500) shares of the first preferred stock at par, and the party of the first part agrees to sell the same. The parties of the fourth part further agree that the party of the first part shall also be entitled to receive at the time of the formation of the corporation any unpaid salary at the rate of seventy-five hundred ($7,500) dollars per annum up to December 31st, 1919, and shall further be entitled to receive interest at the rate of six (6%) per cent per annum on the net amount of his capital account, as the same now appears on the books of the firm of Smith Kaufmann up to December 31st, 1919."
"Sixth. The parties of the fourth part agree to and do hereby jointly and severally guarantee to the parties of the first, second, and third parts, their respective legal representatives, successors, and assigns, that the shares of the first preferred and second preferred class A stock shall earn annual dividends at the rate of six per cent payable quarterly on January first, April first, July first, and October first in each year.
"Seventh. The parties of the fourth part each hereby respectively agrees to accept from said corporation in full payment of all of his interest and claims against said copartnership, the following:
"(a) Such number of shares of the second preferred stock, class B, of a total aggregate value, figured at par, as shall be equal to his capital account as shown by the books of the firm of Smith Kaufmann, in dissolution, on the 31st day of December, 1919, plus
"(b) One-third of the total issue of common stock of the corporation.
"Eighth. The parties of the fourth part agree to be incorporators, directors, and officers of the corporation and shall be entitled to receive from the corporation yearly salaries as such in the amounts hereinafter in this paragraph set forth beside their respective names:
"Edward M.C. Tower ............. $12,000 "Fritz Kaufmann ................ 12,000 "Ernst B. Kaufmann ............. 12,000
"That none of said salaries shall be enlarged so long as any first preferred stock of the corporation or second preferred stock, class A, hereinbefore mentioned, remains outstanding. The parties of the fourth part further agree that so long as any of the first preferred stock and second preferred stock, class A, remain outstanding they will devote their best efforts, entire time, and attention to the business of the corporation, and will not engage in any other business."
The articles of incorporation for the corporation known as Smith Kaufmann were filed with the secretary of state of New York December 31, 1919. The corporation was organized on January 2, 1920, on which date the corporation took over the assets of the partnership and authorized and issued to plaintiff $450,000 par value of its first preferred stock for his interests.
9. After the execution of this agreement plaintiff ceased to be a member of the partnership or to participate in its earnings beyond his salary of $7,500 and 6 per cent. interest on his capital account until the end of the year.
Plaintiff had been in charge of the books of the partnership up until the time of his withdrawal from the firm on November 18, 1919, and supervised the bookkeeper. At June 30, 1919, when the books were closed, no profits were credited to plaintiff. From January 1 until Wackerhagen's death his interest was only 1/10 of 1 per cent. At the end of the year 1919 plaintiff was no longer in the firm and the amount he would receive on incorporation of the business had been fixed by the agreement of November 18. The net earnings of the partnership for the last six months of the year 1919 amounted to $300,940.68. Upon closing the books on December 31, 1919, plaintiff was credited thereon at December 31 with a distributive share of $121,701.25, which was equivalent to 40.44 per cent. thereof, or $95,170.41 in excess of what his distributive share for the whole year had actually been. The method adopted by Fritz Kaufmann, Ernst Kaufmann, and Tower at the end of 1919 for computing the distributive share to be credited upon the books had no relation to the distributive interests of the partners as fixed by the partnership agreements. What was done was to take the arbitrary figure of $450,000, at which plaintiff had agreed to sell his interest to the corporation to be formed, and to subtract therefrom his capital as shown by the books, or $328,298.75. The difference of $121,701.25 was "charged to Hellman as coming from the profits of the fall." "Fall" was the bookkeeper's expression used in bookkeeping to denote the last six months of the year. In other words, to determine plaintiff's share of the partnership profits for the last six months of 1919, his capital and reserve accounts were subtracted from the price at which he had agreed to sell his entire interest in the capital, income, good will, increment, and any other values not reflected by the books. The entire net earnings of the partnership for the calendar year 1919 were $531,141.26.
10. Fritz Kaufmann, Ernst Kaufmann, and Tower prepared a return for the partnership of Smith Kaufmann for the entire calendar year 1919. In this return distribution was made under "Schedule C — Member's Share of Income," as follows:
Edward M.C. Tower ............. $116,066.86 Fritz Kaufmann ................ 84,566.86 Ernst Kaufmann ................ 84,566.86 Julius Kaufmann ............... 26,000.00 Isidor Hellman ................ 121,701.25 Estate of Edward Wackerhagen .. 124,239.43 __________ Total ......................... 557,141.26
There appeared in part of Schedule C of this return immediately preceding the above entries the following: "Enter below the shares of net income (whether distributed or not) of each member of the partnership." With the exception of $26,000 shown opposite the name of Julius Kaufmann, the above distribution equaled the net income of the partnership of $531,141.26.
Julius Kaufmann was not a member of the firm. He was a creditor. The firm paid him $26,000, but this was not as a distributive share of a partner but as a bonus for relinquishing his position as a creditor and becoming a stockholder of the corporation and as compensation for certain services rendered.
Upon receipt of information that a return was being filed showing the distributive shares as above set forth, plaintiff objected thereto but without avail, and the same was filed on March 15, 1920.
11. In his individual income-tax return filed for 1919, plaintiff reported as income a salary of $7,500 and the interest at 6 per cent. on his capital account, but no other income from Smith Kaufmann, believing that the $121,701.25 which the other partners had shown on the partnership return was a distribution to him of surplus previously taxed, and not of profit. Thereafter a revenue agent made an investigation and audit of the partnership books and the returns of the individual partners and determined that plaintiff's distributive share of the partnership earnings from January 1 to August 20, 1919 (the date of Wackerhagen's death), was $337.60, being 1/10 of 1 per cent. of $337,601.76, the latter amount being 232/365 (January 1 to August 20, 1919) of $531,141.26, the net earnings of the partnership for the entire year 1919. After Wackerhagen's death on August 20, 1919, which ended the plaintiff's distributive share as set forth in Exhibit C, hereinafter referred to, plaintiff became entitled to a distributive share of 20 per cent. of the net earnings of the partnership from that date. From and after August 20, 1919, the revenue agent applying the same method determined plaintiff's distributive share in excess of his salary and interest to be 20 per cent. to December 31, 1919, amounting to $38,707.93, which, together with his 1/10 interest in the profits to August 20, 1919, amounted to $39,045.53. Upon receipt of the result of the audit of the revenue agent plaintiff took the position that he was taxable upon a distributive share of only 20 per cent. of the earnings of the partnership as determined by the revenue agent from August 20, to November 18, 1919, but, in order to dispose of the matter, plaintiff filed an amended return for 1919 conforming to the audit of the revenue agent and reported in said return the amount of $39,045.53 more income than he had shown in his original return; the last-mentioned amount being the amount determined by the revenue agent to be plaintiff's distributive share of the net earnings of the partnership for 1919 exclusive of his salary and interest on his capital account. The Commissioner of Internal Revenue mailed notices to the plaintiff and to Fritz and Ernst Kaufmann proposing to assess the tax as shown in the revenue agent's report. The other members objected thereto, and finally the Commissioner of Internal Revenue took the position that plaintiff's distributive share of the net earnings of the partnership of Smith Kaufmann for 1919 was $121,701.25, as shown on the partnership return filed. Based upon that computation, he determined an additional tax of $54,633.66 which was assessed in 1924 and was paid by plaintiff under written protest. Subsequently plaintiff filed a claim for refund for $44,194.79, being the amount of tax paid in excess of the tax shown in his amended return made in conformity with the revenue agent's report. This claim for refund was rejected by the commissioner December 15, 1924.
Plaintiff filed his income tax return for 1920 on December 21, 1921.
J.S.Y. Ivins, of Washington, D.C. (Holmes, Brewster Ivins, of Washington, D.C., on the brief), for plaintiff.
McClure Kelley, of Washington, D.C., and Herman J. Galloway, Asst. Atty. Gen. (C.M. Charest and Eldon O. Hanson, both of Washington, D.C., on the brief), for the United States.
BOOTH, Chief Justice, and GREEN, LITTLETON, and WILLIAMS, Judges.
A new trial was allowed in this case. The partnership, Smith Kaufmann, made a return for 1919 on which plaintiff's distributive share of the partnership profits for that year was shown as $121,701.25. Plaintiff had withdrawn from the partnership in November, 1919, and had nothing to do with the preparation of this return. Upon receipt of information that the return showed his 1919 distributive share as stated, he objected to it, but the return as prepared was filed, and the Commissioner of Internal Revenue held that in addition to certain other income, consisting of his salary of $7,500 and 6 per cent. interest upon his capital in the partnership, included by plaintiff in his original individual income-tax return, the amount of $121,701.25 represented his distributive share of the net earnings of the partnership for 1919 and increased his income accordingly. Plaintiff insists that he was not taxable in 1919 upon the $121,701.25, and as a result of the action of the commissioner plaintiff brings this suit to recover $44,194.79.
Plaintiff contends, first, that the two documents, Exhibits C and B, referred to in the findings and executed by all of the partners on July 26, 1918, upon the retirement of John Roberts, constituted in legal effect only one partnership agreement and fixed his interest in the partnership profits at 1/10 of 1 per cent. of the net earnings until the date of death of Wackerhagen on August 20, 1919, and thereafter until he withdrew he was taxable upon 20 per cent. of the net earnings under said partnership agreement; that even if these two instruments be regarded as separate contracts, the result is the same, for the transfer by plaintiff to each of the other partners of 199/800 of the 20 per cent. interest in the net earnings to which he would otherwise have been entitled in consideration of the assumption by each of the other partners of such proportionate amount of any losses that might result was an agreement between all the partners fixing their distributive share; secondly, that on November 18, 1919, he withdrew and retired from the partnership and agreed with the other partners, as evidenced by Exhibit D referred to in the findings, to sell and transfer all of his interest in and claims against the partnership to a corporation to be organized by certain of the other partners in exchange for the issuance by such corporation to him of $450,000, par value of its first preferred stock; that this agreement was not a sale completed in 1919 giving rise to a taxable gain, because the corporation to which he agreed to sell was not organized and the stock was not authorized or issued therein until January 2, 1920; that the action of the other partners in showing the amount of $121,701.25 on the partnership return for 1919 as his distributive share of the partnership earnings for 1919 was wrong; that the figure of $121,701.25 was purely an arbitrary one representing merely the difference between $450,000, at which he agreed to sell, and $328,298.75, his tangible capital and his share of the reserve of the partnership; that, in no event, could his distributive share of the partnership net earnings have exceeded 20 per cent. of the net earnings of $531,141.26, or $106,228.25; thirdly, that the action of the other partners in showing his distributive share of the partnership profits for 1919 at $121,701.25 and the action of the commissioner in including that amount in his income resulted in shifting the burden of the other partners for their lawful taxes to him.
Defendant contends, first, that plaintiff was bound by the partnership return showing his distributive share as $121,701.25; and, secondly, assuming that the amount did not represent his share of the partnership earnings, it was nevertheless taxable to him as a gain realized in 1919 upon the sale by him in that year of his interest in the partnership.
The two instruments executed by plaintiff and the other members of the partnership on July 26, 1918, forming a new partnership arrangement upon the retirement of John Roberts, constituted in our opinion but one agreement between the new partners fixing their distributive shares. Under them, plaintiff's distributive share was 1/10 of 1 per cent. of the net earnings until December 31, 1921, the date fixed for termination of the partnership unless before that time it should be terminated for any reason, in which event it was provided that plaintiff's distributive share should become the full 20 per cent. of the net earnings. Partners may adjust between themselves their distributive share in such proportion and in such manner as they may desire. Cf. Leo Schwartz, 7 B.T.A. 223. The facts show that when the new partnership arrangement was formed in July, 1918, the plaintiff was contemplating retiring and desired only a small interest sufficient to produce a nominal return in addition to his salary and the interest which he was receiving upon his capital. It was understood by all that his distributive share was to be only 1/10 of 1 per cent. of the net earnings and it was plaintiff's desire that the partnership agreement provide for this. The partnership agreements were prepared by the attorneys for the partners and they deemed it best to embody the understanding of the partners with respect to their distributive shares in the two instruments in question. They were prepared at the same time and were executed simultaneously by all of the partners.
The defendant, relying upon Ormsby McKnight Mitchel, 1 B.T.A. 143, Mitchel v. Bowers (C.C.A.) 15 F.2d 287, and Bing v. Bowers (D.C.) 22 F.2d 450, contends that the fixing of plaintiff's distributive share at 1/10 of 1 per cent. of the net earnings of the partnership was merely an assignment by him of 199/800 of his interest in the partnership profits to each of the other partners and did not relieve him of the tax upon full 20 per cent. of the net earnings. These cases are not in point. They did not involve instruments constituting a part of a partnership agreement. The transactions there considered were entirely independent of the agreement between the partners, and the person to whom the assigment was made was not a partner and was not made one thereby. Partners may adjust between themselves their interest in the net earnings of the partnership in any proportion that they may agree upon, and, when so fixed, they are taxable accordingly. Certainly is this true when the interests are fixed at the formation of the partnership. The plaintiff did not assign a portion of his income to another. Under the agreements he was never entitled to receive 796/800 of 20 per cent. of the net earnings, which the partnership agreement gave to the other partners. Under no circumstances could he ever withdraw any portion of it, or interest upon it, nor could it ever be credited to his capital account. The fact that it might have been credited to him on the books and simultaneously credited to the other partners did not make it income to him in view of the provisions of the partnership agreements. Bookkeeping entries do not constitute income unless there is the right of ownership in the amount disclosed by such entries. Plaintiff's distributive share of the partnership profits upon which he was taxable from January 1, to August 20, 1919, the date of the death of Wackerhagen, was, therefore, 1/10 of 1 per cent. The partnership books were closed on June 30 and December 31 of each year. Upon the death of Wackerhagen the books were not closed to determine the income of the partnership to that date. The revenue agent who audited the books and the returns of the individual partners therefore accordingly determined plaintiff's distributive share of the partnership earnings to that date as $337.60, being 1/10 of 1 per cent. of $337,601.76, the latter amount being 232/365 (January 1 to August 20) of $531,141.26, the net earnings of the partnership for the entire year 1919. This action of the revenue agent was correct. Peter W. Rouss, 4 B.T.A. 516; Rouss v. Bowers (C.C.A.) 30 F.2d 628.
Upon the death of Wackerhagen on August 20, 1919, plaintiff became entitled under the partnership agreement to the full 20 per cent. of the partnership profits from that time forward. On November 18, 1919, due to the strained relations between the parties, and after much discussion and bargaining by the plaintiff, he agreed to retire from the business forthwith and for the remainder of the year 1919 to receive only his fixed salary of $7,500 and 6 per cent. upon his capital account.
The other partners agreed to form a corporation and to take over the entire business and all of the assets of the partnership, both tangible and intangible, and it was further agreed that the corporation when organized would issue $450,000 of par value of the first preferred stock to plaintiff in payment for all of his interest in the partnership and all claims that he might have against the same. The agreement of November 18 was accordingly executed. Under that agreement plaintiff was not, therefore, a member of the partnership and had no right to share in any of its earnings from the date of the agreement until the end of the year 1919. All that the other partners agreed to pay him and all that he was entitled to receive from the partnership was his salary of $7,500 and 6 per cent. interest on his capital account, exclusive of the reserve of which plaintiff's share was $73,000. As a matter of law, therefore, plaintiff was not taxable upon any portion of the net earnings of the partnership from November 18 to December 31, 1919. However, after the revenue agent's first investigation, the plaintiff, desiring to have the matter ended, filed an amended return and voluntarily paid the tax upon 20 per cent. of the earnings, $193,539.50 (i.e., $531,141.26 minus $337,601.76, the proportion up to August 20), from August 20, 1919, to December 31, 1919, determined as hereinabove set forth. The amount of tax so paid upon income thus determined was $4,138.77 in excess of what he should have been required to pay, but no claim for refund was made in respect of that amount and no claim is now made by plaintiff with regard thereto. The total income from the partnership upon which plaintiff voluntarily paid the tax, and which he claims was the amount upon which the commissioner should have taxed him, was $61,845.53 made up of his salary of $7,500, interest on capital of $15,300, his share of partnership profits of $39,045.53. The revenue agent first determined this amount as being the correct income of plaintiff, and the commissioner upon audit mailed notices to the partners proposing to assess the tax to plaintiff and additional taxes against the other members of the partnership upon that basis. The other partners objected and on appeal the commissioner finally decided that plaintiff's distributive share of the partnership profits for 1919 was $121,701.25, as shown on the partnership return, and he taxed the plaintiff and the other partners upon that basis. This amount, in addition to the items of salary and interest, was included in plaintiff's income for 1919 resulting in an additional tax of $54,633.66. In this the commissioner erred. The distributive share of the partnership earnings and the total amount of income therefrom upon which plaintiff was taxable in no event exceeded $39,045.53 upon which he has paid the tax without protest. Cf. Maurice L. Goldman et al., 15 B.T.A. 1341. Even on the commissioner's theory that plaintiff was taxable upon 20 per cent. of the net earnings of the partnership for the entire year 1920, his distributive share of the net earnings of $531,141.26 could not exceed $106,228.65.
The next question is whether plaintiff made a completed sale of his interest in 1919 and derived a taxable gain of $121,701.25 thereon. In our opinion there was no completed sale in 1919 and no taxable gain was derived by plaintiff in that year. At most, plaintiff only agreed in 1919 to sell his interest in the tangible and intangible assets of the partnership to a corporation thereafter to be organized. He sold nothing to the partners. They did not obligate themselves to pay him any amount for his interest, but only to have the corporation, if and when it should be organized, issue him stock. The corporation was not completely organized until 1920 and plaintiff received nothing which could constitute income until January 2, 1920.
The defendant contends that if the commissioner was wrong in taxing the amount of $121,701.25 to the plaintiff as his distributive share of the partnership earnings, there was a completed sale by him of his partnership interest in 1919 which gave rise to a gain derived in that year; that the partnership had no intangible assets of any value, and since plaintiff employed the accrual method of accounting, he was taxable upon the profit of $121,701.25 representing the difference between his interests in the tangible book capital and $450,000 at which he sold.
It is not clear whether plaintiff employed the accrual or cash receipts and disbursements method of accounting, but we deem it unnecessary to decide this point. It is clear from the provisions of the agreement of November 18, 1919, and the facts, that a completed sale was not made in 1919. The articles of incorporation were filed with the Secretary of State on December 31, 1919, but this did not complete the sale. The parties to the agreement of November 18, 1919, were not authorized to act and did not act for the corporation to be formed, and even after the corporation came into existence it was not bound by the agreement until it took action thereon. Morse v. Tillotson Wolcott Co. (C.C.A.) 253 F. 340, 1 A.L.R. 1485; Younker Bros., Inc., 8 B.T.A. 333. The corporation acted on January 2, 1920, at which time it authorized and issued to plaintiff $450,000 par value of preferred stock. If a gain was derived by plaintiff, it accrued and was received by him on that date. The year 1920 is not before us.
Plaintiff is entitled to recover. Judgment for $44,194.79 will be entered in his favor with interest. It is so ordered.