50 T.C. 782 (1968), 1779-63, Danielson v. Commissioner of Internal Revenue

Docket Nº:1779-63, 5489-63, 344-64, 473-64.
Citation:50 T.C. 782
Opinion Judge:DAWSON, Judge:
Attorney:Sidney B. Gambill, Charles C. Cohen, and Linn V. Phillips, Jr., for the petitioners. John W. Tissue, for the respondent.
Case Date:August 29, 1968
Court:United States Tax Court

Page 782

50 T.C. 782 (1968)




Nos. 1779-63, 5489-63, 344-64, 473-64.

United States Tax Court.

August 29, 1968

Sidney B. Gambill, Charles C. Cohen, and Linn V. Phillips, Jr., for the petitioners.

John W. Tissue, for the respondent.

Pursuant to the opinion and mandate in Commissioner v. Danielson, 378 F.2d 771 (C.A. 3, 1967), and further evidence adduced, held, on the facts, that petitioners were not fraudulently induced by Thrift to sign noncompetition agreements in conjunction with the sale of their stock in Butler Loan. Thus, petitioners are bound by the agreements, and the amounts of consideration received therefor are taxable as ordinary income.

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DAWSON, Judge:

These cases are now before the Court on remand from the U.S. Court of Appeals for the Third Circuit pursuant to mandate issued on November 7, 1967. The cases were originally heard by this Court on November 17 and 18, 1964, and decisions were entered in favor of petitioners on September 22, 1965, in accordance with an opinion filed on July 12, 1965, which is reported in 44 T.C. 549. Upon petitions for review filed by the Commissioner in the U.S. Court of Appeals for the Third Circuit, the cases were argued before a three-member panel on September 16, 1966. A rehearing before the Court of Appeals en banc was held pursuant to an order entered sua sponte on December 20, 1966. In an opinion filed May 2, 1967, and reported in 378 F.2d 771, the Court of Appeals reversed the decisions of this Court by a vote of 4 to 3 and remanded the cases ‘ so that the parties may be afforded a further opportunity to produce evidence in accordance with the principles expressed in this opinion.’ Petitioners applied to the Supreme Court of the United States at No. 382, October Term 1967, for a writ of certiorari, which was opposed by the Solicitor General and denied by the Supreme Court on October 9, 1967, in 389 U.S. 858.

Accordingly, pursuant to the mandate issued by the Court of Appeals, this Court entered an order dated November 14, 1967, directing the petitioners to file amended petitions alleging appropriate assignments of error with respect to the issues of fraud, duress, or undue influence as mentioned in the opinion of the Court of Appeals. Respondent was directed to answer the amended petitions. Thereafter, the amended petitions were filed. Each alleges that the written agreements dated November 16, 1959, wherein petitioners agreed not to compete against Thrift Investment Corp. for 6 years ‘ was procured by fraud on the part of an officer of Thrift, Paul M. Hickox.’ Respondent in his answers to the amended petitions has denied this allegation.

A further hearing was held on January 16, 1968, in Pittsburgh, Pa. The general background of these cases is no longer in dispute, and our findings of fact ( 44 T.C. 549) were in no way disturbed by the Court of Appeals. In reversing us, the Court of Appeals adopted a new rule that ( 378 F.2d at 775)-

a party can challenge the tax consequences by his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its enforceability because of mistake, undue influence, fraud, duress, etc.

The Court of Appeals further stated ( 378 F.2d at 777, 779):

Even in these circumstances, we are inclined to believe that the ‘ strong proof’ rule would require that the taxpayer be held to his agreement absent proof of the type which would negate it in an action between the parties to the agreement.

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If our belief is unwarranted then we nevertheless conclude that a taxpayer who enters into a transaction of this type to sell his shares and executes a covenant not to compete for a consideration specifically allocated to the covenant may not, absent a showing of fraud, undue influence and the like on the part of the other party, challenge the allocation for tax purposes. We so conclude even though the evidence, as here, would support a finding that the explicit allocation had no independent basis in fact or arguable relationship with business reality. Such evidence can have no independent legal significance in cases where the consideration is allocated by the parties in their agreement. It would be relevant, but not conclusive, evidence only if some attack is made on the written agreement by a party claiming that because of fraud, etc., it is not his conscious agreement.

However, under the rule here adopted, if either of the parties to a covenant not to compete attempted, in an action against the other, to avoid or alter the agreement he would have a heavy burden of showing fraud, duress, undue influence and the like under what may loosely be called common-law principles.

We are thus confronted, on this remand, with one narrow question: were petitioners fraudulently induced by Thrift Investment Corp. to sign individual agreements not to compete in conjunction with the sale of their stock in Butler Loan Co. so as to nullify for Federal tax purposes the effect of such agreements? In order to resolve this question additional findings of fact must be made.


When Butler County Loan Co. (herein called Butler Loan) was offered for sale in October 1959 it held small loan receivables of approximately $254,000 and its subsidiaries owned consumer discount receivables of approximately $9,500.

Among several responses to the solicitations of offers to purchase Butler Loan were offers to pay substantial premiums on the receivables. In addition to the offer made by Thrift Investment Corp. (herein called Thrift), one small loan company offered $358,600.74, and another small loan company offered $380,129.16.

The stockholders and directors of Butler Loan, including the petitioners, were informed of the receipt of such offers at a special meeting held on November 3, 1959. The various offers were then considered and the decision was made to accept the Thrift offer. The minutes of the meeting of November 3, 1959, further reflect that-

It is unanimously agreed that all directors and/or stockholders present are on record that they individually and collectively will enter a noncompete agreement in Butler area for a period of three years.

Prior to the submission of its offer, Thrift had examined and graded the Butler Loan receivables. The calculation resulted in a total valuation

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thereon by Thrift of $264,395. Thrift could have afforded to pay a premium on the receivables of approximately $103,700.

Paul M. Hickox, executive vice president of Thrift, thought at the time the Thrift offer was submitted that amounts paid pursuant to a noncompetition agreement could be amortized and deducted for Federal tax purposes.

Prior to the submission of its offer to Butler Loan, Thrift had decided that it would ask the stockholders of Butler Loan to sign individual agreements not to compete and that it would allocate as consideration for the covenants the amount of the premium calculated on the receivables. At the time the offer was submitted Hickox thought that amounts received under a noncompetition agreement would be treated as ordinary income to the recipients for Federal tax purposes.

Shortly after the special meeting of Butler Loan stockholders and directors, Thrift was advised that the cash offer for the shares contained in its letter of November 2, 1959, was accepted. Alvin C. Shukis (herein called Shukis), the manager of Butler Loan, then sent a telegram to Thrift stating that he was going to exercise his option with respect to the additional 90 shares on which he held an option. Thereupon, Hickox sent a letter dated November 5, 1959, to Hugh E. McLennan, president of Butler Loan which reads, in pertinent part, as follows:

I am enclosing three copies of an agreement for purchase and sale and nine copies of a non-competition agreement. If it is convenient, all shareholders can sign the original and duplicate of the agreement for purchase and sale, and I provided an extra copy in the event that you find it inconvenient to get all five signatures on the same form.

The non-competition agreement is to be signed separately by each shareholder. I am under the impression that there are five shareholders, but I am not sure. If you need more copies of either of these forms please let me know.

I will be glad to answer any questions you may have on the terms of these forms.

The purpose of the letter was to show to the Butler Loan shareholders the documents drafted by Thrift's attorneys that Thrift would require in closing the transaction. Thrift transmitted copies of the documents to permit McLennan to distribute them to the other shareholders of Butler Loan. Thrift felt that it was discharging an obligation to reveal the precise requirements and terms demanded by it in the transaction by sending the agreements that it would require to be executed at the closing. The agreements were blank as to amounts because Thrift was unable to fill in proper amounts due to the Shukis dispute which involved the amount to be paid for his stock.

On November 5, 1959, Hickox had no idea how the closing of the Thrift-Butler Loan transaction would take place. He did not know how many shareholders were involved in closing with Butler Loan.

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He did not know what procedure McLennan and the other Butler Loan shareholders might wish to employ with respect to the closing. He did not expect that the agreement forms sent by him to McLennan would be returned to Thrift signed in blank. It was anticipated by Hickox that McLennan and the...

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