Diamond v. CIR

• Decision Date: 27 February 1974
• Docket Number: No. 71-1760.,71-1760.
• Citation: 492 F.2d 286
• Parties: Sol DIAMOND and Muriel Diamond, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

492 F.2d 286 (1974)

Sol DIAMOND and Muriel Diamond, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 71-1760.

United States Court of Appeals, Seventh Circuit.

Argued December 11, 1972.

Decided February 27, 1974.

Richard Weinberger, Chicago, Ill., for petitioners-appellants.

Scott P. Crampton, Asst. Atty. Gen., John A. Townsend, Atty., Tax Div., Dept. of Justice, Washington, D. C., for respondent-appellee.

Before KILEY, Senior Circuit Judge, and FAIRCHILD and SPRECHER, Circuit Judges.

FAIRCHILD, Circuit Judge.

This is an appeal from a decision of the Tax Court upholding the commissioner's assessment of deficiencies against Sol and Muriel Diamond¹ for the years 1961 and 1962. The deficiencies for each year were consolidated for trial, but are essentially unrelated. The Tax Court concluded that Diamond realized ordinary income on the receipt of a right to a share of profit or loss to be derived from a real estate venture (the 1962 partnership case), and that certain commission payments he made were not deductible business expenses (the 1961 commissions case). The facts in both cases appear in Diamond v. Commissioner, 56 T.C. 530 (1971). Unnecessary repetitions will be avoided.

The 1962 Partnership Case.

During 1961, Diamond was a mortgage broker. Philip Kargman had acquired for $25,000 the buyer's rights in a contract for the sale of an office building. Kargman asked Diamond to obtain a mortgage loan for the full $1,100,000 purchase price of the building. Diamond and Kargman agreed that Diamond would receive a 60% share of profit or loss of the venture if he arranged the financing.

Diamond succeeded in obtaining a $1,100,000 mortgage loan from Marshall Savings and Loan. On December 15, 1961 Diamond and Kargman entered into an agreement which provided:

(1) The two were associated as joint venturers for 24 years (the life of the mortgage) unless earlier terminated by agreement or by sale;

(2) Kargman was to advance all cash needed for the purchase beyond the loan proceeds;

(3) Profits and losses would be divided, 40% to Kargman, 60% to Diamond;

(4) In event of sale, proceeds would be devoted first to repayment to Kargman of money supplied by him, and net profits thereafter would be divided 40% to Kargman, 60% to Diamond.

Early in 1962, Kargman and Diamond created an Illinois land trust to hold title to the property. The chief motivation for the land trust arrangement was apparently to insulate Diamond and Kargman from personal liability on the mortgage note.

The purchase proceeded as planned and closing took place on February 18, 1962. Kargman made cash outlays totalling $78,195.33 in connection with the purchase. Thus, under the terms of the agreement, the property would have to appreciate at least $78,195.33 before Diamond would have any equity in it.

Shortly after closing, it was proposed that Diamond would sell his interest and one Liederman would be substituted, except on a 50-50 basis. Liederman persuaded Diamond to sell his interest for $40,000. This sale was effectuated on March 8, 1962 by Diamond assigning his interest to Kargman for $40,000. Kargman in turn then conveyed a similar interest, except for 50-50 sharing, to Liederman for the same amount.

On their 1962 joint return, the Diamonds reported the March 8, 1962 $40,000 sale proceeds as a short term capital gain. This gain was offset by an unrelated short term capital loss. They reported no tax consequences from the February 18 receipt of the interest in the venture. Diamond's position is that his receipt of this type of interest in partnership is not taxable income although received in return for services. He relies on § 721 and Reg. § 1.721-1(b)(1).² He further argues that the subsequent sale of this interest produced a capital gain under § 741. The Tax Court held that the receipt of this type of interest in partnership in return for services is not within § 721 and is taxable under § 61 when received. The Tax Court valued the interest at $40,000 as of February 18, as evidenced by the sale for that amount three weeks later, on March 8.

Both the taxpayer and the Tax Court treated the venture as a partnership and purported to apply partnership income tax principles. It has been suggested that the record might have supported findings that there was in truth an employment or other relationship, other than partnership, and produced a similar result, but these findings were not made. See Cowan, The Diamond Case, 27 Tax Law Review 161 (1972). It has also been suggested (and argued, alternatively, by the government) that although on the face of the agreement Diamond appeared to receive only a right to share in profit (loss) to be derived, the value of the real estate may well have been substantially greater than the purchase price, so that Diamond may really have had an interest in capital, if the assets were properly valued. This finding was not made. The Tax Court, 56 T.C. at 547, n. 16, suggested the possibility that Diamond would not in any event be entitled to capital gains treatment of his sale of a right to receive income in the future, but did not decide the question.³

Taking matters at face value, taxpayer received, on February 18, an interest in partnership, limited to a right to a share of profit (loss) to be derived. In discussion we shall refer to this interest either as his interest in partnership or a profit-share.

The Tax Court, with clearly adequate support, found that Diamond's interest in partnership had a market value of $40,000 on February 18. Taxpayer's analysis is that under the regulations the receipt of a profit-share February 18, albeit having a market value and being conferred in return for services, was not a taxable event, and that the entire proceeds of the March 8 sale were a capital gain. The Tax Court analysis was that the interest in partnership, albeit limited to a profit-share, was property worth $40,000, and taxpayer's acquisition, thereof on February 18 was compensation for services and ordinary income. Assuming that capital gain treatment at sale would have been appropriate, there was no gain because the sale was for the same amount.

There is no statute or regulation which expressly and particularly prescribes the income tax effect, or absence of one, at the moment a partner receives a profit-share in return for services. The Tax Court's holding rests upon the general principle that a valuable property interest received in return for services is compensation, and income. Taxpayer's argument is predicated upon an implication which his counsel, and others, have found in Reg. § 1.721-1(1)(b), but which need not, and the government argues should not, be found there.

26 U.S.C. § 721 is entitled "Nonrecognition of gain or loss on contribution," and provides: "No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership." Only if, by a strained construction, "property" were said to include services, would § 721 say anything about the effect of furnishing services. It clearly deals with a contribution like Kargman's, of property, and prescribes that when he contributed his property, no gain or loss was recognized. It does not, of course, explicitly say that no income accrues to one who renders services and, in return, becomes a partner with a profit-share.

Reg. § 1.721-1 presumably explains and interprets § 721, perhaps to the extent of qualifying or limiting its meaning. Subsec. (b)(1), particularly relied on here, reads in part as follows:

"Normally, under local law, each partner is entitled to be repaid his contributions of money or other property to the partnership (at the value placed upon such property by the partnership at the time of the contribution) whether made at the formation of the partnership or subsequent thereto. To the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services (or in satisfaction of an obligation), section 721 does not apply. The value of an interest in such partnership capital so transferred to a partner as compensation for services constitutes income to the partner under section 61. . . ."

The quoted portion of the regulation may well be read, like § 721, as being directly addressed only to the consequences of a contribution of money or other property. It asserts that when a partner making such contributions transfers to another some part of the contributing partner's right to be repaid, in order to compensate the other for services or to satisfy an obligation to the other, § 721 does not apply, there is recognition of gain or loss to the contributing partner, and there is income to the partner who receives, as compensation for services, part of the right to be repaid.

The regulation does not specify that if a partner contributing property agrees that, in return for services, another shall be a partner with a profit-share only, the value of the profit-share is not income to the recipient. An implication to that effect, such as is relied on by taxpayer, would have to rest on the proposition that the regulation was meant to be all inclusive as to when gain or loss would be recognized or income would exist as a consequence of the contribution of property to a partnership and disposition of the partnership interests. It would have to appear, in order to sustain such implication, that the existence of income by reason of a creation of a profit-share, immediately having a determinable market value, in favor of a partner would be inconsistent with the result specified in the regulation.

We do not find this implication in our own reading of the regulation. It becomes necessary to consider the substantial consensus of commentators in favor of the principle claimed to...