Eisler v. Comm'r of Internal Revenue , Docket No. 7463-70.

• Citation: 59 T.C. 634
• Decision Date: 05 February 1973
• Docket Number: Docket No. 7463-70.
• Parties: GEORGE EISLER AND RIANE EISLER, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: United States Tax Court

59 T.C. 634

GEORGE EISLER AND RIANE EISLER, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 7463-70.

United States Tax Court

Filed February 5, 1973.

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...