Estate of Cartwright v. Commissioner
| Decision Date | 20 June 1996 |
| Docket Number | Docket No. 1447-94. |
| Citation | 71 T.C.M. 3200 |
| Parties | Estate of Robert E. Cartwright, Deceased, Dorothy G. Cartwright, Executrix v. Commissioner. |
| Court | U.S. Tax Court |
John M. Youngquist, San Francisco, Calif., and Donald L. Feurzeig, for the petitioner. Cynthia K. Hustad and Elaine L. Sierra, for the respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
Respondent determined that the Estate of Robert E. Cartwright (petitioner) had a deficiency in Federal income tax of $1,142,472 for 1988.
Robert E. Cartwright (decedent) owned 71.43 percent of the stock of the law firm of Cartwright, Slobodin, Bokelman, Borowsky Wartnick, Moore & Harris, Inc. (CSB), a subchapter C corporation. CSB bought life insurance which paid $5,062,029 to CSB upon decedent's death. CSB paid that amount to decedent's estate. After concessions, the issues for decision are:
1. Whether the life insurance proceeds were paid to decedent's estate solely to redeem his CSB stock, as petitioner contends, or partly for his CSB stock and partly for any claims for cases or work in process, as respondent contends. We hold that $1,105,762 of the payment was for decedent's CSB stock, and the remainder was for any claims for cases or work in process.
2. Whether the part of the payment which was made for any claims for cases or work in process is income in respect of a decedent under section 691. We hold that it is.
Section references are to the Internal Revenue Code in effect for the year in issue. Rule references are to the Tax Court Rules of Practice and Procedure.
At the request of CSB, which request neither party opposed, we sealed parts of the transcript and certain documents which were admitted into evidence.
Some of the facts have been stipulated and are so found. Dorothy G. Cartwright lived in California when she filed the petition.
Decedent was born on July 9, 1925. He earned his bachelor of science degree, with honors, from the University of California at Berkeley in 1948, and his law degree, with honors, from the Boalt Hall School of Law, University of California in 1951. Decedent was admitted to practice law in California in 1951. He concentrated his practice in personal injury and products liability law. He authored articles in professional journals and coauthored several treatises on products liability law.
In 1969, decedent and several others started a law firm. They incorporated the firm of Cartwright, Saroyan, Martin & Sucherman, Inc. (CSB),1 as a professional corporation under California law. CSB's office is in San Francisco. CSB has always been a subchapter C corporation. Decedent was CSB's majority shareholder and chairman of the board until he died.
CSB's shareholders were attorneys licensed to practice law in California. A shareholder could sell his shares only to an existing CSB shareholder unless the other shareholders consented to a sale. In the 1973 shareholders' agreement (described in par. C below), CSB set the price of the stock very low and did not consider its value. This was done to give new shareholders an incentive to stay with the firm and to produce business. Decedent and several other shareholders paid $1 per share. Shareholders who joined CSB after 1973 paid $13 and $15 per share.
CSB specialized in personal injury law. CSB earned contingency fees based on the amount awarded to a client in each case. Under CSB's client contingency fee arrangement,2 the client paid fees only if money was obtained by settlement or a judgment. CSB advanced the out-of-pocket costs. For cases settled before trial, CSB deducted costs and then took one-third as attorney's fees and gave two-thirds to the client. For cases that went to trial, CSB deducted out-of-pocket costs, took 40 percent as attorney's fees, and gave 60 percent to the client.
CSB paid a salary to each associate and shareholder. CSB did not pay dividends. Each year, CSB distributed any money not needed for operating expenses as bonuses to the associates and shareholders. CSB's shareholders met to decide how much of the profits each shareholder would receive. CSB paid bonuses based on each attorney's contribution to CSB. There was no formula to calculate each shareholder's bonus. Compensation and bonuses were not set based on how many shares each shareholder owned.
Associates received referral fees but shareholders did not. If an associate brought a case to CSB (i.e., was the "source attorney"), he or she would get 25 percent of CSB's fees after the first $5,000. CSB kept records showing who brought each case to CSB and showing which attorney had a right to receive fees.
CSB's shareholders executed a shareholders' agreement (the 1973 agreement) on January 23, 1973. Under the 1973 agreement, CSB agreed to buy a deceased shareholder's interest in CSB and pay the shareholder's widow3 or estate the following amounts:
1. The amount the deceased shareholder paid for his stock.
2. A share of the amount of any earned but unpaid corporate profits or dividends.
3. The amount of any earned but unpaid salary of the deceased shareholder.
4. The amount of any incurred expenses or loans unreimbursed to the shareholder.
5. Twenty-five percent of the net amount received by CSB after the shareholder's death for cases the deceased shareholder brought to CSB.
6. Ten percent of the net amount CSB received on cases pending when the shareholder died which came to CSB because of the CSB firm name or which were brought by an associate.
7. Twenty-five percent of the net amount received during the 3 years after the shareholder's death from business clients who the deceased shareholder brought to CSB.
8. One-half of the proceeds of life insurance bought by CSB on the life of the deceased shareholder to apply towards the amounts listed in 1.-7., above.
Article IV of the 1973 agreement provides for the buyout of the interest of a shareholder who dies, retires, becomes disabled, or is expelled. The 1973 agreement grants a lien to the deceased shareholder's widow for the amount of the percentages listed in the 1973 agreement of fees earned on cases for which the deceased shareholder was entitled to be paid.
Shareholder H. Greig Fowler (Fowler) left CSB in August 1984. Under the 1973 agreement, CSB owed Fowler $31,794 for his share of CSB's retained earnings when he left the firm plus the amount he paid for his stock. CSB and Fowler agreed in October 1986 that CSB would pay him $25,000 for his stock ($25 per share) and for any claims he had against CSB arising out of his employment by CSB. Fowler agreed to reimburse CSB for any client costs it advanced and to pay CSB 25 percent of the net fees he recovered on any case he took with him.
In 1987, shareholder Lowell Sucherman (Sucherman) left CSB. Under the 1973 agreement, CSB owed Sucherman $233,698 for his share of CSB's retained earnings when he left the firm plus the amount he paid for his stock. CSB offset what it owed Sucherman under the 1973 agreement by the costs it advanced on cases that he took with him and paid him $185,000 (about $46 per share). Sucherman agreed to pay CSB 25 percent of the net fees he recovered on any of the cases he took with him.
The shareholders amended the 1973 agreement on January 4, 1988. The 1988 amendment applied only to decedent.
Decedent's interest in CSB consisted of stock and claims to fees earned on cases he brought to CSB. Under the 1973 agreement, CSB would have owed a large amount to decedent's estate because decedent had brought more than one-half of the pending cases to CSB when he died. Decedent wanted to amend the 1973 agreement in 1988 to provide enough funds to maintain his widow's standard of living and to make it easier for CSB to survive his departure.
Under the 1988 amendment, CSB bought two life insurance policies on decedent's life from Prudential Insurance Co. of America (Prudential). Each policy paid a $2,500,000 death benefit. CSB paid monthly premiums of $10,000 to $11,000 for the two policies. CSB owned and was the beneficiary under the policies. The 1988 amendment stated that the amount of the life insurance proceeds equaled the value of decedent's stock and any claims on behalf of decedent for cases or work in process. It also stated that payment of the insurance proceeds extinguished any claims that decedent or his estate might make against CSB for his interest in CSB and work in process.4
Decedent died on June 30, 1988. No other CSB shareholder had died or retired before decedent. Decedent lived in California when he died. His widow, Dorothy G. Cartwright, was appointed executrix of his estate on August 18, 1988.
In June 1988, the following people owned CSB stock:
Shareholder Ownership Percentage Number of Shares
Robert E. Cartwright ................................. 71.43 10,000
Jack L. Slobodin ..................................... 10.71 1,500
Robert U. Bokelman ................................... 3.57 500
Philip Borowsky ...................................... 3.57 500
Harry F. Wartnick .................................... 3.57 500
Michael B. Moore ..................................... 3.57 500
Lee S. Harris ........................................ 3.57 500
_____ ______
99.991 14,000
1 The stipulation does not state why the ownership percentages total only 99.99 percent
F. The Estate's Receipt and Tax Treatment of the Life Insurance Proceeds
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