Flower v. Comm'r of Internal Revenue , Docket No. 7432-70.

Decision Date31 October 1973
Docket NumberDocket No. 7432-70.
Citation61 T.C. 140
CourtU.S. Tax Court


Morgan Hunter, for the petitioners.

Robert H. Jones, for the respondent.

1. Payments received by petitioner under an agreement terminating a contract under which petitioner had the right to perform personal services on a commission basis is taxable to petitioners as ordinary income rather than capital gain.

2. Business expenses paid by petitioner under an agreement which provided that petitioner would be reimbursed for the expenses upon termination of the agreement are not deductible as ordinary and necessary expenses of petitioner's business.


Respondent determined deficiencies in petitioners' Federal income tax as follows:

                ¦Year  ¦Deficiency   ¦
                ¦      ¦             ¦
                ¦1965  ¦$3,415.34    ¦
                ¦1966  ¦5,057.73     ¦
                ¦1967  ¦4,780.37     ¦

The issues for decision are: (1) Whether petitioners are entitled to capital gains treatment on payments received under a contract which purported to terminate a sales franchise agreement petitioner husband had with Rowell Laboratories, Inc.; and (2) whether petitioners are entitled to certain deductions for business expenditures made under a reimbursement agreement.

FINDINGS of fact

Certain facts have been stipulated and are found accordingly.

Petitioners Harry M. and Gail Flower, husband and wife, filed joint Federal income tax returns for the years 1965, 1966, and 1967, with the district director of internal revenue at Austin, Tex. Petitioners resided Aransas, Tex., at the time the petition was filed. Petitioner will hereafter refer to Harry M. Flower; Gail Flower is before the Court only because she signed the couple's joint returns.

From February 10, 1942, until August 1, 1961, petitioner served as promotional and sales representative for Rowell Laboratories, Inc., formerly Burbot Liver Products Co., of Baudette, Minn., a manufacturer of pharmaceutical products. Hereinafter, this concern will be referred to as Rowell. Rowell had been incorporated August 29, 1935, and was then engaged in the manufacture and sale of burbot (a fresh water fish of the cod family) liver oil, rich in vitamins A and D.

In January 1941, petitioner moved to the Minneapolis-St. Paul, Minn., area with tentative agreements to work as a sales representative for several manufacturers there. Petitioner first became associated with Rowell on February 10, 1942, when he began to promote the latter's products along with those of the other manufacturers he represented, all on a commission basis.

On July 18, 1944, petitioner and Rowell entered into the first of several written contracts relative to petitioner's representation of Rowell. The pertinent features of the agreement were that: (1) No specific territory was allotted to petitioner; (2) petitioner explicitly reserved the right to represent one other company in a sales capacity, but was to be able to represent others only upon Rowell's written consent; (3) one-half of petitioner's commissions over $3,600 was to be spent by him directly on promoting the sale of Rowell's products to the pharmaceutical and medical professions; and (4) either party could terminate the agreement on advance notice of 3 months plus 1 month for every year the agreement lasted beyond 1944.

Promotional and sales efforts in the prescription drug industry are directed primarily at physicians, even though retail sales— and wholesale purchases, upon which petitioner's commissions depend— are made by pharmacists. Such promotional efforts are not based upon price competition, but on persuasion of the quality and purity of the drug in question.

Petitioner's first contacts with physicians in promotion of Rowell's products came through retail pharmacists with whom he had established close personal friendships. His practice thereafter was to build business in a particular area by establishing a nucleus of friends among local doctors and pharmacists and then to hire a salesman to take over the area. Petitioner and his salesmen depended heavily on regular frequent personal contact with physicians to gain their confidence in, and assure them of the availability of, Rowell's products.

In December 1953, petitioner organized Harry M. Flower, Inc., a corporation of which petitioner was at all times president and sole shareholder. In February 1954, petitioner entered into a licensing agreement with the corporation under which the corporation was to perform all duties required of petitioner under his agreements with Rowell and was to receive all compensation petitioner was entitled to under the agreements, but petitioner reserved unto himself all provisions under the agreements relating to petitioner's death, disability, or retirement. The license agreement could be terminated by petitioner on a 30 days' notice and it was agreed that the instrument did not constitute an assignment of the contracts with Rowell. Thereafter until August 1, 1961, the corporation performed petitioner's promotional and selling obligations under petitioner's contracts with Rowell, employed the salesmen, received the compensation due petitioner, and paid the related expenses. By 1961 there were eight salesmen, in addition to petitioner, performing the above functions as employees of the corporation. The corporation was dissolved after the termination of petitioner's contract with Rowell in 1961.

In 1946 and 1954, petitioner and Rowell executed agreements which substantially specified and then increased petitioner's sales territory. Rowell consented to petitioner's licensing of the corporation, Harry M. Flower, Inc., to perform his sales duties. Petitioner, however, was required to be in his territory personally performing his duties 30 weeks per year from 1954 to 1959 and was to spend one-half of his commission income directly on promoting sale of Rowell's products. Rowell could terminate the agreements upon 6 months' notice for petitioner's disability to perform; either party could terminate upon 30 days' notice for default of the other party.

On December 21, 1955, petitioner and Rowell executed an agreement incorporating and modifying their earlier agreements. The new contract provided, in pertinent part:

WHEREAS, the parties hereto do desire to enter into a new agreement incorporating the original agreement of January 1, 1946 and all changes and modifications thereto to facilitate the interpretation of said contract of January 1, 1946 and contracts supplemental thereto, and

WHEREAS, the parties hereto desire to make certain modifications and amendments to the foregoing agreements and the agreements supplementary thereto, and

WHEREAS, Flower has expended large sums since the 1st day of January 1946 in developing his selling organization and in promoting and selling the products of Manufacturer (Rowell) and has invested substantial sums in said organization.

Now THEREFORE, in consideration of the respective covenants herein contained and the sum of One Dollar ($1.00) in hand paid by Flower to the Manufacturer, the receipt whereof is hereby acknowledged, the parties hereto agree as follows:

1. The Manufacturer agrees to appoint Flower and Flower agrees to act in the capacity of an independent contractor as the promotional and selling representative of the Manufacturer in the States of Minnesota, North Dakota, South Dakota, Texas, the northern peninsula of Michigan, and such portions of the northern portion of the State of Wisconsin and the eastern portion of the States of Montana and Wyoming as the parties hereto have or shall agree upon from time to time, and Flower shall so act during the life of this agreement for the sale of pharmaceutical or drug products of the Manufacturer for human consumption. * * *

2. Flower agrees to represent and promote the sale of said products within said territory to wholesale and retail drug companies or drug merchandisers and to the medical profession to the best of his ability, energy and skill. Flower may use his own methods for carrying out the terms of this agreement and for the sale of said products so long as they are not in conflict with the policies and methods of Manufacturer and need devote only such time thereto as he deems necessary, except as is hereinafter provided. Flower agrees not to represent, handle or sell any other products of a competitive or non-competitive nature. Flower further agrees that he and his license shall devote all of their ability, energy and skill exclusively for the promotion and sale of the products of Manufacturer and that all salesmen employed by Flower or his licensee shall likewise devote all of their ability, energy and skill exclusively for the promotion and sale of the products of Manufacturer. It is understood that Flower shall have the right to employ, at his own expense, salesman to assist him in the promotion and sale of such products within said territory. Such salesmen shall be employees of Flower and not of the Manufacturer, and the Manufacturer shall have no right to supervise the activities of Flower or of his salesmen, except to see that the terms of this agreement are being performed. * * *

3. The Manufacturer shall pay Flower a commission on all eligible sales as defined in Subparagraph (a) hereof. * * * (a) Eligible sales upon which a commission shall be paid hereunder shall include all sales of all products of the Manufacturer for human consumption made by or on behalf of the Manufacturer in the States of Minnesota, North Dakota, South Dakota, Texas, the norther peninsula of Michigan and the portions of norther Wisconsin and eastern Montana and Wyoming as hereinabove set forth, during the life of this agreement, * * *

5. Flower agrees that he or his licensee will expend in each...

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