Handelman v. C. I. R.

• Decision Date: 27 January 1975
• Docket Number: No. 37,D,37
• Citation: 509 F.2d 1067
• Parties: 75-1 USTC P 9208 Philip HANDELMAN and Esther Handelman, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant. ocket 74--1166.
• Court: U.S. Court of Appeals — Second Circuit

Page 1067

509 F.2d 1067

75-1 USTC P 9208

Philip HANDELMAN and Esther Handelman, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.

No. 37, Docket 74--1166.

United States Court of Appeals, Second Circuit.

Argued Dec. 4, 1974.

Decided Jan. 27, 1975.

Stephen M. Gelber, Washington, D.C. (Scott P. Crampton, Asst. Atty. Gen., Meyer Rothwacks, Jonathan S. Cohen, Tax Div., Dept. of Justice, of counsel), for appellant.

Robert M. Trien, New York City, for appellees.

Before KAUFMAN, Chief Judge, and ANDERSON and OAKES, Circuit Judges.

OAKES, Circuit Judge:

This is an appeal by the Commissioner of Internal Revenue from an adverse decision of the United States Tax Court, William H. Quealy, Judge, according capital gains treatment to $95,000 received by the taxpayers in connection with the purported sale of stock of Graphic Arts Exhibit Building, Inc. (Graphic Arts), and allowing taxpayers to deduct 60 per cent of their expenses incurred in connection with the maintenance and operation of a 46-foot sailing sloop during the taxable years 1963 to 1965, inclusive, as entertainment expense in connection with taxpayer Philip Handelman's business, the practice of law. ¹ We disagree with the Tax Court in both respects as a matter of law and accordingly reverse the judgment.

On or about January 20, 1961, taxpayer caused Graphic Arts to be organized under New York law for the purpose of constructing and leasing space in a building at the site of the New York World's Fair which was to be held in 1964--65. Apparently taxpayer had obtained a commitment for a particular lot on the World's Fair grounds on which a graphic arts pavilion was to be built. In June, 1961, an agreement was entered into with Thomas R. O'Connor providing that O'Connor was to be employed by Graphic Arts in exchange for advancing working capital in the amount of about $100,000, with the understanding that he was to acquire some stock in the corporation. Subsequently O'Connor, acting on behalf of himself and of his partner and financial backer, Joan G. Van de Maele, offered to purchase all of the stock of the Graphic Arts corporation. During 1961 Van de Maele paid Handelman $25,000 which he incidentally originally reported as ordinary income from his legal practice. In December, 1961, it was agreed that O'Connor and Van de Maele would buy 59 shares of Graphic Arts stock owned by the taxpayer and 24 shares belonging to a Dr. A. Alfred Solomon. Van de Maele accordingly executed on December 8, 1961, two notes payable to taxpayer on June 8, 1962, in the amounts of $50,000 and $17,000. Van de Maele and O'Connor also executed a note in the amount of $48,000 payable to Dr. Solomon. On February 20, 1962, and thereafter on March 26, 1962, Van de Maele made additional payments to taxpayer in the amounts of $30,000 and $40,000, respectively. These amounts were not applied in reduction of the two notes payable to taxpayer which had been executed in December, 1961. When the notes were presented for payment on June 8, 1962, they were returned unsatisfied.

Thereafter, by an agreement between the taxpayer and O'Connor dated June 13, 1962, O'Connor and Van de Maele jointly executed an additional note in the amount of $59,000, payable September 14, 1962, and it was provided that 88 shares of Graphis Arts stock, not the previous total of 83 shares, would be held in escrow, 63 shares to be delivered to O'Connor upon payment of the original notes of $50,000 and $17,000 payable to the taxpayer and $48,000 payable to Dr. Solomon. The remaining 25 shares were to be delivered after payment of the additional note of $59,000 executed on June 13, 1962. The terms of the agreement provided that the voting rights of the stock were to remain with taxpayer during the escrow and that in the event the notes were not paid by the closing date the stock was to be returned to him. The notes were not in fact paid. The escrow was accordingly terminated and the stock returned to taxpayer. He thereupon also became entitled to retain the original $25,000 payment made to him in 1961 by Van de Maele. This, together with the $70,000 cash received in February and March, 1962, made up the $95,000 here in question.

Thereafter on or about March 14, 1963. a second escrow arrangement was entered into under terms differing from those of the escrow agreement of June 13, 1962. Under the March 14, 1963, agreement, the taxpayer deposited 104 shares of Graphic Arts stock, 16 more shares than were covered by the agreement of June 13, 1962, and was to receive $150,000 or $24,000 more than was payable to him by virtue of the two notes of December, 1961, and the one note of June 13, 1962. This new escrow arrangement did not include the shares of Graphic Arts stock held by Dr. Solomon which had been included in the earlier escrow agreement. This arrangement was extended by still another escrow dated March 20, 1963, also providing that the stock was to be returned in the event payment was not made to the taxpayer. The payments were not in fact made and the escrow was terminated.

Thereafter taxpayer initiated an action against O'Connor and Van de Maele, not upon any purportedly enforceable contract of sale, but upon the three notes payable to him in the aggregate amount of $126,000 (i.e., $50,000, $17,000 and $59,000, respectively), also seeking, however, an additional $24,000 which was to have been paid under the escrow arrangement of March, 1963. Van de Maele and O'Connor in their answer in the Supreme Court of the State of New York asserted in defense the clauses of the escrow agreements of June 13, 1962, and March 14, 1963, directing the return of the stock and claimed that these provisions comported with an oral understanding of the parties to the effect that any agreement to purchase the stock would be cancelled if Van de Maele were unable to satisfy the notes. The state court held that this defense was insufficient and that parol evidence was impermissible to raise a defeasance provision in derogation of the unconditional terms of the promissory notes but denied taxpayer's motion for summary judgment insofar as it related to the additional $24,000, as 'not proved by document.' Meanwhile, the corporation had never erected any building, and, indeed, it defaulted on its lease of the business site and subsequently, in 1965, was dissolved by proclamation by the Secretary of State of New York for nonpayment of taxes.

Ultimately, in April, 1971, the litigation brought by taxpayer against Van de Maele and O'Connor was settled, with the partners paying taxpayer an additional $89,500 (not here in question) in return for a general release, the three notes held by him and certificates representing 64 shares of the then totally defunct Graphic Arts stock.

The question, thus, is whether there was a 'sale or exchange' within the meaning of § 1222(3) ² of the Internal Revenue Code, 26 U.S.C. § 1222(3), so that the $95,000 received by taxpayer was long-term capital gain therefrom.

Taxpayer does not really dispute the proposition that whether a sale or exchange occurred involves 'the legal characterization, for federal income tax purposes, of the transactions between the parties' which is 'not a question of fact, but rather one of law' fully reviewable by us on appeal. Union Planters National Bank of Memphis v. United States, 426 F.2d 115, 117 (6th Cir.), cert. denied, 400 U.S. 827, 91 S.Ct. 53, 27 L.Ed.2d 56 (1970).

Where a seller receives payment but retains control and dominion over the capital asset so that the agreement remains executory and is ultimately uncompleted, he cannot obtain the benefit of the capital gains provision of the Code. Mittleman v. Commissioner, 56 T.C. 171, 178--179 (1971), aff'd, 464 F.2d 1393 (3d Cir. 1972) (per curiam) (advance on purchase of stock retained by seller when purchaser withdrew treated as ordinary income); Smith v. Commissioner, 50 T.C. 273 (1968), aff'd, 418 F.2d 573 (9th Cir. 1969) (per curiam) (deposit on contract to purchase stock treated as ordinary income to seller when purchase not completed); Binns v. United States, 385 F.2d 159 (6th Cir. 1967) (amount of down payment retained by seller when buyer failed to complete purchase of stock was ordinary income although stock was escrowed, despite absence of liquidated damage provision); Melone v. Commissioner, 45 T.C. 501 (1966) (amount received by seller on settlement of litigation over buyer's failure to complete purchase of residential property treated as ordinary income because seller regained possession upon default and sale not completed); Boatman v. Commissioner, 32 T.C. 1188, 1192 (1959) (amount received by seller from settlement entered into when agreement for sale of farm not completed treated as ordinary income since no sale or exchange occurred); Johnson v. Commissioner, 32 B.T.A. 156, 161 (1935) (amount received by seller when purchaser failed to complete purchase of stock treated as ordinary income).

Here Van de Maele and O'Connor entered into executory agreements, but none of these was ever consummated. Taxpayer retained all the voting rights to the stock, one circumstance indicating that a sale or exchange was never completed. See Kuehner v. Commissioner, 214 F.2d 437, 441 (1st Cir. 1954). The payments received were to secure taxpayer's agreement to escrow the particular number of shares of Graphic Arts stock to which each executory transaction related. No part of the $95,000 was ever applied in reduction of the notes. Rather, taxpayer brought suit on the notes and no credit on them was given for the $95,000 payments made. Thus, the payments were more in the nature of liquidated damages; as such they were taxable as ordinary income. Mittleman, Smith, Melone, Boatman, and Johnson, supra. There need have been no specific provision for liquidated damages in any of the escrow agreements. Binns v. United States, supra; Melone v. Commissioner, supra; Myers v. Commissioner, 287 F.2d 400 (6th Cir.), cert....