Hatch's Estate v. Commissioner of Internal Revenue

• Citation: 198 F.2d 26
• Decision Date: 19 June 1952
• Docket Number: No. 12928.,12928.
• Parties: HATCH'S ESTATE v. COMMISSIONER OF INTERNAL REVENUE.
• Court: United States Courts of Appeals. United States Court of Appeals (9th Circuit)

198 F.2d 26 (1952)

HATCH'S ESTATE v. COMMISSIONER OF INTERNAL REVENUE.

No. 12928.

United States Court of Appeals Ninth Circuit.

June 19, 1952.

Frederic D. Dassori, Dee R. Bramwell, Washington, D. C. (Edwin A. Mooers, Jr., Stokes, Bramwell & Dassori, Washington, D. C., of counsel), for petitioners.

Ellis N. Slack, Acting Asst. Atty. Gen., Lee A. Jackson, Melva M. Graney, Loring M. Post, Sp. Assts. to the Atty. Gen., for respondent.

Before DENMAN, Chief Judge, and STEPHENS and BONE, Circuit Judges.

STEPHENS, Circuit Judge.

On December 1, 1942, Herbert B. Hatch, now deceased, Juanita O. Hatch, and Herbert B. Hatch, Jr., all of Stockton, California, entered into a partnership under the laws of California for, and thereafter they conducted a business of, selling, distributing, repairing, and servicing motor vehicles and motor vehicle parts at wholesale and retail under the business name of Hatch Chevrolet Co.¹ On February 16, 1944, the partners and King M. Chase signed a written agreement providing for the sale of "all of the business of Hatch Chevrolet Company" to Chase and that Chase should take "possession of the physical assets of the business" on February 21, 1944, with "permission to operate the business under the name of Hatch Chevrolet Company for a limited period of time to enable him to make the necessary arrangements for the future title or trade name of said business." (All of the above quotations are from the written instrument.)

Pursuant to the agreement the parties executed a Bill of Sale on the 3rd day of March, 1944, to personal property described in detail,² and $161,807.77 was paid by check and thereafter deposited by the co-partners in their co-partner bank account where it remained intact until June, 1944, a couple of weeks after the death of Herbert B. Hatch. All of the partnership assets were transferred except for $35,249.90 in cash, two automobiles of the total book value of $1,542.66 and debts owing in the amount of $15,588.55.

An amended partnership return of income for the fiscal year beginning July 1, 1943, and ending June 30, 1944, was filed by the "Hatch Chevrolet Company" on September 19, 1944, by which the partnership reported an ordinary net income in the amount of $75,444.43 and a long-term capital gain from the sale of the business of $36,669.07, of which $18,334.54, or one-half, was taken into account in the computation of taxes.³ Since a partnership is not taxable as a whole, the taxpayers reported their individual incomes for 1944 as follows:

                                                   Recognized
                                  Ordinary         Long Term
                                   Income        Capitol Gains
                  Herbert B. Hatch .... $42,337.04  $ 9,778.42
                  Juanita O. Hatch ....  27,431.85    7,089.35
                  Herbert B. Hatch, Jr.   5,675.54    1,466.77
                                        __________  __________
                                        $75,444.43  $18,334.54
                

The Commissioner disagreed with the taxpayers' treatment of the tax aspects of the sale, and on February 20, 1948, notified them of a deficiency in each of their returns for the tax year 1944. The Commissioner allowed a capital gain in the amount of $22,486.36, which is recognizable for tax purposes to the extent of $11,243.18; but assessed a deficiency on the ground that gain from the sale in the amount of $14,182.71 was ordinary income from the sale of property other than capital assets. As divided among the individual taxpayers the deficiencies claimed are as follows:

                  Estate of Herbert B. Hatch, Deceased ....... $3,702.31
                  Juanita O. Hatch ...........................  2,199.38
                  Herbert B. Hatch, Jr. ......................    187.22
                

The Commissioner's deficiency assessment against each of the appellants was sustained by the Tax Court, 14 T.C. 251, in accordance with the following thesis: "Where individuals acting as partners sell to another most of the assets of a partnership subject to some of its liabilities, without a distribution of the assets to the partners prior to the sale, and the partnership survives the sale, the transaction is a sale by the partnership of some of its assets and not a sale by the partners individually of their interests in the partnership, for the purpose of determining to what extent the gain realized upon the sale is taxable to the partners as capital gain." The taxpayers appeal from the decision of the Tax Court.

Generally speaking, the rule used by the Tax Court appears sound enough, but in dealing with a tax matter we must be guided by the substance and effect of what was done. United States v. Phellis, 1921, 257 U.S. 156, 168, 42 S.Ct. 63, 66 L.Ed. 180. This is not to say that we are to disregard the language used in a contract which may be involved, or the methods used to effect the transaction. But rather, we must consider the form and steps used in their relation to the intended and accomplished entire transaction. Halliburton v. C. I. R., 1935, 9 Cir., 78 F.2d 265. As the old homely saying has it, "The tail must not wag the dog."

The Commissioner contends, and the Tax Court held, that what the taxpayers sold were the various separate assets of the business, the gains from which would be the subject of ordinary income for tax purposes, and not their partnership interests at all. Decision in this case pivots on this point.

Section 117(b) of the Internal Revenue Code permits a person who sells a capital asset which he has held for over 6 months to report only 50 per centum of his gain or loss for income tax purposes. A partnership is not a taxable entity. Thus, persons who carry on business in partnership are liable for income tax in their individual capacities. Section 181, I.R.C., 26 U.S. C.A. § 181. And in computing the net income of each partner, the distributive share of the partnership's gains or losses from its sales or exchanges of capital assets held for over 6 months must be reported as part of the partner's capital gains or losses whether or not distribution has been made to him. Section 182(b), I.R.C., 26 U.S. C.A. § 182(b).

Where a partnership interest had been sold, the Commissioner of Internal Revenue for many years treated it as the sale of the selling partner's undivided interest in each specific partnership asset and thus ordinary income to the partner under Section 182(c) I.R.C. This position was based on the reasoning that since a partnership, both at common law and as codified under the Uniform Partnership Act,⁴ is "an association of two or more persons to carry on as co-owners a business for profit",⁵ it is not an entity in which a person could have a separate and distinct part interest. And since each partner "is co-owner with his partners of specific partnership property holding as a tenant in partnership,"⁶ any sale by a partner of what he owned in a partnership amounted to the sale of his undivided share of each specific partnership asset.

However, in 1950, the Commissioner of Internal Revenue acquiesced to the overwhelming case authority⁷ to the effect that for income tax purposes the sale of a partnership interest in a going concern should be treated as the sale of a capital asset.⁸ Such has been the rule in this circuit since the decision of Stilgenbaur v. United States, 9 Cir., 1940, 115 F.2d 283, 286, 287. For despite the fact that a partner is said to be a co-owner of "specific partnership property", his right to possess such property is limited to partnership purposes,⁹ and his right to the specific property is non-assignable.¹⁰ Thus, the nature of the interest which a partner actually has in the partnership itself is the right to share in profits and surplus¹¹ and the right to share in the net value of the partnership after settlement of its affairs. Clarke v. Fiedler, 1941, 44 Cal.App.2d 838, 113 P.2d 275. And this partnership interest is personal property which is separate and distinct from his co-ownership of the specific partnership property. Dudley T. Humphrey v. C. I. R., 1935, 32 B.T.A. 280.

The Commissioner qualified his acquiescence to the treatment of a partnership interest as a capital asset with the proviso: "The application of this rule should, of course, be limited to those cases in which the transaction in substance and effect, as distinguished from form and appearance, is essentially the sale of a partnership interest. See Estate of Herbert B. Hatch, et al. v. Commissioner, 14 T.C. 251."¹² While we agree with the statement of the Commissioner, we believe it is unsupported by the facts of the case cited.

Thus the controversy here is reduced to a determination of whether what the taxpayers sold were the business assets, and as such the source of ordinary income, or their partnership interests, and as such the source of capital gains.

The Commissioner contends that this was a sale of the business assets since the Bill of Sale sets forth the specific items of personal property which were transferred.¹³ He further argues that the taxpayers did not sell their partnership interests since they kept all of the firm's cash in the amount of $35,249.90, two used automobiles, certain partnership liabilities, the garage, the Chevrolet sales and service franchise, the good will, and the firm name, all of which would enable the taxpayers to continue the partnership business. And finally, the Commissioner contends that the taxpayers continued to keep the partnership in existence, after the sale here involved, as evidenced by the fact that the proceeds of the sale were kept in the bank under the name of the Hatches, as co-partners, without distribution until several months after the sale; and that appellants filed a partnership return of income on September 19, 1944.

The first suggestion is that the list of assets set forth in the Bill of Sale is the exclusive list of what was sold. However, this document must be read as a part of the whole transaction. The list of property entitled "Bill of Sale" was only an appendage to the principal agreement which was embodied in the...