Kingsbury v. Comm'r of Internal Revenue

Decision Date03 March 1976
Docket NumberDocket No. 8444-72.
Citation65 T.C. 1068
PartiesHOWARD G. KINGSBURY AND ANNA Z. KINGSBURY, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
CourtU.S. Tax Court

OPINION TEXT STARTS HERE

In 1962 petitioner entered into an agreement with Mildred Sekyra, whereby petitioner took over the operation of a cardroom on premises owned by Sekyra. The agreement called for fixed monthly payments from petitioner to Sekyra. There was no formal assignment of Sekyra's license to operate the cardroom because any such assignment would have resulted in revocation of the license by county officials. In 1965 county officials determined that the 1962 agreement between petitioner and Sekyra was in fact an assignment of the license to operate a cardroom and, consequently, suspended the license. In January 1966 petitioner and Sekyra entered into a settlement agreement terminating their prior operating agreement. Under the settlement agreement petitioner was to receive a lump-sum payment of $14,000 plus 25 percent of the first $416,000 of the club's gross receipts in each year until February 1977.

1. Held: The 1962 agreement constituted a lease, the termination of which was a sale or exchange of property described in sec. 1231. Payments received pursuant to the settlement agreement were capital gains subject to recapture under sec. 1245 of depreciation taken with respect to the leasehold.

2. Held, further, amounts received pursuant to the settlement agreement are not subject to the self-employment tax.

3. Held, further, petitioner must include in income for 1966 the principal amount of a promissory note received in that year.

4. Held, further, petitioner realized commission income in 1966 in the amount of $2,042. Horace N. Freedman and Stephen Solomon, for the petitioners.

IRWIN, Judge:

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

+--------------------+
                ¦Year  ¦Amount       ¦
                +------+-------------¦
                ¦      ¦             ¦
                +------+-------------¦
                ¦1966  ¦$40,948.60   ¦
                +------+-------------¦
                ¦1967  ¦1  35,905.73 ¦
                +------+-------------¦
                ¦1968  ¦25,405.00    ¦
                +------+-------------¦
                ¦1969  ¦38,024.00    ¦
                +--------------------+
                
                

After concessions by the parties, the issues remaining for decision are as follows:

(1) The proper characterization of payments received upon the termination of an agreement which gave the petitioner husband the right to operate a cardroom.

(2) Whether amounts received pursuant to a settlement agreement are subject to the self-employment tax.

(3) Whether petitioners must include in income in 1966 the principal amount of a promissory note received in that year.

(4) Whether petitioners realized commission income in 1966 in the amount of $2,042.

FINDINGS OF FACT

Some of the facts have been stipulated and the stipulation of facts, together with the exhibits attached thereto, are found accordingly.

Petitioners Howard G. Kingsbury and Anna Z. Kingsbury, husband and wife, were legal residents of Canoga Park, Calif., at the time of the filing of the petition herein. Petitioners' joint returns for the years 1966, 1967, 1968, and 1969, based on the cash method of accounting, were timely filed with the District Director of Internal Revenue, Los Angeles, Calif., and/or the Internal Revenue Western Service Center, Ogden, Utah. Anna Z. Kingsbury is before the Court only because of having signed joint returns; petitioner will hereinafter refer to Howard G. Kingsbury.

The issues in this case arise in connection with petitioner's association with the Pass Club, a cardroom located in Ventura County, Calif. The Pass Club (hereafter the club), which was built in 1953, was originally owned and operated by Paul W. Coons. After Coons' death in 1954 his widow (now Mildred Sekyra and hereafter referred to as Sekyra) took over the operation of the club.

In 1958 the board of supervisors of Ventura County, Ventura, Calif., passed an ordinance, article 4, section 6141, prohibiting the operation of a cardroom. Section 6142 provided an exception to section 6141 for cardrooms which on the effective date of the ordinance were being operated pursuant to a valid cardroom license. Section 6143 provided: ‘Card room licenses in effect on the date of this ordinance are valid only for the place and operator stated in the license and shall not be transferred to any other place or person.’ Sekyra has, since before 1959, been licensed to operate a cardroom in Ventura County.

In April 1959, Sekyra hired Salvador Valdivia (hereafter Valdivia) to manage the Pass Club for a period of 5 years. Pursuant to a written agreement between Sekyra and Valdivia, Valdivia was to receive one-half of the net profits from the operation of the club. During the period that Valdivia managed the club, the gross receipts never exceeded $3,000 per month.

In 1961 the club was completely destroyed by fire. The insurance proceeds, approximately $18,000, were inadequate to cover the costs of reconstruction. Unable to secure financing elsewhere, Sekyra borrowed $30,000 from a personal acquaintance giving him a trust deed on the property as security. As construction on the new building progressed, however, Sekyra realized that she would need additional financing in order to reopen the club.

Petitioner, who had been a regular customer during the 2-year period preceding the fire, was approached by Valdivia as a possible source for the funds needed to complete the new building. Petitioner became interested in the possibility of working out an arrangement whereby he could take over the operation of the club. After conducting a survey of other cardrooms in the area, petitioner was convinced that the club could be a very profitable enterprise— given some changes in its operation.

Sekyra was receptive to the idea of working out an arrangement with petitioner. She had not been entirely satisfied with Valdivia's work and she believed that petitioner was more qualified to direct the club's operation than either Valdivia or herself. Furthermore, Sekyra was in poor health and wanted to be free from the responsibilities of operating the club.

Both petitioner and Sekyra were aware that an outright assignment of the cardroom license to petitioner would result in the revocation of the license by county officials. Petitioner employed an attorney, Karl G. Kappel (hereafter Kappel), to represent him in the negotiations with Sekyra and to draft an agreement between them. At the conclusion of the negotiations, Kappel understood that petitioner and Sekyra wanted an arrangement whereby petitioner would take over the operation of the club and have full use and benefit of the license, together with the use and benefit of the premises, without technically violating the county ordinance which prohibited the transfer of the license. On February 26, 1962, petitioner and Sekyra entered into a written agreement, drafted by Kappel, which was entitled ‘Operating Agreement.’ Relevant portions of this agreement follow:

II

(Sekyra)2 does hereby hire * * * (petitioner)3 exclusively to manage and operate the aforedescribed premises, its structures, and appurtenances under the aforedescribed license for a period of five (5) years from the date of this agreement under the terms and conditions as hereinafter set forth. * * * (Petitioner) does hereby accept said management under this Operating Agreement under the terms and conditions as hereinafter set forth for the term of five (5) years.

III

The parties hereto mutually agree that the compensation to each of the parties hereto shall be as follows:

(Sekyra) is to receive the first Two Thousand Dollars ($2,000.00) of the gross income in each and every month during the term of this agreement, beginning on the first day of the first month that said card club is open for business; that all other gross income in excess of Two Thousand Dollars ($2,000.00) is to be received by * * * (petitioner). * * *

IV

(Sekyra) agrees that she will:

A. Build said building to completion as rapidly as possible and will as rapidly as possible complete all road work, parking area work, and appurtenances to said building, and will as rapidly as possible fixturize, furnish and equip said premises, and supply chips for the operation of said premises.

B. Maintain and insure where necessary said premises, including the building, road, and parking area.

C. Faithfully pay when due all mortgage payments, lease payments, taxes, assessments, and any other obligations on said land, structures, and improvements thereon, and furnishings, fixtures, and equipment therein.

V

(Petitioner) agrees that he will:

A. Pay to * * * (Sekyra) as further consideration for his rights under this Operating Agreement the sum of Seven Thousand Five Hundred Dollars ($7,500.00), payable one-half (1/2) upon the execution of this agreement and one-half (1/2) at the time the premises is completed so that he may actively take over as manager of said card club.

B. Carefully and honestly take care of the business conducted on said premises.

C. Pay from his portion of the gross income all operating expenses of said card club not heretofore agreed to be paid by * * * (Sekyra), including, but not limited to all employee taxes due Federal and State governments, all playing cards, linens, labor costs, license renewal fees, and breakage.

D. Keep the inside of said premises in good repair and maintenance, and carry and maintain adequate public liability insurance on the whole of said premises, for the benefit of both parties.

VI

E. * * * (Petitioner) shall have the sole and exclusive right to conduct the business on said premises subject to the terms of this agreement, and has the sole right to hire or fire any and all employees as he sees fit and proper.

F. Neither the premises nor the business conducted therein shall be used in such a manner as to violate the terms of this agreement, nor shall they be mortgaged or hypothecated in such a manner as to interfere with the operation of said...

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