Ldanielson v. Comm'r of Internal Revenue, Docket Nos. 1779-63

CourtUnited States Tax Court
Writing for the CourtDAWSON
Citation44 T.C. 549
Docket Number344-64,Docket Nos. 1779-63,5489-63,473-64.
Decision Date12 July 1965

44 T.C. 549


Docket Nos. 1779-63




Tax Court of the United States.

Filed July 12, 1965.

[44 T.C. 549]

Sidney B. Gambill and Linn V. Phillips, Jr., for the petitioners.

Hobart Richey, for the respondent.

Held, on these facts, that amounts allocated by the purchaser to petitioners' covenants not to compete, which accompanied their sale of the stock of a small loan company, were in reality payments for corporate assets, thus making the payments so received taxable as taxable gains.

DAWSON, Judge:

Respondent determined the following deficiencies in petitioners' income taxes for the year 1959:

                ¦Docket No.¦Petitioner ¦Deficiency¦
                ¦1779-63 ¦Carl L. and Pauline Danielson ¦$12,016.88¦
                ¦5489-63 ¦Helen P. Sherman ¦4,625.30 ¦
                ¦344-64 ¦Estate of Jacob F. Schaffner, Deceased, Elizabeth¦1,770.96 ¦
 Schaffner and Erwin Marsch, Executors, and Elizabeth Schaffner
                473-64 Hugh E. and Katherine McLennan 5,001.49
In docket No. 5489-63 Helen P. Sherman has claimed in her petition an overpayment in the amount of $2,675.81.

Petitioners sold the stock of their small loan company for $374 per share and the buyer allocated a portion thereof to separate covenants not to compete just prior to the closing. The principal issue is whether the amounts received by the petitioners pursuant to these covenants actually reflect payment for them. A secondary issue relates to the fair market value of the small loan company's stock on June 20, 1958.


Some of the facts were stipulated by the parties and are hereby found accordingly.

Carl L. and Pauline Danielson are husband and wife residing at R.D. 6, Butler, Pa. Helen P. Sherman resides at 203 Filbert Road, Butler, Pa. Hugh E. and Katherine McLennan are husband and wife residing at 308 Castle Shannon Boulevard, Pittsburgh, Pa. Jacob F.

[44 T.C. 550]

and Elizabeth Schaffner were husband and wife during 1959, and they resided in Butler, Pa. All of the petitioners kept their books and filed their income tax returns on a calendar year basis for 1959, using the cash receipts and disbursements method of accounting, with the district director of internal revenue at Pittsburgh, Pa.

Jacob F. Schaffner died on October 20, 1964. His executors were substituted as petitioners.

The Butler County Loan Co. (hereafter called Butler Loan), a Pennsylvania corporation, was organized in 1946 by Hugh McLennan and Paul Sherman, the deceased husband of Helen Sherman. The company conducted a small loan business in Butler, Pa., in its own name and engaged in the consumer finance and consumer discount businesses through a subsidiary corporation.

Prior to forming Butler Loan, Paul Sherman had managed another loan office in Butler, Pa. Because of his experience and ability Sherman developed Butler Loan into a successful business before his death on June 20, 1958.

After Sherman's death, the stockholders called upon Alvin C. Shukis to evaluate the business. Shukis had known Sherman for many years and was then managing a loan company in Oakmont, Pa. Shukis analyzed the accounts of Butler Loan, determined that its stock had a book value of $225 per share, and concluded that it was in a health position and should be kept in operation. The petitioners offered the position of manager at Butler Loan to Shukis and he accepted. He received an annual salary of $8,400 plus the option to buy 100 shares of the company's stock over a 5-year period at the then book value of $225 per share. Shukis began his employment with Butler Loan on July 2, 1958.

On December 10, 1958, Butler Loan purchased the 114 outstanding shares of a stockholder who had died. The company paid $226 per share for the stock and held it in the treasury. On September 9, 1959, Shukis exercised his option to buy 10 shares of Butler Loan's stock at $225 per share. After he did so, the stock of Butler Loan was then held as follows:

                ¦Stockholders ¦Shares ¦
                ¦Carl L. and Pauline Danielson ¦244 ¦
                ¦Helen P. Sherman ¦194 ¦
                ¦Hugh E. and Katherine McLennan¦148 ¦
                ¦Jacob F. Schaffner ¦90 ¦
                ¦Alvin C. Shukis ¦10 ¦
                ¦Total ¦686 ¦

Carl Danielson is a physician, specializing in surgery in Butler. He has been engaged in his profession since 1931. Throughout 1959

[44 T.C. 551]

he actively pursued his medical practice. His wife Pauline was not employed.

Helen P. Sherman is a widowed housewife who devoted her time in 1959 to maintaining her home and raising her three children.

Hugh McLennan has been in the real estate and insurance business for many years in Pittsburgh. During 1959 he actively conducted his business. His wife Katherine devoted her time to their home.

Jacob F. Schaffner was a 93-year-old retired businessman in 1959 who spent his entire time at home. His wife Elizabeth handled almost all of his affairs. He maintained no active participation in any business activities, although he did attend the meetings of Butler Loan's board of directors.

On October 23, 1959, the stockholders of Butler Loan put the business up for sale by soliciting offers from other small loan companies.

Thrift Investment Corp. (hereafter called Thrift) conducts small loan, sales finance, and consumer discount businesses in a number of branch offices. At the time Butler Loan was offered for sale, Thrift already had a branch office operating in Butler. When Thrift's officials learned that the stockholders of Butler Loan wanted to sell, Thrift sent its representatives to examine the outstanding receivables. Based on its analysis, Thrift submitted three alternative bids which were considered, along with those received from other prospective buyers, at a meeting of Butler Loan's stockholders and directors on November 3, 1959. The Thrift offers were contained in the following letter written by Paul M. Hickox, executive vice president, to Hugh McLennan:

We are pleased to submit an offer of $374 per share cash in consideration for all of the common stock of the Butler County Loan Company and our usual non-compete agreement in the Butler area.

While we prefer to make a cash purchase, we are willing to make an alternative offer of 24 shares of Thrift Investment Corporation common stock (available over-the-counter currently at $9.25 per share) and $152 cash. We believe that this alternative method would avoid capital gains taxes on that part of the consideration paid in stock, if all shareholders accept the alternative plan.

In the event that you wish to sell the assets of the company instead of its capital stock, we would be willing to pay $336,791 for the small loan receivables, net book value for the furniture and fixtures, and net book value for the consumer discount and sales finance receivables after deducting unearned discount. We would also assume the remainder of your lease.

We appreciate the opportunity to submit this offer and are prepared to close this transaction immediately.

Thrift based its offer of $374 per share upon the assumption that by combining Butler Loan's business with Thrift's then-existing branch office in Butler, it could anticipate increased profits of $19,900. Thrift determined that it would need a return of 3 percent on Butler Loan's

[44 T.C. 552]

outstanding receivables so as not to dilute its existing holdings. The excess earnings were then computed in the following manner:

                ¦Estimated annual profit from acquisition¦¦$19,900¦
Less 3 percent return on outstanding receivables purchased
                Small loans receivables $264,000
                Consumer discount loans 57,000
                Sales finance loans 9,000
                Total outstanding receivables 330,000
                3 percent of $330,000 9,900
                Excess earnings 10,000

Thrift decided to offer the stockholders of Butler Loan the book value of its assets plus 6 times excess earnings as an inducement to sell. This sum ($60,000) was divided by 55 percent to reflect the tax effects which would accrue to Thrift if the amount were amortizable by them.2

When the shareholders decided to accept the first of Thrift's alternate proposals, Shukis announced that he would exercise his option to purchase the 90 additional shares allotted him in his employment contract. The remaining shareholders refused to honor the exercise of his option and notified Thrift that they were ready to sell.

On the same day Thrift learned that Butler Loan had accepted its offer. Thrift received a telegram from Shukis stating that he was exercising his option to buy the 90 shares.

On November 5, 1959, Butler Loan received copies of the proposed sales agreement and covenant not to compete. These documents were silent as to any allocation of purchase price between the stock and the covenant not to compete. At a special meeting of the board of directors of Butler Loan, held on the evening of November 5, 1959, Shukis was discharged as manager.

The covenant not to compete contained the same language for each shareholder. It provided that:

NOW, THEREFORE, in consideration of the mutual...

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