Michot v. Commissioner, Docket No. 10474-79

Citation43 TCM (CCH) 792,1982 TC Memo 128
Decision Date16 March 1982
Docket Number2257-80.,Docket No. 10474-79
PartiesLouis J. and Patricia A. Michot v. Commissioner.
CourtUnited States Tax Court

F. Kelleher Riess, 821 Gravier St., New Orleans, La., William T. Steen, Pan American Life Ins. Co., New Orleans, La. and James Parkerson Roy, for the petitioners in docket No. 10474-79. F. Kelleher Riess, for the petitioners in docket No. 2257-80. Deborah R. Jaffe, for the respondent.

Memorandum Findings of Fact and Opinion

FAY, Judge:

Respondent determined the following deficiencies in petitioners' Federal income tax:

                  Year                 Deficiency
                  1974 ..............   $40,511
                  1975 ..............    21,361
                  1976 ..............     3,582
                  1977 ..............     9,837
                

The issue for decision is whether amounts received by petitioner Louis J. Michot upon termination of franchising agreements are taxable as ordinary income or as capital gain.

These cases have been consolidated for trial, briefing, and opinion.

Findings of Fact

Some facts have been stipulated and are found accordingly.

Petitioners, Louis J. and Patricia A. Michot, were residents of Lafayette, La., when they filed their petitions herein.

During 1958, Louis J. Michot (petitioner) was working in Washington, D.C., but wanted to return to Louisiana where he had lived previously. With that desire in mind, he contacted Burger Chef Systems, Inc. (Burger Chef) to acquire the right to develop Burger Chef franchises in Louisiana. At that time, Burger Chef was a young, family-owned business operating one store in Indianapolis, Ind.

On October 15, 1958, petitioner and Burger Chef entered into a Territory Franchise Agreement. Under that agreement, petitioner became the exclusive franchising agent for Burger Chef in Louisiana and, as such, gained the right to franchise the Burger Chef name and to sell Burger Chef franchises, equipment, and products to franchisees. Petitioner paid Burger Chef $13,000 for such rights.1

Petitioner promised to franchise 10 equipped stores within 5 years, to execute all franchises on Burger Chef's forms with Burger Chef's approval, to inspect each franchised store at least twice a month, to complete and forward all forms required by Burger Chef, and to operate certain opened but unfranchised stores. For his efforts, petitioner was entitled to a set commission whenever a store opened. Petitioner was also entitled to 50 percent of the royalties Burger Chef received from the operation of the store.2

The agreement provided that

nothing herein contained shall be construed to vest in Licensee petitioner any right, title, or interest in and to the tradename, trademarks, goodwill, building signs and/or blueprints * * * other than the right and license to use said * * * pursuant to the terms and conditions during the effective term of the franchise and license granted hereunder.

On January 22, 1962, petitioner and Burger Chef entered into another Territory Franchise Agreement. Under that agreement, petitioner became the exclusive franchising agent for Burger Chef in Mississippi. The Mississippi agreement is substantially similar to the Louisiana agreement in all respects material herein, except petitioner paid Burger Chef $3,250 for his rights in Mississippi and promised to franchise 11 equipped Burger Chef stores within 5 years.

Sales of franchises under the agreements were handled on a "turn key" basis — the franchisee bought a franchise for a ready to operate store. Initially, petitioner sold franchises to unrelated third parties. However, as the sale of franchises became increasingly difficult, petitioner adopted a policy of selling to himself. In other words, petitioner or an entity owned or controlled by him acted as franchisee-operator. By 1973, over 80 percent of the Burger Chef stores in Louisiana and Mississippi came under that dual system whereby petitioner was essentially both franchisor and franchisee.3

Petitioner was involved from the ground up in the development of Burger Chef in his two-state area. He conducted market studies, chose sites, arranged land leases or purchases, supervised construction, arranged equipment installation, hired and trained employees, made periodic inspections, and provided general supervisory support.4 While certain of petitioner's activities are directly traceable to his obligations as a franchisor for Burger Chef, most served both to fulfill his duty as franchisor and to aide his investment as a franchisee. Petitioner received substantial income as a franchisor for Burger Chef. Between 1961 and 1973 he received an average of $17,368.73 in commissions each year and an average of $58,368.14 in royalties each year.

In 1968, General Foods acquired Burger Chef, and petitioner's relationship with Burger Chef deteriorated. On May 21, 1973, Burger Chef took two actions: (1) it notified petitioner by letters that the agreements covering Louisiana and Mississippi would be terminated as of August 21, 1973, and (2) it filed declaratory judgment actions in Federal district courts in Louisiana and Mississippi seeking a declaration that either the agreements between it and petitioner were terminable upon reasonable notice or that petitioner had defaulted so as to justify termination of the agreements. By answer, petitioner denied the agreements were terminable upon reasonable notice, denied any default, and counterclaimed for injunctive relief and damages.

The Federal district courts issued injunctions preventing Burger Chef from terminating the agreements pending the outcome of litigation. Trial on the merits commenced in the Federal District Court for the Eastern District of Louisiana. However, before the conclusion of that trial, a settlement was reached.

Under the settlement agreement, petitioner agreed to termination of the Louisiana and Mississippi agreements as of August 21, 1973, and waived any claim to certain disputed commissions. In return, petitioner received (1) a $300,000 reduction in royalties to be paid to Burger Chef over a 5-year period from stores operated by petitioner as a franchisee, (2) $250,000 in credits on future equipment purchases, and (3) the right to buy one new Burger Chef franchise in either Louisiana or Mississippi for $1.00. The last right was valued at $25,000; thus, petitioner was entitled to a total of $575,000 under the settlement agreement.5

Petitioner treated $56,405 of the $575,000 settlement amount as interest. The remainder, $518,595, was received by petitioner as follows:6

                  1974 ..............    $121,407
                  1975 ..............      75,317
                  1976 ..............     115,214
                  1977 ..............     125,856
                  Post 1977 .........    Remainder
                

The settlement agreement only effected the termination of the agreements entitling petitioner to act as Burger Chef franchisor in Louisiana and Mississippi; it did not terminate petitioner's status as a Burger Chef franchisee.

On their Federal income tax returns for 1974 through 1977, petitioners reported the settlement proceeds as long-term capital gain from the sale of the franchise agreements and elected the section 4537 installment method.8 In his statutory notices of deficiency, respondent determined that the settlement proceeds received in each year were ordinary income.

Opinion

At issue is whether the settlement proceeds received by petitioner upon termination of his franchising agreements with Burger Chef are long-term capital gain or ordinary income.

Capital gain is the gain derived from the sale or exchange of a capital asset. Sec. 1222(1) and (3).9 The parties agree the termination of the franchising agreements was a sale or exchange. Thus, their disagreement centers on whether those franchising agreements were capital assets.

A capital asset is defined as "property held by the taxpayer" which does not fall within any of six enumerated categories. Sec. 1221. The parties agree the franchising agreements, if property, are not within any of those six categories. Petitioner maintains the franchising agreements were property, and, thus, he reasons they were capital assets. Respondent contends the franchising agreements represent contract rights which do not rise to the level of property within the meaning of section 1221. Additionally, respondent argues the settlement proceeds are merely a substitute for future ordinary income and cannot be characterized as capital gain.

While syntactically logical, petitioner's argument that the agreements are capital assets simply because they are property and do not fall within any of section 1221's enumerated exceptions is not legally sound. See Commissioner v. Gillette Motor Co. 60-2 USTC ¶ 9556, 364 U.S. 130 (1960); Vaaler v. United States 72-1 USTC ¶ 9200, 454 F. 2d 1120 (8th Cir. 1972); Bellamy v. Commissioner Dec. 27,216, 43 T.C. 487 (1965). Focusing on the spirit, rather than the letter, of the statutory capital gains provisions, the courts have developed three theories to exclude items commonly denominated as property from section 1221 capital asset status.

First, some cases derive from Gillette Motor Co., supra, the rule that all that is property in a common sense is not property within the meaning of section 1221. See, e.g., Commissioner v. Ferrer 62-2 USTC ¶ 9518, 304 F. 2d 125 (2d Cir. 1962), modifying Dec. 24,618 35 T.C. 617 (1961); Regenstein v. Commissioner Dec. 24,430, 35 T.C. 183 (1960). Second, other cases, relying on Commissioner v. P.G. Lake, Inc. 58-1 USTC ¶ 9428, 356 U.S. 260 (1958); and Hort v. Commissioner 41-1 USTC ¶ 9354, 313 U.S. 28 (1941), deny capital asset status when a substitute for future ordinary income is perceived. See, e.g., Bisbee-Baldwin Corporation v. Tomlinson 63-2 USTC ¶ 9562, 320 F. 2d 929 (5th Cir. 1963); Wiseman v. Halliburton Oil Well Cementing Company 62-1 USTC ¶ 9449, 301 F. 2d 654 (10th Cir. 1962); Brown v. Commissioner Dec. 26,260, 40 T.C. 861 (1963). Third, still other cases apply the doctrine of Corn Products Co.v....

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