Nye v. Comm'r of Internal Revenue
| Decision Date | 02 May 1968 |
| Docket Number | Docket Nos. 5333-66— 5335-66. |
| Citation | 50 T.C. 203 |
| Parties | GEORGE A. NYE AND MYRTLE E. NYE, ET AL.,1 PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Dermot R. Long, for the petitioners.
Roger Rhodes, for the respondent.
In 1961, two partners organized a corporation to take over their partnership business. On Oct. 31, 1961, they paid cash for all the stock of the corporation. On Nov. 1, 1961, they transferred all the partnership assets (except cash and accounts receivable) to the corporation in exchange for a 10-year promissory note. Held, the stock purchase and asset transfer were parts of a single transaction to which sec. 351(a), I.R.C. 1954, applies. Held, further, the 10-year promissory note constituted a bona fide indebtedness of the corporation and was a security within the meaning of sec. 351(a), I.R.C. 1954. Held, further, a purported covenant not to compete entered into by the partners with the corporation lacked economic substance and reality. The corporation is not entitled to amortize the ‘cost’ thereof.
Respondent determined deficiencies in income taxes of the petitioners as follows:
All issues presented for decision2 arise from the creation of a corporation, Delta Sheet Metal & Air Conditioning, Inc. (sometimes referred to herein as corporation), and the transfer thereto of assets of a partnership composed of petitioners, Dale Thornton and George Nye. The issues to be decided are as follows:
(1) Whether the transaction whereby the partnership assets were transferred to the corporation falls within the provisions of Code section 351. 3 Our resolution of this issue is also dispositive of the following subsidiary issues: (a) Whether payment on the principal of a note for $73,889.30 are taxable to Thornton and Nye as capital gain or as dividends; (b) whether interest payments on the note are deductible by the corporation and taxable as such to Thornton and Nye; and (c) whether the corporation takes the partnership's basis as its basis for the transferred assets.
(2) Whether the corporation is entitled to deductions for amortization of an alleged covenant not to compete executed in connection with the transaction.
Some of the facts are stipulated and are found accordingly.
George A. Nye and Myrtle E. Nye4 are husband and wife, and resided in Northridge, Calif., at the time their petition was filed. They filed joint Federal income tax returns on the cash basis of accounting for the periods in question with the district director of internal revenue at Los Angeles, Calif.
Dale Thornton and Lucille M. Thornton are husband and wife and resided in Sepulveda, Calif., at the time their petition was filed. They filed joint Federal income tax returns on the cash basis of accounting for the periods in question with the district director of internal revenue at Los Angeles, Calif.
Delta Sheet Metal & Air Conditioning, Inc., is a corporation formed under the laws of the State of California. On the date its petition was filed, the corporation's principal office and principal place of business was located in Van Nuys, Calif. The corporation filed its Federal income tax returns for the periods in question with the district director of internal revenue at Los Angeles, Calif.
On or about September 1, 1954, Thornton and Nye, as equal partners, formed a partnership, Delta Sheet Metal Co. (sometimes referred to herein as partnership) to engage in the business of operating a sheet-metal shop and doing sheet-metal contracting. In 1961, Thornton and Nye decided to expand their business. They consulted their attorney and, for various reasons including limiting their personal liability, decided to form a corporation through which their business would be conducted. The corporation was formed on October 10, 1961, to succeed the partnership in the operation of the sheet-metal business. It had authorized stock consisting of 2,000 shares of $100 par value common stock.
On October 31, 1961, a check in the amount of $4,000 was drawn on the partnership bank account and made payable to the corporation and the corporation later issued a total of 40 shares of its common stock to Thornton and Nye. No other stock was outstanding during the periods relevant to this proceeding. On October 31, 1961, another check in the amount of $10,000 representing a loan was drawn on the account of the partnership and made payable to the corporation.
The cash disbursements journal of the partnership contains the following entry dated October 31, 1961:
+--------------------------------------------------------------------------+
¦Investments—stock ¦$4,000 ¦ ¦
+------------------------------------------+---------------+---------------¦
¦Cash ¦ ¦$4,000 ¦
+------------------------------------------+---------------+---------------¦
¦Loan receivable ¦10,000 ¦ ¦
+------------------------------------------+---------------+---------------¦
¦Cash ¦ ¦10,000 ¦
+--------------------------------------------------------------------------¦
¦To record the issuance of checks 6833 and 6834 to Delta Sheet Metal & Air ¦
+--------------------------------------------------------------------------¦
¦Conditioning, Inc. ¦
+--------------------------------------------------------------------------+
On November 1, 1961, all assets of the partnership, except cash in bank and accounts receivable, were transferred to the corporation pursuant to an ‘agreement’ and ‘amendment to agreement’ signed by Thornton and Nye as ‘Sellers' and, on behalf of the corporation, as ‘Buyer.’ The agreement transferred the physical assets of the partnership as well as intangibles, including goodwill, to the corporation. The recited consideration was $177,179.30, which consisted of $3,290 cash designated for inventory; a $73,889.30 promissory note designated for the transfer of the tangible and intangible assets of the partnership (other than inventory, cash, and accounts receivable); and a $100,000 promissory note designated for a covenant not to compete. The agreements allocated the consideration as follows:
+-----------------------------------------------------------------+
¦1.¦Inventory ¦$3,290.00 ¦
+--+---------------------------------------------------+----------¦
¦2.¦Heavy equipment, excluding trucks ¦60,000.00 ¦
+--+---------------------------------------------------+----------¦
¦3.¦Leasehold improvements ¦2,274.00 ¦
+--+---------------------------------------------------+----------¦
¦4.¦Trucks and vehicles ¦7,000.00 ¦
+--+---------------------------------------------------+----------¦
¦5.¦Office equipment, customer lists and contracts, and¦ ¦
+--+---------------------------------------------------+----------¦
¦ ¦other tangible property ¦4,614.60 ¦
+--+---------------------------------------------------+----------¦
¦6.¦Restrictive covenant to be executed by sellers ¦100,000.00¦
+-----------------------------------------------------------------+
The allocations to items 1, 2, 3, 4, and 5 reflected the approximate fair market values of the properties transferred. The remaining cost basis of items 2, 3, 4, and 5 (excluding customer lists and contracts) in the hands of the partnership was $29,542.89. The value of the business as a going concern and of its goodwill was substantial, but no part of the recited consideration was allocated to them.
On November 1, 1961, the corporation executed an unsecured promissory note payable to Thornton and Nye in the amount of $73,889.30, with interest of 6 percent per annum. The note was payable in annual installments of $7,388.93, or more, plus interest, the first payment to become due ‘on or before’ December 31, 1962. The corporation executed another document dated November 1, 1961, entitled ‘Promissory Note,‘ calling for the corporation to pay $100,000, without interest, in annual installments of $10,000 or more, the first payment to become due December 31, 1962.
The $73,889.30 promissory note was not subordinated to claims of stockholders or other creditors, and payments of principal and interest were made annually when due. Payments of principal on the...
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