Peterson Mach. Tool, Inc. v. Comm'r of Internal Revenue

• Decision Date: 14 July 1982
• Docket Number: 8980-80—-8982-80.,Docket Nos. 8607-80
• Citation: 79 T.C. 72
• Parties: PETERSON MACHINE TOOL, INC., and ITS SUBSIDIARY, KANSAS INSTRUMENTS, INCORPORATED, et al.,1 PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

79 T.C. 72

PETERSON MACHINE TOOL, INC., and ITS SUBSIDIARY, KANSAS INSTRUMENTS, INCORPORATED, et al.,1 PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket Nos. 8607-80

8980-80—-8982-80.

United States Tax Court

Filed July 14, 1982.

Buyer purchased the stock of KI from sellers. The contract of sale provided that the purchase price was paid for all of the stock of KI and for covenants not to compete. It further provided that the covenants were “materially significant and essential to the closing” and that the “covenants are a material portion of the purchase price.” Held, “strong proof” doctrine not applicable where neither party seeks to vary the terms of the contract, but only to construe obviously ambiguous terms in light most favorable to their respective causes. Held, further, covenants not to compete were intended to be part of the contract, had independent economic significance, and a portion of the purchase price is allocable to them. Held, further, amount allocable to the covenants determined. Merrill R. Talpers, Glenn E. Bradford, and Ronald S. Bronstein, for the petitioners in docket No. 8607-80.

Laurin W. Schutter, for the petitioners in docket Nos. 8980-80, 8981-80, and 8982-80.

James E. Cannon, for the respondent.

FORRESTER , Judge:

In these consolidated cases, respondent has determined deficiencies in petitioners' Federal income taxes as follows:

+---------------------------------------------------------------+
                ¦                            ¦            ¦Year    ¦            ¦
                +----------------------------+------------+--------+------------¦
                ¦Petitioner                  ¦Docket No.  ¦ending  ¦Deficiency  ¦
                +----------------------------+------------+--------+------------¦
                ¦Peterson Machine Tool, Inc.,¦8607-80     ¦8/31/76 ¦$22,997.00  ¦
                +----------------------------+------------+--------+------------¦
                ¦and its subsidiary,         ¦            ¦8/31/77 ¦11,154.00   ¦
                +----------------------------+------------+--------+------------¦
                ¦Kansas Instruments, Inc.    ¦            ¦        ¦            ¦
                +----------------------------+------------+--------+------------¦
                ¦Carl U. Hansen              ¦            ¦        ¦            ¦
                +----------------------------+------------+--------+------------¦
                ¦and Merida Hansen           ¦8982-80     ¦12/31/75¦17,950.00   ¦
                +----------------------------+------------+--------+------------¦
                ¦M. V. Welch                 ¦            ¦        ¦            ¦
                +----------------------------+------------+--------+------------¦
                ¦and Lucy L. Welch           ¦8980-80     ¦12/31/75¦3,140.65    ¦
                +----------------------------+------------+--------+------------¦
                ¦Robert W. Moses             ¦            ¦        ¦            ¦
                +----------------------------+------------+--------+------------¦
                ¦and Dixie L. Moses          ¦8981-80     ¦12/31/75¦2,515.00    ¦
                +---------------------------------------------------------------+
                

Concessions having been made, the only issue remaining for decision is whether any portion of the sale price of all of the corporate stock of Kansas Instruments, Inc., is properly allocable to covenants not to compete.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

Peterson Machine Tool, Inc. (hereinafter referred to as Peterson, Inc.), is a Missouri corporation with its principal place of business, at the time its petition herein was filed, in Shawnee Mission, Kans. It filed U.S. Corporation Income Tax Returns (Forms 1120) for the fiscal years ending August 31, 1976, and 1977, with the Internal Revenue Service Center in Austin, Tex. ²

The individual petitioners in each docket number are husbands and wives who, at the time their petitions herein were filed, resided in the State of Kansas. They timely filed their joint Federal income tax returns for 1975 with the Internal Revenue Service Center in Austin, Tex.

Peterson, Inc., has been engaged in the business of manufacturing and distributing equipment for the automobile engine rebuilding and reconditioning field since 1962. It also purchases certain products for resale in this field, particularly cleaning equipment. Peterson, Inc.'s president and controlling stockholder is D. R. Peterson (hereinafter Peterson).

Kansas Instruments, Inc. (hereinafter Instruments), is a Kansas corporation engaged in the manufacture, distribution, and sale of cleaning tanks and automobile rebuilding equipment.

In 1969, Carl U. Hansen (hereinafter sometimes referred to as Hansen), a 59-year-old graduate mechanical and industrial engineer, purchased one-ninth of the stock of Instruments.³ By 1971, most of the other owners of Instruments had been bought out by Hansen. With his technical expertise, Hansen assisted Instruments in various ways, including the design of its product line. He was never, however, a paid employee of Instruments.

In 1970 or 1971, Robert W. Moses (hereinafter sometimes referred to as Moses), a graduate industrial engineer, who was then 1 year out of college, began to work for Instruments. He soon became its general manager, and was largely responsible for new products and improvements in old ones.

By 1975, Instruments had gained significantly in financial success, having gone from a loss of approximately $8,500 in 1971 to a profit of approximately $30,000 in 1974. As of that time, Moses owned 18 percent of the stock of Instruments. He had primary knowledge and responsibility regarding design, development, and function of Instruments' product line, its labor force, marketing and sales force, and its customer relations. He spent 40 to 60 hours per week on that corporation's affairs.

At this time Hansen, then 65 years of age and owner of 71 percent of Instruments' stock, was only marginally involved in Instruments. While he was generally aware of the corporation's activities, and fully capable of performing any of the tasks of general manager, he usually went into the office only 1 day each week, and then only for 2 to 4 hours. Only rarely did he involve himself in customer relations and product concerns. He never received a salary from Instruments, nor did that corporation ever pay any dividends while he was a shareholder.

In addition to Hansen and Moses, during 1975 there was a third shareholder in Instruments—-M. V. Welch (hereinafter sometimes referred to as Welch). Welch owned 11 percent of that corporation's stock, but was not actively involved in its operations. He was 66 years of age and president and controlling stockholder of Welch Manufacturing Corp. Although Welch Manufacturing Corp. did not produce the same type of equipment as did Instruments, the machinery and tools used in its manufacturing processes were substantially similar to those used by Instruments in its business. Welch retired from active participation in his corporation in 1978.

In early 1975, Peterson, Inc., first began to do business with Instruments. Peterson went to the latter's place of business and saw that it could make a cleaning tank needed in Peterson, Inc.'s product line. A few such tanks were ordered and delivered. Hansen and Moses delivered the products to Peterson, Inc., personally. Peterson, Hansen, and Moses then went to lunch, at which time Peterson asked Hansen if he would consider selling Instruments. Hansen's reply was “I'm not interested in selling it at the present time.”

Peterson's interest in acquiring Instruments stemmed from the fact that that corporation manufactured a revolutionary dishwasher-type cleaning machine which was then the only one of its kind in the United States and which was in great demand. Additionally, Instruments was a major competitor of Peterson, Inc., with regard to other products. Peterson believed that the product lines of both companies would compliment each other, increasing sales of both.

Approximately 6 weeks after Peterson's first inquiry into the purchase of Instruments, Hansen called Peterson on the phone to inform him of his interest in selling all of Instruments' stock for $280,000. Hansen's change of heart was a result of his age (65 years), his relative inactivity at the business, and his desire to retire and travel. Hansen had previously discussed the sale with Welch and Moses, who agreed to go along with Hansen's decision to sell all of Instruments' stock for $280,000.

Negotiations ensued between Hansen and Peterson, lasting from approximately June 1975 through October 1975. The primary issue throughout the negotiations was price. Peterson made offers of $100,000, $150,000, and $250,000, each of which was rejected by Hansen, who would not waiver from his original price of $280,000. Peterson's increasing offers were made notwithstanding advice from the bank where Peterson, Inc., maintained a $650,000 line of credit, that Instruments was worth only $100,000 and, in the most favorable light, possibly as high as $180,000. This conclusion was based on book value ($90,000) and earnings ($30,000 in 1974) as shown on Instruments' financial statements for 1971 through 1974, and for the first 7 months of 1975.

Finally, on October 29, 1975, Peterson agreed to Hansen's price of $280,000 because of his belief that the corporations would compliment each other so well. Based solely on Peterson, Inc.'s good credit, and not on Instruments' credit or its assets, the bank agreed to increase Peterson, Inc.'s line of credit to $750,000, and to loan that corporation the money to purchase Instruments' stock.

At the meeting between Peterson and Hansen on October 29, 1975, the former agreed to pay $280,000 for Instruments' stock, and the parties shook hands on it. Prior to that handshake, there had been no discussion of a covenant not to compete as part of the transaction, but almost immediately thereafter (within 2 or 3 minutes), Peterson said “we want a covenant not to compete” and Hansen replied “we will give you one.” Shortly thereafter Hansen told Moses that Peterson wanted a covenant not to compete and an employment contract from Moses, to...