Rothstein v. Comm'r of Internal Revenue

• Decision Date: 30 March 1988
• Docket Number: Docket Nos. 11535-85,19524-86.
• Citation: 90 T.C. No. 34,90 T.C. 488
• Parties: ROBERT AND ANN ROTHSTEIN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, RespondentEUGENE AND LOIS COLE, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

90 T.C. 488

90 T.C. No. 34

ROBERT AND ANN ROTHSTEIN, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, RespondentEUGENE AND LOIS COLE, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 11535-85

19524-86.

United States Tax Court

Filed March 30, 1988.

Ps signed employment agreements which provided, inter alia, for each of them to receive 12-1/2 percent of the amount, if any, by which the adjusted proceeds from a sale of substantially all of the assets of their employer corporation exceeded $825,000. The employment agreements contained to provisions for Ps to be issued stock certificates or for Ps to have any rights of stockholders. No stock certificates in fact ever were issued to Ps. Ps subsequently each received, pursuant to the employment agreements, $627,866 on account of the sale of all the assets of the employer corporation. HELD: The only relationship created by the employment agreements was that of employer-employee; the payments therefore are ordinary income to Ps as compensation for services. Freese v. United States, 455 F.2d 1146 (10th Cir. 1972), followed. Leonard Bailin and William Seplowitz, for the petitioner.

Steven Z. Ettinger, for the respondent.

WELLS, JUDGE:

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

+---------------------------------------------------+
                ¦Docket No.¦Petitioners             ¦Year¦Deficiency¦
                +----------+------------------------+----+----------¦
                ¦11535-85  ¦Robert and Ann Rothstein¦1982¦$565,539  ¦
                +----------+------------------------+----+----------¦
                ¦19524-86  ¦Eugene and Lois Cole    ¦1982¦225,990   ¦
                +----------+------------------------+----+----------¦
                ¦          ¦                        ¦1983¦5,029     ¦
                +---------------------------------------------------+
                

In addition, respondent determined that petitioners in docket no. 19524-86 were liable for additions to the tax as follows:

+----------------------------------------------------+
                ¦Year¦Sec. 6653(a)(1)1  ¦Sec. 6653(a)(2)¦Sec. 6661(a)¦
                +----+------------------+---------------+------------¦
                ¦1982¦$11,299.50        ¦(*  )          ¦$22,599.00  ¦
                +----+------------------+---------------+------------¦
                ¦1983¦251.50            ¦(*  )          ¦502.90      ¦
                +----------------------------------------------------+
                

After concessions, the issues remaining for decision are (1) whether payments received by petitioners Robert Rothstein and Eugene Cole in 1982 pursuant to an employment agreement are taxable as ordinary income or as income from capital gains, and (2) whether petitioners Eugene and Lois Cole are liable for additions to the tax pursuant to section 6651(a) for 1982 and 1983. ²

FINDINGS OF FACT

Some of the facts are stipulated. The stipulation of facts and exhibits thereto are incorporated herein by this reference. Petitioners in docket no. 11535-85 (the Rothsteins) resided in North Bergen, New Jersey, when they filed their petition herein. Petitioners in docket no. 19524-86 (the Coles) resided in Oyster Bay Cove, New York when they filed their petition.

Petitioners Robert Rothstein and Eugene Cole were employed by Royal Paper Corporation (‘Royal‘) from prior to January 1, 1973, until December 31, 1981. ³ At all times relevant hereto, Leonard Baron (‘Mr. Baron‘) was Chief Executive Officer and the sole common shareholder of Royal.

Historically, Royal had been a family business with several members of the Baron family involved in the management of the business. After the death of one of Mr. Baron's uncles, however, Mr. Baron was left by himself to manage Royal. Royal's business was expanding and Mr. Baron needed help to run the business. Consequently, Mr. Baron in 1972 asked petitioners to help him run the business as executives. Mr. Cole expressed a desire to ‘become a partner in the corporation;‘ however, he did not have the ‘kind of money that it would take to buy the assets or a share of the assets.‘ ⁴ Petitioners and Mr. Baron (acting on behalf of Royal) had subsequent discussions and negotiations, and a tentative agreement was drafted to provide for petitioners' duties and rights as executives of Royal. Mr. Rothstein had his attorney review the proposed agreement. ⁵ Petitioners subsequently each entered into identical agreements with Royal, effective January 1, 1973. (Those agreements hereinafter will be referred to as the employment agreements.) The employment agreements contained the following provisions: ⁶

3. COMPENSATION

As full compensation for his Services under this agreement in any capacity, the Executive shall be entitled to receive the following:

(a) SALARY * * *

(b) PROFIT SHARING * * *

(c) SHARE OF PROCEEDS UPON SALE OF STOCK OR ASSETS. If at any time during the term of the Executive's employment by the Company or within six months after termination of his employment, the Company sells substantially all of its assets or Leonard B. Baron and all other stockholders in the company sell, in a single transaction or a related series of transactions, all of the shares in the company owned by them (other than in connection with a redemption of the shares by the Company or a sale to any stockholder of the Company or to any stockholder's relatives), the Executive shall be entitled to receive as additional compensation an amount equal to 12-1/2% of the amount, if any, by which the Sales Price (as defined in paragraph 3(e) below) exceeds $825,000. * * *

(e) ADDITIONAL PROVISIONS RELATING TO PROFIT SHARING AND SALE OF ASSETS OR STOCK. * * *

(i) * * * As used in paragraph 3(c) the term ‘Sales Price‘ means the gross proceeds received by the seller from the purchaser with the following adjustments:

(A) the fair market value, as of the date of the closing of the sale, of all land and buildings sold (directly or indirectly by sale of stock), less the amount of any mortgage liability thereon, shall be deducted (such value shall be determined by the Company's independent certified public accountants whose determination shall be final and binding);

(B) the amount of the liquidation preference on the Company's preferred stock to the date of the closing of the sale shall be deducted;

(C) all of the expenses incurred by the sellers in connection with the sale (including attorneys' and accountants' fees) shall be deducted; and

(D) in any transaction involving a sale of assets, appropriate adjustment shall be made to reflect the net amount of any accounts receivable and other assets (other than land or buildings) not included in the sale and the amount of any liabilities (other than those relating to land and buildings) not assumed by the purchaser.

* * *

(vii) Nothing in this paragraph 3 shall (A) give the Executive any right to continue in the employ of the Company or prevent the termination of the Executive's employment in accordance with this agreement, whether or not negotiations for any sale of stock or assets of the Company are then pending, (B) limit the right of the board of directors to manage the business and affairs of the Company (including the determination of the nature and amount of the obligations and liabilities incurred by the Company, the products and services offered by the Company, and the price charged by the Company for its products and services), (C) give to the Executive any claim against the Company or any of its officers or directors with respect to any decision relating to the conduct of the Company business, whether or not that decision affects the share of profits and other compensation to which the Executive is entitled under this agreement, or (D) limit the right of the Company or any subsidiary, or any of the Company's shareholders, to determine in its or his sole and absolute discretion the terms of any sale of stock or assets of the Company or any subsidiary or give the executive any right to participate in the negotiations regarding any proposed sale.

The terms of the employment agreements contained no provisions requiring petitioners to make payment to or execute any promissory note in favor of either Royal or Mr. Baron. Petitioners also had no liability for any decrease in the value of Royal's stock or assets. The agreements contained no provision whereby stock certificates would be issued to petitioners, but they also contained no provision specifically stating that petitioners had no equity interest in Royal. No stock certificate and no other evidence of equity interest in Royal ever was issued to either petitioner.

The employment agreements were for a duration of three years and provided for automatic three year renewals in the absence of one of the parties giving notice of intent to terminate the agreement. Pursuant to those terms, the employment agreements renewed automatically for the three year periods ending on December 31, 1978, and December 31, 1981. On October 13, 1981, Royal notified petitioners of its intent to terminate the employment agreements effective December 31, 1981.

On December 31, 1981, Royal and three related corporations, as sellers, entered into an Asset Purchase Agreement with WWF Paper Corporation (‘WWF‘), as buyer, whereby WWF would purchase assets from the other corporations as of January 1, 1982. Pursuant to the Asset Purchase Agreement, WWF acquired substantially all of the assets of Royal and the other seller corporations.

A dispute arose as to the amount owed to petitioners on account of Royal's sale of its assets. In June 1982 petitioners each brought suit against Lenbar Enterprises, Inc., the successor corporation to Royal which was owned by Mr. Baron. On or about September 16, 1982, the parties to that suit reached a settlement of the suit and executed stipulations discontinuing the action. Pursuant to the settlement, each petitioner in 1982 received $627,866 pursuant to paragraph 3(c) of his employment agreement.

OPINION

We are asked to decide whether the payments received by petitioners pursuant to the employment agreements represent ordinary income or...