Scherf v. Commissioner of Internal Revenue

• Decision Date: 17 June 1947
• Docket Number: No. 11855.,11855.
• Citation: 161 F.2d 495
• Parties: SCHERF v. COMMISSIONER OF INTERNAL REVENUE. BARNES et al. v. SAME.
• Court: U.S. Court of Appeals — Fifth Circuit

161 F.2d 495 (1947)

SCHERF v. COMMISSIONER OF INTERNAL REVENUE.

BARNES et al. v. SAME.

No. 11855.

Circuit Court of Appeals, Fifth Circuit.

May 16, 1947.

Rehearing Denied June 17, 1947.

W. H. Albritton and Robert B. Albritton, both of Andalusia, Ala., for petitioners.

Sewall Key, Acting Asst. Atty. Gen., Hilbert P. Zarky, Robert N. Anderson and Harry Baum, Sp. Assts. to the Atty. Gen., J. P. Wenchel, Chief Counsel, Bureau Internal Revenue, and John M. Morawski, Sp. Atty., Bureau Internal Revenue, both of Washington, D.C., for respondent.

Before SIBLEY, HUTCHESON, and LEE, Circuit Judges.

HUTCHESON, Circuit Judge.

What is in controversy here is the tax liability for 1940 of petitioners on account of income derived from a pants manufacturing business.

Taxpayers, John Scherf and George H. Barnes, were until May 15, 1940, equal business partners in name and in fact, engaged under the firm name of S & B Manufacturing Company in the manufacture and sale of work pants. On May 16, of that year, Barnes gave to each of his two minor daughters, and Scherf to each of his two sons, a one-sixth interest in the business assets and property of S & B, and thereafter the two partners and the four children entered into what purported to be a new partnership agreement for the future conduct of the business.

In returning the income from the business for 1940, taxpayers reported the part of it attributable to the period up to May 16, 1940, as distributable one-half to each of them, and that part attributable to the balance of the year as distributable to taxpayers and their children in equal one-sixth shares.

The Tax Court found¹ that the arrangements taxpayers had made, though taking the form of a partnership had not in fact resulted for federal income tax purposes in creating one, because they had been entered into not with the purpose, expectation, or result of obtaining economic or business advantages, but for the purpose merely of enabling taxpayers to reduce their taxes on future income from their business by dividing the income with their children. On these findings and on the authority of Commissioner v. Tower, 327 U.S. 280, 66 S.Ct. 532, 90 L.Ed. 670, 164 A.L.R. 1135, and Lusthaus v. Commissioner, 327 U.S. 293, 66 S.Ct. 539, 90 L.Ed. 679, it sustained the commissioner's determination.

Urging that the Tax Court has refused to give effect to the undisputed facts that taxpayers made to their children effective gifts of interests in the business and thereafter entered into binding partnership agreements precisely fixing the shares in the business of each partner in the earnings of the business, and has misconstrued and misapplied the Tower and Lusthaus cases, taxpayers are here insisting that the judgment may not stand.

The commissioner urges that this is just another of those abortive efforts, of which the books are full, to make effective for tax purposes an arrangement entered into not for business purposes and upon business considerations to create and operate a business partnership but one to create a partnership in tax reduction, a partnership in short for sharing taxpayers' income from the business in order, and only in order, to reduce the taxes they would in the future pay on income derived from it.

Taxpayers agree with the commissioner that no device or arrangement, be it ever so shrewdly and cunningly contrived, "can make earnings from personal services taxable to any but the real owner of them, can make future incomes from property taxable to any but the owner of the right or title from which the income springs". They insist, however, that the business in question here is not a personal service but a manufacturing business requiring and using capital to run it, and that the income from it is income not from services but from the capital invested. They insist, too, that the effect of the transfers to the children was to make them owners, to the extent of their interest, of the right or title to the property, from the use of which the income has sprung. In effect they argue that for tax purposes, the situation is the same as it would be if the business were owned and conducted by a corporation and the transfer had been of shares in it.

We think this is an over simplification, indeed a distortion, of the situation the facts present. It disregards the fundamental differences in fact and in law between partnerships and corporations, and the fundamental distinctions the income tax law makes as to income earned by and through them. As to corporations, the statutes taxing them recognize them as entities and tax them as such.

As to partnerships, the taxing statutes do not recognize or tax them as entities separate from the partners.² They specifically provide that individuals carrying on business in partnership shall be liable for income taxes only in their individual capacities.³ If the business in question were conducted by a corporation the corporation would be taxed on its earnings, and the stockholders would be taxed only on dividends distributed to each. Since it is conducted by a partnership, the business as such, and the partners as such, pay no taxes. Each partner as an individual pays taxes on his distributive share of the net income from the business whether distributed or not. A partnership, then, is, for tax purposes, neither...