Schulz v. CIR

• Decision Date: 28 August 1961
• Docket Number: No. 17160.,17160.
• Citation: 294 F.2d 52
• Parties: Ray H. SCHULZ and Doris L. Schulz, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee. John W. SCHULZ and Lucille Schulz, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee. Melvin F. KLAGUES and Pauline Klagues, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee. COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. Stanley C. LANDEN and Victoria M. Landen, Respondents.
• Court: U.S. Court of Appeals — Ninth Circuit

294 F.2d 52 (1961)

Ray H. SCHULZ and Doris L. Schulz, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

John W. SCHULZ and Lucille Schulz, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

Melvin F. KLAGUES and Pauline Klagues, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. Stanley C. LANDEN and Victoria M. Landen, Respondents.

No. 17160.

United States Court of Appeals Ninth Circuit.

August 28, 1961.

Arthur B. Willis, John E. Scheifly and Willis, MacCracken & Butler, Los Angeles, Cal., for petitioners.

Hugh J. Ritchie and John C. McCall, both of Los Angeles, Cal., for respondents.

Louis F. Oberdorfer, Asst. Atty. Gen.; Lee A. Jackson, Hary Baum and Douglas A. Kahn, Attorneys Dept. of Justice, Washington, D. C., for Commissioner of Internal Revenue.

Before BARNES, MERRILL, Circuit Judges, and CROCKER, District Judge.

CROCKER, District Judge.

Two questions arise on appeal from the Tax Court: (1.) Whether the amount paid to a retiring partner for his share of a partnership, above the tangible asset value of the partnership, represents good will or a covenant not to compete, and (2.) Whether income from the business for February, 1952 should be reported in a separate return for that month and included in the individual returns of the partners for 1952, or whether such amounts should be included in the partnership return for the fiscal year beginning February 1, 1952 and ending January 31, 1953, and hence included in the partner's returns for the year 1953. The Tax Court decided against the taxpayers on both issues, and its judgment is affirmed in that its findings on the facts are not clearly erroneous.

We summarize the findings of the Tax Court:

On November 1, 1946, Ray H. Schulz, John W. Schulz and Melvin F. Klagues (hereinafter called "continuing partners") and Stanley C. Landen (hereinafter called "Landen"), organized a partnership by oral agreement under the firm name of Schulz Tool and Manufacturing Company (hereinafter the business will be called "Schulz Tool").

In the years that followed, Schulz Tool grew successfully, changing back and forth from a corporate enterprise to a partnership, always under the ownership of the original four. Initially, Schulz Tool had two branches of manufacture and sale, "proprietary items" and "job machine work." The "proprietary items" — mostly airplane fuel valves — were designed and developed by Schulz Tool to meet the requirements of aircraft manufacturers. By contrast, "job machine work" consisted of custom machining parts on orders from manufacturers who provided the necessary blueprints and designs. As the "proprietary items" became more profitable the company devoted more of its plant and labor to these items and less to "job machine work."

By January, 1952, the business, now a partnership, was heavily committed to the proprietary item field. Landen disagreed with the "continuing partners" on the emphasis on proprietary items. He was concerned about the risk factors, the amount of capital investment required and the research and engineering problem involved in the development and manufacture of such items.

These disagreements culminated in an all day meeting of the partners late in January, 1952, during which Landen suggested that it might be better if he sold his interest in the partnership. The continuing partners concurred. It was orally agreed to purchase Landen's interest as of January 31, 1952, and to close the partnership's fiscal year on that date. No discussion was had of the price to be paid Landen. All agreed that a physical inventory should first be taken as of January 31, 1952.

Subsequent to that date Landen contributed no services to the partnership nor did he participate in management. The other partners agreed to pay him a salary for the month of February inasmuch as he had no other source of income. Otherwise, he was not to participate in partnership profits.

Prior to mid-February, 1952, Landen submitted an offer to sell his interests to the other partners for $111,000. This figure was based on his estimates of the values of the physical plant and inventory ($93,000) and a figure of $18,000 attributed by Landen to good will. He did not disclose the breakdown of these figures to the other partners.

A meeting was held by all the partners on February 29, 1952, at which Landen submitted his offer and first told the "continuing partners" of his allocation of $18,000 to good will. The "continuing partners" made a counter offer for an overall price of $105,000, later increased to $107,000. At this point a stalemate occurred. Someone then suggested that they split the difference and buy the interest for $109,000. The attorney for the "continuing partners", who was primarily a tax practitioner, indicated that the figure might be acceptable, but he first wished to confer with the "continuing partners". In private the attorney advised that payments for a covenant not to compete enjoyed the income tax advantage of being deductible over the life of the covenant, whereas payments for good will were in no way deductible. Landen, however, was apparently not told of these tax consequences nor was he told that an amount which he received as payment for a covenant not to compete would be taxed as ordinary income, but that amounts received for "good will" would receive capital gains treatment.

Being thus advised, the other partners agreed to the $109,000 compromise provided that $18,000 thereof would be designated as separate consideration for Landen's covenant not to compete, and that no amount would be designated as consideration for good will.

After some discussion, it was agreed that the "continuing partners" would pay Landen $18,000 for refraining for one year from (a) hiring Schulz Tool's employees; (b) soliciting Schulz' active customer accounts; and (c) opening a machine shop within a radius of five miles from the then location of Schulz Tool's plant. Upon Landen's objection the five-mile limitation was reduced to one mile.

Prior to the aforementioned meeting no suggestion had ever been made to Landen that the "continuing partners" were interested in his covenant not to compete either for customers or for labor supply.

The February agreement was reduced to writing which specified January 31, 1952, as the date of dissolution. The written agreement stated the price of Landen's interest as $91,000. A separate covenant not to compete appeared in Article IV of the agreement and provided in part: "In consideration of the faithful observance of the covenant not to compete, the continuing partners agree to pay to the retiring partner the amount of Fifteen Hundred Dollars ($1500) for each month that the retiring partner refrains from competitive acts * * * until a total of Eighteen Thousand Dollars ($18,000) has been paid."

The partners also published and filed a notice of dissolution which specified January 31, 1952 as the date of dissolution.

Pursuant to Section 188 of the Internal Revenue Code of 1939, the continuing partners included the distributive shares of the new partnership (i. e. the same business, without Landen as a partner) for the fiscal year beginning February 1, 1952, and ending January 31, 1953, in their respective individual returns for the calendar year ending December 31, 1953.¹ Hence, the individual returns of the continuing partners for the calendar year 1953 reflected the deduction of the amounts paid by the partnership for the alleged covenant. The Commissioner sent a deficiency notice disallowing this deduction.

In their petition for a redetermination of the deficiency filed in the Tax Court, the "continuing partners" objected to the disallowance of the deduction and also raised a new point. They contended that the old partnership — including Landen — was not, in fact, terminated on January 31, 1952, but rather on February 29, 1952. Hence, income earned by the partnership in the month of February 1952 should not be included in their individual returns for the year 1953, but rather in the individual returns for the year 1952 pursuant to Section 188, supra.

All of the returns in question were filed with the District Director in Los Angeles, California. This court has jurisdiction to review the decision of the Tax Court pursuant to Section 7482 of the Internal Revenue Code, 26 U.S.C.A. § 7482.

Alleged covenant. We think the Tax Court was correct in...