Schulz v. Comm'r of Internal Revenue, Docket Nos. 67160-67162

• Citation: 34 T.C. 235
• Decision Date: 19 May 1960
• Docket Number: Docket Nos. 67160-67162,67310.
• Parties: RAY H. SCHULZ AND DORIS L. SCHULZ, ET AL.,1 PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: United States Tax Court

34 T.C. 235

RAY H. SCHULZ AND DORIS L. SCHULZ, ET AL.,1 PETITIONERS,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket Nos. 67160-67162

67310.

Tax Court of the United States.

Filed May 19, 1960.

Arthur B. Willis, Esq., and John E. Scheifly, Esq., for the petitioners in Docket Nos. 67160, 67161, 67162.

Hugh J. Ritchie, Esq., and John C. McCall, Esq., for the petitioners in Docket No. 67310.

Jack E. Roberts, Esq., for the respondent.

Held: Monthly payments to a retiring partner, specifically allocated in the formal agreement of partnership dissolution as consideration for his separately stated covenant not to compete, in fact reflected partnership goodwill and were a ‘nonseverable’ portion of the consideration paid him for his capital interest in the partnership as a going business. Accordingly, the payments in question were capital gain to the retiring partner and unamortizable, nondeductible capital expenditures to the continuing partners. Held, further, that the continuing partners correctly reported in their individual 1953 returns their distributive shares of partnership income for the full 12-month period ending January 31, 1953, including the disputed income for the month of February 1952.

In these consolidated proceedings, petitioners contest the following deficiencies and allege the following overpayments in income taxes for the years indicated:

+----------------------------------+
                ¦Docket¦Year¦Deficiency¦Overpayment¦
                +------+----+----------+-----------¦
                ¦No.   ¦    ¦          ¦           ¦
                +------+----+----------+-----------¦
                ¦67160 ¦1953¦$6,914.60 ¦$8,889.50  ¦
                +------+----+----------+-----------¦
                ¦67161 ¦1953¦6,914.62  ¦8,917.62   ¦
                +------+----+----------+-----------¦
                ¦67162 ¦1953¦6,700.46  ¦9,099.34   ¦
                +------+----+----------+-----------¦
                ¦67310 ¦1952¦7,852.32  ¦           ¦
                +----------------------------------+
                

The questions remaining for decisions are as follows:

1. (a) Whether a partnership, in which the male petitioners in Docket Nos. 67160, 67161, and 67162 were members, was entitled to deduct on its return for the fiscal year ending January 31, 1953, certain amounts paid to Stanley C. Landen (petitioner in Docket No. 67310), allegedly for his covenant not to compete.

(b) Conversely, whether Landen was entitled to treat that portion of such amounts received in 1952 as capital gain upon the sale of his interest in the partnership.

2. Whether petitioners in Docket Nos. 67160, 67161, and 67162 properly reported their distributive shares of partnership income for February 1952 on their individual returns for the calendar year 1953, or whether, as now alleged by petitioners, they should have reported this income on their returns for the calendar year 1952.

FINDINGS OF FACT.

Certain facts have been stipulated and are incorporated herein by reference.

Ray H. and Doris L. Schulz are husband and wife residing in Pasadena, California. John W. and Lucille Schulz are husband and wife residing in San Gabriel, California. Melvin F. and Pauline Klagues are husband and wife residing in Arcadia, California. The aforementioned husbands and wives, respectively, filed joint income tax returns for the calendar year 1953 with the district director of internal revenue, Los Angeles, California.

Stanley C. and Virginia M. Landen, husband and wife residing in San Marino, California, filed a joint income tax return for the calendar year 1952 with the district director of internal revenue, Los Angeles, California.

On or about November 1, 1946, Stanley C. Landen (hereinafter referred to as Landen), Ray H. Schulz (hereinafter referred to as Ray), John W.Schulz (hereinafter referred to as John), and Melvin F. Klagues (hereinafter referred to as Klagues) organized a partnership by oral agreement under the firm name of Schulz Tool and Manufacturing Company (hereinafter referred to as Old Tool). Each partner made an original investment in the approximate amount of $3,000 and each had an equal interest in the partnership. Subsequently, all additional capital employed in the business was obtained by the retention of earnings.

Old Tool operated continuously with the four original partners until March 31, 1950, when it was dissolved. On or about April 1, 1950, the business theretofore operated as Old Tool was transferred to Schulz Tool and Manufacturing Co., Inc. (hereinafter referred to as Corporation), which had been organized on November 29, 1949. The capital stock of Corporation was held equally by Landen, Ray, John, and Klagues.

Corporation, under the continuous ownership of Landen, Ray, John, and Klagues, operated the business until May 31, 1951, when its assets and liabilities were distributed in liquidation to the stockholders. On or about June 1, 1951, Landen, Ray, John, and Klagues organized a partnership under the firm name of Schulz Tool and Manufacturing Company (hereinafter referred to as Tool), and transferred to it the assets and liabilities which they had received in liquidation of Corporation.

In 1952, Landen's interest in Tool was sold to Ray, John, and Klagues, and Tool was dissolved. Thereafter, Ray, John, and Klagues continued the operation of the business as equal partners under the same firm name of Schulz Tool and Manufacturing Company (hereinafter referred to as Manufacturing). The business carried on continuously by Old Tool, Corporation, Tool, and Manufacturing is hereinafter referred to collectively as Schulz Tool.

The initial business of Schulz Tool had two branches: The manufacture and sale of aircraft system fuel valves, and the performance of ‘job machine work.’ The fuel valves were ‘proprietary items' of Schulz Tool, being designed and developed by it to meet the requirements of aircraft manufacturers. ‘Job machine work,‘ in contrast, consisted of custom machining parts on orders from manufacturers who provided the necessary blueprints and designs. As the valve manufacturing aspect of the business developed and became increasingly profitable, it required a greater percentage of the machine time and resources available to Schulz Tool. This resulted in decreasing emphasis on job machine work. By January 31, 1952, Schulz Tool had either wound up or terminated existing machine work orders, and had ceased soliciting further orders.

After the close of World War II, and prior to the formation of Old Tool, Ray had purchased from Public Service Brass Corporation, his then employer, the manufacturing and engineering specifications for a fuel level control valve and a fuel vent float valve which he had developed while an employee and which were of potential use in the aircraft industry. However, there were no production orders for these valves in late 1946. They were being used experimentally by Lockheed Aircraft Corporation on its F-80 jet fighter and its Constellation, but the rubber diaphragms used in their operation were subject to deterioration, and to bursting at high flow refueling speeds.

At the time Old Tool was formed, Ray had some of these valves in process in his garage where he was manufacturing them under the name Schulz Tool and Manufacturing Company; the partnership retained this name. The experimental use of these valves by Lockheed gave Schulz Tool an ‘in’ to that company. The partners devoted their combined efforts to developing an improved valve without the defects of the original rubber diaphragm type. In the early months, each partner worked an average of approximately 90 hours per week; thereafter, and as of January 31, 1952, each partner worked an average of approximately 60 hours per week.

After 2 years of developmental work, the partners succeeded in producing a piston type valve which, through extensive engineering tests and promotional efforts, was shown to be superior in quality and performance to valves produced by competitors, as well as being cheaper in price. The piston type valve received ‘most favorable acceptance’ from substantially all major aircraft manufacturers and by the Government for use by the Air Force and Navy.

Schulz Tool's customers included Convair, Lockheed Aircraft Corporation, Republic Aviation Corporation, Canadair, North American Aviation, Northrop Aircraft, Inc., Rohr Aircraft Corporation, and Boeing Aircraft Company. A letter received from Republic Aircraft Corporation in 1949 stated that the continued production and delivery of its F-84G airplane was contingent on the uninterrupted supply of Schulz Tool's valves, and that Schulz Tool was Republic's sole source of supply for these valves. Schulz Tool also held prime military contracts with the Air Force and Navy. As of January 31, 1952, Schulz Tool valves were being used on all types of jets and reciprocating engine aircraft for military use.

Sales and product acceptance were achieved by direct contact with the Air Force, Navy, and major aircraft companies, which entailed extensive travel and numerous conferences with prospective purchasers. All of the sales activities, including customer relations and customer engineering liaison, were handled by Ray. Klagues also handled ‘some’ contract work, but his responsibilities included plant administration and supervision of industrial relations and personnel. Landen and John were primarily concerned with internal operations. Both were machinists and toolmakers by trade, Landen being considerably more experienced. Landen had no duties in the sales, design, or engineering phase of the business, although he did have some sales contacts with respect to the job machine work which he supervised before it was discontinued.

Demand for Schulz Tool's valves for military use outstripped its own ability to supply, to the extent that the partners were obliged to subcontract a substantial portion of machine work on its proprietary items. Schulz Tool also experienced a considerable repeat order business, as was customary with aircraft suppliers. From 1948 through 1954, the same basic valves, with modifications, were manufactured by Schulz Tool...