Smith v. Comm'r of Internal Revenue

• Decision Date: 13 May 1968
• Docket Number: 5926-64.,Docket Nos. 5673-64
• Citation: 50 T.C. 273
• Parties: HAROLD S. SMITH AND LOIS M. SMITH, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENTRAYMOND A. SMITH AND OLGA SMITH, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

50 T.C. 273

HAROLD S. SMITH AND LOIS M. SMITH, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENTRAYMOND A. SMITH AND OLGA SMITH, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket Nos. 5673-64

5926-64.

Tax Court of the United States.

Filed May 13, 1968.

Valenine Brookes and Paul E. Anderson, for the petitioners.

James E. Merritt, for the respondent.

Petitioners and others contracted to sell all the stock of a gambling casino for $10 million, the initial payment of $500,000 to be deposited in escrow and to be paid the sellers as liquidated damages for breach of contract if the buyer did not consummate the purchase. The buyer defaulted and sued to recover the deposit. The State court gave judgment for the sellers for the deposited amount. Pending appeal, the parties agreed upon a settlement whereby a part of the fund was returned to the buyer and a part distributed among the sellers. Held, the amounts received by the petitioners under the settlement are taxable as ordinary income, following Ralph A. Boatman, 32 T.C. 1188 (1959), and A. M. Johnson, 32 B.T.A. 156 (1935), and not as capital gains from a sale of capital assets, as in Alvin B. Lowe, 44 T.C. 363 (1965), or as damages for injury to the value of their stock.

BRUCE, Judge:

Respondent determined deficiencies in income tax for the calendar year 1957 as follows:

+-----------------------------------------------------------+
                ¦Docket No.  ¦Petitioner                       ¦Deficiency  ¦
                +------------+---------------------------------+------------¦
                ¦            ¦                                 ¦            ¦
                +------------+---------------------------------+------------¦
                ¦5673-64     ¦Harold S. Smith and Lois M. Smith¦$32,131.00  ¦
                +------------+---------------------------------+------------¦
                ¦5926-64     ¦Raymond A. Smith and Olga Smith  ¦30,782.37   ¦
                +-----------------------------------------------------------+
                

The sole issue for decision is whether certain amounts received by Harold S. Smith and Raymond A. Smith in 1957 are taxable as capital gains or as ordinary income.

FINDINGS OF FACT

The stipulations of facts and exhibits attached thereto are incorporated herein by this reference.

Harold S. Smith and Lois M. Smith were husband and wife during 1957 and resided in Reno, Nev., at the time the petition herein was filed. They filed a joint Federal income tax return for 1957 with the district director of internal revenue at Reno.

Raymond A. Smith and Olga Smith were husband and wife during 1957 and resided in Reno at the time the petition herein was filed. They filed a joint Federal income tax return for 1957 with the district director of internal revenue at Reno.

Harolds Club was a Nevada corporation engaged in the business of operating a casino in Reno, where gambling is legal. In 1956 the stock of Harolds Club was held by Harold S. Smith, Raymond A. Smith, and Dorothy M. Smith (former wife of Harold), each owning 50,000 shares. Harold and Raymond A. Smith had held their stock since 1946. Their basis in this stock was zero.

Raymond I. Smith, father of Harold and Raymond A., was general manager of the club. He was owner of all the stock, 50,000 shares of Raymond I. Smith, Inc., a Nevada corporation, which operated various bars connected with the club.

St. Charles Building Co., a Nevada corporation, in 1956 was owner of certain real property in Reno. Raymond A. Smith was president of this corporation.

Harold S. Smith, Raymond A. Smith, Dorothy M. Smith, and Raymond I. Smith are sometimes hereinafter referred to as the Smiths.

On February 29, 1956, the Smiths and St. Charles Building Co., as sellers, entered into a contract with Jules J. Agostini, Jr., as buyer, for the sale to the buyer of all the stock of Harolds Club and of Raymond I. Smith, Inc., and of certain real property. The price stated was $9,500,000 payable $500,000 immediately to an escrow holder and the balance on or before April 30, 1956. The deposit of $500,000 was made. The contract included a provision that no disclosure of the sale would be made unless the statement was agreed upon by the parties. A Reno newspaper of March 2, 1956, reported that the sale of the club was announced in a joint statement issued by Agostini and Raymond I. Smith.

The time for full payment as originally required by the contract of February 29, 1956, was extended on the same date to May 29, 1956, and on May 24, 1956, was again extended to September 29, 1956. On May 28, 1956, Agostini, with consent of the sellers, assigned to H.H.B., Inc., a Nevada corporation, his rights and interests in the contract and the deposit in escrow.

On June 25, 1956, the Smiths and St. Charles Building Co., as sellers, executed an amended contract with H.H.B., Inc., as buyer, which provided:

WHEREAS, BUYER and SELLERS mutually agree that the contract heretofore executed, dated the 29th day of February, 1956, between JULES J. AGOSTINI, JR., as BUYER, and the SELLERS herein designated as ‘SELLERS', is hereby cancelled, annulled and set aside, together with the escrow instructions based thereon, and that this agreement is substituted in full for the above and foregoing described contract;

NOW, THEREFORE, the SELLERS, for the consideration hereinafter recited, have agreed to sell and deliver, and the BUYER has agreed to purchase from the SELLERS, at the price, and upon the terms hereinafter mentioned, ONE HUNDRED FIFTY THOUSAND SHARES (150,000) of the capital stock of HAROLDS CLUB, a corporation, being all of the issued and outstanding stock of said corporation, and FIFTY THOUSAND SHARES (50,000) of the capital stock of RAYMOND I. SMITH, INC., a corporation, being all of the issued and outstanding stock of said corporation, together with the following described parcel of land * * *

UPON THE FOLLOWING TERMS AND CONDITIONS:

FIRST: BUYER agrees to pay for said stock and real property, above described, the sum of TEN MILLION DOLLARS ($10,000,000.00), lawful money of the United States of America, payable as follows, to wit: FIVE HUNDRED THOUSAND DOLLARS ($500,000.00) to be paid by BUYER SIMULTANEOUSLY with the execution of this agreement to the WASHOE TITLE INSURANCE COMPANY, of Reno, Nevada, as escrow agent, to be applied on the purchase price and the further sum of FIVE MILLION FIVE HUNDRED THOUSAND DOLLARS ($5,500,000.00) to be paid by the BUYER in cash on or before the 29th day of September, 1956, at twelve o'clock noon. Said further payment to be made to WASHOE TITLE INSURANCE COMPANY, as escrow agent, for the account of SELLERS. Upon the payment of the said further sum, as aforesaid, on or before the 29th day of September, 1956, and by noon said day, the SELLERS agree to accept a promissory note for the balance of said purchase price in the sum of FOUR MILLION DOLLARS ($4,000,000.00), duly executed by the BUYER, said sum to be secured by a First Deed of Trust and Chattel Mortgage, executed by the BUYER, in favor of the SELLERS.

* * *

SECOND: The SELLERS agree, upon the payment to the escrow agent of the sum of FIVE MILLION FIVE HUNDRED THOUSAND DOLLARS ($5,500,000.00), on or before September 29, 1956, at noon of said day, and upon receiving notice of such payment, they shall immediately deposit with the escrow agent, subject to the terms hereof, certificate for ONE HUNDRED FIFTY THOUSAND (150,000) shares of the capital stock of HAROLDS CLUB, a corporation, and FIFTY THOUSAND (50,000) shares of the capital stock of RAYMOND I. SMITH, INC., a corporation, properly endorsed in blank, together with resignations of the present officers and directors of HAROLDS CLUB, a corporation, and RAYMOND I. SMITH, INC., a corporation, to become effective at the pleasure of BUYER. * * *

THIRD: If the BUYER shall fail to pay and deposit the balance of the consideration with the escrow agent, to-wit, the sum of FIVE MILLION FIVE HUNDRED THOUSAND DOLLARS ($5,500,000.00) on or before the 29th day of September, 1956, or should fail to dissolve HAROLDS CLUB, a corporation, and transfer all of its assets to BUYER, or to effect the retirement of the capital stock of RAYMOND I. SMITH, INC., a corporation, within the times hereinafter designated, or should fail to execute and deliver the promissory note for the balance due, securing the same with a Trust Deed, Chattel Mortgage and Pledge of stock of RAYMOND I. SMITH, INC., a corporation, within the time herein designated, or should fail to perform the other terms and provisions of this contract within the time designated, the escrow holder shall pay and deliver to the SELLERS the deposit of FIVE HUNDRED THOUSAND DOLLARS ($500,000.00), which deposit so made shall be retained by the SELLERS by way of liquidating damages for breach of contract on the part of the BUYER for failure to consummate said purchase, and the BUYER agrees that said amount represents damages accruing to SELLERS by reason of said breach of contract, and this agreement, and all of its provisions, shall terminate, and the contract shall no longer be of any force or effect, and all documents and instruments deposited by SELLERS with escrow agent, described in the ‘SECOND’ paragraph hereof, shall be immediately returned to the SELLERS.

The contract further provided that the sellers should remain in possession of the business of the corporations until the terms of the purchase were complied with; that until the closing date the buyer, its agent or representative, should have the right to observe the business transactions of the sellers to determine the expenditures and receipts and assets and liabilities and all data connected with the operations; and that the business was to be carried on in the ordinary course, with the limitations that no dividends would be declared, no increase made in compensation of employees, bonuses would be limited to specified amounts, and no capital expenditure in excess of $5,000 would be made without consent of the buyer. It was also agreed that the buyer would employ Ronald I....