United States v. Wernentin, 17633

• Decision Date: 27 December 1965
• Docket Number: No. 17633,17688.,17633
• Citation: United States v. Wernentin, 354 F.2d 757 (8th Cir. 1965)
• Parties: UNITED STATES of America, Appellant, v. Fred C. WERNENTIN, Esther Wernentin, Robert J. Jester and Bobbette Jester, Appellees. Fred C. WERNENTIN, Esther Wernentin, Robert L. Jester and Bobbette Jester, Appellants, v. UNITED STATES of America, Appellee.
• Court: U.S. Court of Appeals — Eighth Circuit

354 F.2d 757 (1965)

UNITED STATES of America, Appellant, v. Fred C. WERNENTIN, Esther Wernentin, Robert J. Jester and Bobbette Jester, Appellees.

Fred C. WERNENTIN, Esther Wernentin, Robert L. Jester and Bobbette Jester, Appellants, v. UNITED STATES of America, Appellee.

Nos. 17633, 17688.

United States Court of Appeals Eighth Circuit.

December 27, 1965.

John C. Owen, Washington, Iowa, for Fred C. Wernentin and others.

David I. Granger, Atty., Tax Div., Dept. of Justice, Washington, D. C., for the United States with Louis F. Oberdorfer, Asst. Atty. Gen., and Lee A. Jackson, Harry Baum, Attys., Tax Div., Washington, D. C., and Donald A. Wine, U. S. Atty., Des Moines, Iowa.

Before VOGEL and BLACKMUN, Circuit Judges, and REGISTER, District Judge.

BLACKMUN, Circuit Judge.

At issue here is the character — as long-term capital gain or as ordinary income — of a partnership's net receipts under certain Dairy Queen contracts during the calendar years 1951-1953, inclusive.

The taxpayers are Fred C. Wernentin and his wife Esther and Robert L. Jester and his wife Bobbette. The partnership, known as Wernentin and Jester, was originally one between the two men but on January 1, 1952, was expanded to include their wives.

The net receipts in question were reported in the filed partnership returns as ordinary income and were correspondingly reflected in the taxpayers' individual returns. The taxpayers bring this suit to recover the difference in tax which results if the income qualifies as long-term capital gain. Judge Van Pelt, in a thoughtful and scholarly opinion (described as "an extremely able decision" in 3B Mertens, Law of Federal Income Taxation, § 22.12, note 94 (Supp. 1965), and § 22.93, note 65 (Supp.1965)), held that that Dairy Queen income which was received under a 1949 contract, hereinafter described, was capital gain but that that which was received under a 1951 agreement did not so qualify and was ordinary income. Wernentin v. United States, 218 F.Supp. 465 (S.D. Iowa 1963). These conclusions resulted in the entry of judgment in favor of the respective taxpayers for each of the tax years but in amounts less than they claim are due. Both sides appeal.

The facts are not in dispute. Dairy Queen is a soft-serve dairy product dispensed from a patented freezer machine directly to the customer. J. F. McCullough and H. A. McCullough are father and son. Esther Wernentin and Bobbette Jester are mother and daughter. Mrs. Wernentin is a daughter of J.F. McCullough. The male McCulloughs possessed trademark rights in the name Dairy Queen and, under grant from the patent holder, the right to manufacture and use the freezer. They also had the right to effect subcontracts with others.

The McCullough-Jester arrangement. In 1948 the McCulloughs by written "Freezer and Territory Agreement" granted to Jester (evidently acting on behalf of the partnership) the right to use the freezer and the trademark within the State of New Jersey. This right apparently was an exclusive one; at least the parties understood it to be so. The agreement called for Jester's ordering freezers through the McCulloughs and taking up adjustments directly with the manufacturer; the payment to the McCulloughs and to the patent owner of specified amounts per gallon of mix used or sold; the maintenance of records to which McCullough and the patent owner were to have access; the non-removal of any freezer from New Jersey for purposes of operation; and the non-use of "any other frozen or semi-frozen dairy product" or any other freezer without the prior written consent of the McCulloughs. Jester was given "the right to subdivide the State of New Jersey from time to time among other subcontractors subject to prior approval" of the McCulloughs but he was to give a copy of each subcontract to the McCulloughs and to the patent holder. He was obligated to have a designated number of stores in operation by stated dates. He was to collect a starting fee, between $1,000 and $2,000, from each subcontractor and to pay one-third of it to the McCulloughs. His maximum gallonage charge to an operator was not to exceed 29¢. Title to the territory was said to remain in the McCulloughs "until released in part under contracts approved by" them. This was the basic agreement between the McCulloughs and Jester and was the contract which gave Jester, and hence the partnership, the interest with which the present controversy is concerned.

Jester himself also operated personally at least one store in Iowa from 1949 on.

The May 5, 1949 contract. This was a "Freezer and Territory Agreement" between Jester and Robert U. Dinkins. By it Jester, who then lived in Iowa, gave Dinkins exclusive and perpetual Dairy Queen rights, including the right to subcontract, in three New Jersey counties. Dinkins agreed (a) not to move any freezer outside the territory for operation; (b) to order freezers through Jester and to have Jester negotiate defective parts adjustments with the manufacturer; (c) to pay $333.33 on the starting date of each of the first three stores and $1,000 on the starting date of each store thereafter; (d) to pay, by monthly remittance, 19¢ per gallon on all mix used or sold; (e) to charge in all further subcontracts maximums of $2,000 as a starting fee and 29¢ per gallon for mix; (f) to furnish Jester copies of each subcontract within ten days; (g) to maintain records of mix and freezers to which Jester, H. A. McCullough, and the patent holder all were to have access; (h) to sell Dairy Queen as "the only product" on the premises and to use no other type of freezer unless, in either event, written permission was first obtained from Jester; (i) to use only high grade equipment and mix; and (j) to perform in accord with the following:

"10. That the Buyer shall make every effort to have at least Three (3) Dairy Queen establishments within the above described territory in complete and continued normal seasonal operation on or before October 1, 1949. These may be his own stores or under sub-contract. In the event the Buyer does not have the required number of stores in operation on or before the above required date, then, at the option of the Seller, the Buyer shall lose his rights to further develop the above described territory. The rights of the Buyer to operate under this agreement shall continue only for the areas under sub-contract, plus areas within a two mile radius of any store or stores which the Buyer may own himself."

The contract also provided that every subcontract "must have the written consent and approval of Jester before it is dated and signed."

It is to be observed that most of the provisions of this Jester-Dinkins contract were in line with, and undoubtedly occasioned by, the provisions of the McCullough-Jester contract. Certainly the two were parallel. Specifically, however, the agreement with Dinkins contained, perhaps naturally, at least four provisions which have no precise counterparts in Jester's agreement with the McCulloughs: The first was Jester's option in paragraph 10 to terminate Dinkins' development rights. The second was the requirement that Dinkins purchase "only high grade equipment, supplies, and mix, produced and distributed by reputable concerns". The third was the provision for Jester's making adjustments with the manufacturer as to defective parts. The fourth was Jester's power, broader than McCullough's, to control the handling of other products.

Subsequent to the 1949 contract Jester and Dinkins executed four supplemental agreements (one of them subsequent to May 5, 1951) by each of which Dinkins was given similar Dairy Queen rights in additional New Jersey territory. This was effected by what essentially were incorporations of the 1949 agreement by reference. Three of these contracts recited the payment by Dinkins to Jester of a lump sum upon execution.

The May 5, 1951 contract. On this date Jester and Dinkins executed still another agreement. This contract applied to what appears to be the remainder of New Jersey. For the most part it followed the very form and content of the 1949 agreement but it differed from the earlier contract in that (a) it called for a flat $1,000 payment for each new store, (b) it fixed the gallonage payment at 21½¢, and (c) it contained the following new and different paragraph 10:

"10. That the Buyer shall make every effort to secure the establishment of Dairy Queen stores within the above described territory at desirable locations until said territory has been fully developed. In the event the Buyer defaults in his performance of the terms, conditions and provisions of this agreement, and the Seller desires to exercise his right to extinguish the Buyer\'s rights to further develop the above described territory, the Seller shall furnish the Buyer with Ninety (90) Days written notice by registered mail to the address herein given, notifying the Buyer of the termination of said rights."

We therefore have in the 1951 contract, as we have in the 1949 agreement, at least four particular provisions which have no counterparts in Jester's agreement with the McCulloughs: The first is the termination right set forth in paragraph 10. The second is the requirement as to the purchase of only high grade equipment and mix. The third concerns adjustments for defective freezer parts. The fourth is the product control.

So much for the literal language of the formal contracts. A word as to the parties' conduct thereunder is in order:

Dinkins had three stores in operation by October 1949. He eventually developed 116 stores in New Jersey.

Jester and Dinkins observed the terms of their contracts closely. Jester exercised most of his rights and held Dinkins to most of his obligations. On the few occasions Dinkins deviated from his contract obligations he acted only with Jester's consent. Thus, Dinkins began to place freezer orders directly with the manufacturer but only when Jester had agreed to this practice...