Opinion
Docket No. 10162.
1947-10-20
JAMES WESLEY MCAFEE AND ALICE B. MCAFEE, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Walter S. Alt, Esq., for the petitioners. Harlow B. King, Esq., for the respondent.
A retiring partner of a law firm in 1941 entered into a contract with the other partners whereby he was to receive his aliquot proportion of the fees collected in cases in which he was deemed to have an interest. Held, that this was not a sale of a capital asset and that the income received by the petitioner under the contract in 1944 is taxable as ordinary income, rather than capital gain. Walter S. Alt, Esq., for the petitioners. Harlow B. King, Esq., for the respondent.
The respondent has asserted an income tax deficiency of $823.86 in the joint return filed by the petitioners for 1944. The sole question at issue is whether the payment of $1,647.67 which petitioner James Wesley McAfee received in 1944 from his former law partners after dissolution of the partnership was a capital gain or was ordinary income.
The term ‘petitioner,‘ as hereinafter used, will refer to James Wesley McAfee; his wife, Alice B. McAfee, being a party to the proceeding only by reason of the fact that she filed a joint return with him for the taxable year.
FINDINGS OF FACT.
The petitioner is a resident of St. Louis, Missouri. He filed his return for the taxable year 1944 with the collector of internal revenue for the first district of Missouri.
The petitioner and three other attorneys, by oral agreement, formed a partnership in 1937 for the practice of law in St. Louis, Missouri, under the name of Igoe, Carroll, Keefe & McAfee. This partnership continued until December 6, 1941, when the petitioner withdrew to accept employment as president and a director of Union Electric Co. of Missouri. This company was one of the clients of petitioner's law firm. At the time of his withdrawal from the partnership the petitioner entered into an oral agreement with the other members of the firm in settlement of his financial interests therein. This agreement was reduced to writing on December 30, 1941. The written agreement reads in material part as follows:
I
1) First Parties and Second Party have been partners, engaged in the practice of law under the firm name of Igoe, Carroll, Keefe & McAfee with offices in the Boatmen's Bank Building, Saint Louis, Missouri. Second Party having withdrawn from said firm, the partnership has been dissolved as of December 6, 1941, upon the understanding and agreement, however, that the books of the firm should not be closed until December 31, 1941 and that all receipts up to and including the last-named date, subject to payment of expenses therefrom, shall belong to the parties in one-fourth shares just as though the partnership had continued until said last-named date and that the accounting among the parties, upon dissolution of the partnership, shall be upon that basis.
2) In addition to moneys received and receivable up to and including December 31, 1941, there will be receipts after that date on account of fees for services rendered to clients prior to the dissolution of the partnership, on account of reimbursement for advancements made during the existence of the partnership and on other accounts in all of which Second Party has a one-fourth interest; and Second Party also has an interest in certain of the physical property used by the firm.
3) It is the desire of First Parties and of Second Party to liquidate and satisfy as of this date the entire interest of Second Party in and to all firm property as well as receipts subsequent to December 31, 1941, upon sale by Second Party and purchase by First Parties of all such rights and interests. The exact value of Second Party's said rights and interests is not now definitely ascertainable and will not be definitely ascertained for a period of at least one year after December 31, 1941. In view of that fact the parties, in order to liquidate and satisfy now Second Party's full interest and to effect now a full transfer and assignment by Second Party to First Parties of all of his right, title and interest in and to firm property and all amounts receivable in the future, have agreed upon the sum of Twenty Thousand Dollars ($20,000) as the approximate value of Second Party's said rights, title and interest and that said sum be now paid by First Parties to Second Party in consideration of such full transfer and assignment, subject to adjustment of the amount paid as hereinafter provided.
II
In consideration of the premises, it is hereby agreed:
1) In consideration of the sum of $20,000, this day paid by First Parties to Second Party, the receipt of said sum by Second Party being hereby acknowledged, Second Party does hereby sell, grant, assign, transfer and release to First Parties all of his right, title and interest in and to all property owned or held by First Parties and by Second Party as members of the aforesaid partnership of Igoe, Carroll, Keefe & McAfee, including all of his right, title and interest in and to any and all amounts receivable by said partnership subsequent to December 31, 1941, excepting, however, from said sale, grant, assignment, transfer and release cash on hand and bank accounts credits to the partnership on and prior to December 31, 1941, so that First Parties shall be and are hereby vested with all of the rights, title and interest of Second Party in and to all such property including receivables.
2) After First Parties shall have collected all amounts receivable on account of the business of said partnership done up to and including December 31, 1941, a determination shall be made of the exact amount of a one-fourth share of net receipts after December 31, 1941 attributable to business done by the aforesaid firm up to and including that date. If the amount of a one-fourth share of such collections after December 31, 1941 shall be more than $20,000, First Parties shall thereupon pay to Second Party the amount of such difference. If the amount of a one-fourth share of such collections be less than $20,000, Second Party shall thereupon pay the amount of the difference to First Parties.
3) It is understood and agreed that the sole purpose of the provisions in the last preceding paragraph for future payment by First Parties or by Second Party, as the case may be, is to provide compensation for loss to First Parties or to Second Party, should the amount of the purchase price now paid to Second Party prove to be either inadequate or excessive, and that the inclusion in this agreement of said provisions is not intended, nor shall the same be construed, as in any wise impairing or affecting the absoluteness and finality of the sale by Second Party and the purchase by First Parties, hereby effected, of all of Second Party's right, title and interest in and to the firm property and all amounts receivable after December 31, 1941 on account of firm business done up to and including that date.
Upon entering the partnership the petitioner received one-seventh of the partnership's earnings up to June 30, 1939. Thereafter he received one-fourth.
At the time of his withdrawal from the firm the petitioner had a credit in his capital account with the firm of $5,040.14, which consisted for the most part of fees previously earned and collected by the firm but not distributed to the individual partners. This amount was paid to the petitioner in cash on December 6, 1941. The $20,000 referred to in the dissolution agreement was paid to the petitioner on or about December 30, 1941. He reported that amount in his 1941 return as ordinary income, but later filed an amended return and claim for refund in which he treated the amount as capital gain. The claim for refund is still pending.
Under the contingent provisions of the dissolution agreement, paragraph II(2) above, the petitioner received a further payment in 1941 of $1,927.39, representing a one-fourth portion of the earnings of the partnership for the period December 7 to December 31, 1941. The earnings of the partnership for the entire year 1941, as reported in the partnership return, amounted to $112,599.36. The returns showed one-fourth of that amount, or $28,149.84, as the petitioner's distributable share and the petitioner reported that amount in his individual return for 1941 as his share of the partnership earnings. The petitioner has received additional payments under the agreement in each of the subsequent years. The amount received in the taxable year 1944, about which this controversy has arisen, was $1,647.67. This was the amount of partnership profits allocated to the petitioner, based on the amount of work done or time spent on the cases during the different periods; that is, before and after petitioner's withdrawal from the firm. The petitioner was not considered as having any interest in the retainers after his retirement. The firm's only income was from fees received for regular services performed by its members.
The petitioner reported the amount which he received in 1944 in his 1944 return as a capital gain, only one-half of which was to be taken into account for tax purposes. The respondent has determined that the whole amount is taxable to the petitioner as ordinary income.
OPINION.
LEMIRE, Judge:
The crux of our question is, Did the petitioner sell to the other partners his interest in the partnership, or did he merely agree with them as to what he should be entitled to receive out of the fees thereafter collected on the work already performed or contracted for during his association with the firm?
In their briefs the parties have cited numerous cases in support of their respective contentions, including: Bull v. United States, 295 U.S. 247; Hill v. Commissioner, 38 Fed.(2d) 165; Pope v. Commissioner, 39 Fed.(2d) 420; Helvering v. Smith, 90 Fed.(2d) 590; Doyle v. Commissioner, 102 Fed. (2d) 86; McClennen v. Commissioner, 131 Fed.(2d) 165; Allan S. Lehman, 7 T.C. 1088; Estate of George R. Nutter, 46 B.T.A. 35. The cases cited in the briefs may be said to stand for the proposition that the payments which a retired partner, or his estate in case of his death, receives from his firm, or from the individual members, constitutes capital gain if there was in fact a sale by the retired or deceased partner of his interest in the partnership, and ordinary income if the payments were in fact the retired or deceased partner's share of the income which he had earned during his association with the firm.
The parties here have stipulated that at the time of the petitioner's retirement the physical assets of the firm, acquired after the petitioner became associated with it, consisted of a library and other office equipment which had an undepreciated cost of $1,752.99 and in which the petitioner had a one-fourth interest. The firm carried no good will on its books and no mention was made of good will in the dissolution agreement. There was carried in the books a ‘capital account‘ consisting of a cash working fund. The petitioner's share of that fund was paid to him or, as he described it, ‘withdrawn‘ by him, at the time the old agreement was entered into. This capital account was not mentioned in the written agreement and had no connection with the subsequent payments which the petitioner received under that agreement.
There is no doubt that the petitioner and his associates intended for the agreement to have the form and appearance of a sale by the petitioner to his associates of his interest in the partnership. The reason for this, as the petitioner and one of his associates testified before us, was that they thought it might be considered unethical for the petitioner to continue receiving profits of the law firm and at the same time receive compensation as an officer of one of its principal clients. The firm expected to continue representing the Union Electric Co. of Missouri in legal matters.
We must construe the agreement according to its substance and effect, rather than its form and appearance. The purpose of the parties to have an agreement in writing evidencing final and complete severance of the petitioner's relations with the partnership does not mean that there was in actuality a sale by the petitioner of his interest in the partnership. In the Bull case, supra, one of the leading cases on this point, the Court of Claims held that all of the income paid by a trading partnership to the estate of a deceased partner, including that earned prior to his death as well as that subsequently earned, constituted income taxable to the deceased partner's estate and was includible in the decedent's estate for estate tax purposes. The Supreme Court sustained as to the income tax, both as to the income earned before and that earned after the deceased partner's death, but held that the later income was not includible in the gross estate for estate tax purposes. The Court said in its opinion:
We concur in the view of the Court of Claims that the amount received from the partnership as profits earned prior to Bull's death was income earned by him in his lifetime and taxable to him as such; and that it was also corpus of his estate and as such to be included in his gross estate for computation of estate tax. We also agree that the sums paid his estate as profits earned after his death were not corpus but income received by his executor, and to be reckoned in computing income tax for the years 1920 and 1921. Where the effect of the contract is that the deceased partner's estate shall leave his interest in the business and the surviving partners shall acquire it by payments to the estate, the transaction is a sale, and payments made to the estate are for the account of the survivors. It results that the surviving partners are taxable upon firm profits and the estate is not. (Hill v. Commissioner, supra; Pope v. Commissioner, supra.) Here, however, the survivors have purchased nothing belonging to the decedent, who had made no investment in the business and owned no tangible property connected with it. The portion of the profits paid his estate was therefore income and not corpus; * * *
The Court pointed out that there were no tangible assets involved in the contract.
The Hill and Pope cases, which were cited with approval in the Bull case, involved payments made to the estate of a deceased partner of agreed shares of the subsequent earnings of insurance brokerage firms. It was held that the partnership agreements under which the payments were made constituted sales by the deceased partners' estates and purchases by the continuing partner of the deceased partners' interests; and that the surviving partners were therefore taxable pro rata on all of the partnership earnings. Neither of the cases involved any question as to whether the payments made were capital gains or ordinary income to the estates of the deceased partners. The question in each case was whether the income payable to the deceased or retired partner was taxable income to the continuing partner or was a deductible expense of the partnership.
In Estate of George R. Nutter, supra, one of the cases relied
upon by petitioner, we held that the value of a contract providing for payment of a certain portion of the earnings of a law partnership to the estate of a deceased partner was includible in his gross estate. The Bull case, supra, was distinguished on the grounds that in the Nutter case there were substantial ‘capital and tangible assets‘ which were taken into account in the dissolution agreement. We said in our opinion:
* * * In this matter there appear to have been both an investment of capital in, and tangible property owned by, the partnership and a clear recognition by the partnership in the partnership agreement that each partner had a capital interest; whereas in the Bull case there was neither capital interest nor tangible property owned by the partnership. * * *
Helvering v. Smith, supra, involved substantially the same question as that presented in the instant case; that is, whether the payments made to a retired partner of a law firm out of the earnings thereafter received for services performed, or on business obtained, while he was in the firm are taxable as capital gains or as ordinary income. The Circuit Court held that the payments were ordinary income. In his opinion, Judge Learned Hand said:
* * * The transaction was not a sale because he got nothing which was not his, and gave up nothing which was. Except for the ‘purchase‘ and release, all his collections would have been income; the remaining partners would merely have turned over to him his existing interest in earnings already made. As he kept his books on a cash basis, it is true that he would have been taxed only as he received the accounts in driblets, but he would have been taxed upon them as income. The ‘purchase‘ of that future income did not turn it into capital, any more than the discount of a note received in consideration of personal services. The commuted payment merely replaced the future income with cash. Indeed, this very situation was suggested in Bull v. United States, supra, 295 U.S. 247. * * *
Here the extent of petitioner's interest in the physical assets of the firm was only about $438. The claim is made that there was some good will which was attributable to the petitioner's association with the firm, but there was no attempt to value it and no account was taken of it in the dissolution agreement. The fact that the amount which the petitioner would ultimately receive from the firm was contingent upon the amount of fees collected on the cases in which he had an interest indicates that no part of the consideration was intended to cover either good will or physical assets. The ultimate amount which the petitioner was entitled to receive under the agreement was not $20,000, but was $20,000 plus or minus the difference between that amount and his one-fourth portion of the fees collected in the cases in which he was deemed to have an interest. This contingent provision of the agreement seems to us to mean that what the petitioner was to receive was nothing more or less than his share of the partnership earnings. The fact that the continuing partners did not report the petitioner's share of subsequent earnings in their individual returns indicates that they so understood the agreement.
In Allan S. Lehman, supra, another of the cases relied upon by the petitioner, there was an admitted capital gain on the sale by partners of a fractional interest in a securities brokerage business. Our only question was whether the holding period for such capital asset dated from the taxpayer's acquisition of his interest in the partnership or from the date or dates of acquisition by the firm of specific assets which it held at the time of the transaction. The case obviously is not authority for the petitioner's contentions here.
On the evidence here we have found as a fact that the petitioner did not sell an interest in the partnership firm or in the assets of the firm. The agreement of December 30, 1941, as we construe it, was not in substance a contract of sale, but was merely a contract of partnership dissolution by which the partners settled their respective rights in the subsequent earnings of the partnership. The question here is not materially different from that in Helvering v. Smith, supra. We think the respondent has correctly determined that the income which the petitioner received from the partnership in 1944 is taxable to him as ordinary income.
Decision will be entered for the respondent.