Proctor v. Commissioner

*67 The Commissioner determined deficiencies in petitioners' income. taxes $886.98 for 1934 and $2,634.03 for 1935, by increasing petitioner's distributive share of partnership income.

FINDINGS OF FACT.

Petitioners are husband and wife and reside in Concord, Massachusetts. They filed joint income tax returns for 1934 and 1935. During those years petitioner ¹ was a member of a partnership which conducted a general insurance business in Boston under the firm name of Patterson, Wylde & Windeler. This partnership was formed by an agreement executed on December 31, 1929, by Henry H. Wilder and petitioner. A prior partnership of the same name had been formed on December 1, 1919, by*1077 Charles C. Patterson, John Wylde, G. Herbert Windeler, Henry H. Wilder, Allan McKissock, and petitioner, to continue for ten years. It was agreed that the firm name might be used by any successor partnership of which Wilder, McKissock, and petitioner, or any two of them, were members, and in the event of a partner's death or withdrawal (except Windeler's) the others might continue the business, paying to the former partner, his estate or his assigns his part of the cash capital and, for a five-year period, two-thirds of the share of profits to which his interest would have entitled him if he had remained a partner, "in full payment of all claims * * * in all the partnership's assets, goodwill, trade name and business." If the five-year period of payments should extend beyond the duration of the partnership, then the obligations "shall be carried out by the partner or partners succeeding to the business of the partnership * * *."

The partnership of 1919 expired by its terms on December 31, 1929. During its existence other partners*1078 had been admitted, Patterson had *68 died and McKissock had retired. On the date of its expiration, Wilder and petitioner formed a new partnership under an agreement which recited that it succeeded the former one; that Patterson had died in 1928 and his estate had become entitled, "in lieu of his interest in the assets and good will", to certain payments not fully discharged; that McKissock had retired in 1928 and had assigned his "benefits" to Wilder and petitioner for a cash payment; that Wylde and Windeler:

* * * by agreements of even date herewith released and transferred all their respective right, title and interest in the assets and good will of said partnership to the parties hereto * * * and * * * consented to the use by the parties hereto of said firm name; * * *

The agreement then provided for the partnership's conduct of an insurance business, and Wilder and petitioner:

* * * hereby jointly and severally grant, transfer and assign to said partnership, its successors and assigns, their right, title and interest * * *

to all the assets of the predecessor partnership, including good will, subject to its liabilities which the new partnership agreed to assume. *1079 The net profits and losses of the new partnership were to be shared equally by them:

* * * provided that there shall first be taken from said profits such amount as shall be necessary to discharge the yearly obligation to the Estate of Charles C. Patterson and the obligation to said Wilder and said Proctor as Assignees of said McKissock. * * *

Upon the death or withdrawal of either partner, the other was to become sole proprietor of the business and assets, making settlement in a prescribed manner with the other or the other's estate if he elected to discontinue the business, and in case he elected to continue, to make settlement by paying over the former partner's cash capital and making other payments determined on the basis of his salary and share of profits, varying in periods and amount according to stipulated contingencies.

* * * The continuing partner shall assume and carry out the obligation to the Estate of Charles C. Patterson, and payments made on account thereof shall be deducted in computing net profits, but the rights of the individual partners to reimbursement as assignees of McKissock shall cease and determine upon the happening of any of said events.

Simultaneously*1080 with the execution of the new partnership agreement, petitioner and Wilder entered into separate but entirely similar agreements with Wylde and Windeler, which recited that petitioner and Wilder had paid to each of the latter "his share of the cash capital" of the expired partnership and that the parties desired "to enter into an agreement with respect to the rights and obligations" of the latter. Petitioner and Wilder then agreed to "pay or cause to be *69 paid" to Wylde and to Windeler each his "share of the net profits of said firm for the year 1929" in accordance with the 1919 articles of partnership and that the new partnership would include each:

* * * as consultant or advisory associate of the firm and will pay to him as compensation for his services thereas an amount equal to five per cent. of the net profits of the business conducted by said firm, * * *.

In case of the resignation or death of such "associate", the firm agreed to pay to him or his representative an amount which, added to that "drawn by him on account of compensation", should be equivalent to 5 percent of the net profits for the whole year in which the resignation or death occurred, and if such*1081 death should occur in 1930 or 1931, the firm was to pay to the deceased's representative 5 percent of its net profits for 1931 and 1932. Resignation by an "associate" was permitted at any time until the end of 1932 and on ninety days' notice thereafter. The two "associates" were not responsible for any losses of the new partnership, which agreed further to pay all liabilities of the old one.

5. Said * * * [associate] in consideration of the foregoing hereby releases * * * [Wilder and petitioner], their executors, administrators and assigns, of and from all claims and demands which he has or may have against them under said articles of copartnership dated December 31, 1919 and/or any amendment or modification thereof, and he hereby irrevocably consents to the use of the name Patterson, Wylde & Windeler by a firm to be composed of * * * [Wilder and petitioner] and their successors and assigns, and he further releases and transfers to * * * [Wilder and petitioner] all his right, title and interest in the partnership assets, good will, trade name and business of said firm existing under said articles dated December 31, 1919.

The obligation to make payments to the "associates" *1082 was to cease upon the partnership's termination, except that $2,500 a year was to be paid until December 31, 1932, and if the business was continued by either of the partners, the new firm was to be obligated to make the prescribed payments.

On December 31, 1929, the balance sheet of the partnership of 1919 indicated assets of $334,960.42, of which $295,337.37 was represented by accounts receivable. Of this amount $22,450.99 was worthless and charged off in subsequent years. Furniture and fixtures, appearing on the books at $1, were worth $6,000. The balance sheet further indicated liabilities of $319,729.80, partners' capital of $5,000, and a "Net Balance Due Partners" of $10,230.62. The share of Wylde and Windeler in the partnership's earnings and also in the partners' capital, $294.12 each, was paid to them on or about December 31, 1929.

The association of Wylde and Windeler with the new partnership was continued until their deaths at advanced ages in 1934 and 1937, respectively. They rendered occasional services to the firm in approaching customers and handling accounts, and were frequently *70 called in consultation. They were founders of the business, had a*1083 high standing and wide acquaintance, and their services were sometimes important. Windeler had a desk at the partnership's office; Wylde had no desk, but made use of the office facilities.

In 1934 Wylde and Windeler each received $3,217.21 under their respective agreements of December 31, 1929, and in its 1934 income tax return the partnership reported these amounts, 5 percent of its net income, as "Partners' or Members' Shares of Income and Credits" distributable to Windeler and Wylde's estate. In 1935 Windeler received $2,766.72 under his agreement, and in its 1935 income tax return the partnership similarly reported this amount, 5 percent of its net income, as distributable to Windeler. In determining petitioner's income taxes, the Commissioner included in income for 1934 one-half of the amounts paid to Wylde and Windeler, or $3,217.21, and for 1935, seven-twelfths of the amount paid to Windeler, or $1,613.92.

OPINION.

STERNHAGEN: The amounts which went to Wylde and Windeler in 1934 and 1935 by virtue of their individual contracts with Proctor and Wilder have been treated by the Commissioner as if in the first instance they had gone to Proctor and Wilder as their distributive*1084 shares of the income of their partnership and then had been used by them to purchase from Wylde and Windeler their rights and interests in intangible property constituting assets of the old partnership which expired in 1929. Cf. . In his brief the respondent states the issue thus:

The sole issue involved in this proceeding is whether the sums paid to Wylde in 1934 and to Windeler in 1934 and 1935 were paid by the partnership firm of Patterson, Wylde & Windeler to acquire on behalf of the petitioner and Henry H. Wilder the interests of retiring partners in the "good will" of a prior partnership and therefore such payments should not be deducted from the distributive partnership income of the petitioner and Wilder as partners of Patterson, Wylde & Windeler.

The petitioner contends that the amounts were paid to Wylde and Windeler in either of two possible characters - (1) as their several distributive shares of the partnership income, or (2) as compensation for services contracted to be rendered by them to the partnership; that either character precludes their being regarded as petitioner's "distributive share, whether distributed*1085 or not, of the net income of the partnership for the taxable year." Revenue Act of 1934, sec. 182.

The essential problem is not that of finding the correct characterization of the amount as it was received by Wylde and by Windeler, but to determine whether it can properly be called partnership *71 income which this petitioner may properly be said to have received as his distributive share. We are of opinion that it was not, and that the Commissioner was therefore in error in including it within the petitioner's taxable income. Whether Wylde and Windeler be be treated as partners with petitioner and Wilder, having a 5 percent right in partnership income, or as being merely employed as consultants and advisers with compensation fixed at such 5 percent, it is clear that the amounts to which they were thus entitled were charges upon partnership income before the distributive shares of petitioner and Wilder could be determined. To treat these percentage charges as if they were first distributable to petitioner and Wilder and then as if used by petitioner and Wilder as the consideration for the acquisition of the interests of Wylde and Windeler in the old partnership is not*1086 only an artificial conception, but is directly contrary to the fact.

The only justification which can be found for the theory is that the separate agreement made by the new partners with each of Wylde and Windeler ambiguously treats the 5 percent which the latter were each to receive in one place as compensation for services and, in another, as the consideration for the release of all their right in the old partnership's assets. As a matter of fact, it happened that there were no such rights which Wylde and Windeler gave up, because in fact the $10,230.62 which appeared to be the net balance of the old partnership's assets on December 31, 1929, had been shown to be merely a book figure of nonexistent assets when it appeared that $32,450.99 of accounts receivable were worthless. This left only the possible assets of firm name and good will, and both of those had already become rightfully owned by the partnership consisting of Proctor and Wilder. It would be unwarranted, therefore, to resolve the ambiguity of each of the separate contracts by treating the 5 percent as being paid by the petitioners for something of no substance. It can more reasonably be resolved by treating the*1087 5 percent as compensation for the services which Wylde and Windeler were expected for the services which Wylde and Windeler were expected to perform and which in fact to some extent they did perform. there is reason to believe that the provision in subdivision fifth of the separate contracts was merely a precautionary provision to avoid possible controversy as to whether Wylde and Windeler or their estates might be entitled to further compensation for an intangible right which they might have retained. Respondent further bolsters his conception of the 5 percent as consideration for Wylde and Windeler's release by pointing to a provision of the contract that in case of the death of either of them in 1930, 1931, or 1932 his estate was to receive 5 percent through 1932. Even if this conception were to be adopted *72 it would still fall short of coloring the payments made after 1932, and would not support a holding to that effect in the taxable years 1934 and 1935. It seems the most reasonable interpretation of the several contracts and the conduct of the parties that what Wylde and Windeler were receiving was compensation for services paid by the partnership to them and constituting, *1088 in computing partnership income, a deduction for ordinary and necessary expenses of carrying on the partnership's trade or business, Revenue Act of 1934, secs. 23(a) and 183.

The reversal of the Commissioner's determination upon this ground makes it unnecessary to decide whether Wylde and Windeler are properly to be regarded as partners with Proctor and Wilder so that the amounts received by them may be said to be their distributive shares of partnership income. Apparently among the four themselves neither Wylde nor Windeler was in a partnership relation. This the agreements were careful to recognize, leaving Proctor and Wilder as the sole partners. There was, however, enough to raise a serious question whether Wylde and Windeler were ostensible partners so as to impose liability upon them at the behest of a third person. Whether this is enough to require the application to them of the partnership provision of the revenue act is a question which need not be decided.

The Commissioner's determination is reversed.

Decision will be entered under Rule 50.