Grace v. Commissioner

William E. Grace, Petitioner, v. Commissioner of Internal Revenue, Respondent Grace v. Commissioner Docket No. 11352 United States Tax Court 10 T.C. 1; 1948 U.S. Tax Ct. LEXIS 299; January 6, 1948, Promulgated *299 Decision will be entered under Rule 50. 1. Petitioner is engaged in the business of manufacturing road machinery, which he started in 1932 in Texas. In the beginning petitioner's brother worked for him about two years and then went into business for himself. The brother returned in 1939 and worked for petitioner on a salary basis. In the early part of 1941 petitioner and his brother entered into a contract whereby the brother's compensation should be based upon 10 per cent of the net profits of the business. At the beginning of 1942 they entered into a partnership agreement for the conduct of the business, whereby petitioner was to furnish the capital and his brother, services; and the profits were to be shared in the ratio of 90 per cent and 10 per cent, respectively. Petitioner's brother devoted his full time to the business and was plant manager. He had charge of all employment and supervised the work of between 50 and 75 employees and performed other executive functions. Held, petitioner is not taxable on the 10 per cent share paid to his brother in 1942. 2. Petitioner and his wife separated in February 1943 and she sued for divorce. In April they signed a property*300 settlement agreement, which was conditional upon the granting of a divorce and remained entirely executory until June 14, 1943, when the divorce was granted. Held, the business income from January 1 to June 14, 1943, was the community income of petitioner and his wife. Eric Eades, Jr., Esq., for the petitioner. Donald P. Chehock, Esq., for the respondent. Arundell, Judge. ARUNDELL *1 The respondent determined a deficiency in income and Victory tax for 1943 in the amount of $ 18,833.14. The computation involves income for both 1942 and 1943, pursuant to the Current Tax Payment Act of 1943. Certain adjustments made by the respondent were not challenged in the petition, and an issue raised by the respondent in his amended answer has been conceded by the petitioner. That leaves for consideration the questions: *301 (1) Whether petitioner's brother was doing business in partnership with petitioner in 1942, or, if not, whether the amount of money which the brother received from the business constituted reasonable compensation for services rendered by him. *2 (2) Whether income accruing between the date on which petitioner and his wife signed a property settlement agreement and the date a divorce was granted constitutes separate or community income. FINDINGS OF FACT. Petitioner is a resident of Dallas, Texas, and his tax returns for the period in controversy were filed with the collector of internal revenue for the second district of Texas. In 1932 petitioner began the operation of a business under the name W. E. Grace Manufacturing Co. in Dallas. At that time he was the sole proprietor. The business at first consisted of the manufacture of road signs, brushes for road sweepers, and other similar items, and it later developed into the manufacture of heavier road machinery. L. J. Grace, a brother of the petitioner, was first employed by petitioner in 1933, on a salary basis, and worked for him about two and a half years. In 1935 L. J. Grace left the petitioner and went into business for *302 himself at Springfield, Missouri. He continued in the retail and wholesale bottle milk business until 1939. At that time he returned to work for the petitioner on a salary basis. The petitioner's business grew steadily and the profits increased from year to year. In the early part of 1941 L. J. Grace and petitioner entered into an agreement whereby L. J. Grace was to receive for his services an amount equal to 10 per cent of the net profits of the business. Pursuant to that agreement, petitioner paid L. J. Grace $ 15,164.81 for his services during 1941. Upon audit in the fall of 1942, respondent disallowed $ 3,052.31 of that amount and allowed only the difference of $ 12,112.50 as a deduction from petitioner's 1941 income tax liability. On January 1, 1942, petitioner and L. J. Grace entered into an agreement to carry on the business of W. E. Grace Manufacturing Co. in partnership. Under the agreement petitioner contributed his capital investment in the business and L. J. Grace agreed to devote his full time, skill, and ability to the promotion and conduct of the business. In consideration of their respective contributions, the parties agreed that business profits should be shared*303 90 per cent to the petitioner and 10 per cent to his brother. L. J. Grace was not to bring suit to dissolve the partnership without giving petitioner an option to purchase his partnership interest; and in the absence of an agreement as to price, the matter was to be settled by arbitration. L. J. Grace further agreed not to assign or in any way encumber his partnership interest without the written consent of petitioner, and petitioner was to have the sole authority to write all checks on the partnership bank accounts. L. J. Grace was not to incur any obligations binding the partnership without first consulting the petitioner and obtaining his consent. *3 The partnership was to be terminated by the death of either partner or by mutual consent. The agreement also provided that, if L. J. Grace should breach any of its terms, petitioner should have the right to take over the business without further liability to L. J. than to account to him for 10 per cent of the profits accrued up to the time of the breach, less any obligations which L. J. then owed the partnership, together with the proportionate part of any and all partnership obligations owing by L. J. at that time by virtue*304 of his interest in the business. In the event of petitioner's death, L. J. was to have an 180-day option to purchase petitioner's interest from his estate for $ 100,000; and in the event of L. J.'s prior death, petitioner was given a like option to purchase his interest for $ 10,000. During 1942 L. J. Grace contributed no cash or other property as capital to the business. In that year petitioner was approximately 33 years old and L. J. Grace approximately 29. They were the only executives of the business. L. J. had had more education than the petitioner. L. J. devoted his full time to the business throughout the year. He supervised construction work in the shop and had charge of all the hiring and firing of employees. The business had between 50 and 75 employees in 1942. During about half the year 2 shifts were operated and L. J. covered both shifts, very often working until midnight or later. In addition, he did some sales promotion work and closed sales contracts with customers. He had charge of the pay roll for the entire shop and of the purchasing of needed supplies and materials. For the year 1942 a partnership return was filed for W. E. Grace Manufacturing Co. showing*305 a net income of $ 196,481.22, with $ 176,833.10 as petitioner's distributive share and $ 19,648.12 as L. J. Grace's distributive share. L. J. Grace reported the $ 19,648.12 in his individual return for 1942 and paid the tax thereon. In the early part of 1943 L. J. Grace severed his connection with W. E. Grace Manufacturing Co. and he and the petitioner entered into a written agreement of dissolution. Upon termination, L. J. Grace received nothing more than his 10 per cent share of the net profits through 1942. In computing the deficiency, the respondent determined that no partnership existed in 1942 and allowed petitioner a deduction of only $ 12,112.50 for the services of L. J. Grace. Both the 1941 agreement to pay L. J. Grace 10 per cent of the net profits and the 1942 partnership agreement under which his share was 10 per cent of the net profits were fair and reasonable when entered into. The amount of $ 19,648.12 which L. J. Grace received in 1942 is no more than reasonable compensation for services actually rendered by him to the business in that year. *4 Petitioner and Helen Grace were married June 14, 1935, and lived together in Texas as husband and wife until February*306 14, 1943. On February 17 of that year Helen Grace instituted suit for divorce against petitioner in the District Court of Dallas County, Texas. On April 5, 1943, while the suit was pending, petitioner and his wife signed a property settlement agreement incident to the divorce and on April 14 an addendum to the agreement. Therein they recited the pendency of the divorce action and listed the existing community property. It was stated that the value of the community estate was uncertain and indeterminate and that the parties desired to effect an amicable, fair, and equitable settlement. It was agreed that "before or simultaneously with the granting of this divorce" petitioner should pay Helen Grace $ 83,500 cash and execute and deliver to her a deed to the family residence and bills of sale for the household furniture, fixtures, and effects, and an automobile. In consideration therefor Helen Grace agreed to execute and deliver to petitioner a quitclaim deed to the business property. The contract provided: It is further agreed and understood by and between the parties that this contract is based upon the contingency of the plaintiff, Helen Grace, prosecuting this suit to a conclusion, *307 and being awarded judgment of divorce from the defendant, Wm. E. Grace. If for any reason the suit for divorce should not be prosecuted to final judgment, then this contract is to be null and void. They also agreed that, with the approval of the court, their three children should live with the petitioner three months in each year and nine months with Helen Grace. The agreement made no reference to future income of the community. The agreement remained executory until the divorce was granted. Both petitioner and Helen Grace made numerous attempts to effect a reconciliation. Neither intended that the property settlement agreement should be performed unless the divorce should be granted. Until June 14, 1943, petitioner continued to support his wife and his three children. On that date the District Court for Dallas County entered its judgment awarding Helen Grace a divorce and approving the property settlement agreement. Thereupon, on June 14, 1943, petitioner delivered to Helen Grace cash and government securities in the amount of $ 83,500 and executed and delivered to her a deed to the family residence and bills of sale covering the household furniture, fixtures, etc., and an*308 automobile, the value of these latter items being approximately $ 10,250. On the same day Helen Grace executed and delivered to the petitioner a quitclaim deed to the business property. In the individual separate returns of petitioner and Helen Grace for 1943 the business income of the W. E. Grace Manufacturing Co. was prorated from January 1 to June 16, 1943. The community share *5 of Helen Grace was reported as $ 37,752.62, and petitioner's community share, together with all the business income for the remainder of the year, was reported as $ 128,267.94. In determining the deficiency, the respondent prorated the income only up to April 5, 1943. OPINION. Petitioner contends that he is not taxable on the amount of $ 19,648.12 received by his brother, L. J. Grace, for 1942 because that amount represented his brother's distributive share of partnership income. In the alternative, petitioner contends that that amount is reasonable compensation for services actually rendered by his brother. It is not too clear to us why the respondent determined that no partnership existed between petitioner and his brother. Certainly this is not a Tower case. 1 Petitioner's brother was*309 only 4 years younger than petitioner. Not only had he worked for petitioner 2 or 3 years in the beginning of the business, but he had also had independent experience in his own business. The fact that he did not contribute any capital to the business does not mean that he could not be a partner. Petitioner's contribution of the entire capital would seem to be adequately and fairly compensated for by the profit-sharing ratio of 90 per cent to petitioner and only 10 per cent to his brother. The evidence convincingly demonstrates that L. J. Grace performed vital services. He had charge of the hiring and firing of all shop personnel, supervised between 50 and 75 employees, purchased all supplies and materials needed for the shop, worked long hours, and even operated two shifts during about half the taxable year. Obviously, he exercised executive functions of a very important character. That under the terms of the partnership agreement his authority as to the financial end of the business was more restricted than petitioner's does not negative the existence of a partnership. *310 In any event, if the partnership agreement be viewed only as a bonus or contingent compensation contract, we think the amount paid to L. J. Grace was reasonable compensation, in view of the character and extent of the services performed by him in 1942. He returned to work for the petitioner in 1939. Early in 1941 petitioner and his brother entered into a contract whereby the brother's compensation for that year was to be an amount equal to 10 per cent of the net profits of the business. That same percentage was carried over into 1942 and continued in the partnership agreement. We have found from all the evidence that both the 1941 and 1942 contracts were fair and reasonable when entered into. The respondent's *6 own regulations provide for the deduction of contingent compensation paid pursuant to a contract which was fair when entered into, "even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid." Regulations 111, sec. 29.23 (a)-6 (2). We hold that the petitioner should be sustained on this issue. The second issue relates to the ownership of the business income accruing between April 5 and June 14, *311 1943. In determining the deficiency, respondent took the view that the community was dissolved on April 5 (the date on which petitioner and his wife signed a property settlement agreement) and that all income after that date was petitioner's separate property. We think the complete answer to the respondent's contention is that the property settlement agreement was purely executory and by its own terms contingent upon the granting of a divorce. Neither party thereto intended that it be executed unless and until a divorce should be granted, and nothing was in fact done under the contract until after the divorce was granted. In these respects the instant case is unlike , relied upon by the respondent. There the settlement agreement was not conditional upon a divorce, but was fully executed and performed long prior to the granting of a divorce. Aside from the fact that the property settlement agreement was executory, it makes no mention of future income; and, even if the parties thereto had attempted to divide the income to accrue in the future and before the community should be dissolved by divorce, it is quite *312 doubtful whether the agreement to that extent would be valid under Texas law, in view of ; ; ; ; . These cases stand for the proposition that under Texas law a husband and wife do not have the power to change, by mere agreement made in advance, the status of community property yet to be acquired or yet to come into existence to that of separate property of one of the spouses. See also ; affd., . But see , and We hold that the respondent erred in prorating the income only up to April 5. In the recomputation, the business income should be prorated up to June 14, the *313 date the community was dissolved by the divorce decree, and only one-half thereof is taxable to petitioner. Decision will be entered under Rule 50. Footnotes 1. .↩