Trousdale v. Commissioner

Paul W. Trousdale, Petitioner, v. Commissioner of Internal Revenue, Respondent. Marguerite R. Trousdale, Petitioner, v. Commissioner of Internal Revenue, Respondent Trousdale v. Commissioner Docket Nos. 21111, 21112 United States Tax Court 16 T.C. 1056; 1951 U.S. Tax Ct. LEXIS 190; May 16, 1951, Promulgated *190 Decisions will be entered for the respondent. Petitioner, Paul W. Trousdale, was a partner in Housing Construction Co. The business of the partnership consisted of supervising the construction of defense housing projects for various construction companies. Its duties on several projects had been completed and it had substantially performed those required by its contract on the project for Overland Housing Co. when the partners decided to sever their business relations. The partnership had no liabilities and its only assets consisted of a $ 1,000 proprietary interest and $ 274,000 in accounts receivable. Trousdale, who was also vice president of Overland, assigned his one-half interest in the partnership at a discount of its true value to three parties procured therefor by Overland's president. Prior to this assignment Trousdale and the partnership had assigned their interest in all contracts which the firm had calling for supervision of proposed projects to the remaining partner, and thereafter no other new projects were undertaken by the partnership. Held: The partnership was in a state of liquidation at the time of the assignment. Held, further: The gain realized*191 by Trousdale from the transaction, over and above his original investment, constituted ordinary income and will be taxed as such, one-half to each petitioner. J. Everett Blum, Esq., for the petitioners. L. C. Aarons, Esq., for the respondent. Van Fossan, Judge. Arundell, J., concurs in the result. VAN FOSSAN *1057 These proceedings involve deficiencies in income tax for the taxable year ended December 31, 1945, in the amount of $ 25,546.39 as to each petitioner. They present the question whether under the facts the sale of an interest in the partnership involved constituted the sale of a capital asset resulting in a gain taxable under section 117 (b), Internal Revenue Code. Most of the following facts were stipulated. FINDINGS OF FACT. The petitioners, Paul W. and Marguerite R. Trousdale, husband*192 and wife, and residents of California, filed their income tax returns for the calendar year 1945 on a community property basis, with the collector of internal revenue for the sixth district of California. The laws of the State of California provide that the property and income (with certain exceptions not here applicable) of a married person resident in the State are the community property of both spouses, and petitioners are entitled, as such residents, to the benefit of such provisions of the laws of the State of California. Petitioners used the cash receipts and disbursements method of reporting. Petitioner, Paul W. Trousdale (hereinafter referred to as "petitioner"), also filed an amended return for the taxable year on May 7, 1946. On or about August 1, 1943, petitioner and one Hyatt R. Dehn, formed Housing Construction Company (hereinafter sometimes referred to as "the partnership"), the stated purpose of which was "carrying on and conducting a residential construction contracting business in Southern California." Petitioner contributed $ 500 to Housing Construction Company, thus acquiring a one-half interest in the partnership. Like both petitioners, Housing Construction*193 Company used the cash receipts and disbursements method of reporting its income. Subsequent to its formation and prior to September 1944, the partnership entered into separate agreements with Third Defense Housing Co., Fourth Defense Housing Co., Fifth Defense Housing Co., and Ventura Defense Housing Co., each a corporation, wherein *1058 among other things the partnership was engaged to supervise the construction of defense housing projects for the respective corporations on a per housing unit fee basis. Housing Construction Company at no time had any employees. As of March 23, 1945, it had no liabilities of any nature whatsoever, and it had no tangible assets. The proprietary interest consisted of $ 1,000 cash, and the remaining assets consisted entirely of accounts receivable totaling $ 274,000 for services rendered. These accounts receivable consisted of the following: A. $ 50,000 due to Housing Construction Company from the Fourth and Fifth Defense Housing Companies. This was the balance on contracts pursuant to which Housing Construction Company supervised construction of defense housing projects on a per housing unit fee basis. Prior to March 23, 1945, Housing Construction*194 Company had received and collected $ 92,046.60 net fees on these and similar contracts, and all services relating to such contracts had been completed. No part of $ 50,000 has been reported in the income tax returns of the petitioner. B. $ 224,000 due to Housing Construction Company from Overland Housing Co. The contract giving rise to this obligation is evidenced only by the minutes of Overland Housing Co. Under this contract Housing Construction Company was to receive $ 224,000 (i. e. $ 350 per house for 640 houses), as funds became available therefor, for services "in connection with the procurement of building sites, priorities, loan commitments, construction bonds and loans and the actual construction of said 640 residences and garage slabs." By the end of March 1945, building sites had been procured, priorities and loan commitments had been obtained, and actual construction of the 640 residences and garage slabs had been substantially completed and notices of completion filed. Most of the houses included in the original program had been sold or rented as of that date, and, except for 28 houses, all remaining notices of completion were filed within two months thereafter. *195 The recapitulation sheet of the Building Loan Funds' ledger of the Bank of America shows $ 3,007,121 of the total loan commitment of $ 3,449,900, or 87.2 per cent thereof, had been disbursed by March 23, 1945. As of March 28, 1945, the records of Builders' Control Service, Inc., show that the average percentage of completion figure on the 640 houses was 79.3 per cent. Few supervisory services remained to be performed. The petitioner is a well known building contractor, duly licensed to carry on the business as such. His partner in Housing Construction Company, Dehn, was engaged in real estate development and investments. Both petitioner and Dehn had interests as stockholders in the corporations referred to above, and as officers in some of them. Petitioner was also vice president of Overland Housing Co. (hereinafter called "Overland"). The capital stock of the latter was, on March 23, 1945, held as follows: *1059 Common stock Preferred stock ($ 1 par value) ($ 1 par value) Ince Investment Co 4,000 8,500 Gaylor H. Boggs 2,000 3,000 Howard Burrell 6,000 9,000 Edward A. Tomlin 6,000 9,000 William A. Godshall 6,000 9,000 Lloyd G. Rainey 6,000 9,000 A. R. Benedict 6,000 9,000 Hyatt R. Dehn 6,000 11,500 Paul W. Trousdale 6,000 11,000 William L. Rawn 4,000 6,000 Leonard W. Ross 4,000 6,000 M. Kinzie Miller 4,000 6,000 Howard M. Vincent 1,000 Louise Harkness [500] Howard Vincent 1,000 Walter J. Fish [500] Total shares outstanding 60,000 100,000 *196 The petitioner and Dehn became desirous of terminating their business relationship, and the petitioner offered to sell his interest in Housing Construction Company to Dehn. Petitioner and Dehn then consulted Lloyd G. Rainey, an attorney, in February 1945 and informed him that they were terminating their business association; that Trousdale had offered to sell Dehn his interest in the partnership and that they wanted advice with respect to the tax consequences of a sale by Trousdale to Dehn and a sale by either or both of them to one or more third parties. Rainey informed them that in his opinion an interest in a partnership constituted a capital asset of the partner, and that, in his opinion, if any sale were contemplated, only one partner should sell his partnership interest and the sale should be made to a third party and not to the other partner. Dehn then rejected petitioner's offer to sell him his interest in the partnership. William A. Godshall, who was president of Overland, and also associated as an officer, director, or stockholder of the corporations referred to above, then interested Elinor K. Ince, William T. Ince, and Elizabeth Elinor Bonner (hereinafter referred to*197 as Elinor, William, and Elizabeth, respectively) in becoming "assignees" of the interest of the petitioner in the partnership. Godshall was the father of Elizabeth and was also trustee of the estate of Thomas H. Ince, the deceased husband of Elinor and father of William. By instrument dated March 23, 1945, in consideration of the sum of $ 112,500 to be paid by Elinor, William, and Elizabeth to the petitioner, petitioner executed an "Assignment" purporting to transfer to them his interest in the partnership. The "Assignment" specifically set forth the then outstanding receivables of Housing Construction Company, totaling $ 274,000, as being its only assets aside from *1060 $ 1,000 in cash, representing capital. Before consummating this transaction, the petitioner, Dehn, and Housing Construction Company, on March 22, 1945, entered into an agreement mutually releasing each other of all claims and demands with the exception of capital contributions of $ 500 on the part of each of the two original partners and the accounts receivable from Fourth and Fifth Defense Housing Companies and Overland. In addition, Housing Construction Company assigned to Dehn all claims, demands, and*198 obligations existing in its favor against Willowbrook Development Company and Avalon Housing Company arising out of advances made or in connection with construction programs proposed to be carried on by such corporations. As of March 23, 1945, Overland had not yet made its first payment to the partnership on the 640 house project. The amount of $ 112,500 represented a discount of $ 25,000 under the face value of the petitioner's one-half interest in the partnership's accounts receivable of $ 274,000 and capital of $ 1,000. The total of the deficiencies asserted herein results from the reporting of $ 112,000 of the amount of $ 112,500 as a long term capital gain. The sum of $ 112,500 was paid by the "purchasers" by paying to the petitioner the sum of $ 35,500 cash and the execution and delivery of a demand promissory note in the sum of $ 77,000, bearing interest at 4 per cent per year. Subsequently, as payments were made to the partnership by Overland and Fourth and Fifth Defense Housing Companies, one-half of each such payment, either directly by Housing Construction Company or indirectly by petitioner's "assignees," was paid to the petitioner, until finally, on or about July 25, *199 1946, the promissory note in the amount of $ 77,000 was fully satisfied. Up to and including July 6, 1945, such payments to the petitioner (totaling $ 50,000 up to that date) were made directly to the petitioner by the partnership in the same manner as they would have been made had the "Assignment" dated as of March 23, 1945, not been executed. On July 10, 1945, Godshall, who was then handling the checking account of Housing Construction Company, signed letters addressed to Elinor, William, and Elizabeth stating that such payments had been made directly to the petitioner. On July 17, 1945, Elinor, William, and Elizabeth each wrote identical letters to Godshall requesting that future payments be made directly to them. Subsequent to the date of the "Assignment" by petitioner to Elinor, William, and Elizabeth, petitioner, on March 24, 1945, sought a further opinion as to the tax consequences of the "Assignment" from Melvin D. Wilson, an attorney also specializing in taxation. In the letter dated March 24, 1945, from Howard Burrell, petitioner's general attorney, addressed to Wilson, requesting his opinion, the latter was asked whether the papers were in proper form to effect "the results*200 desired by the parties." He was also asked to suggest any amendments *1061 which might improve the situation "inasmuch as the same can and will be made without delay or difficulty." Wilson rendered an oral opinion in which he stated that the weight of authority was to the effect that the sale of an interest in a partnership was the sale of the individual assets of the partnership and resulted in ordinary income or loss or a capital transaction depending on the nature of each partnership asset; that in his opinion the assets of the partnership were capital assets and that, therefore, sale by petitioner of his interest in the partnership would result in a capital transaction. Following the "Assignment" dated March 23, 1945, and on March 24, 1945, Dehn, Elinor, William, and Elizabeth entered into purported "Articles of Copartnership" by the terms of which the business was to be carried on under the name of "Housing Construction Company." The purported capital was to consist of the sum of $ 1,000 (in which sum Dehn was to have a 50 per cent interest, Elinor a 20 per cent interest, William a 20 per cent interest, and Elizabeth a 10 per cent interest), and the management of the business*201 and affairs of the "copartnership" was to be equally vested in the "copartners," each of whom was to devote such of his time and attention to the business as might be necessary for the proper operation and conduct thereof. A certificate of doing business under a fictitious name, showing the names of the new "partners" was filed and published on or about April 10, 1945. Neither William, Elinor, nor Elizabeth had ever had any experience in the construction business or in any cognate business, nor had any of them had any experience in business affairs generally. Such persons lacked all qualifications and capability for carrying on and managing the business of Housing Construction Company. Up to the date of the hearing, neither Elinor nor Elizabeth had ever met their "partner" Dehn. The reason that Elinor and William participated as "assignees" under the "Assignment" dated March 23, 1945, was that Godshall, in whom they reposed full trust and confidence, represented to them that the transaction would be a very good one for them as an investment. Elizabeth had only hazy recollections of the transaction, but viewed it as a financial transaction, and relied completely on her father, *202 Godshall. None of such "assignees" had any intention of participating in the business and management of the affairs of Housing Construction Company, and, in fact, none did so participate. Subsequent to March 23, 1945, Godshall participated in the affairs of Housing Construction Company to the extent of handling its bank account and making the payments referred to above. Elinor regarded the "assignment" transaction as just an investment, with the thought of getting the money back over a period of a "couple of years." The "assignees" never discussed the business of Housing Construction Company. *1062 Subsequent to March 23, 1945, Housing Construction Company undertook no additional projects. Such supervisory services as remained to be performed were rendered by petitioner, Godshall, and one Howard Vincent, who was superintendent of construction for Overland. Petitioner's services after such date consisted of the examination of the project and of payment orders to Builders' Control Service, Inc. On October 13, 1945, the petitioner resigned as vice president of Overland, his resignation reading as follows: In view of the completion of your construction program I am handing to*203 you herewith my resignation as vice-president of Overland Housing Co., the same to take effect immediately upon its acceptance. As vice president of Overland, the petitioner had authority to execute, on behalf of the company, instruments, bonds, orders for disbursements, bills of sale, affidavits, and other documents required by Builders' Control Service, Inc. Until August 28, 1944, the petitioner was the only person authorized to execute such documents. He also had authority to sign checks and drafts on the bank accounts of Overland. The petitioner received no salary from Overland. On or about May 31, 1946, Dehn disposed of his rights in the partnership (Housing Construction Company) to Howard Burrell, and it was dissolved on November 20, 1946. The petitioner's total gain as a result of the "Assignment" was $ 112,000, of which he and petitioner Marguerite R. Trousdale each reported the sum of $ 56,000 in their respective income tax returns filed for the taxable year ended December 31, 1945, such gain being reported as a gain from the sale of a capital asset held for a period of more than six months. The respondent determined that the gain so reported was taxable as ordinary income, *204 one-half to each partner, and was not taxable as a gain from the sale of a capital asset held for a period of more than 6 months. Ultimate Findings of Fact. From and after March 22, 1945, the date on which the petitioner and Dehn and Housing Construction Company mutually released each other of all claims and demands and there was assigned to Dehn any and all interest which the partnership had in any projects and contracts other than the outstanding accounts receivable for services performed for Fourth and Fifth Defense Housing Companies and Overland Housing Co., Housing Construction Company was in a state of liquidation. Neither Elinor, William, Elizabeth, petitioner nor Dehn anticipated, on March 23, 1945, that any further activities would be carried on by Housing Construction Company as a going concern. The "Articles of Copartnership" between Elinor, William, Elizabeth, and Dehn, dated March 24, 1945, and the subsequent certificate of *1063 doing business under a fictitious name were without substance and in no way represented the real intentions of the parties. The "Assignment" dated March 23, 1945, was not a bona fide sale of a genuine partnership interest, but was *205 a device motivated, in so far as the petitioner was concerned, only by tax considerations for the purpose of assigning to others than the person who had earned them, ordinary income distributions on liquidation of a personal service partnership. The sum of $ 112,000 received by the petitioner as a result of the "Assignment" dated March 23, 1945, is taxable to petitioners Paul W. and Marguerite R. Trousdale, one-half to each, as ordinary income and not as gain from the sale of a capital asset held for a period of more than 6 months. OPINION. The sole issue to be resolved in these cases is whether under the facts the gain derived by petitioner upon the purported assignment of his interest in a partnership is to be taxed as a capital gain or as ordinary income. In 1943 petitioner and Dehn formed a partnership to engage in the construction business. Each partner had an equal interest and contributed $ 500 toward the firm's capital. Subsequent to its formation the partnership entered into a number of contracts pursuant to which it was engaged to supervise the construction of defense housing projects for various construction companies. Early in 1945, petitioner and Dehn decided to terminate*206 their business relationship. Petitioner offered to sell his interest to Dehn. They sought the advice of tax counsel and were advised that they could gain the desired objective and the sale would be more clearly a sale of a capital asset if it were made to a third party. Thereupon Dehn refused petitioner's offer and Elinor, William, and Elizabeth were procured to become the "third party" assignees of petitioner. Petitioner then assigned them his interest in the partnership in consideration of the amount of $ 112,500. The firm had no liabilities and its only assets consisted of $ 274,000 in accounts receivable and the $ 1,000 capital interest. Petitioner realized a gain of $ 112,000 over the amount of his original investment and contends that this represents a long term capital gain and should be taxed as provided in section 117 (b) of the Internal Revenue Code. 1 *207 The weight of authority is to the effect that a partnership interest constitutes a capital asset and that the sale of such interest which has been held for more than 6 months is a capital transaction resulting *1064 in long term capital gain or loss. E. g., Commissioner v. Estate of Daniel Gartling, 170 F. 2d 73; McClellan v. Commissioner, 117 F. 2d 988, affirming 42 B. T. A. 124; Commissioner v. H. R. Smith, 173 F. 2d 470, affirming 10 T. C. 398, certiorari denied, 338 U.S. 818; Commissioner v. Shapiro, 125 F. 2d 532, affirming 41 B. T. A. 1339. Here, however, the partnership, prior to the date of the assignment, had completed its performance under several contracts and had substantially rendered all services required by its contract with Overland. The partnership agreement executed between Dehn and the assignees was a meaningless formality since the evidence shows that none of the parties thereto were qualified to render services*208 or ever intended a continuation of the business. Commissioner v. Culbertson, 337 U.S. 733. The contracts by which the original partnership had been engaged to supervise the construction of proposed projects had previously been assigned to Dehn. Petitioner argues, however, that his assignees intended to and did, in fact, engage in the partnership's continuance through the agency of Godshall. While it is legally possible to engage in business through an agent, we are not convinced that such was the case here. True, Godshall participated in the partnership to the extent of handling its bank account and making the distribution referred to in our Findings of Fact. The query is pertinent whether he was acting as an active partner or as a liquidating trustee. Further, together with petitioner, who was also vice president of Overland, and Vincent, Overland's superintendent of construction, he helped render such supervisory services as remained to be performed on the Overland project. But in so doing, again we may well ask whether he was acting in the interest of Overland, of which he was president, or in the interest of Elinor, William, and Elizabeth*209 as partners in Housing Construction Company. On these two points the record is not clear. We are persuaded, however, that the so-called purchasers never engaged in the construction business of the Housing Construction Company through the agency of Godshall or otherwise, nor had they any intention of doing so at the time they executed the agreement with Dehn. Moreover, it appears that Dehn, who was not qualified alone to continue the business, took no further interest in its continuance. We recognize, of course, the general principle that a taxpayer is entitled "to decrease the amount of what otherwise would be his taxes or altogether avoid them" by any bona fide means which the law permits. Gregory v. Helvering, 293 U.S. 465, 469; Commissioner v. Tower, 327 U.S. 280, 288; and where the law is clear as to the tax consequences resulting from a particular course of action, such course of action will be given effect and governed by the clear provisions of the law even though it was followed for the primary purpose of tax *1065 avoidance. United States v. Cumberland Public Services Co., 338 U.S. 451.*210 But when such is the primary motive of a particular transaction, that transaction should be closely scrutinized. If, after considering all of the actualities, it is found to be but a subterfuge, it may then be disregarded for tax purposes. Substance will prevail over form. Commissioner v. Tower, supra;Yiannias v. Commissioner, 180 F. 2d 115. Having thoroughly considered all of the actualities, we are firmly convinced that the Housing Construction Company was in a state of liquidation at the time the purported assignment took place; that the entire transaction was but a cloak for the purpose of decreasing petitioner's tax on his distributive share of the profits; that the partnership purportedly formed between Dehn and the assignees must be disregarded for tax purposes; and that petitioner's so-called assignment of his partnership interest was in fact but an assignment of his distributive share of the income due for personal services previously rendered. The sole aim of the assignment appears to have been to confer upon the assignees the power to collect a portion of the fees due petitioner. The record affords *211 no other conclusion. But it has long been held that a taxpayer may not avoid his tax liability on income which he has earned by the simple expedient of drawing up legal papers and assigning that income to others. Commissioner v. Tower, supra;Helvering v. Horst, 311 U.S. 112; Yiannias v. Commissioner, supra.The fundamental principle in all income tax statutes is to tax income to those who earn or otherwise create the right to receive it. Lucas v. Earl, 281 U.S. 111; Helvering v. Horst, supra;Yiannias v. Commissioner, supra. Here the partnership of which petitioner was a member earned the fees due it by rendering certain personal services. Petitioner was entitled to his distributive share thereof when and as they were collected. Granted these collections would be taxable only as they were received, his proportionate part of them would, nonetheless, have been taxed to him as income whether or not distributed. Section 182 (a), Internal Revenue Code. Petitioner, however, chose to*212 assign, at a discount, the right to receive his distributive share to Elinor, William, and Elizabeth. The consideration involved was $ 112,500 and was paid by a cash payment of $ 35,500 and the execution and delivery of a demand promissory note for $ 77,000. "The 'purchase' of that future income would not turn it into capital any more than the discount of a note received in consideration of personal services." Helvering v. Smith, 90 F. 2d 590, 592. The cash payment of $ 35,500 was merely a collection in advance of the money that petitioner had previously earned as ordinary income. Doyle v. Commissioner, 102 F. 2d 86, affirming 37 B. T. A. 323. *1066 As for the promissory note for $ 77,000, we have found that it was paid as payments were made to the partnership on its accounts receivable. In fact, $ 50,000 of the amount was distributed directly to petitioner by the firm in a manner similar to that which would have been employed had no assignment been executed. On July 10, 1945, Godshall informed each assignee of the method employed for making payment, whereupon they sent three*213 identical letters to Godshall expressing their satisfaction but "requesting" that henceforward the distributions be made to them. Each letter bore the date of July 17, 1945, and had obviously been prepared by the same person for signature by each assignee. From that time onward one-half of each payment that was made to the Housing Construction Company on its accounts receivable was distributed to Elinor, William, and Elizabeth, and they in turn paid petitioner the balance due him. As we see it, this commuted form of making distributions to petitioner did not essentially alter the substance of the transaction. Petitioner still received his distributive share of the income which he had previously helped to earn albeit in a more indirect fashion and causing a bit more delay in its receipt by him. In effect, the assignees merely acted as conduits for transmitting to petitioner his distributive share of the old partnership's income. And the sale of this claim for ordinary income, which petitioner had earned as a result of the personal services previously rendered, is not a sale of a capital asset. Doyle v. Commissioner, supra.The fact that he *214 chose to sell that claim at a discount does not concern us here. We are convinced that the gain of $ 112,000 over petitioner's original investment constituted ordinary income to petitioner and should be taxed as such. "To hold otherwise would be to exalt artifice above reality * * *," Gregory v. Helvering, supra, and open the door to tax avoidance entirely repugnant to the meaning and intent of section 117 (b), supra. The situation here presented is to be distinguished from that in Swiren v. Commissioner, 183 F. 2d 656, certiorari denied, 340 U.S. 912, on which case petitioner relies. In that case the sale was one of a partnership interest in a going concern to the remaining partners while here we find that the partnership was in a state of liquidation at the time of the "sale." 2 The transaction constituted nothing more than an assignment of an interest in a liquidating enterprise and of petitioner's distributive share of the previously earned income thereof. "Nobody would suggest that the sale of a declared dividend payable in the future turns the cash received into capital." *215 Helvering v. Smith, supra. *1067 Accordingly, we hold that respondent did not err in his determination. Decisions will be entered for the respondent. Footnotes 1. SEC. 117. CAPITAL GAINS AND LOSSES. * * * * (b) Percentage Taken into Account. -- In the case of a taxpayer, other than a corporation, only the following percentages of the gain or loss recognized upon the sale or exchange of a capital asset shall be taken into account in computing net capital gain, net capital loss, and net income: * * * * 50 per centum if the capital asset has been held for more than 6 months.↩ 2. In the Swiren↩ case, the Court of Appeals quoted approvingly the following: "The application of this rule [that the sale of a partnership interest should be treated as the sale of a capital asset] should, of course, be limited to those cases in which the transaction in substance and effect, as distinguished from form and appearance, is essentially the sale of a partnership interest."