Rosenbaum v. Commissioner

George D. Rosenbaum, Petitioner, v. Commissioner of Internal Revenue, Respondent. Alfred Louis Stamm, Petitioner, v. Commissioner of Internal Revenue, Respondent Rosenbaum v. Commissioner Docket Nos. 21840, 21841 United States Tax Court 16 T.C. 664; 1951 U.S. Tax Ct. LEXIS 241; March 29, 1951, Promulgated *241 Decision will be entered under Rule 50. A partnership, in which the senior partners, the petitioners herein, contributed the capital and the junior partners services and customer contacts, suffered losses during the years 1937-1939, inclusive. Under the partnership agreement the junior partners were chargeable with 5 per cent of such losses. Because of the complaints of the junior partners and to encourage them to stay with the business a compromise settlement was entered into in 1944 whereby the junior partners were released from the obligation to repay their shares of the 1937-1939 losses in consideration of certain cash payments and the release of their 5 per cent interests in the firm's trading account. The net amount charged off as a result of the compromise was reflected on the partnership books by reductions in the capital accounts of the senior partners. Held, that the compromise settlement was a capital transaction involving a readjustment of partnership interests between the partners and the determination of whether the senior partners incurred a gain or loss therefrom, and the amount thereof, must be postponed until such time as the partnership is liquidated*242 or the partnership interests of the senior partners are otherwise disposed of and their capital accounts closed out. Bernard Wall, Esq., and Irving T. Palmer, C. P. A., for the petitioners. Thomas R. Charshee, Esq., for the respondent. Arundell, Judge. ARUNDELL *665 Respondent has determined deficiencies in the income tax of petitioners Rosenbaum and Stamm in the sums of $ 12,798.75 and $ 24,810.63, respectively, for the taxable year 1944. The issue is whether the petitioners may deduct from their 1944 taxable income the sums of $ 13,317.41 and $ 26,634.81, respectively, as "expenses" within the meaning of section 23 (a) (1) (A) or section 23 (a) (2) of the Internal Revenue Code; or as a "loss" within the meaning of section 23 (e) (1) or section 23 (e) (2) of the Internal Revenue Code. FINDINGS OF FACT. The petitioners are individuals whose respective returns for the calendar year 1944 were filed with the collector of internal revenue for the second district of New York. The petitioners are senior partners in the firm of A. L. Stamm & Co., a partnership conducting a general stock, bond, commodity and securities brokerage and commission business. A. L. Stamm & Co. was organized under a partnership agreement entered into on October 16, *244 1936, and subsequent partnership agreements were entered into on December 28, 1940, December 30, 1942, and December 28, 1943. The petitioners were the senior partners who contributed all of the firm's capital, which consisted of $ 1,000,000 contributed by the petitioner, Alfred Louis Stamm, and $ 500,000 by the petitioner, George D. Rosenbaum. The remainder of the firm consisted of the junior partners who, among others not material to these proceedings, were Samuel S. Lerner and Harry Rosenbaum. The junior partners made no contribution to the firm's capital. *666 The junior partners were "producing partners" who brought in a large share of the partnership business. They serviced and controlled the business they brought in and performed valuable and necessary services for the partnership. They were well trained in the security business. Harry Rosenbaum, besides being a producing partner, also performed valuable and necessary services for the partnership as an over-the-counter market trader, railroad securities analyst and bond specialist. An accounting was made of the operations of the partnership to all of the partners at the end of each year in accordance with the terms*245 of the partnership agreements. The junior partners each held a 5 per cent interest in the partnership; each was entitled to receive 5 per cent of the distributable share of the net profits of the partnership, and each was chargeable with 5 per cent of the losses. The junior partners also held a 5 per cent interest each in certain securities held by the partnership in an account entitled "A. L. Stamm & Co. December 31, 1939 Accounts in Liquidation." During the years 1937 to 1939, inclusive, the partnership sustained losses from operations and from trading on its own account. The junior partners were each charged with 5 per cent of these losses on the partnership books of account. This charge resulted in a "debit balance" in the accounts of the junior partners, only part of which was liquidated as of December 12 and December 29, 1944. As of December 29, 1944, the balance due by Harry Rosenbaum on his 5 per cent share of the trading losses was $ 18,638.70, and as of December 12, 1944, the balance due by Samuel S. Lerner on his 5 per cent share of the trading losses was $ 22,813.52. The junior partners were dissatisfied with the charges made to their account as the result of these*246 trading losses. In the latter part of 1937 or the early part of 1938 when they received the annual accounting of the partnership, they complained to the petitioners that they should not be held responsible for these losses since the trading was conducted by the petitioners without their knowledge or approval. They denied liability for these losses, maintaining only that those losses arising out of operations should have been charged to them even though the partnership agreement then in force to which they were signatories made no such exception. The junior partners and the petitioners had many disputes and arguments over this issue. The junior partners' dissatisfaction became acute when the partnership began earning profits in the period 1940 to 1944, inclusive. The senior partners applied the junior partners' distributable share of the partnership profits to the liquidation of their debit balances which resulted in the junior partners paying income taxes on income they never received. They complained to the petitioners, pointing out this onerous burden and explaining that they were without funds to pay *667 these taxes, their living expenses, and the cost of entertaining*247 customers. On December 28, 1943, a new partnership agreement was executed providing for an increase in the junior partners' salaries and providing also that only their share of the profits that remained after income taxes payable on these profits and salary was to be applied to their debit balances. The junior partners continued to complain that although the firm was now earning profits they remained without funds because of having to liquidate this debit balance, and threatened to withdraw from the partnership and take with them that part of the business they "controlled," that is, their customer following, unless relieved of this liability. Because of these continued complaints and disputes, the petitioners in the early part of 1944 sought a settlement of the dispute. On December 12, 1944, and December 29, 1944, the petitioners, as individuals, entered into agreements with Samuel S. Lerner and Harry Rosenbaum, whereby their debit balances were compromised. The consideration given by Samuel S. Lerner to petitioners by the agreement dated December 12, 1944, was the payment of $ 500 and his release to them of his 5 per cent interest in the trading account entitled "A. L. Stamm & *248 Co. December 31, 1939, Accounts in Liquidation." The consideration given by Harry Rosenbaum to petitioners by the agreement dated December 29, 1944, was the payment of $ 1,000 and his release to them of his 5 per cent interest in this trading account. On December 12, 1944, when the compromise agreement was entered into with Samuel S. Lerner, the value of the firm's equity in this trading account was $ 27,378.22 and Samuel S. Lerner's 5 per cent interest therein was equal to $ 1,368.91. On December 29, 1944, when the compromise agreement was entered into with Harry Rosenbaum, the value of the firm's equity in this trading account was $ 60,656.35 and Harry Rosenbaum's 5 per cent interest therein was equal to $ 3,032.82. The distributable shares of the net income of the partnership to the junior partners during the years 1943 to 1945, inclusive, were as follows: Samuel Harry S. Lerner Rosenbaum [1943] $ 18,699.56 $ 16,999.56 [1944] 29,899.96 27,912.45 [1945] 38,944.64 35,855.81 Because of the partnership agreement in effect in 1944 which provided for the payment of the junior partners' income taxes and because of the drawings by the junior partners in 1944, only $ 5,880.07*249 of Harry Rosenbaum's distributable share for 1944 and $ 5,197.11 of Samuel S. *668 Lerner's distributable share for 1944 could have been applied to the reduction of their respective debit balances. The distributable shares of Harry Rosenbaum and Samuel S. Lerner in the partnership for the calendar year 1944 were not determined or known either on December 12 or December 29, 1944. The petitioners, in entering into the agreements compromising these debit balances, were motivated by a desire to put an end to these complaints and disputes which they deemed harmful to the business and by a desire to retain the organization as it then existed. They did not intend to make a gratuity to the junior partners. After this compromise was executed, the capital account of Alfred L. Stamm in the partnership was reduced by the amount of $ 26,634.81 and the capital account of George D. Rosenbaum in the partnership was reduced by the amount of $ 13,317.41. In their individual Federal income tax returns for 1944, Alfred L. Stamm claimed the amount of $ 26,634.81 as a bad debt deduction and George D. Rosenbaum claimed the amount of $ 13,317.41 as a bad debt deduction. In computing these amounts, *250 the petitioners failed to take into account the value of the 5 per cent interest which each of the junior partners had in the securities in the trading account on December 12, 1944, and December 29, 1944, the respective dates of the compromise agreements, which interests in the old trading account the junior partners relinquished to petitioners in the compromise settlement. OPINION. The facts as we have found them, and they are not seriously in dispute, disclose that the partnership suffered losses during the years 1937, 1938, and 1939 from the operation of the partnership and from trading in securities on its own account. Under the partnership agreement then in effect, each of the junior partners was chargeable with 5 per cent of such losses. As neither of the junior partners had contributed any capital to the business, the partnership books carried no capital accounts in their names and in order to reflect their share of the losses accounts were opened on the books in which appropriate "debit balances" were recorded. Thereafter, the junior partners were indebted to the partnership and/or the senior partners in the amount of the "debit balances" which were reduced from time to*251 time by the application thereto of portions of the junior partners' shares of the profits of the business. In 1944, the senior partners, because of the complaints of the junior partners as to the heavy burden and the unfairness of having to repay the 1937-1939 losses from current earnings, and apparently to discourage the junior partners from leaving the business, entered into *669 a compromise with the junior partners even though it appeared that the partnership could enforce a collection of the full amount owing from the junior partners. The services of the junior partners as "customers' men" were invaluable to the partnership and it was clear that the business would suffer materially if they were to leave and take their customer following with them. It was this latter consideration which primarily prompted the senior partners to enter into the compromise. Petitioners now contend that the net amount of the indebtedness owing by the junior partners which was charged off in 1944 as a result of the compromise was deductible in that year as ordinary and necessary business expense under section 23 (a) (1) (A); as nonbusiness expense under section 23 (a) (2); or as a loss under*252 either section 23 (e) (1) or 23 (e) (2) of the Internal Revenue Code. On their income tax returns for 1944 petitioners claimed the amounts charged off as bad debt deductions. The petitioners have brought to our attention a number of cases involving somewhat comparable facts wherein deductions have been allowed under the statutes upon which they rely but none of the cited cases can be regarded as controlling of the issue herein. For example, petitioners place considerable emphasis upon our recent decision in Lab Estates, Inc., 13 T. C. 811, wherein unpaid rents for the taxable year and prior years were forgiven by the taxpayer in order to retain the tenants. We there held that the rents forgiven were deductible as ordinary and necessary business expense under section 23 (a) (1) (A) or as business losses within the meaning of section 23 (f). To distinguish the present case we need go no farther than to point out that the taxpayer in Lab Estates, Inc., supra, was dealing upon a strict debtor-creditor basis with an outside party, whereas we are here concerned with a compromise between partners within the firm carried out*253 by means of a reallocation or readjustment of partnership interests. The situation here is somewhat unique. The two senior partners contributed all the capital to the business and the junior partners agreed to contribute their services and customer contacts with the understanding that they would have a 5 per cent interest in the profits and losses. The junior partners' failure to make good their share of the losses sustained from 1937 to 1939 impaired the working capital of the business although apparently not to such an extent that it was necessary for the partnership to obtain additional contributions of capital from the senior partners or outsiders in order to continue the business. The record would indicate that no reduction was made in the capital accounts of the seniors prior to 1944 to reflect that portion of the 1937-1939 losses for which the juniors were responsible under the partnership agreement. *670 Under the compromise agreement entered into in 1944, the senior partners released each of the junior partners from the obligation to repay his share of the 1937-1939 losses in consideration of $ 500 paid by one, and $ 1,000 paid by the other junior partner, plus the*254 relinquishment of the 5 per cent interest of each junior partner in the trading account entitled "A. L. Stamm & Co. December 31, 1939 Accounts in Liquidation." Thereafter, the amount of the indebtedness owing from the junior partners which was charged off as a result of the compromise was not treated as a current operating expense or as a loss of the partnership in 1944 but was handled as a capital transaction between the partners, which was reflected on the partnership books by appropriate reductions in the capital accounts of the senior partners. Had the partnership been terminated and liquidated incident to the compromise, it may well be that the difference between the total amount recovered from the junior partners and the amount of the indebtedness would have been deductible by the senior partners insofar as it resulted in a loss of their original investments of capital. However, the compromise did not entail a liquidation of the partnership or the disposition of the interest of any partner. It was a capital transaction and its net effect was to enlarge the partnership interests of the senior partners and to reduce the partnership interests of the junior partners. Moreover, *255 the fluctuation of the firm's equity in the trading account from a value of $ 27,378.22 on December 12, 1944, to a value of $ 60,656.35 on December 29, 1944, is evidence that whether the petitioners would ultimately suffer a loss in their capital investments from the readjustment of partnership interests could not be known until an identifiable event occurred in connection with the partnership interests which would serve to register their gain or loss. Such an event would be the liquidation of the partnership as was present in Charles S. Guggenheimer, 8 T. C. 789, or the sale or other disposition of the partnership interest of either senior partner. The deduction claimed by petitioners, in our opinion, cannot be characterized as an ordinary and necessary business or nonbusiness expense of the partnership or the petitioners; nor were the amounts in controversy intended as additional compensation to the junior partners for services rendered the business in prior years or during the taxable year. On the contrary, the compromise was carried out with the hope that the juniors once relieved of the burden of their debts would remain with the business in the*256 future. The compromise having been effectuated by means of a readjustment of the partnership interests between the partners, it follows that the determination of the ultimate gain or loss to the petitioners therefrom must be postponed until such time as the partnership is liquidated or their partnership interests are otherwise disposed of *671 and their capital accounts closed out. The respondent's determination that the amounts in controversy are not deductible by the petitioners in 1944 as ordinary and necessary business or nonbusiness expense under sections 23 (a) (1) (A) and 23 (a) (2), respectively, or as losses under sections 23 (e) (1) and 23 (e) (2) is, therefore, sustained. Decision will be entered under Rule 50.