Silberman v. Commissioner , 22 T.C. 1240 ( 1954 )

Frances Silberman, et al., ¹ Petitioners, v. Commissioner of Internal Revenue, Respondent

Silberman v. Commissioner

Docket Nos. 47886, 47887, 47888

United States Tax Court

22 T.C. 1240; 1954 U.S. Tax Ct. LEXIS 97;

September 22, 1954. Filed September 22, 1954, Filed

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Decisions will be entered under Rule 50.

Held, upon the facts, that petitioners have established that the sum of $ 14,375 was paid for a covenant not to compete for a period of 3 years beginning January 10, 1944. Held, further, that said amount is to be amortized ratably over the period of the covenant, one-third thereof being attributable to the taxable year in issue.

N. H. Sirota, Esq., and I. Frederick Shotkin, Esq., for the petitioners.

Robert J. Cowan, Esq., for the respondent.

Fisher, Judge.

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FISHER

Respondent determined deficiencies in income tax for the year 1946 as follows:

Frances Silberman	$ 349.00
Samuel Silberman	1,276.87
Joseph Silberman	2,691.91

The deficiencies were based upon adjustments in relation to the income tax return of Tissue Products Company. Petitioners were the partners composing the partnership in 1946. The adjustments resulted from disallowances of deductions attributed by the partnership (a) to a restrictive covenant, (b) to repairs, and (c) to depreciation. The distributive shares of the partners were increased accordingly.

Petitioners contest only the adjustment relating to the restrictive covenant.

The cases were consolidated by appropriate order.

A Rule 50 computation will be necessary.

FINDINGS OF FACT.

The facts were stipulated in part, and, to the extent so stipulated, are incorporated herein by reference.

Petitioners during the year 1946, were the partners composing the partnership known as Tissue Products Company, New York City Petitioners Frances Siblerman and Joseph Silberman filed Federal individual income tax returns for the year in question with the collector of internal revenue for the third district of New York. Petitioner Samuel Silberman filed a Federal individual income tax return for the same year with the collector for the first district of New York. The partnership return in question was filed with the collector for the fourteenth district of New York.

During the partnership taxable year 1946, and also during the partnership taxable years 1944 and 1945, profits of Tissue Products Company were divided 50 per cent to Joseph Silberman, 30 per cent to Samuel Silberman, and 20 per cent to Frances Silberman. Said partnership was on the accrual basis of accounting for the years 1944, 1945, and 1946.

On the partnership income tax return of Tissue Products Company for the year 1946, a deduction in the amount of $ 12,000 was taken as payment for a restrictive covenant. No deduction was taken as payment for the restrictive covenant on the partnership income tax returns for the years 1944 and 1945.

On September 27, 1938, Joseph Silberman and Harry Rothman, as partners, purchased a business from Sidney Luby known as Tissue Products Company. The purchase price of the business was based upon the book value of the business as of September 27, 1938. No amount was included in the purchase price for goodwill and nothing was paid to Sidney Luby for goodwill. No item of goodwill was set up on the opening balance sheet of Tissue Products Company as of September 28, 1938.

Joseph Silberman and Harry Rothman operated the business as partners until 1939 when Rose Silberman was admitted as a partner. Rose Silberman contributed $ 4,500 for her interest in the partnership. At the time Rose Silberman paid $ 4,500 for her interest in the partnership, the approximate book value of the capital accounts of each of the other partners was also $ 4,500. Nothing was included for goodwill in the payment made by her.

Rose Silberman remained as a partner with Joseph Silberman and Harry Rothman in Tissue Products Company until the end of 1940 when she withdrew from the partnership. Upon Rose Silberman's withdrawal, she was paid the sum of $ 5,000 for her interest, and nothing was included in such amount for goodwill.

Joseph Silberman and Harry Rothman continued as the sole partners of Tissue Products Company until December 31, 1943.

During the period that Joseph Silberman and Harry Rothman were partners doing business as Tissue Products Company the nature of the business was the packing and converting of private imprint tissues which were sold for resale. The partnership was not in competition with Kleenex or Ponds or other manufacturers of "name brand" tissues. The major inducement offered to prospective purchasers of the product was that the partnership would print the purchaser's own name on the boxes of tissues so that it would appear to the purchaser's customers as if the purchaser were selling his own brand of tissues. The partnership did not have and did not promote any brand name of its own. The partnership did no substantial advertising.

There was nothing about the tissues sold by the partnership that was different from tissues that might be sold by any other producer of tissues. There were several other companies in competition with the partnership during the time that Joseph Silberman and Harry Rothman were partners.

The partnership sales were made by personal contact, and if a salesman did not get around to the retailer to solicit orders, no sales were made. A continuous followup of prospective purchasers of the partnership's product was essential. In the absence of such followup, the prospective purchaser would buy from the first salesman who came along.

Personal contact with the customer was the dominant factor in making sales. Any salesman who left the partnership's employ was in a position to take away trade by actively contacting customers of the partnership. The partnership, at various times, had several salesmen in its employ. Rothman and Joseph Silberman devoted their entire time to the business, Rothman concentrating mainly on sales while Silberman handled the "inside" work including converting and packing.

No special skill or large investment in machinery is necessary in order to engage in a business similar to, and competing with, that engaged in by the partnership. The name "Tissue Products" was not a significant factor in taxpayer's business.

The war affected the business of the partnership in that a shortage of tissue developed due to the fact that the National Production Authority had curtailed the use of facial tissue. Because of the shortage, the partnership had no difficulty in disposing of its product, and could have sold much more than it could buy. During the war period it was difficult to obtain a supply of tissue, and the partnership had only one source of supply during that period. It was able to obtain some tissue from this one source due to the fact that both Joseph Silberman and Harry Rothman were on friendly terms with one of the executives employed by their source of supply, and the latter allocated a certain amount of paper to the partnership. In their relations with said executive, there was no distinction between his attitude towards Joseph Silberman and his attitude towards Harry Rothman.

Both Joseph Silberman and Harry Rothman devoted their full time to the business of the partnership.

The business engaged in by the partnership, Tissue Products Company, was risky.

The net profits earned by the partnership during the years 1939, 1940, 1941, 1942, and 1943 were as follows:

	Total	Harry	Joseph	Rose
Year	profit	Rothman	Silberman	Silberman
1939	$ 7,424.74	$ 2,474.92	$ 2,474.91	$ 2,474.91
1940	8,140.56	2,713.52	2,713.52	2,713.52
1941	16,189.02	8,094.51	8,094.51
1942	8,830.51	4,415.25	4,415.26
1943	19,157.82	9,578.91	9,578.91
	$ 59,742.65	$ 27,277.11	$ 27,277.11	$ 5,188.43
Average profit for the 5 years	$ 11,958.53	$ 5,455.42	$ 5,455.42

The capital of the partnership as of December 31, 1939, December 31, 1940, December 31, 1941, December 31, 1942, and December 31, 1943, was as follows:

December 31
	1939	$ 17,321.53
	1940	22,079.95
	1941	40,311.81
	1942	41,826.04
	1943	46,250.00
		$ 167,789.33
	Average capital	$ 33,557.86

The assets of the partnership as of December 31, 1939, December 31, 1940, December 31, 1941, December 31, 1942, and December 31, 1943, were as follows:

	Dec. 31,	Dec. 31,	Dec. 31,	Dec. 31,	Dec. 31,
	1939	1940	1941	1942	1943
Cash	$ 897.08	$ 1,686.63	$ 1,952.13	$ 5,517.97	$ 12,896.65
Accounts receivable	11,259.86	12,775.47	15,561.96	18,162.82	19,653.58
Merchandise
inventory	9,612.06	15,799.85	19,489.47	16,019.63	17,075.87
Machinery and
fixtures (net)	3,562.29	3,189.40	14,244.90	14,966.70	13,560.20
Loans and exchanges		59.43	131.00	133.00	126.00
Deposit	450.00	450.00	400.00	235.00
Truck (net)				375.00
Total assets	$ 25,781.29	$ 33,960.78	$ 51,779.46	$ 55,410.12	$ 63,312.30

Year	Total assets
1939	$ 25,781.29
1940	33,960.78
1941	51,779.46
1942	55,410.12
1943	63,312.30
	$ 230,243.95
Average value of total assets employed in business	$ 46,048.79

The closing balance sheet of Tissue Products Company as of December 31, 1943, was as follows:

	Dr.	Cr.
Cash	$ 12,883.01
Cash on hand	13.64
Accounts receivable	19,653.58
Inventory	17,075.87
Machinery and fixtures	17,876.78
Reserve for depreciation -- Machinery and fixtures		$ 4,316.58
Loans and exchanges	126.00
Accounts payable		8,853.25
Notes payable		8,000.00
Capital		46,250.00
Accrued expenses		309.05
	$ 67,628.88	$ 67,628.88

Joseph Silberman and Harry Rothman continued to do business as the sole partners of Tissue Products Company until December 31, 1943. On January 10, 1944, Joseph Silberman and Harry Rothman entered into an agreement wherein Joseph Silberman agreed to purchase Harry Rothman's interest in the partnership for $ 37,500. One-half of the partnership capital as shown on the books of Joseph Silberman and Harry Rothman doing business as Tissue Products Company as of December 31, 1943, was $ 23,125. Each of the partners had an equal interest in said capital.

Joseph Silberman agreed to pay to Harry Rothman an excess of $ 14,375 over and above the book value of Rothman's interest in the partnership as of December 31, 1943.

The payment of $ 14,375 by Joseph Silberman to Harry Rothman in excess of the book value of Rothman's interest in the partnership was made in consideration of Rothman's agreement not to compete with Joseph Silberman and his assigns for a period of 3 years from January 10, 1944.

The provisions of the contract under the terms of which Joseph Silberman purchased the interest of Harry Rothman, insofar as such contract related to the covenant not to compete, were as follows:

TENTH: That the Second Party hereby covenants and agrees with the First Party and his assigns at any time that he will not, during a period of three (3) years from and after the date hereof, directly or indirectly, under any circumstances or conditions whatsoever, engage in, or be, or become interested as an individual, partner, stockholder, director, officer, clerk, principal, agent, employee or in any relation or capacity whatsoever, in or to the business of manufacturing, converting and selling paper tissues, within the City of New York and that part of the State of New Jersey and State of New York, adjoining or near the City of New York, which are referred to as the Metropolitan area.

TENTH: (a) The Second Party agrees to return to the First Party, the sum of $ 12,000.00 if, at any time prior to May 31, 1946, the Second Party engages, directly or indirectly, or becomes interested as an individual partner, stockholder, director, officer, clerk, principal agent or employee in any relation or capacity whatsoever, in or to the business of manufacturing, converting or selling paper tissues within the area referred to as the Metropolitan area.

Joseph Silberman insisted that the covenant not to compete be made a part of his agreement with Rothman as it was an important, if not the most important, factor in his desire to buy out Rothman.

Joseph Silberman was willing to pay the additional $ 14,375 to Rothman for the covenant not to compete because he feared that competition by Rothman would reduce the supply of tissue that he would be able to get, since the executive that Silberman and Rothman both knew at the source of supply would give equal consideration to both parties, and because he feared that, if the war stopped so that tissue supply was no longer a problem, Rothman's competition would substantially hurt the business.

In determining the amount to be paid to Harry Rothman for his interest in the partnership, nothing was included in such amount for trade name or customers' lists.

The books of Tissue Products Company carried an account entitled "Good Will" bearing the date January 1, 1944, in the amount of $ 14,375, and this amount was carried forward as a balance in this account as of January 1, 1945, and January 1, 1946.

Joseph Silberman never instructed his accountant as to how to enter on the books the excess amount of $ 14,375 paid to Harry Rothman, and was not aware, at the time the transaction in question took place or at the time that the entry was made on the books, that it had been so made.

Joseph Silberman formed a new partnership with Frances Silberman and Samuel Silberman as of January 1, 1944. The newly formed partnership agreed to assume the obligation to Harry Rothman pursuant to the contract between Joseph Silberman and Harry Rothman dated January 10, 1944, and the partnership was to receive all of the benefits arising from said contract, which Joseph Silberman would have had if he had owned the business himself.

Pursuant to the agreement between Joseph Silberman and Harry Rothman dated January 10, 1944, the new partnership consisting of Joseph Silberman, Samuel Silberman, and Frances Silberman, doing business under the name Tissue Products Company, paid to Harry Rothman the sum of $ 37,500, the amount due him under such agreement.

The partnership formed as of January 1, 1944, transferred certain assets to Tissue Products Company, Inc., a newly formed corporation, on May 31 or June 1, 1946, but the partnership continued its existence up to and including December 31, 1946. Its activities after June 1, 1946, included investment of money in the stock of Wiffs, Inc., on June 5, 1946; payment of certain tax liabilities; collection of certain accounts receivable; and continuation of its bank account until December 31, 1946. The 1946 tax return of the partnership was filed on a full calendar year basis.

Upon consideration of the whole record, we find the following ultimate facts:

(a) The partnership interest of Rothman purchased by Joseph Silberman on January 10, 1944, had no goodwill value; and

(b) The sum of $ 14,375 in excess of book value, paid to Rothman as part of the consideration provided for in his contract with Joseph Silberman was in consideration of Rothman's agreement not to compete with Silberman and his assigns for a period of 3 years from January 10, 1944. No part of said sum was paid for goodwill or for any asset of the partnership. The description of the account on the books in which said item was entered as "Good Will" was not consistent with the underlying facts.

OPINION.

We are convinced that out of the total amount of $ 37,500 which Joseph Silberman paid to Harry Rothman pursuant to their agreement of January 10, 1944, the sum of $ 14,375 (being the excess over $ 23,125 representing the book value of Rothman's interest in the partnership known as Tissue Products Company) was paid in consideration of Rothman's agreement not to compete with Silberman and his assigns for a period of 3 years from January 10, 1944. We have so found as a fact on the basis of our analysis of the record as set forth below.

Joseph Silberman testified that said sum of $ 14,375 was paid solely for the agreement not to compete. Our observation was to the effect that he was a reliable witness. Perhaps of greater significance is the fact that the surrounding circumstances support his testimony.

We think it clear that Rothman's interest in the business had no goodwill value. Tissue Products Company was in the business of packing and converting private imprint tissues which it sold to customers such as drug stores for retail resale. The business was not in competition with large manufacturers of "name brand" facial tissues. Its main selling point was that it printed the name of its customer on the box, so that the retail purchaser, in turn, had the feeling that the item purchased was the retailer's own brand of tissues. Prices were cheaper than those of the large manufacturers, and the name of the retailer was printed on the box even though his purchases were in relatively small quantities. Tissue Products Company had no brand name of its own, and did not go in for extensive advertising.

During the war period, the significant problem for Tissue Products Company was to obtain a supply of tissue, because there was a shortage of tissue due to the fact that National Production Authority had curtailed its use. Both Rothman and Joseph Silberman were fortunate enough to be friendly with an executive of the business which was their source of supply. They received an allocation of supplies, but could have sold much more facial tissue if they had been able to get more.

During periods when there was no shortage of tissue, the focus was upon sales. There were several concerns competing in the same field. While the main selling point was the printing of the customer's name on the box, the sales depended upon continuing personal contact by salesmen, including the partners. Rothman, in addition to salesmen, handled sales while he was a partner, Joseph Silberman devoting most of his time to inside work, including packing and converting. Sales would not have been made without direct personal contact. The name of the business had no sale significance. Customers' lists had no importance, and anyone in the same type of business could readily have obtained a list of prospects from the telephone book.

The earnings of the business for the period leading up to the sale of Rothman's interest are not suggestive of any abnormal profits. On the contrary, we think the record clearly demonstrates that the earnings of the business are attributable to the personal services of the partners and paid employees, together with a very moderate return on investment.

Upon the basis of the foregoing, we find no goodwill value attributable to Rothman's interest. See . Respondent's argument to the contrary is largely based upon the fact that, in connection with the Rothman transaction, a "Good Will" account was opened on the books in the amount of $ 14,375, which was the same amount as that which petitioners claim was paid for the covenant not to compete. Joseph Silberman testified that he had not known that the item was so set up on the books, and had given no instructions for such an entry. An experienced accountant (not the one who had made the entry) testified, in effect, that some balancing debit entry was necessary to offset the entry of the liability to Rothman, and that he would have entered it as "good will" for lack of a better name, even though he knew it was actually for a covenant not to compete. He stated that he had never heard of an account entitled "covenant not to compete." There is nothing in the record to establish any recognized accounting practice in the above respect, but since we find that the underlying facts not only negative goodwill, but establish that the consideration was for the covenant not to compete, we hold that the naming or misnaming of the account is not determinative to the contrary.

We may add that in prior transactions in which interests in the same business were acquired or disposed of, no value was attributed to goodwill.

The affirmative reasons supporting Joseph Silberman's insistence upon a covenant not to compete are clear and convincing. Without such a covenant, Rothman would have been in a position, during the period of shortage of tissue, to cut into Silberman's source of supply, thereby reducing the latter's saleable product. During other periods, Rothman could readily have taken away a substantial amount of Silberman's sales by contacting the same customers. We are convinced that Silberman would have been foolhardy if he had not insisted upon such a covenant.

Absent goodwill, we find nothing in the record which would require us to draw any inference to the effect that Joseph Silberman's testimony was not to be believed. There is nothing to indicate that the value of the assets of the business was in excess of book value. As already indicated, the average earnings of the partners were not such as to suggest that any intangible value was attached to the business as such. The nature of the business was substantially one of personal service. At the same time, Rothman was yielding up an opportunity either to continue as a partner in a gainful occupation, or to compete with it, and the exaction for a 3-year covenant not to compete of an amount roughly approximating, but totaling less than, what he might have expected to earn from such business during such period is hardly to be classified as unusual or unreasonable.

Under all of the circumstances, we think that petitioner has established a severable consideration which he paid for the covenant not to compete, for the benefit of himself and his assigns, and that he and his assigns are entitled to amortize the amount of the consideration so paid ratably over the period of the covenant. We find that the principles outlined in (see concurrence of Court of Claims, ) are applicable. See also, affd. (C. A. 10) . The deduction allocable to the partnership for the year 1946 is therefore $ 4,791.67. The shares of the partners may be adjusted in accordance with the partnership agreement.

The actual deduction taken by the partnership in its return for 1946 was $ 12,000. This was apparently based upon the theory that since paragraph Tenth (a) of the agreement of January 10, 1944, between Joseph Silberman and Rothman provided that if Rothman actually competed at any time prior to May 31, 1946, he would return the sum of $ 12,000 -- the allowable deduction for the covenant did not accrue until that date -- but upon that date, in the absence of such competition, Rothman's liability for the return of the particular amount ceased, and the right to the deduction of $ 12,000 accrued. This view was not urged in the briefs filed on behalf of petitioners, who, as indicated in the briefs, appear now to accept the principle of ratable amortization. Respondent also agrees with the applicability of the principle of ratable amortization, assuming that a severable consideration for a covenant not to compete for a limited period is established. In all events, we think the principle is well established and we limit the deduction accordingly. See We are not called upon in this case to determine what the tax consequences would have been if Rothman had actually repaid $ 12,000.

Finally, we point out that the very fact that the terms of the agreement of January 10, 1944, required Rothman to return $ 12,000 of the contract price if he had competed prior to May 31, 1946, is strong corroboration of the intention of the parties that a substantial amount of the consideration provided in the contract was for the covenant not to compete. While we have determined that the consideration for the covenant was $ 14,375, the difference between that amount and $ 12,000 appears to be explained by the fact that the covenant ran until January 10, 1947.

Decisions will be entered under Rule 50.

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Footnotes

• 1. Proceedings of petitioners Samuel Silberman, Docket No. 47887, and Joseph Silberman, Docket No. 47888, are consolidated herewith.↩