Johnson v. Commissioner , 21 T.C. 733 ( 1954 )

George F. Johnson and Marion D. Johnson, Petitioners, v. Commissioner of Internal Revenue, Respondent

Johnson v. Commissioner

Docket No. 36339

United States Tax Court

21 T.C. 733; 1954 U.S. Tax Ct. LEXIS 294;

February 18, 1954, Promulgated

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">*294 Decision will be entered for the respondent.

Petitioner's 50 per cent share of partnership earnings held taxable to him until date of sale of such partnership interest to remaining partner notwithstanding that by the agreement of sale he relinquished his right to part of such share.

William J. Flynn, Esq., and Rayford W. Lemley, Esq., for the petitioners.

Robert R. Veach, Esq., for the respondent.

Opper, Judge.

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OPPER

">*733 This proceeding involves a deficiency in Federal income tax for the calendar year 1944 in the amount of $ 9,395.92. The sole issue to be decided is whether petitioner George F. Johnson's distributive share of the partnership income of Special Foods Company for the period January 1, 1944, through May 20, 1944, was one-half of such income or only the amount he withdrew from the partnership during 1944. All">*295 other issues presented by the pleadings were either waived or conceded by petitioner.

FINDINGS OF FACT.

Some of the facts were stipulated and they are hereby found.

Petitioners George F. Johnson, hereinafter referred to as petitioner, and Marion D. Johnson are husband and wife. They now reside in Terre Haute, Indiana. Their joint income tax return for the year involved was filed with the collector of internal revenue for the first district of Illinois. At that time, they resided in Chicago, Illinois.

">*734 On their 1944 return, petitioners reported adjusted gross income of $ 85,090.32 set forth in the return as follows:

Dividends and interest	$ 325.00
Net gain on sale or exchange of capital assets	48,213.20
Income from partnership Special Foods Company	36,552.12
Total	$ 85,090.32

The capital gain reported by petitioners related to the sale of petitioner's interest in a partnership which operated under the trade name of Special Foods Company. The gain was reported by petitioners in their return as follows:

Gross sales price	$ 151,000.00
Cost or other basis	54,573.60
Long-term gain	$ 96,426.40
50% thereof taken into account	$ 48,213.20

The total">*296 consideration paid for petitioner's interest in Special Foods Company was actually $ 152,950.

The partnership of Special Foods Company, sometimes hereinafter referred to as the partnership, was formed by petitioner and Leonard M. Japp, hereinafter referred to as Japp, on July 1, 1938. Its operations related to the manufacture, sale, and distribution of potato chips and allied products.

Petitioner and Japp each owned a one-half interest in Special Foods Company, and it was agreed at the formation of the partnership that profits and losses would be shared equally. This agreement was in effect at all times prior to the year 1944.

The partnership returns were filed on an accrual basis of accounting. The partnership's net income for the calendar years 1939 through 1943 was as follows:

1939	$ 9,474.22
1940	13,329.94
1941	19,363.68
1942	52,401.04
1943	109,773.92

The respective wives of petitioner and Japp assisted them in the operation of the partnership from 1939 until the date of its dissolution. The wives received no compensation for their services and were never partners in the Special Foods Company during this period.

In the latter part of 1943, petitioner and Japp ">*297 had some disagreements about partnership policies. During that year they attempted to sell their interests in Special Foods Company to two other organizations. During 1944 a series of differences developed between petitioner and Japp, and they discussed the possibility of severing their ">*735 partnership relationship. Japp was at first unwilling to dissolve the partnership.

In March 1944 the partners had an opportunity to purchase a potato chip firm in Milwaukee, Wisconsin, known as the Waulters Potato Chip Company. They thought it might be an opportunity for their wives to get into business for themselves and they also had in mind the breakup of the partnership. On April 24, 1944, Marion D. Johnson and Eugenia Japp, the wives of petitioner and Japp, respectively, purchased the Milwaukee firm as partners for a total consideration of $ 15,000.

On or about April 24, 1944, petitioner and Japp also agreed to equalize their drawing accounts in Special Foods Company and to limit their withdrawals to $ 100 per week thereafter until there was a complete settlement of the partnership's affairs. Both petitioner and Japp realized that the partner who remained in Special Foods Company">*298 would need all the available cash to continue that business successfully.

After their drawing accounts were equalized on April 24, 1944, their 2 accounts totaled about what they believed were the partnership's net profits for 1944 to that date. Thereafter, petitioner and Japp each drew $ 100 weekly until June 22, 1944. As of May 20, 1944, they each had made total withdrawals in 1944 of $ 36,552.12. Between May 20, 1944, and June 22, 1944, they each withdrew a total of $ 500. Petitioner omitted to include his $ 500 as income in his 1944 Federal income tax return.

On or about May 8, 1944, Japp finally decided that they would have to sever their relations. A meeting was held on May 8, 1944, for the purpose of discussing the dissolution. Besides the partners, the meeting was attended by William Flynn who was then acting as attorney for the partnership. Flynn made several suggestions which were not followed. No agreement was reached except to allow each other 30 days to think the matter over.

Subsequent to May 8, 1944, the partners continued to negotiate as to one partner buying the interest of the other. Each partner retained legal counsel to represent his interest in the negotiations.

">*299 Around May 26, 1944, petitioner and Japp reached a tentative agreement whereby Japp agreed to purchase petitioner's interest in Special Foods Company for $ 150,000, with the understanding that petitioner would purchase Eugenia Japp's interest in Waulters Potato Chip Company.

On May 26, 1944, petitioner, Japp, Flynn, and an accountant met at the offices of Blanksten & Lansing, attorneys representing Japp, to discuss the details of the transaction. This was the first time petitioner and Flynn had met Blanksten and Lansing. Flynn sent a ">*736 letter to Blanksten & Lansing dated June 14, 1944, regarding the proposed sale.

On or after May 20, 1944, petitioner and Japp executed a document which is entitled "Articles of Dissolution." This agreement, which begins with "This Memorandum of Agreement, made and entered into at Chicago, Illinois this 20th day of May, A. D. 1944," provides (1) that the partnership shall be and is hereby dissolved, and (2) that the business shall be liquidated unless within 60 days from the date thereof the parties shall reach an agreement whereby one shall purchase the partnership interest of the other.

Details regarding the sale were determined and on June">*300 20, 1944, the parties executed a sales contract, dated June 20, 1944, whereby petitioner sold his entire interest in Special Foods Company to Japp. The preamble to that contract stated:

"Whereas, the aforesaid partnership was dissolved by the parties hereto on May 20, 1944, by written articles of dissolution * * *."

The sales agreement then provided that the $ 150,000 cash, plus other personal property consideration which petitioner was to receive as the selling price, was to be in payment of his entire interest; specifically, that petitioner was thereby relinquishing all "right, title, claim or interest in or to any profits or earnings earned or accrued to Special Foods Company prior to or after May 20, 1944, other than profits already received by Johnson * * *."

The details for petitioner's purchase of Eugenia Japp's interest in Waulters Potato Chip Company were likewise determined by counsel, and the necessary documents were executed June 20, 1944, simultaneously with the documents relating to Special Foods Company. The purchase price paid by petitioner for Eugenia Japp's one-half interest was $ 11,500. Petitioner owned no interest in the Milwaukee firm prior to this time.

">*301 Immediately after June 20, 1944, petitioner and his wife went to Milwaukee and operated the Waulters Potato Chip Company. All of the profits of Waulters Potato Chip Company earned during the period from April 24, 1944, to June 20, 1944, were retained by petitioner and his wife.

The sale of petitioner's interest in Special Foods Company was completed on or about July 10, 1944, upon execution and delivery of the necessary supporting documents. Prior to July 10, 1944, petitioner had continued to perform some services for Special Foods Company. Thereafter he severed his entire relationship.

Until June 20, 1944, all partnership Federal tax returns of Special Foods Company and petitioner's personal income tax returns had been prepared by O. G. Osburn, bookkeeper for the partnership. Petitioner had no training in Federal tax matters and had never prepared an income tax return.

">*737 After petitioner had severed all relationship with Special Foods Company, Japp employed independent accountants to make an examination of the records and prepare a final partnership return. The adjustments made by Japp and his auditors to O. G. Osburn's work sheet of May 20, 1944, served to increase ">*302 the net income of the partnership during the period January 1 to May 20, 1944.

On December 29, 1944, Japp filed a partnership return for Special Foods Company with the collector of internal revenue for the first district of Illinois for the period January 1, 1944, through May 20, 1944. Except for an odd cent, the $ 110,757.79 ordinary net income reported therein was allocated equally between Japp and petitioner. Japp subsequently filed his individual return for the year 1944 upon which he reported that equal share as his partnership income from Special Foods Company.

On February 8, 1945, petitioner filed a partnership return for Special Foods Company with the collector of internal revenue for the first district of Illinois for the period January 1, 1944, through May 20, 1944. On this return, petitioner allocated $ 36,552.12 of the $ 91,555.14 ordinary net income reported therein to himself, and the remainder to Japp. This return was prepared by O. G. Osburn, who had kept the books for the partnership, and it conformed to a work sheet prepared from those books by O. G. Osburn on or about May 20, 1944. That work sheet showed the net income of Special Foods Company for the period">*303 involved to be $ 91,555.14.

The ordinary net income of Special Foods Company for the period January 1, 1944, through May 20, 1944, was $ 112,085.80.

The $ 36,552.12 which petitioner allocated to himself on the partnership return filed by him, and which he reported as partnership income on his individual return, was the amount of his withdrawals from Special Foods Company during the period January 1, 1944, through May 20, 1944.

On April 12, 1948, petitioners filed with respondent a sworn statement protesting proposed adjustments outlined in a revenue agent's report transmitted to them under date of July 28, 1947. That statement read in part:

An agreement dissolving the partnership on May 20, 1944 was signed by both parties. An agreement dated June 20, 1944, was signed relating to the details of the sale of the taxpayer's proprietary interest in the business to Mr. Japp for $ 150,000.

The contract of June 20, 1944 formally incorporated the agreement reached by both parties as to the dissolution of the partnership -- that the taxpayer was to have no share in the profits of the partnership other than what he had actually received.

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On a previous examination of these returns, ">*304 the examining officer substantially accepted the adjustments to partnership net income as scheduled by Mr. Japp but allocated the profits to the partners on the basis of their agreement, or ">*738 $ 36,552.12 to the taxpayer and the balance to the other partner. On re-examination, the examining officer in order to protect the Government's interest proposes to tax the difference between the taxpayer's share of the profits as reported by the taxpayer and as claimed by Mr. Japp to both of the former partners. There is quoted below an excerpt from the examining officer's report:

Pending final determination of the issue as to which of the two partners, Mr. Japp or Mr. Johnson, is taxable on a certain amount of income in controversy, $ 19,490.78, both partners have been taxed on such amount, in order to protect the Government's interest.

In the deficiency notice addressed to petitioners, respondent explained his adjustments as follows:

(a) In your individual income tax return filed for the calendar year 1944 you included $ 36,552.12 as income from the partnership of Special Foods Company, Chicago, Illinois. You had a 50% interest in this partnership from January 1, 1944 through">*305 May 20, 1944, for which period its net income was $ 112,085.80. Your one-half distributive share was therefore $ 56,042.90, under the provisions of section 182 of the Internal Revenue Code and accordingly, your income has been increased by the difference of $ 19,490.78.

* * * *

(c) You sold your partnership interest on May 26, 1944 and realized a long-term capital gain of $ 37,699.19 within the meaning of Code section 117, computed as follows:

Selling price	$ 152,950.00
Basis	77,551.63
Gain from sale	$ 75,398.37
50% taken into account	$ 37,699.19

You reported a gain from the sale of the aforesaid partnership interest of $ 48,213.20, and accordingly your income has been reduced by the difference of $ 10,514.01.

Petitioner's right to a 50 per cent share of the partnership profits ended by agreement on or after May 20, 1944, at the dissolution of the original partnership, and petitioner was thereafter entitled to no more of the profits.

Petitioner and Japp had no disagreements as to their 50-50 profit-sharing ratio prior to the time they reached an agreement as to the sale of petitioner's interest.

Petitioner owned a one-half interest in the partnership Special Foods ">*306 Company during the period January 1, 1944, through May 20, 1944. At all times during that period he was entitled, pursuant to the original partnership agreement, to one-half of the partnership profits.

OPINION.

It is by now well settled that a withdrawing partner is chargeable with ordinary income on his share of the partnership profits, whether currently distributed or not, up to the time of his withdrawal. LeSage v. Commissioner, (C. A. 5) 173 F.2d 826; Louis ">*739 , 8 T.C. 1327. This is so notwithstanding that he sells his interest to the continuing partner.

Respondent has determined the deficiency here as though petitioner's 50 per cent partnership interest terminated on May 20. The sole question is whether there was a termination of that 50 per cent interest at any earlier time.

That there was no change in the equal profit sharing ratio prior to the sale of petitioner's interest is clear from petitioner's own testimony. ¹ And the purpose of restricting the drawing accounts in April was not to change the profit ratio but rather to make an interim agreement "until [as petitioner testified] we came">*307 to some settlement of selling out to one another."

Nor was petitioner's interest terminated at an earlier time. It was not until May 20 or later that the identity and price of the partnership interest to be sold were settled. Only then did petitioner cease to be entitled to his full partnership earnings. LeSage v. Commissioner, supra.

Since petitioner no longer contests the figure to be used as net partnership income, we find no error in the deficiency.

Decision will be entered for the respondent.

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Footnotes

• 1. CROSS-EXAMINATION

  By Mr. Veach (respondent's counsel):

  Q. Did you or Mr. Japp at any time have any disagreements as to your profit-sharing ratio that you would not be 50-50 partenrs?

  A. No, we never had any.

  Q. No, that is prior to the sale of your interest?

  A. That is right.↩