Commissioner of Internal Revenue v. The Pittston Company

SMITH, District Judge.

This is a petition by the Commissioner of Internal Revenue for review of a decision of the Tax Court of the United States reported in 26 T.C. 967, holding the taxpayer The Pittston Company entitled to treat the sum of $500,000 received in 1949 as consideration for the termination of an exclusive contract to purchase the output of Russell Fork Coal Company’s leased Pike County coal mines, as long term capital gain, derived from a sale or exchange within the meaning of Section 117(a) (4) of the Internal Revenue Code of 1939. The pertinent sections of the statutes are as follows:

Ҥ 22. Gross Income. (26 U.S. C.1952 ed., Sec. 22)

“(a) General Definition. — ‘Gross income’ includes gains, profits, and income derived from salaries, wages, or compensation for personal service of whatever kind and in whatever form paid, or from professions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever. * * *

******

Ҥ 117. Capital Gains and Losses. (26 U.S.C. 1952 ed., Sec. 117)

“(a) Definitions. — As used in this chapter—

“(1) (As amended by Sec. 115 <b), Revenue Act of 1941, c. 412, 55 Stat. 687, and Sec. 151(a), Revenue Act of 1942, c. 619, 56 Stat. 798) Capital Assets. — The term ‘capital assets’ means property held by the taxpayer (whether or not connected with his trade or business), but does not include stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, or property, used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 23 (Z), or an obligation of the United States, or any of its possessions, or a State or Territory, or any political subdivision thereof, or of the District of Columbia, issued on or after March 1, 1941, on a discount basis and payable without interest at a fixed maturity date not exceeding one year from the date of issue, or real property used in the trade or business of the taxpayer;

* * * * * *

“(4) (As amended by Sec. 150(a) (1), Revenue Act of 1942, supra) Long-term capital gain. The term ‘long-term capital gain’ means gain from the sale or exchange of a capital asset held for more than 6 months, if and to the extent such gain is taken into account in computing gross income; * * *

The Pittston Company and its wholly owned subsidiary, Pattison & Bowns, Inc., filed consolidated returns for the taxable year 1949. The subsidiary, which was the contracting party with Russell Fork Coal Company (hereinafter called Russell) and the recipient of the amount in question, will be referred to as the taxpayer.

On January 25, 1944, taxpayer (as buyer) and Russell (as seller) entered into a written contract, which provided, in part, as follows:

“That in consideration of the mutual covenants and conditions herein set forth and of an agreement executed and delivered simultaneously with the execution and delivery of this agreement, it is agreed as follows:

“(1) Subject to the provisions of Paragraph 2 of this agreement the Seller (Russell Fork) agrees to sell to the Buyer (Pattison & Bowns), and any other affiliated person, partnership or corporation whom and which the Buyer may from time to time designate in writing, F.O.B. the mine, all of the coal which shall be mined and sold for resale from the mining plant or plants which the Seller expects to install or does install upon its leased property in Pike County, Kentucky, as set forth in the agreement executed simultaneously herewith.

******

“(3) The title to all coal sold to the Buyer hereunder shall pass to the Buyer at the time said coal is loaded into cars or trucks at the mines for transportation and before transportation begins.

“(4) The Buyer shall be entitled to and is hereby authorized to deduct a discount of 8% of the gross selling price on all coal purchased by it, which amount shall include all expenses and compensation of every kind of the Buyer and its designees and under no circumstances shall any affiliate of the Buyer be entitled as a wholesaler, jobber or otherwise to any additional discount, compensation and expenses all of which shall be included in the foregoing 8%, * * *

******

“(6) The Buyer agrees for itself and its designees and binds itself and each of them that it and each of them will at all times have and maintain proper facilities and employees so as to be able efficiently to resell the said coal and agrees to endeavor with diligence and in every proper manner to resell the largest available amount of said coal at prices specified from time to time by the Seller, and further agrees to comply with all laws that are now in force, or may hereafter be enacted, and all valid rules and regulations thereunder relating to the selling of coal or all other related or incidental matters. * * * if the Buyer and its designees, as the case may be, complies with the obligations binding upon it and them, then this agreement shall be irrevocable for a period of ten (10) years from this date and for such additional period of extensions as is provided in Paragraph 3 of the agreement executed and delivered simultaneously with the execution and delivery of this agreement. * * * ”

On the same date, January 25, 1944, taxpayer and Russell entered into another contract, under the terms of which taxpayer agreed to loan Russell $250,000, which loan was to be repaid in periodic installments over a period of 10 years and was to bear interest at 4 per cent per annum. During the period January 25, 1944 to October 14, 1949, taxpayer purchased from Russell 1,959,-563.15 tons of coal for $9,855,089.64 which it resold at a gross profit of $273,-411.14. Taxpayer carried out its agreement to loan Russell $250,000 and it also-made various additional advances on-open account; these loans were finally-liquidated by Russell during 1948. On-October 14, 1949, Russell paid $500,000-to taxpayer in consideration of taxpayer’s surrender of all of its rights-under the coal agreement of January 25, 1944. The transaction was reflected in-a letter agreement dated October 14, 1949; the letter was sent to Russell by taxpayer, and read as follows:

“In consideration of the payment by you to us of the sum of Five Hundred Thousand Dollars ($500,-000), receipt of which is hereby acknowledged, it is understood that you have as of this day acquired all of our right and interest in and to the agreement dated January 25, 1944 between us, which agreement provides for the exclusive right by Pattison & Bowns, Inc. to purchase all of the coal produced by you at your Russell Fork Mine, said contract expiring by its terms on January 25, 1954.”

In its income tax return for the year 1949, taxpayer reported the $500,000 as long-term capital gain. In his notice of deficiency, the Commissioner determined that this amount “was not received as the result of a sale or exchange and therefore is reportable as ordinary income.” The Tax Court held that the $500,000 was taxable as long-term capital gain, not as ordinary income, and accordingly overruled the Commissioner.

The courts have not been entirely consistent in their treatment of lump sum payments received by a taxpayer for the termination of jural relations between the taxpayer and another as falling within or without the area entitled to more favored treatment as long-term capital gains rather than ordinary income.¹ This circuit has steered a middle course. In McAllister v. C. I. R., 2 Cir., 157 F.2d 235, payment received for transfer by a taxpayer of a life interest in a trust to a remainderman was held a capital gain, Judge Frank dissenting. The McAllister holding and its possible consequences were criticized in Judge Frank’s dissent and in comments on the problem in law journals (see 56 Yale L.J. 570-574 and 14 U. of Chic.L.Rev. 484-493). The court thereafter held in C. I. R. v. Starr Bros., 2 Cir., 204 F.2d 673, that payment received by a taxpayer, a New London retail druggist, for relinquishing its rights under a provision in a contract with a manufacturer, binding the manufacturer not to sell drugs to taxpayer’s competitors in New London, was ordinary income and not a capital gain. In the same year, consistently with Starr, the court in General Artists Corp. v. C. I. R., 2 Cir., 205 F.2d 360, certiorari denied 346 U.S. 866, 74 S.Ct. 105, 98 L.Ed. 376, held that payments received by a taxpayer for transfer of its contracts with a singer as his exclusive booking agent to another such agent by an agreement providing for cancellation of the contracts and execution of new contracts with the singer by the transferee were ordinary income and not capital gains received as gain from sale of a capital asset. However, in C. I. R. v. McCue Bros. & Drummond, Inc., 2 Cir., 210 F.2d 752, the court held a payment received by a taxpayer lessee from a landlord for vacating premises where the taxpayer had a right to continued possession under rent control laws was a capital gain from the sale or exchange of a capital asset held more than six months. In so doing the court followed the third circuit in C. I. R. v. Golonsky, 3 Cir., 200 F.2d 72, certiorari denied 345 U.S. 939, 73 S.Ct. 830, 97 L.Ed. 1366, holding payment received by a lessee from the landlord for cancelling the lease and surrendering the premises to be a capital gain. The court distinguished Starr and General Artists because there the contractual right was not transferred, but was released and merely vanished. The right to possession of the realty was considered a more substantial property right which does not lose its existence when it is transferred.

The Tax Court in the instant case concluded that the contractual right held by the taxpayer constituted capital assets, which petitioner does not dispute, and concluded that the right was not extinguished by its cancellation, but continued to exist as property of the transferee-payor. It distinguished Starr and General Artists on the ground that the court had held in those cases the contractual right was not transferred, but was released and merely vanished. The Tax Court says in effect that the ex-tinguishment of a contract duty to deal only with one person transfers to the one formerly bound a right to deal with all the world. It would be more in accord with common understanding to say that the payment is solely for the termination of the right-duty relationship between the two parties to the agreement. To be sure, the same might be said of the termination of lessee’s or life tenant’s rights, but they have been distinguished as relating to matters of greater “substance” than mere contract rights.

The instant case appears on the facts closer to the payment for the extinguishment of the taxpayer’s rights under the negative covenant in Starr than to the cases such as McAllister where a life estate was transferred to the remainder-man, or the release of right to possession of realty under lease or otherwise as in McCue and in Golonsky. While the contract right here surrendered was “property” of value it carried with it no direct interest in the mine itself, or in the coal produced until delivery f. o. b. car or truck. It was a naked contract right, not in the nature of a lease or profit d prendre. If Russell Fork was able to do better elsewhere it might have sold its coal through anyone, responding in damages to the taxpayer, for so far as appears similar coal would have been obtainable elsewhere by taxpayer at a price. The large amount received by the taxpayer for the 4% years the contract had to run compared with its gross returns for the 5% years already expired, while not explained on the record, may reflect an expectation of lower expense to the taxpayer since taxpayer no longer is financing Russell. In any case, the cancellation brought the taxpayer at one time a return which it might otherwise have realized over a relatively short period of years as ordinary income under the sales contract. Whatever brought it about, it suggests a possible method of returning future income to a taxpayer in a lump sum from the other contracting party in advance for tax avoidance purposes, which the court has been unwilling to sanction except where the consideration surrendered had more “substance” than mere contract rights.

The Congress has since the tax year here in question more fully provided for the application of the sale or exchange concept when a lease or distribution agreement is cancelled, by Section 1241 of the Internal Revenue Code of 1954, 26 U.S.C.A. § 1241, allowing the more favorable capital gains treatment of the amount received on cancellation, but in case of distributorships only where the distributor has a “substantial investment” in the distributorship, as in facilities for storing, processing, etc. the physical product or as in maintaining a substantial inventory. This amendment is not applicable in this case, and of course no showing was made as to whether such a substantial investment in facilities or inventory was or was not maintained. The amendment is of little assistance in interpreting the original provision for we cannot tell whether the intent of Congress was to broaden or narrow the capital gains on sale or exchange exception to the income tax, and', its apparent result falls somewhere between the contentions of the opposing-parties here. See Senate Report on H. R. 8300, 3 U.S.Code Cong. & Adm.News,. 83rd Cong., 2nd Session, 1954, pp. 5087, 5088, Conf. Report, id. p. 5332. The heavy burden of income taxation inevitably leads to the broadening of exceptions such as the capital gains provision.. This court has endeavored to define what it conceived to be the limits to this exception in Starr and United Artists by a somewhat literal definition of “sale or exchange.” Even though the logic of setting the limit by drawing the line’ where it now is may be open to debate,, any line set must be to some degree arbitrary. This case falls outside the limit, thus far set for the exception by this, court. We should leave further expansion of the exception, to include the release of naked contract rights as a “sale,” to legislative action.

The judgment of the Tax Court is reversed and the case is remanded for entry of judgment in favor of the Commissioner in accordance herewith.

1 . Bingham v. C. I. R., 2 Cir., 105 F.2d 971; McAllister v. C. I. R., 2 Cir., 157 F.2d 235; Jones v. Corbyn, 10 Cir., 186 F.2d 450: C. I. R. v. Golonsky, 3 Cir., 200 F.2d 72; C. I. R. v. Starr Bros., 2 Cir., 204 F.2d 673; General Artists Corp. v. C. I. R., 2 Cir., 205 F.2d 360; C. I. R. v. Ray, 5 Cir., 210 F.2d 390; C. I. R. v. McCue Bros. & Drummond, Inc., 2 Cir., 210 F.2d 752; C. I. R. v. Goff, 3 Cir., 212 F.2d 875; Roscoe v. C. I. R., 5 Cir., 215 F.2d 478; Marc D. Leh, 27 T.C. 892.