Merrill v. Commissioner

Joseph L. Merrill, Petitioner, v. Commissioner of Internal Revenue, Respondent

Merrill v. Commissioner

Docket No. 8190

United States Tax Court

9 T.C. 291; 1947 U.S. Tax Ct. LEXIS 113;

September 9, 1947, Promulgated

---

">*113 Decision will be entered for the respondent.

Petitioner, a general partner in a New York limited partnership, with a fixed term ended December 31, 1939, was permitted to retire as of March 31, 1939. On March 30, 1940, petitioner and the firm executed an agreement whereby in consideration of certain further payments by the petitioner, mutual releases were exchanged and petitioner was assigned his pro rata share of recoveries on certain doubtful but unliquidated accounts as of March 30, 1940. On his Federal income tax return for 1940 petitioner claimed as an ordinary loss the sum of $ 103,457.84 in connection with his participation as a partner in such firm, resulting in a net loss of $ 41,281.28. In the taxable year 1941 petitioner claimed as a deduction such amount as a net loss carry-over, which the respondent disallowed. Held, on petitioner's retirement his interest in the partnership was transferred to the remaining partners, constituting a capital transaction, from which petitioner sustained a capital loss. Since the transaction was not related to the business of the partnership and outside the business regularly carried on by petitioner, under the limitations prescribed">*114 in section 122 (d) (5), I. R. C., petitioner had no net operating loss in 1940 which he was entitled to carry over into the taxable year 1941.

Richard P. Jackson,">*115 Esq., for the petitioner.

William A. Schmitt, Esq., for the respondent.

Leech, Judge.

---

LEECH

">*291 Respondent has determined a deficiency in petitioner's income tax for the calendar year 1941 in the amount of $ 23,388.24. Certain adjustments by respondent in determining the deficiency are not in dispute. The only issue submitted is petitioner's right to the deduction in the taxable year of $ 41,281.28 as an operating net loss carry-over ">*292 from the preceding year. Some of the facts are stipulated, and such additional facts as are hereinafter set out in our findings of fact are found upon evidence adduced at the hearing.

FINDINGS OF FACT.

Petitioner is a resident of Bronxville, New York, and has for many years been engaged in the brokerage business. For the taxable years 1940 and 1941 his income tax returns were filed on a cash basis with the collector of internal revenue at Albany, New York.

Prior to 1930 petitioner was a general partner in the firm of Merrill, Lynch & Co., a limited partnership doing business as stockbrokers and dealers in securities. On January 18, 1930, petitioner withdrew from that firm and on the same date was admitted as a general partner">*116 in the firm of E. A. Pierce & Co. (hereinafter referred to as the partnership). This firm is a limited partnership, carrying on a general brokerage business in stocks, bonds, and other securities and commodities and the purchasing, selling, and underwriting of securities. Article V of the certificate of limited partnership, as amended, provides: "V. The term for which the partnership is to exist is until December 31, 1939. * * *"

Article XIII, as amended, provides:

XIII. In the event of the death, retirement, expulsion or insanity of a General Partner, the remaining General Partners shall have the right to continue the business of the partnership for the remainder of the unexpired term of the partnership.

Petitioner retired as of March 31, 1939, and a certificate showing such retirement was filed on June 13, 1939. Petitioner's original contribution, as such general partner, was $ 400,000. It was the general practice to charge the account of a general partner with the losses sustained and to credit his account with the firm's profits. It was also the practice on the death or withdrawal of a partner to revalue the exchange memberships held by the partnership. Any decrease in value">*117 was charged and any increase was credited to the respective partner's capital account. Such increases or decreases were not treated as realized and were not reflected in the partner's income tax returns.

The amount of the decreases in the revaluations of exchange memberships charged against the account of the petitioner at the time of his retirement was $ 113,300.34, and the amount credited was $ 11,442.05. The operating losses that had been charged to his capital account up to the time of his retirement were $ 458,589.99 and the amount of profits credited was $ 215,816.78. These operating losses and profits were reflected on the income tax returns of the petitioner in the respective taxable years. Giving effect to these various debits ">*293 and credits, petitioner's capital account on the date of his retirement on March 31, 1939, had a credit balance of $ 55,368.50. Sometime thereafter petitioner's account was charged with an amount of $ 73,256.26, as his share of obligations of the firm incurred prior to, but which had not been paid by the partnership at, the date of petitioner's retirement. On April 26, 1939, petitioner's personal account was charged with the sum of $ ">*118 17,887.76 and his capital account credited with such amount, balancing his partnership capital account. Under date of March 30, 1940, an agreement was executed by the firm and the petitioner, "which shall constitute a complete and final accounting by the Limited Partnership for the partnership interest of the party of the second part," the petitioner herein. This agreement, in part, provides as follows:

Whereas, as of March 31, 1939, there were various large unliquidated disputed and undeterminable claims and items in litigation pending against said Limited Partnership, and it was not possible at that time to make a final settlement; and

Whereas, on said 30th day of March 1940, it was claimed by the Limited Partnership that the balance to the credit of Joseph L. Merrill, amounting to $ 73,256.26, which amount represented the balance of the capital account of $ 55,368.50 plus payment of $ 17,887.76 on April 26, 1939, together with a further payment of $ 9,570.73 on January 9, 1940, was insufficient to meet his partnership liabilities, and the party of the second part paid to the Limited Partnership on said 30th day of March, 1940, an additional sum of $ 60,000., which was the amount">*119 as then estimated that would be required to be paid by the party of the second part to meet his partnership liabilities; and

Whereas, the Limited Partnership has asserted that the party of the second part is further indebted to the Limited Partnership in the sum of approximately $ 37,000.; and

Whereas, the party of the second part has asserted that the Limited Partnership is indebted to him in a sum approximating $ 52,000.; and

Whereas, it was proposed in an agreement to be entered into bearing date the 30th day of March, 1940, that a settlement agreement be entered into by the Limited Partnership with the party of the second part, whereby the party of the second part be released of further liability to the Limited Partnership, and the Limited Partnership and its partners be released of any liability to the party of the second part, except with reference to any recovery which might be effected in certain doubtful accounts, by reason whereof the account of the party of the second part had been charged with the sum of $ 61,595.48, and a schedule of which doubtful accounts was attached to said proposed agreement; and

Whereas, certain of the partners of the Limited Partnership took exception">*120 to said proposed agreement, and it was thereupon decided, with the consent of the party of the second part and all of the partners in interest of the Limited Partnership, that the question be submitted to Charles E. Merrill, Esq., as to whether said settlement agreement was fair and just under all of the circumstances, and if not, what would be a fair and just settlement; and

Whereas, said Charles E. Merrill, Esq. has determined that said proposed settlement was fair and just, with the exception that the party of the second part pay to the Limited Partnership the sum of Three thousand five hundred Dollars ($ 3,500.); and

">*294 Whereas, the Limited Partnership and the party of the second part are now desirous of entering into this agreement, which shall constitute a complete and final accounting by the Limited Partnership for the partnership interest of the party of the second part, and the release of the Limited Partnership and the party of the second part of all liability, one to the other, arising out of or in connection with the partnership interest of the party of the second part in the Limited Partnership, except as specifically provided herein;

Now, therefore, in consideration">*121 of the premises, and the sum of One Dollar, interchangeably in hand paid, the receipt whereof is hereby acknowledged, the parties hereto do hereby agree as follows:

First: The party of the second part does hereby release the Limited Partnership of any or all claims arising out of his general partnership interest in the Limited Partnership, his original contribution of capital in the sum of $ 400,000., the additional payments made by him of $ 17,887.76 and $ 9,570.73, and the payment of $ 60,000. made by said party of the second part on March 30, 1940.

The party of the second part further agrees that the Limited Partnership is released and discharged of any and all claims arising out of his capital contribution or contributions, and of any and all other claims or demands arising out of or in connection with the Partnership Agreement bearing date the 18th day of January, 1930, and all amendments and supplements thereto, and the said Limited Partnership and all of the partners, general and limited, are hereby jointly and severally released and discharged of any and all further liability to the party of the second part in connection with the amounts contributed by the party of the second">*122 part to the Limited Partnership, and likewise in connection with any claims or demands that might be asserted by the party of the second part in connection with the partnership affairs of the Limited Partnership, except only to the extent hereinbelow provided in Article "Third" hereof.

Second: The party of the second part has agreed to pay to the Limited Partnership, upon the execution of this agreement, the sum of Three thousand five hundred Dollars ($ 3,500.), the receipt whereof is hereby acknowledged by the Limited Partnership; and the Limited Partnership does hereby acknowledge the receipt of said payment, and the payments heretofore made by the party of the second part to the Limited Partnership, including his original capital contribution of $ 400,000., the payments of $ 17,887.76 and $ 9,570.73 and the payment of $ 60,000., which was made by the party of the second part on March 30, 1940; and the Limited Partnership and all of its partners, general and limited, do hereby agree that said amounts shall be and the same hereby are accepted by the Limited Partnership in full payment, satisfaction and discharge of any liability owing or which might be claimed to be owing by the ">*123 party of the second part to the Limited Partnership, arising out of the Partnership Agreement bearing date the 18th day of January, 1930, or by reason of any participation in the affairs of the Limited Partnership by the party of the second part.

Third: It is mutually understood and agreed, irrespective of the foregoing provisions set forth in Articles "First" and "Second" hereof, that the party of the second part shall have an interest in any recoveries which may be effected by the Limited Partnership in connection with certain doubtful accounts, for which the capital account of the party of the second part has been charged with his pro rata share.

A statement of the specific items constituting said doubtful accounts is attached hereto marked "Schedule 1", and it is understood and agreed that the rights of the party of the second part against the Limited Partnership surviving the execution of this agreement are confined strictly to any recoveries which may be realized by the Limited Partnership from the accounts set forth upon said ">*295 schedule and that, except to such extent, the Limited Partnership and the party of the second part are mutually released, one as against the ">*124 other, as hereinabove set forth.

The Limited Partnership agrees that the party of the second part shall be entitled to receive his share, as specified upon said schedule, of any and all moneys which may be received by the Limited Partnership from the accounts set forth on said schedule from time to time, and that payment of his said share of any sums so received by the Limited Partnership shall be made by the Limited Partnership to the party of the second part not less frequently than semi-annually, accompanied by an appropriate statement with respect to any such recoveries.

* * * *

Attached to this agreement was a list of doubtful accounts not liquidated as of March 30, 1940, showing ledger amounts totaling $ 1,142,432.50, of which petitioner's pro rata share was $ 61,595.48. Some recoveries were made in later years on these accounts and petitioner received $ 8,732.68, which he returned as income in the years in which received.

Petitioner, in his return for the year 1939, claimed and was allowed an ordinary loss in the sum of $ 103,457.84, which the parties agree was made up of the following items: Loss on revaluation of exchange memberships, $ 80,693.26; $ 13,193.85, petitioner's">*125 pro rata share of the operating loss of the partnership for the period January 1 to March 31, 1939; and $ 9,570.73 representing a charge made against petitioner to cover his share of a deficit in the account of Robert Cassels, who also withdrew as general partner on March 31, 1939.

Petitioner, in his 1940 income tax return, claimed as a deduction as an ordinary loss from the partnership the sum of $ 133,256.26, made up of the sum of $ 55,368.50 representing the balance in his capital account as of March 31, 1939, the debit on April 26, 1939, to his personal account of $ 17,887.76, which was credited to his partnership account, and the payment of $ 60,000, made on March 30, 1940, resulting in a net loss as shown on his return of $ 43,848.43. In his income tax return for the taxable year 1941 petitioner claimed a deduction of the sum of $ 43,848.43 as an operating loss carry-over from the preceding year. The parties are agreed that the correct amount of net loss for the preceding year 1940 is the sum of $ 41,281.28.

In his deficiency notice for the taxable year 1941 respondent disallowed the deduction of $ 43,848.43. The respondent's explanation of the disallowance was as follows:

">*126 (e) An examination discloses that you retired from the partnership E. A. Pierce & Co. on or about March 31, 1939, and that in order to reimburse the partnership for your portion of various claims against the partnership you expended $ 60,000.00 in cash and relinquished your capital account of $ 73,256.26 in the partnership on or about March 30, 1940. As a result of the above you sustained a loss in 1940 from the liquidation of the partnership. Inasmuch as the loss was sustained in the year 1940, it is held that no portion of such loss is deductible ">*296 in the taxable year under the provisions of Section 23 of the Internal Revenue Code. It is further held that the expenditure of $ 60,000.00 and the surrender of your partnership capital account in the year 1940 were not attributable to the operation of a trade or business carried on by you in the year 1940 since you retired in 1939 and are, therefore, deductible in computing your net operating loss deduction for the current year only to the extent provided by Section 122 (d) (5) of the Internal Revenue Code. After applying the limitation prescribed by Section 122 (d) (5), it has been determined that you sustained no net operating">*127 loss which is allowable as a deduction in the taxable year.

Subsequent to his retirement from the partnership on March 31, 1939, petitioner continued actively in business of a similar character in his own behalf. During the balance of the year 1939 he realized substantial income from these activities. On March 30, 1940, petitioner became a limited partner in the firm of Merrill, Lynch, E. A. Pierce & Cassatt, which was formed to take over the business of the old firm of E. A. Pierce & Co. from which petitioner had retired on March 30, 1939.

The only payment made by petitioner to the old firm in the year 1940 was the sum of $ 60,000. The debit to petitioner's capital account in the firm of E. A. Pierce & Co. of the sum of $ 55,368.50, and the debit to his personal account of the sum of $ 17,887.76 which was made on April 26, 1939, and credited to his partnership account, were to cover debts of the partnership charged to his account in 1939.

OPINION.

Petitioner contends that the only issue raised by the pleadings is whether the loss sustained in 1940 was attributable to the operation of a trade or business regularly carried on by the petitioner.

The deficiency notice, as will be ">*128 noted in the findings of fact, explained that the deficiency resulted from the disallowance by respondent of the deduction in the taxable year, 1941, of any carry-over loss from 1940 because of the provisions of section 122 (d) (5) of the Internal Revenue Code. Several reasons for that action were there stated. The petition assigned error as to the validity of those reasons. The action of the respondent affirmed their validity. But the basic issue was and is whether petitioner is entitled to deduct in the taxable year, as a net operating loss carry-over from the preceding year, the sum of $ 41,281.28, under the provisions of section 122 (d) (5) of the code, the deduction of which was disallowed. Thus, at the trial respondent modified some of the statements in the deficiency notice and advanced several additional grounds in support of the disallowance under section 122 (d) (5). One of the additional grounds was that the amounts of $ 55,368.50 and the $ 17,887.76 charged against petitioner's partnership account were losses sustained in 1939. Another ground was that on the retirement of petitioner from the firm on March 31, 1939, he transferred his interest in the partnership to">*129 the remaining ">*297 partners, and this constituted a capital transaction. These are not new issues, but additional reasons in support of the disallowance of the deduction. They were timely raised. There was no surprise. Petitioner neither asserts nor is there anything to indicate any evidence other than that presented could have been offered by the petitioner under any other circumstances. The authorities support the right of the respondent to advance additional grounds in support of the action taken by him where no element of surprise is involved. Helvering v. Gowran, 302 U.S. 238">302 U.S. 238; Estate of Arthur D. Cronin, 7 T.C. 1403; James W. Pennock, Jr., 25 B. T. A. 1331; affd., 64 Fed. (2d) 1018; Standard Oil Co., 43 B. T. A. 973; affd., 129 Fed. (2d) 363; certiorari denied, 317 U.S. 688">317 U.S. 688.

To entitle the petitioner to succeed here it is incumbent upon him to establish that the deduction claimed on his 1940 return was an operating loss as defined in section 122, and as limited">*130 by subdivision (d) ( 5) of the Internal Revenue Code. ¹ We think on this record he has failed to establish this necessary premise. Under the controlling authorities, he disposed of a capital asset, and the resulting loss was not incurred in the operation of a business regularly carried on by him in the year 1940. It is to be noted that the partnership was validly created pursuant to the laws of the State of New York pertaining to a limited partnership. The legal character of the interest of a partner is controlled by the law of that state. Lyeth v. Hoey, 305 U.S. 188">305 U.S. 188; Allan S. Lehman, 7 T.C. 1088. This partnership was to continue for a fixed term. Petitioner was permitted to retire prior to the expiration date. No sale or liquidation of the partnership assets was effected. As a partner in a going concern, he had no specific interest in any specific partnership assets. Sec. 51 (2) (a), New York Partnership Law; Robert E. Ford, 6 T.C. 499. ² His interest is defined as "his share of the profits and surplus and the same is personal property." Sec. 52, New York Partnership Law; ">*131 Blodgett v. Silberman, 277 U.S. 1">277 U.S. 1; Case v. Beauregard, 99 U.S. 119">99 U.S. 119. When a partner retires from a continuing partnership the remaining partners succeed to the exclusive possession and contol of the partnership assets. The situation is different where the partnership is being liquidated and the assets distributed. ">*298 Annie Laurie Crawford et al., Executors, 39 B. T. A. 521. Since the certificate of limited partnership did not provide otherwise, he was entitled to have his interest valued in the event he was unable to agree with the remaining partners as to its value. Sec. 73, New York Partnership Law. That they did so agree is evidenced by the agreement of March 30, 1940. Petitioner and the firm not only exchanged mutual releases, but he received his pro rata share of doubtful accounts not liquidated as of March 30, 1940, totaling $ 1,142,439.50, of which his share was $ 61,595.48. True, petitioner testified that these assets were of no value. We do not accept this appraisement. The record shows that $ 45,197.24 consisted of cash in insolvent banks. These accounts had">*132 not been finally liquidated. So, on this record we must assume substantial recoveries would result. In fact, at the time of the trial petitioner had received $ 8,732.68 on account of his interest in the doubtful accounts which were assigned to him as part consideration for the transfer of his partnership interest. We think the conclusion to be drawn from this record is that on March 30, 1940, petitioner transferred his interest as of March 1939 to the remaining partners for a valuable consideration, and the transaction constituted a capital transaction. In Williams v. McGowan, 152 Fed. (2d) 570, the Circuit Court of Appeals for the Second Circuit, in which this case arises, said:

It has been held that a partner's interest in a going firm is for tax purposes to be regarded as a "capital asset." Stilgenbaur v. United States, 115 Fed. (2d) 283; Commissioner v. Shapiro, 125 Fed. (2d) 532. We too accepted the doctrine in McClellan v. Commissioner, 117 Fed. (2d) 988, although we had held the opposite in Helvering v. Smith, 90 Fed. (2d) 590">*133 * * *.

In McClellan v. Commissioner, 117 Fed. (2d) 988, the Second Circuit Court of Appeals said:

The question presented is whether a loss sustained by a partner upon withdrawing from a partnership in 1934 is an ordinary loss or a capital loss. The Board held">*134 it to be the latter, limited by section 117 (d) of the Revenue Act of 1934. * * * The effect of the retiring partner's withdrawal was to transfer to the other partners for continuance in the business his interest in the stock exchange seat and real estate. The Board correctly held that the transaction amounted to a sale of a capital asset to the remaining partners. * * * [Italics supplied.]

See also Annie Laurie Crawford et al., Executors, supra;Dudley T. Humphrey, 32 B. T. A. 280; Robert E. Ford, supra.

Having concluded the transaction was a transfer of petitioner's interest in the partnership to the remaining partners, it is necessary to determine the extent to which the loss resulting therefrom is a net operating loss within the limitations prescribed in subsection (d) (5) of section 122 of the code. Obviously, such transaction was not ">*299 a part of the business of the partnership, and, so far as is revealed here, petitioner was not engaged in the business of buying and selling partnership interests. Cf. United States v. Adamson, 161 Fed. (2d) 942.">*135 The transaction was clearly outside the "business regularly carried on" by the petitioner and no part thereof can be taken into consideration in determining petitioner's net operating loss for 1940, subject to be carried over into the taxable year 1941. The respondent's disallowance of the deduction is sustained.

Decision will be entered for the respondent.

---

Footnotes

• 1. SEC. 122. NET OPERATING LOSS DEDUCTION.

  * * * *

  (d) Exceptions and Limitations. -- The exceptions and limitations referred to in subsections (a), (b), and (c) shall be as follows:

  * * * *

  (5) Deductions otherwise allowed by law not attributable to the operation of a trade or business regularly carried on by the taxpayer shall (in the case of a taxpayer other than a corporation) be allowed only to the extent of the amount of the gross income not derived from such trade or business. For the purposes of this paragraph deductions and gross income shall be computed with the exceptions and limitations specified in paragraphs (1) to (4) of this subsection.↩

• 2. Respondent acquiesces, 1946-2 C. B. 2↩.