the same deduction should be allowed on payment when section 357 (c) treats the liability as assumed in exchange for receivables. Admittedly no such deduction is available where assets are transferred in a section 351 transaction to the extent not treated as a sale under section 357. Arthur L. Kniffen, 39 T.C. 553, 566–567 (1962); 1 Doggett v. Commissioner, 275 F. 2d 823 (C.A. 4, 1960), affirming a Memorandum Opinion of this Court, certiorari denied 364 U.S. 824 (1960); Citizens Nat. Trust & Savings Bank v. Welch, 119 F. 2d 717 (C.A. 9, 1941). Likewise, a bankrupt gets no deduction on the mere transfer of assets to a trustee, where a new entity is created and there is no direct correspondence between transfer of assets and subsequent payment of the bankrupt's liabilities. Henry C. Mueller, 60 T.C. 36, 43-44 (1973); B & L Farms Co. v. United States, 238 F. Supp. 407, 409-410 (S.D. Fla. 1964), affirmed per curiam 368 F. 2d 571 (C.A. 5, 1966), certiorari denied 389 U.S. 835 (1967). Neither of these situations is comparable to the present facts, where (in order to avoid a negative basis) section 357 treats a portion of what would otherwise be a section 351 transaction as a taxable sale. Our analysis is fully in accord with the purpose of section 357 (c). Under it, there is no need to strain, as does Bongiovanni v. Commissioner, 470 F. 2d 921 (C.A. 2, 1972), to read the word "liabilities" in a difficult-to-define, artificial "tax" sense. Section 357 (c) is given full, literal effect. As a matter of appropriate allocation, in the case of incorporation of a cash basis business, the trade accounts payable should, for this purpose, be netted against the trade accounts receivable, up to the lesser of the trade accounts payable or the amount of liabilities treated as paid under section 357 (c). Such an allocation is simple, straightforward and best follows the statutory intent. Applying these principles to the present case, the liabilities assumed exceeded the adjusted basis of assets transferred by $102,367.73. Accordingly, there is $102,367.73 of section 357 (c) gain. There were $164,065.54 of unrealized accounts payable, and $317,146.96 of unrealized receivables. The corporation paid all the payables in peti 1 In Arthur L. Kniffen, 39 T.C. 553 (1962), the cash method taxpayer conceded and the Court found $8,246.58 of income under sec. 357 (c) (1) on the transfer to a corporation of a sole proprietorship, the liabilities of which exceeded the adjusted basis of its assets by that amount. Among the liabilities so transferred and paid by the transferee were $22,466.31 in unpaid business expenses. The taxpayer claimed the full amount thereof as a deduction and it was denied on the authority of Doggett v. Commissioner, 275 F.2d 823 (C.A. 4, 1960), affirming a Memorandum Opinion of this Court, certiorari denied 364 U.S. 824 (1960), and Citizens Nat. Trust & Savings Bank v. Welch, 119 F. 2d 717 (C.A. 9, 1941). The findings of fact do not indicate whether the assumed payables were in fact paid during the same taxable year. The taxpayer did not, in any event, contend that he was entitled to a deduction limited to the extent of his sec. 357 (c) (1) gain, and the Court did not consider the point. The authorities cited in Kniffen by the Court, while clearly barring the deduction of the full $22,466.31, do not involve the present question of whether amounts taken out of sec. 351 by application of sec. 357 (c) should give rise to deductions on payment of the liabilities giving rise to the application of that section. tioner's same taxable year. Accordingly, all $102,367.73 of the section 357 (c) gain would properly be allocated to sale of the receivables in exchange for assumption and payment of the payables, and the partnership should be treated as having paid $102,367.73 of the payables. Since the payables appear to have represented ordinary and necessary business expenses (they were all deducted by the corporation), the partnership was entitled to deduct that amount, which exactly offsets the section 357 (c) ordinary gain on the receivables. There should be no net addition to taxable income on the transaction. It is not necessary for present purposes to consider the effect, if any, of application of the above analysis to the subsequent corporate payment of the payables assumed and receipt of the receivables purchased thereby. FORRESTER and FEATHERSTON, JJ., agree with this dissent. LIBERO P. BALDARELLI AND RITA I. BALDARELLI, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT JACK H. AND ERLENE SHAFFER, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT Docket Nos. 3338-70, 3482-70. Filed October 9, 1973. In 1966, S sold his partnership interest in an H & R Block franchise to B for $45,000 payable in four annual installments. The purchase and sale agreement included a covenant not to compete to which the parties allocated no value. Held: The noncompete covenant will not be assigned a value by this Court absent "strong proof" as to what its value might be. Therefore, S correctly reported the income he received as a long-term capital gain and B is not entitled to amortization deductions. Charles W. Froehlich, Jr., and Edward E. Weissman, for the petitioners in docket No. 3338–70. Gino P. Cecchi, for the petitioners in docket No. 3482–70. DAWSON, Judge:* In these consolidated cases the respondent determined the following Federal income tax deficiencies: *Pursuant to a notice of reassignment sent to counsel for all parties, and to which no objections were filed, these cases were reassigned on Aug. 9, 1973, from Judge Austin Hoyt to Judge Howard A. Dawson, Jr., for disposition. We must decide the proper treatment under sections 167 and 1221, I.R.C. 1954,1 to be given certain payments made pursuant to a sale of a partnership interest. Respondent initially took inconsistent positions in order to protect the revenue by denying to the buyer amortization of an alleged covenant not to compete while simultaneously denying capital gain treatment to the seller. In his brief the respondent has chosen to side with the seller. FINDINGS OF FACT Some of the facts have been stipulated. This stipulation and the exhibits attached thereto are incorporated herein by this reference. Libero P. and Rita I. Baldarelli, husband and wife, were legal residents of Sacramento, Calif., when they filed their petition herein. Their joint Federal income tax returns for the years 1966 and 1967 were prepared on the cash receipts and disbursements method and were filed with the district director of internal revenue at San Francisco, Calif. Jack H. and Erlene Shaffer, husband and wife, were legal residents of Concord, Calif., when they filed their petition herein. Their joint Federal income tax returns for the years 1966 and 1967 were prepared on the cash receipts and disbursements method and were filed with the Internal Revenue Service Center at Ogden, Utah. On July 1, 1961, Baldarelli agreed with H & R Block, Inc., that in consideration for his operating an H & R Block tax return preparation service, H & R Block would grant him a franchise to operate in San Francisco and Oakland, Calif. The franchise was to be operated only under the name of H & R Block, Inc. The franchise agreement specifically detailed the services to be provided by Baldarelli. The hours of operation were set; the source and price of any forms used were determined; and the required accuracy and quality control of the final work product were specified. Baldarelli agreed to charge for his service according to a schedule of fees established by H & R Block, Inc. For the use and recognition of the corporate name H & R Block, Inc., Baldarelli promised to pay a certain percentage of his gross receipts with a discount for prompt payment. Baldarelli retained the right to "sell, assign, transfer or convey in any lawful manner," his rights under the agreement subject to the approval of H & R Block, Inc. Such approval was not to be "unreasonably" withheld. 1 All statutory references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated. Baldarelli agreed that if the franchise agreement was terminated by virtue of a breach on his part he would not, directly or indirectly, compete with H & R Block, Inc., for 5 years. No geographic limitation to this covenant was provided. No specific value was assigned to this portion of the franchise agreement. On December 14, 1962, Baldarelli, without objection from H & R Block, Inc., amended the franchise agreement by making two additional individuals parties to the franchise agreement. The additional parties were George Brenner and Jack Shaffer. Prior to this, on December 12, 1962, Baldarelli, Brenner, and Shaffer entered into a joint venture agreement. They agreed to form a corporation to be called Libero Corp. with ownership to be 60 percent to Baldarelli and 20 percent to Brenner and 20 percent to Shaffer. The joint venture agreed to abide by the terms and conditions of the franchise agreement with H & R Block, Inc. Brenner and Shaffer were to divide equally the first $16,000 in yearly profits. Profits greater than that amount were to be distributed according to percentage of ownership. If yearly profits reached $100,000, Brenner and Shaffer each agreed to relinquish one-half of their interest in the venture. At that point they were each to receive a yearly salary of $20,000. There were provisions dealing with the withdrawal of either Brenner or Shaffer from the joint venture. Neither would have any interest whatsoever in the H & R Block, Inc., franchise; however, their capital contribution of $1,000 would be returned. The agreement of December 12, 1962, was amended to provide alternative procedures following the withdrawal of Brenner or Shaffer from the joint venture and to provide a buy-out price for a portion of any deceased joint venturer's interest. On December 16, 1962, the three joint venturers agreed to assign all their rights under the H & R Block, Inc., franchise to the Libro 2 Corp. It was agreed that any ownership interest in the franchise would exist only to the extent of stock ownership in the corporation. No such corporation was formed prior to July 1966. Partnership returns (Form 1065) were filed for 1963, 1964, 1965, and 1966 (to June 30, 1966). Each of these returns listed Baldarelli, Brenner, and Shaffer as partners. The profits for these years were apportioned in accordance with the ratio established in the joint venture agreement. On June 21, 1966, Baldarelli and Shaffer signed an agreement whereby Shaffer sold and Baldarelli bought Shaffer's partnership interest in the H & R Block, Inc., franchise operation. At that time This agreement used this spelling. All other references in the record are to the Libero Corp. Libero is the first name of Baldarelli, petitioner in docket No. 3338-70. Baldarelli, Shaffer, and Brenner were parties to a total of 11 franchise agreements with H & R Block, Inc., all with respect to operations in California. This sales agreement recognized that Baldarelli owned 60 percent of the partnership and desired to acquire Shaffer's 20percent interest.3 For Shaffer's interest in the partnership Baldarelli agreed to pay $45,000 in annual installments of $11,250. Payment was evidenced by four unsecured promissory notes bearing interest at 5 percent per annum. Had the franchises under which the partnership was operating been lost due to conditions beyond the control of the parties to the sales agreement, the balance due on the promissory notes was to be forgiven. This was the only condition attached to the sales price. No allocation of any sort was made with respect to the sales price. Shaffer's share of the profits for the year of sale was to be computed after adjustments for numerous contingent claims and withdrawals. Paragraph 5 of the Sale and Purchase of Partnership Interest Agreement signed by the parties provided as follows: 5. COVENANT NOT TO COMPETE: Seller expressly agrees that he shall not hereafter engage, directly or indirectly, actively or inactively, in any phase of the tax service business as such is now generally conducted, or may hereafter be conducted, within the States of California and Nevada, for a period of three (3) years from the date of this agreement, and said proscription shall apply whether Seller be engaged as a partner, as sole proprietor, an officer, director or shareholder of a corporation, or as an employee of any such, or similar, business entity, except that Seller shall have the right to be employed, solely in the status of an employee, in the tax service business hereafter provided, however, he is compensated only upon an hourly or weekly basis for his personal services rendered and that he in no way shares in profits from said business, either directly or indirectly, on a profit sharing or other incentive basis related to profits or efficiency of said tax service business. The continuing partners in said joint venture shall have the exclusive right to utilize the firm name of said partnership and Seller does expressly agree that he shall not, directly or indirectly, utilize or appropriate said name or any other name similar to said name, whether such similarity be in spelling, style or connotation. Rough drafts of the final agreement show significant changes in terms and conditions of the sale. Both of the rough drafts contain a covenant not to compete. The only difference between the two is that the first covenant provides that the seller could not engage in the tax preparation business for 3 years within the States of California and Nevada. The second draft makes explicit the seller's permissible work activities. He could work only as an hourly paid employee of such a 3 The amendment of Dec. 12, 1962, provided that when profits reached $100,000 both Brenner and Shaffer were to relinquish 50 percent of their holdings to Baldarelli. Although profits had reached this level no such transfer was made. The June 21, 1966, sales agreement provided that Shaffer was selling his 20-percent interest in the joint venture. |