1968 U.S. Tax Ct. LEXIS 198">*198 Decision will be entered for the respondent.
Taxpayer sold the assets of his business for $ 50,000. The agreement of sale allocated the purchase price between three groups of assets, the amount allocated to inventory being taxpayer's cost therein. The purchase price was payable $ 15,000 down and $ 1,000 per month with no notes being given to evidence the deferred payments and nothing being said about how the payments should be applied between the different groups of assets. Held: The payments received by taxpayer must be allocated ratably among the three groups of assets sold according to the respective values thereof as set out in the agreement of sale. Taxpayer may not apply the payments received first to inventory until he recovers his full cost therein thus having no gain recognized until the full cost of inventory is received.
49 T.C. 324">*324 Respondent determined deficiencies in petitioners' income tax for the year 1961 in the amount of $ 3,389.39 and for the year 1962 in the amount of $ 428.25.
The issue is whether payments made by a purchaser to petitioner, pursuant to a written contract of sale whereby petitioner sold three 49 T.C. 324">*325 categories of business assets, should be ratably allocated by petitioner to the three categories according to the prices for each set forth in the contract.
FINDINGS OF FACT
Some of the facts have been stipulated and they are found accordingly.
Petitioners James A. Johnson (hereinafter referred to as petitioner) and his wife, Pearl J. Johnson, live in Minneapolis, Minn.; they filed their joint income tax returns for 1961 and 1962 with the district director of internal revenue, St. Paul, Minn.; and they were residents of Minneapolis, Minn., when the petition herein was filed.
In 1961 petitioner1968 U.S. Tax Ct. LEXIS 198">*201 was the sole proprietor of an acoustical construction business called the Sound Engineering Co., located in Davenport, Iowa. Petitioner reported his income from Sound Engineering Co. on an accounting method which considered inventories and depreciation but which otherwise was on a cash receipts and disbursement basis. On June 16, 1961, petitioner entered into a written contract for the sale of the assets of his business, which contract provided in part as follows:
AGREEMENT OF SALE
This Agreement made this 16 day of June, 1961, between James A. Johnson, a sole proprietor doing business as Sound Engineering Co., (herein called "Seller") and Sound Engineering, Inc., an Iowa Corporation, (herein called "Buyer").
Whereas, Seller has been engaged in the acoustical construction business in the area in and around Davenport, Iowa and desires to sell certain assets of said business to Buyer, and
Whereas, Buyer desires to purchase said assets upon the terms and conditions hereinafter provided:
Now, Therefore, it is Agreed as Follows:
Section 1. Seller hereby sells to Buyer and Buyer hereby purchases from Seller the following assets for the following prices:
(a) All inventory now on hand 1968 U.S. Tax Ct. LEXIS 198">*202 and used by Seller in the conduct of said business for a total price of $ 22,943.00.
(b) The equipment now used by Seller in the conduct of said business, as more particularly described in Exhibit "A" attached hereto, for the total purchase price of $ 8,500.00;
(c) Those contracts for acoustical construction work between Seller and certain customers of Seller which are listed on Exhibit "B", attached hereto, for a total purchase price of $ 18,557.00; the price for each such contract to be the amount set opposite the description thereof on said Exhibit "B".
Section 2. The purchase prices above provided aggregating [$] 50,000 shall be payable as follows:
(a) $ 15,000.00 at time the Agreement is executed, receipt of which is acknowledged.
(b) $ 1,000.00 per month, commencing January 2, 1962, and a like amount on the first of each month thereafter until balance of purchase price is paid.
(c) There shall be no interest payable as to unpaid principal balance until such time as an installment becomes due, and if any installment be not paid when due, then until paid such unpaid installment shall draw interest at the statutory rate.
49 T.C. 324">*326 (d) Purchaser shall have the right 1968 U.S. Tax Ct. LEXIS 198">*203 to any amounts payable as to the Contracts listed in Exhibit B. However, Seller retains the right to all other accounts receivable appearing on the books of the Seller as of the date of this Agreement.
Exhibit A, referred to in section 1(b) above, is a list of pieces of equipment petitioner used in the conduct of his business consisting of a GMC truck, dies, saws, drills, and other tools, and also office furniture and equipment such as an adding machine, checkwriter, typewriter, desks, chairs, files, and miscellaneous office supplies.
Exhibit B, referred to in section 1(c) above, is a list of some 14 contracts, identified by amounts payable and job names such as Muscatine Bank, Le Claire, Walcott, etc., with the amount the buyer was paying for each contract set opposite the described job. These amounts totaled the $ 18,557 purchase price set forth in section 1(c). The list of amounts payable for the acoustical construction work to be performed pursuant to these contracts total $ 64,699.
The allocation of the $ 50,000 among the three groups of assets is not in dispute.
In section 3 of the contract seller warrants he has good title to the assets sold. In section 4 it is stated that1968 U.S. Tax Ct. LEXIS 198">*204 the buyer does not assume liabilities or obligations of seller other than the job contracts described above which buyer agrees to perform. In section 5 seller agrees not to engage in the acoustical business for a period of 5 years in a described area in Iowa and Illinois, if buyer is not in default in any payments. In section 6 seller warrants the job contracts are valid binding contracts and that they provide for a total of not less than $ 64,699 and are assignable to buyer. In sections 7, 8, 9, and 10, provision is made for the seller to deliver required instruments of conveyance or assignment; for the buyer to use the name "Sound Engineering, Inc.," if the buyer was not in default; for buyer to have possession of the assets sold upon execution of the agreement of sale and making the downpayment provided in section 2; and for the seller to remain in Davenport for 4 weeks to assist with personnel training and advice.
Section 11 provides as follows:
Section 11. It is expressly agreed that in the event Purchasers shall default in making any payment called for under this Contract and such default shall not be corrected within ninety (90) days from the occurrence thereof, or in the1968 U.S. Tax Ct. LEXIS 198">*205 event the Purchasing Corporation shall be dissolved or liquidated, then the entire unpaid principal balance shall become due and payable.
Section 12, the last paragraph of the agreement, merely provides the agreement shall be binding on legal representatives and assigns.
It is stipulated that the foregoing agreement of sale was "the sole and entire contract between the parties." The contract was fully performed in that the buyer received the assets and petitioner, the seller, received payments totaling $ 15,000 in 1961; $ 12,000 in 1962; $ 12,000 in 49 T.C. 324">*327 1963; and $ 11,000 in 1964. There were no promissory notes, or mortgages, or other evidences of indebtedness taken by the petitioner as security for this sale.
In petitioners' income tax return for 1961 there was a schedule entitled "Gain on Sale of Inventory, Equipment, and Executory Contracts." In this schedule it was reported that the inventory was sold for cost ($ 22,943); that the sale of the equipment, furniture, and truck for $ 8,500 resulted in 75 percent or $ 6,374.41 gain; and that the sale of the executory contracts for $ 18,557 resulted in 100-percent gain. The closing paragraph of this schedule is as follows:
Taxpayer1968 U.S. Tax Ct. LEXIS 198">*206 hereby elects, under section 453 of the Internal Revenue Code, to use the installment method of recording the gain on sale of the above equipment, furniture, 1958 GMC truck and executory contracts.
On their Federal income tax returns for the taxable years 1961 and 1962, petitioners allocated the first $ 22,943 1 received to the sale of the inventory. Petitioners allocated the remaining $ 4,057 reported on the returns to the sale of the equipment and executory contracts. The allocation of the $ 4,057 between equipment and executory contracts was made in a prorata manner, based on their respective sales prices.
1968 U.S. Tax Ct. LEXIS 198">*207 The Commissioner determined that the entire $ 27,000 received during the taxable years 1961 and 1962 must be allocated among all of the three asset groups in a prorata manner, based on their respective sales prices. 2
Respondent's adjustments based on the allocation of proceeds received under the agreement of sale and other adjustments not contested result in the deficiencies determined.
OPINION
The question is whether, as respondent contends, both the downpayment of $ 15,000 in 1961 and the $ 12,000 payment in 1962 must be ratably allocated to all three groups of assets sold in the year such payments were received or whether, as petitioner contends, these payments must first be applied entirely to a single group of assets, inventory, until the sales price (and cost basis) of1968 U.S. Tax Ct. LEXIS 198">*208 such group ($ 22,943) is completely paid.
49 T.C. 324">*328 Since the inventory was sold at cost ($ 22,943), it is obvious that under petitioner's interpretation no gain from the sale of the business assets would be reported until the entire inventory cost was recovered. There is no factual justification in this record for allocating any of the payments received to any particular one of the three groups of assets sold. While the contract of sale carefully allocated the $ 50,000 purchase price for the business among the three groups of assets, there is nothing to indicate that the downpayment or indeed any of the payments was to be first applied to inventory. Section 2 of the agreement, which outlines the schedule of payments, contains no such intimation. Nor did petitioner's testimony at the trial establish any such understanding between the parties as to priority of payment. In fact, petitioner was asked on direct examination whether he had any particular understanding with the buyer "as to which assets were to be paid for in what order" and his answer was "Not that I recall." So if the issue turns on whether the payments as received should be allocated ratably among all three groups1968 U.S. Tax Ct. LEXIS 198">*209 of assets, or may be allocated first to one group of assets and then to the others, we would decide the issue for respondent.
But, while it is not too clear from the briefs, we believe petitioner argues primarily that where assets are sold for a cash downpayment with the balance payable in installments but with no notes or security being given by the buyer for the unpaid installments, the seller is entitled, for tax purposes, to apply all payments against his total cost in the assets sold before any gain must be reported. Petitioner's allocation of the first $ 22,943 received against the cost of the inventory sold is consistent with this argument but, of course, his treatment of the $ 4,057 received in 1962 (only a part of which was allocated to the cost of the equipment and the balance of which was reported as gain) is not consistent with the above argument. We assume this may be because petitioner felt he was bound by the installment rules of accounting for gain with respect to the equipment and contracts. Petitioner cites such cases as Burnet v. Logan, 283 U.S. 404">283 U.S. 404, and Nina J. Ennis, 17 T.C. 465">17 T.C. 465, in support of1968 U.S. Tax Ct. LEXIS 198">*210 his argument. However, we think petitioner misapplies the rules espoused in those cases to the transaction here involved and that those cases do not support his position here.
283 U.S. 404">Burnet v. Logan, supra, and its progeny establish the rule that when a cash basis taxpayer sells property for a cash downpayment and further payments which are indeterminate in amount, he may apply the payments received first to recover his cost or basis before reporting any taxable profit. Because of the uncertainty as to the total amount to be received, the transaction is not considered closed. This rule does not mean, as petitioner seems to contend it does, that in any transaction where several different types of property are sold for fixed amounts 49 T.C. 324">*329 with a part of the purchase price being paid in cash and the balance in deferred installments, the taxpayer may allocate the payments received among the various groups of assets sold in such a manner as to first recover his cost or basis in all the assets sold simply because the deferred payments are not evidenced by a note and no security is given.
17 T.C. 465">Nina J. Ennis, supra, also relied 1968 U.S. Tax Ct. LEXIS 198">*211 upon by petitioner, stands for the proposition that a mere contractual obligation of the buyer to pay the balance of the purchase price in years subsequent to the year of sale, not secured or evidenced by a note, is not the equivalent of cash, so a cash basis taxpayer does not have to include in his income in the year of sale his profit computed on the entire amount of the purchase price. In this case respondent is not seeking to tax petitioner on his entire profit on the sale before the entire purchase price is paid. He is simply allocating the amounts of cash actually received by the taxpayer in the 2 years before us ratably among the three different groups of assets sold, instead of allocating the first payment received all to the inventory group. It is clear that the rationale of the Ennis case does not support petitioner's position either.
The contract herein specified the selling price of each group of assets. Finding no rule of law which would permit petitioner, under these circumstances, to recover his entire basis in all three groups of assets sold before reporting his gain on the sale of the equipment and the executory contracts on the installment method, as he elected1968 U.S. Tax Ct. LEXIS 198">*212 to do, and finding no agreement, understanding, or other justification for permitting petitioner to allocate the payments received first to inventory until his cost therein was fully recovered, we must conclude that the payments as received by petitioner must be allocated ratably among the three groups of assets sold on the basis of the percentage of the total sales price represented by the amount of the sales price allocated to each group of assets in the sales contract. See C. D. Johnson Lumber Corporation, 12 T.C. 348">12 T.C. 348, 12 T.C. 348">363; 2 Mertens, Installment Sales, sec. 15.18; Rev. Rul. 57-434, 1957-2 C.B. 300; Rev. Rul. 55-79, 1955-1 C.B. 370. This is the procedure followed by respondent in determining the deficiencies. Consequently,
Decision will be entered for the respondent.
Footnotes
1. Petitioners included the $ 15,000 received in 1961 and $ 7,943 of the $ 12,000 installment payments received in 1962 in their income reported on their 1961 return, with the remaining $ 4,057 of the $ 12,000 installment payments being reported on their 1962 return, allocated $ 1,275 to equipment and $ 2,782 to contracts. The $ 22,943 reported on the 1961 return simply offset the cost of the inventory, resulting in no gain. Seventy-five percent of the $ 1,275 reported on the 1962 return was reported as long-term capital gain and 100 percent of the $ 2,782 was reported as short-term capital gain.↩
2. The $ 15,000 received in 1961 was allocated $ 6,882.90 to inventory, $ 2,550 to equipment, and $ 5,567.10 to contracts. The $ 12,000 received in 1962 was allocated $ 5,506.32 to inventory, $ 2,040 to equipment, and $ 4,453.68 to contracts.↩