*114 Decision will be entered under Rule 50.
A payment in settlement of a suit for the rescission of a sale of stock, on the ground that it was induced by fraud, represents payment for the stock, resulting only in capital gain and not ordinary income. The position maintained by the defendants and here relied upon by the respondent that the payment was not related to the grounds of the suit but represented "severance pay" was unfounded in fact.
*1137 The respondent determined a deficiency of $ 866.11 in the income tax liability of the petitioner for the taxable year 1949. The petitioner claims an overpayment of $ 974.97. The sole issue presented by the pleadings is whether the sum of $ 8,000 received by the petitioner or paid for his account in settlement of certain litigation constitutes ordinary income, as the respondent has determined, or proceeds from the sale of capital assets, as reported by the petitioner.
In addition to a stipulation of facts, with exhibits annexed, evidence was introduced by testimony and exhibits.
FINDINGS OF FACT.
The facts stipulated*115 by the parties are found accordingly and by this reference are incorporated herein, together with the appended exhibits.
The petitioner resides in Forest Hills, New York, and filed his income tax return for the taxable year 1949 with the collector of internal revenue for the first district of New York.
The petitioner came to this country from Germany in March 1937. Prior to 1939 he operated a business as an individual proprietor under the name of Gobro Textile Manufacturing Company.
On May 17, 1939, General Gummed Products, Inc., hereinafter referred to as Products, was organized under the laws of the State of New York by the petitioner and his brothers-in-law, Otto Nathan Weil and Julius Weil, for the purpose of engaging in the business of manufacturing gummed tape for use on corrugated boxes. The petitioner transferred to the corporation certain new machinery and equipment costing $ 6,859.11 and received in exchange therefor 30 shares of the capital stock of Products. The remaining 30 shares *1138 of capital stock then issued by Products were issued to Otto Weil and Julius Weil, each of whom received 15 shares, for which the consideration is not disclosed.
During 1939, at*116 the request of his brothers-in-law, the petitioner executed various legal documents, the import of which he did not understand, as he was not then familiar with the English language. One of those documents conferred upon Otto Weil and Julius Weil certain rights to acquire the petitioner's stock in Products upon stated contingencies and to require the sale of certain machinery belonging to him and leased to the corporation if he should fail to loan $ 2,370 to the corporation when demanded by them. The assets of Products were also encumbered by a mortgage of which the petitioner was not informed.
The petitioner, who was in charge of production, spent the fall of 1939 in redesigning and changing the machinery of Products to increase its productivity. The petitioner was aided in these efforts by his son, Fred Goldsmith. In December 1939 the changes in the machinery were completed.
The petitioner was then informed by his brothers-in-law that Products was insolvent. To support this position the brothers-in-law exhibited to the petitioner certain financial statements purporting to show a deficit of about $ 6,000. The petitioner challenged the amounts given in these financial statements*117 and prepared a new statement showing a deficit of about $ 2,777.
The petitioner was also informed by his brothers-in-law at that time that one Daniel Rothschild was willing to give financial assistance to Products if the petitioner would withdraw as a stockholder, and that if the petitioner should refuse to do so the activities of the corporation would be terminated by foreclosure or bankruptcy proceedings.
In February 1940 the petitioner sold his 30 shares of Products stock to Otto Nathan Weil and received in that year the sum of $ 3,000 in payment therefor. The petitioner believed that his stock was acquired by Daniel Rothschild.
The petitioner did not file an income tax return for the taxable year 1940 and has received no tax benefit as the result of the transaction in that year.
Thereafter, the petitioner remained in the employment of Products until April 1947. His salary ranged from $ 25 to $ 80 per week during this period. His compensation in 1946 and 1947 amounted to $ 4,040.95 and $ 1,395.60, respectively.
In April 1947, as the result of conversations with Daniel Rothschild, the petitioner concluded that the representations of his brothers-in-law which led to the sale of*118 the petitioner's stock were false. *1139 On October 10, 1947, he commenced an action in the Supreme Court of the State of New York, County of Queens, naming as defendants Otto Nathan Weil, Julius Weil, Daniel Rothschild, and Products.
Alleging the facts relied upon, the complaint charged as a first and second cause of action, and demanded judgment, as follows:
20. That by reason of the fraudulent concealment and the false and fraudulent representations hereinbefore referred to, plaintiff has been defrauded of his stock and his interest in the defendant corporation and has been greatly damaged.
* * * *
23. That by reason of the fraudulent concealment and the false and fraudulent representations hereinbefore referred to, plaintiff has been defrauded of his stock and his interest in the defendant corporation and has been damaged in the sum of One Hundred Thousand ($ 100,000.) Dollars.
WHEREFORE, Plaintiff demands judgment, as follows:
AS TO THE FIRST CAUSE OF ACTION
1. That the sale of his stock, representing a fifty (50%) per cent interest in the corporate defendant be rescinded and set aside.
2. That the defendants be required to transfer to the plaintiff his shares of stock *119 in the corporate defendant, upon the plaintiff's paying to the defendants the consideration received therefor.
3. That the defendants be required to account to the plaintiff for all profits and dividends which have accrued to his shares.
AS TO THE SECOND CAUSE OF ACTION
4. That plaintiff have judgment against the defendants in the sum of One Hundred Thousand ($ 100,000.) Dollars, with interest thereon from the 13th day of March, 1947.
5. That the plaintiff have such other and further relief in the premises as may be just and proper, together with the costs and disbursements of this action.
After the action was filed but before the trial, in a conference between the petitioner's son, Otto Weil, an accountant representing the petitioner, and the attorneys for the parties, a settlement was agreed upon which provided that the petitioner should receive $ 7,000 to be denominated as severance pay. The petitioner refused to accept this settlement.
The case proceeded to trial on June 6, 1949. At the end of the first day, the trial judge invited the parties and their counsel to his chambers. Under his urging the case was then settled with an agreement that the defendants would pay to the *120 petitioner the sum of $ 8,000.
In the conference with the trial judge it was stated that the defendant corporation had previously made the offer of severance pay which the petitioner had refused, as above stated. The nature of the consideration and the character of the payment to be made in the settlement then agreed upon was not discussed.
*1140 On June 14, 1949, the petitioner's attorney presented himself at the office of the attorneys for the defendants to conclude the settlement. He was then offered two checks of Products, one drawn to the order of the attorney for the petitioner in the amount of $ 7,000.10 and the other drawn to the order of the Bank of Manhattan Company, withholding agent for Products, in the amount of $ 999.90. These checks were refused, on the ground that they were not in accordance with the agreement of settlement.
There followed correspondence between the attorneys and the trial judge concerning the conflicting positions of the parties, which were stated at length by the attorneys in the letters from which the following portions are abstracted.
Letter of June 14, 1949, from plaintiff's attorney to trial judge:
A general discussion then ensued [in *121 the conference in the judge's chambers], and the previous negotiations were then brought to the Court's attention wherein the Court was advised that the defendants had previously offered $ 7,000.00 in settlement of the action. Your Honor then asked plaintiff to submit a reasonable figure so that the Court might attempt to negotiate the settlement with the parties. The plaintiff then reduced his demand for damages to the sum of $ 10,000.00 in cash and in one payment. The Court then asked the defendants to pay $ 8,000 in one payment, and the same was readily accepted by the defendants provided plaintiff would furnish them a letter satisfactory in form to both sides whereby plaintiff would withdraw his previous charges of fraud. All papers have been agreed upon by counsel for both sides, and the same are now ready for delivery.
* * * *
The entire discussion in chambers pertained to the amount of the settlement, and the plaintiff was not interested in the legal fiction used by the defendants through which the money was to be paid. If the defendants by virtue of the payment could secure a tax reduction, it was not plaintiff's concern, but surely it should not be used to prejudice the*122 plaintiff. It was never contemplated that the settlement figure be reduced by approximately $ 1,000.00 especially since the Court was advised, and the Court took cognizance of the additional expenses of the plaintiff in retaining new counsel. The figure of $ 8,000.00 is in settlement of an action for damages and/or recission [sic], and the mere fact that the defendants desire to term the payment as separation pay is not a factor to be used to the plaintiff's prejudice.
I would appreciate your advice as to the disposition of this controversy.
Letter of June 15, 1949, from defendants' attorney to trial judge:
I am greatly surprised at the position which I understand you are taking and I can only say that it must be because I did not make my position as clear as I might have.
You will remember that I explained to you what had been agreed upon in my office at the time we all thought that the matter had been cleared up for $ 7,000. The whole basis of adjustment was (1) that the individual defendants would not make any payment as that might involve an admission of the plaintiff's charges, (2) that the corporation would give the plaintiff $ 7,000 severance pay, (3) that each defendant*123 was to be given a general release by the plaintiff and (4) the plaintiff was to give each defendant a letter of exoneration.
* * * *
*1141 You asked me whether we were still willing to settle the matter on the same basis and I told you we were. From that point on the only thing that was discussed was whether we would pay more than $ 7,000. Nothing further was mentioned about the mechanics of any settlement which might be arrived at as the only question was, as you so aptly put it, a matter of dollars.
The trial judge stated his view of the controversy in a letter of June 24, 1949, addressed to the attorneys for the defendants, as follows:
My understanding of the settlement arrived at in the above-entitled action is that the plaintiff was to receive from the defendants the sum of $ 8,000. I recall that during the negotiations leading to the settlement, mention was made of an offer to the plaintiff of severance pay.
Severance pay was not contemplated by me at the time the figure of $ 8,000 was arrived at. It makes no difference to me how this sum is designated on your books. However, there should be no deductions made therefrom and the amount of $ 8,000 should be paid to the*124 plaintiff, all other things spoken about being satisfactory.
This did not change the attitude of the defendants' attorney, who wrote to the trial judge on June 28, 1949:
My letters to you and Mr. Kauder have set forth the terms of settlement as they were understood by the defendants as well as by myself. Inherent in this settlement was the fact that payment to the plaintiff would be made by General Gummed Products, Inc. on account of services rendered by him to that corporation. Through your efforts the amount to be paid on that basis was raised from $ 7,000.00 to $ 8,000.00. That is the amount which my client is still ready to pay after withholding and paying to the United States Treasury the amount required in the same manner as the $ 7,000.00 settlement would have been paid had plaintiff consummated the agreement made by his authorized representatives.
Might I respectfully point out that the manner in which the $ 8,000.00 is designated on the books of the corporation is of great significance to our client. Nothing was ever agreed to be paid in settlement of a fraud action. This was basic in the negotiations leading up to the original $ 7,000.00 settlement. Exactly the same*125 conditions existed when we were asked to increase our offer from $ 7,000.00 to $ 8,000.00. We never agreed to pay $ 8,000.00 plus plaintiff's income tax for 1949.
The trial sessions of the court recessed for the summer during the last week of June 1949. The trial judge had been ill during part of that month. The case could not have been tried again until the fall of 1949. In the light of these circumstances and the fact that the petitioner had divulged all of his evidence, the petitioner's attorney was of the opinion that the petitioner would be prejudiced by a retrial. He therefore advised the petitioner to accept payment in the manner in which it was offered. He also advised that a claim should be filed with the Government for refund of the $ 999.90 which had been withheld as income tax. Accordingly on July 7, 1949, the check for $ 7,000.10 was accepted. The refund claim was later filed.
On July 7, 1949, the petitioner's attorney delivered to the attorney for the defendants a general release, a stipulation discontinuing the *1142 court action, and the letter set out below. Each of these papers was dated June 8, 1949.
The letter mentioned above was signed by the petitioner*126 and stated:
In connection with the action instituted by me in the Supreme Court, Queens County, against Julius Weil, Otto N. Weil, Daniel Rothschild and General Gummed Products, Inc., in which I claimed damages, recission [sic] of sale of my stock in General Gummed Products, Inc., and an accounting of profits, all based upon claims made by me that I was defrauded at the time I sold my said stock in said corporation, I have caused an investigation to be made and as a result thereof I hereby withdraw all charges previously made.
In his income tax return for the taxable year 1949 the petitioner reported as capital gain the gross amount of the settlement, or $ 8,000, with no deduction for cost, and reported the sum of $ 999.90 as tax withheld. The petitioner also reported $ 1,582.97 as wages earned by him in that year from other sources and $ 148.10 withheld as tax therefrom. In addition, the petitioner reported $ 34.08 as interest received, and $ 3,406.45 as total deductions. The return showed a tax liability of $ 267.36, payments of $ 1,148 "by tax withheld" and an overpayment of $ 880.64, and claimed a refund of that amount.
The respondent's determination of deficiency does *127 not allow or otherwise recognize any credit with respect to any payments of withheld taxes or other tax payments by or for the account of the petitioner in excess of the amount of $ 267.36, the tax liability disclosed by the return. The deficiency of $ 866.11 determined represents the excess of the corrected liability, determined as $ 1,133.47, over the "income tax liability disclosed by return," $ 267.36.
The series of transactions culminating on July 7, 1949, constituted a sale of the stock of Products or of rights therein and resulted in a capital gain of $ 4,140.89 in the year 1949, to be measured by the difference between the petitioner's adjusted basis for the shares on that date, or $ 3,859.11, and the amount of $ 8,000 received in the settlement.
There is an overpayment of the income tax of the petitioner for the year 1949.
OPINION.
This case involves no controversy as to the rules of law to be applied but presents merely an issue of fact as to the character of the payment of $ 8,000 and the nature of the consideration for which it was made.
The respondent does not challenge the proposition that if the payment in question was actually made in consideration of the dismissal*128 of petitioner's suit the income tax consequences would be determined by the nature of the grounds of the action which was thereby settled. ; , affirming , certiorari denied .
*1143 Since the basis of the petitioner's action was his claim that the sale of his stock in 1940 had been induced by fraud and should therefore be rescinded, it is clear that any payment actually made in settlement of that suit would result in capital gain. With respect to a situation essentially analogous, the law was analyzed and applied in the case of . There the taxpayer instituted a suit praying for the rescission of a conveyance of stock in reliance upon representations which she considered to be fraudulent. The suit was settled for cash. The Court held that the transaction resulted, for tax purposes, in a sale or exchange of the taxpayer's stock occurring in the year of the settlement and that the*129 proceeds received were taxable as capital gains. That case would be decisive here if there was no dispute as to the facts.
The respondent, however, relies upon the conclusion of fact, which he requests us to find, that the payment "was both given and received as severance pay" and that "the petitioner has failed to prove that the payment was actually related to the basis for the litigation."
The issue arises only because the parties to the settlement transaction have consistently taken conflicting positions concerning the nature of the payment and of the consideration for which it was actually made. The petitioner contends that at the time of the transaction, as at present, he has consistently maintained that he had no claim except that he had been defrauded and that the money received by him was solely in consideration for his relinquishment of this claim. The respondent, relying upon the testimony of one of the defendants and one of their lawyers, the letters written at the time of the transaction, and other documentary evidence, contends that this was not in fact the nature of the payment made by the defendants in the suit, but that at all times they made it clear that their*130 payment was based upon entirely different considerations.
At many times before and after the disposition of the action, the defendants consistently took the position that they recognized no merit in the claim of fraud, refused to make any payment whatever to dispose of it, demanded and obtained a complete exoneration and withdrawal of the charges, and made the payment in question only for personal considerations urged by the petitioner's representatives, such as his age and failing health, his long association with the business, the family relationship, and the financial ability of the defendants to dispose of the matter without undue burden.
Under this view, the dismissal of the court proceeding was merely a required condition and not a consideration for the payment.
This position is sustained by the fact that the entire settlement payment was made by the corporation, which probably could have incurred no more than a nominal liability under a judgment in the suit, *1144 compelling it to transfer the shares and perhaps to account for dividends, if any. No payment whatever was made by the individual defendants who were guilty of the fraud, if any, and who presumably would have*131 borne substantially the entire burden of a judgment in favor of the plaintiff.
On the other hand, the alleged position of the defendants, upon which the respondent must prevail or fail in these proceedings, is opposed and contradicted by the evidence in so many respects that we are compelled to conclude that the inducements for their action were in fact quite different from those which they have represented.
First, the evidence makes it clear that the suggestion for designating the settlement payment as "severance pay" did not originate with the individual defendants, but came from their lawyer and accountant. This strongly suggests that the defendants were advised of the tax advantages of obtaining an income tax deduction for the corporation, as compared with a capital loss to the individuals. Their ostensible position therefore may have been merely a screen for undisclosed motives.
Second, it is obvious that the designation as "severance pay" was entirely unrealistic, if not insincere. The evidence strongly suggests that all parties felt that the petitioner had been adequately or even excessively compensated for his services, and there is not the slightest support for the conclusion*132 that the corporation was legally or morally or otherwise obligated for any additional payments to him. The payment amounted to more than twice the annual salary paid during most of the period of employment, and there is no evidence whatever that it represented compensation of reasonable amount.
The petitioner's employment had terminated more than 2 years before the settlement was made, and about a year before there was any discussion of severance pay. Such discussions originated with reference to his claims of fraud and his suit for rescission. With his rejection of the first offer of settlement, the petitioner emphatically informed the defendants that he was making no claim for severance pay or any other compensation for services.
Under such circumstances any action to force upon him the acceptance of such compensation would represent an unlawful diversion of corporate funds for the personal benefit of the controlling stockholders and officers, made only to obtain a discharge of their personal liabilities by a corporate payment based upon no corporate liability and made without any consideration to the corporation.
The essential character of the payment is not to be determined*133 by a mere description or designation, not even by one in which one party has forced the other to acquiesce; on the contrary, the actualities of the situation must govern our decision as to the true nature of the amount received.
*1145 In the case of , with respect to a transaction in some respects similar to the one here involved, we said:
Motycke disposed of or sold his stock in petitioner and J. W. Nunamaker, Jr., acquired it. The fact that J. W. Nunamaker, Jr., and Motycke agreed in the course of settlement of their disputes and lawsuits that $ 35,000 of the consideration flowing to Motycke for the stock should be paid for Nunamaker by petitioner, does not make it otherwise. Neither is its character or substance changed by the wording or formalities of the documents used in the settlement. The payment by petitioner to Motycke was not an ordinary and necessary expense incurred by it in the operation of its business. * * *
It is our conclusion that in fact the defendants' designation of this payment as "severance pay" was entirely unfounded and apparently was not made in good faith. *134 It therefore can not be accepted as a true description of the nature of the consideration paid by the defendants, even from their own point of view and disregarding the understanding of the recipient. This alone might justify this Court in accepting for the purposes of this opinion the characterization of the payment which accords with the understanding of this petitioner at the time he received the money. It is not necessary, however, to rely only upon this choice, since the evidence furnishes additional support for the conclusion that even from the point of view of the defendants in the action the payment was in fact made in settlement and discharge of the claim presented in the suit.
There is adequate evidence to sustain the finding that the disposition of the suit was the dominant inducement for which the defendants made the payment. Not only was the settlement made in the course of the trial and under the urgent intervention of the trial judge, but Otto Weil, apparently the leader of the defendants, testified: "My lawyers and accountants said, 'You had better give them this to have this off. You spend more than the lawyer's fee'."
Interpreting the inadequate English of the*135 witness, it seems clear that a motivating consideration in the settlement was to avoid the expenditures which otherwise would be necessary to continue with the defense of the suit.
The respondent raises for the first time in his brief the further point that, since the court action sought the recovery of profits, dividends, and interest, even if the payment was made in settlement of the action some portion of it must be allocated to these items and would therefore constitute ordinary income. In the absence of any evidence of the receipt of any income of this character or of the amount thereof, we do not believe that it is necessary to consider this contention.
The 1949 income tax of the petitioner has been overpaid in an amount which will be determined under Rule 50.
Decision will be entered under Rule 50.