*86 Decisions will be entered under Rule 50.
Petitioners were members of a partnership which realized $ 90,610.35 from a sale of property to a corporation which they owned completely. Respondent contends that the only asset sold was machinery in the amount of $ 29,331.50, and the balance of the purchase price constituted a distribution of dividends from the corporation which was the purchaser. Held, that the sale by the partnership was a bona fide sale of a going business and the fair market value of the good will was $ 61,278.85, and the profit realized on the sale was capital gain as treated by petitioners on their returns.
*834 These proceedings which have been consolidated involve deficiencies in income tax for the taxable*87 year 1947, as follows: *835
| Petitioner | Docket No. | Deficiency |
| George J. Staab | 38732 | $ 13,384.09 |
| Mary D. Staab | 38733 | 8,774.62 |
The deficiency in Docket No. 38732 is due to two adjustments which the Commissioner has made to the income as reported by petitioner George J. Staab on his return for 1947. These adjustments are explained in the deficiency notice as follows:
(a) It has been determined that you received income from dividends from Sterling Plastics Co. in the amount of $ 30,639.43 during the taxable year 1947.
(b) It has been further determined that upon the sale of your interest in New Jersey Engraving Company during the taxable year 1947 you realized a long-term capital gain to be taken into account in the amount of $ 4,195.50 and not $ 19,702.71 as reported in your income tax return, thus resulting in an adjustment of $ 15,507.21.
The deficiency in Docket No. 38733 is due to two similar adjustments as in Docket No. 38732 which the Commissioner has made to the income as reported by petitioner Mary D. Staab on her return for 1947. These adjustments are explained in the deficiency notice in the same way as in Docket No. 38732.
To the foregoing adjustments*88 each petitioner assigns errors as follows:
(a) error in holding that, or proceeding as if, the petitioner received income from dividends from Sterling Plastics Co., in the amount of $ 30,639.43 during the taxable year 1947:
(b) error in holding that, or proceeding as if, the petitioner upon the sale of his interest in New Jersey Engraving Company during the taxable year 1947 realized a long-term capital gain to be taken into account in the amount of $ 4,195.50 and not $ 19,702.71 as reported in his income tax return, thus resulting in an adjustment of $ 15,507.21.
FINDINGS OF FACT.
Many of the facts have been stipulated and are adopted as a part of these findings and incorporated herein by this reference.
Petitioners are husband and wife residing in Springfield, New Jersey. Their separate returns for the calendar year 1947 were filed with the collector of internal revenue for the fifth district of New Jersey.
The partnership in question, New Jersey Engraving Co., sometimes hereafter referred to as New Jersey, was engaged in the manufacture, engraving, and sale of precision molds, dies, and machine tools. The partnership, organized on December 31, 1945, by petitioners, was a continuation*89 of the business conducted by another partnership also known by the same name. The last-mentioned partnership composed of George J. Staab and Ludwig Stark was organized on March 1, 1941. The Stark-Staab partnership was a continuation of the business conducted by a corporation known as the New Jersey Engraving *836 Co., which was organized under the laws of the State of New Jersey in March 1935. The outstanding capital stock of that corporation was owned 60 per cent by the petitioners and the balance, or 40 per cent, by Ludwig Stark and his family. The corporation was liquidated on or about March 1, 1941, and its business was continued as a partnership in which George J. Staab had a 60 per cent interest and Ludwig Stark, 40 per cent. The partnership agreement between Stark and Staab provided that the surviving partner could buy out the partnership interest of the deceased partner at book value with no consideration to be paid for the good will of the business.
The Sterling Plastics Co., sometimes hereafter referred to as Sterling, was organized in September 1939. Its capital stock was issued 60 per cent to the petitioners and the remaining 40 per cent to Ludwig Stark and *90 his family. Sterling's business is the manufacture and sale of plastic products in which business it uses molds and dies of the high-precision type manufactured and engraved by New Jersey.
Ludwig Stark and George Staab were neighbors, and sometime in the early part of 1945 they had a personal disagreement. As a result Stark sold his stock in Sterling to the petitioners about May or June 1945. At that time George Staab agreed that Ludwig Stark could stay on as a partner in New Jersey. In October, however, the rift appeared again, managing difficulties were experienced, and an additional agreement was entered into. That agreement provided, in addition to certain internal or administrative changes, that the partnership would continue until December 31, 1945. If satisfactory to both parties the partnership could be continued for additional periods of 3 months each. But if either party was dissatisfied the partnership could be terminated and the assets distributed 60 per cent to George J. Staab and 40 per cent to Ludwig Stark, with no provision being made for good will.
On December 31, 1945, the partnership between George J. Staab and Ludwig Stark was dissolved and Ludwig Stark withdrew*91 40 per cent of the tangible assets. The machinery account on New Jersey's books was credited with $ 8,487 representing the assets withdrawn by Stark, and the balance of $ 12,730.49 was carried forward. At the time of the dissolution of the partnership between Stark and George J. Staab, there was no discussion as to any good will attaching to the partnership because the agreement of October 1, 1945, made no provision for good will.
On the same date, December 31, 1945, a partnership agreement was entered into between the petitioners under the terms of which George J. Staab admitted Mary D. Staab as a partner in New Jersey. George J. Staab contributed all of the assets retained by him upon the withdrawal *837 of Ludwig Stark, and Mary D. Staab contributed cash in an amount equivalent to the value of the assets of New Jersey as reflected on its books as of December 31, 1945. Mary Staab's purchase of a 50 per cent interest in the business was financed by her out of her own funds, and the respondent has not questioned the existence and validity of the partnership relation between the petitioners. Mary Staab paid nothing for good will.
At the time Ludwig Stark withdrew from New*92 Jersey there was no loss of business or good will. The sales stood up as well as the year before. The only employee who left New Jersey at that time was Stark's nephew who was only 21 or 22 years old and had spent 2 years in the army and 2 years with New Jersey as a draftsman. He was not a toolmaker. There was no interruption of New Jersey's operations. Stark took 40 per cent of the machinery but the machines he took were concerned with engraving rather than tool and diemaking. Stark was an engraver, not a toolmaker or diemaker. The machines selected by Stark were delivered to him sometime in February 1946, because he no place to keep them and Sterling held them for him in the meantime.
New Jersey's business was not a speculative business. It was definitely stable, there being a steady demand for its products which were quite varied. It made steel dies, steel molds for plastic and metal products, fancy dies, ornamental dies for metal stamping, etc. It had customers in the pharmaceutical, automotive, and household fields. It made molds for a series of combs for the notion line and for novelties in the school supply field, such as pencil sharpeners, penholders, rulers, etc.
*93 New Jersey had about 25 highly skilled men -- tool and diemakers, modelmakers, and engravers -- most of whom were employed by the company for over 15 years. Between 70 and 75 per cent were with the company for over 10 years. They were all still with Sterling at the time of the hearing. It is hard to get skilled moldmakers and diecutters. The mold is the main thing in 80 per cent of any kind of diecasting or molding process. The tolerances are very close and the dies have to be perfect because they are precision made. If the mold or die is not in compliance with specifications the product is inferior and requires finishing operations. The die has to be reworked in order to bring it back into the required shape.
Sterling is engaged in the manufacture and sale of plastic products, in which business it uses molds and dies of the high precision type manufactured and engraved by New Jersey. On January 3, 1947, petitioners sold their respective interests in New Jersey to Sterling for the sum of $ 90,610.35. Petitioners each realized a net profit from this sale in the amount of $ 39,030.43, which figure is not in dispute. Petitioners reported this profit as $ 39,405.42 on their *94 respective income *838 tax returns as a capital gain under the provisions of section 117, Internal Revenue Code, and each took into account $ 19,702.71. Respondent in his notices of deficiency determined that $ 30,639.42 of the above amount was taxable to each of the petitioners as a dividend from Sterling.
In determining the sales price the contracting parties considered two factors: (1) The market value ($ 29,331.50) of the physical assets of New Jersey and (2) its good will and going concern value determined by the contracting parties in the manner hereinafter set forth:
| Net profits of New Jersey Engraving Co. (corporation) for the | |
| period Jan. 1, 1937 to Feb. 28, 1941, before officers' salaries | $ 67,982.71 |
| Net profit of New Jersey Engraving Co. (partnership) for the | |
| period Mar. 1, 1941 to Dec. 31, 1946 | 238,411.54 |
| Total | $ 306,394.25 |
| Average annual net profits for the years 1937 to 1946 | |
| ($ 306,394.25 divided by 10) | $ 30,639.42 |
| Good-will and going concern value of New Jersey Engraving Co. | |
| (equal to two years of average annual net profits) | $ 61,278.85 |
The basis of the physical assets according to the partnership books was $ 12,549.52.
The books and records*95 of New Jersey and its predecessor disclose the following information:
| NEW JERSEY ENGRAVING CO. (CORPORATION) | ||
| Net profits | ||
| Year or period | Sales | before salaries |
| 1937 | $ 40,774.61 | $ 15,399.31 |
| 1938 | 46,889.07 | 14,952.15 |
| 1939 | 63,112.90 | 15,231.11 |
| 1940 | 67,932.50 | 19,212.21 |
| Jan. 1 to Feb. 28, 1941 | 10,175.03 | 3,187.93 |
| $ 228,884.11 | $ 67,982.71 |
| NEW JERSEY ENGRAVING CO. (CORPORATION) | ||
| Net profits | ||
| Year or period | Salaries | after salaries |
| 1937 | $ 14,040.00 | $ 1,359.31 |
| 1938 | 14.040.00 | 912.15 |
| 1939 | 14,040.00 | 1,191.11 |
| 1940 | 16,960.00 | 2,252.21 |
| Jan. 1 to Feb. 28, 1941 | 2,560.00 | 627.93 |
| $ 61,640.00 | $ 6,342.71 |
| NEW JERSEY ENGRAVING CO. (PARTNERSHIP) | ||
| Year or period | Sales | Net profits |
| Mar. 1 to Dec. 31, 1941 | $ 55,872.22 | $ 13,234.37 |
| 1942 | 90,178.52 | 41,116.24 |
| 1943 | 105,853.62 | 46,794.45 |
| 1944 | 93,790.70 | 35,653.21 |
| 1945 | 120,278.11 | 51,853.67 |
| 1946 | 129,182.11 | 49,759.60 |
| $ 595,155.28 | $ 238,411.54 |
The adjusted earned surplus and undivided profits of Sterling was as follows:
| Jan. 1, 1946 | $ 192,339.63 |
| Dec. 31, 1946 | 267,828.61 |
| Dec. 31, 1947 | 320,273.73 |
*839 The net sales, compensation to officers, and net income of Sterling*96 for the calendar years 1946 and 1947 (the amounts for 1947 were after New Jersey was acquired) were as follows:
| Year | Net sales | Salaries | Net income |
| 1946 | $ 1,065,155.40 | $ 29,200.00 | $ 120,290.88 |
| 1947 | 1,067,060.97 | 43,200.00 | 175,033.55 |
The net profit of New Jersey for the year 1946 was $ 49,759.60. The combined net profit of Sterling and New Jersey for the year 1946 was $ 170,050.48, derived as follows:
| Sterling Plastics Co | $ 120,290.88 |
| New Jersey Engraving Co | 49,759.60 |
| Total | $ 170,050.48 |
In September of 1945 Staab was offered the sum of $ 90,000 for the sale of New Jersey.
Sterling never paid a dividend from the date of its incorporation in 1939 through the year 1947.
The sale of the partnership assets by petitioners to the corporation whose stock they owned was made for a business purpose, and the sale was not motivated by the tax consequences of the sale. Included in the sale of physical assets was the sale of partnership good will. The value of the good will sold was not less than that as used by petitioners in the transaction, namely, $ 61,278.85.
The $ 90,610.35 paid to the petitioners by Sterling represented the purchase price of New Jersey and*97 no part of it constituted a taxable dividend to the petitioners.
OPINION.
The issue to be decided here is the tax consequences of a sale of partnership assets. The two petitioners, husband and wife, were the members of the partnership and, at the same time, they were the sole stockholders of the purchasing corporation.
The parties have stipulated that the profit realized by each from the sale was $ 39,030.43. 1
Respondent contends that each petitioner realized a long-term capital gain of $ 8,391 and received dividends of $ 30,639.42. Respondent arrived at these figures in the following manner:
| Price paid to petitioners by the corporation | $ 90,610.35 |
| Less: Appraised value of machinery sold | 29,331.50 |
| Dividend distributed to petitioners | $ 61,278.85 |
| Appraised value of machinery sold | $ 29,331.50 |
| Adjusted basis of machinery sold | 12,549.50 |
| Long-term capital gain realized by petitioners | $ 16,782.00 |
*98 Respondent contends that the only assets sold consisted of machinery, that the sums paid in excess of the appraised value of the machinery were dividends distributed by the corporations, that the sale was a subterfuge used by the petitioners to syphon off the corporate earnings of Sterling as capital gains, and that in reality the payments were dividends and should be taxed as such.
On the other hand, petitioners contend that a going business was sold, including good will of $ 61,278.85, and that the value of that business was $ 90,610.35, the sum paid for the business.
Our decision here is essentially a question of fact. We think the facts clearly support petitioners. The facts have been fully stated in our Findings of Fact and need not be repeated here. Briefly these facts show that the petitioners as partners in New Jersey sold more than just business machinery, the partnership assets consisted of a going business. Whether the partnership business had any value greater than the value of its machinery depends upon the earning power of the partnership. If the partnership had any excess earning power that is the basis for computing its good will. See A. R. M. 34, 2 C. B. 31.
*99 It is to be noted that we do not have here a situation where the stockholder of a close corporation is transferring to the corporation assets unrelated to and not used in the corporate business. Our prime concern here is arriving at a value of partnership good will, if any. Good will may be defined by the following formula: Good will equals a-b, where "a" is capitalized earning power and "b" is the value of assets used in the business. Good will, then, is an intangible consisting of the excess earning power of a business. A normal earning power is expected of the business assets, and if the business has greater earnings, then the business may be said to have good will. This excess in earning power may be due to any one or more of several reasons, and usually this extra value exists only because the business is a going concern, being successful and profitable. Good will may arise from: (1) the mere assembly of the various elements of a business, workers, customers, etc., (2) good reputation, customers' buying habits, (3) list of customers and their needs, (4) brand name, (5) secret processes, and (6) other intangibles affecting earnings.
Sterling paid petitioners $ 90,610.35 *100 for the partnership assets, including good will, and it is stipulated that the value of the machinery was $ 29,331.50. Thus the price paid by Sterling in excess of the value of the physical assets was $ 61,278.85. There was no cost basis to petitioners of this good will and they have returned it all as capital gain. *841 The petitioners also returned as capital gain the excess amount which they received for the machinery, namely, $ 29,331.50 over its cost basis, which is not in dispute.
It seems to us that petitioners have correctly reported the transaction as a sale by them of partnership assets, including good will to Sterling, and there are no facts to support the Commissioner's determination that $ 30,639.42 of the amount received from Sterling represented a dividend to each petitioner from Sterling.
On the facts which have been stipulated, coupled with other facts which petitioners proved at the hearing, we think petitioners must be sustained and the Commissioner's determination must be reversed. Both of petitioners' assignments of error are sustained. The parties have stipulated that each petitioner's gain was $ 39,030.43, slightly less than that reported on their respective*101 returns.
Decisions will be entered under Rule 50.
Footnotes
1. Computation.
↩
Sale price $ 90,610.35 Unrecovered cost basis 12,549.52 [3 cents off] Total profit of petitioners $ 78,060.86 Profit of each petitioner (1/2) $ 39,030.43