*242 Decisions will be entered for the respondent.
Held, amount received by petitioners in settlement of threatened litigation for recovery of anticipated loss of profits and increased rental expense is taxable as ordinary income under section 22(a), I. R. C. 1939.
*932 The respondent determined deficiencies in petitioners' income tax for 1951 in the indicated amounts as follows:
| Docket | ||
| No. | Petitioner | Deficiency |
| 58834 | Harry L. and Brenetta Booker | $ 1,886.76 |
| 58835 | Orville C. and Goldie V. Booker | 1,642.66 |
*243 The issue presented for our decision is the correctness of the respondent's action in determining that an amount received by petitioners on January 3, 1951, in settlement of their claims for lost profits and additional rental expense is taxable to them as ordinary income.
FINDINGS OF FACT.
Some of the facts have been stipulated and are found accordingly.
Petitioners Harry L. Booker and Brenetta Booker are husband and wife and residents of Aurora, Colorado. Petitioners filed a joint income tax return for 1951 with the then collector of internal revenue for the district of Colorado.
Petitioners Orville C. Booker and Goldie V. Booker are husband and wife and reside in Aurora, Colorado. They likewise filed their joint income tax return for 1951 with the then collector of internal revenue for the district of Colorado. Harry L. Booker and Orville C. Booker (sometimes hereinafter referred to as petitioners) are brothers.
During 1946 petitioners, as partners, operated a retail variety store in Aurora, Colorado, under the name of "Booker's 5 cents to $ 1.00 Store." The business was conducted in leased premises located at 9600 East Colfax Avenue, the main street in Aurora, in a building *244 owned by Edward V. Dunklee. Petitioners had conducted the business at the *933 above location since March 30, 1945. The property leased to the Bookers on that date constituted one of three rental units in the building owned by Dunklee, for which they paid a monthly rental of $ 75. The lease was for a term of 5 years with an option extended to petitioners to renew for 5 additional years at a rental of $ 100 per month.
The rental unit occupied by the Bookers was designated "Tenement B" and was situated between two other units in the same building; Tenement A was occupied by New Fashion Cleaners, a dry cleaning establishment, and Tenement C was occupied by Friend Furniture Company.
On February 9, 1945, Edward V. Dunklee, the owner of the building, granted Harry L. Booker for the benefit of the partnership an option to lease both Tenements A and C at the existing rentals in the event of a vacancy, change of tenancy, or the expiration of an existing lease. The agreement was as follows:
Whereas, Edward V. Dunklee, hereinafter designated as the party of the first part, is the owner of a property in Aurora, Colorado, known and described as Lots 20, 21, 22 and 23, except the West 25*245 feet, Block 25, Aurora, together with improvements thereon; that among the stores in said property is the Friend Furniture Company, which rents 9605 E. Colfax, and includes the West Half of the entire building, and also the New Fashion Cleaners, which occupy the East quarter of the building and the garage in the rear half of the building; and
Whereas, H. L. Booker, hereinafter designated as the party of the second part, has rented the store in between, known as one of the Franklin Variety Stores, and is desirous of having an option on both of said aforementioned stores in case of a vacancy or at the termination of their present leases, which on the New Fashion Cleaners is Dec. 1st, 1949, and the Friend Furniture on July 1st, 1949. That the rent on said Friend Furniture Store was fixed while the owner was in Washington and should be $ 150.00 a month, which is in accord with rents on similar locations in this community, while the rent on the New Fashion Cleaners, including the garage in the rear half of the building should be $ 125.00 per month, so that if new leases are made to any party these rents would control.
Now, Therefore, In consideration of $ 100.00 an option is hereby given*246 to the said H. L. Booker for 30 days after any of said contingencies arise -- either a vacancy, change of tenancy or expiration of lease, in any of said locations, the Friend Furniture Company or the New Fashion Cleaners, to rent the same at said rents of $ 150.00 and $ 125.00 per month, respectively, as above outlined. It is further understood and agreed that upon said basis of rent any term of lease agreeable to the said Booker will be satisfactory to the owner.
Dated this 9th day of February, 1945.
(Signed) Edward V. Dunklee,
First Party.
H. L. Booker & A. O. Booker,Second Party.
In connection with the foregoing option agreement, Dunklee, on February 9, 1945, wrote Harry L. Booker as follows:
*934 Denver, Colo., Feb. 9, 1945.
Mr. H. L. Booker,
2129 Hanna St.,
Ft. Wayne, Ind.
Dear Sir: --
Pursuant to your request I am sending you the enclosed option which I believe is exactly what we discussed, and gives you a 30 day option upon notice by me of either vacancy, change of tenancy or termination of either of the present leases with the Friend Furniture Co., or the New Fashion Cleaners. I believe you will have no question about the proposed rents, as certainly*247 the Friend Furniture Store is worth $ 150.00 if yours is worth $ 75.00, as it is over three times as large, while the New Fashion Cleaners store includes not only the store but also the garage in the rear and is reasonably worth $ 125.00.
We have not put in the extent of the lease to be made to you if you take up the option, as that can be discussed at that time and made agreeable to all parties.
It may be that if you would want a short time lease on either of said places that the above rents might be cut, if it appears that rents at that time are lower on short term leases, but on 5 or 10 year terms we submit that the above rentals are wholly reasonable, based upon the location, condition of premises and similar rents in that neighborhood. If you will sign these copies and send check I will sign two of them and send them back to you for your brother and you.
Trusting that this is satisfactory and with kindest personal regards, I am,
Very truly yours,
(Signed) Edward V. Dunklee.
On January 2, 1946, Dunklee sold and conveyed his fee simple title in the above-mentioned land and building to George J. Friend and Addie B. Friend, who at that time were doing business as Friend Furniture*248 Company and were tenants of Dunklee occupying Tenement C of the building conveyed. The conveyance was by warranty deed. The deed did not mention the option agreement with petitioners. During the negotiations preceding the sale Dunklee informed the Bookers that he was then negotiating with the Friends for the sale of the building but advised them that the proposed sale would have no effect on the option to lease. No vacancy, change of tenancy, or expiration of lease had occurred prior to the sale of the property. The option agreement as set out above was recorded by Harry L. Booker on March 15, 1946, but the accompanying letter has not been recorded.
On May 13, 1946, the Bookers filed in the District Court for the City and County of Denver, Colorado, a summons and complaint against both Dunklee and the Friends. In the complaint the Bookers sought possession of the building conveyed by Dunklee to the Friends, and damages in addition thereto. On May 14, 1946, the summons and complaint were voluntarily withdrawn by counsel for the Bookers.
On July 8, 1949, petitioners demanded that the Friends surrender to them possession of Tenement C and extend them a 10-year lease on Tenement*249 C at a rental of $ 150 per month. The Friends refused to comply with the demand and during November 1950 petitioners moved *935 their retail variety store from Tenement B to another location in Aurora on which the rental was $ 500 per month plus a percentage of gross profits. Rental values in Aurora had advanced substantially between the years 1945 and 1950.
On July 27, 1949, the Bookers filed suit in the District Court of Adams County, Colorado, against George J. Friend, Addie B. Friend, and both of them doing business as Friend Furniture Company. The complaint filed by counsel for the Bookers contained the following allegations:
That as a result of the refusal of said defendants to deliver possession of said premises, plaintiffs have been damaged in the amount of $ 5,000.00; and that if said plaintiffs are unable to obtain possession of said premises by reason of the failure, refusal or inability of said defendants to deliver the same, they will suffer additional damages in the amount of $ 45,000.00.
Wherefore, plaintiffs pray that defendants be required to specifically perform the terms of said option agreement hereinabove referred to in paragraph IV hereof, and that the*250 Court enter a decree awarding possession of said premises to said H. L. Booker at the rental provided for in said option; or, in the alternative, in case the Court determines that plaintiffs are entitled to possession, but for equitable reasons does not grant possession to said plaintiffs, then judgment in the sum of Fifty Thousand Dollars ($ 50,000).
On August 31, 1950, the District Court of Adams County, Colorado, entered findings of fact, conclusions of law, and a decree in the foregoing proceeding. The court denied petitioners' prayer for specific performance and damages and ordered an entry of judgment dismissing the complaint. In its opinion the court stated that the Friends' lease on Tenement C had not expired on July 1, 1949, as provided in their lease with Dunklee, because the Friends' leasehold interest had merged in the fee by reason of the conveyance to them on January 2, 1946. The court also held that at the time of acquisition of the property the Friends were without notice, either actual or constructive, of the existence of the option agreement between petitioners and Dunklee and, in addition, made further conclusions of law as follows:
The Court further finds *251 that the contingency set out in the option as a condition precedent to the right of the plaintiffs to exercise their option has not arisen. There has been no vacancy, no change of tenancy, and no expiration of lease.
* * * *
The Court further finds that the plaintiffs have an adequate remedy at law for damages, if any, against their grantor.
* * * *
After considering the option and letter together * * * as they must be considered, this Court does not find them sufficiently definite and certain for it to write a lease between the original parties and therefore will not write an arbitrary lease between plaintiffs and the intervening purchasers.
"The contract should not only contain all the material terms necessary to make a complete and legal contract, but each one of the terms should be expressed in a sufficiently exact and definite manner that a court may, with reasonable certainty, enforce the specific performance of it. [Citation]" * * *
*936 "A greater amount or degree of certainty is required in the terms of an agreement, which is to be specifically executed in equity, than is necessary in a contract which is to be the basis of an action at law for damages. [Citation]" *252 * * *
Upon dismissal of their action against the Friends, petitioners during the latter part of 1950 threatened to institute an action at law against Edward V. Dunklee to recover $ 50,000 in damages representing profits which they contended would have been earned in the event the option agreement had been exercised, and reimbursement for the increase in rental expense anticipated because of the transfer of their business to a new location. This litigation against Dunklee was never commenced. However, Dunklee and counsel for the Bookers held at least two conferences during December 1950 in which they sought to compromise the threatened litigation. During the conferences, or immediately thereafter, Dunklee and his counsel prepared memoranda outlining the claims advanced by counsel for the Bookers. In the memorandum covering the conference held on December 7, 1950, Dunklee recorded the following observation with respect to petitioners' claims:
1. When I say that his figure on Mr. Booker's losses and damages are highly speculative I am putting it mildly. He not only figures the difference in rent between an old store rebuilt out of a garage, in a second grade location, to his new *253 store in a new block in the center of town, which will be naturally better anyway, but he also figures the loss of imaginary profits on account of his moving. On top of this his figuring both imaginary profits and difference in rent for moving back in 1945 is again most speculative, and he has included everything but the contingencies of world war III as a basis of probable damage to his business.
On January 3, 1951, petitioners and Dunklee entered into an out-of-court agreement in compromise of all claims which the petitioners were then asserting. The agreement provided for the payment to petitioners of $ 15,000 in consideration for their release of all claims of whatever nature which they may have had against Dunklee from the beginning of time. Throughout the course of the negotiations, and in the compromise agreement itself, Dunklee denied any liability to petitioners. Pursuant to the agreement Dunklee paid the Bookers $ 15,000 on January 3, 1951. Dunklee, who was then preparing to leave on a world-wide goodwill trip on behalf of the United Nations, agreed to the compromise in order that he might continue on schedule the goodwill mission and avoid litigation. Dunklee thought*254 that in the event the controversy with the Bookers was to be tried in the local courts a jury might return a verdict in favor of the plaintiffs and fix the damages at $ 15,000 or more.
No part of the $ 15,000 amount received by petitioners from Dunklee on January 3, 1951, has been reported by them on their income tax *937 returns. However, on the partnership information return filed in connection with Booker's 5 cents to $ 1.00 Store, petitioners claimed only $ 4,500 as a deduction for rent paid during 1951, whereas the rent actually paid by them during that year amounted to $ 6,000.
OPINION.
Respondent has determined that the amount received by petitioners from Edward V. Dunklee on January 3, 1951, in settlement of their claims against him is taxable to them as ordinary income. Petitioners concede that the $ 15,000 amount received by them on that date in exchange for the release of their claims against Dunklee is reportable by them, but they contend that it is taxable only as long-term capital gain pursuant to section 117(a) 1 of the Internal Revenue Code of 1939.
*255 Since the taxability of an amount received pursuant to an agreement compromising a contested claim depends upon the nature of the claim and the actual basis of recovery, it is incumbent upon petitioners to demonstrate clearly the essential character of each of their claims against Dunklee. Raytheon Production Corporation, 1 T. C. 952, affd. 144 F. 2d 110; Nicholas W. Mathey, 10 T.C. 1099">10 T. C. 1099, affd. 177 F.2d 259">177 F. 2d 259. If the amount received by the Bookers represented the settlement of a claim for ordinary income, it would be taxable as such, but if under any of the compromised claims petitioners sought recovery for the replacement of a capital asset, such amounts would be taxable under section 117(a) of the 1939 Code as a return of capital. Raytheon Production Corporation, supra;Commercial Electrical Supply Co., 8 B. T. A. 986.
It is clear from the record herein that the basis of the out-of-court recovery in question was an asserted breach of the option contract on the part of Dunklee. 2 Further, it is undisputed*256 that the damages *938 originally claimed by petitioners in the amount of $ 50,000 and finally compromised at $ 15,000, represented profits which the Bookers insisted would have been earned in the event the option had been exercised and reimbursement for additional rental expense anticipated because of the acquisition of new quarters.
It is settled law that amounts received pursuant*257 to a settlement agreement on a claim for recovery of damages for loss of profits are taxable as ordinary income. Raytheon Production Corporation, supra;Swastika Oil & Gas Co., 40 B. T. A. 798, affd. 123 F. 2d 382, certiorari denied 317 U.S. 639">317 U.S. 639; Commercial Electrical Supply Co., supra.
In addition, without the increased rental expense caused by the relocation of their business, petitioners would have realized additional net profit which obviously would have been taxable to them as ordinary income. Consequently, amounts received as reimbursement for increases in anticipated operating expenses are taxable as ordinary income. Baltimore & Ohio Railroad Co., 30 B. T. A. 194.
Petitioners insist that they transferred property in the nature of a capital asset to Edward V. Dunklee in exchange for the amount in question. In support of their position they rely on our decisions in Isadore Golonsky, 1450">16 T. C. 1450, affd. 200 F. 2d 72, certiorari denied 345 U.S. 939">345 U.S. 939;*258 McCue Bros. & Drummond, Inc., 19 T. C. 667, affd. 210 F. 2d 752, certiorari denied 348 U.S. 829">348 U.S. 829; and Louis W. Ray, 18 T.C. 438">18 T. C. 438, affd. 210 F.2d 390">210 F. 2d 390.
In those cases we held that payments received by a lessee from his lessor in return for the cancellation of a lease or the surrender by the tenant of his right to remain in possession of the premises are made for the purchase of a capital asset and may be reported as capital gain by the lessee. In Isadore Golonsky, supra, we held that an amount received by the lessee from the owner of the premises for the accelerated cancellation of a lease constituted capital gain since the tenant's right to the use and possession of the unexpired term was a property right which thereby was transferred by him to the lessor.
Louis W. Ray, supra, involved the relinquishment by the lessee of a restrictive covenant contained in the lease which was preventing the owner from selling the reversion. In holding that the transaction constituted a sale of a*259 capital asset under section 117 of the 1939 Code, we stated:
A lease of land is property and constitutes a capital asset in the hands of the leasehold owner and gain realized by him from its sale is capital gain. * * *
* * * *
An agreement in a written lease which affects the use and enjoyment of the premises by the tenant, or is such as to benefit either the landlord or tenant by reason of his relation thereto, is a property right, being a covenant which runs with the land and is enforceable against not only the makers of the agreement, but their assigns. * * *
*939 In McCue Bros. & Drummond, Inc., supra, the taxpayer occupied business premises under a lease which expired during the taxable year in question, but it continued in possession as a statutory tenant under the New York emergency rent control laws. As a statutory tenant, the taxpayer had a right to remain in possession of the premises so long as it paid a reasonable rental. Its landlord paid it $ 22,500 to vacate and surrender the premises. We upheld the taxpayer's contention that it had transferred property rights to its landlord in exchange for the $ 22,500 received, and that the *260 amount realized from the sale represented capital gain.
It is clear that none of the foregoing decisions is applicable to the facts here presented. At the time payment was made to petitioners pursuant to the compromise agreement, Edward V. Dunklee was not the owner of the premises in question and was not a landlord of petitioners. Petitioners at that time had vacated the premises covered by the option agreement with Dunklee. Moreover, the option agreement created no restrictive covenant running with the land as in Louis W. Ray, supra.Thus, Dunklee obviously did not acquire the right to the use and possession of the premises or the release from a covenant or restriction running with the land as in the foregoing cases. As a result of the settlement agreement with petitioners, he was not able to convey any greater right or clearer title to the property originally leased to petitioners, and subsequently disposed of, than he had already transferred. Dunklee acquired only the guaranteed freedom from threatened litigation in exchange for the $ 15,000 settlement payment made to the Bookers. Accordingly, the decisions upon which petitioners rely are readily*261 distinguishable from the facts here in question.
It is clear that the contingencies which, under the terms of the option agreement, would create in petitioners prior rights of possession have never occurred. Further, the provisions of the agreement were characterized by the District Court of Adams County, Colorado, as being so vague and indefinite as to be unenforceable. In view of the fact that petitioners as optionees possessed nothing more than a mere expectancy, we are unable to conclude that the option contract in their hands constitutes property within the meaning of section 117 (a) of the 1939 Code.
Moreover, inasmuch as Dunklee was a party to the option contract and petitioners therefore could not transfer to him, as optionor, their contingent rights of priority to lease the premises previously owned by Dunklee, no contractual rights can be held to have been transferred to him. Seth M. Milliken, 15 T.C. 243">15 T. C. 243, affirmed on this point 196 F. 2d 135. That Dunklee himself did not regard his payment to petitioners of $ 15,000 in exchange for the execution by them of a release *940 as a purchase of any rights under*262 the option contract is clear from his testimony at the hearing:
Q. Now, I will ask you, Mr. Dunklee, to state whether or not it was your intention at that time to buy your option contract from the Bookers.
A. No, no. It was not. That didn't have anything to do with the option at all. It had to do with the settlement of the lawsuit for $ 50,000, that I thought was a wise thing to do, since I was going away, to settle it on the theory that the jury might bring in a compromise verdict for around $ 15,000, anyway. * * * [Transcript, p. 49.]
Thus, even if petitioners' inchoate rights under the option agreement were held to be in the nature of property under section 117 (a) of the 1939 Code, there was nevertheless no transfer of such rights so as to constitute a sale or exchange within the meaning of that section.
For the foregoing reasons, we hold that the amount received by petitioners on January 3, 1951, in compromise of their claims for damages is taxable to them as ordinary income under section 22 (a) of the 1939 Code.
Decisions will be entered for the respondent.
Footnotes
1. SEC. 117. CAPITAL GAINS AND LOSSES.
(a) Definitions. -- As used in this chapter --
(1) Capital assets. -- The term "capital assets" means property held by the taxpayer (whether or not connected with his trade or business) * * *
* * * *
(4) Long-term capital gain. -- The term "long-term capital gain" means gain from the sale or exchange of a capital asset held for more than 6 months, if and to the extent such gain is taken into account in computing gross income * * *↩
2. On cross-examination by petitioner's counsel, Dunklee testified as follows (Transcript, p. 58):
Q. Mr. Dunklee, in a nutshell, isn't it fair to say that the $ 15,000 payment you made to the Bookers was simply the compromise of a threatened lawsuit brought against you for breach of an option contract?
A. Yes, except that I didn't personally feel there was any breach.
Q. Well, I am not asking you to pass your judgment on a legal theory. I am asking you, Wasn't it a compromise of a threatened lawsuit?A. Oh, I would say it was.
Q. And that the basis of the lawsuit was the breach of an option contract?
A. The basis of the lawsuit was, yes.↩