*119 Decisions will be entered under Rule 50.
Sale by sole proprietor of an accounting business, including files showing who were the clients of the business, copies of audit records and work papers for the clients, and good will, accompanied by an agreement not to compete for a period of six years, held to result in capital gain to the extent that the payments were made for good will; held, further, that the part of the payments allocable to the covenant not to compete is taxable as ordinary income.
*143 The Commissioner has determined deficiencies against each of the petitioners in the amounts of $ 241.57 for the year 1943. The year 1942 is involved because of the forgiveness provisions of the Current Payment Tax Act of 1943. The deficiency in each case is due to adjustments made by the Commissioner in the net community income reported by the taxpayers on their respective returns. The adjustment for 1942 was explained in the deficiency notices as follows:
(a) It is held the amount of $ 3,010.33 which you received during the year 1942, pursuant to a contract entered into on October 1, 1941, represents ordinary income taxable under section 22 (a), Internal Revenue Code, and does not represent long-term capital gains as reported on your income tax return for that year.
Your community income for this year has been adjusted as follows:
| Taxable capital gain per return | $ 1,505.17 |
| Correct amount -- ordinary income | 3,010.33 |
| Adjustment -- increase | $ 1,505.16 |
A similar explanation, except as to amounts, was made in the deficiency notices for the year 1943. Each petitioner by an appropriate*121 assignment of error has contested the Commissioner's action in making the above adjustments.
FINDINGS OF FACT.
Petitioners Rodney B. Horton and Eileen H. Horton, husband and wife, now reside in Fort Worth, Texas, but during the years 1942 and 1943 and prior thereto they lived in Albuquerque, New Mexico. Their income tax returns for the calendar years 1942 and 1943 were filed with the collector of internal revenue for the district of New *144 Mexico. Petitioners were on the cash receipts and disbursements basis of accounting. Similar returns were filed by petitioners, since all income was community income. Rodney B. Horton will hereinafter be referred to as petitioner.
The petitioner is a certified public accountant. On September 8, 1930, petitioner and another accountant, named Gould, opened an accounting office at Albuquerque under the name of Horton & Gould. This partnership continued for two or three years, when another accountant, named Bixler, was taken into the partnership. Later Horton and Bixler bought out Gould. Subsequent to this, around 1938 or 1939, Bixler left the partnership and Horton operated the accounting office as sole owner under the name of Horton*122 & Bixler until October 1, 1941. At that time there were six or seven accountants employed in Horton's office and about two stenographers, and the office had annual gross income of about $ 40,000. It was a general accounting office, the business consisting of audits, tax work, and preparing tax returns, protests and other matters before the Bureau of Internal Revenue. The office had been in its present location three or four years prior to October 1, 1941. As a part of the conduct of the business, petitioner Rodney B. Horton owned, in community with his wife, and used, the furniture, fixtures, and office supplies of the office, the depreciated cost of which was approximately $ 2,500 on October 1, 1941. In the conduct of the business petitioner had accumulated files showing who were the clients of this office and containing copies of audit records and work papers, and correspondence relating to accounting work theretofore done in the office for the clients. These records were of value to the accounting business which petitioner conducted under the name of Horton & Bixler.
On October 1, 1941, petitioner and F. G. Masquelette & Co., an accounting copartnership of El Paso, Texas*123 (hereinafter referred to as "Masquelette"), entered into an agreement of sale and purchase. This agreement is incorporated herein by reference and the parts which are regarded as pertinent to the issue to be decided herein are as follows:
Witnesseth:
Whereas, Horton has heretofore been a partner in the firm of Horton and Bixler, which firm has been engaged in the accounting practice in Albuquerque, New Mexico, prior hereto, and
Whereas, Horton has heretofore acquired all of the outstanding interest in the accounting practice at present and heretofore conducted under the name of Horton and Bixler through its offices in Albuquerque, New Mexico, and is now the owner of all of the business and assets of said firm,
Now, Therefore, It Is Agreed as follows:
(1) Horton agrees to sell, and Masquelette agrees to buy, upon the terms and conditions hereinafter set forth, the business and assets hereinafter specifically mentioned, of said firm of Horton and Bixler (all of which are now owned by *145 Horton) free and clear of any and all encumbrances, liens and indebtedness of whatsoever nature, to-wit:
(A) The good will of said firm of Horton and Bixler, including the right to the exclusive*124 use of the firm name of Horton and Bixler within the State of New Mexico, which firm name Masquelette may use or not, at its option, but in any event, Horton agrees not to use any such trade name at any time within The State of New Mexico or adjoining states, in connection with the practice of accounting.
(B) All furniture, fixtures, furnishings, library, stationery, printing and office supplies located at this date at the office of Horton and Bixler at 108 North 6th Street, Albuquerque, New Mexico, as further described in the books, records and accounts of said firm of Horton and Bixler, including said books, records and accounts.
(C) All right and title to the uncompleted portions of any audit contracts or assignments of Horton and Bixler as of October 1, 1941.
(D) All right and title to all the office copies of audit records, workpapers and correspondence files, with clients and others, heretofore belonging to said firm of Horton and Bixler and now owned by Horton.
(2) Horton agrees to assign, or cause to be assigned to Masquelette, simultaneously with the execution of this contract, the lease of the premises, at 108 North 6th Street, heretofore held by Horton and Bixler as lessee.
*125 (3) Horton agrees that he will not, except as otherwise specifically herein, engage in the practice of public accounting, either in his own name or under the name of another, as principal or as an employee, in the State of New Mexico, for a period of six years from and after October 1, 1941.
(4) Horton agrees that he will in every manner consistent with the ethics of the profession of public accountancy recommend to the present clients of Horton and Bixler that they continue to allow their accounting requirements to be handled by Masquelette as successors to said business.
(5) Masquelette agrees to pay as consideration for the foregoing, the following:
(A) $ 2,500.00 in cash upon the execution of this agreement, receipt whereof is hereby acknowledged by Horton.
(B) The sum of $ 416.66 each month for the months of October, November and December, 1941, payable monthly upon October 31, November 30, and December 31, 1941.
(C) Monthly for a period of five years from October 1, 1941, an amount equal to 10% upon all fees collected by Masquelette from its business conducted through or arising out of, its Albuquerque office, arising out of professional assignments and contracts other than *126 from state, county or city auditing assignments, and an amount equal to 15% upon all such fees collected arising out of state, county, or city auditing assignments. * * *
* * * *
(8) Horton agrees to devote a reasonable amount of his time to the details involved in turning over the accounting practice to Masquelette during the months of October, November and December, 1941, compensation for which is to be paid as hereinbefore stated. * * *
(9) It is recognized that a portion of the good will being purchased by Masquelette will be dependent upon the continued support and good will of Horton and it is therefore, agreed that if, prior to March 31, 1943, Horton ceases to be a bona fide resident of the State of New Mexico, or dies, the percentages named in paragraph 5-C shall be reduced by 50% and, in case of death, shall be payable to the estate of Horton.
(10) After payment in full of all of the consideration herein outlined, Horton will have no further right to any of the fees or revenues arising out of the *146 accounting practice conducted by Masquelette as successors to Horton and Bixler, nor to any of the assets of said accounting business hereby purchased by Masquelette, *127 whether such assets be tangible or intangible.
On October 1, 1941, the depreciated cost of the physical assets, including furniture and fixtures, calculators, adding machines, typewriters, desks, and miscellaneous articles was approximately $ 2,500. Masquelette took possession of the office on October 1, 1941, and opened immediately under its own name, Masquelette & Co. On October 1, 1941, all work papers, correspondence, and office copies of the files of clients were turned over to Masquelette. Thereafter both parties fully carried out the provisions of the agreement.
Petitioner received percentages of all fees taken in by Masquelette during the five-year period commencing October 1, 1941, whether the fees were from former clients of petitioner or new clients of Masquelette. During 1942 Masquelette paid the petitioner $ 3,010.33 and in 1943, $ 3,392.91. Petitioners reported these amounts as received from the sale of good will, claimed no cost basis, and showed 50 per cent of the amount received as taxable income. The $ 2,500 in cash which petitioner received from Masquelette upon the signing of the agreement was paid him for the physical assets of the accounting business, such*128 as desks, filing cabinets, calculators, adding machines, typewriters, and other office furniture and equipment. The $ 416.66 paid petitioner for each of the months October, November, and December, 1941, was paid him for personal services. Of the percentage payments which Masquelette agreed to make to petitioner for a period of five years beginning with October 1, 1941, 50 per cent was in consideration of the good will of the accounting business which petitioner transferred to Masquelette. Fifty per cent of these percentage payments was in consideration of petitioner's covenant in the contract that he would not engage in the practice of public accounting, either in his own name or under the name of another, in the State of New Mexico for a period of six years from and after October 1, 1941.
OPINION.
We have but one issue in these proceedings, and that is whether payments received by the petitioners in the years 1942 and 1943 pursuant to the terms of a contract of October 1, 1941, constitute ordinary income, as the Commissioner has determined, or capital gain resulting from the sale of good will, as the petitioners contend. Section 29.22 (a)-10, Regulations 111, relating to the *129 sale of good will, is printed in the margin. 1 There is no issue as to the amount of income *147 received under the contract and petitioners concede that the payments had no cost basis.
The contract of sale *130 between petitioner and Masquelette provided for three separate classes of payments designated in the contract as (A), (B), and (C). (A) consisted of $ 2,500 paid in cash. The testimony at the hearing was that petitioner's furniture and fixtures had a depreciated cost at the time of sale of approximately $ 2,500 and that the purchaser agreed to pay that amount for these tangible assets. This payment was made in 1941 and is not in issue here. (B) was a provision for three payments of $ 416.66 for each of the months of October, November, and December, 1941. Petitioner testified that these payments were for his personal services in helping the purchasers to get started in the business, introducing them to petitioner's old customers, and other related matters of that kind. Petitioner testified that these amounts were returned as ordinary income in 1941. As in (A), these payments under (B) are not in issue here. (C) was a provision for percentage payments to continue for a period of five years, monthly from October 1, 1941. It is these percentage monthly payments made to petitioner in 1942 and 1943 which are in issue.
Petitioners claim these payments were made as part of the purchase*131 price of the good will of the accounting business which petitioner was conducting at the time of sale under the name of Horton & Bixler, along with petitioner's covenant not to compete for a period of six years. Petitioners contend that the covenant not to compete accompained the transfer of a going business and had the function primarily of assuring to the purchaser the beneficial enjoyment of the good will which it acquired and is not severable from good will so as to allocate to this covenant not to compete any separate portion of the purchase price. He cites Aaron Michaels, 12 T. C. 17.
It is well settled that if, in an agreement of the kind which we have here, the covenant not to compete can be segregated in order to be assured that a separate item has actually been dealt with, then so much as is paid for the covenant not to compete is ordinary income and not income from the sale of a capital asset. Estate of Mildred K. Hyde, 42 B. T. A. 738. On the other hand, where the covenant not to compete accompanies the tranfer of good will in the sale of a going concern and it is apparent that the covenant not to compete*132 has the function primarily of assuring to the purchaser the beneficial *148 enjoyment of the good will which has been acquired, the covenant is regarded as nonseverable and as being in effect a contributing element of the assets transferred. Toledo Newspaper Co., 2 T. C. 794; Toledo Blade Co., 11 T. C. 1079; Aaron Michaels, supra.
In the instant case we have found, after a consideration of all the facts, that the percentage payments which were to be made under the contract are severable as between good will and the covenant not to compete and that 50 per cent of such payments was made in consideration of good will transferred and 50 per cent was made in consideration of the covenant not to compete for a period of six years from October 1, 1941.
It is respondent's argument in his brief that all of these percentage payments should be allocated to the covenant not to compete because, as he argues, the covenant not to compete was in conjunction with personal services and not in conjunction with the sale of good will. We do not agree with this contention. We think the contract shows clearly*133 that a part of the percentage payments was to be made in consideration of the purchase of good will. However, that fact does not prevent us from allocating the purchase price between good will and the covenant not to compete, if the facts permit us to do so, and in the instant case we think the facts do permit such an allocation and we have made it. That good will was being sold by the seller and purchased by the buyer seems clear from the contract. The first two paragraphs of the contract read:
(1) Horton agrees to sell, and Masquelette agrees to buy, upon the terms and conditions hereinafter set forth, the business and assets hereinafter specifically mentioned, of said firm of Horton and Bixler (all of which are now owned by Horton) free and clear of any and all encumbrances, liens and indebtedness of whatsoever nature, to-wit:
(A) The good will of said firm of Horton and Bixler, including the right to the exclusive use of the firm name of Horton and Bixler within the State of New Mexico, which firm name Masquelette may use or not, at its option, but in any event, Horton agrees not to use any such trade name at any time within The State of New Mexico or adjoining states, in connection*134 with the practice of accounting.
In "Words and Phrases," vol. 18, p. 561, this recital of the meaning of "good will" appears:
Lord Eldon, in Cruttwell v. Lye, 17 Vesey, 335, said: "The 'good will' which has been the subject of sale is nothing more than the probability that the old customers will resort to the old place." "'Good will' has been defined as 'all that good disposition which customers entertain towards the house of business, identified by the particular name or firm, and which may induce them to continue giving their custom to it.' * * * That it is property is abundantly settled by authority." See v. Heppenheimer, 61 A. 843, 846, 69 N. J. Eq. 36, quoting Washburn v. National Wall Paper Co., 81 F. 17, 20, 26 C. C. A. 312, 315.
*149 In the instant case the contract from which we have already quoted shows plainly that the seller thought he was selling, among other things, the good will of his accounting business, which he was operating under the name of Horton & Bixler. The purchaser certainly thought it was buying good will and agreed to pay for it. *135 We agree that good will was a part of the assets transferred, and that payment was made for it. Good will is a capital asset and any gains resulting from the sale thereof are capital gains. Aaron Michaels, supra.In the instant case we do not have the task of determining the cost basis of the good will sold, because petitioner concedes that he had no cost basis for the good will.
In accordance with our findings of fact, it is held that 50 per cent of the percentage payments which petitioners received in the taxable years should be taxed as capital gains from the sale of good will and 50 per cent should be taxed as ordinary income received because of a covenant not to compete.
Decisions will be entered under Rule 50.
Disney, J., dissenting: I can not agree with the majority opinion in so far as it recognizes good will as a factor in a sale by a certified public accountant of his business. It seems well established by the books that no good will grows out of personal efforts and ability. Thus, in In re Martin's Estate, 33 N. Y. S. (2d) 81, the estate of an attorney was suing for value of good will and *136 it was held there was none. In Magee v. Pope, 112 S. W. (2d) 891, it was likewise so held in the case of a physician. In Master v. Brooks, 117 N. Y. S. 585, it was held that there was no good will as to the business of a revenue attorney. It is true, of course, that some people will go back to a place of business even after the death of the principal figure there, merely for lack of any idea of where else to go and out of habit, but any such tendency seems so rare and of such small importance, in the case of a professional man, as not to be recognizable as vendible good will. Moreover, if a man's business is such that he must take an examination set by the state, there would appear to be public policy against his transmitting "good will" growing out of his abilities, to any degree which should be recognized for tax purposes. Aaron Michaels, 12 T. C. 17, as to laundry business, is not to the contrary, and the Toledo Blade Co., 11 T. C. 1079, of course involved a newspaper business, as did Toledo Newspaper Co., 2 T. C. 794,*137 so that they offer no logical help on this question. In E. C. O'Rear, 28 B. T. A. 698, we said that a lawyer did *150 not have capital gain in receiving, when he formed a partnership with two other attorneys, an amount "due to the conceded excess value of good will and unearned fees of said O'Rear put into the firm" over what the other attorneys put in. We said that the attorney's reputation as an able lawyer attached to his person; he could not transfer it. We recognized this rule in D. K. MacDonald, 3 T. C. 720. I would adhere to it. I therefore respectfully dissent.
Footnotes
1. Sec. 29.22 (a)-10. Sale of Good Will. -- Gain or loss from a sale of good will results only when the business, or a part of it, to which the good will attaches is sold in which case the gain or loss will be determined by comparing the sale price with the cost or other basis of the assets, including good will. (See sections 29.111-1, 29.113(a)(14)-1, and 29.113(b)(1)-1 to 29.113(b)(3)-2, inclusive.) If specific payment was not made for good will, there can be no deductible loss with respect thereto, but gain may be realized from the sale of good will built up through expenditures which have been currently deducted. It is immaterial that good will may never have been carried on the books as an asset, but the burden of proof is on the taxpayer to establish the cost or other basis of the good will sold.↩