*1546 Amounts paid by the petitioners to a retiring member of a partnership, of which they also were members, in settlement of a claim made by him for payment for his share or interest in the partnership good will, held to be capital expenditures and as such not allowable deductions in determining taxable net income.
*1071 These proceedings, which were consolidated for hearing, are for the redetermination of deficiencies in income tax for 1923 as follows:
| Docket No. 37554, Arthur P. Williams | $4,396.69 |
| Docket No. 37555, William L. Juhring | 4,823.73 |
The only matter in controversy is the correctness of the respondent's action in not allowing as a deduction as an ordinary and necessary expense, or as a loss, the amount of $13,333.33 to Williams and $13,777.77 to Juhring representing their proportional parts of an amount of $36,000 paid in 1923 by the petitioners and two others as members of a partnership to a retiring member of the partnership in satisfaction of certain demands he was making with respect*1547 to a share in the good will of the partnership.
FINDINGS OF FACT.
Prior to January 20, 1920, the petitioners and certain others were members of a limited partnership conducting a general wholesale grocery business in the city of New York under the firm name of R. C. Williams & Company. On January 20, 1920, the petitioners, with Edwin H. Sayre, Howell S. Sayre and William F. Vossler entered into an agreement to form a general partnership to take over the assets of and carry on the general wholesale grocery business theretofore carried on by the limited partnership.
The agreement provided that the name under which the new partnership would carry on business should be R. C. Williams & Company and that the partnership should continue for a term of three years from February 1, 1920, to and including January 31, 1923. The amount of capital contributed by the respective partners, the share of each in the profits of the partnership, and their salaries as provided in the agreement, were as follows:
| Partner | Capital contributed | Share of profits | Salary |
| Per cent | |||
| Edwin H. Sayre | $300,000 | 19 | $15,000 |
| William L. Juhring | 325,000 | 31 | 23,500 |
| Arthur P. Williams | 350,000 | 30 | 21,000 |
| Howell E. Sayer | 200,000 | 15 | 13,000 |
| William F. Vossler | 25,000 | 5 | 7,500 |
*1548 With the exception of Vossler, the parties to the agreement of January 20, 1920, were members of the limited partnership which expired by limitation on January 31, 1920.
Prior to January 20, 1920, differences of opinion had arisen between Williams and Edwin H. Sayre, hereinafter referred to as Sayre, with respect to matters of business policy. Williams was young and aggressive and believed that the business should be expanded *1072 through advertising, broadening of accounts, and selling of new accounts. Sayre, at that time the senior member of the firm, was older and more conservative than Williams and was opposed to these plans for the expansion of the business. Because of this restraint upon his freedom of action Williams decided that he could no longer continue in the business with Sayre and informed Sayre that it would be advisable for them to separate. Williams thereupon offered to sell his interest in the business to Sayre or to buy Sayre's interest.
For several years prior to 1920 it had been Sayre's intention to retire from the business because of his age. Accordingly he gradually had been reducing the amount of his investment in the business so that by*1549 1920 he had reduced it from $700,000 to $300,000.
It was finally agreed that Sayre should retire from the business at the end of three years and in drawing the partnership agreement of January 20, 1920, the following provision was made therein respecting his retirement and the withdrawal of the amount of capital contributed by him:
SEVENTH. - It is understood and agreed that Edwin H. Sayre, one of the partners above mentioned, is to retire from the partnership at the expiration of the term hereby created, to wit: On January 31st, 1923, and in view of said contemplated retirement, is to withdraw the amount of capital contributed by him at the rate of $10,000, on the 1st day of each month, beginning on the 1st day of March, 1920, until the full amount of capital contributed by him as hereinbefore provided shall have been fully withdrawn.
Withdrawals of capital were made by Sayre pursuant to the agreement at the rate of $10,000 a month and by January 31, 1923, his entire capital investment of $300,000 had been returned to him. On that date Sayre's capital account on the books of the partnership showed no balance and his loan account showed a credit balance of $55,546.53.
*1550 Throughout the existence of the partnership created by the agreement of January 20, 1920, Sayre received each year 19 per cent of the profits of the business in accordance with the terms of the agreement. This percentage was not reduced or diminished in any way by reason of the withdrawals of capital at the rate of $10,000 per month. Sayre was actively engaged in the business of the partnership and received an annual salary of $15,000.
During the latter part of 1922 plans were considered by the partners other than Sayre for continuing the business after January 31, 1923, when Sayre was to retire and the then existing partnership terminate and it was decided that it would be in the best interest of the business to form a corporation for this purpose.
About this time Sayre made a claim to the other partners that upon the termination of the partnership he should be paid $100,000 *1073 in addition to the amounts he was entitled to under the terms of the partnership agreement of January 20, 1920. He based his claim upon the grounds that he was entitled to payment for his share or interest in the good will of the business, that some adjustment should be made because the*1551 actual value of machinery, fixtures, trucks, horses, and automobiles was in excess of their depreciated book values and that the merchandise inventory, which according to the practice of the partnership would be taken on the basis of cost or market, whichever was lower, should be adjusted to market value, which would be in excess of cost.
In settlement of that portion of the claim based on the last two of the above-mentioned grounds, Sayre's account was credited with $4,420, representing 19 per cent of the difference between the cost of merchandise included in the inventory and its market value, and the amount of $2,050 representing his share of the difference between the depreciated book value and the actual value of machinery, fixtures, etc.
The other partners did not consider Sayre's claim for payment on account of good will to have any merit and protested vigorously against the payment of any amount to him. They informed him that under the partnership agreement of January 20, 1920, he had no claim for good will and that the agreement was specific that he was to retire on January 31, 1923, upon having had his capital repaid to him and having been paid his share of the profits*1552 as provided in the agreement.
No account for good will was ever carried on the books of this partnership or that of any of its predecessors. The question of Sayre's interest in the good will was not mentioned or discussed by the partners at the time of entering into the agreement of January 20, 1920, nor at any time prior thereto. It was not until about October, 1922, when Sayre made his claim for an additional payment on account of good will, that the question of his interest in the good will was discussed between the partners.
At a conference held at the residence of Williams, at which all of the partners were present, Sayre's claim was discussed and the question arose as to why the agreement of January 20, 1920, should not be binding and why it should be abrogated by paying Sayre any amount in excess of that provided for in the agreement. During this discussion Sayre stated that the business was running smoothly, was making profits, that the prospects were that it would make larger profits, and that he therefore thought that the agreement should not be binding and he should receive some additional payment.
Various other conferences were held between the petitioners and*1553 Sayre with respect to his claim for payment for an interest in the good will of the business. During one such conference Sayre informed *1074 them that he would bring suit unless the claim could be settled in some way.
The petitioners believed that Sayre would bring suit unless a settlement was made of his claim. They also believed that if Sayre brought suit it would produce a bad effect upon the employees of the partnership and upon the public generally, would result in heavy expenses and losses, and would be detrimental in every way to the business. Furthermore, plans for the continuance of the business after January 31, 1923, could not be completed with the threat of legal action pending and with the uncertainty of the outcome thereof.
Finally the four other partners agreed to pay Sayre $36,000 in settlement of the claim he was making as to his interest in the good will of the business. Accordingly under date of January 12, 1923, Sayre and the four other partners executed an agreement which provided in part as follows:
WHEREAS, said Edwin H. Sayre claims that he is further entitled to receive an additional sum for his interest in the good will of said partnership*1554 which has been agreed upon at the sum of Thirty-six thousand Dollars ($36,000); and
WHEREAS, it is proposed that a corporation shall be organized under the laws of the State of New York under the name of R. C. Williams & Company, Inc., or some other suitable name, hereinafter called "New Corporation," with a capital stock consisting of Twenty thousand (20,000) shares of cumulative seven per cent preferred stock of the par value of $100 each, with the rights, privileges, and preferences hereinafter set forth, and Twenty thousand (20,000) shares of common stock of no par value; and
WHEREAS, it is proposed to transfer and convey to said New Corporation immediately upon the termination of said partnership all of the assets and property of every kind, and the entire good will of said R. C. Williams & Company, a partnership, with the exception, however, of the stock of the De Soto Coffee Company and a certain amount of cash to be determined as provided in this agreement, in the manner and according to the terms and conditions hereinafter set forth;
NOW, THEREFORE, the parties hereto hereby agree as follows:
* * *
III. Said Edwin H. Sayre further agrees to accept Thirty-six thousand*1555 Dollars ($36,000) as full payment for his share of the good will of said partnership, such amount to be paid by the delivery to him of Thirty-six thousand Dollars ($36,000) par value of seven per cent cumulative preferred stock of the said New Corporation, which the second parties agree to deliver to said Edwin H. Sayre as soon as the same has been issued.
IV. Said Edwin H. Sayre, first party, hereby agrees and consents that all of the business, assets, and property of every kind, rights and all of the good will of said partnership, with the exception of the stock of the De Soto Coffee Company, shall be transferred to said New Corporation on January 31, 1923 as long as said transfer is made subject to the assumption by the New Corporation of the amounts shown to be due to him on said audit for capital and profits, less any sums which may be due by him to said partnership, and less the amount of his interest in the shares of stock of the De Soto Coffee Company, being all that said Edwin H. Sayre is entitled to in said partnership, payment of which is guaranteed by second parties as provided in paragraph numbered *1075 II hereof, and hereby accepts the agreement of the second*1556 parties to deliver to him Thirty-six thousand Dollars ($36,000) par value of seven per cent cumulative preferred stock of said New Corporation, and agrees that on and after January 31, 1923, he shall have no further interest, rights or claims of any kind whatsoever in the said partnership or any of its property, good will or other rights, and hereby agrees to execute at any time upon request such other instruments as may be necessary or requisite to accomplish the relinquishment of all of his rights and interest in said partnership on January 31, 1923.
V. That the said Thirty-six thousand Dollars ($36,000) par value seven per cent cumulative preferred stock of the New Corporation to be delivered to Edwin H. Sayre, first party, as provided in paragraph numbered III shall be contributed by the second parties as follows:
| Contributed by | Par Value, Preferred Stock |
| Arthur P. Williams | $13,300 |
| William L. Juhring | 13,800 |
| Howell E. Sayre | 6,700 |
| William F. Vosseler | 2,200 |
* * *
XII. It is further understood that the first party [Edwin H. Sayre] will not directly or indirectly become interested in or identified with any business of a similar character to*1557 that of the present R. C. Williams & Company or of the New Corporation, R. C. Williams & Company, Inc., for a period of Five (5) years from the date hereof, and even after that time will not use the name of R. C. Williams & Company, Inc., or refer to it in any way in connection with any other business.
The terms of the agreement of January 12, 1923, were carried out and the business and property of the partnership were transferred to the new corporation, R. C. Williams & Company, Inc. The partnership assets were taken over by the corporation at their then book value, the petitioners and the other two partners receiving therefor preferred stock in proportion to their interests in the partnership.
Sayre was paid $36,000 par value preferred stock of the new corporation. Payment to the corporation for this stock was contributed by the four other partners in proportion to their interests in the partnership, Williams and Juhring paying in 1923 as their share the amounts of $13,333.33 and $13,777.77, respectively.
In determining the deficiencies here involved the respondent refused to allow the petitioners as deductions the amounts paid by them as their proportional parts of the*1558 cost of the stock paid to Sayre in settlement of his claim with respect to the good will of the business.
The business carried on by the partnership under the agreement of January 20, 1920, was the continuation of a business that had been carried on continuously by various predecessor partnerships since 1811. In 1871 the business was carried on under the name of Potter and Williams. Upon a later change in the membership of the partnership the name was changed to Williams and Potter. Beginning *1076 in 1880, and upon the creation of a new partnership, the business was conducted under the name of R. C. Williams & Company, under which name it continued to be conducted until January 31, 1923, when it was taken over by the new corporation of R. C. Williams & Company, Inc. Sayre was connected with the business from 1871, when at the age of 17 he entered the employ of the then partnership which was conducting it, to January 31, 1923, the date of the termination of the partnership formed under the agreement of January 20, 1920. About 1880 he was admitted to membership in the partnership then carrying on the business. By about 1885 he was practically the senior member of the*1559 firm from the standpoint of capital invested and the general management of the business other than finances. About 1894 Sayre designed, and the then existing partnership adopted, the trade brand "Royal Scarlet," which was used upon the highest grade of merchandise handled in the business. A number of other trade brands were used on the intermediate grades of merchandise handled. From 1871 down to January 31, 1923, the business produced a profit every year except two, 1896 and 1920. In only one of these, 1920, did it operate at a loss. The sales of the business grew from about $1,250,000 in 1880 to practically $10,000,000 for the year ending January 31, 1923. During this latter year sales of merchandise bearing the "Royal Scarlet" brand amounted to about $2,000,000. The new corporation which took over the assets and business of the partnership upon its expiration on January 31, 1923, shortly thereafter carried the good will in its balance sheet at a value of $500,000.
OPINION.
TRAMMELL: The petitioners contend that their proportional shares of the amount of $36,000 which was paid in stock to Sayre in 1923 in settlement of his claim for his share or interest in the good*1560 will of the partnership are allowable deductions either as an ordinary and necessary business expense and/or as a loss. The respondent contends that the amounts represent payment for Sayre's interest in the good will of the partnership, that they are therefore capital expenditures and as such are not allowable deductions.
In support of their contention the petitioners urge that the payment made to Sayre was for the purpose of avoiding the legal action threatened by him and its injurious effects as well as to assure his retirement from the business. They also urge that under the agreement of January 20, 1920, he was barred from any payment for good will.
The petitioners testified that in making the payments here in controversy they did not consider that they were made for any interest *1077 that Sayre might have had in the good will of the partnership, but that they made them for the purpose of preventing legal action. They also testified that they considered that when Sayre had received the payments provided for in the agreement of January 20, 1920, he would not be entitled to any further payments of any kind.
An examination of the partnership agreement of January 20, 1920, discloses*1561 that the term "good will" is used only twice. Once, in a provision giving four in number of the partners the power, in event that number of the partners desired to sell "the assets, business, and good will of the partnership as a going concern, either for cash or wholly or in part for securities or other property," to make such sale. The term is used again in the following provision:
TENTH. - In the event of the termination of this partnership at the end of the term hereby created or prior thereto (except in the event of sale as hereinbefore provided) the share of the said partner, William F. Vossler, shall be limited to the amount of capital contributed by him and his percentage of profits without taking into consideration any good will attached to the business of said partnership.
In view of the foregoing provision that the partner, Vossler, was not to receive anything on account of the good will of the business upon the expiration of the partnership, it is difficult to understand why a similar provision was not inserted in the agreement with respect to Sayre if it was intended, as the petitioners contend, that he, too, should not receive anything because of good will. It*1562 is true that the agreement did not specifically provide that upon expiration of the partnership Sayre should be paid anything on account of any interest he might have in the good will. However, on the other hand, it does not contain any provision that he should not be entitled to a payment on account thereof, as was specifically inserted with respect to Vossler. The absence of a provision barring Sayre from an interest in the good will becomes more significant when it is considered that he was to retire from the business at the expiration of the partnership agreement and that also he was to retire monthly the capital he had invested in the partnership, while Vossler was not to do either. Since there was no discussion among the partners prior to or at the time the agreement of January 20, 1920, was entered into as to what should be Sayre's rights with respect to the good will of the petitioner at the expiration of the agreement, and in view of the fact that the agreement was silent with respect to Sayre's rights thereto, but was specific that another partner should not be entitled to an interest therein, we are unable to concur in the contention of the petitioners that the agreement*1563 precluded Sayre from receiving any payment for good will.
The business carried on by the partnership formed under the agreement of January 20, 1920, had been carried on continuously *1078 by various partnerships since 1811. Since 1871 it had been operated at a profit every year except 1896 and 1920 and only in the latter year was it operated at a loss. Sales had increased from about $1,250,000 in 1880 to about $10,000,000 in the year ending January 31, 1923. The corporation which took over the assets and business of the partnership at its expiration on January 31, 1923, shortly thereafter carried the good will in its financial statement at a value of $500,000. We think it is clear that the partnership had good will of a substantial value. However, for our purpose it is not necessary to determine what that value was.
The good will of a partnership is ordinarily considered part of the property and assets of the firm and in the absence of a contrary agreement is to be accounted for upon the termination of the partnership. Here the partnership had a valuable asset which was not carried on its books, and consequently was not reflected in the capital accounts of the partners*1564 upon the partnership books. Sayre demanded that upon termination of the partnership this asset should be considered and that upon his retirement from the business he should be paid something on account of it. Since there was no agreement to the contrary, he was entitled to have the good will accounted for upon termination of the partnership. To the extent that the value of the good will increased the surplus of the partnership assets over liabilities, he had an interest therein. From the record in the case we think it was for this interest that the remaining partners agreed to pay him $36,000. The amount having been paid to Sayre for this purpose, we think it constituted a capital expenditure, and consequently the proportional parts thereof contributed by the partners were likewise capital expenditures and are therefore not allowable deductions in determining net income.
It may be well that the partners in contributing their porportional parts of the payments made to Sayre considered that they were making such payments solely for the purpose of avoiding litigation, but the fact remains that as a result of the expenditures so made by them they increased their own interest in*1565 the excess of the partnership assets over liabilities. The avoidance of litigation was only incidental to the object accomplished by the payment.
In this connection it is to be observed that by the agreement of January 12, 1923, Sayre agreed that for a period of five years he would not become interested in or identified with any business of a similar character to that carried on by the partnership or by the new corporation. The record does not show what consideration, if any, was given for this promise on the part of Sayre. But whatever the consideration was, the fact remains that the promise was acquired in connection with the settlement of Sayre's claim with respect to *1079 good will. To the extent that any part of the $36,000 was in payment for this promise it was capital expenditure. See ; .
Judgment will be entered for the respondent.