Diamond, Sol, et ux. v. Comm.

Decision will be entered for the respondent.

Richard Weinberger, for the petitioners. Lewis M. Porter, Jr., for the respondent.

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The Commissioner determined deficiencies of 36,657.57 and 16,507.27 in petitioners' income tax for the calendar years 1961 and 1962 respectively. After concessions, the following issues remain for decision: (1) Whether certain commissions received by petitioner Sol Diamond in 1961 must be included in petitioners' gross income for that year under section 61, I.R.C. 1954, and if so, whether purported "consultants fees" paid by him in respect of such commissions during that year are deductible as ordinary and necessary business expenses under section 162, I.R.C. 1954; and (2) whether petitioner Sol Diamond received ordinary income in the amount of 40,000 in 1962 as compensation for services rendered, and if so, whether petitioners are entitled to a deduction in that year for petitioner's share of an alleged 40,000 loss on termination of a partnership. FINDINGS OF FACT

The parties have stipulated certain facts which are incorporated herein by this reference.

Petitioners Sol and Muriel Diamond are husband and wife. They filed joint Federal income tax returns for the calendar years 1961 and 1962, prepared on the cash receipts and disbursements method of accounting, with the district director of internal revenue at Chicago, Ill. They resided in Chicago, Ill., at the time the petition in this case was filed.

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I

During 1961 and 1962 Sol Diamond (petitioner) was a builder and a mortgage broker. His building activities included the purchase of land, construction of buildings and homes on the land, and ultimately sale of the improved properties. In his capacity as a builder, petitioner served as president of First Federal Townhouses, Inc. From time to time petitioner arranged for loans to be made to that corporation on the basis of real estate mortgages. He arranged for the loans through a mortgage broker, and the corporation paid the broker a percentage commission for each loan.

While engaged in the building business, petitioner became acquainted with Henry Moravec, Sr. (Henry, Sr.), and his son, Henry Moravec, Jr. (Henry, Jr.), who were officers of Marshall Savings & Loan Association (Marshall) of Riverside, Ill., licensed and operated under the laws of the State of Illinois. At all times relevant herein, its deposits were insured by the Federal Savings & Loan Insurance Corporation. During 1961 Marshall was a "mutual association of depositors," and had at least 20,000 depositors. The Moravecs obtained and voted a majority of the depositors' proxies at the association's annual meetings, and as a result, they were able to name and elect a slate of directors at the meetings. Marshall's officers included Henry J. Moravec, Sr., as president, Henry J. Moravec, Jr., as executive vice president and secretary, and Jerome Moravec (Henry, Sr.'s brother) as vice president and treasurer.

During 1960 or 1961, Henry, Jr., suggested that petitioner become a mortgage broker. He told petitioner that Marshall needed responsible and successful builders as borrowers and that, as the result of his contacts in the building industry, petitioner could make more money by bringing borrowers to Marshall than he could by building homes. Petitioner accepted the offer and began work as a mortgage broker.

Both Henry, Sr., and Henry, Jr., instructed petitioner in his duties. As a mortgage broker, petitioner's functions included calling on builders, persuading them that he could provide them with better service than could the brokers with whom they were currently doing business, and assisting them in obtaining "payouts" on loans that he might arrange on their behalf.

Before approving a loan to any of petitioner's clients, Henry, Jr., visited and examined the property to be mortgaged. On occasion he told petitioner how much to charge as a broker's commission for arranging a loan from Marshall. However, Henry, Jr., did not determine whether petitioner in fact received such commissions.

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For about 6 months petitioner was unable to produce any business for Marshall. But during 1961 business improved, and petitioner was able to produce a number of builders in need of mortgage loans.

During 1961 petitioner received the following payments as commissions from borrowers with respect to loans which he had placed with Marshall:

 Borrower                      Date       Amount

At about the time that petitioner received each of the four foregoing commissions identified by an asterisk, he made a payment or payments by check for the benefit of the Moravecs which was equal to approximately 50 percent of the amount of the commission payment. Such payments were made as follows:

(1) Petitioner received a commission from Jack Netchin in the amount of 18,610.75 on March 14, 1961, and deposited that amount in his checking account at Peoples National Bank of Chicago. On the same date petitioner also remitted to the Moravecs 9,305 by check issued to "Real Consultant Associates." Real Consultant Associates was a partnership, formed in late 1960 or early 1961, and operated for

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a period of about 1 to 2 years. Its members were Henry, Sr., Henry, Jr., and Jerome Moravec, and it used Marshall's place of business, 3722 South Harlem, Riverside, Ill., as its address. (2) On May 4, 1961, petitioner received a commission from Netchin in the amount of 30,000 and deposited that amount in his checking account. Petitioner remitted 15,000 to the Moravecs by two checks, issued to Real Consultant Associates and dated April 26, 1961. The checks were deposited and cleared on May 9, 1961. (3) On May 26, 1961, petitioner received a third commission from Netchin in the amount of 7,539.50, and again deposited that amount in his checking account. On the same date he remitted 3,750 to the Moravecs by a check issued to "M. Bonke." M. Bonke was Marlene Bonke Moravec, the wife of Henry Moravec, Jr. (4) On September 20, 1961, petitioner received a commission from Krilich Builders in the amount of 2,687, and deposited that amount in his checking account. On September 21, 1961, he remitted to the Moravecs 1,343.50 by a check issued to M. Bonke.

In addition to the payments just described, petitioner made an additional payment by check in the amount of 10,000, issued to M. Bonke, and dated August 3, 1961. ¹

Petitioner made the foregoing payments, in the aggregate amount of 39,398.50, pursuant to an arrangement between him and Henry, Jr. The amount of each payment was determined at least in part, on the basis of the size and nature of the project being financed and the amount of the loan. There was some disagreement between petitioner and the Moravecs as to the amount or amounts which he owed them, and the final 10,000 payment was intended as a settlement of that dispute. The checks were issued to Real Consultant Associates and M. Bonke at the direction of Henry, Jr.

Real Consultant Associates included all of petitioner's payments in income on its 1961 partnership return. It also included in income payments received from three other individuals which were comparable in nature to those made by petitioner. None of Marshall's officers, directors, or depositors, other than the Moravecs, knew of the amounts paid by petitioner and the other three individuals to Real Consultant Associates. Indeed, with the exception of one employee, no one else in the Marshall organization was aware of the existence of the partnership.

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In addition to the commissions which they paid to petitioner, the borrowers also paid commissions directly to Marshall.

In December of 1964, the assets of Marshall were taken over by the State of Illinois.

The parties have stipulated that at all times relevant herein sections 2 and 1006 of title 18 of the United States Code ² were enforced by the U.S. Department of Justice.

On their 1961 joint Federal income tax return petitioners included in gross income all of the commission payments received from the borrowers and claimed a deduction in the amount of 39,398.50 as "Consultants fees," attributable to the six checks issued to Real Consultant Associates and M. Bonke, described above. In his statutory notice of deficiency, the Commissioner disallowed the claimed deduction. II

At all times relevant herein, Philip Kargman was involved in real estate activities in Chicago. His general mode of operation was to organize syndicates for the purpose of purchasing real property. The coventurers in such syndicates generally did not know one another and did not enter into partnership agreements. Ordinarily a land trust was established to hold title to the acquired property, and each coventurer retained a beneficial interest proportionate to his contribution to the total purchase price. Kargman managed the syndicates which he organized, and through his sole proprietorship, P. Kargman & Co., managed the acquired properties in return for a commission of about 3 or 4 percent.

In late 1961 Kargman was informed of the availability of a 10-story office building located at 201-207 West Monroe Street in Chicago. On December 6, 1961, the property became the subject of a real estate contract which Zel Kelvin (Kelvin) had executed as the purchaser, and which had not yet been executed by the seller. Kelvin made a deposit of 50,000 on the purchase price under the contract of 1,100,000. On the same day, December 6, 1961, Kargman and Kelvin entered into an agreement under which Kelvin agreed to assign to Kargman his entire interest in the real estate contract if it should be executed by the

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seller ³ on or before December 27, 1961. In return Kargman paid Kelvin 25,000 (which was to be refunded if the seller had not executed the contract by December 27) and agreed that upon delivery of the assignment he would assume Kelvin's obligations under the real estate contract and reimburse Kelvin for his 50,000 deposit. It was also contemplated that Kargman would pay any broker's fees or commissions due as the result of the transaction.

Kargman had known petitioner for many years at the time and was aware that petitioner engaged in a variety of real estate activities. (In fact, at about the same time Kargman and petitioner participated together in the acquisition of an unrelated motel property.) While he was negotiating for the West Monroe Street property, Kargman asked petitioner if he could arrange financing for the acquisition in the amount of 1,100,000. In return, Kargman offered to permit petitioner to participate with him in the venture. Petitioner stated that he could arrange for the financing, but insisted on a 60-percent interest in the venture. Although Kargman thought that they should each have 50-percent interests, he accepted petitioner's terms.

Petitioner succeeded in obtaining a mortgage loan from Marshall in the full amount of the 1,100,000 purchase price. Petitioner and Kargman executed a document, dated December 15, 1961, setting forth their agreement with regard to the venture. It provided in part as follows: AGREEMENT

This Agreement, made this 15th day of December, 1961, by and between PHILLIP KARGMAN, hereinafter referred to as Party of the First Part, and SOL DIAMOND, hereinafter referred to as Party of the Second Part, Witnesseth:

Whereas, Party of the First Part is in the process of purchasing a ten story office building commonly described as 201-7 West Monroe Street, Chicago, Illinois, and

Whereas, Party of the Second Part shall, if the contemplated acquisition is completed, be instrumental in obtaining mortgage financing in the sum of One Million one hundred Thousand (1,100,000.00) Dollars for the Party of the First Part from Marshall Savings and Loan Association, which mortgage shall bear interest not exceeding six and one-half (6 1/2%) per cent and which shall be for a period of not less than twenty-four (24) years and at a service cost not exceeding three (3) points, and

Whereas, said parties hereto are desirous of providing adequate and sufficient compensation to the Party of the Second Part for the services to be rendered by the Party of the Second Part in pursuance of the terms hereinafter recited and by reason thereof are desirous in joining in a joint venture agreement;

Now, Therefore, in Consideration of the sum of One (1.00) each to the other in hand paid and the mutual covenants herein contained, It Is Agreed as Follows:

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1. The parties hereto shall be associated as joint venturers, in pursuance of the terms hereof, for the purpose of owning and controlling the property owned by the Party of the First Part.

2. The name of the joint venture shall be "201-7 W. Monroe Street Building", 201-7 W. Monroe Street, Chicago, Illinois, or such other name or names as shall be determined by the parties hereto.

3. The term of this joint venture shall commence immediately upon the acquisition of the subject property and shall continue thereafter for a period of twenty-four (24) years unless sooner terminated by: (a) Agreement of the parties;

(b) Sale, liquidation or disposition by the parties of all or substantially all of the assets of the venture;

(c) Breach or violation of the terms hereof by Party of the Second Part.

4. All capitals and monies required for the acquisition of said office building in excess of One Million One Hundred Thousand (1,100,000.00) Dollars, shall be contributed by the Party of the First Part, provided, however, that notwithstanding that said capital or monies required shall not be deposited in the same proportion in which they shall be entitled to profits or losses, the Party of the First Part shall receive forty (40%) per cent of the profits and the Party of the Second Part shall receive sixty (60%) per cent of all profits and shall be chargeable with all losses in the same proportions.

5. In the event the premises acquired by the Party of the First Part are sold to a Bona Fide purchaser, it is agreed that the net cash received from the sale price, less all expenditures, including without limitation thereby, closing expenses, professional fees, broker's commission, title charges and deductions for pro-rations, shall be apportioned and paid as follows:

(a) First to the repayment to the Party of the First part of any sums of money spent or required in the acquisition of the subject premises;

(b) The net profits thereafter to be distributed in accordance with the holdings of the parties hereto, namely: PHILLIP KARGMAN -- 40% SOL DIAMOND -- 60%

If said sale is consummated on an installment basis, this venture shall not terminate, but shall continue for the duration of such payments, however, provided, from all such installment payments the sums thereunder paid by the purchaser shall be paid and distributed as hereinabove set forth.

On or about January 3, 1962, Kelvin assigned his interest in the real estate contract to Kargman.

On or about January 5, 1962, Kargman and petitioner executed a form "trust agreement," sometimes known as an Illinois land trust. Under the agreement title to the Monroe Street property was to be held by the Exchange National Bank of Chicago as trustee for the benefit of Kargman and petitioner, with beneficial interests of 40 percent and 60 percent, respectively. The trust agreement provided in part as follows:

It Is Understood And Agreed between the parties hereto * * * that the interest of any beneficiary hereunder shall consist solely of a power of direction to deal with the title to said property and to manage and control said property as hereinafter

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provided, and the right to receive the proceeds from rentals and from mortgages, sales or other disposition of said premises, and that such right in the avails of said property shall be deemed to be personal property, and may be assigned and transferred as such * * * and that no beneficiary now has, and that no beneficiary hereunder at any time shall have any right, title or interest in or to any portion of said real estate as such, either legal or equitable, but only an interest in the earnings, avails and proceeds as aforesaid. * * * * * * *

It is understood and agreed by the parties hereto and by any person who may hereafter become a party hereto, that said The Exchange National Bank of Chicago will deal with said real estate only when authorized to do so in writing and that (notwithstanding any change in the beneficiary or beneficiaries hereunder) it will on the written direction of all the beneficiaries

or such other person or persons as shall be from time to time named in writing by the beneficiary or beneficiaries, or on the written direction of such person or persons as may be beneficiary or beneficiaries at the time, make deeds for, or otherwise deal with the title to said real estate, provided, however, that the trustee shall not be required to enter into any personal obligation or liability in dealing with said land or to make itself liable for any damages, costs, expenses, fines or penalties, or to deal with the title so long as any money is due to it hereunder. The trustee shall not be required to inquire into the propriety of any such direction.

The beneficiary or beneficiaries hereunder, in his, her or their own right shall have the management of said property and control of the selling, renting and handling thereof, and shall collect and handle the rents, earnings, avails and proceeds thereof, and said trustee shall have no duty in respect to such management or control, or the collection, handling or application of such rents, earnings, avails or proceeds, or in respect to the payment of taxes or assessments or in respect to insurance, litigation or otherwise, except on written direction as hereinabove provided, and after the payment to it of all money necessary to carry out said instructions. * * *

Closing activities in respect of the acquisition of the West Monroe Street property were commenced on February 15, 1962, and became final on February 18, 1962. The Exchange Bank as trustee took title to the property and executed the mortgage and mortgage note. As arranged previously, the amount of the loan from Marshall was 1,100,000. From this amount, 38,000 was placed in an escrow account for payment of taxes and insurance, 8,596.50 was deducted as interest expense, and 33,000 was retained by Marshall as the cost of obtaining the loan. The remainder, 1,020,403.50, was initially placed in an escrow account and used to pay the net amount owed to the seller, 1,011,598.83. ⁴ In connection with the acquisition of the property Kargman

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made net cash outlays in the aggregate amount of 78,195.33, as follows:

 (a) Payment to Kelvin                                      $ 25,000.00

In accordance with the understanding between Kargman and petitioner, the property was managed by Kargman's sole proprietorship, P. Kargman & Co.

During the course of the foregoing events, Kargman was approached by George Liederman with regard to the Monroe Street property. Liederman had originally referred the broker handling the property to Kargman, and complained that therefore he, rather than petitioner, should have participated in the venture. Kargman suggested that Liederman make an offer for petitioner's interest in the land trust. Kargman and Liederman agreed that they would each hold 50-percent interests in the trust if petitioner accepted the offer. Liederman offered petitioner 20,000 for his interest and they eventually agreed upon a purchase price of 40,000. The sale was effected in the following manner: On March 8, 1962, petitioner assigned his 60-percent interest in the trust to Kargman in exchange for Kargman's check for 40,000. Liederman then paid Kargman 40,000, practically all of it in cash, and acquired in return a 50-percent interest in the trust. As a result, Kargman's interest in the trust was increased from 40 to 50 percent.

On their 1962 joint income tax return, petitioners reported a 40,000 short-term capital gain attributed to "sale of partnership interest, 201 W. Monroe Building." In his statutory notice of deficiency the Commissioner determined that the 40,000 reported as short-term capital gain was instead includable in petitioner's ordinary income for 1962. ⁵

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OPINION

1. Payments to the Moravecs. -- In 1961 petitioner Sol Diamond, as a mortgage broker, received an aggregate of 145,186.37 in commissions or fees from various borrowers for obtaining some 24 loans on their behalf from Marshall Savings & Loan Association, which was controlled by members of the Moravec family. He reported that amount as income and claimed various deductions as expenses incurred in the conduct of his mortgage brokerage business. Among those deductions was an item of 39,398.50 described as "Consultants fees." That item represents the sum of payments made by petitioner to the Moravecs in connection with four of the foregoing loans plus a further payment to them that was not identified with any particular loan. The Commissioner disallowed the claimed deduction. He ruled that the "Consultants fees" item was "not deductible under the provisions of section 162 of the Internal Revenue Code of 1954, or any other section thereof." Section 162(a) grants a deduction for "all the ordinary and necessary expenses paid or incurred * * * in carrying on any trade or business."

In their original petition in this Court petitioners' sole allegation of error was that the Commissioner had erroneously determined that the moneys paid by petitioner Sol Diamond "for services of others in assisting him in arranging and expediting loans was not deductible under Section 162 of the Internal Revenue Code as an ordinary and necessary business expense." It was not until the trial of this case that petitioners filed an amendment to their petition, claiming in the alternative that petitioner acted merely as a conduit for the Moravecs in respect of the amounts paid to them and that the aggregate of such amounts ⁶ should never have been included in gross income in the first instance. While petitioners argue both points on brief, they appear to place their principal emphasis upon their new alternative position. We conclude that they cannot prevail on either theory.

(a) Exclusion from gross income. -- We note at the outset that petitioners' alternative position is inconsistent not only with their 1961 income tax return, which reported the full 145,186.37 mortgage loan commissions (unreduced by the payments to the Moravecs), but also with the original petition filed in this Court. Thus, in their original petition they painted a picture of services rendered by the Moravecs, of petitioner's having engaged them to assist him in his activities as a mortgage broker, and of the payments made by him to the Moravecs for such services. The theory of the amended petition was entirely

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different. It treated the Moravecs as being in complete control of the commissions received by petitioner from the borrowers, and proceeded upon the explicit assumption that the Moravecs merely "permitted Petitioner to retain all commissions other than the amounts" which he paid over to them. Thus, it portrayed petitioner "as a conduit for the Moravecs," and sought to have excluded from the commissions actually received by petitioner the amounts which he paid to them as "Consultants fees." While it is of course open to petitioners to present alternative theories, we must nevertheless evaluate the evidence with particular care to the extent that a new theory depends upon facts that may be inconsistent with allegations in the original petition which petitioners had verified as true.

We accept as sound law the rule that a taxpayer need not treat as income moneys which he did not receive under a claim of right, which were not his to keep, and which he was required to transmit to someone else as a mere conduit. ⁷ But, as we evaluate the evidence, petitioner in this case was no mere conduit.

Petitioner testified that he originally had an understanding with Henry Moravec, Jr., that he would pay over to the Moravecs 50 percent of the commissions he received, but that after making a number of such payments, he was released from his obligation as the result of unexpected expenses which he incurred. We found his testimony altogether unconvincing. To be sure, four of petitioner's five payments to the Moravecs were equal or approximately equal to 50 percent of commissions he received at about the same time. But petitioner made no payments that could be identified with the 20 other commissions he received during 1961. Moreover, the chronology of the commissions and payments belies petitioner's account of his original understanding with Henry, Jr.; payments were not made when the first commissions were received in 1961, nor were they made regularly. Furthermore, although Henry Moravec, Jr., did not testify at the trial herein, the parties have stipulated what his testimony would have been if he had been called to testify. As stipulated, his testimony does not support petitioner's account of their understanding and in some respects conflicts with petitioner's testimony. We conclude that petitioners have failed to carry their burden of proof, that the commissions were received by petitioner under a claim of right, and that they must include all commissions received in 1961 in their gross income. Cf.

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North American Oil Consolidated v. Burnet, 286 U.S. 417, 424; United Draperies, Inc. v. Commissioner, 340 F. 2d 936, 938 (C.A. 7), affirming 41 T.C. 457, certiorari denied 382 U.S. 813. As we pointed out in Boyle, Flagg & Seaman, Inc., 25 T.C. 43, 48, "If petitioner is to be entitled to a tax benefit with respect to the amounts paid to the [Moravecs] * * *, such benefit must be in the form of a deduction from gross income * * *." ⁸

(b) Ordinary and necessary business expenses. -- We also conclude that petitioners may not deduct the payments made to the Moravecs as ordinary and necessary business expenses. As noted above, the Commissioner's disallowance of the claimed deduction was based generally upon his determination that it failed to comply with the requirements of section 162, which grants a deduction for "ordinary and necessary" business expenses. These provisions have been regarded as excluding those deductions the allowance of which would "frustrate sharply defined national or state policies proscribing particular types of conduct." Commissioner v. Heininger, 320 U.S. 467, 473; Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30; Commissioner v. Tellier, 383 U.S. 687, 694; Dixie Machine Welding & Metal Works, Inc. v. United States, 315 F. 2d 439 (C.A. 5), certiorari denied 373 U.S. 950; Coed Records, Inc., 47 T.C. 422; see also Boyle, Flagg & Seaman, Inc., 25 T.C. 43, 48-51, cited with apparent approval in Tank Truck Rentals, Inc., 356 U.S. at 35. In its opening statement to this Court at the trial, the Government indicated that it was challenging the claimed deduction not only on the grounds that the expenditures were not "ordinary and necessary" to petitioner's business, but also on the further ground that they were in contravention of sharply defined public policy. ⁹ Petitioners were thus put on notice, if such notice were deemed to be necessary, that their burden of proof related to both aspects of the deductions which they sought to defend. And while it is true that the Government's brief, filed after the trial, appears to rely only upon the public policy ground, it is open to this Court to decide this issue upon either ground. ¹⁰

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Accordingly, although we think that there is considerable force to the public policy argument that the allowance of the deduction would contravene a sharply defined policy of the United States, ¹¹ we prefer to rest our decision on the other ground that petitioners have failed to establish that the payments to the Moravecs were "ordinary and necessary" expenses of the mortgage brokerage business.

The payments were designated on petitioners' returns as "Consultants fees," but the record does not contain any satisfying evidence as to the reason why they were made. To be sure, there was testimony that the Moravecs, or one of them, rendered some services to petitioner, but it had a hollow ring. The payments were made secretly and deceptively. With the exception of one person, none of Marshall's officers, directors, or depositors knew of the payments or even of the existence of Real Consultant Associates. Some of the checks were issued to Real Consultant Associates; others were issued to "M. Bonke." No explanation has been offered for this highly unusual procedure. Apart from Henry, Jr.'s stipulated testimony that three other individuals made similar payments to the Moravecs, the record is devoid of proof that such payments were customary or normal in the savings and loan industry. What we said in Frederick Steel Co., 42 T.C. 13, 25, is equally applicable here:

This case is to be sharply distinguished from Lilly v. Commissioner, 343 U.S. 90 * * * where the Court concluded that the payments were "ordinary." The Court stated, at page 93, that the facts were "not in dispute" and that under the "long-established practice in the optical industry in the localities where petitioner did business, [the payments] * * * were normal, usual and customary in size and character. The transactions from which they arose were of common or frequent occurrence in the type of business involved. They reflected a nationwide practice." ⁵ We cannot make any such a finding in this case. The payments herein were not deductible. Cf. United Draperies, Inc., 41 T.C. 457. [Footnote omitted.]

The burden of proof is upon petitioners and in our judgment they have failed to prove the payments in issue to be "ordinary" within the meaning of section 162. The deduction is therefore disallowed. See United Draperies, Inc. v. Commissioner, 340 F. 2d 936, 938 (C.A. 7), affirming 41 T.C. 457, 463, certiorari denied 382 U.S. 813.

2. 201-207 W. Monroe Street property. -- Petitioner performed services for Kargman in obtaining a 1,100,000 mortgage loan for the Monroe Street property which Kargman was in the process of purchasing. The loan was in the full amount of the purchase price. As compensation for his services Kargman agreed to give petitioner an

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interest in the venture whereby for 24 years petitioner would become entitled to 60 percent of the earnings from the property and would be chargeable with losses in the same proportion; also,in the event of future sale of the property petitioner would become entitled to 60 percent of the net proceeds after Kargman had been reimbursed in full for the funds expended by him in the acquisition of the property. Petitioner in fact acquired that interest on February 18, 1962, when title was finally transferred to The Exchange National Bank under a so-called Illinois land trust, and he thereby became a 60-percent beneficiary of that land trust. On March 8, 1962, less than 3 weeks after he had acquired that interest, he sold it for 40,000. The Commissioner argues that the interest had a fair market value of 40,000 when petitioner got it on February 18, 1962, and that since it was received by him as compensation for services it represented ordinary income to him under section 61(a)(1), I.R.C. 1954, ¹² and regs. sec. 1.61-2(d)(1). ¹³ We agree.

Petitioners do not appear to challenge the basic argument that the fair market value of property received for services must be treated as ordinary income. They seek to avoid the consequences of that result here, however, by contending that petitioner received only an interest in a partnership (limited to a percentage of its future earnings) for his services and that he realized no income thereby by reason of section 721, I.R.C. 1954, as interpreted by regs. sec. 1.721-1 (b)(1); that in any event the interest had no value when received; and finally that when petitioner sold his interest there was a termination of the alleged partnership and that he is entitled to an "offset deduction" for his share of an alleged loss of the partnership. We think that none of these points is sound.

(a) Although the relationship between petitioner and Kargman was referred to in some of the documents in evidence as a "partnership," it is by no means clear that petitioner's 60-percent beneficial interest in the land trust was that of a partner. However, we need not pass upon the matter, because we think that even if it were a partnership interest, its fair market value must nevertheless be included in

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income under section 61 and that neither section 721 nor the regulations construing it render section 61 inapplicable here. Section 721 provides:

SEC. 721. NONRECOGNITION OF GAIN OR LOSS ON CONTRIBUTION.

No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.

As its terms plainly indicate, it provides merely that no gain or loss shall be recognized to a partner who contributes property to a partnership in exchange for an interest therein. The present case simply does not come within these provisions, for it is clear that a contribution of services is not a contribution of "property." ¹⁴

In construing section 721, the regulations state: Sec. 1.721-1 Nonrecognition of gain or loss on contribution.

(b)(1) Normally, under local law, each partner is entitled to be repaid his contributions of money or other property to the partnership (at the value placed upon such property by the partnership at the time of the contribution) whether made at the formation of the partnership or subsequent thereto. To the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services (or in satisfaction of an obligation), section 721 does not apply. The value of an interest in such partnership capital so transferred to a partner as compensation for services constitutes income to the partner under section 61 * * *

Relying upon these provisions, petitioners contend that when a taxpayer receives a partnership interest as compensation for services he is required to account for that interest at once as ordinary income if he acquires an interest in partnership capital, but not if he receives only the right to share in the partnership's future profits and losses. It is true that the regulations make section 721 inapplicable in the case of a taxpayer who has received an interest in the capital contribution made by another partner. Cf. United States v. Frazell, 339 F. 2d 885 (C.A. 5), denying petition for rehearing of 335 F. 2d 487, certiorari denied 380 U.S. 961. But the effect of the first parenthetical clause in the second sentence of these regulations, "(as distinguished from a

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share in partnership profits)," upon which petitioners place their sole reliance, is obscure. Certainly, unless section 721 of the Code grants the relief which petitioners seek, they are left subject to section 61. Yet nothing in the foregoing regulations explicitly states that a partner who has received a partnership interest like the one before us in exchange for services already performed comes within the provisions of sectio/721/. The parenthetical language does not so state. At most, it excludes that type of situation from the rule which the regulations affirmatively set forth in respect of readjustments of capital interests; but it does not deal one way or the other with situations described in the parenthetical clause. The reason for this kind of opaque draftsmanship in the regulations is by no means clear to us. However, what is plain is that the regulations do not call for the applicability of section 721 where a taxpayer has performed services for someone who has compensated him therefor by giving him an interest in a partnership that came into being at a later date. Regardless of whether there may be some kind of equitable justification for giving the parenthetical clause some limited form of affirmative operative scope, as perhaps where there is a readjustment of partners' shares to reflect services being performed by one of the partners, we cannot believe that the regulations were ever intended to bring section 721 into play in a situation like the one before us. The Commissioner disavows such intention, and we agree with him. To apply section 721 here would call for a distortion of statutory language, and we cannot believe that the regulations were ever intended to require that result. Certainly, in the absence of a clearer statement to that effect, we will not approve any such interpretation of them as is requested by petitioners.

(b) The alternative argument that petitioner's interest in the venture had no value at the time he acquired it is unconvincing. To be sure, as he points out, the December 15, 1961, agreement between him and Kargman provided that neither party could assign it without the consent of the other. But even if that restriction on assignment carried over to the interests in the land trust, which were explicitly declared to be assignable, such restriction would not deprive petitioner's interest of any fair market value. It was a conditional, not an absolute restriction, and, at most, it would merely be a factor to be taken into account in determining the amount of such value. ¹⁵ Cf. Estate of Pearl Gibbons Reynolds, 55 T.C. 172, 188-191, and cases cited therein; Heiner v. Gwinner, 114 F. 2d 723 (C.A. 3), certiorari denied 311 U.S. 714. In the present case petitioner sold his interest to Liederman less than 3 weeks after he received it for 40,000. Presumably -- and petitioner

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has not shown otherwise -- Liederman acquired the interest subject to the same restriction (if any); yet he was willing to pay 40,000 for it. On this record, we cannot say that the Commissioner erred in valuing petitioner's interest at that amount. ¹⁶

(c) Petitioners have also urged that they are entitled to a deduction for petitioner's share of partnership loss stemming from the "termination" of the partnership. They rely upon sections 708 ¹⁷ and 752, ¹⁸ I.R.C. 1954. Cf. regs. sec. 1.708-1(b)(1)(ii). Petitioners urge that on termination of the partnership, each partner was entitled to take into account, in determining his distributive share of the partnership's taxable income or loss, his distributive share of the partnership's unamortized loan expense of 33,000. See sec. 702(a)(9); ¹⁹ cf. Anover Realty Corp., 33 T.C. 671, 675. However, regardless of whatever validity their argument may have, they have produced no evidence of the venture's income for the period during which Kargman and petitioner

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were associated. Consequently they have failed to carry their burden of proof in establishing the purported partnership loss. We uphold the Commissioner's determination.

Decision will be entered for the respondent.

* These payments are described in greater detail below.

¹ The three checks issued to "M. Bonke" were subsequently endorsed as follows. The first check, dated May 26, 1961, was endorsed: "Payable only to: Henry J. Moravec, Jr., M. Bonke, agent", "Payable only to Real Consultant Assoc., Henry J. Moravec, Jr.", and "Pay to the order of Continental Illinois National Bank and Trust Company of Chicago, Chicago, Ill. Real Consultant Associates." The second check, dated Aug. 3, 1961, was endorsed: "M. Bonke", and "Pay to the order of Continental Ill. National Bank & Trust Co. to my account, Henry J. Moravec, Jr." The third check, dated Sept. 21, 1961, was endorsed: "M. Bonke. For deposit only to the checking account of: Henry J. Moravec, Jr. and Marlene B. Moravec."

² Sec. 2. Principals.

(a) Whoever commits an offense against the United States or aids, abets, counsels, commands, induces or procures its commission, is punishable as a principal.

Sec. 1006. Federal credit institution entries, reports and transactions.

Whoever, being an officer, agent or employee of or connected in any capacity with * * * any institution the accounts of which are insured by the Federal Savings and Loan Insurance Corporation, * * * with intent to defraud * * * any corporation, institution, or association referred to in this section, participates or shares in or receives directly or indirectly any money, profit, property, or benefits through any transaction, loan, commission, contract, or any other act of any such corporation, institution, or association, shall be fined not more than 10,000 or imprisoned not more than five years, or both.

³ The seller was a trust that was required to obtain the consent of the owners of 66 2/3 percent or more of the beneficial interests in the trust before it could execute the contract.

⁴ The 1,100,000 purchase price originally owing to the sellers was reduced by the 50,000 deposit and by 38,401.17 of the seller's liabilities which were assumed by the purchaser.

⁵ The reclassification of this item as ordinary income resulted in a deficiency because it thereby became unavailable to absorb a reported short-term capital loss which then was required to be used as an offset against a reported long-term capital gain.

⁶ The amended petition referred to a figure of 36,657.57. However, the sum of the payments to the Moravecs was 39,398.50, and it was this figure that was probably intended. The 36,657.57 figure is precisely the amount of the deficiency determined for 1961.

⁷ See Stevens Bros. & Miller-Hutchinson Co., 24 T.C. 953, 957; Horace Mill, 5 T.C. 691, 694; Mark D. Eagleton, 35 B.T.A. 551, 561-563, affirmed on other issues 97 F. 2d 62 (C.A. 8); Joan A. Nunez, 28 T.C.M. 1150, P-H. Memo. 69-1246; Estate of John Kalichuk, 23 T.C.M. 2089, P-H. Memo. 64-2307. Compare also those cases in which payments or rebates between vendor and vendee have been regarded as merely affecting the determination of the net sales price. Pittsburgh Milk Co., 26 T.C. 707; Atzingen-Whitehouse Dairy, Inc., 36 T.C. 173; cf. Allen Schiffman, 47 T.C. 537.

⁸Lashells' Estate v. Commissioner, 208 F. 2d 430 (C.A. 6), relied upon by petitioners, was distinguished in Boyle, Flagg & Seaman, Inc., 25 T.C. at 48, as well as in United Draperies, Inc. by the Seventh Circuit to which appeal in the present case lies. The Sixth Circuit in Lashells regarded the taxpayer as a mere conduit on the record in that case. We think that United Draperies is controlling here on the facts before us.

⁹ Government counsel stated as follows:

"The questions presented to the Court, with respect to the foregoing issue, are, one, whether the expenditures for which petitioners claimed a deduction as consultants fees constitute expenses which are ordinary and necessary within the meaning of Section 162 of the 1954 Code, and/or, two, whether such expenditures are in contravention of sharply defined public policy as expressed in Sections Two and 1006 of Title Eighteen United States Code."

¹⁰ Indeed, the rule is well settled that a deficiency may be approved on grounds other than those relied upon by the Commissioner or even where the grounds advanced by him may be incorrect. See Wilkes-Barre Carriage Co., 39 T.C. 839, and cases cited at 845-846, affirmed 332 F. 2d 421 (C.A. 2).

¹¹ In this connection the Commissioner contends that the receipt of the payments by the Moravecs was a violation of sec. 1006, tit. 18, of the United States Code, see fn. 2 supra p. 535, as those provisions have been construed in Beaudine v. United States, 368 F. 2d 417 (C.A. 5), and that petitioner himself was guilty in respect thereof by reason of sec. 2 of that title.

¹² SEC. 61. GROSS INCOME DEFINED.

(a) General Definition. -- Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

(1) Compensation for services, including fees, commissions, and similar items; * * *

¹³ Sec. 1.62-2 Compensation for services, including fees, commissions, and similar items. * * * *

(d) Compensation paid other than in cash. -- (1) In general. If services are paid for other than in money, the fair market value of the property or services taken in payment must be included in income. If the services were rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary. * * *

¹⁴ Cognate provisions of the 1954 Code in sec. 351, relating to nonrecognition of gain or loss in respect to contributions of property to a corporation in return for its stock or securities explicitly state that for purposes of that section "stock or securities issued for services shall not be considered as issued in return for property." However, the quoted language simply codified what was implicit in prior case law; under the predecessor of sec. 351 in the 1939 Code, which contained no such language, there was no suggestion that services might be included within the meaning of "property." See Mojonnier & Sons, Inc., 12 T.C. 837, 847-849; Florida Machine & Foundry Co. v. Fahs, 73 F. Supp. 379, 380-381 (S.D. Fla.), affirmed 168 F. 2d 957 (C.A. 5); Columbia Oil & Gas Co., 41 B.T.A. 38, 44-45, affirmed on other issues 118 F. 2d 459 (C.A. 5); Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders sec. 3.02 at 70 (1960); Mertens, Law of Federal Income Taxation sec. 20.47 at 138 (1965); Willis, Handbook of Partnership Taxation sec. 5.03 at 55 fn. 7 (1957).

¹⁵North American Philips Co., Inc., 21 T.C.M. 1497, 1506, P-H Memo. 62-1658, 62-1669; cf. Edward C. Victorson, 21 T.C.M. 1238, 1246, P-H Memo. 62-1370, 62-1379, affirmed 326 F. 2d 264 (C.A. 2).

¹⁶ Even if one of petitioners' two foregoing arguments had prevailed, it would still not be altogether clear that the 40,000 petitioner received on the sale of his interest in the land trust would qualify as a short-term capital gain. Although sec. 741, I.R.C. 1954, provides for capital gain treatment on the sale of an "interest in a partnership," it is not at all clear that it contemplates the sale of a right to receive income in the future in return for a lump sum payment which would enable a taxpayer to convert what would otherwise be taxable as ordinary income intocapital gain. Cf. Commissioner v. Gillette Motor Transport, Inc., 364 U.S. 130, 134-135; Commissioner v. P. G. Lake, Inc., 356 U.S. 260, 265-266; Hort v. Commissioner, 313 U.S. 28; Nat Holt, 35 T.C. 588, 599-600, affirmed 303 F. 2d 687 (C.A. 9). In view of our disposition of this case, however, we need not reach this question.

¹⁷ SEC. 708. CONTINUATION OF PARTNERSHIP.

(a) General Rule. -- For purposes of this subchapter, an existing partnership shall be considered as continuing if it is not terminated. (b) Termination. --

(1) General Rule. -- For purposes of subsection (a), a partnership shall be considered as terminated only if -- * * * *

(B) within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.

¹⁸ SEC. 752. TREATMENT OF CERTAIN LIABILITIES.

(a) Increase in Partner's Liabilities. -- Any increase in a partner's share of the liabilities of a partnership, or any increase in a partner's individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership.

(b) Decrease in Partner's Liabilities. -- Any decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities by reason of the assumption by the partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the partnership.

(c) Liability to Which Property is Subject. -- For purposes of this section, a liability to which property is subject shall, to the extent of the fair market value of such property, be considered as a liability of the owner of the property.

(d) Sale or Exchange of an Interest. -- In the case of a sale or exchange of an interest in a partnership, liabilities shall be treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships. ¹⁹ SEC. 702. INCOME AND CREDITS OF PARTNER.

(a) General Rule. -- In determining his income tax, each partner shall take into account separately his distributive share of the partnership's -- * * * *

(9) taxable income or loss, exclusive of items requiring separate computation under other paragraphs of this subsection.