34 T.C. 235">*235 In these consolidated proceedings, petitioners contest the following deficiencies and allege the following overpayments in income taxes for the years indicated:

The questions remaining for decisions are as follows:

1. (a) Whether a partnership, in which the male petitioners in Docket Nos. 67160, 67161, and 67162 were members, was entitled to deduct on its return for the fiscal year ending January 31, 1953, certain amounts paid to Stanley C. Landen (petitioner in Docket No. 67310), allegedly for his covenant not to compete.

(b) Conversely, whether Landen was entitled to treat that portion of such amounts received in 1952 as capital gain upon the sale of his interest in the partnership.

2. Whether petitioners in Docket Nos. 67160, 67161, 1960 U.S. Tax Ct. LEXIS 153">*155 and 67162 properly reported their distributive shares of partnership income 34 T.C. 235">*236 for February 1952 on their individual returns for the calendar year 1953, or whether, as now alleged by petitioners, they should have reported this income on their returns for the calendar year 1952.

FINDINGS OF FACT.

Certain facts have been stipulated and are incorporated herein by reference.

Ray H. and Doris L. Schulz are husband and wife residing in Pasadena, California. John W. and Lucille Schulz are husband and wife residing in San Gabriel, California. Melvin F. and Pauline Klagues are husband and wife residing in Arcadia, California. The aforementioned husbands and wives, respectively, filed joint income tax returns for the calendar year 1953 with the district director of internal revenue, Los Angeles, California.

Stanley C. and Victoria M. Landen, husband and wife residing in San Marino, California, filed a joint income tax return for the calendar year 1952 with the district director of internal revenue, Los Angeles, California.

On or about November 1, 1946, Stanley C. Landen (hereinafter referred to as Landen), Ray H. Schulz (hereinafter referred to as Ray), John W. Schulz (hereinafter1960 U.S. Tax Ct. LEXIS 153">*156 referred to as John), and Melvin F. Klagues (hereinafter referred to as Klagues) organized a partnership by oral agreement under the firm name of Schulz Tool and Manufacturing Company (hereinafter referred to as Old Tool). Each partner made an original investment in the approximate amount of $ 3,000 and each had an equal interest in the partnership. Subsequently, all additional capital employed in the business was obtained by the retention of earnings.

Old Tool operated continuously with the four original partners until March 31, 1950, when it was dissolved. On or about April 1, 1950, the business theretofore operated as Old Tool was transferred to Schulz Tool and Manufacturing Co., Inc. (hereinafter referred to as Corporation), which had been organized on November 29, 1949. The capital stock of Corporation was held equally by Landen, Ray, John, and Klagues.

Corporation, under the continuous ownership of Landen, Ray, John, and Klagues, operated the business until May 31, 1951, when its assets and liabilities were distributed in liquidation to the stockholders. On or about June 1, 1951, Landen, Ray, John, and Klagues organized a partnership under the firm name of Schulz Tool and1960 U.S. Tax Ct. LEXIS 153">*157 Manufacturing Company (hereinafter referred to as Tool), and transferred to it the assets and liabilities which they had received in liquidation of Corporation.

34 T.C. 235">*237 In 1952, Landen's interest in Tool was sold to Ray, John, and Klagues, and Tool was dissolved. Thereafter, Ray, John, and Klagues continued the operation of the business as equal partners under the same firm name of Schulz Tool and Manufacturing Company (hereinafter referred to as Manufacturing). The business carried on continuously by Old Tool, Corporation, Tool, and Manufacturing is hereinafter referred to collectively as Schulz Tool.

The initial business of Schulz Tool had two branches: The manufacture and sale of aircraft system fuel valves, and the performance of "job machine work." The fuel valves were "proprietary items" of Schulz Tool, being designed and developed by it to meet the requirements of aircraft manufacturers. "Job machine work," in contrast, consisted of custom machining parts on orders from manufacturers who provided the necessary blueprints and designs. As the valve manufacturing aspect of the business developed and became increasingly profitable, it required a greater percentage of the 1960 U.S. Tax Ct. LEXIS 153">*158 machine time and resources available to Schulz Tool. This resulted in decreasing emphasis on job machine work. By January 31, 1952, Schulz Tool had either wound up or terminated existing machine work orders, and had ceased soliciting further orders.

After the close of World War II, and prior to the formation of Old Tool, Ray had purchased from Public Service Brass Corporation, his then employer, the manufacturing and engineering specifications for a fuel level control valve and a fuel vent float valve which he had developed while an employee and which were of potential use in the aircraft industry. However, there were no production orders for these valves in late 1946. They were being used experimentally by Lockheed Aircraft Corporation on its F-80 jet fighter and its Constellation, but the rubber diaphragms used in their operation were subject to deterioration, and to bursting at high flow refueling speeds.

At the time Old Tool was formed, Ray had some of these valves in process in his garage where he was manufacturing them under the name Schulz Tool and Manufacturing Company; the partnership retained this name. The experimental use of these valves by Lockheed gave Schulz Tool1960 U.S. Tax Ct. LEXIS 153">*159 an "in" to that company. The partners devoted their combined efforts to developing an improved valve without the defects of the original rubber diaphragm type. In the early months, each partner worked an average of approximately 90 hours per week; thereafter, and as of January 31, 1952, each partner worked an average of approximately 60 hours per week.

After 2 years of developmental work, the partners succeeded in producing a piston type valve which, through extensive engineering tests and promotional efforts, was shown to be superior in quality and performance to valves produced by competitors, as well as being 34 T.C. 235">*238 cheaper in price. The piston type valve received "most favorable acceptance" from substantially all major aircraft manufacturers and by the Government for use by the Air Force and Navy.

Schulz Tool's customers included Convair, Lockheed Aircraft Corporation, Republic Aviation Corporation, Canadair, North American Aviation, Northrop Aircraft, Inc., Rohr Aircraft Corporation, and Boeing Aircraft Company. A letter received from Republic Aircraft Corporation in 1949 stated that the continued production and delivery of its F-84G airplane was contingent on the uninterrupted1960 U.S. Tax Ct. LEXIS 153">*160 supply of Schulz Tool's valves, and that Schulz Tool was Republic's sole source of supply for these valves. Schulz Tool also held prime military contracts with the Air Force and Navy. As of January 31, 1952, Schulz Tool valves were being used on all types of jets and reciprocating engine aircraft for military use.

Sales and product acceptance were achieved by direct contact with the Air Force, Navy, and major aircraft companies, which entailed extensive travel and numerous conferences with prospective purchasers. All of the sales activities, including customer relations and customer engineering liaison, were handled by Ray. Klagues also handled "some" contract work, but his responsibilities included plant administration and supervision of industrial relations and personnel. Landen and John were primarily concerned with internal operations. Both were machinists and toolmakers by trade, Landen being considerably more experienced. Landen had no duties in the sales, design, or engineering phase of the business, although he did have some sales contacts with respect to the job machine work which he supervised before it was discontinued.

Demand for Schulz Tool's valves for military1960 U.S. Tax Ct. LEXIS 153">*161 use outstripped its own ability to supply, to the extent that the partners were obliged to subcontract a substantial portion of machine work on its proprietary items. Schulz Tool also experienced a considerable repeat order business, as was customary with aircraft suppliers. From 1948 through 1954, the same basic valves, with modifications, were manufactured by Schulz Tool for Lockheed's F-80 and Constellation. Orders for valves to be installed on aircraft were normally accompanied by orders for spare parts in the amount of "probably four times" the orders for installation.

Pursuant to specification requirements imposed by the Government, through the airframe manufacturers, each valve manufactured and sold by Schulz Tool was marked with an identification number and labeled with the name of Schulz Tool. The name was also stamped on valves produced for commercial aircraft as identification for possible replacements and for "good advertising." These markings were accomplished by affixing a metal name plate by screws or pins to the side of one of the main castings of the valve.

34 T.C. 235">*239 Schulz Tool developed numerous manufacturing techniques and machining operations of its own, resulting1960 U.S. Tax Ct. LEXIS 153">*162 in cost reductions, improved products, and an overall conservation of labor and material. In instances where specialized machines were unavailable on the open market, Schulz Tool redesigned and reworked other machines to enable them to perform operations necessary to experimental work and production.

Whereas competitors usually sent their newly developed products to outside laboratories for testing, Schulz Tool built its own modern completely equipped laboratory. It was estimated that testing costs, when sent to outside laboratories, averaged approximately $ 4,000 to $ 5,000 per unit. With its own laboratory, Schulz Tool was able to perform the same tests at an approximate 25 per cent reduction in costs.

A "Quality Control Department," staffed by experts of many years' experience, was maintained and rigid high quality control methods were employed at all stages of production, both in-plant as well as at subcontractors' plants. These control methods enabled Schulz Tool to stop production on units where defects developed in the early stages of production, thus keeping scrap costs to a minimum.

These efficiencies were reflected in the fact that during the fiscal year ended January1960 U.S. Tax Ct. LEXIS 153">*163 31, 1952, 95 per cent of Schulz Tool's deliveries were made on time, pursuant to the production schedules of customers. Similarly, Schulz Tool kept its product rejection rate by customers to less than 2 1/2 per cent of sales, whereas the generally accepted rejection rate for aircraft parts ranged from 5 to 7 per cent. The average earnings of Schulz Tool per employee per month (including partners) increased as follows during the periods noted:

Based on industry standards, an average return of $ 1,000 per employee per month was considered satisfactory.

Average monthly sales, and average monthly net profits before partners' salaries, similarly increased, as shown by the following table: 34 T.C. 235">*240

1960 U.S. Tax Ct. LEXIS 153">*164 Schulz Tool's average per cent of profit to sales during the period November 1, 1946, to January 31, 1953, was 34.3, a "relatively high level."

There were many risks inherent in proprietary items manufactured by Schulz Tool. If the design proved faulty, the expense of rerunning and redesigning the item was borne by Schulz Tool. For example, in 1950 or 1951, a fuel filter manufactured for Lockheed failed to meet specifications and the castings had to be reworked at substantial additional cost. In 1954, a latent defect was discovered in valves produced for Lockheed's P2V7, and "secondary charges" in excess of $ 20,000 were incurred by Schulz Tool in removing the valves from the airplane, reworking their castings, and reinstalling them.

The typical purchase order received by Schulz Tool included a provision for termination of the contract by the purchaser, and the business did experience some cancellation of Government contracts. In addition, delivery schedules material, workmanship and performance of designs were guaranteed, although many of the items represented "first time" designs and developments. At one point, a decrease in the production requirements of airframe manufacturers1960 U.S. Tax Ct. LEXIS 153">*165 resulted in Schulz Tool's servicing a greater percentage of units than they were producing.

In order to meet rapidly changing specifications and design requirements, Schulz Tool was under constant pressure to modify its proprietary items or develop new ones. Such modifications might be required even during the production of a single type of aircraft. For example, the company repeatedly modified its valve for Lockheed's F-80, to the extent that the valve produced today is "not even similar to the valve as it started out." Without such changes, the company would not have enjoyed continued orders for this valve. During its fiscal year ending January 31, 1953, Manufacturing produced and sold 57 units developed prior to that year; during the same year it developed 73 "new" units, many of which represented modifications of previously existing designs.

Either while Landen was a partner "or shortly afterwards," the partners attempted to procure product liability insurance, but found 34 T.C. 235">*241 the cost of premiums to be "prohibitive"; it was therefore forced to assume the role of self-insurer. This experience reflects both the risks of Schulz Tool's products, and the fact that insurance1960 U.S. Tax Ct. LEXIS 153">*166 companies had insufficient experience in such products on which to base a rate.

Schulz Tool's valves were not protected by patents. Other aircraft suppliers made valves which, while not identical to those produced by Schulz Tool, served the same purpose and were competitive therewith.

In their income tax returns for the calendar year 1951, each of the partners reported capital gain upon the liquidation of Corporation during that year. In computing such capital gain, the partners did not include any amount for the goodwill of Corporation.

On January 31, 1952, Schulz Tool had a backlog of orders on hand in the amount of $ 3,498,254, all of which were for valves and components thereof.

Landen disagreed with Ray, John, and Klagues as to Schulz Tool's emphasis on proprietary items. He was concerned about the risk factors, the amount of capital investment required, and the research and engineering problems involved in the development and manufacture of such items.

In the latter part of January 1952, the four partners held an all-day meeting to discuss the aforementioned disagreements as to company policy. During the meeting Landen suggested that it might be better if he sold his interest1960 U.S. Tax Ct. LEXIS 153">*167 in the partnership, and the other partners concurred. It was orally agreed to purchase Landen's interest as of January 31, 1952, but no discussion was had of the price to be paid Landen for his interest, nor was any formula set by which the price would be determined. It was agreed that the partnership's fiscal year would be closed on January 31, 1952, that a physical inventory would be taken as of that date, and that negotiations as to the terms of sale would be postponed until these events occurred.

On or about January 30, 1952, Ray, John, and Klagues spent 3 3/4 hours conferring with Arthur B. Willis, an attorney, with respect to drawing up an agreement for the purchase of Landen's interest. Willis' law practice was primarily in the tax field. On January 31, 1952, Willis spent 4 1/4 hours drafting a dissolution agreement and discussing it with Landen on the telephone.

Landen rendered no services to the partnership, nor did he participate in its management, after January 31, 1952. His visits to the plant during February were only for the purpose of getting information (e.g., with respect to inventory) to be used in the negotiations for the sale of his interest. Inasmuch as 1960 U.S. Tax Ct. LEXIS 153">*168 Landen had no other income during February, the other partners agreed to pay him an equal 34 T.C. 235">*242 "salary" for that month, but Landen did not otherwise participate in partnership profits after January 31, 1952. The business of Schulz Tool continued as a partnership after January 31, 1952, composed of three equal partners, namely, Ray, John, and Klagues.

In early February 1952, but prior to a final accounting for the partnership's fiscal year ended on January 31, 1952, Landen compiled figures for partnership assets and liabilities on a worksheet in order to arrive at an offering price for the sale of his interest. The worksheet figures for cash, receivables, deposits, prepaid insurance, and deferred charges were taken from the books of account. Landen obtained his figures for physical assets by reference to an appraisal made by Union Appraisal Company in 1951 in connection with the liquidation of Corporation and brought up to date by him to reflect assets subsequently acquired and his awareness of values. Inventory valuation was based on a physical inventory as of January 31, 1952, which was available early in February, and from figures which Landen had received from J. A. Kendall1960 U.S. Tax Ct. LEXIS 153">*169 & Company, the firm of certified public accountants employed by the partnership. Landen also entered the amount of $ 18,000 as representing his estimated interest in "Customer Accts. & Good Will." In estimating goodwill, Landen was not aware that Schulz Tool's order backlog on January 31, 1952, was $ 3,498,254; the only purchase orders he saw were "just shy of $ 1,000,000."

Prior to mid-February 1952, Landen submitted an offer to the other partners to sell his interest for $ 111,000. According to the worksheet, the $ 111,000 offering price included Landen's estimate of $ 18,000 for goodwill. The remaining $ 93,000 represented approximately the amounts ascribed by Landen to his interest in partnership assets other than goodwill, less his share of partnership liabilities. However, Landen did not furnish the other partners with a breakdown of his worksheet figures, nor did he inform them at this time of his $ 18,000 allocation to goodwill. In mid-February 1952 Landen consulted an attorney, Arthur Sullivan. Sullivan was a general practitioner; he was neither a "tax attorney" nor engaged in tax matters.

On February 29, 1952, a meeting was held in Sullivan's office in Los Angeles 1960 U.S. Tax Ct. LEXIS 153">*170 to determine a mutually acceptable price for the sale and purchase of Landen's interest. Landen and Sullivan were present at this meeting, as were Ray, John, Klagues, and their attorney, Willis.

The basis of discussion was Landen's offer to sell for $ 111,000. Although Landen did not show his worksheet to the other partners, he did, at Willis' request, furnish them with the figures he had arrived at for various partnership assets, including the $ 18,000 for 34 T.C. 235">*243 goodwill. This was the first time that the figure for goodwill was specifically mentioned to the other partners. The partners also had with them a copy of the 1951 appraisal report by the Union Appraisal Company.

The partners had a specific discussion as to the correct evaluation of inventory and depreciable assets, and as to the liability of the partners for renegotiation of profits on Government contracts. Agreement was reached with respect to each of these items.

When these items had been disposed of, Ray, John, and Klagues made a counter offer to purchase Landen's interest for an overall price of $ 105,000, later increasing their offer to $ 107,000. Sullivan, with Landen's approval, then suggested a compromise1960 U.S. Tax Ct. LEXIS 153">*171 price of $ 109,000. Willis indicated that the $ 109,000 figure might be acceptable, but that he desired first to confer privately with his clients. In private conference, Willis advised Ray, John, and Klagues that payments for a covenant not to compete enjoyed the income tax advantage of being deductible whereas payments for goodwill did not. Considering the reduced net cost resulting from anticipated deductibility of payments for a covenant not to compete, Ray, John, and Klagues determined to accept the compromise price of $ 109,000, provided that $ 18,000 thereof would be designated as separate consideration for Landen's covenant not to compete, and that no amount would be designated as consideration for goodwill.

Accordingly, after their return to the meeting, Ray, John, and Klagues offered to pay Landen $ 18,000 for refraining for 1 year, from (a) hiring Schulz Tool's employees; (b) soliciting the active customer accounts of Schulz Tool; and (c) opening a machine shop within a radius of 5 miles from the then location of Schulz Tool's plant. Upon Landen's objection, the 5-mile limitation was reduced to 1 mile. Willis stated that he would draft the written agreement of sale, 1960 U.S. Tax Ct. LEXIS 153">*172 and that the $ 18,000 would be separately stated therein as consideration for the covenant. Sullivan informed Willis that he could see no reason for such separate statement since the parties were concerned "with only one lump sum," but Willis replied that that was his customary procedure and that was the way he wanted to do it. He did not tell either Landen or Sullivan that the payments allocated to the covenant might be taxable as ordinary income. Landen thought the covenant unobjectionable, as modified, and accepted it.

Prior to the aforementioned offer, no suggestion had ever been made to Landen that the other partners were interested in his covenant not to compete. They knew that Landen intended to engage in job machine work rather than the manufacture of proprietary items. In conversation with Sullivan, Klagues stated that Schulz Tool would be willing to subcontract a portion of its job machine work 34 T.C. 235">*244 to Landen. Equipment necessary to carry on an operation similar to that of Schulz Tool could not have been obtained by Landen in 1952, or within a year of his leaving Schulz Tool, because of a priority system in effect during the Korean conflict, and Landen was not1960 U.S. Tax Ct. LEXIS 153">*173 qualified from an engineering standpoint, nor did he have the sales representation or contacts, to begin such a business.

The agreement reached on February 29, 1952, was subsequently reduced to writing by Willis. After certain changes in the draft, requested by Sullivan, including a specification of the dissolution date as January 31, 1952, the partners signed the agreement in final form.

Article I, dealing with dissolution of the partnership, provided that:

The partnership heretofore existing between the parties is dissolved as of January 31, 1952. Due notice of such dissolution shall be given forthwith by publication in a newspaper of general circulation.

Article II, dealing with the sale of Landen's interest, provided as follows:

A. The retiring partner, in consideration of the payment of the sum specified and in consideration of the covenants of the continuing partners, all as contained in this Article II, hereby sells, assigns, transfers and conveys unto the continuing partners, all of his part, share and interest in and to all and singular, the leasehold and premises and the machinery and equipment, leasehold improvements, stock in trade and other effects, and debts, credits, 1960 U.S. Tax Ct. LEXIS 153">*174 contracts, effects, profits and assets of every description of the partnership.

B. The price at which the interest of the retiring partner is sold to the continuing partners is Ninety-One Thousand Dollars ($ 91,000), payable as follows:

The remainder of article II provided for payment of the $ 91,000 in installments: $ 36,000 within 7 days after execution of the agreement; $ 36,000 within 45 days after execution of the agreement; and $ 19,000 in the form of a promissory note, secured by a chattel mortgage and payable in 12 monthly installments beginning April 1, 1952, each of the first 4 installments to be in the amount of $ 1,584 and the succeeding 8 installments to be in the amount of $ 1,583. Interest on the unpaid balance of the note accrued at 4 per cent beginning March 1, 1952.

Manufacturing subsequently issued two checks to Landen, each in the amount of $ 36,000 and each bearing the legend, "Part payment of Stanley C. Landen's interest in partnership assets as per agreement of February 29, 1952." The remaining $ 19,000 was paid by 12 checks, 11 of which bore the legend, "Monthly payment on note of $ 19,000 as provided in Article II of agreement of February 29, 1952," and1960 U.S. Tax Ct. LEXIS 153">*175 the last of which bore the legend, "Final monthly payment on note of $ 19,000 as provided in agreement of February 29, 1952." The 34 T.C. 235">*245 chattel mortgage delivered as security for the remaining $ 19,000 was released upon payment of the note in full.

The covenant not to compete was set forth in article IV, as follows:

A. The retiring partner agrees that for a period of twelve (12) months following the execution of this Agreement he will not compete with the continuing partners. For the purpose of this Article IV, only the following acts, or any of them, shall be considered as violating the agreement not to compete:

1. The employment by the retiring partner, or the soliciting for employment by him, either for himself or for another, of any of the employees of the continuing partners or of the business entity in which they do business.

2. The soliciting of customer accounts of the partnership which are active at date of this Agreement.

3. The opening by the retiring partner, either as a sole proprietor or in conjunction with others, of a machine shop within a radius of one (1) mile of the present location of the partnership plant.