41 T.C. 535">*535 The Commissioner1964 U.S. Tax Ct. LEXIS 163">*167 determined deficiencies in income tax for 1958 in the amounts of $ 57,754.29, $ 57,735.46, and $ 129,092.04 against David A. and Dorothy A. Foxman, Horace W. and Judith Grenell, and Norman B. and Laura Jacobowitz, respectively. By amended pleadings the Commissioner revised the first two of these determinations, claiming total deficiencies in the amounts of $ 144,754.44 against the Foxmans and $ 144,441.45 against the Grenells.

The principal issue common to all three cases is whether an agreement dated May 21, 1957, between petitioner Jacobowitz and petitioners 41 T.C. 535">*536 Foxman and Grenell resulted in a "sale" of Jacobowitz's interest in a partnership to the two remaining partners under section 741, I.R.C. 1954, or whether the transaction must be considered a "liquidation" of Jacobowitz's partnership interest under sections 736 and 761(d). A second issue is whether $ 16,790 received by Jacobowitz represents his share of the partnership earnings for the period March 1-May 21, 1957, in accordance with the partnership agreement, as modified by the foregoing agreement of May 21, 1957, pursuant to section 761(c). The third issue, involving only Foxman and Grenell, is whether the partnership1964 U.S. Tax Ct. LEXIS 163">*168 "terminated" on June 2, 1958, under section 708, by reason of a certain transaction, so as to render them accountable in their 1958 returns for their respective shares of distributive partnership income during the period March 1-June 2, 1958. If the partnership did "terminate" on June 2, 1958, then a number of other questions are presented involving the determination of the partnership's income for the period March 1-June 2, 1958; these include nonrecognition of gain under section 351 realized upon the transfer of partnership assets to a corporation, the determination of the amount of that gain if it is to be recognized, and the proper allowance for depreciation of the partnership's assets prior to such transfer.

FINDINGS OF FACT

Some of the facts and exhibits have been stipulated and are incorporated herein by this reference.

The petitioners in each case, David A. and Dorothy A. Foxman, Horace W. and Judith Grenell, and Norman B. and Laura Jacobowitz, are husband and wife, all residing in New Jersey. They timely filed their respective 1958 joint income tax returns with the district director of internal revenue, Newark, N.J. The wives are parties herein merely by reason of the 1964 U.S. Tax Ct. LEXIS 163">*169 joint returns.

Prior to 1954, Abbey Record Manufacturing Co. was a partnership composed of petitioner Jacobowitz and two associates named Zayde and Brody, engaged in the business of custom manufacturing of phonograph records. The enterprise had been founded about 1948, with Jacobowitz as the active principal. Prior to 1954 the partnership, hereinafter referred to as Abbey, manufactured primarily 10-inch 78 r.p.m. records on contract for various companies. Petitioner Grenell purchased the interests of Zayde and Brody on December 31, 1953, and became an equal partner with Jacobowitz on January 2, 1954. Early in 1954 the partners agreed to enter the business of manufacturing 12-inch long playing records, known as LPs. Petitioner Foxman, who had been a consultant to the business when it was originally formed in 1948, was hired as a salaried employee in June 1954 to provide the necessary technical assistance for the changeover in machinery and production methods. Thereafter, as a result of certain 41 T.C. 535">*537 agreements dated February 1, 1955, and January 26, 1956, Foxman, Grenell, and Jacobowitz became equal partners in Abbey, each with a one-third interest.

Abbey kept its accounts1964 U.S. Tax Ct. LEXIS 163">*170 and filed its Federal income tax returns on an accrual basis of accounting and on the basis of a fiscal year ending February 28.

A related venture commenced by Jacobowitz, Foxman, and Grenell, individually, was represented by Sound Plastics, Inc., a corporation in which each owned one-third of the stock; it was engaged in the business of manufacturing "biscuits" or vinyl forms used in the making of records.

During the early period of the changeover to LPs, Abbey faced many problems in production and quality control. However, with Foxman and Jacobowitz in charge of production and with Grenell responsible for much of the selling, Abbey's fortunes were on the upswing. Its net income for the fiscal year ending February 29, 1956, was approximately $ 108,000, and for the fiscal year ending February 28, 1957, was approximately $ 218,000. Grenell, who acted as consultant and repertory director for two mail-order record companies, Music Treasures of the World and Children's Record Guild, was able to get these companies as customers of Abbey and they accounted for approximately 50-75 percent of Abbey's business.

Notwithstanding Abbey's success there was 1964 U.S. Tax Ct. LEXIS 163">*171 considerable disharmony among and between the partners. As a result there were discussions during the spring of 1956 relating to the withdrawal of Jacobowitz from Abbey. These negotiations did not lead to any agreement and the partners continued to work and to quarrel. Early in 1957, Foxman and Grenell decided to resolve the conflict by continuing the partnership without Jacobowitz and discussions were resumed again in March 1957. It was at about this time that Foxman offered Jacobowitz $ 225,000 in cash, an automobile which was in Abbey's name, and Foxman's and Grenell's interest in Sound Plastics, Inc., for Jacobowitz's interest in Abbey. Jacobowitz prepared a draft of an option agreement providing for Foxman's purchase of his one-third interest in the partnership and sent it to Foxman. Foxman never signed the option agreement. During the latter part of March or early April 1957, the negotiations of the three partners led to a tentative agreement whereby Jacobowitz's partnership interest would be purchased for $ 225,000 plus the aforementioned auto and stock in Sound Plastics, Inc. Jacobowitz, who did not trust either Foxman or Grenell, initially desired cash. Foxman and1964 U.S. Tax Ct. LEXIS 163">*172 Grenell explored the possibilities of a $ 200,000 bank loan from the First National Bank of Jersey City, hereinafter referred to as First National, and informed 41 T.C. 535">*538 First National of their tentative agreement to buy Jacobowitz's interest for $ 225,000; they had further discussions with First National concerning a possible loan on May 1, 1957, and on May 3, 1957. First National indicated, on the basis of an examination of the financial assets of Abbey, that it would consider a loan of approximately only $ 50,000.

The negotiations of the three partners culminated in an agreement dated May 21, 1957, for the "sale" of Jacobowitz's partnership interest; the terms of this agreement were essentially the same terms as the terms of the option agreement which Foxman did not execute.

Relevant portions of the May 21, 1957, agreement are as follows:

Agreement, made this 21st day of May 1957, between Norman B. Jacobowitz, hereinafter referred to as the "First Party", and Horace W. Grenell, and David A. Foxman, individually, jointly and severally, hereinafter referred to as the "Second Parties" and Abbey Record Mfg. Co., hereinafter referred to as the "Third Party", Witnesseth:

Whereas, the1964 U.S. Tax Ct. LEXIS 163">*173 parties hereto are equal owners and the sole partners of Abbey Record Mfg. Co., a partnership, hereinafter referred to as "Abbey", and are also the sole stockholders, officers and directors of Sound Plastics Inc., a corporation organized under the laws of the State of New York; and

Whereas, the first party is desirous of selling, conveying, transferring and assigning all of his right, title and interest in and to his one-third share and interest in the said Abbey to the second parties; and

Whereas, the second parties are desirous of conveying, transferring and assigning all of their right, title and interest in and to their combined two-thirds shares and interest in Sound Plastics, Inc. to the first party;

Now, Therefore, it is Mutually Agreed as Follows:

First: The second parties hereby purchase all the right, title, share and interest of the first party in Abbey and the first party does hereby sell, transfer, convey and assign all of his right, title, interest and share in Abbey and in the moneys in banks, trade names, accounts due, or to become due, and in all other assets of any kind whatsoever, belonging to said Abbey, for and in consideration of the following:

A) The payment1964 U.S. Tax Ct. LEXIS 163">*174 of the sum of two hundred forty two thousand five hundred & fifty ($ 242,550.00) dollars, payable as follows:

$ 67,500.00, on the signing of this agreement, the receipt of which is hereby acknowledged;

$ 67,500.00 on January 2nd, 1958;

$ 90,000.00 in eighteen (18) equal monthly installments of $ 5,000.00 each, commencing on February 1st, 1958 and continuing on the first day of each and every consecutive month thereafter for seventeen (17) months;

$ 17,550.00, for services as a consultant, payable in seventy-eight (78) equal weekly installments of $ 225.00 each, commencing on February 1st, 1958 and continuing weekly on the same day of each and every consecutive week thereafter for seventy-seven (77) weeks.

The balance set forth hereinabove is represented by a series of non-interest bearing promissory notes, bearing even date herewith, and contain an acceleration clause and a grace period of ten (10) days.

Said balance is further secured by a chattel mortgage, bearing even date herewith and contains a provision that same shall be cancelled and discharged upon the payment of the sum of $ 67,500.00 on or before January 2nd, 1958.

41 T.C. 535">*539 The right is hereby granted to the second parties1964 U.S. Tax Ct. LEXIS 163">*175 to prepay all or part of the balance due to the first party. If prepayment is made of both of the sums of $ 67,500.00 and $ 90,000.00 set forth above, prior to February 1st, 1958, there shall be no further liability for the balance of $ 17,550.00 or any of the payments of $ 225.00 weekly required thereunder. If such prepayment is made after February 1st, 1958, the first party shall be entitled to retain payments made to date of payment of the full sums of $ 67,500.00 and $ 90,000.00 (plus any weekly payments as aforesaid to date of payment) and there shall be no further liability for any remaining weekly payments.

B) In addition to the payments required under paragraph "A" hereof, the second parties hereby transfer, convey and assign all of their right, title and interest in Sound Plastics, Inc. to the first party. Simultaneously herewith, the second parties have delivered duly executed transfers of certificates of stock, together with their resignations as officers and directors of said Sound Plastics, Inc. Receipt thereof by the first party is hereby acknowledged.

C) In addition to the payments required under paragraph "A" hereof and the transfer of stock referred to in paragraph1964 U.S. Tax Ct. LEXIS 163">*176 "B" hereof, the second parties hereby transfer, convey and assign all of their right, title and interest in and to one, 1956 Chrysler New Yorker Sedan, as evidenced by the transfer of registration thereof, duly executed herewith, the receipt of which by the first party is hereby acknowledged.

Second: So long as a balance remains due to the first party, the second parties agree to continue the partnership of Abbey and each of the second parties agree to devote the same time, energy, effort, ability, endeavors and attention to furthering the business of said Abbey and to promote its success as heretofore and will not engage in any other business or effort, except that Horace W. Grenell shall be permitted to continue to create master records for other persons or companies.

The second parties further agree not to substantially change the form of business, engage in a new business, assign or transfer any of the assets or the lease of Abbey, without the written consent of the first party, unless such new business and/or assignee and/or transferee, by an agreement in writing, assumes all the obligations, terms, covenants and conditions of this agreement and delivers such assumption agreement1964 U.S. Tax Ct. LEXIS 163">*177 to the first party in person or by registered mail, within five (5) days from the date of the commencement of such new business and/or assignment and/or transfer. It is expressly understood and agreed that such assumption agreement shall in no wise release the second parties from any of their obligations hereunder.

* * * *

Fourth: All parties do hereby agree that the true and accurate status of Abbey and Sound Plastics, Inc. as to liabilities and assets are reflected in the balance sheets attached hereto and made a part hereof and represent the true condition of the companies as of March 1, 1957. First party shall not be entitled to any further share of profits that may accrue since March 1, 1957 and may retain any sums received therefrom to date hereof. [Italicized words inserted by hand.]

Fifth: Except as herein otherwise expressly provided, the second parties do hereby forever release and discharge the first party from any and all liability of whatsoever nature, description, character or kind arising out of any transaction or matter connected directly or indirectly between themselves or in connection with Abbey and/or Sound Plastics, Inc.

* * * *

Eleventh: The second parties1964 U.S. Tax Ct. LEXIS 163">*178 agree that they will forever indemnify and save the first party, free, clear and harmless of and from all debts, taxes (other 41 T.C. 535">*540 than personal income taxes) claims, damages or expenses, upon, or in consequence of any debt, claim or liability, of whatsoever kind or nature due or claimed by any creditor to be due from Abbey and/or the first party, by reason of the first party having been a member of the partnership of Abbey, except as set forth in paragraphs "Eighth" and "Fourth" hereof. The first party likewise agrees that he will forever indemnify and save the second parties, free, clear and harmless of and from all debts, taxes (other than personal income taxes) claims, damages or expenses, upon, or in consequence of any debt, claim or liability of whatsoever kind or nature due or claimed by any creditor to be due from Sound Plastics, Inc., and/or the second parties, by reason of the second parties having been stockholders, officers and directors of said corporation, except as provided in paragraph "Fourth" hereof.

Paragraph Twelfth of the agreement provides that "The first party [Jacobowitz] hereby retires from the partnership." The part of the agreement designating payment1964 U.S. Tax Ct. LEXIS 163">*179 of $ 17,550 in weekly installments of $ 225 per week found in paragraph "First: A)" was embodied in a separate document also dated May 21, 1957; it was signed by Abbey, Foxman, and Grenell, respectively.

The chattel mortgage mentioned in "First A)" of the agreement, in describing the translation provided for in the agreement of May 21, 1957, stated in part:

the party of the second part [Jacobowitz] has sold, transferred, assigned and conveyed all his right, title and interest as a partner * * * to the parties of the first part [Foxman and Grenell, individually and trading as Abbey].

Samuel Feldman, a New York City attorney who represented Foxman and Grenell, drafted the agreement of May 21, 1957; at Feldman's suggestion, Abbey was added as a party to the agreement. An earlier draft of the proposed agreement did not include Abbey as a party. During the negotiations leading to the May 21, 1957, agreement, the words "retirement" or "liquidation of a partner's interest" were not mentioned. There was no specific undertaking by the third party (Abbey) any place in the instrument. A sale of a partnership interest was the only transaction ever discussed.

Jacobowitz unsuccessfully tried1964 U.S. Tax Ct. LEXIS 163">*180 to obtain guarantees of payment of the notes he held from the wives of Foxman and Grenell; he was also unsuccessful in trying to obtain the homes of Foxman and Grenell as security on the notes.

The first $ 67,500 payment due on the signing of the agreement was made by cashier's check. On the promissory note due January 2, 1958, the name of Abbey appears as maker; the signatures of Foxman and Grenell appear on the face of the note as signatories in behalf of Abbey and on the back of it as indorsers. The 18 promissory notes, each in the amount of $ 5,000, also bear the signatures of Foxman and Grenell on the face of the instrument as signatories in behalf of Abbey, the maker, and on the back of the instrument as indorsers.

41 T.C. 535">*541 Payments to Jacobowitz pursuant to the May 21, 1957, agreement were timely made. Foxman and Grenell made an election to prepay pursuant to "First A)" of the May 21, 1957, agreement, and Jacobowitz returned the series of 18 promissory notes of Abbey, in the amount of $ 5,000 each, and the promissory note of Abbey in the amount of $ 17,550 payable in 78 weekly installments of $ 225. Jacobowitz was paid this $ 90,000 amount by check with Abbey's name appearing1964 U.S. Tax Ct. LEXIS 163">*181 as drawer and the names of Foxman and Grenell appearing as signatories in behalf of Abbey; they did not indorse this check. Payments made to Jacobowitz for his interest were charged to Abbey's account. The parties did not contemplate any performance of services by Jacobowitz in order for him to receive the $ 17,550 under the May 21, 1957, agreement; this amount was considered by the parties either as a penalty or in lieu of interest if Foxman and Grenell failed to pay the $ 90,000 amount prior to February 1, 1958.

Just prior to May 21, 1957, Abbey borrowed $ 9,000 from each of four savings banks and also borrowed $ 9,000 from Foxman and Grenell. On December 27, 1957, Abbey borrowed $ 75,000 from First National.

Abbey had no adjusted basis for goodwill as of February 28, 1957, nor at any time subsequent thereto. The balance sheets of Abbey for its fiscal years ending February 28, 1957, and February 28, 1958, do not reflect an account for goodwill. The balance sheet of Abbey as of February 28, 1957, was as follows:

1964 U.S. Tax Ct. LEXIS 163">*182 On May 21, 1957, Foxman and Grenell entered into an agreement providing for a continuation of the Abbey partnership which recited that Abbey had purchased the interest of Jacobowitz in Abbey.

After May 21, 1957, the date of Jacobowitz's termination of his interest in Abbey, improvements were made at Abbey's plant.

41 T.C. 535">*542 The reported earnings of Abbey for the fiscal year ending February 28, 1958, without reduction for alleged payments to partners, were $ 303,221.52.

In its tax return for the fiscal year ending February 28, 1958, Abbey treated the sum of $ 159,656.09 as a distribution of partnership earnings to Jacobowitz in the nature of a guaranteed payment under section 736 of the Internal Revenue Code of 1954. This amount was computed as follows:

Jacobowitz, on the other hand, treated the transaction as a sale in his return for 1957, reporting a long-term capital gain in the amount of $ 164,356.09.

Jacobowitz received1964 U.S. Tax Ct. LEXIS 163">*183 $ 16,790 from Abbey during the period March 1, 1957, to May 21, 1957; the books and records of Abbey show that $ 2,790 was debited to an account entitled "Salaries-Partners," and $ 14,000 was debited to his drawing account. Abbey had earnings before partners' salaries of $ 39,807.43, $ 38,164.32, and $ 27,478.26 for the months of March, April, and May 1957, respectively. This $ 16,790 amount was reported by Jacobowitz on his 1957 income tax return as ordinary income, and was subtracted from the partnership income for its fiscal year ending February 28, 1958, in determining the distributive shares of Foxman and Grenell.

The handwritten insertion in Paragraph Fourth of the May 21, 1957, agreement was made at Jacobowitz's suggestion so that he could keep the foregoing $ 16,790 received by him during the period March 1 to May 21, 1957; it was also a waiver of his right to the balance of his share of Abbey's earnings during that period, and thus constituted a modification of the partnership agreement in respect of his distributive share of earnings for that period.

The May 29-June 2, 1958, Transfer of the Record Manufacturing Business to Abbey Record Manufacturing Co., Inc.

For some1964 U.S. Tax Ct. LEXIS 163">*184 time prior to May 9, 1958, Richard D. Gittlin, in behalf of himself and two brothers, A. S. Gittlin and B. Morton Gittlin, had been negotiating with Foxman and Grenell to acquire a one-half 41 T.C. 535">*543 interest in the Abbey enterprise. These negotiations culminated in an agreement executed May 9, 1958, by Foxman, Grenell, and the Gittlins. The agreement contemplated the payment of $ 300,022.98 by the Gittlins who would emerge as the owners of 50 percent of the stock and debentures of a corporation named Abbey Record Manufacturing Co., Inc., which was to succeed to the entire business and assets of the partnership; the remaining 50 percent of the stock and debentures was to be owned by Foxman and Grenell individually. The corporation had been organized on April 11, 1955, with Foxman, Grenell, and an employee of the partnership named Ben Goldman, each owning five shares of stock. The corporation had remained dormant since its incorporation and had no assets of any consequence prior to the transaction here under consideration. The agreement of May 9, 1958, contemplated that the 15 outstanding shares would be cancelled and new shares and debentures issued in accordance with the agreement. 1964 U.S. Tax Ct. LEXIS 163">*185 The agreement provided in form for a sale of the fixed assets of the partnership to the Gittlins for $ 300,022.98, such fixed assets to be transferred by them, in turn, to the corporation. The agreement read in part as follows:

1. May 29, 1958, Abbey Record Mfg. Co., a New Jersey partnership (the "partnership"), will sell all of its fixed assets (including all deposits on equipment and under leases) to Richard D. Gittlin ("R. D. Gittlin") for an aggregate purchase price of $ 300,022.98. Against such sale to him, R. D. Gittlin will pay $ 22.98 in cash and R. D. Gittlin, A. S. Gittlin and B. Morton Gittlin will deliver to David A. Foxman ("Foxman") and Horace W. Grenell ("Grenell"), trading as Abbey Record Mfg. Co. their three 5% promissory notes each in the amount of $ 100,000 and each payable jointly to Foxman and Grenell, trading as Abbey Record Mfg. Co. The first such note will be due on July 15, 1958, the second on September 2, 1958 and the third on January 15, 1959 (with provision being made for acceleration of the maturity thereof in the event of default1964 U.S. Tax Ct. LEXIS 163">*186 under any of said notes). Payment of the indebtedness represented by said notes will be secured by the capital stock of the below-mentioned Corporation issued to R. D. Gittlin, A. S. Gittlin, and B. Morton Gittlin and all of the Debentures (hereinbelow defined) issued to R. D. Gittlin as herein provided, such stock to be held in escrow until payment in full of said notes provided that on or after July 15, 1958, such Debentures or part thereof may be withdrawn from the escrow and discounted or pledged, provided that the proceeds therefrom shall be applied to payment of any balance remaining on said notes then outstanding.

2. On June 2, 1958, R. D. Gittlin will transfer to Abbey Record Manufacturing Co., Inc., a New Jersey corporation (the "Corporation"), all of the aforesaid fixed assets received from the partnership, after Foxman and Grenell will have transferred on May 29, 1958, the balance of the partnership assets subject to all of its liabilities to the Corporation. In exchange therefor, the Corporation will then issue:

(a) to R. D. Gittlin, 498 shares of its capital stock, without par value; to A. S. Gittlin, 1 share of said capital stock; to B. Morton Gittlin, 1 share of said1964 U.S. Tax Ct. LEXIS 163">*187 capital stock;

41 T.C. 535">*544 (b) to Foxman, 250 shares of said capital stock;

(c) to Grenell, 250 shares of said capital stock, said shares to constitute all of the outstanding shares of capital stock of the Corporation; and

(d) 6% Debentures of the Corporation maturing in 10 years in the amount of $ 400,000 (the "Debentures"), one-half of which shall be issued to R. D. Gittlin, one-fourth of which shall be issued to Foxman, and one-fourth of which shall be issued to Grenell.

3. Foxman and Grenell have delivered to R. D. Gittlin an audited balance sheet of the partnership as of March 31, 1958, indicating a net worth of the partnership at said date of $ 176,082.55. As promptly as practicable, the accountants now servicing the books of the partnership will prepare a certified audit of the partnership as at April 30, 1958.

* * * *

The balance sheet of Abbey, as of May 31, 1958 (but before giving effect to the "sale" of assets on May 29, 1958), reflected the following:

1964 U.S. Tax Ct. LEXIS 163">*188 On May 29, 1958, Abbey transferred its fixed assets to R. D. Gittlin for $ 300,022.98, $ 300,000 of which was in the form of three promissory notes; and R. D. Gittlin, at about the same time, transferred the identical fixed assets to the corporation for 500 shares of its capital stock and $ 200,000 6-percent 10-year debentures. Also, on May 29, 1958, Abbey transferred its remaining assets, subject to its liabilities, to the corporation in return for 500 shares of the latter's capital stock and $ 200,000 6-percent 10-year debentures, all of which were distributed to Foxman and Grenell in equal amounts. The original 15 shares of stock which had been issued on April 13, 1955, to Foxman, Grenell, and Ben Goldman, were canceled.

41 T.C. 535">*545 Abbey reported a capital gain of $ 201,550.40 in a partnership return filed by it for the fiscal year ending February 28, 1959, in respect of the foregoing "sale" of its assets to the Gittlins.

The minutes of a special meeting of the board of directors of the corporation held on May 29, 1958, show that the following resolution was adopted:

Resolved, that it is the judgment of this Board of Directors that:

(a) the fair value of certain fixed assets to1964 U.S. Tax Ct. LEXIS 163">*189 be acquired by this corporation from R. D. Gittlin, as provided in the preceding resolutions, is $ 300,022.98 in the aggregate, consisting of office equipment, valued at $ 13,270, automobiles, valued at $ 6250, dies, valued at $ 37,550, machinery and equipment, valued at $ 234,741.44, deposit on lease, valued at $ 3,411.54 and deposit on machinery, valued at $ 4,800, all of which assets are more particularly listed together with the value of each on "Schedule A" appended to these minutes; and

(b) the fair value of certain assets of Abbey Record Mfg. Co. to be acquired by this Corporation from David A. Foxman and Horace W. Grenell, trading as Abbey Record Mfg. Co., as provided in the preceding resolutions, is $ 439,810.41, consisting of assets valued at $ 259,506.54, all of which assets are more particularly listed together with the value of each on "Schedule B" appended to these minutes, and good will, valued at $ 180,303.87, subject to liabilities of Abbey Record Mfg. Co. in the amount of $ 139,810.41, which are being assumed by this Corporation, the net fair value to this Corporation being $ 300,000;

* * * *

Resolved, that the value of the consideration to be received by this Corporation1964 U.S. Tax Ct. LEXIS 163">*190 for the issuance of said 1,000 shares of its Capital Stock, as provided in these resolutions, is found by this Board to be and is hereby determined to be $ 200,022.98; and that such consideration shall be, and is hereby determined to be, allocated in its entirety to the Capital Stock Account of this Corporation.

In a letter agreement dated May 29, 1958, Foxman and Grenell, purporting to act "individually and as partners trading as Abbey Record Mfg. Co.," agreed to pay $ 15,000 to a man named Lawrence Jasie for his services in bringing about the foregoing transaction with the Gittlins. Jasie appeared as the writer of the letter, and the terms of payment were spelled out therein as follows:

(1) $ 5,000 on the closing of such transaction by check to my order, receipt of which is hereby acknowledged; and

(2) $ 5,000 on or before July 1, 1959, and $ 5,000 on or before Jan. 2, 1960, each such payment to be evidenced by the promissory note of David A. Foxman and Horace W. Grenell, trading as Abbey Record Mfg. Co., bearing interest at the rate of 5% per annum, one payable on or before July 1, 1959, and the other payable on or before Jan. 2, 1960.

In connection with the transfer of assets1964 U.S. Tax Ct. LEXIS 163">*191 to the corporation, Abbey closed out its then existing asset and liability accounts. Abbey, upon receiving the aforementioned notes from the Gittlins in exchange for its fixed assets, recorded their receipt in an entry in its journal. Abbey also set up a liability account, Accrued Commissions Payable, in the amount of $ 15,000 to accrue the commission due to Lawrence Jasie.

41 T.C. 535">*546 In recording the transfer of assets from Abbey to the corporation, an account titled Goodwill was set up on the books of the corporation in the amount of $ 180,303.87. The corporation reflected the acquisition of fixed assets from the Gittlins in its journal dated June 2, 1958, as follows:

The three aforementioned $ 100,000 notes issued by the Gittlins bore interest at 5 percent and were payable to the order of Foxman and Grenell, trading as Abbey; the notes were due on July 15, 1958, September 2, 1958, and January 15, 1959, respectively. On May 29, 1958, Foxman and Grenell discounted the $ 100,000 note due on July 15, 1958, and shared equally the $ 99,995.74 proceeds1964 U.S. Tax Ct. LEXIS 163">*192 of the discounted note. Foxman and Grenell redeposited $ 20,000, in total, to their capital accounts. The remaining $ 200,000 notes were retained by Abbey until paid; the final payment was received on or about January 15, 1959.

Abbey's sole business activity was the manufacture of phonograph records; prior to June 2, 1958, it never owned any real estate or mortgages. After the transfer of assets to the corporation on May 29, 1958, Abbey did not engage in the manufacture of phonograph records, and did not have any sales income or any expenses from the manufacture of phonograph records.

Upon the advice of an accountant, in an effort to prevent the termination of the partnership, Foxman and Grenell began to look for some income-producing property for Abbey prior to June 2, 1958. In furtherance of that objective Abbey purchased a 6-percent mortgage in the face amount of $ 5,000 on July 28, 1958, and thereafter, on September 16, 1958, it purchased real estate for about $ 6,500 or $ 7,000 from the wife of one of the partners in the accountant's firm. The real estate was in a "very low-income housing area," and consisted of land and a frame residential building containing several apartments. 1964 U.S. Tax Ct. LEXIS 163">*193 The return filed on behalf of Abbey for the fiscal year ending February 28, 1959, showed rents of $ 485 from this property, but a net loss of $ 62.11 after deducting expenses and depreciation. Neither the foregoing mortgage nor the real estate was related in any way to Abbey's previous record manufacturing business. Subsequent to June 2, 1958, Abbey received not only the foregoing rent but also interest on the mortgage and interest on the Gittlin notes. Foxman and Grenell had no intention of terminating Abbey during 1958.

41 T.C. 535">*547 On January 13, 1959, an agreement was entered into between Foxman and Grenell whereby Grenell purchased Foxman's interest in Abbey, his 250 shares of stock in the corporation, his $ 100,000 6-percent 10-year debentures of the corporation, and his 220 shares of stock in Arco Recording Corporation, which had been organized to handle sales for the corporation. In return, Foxman received $ 65,000, an automobile belonging to the corporation, and the assumption by Grenell of Foxman's deficit in his capital account in Abbey in the amount of $ 1,200. Various distributions had previously been made by Abbey to Foxman and Grenell.

At the time of the sale by 1964 U.S. Tax Ct. LEXIS 163">*194 Foxman there was outstanding the $ 10,000 liability to Jasie and Abbey had among its assets the then unmatured third Gittlin $ 100,000 note and the mortgage and property purchased after June 2, 1958.

On January 13, 1959, there was filed with the State of New Jersey a "Cancellation of Business Name, Form 868" which noted the dissolution of Abbey.

On April 11, 1959, the Gittlins sold their 50-percent stock interest in the corporation and the $ 200,000 face value debentures to Grenell for $ 410,000. On April 11, 1959, the corporation sold its assets to National Aircraft Corporation for $ 750,000 cash.

Respondent, in his Amendment to Answer, alleged:

The assets of Abbey were transferred on or about May 29, 1958 and June 2, 1958 to Abbey Record Manufacturing Co., Inc. (hereafter "Abbey, Inc.").

Since June 2, 1958, no part of any business, financial operation, or venture of Abbey continued to be carried on by any of its partners in the Abbey partnership.

On June 2, 1958, the Abbey partnership was terminated.

The taxable year of Abbey commencing on March 1, 1958 was closed on June 2, 1958.

OPINION

1. Tax consequences of termination of Jacobowitz's interest in Abbey; the agreement of May1964 U.S. Tax Ct. LEXIS 163">*195 21, 1957. -- On May 21, 1957, Jacobowitz's status as a partner in Abbey came to an end pursuant to an agreement executed on that day. The first issue before us is whether Jacobowitz thus made a "sale" of his partnership interest to Foxman and Grenell within section 741²1964 U.S. Tax Ct. LEXIS 163">*196 of the 1954 Code, as contended by him, or whether the payments to him required by the agreement are to be regarded as "made in liquidation" of his interest 41 T.C. 535">*548 within section 736, ³1964 U.S. Tax Ct. LEXIS 163">*197 as contended by Foxman and Grenell. Jacobowitz treated the transaction as constituting a "sale," and reported a capital gain thereon in his return for 1957. Foxman and Grenell, on the other hand, treated the payments as having been "made in liquidation" ⁴ of Jacobowitz's interest under section 736, with the result that a substantial portion thereof reduced their distributive shares of partnership income for the fiscal year ending February 28, 1958.

The Commissioner, in order to protect the revenues, took inconsistent positions. In Jacobowitz's case, his determination proceeded upon the assumption that there was a section 736 "liquidation," with the result that payments thereunder were charged to Jacobowitz for the partnership fiscal year ending February 28, 1958, thus not only attributing to Jacobowitz additional income for his calendar year 1958 but also treating it as ordinary income rather than capital gain. In the cases of Foxman and Grenell, the Commissioner adopted Jacobowitz's position that there was a section 741 "sale" on May 21, 1957, to Foxman and Grenell, thus disallowing the deductions in respect thereof from the partnership's income for1964 U.S. Tax Ct. LEXIS 163">*198 its fiscal year ending February 28, 1958; as a consequence, there was a corresponding increase 41 T.C. 535">*549 in the distributive partnership income of Foxman and Grenell for that fiscal year which was reflected in the deficiencies determined for the calendar year 1958 in respect of each of them.

As is obvious, the real controversy herein is not between the various petitioners and the Government, ⁵ but rather between Jacobowitz and his two former partners. We hold, in favor of Jacobowitz, that the May 21, 1957, transaction was a "sale" under section 741.

The provisions of sections 736 and 741 of the 1954 Code have no counterpart in prior law. They are contained in "Subchapter K" ⁶ which for the first time, in 1954, undertook to deal comprehensively with the income tax problems of partners and partnerships.

1964 U.S. Tax Ct. LEXIS 163">*199 That a partnership interest may be "sold" to one or more members of the partnership within section 741 is not disputed by any of the parties. Indeed, the Income Tax Regulations, section 1.741-1(b), explicitly state:

Sec. 1.741-1Recognition and character of gain or loss on sale or exchange.

* * * *

(b) Section 741 shall apply whether the partnership interest is sold to one or more members of the partnership or to one or more persons who are not members of the partnership. * * *

And it is clear that in such circumstances, sections 736 and 761(d), do not apply. See regulations, sec. 1.736-1(a)(1)(i):

Sec. 1.736-1Payments to a retiring partner or a deceased partner's successor in interest.

(a) Payments considered as distributive share or guaranteed payment. (1)(i) Section 736 and this section apply only to payments made to a retiring partner or to a deceased partner's successor in interest in liquidation of such partner's entire interest in the partnership. See section 761(d). * * * Section 736 and this section apply only to payments made by the partnership and not to transactions between the partners. Thus, a sale by partner A to partner B of his entire one-fourth interest1964 U.S. Tax Ct. LEXIS 163">*200 in partnership ABCD would not come within the scope of section 736. [Italics supplied.]

Did Jacobowitz sell his interest to Foxman and Grenell, or did he merely enter into an arrangement to receive "payments * * * in liquidation of [his] * * * interest" from the partnership? We think the record establishes that he sold his interest.

At first blush, one may indeed wonder why Congress provided for such drastically different tax consequences, depending upon whether the amounts received by the withdrawing partner are to be classified as the proceeds of a "sale" or as "payments * * * in liquidation" 41 T.C. 535">*550 of his interest. ⁷1964 U.S. Tax Ct. LEXIS 163">*202 For, there may be very little, if any, difference in ultimate economic effect between a "sale" of a partnership interest to the remaining partners and a "liquidation" of that interest. In the case of a sale the remaining partners may well obtain part or all of the needed cash to pay the purchase price from the partnership assets, funds borrowed by the partnership or future earnings of the partnership. See A.L.I., Federal Income Taxation of Partners and Partnerships 176 (1957). Yet the practical difference between such transaction and one in which the1964 U.S. Tax Ct. LEXIS 163">*201 withdrawing partner agrees merely to receive payments in liquidation directly from the partnership itself would hardly be a meaningful one in most circumstances. ⁸ Why then the enormous disparity in tax burden, turning upon what for practical purposes is merely the difference between Tweedledum and Tweedledee, and what criteria are we to apply in our effort to discover that difference in a particular case? The answer to the first part of this question is to be found in the legislative history of subchapter K, and it goes far towards supplying the answer to the second part.

In its report on the bill which became the 1954 Code the House Ways and Means Committee stated that the then "existing tax treatment of partners and partnerships is among the most confused in the entire tax field"; that "partners * * * cannot form, operate, or dissolve a partnership with any assurance as to tax consequences"; 1964 U.S. Tax Ct. LEXIS 163">*203 that the proposed statutory provisions [subchapter K] represented the "first comprehensive statutory treatment of partners and partnerships in the history of the income tax laws"; and that the "principal objectives have been simplicity, flexibility, and equity as between the partners." H. Rept. No. 1337, 83d Cong., 2d Sess., p. 65. Like thoughts were expressed in virtually identical language by the Senate Finance Committee. S. Rept. No. 1622, 83d Cong., 2d Sess., p. 89.

41 T.C. 535">*551 Although there can be little doubt that the attempt to achieve "simplicity" has resulted in utter failure, ⁹1964 U.S. Tax Ct. LEXIS 163">*205 the new legislation was intended to and in fact did bring into play an element of "flexibility." Tax law in respect of partners may often involve a delicate mechanism, for a ruling in favor of one partner may automatically produce adverse consequences to the others. Accordingly, one of the underlying philosophic objectives of the 1954 Code was to permit the partners themselves to determine their tax burdens inter sese to a certain extent, and this is what the committee reports meant when they referred to "flexibility." The theory was that the partners would take their prospective tax liabilities1964 U.S. Tax Ct. LEXIS 163">*204 into account in bargaining with one another. ¹⁰ Nor is this concept before us for the first time. We considered it in the interpretation of some related provisions of section 736 in V. Zay Smith, 37 T.C. 1033">37 T.C. 1033, affirmed 313 F.2d 16 (C.A. 10), involving payments in respect of goodwill in the liquidation of a partner's interest. We there said (37 T.C. 1033">37 T.C. 1038):

This interpretation will also make for the flexibility and equity between the partners stressed by Congress. It will allow the partners flexibility in that they may determine the tax consequences of a liquidation payment by the choice of words in the partnership agreement. * * *

Recurring to the problem immediately before us, this policy of "flexibility" is particularly pertinent in determining the tax consequences of the withdrawal of a partner. Where the practical differences between a "sale" and a "liquidation" are, at most, slight, if they exist at all, and where the tax consequences to the partners can vary greatly, it is in accord with the purpose of the statutory provisions to allow the partners themselves, through arm's-length negotiations, to determine whether to take the "sale" route or the "liquidation" route, thereby allocating the tax burden among themselves. ¹¹1964 U.S. Tax Ct. LEXIS 163">*206 41 T.C. 535">*552 And in this case the record leaves no doubt that they intended to and in fact did adopt the "sale" route. ¹²

1964 U.S. Tax Ct. LEXIS 163">*207 The agreement of May 21, 1957, indicates a clear intention on the part of Jacobowitz to sell, and Foxman and Grenell to purchase, Jacobowitz's partnership interest. The second "whereas" clause refers to Jacobowitz as "selling" his interest and part "First" of the agreement explicitly states not only that the "second parties [Foxman and Grenell] hereby purchase * * * the * * * interest of * * * [Jacobowitz] * * * in Abbey," but also that "the first party [Jacobowitz] does hereby sell" his interest in Abbey. Thus, Foxman and Grenell obligated themselves individually to purchase Jacobowitz's interest. Nowhere in the agreement was there any obligation on the part of Abbey to compensate Jacobowitz for withdrawing from the partnership. Indeed, a portion of the consideration received by him was the Sound Plastics stock, not a partnership asset at all. That stock was owned by Foxman and Grenell as individuals and their undertaking to turn it over to Jacobowitz as part of the consideration for Jacobowitz's partnership interest reinforces the conclusion that they as individuals were buying his interest, and that the transaction represented a "sale" of his interest to them rather1964 U.S. Tax Ct. LEXIS 163">*208 than a "liquidation" of that interest by the partnership. Moreover, the chattel mortgage referred to in part "First" of the agreement of May 21, 1957, states that Jacobowitz "has sold * * * his * * * interest as a partner."

In addition to the foregoing, we are satisfied from the evidence before us that Foxman and Grenell knew that Jacobowitz was interested only in a sale of his partnership interest. The record convincingly establishes that the bargaining between them was consistently upon the basis of a proposed sale. ¹³ And the agreement of May 21, 1957, which represents the culmination of that bargaining, reflects that understanding with unambiguous precision. The subsequent 41 T.C. 535">*553 position of Foxman and Grenell, disavowing a "sale," indicates nothing more than an attempt at hindsight tax planning to the disadvantage of Jacobowitz.

1964 U.S. Tax Ct. LEXIS 163">*209 Foxman and Grenell argue that Jacobowitz looked only to Abbey for payment, that he was in fact paid by Abbey, that there was "in substance" a liquidation of his interest, and that these considerations should be controlling in determining whether section 736 or section 741 applies. But their contention is not well taken.

Jacobowitz distrusted Foxman and Grenell and wanted all the security he could get; he asked for, but did not receive, guarantees from their wives and mortgages on their homes. Obviously, the assets of Abbey and its future earnings were of the highest importance to Jacobowitz as security that Foxman and Grenell would carry out their part of the bargain. But the fact remains that the payments received by Jacobowitz were in discharge of their obligation under the agreement, and not that of Abbey. It was they who procured those payments in their own behalf from the assets of the partnership which they controlled. The use of Abbey to make payment was wholly within their discretion and of no concern to Jacobowitz; his only interest was payment. The terms of the May 21, 1957, agreement did not obligate Abbey to pay Jacobowitz.

Nor is their position measurably stronger1964 U.S. Tax Ct. LEXIS 163">*210 by reason of the fact that Jacobowitz was given promissory notes signed in behalf of Abbey. These notes were endorsed by Foxman and Grenell individually, and the liability of Abbey thereon was merely in the nature of security for their primary obligation under the agreement of May 21, 1957. The fact that they utilized partnership resources to discharge their own individual liability in such manner can hardly convert into a section 736 "liquidation" what would otherwise qualify as a section 741 "sale." It is important to bear in mind the object of "flexibility" which Congress attempted to attain, and we should be slow to give a different meaning to the arrangement which the partners entered into among themselves than that which the words of their agreement fairly spell out. Otherwise, the reasonable expectations of the partners in arranging their tax burdens inter sese would come to naught, and the purpose of the statute would be defeated. While we do not suggest that it is never possible to look behind the words of an agreement in dealing with problems like the one before us, the considerations which Foxman and Grenell urge us to take into account here are at best of an ambiguous1964 U.S. Tax Ct. LEXIS 163">*211 character and are in any event consistent with the words used. We hold that the Commissioner's determination in respect of this issue was in error in Jacobowitz's case but was correct in the cases involving Foxman and Grenell. Cf. Charles F. Phillips, 40 T.C. 157">40 T.C. 157; Karan v. Commissioner, 319 F.2d 303 (C.A. 7).

41 T.C. 535">*554 2. The $ 16,790 received by Jacobowitz from Abbey. -- During the period March 1, 1957, to May 21, 1957, inclusive, Jacobowitz received a total of $ 16,790 from Abbey, and reported it as ordinary income in his 1957 return. The Commissioner treated this item as reportable by Jacobowitz in 1958, but made a corresponding inconsistent adjustment in the cases of Foxman and Grenell by ruling that this amount was improperly subtracted from the partnership income for its fiscal year ending February 28, 1958, in computing the distributive shares of Foxman and Grenell. Jacobowitz now contends that this item represented merely a withdrawal of capital. We hold that Jacobowitz correctly reported this amount as ordinary income in his 1957 return, and that it was properly taken into account by Foxman and Grenell1964 U.S. Tax Ct. LEXIS 163">*212 in the computation of their distributive shares of partnership income in their 1958 returns.

Section 702(a) requires a partner to take into account his distributive share of the partnership's taxable income in determining his income tax. ¹⁴1964 U.S. Tax Ct. LEXIS 163">*213 Section 704(a) provides that a partner's distributive share of income shall be determined by the partnership agreement.¹⁵ Under section 761(c) a partnership agreement "includes any modifications of the partnership agreement made prior to, or at, the time prescribed by law for the filing of the partnership return for the taxable year (not including extensions) which are agreed to by all the partners, or which are adopted in such other manner as may be provided by the partnership agreement." The effect of such modification is that it relates back to the beginning of the taxable year in which the modification occurs. Thus the partners may, by agreement, adjust among themselves their interests in earnings and are taxable accordingly. Cf. Hellman v. United States, 44 F.2d 83 (Ct. Cl.); Raymond R. Goodlatte, 4 B.T.A. 165">4 B.T.A. 165 (acq. VI-2 C.B. 3).

Prior to May 21, 1957, the partners shared profits equally. In paragraph Fourth of the agreement of May 21, 1957, the following handwritten provision was inserted at the request of Jacobowitz:

First party [Jacobowitz] shall not be entitled to any further share of profits that may accrue since March 1, 1957 and may retain any sums received therefrom to date hereof.

Absent this modification of the partners' agreement to share net profits equally, Jacobowitz would have had to include in his taxable 41 T.C. 535">*555 income for his taxable year ending December 31, 1957, one-third of Abbey's earnings during the period March 1, 1957, to May 21, 1957, ¹⁶ since the taxable year of Abbey closed on May 21, 1957, under section 706(c)(2)(A)(i) with respect to Jacobowitz, who sold his entire interest in Abbey at that time, although it did not close at that time, 1964 U.S. Tax Ct. LEXIS 163">*214 pursuant to section 706(c)(1), in respect of the remaining partners. ¹⁷

1964 U.S. Tax Ct. LEXIS 163">*215 The language "may retain any sums received therefrom to date hereof" plainly refers to the $ 16,790, which, the record shows, consists in part of "salary" and in part of "drawings." Jacobowitz's own testimony bears this out. He testified that it was his intention that the $ 16,790 represented moneys coming out of profits and pursuant to this reported it as ordinary income in his 1957 return. The option letter prepared by Jacobowitz also indicates that this amount was intended to be a charge against profits; it stated, in part: "Pending final settlement, you [Jacobowitz] will continue to draw $ 225.00 per week. If we consummate the agreement, you [Jacobowitz] relinquish all rights to profits and drawings from March 1, 1957, except those you have already received."

We are satisfied that the $ 16,790 reflects Jacobowitz's share of Abbey profits for the period March 1, 1957, to May 21, 1957, and was ordinary income to him for his taxable year ending December 31, 1957; Foxman and Grenell are entitled to have Abbey's income for the year ending February 28, 1958, reduced by that amount in computing their respective shares of Abbey profits for that fiscal year. ¹⁸

1964 U.S. Tax Ct. LEXIS 163">*216 41 T.C. 535">*556 3. Whether Abbey "terminated" on June 2, 1958. -- By amendments to the Commissioner's pleadings a number of additional issues are raised, all of them depending in the first instance upon a new major issue as to whether Abbey "terminated" on June 2, 1958, within the meaning of section 708. ¹⁹ These new matters do not involve Jacobowitz; they relate solely to Foxman's and Grenell's cases.

Abbey was 1964 U.S. Tax Ct. LEXIS 163">*217 on a fiscal year ending February 28, and Foxman and Grenell each reported in his 1958 return his distributive share of Abbey's income for its fiscal year ending February 28, 1958, as reflected in the partnership return for that fiscal year. The first two issues in these cases, dealt with above, relate to a revision of Abbey's reportable income and the distributive shares of the partners for Abbey's fiscal year ending February 28, 1958. The third issue, now under consideration, relates to Abbey's income realized after February 28, 1958. A "final" return was filed on Abbey's behalf purportedly for the fiscal year ending February 28, 1959, and Foxman and Grenell reported in their own returns for the calendar year 1959 their respective distributive shares of the income shown on that partnership return. The Commissioner, on the other hand, has taken the position in his amended pleadings that Abbey "terminated" on June 2, 1958, with the consequence that Foxman and Grenell were charged in 1958 with their distributive shares of Abbey's income for the short taxable year March 1, 1958, to June 2, 1958, in addition to their distributive shares for the full fiscal year ending February 1964 U.S. Tax Ct. LEXIS 163">*218 28, 1958. Important subsidiary issues are also raised in this respect by the Commissioner involving the determination of the partnership's income for that short period. These subsidiary issues include the question whether the transfer of Abbey's assets to the corporation was nonrecognizable under section 351, the amount of gain realized if the transfer were recognizable, the amount of partnership income otherwise realized by Abbey during the period March 1-June 2, 1958, which in turn depends in part upon a proposed revision by the Commissioner of the depreciation allowance claimed on Abbey's behalf. We hold that Abbey did not terminate on June 2, 1958, as urged by the Commissioner. The subsidiary issues in this connection therefore become moot.

Upon consummation of the so-called Gittlin transaction on June 2, 1958, all of Abbey's assets had been transferred to the corporation, 41 T.C. 535">*557 and the stock and debentures allocable to Abbey had been distributed to Foxman and Grenell. Also, the first of the three $ 100,000 Gittlin notes had been discounted and the proceeds distributed to Foxman and Grenell. Nevertheless, Foxman and Grenell promptly redeposited an aggregate of $ 20,0001964 U.S. Tax Ct. LEXIS 163">*219 of such proceeds to their capital accounts in Abbey, and Abbey continued to own the two remaining $ 100,000 Gittlin notes, one due on September 2, 1958, and the other on January 15, 1959. Moreover, there were still outstanding the two Jasie notes in the amounts of $ 5,000 each, due July 1, 1959, and January 2, 1960. The evidence further shows that in an effort to prevent the termination of Abbey, Foxman and Grenell began looking for income-producing property prior to June 2, 1958, to be purchased in behalf of Abbey. Two such items were in fact purchased by Abbey, a mortgage in July and rental property in September of 1958. While it is true that these items were of comparatively minor character in contrast to the enterprise previously carried on by Abbey, the fact that they were actually acquired by Abbey cannot be ignored. Abbey did receive interest on the Gittlin notes after June 2, 1958, as well as interest on the mortgage and rents from the real estate. It continued to be liable on the Jasie notes. Its affairs were not wound up on June 2, 1958. Cf. Income Tax Regs., sec. 1.708-1(b)(1)(iii). The situation is similar to that in Emmette L. Barran, 39 T.C. 515">39 T.C. 515.1964 U.S. Tax Ct. LEXIS 163">*220 The Commissioner attempts to distinguish Barran on the ground that a comparatively minor piece of real estate was not included among the assets that the partnership transferred to the new owner in that case. We think that, notwithstanding this circumstance and notwithstanding the different manner in which Barran arose, the cases are not fairly distinguishable. The Court in Barran could not find that the partnership had terminated under any part of section 708. We reached the same result. We hold that the Commissioner has failed to establish that Abbey "terminated" on June 2, 1958. Accordingly, the various proposed adjustments based upon such alleged termination cannot be approved.

Decisions will be entered under Rule 50.