8 T.C. 732">*732 Respondent has determined that petitioner is liable for gift tax for the year 1939 in the amount of $ 11,108.12. A penalty in the amount of $ 2,777.03 has been added to the tax deficiency under section 406 of the Revenue Act of 1935, for failure to file a gift tax return. The determination has been made with respect to a partnership agreement made by petitioner and his two sons on January 1, 1939, in which it was agreed that the profits and losses of a business conducted under the firm name "Fischer Machine Company" would be divided equally among the three partners. The respondent has determined that the agreement contained an element of gift which he has valued at $ 101,219, and he has held that $ 93,219 thereof, after exclusions, is subject to gift tax.

The main issue is whether petitioner made gifts in the amount of $ 376,129 to his sons. If it is held that gifts were made, there 1947 U.S. Tax Ct. LEXIS 245">*247 is presented the question of the value of the gifts and whether the penalty for failure to file a gift tax return shall be imposed.

The record consists of a stipulation of facts and exhibits.

FINDINGS OF FACT.

The stipulation of facts is incorporated herein by this reference.

Petitioner resides in Philadelphia. He has three children. His two sons are, William F. Fischer, Jr., who was born on September 23, 1905; and Herman W. Fischer, who was born on July 18, 1909. Petitioner was born on January 6, 1877.

8 T.C. 732">*733 On January 1, 1939, petitioner and his two sons executed an instrument entitled "Agreement of Partnership." On that date petitioner was nearly 62 years old; William, Jr., was 33 years old; and Herman was 29 years old. Both sons were married, and each son had two children on the above date.

Prior to January 1, 1939, petitioner was the sole proprietor of a business operating under the name of "Fischer Machine Company," which engaged in the business of the manufacture and sale of specialized machines and related products. The business was started in June 1900, and continued without change of ownership, except for the first few months, until January 1, 1939.

The agreement1947 U.S. Tax Ct. LEXIS 245">*248 of partnership provided, inter alia, that the three parties associated themselves as partners under the firm name "Fischer Machine Company"; that the purpose of the partnership was to manufacture and sell machinery and related products; that the partnership should continue until December 31, 1941, unless terminated prior thereto by consent of all three parties or by the death of one, and thereafter for one year, and thereafter from year to year unless one of the parties gave to the others sixty days' written notice of his desire to terminate the agreement; that no partner should assign or sell his share or interest to any person without the consent of the others, and should not encumber his interest; that none of the partners should engage in any other business or occupation during the continuance of the partnership; and that the profits and losses should be divided equally among the partners.

The agreement of partnership contains the following clauses:

* * * ^*

4. That the capital invested in said co-partnership has been invested therein as follows: William F. Fischer, the amounts hereinafter set forth in paragraph 5; William F. Fischer, Jr., $ 32,000 and Herman W. Fischer $ 32,000.

1947 U.S. Tax Ct. LEXIS 245">*249 5. That the capital invested in said co-partnership by William F. Fischer shall be in accordance with the books of account after giving effect to changes made in Federal Revenue Agent's Report covering the year 1936 and comparable changes for the year 1937, the capital invested by William F. Fischer then being in accordance with the annexed Statement of Assets and Liabilities, marked Exhibit "A", and made a part of this agreement.

* * * *

8. That William F. Fischer shall receive a salary of Two Hundred Dollars per week, and that William F. Fischer, Jr., and Herman W. Fischer shall each receive a salary of Sixty Dollars per week, chargeable as expense before distribution of net income or loss.

Reasonable withdrawals may be made from time to time subject to the approval of all three partners.

* * * *

12. In the event of death of one partner, his interest in the profits and losses of the partnership shall continue until the last day of the month during which death occurs. At the end of said month the value of his interest in the partnership 8 T.C. 732">*734 shall be the balance in his capital account as reflected by the books of the partnership after giving effect to the following:

(a) Proper1947 U.S. Tax Ct. LEXIS 245">*250 allowance for Bad Debts and uncollectible accounts.

(b) Accrued Expenses payable.

(c) A Physical Inventory of all merchandise and stock in trade priced at cost or market whichever is lower.

(d) All Machinery, Equipment, Fixtures and Furniture shall be inventoried at book value, less reserves for depreciation or obsolescence provided at book balances adjusted to the last day of the month during which death occurs.

(e) Nothing shall be allowed for goodwill.

13. The value of the deceased partner's interest made in the manner previously described in paragraph 12 shall be paid to his estate as soon as payment can be conveniently made (which may if the surviving partners so desire be not less than one year from the death of such partner) without interest thereon.

14. The right to use the name "Fischer Machine Company" is the sole and exclusive property of William F. Fischer and no other partner shall have any rights therein upon the termination of this agreement by either expiration of term, mutual consent or the death of any member. William F. Fischer shall have the exclusive right to use the name in connection with any business with which he may in any way become associated.

15. It is1947 U.S. Tax Ct. LEXIS 245">*251 hereby agreed that in the absence of written notice being given by either party hereto sixty days prior to the termination of this agreement that the said partnership shall continue under the said terms hereof for a further period of one year, and thereafter from year to year unless either party hereto shall give to the others sixty days' written notice of his desire to terminate said agreement prior to the expiration of the then current term.

* * * *

On December 31, 1938, the assets, liabilities, and capital of the sole proprietorship, Fischer Machine Co., which was owned by petitioner, were as follows:

8 T.C. 732">*735 The newly formed partnership took over the business which had been conducted just 1947 U.S. Tax Ct. LEXIS 245">*252 before January 1, 1939, as a sole proprietorship, and all of its assets and liabilities. The net worth of the business on December 31, 1938, was $ 260,091.07. Each son contributed $ 32,000 in cash to the partnership, and petitioner contributed $ 260,091.07.

On January 1, 1939, new books of account were opened by a certified public accountant. On the books of account of the partnership there was credited to petitioner's capital account on January 1, 1939, $ 260,091.07; and to the capital account of each son, William, Jr., and Herman, credits of $ 32,000 were made. The assets, liabilities, and capital of the partnership on January 1, 1939, were as follows:

1947 U.S. Tax Ct. LEXIS 245">*253 The newly formed Fischer Machine Co. maintained bank accounts in four financial institutions in Philadelphia and leased a safety deposit box in one. Cards containing the signatures to be honored in matters pertaining to the affairs thereof and of those entitled to access to the safety deposit box were filed with such institutions, the signatures thereon being those of petitioner, William, Jr., and Herman. Each had absolute and independent authority to represent the company.

On January 1, 1939, the personal wealth of William, Jr., was $ 177,000, and that of Herman was $ 150,000. Each paid $ 32,000 cash into the newly formed partnership from his own personal funds.

8 T.C. 732">*736 The agreement of January 1, 1939, created a valid, legal, and bona fide partnership, comprising as members thereof petitioner and his two sons.

William, Jr., was graduated from the Wharton School of Finance and Commerce, University of Pennsylvania, in 1928, where he specialized in industrial management. Later, he took a one-year course in metallurgy. Herman graduated from the Wharton School in 1930. Before graduating from the university, and from the time each son was 16 years old, each son worked for petitioner1947 U.S. Tax Ct. LEXIS 245">*254 without compensation. It had been petitioner's plan to have his sons eventually associated with him in business. After graduation each son was employed by petitioner on a full time basis. Each son spent 3 years in the plant operating machines and machine tools and learning matters of production; and thereafter each son was trained in office procedure and business management, preparatory to becoming executives. By 1933 the sons were well versed in plant management, business management, and production. In that year, and in years following, each was given and assumed executive responsibilities, and by 1938 the sons were capable of running the business.

During the period in which Fischer Machine Co. was operated as a sole proprietorship, petitioner received a salary of $ 10,000 a year, i. e., from 1920 through 1938. William, Jr., was paid a salary of $ 1,300 a year from 1927 through 1932; and Herman was paid a salary of $ 1,300 a year from 1931 through 1934. The salary of William, Jr., was increased to $ 2,340 in 1933; and in 1934 it was the same amount plus 10 per cent of the profits. For the years 1935 to 1938, it was the same plus 33 1/3 per cent of the profits. The salary1947 U.S. Tax Ct. LEXIS 245">*255 of Herman was $ 1,300 plus 10 per cent of the profits in 1934. For the years 1935 to 1938, he was paid on the same basis as his brother, William, Jr., i. e., $ 2,340 per year plus 33 1/3 per cent of the profits.

For the years 1935 to 1938, both years inclusive, the amounts of the salary and bonus paid by petitioner to each son, William, Jr., and Herman, were as follows, and the portions thereof allowed by the Commissioner as deductions for compensation paid to William, Jr., and Herman were as follows:

Management of the business of Fischer Machine Co. never has been along departmental lines. Petitioner and his sons operate as a team. 8 T.C. 732">*737 Each son has assumed responsibilities along specific lines, but the two work in close harmony with each other and in many respects their duties dovetail. If either has more work than he can handle, the other steps in and takes over a portion. William, Jr., primarily attends to the purchase of raw materials, supplies, equipment, and machinery; labor 1947 U.S. Tax Ct. LEXIS 245">*256 relations, including the hiring and discharging of employees; supervision of cost-keeping procedure and technique; Government relations in matters of priority, salary stabilization, renegotiation, preparation of reports filed with governmental agencies, etc. Herman, among other duties, has charge of most of the financial affairs of the business; estimating for bids on prospective contracts; supervision of matters pertaining to production, etc. Each negotiates for sales and signs sales contracts.

Since about 1936 petitioner has gradually relinquished active management of the business, although he has been available in an advisory and consultative capacity. Particularly since the execution of the partnership agreement have the burdens of the business been on the sons, petitioner in the immediately succeeding years having found it necessary to devote the major portion of his time to the affairs of a large corporation in the capital stock of which he and his wife are substantial investors. In 1940 and 1941 he was president of the corporation.

In 1933 and 1934 petitioner consulted his attorney with respect to forming a partnership with his sons. The latter suggested delay of a few 1947 U.S. Tax Ct. LEXIS 245">*257 years because of the responsibilities involved in a partnership and until the sons had had more experience. Petitioner waited until 1939, at which time he felt the sons had ripened into seasoned businessmen.

Under the partnership agreement, the annual salary of petitioner amounted to $ 10,400, and that of each son amounted to $ 3,120. For the years 1939 and 1940, and thereafter, each capital account of petitioner, William, Jr., and Herman was credited with one-third of the earnings of the business, and each account was charged with the respective withdrawals of each. Also, during 1939 and 1940 the salaries of each were credited to their accounts on the partnership books. The credits to each on account of salary and shares of profits for 1939, 1940, 1941, 1942, and 1943 were as follows:

8 T.C. 732">*738 1947 U.S. Tax Ct. LEXIS 245">*258 In 1939 petitioner's distributive share in the profits of Fischer Machine Co., including his fixed salary under the partnership agreement, was $ 69,825.62; and in 1940, it was $ 115,832.44.

Neither one of petitioner's sons has ever returned to petitioner, directly or indirectly, any of the compensation which he received for services rendered prior to the formation of the partnership or any part of his distributive share of the partnership earnings.

The number of employees, the net sales, and the net income per books of the business conducted as a sole proprietorship from 1926 through 1938, and of the business conducted as a partnership from 1939 through 1943, are as follows:

For the years 1939 and 1940, partnership returns were filed by Fischer Machine Co. For the same years, petitioner and his two sons filed individual returns in which each reported his distributable share of the profits of the business for each year in accordance with the terms of the partnership agreement.

The notice of deficiency in gift tax for the year 1939 was mailed to petitioner on October 26, 1944. The petition in this proceeding was filed with this Court on November 13, 1944. On November 13, 1944, petitioner filed Form 709 with the collector for the first district of Pennsylvania, purporting to be a gift tax return for the year 1939. In this return, petitioner reported that no gifts had been made during 1939.

8 T.C. 732">*739 OPINION.

The question relates to a business which had been in existence many years prior to January 1, 1939. Petitioner took his sons into partnership. In the formation of the partnership the capital contributions were equal as to the two sons, who contributed in cash $ 64,000, ($ 32,000 each). Petitioner contributed assets, including cash, amounting to $ 260,091. The partnership created under the agreement1947 U.S. Tax Ct. LEXIS 245">*260 of January 1, 1939, was a bona fide partnership, valid for purposes of taxation. . The parties to the agreement agreed that the partnership was to continue for an initial period of three years, and that it could continue beyond that period. The determination of the respondent which has given rise to this proceeding has been made under sections 501 and 503 of the Revenue Act of 1932, which provide for tax upon gifts.

Respondent's determination is that petitioner gave something to his sons when he took them into partnership with him to carry on a profitable and established business. The partnership agreement provided that each son should share in the profits and losses of the business to the extent of one-third each. That provision of the agreement, respondent has determined, "contained an element of gift." The interest in the future annual profits of the business for a period of three years which was vested in each son is alleged by the respondent to be, in part, the property which was given. Respondent has determined that such interest in earnings for three years in the two sons had a value on January 1, 1939, of $ 1947 U.S. Tax Ct. LEXIS 245">*261 101,219. Upon that value respondent has determined gift tax in the net amount of $ 11,108.12. Petitioner did not file a gift tax return for the year 1939 because he did not consider that there was any element of gift in the creation of the partnership. Respondent has added a 25 per cent penalty to the tax for failure to file a gift tax return.

The position of the petitioner is that the agreement of partnership was a bona fide business arrangement and the transfer of property to the partnership, by petitioner, was for an adequate and full consideration in money or money's worth, and, as such, did not contain any element of gift. Petitioner refers to article 8 of Regulations 79, relating to gift tax, which is set forth in the margin. ¹ He argues 8 T.C. 732">*740 that respondent's present position is inconsistent with the part of the regulation which states that, where there is a transfer of property in the ordinary course of business, the transfer of property will be considered as made for an adequate and full consideration in money's worth because the transaction in question was a bona fide transaction. He contends that, since the two sons agreed to share in the losses, if any, of 1947 U.S. Tax Ct. LEXIS 245">*262 the business, thereby putting their own fortunes of at least $ 150,000, each, at the risk of the business, and, since the sons expended greater efforts and assumed greater managerial responsibilities, while petitioner reduced his efforts and responsibilities, the undertaking of each party was equal and full consideration was received by the petitioner. Petitioner argues that the holdings made by this Court in the earlier proceeding, , support the above contention.

1947 U.S. Tax Ct. LEXIS 245">*263 The argument of the respondent is, in substance, as follows: The petitioner effected the formation of a partnership for a limited period of three years, but retained the power to reassume the business, by electing to terminate the partnership at the end of three years if he saw fit to recapture the business. Upon termination of the partnership all of the assets of the business, plus the right to use the name "Fischer Machine Company," will revert to petitioner. Respondent contends that, from the provisions of the partnership agreement, the net result of the arrangement was that no proprietary right in Fischer Machine Co. was conveyed to the two sons and that the net result was to divest petitioner of two-thirds of the net profits of Fischer Machine Co. for three years, and to vest the two-thirds of the net profits in his sons, who (respondent contends) "in the final analysis had no real proprietary interest in the Fischer Machine Company over and above what they themselves might contribute to their own capital accounts, which itself was, in effect, no different than had they deposited the same to their accounts at a bank instead of to their accounts at Fischer Machine Company." 1947 U.S. Tax Ct. LEXIS 245">*264 Respondent says that the arrangement served to divest petitioner of taxable income during the years involved, and that it is the transfer of the right to receive a portion of the net profits of Fischer Machine Co. for the period of the three years involved that he seeks to tax as a gift, rather than a transfer of a proprietary interest. The position of the respondent is explained, in part, by reference to his method of arriving at the value of $ 101,219 for the alleged gifts. For convenience, the determination of value is set forth in the margin. ²

1947 U.S. Tax Ct. LEXIS 245">*265 The petitioner had conducted the business of Fischer Machine Co. as a sole proprietorship until December 31, 1938. The business had 8 T.C. 732">*741 been successful and had produced substantial earnings. Petitioner was 62 years old, and he was desirous of gradually withdrawing from business and having his sons assume the burden thereof. His sons were trained in the business and had worked in it as employees for several years. By 1938 they had gained sufficient training and experience to be capable of running the business. Petitioner and his sons desired to form a partnership to carry on the business which had been conducted as a sole proprietorship. Since the parties to the partnership agreement were members of a family, the transaction among them is subject to careful scrutiny for tax purposes.

Respondent does not contend that petitioner made a gift of any of his property which made up the assets of the business which he had conducted as a sole proprietorship. The facts show that he did not make such gifts to his sons. Rather, he treated the net worth of the going concern as his capital contribution to the partnership. Upon a dissolution of the partnership by agreement of the parties1947 U.S. Tax Ct. LEXIS 245">*266 petitioner will take out of the partnership the value of what he contributed. If petitioner should die while the partnership is in existence, his estate will receive the value of his capital interest. If, on dissolution of the partnership, petitioner's sons desire to take over any property which petitioner contributed to the partnership, they will have to pay petitioner the value of the property they wish to take over. This applies to the name "Fischer Machine Company," in which petitioner retained the sole and exclusive property.

8 T.C. 732">*742 The respondent contends that an intangible property right was given by petitioner to his sons, namely, the right to receive a portion of the net profits of Fischer Machine Co. The contention is not readily understood. One may make a gift of property which is productive of income. See . If there is a transfer of property the income produced by the property or resulting from the property interest is taxable to the transferee. Or, one may make a gift of earnings. The earnings are taxable to the donor and the gift is taxable at the value of the gift. See ;1947 U.S. Tax Ct. LEXIS 245">*267 affd., , involving a gift of dividends on stock.

In this partnership contract, petitioner put in about eight-tenths of the capital for a one-third interest in the partnership business, and each son put in about one-tenth of the capital for a one-third interest in the business. All agreed to devote their efforts to the business and each contributed his personal services. It was understood that petitioner would relinquish active management of the business, devote less time to the business, and be available in an advisory and consultative capacity; and that the two sons would assume the burdens and responsibilities of management and, thereby, increase their responsibilities. Thus, although the capital contribution of petitioner was larger than that of either son, his personal services in the business were to be substantially less than those of his sons. Under that arrangement, the shares of the three parties to the partnership contract in the profits and losses were to be equal. The consideration received by petitioner for his contribution to the partnership was the undertaking of each of the other parties to the partnership agreement. 1947 U.S. Tax Ct. LEXIS 245">*268 If the contribution of capital of the two sons, as among the partners, can be said to have been so small as to be nominal, nevertheless, as between the partnership and third parties, the sons put all of their personal accumulations of money and property at the risk of the business. While the petitioner's contribution of capital was large, the services and managerial responsibility undertaken by the two sons was to be large compared to petitioner's services and managerial control.

The agreement of January 1, 1939, brought about a new combination of capital and services in the joint conduct of a business. When the partnership was created, the Commissioner refused to recognize it as a valid partnership for income tax purposes. In , this Court concluded that there was substance in the change of conducting the business after January 1, 1939, saying "It was, we think, as real and bona fide as any business transaction could possibly be." Elsewhere in that opinion, it was said that it was the intention that the sons would contribute the largest part of 8 T.C. 732">*743 the services and thus gradually relieve petitioner of that1947 U.S. Tax Ct. LEXIS 245">*269 burden, and that the intention was carried out.

In considering the income tax aspects of the family partnership problem, the source of the income in question is examined; it may be capital, it may be personal services, or it may be a combination of both. In the partnership here involved, the income of the business which was to be conducted as a partnership was to be produced by a combination of all of the capital contributed by the three parties, and of their respective services. The business which had been conducted as a sole proprietorship was that of manufacturing. The business had machinery, but the facts before us do not show that there were included in the assets any "crucial asset" or any unusual assets of special value which could be said to be the primary or chief factors in creating the earnings of the business. Cf. . Rather, the record indicates that the earnings of the business were the result of managerial skill and the use of ordinary capital. Hence, if those who were to assume the chief responsibilities of management under the partnership, the sons of petitioner, were not efficient and skillful, the1947 U.S. Tax Ct. LEXIS 245">*270 earnings of the partnership would be affected adversely; or, if the new managers were skillful, the earnings of the partnership would reflect their abilities. In other words, the earnings of the partnership were to be created by the partners' efforts and by their ability in utilizing the ordinary capital at their command. Under such facts, it must follow that the interest in the profits and losses which each party to the partnership agreement received was derived from the agreement of partnership itself. We are unable to "isolate and identify" any subject of gift from petitioner to his sons in the agreement. Cf. And, under the facts of this case, it does not necessarily follow that, because there had been an established and going concern, the future earnings under the partnership were bound to be just what they had been when the business had been conducted as a sole proprietorship. The new parties, the sons, put some capital into the business, they agreed to share losses, if any, and they increased their responsibilities. The arrangement was a bona fide one. Under1947 U.S. Tax Ct. LEXIS 245">*271 these facts, we are unable to find that petitioner made a gift to his sons of any intangible or tangible interest under the contract he made with them, within the purview of section 503. . The quid pro quo for petitioner's contributions were the services to be rendered by the sons, their assumption of risk, and their capital.

The partnership transaction is examined here for the purpose of the gift tax. As was pointed out in , the statute providing for the gift tax lacks the broad scope of section 8 T.C. 732">*744 22 (a). Furthermore, the bona fides of the partnership agreement has been the subject of judicial review in the earlier case of William F. Fischer. The argument of the respondent in this proceeding, which has been set forth above, attacks the bona fides of the arrangement again in that it presents the contention that the partnership agreement did no more than work out a transfer of two-thirds of the future earnings of the business to petitioner's two sons. In his valuation of the alleged gift, the respondent plainly shows that his real1947 U.S. Tax Ct. LEXIS 245">*272 contention is that petitioner gave part of the future earnings of the business over and above an amount which respondent regards as the value of the services of the two sons. Under his theory here, the partnership agreement could not have effected any change in the conduct of the business. We think that contention has been disposed of adversely to respondent in the earlier proceeding.

The respondent's determination is reversed.

The deficiency results solely from the determination that gifts of an interest were given to the sons. If there were no gifts there is no gift tax deficiency. It follows that there can be no addition for failure to file a gift tax return.

Decision will be entered for the petitioner.