264 F.

2d 305
59-1 USTC P 9314

David H. ULLMAN and Claire W. Ullman (husband and wife),

Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
David H. ULLMAN, Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
Benjamin ULLMAN, Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
Benjamin ULLMAN and Anna Ullman (husband and wife),
Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
Nos. 103-106, Docket 25068-25071.

United States Court of Appeals Second Circuit.

Argued Nov. 5, 1958.
Decided March 4, 1959.

Philip A. Brenner, New York City (Philip A. Brenner, Julius Kuschner, of

counsel), for petitioners.
Charles K. Rice, Asst. Atty. Gen., Lee A. Jackson, Melva M. Graney,
Joseph Kovner, Attorneys, Dept. of Justice, Washington, D.C., for
respondent.
Before CLARK, Chief Judge, WATERMAN, Circuit Judge, and
GALSTON, District Judge.
WATERMAN, Circuit Judge.

Petitioners appeal from a decision of the Tax Court, 29 T.C. 129, upholding a
determination by the Commissioner that $350,000 received by petitioners and
another in connection with the sale of the capital stock of three linen supply
corporations was received by them in consideration for their covenants not to
compete with the purchasers, and hence was taxable as ordinary income. The
facts are fully set forth in the Tax Court's opinion, and we state only those we
deem necessary for the purpose of disposing of the questions presented to us.

Petitioners David Ullman and Benjamin Ullman together with their brother
Richard (not a party to this appeal) had been engaged in the operation of a
number of laundries and linen supply companies for some years when they
began negotiations in August 1945 to sell to Consolidated Laundries
Corporation the entire capital stock of three linen supply companies of which
they, in varying proportions, were the sole stockholders.1 About a year later, on
August 8, 1946, written agreements of purchase and sale were entered into. The
sale of the corporate stock in each of the three companies was the subject of a
separate agreement and the sums that Consolidated paid in each case were paid
to the Ullmans in direct proportion to their respective stock interests in each
corporation. Each agreement provided that a sum of money, to be paid over at
the time of closing, represented the sale price of the corporate stock. Each
agreement also provided that an additional sum of money, one-fifth of which
was to be paid at closing, two-fifths payable in 1947, and two-fifths payable in
1948, was being paid in consideration of agreements on the part of the Ullmans
to execute and deliver to Consolidated covenants not to compete with
Consolidated.2 On the same day, August 8, 1946, each of the Ullmans executed
a separate agreement labeled 'Restrictive Covenant' containing several carefully
delineated commitments on each of their parts. These commitments included
promises that for a period of seven years within competitive areas the Ullmans
would not solicit present or former customers of the linen supply companies
Consolidated was acquiring that day, and would not assist financially, engage
in, or be interested in any similar business that could compete with the linen
supply companies so being acquired, or with Consolidated itself; provided,
however, that the Ullmans could continue their present stockholdings or
connections in six other linen supply companies operating in competitive areas
upon condition that these six companies did not solicit customers of the three
companies Consolidated was acquiring. Also on the same day, August 8, 1946,
the Ullmans executed a document labeled 'Guaranties' whereby they agreed,
among other things, to pay Consolidated 'the sum of thirty dollars per dollar of
the weekly average sales for any customer' of the three companies then being
sold if such customer should thereafter cease to be such and thereafter received
linen services from any one of the six companies in which the Ullmans were
permitted to continue to have business interests.

There were other documents also executed on August 8, 1946, some by the
three Ullmans and others by an individual Ullman. These are set forth in the
Tax Court findings of fact and opinion, but their contents have no direct bearing
on the questions before us, except the obvious one that all the documents and
agreements executed on August 8, 1946 were part of the same over-all
transaction.

Some time after the original negotiations began in August 1945 the parties
arrived at a price formula of 'forty dollars per dollar of weekly collections from
customers taking linen service, such collections being in excess of $2,500 per
week.' Accountants and financial men acting for the parties were called upon to
determine the weekly sales of each of the linen supply corporations, the manner
in which the total sums Consolidated was to pay were to be allocated among the
different companies sold, and the details of the payments to the stockholders.
Their computation resulted in a round figure of approximately one million
dollars to be paid to the stockholders of the Ullman corporations. Several
weeks before the legal documents relating to the sale transaction were executed
the question of assigning a certain amount of money for restrictive covenants
came up for consideration. Originally Consolidated wanted $400,000 set aside
for this purpose out of the agreed over-all price, but after this was discussed
with the sellers this sum was reduced to $350,000. The gross sum the
stockholders received under the three purchase agreements that was stated in
the agreements to be for the corporate stock was $647,000, all to be paid in
1946. The gross sum the stockholders received that was stated in the three
purchase agreements to be received for the covenants not to compete was
$350,000, of which $70,000 was paid in 1946, and $140,000 was payable in
each of the years 1947 and 1948.

The petitioners treated their shares of the entire $997,000 received from the
transaction as the price received for the sale of their capital stock, allocating
nothing whatever separately to their covenants not to compete. Consolidated
contrariwise recorded $350,000 on its books as a separate expense item
attributable to the covenants and amortized this cost over a seven-year period.

It is well established that an amount a purchaser pays to a seller for a covenant

not to compete in connection with a sale of a business is ordinary income to the
covenantor is ordinary income to the covenantor and an amortizable covenant is
so closely related to a sale of good will that it fails to have any independent
significance apart from merely assuring the effective transfer of that good will.3
Petitioners do not contest the soundness of that rule. They insist to us that the
Tax Court's determinations that the covenants were separate items apart from
the transferred good will and that the $350,000 was given in specific payment

therefor were clearly erroneous. They argue that the price of the covenants as
stated in the contract was simply a fictitious allocation designed to benefit the
tax position of the buyer, the true value of the covenants being inconsequential
or at least being much less than the $350,000.
7

The burden of proof in the Tax Court is on the taxpayer,4 and we agree with the
Tenth Circuit in their decision in Hamlin's Trust v. C.I.R.5 that when the parties
to a transaction such as this one have specifically set out the covenants in the
contract and have there given them an assigned value, strong proof must be
adduced by them in order to overcome that declaration. The tax avoidance
desires of the buyer and seller in such a situation are ordinarily antithetical,
forcing them, in most cases, to agree upon a treatment which reflects the parties'
true intent with reference to the covenants, and the true value of them in money.

Here we find that petitioners did not sustain their burden of proof. First of all,
they fail to support their contention that the covenants had no independent
significance apart from a transfer of the good will of the businesses. Petitioners
were not in any real sense connected with that good will since they had little, if
any, contact with customers. Hence we fail to see how their covenants were
necessary in order to transfer the good will of the corporations. Petitioners,
however, would have been in a position to supply technical knowledge to and
aid in the financing of a competitive business, and it is logical to believe that in
anticipation of such a possibility and in order to forestall such activity the
purchaser was willing to pay dearly for the covenants.

Petitioners' argument that they never negotiated as to a value for the covenants,
thereby implying that the treatment of them was a unilateral action on the part
of Consolidated, noticed only casually by themselves, is also without support.
The $50,000 reduction in the total sums stated to have been paid for the
covenants, a reduction beneficial taxwise to petitioners and detrimental to
Consolidated, and the careful phrasing of the covenants so as to allow
petitioners to continue their connection with certain other companies, indicate
that some negotiation went on. Petitioners present no proof sufficient to
substantiate their claim of unilateral action. Nor are we impressed with
petitioners' varied attempts to demonstrate that the sums stated to have been
paid for the covenants ought to have been disregarded by the Tax Court
because patently unrealistic. For instance, appellants argue that the chances
were extremely minute in 1946 that David, Benjamin and Richard would have
the desire or the physical capacity to engage in business activities after the sale
to Consolidated, and that consequently Consolidated would not have paid
$350,000 for their covenants. But petitioners offered no convincing proof in
support of this argument. The Tax Court found that ten years later, in December

1956, at the time of the trial, the appellants David and Benjamin were working
in supervisory capacities for two corporations wholly owned by them, and that
the third brother Richard though no longer active in business in 1956 was in
good health in 1946 and could have worked at that time had he wished to do so.
Petitioners also point out that the corporations Consolidated acquired had
contracts with their customers for terms of two years and that these contracts
were 'automatically renewable.' It did not appear how often these contracts
were renewable or whether they were automatically renewable by the linen
supply corporations, but in any event Consolidated could well have believed it
worthwhile to spend $350,000 to prevent the Ullmans from interfering with the
acquisition of new customers. And petitioners mention, too, that economic
considerations made it highly improbable that the sellers could effectively
compete against the buyer, but this suggestion is wholly without evidence to
support it.
10

Finally, in an attempt to show that, even if the covenants and value, their value
was much less than $350,000, petitioners direct attention to the terms of the
guaranties they executed in which they agree to pay stipulated damages to
Consolidated for diversion of customers. They reason that since the guaranties
provided that $30 per dollar of a customer's average weekly sales represented
'the reasonable amount of damages that would be sustained by Consolidated by
reason of the loss of any linen supply customer,' that amount is the value
properly allocable to the good will that was sold. If this theory were adopted
the remaining $10 per dollar of average weekly sales that the Ullmans received
would have to cover the value of linens and fixtures and other transferred assets
as well as the value of the covenants not to compete. On this basis, after
deducting the value of the chattels, petitioners assign to the covenants a value
of $112,311.66. The difficulty here is that there is no real hypothesis to start
with, for there is no real showing tht $30.00 per dollar actually represented the
value of the good will. The Tax Court could well have believed, since there
was no evidence to the contrary, that the statement in the guaranties was just as
fictitious a statement as petitioners contend to us the covenant allocation was.
The Tax Court was not required to give conclusory weight to the phrase 'the
reasonable amount of damages that would be sustained,' for it is a fair inference
that the parties used that language in order to avoid the danger of having
liquidated damages struck down as unenforceable penalties.6

11

The decisions of the Tax Court that there are deficiencies in the income taxes of
the appellants for the calendar years 1946, 1947 and 1948 are affirmed.

Except for six per cent of the stock of Paramount, one of the companies, held

Except for six per cent of the stock of Paramount, one of the companies, held
by an employee

In these respects, as one notes from the Tax Court's findings, the language of
the three agreements was identical. The Tax Court's summary of the contract
for the sale of one of the companies, Champion, follows:
'On August 8, 1946, the three Ullman brothers also entered into a similar
'Agreement' with Consolidated for the sale of all the stock of Champion for the
sum of $105,000, which was to be paid at the time of closing to the sellers as
follows:

Name
Amount
David Ullman ..... $ 66,150
Richard Ullman ..... 21,000
Benjamin Ullman .... 17,850
-------Total ......... $105,000

'The Champion agreement further provided that the sellers of the Champion
stock would execute and deliver to Consolidated covenants not to compete in
the linen supply business, and in consideration thereof Consolidated agreed to
pay them the following sums on the dates indicated:
On signing
of
this
contract
David Ullman ......... $5,796
Richard Ullman ........ 1,840
Benjamin Ullman ....... 1,564

February
15,
1947
$11,592
3,680
3,128

February
15,
1948
$11,592
3,680
3,128"

Wilson Athletic Goods Mfg. Co. v. C.I.R., 7 Cir., 1955, 222 F.2d 355;
Commissioner of Internal Revenue v. Gazette Tel. Co., 10 Cir., 1954, 209 F.2d
926; Hamlin's Trust v. C.I.R., 10 Cir., 1954, 209 F.2d 761; Toledo Blade Co. v.
C.I.R., 6 Cir., 1950, 180 F.2d 357, certiorari denied, 1950, 340 U.S. 811, 71
S.Ct. 38, 95 L.Ed. 596; Beal's Estate v. C.I.R., 2 Cir., 1936, 82 F.2d 268; Cox v.
Helvering, 63 App.D.C. 264, 71 F.2d 987

9 Mertens, Law of Federal Income Taxation 50.61 (1958), and cases cited
therein

10 Cir., 1954, 209 F.2d 761

See 3 Williston on Contracts 776-779 (1936)

The document entitled 'Guaranties' executed by the three brothers contains in
one paragraph the sentence relating to 'the reasonable amount of damages' and

the statement that $30 per dollar 'does not constitute, nor is it intended to be, a
penalty.' The paragraph reads:
'The undersigned hereby acknowledges that the aforesaid sum of Thirty
($30.00) Dollars per dollar represents the reasonable amount of damages that
would be sustained by Consolidated by reason of the loss of any linen supply
customer. The undersigned further acknowledge that the same does not
constitute, nor is it intended to be, a penalty.'