Appeal from the United States Tax Court. No. 4389-81-Richard C. Wilbur, Judge.
Wood and Flaum, Circuit Judges, and Pell, Senior Circuit Judge.
Petitioner-appellant Gene L. Kreider, individually and as executor of the estate of his deceased wife, Berniece L. Kreider, appeals from a decision of the United States Tax Court characterizing a $631,383.80 payment that the Kreiders received in 1977 upon the sale of their trucking company. The issues presented on appeal are: (1) whether the payment in question constituted consideration for the Kreiders' stock in the company, consideration for a covenant not to compete, or compensation for personal services; and (2) if the payment was consideration for a covenant not to compete, whether it qualified as personal service income under the maximum tax provisions of I.R.C. § 1348.*fn1 the Tax Court allocated one-third of the payment to compensation for services and two-thirds to the covenant not to compete, and further held that the portion allocated to the covenant not to compete did not qualify as personal service income under section 1348. Kreider v. Commissioner, 47 T.C.M. (CCH) 1071 (Feb. 13, 1984). We affirm the Tax Court's decision.
On October 27, 1977, Gene and Berniece Kreider sold all of the outstanding stock (200 shares) of Kreider Truck Service, Inc., an Illinois corporation, to Joseph R. Behnken, the president of Behnken Truck Service, Inc. At the time of the sale, the Kreiders were the sole shareholders of Kreider Truck Service and Gene Kreider had served as president of the trucking company for 43 years.
The sale of Kreider Truck Service was carried out pursuant to a sales agreement that the parties had entered into on September 9, 1976. The agreement provided that the Kreiders would sell all of the outstanding stock of Kreider Truck Service to Behnken for $1.2 million. The selling price of $1.2 million was based upon the adjusted book value of the stock as of December 31, 1975. Paragraph 1(a) of the agreement provided that if the company incurred a loss between December 31, 1975, and the date of closing (which turned out to be October 27, 1977), the amount of the loss would be deducted from the $1.2 million selling price. In the event of such a loss, however, Mr. Kreider had the right to void the entire agreement unless Behnken agreed to waive that provision.
If, on the other hand, Kreider Truck Service made a profit between December 31, 1975, and the date of closing, paragraph 8 of the sales agreement provided for the payment of an amount in addition to the $1.2 million sale price. The primary issue in this case is the characterization, for tax purposes, of the payment made to the Kreiders pursuant to paragraph 8.
Paragraph 8 was entitled "Covenant Not to Compete From Sellers And Additional Compensation." Subparagraph (a) provided that the Kreiders would not compete with Behnken, either directly or indirectly, for a period of three years after the date of closing. Subparagraph (b) provided that "in consideration for" the covenant not to compete, Behnken would pay the Kreiders an amount equal to the accumulated after-tax profit of Kreider Truck Service for the period from December 31, 1975, to the date of closing.
Subparagraph (c) of paragraph 8 provided that in addition to the $1.2 million sale price, the Kreiders "shall retain the right to pay themselves as compensation or as a covenant not to compete" the net before-tax profit (or the after tax profit if the compensation paid under this subparagraph resulted in a tax deduction for the company) earned by the company from December 31, 1975, to the date of closing. To confuse matters still further, subparagraph (e) provided that the total amount of the additional payment to be made to the Kreiders under paragraph 8 would not exceed the net before-tax profit earned by the company from December 31, 1975, to the date of closing.*fn2 A supplemental agreement signed by the parties on the same day provided that:
Paragraph 8. . . shall be interpreted to mean that the [Kreiders] shall receive a minimum of but no greater than the net profit before taxes, whether paid in the form of covenant not to complete and/or compensation.
On October 27, 1977, the closing date, Behnken paid the Kreiders $1.2 million for the stock of Kreider Truck Service ($348,000 in cash and the remainder in a note payable on January 3, 1978) plus an additional $631,383.80*fn3 in cash pursuant to paragraph 8. Although the parties did not specify whether the additional payment would be characterized as consideration for the covenant not to compete or as compensation for services, both parties treated the payment as consideration for a covenant not to compete on their 1977 tax returns. The Kreiders reported the payment as personal service income subject to the maximum tax provisions of section 1348.
The Commissioner found a deficiency of $75,577.80 in the Kreiders' 1977 return, based upon his determination that income from a covenant not to compete was not personal service income under section 1348. Mr. Kreider filed a petition with the United States Tax Court for a redetermination of the deficiency on March 9, 1981, pursuant to 26 U.S.C. § 6213(a) (1982). A short trial was held on September 20, 1982. Kreider argued to the Tax Court alternatively that: (1) the $631,383.80 payment should be characterized as additional consideration for the stock for Kreider Truck Service and thus treated as a capital gain, (2) the payment should be characterized under paragraph 8 as compensation for services (and thus personal service income) rather than payment for the covenant not to compete, and (3) if characterized as consideration for the covenant not to compete, the payment qualified as personal service income under section 1348. The Commissioner argued that the payment was consideration for the covenant not to compete and that it did not qualify as personal service income under section 1348.
In a thorough and well-reasoned opinion, the Tax Court first determined that the payment was not additional consideration for the stock of Kreider Truck Service. Kreider v. Commissioner, 47 T.C.M. (CCH) 1071, 1073 (Feb. 13, 1984). The court then refused to characterize the entire $631,383.80 payment either as compensation for services or as consideration for the covenant not to compete, finding that both the covenant and Mr. Kreider's services during the period before closing had some economic value to Behnken and that the parties thus intended some allocation to each. Because the agreement was completely silent as to the method of allocation, the Tax Court reviewed the record and concluded that one-third of the payment was allocable to compensation not to compete. Id. at 1076. Lastly, the court cited a Treasury regulation expressly providing that personal service income does not include amounts received for a covenant not to compete. Treas. Reg. § 1.1348-3(a)(i). The court found the regulation determinative of the final issue after holding that Kreider had failed to establish that the holding that Kreider had failed to establish that the regulation was invalid. 47 T.C.M. at 1077.
On appeal, Kreider essentially presents the same arguments that were made to and considered by the Tax Court.
A. Payment for the Sale ...