
    371 F. 2d 474
    THEODORE MORSE AND CLAIRE MORSE v. THE UNITED STATES
    [No. 350-63.
    Decided January 20, 1967]
    
      
      George T. Altman, attorney of record, for plaintiffs.
    
      Mitchell Samuelson, with whom was Assistant Attorney General Mitchell Bogovin, for defendant. Lyle M. Twmer and Philip B. Miller, of counsel.
    Before CoweN, Chief Judge, Laramore, Dureee, Davis, Collins, Skelton, and Nichols, Judges.
    
   Per Curiam:

This case was referred to Trial Commissioner Mastín G. White, with directions to make findings of fact and recommendation for conclusions of law. The commissioner has done so in an opinion and report filed on November 4, 1965. Exceptions to the commissioner’s report were filed by the defendant. The parties have filed briefs and the case bas been argued orally. Since the court is in agreement with the opinion, findings and recommendation of the commissioner, with modifications, it hereby adopts the same, as modified, as the basis for its judgment in this case, as hereinafter set forth. Therefore, plaintiffs are entitled to recover on the claim relating to the taxability of the proceeds from the sale of the partnership interest, and judgment is entered for plaintiffs to that effect with the amount of recovery to be determined pursuant to Tule 47(c) (2); and since plaintiffs are not entitled to recover on the other claims asserted in the petition, the petition is dismissed as to such claims.

Commissioner White’s opinion, as modified by the court, is as follows:

The plaintiffs, who are a husband and wife residing in Beverly Hills, California, seek in this action to recover a refund of income tax paid for the calendar year 1958. Since the plaintiff Claire Morse is a party to the action merely because she signed a joint Federal income tax return for 1958 with her husband, and she was not otherwise involved in the transactions which gave rise to the litigation, the term “plaintiff” will generally be used throughout the opinion in the singular as referring to the plaintiff Theodore Morse.

The plaintiff has been engaged for many years as part owner and executive in the business of manufacturing women’s lingerie. Allen R. Balton has been a partner of the plaintiff in the lingerie business for the past 15 years.

SALE OE PARTNERSHIP INTEREST

In 1958, the plaintiff received $7,605.42 as the result of a transaction which occurred on October 31, 1957, and which involved the sale by the plaintiff, on the installment basis, of a .723 percent interest in a partnership known as the Sam Berger Investment Company. In his income tax return for 1958, the plaintiff treated this amount as a capital gain. However, when the plaintiff’s return for 1958 was audited by the Internal Revenue Service, it assessed a deficiency against the plaintiff with respect to this item, on the ground that the $7,605.42 constituted ordinary income rather than a capital gain. One of the issues in the present case is whether the $7,605.42 constituted a capital gain, as contended by the plaintiff, or ordinary income, as contended by the defendant.

An interest in a partnership is a capital asset, and ordinarily the sale of such an interest above or below the cost basis results in a capital gain or a capital loss. Kinney v. United States, 228 F. Supp. 656, 662 (W.D. La. 1964). The controlling statutory provision is Section 741 of the Internal Revenue Code of 1954 (68A Stat. 248), which states in pertinent part as follows:

In the case of a sale * * * of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale * * * of a capital asset, except as otherwise provided in section 751 (relating to * * * inventory items which have appreciated substantially in value).

Therefore, the gain which the plaintiff realized in 1958 from the disposition on October 31, 1957, of his .723 percent interest in the Sam Berger Investment Company should be regarded as a capital gain, unless “otherwise provided in section 751.”

Section 751 of the Internal Revenue Code of 1954 provides in subsection (a), inter alia, that the amount of any money received by a transferor partner in exchange for his interest in a partnership that is “attributable to * * * inventory items of the partnership which have appreciated substantially in value, shall be considered as an amount realized from the sale or exchange of property other than a capital asset” (68A Stat. 250).

The evidence in the record clearly shows that the money which the plaintiff received in exchange for his .723 percent interest in the Sam Berger Investment Company was attributable to land which the partnership owned, it being the sole objective of the persons who purchased such interest (and the interests of other partners) to acquire the ownership of the partnership’s land. Therefore, it is necessary to determine whether the land in question came within the category of “inventory items of the partnership” and, if so, whether the land had “appreciated substantially in value.”

Subsection (d) of Section 751 of the 1954 Code defines “inventory items” to mean (among other things) “property of the partnership of the kind described in section 1221(1) ” (68A Stat. 251); and Section 1221(1) of the 1954 Code expressly declares in pertinent part that “property held * * * primarily for sale to customers in the ordinary course of * * * trade or business” is outside the scope of the term “capital asset” (68A Stat. 321).

Accordingly, in determining whether the money which the plaintiff received in exchange for his .723 percent interest in the Sam Berger Investment Company should be regarded as ordinary income (the defendant’s view) or as a capital gain (the plaintiff’s view), it is necessary to consider in the first instance whether the land which the partnership owned on October 31, 1957 (the date when the plaintiff’s interest in the partnership was sold) was “held * * * primarily for sale to customers in the ordinary course of * * * trade or business.” If this primary question is answered in the affirmative, the land must be regarded as falling within the category of “inventory items,” and it will then be necessary to consider the further question of whether the land of the partnership had “appreciated substantially in value.” On the other hand, if the primary question is answered in the negative, it will not be necessary to consider the second question.

Whenever the question of whether land was held primarily for sale to customers in the ordinary course of trade or business is raised in a tax case, the question is treated as one of fact (Friend v. Commissioner, 198 F. 2d 285, 287 (10th Cir. 1952); United States v. RosebrooK, 318 F. 2d 316, 319 (9th Cir. 1963)); and such question is to be answered upon the basis of a careful analysis of the facts of the particular case (Lazarus v. United States, 145 Ct. Cl. 541, 545, 172 F. Supp. 421, 424 (1959)). This requires in the present case a rather detailed statement of a complicated series of events and transactions that began in 1953.

During the period 1953-1954, six corporations designated as Hilltop Homes, Inc., Hilltop Banchos, Inc., Hilltop

Estates, Inc., Hilltop Park, Inc., Hilltop Vista, Inc., and Country Club Park Construction Co., Inc., were formed in the State of California for the purpose of acquiring real estate, developing real estate, and selling and dealing in real estate. Prior to the formation of these corporations, the individual investors who were planning to organize them executed a joint venture agreement under the date of August 28, 1953, in the names of the six prospective corporations. The purpose of the joint venture was to develop 600 homes on approximately 160 acres of land in Chula Vista, California. The joint venture was referred to in the agreement of August 28, 1953, as the “Country Club Park joint venture,” and it will be similarly referred to hereafter in this opinion.

Sam Berger was instrumental in the formation of the several corporations previously mentioned and in the creation of the Country Club Park joint venture, and he held a 30 percent interest in them. Other persons were involved as shareholders in the various corporations comprising the Country Club Park joint venture, and some of them who played roles of varying importance in subsequent events were Jack Barenfeld, Samuel Glaser, and Allen R. Balton.

The plaintiff, from time to time between December 1953 and March 1954, invested in the corporations making up the Country Club Park joint venture. His participation was secured through his partner in the lingerie business, Allen R. Balton. The plaintiff’s total investment amounted to $11,250 and his proportion of the capital stock was 3ys percent.

The Country Club Park joint venture proceeded to develop the 160 acres of land in Chula Vista previously mentioned, by subdividing the land and constructing on it homes for sale. From time to time during this development program, the plaintiff and the other stockholders in the six corporations comprising the joint venture advanced money for the benefit of the joint venture. These advances were in addition to the initial capitalization of the several corporations, and they were usually made by the stockholders in proportion to their stock ownership.

On or about August 6, 1954, while the subdivision of the 160-acre tract of land in Chula Vista and the construction of homes thereon, by the Country Club Part joint venture were in progress, a partnership was formed between Sam Berger and E. L. Freeland for the purpose of purchasing approximately 4,500 acres of land in San Diego, California.

On August 6,1954, Sam Berger purchased, through escrow, on behalf of himself or his nominee, the 4,500 acres of land mentioned in the preceding paragraph. The land was acquired from the Kensington Heights Company for a total consideration of $4,676,666.66. Of the total purchase price, a deposit of $100,000 was to be made within 30 days of the execution of the escrow agreement; and the agreement provided that the remainder of the purchase price would be paid in 20 annual installments beginning August 6, 1955. The escrow agreement further provided in part as follows:

Buyer shall deposit or cause to be deposited with Union Title Insurance and Trust Company * * * the sum of not less than $200,000 in cash, which sum is not a part of the purchase price of said property, for the purpose of paying for the installation of off-site improvements, water facilities, water mains, sewers and roads to and on said property. Said sum shall be disbursed by Union Title Insurance and Trust Company upon instructions of Kensington Heights Company * * * for the payment of said costs. * * *

Pursuant to his agreement with E. L. Freeland, Sam Berger nominated the partnership to take title to the property covered by the escrow agreement mentioned in the preceding paragraph.

The funds for the initial payment of $100,000 that was to be made under the escrow agreement within 30 days from August 6, 1954, were provided by E. L. Freeland to the extent of $70,000 and by Sam Berger to the extent of $30,000.

Several weeks subsequent to August 6, 1954, a formal limited partnership agreement was executed as of August 6, 1954. This limited partnei'ship agreement indicated that Sam Berger and E. L. Freeland were the general partners, and that Miss Margaret Lowthian, the Lake Murray Trust No. 1, the HAB Trust, and the MLB Trust were the limited partners. The document further stated that the purpose of the partnership was to carry on the business of buying, selling, and developing land upon the tract of approximately 4,500 acres previously mentioned. The partnership was to be known as the Sam Berger Investment Company.

The partnership agreement provided (among other things) that each partner, general or limited, was prohibited from selling, assigning, or transferring his interest in the partnership to any person other than another partner. The agreement further provided that “it is specifically understood and agreed that neither partner, general or limited, may sell, assign, transfer, convey, hypothecate, nor encumber his interest nor any part thereof in this limited partnership without the written consent of both general partners.”

The respective interests of the general and limited partners in the Sam Berger Investment Company were as follows: general partner Sam Berger, 20 percent; general partner E. L. Freeland, 32 percent; limited partner HAB Trust, 10 percent; limited partner MLB Trust, 10 percent; limited partner Margaret Lowthian, 8 percent; and limited partner Lake Murray Trust No. 1, 20 percent.

The interests of the HAB Trust and the MLB Trust in the Sam Berger Investment Company were created by Sam Berger for the benefit of two of his sons, Harvey A. Berger and Marshall L. Berger. Sam Berger was trustee of these trusts.

The 20 percent interest in the Sam Berger Investment Company held under the name of Lake Murray Trust No. 1 was established for the benefit of Jack Barenfeld and Samuel Glaser, and represented a hidden, secret profit for them. As previously indicated, the sum of $200,000 was required for off-site improvements under the escrow agreement, and Jack Barenfeld and Samuel Glaser committed themselves to provide the $200,000 in return for a 20 percent interest in the Sam Berger Investment Company.

At the time when the Sam Berger Investment Company purchased the 4,500 acres of land previously referred to, the land was in an undeveloped state, except that approximately 600 acres had been devoted to the growing of barley for several years under a lease issued by the former owner. However, the land was considered developable for urban usage at the time of its acquisition by the Sam Berger Investment Company; and the consideration paid by the partnership for the land was a fair price if the intended nse of the land was for urban development.

On October 21, 1954, the Lake Murray Development Company was formed as a California corporation for the purpose of subdividing land and constructing homes thereon for sale or rental. Sam Berger was instrumental in forming the Lake Murray Development Company. It was intended that this company should engage in a program of purchasing land from the Sam Berger Investment Company for the purpose of constructing homes thereon and then selling the homes.

The capitalization of the Lake Murray Development Company was in the amount of $5,000, and this sum was provided by the corporations comprising the Country Club Park joint venture. Hence, the individuals (including the plaintiff) owning the stock of the corporations making up the Country Club Park joint venture also owned, in effect, proportionate interests in the Lake Murray Development Company.

In order to obtain funds with which to meet the first five annual payments under the purchase agreement of August 6, 1954, the Sam Berger Investment Company on October 26, 1954, executed an option agreement with the Lake Murray Development Company, under which the latter corporation was granted an irrevocable option to purchase, within a 5-year period, a maximum of 500 acres of land within an area described in the document, such area being part of the 4,500 acres previously acquired by the Sam Berger Investment Company. The price to be paid by the Lake Murray Development Company for the land purchased under the option was $2,000 per acre.

As previously indicated in this opinion, the Sam Berger Investment Company was required under the purchase agreement of August 6, 1954, to deposit with the Union Title Insurance and Trust Company the sum of $200,000 to be used for off-site improvements on the land acquired by the partnership, and Jack Barenfeld and Samuel Glaser had made a commitment to provide this sum in exchange for a 20 percent interest in the Sam Berger Investment Company. Jack Barenfeld and Samuel Glaser fulfilled their commitment by causing $200,000 to be provided -by tlie corporations comprising the Country Club Park joint venture, and they received a hidden, secret 20 percent interest in the Sam Berger Investment Company under the name of Lake Murray Trust No. 1. The Lake Murray Development Company was utilized as a conduit for the transfer of the money. The money was deposited with the Union Title Insurance and Trust Company for the account of the Sam Berger Investment Company, under the purchase agreement; and the Union Title Insurance and Trust Company disbursed the funds for the off-site improvements required by the terms of the purchase agreement. The Sam Berger Investment Company did not expect to repay the $200,000, and the transaction was not evidenced by any promissory note or other security instrument executed by the Sam Berger Investment Company.

In addition to granting the 500-acre option to the Lake Murray Development Company, the Sam Berger Investment Company engaged in the following activities: sold y2 acre to the Pacific Telephone and Telegraph Company; granted options to the San Diego School District for the purchase of sites for three elementary schools and a junior high school; sold a small parcel of about four acres near the westerly boundary for use as a reservoir site; granted easements for the laying of a gas line and a water line; had certain portions of the acreage rezoned as R-2 (residential) and commercial; and executed an agreement with the engineering firm of Freeland, Peterson, and Evenson to design a master plan for the development of the land owned by the company.

Within a short time after receiving the option to purchase a maximum of 500 acres of land from the Sam Berger Investment Company, the Lake Murray Development Company partially exercised its option by purchasing a 150-acre parcel of land. The Lake Murray Development Company thereupon proceeded to develop the land by constructing homes thereon and then selling the homes.

Sam Berger was president of the Lake Murray Development Company, and he was in active charge of that company’s development work on the 150 acres acquired by the Lake Murray Development Company from the Sam Berger Investment Company.

Many of the bills and current expenses incurred by the Lake Murray Development Company in developing the 150-acre tract of land previously mentioned were paid by one or more of the corporations making up the Country Club Park joint venture. Funds were freely transferred by such corporations to the Lake Murray Development Company without any evidence of formal indebtedness.

Upon learning that Jack Barenfeld and Samuel Glaser had provided for the Sam Berger Investment Company $200,000 out of the funds belonging to the corporations which comprised the Country Club Park joint venture, in return for a 20 percent interest in the Sam Berger Investment Company under the name of Lake Murray Trust No. 1, the plaintiff and the other stockholders in the corporations comprising the Country Club Park joint venture (excluding Sam Berger, Jack Barenfeld, and Samuel Glaser) contested the hidden interest of Jack Barenfeld and Samuel Glaser in the Sam Berger Investment Company. The plaintiff and his associates in the contest contended that, by virtue of the use of $200,000 belonging to the Country Club Park joint venture for the benefit of the Sam Berger Investment Company, they had a participating interest in the Sam Berger Investment Company through the Lake Murray Trust No. 1. This dispute was settled on May 7, 1956, by dividing the 20 percent limited partnership interest of the Lake Murray Trust No. 1 among all the individuals owning stock in the corporations making up the Country Club Park joint venture (excluding Sam Berger). The plaintiff and his associates in the contest paid no additional monetary consideration for their interests in the Sam Berger Investment Company. The plaintiff’s interest amounted to .723 percent.

In August 1956, Carlos Tavares, representing a group of individuals which included himself and which will be referred to hereafter in the opinion as the “Tavares group,” approached Sam Berger with respect to the acquisition of Mr. Berger’s interest in the Sam Berger Investment Company. On August 10, 1956, Sam Berger and the Tavares group entered into a contract of sale and purchase. In this document, the seller, Sam Berger, warranted that he held his original 20 percent interest in the Sam Berger Investment Company and that he had acquired the interests of the TTAB Trust and the MLB Trust, so that he then had a 40 percent interest in the partnership. The document further stated that this 40 percent interest was conveyed by Sam Berger to the Tavares group for $950,000. It was also stated in the document as follows:

The sale which is the subject of this agreement does not contemplate that the Buyers will acquire any interest in existing partnership cash, whether in partnership bank accounts or on deposit in trust accounts of other persons. As a matter of fact, it is the intention of the parties hereto that the only asset of said partnership which the Buyers will acquire is the land * * * [owned by the partnership].

Sam Berger did not obtain the approval of E. L. Freeland or of the limited partners in the Sam Berger Investment Company before entering into the contract of sale mentioned in the preceding paragraph.

After entering into the contract with Sam Berger for the purchase of his 40 percent interest in the Sam Berger Investment Company, the Tavares group approached E. L. Free-land with respect to the acquisition of his 32 percent interest in the Sam Berger Investment Company. On November 26, 1956, the Tavares group and Mr. Freeland entered into a contract of purchase and sale, under which Mr. Freeland’s interest in the Sam Berger Investment Company was conveyed to the Tavares group for a total consideration of $730,000. This contract stated that the buyers were not to receive any interest in the cash of the Sam Berger Investment Company. E. L. Freeland did not obtain the approval of the limited partners in the Sam Berger Investment Company before entering into the contract.

At the time when the Tavares group entered into the contract with E. L. Freeland mentioned in the preceding paragraph, the Tavares group also acquired the 8 percent interest of Margaret Lowthian in the Sam Berger Investment Company.

As of November 26, 1956, the Sam Berger Investment Company still owed $4,210,666.66 on the purchase price of the land acquired on August 6, 1954.

On October 31, 1957, after some negotiations, the Tavares group entered into a contract of purchase and sale with the limited partnership interests in the Sam Berger Investment Company (other than Margaret Lowthian, the HAB Trust, and the MLB Trust), and thereby received the limited partners’ consent to the prior agreements made by the Tavares group for the purchase of other interests in the Sam Berger Investment Company, as previously outlined in this opinion. By virtue of the contract dated October 31, 1957, the Tavares group completed the acquisition of a 100 percent interest in the land owned by the Sam Berger Investment Company.

Under the contract of October 31, 1957, the Tavares group agreed to pay the limited partners, including the plaintiff, a total of $600,000 in installments for their interests in the Sam Berger Investment Company, the only asset of which was stated to be land.

As of October 31, 1957, the Sam Berger Investment Company still owed slightly more than $4,000,000 on the purchase price for the land acquired on August 6, 1954.

In each of the contracts under which the Tavares group acquired interests in the Sam Berger Investment Company, the Tavares group agreed to assume the remaining liability under the escrow agreement of August 6, 1954, and the promissory note that covered the remainder due under the original purchase agreement.

During the period between the signing of the contract between Sam Berger and the Tavares group on August 10, 1956, and the signing of the contract between the limited partners and the Tavares group on October 31, 1957, no development work was performed on the land owned by the Sam Berger Investment Company, none of the land was sold or offered for sale, and no obligation or indebtedness was incurred for the account of the Sam Berger Investment Company. Some planning work was performed during the period by the Tavares group with respect to the prospective development of the land, but any expense involved in such planning work was defrayed by the Tavares group.

In view of the interlocking relationship of the Sam Berger Investment Company with the Country Club Park joint venture and the Lake Murray Development Company, both of which, were actively engaged in the development of land for urban usage and related sales activities, it might be proper to hold that the Sam Berger Investment Company, despite the limited nature of its own sales activities, held its land up until August 10, 1956, primarily for sale to customers in the ordinary course of trade or business. However, this was not true after August 10, 1956. The partnership began to disintegrate, and it completely lost its original purpose, with the sale by Sam Berger on August 10, 1956, of his 40 percent interest in the partnership to the Tavares group. Thereafter, the only activity or objective of the original partnership was that of liquidation. The process of liquidating the original partnership was continued on November 26, 1956, when the Tavares group acquired the 32 percent interest of E. L. Freeland and the 8 percent interest of Margaret Low-thian in the Sam Berger Investment Company. The affairs of the partnership were completely wound up with the sale of the final 20 percent interest in the partnership by the plaintiff and his associates to the Tavares group on October 31, 1957. The Tavares group made no use whatever of the partnership as an entity, since the Tavares group went through the form of acquiring interests in the partnership for the sole purpose of acquiring the ownership of the partnership’s land.

Therefore, it would be unrealistic to say that the Sam Berger Investment Company, while undergoing the process of liquidation, held its land primarily for sale to customers in the ordinary course of trade or business. During this period, as previously indicated, no development work was performed on the land owned by the partnership, none of the land was sold or offered for sale, and no obligation or indebtedness was incurred for the account of the partnership. Furthermore, the very aspect of liquidation, previously mentioned, militates against a holding that the Sam Berger Investment Company after August 10, 1956, held its land primarily for sale to customers in the ordinary course of trade or business. In sum, all the circumstances show that, at that time, the land was being held for its appreciation in value, and not for sale in the ordinary course of trade or business. cf. Garrett v. United States, 128 Ct. Cl. 100, 104-105, 120 F. Supp. 193, 196 (1954); Tibbals v. United States, 176 Ct. Cl. 196, 208-10, 362 F. 2d 266, 272-3 (1966).

Accordingly, it appears that the partnership’s land as of October 31, 1957 (when the plaintiff’s interest in the partnership was sold) cannot properly be regarded as falling within the category of “inventory items,” as that term is used in Sections 741 and 751 of the Internal Bevenue Code of 1954. This conclusion makes it unnecessary to consider whether such land had “appreciated substantially in value.”

F or the reasons previously stated, the gain which the plaintiff realized in 1958 from the sale of his interest in the Sam Berger Investment Company is covered by the main provision of Section 741 of the 1954 Code, rather than by the exception stated in that section, and, accordingly, such gain should be considered “as gain * * * from the sale * * * of a capital asset.”

SETTLEMENT OE LITIGATION

On August 13, 1956, the corporations comprising the Country Club Park joint venture and individual investors in those corporations (including the plaintiff) filed against Sam Berger an action for money lent, money had and received, and money paid on open book account. The complaint sought a judgment for $52,438.97. Subsequently, the complaint was amended to include additional allegations charging Mr. Berger with fraud, misrepresentation, and diversion of income. This litigation arose out of Sam Berger’s activities in connection with the Country Club Park joint venture and the Lake Murray Development Company.

On October 28, 1957, Sam Berger entered into an agreement of settlement, compromise, and release with the opposing parties, under which it was agreed that the charges against Mr. Berger would be dismissed upon the payment by Mr. Berger to the opposing parties of a total of $208,500. The settlement agreement contemplated that the payment by Mr. Berger of the $208,500 would be made over a period of 6 years.

The plaintiff’s share of the $208,500 to be paid by Sam Berger over a 6-year period amounted to $13,500. During the calendar year 1958, the plaintiff received $5,000 under the settlement agreement of October 28, 1957, with Sam Berger.

In his income tax return for 1958, the plaintiff did not include as taxable income the item of $5,000 mentioned in the preceding paragraph. However, when the Internal Revenue Service audited the plaintiff’s return for 1958, it determined that the sum of $5,000 constituted taxable income to the extent of $3,644, and a deficiency was assessed against the plaintiff with respect to this item.

The answer to the question of whether an amount received in settlement of a lawsuit constitutes taxable income is to be determined on the basis of the nature of the action settled. Carter’s Estate v. Commissioner, 298 F. 2d 192, 194 (8th Cir. 1962), cert. denied, 370 U.S. 910. If the amount received in settlement represents compensation for the loss or impairment of a capital asset, such amount is not taxable as ordinary income. Durkee v. Commissioner, 162 F. 2d 184, 186 (6th Cir. 1947); Jones v. Corbyn, 186 F. 2d 450, 453 (10th Cir. 1950). On the other hand, if the amount received in settlement represents punitive damages on account of wrongful conduct by the person making the payment, the amount of the recovery constitutes ordinary income. Commissioner v. Glenshaw Class Co., 348 U.S. 426, 431 (1955).

In this connection, the taxpayer in a case such as the present one has the burden of proving that money received in settlement of a lawsuit represents a recovery of capital, rather than ordinary income. Phoenix Coal Co. v. Commissioner, 231 F. 2d 420, 423 (2nd Cir. 1956); Sager Clove Corp. v. Commissioner, 311 F. 2d 210, 211 (7th Cir. 1962), cert. denied, 373 U.S. 910 (1963).

In the present case, it has been noted that the litigation out of which the settlement arose was first instituted on the basis of money lent, money had and received, and money paid on open book account — i.e., for the recovery of capital— and the complaint originally sought a judgment for $52,-438.97. However, the complaint was later amended to include additional allegations charging Mr. Berger with fraud, misrepresentation, and diversion of income — i.e., malfeasance. Therefore, in the absence of evidence to the contrary, it is reasonable to infer that when the litigation was ultimately settled through the payment by Mr. Berger of a total of $208,500, not more than $52,488.97 of the total sum represented a recovery of capital by the successful parties under the original allegations of the complaint, and that the remainder represented punitive damages recovered on account of Mr. Berger’s alleged malfeasance.

In any event, the plaintiff has not introduced any evidence tending to show that more than $52,488.97 represented a recovery of capital.

It must be concluded, therefore, that the plaintiff has not sustained his burden of proof by establishing that the Internal Bevenue Service was in error when it regarded as ordinary income $3,644 out of the $5,000 which the plaintiff received in 1958 under the settlement agreement.

SALE OK INTEREST IN LAND OPTION

As indicated in the first part of this opinion, the Lake Murray Development Company received from the Sam Berger Investment Company on October 26, 1954, an irrevocable option to purchase, within a 5-year period, a maximum of 500 acres of land at a price of $2,000 per acre; the Lake Murray Development Company partially exercised the option by purchasing 150 acres of land from the Sam Berger Investment Company; and the Lake Murray Development Company proceeded to develop the 150-acre tract by constructing homes thereon and then selling the homes.

Completion of the Lake Murray Development Company’s program for the construction of homes on the 150-acre tract purchased by the corporation from the Sam Berger Investment Company was guaranteed by the Phoenix Insurance Company of Hartford, Connecticut. In turn, the plaintiff and the other investors in the corporations comprising the Country Club Park joint venture (i.e., the owners of the Lake Murray Development Company) guaranteed the Phoenix Insurance Company against loss.

The Lake Murray Development Company’s project for the development of the 150-acre parcel of land previously mentioned was a failure. As a consequence, the Lake Murray Development Company became insolvent; and on May 4,1956, it assigned to tbe Phoenix Insurance Company all of its assets, except that the Lake Murray Development Company retained the right under the option agreement of August 26, 1954, to purchase 200 acres of land out of the 500-acre area originally covered by the option.

Subsequently, the Lake Murray Development Company assigned this retained interest in the option to the plaintiff and other investors who had advanced additional sums to the corporation during the course of its financial difficulties. The assignment was executed in consideration of the cancellation of claims based upon such advances.

On August 1, 1957, the assignees, as a group, gave written notice to the Sam Berger Investment Company of their intention of exercising the option, to the extent of 150 acres of land, and deposited the necessary consideration therefor with the Union Title Insurance and Trust Company.

On October 31, 1957, the assignees sold their interest in the land option to the Tavares group for $340,000, to be paid in installments. As a part of this transaction, the notice of August 1, 1957, concerning a partial exercise of the option was rescinded, and the deposit which the assignees had made was returned to them.

The sale of the option interest referred to in this part of the opinion was made at the same time when the plaintiff and other limited partners in the Sam Berger Investment Company conveyed their combined 20 percent interest in that company to the Tavares group. Both sales were part of a “package deal.”

In 1958, the plaintiff received $3,691.85 under the contract of sale for the disposition of the option interest to the Tavares group.

In his Federal income tax return for 1958, the plaintiff treated the sum of $3,691.85 as proceeds from the sale of a capital asset, and it was similarly treated by the Internal Bevenue Service in the audit of the plaintiff’s 1958 income tax return. In the present litigation, however, the defendant has asserted as an affirmative defense that the $3,691.85 represents proceeds from the sale of property held by the plaintiff primarily for sale to customers in the ordinary course of his trade or business and, accordingly, that the gain must be considered as ordinary income by virtue of the provision in Section 1221(1) of the Internal Revenue Code of 1954 considered in the first part of this opinion.

Section 1234 of the Internal Revenue Code of 1954, as amended by Section 53 of the Technical Amendments Act of 1958 (72 Stat. 1606, 1644), provides in subsection (a) as follows:

Gain or loss attributable to the sale or exchange of, or loss attributable to failure to exercise, a privilege or option to buy or sell property shall be considered gain or loss from the sale or exchange of property which has the same character as the property to which the option or privilege relates has in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him).

Therefore, it is necessary to determine in this case whether, if the 200 acres of land covered by the option which the plaintiff and his associates sold to the Tavares group on October 31, 1957, had actually been acquired by the plaintiff and his associates, the plaintiff’s interest in such land would have constituted a capital asset.

In this connection, it has been noted in the first part of this opinion that Section 1221(1) of the Internal Revenue Code of 1954 expressly declares that property held primarily for sale to customers in the ordinary course of trade or business is outside the scope of the term “capital asset.” Hence, the present task is to determine whether, if the 200 acres of land had been acquired by the plaintiff and his associates under the option on October 31, 1957, the plaintiff’s interest in such a tract would have been held by him primarily for sale to customers in the ordinary course of trade or business.

Both the plaintiff, when he prepared his income tax return for 1958, and the Internal Revenue Service, when it audited the plaintiff’s return for 1958, took the position that the sale of the plaintiff’s interest in the land option constituted the sale of a capital asset, and, hence, that the plaintiff’s interest in the 200-acre tract, if the land had been acquired, would not have been held by the plaintiff primarily for sale to customers in the ordinary course of his trade or business. I believe that the plaintiff and the IRS were correct.

As indicated in the first part of this opinion, the question of whether land is held primarily for sale to customers in the ordinary course of trade or business is one of fact and is to be answered upon the basis of a careful analysis of the facts of the particular case.

The plaintiff has, for many years, been engaged full-time in the business of manufacturing women’s lingerie. The only evidence in the record respecting sales by the plaintiff of land or interests in land (other than those previously mentioned in this opinion) indicates that on March 16, 1955, the plaintiff sold a hotel property which he had acquired on August 31, 1954; that on September 17, 1958, he sold a building and lot which he had acquired on January 26, 1949; and that on July 31, 1961, the plaintiff sold his private residence, which he had acquired in August 1955. The evidence does show that the plaintiff owned interests in, and received income from, several pieces of real estate other than those mentioned in the preceding sentence, but he testified at the trial that he acquired and held such realty for investment purposes, and there is no evidence to rebut the plaintiff’s testimony in this respect.

On the whole record, I do not believe that there is a reasonable basis for a finding that the plaintiff was engaged in the business of selling land or interests in land to customers on October 31, 1957, or that, if the plaintiff and his associates had exercised the 200-acre option on that date, the plaintiff’s interest in the land thus acquired would have been held by him primarily for sale to customers in the ordinary course of his trade or business.

I am not unmindful of the fact that the plaintiff was a shareholder in the corporations comprising the Country Club Park joint venture and, as such, that he also owned, in effect, an interest in the Lake Murray Development Company, and that both the Country Club Park joint venture and the Lake Murray Development Company were clearly engaged in the business of acquiring sizeable tracts of land, subdividing the land, building homes on the smaller parcels, and then selling the homes. However, the plaintiff did not personally take part in the management or other activities of these corporations ; and I do not believe that he could properly be held to be engaged in the business of selling land to customers merely because he owned stock in corporations that were engaged in that type of business. Gordy, 36 T.C. 855, 859-860 (1961).

It is my opinion, therefore, that the sale by the plaintiff of his interest in the land option on October 31,1957, did not constitute the sale of property held by the plaintiff primarily for sale to customers in the ordinary course of Ms trade or business, but instead constituted the sale of a capital asset, and that the gain received by the plaintiff in 1958 from such transaction should be regarded as a capital gain, under Section 1234(a) of the Internal Revenue Code of 1954, as amended.

It necessarily follows that the defendant’s affirmative defense with respect to the item considered in this part of the opinion cannot properly be sustained.

EXPENSES

Completion of the Lake Murray Development Company’s program for the construction of homes on the 150-acre tract purchased by the corporation from the Sam Berger Investment Company was guaranteed by the Phoenix Insurance Company of Hartford, Connecticut. In turn, the plaintiff and the other investors owning interests in the Lake Murray Development Company guaranteed the Phoenix Insurance Company against loss.

Under the guaranty which the plaintiff and the other investors in the Lake Murray Development Company had made to the Phoenix Insurance Company, the plaintiff was required in 1958 to pay to Phoenix a total of $6,670 as his part of the guaranty, and he also paid legal fees amounting to $1,220.79 in connection with this matter.

Also, in connection with the sale by the plaintiff of his interest in the 200-acre option discussed in the preceding part of this opinion, the plaintiff incurred in 1958 expenses amounting to $213.07.

One of the issues in the present case is whether the amounts of $6,670, $1,220.79, and $213.07 mentioned in this part of the opinion were wholly deductible in 1958 (as contended by the plaintiff), or whether (as determined by the Internal Revenue Service when it audited the plaintiff’s income tax return for 1958) these amounts should be regarded as part of the cost basis for the land option which the plaintiff and his associates received as part of the over-all settlement between the Lake Murray Development Company and the Phoenix Insurance Company, and, therefore, since the proceeds derived by the plaintiff from the sale of the option were reported by him for income tax purposes in the returns for the different years in which such proceeds were actually received in installments, the costs should similarity be allocated on a pro rata basis among the several years in which proceeds were received.

The defendant introduced evidence at the trial, through a representative of the Internal Revenue Service, relative to the reasoning behind the agency’s action respecting these expense items. The plaintiff, on the other hand, did not introduce any evidence to show that the IRS committed error.

A determination by the Internal Revenue Service that certain expenditures were not ordinary expenses in the course of doing business, but rather were in the nature of a capital outlay, is presumed to be correct, and a taxpayer has the burden of disproving it. Welch v. Helvering, 290 U.S. 111, 115 (1933). Therefore, the plaintiff in the present case has not sustained his burden of proof by introducing evidence to prove that the Internal Revenue Service incorrectly handled the items mentioned in this part of the opinion.

FINDINGS oe Fact

1. (a) The plaintiffs are husband and wife. They reside in Beverly Hills, California. (The evidence indicates that the plaintiff Claire Morse was not involved in the events which gave rise to the present litigation, except that she signed a joint Federal income tax return with her husband for the year involved in the suit. Accordingly, when the term “plaintiff” is used hereafter in the singular, it will refer to the plaintiff Theodore Morse.)

(b) The plaintiff has, for many years, been engaged full-time as part owner and executive in the business of manufacturing women’s lingerie.

(c) For the past 15 years, Allen R. Balton has been a partner of the plaintiff in the lingerie business.

2. During the period 1953-1954, sis corporations designated as Hilltop Homes, Inc., Hilltop Ranchos, Inc., Hilltop Estates, Inc., Hilltop Park, Inc., Hilltop Vista, Inc., and Country Club Park Construction Co., Inc., were formed in the State of California for the purpose of acquiring real estate, developing real estate, and selling and dealing in real estate.

3. Prior to the formation of the corporations mentioned in finding 2, the individual investors who were planning to organize such corporations executed a joint venture agreement under the date of August 28, 1953, in the names of the six prospective corporations. The purpose of the joint venture was to develop 600 homes on approximately 160 acres of land in Chula Vista, California. The joint venture was referred to in the agreement of August 28, 1953, as the “Country Club Park joint venture,” and it will be similarly referred to in subsequent findings.

4. Sam Berger was the person instrumental in the formation of the several corporations mentioned in finding 2 and in the creation of the Country Club Park joint venture, and he held a 30 percent interest in them. Other persons were involved as shareholders in the various corporations, and among them were Herbert Glaser 10 percent, Jack Barenfeld 6% percent, Samuel Glaser 6% percent, and Allen E. Balton. E. L. Freeland, who was not an investor in the corporations previously mentioned or in the Country Club Park joint venture, was engaged by the joint venture as its land engineer.

5. (a) The plaintiff, from time to time between December 1953 and March 1954, invested in the corporations making up the Country Club Park j oint venture. His participation was secured through his partner in the lingerie business, Allen E. Balton. The plaintiff’s total investment amounted to $11,250, and his proportion of the capital stock was 3ys percent.

(b) The plaintiff did not personally participate in the management or other activities of the corporations or of the joint venture.

6. In addition to the initial capitalization of each corporation, further advances were made by the stockholders to all six corporations from time to time for the benefit of the Country Club Park joint venture. All money advanced to any one corporation was made available for the general use of the joint venture. These advances were usually made by the stockholders in proportion to their stock ownership.

7. The funds of the several corporations previously mentioned were freely transferred among the group of corporations without any formal evidence of indebtedness.

8. The six corporations previously mentioned had common officers, directors, stockholders, employees, administrative facilities, and offices.

9. The Country Club Park joint venture proceeded to develop the 160 acres of land mentioned in finding 3, by subdividing the land and constructing on it homes for sale.

10. On or about August 6, 1954, while the subdivision of the 160-acre tract of land in Chula Vista and the construction of homes thereon by the Country Club Park joint venture were in progress, a partnership was formed between Sam Berger and E. L. Ereeland for the purpose of purchasing approximately 4,500 acres of land in San Diego, California. The land was commonly known as the Third Annexation of the Waring Property.

11. (a) On August 6, 1954, Sam Berger purchased, through escrow, on behalf of himself or his nominee, a parcel of land containing approximately 4,500 acres located in the County of San Diego, California, and designated as portions of Lots 67, 68, 69, and 70 of Rancho Mission. The total consideration provided for in the purchase agreement was $4,676,666.66. The land was acquired from the Kensington Heights Company, and was the same acreage referred to in finding 10. Of the total purchase price, a deposit of $100,000 was to be made within 30 days of the execution of the escrow agreement, and the agreement contained a promise on the part of the purchaser to pay the balance in 20 annual installments, the first to be due on August 6, 1955. These installment payments began at $180,000 per annum and were increased by $6,000 per annum until the 19th payment totaled $288,000. The 20th payment was to be $130,666.66.

(b) The escrow agreement further provided in part as follows:

Buyer shall deposit or cause to be deposited with Union Title Insurance and Trust Company * * * the sum of not less than $200,000 in cash, which sum is not a part of the purchase price of said property, for the purpose of paying for the installation of on-site improvements, water facilities, water mains, sewers and roads to and on said property. Said sum shall be disbursed by Union Title Insurance and Trust Company upon instructions of Kensington Heights Company * * * for the payment of said costs. * * *

(c) The term “off-site improvements” is used by builders to indicate that certain improvements, e.g., water, sewerage facilities, roads, etc., are to be brought up to the property that is being developed.

12. (a) Pursuant to his agreement with E. L. Freeland, Sam Berger nominated the partnership to take title to the property covered by the escrow agreement mentioned in finding 11.

(b) The funds for the initial payment of $100,000 that was to be made within 30 days from August 6, 1954, were provided by E. L. Freeland to the extent of $70,000 and by Sam Berger to the extent of $30,000.

13. (a) Several weeks subsequent to August 6, 1954, a formal limited partnership agreement was executed, and on November 22, 1954, a certificate of limited partnership was filed with the State of California. It was the intention of the partners that the effective date of the limited partnership would be August 6, 1954.

(b) The limited partnership agreement indicated that Sam Berger and E. L. Freeland were the general partners, and that Miss Margaret Lowthian, the Lake Murray Trust No. 1, the HAB Trust, and the MLB Trust were the limited partners. The document further stated that the purpose of the partnership was to carry on the business of buying, selling, and developing land upon the tract of approximately 4,500 acres referred to in findings 10 and 11. The partnership was to be known as the Sam Berger Investment Company.

(c) The certificate of limited partnership, signed by all of the partners and filed with the State of California in San Diego County, recited that the general nature of the business of the partnership was that of “buying, owning, holding, improving, selling, exchanging, leasing, mortgaging, and dealing in real and personal property.”

(d) Both the agreement and the certificate stated that the partnership would exist for a term of 10 years.

(e) The partnership agreement provided (among other things) that each partner, general or limited, was prohibited from selling, assigning, or transferring his interest in the partnership to any person other than another partner. The agreement further provided that “it is specifically understood and agreed that neither partner, general or limited, may sell, assign, transfer, convey, hypothecate, nor encumber his interest nor any part thereof in this limited partnership without the written consent of both general partners.”

(f) The respective interests of the general and limited partners in the Sam Berger Investment Company were as follows: general partner Sam Berger, 20 percent; general partner E. L. Freeland, 32 percent; limited partner HAB Trust, 10 percent; limited partner MLB Trust, 10 percent; limited partner Margaret Lowthian, 8 percent; and limited partner Lake Murray Trust No. 1, 20 percent.

(g) The interests of the HAB Trust and the MLB Trust in the Sam Berger Investment Company were created by Sam Berger for the benefit of two of his sons, Harvey A. Berger and Marshall L. Berger. Sam Berger was trustee of the HAB Trust and the MLB Trust.

(h) The 20 percent interest in the Sam Berger Investment

Company held under the name of Lake Murray Trust No. 1 was established for the benefit of Jack Barenfeld and Samuel Glaser, and represented a hidden, secret profit for them. The sum of $200,000 was required for off-site improvements in connection with the land purchased by the partnership (see finding 11(b)), and Jack Barenfeld and Samuel Glaser committed themselves to provide the $200,000 (over and above an initial sum of $400 in cash) in return for a 20 percent interest in the Sam Berger Investment Company.

14. The land acquired by the Sam Berger Investment Company, as indicated in findings 11-13, was situated a distance of from 20 to 25 miles away from the project of the Country Club Park joint venture (see findings 3 and 9). It bad been annexed to tbe City of San Diego on December 1, 1953. In connection with the petition for such annexation, a master-plan map was required and was prepared.

15. At the time when the Sam Berger Investment Company purchased the property referred to in findings 11-13, the land was in an undeveloped state, except that approximately 600 acres had been devoted to the growing of barley for several years under a lease issued by the former owner. However, the land was considered developable for urban usage at the time of its acquisition by the Sam Berger Investment Company; and the consideration paid by the Sam Berger Investment Company for the land was a fair price if the intended use of the land was for urban development. During the period 1950-1954, other persons were developing for urban usage adjacent areas both to the east and to the west of the land acquired by the Sam Berger Investment Company. This near-by development enhanced the value of the property purchased by the Sam Berger Investment Company.

16. Of the 4,500 acres of land acquired by the Sam Berger Investment Company, there was a northern section of approximately 1,500 acres which was very hilly. The land in that section had a fair market value of from $200 to $300 an acre in 1954, on an average. The remaining 3,000 acres were divided into two fairly equal areas by a deep gully which formed the apex of a lake, known as Lake Murray. On the eastern side of the lake, the land was fairly flat. The land in this area had a fair market value of approximately $1,250 per acre, on the average, in 1954. On the western side of the lake, there was an area of rolling land close to the lake, totaling about 500 acres, which had a fair market value of approximately $2,000 per acre in 1954, on the average. The remainder of the land on the western side of the lake was hilly. It had a fair market value of approximately $1,250 per acre in 1954, on the average.

17. (a) On October 21, 1954, the Lake Murray Development Company was formed as a California corporation for the purpose of subdividing land and constructing homes thereon for sale or rental.

(b) The person instrumental in forming the Lake Murray Development Company was Sam Berger.

(c) In comiection with the formation of the Lake Murray Development Company, it was intended that this company should engage in a program of purchasing land from the Sam Berger Investment Company for the purpose of constructing homes thereon.

(d) The capitalization of the Lake Murray Development Company was in the amount of $5,000, and this sum was provided by the corporations comprising the Country Club Park joint venture. The shares of stock in the Lake Murray Development Company were initially issued to Herbert Glaser as trustee for the corporations comprising the Country Club Park joint venture. Thereafter, the capital stock was transferred on September 24, 1955, to the Country Club Park Construction Co., Inc., one of the corporations previously mentioned. Hence, the individuals owning the stock of the corporations making up the Country Club Park joint venture also owned, in effect, proportionate interests in the Lake Murray Development Company.

(e) The plaintiff did not personally participate in the management or other activities of the Lake Murray Development Company.

18. (a) In order to obtain the funds with which to meet the first five annual escrow payments under the agreement of August 6, 1954 (see finding 11(a)), the Sam Berger Investment Company on October 26, 1954, executed an option agreement with the Lake Murray Development Company, under which the latter corporation was granted an irrevocable option to purchase, within a 5-year period, a maximum of 500 acres of land within an area described in the document, such area being part of the 4,500 acres of land previously acquired by the Sam Berger Investment Company. The price to be paid by the Lake Murray Development Company for the land purchased under the option was $2,000 per acre.

(b) The option agreement of October 26, 1954, also stated that the Lake Murray Development Company had loaned to the optionor the sum of $200,000 to be deposited with the Union Title Insurance and Trust Company for the financing of off-site improvements, pursuant to the escrow agreement of August 6, 1954.

(c) The area covered by the option referred to in this finding was situated on the eastern side of Lake Murray.

19. After acquiring the 4,500 acres of land mentioned in previous findings, the Sam Berger Investment Company carried on the raising of barley on approximately 600 acres of the land. The necessary labor for the planting and harvesting of the barley in the spring and fall of the year was hired by the Sam Berger Investment Company, as needed. The area in which the barley was raised included part of the 500 acres that were subject to the option agreement between the Sam Berger Investment Company and the Lake Murray Development Company. However, there was an agreement between the two companies that the farming operations would cease as to any portion of the 500 acres on which the Lake Murray Development Company might exercise the option.

20. (a) As indicated in findings 11(b) and 13(h), the Sam Berger Investment Company was required under the escrow agreement of August 6,1954, to deposit with the Union Title Insurance and Trust Company $200,000 for off-site improvements on the land acquired by the former company, and Jack Barenfeld and Samuel Glaser had made a commitment to provide this sum in exchange for a 20 percent interest in the Sam Berger Investment Company, to be held under the name of Lake Murray Trust No. 1. Samuel Glaser and Jack Baren-feld fulfilled their commitment by causing $200,000 to be provided by the corporations comprising the Country Club Park joint venture. The Lake Murray Development Company was used as a conduit for the transfer of the money from the Country Club Park joint venture to the Union Title Insurance and Trust Company for the account of the Sam Berger Investment Company, under the escrow agreement; and the Union Title Insurance and Trust Company disbursed the funds for the off-site improvements required by the terms of the escrow agreement. The Sam Berger Investment Company did not expect to repay the $200,000, and the transaction was not evidenced by any promissory note or other security instrument executed by the Sam Berger Investment Company.

(b)By virtue of the developments mentioned in paragraph (a) of this finding, the escrow closed on October 26, 1954.

21. The off-site improvements financed by the $200,000 referred to in finding 20 were made by the Sam Berger Investment Company on acreage that was covered by the option agreement with the Lake Murray Development Company, although not on the 150-acre parcel purchased by the Lake Murray Development Company pursuant to the partial exercise of its option (see finding 24).

22. In addition to granting the 500-acre option to the Lake Murray Development Company, and carrying on the f arming operations mentioned in finding 19, the Sam Berger Investment Company engaged in the following activities:

(a) sold 1/2 acre to the Pacific Telephone & Telegraph Company;
(b) granted options to the San Diego School District for the purchase of sites for three elementary schools and one junior high school;
(c) sold a small parcel of land near the westerly boundary to a developer of nearby land, in order that such developer might construct a reservoir that would furnish a gravity flow of water to his property (this sale having been a requirement imposed on the Sam Berger Investment Company by the Kensington Heights Company in the purchase and sale agreement between the two parties);
(d) granted easements for the laying of a gas line and a water line;
(e) had certain portions of the acreage rezoned as B-2 (residential) and commercial; and
(f) executed an agreement with the engineering firm of Freeland, Peterson and Evenson to design a master plan for the development of the land owned by the company.

23. On November 8, 1954, E. L. Freeland, as a member of the firm of Freeland, Peterson and Evenson, forwarded to the San Diego Planning Commission, on behalf of the Lake Murray Development Company, copies of a master-plan map for the development of the land owned by the Sam Berger Investment Company, and copies of a master plan giving the details for the proposed development of approximately 1,100 acres for residential and commercial use. The Commission was requested to consider the planned development.

24. Within a short time after the execution of the option agreement referred to in finding 18, the Lake Murray Development Company partially exercised its option by purchasing 150 acres of land from the Sam Berger Investment Company. The latter company did not retain any title to or interest in this acreage.

25. After acquiring the 150 acres of land referred to in finding 24, the Lake Murray Development Company proceeding to develop the land by constructing homes thereon and then selling the homes.

26. Sam Berger was President of the Lake Murray Development Company, and he was in active charge of that company’s development work on the 150 acres of land acquired by the Lake Murray Development Company from the Sam Berger Investment Company.

27. (a) Disagreements arose between Sam Berger and E. L. Freeland fairly early in their association as general partners in the Sam Berger Investment Company. These disagreements related principally to the fact that Sam Berger, as the President and general manager of the Lake Murray Devlopment Company, engaged bulldozers and their operators to work on land which was included in the 500-acre option to the Lake Murray Development Company but as to which the Lake Murray Development Company had not yet exercised its option. Mr. Freeland was concerned over the possibility that charges for such development work might not be paid by the Lake Murray Development Company, with the result that there would be mechanics’ liens on the land, for which the Sam Berger Investment Company would be responsible.

(b) E. L. Freeland, through his attorney, on May 10, 1955, expressed his desire to supervise and concur in any contract that might be made for development work on land owned by the Sam Berger Investment Company, whether such work was for off-site improvements or for lot development.

28. A loan of $100,000 was obtained by the Lake Murray Development Company on July 25, 1955, from the Bank of America. The loan was guaranteed by the plaintiff and the other investors in the corporations comprising the Country Club Park joint venture.

29. Many of the bills and current expenses incurred by the Lake Murray Development Company in developing the 150-acre tract mentioned in findings 24 and 25 were paid by one or more of the corporations making up the Country Club Park joint venture. Funds were freely transferred by such corporations to the Lake Murray Development Company without any evidence of formal indebtedness. Advances made to the Lake Murray Development Company by the corporations comprising the Country Club Park joint venture were all subordinated to the loan made by the Bank of America to the Lake Murray Development Company.

30. Completion of the Lake Murray Development Company’s program for the construction of homes on the 150-acre tract purchased by the corporation from the Sam Berger Investment Company was guaranteed by the Phoenix Insurance Company of Hartford, Connecticut. In turn, the plaintiff and the other investors in the corporations comprising the Country Club Park joint venture guaranteed the Phoenix Insurance Company against loss.

31. On August 8, 1955, the engineering firm of Freeland, Peterson and Evenson wrote to the Sam Berger Investment Company, setting forth alternative plans for development of the 500 acres that were subject to the option agreement with the Lake Murray Development Company. This letter informed the Sam Berger Investment Company of the expenses which it would incur in off-site improvements if the proposed plans for development were adopted. Because of the prospective expense to the Sam Berger Investment Company, the proposed plans were abandoned.

32. The Lake Murray Development Company’s project for the development of the 150-acre parcel of land mentioned in previous findings was a failure. As a consequence, the Lake Murray Development Company became insolvent; and on May 4, 1956, it assigned to the Phoenix Insurance Company all of its assets, except that the Lake Murray Development Company retained the right under the option agreement of October 26, 1954, to purchase 200 acres of land out of the 500-acr,e area originally covered by the option. Therefore, since the Lake Murray Development Company had already partially exercised the option by purchasing the 150 acres of land mentioned in previous findings, the portion of the option assigned to the Phoenix Insurance Company covered the right to purchase 150 acres of land from the Sam Berger Investment Company under the option. This right was subsequently exercised by the Phoenix Insurance Company.

33. (a) Upon learning that Jack Barenfeld and Samuel G-laser had provided $200,000 for the Sam Berger Investment Company out of the funds belonging to the corporations which comprised the Country Club Park joint venture, in return for a 20 percent interest in the Sam Berger Investment Company under the name of Lake Murray Trust No. 1, the plaintiff and the other stockholders in the corporations comprising the Country Club Park joint venture (excluding Sam Berger, Jack Barenfeld, and Samuel Glaser) contested the hidden interest of Jack Barenfeld and Samuel Glaser in the Sam Berger Investment Company under, the name of Lake Murray Trust No. 1. The plaintiff and his associates in the contest contended that, by virtue of the use of $200,000 belonging to the Country Club Park joint venture for the benefit of the Sam Berger Investment Company, they had a participating interest in the Sam Berger Investment Company through the Lake Murray Trust No. 1. This dispute was settled on May 7, 1956, by dividing the 20 percent limited partnership interest of the Lake Murray Trust No. 1 among all the individuals owning stock in the corporations making up the Country Club Park joint venture (excluding Sam Berger). The plaintiff and his associates in the contest paid no additional monetary consideration for their interests in the Sam Berger Investment Company.

(b) As a result of the developments referred to in paragraph (a) of this finding, the plaintiff had a .723 percent interest in the Sam Berger Investment Company.

34. (a) In August 1956, Carlos Tavares, representing a group of individuals which included himself and which will be referred to hereafter in the findings as the “Tavares group,” approached Sam Berger with respect to the acquisition of Mr. Berger’s interest in the Sam Berger Investment Company. On August 10, 1956, Sam Berger and the Tavares group entered into a contract of sale and purchase. In this document, the seller, Sam Berger, warranted that he held his original 20 percent interest in the Sam Berger Investment Company and that he had acquired the interests of the HAB Trust and the MLB Trust, so that he then had a 40 percent interest in the Sam Berger, Investment Company. The document further stated that this 40 percent interest was conveyed by Sam Berger to the Tavares group for $950,000.

(b) The document mentioned in paragraph (a) of this finding further stated as follows:

The sale which is the subject of this agreement does not contemplate that the Buyers will acquire any interest in existing partnership cash, whether in partnership bank accounts or on deposit in trust accounts of other persons. As a matter of fact, it is the intention of the parties hereto that the only asset of said partnership which the Buyers will acquire is the land described in EXHIBIT “A” [i.e., the 4,500 acres acquired by the Sam Berger Investment Company on August 6, 1956, less the acreage disposed of in the meantime, as indicated in previous findings].

(c) Sam Berger did not obtain the approval of E. L. Free-land or of the limited partners in the Sam Berger Investment Company before entering into the contract of sale mentioned in this finding.

35. (a) On August 13, 1956, the corporations comprising the Country Club Part joint venture and the individual investors in those corporations filed against Sam Berger an action for money lent, money had and received, and money paid on open book account. The complaint sought a judgment for $52,438.97. Subsequently, the complaint was amended to include additional allegations charging Mr. Berger with fraud, misrepresentation, and diversion of income.

(b) The litigation referred to in paragraph (a) of this finding arose out of Sam Berger’s activities in connection with the Country Club Park joint venture and the Lake Murray Development Company.

(c) On October 28, 1957, Sam Berger entered into an agreement of settlement, compromise, and release with the opposing parties in the case referred to in the preceding paragraphs of this finding, under which it was agreed that the charges against Mr. Berger would be dismissed upon the payment by Mr. Berger to the opposing parties of a total of $208,500.

(d) Under the settlement agreement, the releasors discharged Sam Berger from “all manner of actions and causes of action, accounts, contracts, claims, and demands of every kind and nature whatsoever * *

(e) The settlement agreement contemplated that the payment by Mr. Berger of the $208,500 would be made over a period of 6 years.

(f) The plaintiff’s share of the $208,500 to be paid by Sam Berger over a 6-year period amounted to $13,500.

(g) During the calendar year 1958, the plaintiff received $5,000 under the settlement agreement of October 28, 1957, with Sam Berger.

36. (a) After entering into the contract with Sam Berger for the purchase of his 40 percent interest in the Sam Berger Investment Company, as indicated in finding 34, the Tavares group approached E. L. Freeland with respect to the acquisition of his 32 percent interest in the Sam Berger Investment Company. On November 26, 1956, a contract of purchase and sale was entered into between the Tavares group and Mr. Freeland, under which Mr. Freeland’s interest in the Sam Berger Investment Company was conveyed to the Tav-ares group for a total consideration of $730,000. This contract stated that the buyers were not to receive any interest in the cash of the Sam Berger Investment Company.

(b) E. L. Freeland did not obtain the approval of the limited partners in the Sam Berger Investment Company before entering into the contract that is mentioned in this finding.

37. At the time when the Tavares group entered into the contract with E. L. Freeland that is mentioned in finding 36, the Tavares group also acquired the 8 percent limited partnership interest of Margaret Lowthian in the Sam Berger Investment Company.

38. As of November 26, 1956, the Sam Berger Investment Company still owed $4,210,666.66 on the purchase price of the land acquired on August 6, 1954.

39. A Federal income tax return was filed on behalf of the Sam Berger Investment Company for the period from January 1, 1956, to November 26, 1956, as a final return for the partnership.

40. (a) On October 31, 1957, after some negotiations, the Tavares group entered into a contract of purchase and sale with the limited partnership interests in the Sam Berger Investment Company (other than Margaret Lowthian, the HAB Trust, and the MLB Trust), and thereby received the limited partners’ consent to the prior agreements made by the Tavares group for the purchase of other interests in the Sam Berger Investment Company, as indicated in findings 34, 36, and 37. The limited partnership group was represented in its negotiations by Jack Barenfeld and Sam Glaser. They contended, through their attorney, that the Tavares group had no right to participate in the affairs of the partnership or to direct or control its affairs. During the negotiations, Barenfeld and Glaser, speaking for themselves, both expressed an intention of joining Mr. Tavares as partners in the development of the subject property.

(b) Under the contract of October 31, 1957, the Tavares group agreed to pay the limited partners, including the plaintiff, a total of $600,000 in installments for their interests in the Sam Berger Investment Company, the only asset of which was stated to be 4,200 acres of land.

(c) By virtue of the contract dated October 31, 1957, the Tavares group completed the acquisition of a 100 percent interest in the land owned by the Sam Berger Investment Company.

(d) During the calendar year 1958, the plaintiff received $7,605.42 under the contract mentioned in this finding.

41. (a) In each of the contracts mentioned in findings 34, 36, 37, and 40, the Tavares group agreed to assume the remaining liability under the escrow agreement of August 6, 1954, and the promissory note that covered the remainder due under the original purchase agreement.

(b)As of October 31, 1957, the Sam Berger Investment Company still owed $4,018,666.66 on the purchase price of the land acquired on August 6, 1954.

42. (a) As indicated in finding 32, when the Lake Murray Development Company assigned its assets to the Phoenix Insurance Company, the former retained the right to exercise the option of October 26, 1954, as to 200 acres. Subsequently, the Lake Murray Development Company assigned this retained interest in the option to the plaintiff and the other investors in the corporations comprising the Country Club Park joint venture (i.e., the owners of the Lake Murray Development Company), who had advanced additional sums to the Lake Murray Development Company during the course of its financial difficulties. The assignment was executed in consideration of the cancellation of claims based upon such advances.

(b) On August 1, 1957, the assignees, as a group, gave written notice to the Sam Berger Investment Company of their intention of exercising the option, to the extent of 150 acres of land, and deposited the necessary consideration therefor with the Union Title Insurance and Trust Company.

(c) On October 31, 1957, the assignees sold their interest in the land option to the Tavares group for $340,000, to be paid in installments. As a part of this transaction, the notice of the exercise of the option mentioned in paragraph (b) of this finding was rescinded, and the deposit which the assignees had made was returned to them.

(d) The sale of the option interest referred to in this finding was made at the same time that the plaintiff and other limited partners in the Sam Berger Investment Company conveyed their combined 20 percent interest in that company to the Tavares group. Both sales were part of a “package deal.”

(e) In 1958, the plaintiff received $3,691.85 under the contract of sale for the disposition of the option interest to the Tavares group.

(f) The plaintiff in 1958 incurred expenses amounting to $213.07 in connection with the sale of the land option.

43. During the period between, the signing of the contract between Sam Berger and the Tavares group on August 10, 1956, and the signing of the contract between the limited partners and the Tavares group on October 31, 1957, no development work was performed on the land owned by the Sam Berger Investment Company, none of the land was sold or offered for sale, and no obligation or indebtedness was incurred for the account of the Sam Berger Investment Company. Some planning work was performed during the period by the Tavares group with respect to the prospective development of the land, but any expense involved in such work was defrayed by the Tavares group.

44. Under the guaranty which the plaintiff and the other investors in the Lake Murray Development Company had made to the Phoenix Insurance Company (see finding 30), the plaintiff was required in 1958 to pay to the Phoenix Insurance Company a total of $6,670 as his part of the guaranty, and he also paid legal fees amounting to $1,220.79.

45. In addition to the transactions previously referred to in the findings of fact, the plaintiff: (a) sold on March 16, 1955, a hotel property which he had acquired on August 31, 1954; (b) sold on September 17, 1958, a building and lot which he had acquired on January 26, 1949; (c) sold on July 31, 1961, his private residence, which he had acquired in August 1955; and (d) owned interests in, and received income from, several other pieces of real estate, which he had acquired for investment purposes.

46. On or before April 15, 1959, the plaintiffs filed a joint Federal income tax return for the calendar year 1958, showing a tax for that year in the amount of $16,790.86. Subsequently, on or before September 11, 1959, the plaintiffs filed an amended joint Federal income tax return for the calendar year 1958, showing a tax due in the amount of $16,184.62.

47. On or before April 15, 1959, the plaintiffs paid to the District Director of Internal Bevenue in Los Angeles, California, $16,184.62 for their income tax liability with respect to the year 1958.

48. The plaintiffs timely extended the time for the assessment of additional income tax respecting the year 1958 to June 30, 1962.

49. (a) In their joint Federal income tax return for 1958, the plaintiffs treated the sum of $7,605.42 mentioned in finding 40(d) as a capital gain. In auditing the plaintiffs’ income tax return for 1958, the Internal Eevenue Service determined that this sum constituted ordinary income.

(b) The plaintiffs in their income tax return for 1958 did not include the item of $5,000 mentioned in finding 35(g) as taxable income. In auditing the plaintiffs’ income tax return for 1958, the Internal Eevenue Service determined that $3,644 out of the $5,000 constituted ordinary income.

(c) In their income tax return for 1958, the plaintiffs treated the amounts of $6,670 and $1,220.79 referred to in finding 44, and the $213.07 referred to in finding 42(e), as wholly deductible in 1958. In auditing the plaintiffs’ income tax return for 1958, the Internal Eevenue Service treated these amounts as allocable to the cost basis of the land option mentioned in finding 42; and, accordingly, these items were utilized by the IES to reduce proportionately the plaintiffs’ gain in 1958 from the sale of that item, the plaintiffs having reported the gain on the installment basis.

(d) In their income tax return for 1958, the plaintiffs treated the sum of $3,691.85 from the sale of their-proportionate share of the land option (see finding 42(e)) as a capital gain, and it was similarly treated by the Internal Eevenue Service in the audit of the plaintiffs’ 1958 income tax return. However, in the present litigation, the defendant has asserted as an affirmative defense that the amount of $3,691.85 actually constituted ordinary income.

50. On or before June 30, 1962, pursuant to the administrative determinations mentioned in finding 49, the plaintiffs were timely assessed additional income tax in the amount of $5,876.25, plus interest thereon in the amount of $1,125.95. The plaintiffs paid these sums on July 10, 1962.

51. (a) On August 7, 1962, the plaintiffs filed a timely claim for refund of the additional sums of tax and interest paid by them, as indicated in finding 50. The grounds alleged in the claim were as follows:

The revenue agent treated a sum of $7,605.42 received by claimants (from the sale of property consisting of tbeir percentage interest in certain acreage, which acreage had at a prior time been held by a partnership known as Sam Berger Investment Company) as ordinary income by virtue of § 735 of INC. This was error. The property sold by claimants was not property other than a capital asset, by virtue of § 735 or any other section of IRC.
The agent also added to income as ordinary income a net sum of $3,644.00 derived by claimants from a settlement with one Sam Berger. (The said net sum represents a sum received of $5,000.00 less a cost factor of $1,356.00.) The said net sum was capital gain, not ordinary income. Furthermore, the said net sum is fully offset by expenses and losses relating to the same transaction and in respect of which the said net sum was received. It should not be taxed at all.
The revenue agent also disallowed deduction of $6,670.00 paid as indemnity to Phoenix Insurance Co. and legal fees and expenses of $1,433.86 related thereto. Claimants believe these are deductible under IRS § 165(c)(2).

(b) The plaintiffs’ claim for refund sought the sum of $7,002.20 “or such other amount as may be refundable based upon the claims made.”

(c) On May 3,1963, the plaintiffs’ claim was denied.

CONCLUSION OE Law

Upon the foregoing findings of fact, which are made a part of the judgment herein, the court concludes as a matter of law that the plaintiffs are entitled to recover on the claim relating to the taxability of the proceeds from the sale of the partnership interest, and judgment is entered to that effect. The amount of the recovery on this claim will be determined in further proceedings pursuant to Rule 47 (c) (2). The court further concludes as a matter of law that the plaintiffs are not entitled to recover on the other claims asserted in the petition, and, accordingly, the petition is dismissed as to such claims. 
      
       The opinion, findings of fact, and recommended conclusion of law are submitted under the order of reference and Rule 57(a).
     