The opinion of the court was delivered by: HERMAN
The plaintiffs filed suit seeking the return of tax deficiencies paid under protest. The parties entered into a complete stipulation of facts. The following history of the case includes those stipulated facts upon which the court relies in making its decision.
Luther W. McCoy, Donald E. Kutz and three other persons incorporated the McCoy Electronics Company (MEC) in 1952 under the laws of Pennsylvania. McCoy held approximately one-third of the stock with each of the remaining persons owning one-sixth. In 1960 MEC and Oak Manufacturing Co. began negotiating the sale of all shares of MEC to Oak. The initial offer of $600,000 was rejected by MEC. On February 22, 1961 the parties agreed to a maximum sales price of $800,000 to be paid over a period of time. Oak agreed to pay $450,000 initially, followed by three annual payments not to total more than $350,000. The exact amount of these payments was directly tied to the net earnings of MEC in each of the three years following purchase. Based on the agreement, however, the payments could not exceed $125,000 for 1961, $125,000 for 1962 and $100,000 for 1963. It was, in effect, an installment sale with an adjustable ultimate price. The three inactive shareholders concluded that the net income provision was too risky. Instead they agreed, before the sale to Oak to each take $105,000 from the initial $450,000 payment as complete satisfaction for their shares.
In hopes of securing the maximum payments, Kutz and McCoy entered into an oral agreement on February 23, 1961 with four key employees of MEC. The agreement was reduced to writing in the Spring of 1963. It assured the employees a total maximum of $35,000 over the three years if MEC's net income was sufficient to secure to Kutz and McCoy the maximum payments.
The key men were to be paid after the annual installment payment from Oak, and only in proportion to the net income of MEC. During each of the three years MEC earned enough to entitle the plaintiffs to the maximum payments.
The plaintiffs made the key men payments as promised, claiming the money from Oak as a capital gain and deducting the key men payments from ordinary income. The IRS disallowed the deduction saying it should have been used instead to reduce the amount of gain. The plaintiffs paid the tax due plus interest, under protest, and filed the instant suit to recover the sum.
The plaintiffs, the burdened parties, urge the appropriateness of the deductions based on 26 U.S.C. § 212:
"In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year --
(1) for the production or collection of income;
(2) for the management, conservation, or maintenance of property held for the production of income; or
(3) in connection with the determination, collection, or refund of any tax."
Plaintiffs argue that the key man payments qualify under the "production or collection of income" subsection. Further, they rely on Treasury Regulation 1.212-1(b) which declares that income "for the purpose of section 212 . . . is not confined to recurring income but applies as well to gains from the disposition of property."
"If an expense is capital, it cannot be deducted as 'ordinary and necessary,' . . . under § 212."
The issue, therefore, reduces itself, in our view, to whether or not the key man payments were capital expenses which is determinative of the availability of § 212. It was WOODWARD which formalized the so-called "origin" test. In sum, the test is whether the origin of the ...