Milton Tolmach and Elaine Tolmach v. Commissioner of Internal Revenue

United States Tax Court
T.C. Memo 1991-538; 1991 Tax Ct. Memo LEXIS 592; 62 T.C.M. (CCH) 1102; T.C.M. (RIA) 91538 (1991)

ELI5:

Rule of Law:

Payments made by a partnership entity to a retiring or withdrawing partner are treated as a liquidation under IRC § 736. The tax character of those payments is governed by the specific terms and allocations within the liquidation agreement, which courts will enforce unless the challenging party can prove mistake, duress, or fraud sufficient to reform the contract.

Facts:

Milton Tolmach was a senior partner in the law firm Hayt, Hayt, Tolmach, & Landau (the Tolmach firm).
From 1971 until 1976, the partnership operated without a written partnership agreement.
Following disagreements about Tolmach's retirement, the other partners, led by Bernard Landau, voted to dissolve the Tolmach firm on April 26, 1976.
The other partners immediately formed a new firm, Hayt, Hayt & Landau (the Landau firm), which continued the business using the Tolmach firm's assets, offices, personnel, and clients.
Tolmach was excluded from participating in the new firm.
After litigation over the firm's dissolution, the parties entered into a settlement agreement to avoid a pending appeal.
The settlement agreement stipulated that Tolmach would receive $1.7 million for his share of 'unrealized receivables' and $155,000 for his interest in 'fixed assets and good will.'
The agreement explicitly stated the $1.7 million payment was 'intended to qualify as guaranteed payments under section 736(a)(2)' of the Internal Revenue Code.

Procedural Posture:

The continuing partners sued Milton Tolmach in the Supreme Court of the State of New York, a state trial court, seeking an accounting of the dissolved firm.
Tolmach counterclaimed for damages arising from his exclusion from the firm.
The trial court confirmed the dissolution and appointed a referee, who valued Tolmach's interest and awarded damages, which the court then confirmed.
The continuing partners, as appellants, filed a notice of appeal of the trial court's judgment.
Before the appeal was prosecuted, the parties settled the dispute via a written settlement agreement.
For the 1983 and 1984 tax years, Tolmach reported payments from the settlement as long-term capital gains on his federal income tax returns.
The Commissioner of Internal Revenue (respondent) disallowed the capital gains treatment, recharacterized the income as ordinary, and issued a notice of deficiency.
Milton and Elaine Tolmach (petitioners) petitioned the United States Tax Court for a redetermination of the tax deficiencies.

Premium Content

Subscribe to Lexplug to view the complete brief

You're viewing a preview with Rule of Law, Facts, and Procedural Posture

Issue:

Does a settlement agreement that explicitly characterizes payments to a withdrawing partner from the successor partnership as 'guaranteed payments' under IRC § 736 constitute a liquidation of the partner's interest, resulting in ordinary income, rather than a sale of the interest to the remaining partners under IRC § 741 that would result in capital gains?

Opinions:

Majority - Halpern

Yes. A settlement agreement that structures payments from the partnership entity to a withdrawing partner constitutes a liquidation under § 736, and its explicit characterization of those payments dictates their tax treatment as ordinary income. The critical distinction between a § 741 sale and a § 736 liquidation is whether the transaction is with the continuing partners individually (sale) or with the partnership as an entity (liquidation). Here, the transaction was a liquidation because the Landau firm, as the successor partnership, was the primary obligor, the agreement explicitly referenced § 736, and the individual partners' liability was only secondary. The court rejected Tolmach's attempt to recharacterize the payments as being for goodwill because § 736(b)(2)(B) requires the partnership agreement to specifically provide for goodwill payments to receive capital gains treatment, and this agreement allocated only $155,000 to goodwill. Under the Danielson rule, a party cannot unilaterally disavow the terms of an agreement for tax purposes without proving grounds such as fraud or duress, which Tolmach failed to do.

Analysis:

This case underscores the doctrine of substance over form, emphasizing that the structure and language of an agreement governing a partner's withdrawal are paramount in determining its tax consequences. It solidifies the principle that partners have wide latitude to negotiate the tax burdens and benefits of a buyout, but they are then bound by that agreement. The decision strongly affirms the high bar set by the Danielson rule, making it difficult for taxpayers to accept the economic benefits of a settlement and later challenge its agreed-upon tax characterization. For legal practice, this means practitioners must be acutely aware that characterizations like 'sale' vs. 'liquidation' and allocations to 'goodwill' have significant and binding tax implications that cannot be easily undone.

Gunnerbot

AI-powered case assistant

Loaded: Milton Tolmach and Elaine Tolmach v. Commissioner of Internal Revenue (1991)

Try: "What was the holding?" or "Explain the dissent"

Premium Feature