## Facts

- V. Zay Smith and three others formed Geophoto Services, a partnership using aerial photography to evaluate geological structures for petroleum exploration.
- The partnership agreement was revised in 1952 to add an expulsion mechanism and to provide that no value would be assigned to goodwill when valuing a departing partner’s interest.
- In January 1957, the other partners voted to expel Smith under the agreement.
- Smith received $77,000 upon expulsion: $72,740.71 in cash and an automobile valued at $4,259.29.
- The stipulated book value of Smith’s partnership interest was $53,264.61, leaving $23,735.39 paid in excess of book value.
- The $23,735.39 excess consisted of $2,045.45 labeled salary and $21,689.94 labeled a premium.
- The Smiths reported the $23,735.39 as capital gain on their 1957 return; the IRS treated it as ordinary income and determined a deficiency.
- The Tax Court sustained the deficiency, and the Smiths petitioned for review in the Tenth Circuit.

## Issues

1. Whether the $23,735.39 paid to Smith in excess of the book value of his partnership interest upon expulsion was capital gain as consideration for goodwill, or ordinary income as a guaranteed payment and/or payment attributable to partnership income.

## Decision

- The Tenth Circuit affirmed the Tax Court.
- The court held that the partnership agreement’s express exclusion of goodwill valuation foreclosed treating any portion of the excess payment as consideration for goodwill.
- The court sustained characterization of the $23,735.39 excess as ordinary income rather than capital gain.

## Legal Principles

- Tax characterization of payments to a withdrawing, retiring, or expelled partner may turn on the partnership agreement’s express terms allocating (or excluding) payment for goodwill.
- When the agreement provides that goodwill will not be valued or paid for in determining a departing partner’s interest, an excess payment over book value cannot be recharacterized as proceeds from the sale of goodwill to obtain capital-gain treatment.
- Amounts paid to a departing partner that function as compensation (including guaranteed-type payments) or as distributions attributable to partnership earnings are ordinary income, not capital gain from the sale of a capital asset.

## Conclusion

Because the partnership agreement barred assigning value to goodwill in valuing a departing partner’s interest, the excess paid to Smith over book value could not be treated as a goodwill buyout and was properly taxed as ordinary income.


Smith v. Commissioner, 313 F.2d 16 (10th Cir. 1962)