(dissenting):

I respectfully dissent. I would reverse the judgment of the district court and remand the case for further factual findings.

I.

The district court found that the trusts were valid partners under Int. Rev.Code § 704(e), since the trusts owned “a capital interest in a partnership [Bateman Brokerage Co.] in which capital is a material income-producing factor.” The district court relied in part on the partnership’s good will, in the form of established client relationships, to support its finding that capital was a material income-producing factor. I would hold that good will in the form of established client relationships is capital for the purposes of § 704(e) only to the extent that it is associated with the business itself and not merely with particular partners individually.

The test that should be applied is whether the good will would remain with the business or follow the individual partner if the partner withdrew from the business and competed with it. Since the district court did not apply this test or make findings of fact that would allow this court to do so, the case should be remanded for a further factual determination.

The majority relies on Rees v. United States, 187 F.Supp. 924 (D.Or.1960), aff’d per curiam, 295 F.2d 817 (9th Cir. 1961), in rejecting the distinction between good will associated with the business itself and good will associated with individual partners. In Rees , a dentist with profitable client relationships sold a partnership interest in his practice. The court permitted the dentist to treat proceeds from the sale of his good will as capital gain.

Good will would normally follow a dentist who withdrew from a partnership and competed in a nearby location. Under the test that I have proposed, a dentist’s good will would not normally be capital for the purposes of § 704(e), yet the Rees court held that the sale of a dentist’s good will was a sale of a capital asset. Therefore, it appears that the proposed test is inconsistent with our holding in Rees .

Rees , however, considered whether the proceeds from the sale of personal good will are capital gain or ordinary income. Section 704(e) deals with the ability of taxpayers to spread income and avoid progressive tax rates. These are very different problems, and the meaning of “capital interest” in this case must be determined with reference to the background and purpose of § 704(e).

Income spreading among family members to avoid progressive tax rates has received considerable judicial attention. In order to restrict the ability of taxpayers routinely to avoid progressive taxation through family income splitting without penalizing bona fide gifts, the Supreme Court developed the distinction between gifts of income itself and gifts of income-producing property. Although a gift of the right to receive income does not shift the tax burden from the person who earns the income, Lucas v. Earl, 281 U.S. 111 , 50 S.Ct. 241 , 74 L.Ed. 731 (1930); Helvering v. Horst, 311 U.S. 112 , 61 S.Ct. 144 , 85 L.Ed. 75 *555 (1940), a gift of income-producing property does shift the tax burden to the donee, Blair v. Commissioner, 300 U.S. 5 , 57 S.Ct. 330 , 81 L.Ed. 465 (1937).

Since they are attractive devices for spreading income to family members, family partnerships were subjected to special scrutiny by the Supreme Court even where the donated partnership interests were clearly capital in nature. Following the Supreme Court’s decision in Commissioner v. Tower, 327 U.S. 280 , 66 S.Ct. 532 , 90 L.Ed. 670 (1946), it was widely believed “that one whose capital interest in a partnership was acquired as a gift, or as the result of the contribution of property acquired as a gift, from a relative who controlled the business would not, in the absence of a participation in the management and control of the business or the performance of other vital services, be recognized as a partner.” Mertens, Law of Federal Income Taxation, Code Commentary § 704.10, p. 33; see e. g., Edwin F. Sandberg, 8 T.C. 423 (1947). The implications of Toiver were mitigated somewhat by Commissioner v. Culbertson, 337 U.S. 733 , 69 S.Ct. 1210 , 93 L.Ed. 1659 (1949), which held that the “vital services” and “original capital” tests were merely indicative rather than conclusive. But even after Culbertson , gifts of capital partnership interests to family members were presumptively ineffective for tax purposes.

In the wake of Culbertson and Tower , Congress passed the predecessor of § 704(e). Its purpose was “to insure that the income properly attributable to a capital interest in a partnership acquired as a gift would be taxed to the donee if he were the real owner of such interest regardless of the motive prompting the transfer to him and regardless of whether or not the business benefited from his participation in its profits.” Mertens, Law of Federal Taxation, Code Commentary § 704.10, p. 33; see H.Rep.No.586, 82d Cong. 1st Sess., p. 34. Thus, § 704(e) overruled the “special services” and “original capital” rules that Tower and Culbertson had established for partnership interests, admittedly capital in nature, that were donated to family members.

Nothing in the history of § 704(e), however, indicates that the standards of Lucas v. Earl, Helvering v. Horst, and Commissioner v. Blair, were no longer applicable for determining, for the purposes of income spreading, whether a capital interest had in fact been transferred. Indeed, the principles of those cases were explicitly approved by the authors of § 704(e):

The two principles referred to in the House Report are derived from Lucas v. Earl, Helvering v. Horst, and Commissioner v. Blair. Thus, it is clear that the drafters of § 704(e) did not intend to overrule those cases, but rather that they merely intended to overrule Tower and Culbertson .

An examination of Lucas v. Earl reveals that income cannot be spread simply because it is generated in part by personal good will. In that case, an attorney attempted to spread half of his income to his wife through an agreement whereby each was to share equally in the income of the other. Certainly the attorney benefited from the same sort of personal good will and client relationships that were found to be a capital interest in Rees . Nevertheless, the taxpayer was prohibited from spreading *556 the income to his wife. By extending Rees to the family income spreading situation and thereby holding that personal good will can be a “capital interest” under § 704(e), the majority permits the very type of income spreading that was condemned in Lucas v. Earl.

The conclusion that personal good will is not a “capital interest” under § 704(e) is also supported by two of the Commissioner’s regulations. Treas.Reg. § 1.704-l(e)(1)(iv) provides:

The income of Bateman Brokerage Co. “consists principally of fees, commissions, or other compensation for personal services performed by members or employees of the partnership.” Under Treas.Reg. .§ 1.704-l(e)(1)(iv), therefore, Bateman Brokerage Co. is the type of business that, “in general,” does not have capital as a material income-producing factor under § 704(e). I would hold that good will excepts a personal service company from the “general” rule of Treas.Reg. § 1.704-l(e)(1)(iv) only when the personal service company has substantial good will that is associated with the company itself.

In addition, Treas.Reg. § 1.704-1 (e) (l)(v) provides:

Good will associated with the company itself can be captured upon dissolution of the partnership, if the business remains intact, by any of the dissolving partners who choose to continue their participation in the business. Personal good will, however, can be captured only by the individual partners with whom it is associated.

Of course, it is desirable that terms of art are used with a uniform meaning throughout the Internal Revenue Code. That personal good will was held to be capital in Rees is a persuasive reason to hold that it is capital under other provisions of the Code. To hold that personal good will is capital for the purpose of § 704(e), however, would be inconsistent with Lucas v. Earl. We should define capital under § 704(e) in a way that is consistent with the Supreme Court’s decision in Lucas v. Earl rather than with our own decision in Rees .

Good will should be defined as a “capital interest” for the purposes of § 704(e) only to the extent that it is associated with the business itself rather than merely with individual partners. I would reverse the judgment of the district court and remand for a factual determination according to this standard.

II.

The district court also found that Group Administrators, Inc. was a valid partner of Bateman Brokerage Co. and that the income of the corporation’s *557 partnership interest was attributable to the corporation rather than to the taxpayers.

Corporate ownership of partnership interests need not be recognized for tax purposes if the corporation is a sham created by the purpose of tax avoidance. Noonan v. Commissioner, 451 F.2d 992 (9th Cir. 1971); Shaw Construction Co. v. Commissioner, 323 F.2d 316 (9th Cir. 1963). Whether a corporation is created for a legitimate business purpose or is a sham is a finding of fact that may be reversed only if “clearly erroneous” under F.R.Civ.P. 52. Id.

The district court found that Group Administrators, Inc. was created for a legitimate business purpose: the creation of a reserve fund from which the partnership interests of withdrawing partners could be purchased to ensure continuity for the partnership. The creation of such a reserve fund is a legitimate business purpose, but the fund can easily be created within partnership funds or within the personal funds of one of the partners. The taxpayers offer no business purpose to explain why the fund was created under the shell of a separate corporation. Although the reserve fund had a legitimate business purpose, the use of a separate corporation to establish the fund had no purpose other than tax avoidance.

If the purpose of the reserve fund itself can serve as the legitimate business purpose for the use of the corporate form, a partnership can spread its income into as many corporations as it has reserve funds to create. I would require the taxpayers to provide a legitimate business purpose for creating the reserve fund under the shell of a separate corporation rather than creating the reserve fund within the partnership or within the personal funds of one of the partners. The taxpayers provided no such legitimate business purpose. Therefore, I would reverse, as “clearly erroneous,” the district court’s finding that Group Administrators, Inc. was a valid partner for tax purposes.