author: Mtjedock:

text:
    James Forrestal, Trustee, Trust u/d James Forrestal, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 96297.
    Promulgated May 8, 1940.

      Harry J. Rudick, Esq., for the petitioner.

      W. Frank Gibbs, Esq., for the respondent.
   OPINION.

Mtjedock:

The Commissioner determined a deficiency of $29,479.13 in income tax for the calendar year 1934. The facts have been stipulated and are found in accordance with the stipulation. The Commissioner, in determining the deficiency, increased the profit of the petitioner from the liquidation of the Beekman Corporation by $74,004.44. The sole issue for decision is the propriety of that adjustment.

James Forrestal incorporated the Beekman Corporation in December 1928. It was his personal holding corporation and issued all of its capital stock, consisting of 100 shares, to him. It was engaged in the business of buying and selling securities. Forrestal created a trust on May 1,1929, which is the petitioner here. He transferred 30 shares of the capital stock of Beekman to the petitioner on June 6, 1932. Forrestal’s basis for gain or loss on those shares at that time was $160,548.57. Forrestal, on December 19,1932, transferred 4,760 shares of the common stock of Dillon, Bead & Co. to Beekman as paid-in surplus. He had acquired those shares prior to 1929 at a total cost of $246,681.46. Beekman immediately sold the Dillon-Read shares for $1,190. Forrestal sold the remaining 70 shares of Beekman stock to the petitioner for $560,000 on April 15, 1934. The petitioner on December 11, 1934, being the owner of all of the stock of Beekman, dissolved that corporation and received all of its assets in liquidation. The total value of those assets at that time was $834,726.89. The petitioner reported on its return for 1934 a gain of $40,173.88 from the liquidation of Beekman, being the difference between $834,726.89, the amount received upon liquidation, and the sum of $560,000, the cost of 70 shares, and $234,553.01 representing its basis for gain on the 30 shares acquired from Forrestal as a gift. The Commissioner, in determining the deficiency, increased the gain to $114,178.32. The only difference between his computation of the gain and the petitioner’s computation was that he used $160,548.57 as the petitioner’s basis for gain on the 30 shares acquired by gift from Forrestal, the $160,-548.57 being Forrestal’s basis for gain on those shares at the time he gave them to the petitioner.

The question for decision is whether the contribution which For-restal made to the paid-in surplus of Beekman at a time when he owned only 70 shares of Beekman, served to increase the basis for gain or loss of another taxpayer, the petitioner, on the 30 shares of Beekman which it owned at that time. The Commissioner proposes to add the entire cost of Forrestal’s Dillon-Read shares to Forrestal’s basis for gain or loss on the 70 shares of Beekman which he owned. Regulations 86, art. 22 (a)-17. However, it does not follow, as the petitioner argues, that any portion of the cost of the Dillon-Read shares should be added to the petitioner’s basis for gain or loss on its 30 shares of Beekman stock. Forrestal could have contributed some of the Dillon-Read shares directly to the petitioner and the petitioner could have increased its basis on the Beekman shares in turn by contributing the Dillon-Read shares to Beekman. But that was not done. “Contributions to a corporation can not be held as a matter of law to be gifts to the shareholders because they may ultimately be beneficially affected.” Weeks v. White, 77 Fed. (2d) 817.

The petitioner relies entirely upon the language of section 113 (a) (2) and (3) of the Revenue Act of 1934, providing that if property has been acquired by gift or by a transfer in trust after December 31, 1920, “the basis shall be the same as it would be in the hands of the donor.” The Commissioner has used as the petitioner’s basis for gain on the 30 shares of Beekman stock the same basis which those shares had in the hands of Forrestal at the time he transferred them to the petitioner. The petitioner argues that the words “would be” in the statute are a clear indication of an intention to give the donee or transferee a basis equal to the amount which “would be” the basis of the transferor at the time of the disposition by the transferee rather than the amount which was the basis of the transferor at the time he transferred them. This is a strange and strained construction. It involves the assumptions that the basis of the transferor might change after he had parted with the shares, that Congress had such a possibility in mind, and that Congress intended to provide therefor. We are unable to accept any of these assumptions. The possibility of changing a basis for property in the hands of any taxpayer would seem to terminate when that taxpayer disposes of the property. Suppose that Forrestal, instead of making a contribution to the paid-in surplus of Beekman on December 19,1932, had received a distribution in partial liquidation of Beekman. Would it be argued that the distribution should be spread not only over the 70 shares which he owned but also over the 30 shares which he did not own, so that the petitioner’s basis for gain or loss on the 30 shares which it owned would thereafter be reduced because of a distribution to Forrestal in which it did not share? Forrestal did not own the 30 shares when he made the contribution to the paid-in surplus of Beekman. His contribution in no way changed the basis for1 gain or loss on the 30 shares, and it is vacuous to speculate what effect his contribution to the paid-in surplus of Beekman. would have had upon his basis for gain or loss on the 30 shares if he had still owned those shares at that time. The words “would be” have no particular significance in this case. There is no error in the determination of the Commissioner in this connection.

Decision will be entered y/nder Bule SO.


source: Caselaw Access Project

author: Murdock : Hill, Mellott,

license: Public Domain

text:
    Farmers & Ginners Cotton Oil Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 93436.
    Promulgated May 8, 1940.

      E. L. All, Esq., A. J. Bowron, Jr., Esq., and Virden Moore, Esq., for tlie petitioner.

      Stanley B. Anderson, Esq., for the respondent
   OPINION.

Murdock :

The question here is substantially the same as that considered in the case of Ben Grote, 41 B. T. A. 247. The only purpose which the petitioner had in buying the futures in refined oil was to attempt to avoid loss upon the crude oil which it was manufacturing. This method was as effective a hedge against loss on its operations as was available to the petitioner. Its raw material was cottonseed, but there was no futures market for that and no hedge could be made by purchases thereof. It did not buy the futures merely as a speculation, but solely to replace its manufactured product which it was forced to sell at a price which it deemed unsatisfactory. All of the transactions were directly related to its business of production and sale. The question of whether or not it could have inventoried the contracts for future delivery of refined oil need not be decided. Cf. G. C. M. 18658, C. B. 1937-2, p. 77. We pointed out in the Grote case that the Commissioner has interpreted and administered section 117 as excluding hedging transactions, citing G. C. M. 17322, C. B. XV-2, p. 151. The facts in this case disclose no satisfactory basis for distinguishing it from the Grote case and on that authority we hold that the petitioner is entitled to a deduction of $24,024.30 as losses sustained in connection with its business for the taxable year.

This opinion supersedes that promulgated on February 6, 1940, 41 B. T. A. 255.

Reviewed by the Board.

Decision will be entered under Bule 50.

Hill,

dissenting: I am unable to agree with the conclusion reached in the majority opinion. The business of petitioner was the operation of a cottonseed oil mill. That business was confined to buying and crushing cottonseed and selling the products derived therefrom, including crude cottonseed oil. Petitioner’s business did not include the processing of crude into refined oil. Its dealings in futures contracts for refined oil were transactions involving mere investment in, and sale of, capital assets having no identity with the products manufactured by petitioner. Refined oil is a distinct and separate commodity from crude oil, notwithstanding the latter is an intermediate source of the former. The manufacturing operations of petitioner did not extend to the production of refined oil and its business operations were completed when it sold the products it manufactured.

Petitioner contends that the initial processing of crude oil is so related to the manufacture of refined oil as to make stocks of the latter product invoiceable as regular “stock in trade” of the processor. It further contends that its transactions in refined oil futures were essentially a part of a process of production or other acquisition of property for sale to customers in the ordinary course of its trade or business.

The first of these contentions has no factual basis of application in this proceeding. Petitioner had no refined oil to invoice either as stock in trade or otherwise and the evidence herein discloses that its intention in dealing in refined oil futures was not to take delivery of oil, notwithstanding it could have demanded and received delivery under the terms of the futures contracts. Its transactions in refined oil futures were merely executory contracts to purchase, which it acquired with a positive intent not to close into completed purchases and not to acquire any commodity thereby.

The second of the above cited contentions of petitioner is (a) that its transactions in refined oil futures were a part of a process of production or (b) other acquisition of property for sale to customers in the ordinary course of its trade or business. As to subdivision (b) of this contention, attention is directed to the fact that by the purchase of such futures contracts the only property acquired was the contracts, which were bought and sold through brokers on petitioner’s own account only and not for customers. They were merely choses in action and represented neither stocks of oil nor any other commodity includable in an inventory of stock in trade. By subdivision (a) of such second contention petitioner obviously means that its transactions in refined futures contracts were a part of the process of production of crude oil. The gist of its supporting argument on this point is that transactions in such futures contracts were necessary to enable petitioner to maintain its position in the oil market, due to the fact that rapid deterioration of crude oil compels its sale shortly after production, regardless of the state of the market. Since, as is found, there is a direct relationship between the market price of crude and refined oil, the purpose of petitioner in maintaining a position in the oil market by purchasing refined oil futures is to enable it to indulge in the speculation that at some future time there may be a better market for oil than when it sold crude. Such speculation also involves, of course, the risk that instead of improving, the market price may descend to a still lower level. If, as is argued for petitioner, its purpose in buying refined oil futures was to maintain the same position it would have had in the oil market if it had not been forced to sell its crude oil on an unsatisfactory market, it failed to accomplish that purpose.

The purchasing of futures contracts at or following the times of corresponding sales of crude oil did not operate as an unbroken maintenance of petitioner’s position in the oil market. It left a hiatus between the dates of sales of crude oil and the delivery dates of the futures contracts. Hence, it can not be said that the futures contracts accomplished the purpose which petitioner acclaimed, namely, to maintain its position in the oil market. That purpose could have been effectuated by purchasing spot refined oil at the related market prices at the times of corresponding sales of crude oil and by adding such refined oil to its inventories and to its stock in trade for sale to its customers in the ordinary course of trade or business. That, however, would not have been insurance or protection against investment risks. It would have afforded only an opportunity for speculation on future oil prices. But such stocks of refined oil would not have been within the classification of capital assets and any losses resulting in respect thereof would have been deductible in full for income tax purposes. This course would have at least continued petitioner’s status in the oil market on the same relative price basis as if it had been able to hold its crude oil. Since petitioner did not adopt this course it can not successfully contend that its purpose was to replace crude oil with refined oil. Petitioner did not seek to maintain its position in the oil market through the replacement of inventories of crude oil with those of refined oil but first closed out its investment in; its crude oil inventories and thereafter made corresponding purchases of refined oil futures contracts which bore no protective relationship to any existing or prospective investment risk. Furthermore, the market prices at which the futures contracts were purchased were the then present prices of future deliveries and had no relation to the market prices at which the corresponding sales of crude oil were made. The purchases of such futures contracts were, therefore, wholly speculative transactions. In view of the purely speculative character of all transactions in futures contracts (except as hedges), it appears to me that, unless such futures contracts constitute hedges against petitioner’s business investment risks, they can not be said to be a part of petitioner’s process of production.

Petitioner does not claim that its transactions in futures contracts possessed all of the elements of a hedge, but it claims that they had a protective purpose and relationship to its business and operations. It is my opinion that sucia transactions had none of the elements of a hedge and in no way afforded insurance or protection against peti-titioner’s existing* or prospective investment risks, either in its raw materials or its crude oil. The purchase of such futures contracts operated only to create new and additional investments, fraught with new and additional investment risks, without any counterbalance of a hedge.

The statute has no provision excluding hedging transactions from the operation of the provisions of section 117 of the Revenue Act of 1934, but the Treasury Department has construed such section as excluding from its operation hedging transactions. G. C. M. 17322, C. B. XV-2, p. 151. The discussion and illustration of hedges set forth therein do not include, as constituting a hedge, the state of facts in the instant proceeding. Two examples are given therein as illustrating typical situations in which protection is obtained by the use of hedging transactions, as follows:

(1) The taxpayer buys quantities of spot cotton, which will necessarily be on hand for some months before being manufactured into goods and sold. In order to be protected against losses which would be incurred if the cotton market declined during those months, the taxpayer, at the same time the above purchases are made, enters into futures sale contracts for the delivery of equivalent amounts of cotton a few months hence. As the above quantities of spot cotton are subsequently disposed of by sales from time to time of manufactured cotton goods, the above futures sale contracts are concurrently) disposed of by futures purchase contracts which serve as offsetting transactions closing out the futures sale contracts.
(2) The taxpayer makes contracts for future delivery of cotton goods, the manufacture of which will require more cotton than the amount on hand or the amount which can be immediately purchased advantageously. In order to secure protection against a rising cotton market during the months that intervene between the date of the order for cotton goods and the agreed delivery date, the taxpayer, at the same time the above orders are taken, enters into futures purchase contracts for cotton in amounts necessary to provide the desired protection. As the taxpayer from time to time buys spot cotton for the manufacture of the goods specified in the above orders, the futures purchase contracts are disposed of by futures sale contracts which serve as offsetting transactions closing out the futures purchase contracts.
*******

The last paragraph of the cited G. C. M. is as follows:

It follows from the above that hedging transactions are essentially to be regarded as insurance rather than a dealing in capital assets within the comprehension of section 117 of the Revenue Act of 1934. Regardless of accounting or inventory methods in use, provisions pertaining to capital gains and losses govern gains or losses on futures contracts which are speculative. Futures contracts representing true hedges against price fluctuations in spot goods are not speculative transactions, though not concurrent with spot transactions. Futures contracts which are not hedges against spot transactions are speculative unless they are hedges against concurrent futures or forward sales or purchases.

Under the interpretation set forth in the cited G. C. M. the futures contracts in the instant proceeding would not be includable in petitioner’s inventories if on hand at the end of the taxable year, for the reason that they are not hedges against actual spot or cash transactions or against forward sales or purchases, as evidenced by a quotation with approval therein from S. M. 5693 (C. B. V-2, p. 20) as follows:

(2) That cotton and grain dealers should incorporate in their balance sheets at the close of the taxable year at market such open future contracts to which they are parties as are hedges against actual spot or cash transactions or against forward sales or purchases, as the case may be; provided, that no purely speculative transactions in futures not offset by actual spot or cash transactions or concurrent forward purchases or sales may be so included or taken into the taxpayer’s account in any manner until such transactions are actually closed by liquidation; and provided further, that the values of the commodity covered by such open future contracts shall not be added to or deducted from the inventory of the taxpayer.

In order for petitioner to avail itself of the protective principle of a hedge as that principle is illustrated and enunciated in the cited G. C. M., it must use as a basis the investment risk involved in the cost of its raw material, namely, cottonseed, and relate its futures purchases to that basis. After the manufacturing processes are complete and the resulting product sold, there remains no investment risk against which to hedge.

It is my opinion that petitioner’s dealings in futures contracts were not in any sense hedging transactions, and by the very circumstances under which they were consummated they could not possibly be other than purely speculative and could not furnish protection against petitioner’s business or investment risks. A hedging transaction is not speculative and eliminates 'pro tombo the speculative character of the investment hedged. It operates as insurance or protection against the investment risk of future loss and must be entered into for operation covering the period of such risk and terminate therewith. A hedging transaction and the investment protected thereby coexistingly operate upon each other. If a gain is realized on the hedging transaction it is counterbalanced either by a realized loss or by some other character of economic disadvantage in respect of the investment hedged. If a loss is realized in the former it is counterbalanced by a realized gain or some other character of economic advantage in respect of the latter. As a result of the counterbalancing effect between the hedging transaction and the investment protected thereby, speculation as to either gain or loss is eliminated.

It is said in the majority opinion:

* * * The only purpose which the petition had in buying the futures in refined oil was to attempt to ávoid loss upon the crude oil which it was manufacturing. This method was as effective a hedge against losses on its operations as was available to the petitioner. * * *

It is my opinion, as hereinabove pointed out, that it was not a hedge and was not of such character as to be effective to accomplish petitioner’s claimed purpose. If, however, petitioner’s transactions in refined oil futures contracts be deemed a hedge for tax purposes, petitioner with equal logic and effectiveness could have created a hedge by purchasing wheat futures contracts or futures contracts in respect of any other commodity listed on the produce exchange. This illustration is employed merely to indicate the wide open spaces revealed in the majority opinion. The opinion of the Board in this proceeding cites the case of Ben Grote, 41 B. T. A. 247, as authority for , its conclusion. Begardless of whether the Grote case, on its facts, supports the conclusion readied by the majority in this case, it is my opinion that the Grote. decision is glaringly erroneous. I dissented from it. The opinion in the Grote case did not discuss the question of what constitutes “hedging transactions.” It merely said “the evidence shows that petitioner’s transactions were all hedging transactions.” Aside from that terse ipse dixit, no reasons are assigned for the conclusion therein reached.

Subdivision (b) of section 117, supra, defines as “capital assets” all property held by a taxpayer except (1) stock in trade of the taxpayer, (2) other property which would properly be included in the inventory of the taxpayer, if on hand at the close of the taxable year, and (8) property held by the taxpayer primarily for sale to customers in the ordinary course of business.

Begardless of whether petitioner’s transactions in such futures contracts constituted a trade or business or were entered into for profit, such contracts were nevertheless capital assets within the above statutory definition. They were choses in action, bought and sold only on a produce exchange through brokers. They were bought and sold by petitioner on its own account only, and not for customers. It held no oil futures contracts in stock for sale to customers and, therefore, had no right to include them in an inventory. Cf. Francis M. Weld, 31 B. T. A. 600; Adirondack Securities Corporation, 23 B. T. A. 61; Oil Shares, Inc., 29 B. T. A. 664; O. L. Burnett, 40 B. T. A. 605; Staerker v. United States (U. S. Dist. Ct., N. Dist. of Texas, Sept. 23, 1938).

Accordingly the losses involved in this proceeding wjere capital losses and the deduction thereof should be limited as prescribed in subdivision (d) of section 117, supra.

Leech and Haeeon agree with this dissent.

Mellott,

dissenting: The case of Ben Grote, 41 B. T. A. 247, which I feel was decided correctly, does not support the conclusion of the majority in the instant proceeding. It approves an administrative ruling (G. C. M. 17322, C. B. XV-2, p. 151) — which it may be is not bottomed upon any specific statutory provision — authorizing the deduction of losses in connection with “hedging” operations as “a legitimate form of business insurance.”

I agree with much that is said by Mr. Hill in his dissenting opinion. It is obvious that petitioner’s dealings in futures in refined oil did not constitute true “hedging” operations in its business. Hedging “is a means by which collectors and exporters of grain or other products, and manufacturers who make contracts in advance for the sale of their goods, secure themselves against the fluctuations of the market by counter contracts for the purchase or sale, as the case may be, of an equal quantity of the product, or of the material of manufacture.” Board of Trade v. Christie Grain & Stock Co., 198 U. S. 236, 249. In United States v. Coffee Exchange, 263 U. S. 611, 619, the Court refers to one of the classes who deal in “futures” as “those who use them to hedge, i. e., to insure themselves against loss by unfavorable changes in price at the time of actual delivery of what they have to sell or buy in their business.” The examples given in the G. C. M. indicate that when the Commissioner used therein the term “hedging” he had in mind the Court’s definition. I would limit the applicability of the ruling to one who has made a counter contract for the purchase or sale of an equal quantity of the product manufactured or raised, or of the material going into the manufacture of it.


author: Disney :

text:
    Anton Dolenz, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 93311.
    Promulgated May 8, 1940.

      John V. Lewis, Esq., Clyde C. Sherwood, Esq., and Jeróme Politzer, Esq., for the petitioner.

      A. L. Murray, Esq., for the respondent.
   OPINION.

Disney :

Royalties, the amounts of which are not in controversy, were received by the petitioner in 1934 and 1935 from the Acme Brewing Co. under the licensing agreement of June 2,1934. The respondent taxed all of the payments to petitioner on the ground that the fees represented earnings of separately owned property of the petitioner, namely, Patent No. 1,481,842. The petitioner contends that by an oral agreement entered into with his wife he converted all of Ms separate property into community property and that only one-half of the income, therefrom, as well as income from property acquired subsequent to marriage, should be taxed to him.

The parties are in agreement that under the laws of California separate property of husband and wife may be transmuted into community property by an oral agreement, provided the understanding to that effect is executed. The rule is established by decisions of the California courts. In re Sill's Estate, 121 Cal. App. 202; 9 Pac. (2d) 243; Siberell v. Siberell, 214 Cal. 767; 7 Pac. (2d) 1003, Kenney v. Kenney, 220 Cal. 134; 30 Pac. (2d) 398; In re Wahlefeld's Estate, 105 Cal. App. 770; 288 Pac. 870; In re Kelpsch’s Estate, 203 Cal. 613; 265 Pac. 214.

The parties differ on whether there was a consummated agreement with respect to the patent. This may be shown by surrounding circumstances, including the conduct of the husband. Title Insurance & Trust Co. v. Ingersoll, 153 Cal. 1; 94 Pac. 94; Smith v. Smith, 47 Cal. App. 650; 191 Pac. 60. The petitioner relies upon his testimony and that of his wife to establish an executed agreement as to the patent. The respondent contends, in effect, that their testimony indicates nothing more than general promises on the subject.

The petition did not allege a premarital agreement between petitioner and his wife for the conversion of their separately owned property into community property upon their marriage or at any other time. It did, however, allege that after the marriage petitioner “in consideration of his natural love and affection gave to his wife a one-half interest in said process and improvements thereon * * Petitioner testified that prior to his marriage he and his wife reached an agreement that their property, including the patent, together with future accumulations, would be shared jointly and that the property arrangement was never changed. Petitioner’s wife testified:

* * * We also promised each other that when we were married everything we owned would become joint property; it would be community property; halt of everything that we owned would belong to him and half of everything— half of everything that he owned would belong to me and half of everything that I owned would belong to him; that did include the patent. The patent was mentioned many times.
*******
We promised each other that at marriage that [personal property of each] would become community property.

She also testified that petitioner informed her that if “he ever should get royalties from that particular patent, or should get anything, if he should sell the patent I should have half * * that his promise was that “I should have half of everything that he should own, intangible property or income”, and that the promises were never reduced to writing.

This testimony of petitioner and his wife, standing alone, discloses a mutual understanding that all of their property would be community property. Their returns, however, do not agree with their testimony.

In the separate income tax returns filed by petitioner and his wife for 1930 unequal amounts were reported as income from interest and dividends, and the petitioner reported interest on foreign bonds but his wife did not. It may be that the differences were due to the marriage within the year 1930. They filed joint returns for 1931 and 1932. Their original separate returns for 1933 reported only one item of community income, that of salary of petitioner. In addition, petitioner reported four, and his wife two, items of income from separate property. In amended returns for 1933, executed on April 8, 1935, petitioner reported all of his income as earnings from community property, and in addition to one-half thereof, petitioner’s wife reported the same interest and dividend income from separate property as she had reported in her original return. All of the income of petitioner for 1934 and 1935 was reported as community income, but petitioner’s wife, as in 1933, reported interest on bank deposits and dividends on stock of domestic corporations as separate income.

It thus appears that petitioner did not consider that any of his property had a community status for income tax purposes prior to the execution on April 8, 1935, of an amended return for 1933 and his original return for 1934, and that his wife continued to hold a bank account and stock as separate property. The manner in which petitioner and his wife returned their income for Federal taxation is directly opposed to the idea of a consummated mutual agreement to convert all of their property into community property, and indicates rather that, as respondent in effect argues, they had general conversations on the subject, which however they themselves never carried into effect. The record contains no explanation for the existence as late as 1935 of separately owned property of the wife in the face of the oral mutual understanding that all such property would be community property. Petitioner’s treatment of the royalties from the patent in his amended return for 1933 and original return for 1934 is no more of an indication of an assignment to his wife of a community interest in the patent than it is of an assignment to her of one-half of the income from the property.

The petitioner points to the joint bank account and the purchase of real property in their joint names as acts disclosing consummation of a previous agreement to convert their separate property into community property. The principal commercial bank account of pe-tioner was not converted into a joint account of himself and his wife until March 1935 and the real estate was not purchased with funds in the joint account until September or October 1935. The opening of the joint account proves nothing particularly material. Pedder v. Commissioner, 60 Fed. (2d) 866.

The.facts here distinguish this proceeding from Estate of J. Harold Dollar, 41 B. T. A. 869. Therein, though some property was returned separately by one spouse, this was consistent with the contention of an internal revenue agent who had examined the taxpayer’s report, made on a community basis for an earlier year, and had taken the view that there was no community as to certain stocks. Also, there the declaration of the community was proved not only by oral statements, but by written recitations in two wills. The inconsistency herein found did not appear in the Dollar case.

In view of the condition in which we find the record, we conclude that it was not error for the respondent to regard the patent as separately owned property of petitioner during the taxable years.

The petitioner contends, necessarily in the alternative, that the royalties in question were derived from the licensing of a process developed by him after his marriage, and that, therefore, all of the income is taxable as community income. At the close of the hearing counsel for the petitioner moved to amend the petition further than had been done by permission at the opening of the hearing, to conform to the proof on the point. The motion was denied and is renewed upon brief.

In his determination of the deficiency the respondent held that the royalties resulted from petitioner’s ownership of the patent and that practically all of the work done to improve the patent was performed prior to petitioner’s marriage. The petition alleges, among other things, that the petitioner’s wife rendered valuable assistance in improving the patented process; that all of the improvements were made during the marriage relationship; and that the license given the Acme Brewing Co. under the terms of the agreement of June 2,1934, was for the use of the patented process and all improvements thereon and thereafter to be made. An amendment to the petition, filed by permission given at the beginning of the hearing, alleges that the amounts paid during the taxable years pursuant to the terms of the agreement of June 2, 1934, represented compensation for services rendered and for the use of the patent with the improvements thereon. In his opening statement at the hearing counsel for the petitioner announced one of his contentions to be that the royalties were paid for the use of a process entirely different from the patent and that it was developed after his marriage, with the assistance of his wife. It thus appears that the allegations of fact in the petition and the amendment thereto were broad enough for the introduction of evidence on this contention of petitioner and that amendment of the petition to conform to the proof is unnecessary.

The petitioner proved the development by him after his marriage of a process for the manufacture of lager beer and the use of the method by the Acme Brewing Co. under the terms of the agreement of June 2, 1934. The process includes elements not used in the manufacture of a beverage under the patent, and we find it to be a different process. But to prevail, the petitioner was obliged to show that the royalties were paid exclusively for the use of the new process.

The royalties were paid under the terms of the agreement of June 2, 1934, the preamble of which recited that petitioner was the owner of Patent No. 1,481,842 and that the Acme Brewing Co. desired to have a license to use the invention.

The agreement gave the Acme Brewing Co. a license to use the patent and “any renewals, amendments, modifications and/or additions thereto” and an option to use any improvements made by petitioner on the process covered by the patent. Petitioner’s new process was then being used by the Acme Brewing Co. Other indirect reference was made in the contract to petitioner’s new process for manufacturing lager beer. A fair construction of the agreement is that the royalty was to be paid not only for the use of the patent, but for any other process then owned or thereafter developed by petitioner for the manufacture of beer.

Petitioner argues, however, that the patent covered the manufacture of near-beer and was not used by the licensee during the taxable years. Assuming that to be the case, it is not decisive. It had the exclusive right to use the patent in California and some portion of the royalties was paid for the privilege.

The petitioner argues that, where separate property and community property are so commingled that it is impossible to trace the funds to their respective sources, the whole of the property will be treated as community property. The rule is supported by decisions of California courts. In re Fellows’ Estate, 106 Cal. App. 681; 289 Pac. 887; Fountain v. Maxim, 210 Cal. 48; 290 Pac. 576; Yager v. Yager, 7 Cal. (2d) 213; 60 Pac. (2d) 422. The rule does not apply here, where the character of the property producing the income can be identified with certainty. Pereira v. Pereira, 156 Cal. 1; 103 Pac. 488; In re Gold’s Estate, 170 Cal. 621; 151 Pac. 12; Clara B. Parker, Executrix, 31 B. T. A. 644. The amount attributable to each class of property is a question of fact to be determined from the evidence in the case. Shea v. Commissioner, 81 Fed. (2d) 937, affirming 30 B. T. A. 1265; In re Gold’s Estate, supra.

We have no evidence showing the value of the patent or the amount of petitioner’s investment therein and are in no position to attribute as income therefrom an amount based upon a fair rate of return on the capital invested, such as was done in the Parker case, supra. Other facts of record, however, furnish a basis for a reasonable allocation. The agreement of October 10, 1925, between the petitioner and the Acme Brewing Co. provided that the petitioner was not to receive a royalty or license fee for the use of his patent so long as he continued to be an employee of the licensee. His salary from the Acme Brewing Co. was $12,000 per year on June 2, 1934, when his services as an employee were terminated. The petitioner’s duties were similar to those of a plant superintendent or manager, for which services the Acme Brewing Co. paid others a salary of $6,000 per year during 1934 and 1935. This indicates that one-half, or $6,000, of his salary was paid for the use of the patent and constitutes the best evidence in the record on the point. It is consistent with testimony of petitioner that during 1934 and 1935 a reasonable value of his services was one-half of the royalties accruing to him. Accordingly, we hold that a sum computed at the rate of $6,000 per year was received by the petitioner for the use of the patent from June 2, 1934, to the close of 1935, and is taxable to petitioner as income from separate property.

The next contention of the petitioner, raised by an amendment to his petition at the hearing, is that a portion of the amounts in question represents compensation for personal services, taxable as community income.

One of the chief reasons for the delay in entering into the contract of June 2, 1934, was the inability of the contracting parties to agree upon the time petitioner would devote to supervisory duties after the agreement was signed. The understanding reached and reduced to writing was that he would instruct representatives on the use of his process and, without conflicting with his other activities, devote such time to the supervision of the licensee’s manufacturing activities as he considered necessary. Any inability to perform the work was not to be regarded as a breach of the contract. During the remainder of 1934 and throughout 1935 the petitioner performed the work contemplated by the agreement. Thus the amounts in question were received for (a) personal services, (b) the use of the patent, and (c) the new process.

The respondent does not deny that if some part of the income was paid for the performance of personal services the amount thereof is taxable as community income. The petitioner contends that the evidence establishes the sum of $24,000 per year to be reasonable compensation for the services performed. The respondent contends that the allowance should not exceed $6,000 a year.

The president of the Acme Brewing Co. testified that petitioner’s services were worth from $18,000 to $24,000 per year as a full time employee and the petitioner testified that a reasonable value of his services was one-half of the royalties paid, $47,355.10 in 1934 and $36,083.15 in 1935. The testimony of the president of the Acme Brewing Co. has little weight in the absence of evidence on the amount of time petitioner spent in the performance of his duties. Neither are we impressed with petitioner’s testimony on the point. Until April 1933 he performed like work as a full time employee for $10,000 per year, and thereafter to June 2, 1934, for an annual salary of $12,000. In addition, his employer had the use of his patent. As already pointed out, the Acme Brewing Co. could and did employ plant superintendents, qualified to carry out petitioner’s instructions, for an annual salary of $6,000. There is no clear proof of the reasonable value of petitioner’s services, but we are under a duty to make a finding from such evidence as there is in the record on the point. Under the circumstances, we attribute $6,000 per year as compensation for services rendered by the petitioner from and after June 2, 1934, under the agreement, of which one-half is taxable to petitioner as community income.

We having concluded that of the income received by the petitioner under the agreement of June 2,1934, amounts computed at the rate of $6,000 per year are allocable to the use of the patent from June 2,1934, to the close of 1935, and are taxable as income from separate property, and that amounts also computed at the rate of $6,000 per year represent compensation for personal services of petitioner from June 2, 1934, to the close of 1935, and are taxable as community income, it necessarily follows that all of the other income in controversy is taxable as community income, received for the use of the new process.

The petitioner urges that he is entitled to an adjustment under section 820 of the Revenue Act of 1938 as to taxes paid for 1933. The Commissioner in determining the deficiency held the amount of royalties on which petitioner paid a tax for 1933 to be income in 1934, and at trial the petitioner abandoned his previous view to the contrary. The matter was not pleaded, but was suggested at the hearing and is discussed in the briefs. Upon study of the statute and the Congressional Committee Reports attendant upon the passage of the act, we are of the opinion that we have no jurisdiction to make the desired adjustment. The statute provides for adjustment after “the date the determination becomes final,” and defines “determination” as including a decision by the Board of Tax Appeals, which has become final. Our function seems to be merely to render a decision upon the issues involved. In any event, information as to “amounts previously abated, credited, refunded, or otherwise repaid in respect of such tax” is by the statute made necessary for an adjustment, and such information is not contained in the record. We make no adjustment.

Reviewed by the Board.

Decision will he entered wider Rule 60.


author: Leech : Oppek,

text:
    Henry A. B. Dunning, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 92629.
    Promulgated May 10, 1940.

      Vernon Cook, Esq., for the petitioner.

      R. P. Hertzog, Esq., for the respondent.
   OPINION.

Leech :

The five trusts in this proceeding were before us in Henry A. B. Dunning, 36 B. T. A. 1222, upon a deficiency proposed for the year 1933 under the Revenue Act of 1932. We there held that none of the trust income was taxable to petitioner under section 166 of the 1932 Act, but that such portion of that income as was used to pay premiums on petitioner’s life insurance was taxable to him under section 167 (a) (3) of the 1932 Act. Petitioner concedes that the latter point is res adjudicaba as to this proceeding, and that he is properly taxable with respect to such portion of the 1934 income as was used to pay premiums on policies of insurance on his life.

Respondent argues that our decision in 36 B. T. A. 1222, supra, was made under the Revenue Act of 1932 and that the change in section 166 by the Revenue Act of 1934 renders all the income of these trusts taxable to the petitioner under that section as thus amended. That change consisted in striking out the words “during the taxable year.” He advances no other ground for taxing the income of these trusts to petitioner.

The income which the respondent seeks to tax as that of the taxpayer is that of trusts which must be assumed here to be juristic entities, for tax purposes, which the taxpayer did not and could not receive at any time.

The controlling enactment reads:

SEC. 166. REVOCABLE TRUSTS.
Where at any time the power to revest in the grantor title to any part of the corpus of the trust is vested—
(1) in the grantor * * *.

The trust instruments may be susceptible of two constructions. The first is that the grantor thus created irrevocable trusts for terms of five years each. The second alternative is that the grantor taxpayer in the quoted trust deeds created trusts for terms longer than five years each.

Upon either such premise of fact, the respondent is, we think, foreclosed by decisions of the courts and the Board.

If it be found that the first alternative premise existed, then we have no more than irrevocable five-year term trusts, with a reversion, in the grantor, in each. The Supreme Court, in Helvering v. Wood, 309 U. S. 344, refused to apply the quoted enactment in such cases.

On the other hand, if the second alternative condition of fact is found to obtain, then, since the power in the grantor to revest the corpora of these trusts could not be exercised unless and until the grantor lived for five years, that power did not exist during that period, which included the taxable year. That is to say, it can not, therefore, be said that “at any time the power to revest in the grantor title to any part of the * * * [corpora;] of the * * * [trusts] is vested — (1) in the grantor.” This conclusion, it seems to us, is inescapable in view of the decision of the Sixth Circuit Court of Appeals in Corning v. Commissioner, 104 Fed. (2d) 329, wherein that court said:

* * * The first question that confronts us, therefore, is whether under the phrasing of § 166 the petitioner as grantor reserved to himself a vested power over the title of any part of the corpus of the trust. The respondent by Article 166-1, Regulation 86, undertook to interpret the section as providing for the taxation of income of a trust to the grantor if there was a power to revoke upon the lapse of a period of years or upon the happening of a specified event, regardless of whether such time be fixed, determinable, or certain to come. The petitioner contends that § 166 does not apply, and since not ambiguous may not be made to apply by regulation, because his right of revocation is subject to a contingency which has not yet happened and the happening of which is beyond his power to control. The Board sustained the Commissioner’s interpretation of the statute and the validity of his regulation. It draws a distinction between the existence of a power to revoke and the right to exercise that power. Even though the right to exercise the power to revoke may be contingent, it says, nevertheless the existence of the power during the tax year is not contingent.
The distinction is difficult to apprehend. It is not consonant with generally accepted concepts of powers, for a power which is not presently exercisable and may never be capable of being exercised does not exist. 1, Sugden on Powers, 3d Amer. Ed. 371, 372. It is difficult, therefore, to comprehend that one may be vested with a power that is not presently nor with certainty exercisable In futuro.
[The 1928 Act]
The immediate precursor of § 166 was the similarly numbered section of the act of 1928. That section provided for the taxing of trust income, to the grantor “where the grantor of a trust has at any time during the taxable year . . . the power to revest in himself title to any part of the corpus of the trust . . This opened the door, if indeed it did not invite, the so-called “year-and-a-day” trusts, sustained in decisions such as Lewis v. White, 56 Fed. (2d) 390 (D. C. Mass.), and Langley v. Commissioner, 61 Fed. (2d) 796 (C. C. A. 2). In the 1934 Act the words “during the taxable year” were eliminated. From this it is argued that the trust is revocable if the power to revest may be exercised by the grantor “at any time”. It does not follow from this, however, that the Congress in the 1934 Act used either the term “power” or the term “vested” in a sense other than these terms were used in the 1928 or preceding Revenue Acts, and the committee reports of the Congress do not so indicate. The term “power” as used in corresponding sections of earlier acts has not been thought to extend to the reservation of a right conditioned upon a contingency that may never occur. Commissioner v. Stokes, 79 Fed. (2d) 256 (C. C. A. 3) [35-2 USTC ¶ 9528]; Higgins v. White, 93 Fed. (2d) 357 (C. C. A. 1) [37-2 USTC ¶ 9601],

The court there thus reversed the Board and denied the validity of the argument which respondent makes here to the effect that, assuming the existence of the second premise of fact, “the power” was “vested” in the grantor “to revest” the corpora of these trusts in himself at any time during the first three consecutive five-year periods — that the exercise, only, of that power was contingent on the survival of the grantor throughout those periods. As the Circuit Court there said:

* * * Subsequent to decision in tbe present case tbe Board of Tax Appeals departed from its presently applied view of tbe existence of a vested power under similar trust provisions in the case of John E. Rovensky, 37 B. T. A., 702 [Dec. 10,006], and that of Sophia P. O. Morton, 38 B. T. A., No. 58 [CCH Dec. 10,410], and bas still more recently expressly reversed itself in the case of Horace Andrews, Docket No. 89152, decided October 22,1938 [CCH Dec. 10,488-B], and in that of Emery May Holden Norweb, Docket Nos. 89291, 91798, 91826, decided December 28,1938 [CCH Dec. 10,554-A],

The Board has consistently followed or approved the rule laid down in that Circuit Court decision, not only in numerous memorandum opinions, but in the following published cases: Ellsworth B. Buck, 41 B. T. A. 99; Emily Trevor, 40 B. T. A. 1241; and Raoul Fleischmann, 40 B. T. A. 672. See also Edna B. Elias, 41 B. T. A. 1109, promulgated simultaneously with the opinion herein. Nothing that appears in Helvering v. Wood, supra; Helvering v. Clifford, 309 U. S. 331; Helvering v. Hallock, 309 U. S. 106, or First National Bank of Chicago v. Commissioner, 110 Fed. (2d) 448, furnishes, we think, a sufficient reason for any present change in attitude toward the rule thus laid down by the Circuit Court in the Corning case.

The case of Estate of A. C. O'Laughlin, 38 B. T. A. 1120, upon which respondent relies here, does lend support to that position. However, that case was decided by the Board on the authority of its decision in the Corning case, supra, and before the reversal of that case. The opinion of the Seventh Circuit Court of Appeals, in affirming the O’Laughlin case, does so without referring to the application of section 166, and decides the case wholly on the application of sections 22 (a) and 167 which, upon an examination of the affirmed decision of the Board, were the primary bases upon which the respondent was there sustained.

Reviewed by the Board.

Decision will be entered under Rule 50.

Disney dissents.

Oppek,

dissenting: While entirely mindful of the intricate and difficult question illustrated by this case, and by Edna B. Elias, 41 B. T. A. 1109, decided therewith, I can not avoid the belief that the present decision has grasped the most untenable horn of a three-pronged dilemma.

Granting the existence of a trust revocable by the settlor upon a wholly future contingency — the assumption made here by the Board— there emerge three possible interpretations of the present language of 166. The trust may be treated as irrevocable for purposes of that section, even though fruition of the power to revoke may be near at hand and almost certain to arrive. That is the Board’s position. The trust may be treated as revocable, even though the contingency permitting revocation be remote in time as well as in likelihood. Or the section may be regarded as intended to draw a line between those cases, on the one hand, where revocation is a reasonable probability and therefore to be regarded as intentionally retained by the grantor as a means of keeping his hand upon property with which he is reluctant to part definitively; and, on the other, cases where it is in the nature of an afterthought inserted from excessive caution and not with any considerable possibility that its exercise will or could be attained. See John Edward Rovensky, 37 B. T. A. 702.

There are obvious difficulties inherent in the choice of any of these alternatives. The second is immediately subject to the reduetio ad absurdnmi objection that Congress could not have regarded a power of revocation, exercisable, say, after fifty years or upon the death of a large number of intervening beneficiaries, as such a retention of economic control as to justify a tax upon the grantor. Cf. Helvering v. Clifford, 309 U. S. 331. The third is objectionable principally on the ground of difficulty of application and of the reluctance of administrative and judicial officers to adopt a principle requiring the disposition of numerous and complicated cases on the basis of their individual facts.

Yet, the first seems to me to carry the greatest objection of all for the refusal, implicit in the Board’s decision, to tax the grantor upon a trust revocable at some time in the future, coupled with the refusal to draw any line between contingencies near and far, likely or unlikely, necessarily carries with it the same result where the trust will become revocable soon, say, in the following year. There, as here on this reasoning, the exercise of the power would be effective only when that time arrived, with the result that section 166 would be inapplicable. Cf. Mabel A. Ashforth et al., Executors, 26 B. T. A. 1188, 1192. But the unquestioned intent of the 1934 amendment was to include in section 166 so-called “year and a day trusts” where the power was exercisable in one year but could not become effective until the next. Unless the legislative purpose was to limit this inclusion to trusts revocable in a “year and a day” but not after any longer period, a result bordering on the absurd and not justified by the legislative history, this situation is indistinguishable from that which Congress expressly sought to cover. The present result accordingly seems to me incompatible with the Congressional purpose.

Even if it were justifiable to construe section 166 to include “year and a day trusts” and exclude those postponing the power to revoke for a longer period, this decision is not written upon that hypothesis, but upon the assumption that a power not immediately effective is no power at all. There is no suggestion of an effort to analyze the situation from the standpoint of the passage of time. And, indeed, such an effort would be interesting, since the end of the tax year in question is just over two years prior to the date of possible revocation. It would be difficult to say that such a period or even the five-year term of the original trust is significantly different from the “year and a day” concept. See DuPont v. Commissioner, 289 U. S. 685. And the legislative history would lend no' support to such an attitude toward the present law.

While, therefore, it might be tenable to construe the section as applying to all trusts which are revocable, no matter when, or, as I believe better still, to give the Board and the courts a latitude to distinguish between real and unreal powers of revocation, I feel that the one thing we may not do is to conclude that section 166 applies only to trusts which are presently and unconditionally revocable. I regard the Board’s decision as necessarily taking that view and am, accordingly, forced to note my dissent.

Murdock, Black, Turner, and Kern agree with this dissent.

         See Corliss v. Bowers, 281 U. S. 376.

       Cf. Genevieve F. Moore, 39 B. T. A. 808.

       Only, however, on the assumption that this has actually been done, can the various decisions of the Board, not consciously intended to be inconsistent, be reconciled. Compare the following, where the conditions of revocation were such that it was not considered significant under 166 or sometimes under 167: William E. Boeing, 37 B. T. A. 178 (death of son, beneficiary, before 30); John Edward, Rovensky, 37 B. T. A. 702, supra (death of wife and daughter, beneficiary, before 40); Genevieve F. Moore, 39 B. T. A. 808, supra (death of six children, beneficiaries, before 35); with the following where the grantor was taxed: Charles Kaplan, 26 B. T. A. 379, Fanny M. Dravo et al., Executors, 34 B. T. A. 190, and Mary Ryerson Frost, 38 B. T. A. 1402 (death of wife); William Lea Taylor, 37 B. T. A. 875 (two years after death of mother); Warren H. Corning, 36 B. T. A. 301 (three years after death of father). And see John N. Fulham, 40 B. T. A. 48.

       From the Report of the Conference Committee:
      “Under the terms of some trusts the power to revote can not be exercised within the taxable year except upon advance notice delivered to the trustee during the preceding taxable year * * *. The Senate amendments require the income from trusts of this type to be reported by the grantor. The House recedes.” [73d Cong., 2d Sess., H. Report 1385, p. 24.)

       Senator Murphy, proponent of the amendment, stated on the Senate floor:
      “* * * In the Langley trust the grantor reserved the right to revoke on the giving of a notice of a year and a day. Since notice was not given during the taxable year 1927 the court held that the income of the trust for 1928 was not taxable to the grantor, since during 1928 he could not revest title to the corpus of the trust. * * *
      “There is no use, when raising surtaxes, to leave the way open, by the creation of these revocable trusts, for the avoidance of the imposition of those surtaxes.
      “My amendment, by striking out the words ‘during the taxable year’, would close this avenue of tax avoidance. * * *.” (78 Congressional Record, 6471.)

       Of course in the “year and a day trusts” the power was exercisable presently with a necessarily postponed effect.
      But so is the power here by its express terms. And see footnote 9D, infra.

      If the present grantor, having executed the “power to revest”, died before it became effective, the estate would naturally never “revest” in him. But neither would it under similar circumstances in the “year and a day” trust.
      This trust therefore seems indistinguishable from the year and a day trusts except on the narrow ground of the length of time involved.

       See Helvering v. Wood, 309 U. S. 344.
      “When the 1934 Act was before the House Committee, the Treasury recommended that income from short term trusts and from revocable trusts should be taxable to the creator. The Congress adopted the latter by an appropriate amendment to § 166; * *

       Whether reliance is placed on technical concepts thought to be implicit in the word “vested,” as it is in John Edward Rovensky, supra, and Edna B. Elias, supra, is not clear. But, if so, the opposite result should be reached, for by analogy to the law of real property the grantor’s right of revocation here would be “vested,” possibly subject to being divested, and not contingent. See Restatement of the Law of Property, pp. 534, 542, 562, 564; 1 Simes Law of Future Interests, 104.

       Since the decision relies heavily upon Corning v. Commissioner, 104 Fed. (2d) 329, it may not be amiss to note the following with respect to that case:
      A. Its authority has been greatly diminished by the subsequent disapproval of Helvering v. St. Louis Union Trust Co., 296 U. S. 39. See First National Bank of Chicago v. Commissioner, 110 Fed. (2d) 448.
      B. Its statement that in the Rovensky proceeding, the Board abandoned the views expressed in its Corning opinion is not in accord with what was said in the Rovensky case. See 37 B. T. A., pp. 704, 705.
      C. Its suggestion that “the Congress in the 1934 Act” did not use “the term ‘vested’ in a sense other than these terms were used in the 1928 or preceding Revenue Acts” is remarkable since the term “vested” does not appear in the corresponding sections of the 1928 or preceding Revenue Acts.
      D. Its reference to Sugden on “Powers” is to a section headed “Death of Person to Consent Destroys Power.” To say that a power which is impossible of exercise is no power at all is a vastly different thing from saying that one which is merely contingent upon a completely probable future event does not exist. It not only exists, it may generally be exercised in advance of the event, though its effectiveness be delayed. Discussing Countess of Sutherland v. Northmore, 1 Dick. 56, Sugden says (Vol. 1, 3d Amer. Ed., p. 331): “This case is an authority that where a power is authorized to be executed on a contingent event it may be executed before the happening of the contingency.” And see Bundy v. United States Trust Co. (Mass.), 153 N. E. 337; Machir v. Funk, 90 Va. 284; 18 S. E. 197; Cowman v. Classen (Md.), 144 A. 367.

       Compare footnote 5, supra, with Senate Finance Committee Report, relating to the 1924 Act (68th Cong., 1st sess., S. Rept. 398, p. 25).

       The justification for such a position, of course, would be that that is what a literal interpretation of the section requires. Cf. Charles Kaplan, 26 B. T. A. 379, supra; Mary Ryerson Frost, 38 B. T. A. 1402, supra.

       If it be assumed that Congress used the term “power” as a word of art, there would be authority for such a view in the principle that a power conditioned upon an impossible contingency, or one that is not “liable to happen” has no “legal existence.” Moores v. Moores, 41 N. J. L. 440. See 49 C. J. 1296. And see footnote 9D, supra.

       This is arrestingly illustrated by a comparison with the prior opinion involving this same trust. The ground there relied on for dismissing section 166 has been removed in the meantime by the 1934 amendment. Yet the Board reaches the same result. In the earlier case, 36 B. T. A. 1228, the opinion states:
      “It is clear that section 166 of the Revenue Act of 1932 is not applicable in determining the issues, for the grantor could not at any time during the tawdble year revest in himself title * * [Italics added.]


author: Hill: Black,

text:
    Edna B. Elias, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 90827.
    Promulgated May 10, 1940.

      Edgar B. Bronson, Esg., for the petitioner.

      Benjamin M. Brodsky, Esq., for the respondent.
   OPINION.

Hill:

Eespondent included in petitioner’s taxable income both the ordinary net income and the capital net gains derived in the taxable years 1934 and 1935 by each of the four trusts established by petitioner in 1929 for the benefit of her children. Eespondent contends that his action is in accordance with the provisions of sections 166 and 167 of the Eevenue Act of 1934.

If we are to sustain respondent in taxing the income of the trusts to petitioner, obviously our approval must rest on one of two grounds, namely, (1) because the income of the trusts, by the facts appearing in the record, is brought within the purview of section 166 or section 167, supra,; or (2) because petitioner retained such dominion and control over the corpus that she did not by creation of the trusts cease to be the owner thereof, and the income therefore, must be regarded for tax purposes as her income within the meaning of section 22 (a), which defines gross income as including “gains or profits and income derived from any source whatever.” Helvering v. Clifford, 309 U. S. 331. Cf. Graham Sumner, 40 B. T. A. 811.

If either section 166 or section 22 (a) is applicable with respect to the ordinary income, it would be taxable to petitioner. If neither section is so applicable, the ordinary income is not taxable to petitioner, but we would still have to consider whether she is taxable on the capital gains under section 167 or section 22 (a).

A brief consideration of the facts will make it clearly apparent, we think, that the ordinary income here in controversy can not be taxed to petitioner under the doctrine of the cited cases and similar decisions. In the Clifford case, the grantor declared himself trustee of certain securities, for a term of five years, to hold the net income for the benefit of his wife. On termination of the trust, the corpus was to revert to the grantor, while all accrued or undistributed income was to be treated as property of the wife. The grantor retained very broad powers respecting the management of the trust property, including the right to accumulate income or pay it over to his wife within his discretion; to sell, exchange, mortgage, or pledge any of the securities, whether as corpus or investment or proceeds, and any income therefrom; and exercise all voting powers incident to the trusteed shares of stock. The Court said:

In this case we can not conclude as a matter of law that respondent [grantor] ceased to be the owner of the corpus after the trust was created. Rather, the short duration of the trust, the fact that the wife was the beneficiary, and the retention of control oyer the corpus by respondent all lead irresistibly to the conclusion that respondent continued to be the owner for purposes of § 22 (a).
So far as dominion and control were concerned it seems clear that the trust did not effect any substantial change. In substance his control over the corpus was in all essential respects the same after the trust was created, as before.

In the case at bar petitioner retained no powers of control over the corpus of her trusts comparable to those retained by the grantor in the Clifford case. On the contrary, petitioner appointed her husband, not herself, to aet as trustee and vested in him all powers of ma.na.gp.ment, including the power to accumulate or expend income for the benefit of the children. And it may be noted in this connection that the husband clearly had a substantial adverse interest in the disposition of both corpus and income. Each trust provided that when the beneficiary reached the age of 21 the accumulated or unexpended income of the trust fund was to be paid over to him, and thereafter he was to receive annually the net income until the death of either the beneficiary or the grantor, at which time the trust would be terminated and the corpus paid over to petitioner’s husband, the trustee. In the event the husband predeceased both the beneficiary and petitioner, the trust was to continue until the death of the beneficiary, when it was to terminate and the corpus revert to petitioner, if she survived the beneficiary; otherwise the corpus would go in remainder to others named in the trust instrument.

Thus, it seems plain that petitioner retained no power oí control over any part of the corpus of either trust during the period ending January 15,1986, nor did she retain any like power exercisable thereafter unless the retention of such a power may be said to have been effected by reservation of the right to modify, alter or revoke the trusts at any time after January 15,1986, upon the giving of 30 days previous notice in writing to the trustee.

Section 166 provides for taxing the income of a trust to the grantor where “at any time” the power to revest in the grantor title to any part of the corpus is. vested in the grantor. The application of the statute depends wholly upon the vesting of the described power. The provision that the trust should terminate and the corpus be paid over to petitioner if she survived both her husband and the beneficiary did not constitute a vested power to recall the corpus, and hence does not make applicable section 166. Such result would follow because of a retained reversion and not because of the retention of a vested power to revest the corpus in petitioner. Helvering v. Wood, 309 U. S. 344, affirming 104 Fed. (2d) 1013, which affirmed 37 B. T. A. 1065. In that case, the Supreme Court pointed out that at least in the law of estates a power to revest or revoke is not synonymous with reversion; that “a reversion is the residue left in the grantor on determination of a particular estate.”

The provision in each of the trust instruments involved here reserving to petitioner the right to revoke and thus to recapture the corpus at any time after January 15,1936, did not constitute the retention of a presently vested power. Such right depended upon the subsequent existence of certain conditions, which were beyond the power of petitioner to control. If either the beneficiary or petitioner had died prior to the date mentioned, the trust would have been thereby terminated and the corpus paid over to petitioner’s husband. Hence petitioner’s power to revoke the trust was contingent upon its not having terminated by its terms prior to January 15, 1936, and whether the trust would terminate by its terms prior to such date was contingent upon the happening or nonhappening of certain events beyond the control of petitioner. Such power did not exist in the taxable years. Prior to January 15,1936, the power not only did not exist, but in the taxable years it was not known, and could not then have been known, whether the power would ever come into existence.

The power to direct revestment of a trust corpus, which is dependent upon a contingency that may never happen or that is beyond the power of the grantor to control, is not a presently existing power, or, as the principle may be otherwise stated, there is no presently existing power in the grantor to revest “at any time” where the reservation of the power is conditioned upon a contingency that may never occur. “A power which is not presently exercisable and may never be capable of being exercised, does not exist.” Corning v. Commissioner, 104 Fed. (2d) 329, reversing 36 B. T. A. 301; John Edward Rovensky, 37 B. T. A. 702; Henry A. B. Dunning, 41 B. T. A. 1101. See also Commissioner v. Stokes, 79 Fed. (2d) 256; Higgins v. White, 93 Fed. (2d) 357. Nor is a possibility of a reverter a “power to revest” within the meaning of section 166, Phebe Warren McKean Downs, 36 B. T. A. 1129. As above indicated, there is a plain and material distinction between reversion and a power to revest.

Respondent’s action in including in petitioner’s income for the taxable years the ordinary income of the trusts in question, consisting of interest and dividends, is disapproved.

A different situation is presented in respect of capital net gains. The trust instruments provided that capital net gains should be accumulated and treated as part of the principal fund of each trust and ultimately go to the one entitled to receive the trust corpus. And such gains were in fact accumulated and paid over to petitioner upon revocation of the trusts in 1936.

We can not agree with petitioner’s construction of the trust instruments, which specifically provided that the term “net income” payable to the beneficiaries, as used therein, “does not and shall not include any profits that may be realized upon a sale or exchange of securities or of any other property that the trust fund at any time may be invested in.” Other references to this point in the trust instruments included the provision that such “profits and appreciations realized shall be added to and become part of the corpus or principal of the trust, to be invested and reinvested by the Trustee as a part thereof.”

Petitioner reserved the right, upon certain conditions heretofore mentioned, to revoke the trust instruments at any time after January 15,1936, and it was provided that in the event of the exercise of such right “the corpus or principal of the trust fund, together with all accumulations and profits and appreciations”, should be paid over by the trustee to her, or to such person or persons as she might designate. The fact that upon the happening of certain specified contingencies the accumulated capital gains, along with the corpus then remaining, would be payable to others, does not prevent the taxation of such gains to petitioner.

The circumstances here disclosed bring the capital gains clearly within the purview of section 167. Paraphrasing the statute, such gains during the taxable years were being held or accumulated for possible future distribution to the grantor; and during the taxable years it was known that such accumulated gains might, in the discretion of the grantor, ultimately be distributed to her. They were in fact so distributed. Where a grantor may and does become a beneficiary of the trust, and may and does utilize the trust to manipulate as be sees fit his receipt of a portion of the income, such income is within section 167. Preston R. Bassett, 33 B. T. A. 182, 187; affd., 90 Fed. (2d) 1004. See also Rollins v. Helvering, 92 Fed. (2d) 390, affirming 34 B. T. A. 319.

[Respondent did not err in taxing the capital gains in controversy to petitioner pursuant to section 167, and this conclusion renders it unnecessary for us to consider whether such income is also taxable to petitioner under section 22 (a).

[Reviewed by the Board.

Decision will ~be entered wider Rule 50.

KbRN and Opper dissent.

Black,

dissenting: I respectfully dissent from the conclusion reached in the majority opinion.

Petitioner, the settlor of the trusts, reserved to herself in each of the trust indentures, “the right to modify, alter, or entirely revoke this instrument at any time after January 15,1936, as to all or any part of the trust herein created, etc.” It seems to me this reserved power in the grantor brings the trusts squarely within the provisions of section 166 of the [Revenue Act of 1934, relating to revocable trusts. It may be true, as the majority opinion points out, that subsequent events might happen, such as the settlor’s death prior to January 15, 1936, which would completely divest her of the power to revoke these trusts. Such a condition subsequent had not, however, happened during the taxable years here in question.

During the taxable years 1934 and 1935 the settlor of the trusts was living and, in my judgment, was completely vested with a power to revoke the trusts, although such power was not exercisable until after January 15,1936, and this, I think, brings the trusts within the provisions of section 166, even though such power could not be exercised until then. Such cases as Corning v. Commissioner, 104 Fed. (2d) 329, and John Edward Rovensky, 37 B. T. A. 702, in my1 judgment, are not in point and do not support the conclusions reached in the majority opinion. In those cases the power to revoke the trusts was not vested in the grantor of the trusts during the taxable year, but was to vest only upon the happening of some future contingency, which might never happen. That fact I think makes the Corning case and the Rovensky case easily distinguishable from the instant case.

As I have already stated, I think the facts of the instant case bring it squarely within the provisions of section 166 of the [Revenue Act of 1934, and, unless that section is unconstitutional when applied to such a situation as we have here, it seems to me that we must give it effect and tax the income of such trusts to the grantor thereof. Considering the nature of the trusts and that the beneficiaries werei petitioner’s four children, and that petitioner retained the unqualified right to revoke the trusts and revest in. herself the corpus after the lapse of only a few years, I see nothing to indicate that section 166, when applied to such a situation, is unconstitutional. Cf. DuPont v. Commissioner, 289 U. S. 685.

Murdock, Turner, and DisNey agree with this dissent.

       SEC. 166. REVOCABLE TRUSTS.
      Where at any time the power to revest in the grantor title to any part of the corpus of the trust is vested—
      (1) in the grantor, either alone or in conjunction with any person not having a substantial adverse interest in the disposition of such part of the corpus or the income therefrom, or
      (2) * * *
      then the income of such part of the trust shall be included in computing the net income of the grantor.
      SBC. 167. INCOME ROR BENEFIT OF GRANTOR.
      (a) Where any part of the income of a trust—
      (1) is, or in the discretion of the grantor or of any person not having a substantial adverse interest in the disposition of such part of the income may be, held or accumulated for future distribution to the grantor ; or
      (2) may, in the discretion of the grantor or of any person not having a substantial adverse interest in the disposition of such part of the income, be distributed to the grantor; or
      (3) * * *
      then such part of the income of the trust shall be included in computing the net income of the grantor.


author: Mellott :

text:
    Robert Gaylord, Incorporated, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 96953.
    Promulgated May 14, 1940.

      Ernest J. Brown, Esq., for tbe petitioner.

      Arthur W. Garndwff, Esq., for tbe respondent.
   OPINION.

Mellott :

The amended petition alleges that the claimed deduction of $12,451.58 should be allowed as a loss not compensated for by insurance or otherwise under section 23 (f) (all references being to the Revenue Act of 1936); under section 23 (a) as an ordinary and necessary expense paid or incurred during the taxable year in carrying on a trade or business; under 23 (q) as a contribution; or under 23 (k) as a debt ascertained to be worthless and charged off.

The respondent denies that the deduction is allowable under any of the sections relied upon. He contends that petitioner merely made a voluntary contribution; that it participated in the “rescue party” purely as a “matter of civic pride”; that the amount was not paid as an ordinary or necessary expense of carrying on its trade or business; and that since petitioner signed an agreement extending the 3931 contract to December 31, 1939, no deduction can be taken until after that date.

Petitioner’s argument in connection with its claim that the amount is deductible as a loss, a contribution, or a debt ascertained to be worthless, is not without substantial merit. We are of the opinion, however, that the issue may be determined by ascertaining whether or not the expenditure constituted “an ordinary and necessary” business expense within the purview of section 23 (a), shown in the margin.

That petitioner places substantial reliance upon this section is indicated by the testimony of its president. When asked why he signed the agreement, he stated: “We were trying to save the situation. It was a tough picture in town. There were rumors going around * * *. Rumors always circulate * * *. We had quite an equity in this picture here. We had accounts receivable that were centered around this area. We had our balances, bank balances, I do not know the exact figure, but I imagine we had around a quarter of a million dollars.” Wb.en asked whether or not he felt that the involuntary closing of the Franklin-American would adversely affect his business he replied: “Most decidedly. It would probably paralyze the Christmas trade right in the center of it. That would mean that our orders would eventually be cut off.”

It has been stipulated, and we have found as a fact, that petitioner’s president signed the agreement because he believed it to be for the best interest of petitioner. This stipulated fact may, if necessary, be supplemented by matters as to which we would take judicial notice, although there is ample testimony in the record to prove all of the necessary facts. Thus, it is a matter of common knowledge that in the fall of 1931 the banking situation throughout the country was in a precarious condition. Large and important banks, many of which had been in existence for decades, were closing, never to reopen. Bank failures during the year 1931 were twice as numerous as during the preceding year, almost four times as numerous as during the year 1929, and almost six times as numerous as during the average of predepression years. The then president of the St. Louis Clearing House Association stated that the whole situation was “very serious. Very acute; runs on banks were frequent and many, and the public was very nervous over the general situation financially.” He stated it was his opinion, when the meeting of business men was held in December of 1931, and he so advised them, that the failure of Franklin-American “would probably bring the failure of other banks and a general run on the various banks.” This, then, was the general picture when they were asked to sign the agreement and to deposit with the absorbing bank the amounts of their subscriptions.

Respondent argues that the agreement constituted a contract of indemnity without consideration inuring to petitioner; that petitioner was not engaged in the indemnity or guaranty business; and that the payment was made purely as a “matter of civic pride.” Upon brief he says: “How can it be said that participation by petitioner in a ‘rescue party’ for a bank with which it had no direct financial relations, no deposits, nor stock, was an ordinary or necessary expense of this business concern?”

It is true that petitioner was not engaged in the indemnity or guaranty business. Petitioner does not contend that the amount is deductible as an expenditure made in carrying on such business. It contends that the payment was made for its own benefit; to preserve, protect, and promote its own business of manufacturing and selling containers. As pointed out by this Board in Edward J. Miller, 37 B. T. A. 830, 833, “Many expenditures made without legal compulsion are deductible, such as insurance premiums on business property, bonuses to a taxpayer’s employees, donations resulting in business benefits, and numerous others.” Of course, if the payment is made for the acquisition of a capital asset it is not deductible.

What constitutes an ordinary and necessary expense has been passed upon in many cases. Many of them are cited in First National Bank of Skowhegan, Maine, 35 B. T. A. 876, some of the more important being Kornhauser v. United States, 276 U. S. 145; Helvering v. Community Bond & Mortgage Co., 74 Fed. (2d) 727; Welch v. Helvering, 290 U. S. 111; and Deputy v. du Pont, 308 U. S. 488.

That the expenditure in question was deemed by the taxpayer to be necessary for the protection of its own business can not be doubted. The fact that it had no direct financial stake in the Franklin-American Bank is not determinative. The effect of the failure of this bank upon petitioner’s business might well have been considerable. As pointed out by its president, it stood to lose upwards of a quarter of a million dollars through the collapse of the financial institutions of the community, which at that time Avas imminent. If the guaranty had not been raised and the apprehended collapse had occurred, it is entirely possible that petitioner’s business would have been wiped out. This must have been in the minds of the officers and directors of petitioner when they authorized the agreement to be signed and the amount to be deposited. We think it must be held, therefore, that the expenditure was a “necessary” one.

Whether the expenditure was or was not an “ordinary” one presents more difficulty. The Supreme Court pointed out in Welch v. Helvering, supra, that ordinary “does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often.” Referring to the expenditure of heavy counsel fees in connection with a lawsuit affecting the safety of a business, the Court characterized such a payment as an ordinary expense because of the fact that it is “the common and accepted means of defense against attack.”

In the recent case of Deputy v. du Pont, supra, the Court quoted with approval its language in Welch v. Helvering: “What is ordinary, though there must always be a strain of constancy within it, is none the less a variable affected by time and place and circumstance.” It refused to permit the deduction from the taxpayer’s gross income of amounts paid by him to a corporation for the loan of certain shares of stock, borrowed by him for the purpose of selling it to some executives of a company in which he had substantial interests, pointing out that there was “no evidence that stockholders or investors, in furtherance of enhancing and conserving their estates, ordinarily or frequently lend such assistance to employee stock purchase plans of their corporations.” It said: “In the absence of such evidence there is no basis for an assumption, in experience or common knowledge, that these payments are to be placed in the same category as typically ordinary expenses of such activities, e. g., rental of safe deposit boxes * * The Court was careful not to overrule Welch v. Helvering, supra, however, and reiterated that: “It is the kind of transaction out of which the obligation arose and its normalcy in the particular business which are crucial and controlling.”

Was the transaction out of which the obligation in question arose, normal? In other words, was it, in the language of Welch v. Helvering, supra, the “common and accepted means of defense” adopted by corporate businesses generally when faced with a situation such as that which confronted the business men of St. Louis in 1981? We think that both questions should be answered in the affirmative. It will be recalled that the states had found it to be impracticable, or at least unworkable, to insure bank deposits. Nor had any plan been devised under which they, either alone or in conjunction with existing financial institutions, could take over the affairs of a bank, except through receivership, which was well known to be an expensive proceeding not conducive to continued faith in such institutions. The Federal Government had not, as yet, undertaken to insure bank deposits or to render aid to distressed banks and financial institutions either directly or through governmental agencies, nor had any provision been made whereby a bank might avail itself of the modicum of protection now given to corporations under sections 77 (a) and 77 (b) of the Bankruptcy Act. In other words, banks and financial institutions were dependent first upon their own assets and secondarily upon such assistance as they might receive, in times of stress, from their officers, directors, and stockholders, from other banks, and from corporations and individuals who came to their rescue either as a gesture of friendship or more frequently, as in the instant proceeding, as a matter of self-defense. The plan, devised and followed by the banhs and business men of St. Louis, or some modification or variation of it, was being carried out in many sections of the country. Cf. O'Connor v. Bankers Trust Co., 289 N. Y. S. 252; First National Bank of Skowhegan, Maine, supra. We think therefore it can not be gainsaid that in December of 1931 the transaction entered into by this petitioner was both “normal” and constituted a then “common and accepted means of defense” to protect it and its business from an imminent loss.

In First National Bank of Skowhegan, Maine, supra, the facts were somewhat analogous to those in the instant proceeding. A national bank paid the sum of $10,000 to another bank in consideration of its taking over the assets and assuming the liabilities of a local bank, thus obviating the failure of the local bank. It was held, as succinctly stated in our headnote: “Since the expenditure was made to protect petitioner’s business, its depositors, and its stockholders, it is an ordinary and necessary expense within the meaning of section 23 (a) * * The Commissioner acquiesced in our decision and apparently does not now contend that it is wrong. He attempts to distinguish it from the instant proceeding on the ground that the participation in the “rescue party” in that case was by a bank, whereas the “petitioner here was a manufacturing and selling corporation with no direct interest in the distressed bank and the effect of its being closed upon petitioner’s business was remote.” The distinction, we think, is without substance. The closing of Franklin-American, even assuming that it did not result in the closing of other banks, would have had a direct effect upon a substantial portion of petitioner’s accounts receivable. To that extent at least, its closing would have affected petitioner’s business adversely; but, as we have pointed out above, the general condition of the country was such that the closing of this bank would probably, as prophesied by the president of the Clearing House Association, have resulted in runs upon, and the closing of, other banks in the city, and this would have been disastrous to petitioner’s business.

We are of the opinion and hold that the amount in question is deductible as an ordinary and necessary expense of carrying on petitioner’s trade or business.

Eeviewed by the Board.

Decision will he entered for the petitioner.

AbuNdell, SterNIIageN, Murdock, ArNOld, and Opfer concur only in the result.

       SEC. 23. deductions FROM GROSS INCOME.
      In computing net income there shall be allowed as deductions :
      (a) Expenses. — All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; * * *