author: Teammell : TueneR,

text:
    Everett J. Crews, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 66767.
    Promulgated September 18, 1935.

      Albert L. MeRill, Esq., for the petitioner.

      W. R. Lansford,, Esq., for the respondent.
   OPINION.

Teammell :

In his petition the petitioner alleges that the respondent erred (1) in including in taxable income the amount of $59,890.62 as his share of the income of the Crews heirs and (2) in not allowing a depletion deduction with respect to his interest in the oil and gas property.

In his brief the petitioner contends that he not only did not have any income from the property, but sustained a loss with respect thereto in the amount of $25,858.06, and that he is entitled to a deduction of $80,668.30 as a depletion allowance. The respondent admits that he erred in not allowing depletion with respect to the petitioner’s interest in the property, but denies that the petitioner is entitled to the amount now claimed by him.

With respect to the allowance for depletion on oil and gas properties, section 114 (b) (3) of the Revenue Act of 1928 provides as follows:

(3) Percentage depletion eor oil and gas wells. — In the case of oil and gas wells the allowance for depletion shall he 27% per centum of the gross income from the property during the taxable year. Such allowance shall not exceed 50 per centum of the net income of the taxpayer (computed without allowance for depletion) from the property, except that in no case shall the depletion allowance he less than it would be if computed without reference to this paragraph.

While in the instant proceeding we are called upon to determine the amount of the petitioner’s share of the income from the property and the amount of his depletion allowance with respect thereto, we shall first determine the amount of the income and the depletion allowance with respect to the Crews'heirs as a unit and then ascertain the amount of the petitioner’s one-sixth share thereof.

There is no contention by either party and nothing in the record to indicate that the petitioner’s depletion allowance is to be computed without reference to the provisions of section 114 (b) (3). We, therefore, conclude that it is applicable. It provides that the depletion allowance in the case of oil and gas wells shall be 27% per centum of the gross income from the property during the taxable year, subject to the limitation that such allowance shall not exceed 50 per centum of the net income of the taxpayer (computed without allowance for depletion) from the property.

The phrase “ gross income from the property ” “ can only be construed as referring to the property with respect to which the depletion allowance is sought. Income from all other sources must be excluded in computing the depletion allowance.” Greensboro Gas Co., 30 B. T. A. 1362. As was said by the Supreme Court in Helvering v. Twin Bell Oil Syndicate, 293 U. S. 312:

The phrase, we think, points only to the gross income from oil and gas. Compare United States v. Dakota-Montana Oil Co., 288 U. S. 459, 461; Greensboro Gas Co. v. Commissioner, 30 B. T. A. 1361. So restricted, it presents no difficulty where the owner of the land is also the operator, and there is none where the lessee turns over royalty oil in kind to the lessor, for the retained oil, in that case, is the basis for the lessee’s computation of depletion and the royalty oil that for the lessor’s. We think Congress did not intend a different result where, as here, the lessee sells all the oil and pays over the royalty in the form of cash.

Ill view of tbe foregoing, income of the Crews heirs received as interest on bonds, notes, and bank balances would not constitute part of the gross income from the property in determining the depletion allowance. To what extent the $355,000 received by the heirs -from the Sinclair Oil & Gas Co. under the compromise agreement settling the litigation represented payment for oil and gas taken by that company from the land of the heirs is not clear from the record. However, since the respondent has determined it to be income from the property, and the petitioner contends that it was, and since the evidence does not show it to be otherwise, we conclude that it constitutes part of the gross income from the property in computing the depletion allowance.

The evidence shows that the proceeds from the oil and gas produced by the Crews heirs during the period of their operations on the property amounted to $1,462,504.02. Is that entire amount to be included in the gross income from the property in computing the depletion allowance? Tn determining the gross income the respondent included therein no amount with respect to United States bonds in the amount of $514,000 supposed to have been in the escrow account when the Crews heirs became entitled to the proceeds thereof but which were not recovered and with respect to which the heirs had never received anything. The petitioner takes the position that the respondent erred in so doing and that the full amount of the proceeds from the sale of oil and gas, $1,462,504.02 including the $514,000, constituted gross income from the property.

The evidence shows that the heirs were faced with the notice served by the Sinclair Oil & Gas Co. upon purchasers of the production of the heirs that it and its associates claimed the income from all production made by the heirs. In order to provide an outlet for their production by affording protection to the purchasers the heirs entered into the escrow agreement of June 13, 1922, whereby seven eighths of the purchase price of the production was to be deposited in an escrow account pending the termination of the litigation either by court judgment or by a settlement out of court, and then to be paid to the Crews heirs if by court judgment they should be held to be entitled to it or if by agreement they should become entitled to it.

The escrow agreement, in paragraph 3, after providing how the purchase price of the production should be. determined, provided that one eighth of such purchase price, apparently the royalty that the heirs were entitled to irrespective of how the litigation terminated, should be paid to the heirs and that the remaining seven eighths of the purchase price was “ to be deposited in escrow in the Farmers State Bank of Garber, Oklahoma.” So far as we can determine from the record the seven eighths of the purchase price which was to be deposited in the escrow account was not paid to the heirs and by them deposited in the escrow account. Considering the provision of the agreement in the light of the circumstances under which it was entered into and its purpose, we think it meant that the purchaser was to make deposit in the escrow account at the bank of seven eighths of the purchase price. Since we find nothing in the record to the contrary, we conclude that such was- the procedure intended by the agreement and that such was the procedure followed.

The record contains no statement as to who originated the idea of the escrow agreement; whether it was proposed by the Crews heirs or by the purchaser of their production, the Garber Refining Co. Irrespective of the originator, it is clear that its purpose was to provide a protection to the purchaser that would not be afforded it if the entire purchase price of the production were paid over to the Crews heirs and thus made available to their unqualified and unrestrained use and disposition. While the purchaser did not actually retain the seven eighths of the purchase price of the production, the evidence shows that its president, G. J. Taft, was also vice president of the Fanners State Bank and its managing director, and by reason of this such portion of the purchase price remained under the control of a man who was a responsible official of the purchaser. There is nothing in the record to indicate that the heirs as a generous gesture to the purchaser freely agreed to the depositing of the seven eighths of the purchase price in the escrow account. What evidence there is bearing on the point indicates that this or some similar arrangement was tlie only course open to them for proceeding with production in view of the notice given by the Sinclair Oil & Gas Co.

So far as the receipt of income by the heirs is concerned, the situation is, we think, very similar to that where a receiver is appointed. In North American Oil Consolidated v. Burnet, 286 U. S. 417, the question for decision was whether certain money received by the company in 1917 constituted taxable income in that year. In 1916 the company operated a section of oil land, the legal title to which stood in the name of the United States. Prior to 1916, the Government, claiming also the beneficial ownership, had instituted a suit to oust the company from possession. In February 1916 it obtained the appointment of a receiver to operate the property or supervise its operations and to hold the net income therefrom. In 1917, after entry by the District Court of the final decree dismissing the Government’s bill, the money was paid to the company by the receiver. The Government took an appeal to the Circuit Court of Appeals which in 1920 affirmed the decree of the District Court. In 1922 a further appeal to the United States Supreme Court was dismissed. In its original return for 1916 the company did not include the amount in its income, but in an amended return for that year filed in 1918 reported the amount as income. The Commissioner took the position that the amount constituted income for 1917. In holding that the amount was taxable income for 1917 and not 1916, the Supreme Court said:

Second. The net profits were not taxable to the company as income of 1916. For the company was not required in 1916 to report as income an amount which it might never receive. See Burnet v. Logan, 283 U. S. 404, 413, 51 S. Ct. 550, 75 L. Ed. 1143. Compare Lucas v. American Code Co., 280 U. S. 445, 452, 50 S. Ct. 202, 74 L. Ed. 538; Burnet v. Sanford & Brooks Co., 282 U. S. 359, 363, 51 S. Ct. 150, 75 L. Ed. 383. There was no constructive receipt of the profits by the company in that year, because at no time during the year was there a right in the company to demand that the receiver pay over the money. Throughout 1916 it was uncertain who would be declared entitled to the profits. It was not until 1917, when the District Court entered a final decree vacating the receivership and dismissing the bill, that the company became entitled to receive the money. Nor is it material, for the purposes of this case, whether the company’s return was filed on the cash receipts and disbursements basis, or on the accrual basis. In neither event was it taxable in 1916 on account of income which it had not yet received and which it might never receive.
Third. The net profits earned by the property in 1916 were not income of the year 1922 — the year in which the litigation with the government was finally terminated. They became income of the company in 1917, when it first became entitled to them and when it actually received them. If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent. See Board v. Commissioner of Internal Revenue (C. C. A.), 51 F. (2d) 73, 75, 76. Compare United States v. S. S. White Dental Manufacturing Co., 274 U. S. 398, 403, 47 S. Ct. 598, 71 L. Ed. 1120. If in 1922 the government had prevailed, and the company had been obliged to refund the profits received in 1917, it would have been entitled to a deduction from the profits of 1922, not from those of any earlier year. Compare Lucas v. American Code Co., supra.

Considering the facts in the instant case in the light of the foregoing statements of the Supreme Court, we think it is clear that until the Crews heirs became entitled to receive the proceeds of the escrow account as a result of the agreement with the Sinclair Oil & Gas Co. by which the litigation was terminated they can not be said to have been in receipt of income therefrom. Did the fact that in 1930 they became entitled under the agreement to receive $514,000 of United States bonds which were supposed to have been in the escrow account but which were not, and with respect to which they have never recovered anything, in and of itself constitute the receipt of income by them to the amount of $514,000 or any other amount? The answer must be no. By becoming entitled to receive the bonds they acquired an empty and worthless right, for the bonds were not in the account, a fact that was brought to their knowledge on the same day and immediately following the execution of the agreement settling the litigation. Under these circumstances we are unable to hold that any income was realized in so far as this item was concerned.

The petitioner takes the position that, in determining the gross and net income of the Crews heirs from the property for the purpose of ascertaining his depletion allowance, no reduction should be made in the amount of the total proceeds from the .oil and gas produced by the heirs on account of their failure to receive anything with respect to the United States bonds, and urges that in computing the net income of the heirs from all sources, including the income from the oil and gas property, the amount of $514,000 should be allowed as a deduction for a loss. While in determining the deficiency the respondent included no amount in income with respect to the item, it appears that his position now is that in determining the gross income from the property no reduction is to be made in the total proceeds from the oil and gas produced by the heirs because of their failure to receive anything on account of the bonds, and that in computing the net income from the property a deduction of $514,000 should be made. We do not think that the position of either party is sound. With respect to the position of the respondent, we think the record is clear that the item in controversy had no connection, either direct or indirect, with the production of income from the property. It in no wise represents an expenditure or cost incurred by the heirs either in producing such income or in obtaining payment of it. The position of the petitioner is anomalous in that he contends that the item was both income and a loss. Under the cash receipts and disbursements method of reporting income which was employed by the heirs, including the petitioner, an amount must have been received either actually or constructively before it constitutes income. Then before the same amount can be considered as a loss it subsequently must have become involved in some transaction whereby it was lost. The record clearly discloses that the amount was never received by the heirs and consequently it was not income to them. It therefore follows that, never having received the amount, they can not be said to have sustained a loss of it.

In taking the position he does the petitioner seeks to obtain the benefit that would come from the allowance of depletion with respect to that portion of the production of the heirs the proceeds from which were supposed to have been invested in United States bonds and at the same time avoid the payment of any tax with respect to the proceeds from such portion of the production. His position with respect to the depletion allowance might be more tenable if under the statute such allowance was to be computed on the value of the oil and gas reserve at the time of inheritance or such value on March 1, 1913, or if the taxable year were governed by some prior act permitting depletion based on discovery value, as under those circumstances the unit of depletion rate would be permissible. Section 114 (b) (3) of the applicable act permits the allowance of depletion computed on cost or a value as of a basic date when the allowance computed under the percentage of income method therein provided is smaller. The petitioner here contends for an allowance computed under the percentage of income method undoubtedly for tlie reason that the allowance would be less if computed on the value as of a basic date. bTor is an allowance computed on discovery value permissible, for, as was pointed out in Helvering v. Twin Bell Oil Syndicate, supra, Congress abandoned this method, beginning with the Revenue Act of 1926, and substituted a percentage of income method because of difficulties in administration.

If it is the contention of the taxpayer that the expression “ gross income from the property ” means the gross income from the oil and gas produced from the property regardless of whether the taxpayer receives it or whether it arises as income of the taxpayer, we can not agree with him. Sections 11 and 12 of the Revenue Act of 1928 impose a normal tax and a surtax upon “the net income of every individual ” who has net income of the amounts specified therein. Section 21 provides as follows:

“ Net income ” means the gross income computed under section 22, less the deductions allowed by section 23.

Section 22 provides:

(a) General definition.- — “Gross income” includes gain, profits and income derived from * * * trades, businesses, commerce, or sales or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also from * * * the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever.

Section 23 provides:

In computing net income there shall be allowed as deductions:
(1) Depletion. — In the case of mines, oil and gas wells, * * * a reasonable allowance for depletion * * * according to the peculiar conditions in each case; * * * In the case of leases the deduction shall be equitably apportioned between the lessor and lessee. * * * In the case of property held in trust the allowable deduction shall be apportioned between the income beneficiaries and the trustee in accordance with the pertinent provisions of the instrument creating the trust, or, in the absence of such provisions, on the basis of the trust income allocable to each. * * *

Section 42 provides:

The amount of all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under section 41, any such amounts are to be properly accounted for as of a different period.

Section 41 provides:

The net income shall be computed upon the basis of the taxpayer’s annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; * * *

From a consideration of the provisions of sections 11, 12, 21, 22, 41, and 42 it seems clear in the case of individuals that the gross income and net income that is to be considered in the determination of their tax liability is their gross income and their net income, both determined in accordance with the act, and that where the books are kept on a cash basis it is income which they have received during the taxable year. It must be income of the individual taxpayer involved and not the income of another. Further, it must be income which he has received and not income which he might have received if certain nonexistent conditions had existed or if certain events had transpired which did not transpire. The income contemplated by the sections of the act is not a mere reservoir of funds or money a portion or all of which a particular individual taxpayer might under some circumstance become the recipient of. It is income which has been derived by the taxpayer and which has been received by him.

The first sentence of section 114 (b) (3) of the applicable act, in providing for a depletion allowance of “ 27% Per centum of the gross income from the property during the taxable year ”, does not specifically state whose gross income from the property is contemplated, as is done in the second sentence with respect to the net income from the property, which reads “ 50 per centum of the net income of the taxpayer * * * from the property.” (Italics supplied.) Is the omission of the phrase “ of the taxpayer ” in the first sentence and its inclusion in the second sentence of any particular significance? Does the omission of the phrase “ of the taxpayer ” in the first sentence mean that in determining the depletion allowance of 27y2 per centum of gross income from the property such gross income is not limited to the taxpayer’s gross income from the property or restricted to his interest in the gross income therefrom? Further, does it indicate that the gross income from the property is to consist of something which would not be gross income to the taxpayer within the meaning of that term under the other provisions of the act?

Section 23 (1) of the act authorizes a deduction for depletion and section 114 (b) (3) merely provides the basis or method for computing the amount of the allowance. Greensboro Gas Co., supra. Under section 23 (1), where the owner or owners of the land are also the operators, as is the case here, they are the ones entitled to the depletion allowance. The section also provides for an allocation or apportionment of the amount of the allowance in cases where other’s than the owners of the land also have an interest in the production or the proceeds therefrom. Considering the provisions of sections 23 (1) and 114 (b) (3) in connection with each other, we think it is clear that only one allowance of 27% per centum is to be made, that such allowance is to be computed on the basis of gross income subject to the limitation with respect to net income and is to be allocated or apportioned to those having an interest in the production or proceeds therefrom on the basis of their respective interests. Greensboro Gas Co., supra, and Helvering v. Twin Bell Oil Syndicate, supra. We are also of the opinion that the gross income referred to in the expression “ 27% per centum of the gross income from the property ” has reference to the portion of the income of the particular taxpayer or taxpayers who are entitled to share therein on the basis of their respective interests. Since the allowance is for the depletion of such interests, we do not think that the income of any other than the owner or owners of the interests is to be included in the computation of the allowance. We find nothing elsewhere in section 114 (b) (3) or elsewhere in the act which supports a contrary view. The use of the words “ of the taxpayer ” in the sentence providing for a limitation of the allowance to 50 per centum of the net income strengthens our conclusion. If a contrary view is taken, we at once run into difficulty in that we will have a net income of a taxpayer from the property computed on the basis of a gross income which in fact was not gross income to the taxpayer. This would he contrary to the general plan set up in the act for determining a taxpayer’s gross income and his net income. The petitioner does not point to anything in the act, nor do we find anything in it, which justifies the conclusion that the “ gross income from the property ” referred to in section 114 (b) (3) is to be determined on a basis other than that contemplated by the act generally. If the amount of $514,000 were included as part of the “ gross income from the property ” we would have a situation where the petitioner’s tax liability would be determined on the basis of an amount of income no portion of which has ever been received or, so far as the record indicates, ever will be received by either him or any of the other owners and operators of the property. We do not think Congress contemplated that such should be done. As we construe the provisions of section 114 (b) (3), an amount must meet the statutory requirements of income and must arise from oil or gas before it can be considered .as gross income from the property within the meaning of the section. In providing for a depletion allowance computed on the basis of a percentage of income we think it was the intention of Congress that such income must actually be income of the taxpayer to whom the allowance is to be made and must be determined by the criteria provided in the act for ascertaining what constitutes income.

Since the $514,000 was not income to the Crews heirs, who were the owners of the property upon which they were operating, we are of the opinion that in computing the gross income from the property the total proceeds of $1,462,504.02 are to be reduced by the $514,000. This leaves $948,504.02. To that amount is to be added the $355,000 received from the Sinclair Oil & 'Gas Co., which gives $1,303,504.02 as gross income from the property.

The determination of the net income of the heirs from the property involves a consideration of the items that are to be deducted from gross income from the property in order to arrive at the net income therefrom. The parties have stipulated that the cost of drilling, equipping, and operating wells and certain miscellaneous expenses applicable to the production of oil and gas amounted to $849,544.31, and they are in agreement that this amount constitutes a proper deduction in determining the net income from the property. We, therefore, hold this amount is an allowable deduction in determining the net income of the heirs from the property.

With respect to fees of $163,000 paid to attorneys for services in connection with the litigation and the recovery of escrow funds and the amount of $10,000 paid to R. L. Williams, a trustee under the indemnity contract, the petitioner takes the position that they had no relation to the production of oil and gas and therefore are not deductible from gross income from the property in determining the net income of the Crews heirs therefrom. In determining the deficiency the respondent determined that these amounts, totaling $173,000, were to be deducted from the gross income from the property in computing the net income of the heirs therefrom. He contends that that was proper.

While the petitioner presented no evidence directed to the detailed activities of the attorneys and to the activities of Williams, such evidence as the record contains as to their activities tends to support the respondent’s determination. The $355,000 received by the heirs from the Sinclair Oil & Gas Co. was in compromise of the litigation. This amount we have held to be a part of the gross income from the property. At least two of the attorneys, Sutton and Dyer, were attorneys for the heirs in this litigation. If the amount-received upon the compromise of the litigation was gross income from the property we perceive no valid reason why the fees of these attorneys, totaling $158,000, should not be deducted from the gross income from the property in determining the net income therefrom. While it may be true that the services of the attorneys never in any wise contributed to the production of oil and gas from the property, nevertheless we think their services were a factor contributing materially to the receipt by the heirs of the amount paid by the Sinclair Oil & Gas Co. The record indicates that the services rendered by Owens, an attorney, and by Williams, a trustee under the indemnity contract, and to whom a total of $15,000 was paid, were rendered in connection with recovery on the escrow account. Since the entire amount deposited in the escrow account in excess of an amount of $514,000 heretofore considered has been held to be gross income from the property, we do not know of any reason why amounts paid for services of those engaged in realizing on the account should not be deducted in determining the net income from the property. We accordingly hold that the amounts paid to the attorneys and Williams are proper deductions in determining the net income from the property.

From the gross income from the property of $1,303,504.02, as found above, there is to be deducted the amount of $849,544.37 representing expenditures for drilling, equipping, and operating wells, etc., and the amount of $173,000 representing expenditures for the services of attorneys and another, or a total of $1,022,544.37. This leaves a net income of $280,959.65 from the property without deduction for depletion. Twenty-seven and one-half percent of the gross income from the property is $358,463.61. Fifty percent of the net income from the property is $140,479.83. Twenty-seven and one-half percent of the gross income from the property being greater than 50 percent of the net income therefrom without deduction for depletion, the statute limits the depletion allowance of the heirs to the amount of the latter, or $140,479.83. Since the petitioner owned a one-sixth interest in the property, his depletion allowance is $23,413.31.

The remaining issue presents for determination the question of what amount is to be included in the gross income of the petitioner as his share of the net income of the Crews heirs from all sources, including the operation of the oil and gas property. The net income of the heirs fz’om the property without deduction for depletion was $280,959.65. In addition they had income of $47,871.79 as interest on bonds, bank balances, and notes. Their total net income from all sources without deduction for depletion, therefore, was $328,831.44, of which the petitioner’s one-sixth interest was $54,805.24.

In a recomputation of the petitioner’s tax liability the amount of $54,805.24, representing his share of the net income of the Crews heirs from all sources without deduction for depletion, will be included in his gross income and the amount of $23,413.31 representing depletion with respect to his interest in the oil and gas property will be allowed as a deduction.

At the hearing the respondent amended his answer and asked for an increase in the deficiency on the ground that he failed to include in the income of the petitioner any portion of the value of the contract of indemnity given the Crews heirs in 1930 guaranteeing them against any losses from the escrow account. The evidence shows that the contract was worthless from the date of its execution and we have so found as a fact. In view of this the request of the respondent must be denied.

Reviewed by the Board.

Decision will he entered under Bule 50.

Seawell and Matthews concur in the result.

TueneR,

dissenting: The unusual and complicated facts in this case have, in my opinion, induced the Board to make an erroneous interpretation of section 114 (b) (3) of the Revenue Act of 1928. The application of this provision to the facts seems to me to be clearly contrary to the plain language of the statute.

In stating my views, it seems advisable to summarize the pertinent facts which are set out in detail in the findings of fact preceding the prevailing opinion. The Sinclair Oil & Gas Co. had, through various transfers, acquired an oil and gas lease to property inherited by this taxpayer and his brothers and sisters. Difficulties arose which brought on court proceedings to set aside the lease. In 1922 this taxpayer, through his guardian, with the coheirs, undertook the operation of the property to prevent its drainage through wells on adjoining properties. By reason of the claim of the Sinclair Oil & Gas Co., it was necessary for the heirs to agree to the deposit in escrow of the proceeds from the' sale of the oil so produced until final disposition of the litigation then pending. An agreement was accordingly entered into with the Garber Befining Co., purchaser of the production, for such deposit with the Farmers State Bank as escrow agent. The fund so held in escrow was finally to- be distributed in accordance with the disposition of the litigation pending between the heirs and the Sinclair Oil & Gas Co. This arrangement continued until 1930, when a settlement of the litigation was concluded by compromise. Up to that time the production from the property had amounted to $1,462,504.02, all of which sum had been deposited with the escrow agent. There had been expended as cost of operation a total of $849,544.31, which amount had been released by the escrow agent for that purpose only. On settlement of the litigation it was discovered that the escrow agent had dissipated the funds. 'Of this amount, $514,000 had been put in bonds, but the bonds had been misappropriated. To cover the losses in the escrow fund, assets of the escrow agent, represented to have a value in excess of $900,000, were placed in the hands of the trustees under an indemnity contract. The work-out of these assets amounted to only an approximate amount of $1,000, while the expenses of the trust amounted to $39,000. The indemnity contract was worthless at the time of its execution. While the operation of the property under the escrow agreement covered the period from 1922 to 1930, it was agreed between the parties herein that full accounting for the income therefrom should be made in 1930, the year of the settlement of rights under the escrow agreement.

In the prevailing opinion the gross income of the heirs from the oil property in question is found to be $1,303,504.02. Of this amount $355,000 represents the recovery from the Sinclair Oil & Gas Co., while the remaining $948,504.02 represents the difference between $1,462,504.02, the amount of the gross sales under the escrow agreement, and $514,000, the sum invested by the escrow agent in the bonds which were later misappropriated. This sum of $514,000 is excluded from the gross income of the heirs under authority of North American Oil Consolidated v. Burnet, 286 U. S. 417. It is then held that the gross income of the heirs from the property is the same as “ the gross income from the property ”, within the meaning of section 114 (b)(3), supra, and that $1,303,504.02 is the amount from which the depletion deduction is to be computed.

In my opinion the conclusion reached is wrong in two respects. In the first place, the holding that the gross income of the heirs from the property is the same as K the gross income from the property ” within the meaning of section 114 (b) (3), supra, requires the reading into the statute of language which Congress did not see fit to place there, and, in the second place, if North American Oil Consolidated v. Burnet, supra, is applicable, no part of the amount deposited with the escrow agent constituted gross income to the heirs in any year and, under the interpretation placed on the statute in the prevailing opinion, the depletion deduction has been computed on the basis of gross income which did not exist.

Considering first the language of the statute, it will be noted that section 114 (b) (3) is divided into two parts. In the first sentence it is stated that the allowance for depletion in the case of oil and gas wells “ shall be 27*/2 per centum of the gross income from the property during the taxable year.” This sentence presents a full and complete thought which is not modified or changed in any respect by any subsequent language appearing in the statute. The language is simple and unambiguous. In that sentence Congress was expressing its judgment of the extent of the exhaustion of oil properties through operation. Nothing is said there about the owners of the property or any individual taxpayer. The individual interests in the property may be varied and numerous. We have found in our findings of fact that the gross production from the property herein involved was $1,462,504.02 and the prevailing opinion accepts this finding. Neither is there any question that the oil properties were exhausted or depleted by this production. In my opinion it would be mere quibbling to say that the amount found as gross production from the property is not the “ gross income from the property ” contemplated by the first sentence of section 114 (b) (3), supra.

In the second sentence of this provision of the statute Congress, for the first time, mentioned the individual taxpayer and there provided that the depletion allowance, computed under the first sentence, may not exceed “ 50 per centum of the net income of the taxpayer * * from the property.” By this sentence Congress made no change whatever in the depletion allowance prescribed by the first sentence, nor in the method of computing such allowance, but did prescribe a limitation on that allowance in respect of each individual taxpayer, the limitation so prescribed being computed on an entirely different basis and without reference to the computation made under the first sentence.

The prevailing opinion justifies its conclusion with reference to the first sentence pf section 114 (b) (3), supra, by saying that since Congress, in the second sentence, dealt with “ the net income of the taxpayer * * * from the property ”, it obviously intended that the words “ of the taxpayer ” should be read into the first sentence. The answer to this contention is that Congress did not place any such phrase in the first sentence. By this omission Congress, itself, drew the distinction between the two sentences. According to the views previously expressed, the first sentence is complete in itself and we are not at liberty to read into the statute something that is not there, merely because we are confronted with an unusual case in which the “ gross income from the property ” is not the same as the gross income of the taxpayer or taxpayers from the property.

If the net income of the heirs from the property has been correctly determined and the 21% per centum depletion allowance is computed in accordance with the views which I have expressed above, the result would not be at variance with the result in the prevailing opinion, since, under such circumstances, the depletion deduction would be finally determined by application of the limitation contained in the second sentence of section 114 (b) (3), supra. But even if the result should be the same in this case, an erroneous interpretation of the statute, such as we have here, should be avoided, for it is altogether unlikely that a similar application of the statute to other cases would produce correct results.

It has previously been suggested, however, that another error is apparent in the prevailing opinion which, if corrected, will not only change the depletion deduction but also the net income of the taxpayer computed without regard to the depletion allowance. The decision of the Supreme Court in North American Oil Consolidated v. Burnet, supra, has been cited as controlling in this case. There the Government and North American Oil Consolidated were both claiming title to certain property. During 1916 and 1917 it was operated by a receiver appointed at the instance of the Government. In 1917 the Government’s bill was dismissed and the proceeds accumulated by the receiver from the operation of the property were paid to North American Oil Consolidated. The suit was not finally disposed of, however, until the dismissal, in 1922, by the United States Supreme Court of the Government’s appeal. Later, in the case above cited, the Supreme Court held that North American Oil Consolidated realized income in 1917, the year in which it actually received the proceeds from the operation of the property. It was stated that “ If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return even though it may still be claimed that he is not entitled to retain the money and even though he may still be adjudged liable to restore its equivalent.” Reasoning from the language of the Court in that case, the prevailing opinion hay excluded, from the gross income of the heirs the sum of $514,000 which represented that part of the escrow fund which had been invested" in bonds and misappropriated by the escrow agent. It does not apply this rule, however, to the remainder of the escrow fund, but includes the remainder in the gross income of the heirs. In my opinion there is no justification under the rule laid down in North American Oil Consolidated v. Burnet, supra, for excluding the $514,000 representing the misappropriated bonds and including the remainder. The facts which are accepted by the prevailing opinion show that no part of the escrow fund was, at any time, received by the heirs in the manner and under the conditions set forth in the language quoted above from the Supreme Court’s decision. According to the facts, $514,000 had been placed in bonds and the bonds misappropriated. This leaves $948,504.02 of the escrow fund, all of which has been included in the gross income of the heirs. Of this remainder, $849,544.37 was expended in the production of the oil which gave rise to the escrow fund. While it is true that this sum was expended by the heirs, or some of them, it should be remembered that it was expended in strict accordance with the terms of the escrow agreement and the heirs never, at any time, received any portion of that amount as their own without restriction as to its disposition.” If any part of the escrow fund is to be excluded from gross income of the heirs under the decision of the Supreme Court above cited, there is no basis for any claim that the amount expended under the escrow agreement as operating expenses, or any part of that amount at any time constituted gross income to this taxpayer, or any of the heirs. But even though it be said that the receipt of the $849,544.37 as expenses of operation was comparable to the receipt by North American Oil Consolidated in 1917 of the amount accumulated by the receiver, and from that it is held that the $849,544.37 was income to the heirs, there is still no basis whatever for the inclusion in the income of the heirs of the remaining $98,959.65 of the escrow fund. No part of this amount has ever been received by the heirs or any of them, from the escrow agent or any other person, and the facts show nothing from which it can be paid, or could have been paid at any time after the litigation was settled. It is to be remembered that all of the escrow fund, except $849,-544.37 which represented the expenses of operation under the escrow agreement, was dissipated by the escrow agent, and the heirs, in their own right, received nothing therefrom. The facts show that when the defalcations were discovered the escrow agent transferred to the trustees certain assets having a claimed value of $900,000 in satisfaction of its liability under the escrow agreement, and we have specifically found as a fact that this contract, whereby the said assets were transferred in trust, was worthless from the date it was-cxecuted.

Under such circumstances it is impossible, in my opinion, to reconcile the conclusion reached in the prevailing opinion, whereby a part x.f the escrow fund is declared to be income to the heirs while another portion is excluded, with the conclusion stated in North American Oil Consolidated v. Burnet, supra.

Smith, Sternhagen, and MoeRis agree with this dissent.


source: Caselaw Access Project

author: Arundell:

license: Public Domain

text:
    Elizabeth P. Patterson, Petitioner, v. Commissioner of Internal Revenue, Respondent. Mary N. Winslow, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 76058, 76059.
    Promulgated September 18, 1935.

      Caesar L. Aiello, Esq., for the petitioners.

      B. M. Coon, Esq., and J. W. Smith, Esq., for the respondent.
   OPINION.

Arundell:

Respondent determined deficiencies in the 1980 and 1931 income tax of Elizabeth P. Patterson in the amounts of $1,211.16 and $6,297.90, respectively, and in the 1931 income tax of Mary N. Winslow in the amount of $61.62. Each of the petitioners challenges the respondent’s determination as to her as erroneous in that respondent used an incorrect basis for the determination of the gains derived from sales of parts of the so-called Patterson tract, in the District of Columbia, with a consequent overstatement of those gains. The proceedings were consolidated for hearing.

The petitioners are individuals, citizens of the United States, and residents of the District of Columbia.

Catherine Pearson, deceased, left a last will and testament, dated December 4, 1862, which was duly probated and recorded, the effect of which was to give and devise all of her residuary estate, including the Patterson tract, in trust, to her daughter, Eliza Patterson, for life, with remainder to her said daughter’s children.

Eliza Patterson died on January 27, 1902, leaving surviving her, as sole heirs at law and next of kin, three daughters, Kate LaMon-tagne, Harriet Winslow, and Elizabeth P. Patterson, petitioner, in whom the title to the Patterson tract, and other property, became rested under the will of Catherine Pearson.

Said Elizabeth P. Patterson and her two sisters, by an indenture in writing dated November 19, 1902, transferred and conveyed to the American Security & Trust Co., of Washington, D. C., Francis Winslow and Augustus Jay, as trustees, all of their property, including the Patterson tract, to be held by the trustees, in and upon the trust, and for the uses and purposes hereinafter set forth.

Under and by virtue of the trust indenture of November 19, 1902, petitioner Elizabeth P. Patterson and her two sisters reserved for themselves a life tenancy in the trust estate so created by them, and further provided:

In tlie event of tlie death of either of said life tenants, to hold the share then held for the life of the one so dying, in trust for such uses and purposes as such life tenant may, by last will and testament, or by paper writing in the nature of a last will and testament, direct and appoint; and in the event of a non-execution of said power of appointment, then in trust for the use of any child or children of hers as may be living at the time of her death, and the descendants then living of such child or children as may have deceased, as tenants in common in fee simple; the descendants of any deceased child to take, per stirpes. * * *

As to the termination of the trust estate, it was provided thereunder :

And upon the death of the last survivor of said life tenants, to hold said property and estate, subject to the provisions of these presents, until the youngest child of either of said life tenants then living, and entitled hereunder, shall attain the age of twenty-one years. And if such youngest child shall then be twenty-one years of age, or when such youngest child shall attain the age of twenty-one years, then in trust to convey the estate and property, held in trust under the provisions of these presents, to the persons lawfully entitled thereto hereunder as aforesaid, in fee simple.

Kate LaMontagne, one of tbe parties to tlie trust indenture, died on August 1, 1917, leaving a last will and testament, which was duly recorded and admitted to probate in the Supreme Court of the District of Columbia. Thereunder, after making bequests not involved herein, she gave, devised, and bequeathed unto her sister, Elizabeth P. Patterson, petitioner, all of the rest, residue, and remainder of her estate, both real and personal, as to which she had the power of appointment by virtue of the indenture of November 19, 1902. Accordingly, petitioner Elizabeth P. Patterson acquired and became entitled in 1917 to an additional one-third interest in the trust estate created by the indenture of November 19, 1902, which had amongst its assets the Patterson tract aforesaid.

Harriet Winslow, another of the parties to the trust indenture, died on June 27, 1923, leaving a last will and testament, which was duly recorded and admitted to probate in the Supreme Court of tbe District of Columbia. Thereunder, after mailing bequests not involved herein, she gave, devised, and bequeathed all of the rest and residue of her estate, real and personal, over which she had the power of testamentary disposition to her two daughters and four sons. Each daughter was given a one-fourth share and each son a one-eighth share. By exercising in this maimer the power of appointment she had under the trust indenture of November 19, 1902, there passed to her children a one-third interest in said trust estate. Accordingly, petitioner Mary N. Winslow acquired and became entitled in 1923 to a one-fourth of one-third fee simple interest in said trust estate, which had amongst its assets the Patterson tract aforesaid.

Thereafter petitioner Elizabeth P. Patterson and six Winslow heirs, being all of the parties then entitled to the rights, title, and interest in and to the assets and property of the trust estate created in 1902, entered into and became parties to three instruments in writing, dated November 8,1924, whereby they undertook to create a new trust, into which they transferred and conveyed personal property, securities and cash, and real estate, including the Patterson tract, namely:

(a) Agreement of November 8, 1924, made by and between Elizabeth P. Patterson et al., parties of the first part, called the grantors, and Carlile P. Winslow, Pearson Winslow, and the American Security and Trust Co., parties of the second part, called trustees. This agreement recites that:

* * * the grantors desire to establish, in the hands of the trustees, a trust fund for the use and purposes hereinafter set forth, including the maintenance of a fund for the payment of taxes, and other expenses necessary for the maintenance and upkeep of certain real estate conveyed by indenture of even date herewith, executed by one Albert H. Shillington, unmarried, of Washington, in the District of Columbia, conveying to the parties hereto of the second part, the said real estate (Patterson Tract) upon certain trusts therein set forth. * * *

Under the aforesaid agreement petitioner Elizabeth P. Patterson was entitled to receive one half of the net income from the personalty and two thirds of the net income from the real estate, and the remaining income was to be divided among the Winslow heirs in the proportions set forth therein.

(b) Agreement of November 8,1924, made by and between Albert H. Shillington, called the grantor, party of the first part, Carlile P. Winslow, of Madison, Wisconsin, Pearson Winslow, of New York City, and the American Security & Trust Co., called the trustees, parties of the second part. This agreement reads in part, as follows:

Whereas, Elizabeth P. Patterson, Harriet P. Winslow, Carlile P. Winslow, Mary N. Winslow, -Francis N. Winslow, Pearson Winslow and Cameron Win-slow, hereinafter called the beneficiaries, conveyed the hereinafter described real estate unto the above named Grantor by deed bearing date on the 8th day of November, 1924, for the purpose of having the same conveyed to said trustee, upon the trusts hereinafter set forth, in evidence whereof said beneficiaries sign these presents:

and then by express terms conveys unto the trustees the Patterson tract, embracing 81.76 acres here involved, in trust upon certain terms and conditions therein set forth. Thereunder, petitioner Elizabeth P. Patterson became entitled to two thirds of the net income derived from the management and sale of the Patterson tract, or any part thereof, and petitioner Mary N. Winslow became entitled to one twelfth of any such net income.

The trustees were empowered to take possession of such real estate and the rents, issues, and profits thereof, with full power to sell the same or any part thereof and convey fee simple title thereto; to borrow money thereon; to lease the same or any part thereof; to pay all taxes, local and Federal, and the cost of repairs and improvements; and to do all things necessary and requisite for the preservation and management of the property.

(c) Deed of November 8, 1924, from Elizabeth P. Patterson, Harriet P. Winslow, Carlile P. Winslow, Mary N. Winslow, Francis Winslow, Pearson Winslow, and Cameron Winslow, and the American Security & Trust Co. and Carlile P. Winslow, as trustees, to Albert H. Shillington, unmarried, conveying the aforesaid Patterson tract. The following statement appears therein referring to the 1902 trust:

Whereas the parties hereto of the first part, in their various capacities, as herein above set forth, are desirous of terminating finally the trusts, in so far as the same still exist under the aforesaid indenture of trust, and of conveying a complete and fee simple title * * *.

Pursuant to the aforesaid agreements and deed, title to the Patterson tract became vested in the American Security & Trust Co., Carlile P. Winslow, and Pearson Winslow, trustees, who took the property and exercised all of the rights of ownership therein on and after November 8, 1924.

Beginning in the year 1928 and subsequently, the trustees under the 1924 trust made sales of parts of the Patterson tract. Such sales were reported by them in appropriate fiduciary returns. For each sale made a basis was taken by the trustees reflecting the fair market value as of 1924 when the trust was created, and the amount received in excess of such basis was reported as capital gain to the beneficiaries of the trust, who reported the same and paid a tax thereon.

The aggregate of the bases claimed by the trustees and allowed by respondent in respect of sales from the Patterson tract in 1928 and 1929 is $458,095.20.

The fiduciary return made by the American Security & Trust Co., trustee, for the year 1930 shows that the trustees under the 1924 trust sold a parcel of ground, consisting of 6,375 square feet, located at the corner of Fourth Street and Florida Avenue, for the sum of $19,125. A cost of $14,343.75 was claimed for this ground, being approximately $2.25 per square foot, leaving a balance of $4,781.25 which was reported as capital gain and a tax paid thereon by the beneficiaries of the trust.

The fiduciary return made by the American Security & Trust Co., trustee, for the year 1931 shows that various parcels of ground were sold by the trustees for the sum of $123,995.46. A cost of $75,759.73 was claimed for this ground, leaving a balance of $48,235.73 which was reported as profit and a tax paid thereon.

The respondent held, in the case of petitioner Elizabeth P. Patterson, that the gains resulting from the trustees’ sales of parcels of the Patterson tract are determinable upon the basis of the fair market value, as of March 1, 1913, of the one-third interest in the tract acquired in 1902 under the will of her grandmother, Catherine Pearson, plus the fair market value, as of August 1,1917, of the one-third interest acquired on that date under the will of her sister, Kate LaMontagne. In the case of the Winslow heirs, of which petitioner Mary N. Winslow is one, he held that the basis is the fair market value, as of June 27, 1923, of the one-third interest in the Patterson tract acquired on that date under the will of their mother, Harriet Winslow. He then determined that the fair market values of the Patterson tract were, as of March 1,1913, and August 1,1917, $429,240, and, as of June 27, 1923, $540,000. With these values fixed, he then determined that the basis to petitioner Elizabeth P. Patterson of her two-thirds interest is $286,160, and that the basis to the Winslow heirs of their one-third interest is $180,000. He then held that two thirds of the aggregate of the bases claimed by the trustees in their fiduciary returns for 1928 and 1929, and allowed, in respect of sales from the Patterson tract in those years, which aggregates amounted to $458,095.20, is chargeable to petitioner Elizabeth P. Patterson, and since that two thirds, amounting to $305,296.80, exceeds the basis for her two-thirds interest, she is entitled to recover nothing further and the full amounts received from sales in 1930 and 1931 constitute capital gains. By the same process he concluded that all but $22,510.35 of the basis to the Winslow heirs of their one-third interest had been exhausted or recovered prior to 1931, and that they were not entitled to recover anything more than that amount.

It is not disputed that the trust created by the instrument of November 8, 1924, is a revocable trust and that the income thereof is, by section 166 of the Bevenue Act of 1928, taxable to Elizabeth P. Patterson and the Winslow heirs, as the grantors.

The sales involved in these proceedings were made in 1930 and 1931 when the Bevenue Act of 1928 was in effect. The provisions of that act, therefore, govern in the determination of the basis for gain or loss. The petitioners quote provisions of the Bevenue Act of 1924 as determinative because that act was in effect when the transfer in trust was made. That view is erroneous. It is plain that the amount of income must be determined under the act in effect when the sales were made, and one of the factors in that determination is the basis. Even though the bases were different under the two statutes, there is nothing invalid in requiring the use of that prescribed in the later act. Cf. Taft v. Bowers, 278 U. S. 470; MacLaughlin v. Alliance Insurance Co., 286 U. S. 244.

Section 113 (a) (3) of the Bevenue Act of 1928, set out in full in the margin, provides in substance that in the case of property transferred in trust after December 31, 1920, the basis shall be the same as it would be in the hands of the grantor. In this case we are concerned with three interests that were transferred in trust, namely, a one-third interest acquired by Elizabeth Patterson as remainderman under the will of Catherine Pearson; a one-third interest acquired by Elizabeth Patterson as appointee of Kate LaMontagne; and a one-twelfth interest acquired by Mary Winslow as appointee of Harriet Winslow.

The one-third interest of Elizabeth Patterson acquired as re-mainderman was acquired prior to March 1,1913, and the basis under section 113 (a) (5) and section 113 (b) (2) of the Bevenue Act of 1928 is fair market value either at the time of the death of the decedent under whose will she acquired the property or at March 1, 1913, whichever is greater. The respondent has used fair market value at March 1, 1913, and we assume that that was greater than the value at the earlier date, as the petitioner has failed to put in evidence of the earlier value. Cf. Huyler's, Inc., 24 B. T. A. 425.

The other two interests transferred to the trustees were acquired by exercise of powers of appointment. Section 113 (a) (4) of the Revenue Act of 1928, set out in the margin, provides, when read in connection with the provisions of the estate tax statutes therein referred to, that the basis applicable to property acquired under a power of appointment is the value at the time of acquisition. The powers here were exercised by will. Wills speak as of the date of the death of the testator, so that in each case the date of the death was the date of acquisition. See Brewster v. Gage, 280 U. S. 327. Hence the basis of the one-third interest acquired by Elizabeth Patterson as appointee of Kate LaMontagne was the value at the date of death of the latter, August 1, 1917; the basis of the one-twelfth interest acquired by Mary Winslow as appointee of Harriet Winslow was the value at the date of death of the latter, June 27,1923. These are the dates used by the respondent in determining the bases and we approve them.

The Patterson tract, which contained 81.76 acres, more or less, is located in the northeast section of Washington, District of Columbia. It is bounded on the north and northeast by New York Avenue, on the east by the grounds of Gallaudet College, an institution for the education and training of the deaf and dumb, on the south by Florida Avenue, and on the west by the main line tracks of the Baltimore & Ohio Railroad and the Pennsylvania Railroad and freight yards and switching tracks of the Baltimore & Ohio. New York Avenue, the northern and northeastern boundary, had not been opened in 1913, and was not opened until several years thereafter, though the necessary ground for that thoroughfare had been condemned and condemnation proceedings were started as early as 1909. The only access to the tract in 1913, and until New York Avenue was opened, was by way of Florida Avenue, on which it fronted for approximately 1,500 feet. In all other respects the accessibility and boundaries of the tract were the same at any date which may be important in these proceedings.

Until 1926, at least, the tract was not subdivided and, except for an old house, which, because of its antiquity and condition of disrepair appears to have been of little or no value, it was wholly undeveloped. The half to the northeast was quite hilly, rough and timbered, and it was taken over by the local government in 1928, through condemnation proceedings, for park purposes. Much grading of the tract was necessary for any development. Except for a few days each year, when it was used for circuses, the tract had not been put to any remunerative use until taken over by the Federal Government in 1917 for temporary use as a military camp.

The potential uses for the tract in 1913 were industrial, second commercial, retail, low rental apartments, and low priced row houses. About 25 percent of the tract was ideally located for industrial purposes. While available industrial sites were less numerous then than today, there was no great demand for ground for industries. Washington is not an industrial city, and such industries as may be located therein are, generally speaking, only those necessary to the needs of the community. After 1913 there was a gradual change in the value of the property, from the standpoint of its potential use, until in 1920 it was zoned about 90 percent residential and the balance commercial and industrial. These zoning restrictions tended to lessen the value of the tract as a whole, because industrial development brought more lucrative returns than any other character of land development. At the present time, the development is largely industrial, second commercial, and retail, while the half acquired by the Government for park purposes is as yet undeveloped.

There were no sales of comparable properties in the immediate vicinity on or about any of the dates important here. There were a large number of sales in the general vicinity over the period 1901 to 1925, but all of these involved small parcels, some only residential lots, from subdivided and improved lands. These sales ranged in price from 35 cents to $5 per square foot, with a preponderance in both number and area at from 85 cents to about $1.50 per square foot. There was little or no change in property values in the vicinity of the tract between 1913 and 1917; but from 1918 to 1924 there was an increase of about 40 percent. In 1926, when the values were at the peak, the owners rejected an offer of $1,750,000 for the whole tract; the offer was on the basis of part cash and the balance extended deferred payments. Another offer in the same year, of $1,500,000, with a small initial payment and extended deferred payments, plus 50 percent of the profits realized from development, was likewise rejected. After 1926 there was some dropping off in values in the vicinity of the tract. The assessed value of the property in 1914 was $286,160.

One expert witness for petitioners expressed the opinion that the fair market values of the tract were $1,750,000 in 1913, $1,925,000 in 1917, and $2,406,250 in 1923 and 1924. Another placed those values at $1,481,232 in 1913 and 1917, and $1,965,708 in 1923 and 1924. Expert witnesses for the respondent fixed the values at from $367,620 to $396,270 in 1913 and 1917, and 35 to 50 percent increase over 1917 in 1923 and 1924. On three points the expert witnesses are practically unanimous — there was little or no change in the value of the tract between 1913 and 1917; the value was the same in 1923 and 1924; and there was an increase in value between 1918 and 1924 of approximately 40 percent. Beyond that the experts for the two sides are, figuratively speaking, as far apart as the poles.

We have carefully scrutinized the entire record with a view to ascertaining the facts in existence or in contemplation on the basic dates and from’ them endeavoring reasonably to predict those to come, to determine what a seller, willing but under no compulsion to sell, and a buyer, willing but under no compulsion to buy, would in their fairly mercenary interests have been most likely to agree upon as a fair price for the property in question. As a result of that study, we conclude and make the following findings of fact:

The Patterson tract had a fair market value of $600,000 as of March 1, 1913, and August 1, 1917. The same tract had a fair market value of $840,000 as of June 27, 1923, and November 8, 1924.

Decision will be entered under Rule SO.

       SEC. 166. REVOCABLE TRUSTS.
      Where the grantor oí a trust has, at any time during the taxable year, either alone or in conjunction with any person not a beneficiary of the trust, the power to revest in himself title to any part of the corpus of the trust, then the income of such part of the trust for such taxable year shall be included in computing the net income of the grantor.

      (3) Transfer in trust after DECEMBER 3t, 1920. — If the property was acquired after December 31, 1920, by a transfer in trust (other than by a transfer in trust by a bequest or devise) the basis shall be the same as it would be in the hands of the grantor, increased in the amount of gain or decreased in the amount of loss recognized to the ■grantor upon such transfer under the law applicable to the year in which the transfer was made.

       (4) Gift or transfer in trust before January i, 1921. — If the property was acquired by gift or transfer in trust on or before December 31, 1920, the basis shall be the fair market value of such property at the time of such acquisition. The provisions 0/ this paragraph shall apply to the acquisition of such property interests as are specified in section Ji02(c) of the Revenue Act of 1921, or in sections ¿02 (†) of the Revenue Act of 192Jf or the Revenue Act of 1926 (relating to property passing under power of appointment) regardless of the time of acquisition. [Italics supplied.]


author: Black :

text:
    Chicago Title and Trust Company, Executor of the Estate of Charles H. Aldrich, Deceased, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 50472.
    Promulgated September 24, 1935.

      Frederic O. Mason, Esq., for the petitioner.

      Claude R. Marshall, Esq., for the respondent.
   OPINION.

Black :

Petitioner seeks the redetermination of deficiencies in income tax against Charles H. Aldrich for the calendar year 1928 and the period January 1 to April 13, 1929, inclusive, in the respective amounts of $34,186.81 and $12,046.86; and also a deficiency in income tax against the estate of Charles H. Aldrich, deceased, for the period April 14 to December 31, 1929, in the amount of $46.88.

Only questions of law are involved, namely, (1) whether certain attorney fees earned by Charles H. Aldrich during his lifetime are income to Aldrich and his estate and therefore taxable to petitioner in the capacity of executor of the estate, or whether such fees are income to a certain trust created by Aldrich in 1925 and therefore taxable to petitioner only in the capacity of trustee of the trust; and (2) whether petitioner is now estopped to deny its liability as executor, having previously, in negotiations with the Commissioner, denied its liability as trustee.

The facts are contained in a stipulation, which we incorporate herein by reference and summarize as follows:

Petitioner, a corporation, is the executor of the estate of Charles H. Aldrich, deceased, and also the trustee of a trust, referred to herein as the Aldrich Living Trust. Prior to his death, which occurred on April 13, 1929, Charles H. Aldrich was a lawyer and a resident of Chicago.

On March 18, 1914, and July 12, 1915, Aldrich entered into contracts of employment as attorney for the L. P. Larson, Jr. Co., in connection with certain litigation which was then pending between that company and the William Wrigley, Jr. Co. Under these agreements Aldrich’s compensation was fixed at 33% percent of such sum or sums as we [the Larson Co.] may recover as damages in said suits or may be paid to us upon settlement thereof * * * payable to you as and when received by us.”

The litigation between the Larson Co. and the Wrigley Co. extended over a period of years and wTas the subject of several appeals on disputed points. The litigation was finally settled out of court by means of a settlement agreement between the litigating parties, executed on December 11, 1928, under which agreement the Wrigley Co. agreed to pay and did pay the sum of $1,900,000, exclusive of certain court costs, in full settlement thereof.

Prior to January 6, 1925, Aldrich, in pursuance of his contracts of employment with the Larson Co. and an Illinois statute creating attorney’s liens, gave notice to the Wrigley Co. of his claim for compensation under the contracts.

On January 6, 1925, Aldrich executed a written trust instrument creating what is referred to herein as the Aldrich Living Trust, in which instrument he designated George F. Porter as first trustee and the Illinois Merchants Trust Co. as successor in trust. Among other things, this instrument recited that Aldrich had entered into the employment contracts with the Larson Co.; that on July 30, 1918, and March 31, 1921, the United States Circuit Court of Appeals, Seventh Circuit, had handed down certain opinions in the Larson and Wrigley litigation (see 253 Fed. 914; certiorari denied, 248 U. S. 580; 275 Fed. 535); that under these opinions, the District Court had held that the Larson Co. was entitled to recover the sum of $1,384,649.48 with interest; that both parties to said cause had announced their intention to appeal; that Aldrich was “the owner of an equal undivided one-third interest in said decree ”; that his one-third interest was subject to certain indebtedness theretofore incurred in excess of approximately $100,000 to four different named persons; that it would be necessary for Aldrich to borrow an additional $50,000 “ to enable him to carry on said litigation to completion ”; that it was Aldrich’s wish to provide for his three children; and to that end Aldrich—

* * * appointed and does hereby appoint George I\ Porter trustee and the Illinois Merchants Trust Company successor in trust of said contracts with the L. P. Larson, Jr. Company without power to negotiate any settlement or arrangement with either the Larson or Wrigley Company to settle or diminish said contracts or the rights of the first party [Aldrich] accruing thereunder during the life of the first party hereto, or after the death of the first party, without the consent of both L. P. Larson, Jr. and Charles Roberts Aldrich [Aldrich’s son], and agrees to and does hereby assign said contracts to said George IT. Porter, Trustee, and said Illinois Merchants Trust Compauy, Successor in Trust for the following uses and purposes, to-wit:
Fikst: To hold and collect the same upon the conclusion of said cause either by final decree, settlement or otherwise * * * and to hold the proceeds arising therefrom in trust for the following uses and purposes:
(a) To pay the debts now against said contracts as above recited and also the sum of * * * ($60,000.00) to the holder or holders of five (5) notes of Charles H. Aldrich payable to his own order and by him endorsed, dated January 6, 1925 * * *
(b) To hold, invest and reinvest in safe, interest bearing securities the sum of * * * ($300,000.00) which sum is assigned to the second party hereto in trust, subject to the aforesaid indebtedness to the parties named, and pay the income therefrom equally and semiannually to my said three children * * *
❖ *&#***
(f) Upon the termination of this trust, the principal of the trust, and all accumulations, if any, shall be divided equally among the grandchildren of the first party hereto * * *
* * * * * * *
(j) The rest and residue, if any, to the first party accruing under said contracts of employment with L. P. Larson, Jr. Company, after the payments to creditors as herein directed, and the setting aside to said second party, as trustee, of the sum of * * * ($300,000.00) to constitute this trust for the uses and purposes herein set forth and declared, shall be paid to the first party hereto, if living, and in the event of his death shall be held and disposed of as said first party in writing shall direct or as may be directed by the last will and testament of said first party.

On or about February 23, 1927, Porter died without ever having received any money or properties as trustee. Thereafter the Illinois Merchants Trust Co. refused to act as successor in trust, which refusal resulted in the institution of a suit in equity for the appointment of a trustee. The cause came on for hearing, and a decree was entered on November 26, 1928, appointing the Chicago Title & Trust Co. (the petitioner herein) as trustee of the Aldrich Living Trust. Petitioner accepted the appointment.

Between January 6, 1925, and December 11, 1928, several disputes arose between Aldrich and his creditors, between Aldrich and the Larson Co., between Aldrich and the attorneys who were assisting him, and between the Larson Co. and certain other attorneys, all of which culminated in a long arbitration agreement, executed by all parties concerned on December 11, 1928, the same date as the settlement agreement above referred to. Under the arbitration agreement the contentions of the several parties were set forth separately, together with the maximum amount of their claims. In the case of each disputant it was provided that the maximum amount—

* * * shall be paid by the said Wm. Wrigley Jr. Company by a separate check to |tke Trustee [petitioner], and shall be held by it in a separate fund apart from the other funds of the said trust, until the amount and the persons to whom it is payable is determined as herein provided.

The provision in the said arbitration agreement for the determination of the amount and the persons to whom each separate amount was payable was that each dispute was to be referred to an arbitrator (Honorable James H. Wilkerson, one of the judges of the District Court of the United States), whose award in each matter was to be final.

In harmony with the arbitration agreement and as provided and agreed to in the settlement agreement, the Wrigley Co. in December 1928 issued and paid the following checks in settlement of its damage suits:

Five separate checks totaling $271,010.62, made payable to petitioner as special trustee for disbursement in accordance with the arbitration agreement_ $271, 010. 62
One check made payable to petitioner as trustee of the Aldrich Living Trust, representing an undisputed balance of $300,000, and $62,322.71 subject to disputes_ 362, 322. 71
Subtotal (% of $1,900,000)_ 633,333.33
Three checks totaling $148,000, made payable to the Larson Co., and by it endorsed to petitioner as special trustee lor disbursement in accordance with the arbitration agreement- 148, 000.00
One check made payable to the Larson Oo- 1,118, 666. 67
Grand total_ 1, 900, 000.00

Pursuant to the terms of the arbitration agreement petitioner held the various funds separately, with the exception of $300,000 which it immediately began to administer under the terms of the Aldrich Living Trust.

During 1929 the arbitrator made awards on all the claims except one, and pursuant to such awards petitioner released to the Aldrich Living Trust the sums of $202,991.31 prior to the decedent’s death and $40,569.02 subsequent thereto.

On or about September 12, 1929, petitioner, as executor of the estate of Charles H. Aldricb, deceased, filed an individual income tax return (Form 1040) for the calendar year 1928, in which it reported as fees from the Larson Co. the amount of $300,000, and attached to the return an explanatory statement, together with a copy of the trust instrument executed by Aldrich on January 6, 1925. The petitioner did not file any returns on behalf of Aldrich for the period January 1 to April 13, 1929, or on behalf of his estate for the period April 14 to December 31, 1929.

During March 1930 petitioner as trustee filed certain returns on behalf of the Aldrich Living Trust for the calendar year 1929, but did not report as income in such returns any amounts as representing attorney fees earned by Aldrich in connection with the litigation conducted by him on behalf of the Larson Co. No returns were filed on behalf of the Aldrich Living Trust or the beneficiaries thereof by petitioner as trustee for the calendar year 1928.

On or about April 29, 1930, an internal revenue agent made an investigation of the books and records of the decedent and of the Aldrich Living Trust and submitted reports to the Commissioner in which he recommended that the income representing fees received as the result of the settlement and arbitration agreements for services rendered by the decedent be taxed and assessed to petitioner as trustee of the Aldrich Living Trust, and not to petitioner as executor of the estate of Charles H. Aldrich, deceased.

On or about June 19, 1930, petitioner submitted to the revenue agent in charge at Chicago a formal protest to the action taken by the revenue agent, in which protest it contended that the fees in question were income to Aldrich and his estate, and therefore taxable to petitioner in the capacity of executor of the estate, rather than in the capacity of trustee of the Aldrich Living Trust. A conference was later held in connection with the protest.

On September 11, 1930, the respondent issued the deficiency notice herein to petitioner in the capacity of executor of the estate of Charles H. Aldrich, deceased, and in a statement attached thereto he said:

As a result of a conference granted you in tlie office of the internal revenue agent in charge at Chicago, Illinois, it has been conceded that income received as fees under a contract with the L. P. Larson, Jr. Company was taxable to Charles H. Aldrich during his life time and that amounts received between April 13, 1929, the date of his death, and December 31, 1929, were taxable income to his estate, instead of to the Aldrich Living Trust, as shown In the report.

In the deficiency notice the respondent determined that $436,747.23 of the fees in question was income to Aldrich in 1928; that $88,467.63 was income to Aldrich for the period in 1929 prior to his death; and that $6,844.13 was income to his estate for the period April 14 to December 31, 1929.

In the stipulation of facts filed in this proceeding the parties agree that, if the Board holds that petitioner is taxable in the capacity of executor rather than in the capacity of trustee, then $300,000 of the fees in question was income to Aldrich in 1928, $202,991.31 was income to Aldrich for the period in 1929 prior to his death, and $40,569.02 was income to his estate for the period April 14 to December 31, 1929. The stipulation also deals with the other items of income and deductions which should receive consideration under Rule 50 in arriving at the net income stipiilated by the parties.

Congress has plainly provided for the inclusion in “ gross income ” of all “gains, profits, and income derived from salaries, wages, or compensation for personal service, of whatever kind and in whatever form paid * * Sec. 22 (a), Revenue Act of 1928. Our problem is to determine the proper entity that is legally responsible for reporting as gross income the $543,560.33 attorney fees in question and paying the correct income tax resulting therefrom. Aldrich earned the fees and ordinarily would be the proper person to report them and pay the tax thereon, which duty because of his death would fall upon the personal representative of his estate, the petitioner herein. The respondent has so determined. Petitioner, however, contends that by reason of the trust instrument executed by Aldrich on January 6, 1925, Aldrich (or because of his death the executor of his estate) is not the proper party to return the fees as income; that the fees were properly the income of the Aldrich Living Trust and should have been returned by petitioner in the capacity of trustee of the trust. Of course, petitioner is not before us in the capacity of trustee of the Aldrich Living Trust, and in any event, it has been stipulated that the assessment of any income tax for the years 1928 and 1929 against the Chicago Title & Trust Co. as trustee of the Aldrich Living Trust is now barred and outlawed by the statute of limitations.

At the outset it should perhaps be noted that petitioner also acted in the capacity of escrow agent or special trustee under the arbitration agreement for a brief period of time relative to $581,-333.33 paid by the Wrigley Co. in December 1928. Since neither the petitioner nor the respondent claims that petitioner incurred any tax liability in that capacity, we will express herein no opinion on that point. We will confine ourselves solely to determining whether petitioner is here liable in the capacity of executor of the estate of Charles H. Aldrich, deceased, and, if necessary, whether it is estopped to deny its liability in that capacity.

Whether petitioner, as executor, is liable for income tax on the earnings of Aldrich depends entirely upon the effect of the execution by Aldrich in 1925 of the trust instrument whereby Aldrich “ agrees to and does hereby assign said contracts ” of employment to the therein- named trustee and successor in trust of the Aldrich Living Trust, Petitioner contends that the alleged assignment therein had the effect of thereafter relieving Aldrich of any income tax liability on any fees that would thereafter be paid by the Larson Co. under such contracts. We do not think the instrument executed by Aldrich had that effect. It is well settled that contracts in which the personal acts and qualities of one of the contracting-parties form a material ingredient are, in general, not assignable. Munsell v. Temple, 8 Ill. 93; Sloan v. Williams, 138 Ill. 43; 21 N. E. 531; Salmon Lake Seed Co. v. Frontier Trust Co., 153 Atl. 671, 673, and cases therein cited. They may, however, be assigned with the consent of the other contracting party. Cleveland, C., C. & St. L. Ry. Co. v. Wood, 189 Ill. 352; 59 N. E. 619; Ginsburg v. Bull Dog Auto Fire Insurance Association of Chicago, 328 Ill. 571; 160 N. E. 145. But we do not think the stipulated facts show that Aldrich or the Larson Co. ever contemplated that the services theretoforel being performed by Aldrich would, after the alleged assignment, be performed by someone else. The assignment, therefore, was not of the contracts themselves, but of the fruits thereof. The law seems to be well settled that under such circumstances the income from such contracts is taxable to the earner thereof. Lucas v. Earl, 281 U. S. 111; Luce v. Burnet, 55 Fed. (2d) 751; Van Meter v. Commissioner, 61 Fed. (2d) 817; Harry A. Daugherty, 24 B. T. A. 531; affd., 63 Fed. (2d) 77; Emery v. Commissioner, 78 Fed. (2d) 437. In the last mentioned case the court, among other things, said:

The general principles of law involved are not in dispute. * * * On the other hand payments for personal services are always due primarily to the person rendering the services; he remains “ the owner of the right or title from which the income springs.” Saenger v. Commissioner, 69 Fed. (2d) 631; Luce v. Burnet, 55 Fed. (2d) 751. When such earnings are assigned, the assignee takes as representative of the assignor and the earnings continue to he taxable to the assignor. Lucas v. Earl, 281 U. S. 111; Luce v. Burnet, supra; Corliss v. Bowers, 281 U. S. 376.

Petitioner in its brief emphasizes the fact that on January 6, 1925, the litigation had reached a point where it was very apparent that Aldrich would receive a substantial fee for his services, which petitioner contends was a definite property right capable of being assigned in praesenti. At the time Aldrich executed the trust instrument both the Larson Co. and the Wrigley Co. had announced their intention to again appeal from the holding of the lower court, and it was not until the settlement agreement was entered into on December 11, 1928, that the litigation was finally settled. Nevertheless, even assuming it to be true that on January 6, 1925, Aldrich did have a chose in action which was capable of being assigned, the assignment thereof, under the above cited cases, would not relieve the assignor, or his executor, from first paying the tax on the income assigned. Daugherty v. Commissioner, supra. In this connection the court in that case said:

Inasmuch as the contract of employment in this case created a relationship of attorney and client, there could be no transfer of the corpus or res, and the gift effected merely an equitable assignment of petitioner’s possible future income. In Poe v. Seaborn, 282 U. S. 101, 117, 51 S. Ct. 58, 61, 75 L. Ed. 239, the court said: “ The very assignment in that case [Lucas v. Earl, 281 U. S. 111. 50 S. Ct. 241, 74 L. Ed. 731] was bottomed on the fact that the earnings would be the husband’s property, else there would have been nothing on which it could operate.” So, here, the assignment could operate on nothing but the earnings of petitioner. The fact that petitioner did no work in connection with the litigation out of which the income arose does not alter the situation. His prior services in connection with that litigation undoubtedly prompted the parties in making the contract of employment which gave rise to the income, and his interest in the contract at the time of the assignment was, of course, wholly uncertain and contingent.
We are therefore unable to distinguish this ease from the broad rule of Lucas v. Earl, supra, that the fruits should not be “ attributed to a different tree from that on which they grew ”, and from cases in which the courts have held that anticipatory arrangements transferring income to accrue from personal services to be rendered by the assignor are unavailing for tax purposes. [Citing cases.]

Petitioner cites and relies upon such decisions as Edith H. Blaney, 13 B. T. A. 1315; Marshall Field, 15 B. T. A. 718; J. V. Leydig, 15 B. T. A. 124; O'Malley-Keyes v. Eaton, 24 Fed. (2d) 436; Young v. Gnichtel, 28 Fed. (2d) 789; and Lowery v. Helvering, 70 Fed. (2d) 713. The first five cases are easily distinguishable from the instant proceeding. In each of those cases the assignor assigned certain income-producing property rights which thereafter earned the income there in question, and the assignee, being the new owner of the property which produced the income, was taxable on the income rather than the assignor. We think the Lowery v. Helvering case is explainable on the same theory, although the distinguishing features are not perhaps as clear as in the first five cases. But be that as it may, the court clearly recognized the applicability of the rule laid down in Lucas v. Earl, supra, to a state of facts such as are present in the instant proceeding, wherein it said:

Cases like Lucas v. Earl * * * and Burnet v. Leininger * * * are to be explained on quite another theory. The choses in action there transferred were indeed as absolutely transferred as though they were unconditional in obligation; but they were conditional upon continued performance by the assignor, the original obligee. There is therefore a real propriety in looking at the obligee’s performance as the source of the income, though strictly his control over it is only negative.

In the instant case, the alleged assignment by Aldrich in 1925 fully contemplated his continued performance under the contracts in question.

It is our opinion that under the authorities which we have cited the attorney fees here involved are properly the income of Aldrich and his estate in the amounts and for the periods covered by the stipulation, and that petitioner as executor of his estate is therefore liable in that capacity for the tax resulting therefrom. It thus becomes unnecessary to decide the question relating to estoppel.

Decision will be entered under Bule 50.


author: Aeundell:

text:
    Houston Land & Trust Company, Trustee of the Estate of Henry Henke, Deceased, and Trustee of the Mrs. Catherine Henke Trust, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 63321.
    Promulgated September 24, 1935.

      Morris D. Meyer, Esq., for the petitioner.

      Bruce A. Low, Esq., and B. B. Cannon, Esq., for the respondent.
   OPINION.

Aeundell:

There have been a number of cases decided involving the question of whether an instrument created one or several trust estates. See Johnson v. United States, 65 Ct. Cls. 285; Lynchburg Trust & Savings Bank v. Commissioner, 68 Fed. (2d) 356; Commissioner v. U. S. Trust Co. of New York, 75 Fed. (2d) 993; Commissioner v. McIlvaine, 78 Fed. (2d) 789. The decisions lay down no comprehensive rule decisive of future cases. In William B. McIlvaine et al., Trustees, 29 B. T. A. 304, we said: “In the final analysis cases of this sort must stand or fall on the basis of their own peculiar facts.”

It is a fundamental rule that in construing wills the intention of the testator shall govern, and the intention is to be sought in the first instance in the words of the will itself. There were two makers of the will before us, each having an undivided interest in community projierty. Ajiparently they felt it would be to the interest of the survivor and the beneficiaries that the death of one should not bring about a physical segregation of the property but that it should remain under a unified management for a period of years before being divided. It does not necessarily follow, however, that the entire property was required to be administered as one trust. Cf. Lynchburg Trust & Savings Bank v. Commissioner, supra. We must search the will to see what intent was expressed therein on this matter.

On examination of the will we find throughout it provisions which could only be carried out if the interests of the two makers were administered as separate trusts. For instance, in paragraph IV, under certain circumstances the numerous cash bequests “ shall be deducted from Henry Henke’s portion of our joint property.” Under paragraph V, the premiums on the Trust Co.’s bond when it became Henry Henke’s executor and trustee were “to be paid out of his estate ”; if the Trust Co. became Catherine Henke’s executor and trustee the bond premiums were “ to be paid out of her estate.” Under paragraph XII, if Henry Henke was the survivor and remarried “then the portion of the said joint property belonging to the Estate of Mrs. Catherine Henke ” was to be distributed to others. These provisions indicate that the makers of the will intended the property to be handled as two trusts. This was also the understanding of the Trust Co., for after the period of administration it carried the property as constituting two trusts and so reported the income. We are of the opinion that the respondent erred in combining the income reported in the two fiduciary returns and treating it as the income of one trust.

If the words of the will itself be considered ambiguous and leave any doubt as to the intention of the makers of the will, there is clarifying oral evidence in the record. The decedent’s personal secretary testified that he discussed with both Mr. and Mrs. Henke the provisions to be included in the joint will; that they wanted the will drawn so as to have the property administered in two' trusts in order to get the benefit of lower income taxes, and Mrs. Henke particularly wanted her share administered so that in the event of Mr. Henke’s remarriage her share would go to her daughter. The secretary conveyed the wishes of the Henkes to the attorney who drafted the will, and was assured by the attorney that the will as drafted and executed by the Henkes created two estates or trusts.

Under the second issue petitioner claims the right to deduct the payments made to Catherine Henke and Leona Bethea. If the payments made to these beneficiaries were required to be paid from income and could only be paid therefrom they were income to the beneficiaries, Irwin v. Gavit, 268 U. S. 161, and deductible by the fiduciary under section 162(b) of the Revenue Act of 1928; if they are annuities payable at all events and not dependent upon trust income, they are not income to the beneficiaries, Burnet v. Whitehouse, 283 U. S. 148, and not deductible by the' trustee. Helvering v. Pardee, 290 U. S. 365. We have set out at length in the findings the provisions of the will under which the payments were made to Catherine Henke and Leona Bethea. They are, in brief, that the payments were to be made from net revenue of the trust property, but if such revenue was insufficient, then the principal of the property was to be used for that purpose. The fact that payments were actually made from income is not decisive of the question. In Burnet v. Whitehouse, supra, it was said: “It would be an anomaly to tax the receipts for one year and exempt them for another simply because the executors paid the first from income received and the second out of the corpus.” The question here was directly decided in Boston Safe Deposit & Trust Co. v. Commissioner, 66 Fed. (2d) 179, affirming 26 B. T. A. 486, where payments to beneficiaries were to be made “ from the income and so much of the principal of the trust fund as may be needed.” The court held the trustee not entitled to deduct the payments to beneficiaries under this provision, saying:

It is perfectly clear from the provisions of the will that the testator made the specific annuities and expenses a charge upon the entire trust fund and not alone upon the income thereof. He made the payment of the annuities certain, especially to his daughter, as long as there was anything left of the corpus of the trust.

Following the case last quoted, we bold that the respondent properly disallowed the deductions claimed for payments to Catherine Henke and Leona Bethea. Deduction for similar payments to others, while urged in the petition to be allowable, are waived in petitioner’s reply brief.

Decision will be entered under Bule SO.