text:
    Inter-Island Steam Navigation Company, Ltd., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 93405.
    Promulgated October 29, 1940.

      Alfred L. Oastle, Esq., for the petitioner.

      B. H. Neblett, Esq., for the respondent.
   OPINION.

Smith:

This proceeding involves a deficiency of $19,236.58 in petitioner’s income tax for 1932. A number of the issues raised in the pleadings have been waived. It is stipulated that the petitioner is entitled to the deduction of additional territorial income tax for 1932 in the amount of $7,172.09. The only issue for our determination is whether, in computing the amount of the loss which petitioner is entitled to deduct in 1932 on account of the worthlessness of the stock of a subsidiary corporation, the cost basis of such stock should be reduced by the operating losses of the subsidiary for all prior years, to the extent that such losses were taken as a deduction in consolidated returns, or only by the amount of the operating losses of the subsidiary for 1929 and subsequent years.

The parties have submitted a written stipulation of facts which, in so far as it relates to the issue under consideration, is substantially as follows:

The petitioner is a corporation organized and existing under the laws of the Territory of Hawaii and is engaged in a general transportation business and matters incidental thereto, including the operation of a hotel.

Petitioner acquired, by purchases for cash, shares of the capital stock of the Kilauea Volcano House Co., Ltd., as follows:

The fair market value on March 1, 1913, of the 517 shares of Kilauea Volcano House Co., Ltd., stock acquired by petitioner prior to said date was $9,688.

The Kilauea Volcano House Co., Ltd., was a domestic corporation organized under the laws of Hawaii on March 18, 1891, to engage in the business of owning and operating a hotel on the brink of the Kilauea Volcano, Island of Hawaii. • Its paid-up and outstanding capital stock at all times subsequent to March 1, 1913, was 4,000 shares, each of the par value of $25.

All of the assets of the Kilauea Volcano House Co., Ltd., were sold on December 30, 1932, under writ of execution issued November 12, 1932, for the benefit of its creditors, and its entire outstanding capital stock became worthless during the calendar year 1932.

Petitioner did not receive, nor did the Kilauea Volcano House Co., Ltd., distribute at any time, any cash or other property in liquidation, partial or complete, of the outstanding capital stock of the Kilauea Volcano House Co., Ltd.

Petitioner and the Kilauea Volcano House Co., Ltd., throughout the years 1924 to 1931, inclusive, duly qualified under the provisions of the applicable revenue acts and the regulations promulgated thereunder, as affiliated corporations, and, after due compliance with the provisions of the revenue acts and regulations appertaining thereto, duly filed consolidated Federal income tax returns for the calendar years 1924. to 1931, inclusive.

In said years losses of the Kilauea Volcano House Co., Ltd., were availed of to reduce consolidated net income for the years 1924 to 1931, inclusive, as follows:

1924 '_$1, 543. 07
1925_ 43,148. 51
1926_ 18, 957. 97
1927_ 19,165. 06
1928_$6, 790.49
1930_ 7,125. 54
1931_20, 512. 03
-
117,242.67

For the calendar year 1932 petitioner and the Kilauea Volcano House Co., Ltd., duly filed separate income tax returns, under the authority of the Revenue Act of 1932 and the regulations authorized by that act and in compliance with the same.

In its individual Federal income tax return for the calendar year 1932 the petitioner claimed a worthless stock loss of $127,218, representing the book value of its investment in 3,820 shares of capital stock of the Kilauea Volcano House Co., Ltd.

In his determination of the deficiency herein the respondent computed the deductible loss on the petitioner’s investment in the shares of stock of the Kilauea Volcano House Co., Ltd., as follows:

Cost of stock_$135,872. 00
Losses of this company while affiliated with your company, availed of to reduce consolidated net income- 117,242. 67
Deductible loss___ 18, 629.33

The petitioner contends in this proceeding that under the Revenue Act of 1932 and, particularly, under the provisions of Regulations 78, the cost basis of its subsidiary’s stock should be reduced only by the amount of the operating losses of the subsidiary company for 1929 and subsequent years ($27,637.57) and that the deductible loss is $108,234.43, or $89,605.10 more than the respondent has determined.

The applicable provisions of the Bevenue Acts of 1926 and 1928, so far as they relate to the filing of consolidated returns, are set up in parallel columns as follows:

Act of 1926
CONSOLIDATED RETURNS or CORPORATIONS.
Sec. 240. (a) Corporations which are affiliated within the meaning of this section may, for any taxable year, make separate returns or, under regulations prescribed by the Commissioner with the approval of the Secretary, make a consolidated return of net income for the purpose of this title, in which case the taxes thereunder shall be computed and determined upon the basis of such retum. If return is made on either of such bases, all returns thereafter made shall be upon the same basis unless permission to change the basis is granted by the Commissioner.
(No corresponding section).
Act of 1928
SEC. 141. CONSOLIDATED RETURNS OP CORPORATIONS 1929 AND SUBSEQUENT TAXABLE TEARS.
(a) Privilege to file consolidated re-t-ums. — An affiliated group of corporations shall, subject to the provisions of this section, have the privilege of making a consolidated return for the taxable year 1929 or any subsequent taxable year, in lieu of separate returns. The making of a consolidated return shall be upon the condition that all the corporations which have been members of the affiliated group at any time during the taxable year for which the return is made consent to all the regulations under subsection (b) prescribed prior to the making of such return; and the making of a consolidated return shall he considered as such consent. ⅝ * ⅜
(b) Regulations. — The Commissioner, with the approval of the Secretary, shall prescribe such regulations as he may deem necessary in order that the tax liability of an affiliated group of corporations making a consolidated return and of each corporation in the group, both during and after the period of affiliation, may be determined, computed, assessed, collected, and adjusted in such manner as clearly to reflect the income and to prevent avoidance of tax liability.

In the Bevenue Act of 1932 the comparable part of section 141 (a) reads:

An affiliated group of corporations shall, subject to the provisions of this section, have the privilege of making a consolidated return for the taxable year in lieu of separate returns. The making of a consolidated return shall be upon the condition that all the corporations which have been members of the affiliated group at any time during the taxable year for which the return is made consent to all the regulations under subsection (b) (or, in case such regulations are not 'prescribed prior to the making of the return, then the regulations prescribed under section llfl (b) of the Revenue Act of 1928 insofar as not inconsistent with this Act) prescribed prior to tbe making of such return; and the making of a consolidated return shall be considered as such consent. * * * [Emphasis supplied.]

The petitioner contends that the italicized portion has a very definite bearing npon the question here in issue.

The following provisions of the Eevenue Act of 1982 are involved:

SEO. 23. deductions FROM GROSS INCOME.
In computing net income there shall be allowed as deductions;
* * * * * ⅞ *
(f) Losses by Corporations. — Subject to the limitations provided in subsection (r) of this section, in the case of a corporation, losses sustained during the taxable year and not compensated for by insurance or otherwise.
(g) Basis for Determining Loss. — The basis for determining the amount of deduction for losses sustained, to be allowed under subsection * * * (f), shall be the adjusted basis provided in section 113 (b) for determining the gain or loss from the sale or other disposition of property.
*******
SEC. 113. ADJUSTED BASIS EOR DETERMINING GAIN OR LOSS.
* * * * * * *
(b) Adjusted Basis. — The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis determined under subsection (a), adjusted as hereinafter provided.
(1) General Bule. — Proper adjustment in respect of the property shall in all cases be made.—
(A) for expenditures, receipts, losses, or other items, properly chargeable to capital account, including taxes and other carrying charges on unimproved and unproductive real property, but no such adjustment shall be made for taxes or other carrying charges for which deductions have been taken by the taxpayer in determining net income for the taxable year or prior taxable years.

Petitioner’s argument that its cost basis for its 3,820 shares of stock of the Kilauea Volcano House Co., Ltd., which became worthless in 1932 should not be reduced by the net losses of that company for the years 1924 to 1928, inclusive, is as follows:

The wording of the report of the Committee on Finance of the Senate which accompanied the Eevenue Bill of 1928, which was also contained in the statement of the managers on the part of the House accompanying the conference report on the bill, reads in part:

Among the Begulations which it is expected that the Commissioner will prescribe are (1) the extent to which gam or loss shall he recognized upon the sale by a member of the affiliated group of stock issued, by any other member of the affiliated group, or upon the dissolution * * * of a member of the group * * *, (3) and the extent to which and the maimer in which net losses sustained during the period for which the consolidated return is filed, shall be deducted in any taxable year after the affiliation is terminated in whole or in part. [Emphasis supplied.]

Following tbe enactment of the Revenue Act of 1928 the Commissioner promulgated Regulations 75, specific regulations dealing with consolidated returns, and specifically providing for the very matters referred to in the Congressional report, supra. Heretofore regulations dealing with consolidated returns were only parts of general regulations.

The title of the regulations is:

Regulations 75
Relating to
CONSOLIDATED RETURNS OF AFFILIATED! CORPORATIONS PRESCRIBED
UNDER SECTION 141 (B) OF THE REVENUE ACT OF 1928
(Applicable to tbe taxable year 1929 and subsequent taxable years)

Following the quotation of the revenue act appear certain introductory sections as follows:

ApplicatioN of Regulations
(a) 1929 and Subsequent Years.
These regulations are applicable only to tbe taxable year 1929 and to subsequent taxable years.
(¾) 1928 and Prior Years.
Tbe regulations applicable to the taxable year 1928 will be found as a part of Regulations 74 (arts. 7S1 to 735, inclusive), and tbe regulations applicable to tbe taxable year 1927 or any prior taxable year will be found in tbe prior regulations, and tbe amendments thereto.
***** * *
AUTHORITY FOB REGULATIONS
The following regulations are hereby prescribed pursuant to tbe authority of section 141 (b) of tbe Revenue Act of 1928.

Congress intended to create, and the Revenue Act of 1928 and Regulations 75 did create, a definite break in the method of dealing with affiliated groups and the problems arising thereunder.

Article 34 of Regulations 75 reads in part:

Abt. 34. Sale of Stoelc — Basis for determining Gain or Loss.
(a) Scope of Article.
This article prescribes tbe basis for determining the gain or loss upon any sale or other disposition (hereinafter referred to as “sale”) by a corporation which is (or has been) a member of an affiliated group which makes (or has made) a consolidated return for the taxable year 1929 or any subsequent taxable year, of any share of stock issued by another member of such group (whether issued before or during the period that it was a member of the group and whether issued before, during, or after the taxable year 1929), and held by the selling corporation during any part of a consolidated return period. (For the basis in the case of sales of bonds, see article 35.) The paragraphs of this article are applicable to sales during different periods of time, as follows:
(c) Sales which bréale Affiliation made while Selling Corporation is Member of Croup.
If the sale is made during a period during which the selling corporation is a member of the affiliated group (whether or not during a consolidated return period, and if, as a result of such sale, the issuing corporation ceases to be a member of the affiliated group, such basis shall be determined as follows:
*******
(2) Prom the sum of the aggregate bases, as determined in paragraph (1) above, there shall be deducted the aggregate of the losses of such issuing corporation sustained during each of the consolidated return periods (including only the taxable year 1929 and subsequent taxable years) after such corporation became a member of the group and prior to the sale of the stock, to the extent that such losses could not have been availed of by such corporation as a net loss in computing its tax for such periods if it had made ai separate return for each of such periods. [Emphasis supplied.]

Under the Act of 1932 Regulations 78 were issued, and (c) of article 34 is precisely the same as the same section of Regulations 75, except that in the first sentence, instead of using the words “there shall be deducted the aggregate of the losses”, the regulations use the words “there shall be deducted the sum of the losses.”

The petitioner then submits:

3. The Law and Regulations Clearly Provide that Petitioner’s Loss is the Difference between Cost and Operating Losses in 1929-1931 which were availed of to Reduce Taxable Income in those Years.
*******
Congress in the Revenue Act of 1928 intended to, and did, make a change in dealing with consolidated returns. Section 141 (a) of the Act specifcaily provides for the privilege of making consolidated returns “for the taxable year 1929 or any subsequent taxable year.” This privilege is, however, “upon the condition” that such corporations “consent to all the regulations under subsection (b) prescribed prior to the making of the return.”
Section 141 (b) provides that the Commissioner, with the approval of the Secretary, shall prescribe such regulations. This is specific, more direct and instructive than the mere general power to regulate under Section 62 of the Act.
*******
On passage of the bill, Regulations 75 were promulgated [January 3, 1929]. Such Regulations, as pointed out, clearly specified that such regulations were applicable to calendar years 1929 and subsequent years, and that they were issued under the authority of Section 141 (b) of the Act.
In order that there can be no doubt on the subject, the official regulations incorporate as a footnote to the statement that they were issued under the authority of Section 141 (b), the quoted section of the Congressional report above set forth.
In other words, Congress, in the Revenue Act of 1928, itself definitely directed the Treasury Department to make regulations for consolidated returns for 1929 and all subsequent years, and specifically asked for regulations which would govern “the extent to which gain or loss shall be recognized upon the sale by a member of the affiliated group of stock issued by any other member of the affiliated group” and “the extent to which and the manner in which net losses sustained during the period for which the consolidated return is filed shall be deducted * * *” etc.
Regulations 76 clearly specified (Art. 34 (c)) that the measure of this loss should be the “aggregate bases” cost, less losses! availed of in the consolidated return periods to reduce taxable net income,” including only the taxable year 1929 and subsequent taxable years.

While conceding that its contention is contrary in principle to a number of cases wherein it has been held that upon a liquidation or sale of a subsidiary company’s stock the deductible loss thereon to the parent company must be computed so as not again to allow the deduction of losses of a subsidiary which have been availed of to reduce the consolidated taxable income for prior years, petitioner submits that in none of those cases was there any ruling on or discussion of the effect of the particular provision of the regulations herein relied upon.

Respondent’s position is that the purpose of the parenthetical clause of the regulations under consideration is merely to limit the application of the regulations to the year 1929 and subsequent years. Respondent disavows any intention to prescribe in his regulations a different method for treating the operating losses of a subsidiary corporation for 1929 and subsequent years from that accorded such losses for prior years.

In Jordahl & Co., 35 B. T. A. 1136, we said:

* * * It is now well settled that the loss on the sale of the stock or liquidation of a subsidiary company must be reduced by the amount of the subsidiary’s operating losses which were availed of to reduce the taxable income of the affiliated group. * * *

Manchester Savings Bank & Trust Co., supra, involved the question of the amount of the taxable gain from the liquidation of. a subsidiary company in the taxable year 1932. We held that in computing the amount of such gain the cost basis of the subsidiary’s stock should be reduced by the losses of the subsidiary company for all of the prior years in which such losses had been availed of in consolidated returns to reduce the parent company’s taxable income.

In American Utilization Co., supra, a loss was claimed in 1935 on account of the worthlessness of stock of a subsidiary company. The subsidiary company had sustained operating losses for a number of prior years and such losses for the years 1925 and 1933 had been used to reduce the parent company’s net income in consolidated returns. We held that in computing the amount 0⅞ the parent company’s loss on its investment in the subsidiary company the cost of such stock should be reduced by all of the subsidiary’s operating losses for 1925 and 1933 which had been deducted in the consolidated returns for those years. In that case we said:

Although the cases cited above involved either the sale or liquidation by a parent company of the stock of its subsidiary and did not involve the situation where the stock of the subsidiary became worthless during the taxable year, the controlling principle of law involved is nevertheless the same in the latter situation as in the former. Cf. H. Liebes & Co., 23 B. T. A. 787, 791. In so holding we are not unmindful of our decision in Manatee Crate Co., 22 B. T. A. 996, wherein we allowed the parent company to deduct the full cost of the stock of its subsidiary in 1924, the year in which the stock of the subsidiary became worthless, without making ^ny inquiry into the extent to which the consolidated group had had the benefit of the losses of the subsidiary for the years 1921, 1922, and 1923. Our holding there was, however, promulgated several years before the decisions of the Supreme Court cited above, and must be regarded as in effect modified to conform therewith. Cf. Prosperity Co., 27 B. T. A. 28.

It is true that in the above cited cases we did not consider the bearing of the question upon the selling corporation’s cost base of the parenthetical clause “(including only the taxable year 1929 and subsequent taxable years)” contained in article 34 (c) (2) of Regulations 78. Our attention was not directed to the article.

But this can not be said of the opinion of the Supreme Court in Ilfeld Co. v. Hernandez, supra. The facts in that case, as stated by the Supreme Court, were as follows:

In 1917 petitioner purchased all the capital stock of the Springer Trading Company for $40,000 and in 1920 all that of the Boy Trading Company for $5,000. It held these shares until late in 1929 when both companies were dissolved. In that period it advanced the Springer Company sums amounting to $69,030.27, and the Boy Company $9,782.22. Nothing having been paid it on account of these advances, petitioner had an investment in the former of $109,030.27 and in the latter of $59,782.22. It made consolidated returns which took into account the gains and losses of each subsidiary. Operations of the Springer Company resulted in losses in all but two of the years and those of the Boy Company in all but four. The losses of the former exceeded its gains by $118,510.53, and those of the latter by $57,127.85. In 1929, before the end of November, the subsidiaries sold all their property to outside interests. After paying debts to others, each had a balance — the Springer Company, $22,914.22, and the Boy Company, $15,106.16 — which it paid petitioner on December 23. Both subsidiaries were dissolved December 30 in that year.
Petitioner made a consolidated return for 1929 based on the results of operation and the liquidation of each subsidiary but made no deduction of losses resulting to itself from the liquidations. The return showed a tax of $20,836.20 which was duly paid. In May, 1931, petitioner filed an amended return and claimed a refund ol $14,406.43. This return does not take into account profits or losses of subsidiaries in that year but deducts the losses above shown to have resulted to petitioner from its investments in them. * * *

The question before the Supreme Court was whether th'e taxpayer was entitled to deduct from its 1929 income any part of the losses resulting from its investments in the subsidiaries. The Supreme Court’s attention was called to tbe provisions of Regulations 75, which in all material resp'ects are the same as those contained in Regulations 78. The Supreme Court said:

* * * Petitioner contends that Articles 37 (b) and 34 (c) cover the case. We are unable so to construe them. Article 37 relates to dissolutions. Subdivision (b) deals with distributions made after a consolidated return period. The record conclusively shows that each subsidiary handed over the balance before the dissolution was consummated and during the consolidated return period. Article 34 relates exclusively to the sale of stock. No sale of stock was involved. The parent and subsidiary corporations were the only parties. Neither subsidiary acquired stock of the other or that issued by itself. The petitioner retained all the shares of each and at the end voted dissolutions that operated to cancel them.

The Supreme Court held that the losses resulting from the investment of the Ilfeld Co. in its subsidiaries were not deductible from gross income in consolidated returns on the theory that the obligations of the subsidiary corporations resulted from intercompany transactions during the consolidated return period and because losses of the subsidiary corporations had been previously deducted in consolidated returns of earlier years.

In the quotation from the Supreme Court opinion above set forth it was held that the parent company made no sale of the stock of the subsidiary companies and that article 34 related “exclusively to the sale of stock.” The same is true in the instant proceeding. The stock of the subsidiary became worthless in petitioner’s hands in 1932. The petitioner made no sale of the stock. It is therefore not within the letter of the regulations.

The respondent further points out in his brief that the petitioner and the Kilauea Volcano House Co., Ltd., did not file a consolidated return for 1932. The petitioner contends that it is immaterial whether it filed a consolidated return or not, since the regulation was intended to cover a case where separate returns were filed if consolidated returns had been filed for prior years. We think, however, that the situation here presented is ruled by the opinion of the Supreme Court in the Ilfeld Co. case. In that case the Supreme Court further said:

Tbe allowance claimed would permit petitioner twice to use tbe subsidiaries’ losses for tbe reduction of its taxable income. By means of tbe consolidated returns in earlier years it was enabled to deduct them. And now it claims for 1929 deductions for diminution of assets resulting from tbe same losses. If allowed, this would be tbe practical equivalent of double deduction. In tbe absence of a provision of the Act definitely requiring it, a purpose so opposed to precedent and equality of treatment of taxpayers will not be attributed to lawmakers. * * * There is nothing in the Act that purports to authorize double deduction of losses or in tbe regulations to suggest that tbe commissioner construed any of its provisions to empower him to prescribe a regulation that would permit consolidated returns to be made on tbe basis now claimed by petitioner.

Without passing upon the question of the validity of the controverted provisions of article 34 (c) (2) of Regulations 78 in a case where the parent corporation sells the shares of stock of an affiliated subsidiary, we are of the opinion that the respondent did not err in the instant proceeding by reducing the petitioner’s cost base by losses of the subsidiary for the years 1924 to 1928 which were availed of by it in reducing the tax liability of the affiliated group.

Reviewed by the Board.

Decision will he entered v/nder Rule 50.

       See Manchester Savings Bank & Trust Co., 34 B. T. A. 1008 ; Jordahl & Co., 35 B. T. A. 1136 ; American Utilization Co., 38 B. T. A. 322; Ilfeld Co. v. Hernandez, 292 U. S. 62; McLaughlin v. Pacific Lumber Co., 293 U. S. 351; Commissioner v. National Casket Co., 78 Fed. (2d) 940; Greif Cooperage Corporation v. Commissioner, 85 Fed. (2d) 365.


source: Caselaw Access Project

author: Smith :

license: Public Domain

text:
    Joel C. Cohen Testamentary Trust, by Hawaiian Trust Company, Ltd., Trustee, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 96231.
    Promulgated October 29, 1940.

      Heaton L. Wremi, Esq., for the petitioner.

      T. M. Mather, Esq., for the respondent.
   OPINION.

Smith :

This proceeding is for the redetermination of deficiencies in income tax of the estate of Joel C. Cohen, deceased, for the years 1984, 3935, and 1936, as follows:

1934_$34.41
1935_152.39
1936_ 445.27
Total_ 632. 07

The questions in issue are (1) whether the decedent’s estate in process of administration is taxable in 1934, 1935, and 1936 on the income from certain property which the decedent during his lifetime had conveyed in trust and, in the alternative, whether, if such income is in-cludable in the gross income of decedent’s estate, it is deductible by the estate as income distributed to a beneficiary in those years; and (2) whether the commissions received by the trustee of the trust estate pursuant to the provisions of the trust in the years 1934, 1935, and 1936 are includable in the gross income of the estate for those years.

The essential facts are contained in a written stipulation of facts, with appropriate exhibits, which is incorporated herein by reference.

The Hawaiian Trust Co., Ltd., petitioner herein, is an Hawaiian corporation, with its principal office located in Honolulu, Hawaii. It is the executor of the will of Joel C. Cohen, who died August 11,1931, in San Francisco, California, being at the time a resident of Honolulu.

On September 14, 1926, Joel C. Cohen executed his last will and testament. After bequeathing certain articles of domestic and household use or ornament, jewelry, clothing, etc., and all the net proceeds of life insurance policies, to his wife, he gave, devised, and bequeathed all the rest, residue, and remainder of his estate to the Hawaiian Trust Co., Ltd., in trust to pay the income thereof to his widow for life, with remainders over.

On February 25, 1931, the decedent, Joel C. Cohen, executed a trust agreement in which he conveyed to the Hawaiian Trust Co., Ltd., as trustee, 5,000 shares of the capital stock of the Consolidated Amusement Co., Ltd., an Hawaiian corporation, to pay the income therefrom to him, the settlor, for life, and upon his death:

* * * to administer tiie estate and to distribute tbe principal and income therefrom in accordance with the instructions given his testamentary trustee under the terms of his last Will and Testament, subject to the terms and provisions hereof which shall continue in force and subject to law.

It was further provided in the trust instrument that:

The Trustee shall receive as compensation for its services hereunder five per cent (5%) on the gross income derived from said trust estate and also two and one-half per cent (2½%) on the principal of said trust estate on the final payment of the same, either in cash or in kind and either in whole or in part at the termination of the trust or at any prior time.
v « 1» * * * *
This agreement of trust cannot be revoked or amended by the Settlor alone but can be revoked or amended at any time during the Settlor’s lifetime by the joint action of the Trustee, the Settlor and the Settlor’s wife, or in case the Settlor’s wife predeceases him or becomes incapable of acting by the joint action of the Trustee, the Settlor and Alan S. Davis of said Honolulu.

The trust agreement was never revoked or amended. The trustee administered the trust from the date of its creation. In accordance with the terms of the trust agreement it opened principal and income ledger accounts for the trust under the name of “Joel C. Cohen Trust”, which were carried through all of the taxable years involved. It paid the income of the trust, after the deduction of trustee’s commissions, to the decedent during his lifetime and after his death it paid such income annually to the decedent’s widow. The trustee’s commissions for 1934, 1935, and 1936 amounted to $366.11, $322.98, and $278.65, respectively.

The decedent’s will was admitted to probate and letters testamentary were issued to the Hawaiian Trust Co., Ltd., on September 24, 1931. The estate was in process of administration during all of the taxable years 1934,1935, and 1936. Probation of the estate was completed in 1939 or 1940 and the residue of the assets was turned over to the Hawaiian Trust Co., Ltd., as trustee of the testamentary trust.

None of the securities which have ever been subject to the trust agreement of February 25, 1931, has been included in any inventory or in any accounts filed by the Hawaiian Trust Co., Ltd., as executor, with the Probate Court, nor were any of them included in the appraisal of assets of the estate made by the appraisers appointed by the Probate Court. No part of the assets of the estate or of the income thereof was distributed by the executor during the taxable years 1934, 1935, and 1936.

During the years 1934, 1935, and 1936 the Hawaiian Trust Co., Ltd., filed separate fiduciary tax returns for the decedent’s estate in process of administration, and for the trust created by the trust indenture of February 25,1931.

In the determination of the deficiencies herein the respondent has added to the income of the estate all of the income of the trust, without deduction therefrom of commissions paid to the trustee, and has not allowed any deduction therefrom of the amounts of trust income which were paid over to the widow.

Our first question is whether the trust created by the decedent under the trust indenture of February 25,1931, in respect of the 5,000 shares of the capital stock of the Consolidated Amusement Co., Ltd., continued after his death as a separate tax entity so that the trust income is not taxable to the executor of the estate in process of administration.

Unquestionably it was the decedent’s intention in executing the trust agreement to create a trust that should continue after his death. He made a completed conveyance of legal title to the trust res to the trustee and expressly directed the trustee:

* * * to administer the estate and to distribute the principal and income therefrom in accordance with the instructions given his testamentary trustee under the terms of his last Will and Testament, subject to the terms and provisions hereof which shall continue in 'force and subject to law. [Italics supplied.]

It is a primary rule in the construction of trusts, as in the case of wills, that the intention of the settlor, if not forbidden by law, be carried out. In Green v. Green, 90 U. S. (23 Wall.) 486, it is said that:

Trusts are the mere creatures of confidence between party and party * * *. They are rights arising solely out of the intent of the party who created them, and therefore such intent could be the only guide in the execution of them.

See also O’Neil v. Dreier, 61 Fed. (2d) 598; Syracuse Trust Co. v. Fuller, 140 Misc. Rep. 918; 252 N. Y. S. 90.

The decedent had executed his will in 1926, several years prior to the creation of the trust, and had named his wife as life beneficiary of his residuary estate. A fair and reasonable construction of the trust agreement is that the decedent intended that she should likewise be the life beneficiary of the trust estate the same as of the residuary estate.

The decedent never made any changes in his will after creation of the trust estate. Upon his death the will became incorporated by reference as a part of the trust instrument in so far as it identified the persons who were to participate, and to the extent to which they were to participate, in the distribution of the remainder of the trust estate.

It has been held generally that it is not essential to the validity of a trust that it be fully contained in a single instrument, but it may be defined in one or more separate writings. See Heermans v. Schmaltz, 7 Fed. 566; Roberts v. Taylor, 300 Fed. 257; Loring v. Palmer, 118 U. S. 321; Joy v. St. Louis, 138 U. S. 1; O’Meara v. Commissioner, 34 Fed. (2d) 390; Adamson v. Black Rock Power & Irrigation Co., 297 Fed. 905; Mayer v. American Security & Trust Co., 33 App. D. C. 391; affd., 222 U. S. 295. Where a will is referred to in a trust deed the effect is to make the words of the will a part of the trust deed except where inconsistent with the trust deed. Hammett v. Farrar, 29 S.W. (2d) 949.

The continuation of the trust after the decedent’s death would not be open to question if the trust agreement of February 25, 1931, had named all of the beneficiaries and defined their respective interests in the trust estate both before and after the termination of the decedent’s life interest. It is sufficient, we think, that the identity of those beneficiaries and the quantum of their several interests in the trust can be clearly determined from the trust indenture and the will to which it refers for that very purpose. There was no time either before or after the decedent’s death when there were not designated beneficiaries of the trust and when the trustee was not under specific instructions as to the administration of the trust estate.

There are many cases decided by the various state courts which support the petitioner’s contentions herein. In Syracuse Trust Co. v. Fuller, supra, the settlor conveyed certain personal property in trust, reserving the income therefrom for life, with the remainder over to such persons as she might appoint in her will, or, in default of such appointment, to her heirs at law. She also reserved the power to revoke the trust. Thereafter, she executed a will in which she made a number of specific bequests and directed that the residue of her estate be distributed to certain named relatives. The court held that the persons named in the residuary clause of the will were entitled to take the remainder of the trust property as beneficiaries of the trust estate and that such trust property did not pass to the executor, but remained in the hands of the trustee for distribution. In its opinion, at page 100, the court said:

* ⅜ * I am of the opinion, however, that the testatrix did not intend the will to operate as an execution of the power contained in the trust agreement ; that she executed that power under the trust agreement; and that she merely designated the beneficiaries and fixed their shares in the residuary clause of her will, and intended that such clause should be read into the trust agreement. In other words, she intended that her appointees, namely, the persons mentioned in the residuary clause of the will, were to take from the older estate, which is the trust estate. Matter of Franklin Trust Co., 103 Misc. Rep. 143, 146, 169 N. Y. S. 812; Guaranty Trust Co. v. Halsted, 245 N. Y. 447, 459, 157 N. E. 739.

To the same effect is United States Trust Co. of New York v. Chauncey, 32 Misc. Rep. 358; 66 N. Y. S. 563.

The Supreme Court of the State of Florida reached a like result in Hamilton v. Florida National Bank of Jacksonville, 151 So. 409, on facts almost identical with those in the instant case. There, certain property was conveyed to a trustee to pay the income to the settlor for life and upon her death to distribute the remainder of the trust property:

* * ⅜ in accordance with the provisions of the last will and testament of the Settlor, and in default of appointment by last will and testament, the principal shall be made over to her next of kin under the laws of Pennsylvania now in existence * * *

In a previously executed will, which was duly probated, the settlor made a number of specific bequests and left the “rest, residue and remainder” of her property to certain named persons. The court held that the residuary clause of the will was a valid execution of the power of appointment reserved in the trust deed, saying:

Where the owner of property transfers it in trust for the owner for life, reserving a power of appointment to designate the beneficiaries of the estate after the death of the settlor, such reserved power of appointment may be executed by the provisions of a pre-existing will of the settlor which takes effect as of the death of the testator, if that is the intent of the settlor as shown by the consistent provisions of the trust deed and of the will, and such provisions are not illegal. The lawful intent of the settlor-testator, as shown by the trust deed and the will, is controlling.
* * * * sfc * *
In Matteson v. Goddard, 17 R. I. 299, 21 A. 914, it is stated that “there is one way, however, in which it may be that a power can be executed by a pre-existing will, namely, where the power is created or reserved with the intent that it shall be so executed, in case the will is left to take effect.” * * ⅜

In Burkett v. Whittemore, 36 S. C. 428; 15 S. E. 616, it was said:

* ⅜ * geems to be the settled doctrine. “A general power of appointment may well be exercised by a will executed previously to the creation of the power, and that, too, by a mere residuary gift. * * * And jt seems that a limited power of appointment may also be well exercised by a will executed previously to the creation of the power, if there be a sufficient reference to the power or the subject-matter thereof.” See the late admirable treatise of Mr. Farwell on Powers (pages 185, 188, and authorities). * * *

See also Osgood v. Bliss, 141 Mass. 474; 6 N. E. 527.

It was said in Stone v. Forbes, 189 Mass. 163, 75 N. E. 141, that:

It is settled in this commonwealth that a general power of appointment is well executed, in the absence of any thing to show a contrary intention, by a general residuary clause in the will of the donee of the power. Amory v. Meredith, 7 Allen, 397; Willard v. Ware, 10 Allen, 263; Bangs v. Smith, 98 Mass. 270; Sewall v. Wilmer, 132 Mass. 131; Cumston v. Bartlett, 149 Mass. 243, 21 N. E. 373; Hassam v. Hazen, 156 Mass. 95, 30 N. E. 469. And, whatever may have been the case formerly, that is now the law in England. Airey v. Bower (1887) 12 A. C. 263; Boyles v. Cook (1880) 14 Ch. 53. And both in this country and in England the fact that the power is created after the execution of the will does not prevent the will from operating as an execution of the power. Willard v. Ware, 10 Allen, 263; Osgood v. Bliss, 141 Mass. 474, 6 N. E. 527, 55 Am. Rep. 488; Airey v. Bower, supra. * * *

The decedent was, of course, free to change his will at any time during his lifetime and to name other beneficiaries of his residuary estate, as well as the trust estate. Appointments by will speak from the death of the testator. Loring v. Massachusetts Horticultural Soc., 171 Mass. 401; 50 N. E. 936. Also, with the consent of his wife and the trustee, the decedent was free to revoke the trust at any time during his lifetime. However, the rule is too well established to require a citation of authorities that a power of revocation in a settlor does not of itself render a trust invalid. The revocability of the trust is not germane to the question here under consideration. We are not concerned either with the includability of the value of the trust property in the decedent’s estate for estate tax purposes or the liability of the decedent for income tax on the income of the trust during his lifetime. Our only question is whether the executor of the decedent’s estate in process of administration is liable to income tax on the income of the trust.

The cases of Helvering v. Hallock, 309 U. S. 106, and Estate of John S. Conant, 41 B. T. A. 739, which the respondent cites in his brief, are not in point. They are both estate tax cases and involve the question of whether certain trust conveyances were “intended to take effect in possession or enjoyment at or after death.” Whether or not the value of the trust property here involved was included in decedent’s gross estate for estate tax purposes (and we may assume that it was if the estate was taxable) is not in any way determinative of the question before us. The revenue acts contain specific statutory provisions for including in the gross estate for estate tax purposes the value of property which a decedent may have transferred in trust during his lifetime, although technically such property does not pass at death and does not fall into the estate for distribution by the executor. See United States v. Field, 255 U. S. 257; Helvering v. Hallock, supra. It was held in United States v. Field, supra, that property passing under a general power of appointment exercised by the donee of the power in her will was' not a “legal asset” of the estate and was not subject to distribution by the executor as part of the estate of the donee of the power.

In determining the tax liability here involved consideration must be given to the fact that the executor of the decedent’s estate, the Hawaiian Trust Co., Ltd., which was also trustee of the trust estate and had the legal duty of administering both estates, did not regard the trust property as belonging to the estate and did not include the value of it in any of the accounts which were submitted to the Probate Court. The trustee has at all times administered the trust fund as a separate fund in accordance with the provisions of the trust agreement and none of the interested parties, so far as the evidence shows, has ever made any objection to the administration of either of the estates.

For the reasons set forth, we are of opinion that the trust estate created by the decedent under the trust agreement of February 25, 1931, continued as a valid trust entity after the decedent’s death and that the income therefrom is not taxable to the decedent’s estate in process of administration.

In view of our ruling on the principal question in issue, it is not necessary for us to consider other issues raised as to the deductibility of the trust income that was paid out to the beneficiary during the taxable years involved, or the deductibility of the trustee’s commissions which were taken out of the trust income in those years.

Beviewed by the Board.

Decision will 5c entered under Bule 50.


author: Black :

text:
    Estate of Katharine H. Talbott, Deceased, Harold E. Talbott, Jr., Nelson S. Talbott and George H. Mead, Executors, Petitioners, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 97128.
    Promulgated October 29 1940.

      W. W. 8folding, Esq., for tlie petitioners.

      Lewis 8. Pendleton, Esq., for the respondent.
   OPINION.

Black :

We are asked here to say whether the gifts which decedent made to her children on April 22, 1932, were transfers made in contemplation of death within section 302 (c) of the Revenue Act of 1926 and are therefore includible in her estate in computing the tax due thereon. Since the gifts in question were consummated more than two years before decedent’s death, there is no presumption under that section favoring the respondent’s determination that they come within that provision of the statute. See McGregor v. Commissioner, 82 Fed. (2d) 948. We think, moreover, that the generally operative presumption which places on the petitioner the burden of showing that respondent’s determination is incorrect has, in this case, been overcome by the evidence presented by the petitioners.

It is seldom that we find evidence which so clearly establishes that the transferor-decedent herself did not have a presentiment of approaching death. See Percy B. Eckhart, Executor, 33 B. T. A. 426. She enjoyed health which was exceptionally good for a woman her age. Her energy and vigor were a source of remark apparently to all who knew her. She had well cultivated! interests, which she pursued actively. She was by nature optimistic and had an exceptionally hopeful outlook. We find nothing in decedent’s mental or physical condition which would support a finding that the gifts which she made constituted transfers in contemplation of death. Respondent does not contend that at the time the decedent made the transfers in question she was in any fear of imminent death. His main argument resolves itself into the contention that the circumstances of the death of decedent’s husband and the disposition of his estate together with the decedent’s often expressed desire to share that estate with her children spell out a dominant motive on her part to dispose of the greater portion of her property prior to and in anticipation of her death. See United States v. Wells, 283 U. S. 102. We do not think respondent’s argument is well taken, in view of the evidence in the record.

In the view which we take of the evidence, it has been shown that decedent’s husband prior to his death had fostered in his nine children the feeling that they with their parents formed a closely knit unit in which each shared with the others all of his or her material goods; that the decedent when she received the whole of her husband’s estate felt that this disposition under a will executed fifteen years previously did not accurately reflect her husband’s desires; that, therefore, decedent’s plans during all of the period following his death down to 1932 were to make some division of his estate among his children as she believed he would have desired. See Estate of Herbert G. Lowe, 38 B. T. A. 117. Accordingly, decedent as early as 1924, when she first received the estate, discussed with her advisers the means of effectuating these designs. She was advised that pending litigation against the Dayton Securities Co., in which she was heavily interested, made it inadvisable to' attempt any disposition then. She accordingly waited for a more opportune moment; her impatience at the delay is reflected in her conversations with her counsel and her children. The latter, indeed, were well informed of their mother’s plans to make a substantial disposition of their father’s estate among them. In the meantime she partially effectuated her desires by setting up in 1926 a trust for her seven daughters and by making gifts from time to time to thei children, including the present of a home for each of the daughters.

It seems reasonable to us, viewing the whole evidence, that the decedent should conclude that 1932 was an opportune time for carrying out the plans which she had made several years before. In 1930-1931 the litigation in which she was vitally interested was finally concluded and a considerable amount of liquid assets came to her through the dissolution and liquidation of the Dayton Securities Co. The decedent instructed her attorney to form a corporation, which he did late in the year 1931 and shortly after the beginning of 1932 the assets intended to form the substance of the gifts were transferred to the corporation, and the stock of the corporation was given in equal proportions to her children. We find the evidence persuasive that decedent in all this procedure was merely effectuating plans long held for the division of her husband’s estate, without thought of her own demise. She retained for herself a very considerable amount of property, as the estate tax return in evidence shows. The value of decedent’s gross estate as reported by the executors on the estate tax return which they filed was $1,510,255.21, and the amount of the net estate was $1,043,617.59 after deductions and the specific exemption of $100,000. Thus we do not have a case where a decedent a few years prior to her death gives away all of her property to her children, thus indicating a testamentary disposition.

The gifts in addition to the Talbott Realty Co. stock which decedent made on April 22,1932, do not by their coincidence in time add to the respondent’s position. The presentation on that day of the deed to Daisy Greene’s home site was, we think, purely mechanical. It seems clear that the actual gift of the realty was made at an earlier time and that the delivery of the deed was delayed only in order to clear up title to the land. In this guise this gift takes its place along with the gifts of houses to each of the other children made over an extended period of time. The forgiveness of the debt of Nelson S. Talbott on this date likewise, it seems to us, does not lend any additional support to the respondent’s view that decedent was attempting a general disposal of her properties in contemplation of death. Her practice through the years prior to 1932 had been to give to her children property or money as they might have need of them. We think the can-celation of the indebtedness was in line with this habit. The evidence shows that the N. S. Talbott Co., which was operated by Nelson Talbott, was engaged in 1932 in extensive underwritings, a business in which its financial position as reflected by its statement counted for a great deal. Its financial condition was not good and it had suffered heavy losses. It was thought that by canceling the indebtedness the personal statement of N. S. Talbott would be greatly improved and that this would be reflected favorably in the company’s financial status. Moreover, it was the purpose of the decedent by her gifts in 1932 to give to each of her children an independent competence, and this in the case of Nelson Talbott might not be accomplished except through the gift of the Talbott Eealty Co. stock and at the same time cancelation of the debt which he owed decedent. We think therefore that no special significance may be attached to the forgiveness of Nelson Talbott’s debt in 1932. Bather we see in it only a further elaboration of the purpose which we have concluded above might most properly be assigned to the gifts made by decedent in 1932.

The claim made by the petitioners for a credit for state estate or inheritance tax has been recognized by respondent on brief as a possible credit upon a proper showing. Under section 802 of the Revenue Act of 1932 the credit should be allowed on proper showing made within the allotted time.

Decision will he entered under Rule 50.


author: Murdock:

text:
    Fairmount Foundry, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 97910.
    Promulgated October 29, 1940.

      Robert F. Lehman, Esq., and Warren S. Spalding, Esq., for the petitioner.

      Paul E. Waring, Esq., for the respondent.
   OPINION.

Murdock:

The petitioner would have us hold that its transaction with Redmond in 1933 was in substance a deposit of the 200 shares of stock with the petitioner as collateral for the debt of $44,713.72, the transaction therefore remained open until the option expired in 1936, and then, for the first time, the petitioner could apply the 200 shares in satisfaction of a portion of the debt ($20,000) and ascertain that the balance of the debt, $24,713.72, became worthless. Neither in form nor in substance was there a deposit of the 200 shares of stock as collateral for the debt. Cf. Edwin P. Shattuck, 42 B. T. A. 557. The debt of Milo in the amount of $44,713.72 was completely and absolutely transferred by the petitioner in March 1933 and at the same time Redmond’s guarantee was returned to him and canceled. Thereafter no part of the above amount was owing to the petitioner as a debt, either from Milo or from Redmond. The debt transaction was forever closed and could not affect the income tax liability of the petitioner for any subsequent year. The petitioner recognized this fact, charged off the account, and claimed a deduction on its return for 1933.

Furthermore, the fact that the petitioner received the 200 shares of stock subject to the right of Redmond to repurchase them within three years did not prevent the petitioner from sustaining a loss in 1933. Had there been a mere bailment or had the petitioner received some valuable right through the option, the situation might be different. But the petitioner, in March 1933, became the absolute owner of the shares subject to the right of Redmond to repurchase them within three years at the fixed price. Cf. D. C. Bothwell, 27 B. T. A. 1351; Helen E. Leatherbee et al., Executors, 34 B. T. A. 196; Helvering v. San Joaquin Fruit & Investment Co., 297 U. S. 496. The petitioner had no right to require Redmond to repurchase the shares. Fluctuation in the value of the shares could not change the amount of the petitioner’s loss, since the stock was accepted in 1933 in complete settlement of the Milo account and the Redmond guarantee. Redmond allowed his option to expire in 1936, but nothing of value owned by the petitioner disappeared at that time. If the petitioner had received property other than it own shares, clearly, the petitioner’s basis for subsequent gain or loss upon the property would have been $20,000, the fair market value of the property in March 1933, when the petitioner acquired title to it, Subsequent gain or loss would depend upon whether the property was later disposed of for more or less than the basis. Even if the petitioner had had reason to anticipate a favorable disposition of the shares to Kedmond during the option period, nevertheless, failure to realize an anticipated profit is not a loss. Furthermore, its loss in 1933 would have been unchanged had Kedmond or any other person purchased the shares during or after the expiration of the option period at any price. Thus, the possible disposition of the shares under the option could have had no effect whatsoever upon the loss. The petitioner sustained no loss in 1936 and is not entitled to any deduction under the law. Nor is a deduction justified by the inconsistency of the Commissioner. The petitioner could have insisted upon its rights as to 1933 had they been of importance. Cf. James Couzens, 11 B. T. A. 1040; Tide Water Oil Co., 29 B. T. A. 1208; R. E. Baker, 37 B. T. A. 1135; Salvage v. Commissioner, 76 Fed. (2d) 112; affd., 297 U. S. 106.

Decision will be entered for the respondent.


author: Black:

text:
    M & N Cigar Manufacturers, Inc., Cleveland, Ohio, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 100679.
    Promulgated October 29, 1940.

      Charles M. Trammell, Jr., Esq., and Marion C. Toomey, Esq., for the petitioner.

      R. E. Transue, Esq., for the respondent.
   OPINION.

Black:

The Commissioner has determined deficiencies against petitioner as follows:

The petitioner assigns two errors as follows:

a. The Commissioner erroneously disallowed for the calendar year 1934 a deduction for taxes paid in the taxable year in the amount of $8,938.98, in the form of processing taxes.
b. The Commissioner erroneously disallowed for the calendar year 1935 a deduction for taxes paid in the taxable year in the amount of $2,761.36, in the form of processing taxes.

Petitioner in support of the foregoing assignments of error alleged the following facts:

a. The taxpayer included in the total sum of taxes deducted in its income tax return for the calendar year 1934 the sum of $8,938.98.
b. The sum of $8,938.98, supra, was processing tax attributable to items processed by the taxpayer in the calendar year 1934.
c. The taxpayer included in the total sum of taxes deducted in its income tax return for the calendar year 1935 the sum of $2,761.36.
d. The sum of $2,761.36, supra, was processing tax attributable to items processed by the taxpayer in the calendar year 1935.
e. Taxpayer in due course filed claims for refund of processing taxes on tobacco for 1933, 1934, 1935 and 1936 pursuant to Title Yu of the Revenue Act of 1936.
f. In May, 1939, taxpayer’s claim for refund of processing taxes on tobacco was compromised for 1933, 1934, 1935 and 1936, whereby taxpayer received the sum of $14,000.00, without interest, for its claim of $17,004.97, with interest.

Respondent in his amended answer admitted the foregoing allegations of fact and also admitted that in determining petitioner’s net income for 1934 he disallowed a deduction claimed for processing taxes in the amount of $8,938.98 and for 1935 he disallowed a deduction claimed for processing taxes in the amount of $2,761.38. All the essential facts having been admitted by the respondent in his amended answer, the question to be decided becomes one of law only.

Petitioner states the issue which we have to decide as follows: “Is the deduction of taxes paid by petitioner under the Agricultural Adjustment Act and later refunded to petitioner on basis of unconstitutionality of the Act a proper deduction for the year in which paid?” We think this question must be answered in the affirmative, and hence in petitioner’s favor.

If we had before us the question: “Is the refund of $14,000, which petitioner received in 1939 of processing taxes paid in prior years and which petitioner had deducted in determining its net income for such prior years, taxable income to petitioner in 1939?”, we would have to answer it in the affirmative. Estate of William H. Block, 39 B. T. A. 338; affd., 111 Fed. (2d) 60; Dixie Margarine Co., 38 B. T. A. 471; Charles W. Nash, 34 B. T. A. 675; affd., 88 Fed. (2d) 477.

In Estate of William H. Block, among other things, we said:

Income tax liability must be determined for annual periods on the basis of facts as they existed in each period. When recovery or some other event which is inconsistent with what has been done in the past occurs, adjustment must be made in reporting income for the year in which the change occurs. No other system would be practical in view of the statute of limitations, the obvious administrative difficulties involved, and the lack of finality in income tax liability, which would result. * * *

Central United National Bank, 33 B. T. A. 588; affd., 99 Fed. (2d) 568, is a case which we think strongly supports the contention of petitioner. In that case, taxpayer, on accrual basis of accounting, took deduction under the Revenue Act of 1928, section 23, in the years 1928, 1929, and 1930 for personal property taxes charged against it but not paid at the end of those years. Suits were filed for the purpose of enjoining collection on the basis that the tax was illegally discriminatory. These taxes were later compromised in the year 1932 and taxpayer reported as income for 1932 the amount saved by compromise. The Commissioner held that this could not be done and readjusted taxpayer’s returns for years 1929 and 1930 so as to allow deductions only for the amounts accrued for those years as reduced by the compromise in 1932. The Board sustained the taxpayer’s treatment of the taxes and overruled the Commissioner. In this we were affirmed by the United States Circuit Court of Appeals.

The Board recently decided, in Cartex Mills, Inc., 42 B. T. A. 894, that processing taxes imposed by the Agricultural Adjustment Act were deductible by a corporation on the accrual basis in the year when such taxes accrued, even though in a later year such taxes were declared by the Supreme Court of the United States to be unconstitutional. It is true that in the Cartex Mills, Inc., case, no refund of the processing taxes paid by the taxpayer in prior years had as yet been made by the Bureau of Internal Bevenue, whereas in the instant case the facts show that in 1939 petitioner received a refund of $14,000 without interest in compromise of its claim for refund of $17,004.97 of processing taxes paid by petitioner in prior years. We think that the fact that a refund has been made to petitioner does not serve to distinguish it from the Cartex Mills, Inc., case.

The instant case is distinguishable from J. A. Dougherty's Sons, Inc., 42 B. T. A. 892, because in that case the taxpayer was resisting the taxes in the years in which they were accrued on its books and never did make payment of them, due to the fact that the law imposing such taxes was later declared unconstitutional.

Decision will be entered for petitioner.


author: Leech :

text:
    Lyon Incorporated, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 93858, 96546, 99832.
    Promulgated October 29, 1940.

      G. A. Donohue, Esq., William, H. West, Jr., Esq., and Elden McFarland, Esq., for the petitioner.

      DeWitt M. Evans, Esq., for the respondent.
   OPINION.

Leech :

This case presents a deliberate attempt by G. Albert Lyon to dispose of his tire cover business and patent applications in such a way that not only would any tax upon him by reason of their disposition be postponed, but also the corporation to be formed to hold the patents would be entitled to use a stepped-up basis for depreciation. Although the law does not condemn this intent, Gregorg v. Helvering, 293 U. S. 465, it requires that the transactions be closely scrutinized to discover whether they may be held to have consummated that intent. Pacific Grape Products Co., 42 B. T. A. 914.

The initial transfer from Lyon to the Lyon Development Co. in exchange for all its stock was tax-free within section 112 (b) (5) of the Revenue .^.ct of 1928 and the basis of the transferred assets then remained the same in the hands of that company. Sec. 113 (a) (6) of the same act. The transfer of the same assets from the Lyon Development Co. to petitioner was planned in such a way that petitioner would be entitled to use the basis of the cost of the patent applications to it, rather than their lower basis in the hands of the Lyon Development Co. Accordingly, Lyon gave his wife Lyon & Wilson, Inc., stock so that she might exchange it for 650 shares of petitioner’s class A stock. Meanwhile the Lyon Development Co. exchanged the assets in its hands for 885 shares of petitioner’s class A stock and 1,600 shares of petitioner’s class B stock.

The exchanges between Elizabeth Aikens Lyon and petitioner, on the one hand, and the Lyon Development Co. and petitioner, on the other, were planned to have a double effect. The stock received by the Lyon Development Co. constituted only 19.27 percent of petitioner’s capitalization. Thereby, so it was thought, the application of section 113 (a) (7) of the Revenue Act of 1928, requiring the transferee to use the transferor’s basis if the property was acquired in connection with a reorganization and immediately thereafter an interest or control of the property of 80 per centum or more remained in the same persons, would be prevented. And, since the interests of Mrs. Lyon and Lyon Development Co. in the property transferred, prior to the exchange, were not substantially proportionate to the amounts of stock of petitioner respectively received by them, the application of sections 112 (b) (5) and 113 (a) (8) of the Eevenue Act of 1928, requiring use of the transferor’s basis if the transferee acquired the property in a section 112 (b) (5) transaction, would likewise be prevented. See United Carbon Co. v. Commissioner, 90 Fed. (2d) 43; Hillyer, Edwards, Fuller, Inc. v. United States, 52 Fed. (2d) 742. Thus, as the plan went, Lyon would pay no immediate tax, but petitioner would be able to use a stepped-up basis.

The same result was sought to be accomplished in Royal Marcher, 32 B. T. A. 76, but failed because in the transactions corresponding to the exchanges here between Elizabeth Aikens Lyon and petitioner and the Lyon Development Co. and petitioner, the stock received was substantially proportionate to the properties transferred and the whole arrangement fell within section 112 (b) (5).

Eespondent does not now urge that the transactions come within section 112 (b) (5). His position is, however, that petitioner has reckoned without section 113 (a) (12) of the Revenue Act of 1934, which reads as follows:

Ii the property was acquired, after February 28, 1913, in any taxable year beginning prior to January 1, 1934, and the basis thereof, for the purposes of the Revenue Act of 1932, was prescribed by section 113 (a) (6), (7), or (9) of such Act, then for the purposes of this Act the basis shall be the same as the basis therein prescribed in the Revenue Act of 1932.

An identical counterpart of the foregoing appears in the Eevenue Act of 1936, with the same section number. Thus, says respondent, petitioner’s basis for depreciation in the taxable years 1934 to 1937, inclusive, is governed by section 113 (a) (7) of the Eevenue Act of 1932, which reads as follows, so far as here material:

If the property was acquired after December 31, 1917, by a corporation in connection with a reorganization, and immediately after the transfer an interest or control in such property of 50 per centum or more remained in the same persons or any of them, then the basis shall be the same as it would be in the hands of the transferor *' * *.

The next step of his argument is that petitioner acquired its property in connection with a reorganization, as that term is defined in section 112 (i) (1) (A) of the Revenue Act of 1932, namely “a merger or consolidation (including the acquisition by one corporation of * * * substantially all the properties of another corporation) .”

Petitioner acquired all of the property of the Lyon Development Co., and the latter received more than 50 percent of petitioner’s stock. There is no doubt that the transaction falls literally within, sections 112 (i) (1) (A) and 113 (a) (7), if a statutory reorganization may be properly held to have occurred. Hence, if such a holding is proper, petitioner will have to use the Lyon Development Co.’s basis, which in turn is the basis of the patents in the hands of G. Albert Lyon, by reason of the provisions of sections 113 (a) (8) and 112 (b) (5). This latter basis is $56,411.90, while the cost of the patents to petitioner is $1,146,201.21.

Petitioner argues that the acquisition of all the property of the Lyon Development Co. by petitioner did not constitute a statutory reorganization, inasmuch as that company was a mere conduit for the transmission' of assets of Lyon to petitioner, and stock in petitioner to Lyon. This transaction, it is said in effect, was “Simply an operation having no business or corporate purpose — a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan, not to reorganize a business or any part of a business, but to transfer a parcel of corporate shares to the [taxpayer]” (see Gregory v. Helvering, supra), and that no reorganization therefore occurred. Petitioner cites Gregory v. Helvering as supporting its position.

Respondent rests on an attempted distinction of the facts in that and the present case.

Thus, the record shows that while the Lyon Development Co. was formally organized, it performed only three corporate functions: It held the assets received from G. Albert Lyon on June 12, 1930, until June 14,1930, at which time it retransferred them to petitioner; it held 885 shares of petitioner’s class A stock and 1,600 shares of petitioner’s class B stock from June 13, 1930, until November 1930, at which time it transferred petitioner’s stock to G. Albert Lyon; and it filed income tax returns for 1930 and 1931. It also earned some royalties during the two days it held the Lyon patent applications and the license agreement, but there is no evidence that such royalties were actually paid to it. Any corporate meetings which were held were only in connection with the foregoing activities. Following its distribution of petitioner’s stock to G. Albert Lyon, it performed no other corporate function until it was dissolved in 1987.

However, whether these facts afford any sound basis for distinguishing the situation here from that present in the Gregory case seems unimportant.

Respondent imposed a tax upon G. Albert Lyon for the year 1930, which was the year in which the transaction now before us was carried out, to the extent to which Lyon received gain in the sale of assets other than the tire cover patents, to the Houdaille-Hershey Co. See Hellebush v. Commissioner, 65 Fed. (2d) 902. Lyon paid this tax. Neither Lyon nor the Lyon Development Co. returned or paid tax on the transfer of the patents and patent rights involved here, to petitioner. Fully informed of all the details of the exchanges among Lyon, the Lyon Development Co., Elizabeth Aikens Lyon, and petitioner, respondent chose not to tax that transfer. It is, then, reasonably to be inferred that he considered the exchange between the Lyon Development Co. and the petitioner to constitute a tax-free reorganization under the law as it had then been construed. Petitioner and respondent thus took the position that the Lyon Development Co. was not a mere conduit in this transaction and that the transfer of its assets to petitioner by that company was not just a fiction, for tax purposes, but was indeed a reality.

However, in Higgins v. Smith, 308 U. S. 473, the Supreme Court held that “* * * the Government may not be required to acquiesce in the taxpayer’s election of that form for doing business which is most advantageous to him. The Government may look at actualities and upon determination that the form employed for doing business or carrying out tire challenged tax event is unreal or a sham may sustain or disregard the effect of the fiction as best serves the purposes of the tax statute.” [Emphasis supplied.] So, in the light of Gregory v. Helvering, and the record, the acquisition of Lyon’s assets by petitioner through the Lyon Development Co. as a mere conduit, may have been, as petitioner argues, a mere device — a disguise — a fiction — but the Government is not compelled to so regard it in the special circumstances before us here. It may and here does continue to treat this fiction as real. It follows that the present transaction did constitute a statutory reorganization for the purposes of this proceeding.

We conclude that petitioner must use as a basis for the depreciation of its patents the cost of those patents to the Lyon Development Co. which was their cost to G. Albert Lyon. Sec. 113 (a) (6), Revenue Act of 1934.

On the second issue, we hold that petitioner is entitled to deduct in 1935 the unpaid balance of the loan to Appleby as a debt ascertained to be worthless and charged olf in that year. Since Appleby had previously become bankrupt, there was no prospect of repayment other than out of the collateral, the Standard Land Co. stock. Petitioner discovered in 1935 that the collateral stock became worthless in that year by reason of the tax sale of the sole asset of Standard Land Co., and charged off the balance then owing. Its right to. the deduction thereupon arose. Kessler Oil & Gas Co., 41 B. T. A. 31.

Reviewed by the Board.

Decision will be entered under Bule 50.

       The property acquired by petitioner had a total value of $2,247,550.50. Mrs. Lyon received 20.73% of petitioner’s stock, worth $445,187.22, but had contributed property (Lyon & Wilson stoch) worth $662,351.19. Lyon Development Co. received 79.27% of petitioner’s stock, worth $1,702,363.28, but had contributed property worth $1,485,199.31 (taking the patent applications to be worth $1,000,000 and the other assets to be worth $485,199.31, or what the purchaser was to pay for them under the agreement of May 3, 1930).

      . The actual value of the patents, as disclosed by uncontradicted expert testimony, and which is substantiated by the subsequent royalty history, was $1,000,000. The other assets were worth $485,199.31, the amount for which they were sold. The stock received from Mrs. Lyon was worth $662,351.19. The total value of the assets received by petitioner was $2,147,500.50, and Its stock was worth that amount. William Ziegler, Jr., 1 B. T. A. 186. Petitioner paid out 79,27% of its stock for the assets contributed by Lyon Development Co., which had a value of $1,702,363.28. But the patents constituted only 67.33% of the assets held by Lyon Development Co. ($1,000,000 out of $1,485,199.31), and therefore only 67.33% of the stock, or $1,146,201.21, was paid for the patents.


author: Hitn:

text:
    Edward C. Lawson and Alice K. Lawson, Petitioners, v. Commissioner of Internal Revenue, Respondent. Roberta C. Lawson, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 99300, 99301.
    Promulgated October 30, 1940.

      Boscoe E. Harper, Esq., and V. M. Kelly, C. P. A. for the petitioners.

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

Hitn:

The issue submitted for decision is whether or not petitioners are entitled to deduct from gross income for the taxable year 1936 the stipulated basis of the shares of preferred stock of the Southwest Utility Dairy Products Co. owned by them, respectively. Eespondent disallowed the deductions claimed by petitioners on the ground that the losses were sustained in a prior year.

Whether or not corporate stock became worthless in a particular year is a question of fact which is often difficult to ascertain, and seldom can be demonstrated with mathematical certainty. It must be determined from a practical consideration of all the facts and circumstances of each case. Forbes v. Commissioner, 62 Fed. (2d) 571; Morton v. Commissioner, 112 Fed. (2d) 320, affirming 38 B. T. A. 1270.

The statute contemplates allowance of deductions for losses which are fixed by identifiable events, United States v. White Dental Manufacturing Co., 274 U. S. 398, 401, but facts which indicate merely imminence of loss, not the present fact of loss, are not such identifiable events, Burdan v. Commissioner, 106 Fed. (2d) 207, and it has been held that a deduction is not allowable in the year claimed by the taxpayer merely because his stock subsequently became worthless, nor is such loss allowable because, in the light only of subsequent events, it may appear to have been inherently worthless in the taxable year. Royal Packing Co. v. Commissioner, 22 Fed. (2d) 536, 538.

Eespondent argues that the preferred stock of the Dairy Products Co. involved herein became worthless prior to the taxable year 1936, and in support of his contention points to the following facts, namely, that the Dairy Products Co. and its two subsidiaries encountered financial difficulties in 1982, and a receiver was appointed on March 1 of that year; in June 1934 proceedings for the reorganization of the companies under section 77 (b) of the National Bankruptcy Act, as amended, were instituted in a Federal court. On November 5, 1934, the court took jurisdiction, the receiverships were terminated, and each company was adjudged to be insolvent. With respect to the Dairy Products Co., the special master’s report, as of June 11, 1934, disclosed that its bonded and unsecured indebtedness amounted to $3,420,919.77, while the combined value of all of its assets amounted to $917,420.03, leaving a deficiency of $2,503,499.74. A substantially similar financial situation was disclosed in respect of the two subsidiaries. Respondent contends that the hopelessness of the financial condition of the three companies during 1934 indicates that the preferred stock in question was without value in that year.

We are unable to agree with respondent’s conclusion, which fails to take into consideration facts tending to establish that, notwithstanding that the preferred stock of the Dairy Products Co. had no liquidating value in 1934, it did have a substantial potential value in the years prior to 1936. The facts cited by respondent are not in themselves conclusive, and indicate at most merely imminence of loss, not the present fact of loss. Neither the receivership, the adjudication of insolvency, nor the reorganization proceedings under the Bankruptcy Act is sufficient to establish worthlessness of the stock. As was pointed out by the Court of Claims in Lyon v. United States, 5 Fed. Supp. 138:

It is generally Reid that the mere appointment of a receiver or even a showing of bankruptcy of a corporation is not sufficient in itself and alone to entitle a taxpayer to deduct the cost of the stock in such corporation as worthless.

See also Van Diest v. United States, 67 Ct. Cls. 655, and Tsivoglou v. United States, 31 Fed. (2d) 706.

So long as corporate stock reasonably has a potential value, it can not be said that the taxpayer’s investment therein has been lost. “The ultimate value of the stock, and conversely its worthlessness, will depend not only on its current liquidating value, but also on what value it may acquire in the future through foreseeable operations of the corporation. Both factors of value must be wiped out before we can definitely fix the loss.” Sterling Morton, 38 B. T. A. 1270, 1278; affd., Morton v. Commissioner, supra. “Until it is clearly shown that there is no probability that any portion of the investment will ever be recovered, no deductible loss under the statute has been sustained.” William E. Metzger, 21 B. T. A. 1271, 1272. And see James L. Byrd, 21 B. T. A. 1183, 1185.

The facts stipulated in the present proceedings show that in March 1935 a plan of reorganization was submitted to the court by the debtor companies which, among other things, provided that one share of common stock of the proposed new or reorganized corporation should be distributed to the holder of each share of the preferred stock of the debtors. It is also shown that in June 1935 a bondholders’ committee prepared and submitted a plan of reorganization which provided that the holders of the preferred stock of the debtors should receive for each such share one share of common stock of the new company. These plans of reorganization were rejected by the court on April 22, 1936, apparently not on the ground that recognition was accorded to the preferred stockholders, but because other provisions were found to be inequitable, not feasible, and discriminatory against certain classes of creditors.

On the same date the court, of its own motion, appointed a reorganization committee. This committee was specifically instructed by the court to endeavor to formulate a plan of reorganization which would preserve the going-concern value of each of the companies, and to afford the debtors an opportunity to be heard for the purpose of determining what recognition should be given to the preferred stockholders in the plan of reorganization to be formulated by such committee.

Under date of June 11, 1936, the committee appointed by the court submitted its plan, which plan was approved and confirmed by the court on November 2,1936. Thereunder, the stockholders of the three debtor corporations received nothing.

All the plans of reorganization above referred to provided for the organization of a new company on a sound financial basis, and we can not assume that the common stock of any such new or reorganized company would have been without value. It is our opinion, therefore, that prior to November 2,1936, the holders of the preferred stock of the Dairy Products Co. had a reasonable basis for the expectation that they would receive a substantial interest in the new company in exchange for their stock in the old company. This expectation was definitely foreclosed on the date last stated, when the court approved the plan of reorganization under which they received nothing. We have, accordingly, found as a fact that the preferred stock of the Dairy Products Co. became worthless during the taxable year 1936. Cf. Jones Oil & Operating Co. v. Commissioner, 114 Fed. (2d) 642.

Petitioners are entitled to the deductions claimed. Respondent’s action on the issue submitted is reversed.

Decisions will be entered wnder Rule SO.


author: Haeeon :

text:
    Rufus S. Cole, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 96589.
    Promulgated October 30, 1940.

      Benjamin P. D&Witt, Esq., and Sidney Pepper, Esq., for the petitioner.

      Allen T. Akim,, Esq., for the respondent.
   OPINION.

Haeeon :

The sole question is whether the cancellation of petitioner’s indebtedness to Hupp resulted in taxable income under section 22 (a) of the Eevenue Act of 1934, the pertinent provisions of which are set forth in the margin.

Eespondent determined that the entire amount of the indebtedness canceled was taxable income under section 22 (a). In his brief petitioner contends that, since he was insolvent immediately prior to the cancellation of the indebtedness, the cancellation did not result in taxable income, and relies on Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 Fed. (2d) 95, and Burnet v. Campbell Co., 50 Fed. (2d) 488.

In our opinion the Board’s decision in Lakeland Grocery Co., 36 B. T. A. 289, is controlling here. In the Laheland case the taxpayer was insolvent immediately prior to the cancellation of his indebtedness by his creditors but solvent immediately after the cancellation, with an excess of total assets over total liabilities. After considering, inter alia, the same cases relied on by petitioner in his brief here, the Board held that the cancellation of the indebtedness resulted in taxable income to the extent of the excess of total assets over total liabilities immediately after the cancellation. The Board stated in part as follows:

⅜ * * xiie petitioner’s net assets were increased from zero to $39,596.93 as a result of the cancellation of indebtedness by its creditors, and to that extent it had assets which ceased to be offset by any liability. The decisions that the increase in clear assets so brought about constitutes taxable “gain” or “income” (United States v. Kirby Lumber Co., supra, and Helvering v. American Chicle Co., 291 U. S. 426) are applicable to the facts of the instant ease, as the cancellation of the petitioner’s debts had the effect of making its assets greater than they were before that transaction occurred. It is true that “gain” or “profit” is essential to the existence of taxable “income” (cf. Dallas Transfer & Terminal Warehouse Co., supra), and we believe that “gain”, as commonly understood, was realized here when the petitioner, who was hopelessly insolvent, received by the action of its creditors an increment to its assets clear and free of any claims of the creditors.

The rule of the Laheland case is applicable here in so far as the cancellation of the indebtedness by Hupp released petitioner’s assets which were subject to claims of creditors. The evidence shows that certain assets of petitioner, aggregating $10,043.95, were released from claims of Hupp, a creditor, and thereafter petitioner’s net assets free from liabilities were in the amount of $4,517.57. Such increase in clear assets, resulting from the cancellation of petitioner’s indebtedness constitutes taxable “gain” or “income” to petitioner. Lakeland Grocery Co., supra.

In determining the amount in which petitioner’s net assets were increased as a result of the cancellation of petitioner’s indebtedness by his creditor, i. e., the amount of petitioner’s assets which ceased to be offset by claims of creditors, there should be, and has been, omitted from the value of petitioner’s assets the value of his equity in ten life insurance policies. Under the applicable law of New York, which was in effect prior to the date of petitioner’s original note to Hupp and at the time of the cancellation of the note, such equity in insurance was free from claims of creditors. See section 55 (a) of the Insurance Law of New York. In determining whether or not petitioner was solvent or insolvent after cancellation of the debt his exempt property should not be considered. Underleak v. Scott, 117 Minn. 136; 134 N. W. 731. Section 55 (a) of the New York Insurance Law has been held to include within its exemption the cash surrender value of insurance policies, notwithstanding that the insured reserved the right to change the beneficiary. See In re Messinger, 29 Fed. (2d) 158, where section 55 (a) was held to allow “exemption” from assets of a bankrupt insured of insurance similar to that involved here, where the claims of creditors arose after March 31,1927, the effective date of section 55 (a). Accordingly, the value of petitioner’s assets was $10,043.95 on January 30, 1935, exclusive of the value of his equity in the insurance policies.

Petitioner does not contend directly that the cancellation resulted in a gift, but he does contend that the agreement between Hupp and petitioner, relating to petitioner’s employment by Hupp as general sales manager and to other matters, dated August 23,1934, was invalid and that his indebtedness to Hupp was not canceled in consideration of the cancellation of the agreement of August 23, 1934. We deem it unnecessary to consider these express contentions, because the evidence clearly shows that the cancellation of petitioner’s indebtedness to Hupp was for a consideration, and, thus, did not result in a gift to petitioner. As was pointed out by the Board in Reginald Denny, 33 B. T. A. 738, 742, “It is elementary that if there is a consideration for a transfer it is not a gift. Noel v. Parrott, 15 Fed. (2d) 669.” In this case, as in the Denny case, there was a consideration which removed the transaction from the, category of a gift. It consisted of petitioner’s agreement to resign as a director of Hupp. Hupp was extremely desirous of terminating petitioner’s entire participation in Hupp’s management, as well as his employment. As stated by petitioner in his brief, “as director, he [petitioner] had steadfastly opposed policies” of the individual then in control of Hupp, and “had embarrassed and incurred the enmity” of that individual, “not only by opposing his policies at meetings of the board of directors of the corporation but also by sending on December 11, 1934, a letter to the Securities and Exchange Commission and an identical letter to the New York Stock Exchange informing those bodies of acts * * * which petitioner believed improper.”

It is held that the cancellation of petitioner’s indebtedness to Hupp resulted in taxable income in the amount of $4,517.57. Lakeland Grocery Co., supra.

Decision will be entered u/nder Rule 50.

       SBC. 22. GROSS INCOME.
      (a) General Definition. — “Gross income” includes gains, profits, and income derived from salaries, wages, or compensation for personal service, of whatever hind and in whatever form paid, or from professions, vocations, 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 interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever.

       Sec. 59 (a). Bights of creditors and beneficiaries under policies of life insurance. — If a policy of insurance whether heretofore or hereafter issued, is effected by any person on his own life or on another life, in favor of a person other than himself, or, except in cases of transfer with intent to defraud creditors, if a policy of life insurance is assigned or in any way made payable to any such person, the lawful beneficiary or assignee thereof, other than the insured or the person so effecting such insurance, or his executors or administrators, shall be entitled to its proceeds and avails against the creditors and representatives of the insured and of the person effecting the same, whether or not the right to change the beneficiary is reserved or permitted, and whether or not the policy is made payable to the person whose life is insured if the beneficiary or assignee shall predecease such person; Provided, that, subject to the statute of limitations, the amount of any premiums for said insurance paid with intent to defraud creditors, with interest thereon, shall inure to their benefit from the proceeds of the policy; but the company issuing the policy shall be discharged of all liability thereon by payment of its proceeds in accordance with its terms, unless before such payment the company shall have written notice, by or in behalf of a creditor, of a claim to recover for transfer made or premiums paid with intent to defraud creditors with specification of the amount claimed. [L 1927 C 468 Eff. Mar. 31, 1927.]


text:
    Charles F. Parsons, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 91990.
    Promulgated October 30, 1940.

      Antonio Perry, Esq., and E. R. Cameron, C. P. A., for the petitioner.

      B. FI. Neblett, Esq., for the respondent.
   OPINION.

Smith :

This is a proceeding for the redetermination of deficiencies in income tax for 1934 and 1935 in the amounts of $526.13 and $255.35, respectively. The question in issue is whether the salary of the petitioner, as associate justice of the Supreme Court of the Territory of Hawaii for the years 1934 and 1935, is liable to Federal income tax.

The proceeding is submitted upon the pleadings, upon certain exhibits admitted in evidence, and upon a signed stipulation of facts incorporated herein by reference.

The petitioner is a citizen of the United States and a resident of the city and county of Honolulu, Territory of Hawaii.

During the calendar year 1926 the petitioner was appointed by the President of the United States, by and with the advice and consent of the Senate, an associate justice of the Supreme Court of the Territory of Hawaii, and duly qualified for and entered upon the duties of that office during October 1926. The petitioner was reappointed to that office on February 23,1931, and duly qualified under the reappointment on March 11, 1931.

During the period March 11,1931, to August 17, 1935, the petitioner performed the duties of his office and received from the Federal Government a salary of $10,000 per annum set therefor by Act of May 29, 1928, chapter 904, sections 1 and 2, 45 Stat. 997, except that during the effective period of the Economy Act of June 30,1932, chapter 314, 47 Stat. 382, 401, as amended, which began July 1, 1932, and ended March 31, 1935, percentage deductions were made from the petitioner’s fixed salary.

The amounts of salary actually received by the petitioner from the Treasurer of the United States during the years 1934 and 1935 for services performed as an associate justice were $9,208.32 in 1934 and $6,152.77 in 1935.

The petitioner duly filed with the collector at Honolulu returns of annual net income for the calendar years 1934 and 1935 and included therein as items of gross income, and also as deductions, the above stated amounts of $9,208.32 and $6,152.77, respectively.

The respondent in his determination of the deficiencies herein for the calendar years 1934 and 1935 included the said amounts of $9,208.32 and $6,152.77 in petitioner’s gross income, but disallowed their deduction. The deficiencies herein result entirely from such adjustments.

The only issue in this proceeding is whether the salary received by the petitioner as an associate justice of the Supreme Court of the Territory of Hawaii during the years 1934 and 1935 is subject to income tax.

In his income tax returns for 1934 and 1935 the petitioner included his salary in gross income but deducted it from the gross income in determining net income. The respondent restored it to net income in the determination of the deficiencies involved herein, stating in his deficiency notice, which forms the basis for this proceeding:

Salary received as associate justice of toe Supreme Court of the Territory of Hawaii, is held by this office to be taxable income since Justices of the Supreme Court of the Territory of Hawaii are not judges of inferior courts of the United States within the meaning of article III, section 1, of the United States Constitution.

The petitioner submits that his salary is exempt from Federal income tax in accordance with paragraph 3 of section 80 of the Organic Act of the Territory of Hawaii, which provides:

The salaries of all officers other than those appointed by the President shall be as provided by the legislature, but those of the chief justice and the justices of the supreme court and judges of the circuit courts shall not he diminished during their term of office.

He submits that this provision of the organic act is traceable through mesne enactments to Article III, section 1, of the Constitution of the United States, which provides:

The Judicial Power of the United States shall be vested in one Supreme Court and in such inferior courts as the Congress may from time to time ordain and establish. The Judges, both of the Supreme and inferior courts shall hold their offices during good behavior, and shall, at stated times, receive for their services, a compensation which shall not be diminished during their continuance in office.

He further submits that the courts of Hawaii, following opinions of the Supreme Court of the United States (Pollock v. Farmers' Loan & Trust Co., 157 U. S. 429; Evans v. Gore, 253 U. S. 245; and Miles v. Graham, 268 U. S. 501), have held, in Robertson v. Pratt and Waimea Sugar Co. v. Pratt, 13 Hawaii, 590; and Frear v. Wilder, 25 Hawaii, 603, 607, that the salaries of the judges of the Supreme Court of the Territory of Hawaii are not subject to the Hawaiian income tax, upon the ground that such a tax would operate to diminish their compensation within the purview of paragraph 3 of section 80 of the Organic Act of the Territory of Hawaii; that this was the law governing the issue herein presented at the time the petitioner received his salary in 1934 and 1935. He further submits that the respondent has not subjected to Federal income tax the salaries of the justices of the Supreme Court of the Territory of Hawaii received prior to 1934.

In O'Malley v. Woodrough, 307 U. S. 277, decided May 22, 1939, the Supreme Court had before it the question as to whether the salary of a judge of one of the United States Circuit Courts of Appeal was subject to income tax under section 22 (a) of the Revenue Act of 1934, which provides in part:

* * * In tbe ease of Presidents of tbe United States and judges of courts of tbe United States talcing office after June 6, 1932, tbe compensation received as sucb shall be included in gross income; and all Acts fixing tbe compensation of sucb Presidents and judges are hereby amended accordingly.

In its opinion the Supreme Court held that the salary of the judge in question, who had entered upon the duties of office after June 6,1932, was subject to income tax, saying:

* * * Congress has committed itself to tbe position that a non-discriminatory tax laid generally on net income, is not, when applied to tbe income of a federal judge, a diminution of bis salary within tbe prohibition of Article III, § 1 of the Constitution. * * *

The facts in the instant case are that the petitioner entered upon the duties of his office prior to June 6, 1932. It is therefore argued that the salary received by him in 1934 and 1935 is exempt from income tax.

It is not necessary in this proceeding to determine whether the salary of a judge of a constitutional court entering upon the duties of his office prior to June 6,1932, is subject to income tax in 1933 and 1934. We have not that question before us.

The Supreme Court of the Territory of Hawaii is not a “constitutional” court within the meaning of Article III, section 1, of the Constitution. It is a “legislative” court created under Article IV, section 3, clause 2 of the Constitution, which vests in Congress the power to “dispose of and make all needful rules and regulations respecting the territory or other property belonging to the United States.” See O'Donoghue v. United States, 289 U. S. 516. Congress clearly has the power under that provision of the Constitution to make any changes which it desires with respect to the terms of office or the salary of justices of a legislative court. It may diminish their compensation if it chooses to do so.

It is furthermore to be noted that the petitioner’s compensation for the years 1933, 1934, and 1935 was reduced by the Economy Act of June 30, 1932, chapter 314; 47 Stat. 382, 401, as amended. That act expressly exempted from its provisions “(⅜ * * judges whose compensation may not, under Constitution, be diminished during their continuance in office).” The petitioner’s compensation was diminished under the provisions of that act because the diminution thereof was not prohibited by the Constitution of the United States.

Charles F. Hatfield, 38 B. T. A. 245, involved the question whether the salary of a judge of the United States Court of Customs and Patent Appeals was subject to income tax for the years 1934 and 1935. There, as here, the judge entered upon the duties of his office prior to June 6, 1932. There, as here, the judge was a member of a legislative court and not of a constitutional court, within the meaning of Article III, section 1, of the Constitution of the United States. We held that his salary was subject to income tax. All that we said there is equally applicable here. Upon the theory of that case it must be held that the salary of the petitioner received as an associate justice of the Supreme Court of the Territory of Hawaii during the years 1934 and 1935 is subject to income tax.

Decision will he entered for the respondent.