source: Caselaw Access Project

author: Black :

license: Public Domain

text:
    Estate of Pamphila H. Phillips, Deceased, Thomas W. Phillips, Jr., Benjamin D. Phillips, and Grace Phillips Johnson, Executors, Petitioners, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 87519.
    Promulgated December 8, 1937.

      W. W. Booth, Esq., for the petitioners.

      H. F. Noneman, Esq., for the respondent.
   OPINION.

Black :

Respondent concedes that petitioners are entitled to a credit on their Federal estate tax for amounts paid to the Commonwealth of Pennsylvania of an amount not in excess of $27,253.06. It has been stipulated that petitioners have actually paid to the Commonwealth of Pennsylvania, in cash, the sum of $27,509.77, exclusive of interest. It can readily be seen that this is $156.11 more than the credit to which respondent concedes that petitioners are entitled if they have paid that much within the statutory definition of “actually paid.” But it is respondent’s contention that under the decision of the Supreme Court of Pennsylvania in In re Markle's Estate (1933), 311 Pa. 472; 166 Atl. 884, petitioners are entitled to a refund of part of the tax which they have paid to the Commonwealth of Pennsylvania, and that when they do get such refund the amount allowable as a credit in the computation of Federal estate tax will be $26,698.06, which, together with the discount of $560, equals $27,253.06, the maximum amount of credit allowable.

We shall not in this opinion enter into any extensive discussion of In re Marble's Estate, supra. It may well be that, under the law as construed in that case by the Supreme Court of Pennsylvania, petitioners have overpaid the estate tax and inheritance taxes due the Commonwealth of Pennsylvania and are entitled to a refund of part of what they have paid, but we have not the power to decide that question. The effect of what the Supreme Court of Pennsylvania decided in that case is stated in the syllabus of its opinion, as follows:

1. The discount permitted by section 38 of the Act of June 20, 1919, P. L. 521, for prompt payment of the normal inheritance tax may be claimed as a credit by the executors of an estate of a decedent by the Act of May 7, 1927, P. L. 859.
2. The “total” taxes actually paid “which by the Act of May 7, 1927, P. L. 859, is to be deducted from the credit of eighty per cent allowed by the federal law is the amount of the tax which was discharged by payment, and not the sum of money which the Commonwealth accepts in satisfaction of the normal tax.”

The decision of the Supreme Court of Pennsylvania on this particular point of discounts allowed in payments in determining the estate and inheritance taxes due the Commonwealth of Pennsylvania seems to be contrary to what the Board has held in determining what credit an estate is entitled to have for amounts of estate and inheritance taxes paid to the state, in determining the amount of estate taxes to be paid the Federal Government.

Under the Board’s decision in Earl F. Smith, Administrator, 23 B. T. A. 278; affd., 59 Fed. (2d) 533, tax-paying estates are not entitled to have credited to them as taxes “actually paid” the amount of discount allowed by the state for the prompt payment of state estate and inheritance taxes. The applicable revenue act involved is section 301 (b) of the Revenue Act of 1926, which reads as follows:

(b) The tax imposed by this section shall be credited with the amount of any estate, inheritance, legacy, or succession taxes actually paid in any State or Territory or the District of Columbia, in respect of any property included in the gross estate. The credit allowed by this subdivision shall not exceed 80 per centum of the tax imposed by this section and shall include only such taxes as were actually paid and credit therefor claimed within three years after the filing of the return required by section 304.

It appears from the facts which have been stipulated that, in the payment of $11,200 inheritance taxes due under the laws of the State of Pennsylvania, petitioners were allowed a discount of 5 percent, which amounted to $560. Undoubtedly under our decision in Earl F. Smith, Administrator, supra, this amount of $560 should not be counted in determining the credit to which petitioners are entitled under section 301 (b), supra. Petitioners do not contend otherwise. But, leaving this $560 discount entirely out of consideration, the facts show that petitioners still have paid to the State of Pennsylvania the net cash amount, exclusive of interest, of $27,509.77 as state estate and inheritance taxes, which is more than they are asking as a credit in the computation of the amount due the Federal Government.

Are we to reduce this amount by some theoretical refund to which respondent claims petitioners are entitled from the Commonwealth of Pennsylvania under the doctrine announced by the Supreme Court of that state in In re Markle's Estate? We think not. Petitioners’ contention in short is that they have paid the amount in controversy to the State of Pennsylvania and they do not want to pay it again to the Federal Government. They say that they have received no refund from the State of Pennsylvania in the amount that respondent says they are entitled to receive and that they have not even filed a claim for a refund. Petitioners contend that, if and when they do receive a refund of any of the amount which they have paid to the State of Pennsylvania, they would be required to report that fact to the Commissioner of Internal Revenue and pay any additional estate tax which might be due the Federal Government by reason thereof. We think petitioners are correct in this contention.

The concluding paragraph of article 9 (b) of Regulations 80 (1937 edition), dealing with credit for estate, inheritance, legacy, or succession taxes, reads as follows:

If, subsequent to the allowance of a credit by the Commissioner, a refund is made of any such estate, inheritance, legacy, or succession taxes, the executor, or if the refund is made after the executor’s discharge, then any person or persons to whom the refund is made, is required to advise the Commissioner of the date of the refund and the amount thereof, furnish the Commissioner • with a description of the property or interest in respect to which the refund was made and pay the Federal estate tax, if any, due as a result of such refund, together with interest.

As we Rave already pointed out, petitioners have received no refund of any part of the estate and. inheritance taxes which they have paid the Commonwealth of Pennsylvania on account of the estate of decedent, Pamphila H. Phillips, and no claim for a refund is pending. If and when any such refund is received, it will be their duty to report it to the Commissioner as provided in the regulation quoted above and pay any additional Federal estate tax which may become due by reason thereof. We would not be justified in denying to petitioners the credit which they are entitled to receive under section 301 (b) of the Revenue Act of 1926, as amended, merely because the Commissioner alleges they are entitled to receive a refund of some part of the estate and inheritance taxes which they have paid to the Commonwealth of Pennsylvania but which refund, so far as we know, they may never in fact receive.

Upon the facts stipulated and the applicable law and regulations, we find in favor of the petitioners on the only issue involved. An order will be entered denying respondent’s motion to vacate our decision of June 16, 1937.


author: Smith :

text:
    Madison Railways Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 85121.
    Promulgated December 8, 1937.

      Arnold R. Petersen, Esq., and Clarence E. Packman, C. P. A., for the petitioner.

      Hartford Allen, Esq., and Willard S. Lines, Esq., for the respondent.
   OPINION.

Smith :

This is a proceeding for the redetermination of deficiencies in income tax for 1931 and 1932 of $7,897.18 and $6,265.38, respectively. The principal question in issue is whether the petitioner derived taxable income from the purchase and retirement of some of its outstanding bonds in each of the taxable years at less than the amount realized upon the original sale of the bonds.

The petitioner filed income tax returns for the calendar years 1931 and 1932 which showed no taxable net income, but a net loss instead of $70,215.80 and $56,151.78, respectively. The respondent has amended the returns and determined that the petitioner had taxable net income for the years in question of $65,809.87 and $45,566.38, respectively. In making such amendments he has treated as taxable income $85,150 and $63,162.50, respectively, representing “Profit on own bonds reacquired.” He made numerous other adjustments in the taxpayer’s returns, some of which are not in issue in this proceeding.

The petitioner alleges that the respondent erred in the determination of the deficiency (1) by reducing claimed allowances for depreciation from $60,470.35 and $60,794.09 to $52,734.38 and $53,058.40; (2) by failing to allow, as reasonable allowances for amortization and obsolescence of intangible railway property costs, $75,521.68 for each year; (3) by including in taxable income $85,150 and $63,162.50 representing gains on the purchase by the petitioner of its outstanding bonds at less than the issue price; and (4) by failing to allow as a deduction from the gross income of 1931 the correct net loss of the petitioner for 1930.

The petitioner is a public utility company which during the taxable years operated street railways in Madison, Wisconsin. During the taxable years, and for several years prior thereto, the petitioner operated at a large loss. The parties have stipulated:

7. That the electric street railway property of petitioner, not usable for the operation of buses, commenced to become obsolete on January 1, 1926, and that on December 31, 1935, such property, had become completely obsolete, except for salvage, and the operations and property of the street railway system had been abandoned. The building originally used for ear barn and offices continued in use for bus operation.

The petitioner is now in process of reorganization under section 77B of the National Bankruptcy Act.

During the years 1930, 1931, and 1932 the petitioner purchased the following amounts of its outstanding bonds:

These bonds were purchased and retired by the petitioner at a cost which was less than the price at which the bonds were issued (allowance being made for unamortized discount) by the amounts of $5,355 for 1930, $81,150 for 1931, and $63,162.50 for 1932. The respondent contends that these amounts constituted taxable income of the petitioner for the years in question.

The parties have stipulated that the book values of the petitioner’s assets during the taxable years and for many years prior thereto were greatly in excess of their values and that the excess amounts at which assets were carried upon its books of account represented no real value at any time.

After allowance is made for adjustments warranted by the stipulation of facts received in evidence in this case, and adjustments made by the respondent in the accounts of the petitioner as shown by the deficiency notice, and after taking into account profits from the purchase and retirement of bonds, there was an excess of liabilities over assets as follows:

December 31, 1930-$95,523.70
December 31,1931_ 47,250.08
December 31,1932_ 1,300.28

It is also true, however, that in the computations resulting in the above excess of liabilities over assets no account has been taken of approximately $452,829.53 of the book value of street railways shown by the balance sheets, which the petitioner contends and the respondent admits had no real value in the tax years in question. When this further adjustment is made the excess of liabilities (exclusive of capital stock liabilities) over fair value of assets is as follows:

December 31,1930_$585,819.03
December 31,1931_ 545,038.57
December 31,1932_ 506,581.93

The petitioner was clearly insolvent during the calendar years 1931 and 1932 and the purchase by it of some of its outstanding bonds in those years did not have the effect of making the petitioner solvent.

We do not think it necessary in this proceeding to decide some of the issues raised by the petitioner. If it derived no taxable income from the purchase and retirement of its outstanding bonds during the years 1931 and 1932 it had no net income for those years and hence no tax liability.

The respondent submits that in United States v. Kirby Lumber Co., 284 U. S. 1, it was held that where bonds are issued by a corporation which thereafter in the same taxable year purchases and retires some of them at a price less than the issuing price, the excess of the issuing price over the purchase price is gain or income for the taxable year, and contends that the purchase at less than face value of bonds assumed on purchase of property likewise results in taxable income, citing Helvering v. American Chicle Co., 291 U. S. 426.

The above cited cases were not, however, dealing with an insolvent taxpayer. It seems clear that where an insolvent debtor turns over a(l of his property to his creditors in full or partial satisfaction of his debts the debtor realizes no taxable gain. Cf. Bowers v. Kerbaugh-Empire Co., 271 U. S. 170; Meyer Jewelry Co., 3 B. T. A. 1319; Burnet v. John F. Campbell Co., 50 Fed. (2d) 487; Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 Fed. (2d) 95; Porte F. Quinn, 31 B. T. A. 142. It is equally clear, we think, that where an insolvent debtor satisfies a portion of his debts without thereby becoming solvent he has likewise realized no taxable income. He has not by such satisfaction of his debt realized “something of exchangeable value”, something “for his separate use, benefit and disposal.” See Eisner v. Macomber, 252 U. S. 189. In Lakeland Grocery Co., 36 B. T. A. 289, the Board held that where an insolvent debtor satisfied his debts with a portion of his assets and was permitted to retain a portion thereof free from liabilities, the taxpayer had realized gain in the amount of the assets freed from claims of creditors. If in this proceeding the purchase and retirement of the petitioner’s bonds at less than the issuing price had resulted in making the petitioner solvent, we would have been constrained to hold that the petitioner had derived taxable income from the transaction, at least to the extent that its assets were freed from claims of creditors. But in the proceeding at bar that situation does not obtain. The petitioner was insolvent after the purchase and retirement of its bonds as well as before.

The petitioner’s purchase and retirement of its own bonds during the taxable years simply reduced its outstanding liabilities. A reduction in outstanding liabilities which does not make a taxpayer solvent does not result in taxable gain. Dallas Transfer & Terminal Warehouse Co. v. Commissioner, supra.

Judgment of no deficiency will be entered.


author: Smith:

text:
    Minnie T. Grippin, Petitioner, v. Commissioner of Internal Revenue, Respondent. Bessie G. Hall, Petitioner, v. Commissioner of Internal Revenue, Respondent. Roland F. Mygatt, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 66345, 66825, 67564.
    Promulgated December 8, 1937.

      Arthur M. Marsh, Esq., for the petitioners.

      D. A. Taylor, Esq., for the respondent.
   OPINION.

Smith:

These proceedings, consolidated for hearing, are for the redetermination of deficiencies in income tax for 1929 as follows:

These proceedings involve three issues, two of which are common to all three cases and the third of which is present in the Grippin and Hall cases only. The two issues in common are:

First, the value of the stock of the United Founders Corporation received by the petitioners in exchange for stock of the American Founders Corporation for the purpose of determining the gain realized on the exchange.

Second, the taxability as dividends of rights to subscribe to the common stock of the United States Electric Power Corporation received from the American Founders Corporation and United Founders Corporation.

The third issue, which is common to the Grippin and Hall cases, is whether or not amounts received by the petitioners upon the sale of such of the rights as were sold should be included in taxable income.

With respect to the first issue, the petitioners concede that the exchange gave rise to taxable income and the value of the stock on the dates of exchange is stipulated by the parties.

The petitioners, Minnie T. Grippin and Bessie G. Hall, concede that they are taxable upon the proceeds realized by them from the sale of the warrants in 1929.

The only question for the determination of the Board is the liability to income tax upon the value of the stock purchase warrants received by the petitioners from the American Founders Corporation and United Founders Corporation in 1929.

Minnie T. Grippin and Bessie G. Hall are residents of Bridgeport, Connecticut, and Roland F. Mygatt of New Milford, Connecticut.

The petitioners were stockholders in 1929 of the American Founders Corporation and of the United Founders Corporation. These corporations were investment companies engaged in 1929 in the purchase and sale of shares of stock of public utility corporations. Up to October 1929 there was a great demand on the part of investors for shares of stock in such corporations. Taking advantage of the enormous demand for such securities, the American Founders Corporation and United Founders Corporation, which owned large blocks of stock in the Standard Gas & Electric Corporation, conceived the idea of organizing a holding public utility corporation and the sale of such shares to their stockholders. They accordingly, with other interests, organized the United States Electric Power Corporation on September 10, 1929, with a capitalization of:

1,000,000 shares of preferred stock, no par value
2,000,000 shares of class A stock, no par value
20,000,000 shares of common stock, no par value

The American Founders Corporation and United Founders Corporation are hereinafter referred to as American Founders and United Founders, and the United States Electric Power Corporation as United States Electric.

The organizers of United States Electric subscribed on September 10, 1929, for the 2,000,000 shares of class A stock at $10 per share and for 1,450,000 shares of common at $13.50 per share. Out of the foregoing, 700,000 shares of class A stock and 350,000 shares of common stock were subscribed and paid for by American Founders and United Founders. Payment for the 2,000,000 shares of class A stock and 1,450,000 shares of common stock was made partly in cash and partly in Standard Gas & Electric Corporation stock at $190 per share, which was approximately the selling price of that stock on the New York Stock Exchange at that time. Payment was made after September 14,1929, and on or about September 17 and 19,1929.

On September 10,1929, American Founders, by its president, Louis H. Seagrave, offered in writing to purchase from United States Electric such number of shares of the common stock of that corporation at $13.50 per share as would be:

* * * necessary to afford to the holders of Common Stock of the undersigned Corporation at the close of business on September 14, 1929, the right to purchase one share of such stock for each two and one-half shares held by such holder, such amount estimated to be not less than 900,000 shares nor more than 1,100,000 shares and to make payment therefor in cash at the office of the Corporation on the 17th day of September, 1929.

On the same date, United Founders, by its president, Louis H. Seagrave, likewise offered in writing to United States Electric to purchase such number of shares of its common stock at a price of $13.50 per share as would be necessary to afford to the holders of common stock of United Founders at the close of business on September 14, 1929, the right to purchase one share of such stock for each five shares held by such holder. The amount estimated to be needed was “not less than 1,100,000' shares nor more than 1,250,000 shares.” Payment was to be made in cash on September 17, 1929, although payment was made partly in shares of stock of the Standard Gas & Electric Corporation at $190 pef share. United States Electric common stock was listed on the Boston Stock Exchange on September 23, 1929, and from the date of listing to October 7, 1929, a total of 25,946 shares were sold at prices ranging from $32⅛ to $33⅜.

American Founders, on or about September 28, 1929, transmitted to its stockholders warrants to purchase a total of 1,017,239 shares, and United Founders on the same date transmitted to its stockholders warrants to purchase a total of 1,297,791 shares of common stock of United States Electric at $15 per share. The warrants expired on October 15, 1929. American Founders stockholders, or their assignees, by the exercise of warrants subscribed for 1,014,753 shares of United States Electric common stock, and United Founders stockholders, or their assignees, subscribed for 733,326 shares. Payment was made to the Equitable Trust Co. at $15 per share on or before October 15,1929.

The stock purchase warrants issued by American Founders and United Founders were not listed on any exchange, but there were over-the-counter transactions in them at $6.25 per right for those issued by American Founders and at $3.25 per right for those issued by United Founders.

The parties have stipulated that the issuance of the warrants above described was at no time set up on the books of either company, either as a charge against gross profits or against surplus, or otherwise; also, that neither corporation formally or expressly declared such issue of warrants as a dividend or so entered them on their books.

The parties have stipulated as follows:

(32) The petitioners herein exercised certain of said rights so received between Sept 28 and Oct. 15, 1929, and sold certain others thereof between Sept. 28 and Oct. 15, 1929, all in the number, on the dates, and at the prices set opposite their respective names, as follows (prior to October 15,1929) :

The reasonable value of the shares of stock of the United States Electric Power Corporation in October 1929 was not in excess of $15 per share.

The respondent in his computation of the deficiencies in tax due from these petitioners for the year 1929 determined that the receipt of the rights to purchase shares of stock of United States Electric from American Founders and United Founders constituted distributions of dividends by those corporations, and that for such purpose the rights received from American Founders had a value at the time of receipt of $6.25 per right, and those received from United Founders a value at the time of receipt of $8.25 per right. He has accordingly taxed the distributions as ordinary dividends at those values.

It is plain from the lengthy stipulation of facts filed by the parties in these proceedings that American Founders and United Founders conceived the idea of marketing shares of stock of United States Electric to their stockholders at a substantial profit to themselves. They acted as a mere conduit for the sale of shares of United States Electric. Each realized a profit of $1.50 per share upon the shares which it sold to its stockholders. United States Electric had no assets except the amounts paid in to that corporation by American Founders and United Founders, viz., $13.50 per share, and it is further to be observed that a large part of the payment made by those corporations to United States Electric was in the form of shares of stock of the Standard Gas & Electric Corporation at $190 per share. Through this means the two Founders corporations were enabled to dispose of large quantities of Standard Gas & Electric Corporation stock without depressing the prices of those shares on the stock exchange. We think it clear from the stipulated facts that the reasonable and fair value of United States Electric was at no time in October 1929 in excess of $15 per share. The petitioners realized no income from the receipt of the stock purchase warrants from the two Founders corporations in which they held shares. As later events show, the stockholders would have been far better off if they had never received the warrants.

In our opinion the decision upon the point in issue in these proceedings is squarely ruled by the decision of the Supreme Court in Palmer v. Commissioner, 302 U. S. 63. In its opinion the Supreme Court stated:

We think that a distribution of assets by a corporation to its stockholders by means of a sale, to which it is committed by appropriate corporate action at a time when their sale price represents their reasonable value, is not converted into a dividend by the mere circumstance that later, at the time of their delivery to stockholders, they have a higher value. The meaning of § 115 must be sought in the light of the situations to which it must be applied. * * *

The “reasonable value” of United States Electric shares of common stock in October 1929 was not in excess of $15 per share. Therefore, the petitioners received no taxable income from the receipt of the stock purchase warrants.

Judgment will be entered under Rule 50.


author: Hill:

text:
    W. S. Farish, Petitioner, v. Commissioner of Internal Revenue, Respondent. Libbie Rice Farish, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 81145, 81146, 83295, 83296.
    Promulgated December 9, 1937.

      Walter E. Barton, Esq., and J. L. Block, C. P. A., for the petitioners.

      DeWitt M. Evans, Esq., and Spalding Glass, Esq., for the respondent.
   OPINION.

Hill:

During the taxable years 1932 and 1933 petitioner was a member of two partnerships known as the Huisache Stables and Farish, Wiess & Evans, respectively, each of which sustained a net loss in each of those years. Petitioner contends that he is entitled to deduct his distributive share of such net loss either as ordinary and necessary expenses paid or incurred in carrying on a trade or business, or as losses incurred in a trade or business and not compensated for by insurance or otherwise,, or as losses incurred in transactions entered into for profit, though not connected with the trade or business, within the meaning of section 23 of the Revenue Act of 1932.

The amounts of net losses sustained by the partnerships, and the amounts of petitioner’s distributive shares, have been stipulated by the parties and set out in our findings of fact above, but respondent disallowed the deductions claimed on the theory that the partnerships represented “pleasure enterprises” and not businesses or transactions entered into for profit.

Many cases involving similar questions have been decided by both the Board and the courts. Among those in which the deductions were allowed as business expenses or losses, petitioner cites: Wilson v. Eisner, 282 Fed. 38; Thomas F. Sheridan, 4 B. T. A. 1299; Hamilton F. Kean, 10 B. T. A. 97; Waiter P. Temple, 10 B. T. A. 1238; Commissioner v. Widener, 33 Fed. (2d) 833; James Clark et al., Executors, 24 B. T. A. 1235; Commissioner v. Field, 67 Fed. (2d) 876; Whitney v. Commissioner, 73 Fed. (2d) 589; William Buchsbaum, 36 B. T. A. 21.

Respondent cites, among others, the following cases in which the deductions were disallowed: Harry C. Fisher, 29 B. T. A. 1041; affd., 74 Fed. (2d) 1014; Thatcher v. Lowe, 288 Fed. 994; Reginald C. Vanderbilt, 5 B. T. A. 1055; affirmed in Deering v. Blair, 23 Fed. (2d) 975, 976; Louise Cheney, 22 B. T. A. 672.

The facts and circumstances vary so widely, that any attempt to analyze and discuss in detail the cited decisions would unduly prolong this opinion to no useful purpose. Each case must stand on its own bottom. However, certain general rules are laid down which may be helpful in arriving at a correct conclusion under the facts of the present proceedings.

Unless it can fairly be said from the evidence that the ventures in question constituted trades or businesses carried on by the partnerships, or that the losses resulted from transactions entered into for profit, the deductions claimed by petitioner do not come within the statute. The question involves a matter of intention, which we must determine not alone from petitioner’s statement that the enterprises were entered into for profit, but from the surrounding facts and circumstances as well.

It has been held that repeated losses do not necessarily indicate that the enterprise was not conducted as a business, Plant v. Walsh, 280 Fed. 722, but where the venture results only in loss year after year without any reasonable prospect of profit, the rule is otherwise. In Reginald C. Vanderbilt, supra, the Board, in holding that the stock-breeding and produce farm operated by the petitioner was not a business conducted for profit, said at page 1059:

In the instant proceeding the enterprise was established at least twelve years before the first taxable year, and * * * sustained losses in each year in which it was operated. In such conditions the operating losses must have extinguished the original invested capital before 1918, and, had the farm been operated for business purposes by anyone relying on the receipts therefrom for livelihood or income, it would probably have been sold by the sheriff long before the beginning of the taxable years here in question.

In affirming our decision, the Court of Appeals, after quoting in part the foregoing extract, expressed the opinion that the Board was justified in its conclusion that the farm was operated “not as a business for profit.” Applying the same rule in Thatcher v. Lowe, supra, the court remarked that in ascertaining the intention of the taxpayer it could “see no escape from making the crux of the determination his receipts and expenditures.”

The Huisache Stables partnership involved in the present case was organized in 1928 for the purpose of breeding, training, and selling polo ponies. At the end of the taxable year 1933 there had been no income and" the operating expenses then totaled $45,606.05. The capital investment was $16,494.54. Thus at the end of the first five years of operation, the expenses amounted to nearly three times the invested capital.

At the end of 1933 the partnership had 175 horses, including stallions and brood mares. Excluding the latter, about 60 percent of the remainder, or 70 horses, represented prospective polo ponies, or horses that might be developed into polo ponies. The cost of those 70 ponies up to that time was approximately $650 each, to which must be added the cost of maintenance and training over a further period of not less than four years, as well as the expense of shipping to market, sales commissions, possible losses from death, and other items. At the time of the hearing in 1937, no polo ponies had been sold, but it was expected that shortly thereafter some 10 to 20 ponies would be shipped to the eastern market for sale. The average sale price of polo ponies was about $750 each.

We think it is apparent from these facts that if the anticipated percentage of the horses bred and raised by the partnership were successfully developed into polo ponies, unless they could be sold at prices in excess of the average, the partnership would sustain considerable loss. Approximately nine years after the organization of the partnership, during which time it had consistently sustained an operating loss each year, it h^d only 10 to 20 polo ponies ready for sale. What they were sold for, or whether they were sold at all, we do not know. But certainly no facts are disclosed by the record which persuade us that there was any reasonable basis to anticipate a future realization of profit from the operations of the partnership, commensurate with the capital invested.

The records suggest that petitioner is a man of sound business judgment. During the taxable years he was an executive of large corporations, and had an income from investments and salaries of approximately $200,000 per annum. The probability of realizing a fair profit from the breeding of polo ponies in the circumstances shown was so remote as to negative the notion that the petitioner was induced to enter into the venture with any such .expectation. It was entirely outside the scope of his prior business activities. What, then, was his primary motive in becoming a member of the partnership? It is not shown that petitioner played polo or was particularly interested, in the game. However, his son and two brothers played polo, and S. P. Farish appears to have been a player of prominence and an enthusiast for the sport. They conceived the idea of breeding a new and perhaps outstanding strain of polo ponies by crossing thoroughbred stallions with common Texas and Arizona mares. The accomplishment of such a result might well have been considered by petitioner and his brother, S. P. Farish, who was also a man of moans, as sufficient compensation even if the venture otherwise produced no monetary gain. We need not decide. Doubtless it was hoped that gain might be realized or at least that the venture would pay its own way, but the facts, in our opinion, do not reasonably support the conclusion that petitioner’s primary or actuating motive was the expectation of realizing reasonable profits on his investment in the Huisache Stables partnership.

Much the same general situation existed with respect to the partnership of Farish, Wiess & Evans. The predecessor partnership, known as Paradise Stock Farms, was organized about February 1929, to breed race horses. This partnership had only losses, and during the taxable years was in process of liquidation. Like the Huisache Stables, the venture was foreign to petitioner’s usual line of business activities and no facts have been established which reasonably indicate that it was a business carried on for profit or that there was any reasonable expectation of profit. Petitioner devoted only a negligible portion of his time to the affairs of either of the partnerships. His participation appears to have been limited, mainly to the contribution, of capital.

Respondent has determined that neither partnership above mentioned was engaged in carrying on a trade or business, and that neither constituted a transaction entered into for profit. Petitioner has the burden of proving by a preponderance of the evidence that such determination is erroneous. This, we think, he has wholly failed to do. Accordingly, on the first issue, respondent’s action is approved.

The second issue is whether the “Ohio Oil Group”, which was engaged in the purchase and sale of stock of the Ohio Oil Co. in 1932, is taxable as a corporation or a partnership. Petitioner and his wife were members of the group in 1932. The group sustained a capital loss in that year, of which the pro rata share of petitioner and his wife was $9,741.68. This amount was claimed in their return as a capital net loss, and the deduction was disallowed by respondent on the ground that the group was an association taxable as a corporation. The parties have stipulated that if the Board should hold that the group is taxable as a partnership, the claimed deduction is allowable.

The facts in the instant case are in all material respects similar to those in N. B. Whitcomb Coca-Cola Syndicate, 35 B. T. A. 1031, where we held that the syndicate was not an association taxable as a corporation. That decision is controlling here, and therefore on the second issue respondent’s determination is reversed.

Judgment will be entered under Rule 50.


text:
    The Cincinnati Gas & Electric Company, Petitioner, et al.,
      v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 44351, 44352, 44353, 46903, 49614, 50424.
    Promulgated December 9, 1937.

      Douglas M. Moffat, Esq., William D. Whitney, Esq., Richmond H. Ritterbush, Esq., James A. Councilor, C. P. A., and John E. Brown, C. P. A., for the petitioners.

      Philip M. Clark, Esq., and Stanley B. Pierson, Esq., for the respondent.

       Proceedings of the following petitioners are consolidated herewith: Columbia Gas & Electric Corporation, The Gas and Electric Appliance Company, The Union Gas & Electric Company, and Cincinnati Gas Transportation Company.

   OPINION.

Hill:

Respondent determined deficiencies in the income tax liability of the petitioners as follows:

The parties stipulated in the case of the Cincinnati Gas Transportation Co., Docket No. 46903, that there is no deficiency and no overpayment.

At the hearing the parties also filed a stipulation in the cases of the Columbia Gas & Electric Corporation, the Gas & Electric Appliance Co., and the Union Gas & Electric Co., Docket Nos. 44351, 44352, and 44353. Paragraph 13 of that stipulation provides that the net income of the Union Gas & Electric Co. for the calendar year 1923, as determined by respondent, is to be reduced by such amount as shall be found by the Board to constitute the Federal income tax liability of the Cincinnati Gas & Electric Co., Docket No. 49614, for the calendar year 1923. With the exception of the adjustment for taxes, the stipulation disposes of all issues between the parties in the cases mentioned, and it is agreed that the Board may enter judgments therein under Rule 50, after the entry of judgment in Docket No. 49614. Subsequent to the hearing and on April 6, 1937, the parties filed a supplemental stipulation in Docket Nos. 44351, 44352, and 44353.

The stipulations of the parties leave for consideration here only the cases of the Cincinnati Gas & Electric Co., Docket Nos. 49614 and 50424. In those cases the parties filed a stipulation of facts, together with numerous and voluminous exhibits, which stipulation disposes of all issues raised by the original and amended pleadings, with the exception of a single issue of law hereinafter discussed. All stipulations above mentioned, and exhibits thereto, are here adopted in full as our findings of fact in the respective cases to which they pertain, and will be given effect in the recomputation of the deficiencies under Rule 50, where applicable.

The issue for decision is whether or not the Cincinnati Gas & Electric Co., hereinafter called petitioner or lessor, is entitled to deductions from gross income for depreciation or obsolescence in respect of physical properties owned by it during the taxable years 1923, 1924, and 1925, which properties had theretofore been demised under a long term lease contract.

The petitioner, the Cincinnati Gas & Electric Co., is an Ohio corporation, organized in 1837. On the date of September 1, 1906, petitioner and the Union Gas & Electric Co., hereinafter referred to as the lessee, entered into a lease contract whereby petitioner demised to the latter company, its successors and assigns, subject to the terms of the lease, for a period of ninety-nine years and one month from September 1, 1906, to October 1, 2005, all of its property, real, personal, and mixed, constituting its gas and electric plants for light, heat, power, and fuel purposes.

In the summer of 1914, petitioner proposed that the lessee construct a new electric generating station, deemed necessary to meet increasing demands for power. The lessee refused to finance the construction of the proposed generating station, and in 1916 petitioner and the lessee entered into an agreement dated April 1, 1916, wherein were set forth the provisions of the lease of 1906 in so far as it was agreed that the same should continue in force, together with such modifications as were deemed necessary by reason of conditions that had arisen since the execution of the 1906 contract.

Under date of January 1, 1921, petitioner and the lessee entered into an agreement, embodying in that one instrument all provisions of the lease of 1906, as modified by the lease of 1916, in so far as the same were to continue in force, together with such modifications as were deemed necessary because of conditions arising since 1916. The agreement of January 1, 1921, remained in full force and effect throughout the taxable year 1928, and provided in part material here as follows:

Article second of the agreements provided that the lessee was to pay as rent, (1) an amount equal to 5 percent upon the outstanding capital stock of the lessor, whether then outstanding or thereafter issued with the consent of the lessee; (2) the sum of $27,500 payable in quarterly installments to cover the cost and expense of maintaining the organization of the lessor; (3) amounts equal to the interest on the first and refunding mortgage bonds and interest on the prior lien bonds of the lessor, including the interest, or payments in lieu of interest, on bonds held uncanceled in the sinking funds under the first and refunding mortgage and the prior lien and refunding mortgage; and also amounts equal to the annual sinking fund installments payable under such mortgages; (4) all taxes and charges imposed upon the lessor on account of its property, capital stock, dividends, rents, and income; (5) rents for the use or occupation of any part of the demised premises; and (6) office quarters for' the lessor to be furnished without charge in the lessee’s office building.

Other material provisions of the agreements are as follows:

Article Fourth. Subject to Article Eight, the Lessee will maintain and preserve the demised premises as a going concern, will keep the demised premises in good order and repair as a first class and efficient gas and electric plant for light, heat,-power and fuel purposes, and will operate the demised premises in good faith and to the best of the Lessee’s ability so as to meet all reasonable demands of public and private consumers and protect and preserve the rights, privileges, franchises and contracts of the Owner; all of the foregoing to be done at the expense of the Lessee; but the foregoing covenant shall not be construed to require the Lessee to make (a) expenditures for renewals or replacements otherwise than as may be required by Article Eight or (b) expenditures for extensions of the demised premises or for additions thereto or to the operating plants or the equipment thereof or for betterments or improvements, or for Capital Expenditures otherwise than as may be required by Article Eighth, which makes provision (which shall be deemed exclusive) for all Capital Expenditures as therein defined.
Article Fifth. The Lessee, out of the gross receipts of the Lessee from the operation during each year of the demised premises, will set aside the following amounts, viz:
For the year ending April 1, 1921, and on or before such day in each year, two per cent, of such gross receipts, but not less, however, than one hundred thousand dollars.
Such amounts shall constitute a fund (hereinafter termed the Depreciation Fund) and shall be applied in accordance with Article Eighth. Amounts in the Depreciation Fund shall be held by the Lessee separately until so used. * * *
All betterments, extensions, improvements and additional property which shall be acquired by the use of the Depreciation Fund shall be the property of the Owner, and shall constitute part of the demised premises.
* * * * * * * *
Article Eighth. All expenditures for the acquisition of lands, easements, and other rights or interests in real property, or for the acquisition or construction of extensions, betterments or improvements to the' demised premises, or for the equipment of the demised premises, or for any other purpose whatsoever which under the regulations, if any, at the time in force, of the Public Utilities Commission of the State of Ohio or other commission having authority in the premises * * * may properly be chargeable against capital and to the extent they may be so chargeable are hereinafter termed Capital Expenditures. For the purpose of this Article, only such expenditures shall be deemed chargeable against capital for which capital in the form of mortgage bonds may be issued, * * * All such expenditures, to the extent that they can not so be properly charged to capital are hereinafter' termed Non-Capital Expenditures. Non-Capital Expenditures for any calendar year so far as they are for renewals or replacements, shall be made out of the Depreciation Fund so far as it shall suffice for the purpose and so far as it shall not suffice, shall be borne by the Lessee. The Depreciation Fund shall then be applied toward the Capital Expenditures for such calendar year and all Capital Expenditures for which the Depreciation Fund shall not suffice, the Owner will bear as hereinafter stated. The Owner from time to time, at the request of the Lessee, will pay:
(a) as to all Capital Expenditures made or incurred for extraordinary replacements at any time necessary by reason of earthquake, flood or other Act of God, * * * against which insurance is not customarily written by standard insurance companies, the whole thereof;
(b) as to all Capital Expenditures made or incurred on or after the date hereof, or prior thereto and not heretofore paid by the Owner to the Lessee * * * the whole thereof;
(c) as to all other Capital Expenditures made or incurred on or after the date hereof or prior thereto and not heretofore paid by the Owner to the Lessee, eighty (80) per cent thereof;
The balance of said Capital Expenditures in the foregoing clause (e) shall be paid by the Lessee.
But the foregoing expenditures in (a), (b) and (c) are to be paid by the Owner only so long as there are funds available from the proceeds of the issue of Bonds under the First and Refunding Mortgage or of Prior Lien Bonds under the Prior Lien and Refunding Mortgage or of notes secured by bonds of either of said issues.
* * * * * * *
All betterments, extensions, improvements and additional property in respect of the cost of which, or of any part of the cost of which the Owner and Lessee shall make payment pursuant to this Article shall on such payment become the property of the Owner and shall be deemed a part of the demised premises.
* * * * * * *

Under date of January 1, 1924, petitioner and the lessee, in order to provide for additions to the demised premises and for the extension of service to additional territory and other matters, entered into an agreement which set forth therein the provisions of the lease of 1906, as modified by the agreements of 1916 and 1921, in so far as the same were to be continued in effect, together with certain further modifications. The contract of January 1, 1924, remained in force and effect throughout the taxable years 1924 and 1925. Such contract did not modify the agreement of 1921, in respect to the provisions set forth above, in any manner material here, except that article fifth as amended required the lessee to set aside for the year ending April 1, 1924, and for each year thereafter, a minimum depreciation fund of $250,000.

The legal principles applicable to the matter in controversy here appear to be well settled by prior decisions of the Board and the courts, and the parties so concede. Difficulty arises only in their application. The issue presented is narrowed to the single question whether petitioner, as lessor, itself suffered the loss resulting from depreciation of the leased properties in the taxable years, or whether such loss was made good to it by the lessee. If petitioner sustained the loss, without compensation therefor or reimbursement by' the lessee, petitioner is entitled to the deductions claimed by it but denied in whole by respondent. If it did not sustain such loss, then respondent’s determination must be approved. The amounts of the deductions, if allowable, have been stipulated by the parties.

Solution of the issue depends upon a proper construction of the provisions of the lease contracts referred to above. Under article fifth of the agreements of 1921 and 1924, in effect during the taxable years, the lessee at its expense was obligated to “maintain and preserve the demised premises as a going concern”, and to “keep the demised premises in good order and repair as a first class and efficient gas and electric plant.” This obligation, of course, did not go to the extent of placing upon the lessee losses resulting from depreciation. While keeping the property in good order and repair would tend to extend the period of its useful life, repairs alone, no matter how carefully and extensively made, could not fully offset the effects of depreciation. Ultimately the useful life will be terminated through exhaustion, wear and tear. When that point has been reached, the property must then be renewed or replaced.

However, in the instant case, all such renewals or replacements were to be paid for by the lessee, and when made became the property of the lessor and a part of the demised premises, to be maintained, repaired, and replaced by the lessee during the term of the lease. By article fifth of the contracts, the lessee was required to set aside, out of its gross receipts from operation of the property, a so-called depreciation fund consisting of 2 percent of the gross receipts, and by article eighth it was provided that all expenditures for renewals or replacements should be made out of the depreciation fund so far as sufficient for that purpose, and so far as insufficient should be borne by the lessee. It appears from the record that the period of time covered by the leases was far in excess of the useful life of the depreciable property involved, and that petitioner’s property, which was in use during the taxable years, will have become worn out and replaced by the lessee probably several times prior to expiration of the leases. It seems clear, therefore, in so far as concerns the property in use during the taxable years 1928, 1924, and 1925, since such particular property will be worn out and replaced by the lessee long prior to termination of the lease in the year 2005, no part of the loss from depreciation sustained in the taxable years will fall upon the lessor, petitioner herein.

Whether, and if so to what extent, petitioner will ultimately sustain a loss on account of depreciation of the property last installed by the lessee as renewals or replacements, and which property will have become deteriorated through exhaustion, wear, and tear to some degree at the expiration of the leases, we do not know and need not here attempt to inquire. Such loss, if any, as may be allowable to petitioner in that connection should be spread over the life of the property involved, but in no event is deductible in the taxable years before us as depreciation sustained on the property in use in those years.

In addition to the foregoing, it must be held that petitioner sustained no loss on account of depreciation of its physical properties in the taxable years for which it was not compensated by the lessee, because of the fact that the lessee was required to make, and did make, expenditures of its own funds for “betterments, extensions, improvements and additional property”, all of which immediately became the property of petitioner and a part of the demised premises. A portion of such expenditures was required to be made directly by the lessee. The balance of all expenditures for capital assets was required to be made by petitioner in the first instance, but only out of the proceeds from the sale of its bonds, and the lessee was obligated to pay both the interest and sinking fund installments due on the bonds. Apparently this arrangement was made to enable the lessee to finance the cost of additions and betterments through the issuance of bonds secured by mortgages on the leased properties, but it is obvious that the cost of all the capital acquisitions is ultimately to be borne wholly by the lessee, as well as the expense of subsequent repairs, maintenance, and replacement of the additional property. The amounts required so to be expended by the lessee were far in excess of the deductions for depreciation claimed by petitioner. The lessee more than restored the capital investment of petitioner lost through depreciation in the taxable years. See A. Wilhelm Co., infra, where, we said, in the light of similar facts:

The revenue act provides that in computing net income a deduction may be taken of a reasonable allowance for exhaustion, wear and tear. What is a reasonable allowance must be determined from all the facts and circumstances. In the peculiar circumstances here involved, considering that the lessee was bound to make good all depreciation by replacements or additions, it is our opinion that no allowance could be justified as reasonable.

Deductions for depreciation were denied to the lessor in A. Wilhelm Co., 6 B. T. A. 1; Georgia Railway & Electric Co. v. Commissioner, 11 Fed. (2d) 897; certiorari denied, 296 U. S. 601; Atlantic Coast Line Railroad Co., 31 B. T. A. 730; affd., 81 Fed. (2d) 309; certiorari denied, 298 U. S. 656, and other cases referred to therein. Despite differences in the provisions of the leases, we think the controlling facts in the cited cases are substantially the same as in the cases at bar.

In A. Wilhelm Co., the lessee agreed to return assets of as great value as then existed, and during the taxable year made repairs and installed new equipment of a value in excess of depreciation. In the Georgia Railway & Electric Co. case, the lessee was bound to maintain the property in its then state of efficiency, good order, repair, and condition, and to furnish at its own cost all new equipment. In Atlantic Coast Line Railroad Co. the lessee was obligated, at its own cost and expense, to keep up, repair, and renew the leased properties and return the same to the lessor at expiration of the lease in good order and condition, ordinary wear and tear excepted, but all additions and betterments were to be paid for in bonds and/or stock of the lessor at market prices. In the present proceedings, the lessee is required (1) to maintain, preserve, and keep the demised premises in good order and repair as a first class and efficient gas and electric plant; (2) to make expenditures out of its own funds for all renewals or replacements; and (3) to pay out of its own funds the cost of all additions and betterments. Thus, petitioner will have returned to it at the expiration of the lease assets of a value greatly in excess of the value of its plant in 1906.

Petitioner cites and relies upon the decisions in the following cases, where the deductions for depreciation were allowed to the lessor: Richmond Belt Railway Co., 13 B. T. A. 1291; Terminal Realty Corporation,, 32 B. T. A. 623; and Gulf, Mobile & Northern Railroad Co. v. Commissioner, 83 Fed. (2d) 788; certiorari denied, 299 U. S. 574. The facts, we think, distinguish the cited cases from the present proceedings.

In the first case cited by petitioner, the lease was nothing more than an operating agreement, which might be terminated upon 60 days’ notice, and the rental to be paid was a share of the gross income. The lessees were only obligated to maintain the property in good repair and operating conditions, and were not required to pay for renewals or replacements, nor for additions or betterments. There, clearly, the loss from depreciation fell upon the lessor.

In Terminal Realty Corporation, the property was leased for a period shorter than its probable physical life, and the lessee was required merely to maintain the property in a good and safe condition and to make necessary repairs and replacements. Since the lease covered a period less than the useful life of the property, replacements, if any, made by the lessee could not be expected to offset the effects of depreciation, and hence the lessor would suffer a loss on account of depreciation resulting from the use of the property in the taxable years. So, deductions for depreciation were allowed to the lessor in order to spread such loss over the years in which it was in fact sustained. An entirely different situation is present in the instant case.

In Gulf, Mobile & Northern Railroad Co., supra, the court pointed out in its opinion that nothing was said in the leases about the condition in which the property was to be returned to the owner. The lessees were not required to return the property in as good condition as when received, or to pay a reasonable allowance for its exhaustion, wear and tear, and obsolescence. Here petitioner is more than compensated for any loss on such account.

On the issue submitted for decision, respondent’s action is approved.

Reviewed by the Board.

In Docket No. 46903, judgment of no deficiency and no overpayment will be entered. In the remaining docket numbers, judgment will be entered under Rule 50.

Disney concurs only in the result.

Black dissents.


author: Harron:

text:
    Phebe Warren McKean Downs, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 86798.
    Promulgated December 9, 1937.

      Virgil Y. Moore, Esq., for the petitioner.

      F. B. Shearer, Esq., and D. A. Taylor, Esq., for the respondent.
   OPINION.

Harron:

Respondent has conceded that petitioner properly deducted $5,000 from gross income which represented interest paid by petitioner on her indebtedness to a trust created by the will of her father. There is no issue remaining as to this item. The two remaining issues relate to whether petitioner is taxable on the net income of two trusts of which she was the grantor.

Respondent contends that the income of the first trust created in 1923 is taxable to the petitioner under the provisions of section 167 of the Revenue Act of 1934, quoted below. The first trust was created in 1923 by the petitioner with her children and grandchildren as the beneficiaries. None of the income of the trust was, under the terms of the trust, currently distributable to the grantor or could, in her discretion, be accumulated for future distribution to her. There was no provision in the trust instrument for revesting in the grantor title to the corpus of the trust. In fact, the trust was expressly “declared by Grantor, after due consideration, to be irrevocable.” All of the children of the grantor, who were the immediate income beneficiaries, had already attained their majority at the time of creation of the trust so that the respondent concedes that the income would not be taxable as that of the grantor under the principle of Douglas v. Willcuts, 296 U. S. 1; Helvering v. Stokes, 296 U. S. 551; and Helvering v. Schweitzer, 296 U. S. 551, because it did not go to discharge any legal obligation of the petitioner’s to support her minor children. The respondent’s case rests on the power reserved by the petitioner to alter the distributive shares of the distributees and his theory is, that under this reserved power the grantor might reduce the distributive shares of every beneficiary of income or principal to a nominal sum of, for example, $1 each. Then, since there was no disposition in the trust instrument of the balance of the income and principal, there would arise by operation of law a resulting trust in the grantor, and presumably she could draw down such principal and any accumulated income upon a possible termination of the trust. We do not need to consider the question of whether she could obtain a termination of the trust during her lifetime, under the law of resulting trusts, which appears doubtful and which apparently would be a necessary condition to the application of either section 167 or section 166 of the Revenue Act of 1934. We believe respondent’s position must be disapproved on his construction of the power reserved by the grantor in the trust instrument itself.

We are of the opinion that the grantor did not retain the power to reduce the share of income and principal of every distributee to a nominal sum and thus effect a resulting trust for herself, but that all of the income and principal was required to be distributed to beneficiaries of the classes specified in the trust instrument and that the only power retained was to alter the distribution as among those beneficiaries. This conclusion is based on our construction of the whole instrument, together with the apparent intention of the grantor as manifested therein, and the conduct of the parties during its operation. At the very outset the instrument provides for current distribution of the “entire net income” to the named beneficiaries. It then provides minutely the terms of distribution of income and principal to children and grandchildren and descendants of deceased children and grandchildren, with no reservation whatever of any income or remainder interest in the corpus to the grantor. But the respondent’s case is based upon his construction of the last paragraph of the instrument. It reads: “All the trusts herein named and established are declared by Grantor, after due consideration, to be irrevocable, save and except that Grantor reserves the right by deed duly executed by her and lodged with Trustees to alter, vary and change the distributive shares of any and all distributees of either principal or income under this deed.” The general grant is contained in the first part of the sentence and clearly declares the instrument to be irrevocable; the “save and except” clause, like any exception to a grant, must necessarily be something of a smaller quantum than the grant itself else the grant would be a nullity. That construction is favored which makes the grant effective, and the trust instrument is always construed against the grantor and in favor of the beneficiaries. The excepting clause here, since it is an excepting clause, must be limited despite its broad terms to the power to alter the distribution as between beneficiaries of the named classes, for otherwise, as the respondent rightly contends, it would comprise the power to revoke, which is absolutely inconsistent with the preceding clause containing the irrevocable] grant. When the trust instrument was declared to be irrevocable we! think that meant irrevocable by any means whatever, whether by a direct revocation or by the exercise of a power reserved under the instrument coupled with the operation of a rule of law such as the rule regarding resulting trusts. We do not think the grantor’s reserved power extended any farther than to alter the distribution as between the classes of beneficiaries specified. It does not appear to have been the grantor’s intention to retain any interest whatever in the income or corpus of the trust for herself, and in the construction of a trust instrument the intention of the grantor is of utmost importance. The instrument carefully provides for the distribution of principal and income to her descendants upon all possible contingencies and the grantor is not named as a beneficiary under any conditions. Furthermore, the conduct of the parties to the trust which can be looked to for assistance in the construction of a trust instrument also bears out our conclusion. Although she made seven alterations in the distributive shares of beneficiaries at various dates from 1923 to 1935, she never attempted in any of these changes to prevent the distribution of the entire net income and principal of the trust to the beneficiaries or to cause any of it to be returned to herself. In fact all of the net income was each year distributed to all of the named beneficiaries.

Construing her reserved power as limited to alterations of the distribution as among beneficiaries of the classes named in the trust instrument, the petitioner is not taxable upon the income of this trust under either section 167 or 166 because there was no possibility whatever of her obtaining possession or beneficial use of either the principal or income of the trust. The $13,426.84 income of this trust, for the year 1934, is not taxable to the petitioner.

The second trust with which we are concerned was created by the petitioner on May 22, 1931. Under its terms $4,000 was to be paid annually to grantor’s then daughter-in-law, Anne Merrick Downs, out of the income of the trust if sufficient, and if not, the deficiency in any year was to be paid out of principal. Any excess of income over $4,000 was distributable to the grantor. In the tax year involved there was such an excess which was distributed to the petitioner and she paid income tax thereon. The daughter-in-law was contemplating a divorce at the time of creation of the trust, and the trust instrument provided that the trust should terminate at the time of her death or remarriage and the corpus of the trust should be paid over to the grantor or to her inter vivos assignees or appointees by will. The grantor had no management or other powers Over the corpus for the duration of the trust. The trust was expressly made irrevocable.

The respondent is attempting to tax as income to the petitioner the $4,000 earned by the trust and paid to Anne Merrick Downs during the taxable year, in other words, respondent’s contention is that all of the income of such a trust is taxable to the donor under section 166. The theory on which he bases this tax is not altogether clear. The deficiency letter lumps together both this trust and the one discussed above and says that the income of both is taxable to the grantor because “the agreement creating the trusts” reserves the right in the grantor to “alter, vary and change the distributive shares of any and all distributees of principal or income.” However, the trusts are in actuality two separate trusts and the instrument creating the Anne Merrick Downs trust contains no such reservation as that quoted in the deficiency letter and no power of alteration whatever was reserved.

At the hearing the respondent’s counsel by his line of questioning indicated that he was attempting to show that the trust was established for the purpose of legally benefiting the grantor by warding off, for example, a suit for alienation of affections by Anne Merrick Downs against the grantor. However, none of the testimony supported such premise. There are no facts present to show that the income remained “in substance that of the grantor” within the rationale of Douglas v. Willcuts, 296 U. S. 1; see Regulations 94, art. 166-1. There was no legal obligation of any kind owing by the grantor to Anne Merrick Downs, nor does it appear that there was any motive of tax avoidance in establishment of the trust by the petitioner rather than by her son because it affirmatively appears that the son was without the property necessary to furnish the required trust corpus. There was not and is not any agreement for repayment by the son to the petitioner on account of her establishment of the trust. She received no legal benefit and discharged no legal obligation by her act and is, therefore, not taxable under the principle of Douglas v. Willcuts, supra.

On brief the respondent elected to submit his case on this issue “without argument.” It is our opinion that respondent’s action respecting the income of the second trust is in error because clearly the trust, by its terms, does not have such characteristics as would result in the application of section 167, Revenue Act of 1934, and we are of the opinion that it is not such trust as comes within the provisions of section 166 quoted in the margin. That section deals with “revocable trusts”, which are a well understood type of trust where a power to revoke either in whole or in part is retained by the grantor. Here the trust was expressly declared to be “irrevocable” in its entirety, the grantor being without power “at any time to revoke, change or annul any of the provisions herein contained.” Respondent has not argued that the possibility of a reversion to the grantor upon the death or remarriage of Anne Merrick Downs brings the trust within section 166. A possibility of a reverter is, in our opinion, different from “the power to revest” which is comprehended by section 166. We have here a trust for an indefinite term, “pour autre vie” or until the occurrence of a contingency over which the grantor has no control. No exercise of volition by the grantor is required nor would have any effect upon the return of the corpus to her. When and if it returns to the grantor or her assignees or appointees it will return by operation of the terms of the trust instrument itself and not by the exercise of any “power” retained by the grantor. We believe such a trust is not covered by the terms or intendment of section 166. See United States v. First National Bank of Birmingham, 74 Fed. (2d) 360, where a trust for a term of one year at the end of which the trust property would revert to the grantor was held to be without the scope of section 166 of the Revenue Act of 1928, which contains language of apparently the same import in the particulars material to this question as section 166 of the Revenue Act of 1934. See also, Magill, Taxable Income, pp. 281, 282. But compare Warren H. Corning, 36 B. T. A. 301, where the facts are distinguishable. There a grantor was held taxable under section 166 of the Revenue Act of 1934 on income of a trust with a power of the ordinary type to amend or revoke although exercisable only upon certain conditions.

We are satisfied that under its terms the trust is outside the scope of both sections 166 and 167.

Petitioner has made claim for a refund and it appears that the Commissioner has made an adjustment in the item of foreign dividends in his determination, not at issue. Therefore, although all the issues are decided for the petitioner, a recomputation may be necessary under Rule 50.

Decision will be entered under Rule 50.

       SEC. 167. INCOME FOR BENEFIT OF GRANTOR.
      (a) Where any part of the income of a trust—
      (1) is, or in the discretion of the grantor or of any person not having a substantial adverse interest in the disposition of such part of the income may be, held or accumulated for future distribution to the grantor; or
      (2) may, in the discretion of the grantor or of any person not having a substantial adverse interest in the disposition of such part of the income, be distributed to the grantor; or
      (3) is, or in the discretion of the grantor or of any person not having a substantial adverse interest in the disposition of such part of the income may be, applied to the payment of premiums upon policies of insurance on the life of the grantor (except policies of insurance irrevocably payable for the purposes and in the manner specified in section 23 (o) relating to the so-called “charitable contribution” deduction) ; then such part of the income of the trust shall be included in computing the net income of the grantor.
      (b) As used in this section, the term “in the discretion of the grantor” means “in the discretion of the grantor, either alone or in conjunction with any person not having a substantial adverse interest in the disposition of the part of the income in question.”

       SEC. 166. REVOCABLE TRUSTS.
      Where at any time the power to revest in the grantor title to any part of the corpus of the trust is vested—
      (1) in the grantor, either alone or in conjunction with any person not having a substantial adverse interest in the disposition of such part of the corpus or the income therefrom, or
      (2) in any person not having a substantial adverse interest in the disposition of such part of the corpus or the income therefrom, then the income of such part of the trust shall be included in computing the net income of the grantor.

       SEC. 166. REVOCABLE TRUSTS.
      Where the grantor of a trust has, * * * the power to revest in himself title to any part of the corpus of the trust * * *. [Italics supplied.]

       SEC. 166. REVOCABLE TRUSTS.
      Where * * * the power to revest in the grantor title to any part of the corpus of the trust is vested—
      (1) In the grantor, * * *. [Italics supplied.]


author: ARNOLD:

text:
    Estate of Frank R. McDermand, Jr., Deceased, Helen H. Nelson, Administratrix, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 74852.
    Promulgated December 15, 1937.

      William, J. Carroll, Esq., for the petitioner.

      Clay C. Holmes, Esq., and E. L. Webber, Esq., for the respondent.
   OPINION.

ARNOLD:

The controlling provisions of the statute occur in the last portion of section 302 (g) of the Revenue Act of 1926, which is set out in full in the margin. It is stipulated that respondent has given effect to the $40,000 exemption, and to the payments made pursuant to the agreements of August 8, 1929, and April 26, 1930, in determining the “amount receivable by all other beneficiaries.” The question is not as to the proper amount to be included, but whether any amount should be included in determining the value of the gross estate.

It is petitioner’s contention that there was no amount receivable by the administratrix as insurance under policies taken out by the decedent upon bis own life; that there was no excess over $40,000 of the amount receivable by all other beneficiaries as insurance under policies taken out by the decedent upon his own life; that the proceeds of the policies here in question were the absolute property of the beneficiary, Helen H. McDermand, subject only to the right of the company to be repaid therefrom the amount of its advances for premiums plus interest and the additional sum of $25,000; that to apply section 302 (g) violates the Constitution and the Fifth Amendment thereof.

Petitioner cites numerous cases which, it is asserted, support her position, but it seems that none of these decided cases involved the exact situation now presented. There is no question here but that decedent personally applied for the policies in question. The applications show this conclusively, and the insurance contracts show that the payment of premiums was primarily decedent’s obligation.

Turning from the applications for and policies of insurance to the agreements, hereinabove set forth, we find certain reasons recited therein for the taking out of these policies by the decedent. It is stated that the death of decedent in the next several years “would be a serious loss” to the company. It is further stated that decedent was “desirous of having his life insured in favor of his wife, * * * and desires the aid of ’ the company “in providing for and paying the premiums on such insurance." (Italics supplied.) Following which the parties set forth their mutual covenants; decedent agreed to insure his life in favor of his wife for $174,500 (increased to $200,000 by the supplemental agreement), and the company agreed to pay the premiums. If the parties had stopped there we would have a more difficult question; but there were additional covenants. The company was to pay the premiums until decedent’s death, or until he attained 40 years of age. If decedent died before he attained the age of 40 the company was to collect $25,000 insurance and was to be repaid the advances for premiums paid plus interest at 5 percent on each premium payment. The company was protected as to the repayment of these advances by making the beneficiary a trustee of the proceeds to the extent of the company’s interest therein, and by the policies being “pledged as collateral security to said payment.”

Repayment of the company’s advances, in the event the decedent survived the age of 40, was also'provided for under the agreement. If decedent survived the age of 40, he and his wife “agree and shall pay” the company, “its successors or assigns, a sum of money equivalent to all sums paid by” the company “to and upon the premiums for insurance aforesaid, together with interest thereon” at 5 percent per annum. Thereafter, no further obligation rested upon the company to pay the premiums, and upon receiving payment for its advances the company “shall have no right, title nor claim in or to said insurance or any of the proceeds arising therefrom.”

The terms of this agreement were carried out. Decedent’s death occurred less than two years after the agreement was consummated. The company had sought by the contract to protect itself against loss from the death of its president to the extent of $25,000. This protection was secured by the agreements hereinabove set forth, rather than by taking out a policy in its own right upon the life of its chief executive. The company profited from this arrangement because it secured the protection against loss without the cost of the insurance if decedent survived the age of 40. It should be noted that the company bound itself to pay no part of the insurance premiums. Under the contract, it was to advance the money necessary to pay the. premiums, but it was to be repaid a sum equivalent to all premiums paid by it. There was no provision binding the company to pay the premiums on the $25,000 insurance carried on decedent’s life for its own benefit. Decedent agreed to repay all the advances for premiums made by the company, either out of the proceeds if he died before 40, or personally if he survived 40. His wife, the sole beneficiary, agreed to be bound by this arrangement, which clearly limits the amount of the proceeds that she would receive under the policies. In other words, she agreed to take the net proceeds of the policies after these payments were made to the corporation.

In view of the foregoing analysis it is impossible to view the relationship between the decedent and the company as other than that of debtor and creditor. Every feature of the agreement points to that relationship. Every act of the parties following the execution of the agreement is based upon such relationship. The advances by the company were made to meet decedent’s obligations under insurance contracts. These advances were conditioned upon repayment with interest. The repayment was secured by a pledge of the policies as collateral, and the advances were repaid with interest as agreed in the contract. Any other determination of the relationship existing between decedent and the company would be a distortion of the facts.

Petitioner advances a second contention regarding the payment of the premiums to the effect that, if the company did not pay the premiums, the sole beneficiary did pay them out of the proceeds from the insurance policies, which proceeds the parties have stipulated she received in her individual right. This contention is grounded upon a misapprehension of the contractual rights of decedent’s widow. The contract provided that, if the insured died prior to attaining the age of 40, the beneficiary should pay out of the insurance proceeds to the company, not individually or in her own right, but as a trustee for the company, the amount advanced for premiums plus interest thereon at 5 percent, and plus the $25,000. The balance only of the proceeds was to be her absolute property. By the contract decedent provided for the trust fund out of which the premiums were to be repaid. The funds used for that purpose did not belong to the beneficiary. Decedent’s widow agreed to this disposition of a portion of the insurance proceeds and waived all right thereto by executing the contract.

One of the cases upon which petitioner relies is Wilson v. Crooks, 52 Fed. (2d) 692. The facts in that decision are distinguishable. There the Kansas City Star Co. paid the premiums on insurance upon the life of one of its principal stockholders. The insurance proceeds were to be used to purchase the stockholder’s interest in the Star Co. upon his death, so that the officers and employees of the Star might be able to purchase the shares formerly owned by said stockholder. This was handled through an insurance trust agreement, with a local bank and trust company as trustee. Upon the stockholder’s death the proceeds from said policies were used to buy the stock from his estate. The court denied the contention that payment by the Star was payment by the stockholder of the premiums. The court pointed out that the premiums were paid by the Star for and on behalf of the real beneficiaries, who were the officers and employees of the Star. It was held that, since the stockholder did not pay the premiums and could not divert the proceeds to his estate or to any other than those recipients named in the trust agreement, the proceeds were not includible in his gross estate under section 302 (g).

In Walker v. United States, 83 Fed. (2d) 103, also cited and relied upon by petitioner, the decedent had six policies outstanding on his life, in each of which his wife was named beneficiary. In four policies decedent reserved the right to change the beneficiary. In the other two there was a survival clause requiring payment to decedent’s executors, administrators, or assigns, if his wife predeceased him. On the four policies the beneficiary paid from her own funds slightly more than half of the premiums. The estate tax return included no proceeds from any of the policies. Later the Commissioner included the proceeds from the four policies and collected a tax of $4,872.27. Thereafter the widow filed suit for refund of $3,746.05 upon the ground that the prorated amount of the insurance covered by her contributions to the premiums on these four policies was exempt from tax. The Commissioner denied the claim and pleaded as an offset that an additional tax was due because of his failure to include the proceeds from the other two policies. The court held that the proportion of the proceeds from the four policies purchased by the premiums paid by the beneficiary was not within the intendment of section 302 (g). The court further held, after analyzing the provisions of the two insurance policies, that the proceeds therefrom should not be included in the gross estate and there was no offset as to the refund due decedent’s widow.

The principles stated in the Walker decision, which arose in the circuit within which petitioner resides, are in no way at variance with our decision. Under the court’s decision premiums paid by the beneficiary removed the proceeds pro rata from inclusion in the gross estate. Here, the decedent obligated himself to pay the premium advanced by his company, and the sole beneficiary assented thereto by joining in the contract. This is quite different from the beneficiary, or another ¡party, paying the premiums from his own funds.

Petitioner contends further that there was a sufficient assignment here, the legal effect of which was to divest decedent of all right, title, and interest in the policies and their proceeds and to deprive him of any of the incidents of ownership, citing Guettel v. United States, 67 Ct. Cls. 613. This argument, and the cited case, go to the question of the assignment of the policies. No assignment is shown by the record, unless the petitioner refers to the pledging of the policies as collateral security for the advances made by the company. This did not divest insured of his rights and privileges under the policies not inconsistent with the pledge. Clark v. Equitable Life Assurance Society, 133 Fed. 816. The policy provisions regarding the assignments are all to the same effect; they permit assignments, but require a copy of the assignment to be filed with the insurer, and in at least one policy, Midland Life Insurance Co., policy No. 55691, the assignment, to be binding on the insurer, had to be “by an instrument in writing endorsed upon the policy or attached thereto.” There was no endorsement on such policy nor an attached writing indicating that any assignment thereof was ever made. Furthermore, if there had in fact been an assignment of these policies, the company could have collected in its own right as assignee. Guettel v. United States, supra, p. 618. There would have been no occasion to return the policies to the beneficiary or to make her trustee for the company’s portion thereof.

We can not agree that decedent was divested of all the incidents of ownership with respect to these policies. He pledged the policies to secure the payment of the advances; he did not pass title thereto, but gave a lien on the proceeds in an amount sufficient to repay the advances. In re Herkimer Mills Co., 39 Fed. (2d) 625, 627. Naturally in view of the short period between the time the policies were taken out and decedent’s death, there was no cash surrender or loan value built up. But if the policies had been more than three years old there is nothing in the agreements of August 8, 1929, and April-26, 1930, which would have prevented decedent from taking the cash value of the policies or securing a loan. He would have been indebted to the company for the advances, plus interest, but he could have exercised his rights under the policies despite any provisions appearing in the agreements. As we stated in Bessie M. Ballinger, Executrix, 23 B. T. A. 1312, 1320, “A power in the decedent to surrender and cancel a policy is one of the ‘legal incidents of ownership’ referred to by the Supreme Court in the Chase case, supra [Chase National Bank v. United States, 278 U. S. 327], and upon the termination of the power by death the beneficiary is freed from the possibility of being cut off by decedent and a transfer within the reach of the taxing power of the Government is thereby effected.”

It is our view, therefore, that the proceeds of the six policies, less) the amounts deducted by respondent, were properly included in the decedent’s gross estate. Cf. Bank of America National Trust & Savings Assn. v. Commissioner, 90 Fed. (2d) 981, affirming 34 B. T. A. 684.

We are unimpressed by petitioner’s argument respecting the unconstitutionality of section 302 (g) when applied to situations like that which exists here. It is our opinion that decedent directly provided for payment of the premiums by contract. We are satisfied that he personally applied for the insurance policies in question, and, with the sole beneficiary, arranged for advances to pay his premiums thereon. By contract he established a debtor-creditor relationship. The performance of this contract was equivalent, for the purposes! of the statute in question, of actual payment by decedent from his own funds. No constitutional question is involved, and to suggest one merely beclouds an otherwise clear-cut issue.

Decision will be entered for the respondent.

       Sec. 302. The value of the gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated—
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      (g) To the extent of the amount receivable by the executor as insurance under policies taken out by the decedent upon his own life; and to the extent of the excess-over $40,000 of the amount receivable by all other beneficiaries as insurance under policies taken out .by the decedent upon his own life.