Opinion
Docket Nos. 107303 107344.
1942-12-10
ROBERT W. JOHNSTON, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.T. ALICE KLAGES, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
George A. Reiss, Esq., for the petitioners. Z. N. Diamond, Esq., for the respondent.
1. Petitioners are life income beneficiaries of inter vivos trusts created by their mother in 1921. In 1932 part of the corpus of the trusts consisted of undivided one-half interests in a bond and mortgage on certain real estate. In that year, because of default, the trustees foreclosed and bid in the mortgaged property and held it until January 11, 1937, when it was sold at a loss for cash and a purchase money bond and mortgage having a fair market value equal to par. The trusts were governed by the laws of New York, under which laws the trustees were required to and did allocate to petitioners a certain portion of the proceeds of the sale to take the place of the income and life beneficiaries would have received in the way of interest if no default had occurred in 1932. Held, the portion of the proceeds so allocated to petitioners should be included in computing the net income of petitioners under section 162(b) of the Revenue Act of 1936. Theodore R. Plunkett, 41 B.T.A. 700;affd., 118 Fed.(2d) 644, followed.
2. Under the laws of New York the net income from the operation of the property from January 1 to January 11, 1937, was required to be credited to principal and was not currently distributable income. Held, such net income should not be included in computing the net income of petitioners under section 162(b) of the Revenue Act of 1936.
3. Each petitioner's gross income from the sources specified in section 211(a) of the Revenue Act of 1936 was more than $21,600. Held, petitioners are taxable as provided in subsection (c) of section 211 of the Revenue Act of 1936, which subsection was added by section 501(b) of the Revenue Act of 1937. George A. Reiss, Esq., for the petitioners. Z. N. Diamond, Esq., for the respondent.
These proceeding , duly consolidated, involve determinations by the respondent of deficiencies in income tax against petitioners for the calendar year 1937 in the amounts of $15,390.56 and $15,322.28, respectively.
The above deficiencies are computed upon determined net incomes of $68,082.97 and $67,875.82, respectively. In a statement attached to the deficiency notice mailed to petitioner Johnston the respondent explained his determination of the net income as follows:
Your distributive share of the income of the Trust for Robert W. Johnston under deed of Caroline H. Field for the year 1937, amounting to $68,082.97, has been included in your net income, as follows:
1. Income distributable to you in the amount of $9,231.24 as shown by the return filed by the fiduciary has been included in your net income.
2. The amount of $75,636.26, representing proceeds from the sale of property apportioned to you as life beneficiary of a trust created by Caroline H. Field on November 28, 1921, is taxable to you under the provisions of the Revenue Act of 1936.
3. The amount of $1,215.47, representing trust income for the period January 1 to January 11, 1937, is also taxable under the provisions of the Revenue Act of 1936.
+---------------------+ ¦Summary ¦ +---------------------¦ ¦1. . . . ¦$9,231.24 ¦ +---------+-----------¦ ¦2. . . . ¦57,636.26 ¦ +---------+-----------¦ ¦3. . . . ¦1,215.47 ¦ +---------+-----------¦ ¦Total . .¦$68,082.97 ¦ +---------------------+
Since the aggregate amount of income received by you from sources within the United States during the year 1937 exceeded $21,600.00, you are subject to the tax at the rates imposed by sections 11 and 12 of the Revenue Act of 1936 in accordance with the provisions of section 211 of the Revenue Act of 1936 as amended by section 501 of the Revenue Act of 1937.
In a statement attached to the deficiency notice mailed to petitioner Klages the respondent made a like explanation except that the trust there was ‘for T. Alice Klages‘ and the three items were in amounts as follows:
+-------------------+ ¦1. . . . ¦$9,023.24¦ +---------+---------¦ ¦2. . . . ¦57,637.11¦ +---------+---------¦ ¦3. . . . ¦1,215.47 ¦ +---------+---------¦ ¦Total . .¦67,875.82¦ +-------------------+
Petitioners do not contest item (1) in the amounts of $9,231.24 and $9,023.24, respectively, but by appropriate assignments of error both petitioners contest both items (2) and (3) and in addition both petitioners allege that:
The respondent erred in determining that petitioner is subject to tax, for the calendar year 1937, at the rates imposed by Sections 11 and 12 of the Revenue Act of 1936 in accordance with the provisions of Section 211 of said Act as amended by Section 501 of the Revenue Act of 1937.
FINDINGS OF FACT.
1. Petitioner Robert W. Johnston throughout the calendar year 1937 and at all times hereinafter mentioned was a citizen of Great Britain, a nonresident alien of the United States not engaged in trade or business within the United States and having no office or place of business therein.
2. Petitioner T. Alice Klages (formerly T. Alice Johnston) throughout the year 1937 and at all times hereinafter mentioned was, and still is, a citizen of Germany. Throughout the calendar year 1937 and at all times hereinafter mentioned she was a nonresident alien of the United States not engaged in trade or business within the United States and having no office or place of business therein. Since September 1939 she has been, and now is, living in the United States.
3. The ‘fiduciary income tax return,‘ Form 1041, for the calendar year 1937, and the ‘annual return of income tax to be paid at source,‘ Form 1042, for the calendar year 1937, hereinafter mentioned, were filed in the office of the collector of internal revenue for the second district of New York. No income tax return was filed by either petitioner.
4. By an instrument in writing dated November 28, 1921, Caroline H. Field (formerly Caroline H. Johnston), the mother of petitioners, transferred and conveyed to Harris D. Colt and A. Henry Mosle, citizens of the United States and residents of the State of New York, as trustees, certain improved real estate located in the Borough of Manhattan, City, County, and State of New York, and more particularly described therein, to have and to hold the same upon the trusts therein set forth, for the benefit of the grantor's son, petitioner Robert W. Johnston, the grantor's daughter, petitioner T. Alice Johnston (now Klages), and the grantor's daughter, Marguerite L. Johnston. Among other things the trust instrument provided that the trustees were:
TO HAVE AND TO HOLD the property hereby granted and assigned to the trustees and the survivor of them, their or his successors and assigns, in three (3) equal shares or portions, but upon the following separate and distinct trusts and conditions:
FIRST: To take possession and management of one of said equal shares or portions, to reinvest the same and keep the same invested, to collect and receive the rents, issues, profits and income thereof during the life of my son ROBERT W. JOHNSTON, and after paying therefrom the expenses attending the said first estate, to pay the net income— half yearly or at such other periods as to the trustees may be practical and convenient— to, or to apply the same to the use of my said son ROBERT W. JOHNSTON, during the term of his natural life, and to take possession and management of one other of said equal shares or portions, to reinvest the same and keep the same invested, to collect and receive the rents, issues, profits and income thereof during the life of my daughter T. ALICE JOHNSTON, and after paying therefrom the expenses attending the said trust estate, to pay the net income— half yearly or at such other periods as to the trustees may be practical and convenient— to, or to apply the same to the use of my said daughter T. ALICE JOHNSTON, to her sole and separate use and free from any right estate or control of any husband, during the term of her natural life; upon and after the death of said ROBERT W. JOHNSTON and T. ALICE JOHNSTON, respectively, to convey, assign and pay over the said equal share or portion held for the one so dying to his or her lawful issue respectively, in equal shares per stirpes and not per capita, absolutely and in fee simple.
Paragraph seventh of the trust instrument was as follows:
SEVENTH: It is understood and agreed that this instrument is to be in all respects governed by the laws of the State of New York, but the securities belonging to said trusts estates respectively may be kept within the State of New York or elsewhere in the discretion of said trustees.
5. The trustees in their records and income tax returns have treated said instruments as creating three separate and distinct trusts, one for the benefit of petitioner Johnston, one for the benefit of petitioner Klages, and one for the benefit of said Marguerite L. Johnston. For the purposes of these proceedings the parties have agreed that the trust indenture may be regarded as creating separate trusts aforesaid, which may be referred to as such.
6. In July 1930 the trust for Marguerite L. Johnston was terminated by her death and thereafter in 1930 by appropriate instrument of transfer one-half of the corpus thereof was added to petitioner Johnston's trust and one-half was added to the trust for petitioner Klages.
7. In the year 1932 part of the corpus or principal of each trust consisted of an undivided one-half interest in a purchase money bond and mortgage on the real estate mentioned in paragraph 4 hereof in an aggregate principal amount of $600,000. The bond and mortgage were received from the purchaser on the sale of said real estate made by the trustees in 1924 to secure the unpaid balance of the sale price.
8. In September 1932, default having occurred in the payment of interest, the trustees began proceedings to foreclose the bond and mortgage. On December 13, 1932, the trustees bid in the mortgaged premises on the foreclosure sale for $600,000.
9. On December 13, 1932, the amount of the unpaid principal of the bond and mortgage was $600,000 and no interest had been paid thereon since February 1, 1932. The rate of interest stipulated in the bond and mortgage was 5 1/2 percent per annum. Foreclosure costs and expenses and taxes paid amounted to $27,262.50.
10. The real estate acquired in foreclosure as aforesaid continued to be held by the trustees, under the instrument of November 28, 1921, and was regarded by them as a part of the principal or corpus of the trusts, from December 13, 1932, until January 11, 1937, when said real estate was sold, as more fully hereinafter set forth.
11. The net income of each petitioner's trust from the operation by the trustees of the real estate for the period January 1 to January 11, 1937, was $1,215.47. That amount was credited by the trustees to the principal account of each petitioner's trust in partial reimbursement of the account for advances previously made therefrom to defray each trust's share of the costs, expenses, and taxes incurred and paid in connection with the foreclosure proceeding. No part of the net income in the total amount of $2,430.94 (twice $1,215.47) was in 1937 or at any other time paid or credited by the trustees to either petitioner, but it was treated by the trustees as nondistributable trust income, taxable to the trustees. This amount was not included by the trustees on their fiduciary income tax return, Form 1041, filed by them for each trust for the year 1937, as income distributable to the respective petitioner, but was reported by them in that return in item 6 as ‘Rents and royalties.‘
12. On January 11, 1937, the said real estate was sold by the trustees for $550,000, for which the trustees received $100,000 in cash and the purchaser's bond and mortgage for $450,000 to secure payment of the balance. For the purposes of this proceeding, it is agreed by the parties hereto that the fair market value of this bond and mortgage was the face amount thereof.
13. For each trust's share of the net proceeds of the sale on January 11, 1937, petitioner Johnston's trust received $44,577.55 in cash and an undivided one-half interest in the $450,000 bond and mortgage, and petitioner Klages' trust received $44,581.55 in cash and an undivided one-half interest in the $450,000 bond and mortgage. The trustees, on their fiduciary income tax return, Form 1041 filed for each petitioner's trust for the year 1937, reported a loss sustained by the trust on the sale in figures as follows:
+----------------------------------------------------------------+ ¦Sale price (one-half undivided interest)¦ ¦$269,960.73¦ +----------------------------------------+-----------+-----------¦ ¦Cost (one-half undivided interest) ¦$313,631.25¦ ¦ +----------------------------------------+-----------+-----------¦ ¦Less depreciation ¦12,813.77 ¦300,817.48 ¦ +----------------------------------------+-----------+-----------¦ ¦Actual loss ¦ ¦30,856.75 ¦ +----------------------------------------+-----------+-----------¦ ¦Recognized loss (60%) ¦ ¦18,514.05 ¦ +----------------------------------------------------------------+
14. At the time of the sale of the premises on January 11, 1937, as set forth in paragraph 12 hereof, interest computed at the 5 1/2 percent per annum rate stipulated in the foreclosed mortgage on the principal amount of $600,000 for the period from February 1, 1932 (the last date to which interest was paid) to January 11, 1937 (the date of sale) amounted to $163,166.66, no part of which at any time has been paid or credited to either of the trusts or by the trustees to either petitioner. The amount of $163.166.66 is 21.380213 percent of the aggregate ($763.166.66) of mortgage principal, $600,000, plus interest, $163,166.66. Said amount of $600,000 is 78,619787 percent of the aggregate of $763.156.66.
15. The following schedules for each trust are the results obtained by applying the percentages set forth in paragraph 14 hereof to the proceeds of the sale on January 11, 1937, received by each trust as set forth in paragraph 13 hereof, that is, (a) to the net cash proceeds, and (b) to the undivided one-half interest in the bond and mortgage:
+--------------+ ¦Johnston Trust¦ +--------------¦ ¦ ¦ ¦ ¦ +--------------+
(a) (a) (1) 21.380213% of $44,577.55 = $ 9,530.78 (a) (2) 78.619787% of $44,577.55 = 35,046.77 ---------- ---------- 100% 44,577.55
(b) (b) (1) 21.380213% of $225,000 = $48,105.48 (b) (2) 78.619787% of $225,000 = 176,894.52 ---------- ---------- 100% $225,000.00
Klages Trust
(a) (a) (1) 21.380213% of $44,581.55 = $9,531.63 (a) (2) 78.619787% of $44,581.55 = 35,049.92 ---------- ---------- 100% 44,581.55
(b) (b) (1) 21.380213% of $225,000 = $48,105.48 (b) (2) 78.619787% of $225,000 = 176,894.52 ---------- ---------- 100% $225,000.00
16. Out of the net cash proceeds of the sale, $44,577.55, received by petitioner Johnston's trust, the trustees in 1937 paid or credited to petitioner Johnston the amount of $9,530.78 computed the determined as set forth in (a)(1) of the foregoing schedule pertaining to his trust. The balance of the $44,577.55, to with, $35,046.77, being the amount computed and determined as set forth in (a)(2) of said schedule, was retained in and as a part of the corpus of the Johnston trust and no part thereof has at any time been paid or credited to petitioner Johnston.
Out of the net cash proceeds of the sale, $44,581.55, received by petitioner Klages' trust, the trustees in 1937 paid or credited to petitioner Klages the amount of $9,531.63 computed and determined as set forth in (a)(1) of the foregoing schedule pertaining to her trust. The balance of the $44,581.55, to wit, $35,049.92, being the amount computed and determined as set forth in (a)(2) of said schedule, was retained in and as a part of the corpus of the Klages trust and no part thereof has at any time been paid or credited to petitioner Klages.
17. No part of the amount of $48,105.48 computed and determined as set forth in (b)(1) of each schedule was, during the year 1937, paid or credited to either petitioner except as follows: In April, July, and October of 1937 each petitioner's trust received payments aggregating $7,500 in reduction of the principal of its undivided one-half interest in the $450,000 bond and mortgage. Thereafter and in 1937, 21.380213 percent of the trustees and 78.619787 percent or $5,896.50 was retained in and as a part of the corpus or principal of each petitioner's trust and no part thereof has at any time been paid or credited to either petitioner. No part of the $1,603.50 was reported by the trustees in their fiduciary income tax return, Form 1041, filed for each trust for 1937, nor in their annual returns of income tax to be paid at source, Form 1042, for said year.
18. The crediting to the principal of each trust of the amount of $1,215.47 as set forth in paragraph 11 hereof, the determination of the percentages as set forth in paragraph 14 hereof, the application of the percentages as set forth in paragraph 15 hereof, and the payment to petitioner Johnston of the amounts $9,530.78 and $1,603.50 and the payment to petitioner Klages of the amounts of $9,531.63 and $1,603.50 as set forth in paragraphs 16 and 17 hereof, all were done by the trustees pursuant to their interpretation and understanding of the law of the State of New York.
19. The trustees, in their fiduciary income tax return, Form 1041, filed for each trust for the year 1937, did not include as income of the respective trust or as income of the respective trust distributable to or paid or credited to petitioners, the said amounts of $9,530.78 and $1,603.50, and $9,531.63 and $1,603.50, respectively, which were paid or credited to petitioners as set forth in paragraphs 16 and 17 hereof. These amounts were not included in the annual return of income tax to be paid at source, Form 1042, filed by the trustees for each trust for the year 1937, nor was any tax withheld or paid at source on said amounts, but the fact of such payments was set forth and disclosed in a rider attached to each petitioner's return. The rider attached to the fiduciary income tax return, Form 1041, for petitioner Johnston's trust (substantially similar riders were attached to all four of the returns that were filed) was as follows:
Real estate located at 27-33 West 23rd Street and 8-18 West 24th Street, New York City, in which this trust had a one-half undivided interest, was acquired in foreclosure December 13, 1932, and sold on January 11, 1937.
The gross proceeds of sale applicable to this trust (being a one-half share) consisted of
+-----------------------------+ ¦cash . . . . . . . ¦50,000. ¦ +-------------------+---------¦ ¦and mortgage . . . ¦225,000. ¦ +-------------------+---------¦ ¦or a total of . . ¦$275,000.¦ +-----------------------------+
In accordance with the decision of the New York Court of Appeals in re Otis' Estate— 276 N.Y. 101— the Trustees, on the books of the trust allocated in 1937 to the sole beneficiary of this trust from the proceeds of sale of the above real estate the following:
+------------------------------+ ¦cash . . . . . . . ¦$9,530.78 ¦ +-------------------+----------¦ ¦and mortgage . . . ¦48,105.48,¦ +------------------------------+
being an undivided interest.
Subsequently the Trustees further allocated to the sole beneficiary from amortization payments on the mortgage, cash amounting to $1,603.50 reducing said undivided interest of the mortgage to $46,501.98. The cash, so allocated, totalling $11,134.28 was distributed in 1937 to the beneficiary.
It is claimed that such allocations and distributions are not income and hence not taxable to the beneficiary of this trust. The trustees have, therefore, not included these items in the attached return, Form 1041.
20. No part of the bond and mortgage acquired from the sale on January 11, 1937, nor at interest therein has at any time been transferred or assigned by the trustees to either of the petitioners or anyone else, nor has any certificate of interest or participation therein been given to either of the petitioners or anyone else by the trustees.
21. Any part of the stipulation of facts filed in each proceeding, including the exhibits thereto, not specifically set forth herein is incorporated herein by reference and made a part of these findings of fact.
OPINION.
BLACK, Judge:
These proceedings involve three questions. The principal question is whether, for the taxable year 1937, there should be included in computing the net income of petitioners under section 162(b)
SEC. 162. NET INCOME.The net income of the estate of trust shall be computed in the same manner and on the same basis as in the case of an individual, except that—(b) There shall be allowed as an additional deduction in computing the net income of the estate or trust the amount of the income of the estate or trust for its taxable year which is to be distributed currently by the fiduciary to the beneficiaries, * * * but the amount so allowed as a deduction shall be included in computing the net income of the beneficiaries whether distributed to them or not. * * *
of the Revenue Act of 1936, the amounts of $57,636.26 and $57,637.11, respectively, representing that portion of the proceeds (cash and bond and mortgage), from the sale of trust property apportioned under New York law by the trustees to petitioners as life income beneficiaries or trusts which were created in 1921 by the mother of petitioners, which trusts were to be in all respects governed by the laws of the State of New York. The second question is whether there should also be included in computing the net income of each petitioner the amount of $1,215.47, representing trust income (net) from the operation of the real estate for the period January 1 to January 11, 1937. The third question is whether petitioners, who are nonresident alien individuals, are subject to tax at the rates imposed by section 11 and 12 of the Revenue Act of 1936 in accordance with the provisions of section 211 thereof as amended by section 501 of the Revenue Act of 1937. The answer to the third question depends upon whether the aggregate amount received during the taxable year by each petitioner from the sources specified in section 211(a) is more than $21,600, and this will in turn depend upon our solution of the first two questions.
SEC. 22. GROSS INCOME.(a) GENERAL DEFINITION.— ‘Gross income‘ includes gains, profits and income derived from salaries, wages or compensation for personal service, of whatever kind 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. * * *
1. The portion of the proceeds from the sale of trust property apportioned under New York law by the trustees to petitioners is, as set out in paragraph 15 of our findings, made up of the following:
+--------------------------------------------+ ¦ ¦Johnston ¦Klages ¦ +------------------------+---------+---------¦ ¦Portion of cash proceeds¦$9,530.78¦$9,531.63¦ +------------------------+---------+---------¦ ¦Portion of bond proceeds¦48,105.48¦48,105.48¦ +------------------------+---------+---------¦ ¦Total ¦57,636.26¦57,637.11¦ +--------------------------------------------+
Petitioners contend that, because the trustees sold the trust property at a loss, any apportionment of the proceeds of the sale to petitioners would be an apportionment of principal or corpus to petitioners and as such would constitute gifts to them from their mother, the creator of the trusts, exempt from taxation under section 22(b)(3) of the Revenue Act of 1936,,
citing in support thereof Burnet v. Whitehouse. 283 U.S. 148;, and Helvering v. Butterworth, 290 U.S. 365.
(b) EXCLUSIONS FROM GROSS INCOME.-The following items shall not be included in gross income and shall be exempt from taxation under this title:* * * * * * *(3) GIFTS, BEQUESTS, AND DEVISES.— The value of property acquired by gift, bequest, devise, or inheritance (but the income from such property shall be included in gross income).
The respondent contends that under the so-called Chapal-Otis rule of New York as expressed in In re Chapal's Will, 269 N.Y. 464; 199 N.E. 762, and In re Otis' Will, 276 N.Y. 101; 11 N.E.(2d) 556, the amount of the proceeds apportioned to petitioners under this rule must, as far as petitioners, the life income beneficiaries, are concerned, be considered as ‘income‘ received by them, since under the instrument creating the trusts petitioners were only entitled to receive ‘income‘ and nothing else.
In the Chapal case, supra, the basic situation here involved was presented. Chapal died in 1928. He divided his residuary estate into two equal parts which he devised in trust, with instructions to the trustees to pay the income of one part to his wife for life and to pay the income of the other part to his daughter for life and at her death to distribute the principal to her surviving issue. The trust for the daughter was the only disposition involved in the case. With the exception of certain real estate, the assets of the trust consisted of personal property, including mortgages. In 1934 foreclosure of certain mortgages was effected and the trustees acquired the securing real estate. The trustees thereupon sought the surrogate's directions as to the procedure from then on with respect to the opposing interests of life tenant and remaindermen. The appeal before the Court of Appeals was from the order of the appellate division affirming the surrogate's decree construing the will and instructing the testamentary trustees with respect to the disposition of the acquired real estate and the income therefrom. The Court of Appeals, in reversing the order of the appellate division and in modifying the decree of the surrogate, among other things, said:
In such an investment situation what is involved is the salvage of a security. The security it is to be remembered is a security not for principal alone but for income as well. On a sale, therefore, the proceeds should be used first to pay the expenses of the sale and the foreclosure costs, and next to reimburse the capital account for any advances of capital for carrying charges not theretofore reimbursed out of income from the property. Then the balance is to be apportioned between principal and income in the proportion fixed by the respective amounts thereof represented by the net sale proceeds. In the capital account will be the original mortgage investment. In the income account will be unpaid interest accrued to the date of sale upon the original capital. The ratio established by these respective totals determines the respective interests in the net proceeds of a sale. Since that matter has not been argued before us, we do not fix the rate at which interest is to be computed.
The Otis decision concluded the interest question which the Chapal decision had left open, holding that interest was to be computed at the mortgage rate for the whole period, as opposed to the rate which generally prevailed for legal investments during that period.
In the instant proceedings the trustees have followed exactly the rule laid down by the Chapal and Otis decisions. On the sale of the property in question for $550,000 the proceeds were used first to pay the expenses of the sale and the foreclosure costs, and next to reimburse the capital account for any advances of capital for carrying charges not theretofore reimbursed out of income from the property, and then the balance was apportioned and allocated on the books of the trusts as set out in paragraphs 14 to 18, inclusive, of our findings. The question we have to decide is whether the amounts apportioned to the trust for each petitioner, or any part thereof, should be included in computing the net income of the life income beneficiaries for the taxable year 1937 under either the above mentioned sections 162(b) or 22(a) of the Revenue Act of 1936.
Section 162 (footnote 1, supra) defines net income of a trust. Paragraph (b) of that section provides that there shall be allowed as a deduction to the trust the amount of the income of the trust for the taxable year which is to be distributed currently by the fiduciary to the beneficiaries. The same section further provides: ‘but the amount so allowed as a deduction shall be included in computing the net income of the beneficiaries whether distributed to them or not.‘ It is the contention of petitioners that before any amount is to be included in computing the net income of the beneficiaries it must first be (1) income of the trust for the taxable year, (2) which is to be distributed currently by the fiduciary to the beneficiaries, and (3) is therefore allowed as a deduction in computing the net income of the trust.
It is the further position of petitioners that the two trusts, of which they were the income beneficiaries, had no income from the transactions in question, but on the contrary had losses; that any distributions which were made to the petitioners as beneficiaries were of principal of the trusts and not income, and therefore such amounts as the petitioners received were not taxable income to them under section 162(b). We do not think petitioners can be sustained in their contention that they are not taxable on the amounts in question.
As we understand the situation, it is substantially this: Under the two New York decisions which we have cited, when the trustees sold the real estate in question they were engaged in salvaging a security. It was first their duty to reimburse the principal of the trust estates for the expenses of foreclosure costs, carrying charges, and items of that sort. This has been done and there is no controversy on that point. The remainder of the proceeds of the sale was to be treated as if a certain part of interest had been collected and a certain part of the principal had been collected. These proportions are set forth in our findings of fact and need not be repeated here. Although in reality there was no interest collected by the trusts and the amounts represented thereby did not represent taxable income to the trusts, nevertheless, under New York law, these amounts stood in lieu of interest and had to be passed on to petitioners, who were the income beneficiaries of the trusts. What was distributable to them was in lieu of interest and we think that which stands in lieu of interest must be taxed as interest.
In Theodore R. Plunkett, 41 B.T.A., 700; affd., 118 Fed.(2d) 644, a question somewhat similar to the one here presented was decided in favor of the Commissioner. In that case the petitioner was a life income beneficiary of a testamentary trust subject to the laws of the Commonwealth of Massachusetts. The trust originally consisted, besides other property, of certain shares of stock in two corporations. Under the terms of the trust the trustee, with certain specified exceptions, was directed to keep the stock as a permanent investment. In violation of its trust, the trustee in 1929 exchanged these shares for shares of stock in another corporation. The petitioner objected to the exchange and in 1933 the probate court having jurisdiction under the testator's will ordered the trustee to substitute $547,5s0 in cash for the stock received in exchange. The trustee appealed to the Supreme Judicial Court of Massachusetts. Later this appeal was withdrawn and an agreement was filed with the court whereby the trustee substituted $500,000 in cash for the stock received in exchange and then resigned as trustee. A new trustee was appointed, and on October 9, 1934, the petitioner filed a petition with the probate court and prayed the court to authorize the new trustee to withdraw from the $500,000 an amount which would have accrued as income had the trust property been properly invested, and to allocate the amount so withdrawn to income in order that it might be paid forthwith to the petitioner as the life tenant of the trust fund. On the same day the court found the allegations of the petitioner to be true and ordered the new trustee ‘to allocate the sum of seventy thousand (70,000) dollars to income from principal of said fund, and to pay said seventy thousand (70,000) dollars forthwith to said Theodore R. Plunkett.‘ The taxpayer, in his proceeding before the Board of Tax Appeals, contended that the $70,000 received by him constituted a bequest under the interpretation of his father's will and that it was exempt from income tax under section 22(b)(3) of the Revenue Act of 1934 (identical with section 22(b)(3) of the Revenue Act of 1936), citing Burnet v. Whitehouse, supra, and other similar cases. The Board held that the statute and cases cited had no application and that the effect of the court's decree was to make the $70,000, notwithstanding it was part of the principal of the trust, distributable income of the trust for 1934. In affirming the decision of the Board the First Circuit, among other things, said:
* * * The $70,000 was distributed by the trustee to the petitioner as income and was properly included in computing his net income as provided in section 162(b),
Section 162(b) of the Revenue Act of 1934 is identical with section 162(b) of the Revenue Act of 1936.
As already set forth, by the terms of the will the petitioner's interest was limited to income from the trust estate. The $70,000 was paid to him as income, and income from the bequest of the trust property which the testator had left to the trustee. To that extent only was he a beneficiary, and the money was paid to him pursuant to the terms of the will as income from the bequest of the trust property which the testator had left to the trustee. To that extent only was he a beneficiary, and the money was paid to him pursuant to the terms of the will as income from the trust. Clearly the payment was not a bequest, devise or inheritance * * * .
We think the principle of law decided in the Plunkett case is the same as is involved in the instant proceedings. Petitioners contend, however, that the Plunkett case is in no way controlling upon, or analogous to, the cases at bar, for the reason that the trust in that case realized a capital gain upon the receipt of the $500,000, whereas in the instant proceedings the trust property which was sold for $550,000 was sold at a loss. In other words, it is the petitioners' position that before a life income beneficiary can be charged with currently distributable income under section 162(b), supra, the actual existence of ‘income‘ to the trust must always appear as an affirmative factor. It is true that in the Plunkett case it appears that the respondent determined that the trust had a capital gain of $54,798.99 and a taxable net income of $16,439.70, but neither the Board nor the First Circuit made its respective decision turn upon the fact. Under the laws of Massachusetts whatever gains the trust received from a conversion of the corpus of the trust became immediately a part of the principal of the trust and as such did not represent distributable income to the beneficiary. Both the Board and the First Circuit recognized in the Plunkett case that under the laws of Massachusetts the entire $500,000 was principal just as the $550,000 in the instant proceedings would be principal except for the rule of apportionment to which we have heretofore alluded. The basis for the decision in the Plunkett case was that, since under the law of Massachusetts $70,000 of the principal should be allocated to income, and since income was all that the life tenant was entitled to receive, the amount received by him was income and properly included in computing his net income as provided in section 162(b).
The trusts in the instant proceedings are governed by the laws of the State of New York. The trustees determined that under the New York law there would be allocated to each petitioner 21.380213 percent of the cash proceeds received by each trust and also 21.380213 percent of an undivided one-half interest in the $450,000 bond and mortgage, or $48,105.48. It was stipulated that the fair market value of the bond and mortgage was $450,000, or par. Although no part of the bond and mortgage nor any interest therein has at any time been transferred or assigned by the trustees to either of the petitioners (see paragraph 20 of our findings), it would seem that from and after the date of sale on January 11, 1937, each petitioner was the equitable owner of property rights in the bond and mortgage which had a fair market value of $48,105.48. It was a right which either one could have sold or given away. It is true that it may have been impracticable for the trustees to have divided the bond and mortgage and to have distributed to petitioners their part within the taxable year, but nevertheless we think petitioners' proportional part of the bond and mortgage represented distributable income to them in that year. Cf. Estate of Austin C. Brant, 44 B.T.A. 1306. In that case, among other things, the Board said:
We conclude that the net income of the Whiting estate trust was currently distributable by the fiduciary of the beneficiaries within the meaning of section 162(b), supra, and pursuant to that section the fiduciary is entitled to a deduction of the amount of the net income realized by the trust from the acquisition of the new building in 1934. The fact that such income was not severable from the land owned by the trust did not prevent its recognition as taxable gain and likewise its inseparability for purposes of distribution is immaterial, for, under section 162(b), supra, the deduction is to be allowed whether the income is distributed or not.
While in the instant case the trusts, as such, had no income from the sale of the property, whereas in the Brant case there was income resulting from acquisition of the new building, nevertheless, we think, the principle of the Brant case is applicable because, as we have held above, the proportions of the cash and bond and mortgage which were allocated to petitioners under the laws of the State of New York upon the sale of the property were distributable income to them and not an allocation of part of the principal or corpus of the trusts.
If the trusts here were discretionary trusts such as are covered by section 162(c) of the Revenue Act of 1936, then petitioners' proportion of the bond and mortgage would not be taxable to them in 1937, except as to the 21.380213 percent of the $7,500 or $1,603.50 which was paid or credited to each petitioner in 1937 from cash collections by the trustees on the bond and mortgage. But the trusts here are not discretionary trusts. Both sides seem to be in agreement that the trusts involved are those where the income is currently distributable and are covered by section 162(b).
If we are wrong in holding that section 162, particularly subparagraph (b) thereof, is applicable to these proceedings, we think petitioners would be taxable on the cash amounts in question under section 22(a). Among the numerous items which go into income under that section is income derived from interest. While, as we have already said, the amounts which were distributable to petitioners were not in fact interest, nevertheless, they were in lieu of interest and we see no reason why they would not be taxed as such. On this issue we sustain respondent.
2. We shall now consider the second question. During the period January 1 to January 11, 1937, each trust earned a net income of $1,215.47 from the operation of the real estate which was sold on January 11, 1937. Under the Chapal-Otis rule, the trustees were required to apply such net income to the reimbursement of the principal account of each trust for its share of the advances previously made therefrom for the foreclosure expenses and carrying charges. In re Chapal's Will, supra; In re Otis' Estate, 158 Misc. 808, 816; 287 N.Y.S. 758, 766. The state law is controlling as to what is or is not currently distributable income under the trust instrument. Freuler V. Helvering, 291 U.S. 35. Since under the law of the State of New York the net income of the trusts from the operation of the real estate prior to its sale in 1937 was not income currently distributable to petitioners, it should not be included in computing the net income of petitioners under section 162(b), supra. We, therefore, decide the second question for the petitioners. Cf. Estate of Sallie Houston Henry, 47 B.T.A. 843.
3. The third question must be decided in favor of the respondent. In view of our holdings on the first two questions, the gross income of each petitioner for the taxable year from the sources specified in section 211(a) of the Revenue Act of 1936 was more than $21,600. It follows that petitioners are taxable as provided in subsection (c) of section 211 of the Revenue Act of 1936, which subsection was added by section 501(b) of the Revenue Act of 1937.
Reviewed by the Court.
Decision will be entered under Rule 50.
MURDOCK, P. J., dissenting:
I dissent from the majority opinion in so far as it holds that these life beneficiaries had income within the meaning of section 162(b). The primary purpose of that section was to define net income of a trust, which in general is the same as that of an individual but with some additional deductions. Paragraph (b) allows as a deduction to the trust the amount of the income of the trust for the taxable year which is to be distributed currently by the fiduciary to the beneficiaries. It further provides that the amount so allowed as a deduction shall be included in computing the net income of the beneficiaries, the thought being that, if the trust is allowed to deduct distributable income, then the beneficiaries should be required to report it. Thus, this particular section requires the beneficiaries to include an amount in their income only if the amount is first income of the trust for the taxable year and allowable as a deduction in computing the income of the trust. The revenue act has its own test of what is income to the trust. This trust had no net income from the disposition of this property and no net income within the meaning of section 162(b). It was not entitled to any deduction under that section. Under such circumstances, no amount is to be included in the net income of the beneficiaries under that particular section.
The New York cases establish an equitable rule for the purposes of making a fair division between life tenant and remaindermen, in accordance with the intent of the testator or grantor. The decisions cited recognize that the allocation to income of a part of the amount realized from the sale is a pure fiction. The rule, appropriate enough in its place, is in nowise adopted by the revenue act as determinative of what is or is not income under section 162(b). The above reasoning, based upon a close and literal application of section 162(b), was not considered in the Plunkett case, and that case should not be followed here in making an improper application of section 162(b).
OPPER, J., dissenting in part:
I agree that petitioners received income to the extent of the cash distributed in the tax year and that they are taxable on it under both section 162 and 22. But it seems to me highly questionable that the unliquidated share in the mortgage was ‘currently distributable‘ under 162 or constructively received under 22.
Income was to be distributed semiannually, pursuant to the trust instrument, only to the extent that the trustees found it ‘practical and convenient.‘ The parties have stipulated that no part of the mortgage allocated to income was ‘pair or credited to either petitioner,‘ except for an installment received, and distributed, in cash. It is easy to understand why the trustees did not find it either practical or convenient to distribute the balance, but I have difficulty in ascertaining that the trust instrument made income ‘currently distributable‘ if they did not. Whether this also follows where the trustees insist that the distribution can and should take place, as in Estate of Austin C. Brant, 44 B.T.A. 1306, need not be disposed of here.
In Theodore R. Plunkett, which the Court follows, the Massachusetts decree had ordered a distribution ‘forthwith,‘ and this was made in cash, most of it immediately. No one could say that this was not a current distribution. That is what I conceive to be the distinction from the present facts.
This reasoning would, of course, require and opposite conclusion on the last point.
SMITH, J., agrees with this dissent.
MURDOCK, J.,
I agree with the dissent except for the first sentence thereof.