Kennedy v. Commissioner ( 1938 )

ELIZABETH EARHART KENNEDY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Kennedy v. Commissioner

Docket No. 88180.

United States Board of Tax Appeals

38 B.T.A. 1307; 1938 BTA LEXIS 761;

December 6, 1938, Promulgated

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TRUST INCOME. - A trust, the income of which was distributable in the discretion of the trustee, received income during the calendar year subsequent to the last distribution to the beneficiary of the trust. Held, such income, not having been distributed, is not taxable to the beneficiary. Sec. 162(c), Revenue Act of 1932.

James A. Kennedy, Esq., for the petitioner.

Edward C. Adams, Esq., for the respondent.

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TURNER

This proceeding involves a deficiency of $648.30 in income tax for the year 1933. The only issue is whether the beneficiary of a trust, the income of which is distributable in the discretion of the trustee, is taxable on income received by the trust during the taxable year but subsequent to the date on which the last distribution of income was made, where the trust on the date of distribution had accumulated income, received partly during the taxable year and partly in prior years, sufficient to cover the distribution so made but where the amount so distributed by the trust was substantially in excess of the total net income received by the trust during the entire year, exclusive of the deduction of any amounts paid to the beneficiary.

FINDINGS OF FACT.

The petitioner is an individual, residing in Ann Arbor Township, Washtenaw County, Michigan. She filed her income tax return for the calendar year 1933 with the collector of internal revenue at Detroit, Michigan, at which time she was a resident of that city.

At various times between 1917 and 1927 the petitioner's father, Harry B. Earhart, created various trusts for the benefit of his wife, Carrie B. Earhart, his children, including petitioner, and his niece. In 1929 Earhart desired to make new provisions in trust for additional beneficiaries and, since the trusts already created and those to be created were so interrelated, he decided to collect all the trust provisions made for the various beneficiaries and incorporate them in one trust instrument. The rights of the beneficiaries under the former trusts were not to be curtailed under the new trust except for the children of the donor, including petitioner, as to whom certain rights were to be given up in order that their issue might be provided for. On September 19, 1929, a new trust instrument which defined the rights of the various beneficiaries was executed by the donor and all parties, including petitioner, as to whom the new trust constituted a modification of the former trust instruments. The new trust instrument listed all the properties held in former trusts, and in order to preserve their character and in order to insure the rights of the various beneficiaries of those trusts, a tabulation was attached thereto showing allocations of the trust properties. Pertinent provisions of this new trust instrument applicable to the petitioner herein read in part as follows:

II.

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The rights of the beneficiaries so named with respect to such property so allocated are as follows:

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(c) The income of the portions of the trust property now or hereafter allocated to the said children shall be paid or accumulated, and the portions shall be re-allocated, or finally be paid and transferred in the manner set forth in the succeeding paragraphs, numbered three (3) and four (4) of this instrument.

III.

Each of the portions of the trust property allocated to the children and their issue, and such additions as shall be made thereto as above provided, shall remain in the hands of the trustees for a period which shall equal the life of the child for whom same is held and twenty-one (21) years thereafter, at which time the portion so held and additions thereto shall be paid and distributed to the issue of such child then alive in equal amounts, provided all of such issue stand in equal degree of kinship to the said child for whom such portion is allocated, but in case the degree of kinship of the persons constituting such issue varies, distribution shall be made among such issue per stirpes and not per capita. But if such child die without issue, or if his or her issue do not survive for such period of twenty-one (21) years, then said portion of the trust property, and additions thereto, shall be divided and allocated to the portions of trust property held for other children or their issue, and if there be not at such time any other portions so held, then the trustees shall pay and transfer such portion and additions thereto to H. B. Earhart and Carrie B. Earhart, or their survivor, and if neither survive, then to the heirs of Harry B. Earhart entitled to receive his personal property; * * *

IV.

The net income from the several portions held for the children of Donor and their issue shall be handled in the following manner, to-wit: While each child is under the age of thirty (30) years the trustees shall pay to him or her such part of the net income from the portion of the trust property allocated for him or her, and additions thereto, as the trustees shall deem advisable for his or her needs, interpreting the term "needs" in a liberal manner. After his or her arrival at the age of thirty (30) years the trustees shall pay him or her a sum not less than Twelve Thousand ($12,000.00) Dollars per annum from such income, and may utilize accumulations of income from former years to make such payment where the income for any one year is insufficient therefor. After the death of any child leaving issue the trustees shall pay to such issue, or expend for their benefit, such portions of net income as they shall deem advisable for their needs, but if any of the issue of any child shall have arrived at the age of thirty (30) years, he or she shall receive a fixed income which shall represent the same portion of Twelve Thousand ($12,000.00) Dollars as the share in the personal estate of such child that such person would inherit in case of the death of the child intestate, and without surviving spouse. In case, however, the net income from the property allocated for such issue should not equal $12,000.00, then such person shall receive the proportion specified of such net income.

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V.

The trustees to whom the performance of this trust is confided are Harry B. Earhart, Carrie B. Earhart, and Richard Earhart. They shall, however, perform their duties as trustees individually and not collectively; that is to say, Harry B. Earhart shall act as trustee hereunder until his death, disability or resignation; thereafter Carrie B. Earhart shall act as trustee until her death, disability or resignation; and thereafter in like manner Richard Earhart shall act as such trustee. * * * The trustees are hereby required to make an annual report to each of the adult beneficiaries to whom income is payable, setting forth the condition of said trust property, and the income derived therefrom. Wherever in this instrument a duty or discretion is imposed or conferred upon the trustees, same shall be deemed to apply to the trustee then actively performing the trust and shall not require the concurrence of the other trustees herein named.

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VIII.

Income from the corpus of the trust estate shall be construed to include the ordinary cash or specie dividends received from corporate stocks, interest received on bonds, notes and other securities, rentals from the use of property, real or personal, and all like returns or yield from the ordinary control and use of property, and shall be deemed to exclude stock dividends, profits upon liquidation, and all other return which represents the increment upon property liquidated, sold or exchanged. The decision of the trustee made in good faith, determining the class to which receipts of money or other property shall belong, shall not be questioned by any beneficiary after ninety (90) days have expired from and after the date upon which the trustees have reported the same as above provided.

Whenever the trustees acting within their discretion shall accumulate income, such accumulation shall be treated as surplus income, which may later be paid to the beneficiary in order to make the annual payments directed under certain conditions, or may be paid to such beneficiary at the times that the trustees determine that such beneficiary requires same. The trustees shall keep said accumulations of income invested in such securities as shall yield a safe return, and which under ordinary circumstances shall be readily salable. Income and increment of every nature accruing with respect to investments of such accumulated income shall be treated as income.

IX.

The powers of the trustees with respect to the management of the trust property are as follows: To sell and exchange the trust property, or any portions thereof, in their discretion and as they shall deem proper, and to invest and reinvest the proceeds thereof in such manner as they shall deem advisable; to collect the income from such property and the proceeds thereof, to pledge said property, or any part thereof, in their discretion; to exercise, except as herein limited, full dominion and control over said property to the same extent as if the said property had been given to them for their own use. * * * The trustees shall not be required to recognize any assignment or transfer, whether voluntary or involuntary, of any beneficial interest hereunder.

X.

No beneficiary shall have power to anticipate or alienate the income, or his interest in the principal of any trust estate. In case any action be commenced by any beneficiary to set aside or abrogate the provisions herein contained, he or she shall forfeit all interest therein, but this provision shall not apply to any proceedings to determine the competency of the trustee. This instrument may be amended, altered or modified, provided the agreement for that purpose is executed by the Donor, Harry B. Earhart, and the members of his immediate family, i.e., his wife and his children, or such of them as are alive and competent at the date of said amendatory agreement, and also assented to by the trustee then actively performing the duties of the trust, but no amendment to this instrument shall be effective which shall have for its purpose any of the following objects:

(1) The payment or transfer of the principal of the trust estate to the Donor, or any part of the income therefrom in excess of the amount herein stipulated as his compensation for acting as trustee.

(2) The payment or transfer of the principal or any greater portion of the income than is here provided, to the children of said Donor.

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XI.

This instrument is executed by the original Donor of the trust property, Harry B. Earhart, to confirm the gifts herein made, and to signify his acceptance of the trust duties; by Carrie B. Earhart and Richard Earhart to signify their consent to changes in previous trust instruments made for their benefit, and their acceptance of the trust duties; by Margaret Earhart Smith, Louise Earhart Guiles and Elizabeth Earhart [petitioner] to signify their consent to changes in previous trust instruments made for their benefit; and by Alexander W. Beal and William V. Butler to signify their resignation of trusteeships accepted under previous declarations of trust for the benefit of some of the beneficiaries herein named.

On September 1, 1931, and on April 18, 1932, the donor, Harry B. Earhart, caused the trust instrument of September 19, 1929, to be amended by assigning additional properties to the trust.

The petitioner herein was born on February 23, 1909, and was under twenty-one years of age when the trust instrument of September 19, 1929, was executed. On March 25, 1930, after reaching the age of twenty-one, she executed a written instrument ratifying and confirming the trust agreement of September 19, 1929.

The parties have stipulated the following additional facts:

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6. The net income realized in the year 1933, prior to December 11th, by the trust of which the petitioner was the original beneficiary, together with accumulated (surplus) income of prior years, was more than sufficient to cover all distributions made from said trust to the petitioner during the year 1933. All of such accumulated (surplus) income of said prior years in the hands of the trustee of said trust on December 31, 1932, had been included in income tax returns duly filed by the trustee of said trust, and the full amount of the income taxes on all of such income so included in said returns had been duly paid by said trustee, it being understood that there is no question of double income taxation involved in this proceeding, if it is determined as a matter of law that all of the net income realized by the said trust during the full calendar year 1933 was distributed to and taxable to the petitioner during such year. If the entire trust income for the calendar year 1933 should be held taxable to the petitioner, the amount of surplus income in the hands of the trustee, upon which taxes have been paid by such trustee in years prior to 1933 and which might be subsequently distributed to the beneficiary tax free, is accordingly increased. As a protective measure the trustee of said trust has filed a timely claim for refund, being Claim No. 2366119 for the calendar year 1933 in the amount of $72.14 for the purpose of enabling said trust to recover the taxes paid by the trustee, in the event a determination in this proceeding should be adverse to the petitioner.

7. Both the petitioner and the trust of which she is the beneficiary filed their respective Federal income tax returns for the year 1933 on the calendar year cash basis.

8. The last distribution made during the year 1933 by the trustee of said trust to the petitioner was on December 11th.

9. The total amount of the distributions from the said trust to the petitioner during the year 1933 was substantially in excess of the net taxable income of $28,757.74 (before deduction of the amount of the income paid to the beneficiary, this petitioner), realized by the said trust during the period January 1, 1933 to December 31, 1933.

10. On December 11, 1933, the trustee of the said trust had knowledge that a dividend had been declared on certain shares of stock held in said trust, which dividend was declared payable on December 15, 1933. On December 15, 1933, the said trustee received a check in payment of said dividend.

11. Between January 1, 1933 and December 11, 1933, the said trust realized net taxable income of $18,447.24 (Before deduction of the amount of the income paid to the beneficiary, this petitioner.) Between December 12, 1933 and December 31, 1933, the said trust realized net taxable income of $10,310.50, making the net taxable income of said trust for the year January 1, 1933, to December 31, 1933, the sum of $28,757.74 (Before deduction of the amount of the income paid to the beneficiary, this petitioner,) which amount the Commissioner has treated as income taxable to the beneficiary, this petitioner, for the calendar year 1933. Of the said $28,757.74 there was reported by the petitioner in her income tax return for such year the amount of $17,150.67; and $11,607.07 was added by the Commissioner in his notice of deficiency. The trustee reported said sum of $11,607.07 in his 1933 income tax return filed on Form 1040 as ordinary income (exclusive of net capital gains), and paid the tax thereon, and has filed a protective claim for refund thereof as hereinbefore set forth in paragraph 6.

OPINION.

TURNER: Under the terms of the trust instrument the trustee was empowered to distribute to the petitioner during her lifetime such part of the net income of the trust as he deemed necessary for her needs. She had no power to anticipate or alienate any income of the trust and she had no right to receive any of the corpus of the trust. All income not distributed currently but accumulated by the trustee retained the status of surplus income and could be distributed by the trustee, in his discretion, to the petitioner at any time. Upon the petitioner's death the corpus and the accumulated surplus income went to certain remaindermen.

Between January 1 and December 11, 1933, the trust realized net taxable income in the sum of $18,447.24 before deduction of any amount distributed to the beneficiary. Between December 12 and December 31, 1933, the trust realized net taxable income of $10,310.50 without the deduction of any amount paid to the beneficiary. Between January 1 and December 11, 1933, the trustee distributed to the petitioner an amount substantially in excess of $28,757.74, the total of the two sums just described. No distribution was made by the trustee to the petitioner in 1933 subsequent to December 11, 1933. The net income realized by the trust in the year 1933 prior to December 11, together with the accumulated surplus income of prior years, was more than sufficient to cover all distributions made from the trust to the petitioner during that year.

The petitioner concedes that the trustee, in making a distribution, had to first exhaust the income of the trust realized during the current year up to the time of the distribution, but contends that after such income was exhausted further distributions came from accumulated income of prior years upon which the trust had already paid income taxes. The respondent contends that petitioner's income from the trust must be computed on the basis of a full calendar year and that the income received by the trust during the calendar year subsequent to the last distribution was nevertheless in effect paid to the petitioner and must be included in computing her income under sections 162(b) and (c) of the Revenue Act of 1932. The pertinent provisions of the statute are set forth in the footnote. ¹

The statutory provisions show that Congress contemplated the taxation of the entire net income of a trust, the tax to be paid in some cases by the fiduciary and in others by the beneficiary. If the income of the trust is to be distributed "currently" by the fiduciary to the beneficiary, such income is taxable to the beneficiary under section 162(b) whether actually distributed or not. If the income may be either distributed to the beneficiary or accumulated, in the discretion of the fiduciary, such income "properly paid or credited" to the beneficiary is taxable to the beneficiary under section 162(c), but if such income is accumulated it is taxable only to the fiduciary. ; . The only question we have to decide is whether the income realized by the trust during the calendar year subsequent to the last distribution was "properly paid or credited during such year" to the petitioner. We do not think it was. Since the petitioner had no power to anticipate or alienate any of the income of the trust, obviously she had no right to such income prior to its receipt by the trust, and obviously the trustee could not "properly" pay to or credit the petitioner with income before it was received. To do so would have constituted a violation of the trust. Since the trustee's distributions during the calendar year more than exhausted the current income of the trust up to the time of the last distribution, additional distributions over and above such current income necessarily came out of surplus income accumulated from prior years upon which the trust has already paid income taxes. We think the income of the trust received during the calendar year subsequent to December 11, 1933, must be treated as accumulated in trust and taxable to the trustee under section 161 of the act. It is not taxable to the petitioner. Cf. .

The respondent has cited and relies upon , but that case is clearly distinguishable in that the income of that trust was "currently" distributable to trust beneficiaries and under section 162(b) of the Revenue Act of 1932 such income was taxable to the beneficiaries whether distributed or not. In the present case the income was not distributable "currently" but was to be distributed in the discretion of the trustee. It is not governed by section 162(b) but by section 162(c), which provides that only that part of the income of the trust which is "properly paid or credited" to the beneficiary shall be included in computing the income of the beneficiary.

We therefore hold that the respondent was in error in his determination that income of the trust received during the calendar year subsequent to the last distribution was income taxable to the petitioner as beneficiary of the trust.

Decision will be entered under Rule 50.

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Footnotes

• 1. SEC. 161. IMPOSITION OF TAX.

  (a) APPLICATION OF TAX. - The taxes imposed by this title upon individuals shall apply to the income of estates or of any kind of property held in trust, including -

  (1) Income accumulated in trust for the benefit of unborn or unascertained persons or persons with contingent interests, and income accumulated or held for future distribution under the terms of the will or trust;

  (2) Income which is to be distributed currently by the fiduciary to the beneficiaries, and income collected by a guardian of an infant which is to be held or distributed as the court may direct;

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  (4) Income which, in the discretion of the fiduciary, may be either distributed to the beneficiaries or accumulated.

  SEC. 162. NET INCOME.

  The net income of the estate or trust shall be computed in the same manner and on the same basis as in the case of an individual, except that -

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  (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, and the amount of the income collected by a guardian of an infant which is to be held or distributed as the court may direct, 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. Any amount allowed as a deduction under this paragraph shall not be allowed as a deduction under subsection (c) of this section in the same or any succeeding taxable year;

  (c) In the case of income received by estates of deceased persons during the period of administration or settlement of the estate, and in the case of income which, in the discretion of the fiduciary, may be either distributed to the beneficiary or accumulated, 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 properly paid or credited during such year to any legatee, heir, or beneficiary, but the amount so allowed as a deduction shall be included in computing the net income of the legatee, heir, or beneficiary. ↩