Brodhead v. Commissioner , 18 T.C. 726 ( 1952 )

Thomas H. Brodhead and Elizabeth S. Brodhead, Petitioners, v. Commissioner of Internal Revenue, Respondent

Brodhead v. Commissioner

Docket Nos. 29391, 29392

United States Tax Court

18 T.C. 726; 1952 U.S. Tax Ct. LEXIS 144;

July 7, 1952, Promulgated

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Decisions will be entered under Rule 50.

A trust created by the husband-petitioner for minor children, only one of whom was then in being, became a special partner in a partnership in which the petitioner was the general partner. The next year, when the petitioners had two children, the wife-petitioner created a trust for minor children, which trust purchased the interest of the first trust in the partnership and became a special partner. The trusts' contributions to the partnership originated with the husband. The trusts were long term trusts, irrevocable, and the trustees were independent of the settlors.

1. Held, that the trusts were bona fide partners in the partnership and their distributive shares of partnership income were not income of the settlors.

2. Held, further, that the settlors did not retain sufficient control over, or interest in, the trusts to make the trust income taxable to them.

Milton Cades, Esq., and Urban E. Wild, Esq., for the petitioners.

Charles W. Nyquist, Esq., for the respondent.

Arundell, Judge.

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ARUNDELL

The respondent determined deficiencies in income tax for the years and in the amounts as follows:

1943	$ 42,280.89
1944	$ 79,944.90
1945	$ 48,666.11
1948	$ 1,177.22

The principal cause of the deficiencies is the inclusion in income of the petitioners of income of successive trusts created by the petitioners -- the first by the husband and the second by the wife -- each of which trusts became a partner with the husband in a business which the husband had theretofore operated. The propriety of such inclusion is the main issue. If that issue is decided adversely to the petitioners, there is a further issue as to whether the statute of limitations has run against the year 1943.

FINDINGS OF FACT.

The petitioners at all times material to these proceedings were husband and wife and residents of the Territory of Hawaii. They filed their income tax returns with the collector of internal revenue for the district of Hawaii.

The petitioners have three children born December 29, 1939, November 19, 1942, and May 1, 1945.

In and prior to 1942 the petitioner Thomas H. Brodhead was engaged as an individual in operating a wholesale merchandise business in Honolulu. The merchandise handled consisted of a great variety of articles which were sold to post exchanges and ships' service stores and included drug items, razor blades, dungarees, shoes, underware, work shirts, shower clogs, pocket knives, candy, gum, and miscellaneous items.

The petitioner Thomas H. Brodhead came from a family of short-lived people on his father's side and he was quite concerned about the length of his own life. Conditions in Hawaii in 1942 were not conducive to a feeling of long life. He was determined to make some provision for his children so that they would have a better education than he had. In September 1942 the petitioners had one child, and were expecting the birth of another. Thomas H. Brodhead's business grew rapidly after the start of World War II, and he wanted some means of having it carried on for the benefit of his children in the event of his death. Also, because of the size to which the business had grown in 1942 he felt that he needed someone to help him with it.

Mortimer J. Glueck had been a personal and business acquaintance of the petitioner Thomas H. Brodhead for a number of years, had kept his books on a part time basis, and had advised him generally. Glueck had a commission business, and in 1942 he was getting too busy with it to be able to assist petitioner Brodhead and advised him to get other assistance. Glueck and Brodhead had many discussions as to what provision the latter should make for his children.

Bishop Trust Company, Limited, in and prior to 1942 conducted a trust company business in the Territory of Hawaii. It is operated as a professional fiduciary, with side issues such as insurance, real estate sales, and brokerage. Its main business is the administration of estates, trusts, guardianships and agency accounts. The normal trust or estate handled by the trust company consists of securities or interests in real estate. However, it has at times administered proprietorships and the controlling shares of incorporated businesses. In the administration of such properties it has operated various businesses including a structural steel mill, a department store, dairies, ranches, a bottling company, and an automobile agency.

In 1942 Glueck and Brodhead sought the advice of counsel, and it was agreed that a trust should be created for the benefit of the petitioners' children and that the trust should become a partner with Brodhead in his business. Brodhead asked Glueck to be one of the trustees so that with his knowledge of the business he could carry it on in the event of Brodhead's death. Brodhead also wanted Bishop Trust Company, Limited, as a trustee for the general assistance and advice that it could give.

On September 30, 1942, the petitioner Thomas H. Brodhead created the Thomas H. Brodhead Trust, naming Mortimer J. Glueck and Bishop Trust Company, Limited, as trustees. Corpus of the trust was stated to be $ 40,000. It consisted of a one-half interest in the petitioner's business which at that time had a net worth of $ 80,000. Under the trust agreement, the $ 40,000 corpus was to be contributed to the capital of a special partnership to be organized concurrently for a 50 per cent interest therein.

The trustees were required to accumulate all trust income during the continuance of the trust, but they had discretion to pay out net income for the maintenance, support, and education of the children of the settlor, or if income was insufficient they could use corpus. All income not used for such purposes was to be accumulated and added to corpus. The trustees were authorized to pay to any child of the settlor any time after attaining age 21, as they deemed proper, such portion of corpus and accumulated income as constituted one share, such share to be determined by considering the trust estate to be divided into as many equal shares as there should be children then surviving or lineal descendants of any deceased child.

The trust was to continue until 20 years after the death of the settlor. The trust property and accumulated income were then to be distributed to the surviving children of the settlor (other than those to whom the distribution of a share may have previously been made) and the issue of any deceased children. If there were no children or issue then surviving, distribution was to be made to those persons, other than the settlor, who would be the heirs-at-law of the last survivor of the children of the settlor.

The trustees could terminate the trust at any time after the termination of the special partnership, in which event distribution was to be made to the settlor's children and issue of any deceased children.

The trustees were given broad powers to invest and reinvest and manage the trust property, but during the life of the settlor they were required to obtain his consent to all investments. After the settlor's death the trustees were to be restricted in making investments to those which trustees are permitted by law to make. However, they could in any event make advances or loans to the special partnership without liability for any loss resulting therefrom.

The settlor reserved the right to transfer additional property to the trust. The trustees were required to furnish annual statements of account to the beneficiaries. The corporate trustee was given the custody of all money or securities in the trust.

The trust was declared to be irrevocable by the settlor. It was provided that in no event should any of the trust property or income be paid to or inure to the benefit of the settlor.

Any alteration, amendment, cancelation, or revocation of any provisions of the trust required the written consent of the trustees and all of the beneficiaries.

A special partnership was formed by a document dated as of September 30, 1942. The petitioner Thomas H. Brodhead was referred to therein and signed the agreement as "General Partner." The trustees of the above described trust are referred to and signed as "Special Partner." The partnership adopted the name of T. H. Brodhead Co. Its purpose was to acquire the assets and carry on the business theretofore conducted by the petitioner Thomas H. Brodhead. Other purposes are stated including the carrying on of any business that may lawfully be carried on by a partnership.

The initial capital of the partnership was $ 80,000 which was the book value of the net assets that it acquired. It was agreed that $ 40,000 was the capital contribution of each of the partners and that each had a 50 per cent interest.

The general partner who was actively engaged in the business was to receive compensation for his services which was to be charged as an expense in computing partnership profits. The remaining profit, or loss, was to be divided in proportion to the capital contributions. Profits attributable to each partner's interest could be withdrawn from time to time as the partners deemed advisable.

The trustees had all the powers, rights, and duties of a special partner as prescribed by designated sections of the Special Partnership Law of the Territory of Hawaii, and were not liable for partnership debts beyond the extent prescribed by law.

Only the general partner had authority to transact the business of the partnership, or incur obligations. He was to establish the policy of the partnership. The special partner could at all times investigate the partnership affairs and advise the general partner as to its management.

The general partner could not assign or mortgage any part of his interest. The special partner could assign its interest with the consent of the general partner.

Proper partnership books and records were to be kept and each partner was to have full access to them. The books were to be audited at least once a year, and a copy of the auditor's report was to be delivered to each partner. Annual accounts were to be taken, showing the capital of the partnership and the interest of each partner therein and copies were to be furnished to each partner.

The partnership could be terminated by the general partner on 2 months' written notice. On termination, debts were to be paid, and any balance remaining was to be applied first to advance accounts of the partners, then to capital, then between the partners in the manner provided for division of profits. If the balance after payment of debts was insufficient to pay in full the advance accounts of all partners, the special partner was to be paid first.

In the event of the death of the general partner, his representative had the option of succeeding to or carrying on his interest in the business as a general partner.

The partnership was to continue for a 10-year period and thereafter from year to year until terminated by either partner giving 3 months' notice.

By bill of sale dated as of the close of business on September 30, 1942, the petitioner Thomas H. Brodhead conveyed to the special partnership the rights, property, assets, and privileges owned by him and used in his merchandising business. The partnership agreed in the bill of sale to assume the liabilities disclosed by the balance sheet attached thereto. The balance sheet listed assets in the amount of $ 178,598.73, current liabilities in the amount of $ 98,598.73, and capital in the amount of $ 80,000. Among the assets listed were cash, $ 21,532.34; accounts receivable, $ 64,667.35; and merchandise inventory, $ 27,310.44.

The required documents concerning the organization of the special partnership were duly filed and publication was made in a Honolulu paper.

Early in 1943, the petitioner Thomas H. Brodhead was advised by his attorney that under a recent court decision he might be subject to Federal income tax on all of the income of the Thomas H. Brodhead trust without being able to get any of the trust income to use to pay the tax. In that situation, it was possible that he might have been unable to pay the tax. He was advised by counsel that a new trust could be created, omitting the features that might make the income of the first trust taxable to him, to acquire the interest of the first trust in the partnership.

Following discussions among the petitioners, the trustees of the Thomas H. Brodhead trust, and counsel, the petitioner Elizabeth S. Brodhead on February 28, 1943, created the Elizabeth S. Brodhead trust. The trustees of that trust were the same as those of Thomas H. Brodhead trust. At that time, Thomas H. Brodhead gave his wife $ 10,000 which she paid in to the trust created by her. Both petitioners filed Federal gift tax returns in which they reported the gifts of $ 10,000 made by them.

The provisions of the Elizabeth S. Brodhead trust were substantially the same as those of the Thomas H. Brodhead trust. The principal differences were that the wife's trust did not give discretion to the trustees to distribute income for maintenance, support, or education of the beneficiaries during minority, and it was to terminate when the youngest child attained the age of 33 years.

On February 28, 1943, the Elizabeth S. Brodhead trust purchased from the Thomas H. Brodhead trust its 50 percent interest in the special partnership. That interest was duly assigned to the Elizabeth S. Broadhead trust by an instrument dated February 28, 1943, in which Thomas H. Brodhead, as general partner, gave his consent to the assignment. The Elizabeth S. Brodhead trust paid the Thomas H. Brodhead trust the sum of $ 10,000, and gave its note for the unpaid balance of the purchase price of the 50 per cent interest in the amount of $ 30,000 with interest at 5 per cent. Interest was paid periodically, and the principal of the note was paid off by payments made in 1945 and 1949. The legally required certificate of change of the special partnership and affidavits were duly filed, and notice was duly published.

An independent firm of auditors was employed by the partnership to make audits of the partnership business and to prepare annual statements.

The petitioner Thomas H. Brodhead received compensation for his services to the partnership for the periods and in the amounts as follows:

Period or year	Amount
Oct. 1, 1942 to Feb. 28, 1943	$ 6,250
Fiscal year ended Feb. 28, 1944	15,000
Fiscal year ended Feb. 28, 1945	18,000
Fiscal year ended Feb. 28, 1946	18,000
Fiscal year ended Feb. 28, 1947	18,000

As of the close of business on February 28, 1947, the name of the special partnership was changed from T. H. Brodhead Co. to Ace Distributors. The instrument changing the name was executed by Thomas H. Brodhead as general partner and by Mortimer J. Glueck and Bishop Trust Company, Limited, trustees under the Elizabeth S. Brodhead trust, as special partner. The necessary documents to effect the change were duly filed and publication was duly made.

As of the close of business on February 28, 1947, the partnership, under its new name of Ace Distributors, assigned T. H. Brodhead Co., Ltd., a Hawaiian corporation, certain rights, property and assets used in its business, subject to balance sheet liabilities, which properties had a net book value of $ 80,000. In payment therefor the corporation issued 4,000 shares of its stock to the general partner and an equal number to the special partner. The necessary documents in connection with the organization of the corporation and the issuance of its stock were duly filed.

During the period of operations of the special partnership, the general partner discussed the problems of the business frequently with the trustees of the two trusts. Whenever a financial report on the business was issued he furnished copies to the trustees. The general partner conferred with the corporate trustee as to investment of the funds of the first trust. In one instance it accepted his suggestion as to an investment and in another instance it refused to do so. He discussed with the trustees possible means of financing an expansion of the partnership business which in the war years was increasing in volume.

The partnership T. H. Brodhead Co. filed partnership returns on an accrual and fiscal year basis ending on the 28th of February. Its first return on that basis was filed for the fiscal year ended February 28, 1943. Returns were filed on that basis for each of the subsequent fiscal years 1944 through 1949.

The Thomas H. Brodhead trust and the Elizabeth S. Brodhead trust filed Federal fiduciary returns each year and duly paid the tax shown to be due thereon. None of the funds of the trusts has ever been paid out to the beneficiaries thereof. Out of the income of the trusts there have been paid the expenses of each, such as trustee fees, tax service fees, and the Federal and territorial income taxes.

On September 30, 1950, the assets of the Thomas H. Brodhead trust amounted to a total of $ 86,918.97 which consisted of cash in the amount of $ 2,109.48 and investments in stocks, bonds, and savings and loan certificates with a cost of $ 84,809.49.

On February 28, 1951, the assets of the Elizabeth S. Brodhead trust amounted to a total of $ 85,673.03, which was made up of cash, $ 3,858.90; partnership equity in Ace Distributors, $ 2,904.85; accounts receivable received in partial liquidation of Ace Distributors, $ 17,000; 4,000 shares of stock in T. H. Brodhead Co., Ltd., $ 40,000; other stocks having a cost of $ 13,409.28; savings and loan certificates with a cost of $ 8,500.

The joint Federal income tax return of the petitioners for the year 1943 was filed with the collector on or about March 20, 1944. The gross income shown thereon was in the amount of $ 74,888.57. On or about January 18, 1949, the petitioners and the respondent executed a consent extending to June 30, 1950, the period within which an income tax may be assessed or a deficiency notice mailed to the petitioner for the year 1943.

The deficiency notices in these proceedings were mailed to the petitioners on February 7, 1950.

The petitioner Thomas H. Brodhead and the trustees of the Thomas H. Brodhead trust and of the Elizabeth S. Brodhead trust really and truly intended to, and did, join together for the purpose of carrying on the business of T. H. Brodhead Co. and sharing in its profits and losses.

The two trusts were bona fide trusts for the benefit of the children of the settlors, and the petitioners had no substantial control over, or interest in, the corpus or income thereof.

OPINION.

The respondent has determined, as set forth in the notices of deficiency, that "the T. H. Brodhead Company, (Ace Distributors in 1948) an alleged partnership * * * is not a valid partnership for Federal income tax purposes" with the consequence that all of the income from such partnership is taxable to the petitioners. This determination is assigned as error.

An alleged error concerning a deduction for legal fees for the year 1943 has been abandoned by the petitioners.

While the pleadings are directed to the question of the validity of the special partnership, the parties argue not only that question but also that of whether the income reported by the trusts is taxable to the petitioners under the rationale of Helvering v. Clifford, 309 U.S. 331">309 U.S. 331.

The Partnership Question.

It is our opinion, and we so hold, that the successive trusts were bona fide partners in the partnership of T. H. Brodhead Co. (the name of which was changed in 1947 to Ace Distributors).

The ultimate factual question in the tax treatment of family arrangements in the form of partnerships is "whether, considering all the facts * * * the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise." Commissioner v. Culbertson, 337 U.S. 733">337 U.S. 733. The evidence satisfies us that in forming the partnership the parties were acting in good faith and with a business purpose. There is no doubt that Thomas H. Brodhead was genuinely concerned about the possibility of his death, which event would have affected his one-man business. The welfare of his family was tied in with the degree of success of the business. In order to insure, as far as possible, that neither would suffer in the event of his untimely death, the partnership was formed. There was a business purpose in bringing in Glueck and the trust company as a special partner. Glueck had been Brodhead's business advisor, and an employee in the business. In those capacities he had a good grasp of the various aspects of the business and was in a position to carry it on if that became necessary. Brodhead wanted the trust company as a participant because of its broad experience in the management of businesses and for the advice that it could give in the operation of a rapidly expanding business. While a special partner cannot transact the business of the partnership, it may at all times investigate partnership affairs and advise the partners as to management. ^{*162 of the trusts was capital -- as distinguished from services. The fact that it was gift capital which originated with the petitioners does not preclude recognition of it as a genuine capital contribution where the facts indicate "that the amount thus contributed and the income therefrom should be considered the property of the donee for tax, as well as general law, purposes. * * * Whether he [the donee] is free to, and does, enjoy the fruits of the partnership is strongly indicative of the reality of his participation in the enterprise." Commissioner v. Culbertson, supra;Theodore D. Stern, 15 T.C. 521">15 T. C. 521.}

The respondent contends against the recognition of the trusts as partners because of the settlors' control over corpus and income. Corpus was required to be paid into the business of which Brodhead was the manager. Distributable income was what was left after Brodhead took out his salary. We do not see wherein these factors should serve to operate against recognition of the trusts as partners, at least in the absence of any abuse by Brodhead of his discretion in his handling of corpus or income. Trusts normally provide for some degree of control over corpus and/or income by someone other than the beneficiary. If they did not, the transfer would result in an outright gift rather than the creation of a trust. ^{Harrison v. Schaffner, 312 U.S. 579">312 U.S. 579. The question of where to draw the line as to the permissible degree of control which will shift tax liability is of particular concern where income is produced by property rather than by services. In such cases, the tax liability attaches to ownership. Poe v. Seaborn, 282 U.S. 101">282 U.S. 101; Hoeper v. Tax Commission, 284 U.S. 206">284 U.S. 206. A beneficiary of a trust may assign a share of the trust income to another for life without retention of any form of control, and such assignment is treated as a transfer in praesenti of a life interest in the trust corpus with income taxable to the donee. Blair v. Commissioner, 300 U.S. 5">300 U.S. 5.One step removed from such complete assignment is the assignment of trust income for a limited period. In such a case, the gift of the income "for the period of a day, a month or a year involves no such substantial disposition of the trust property as to camouflage the reality" that the assignor continues to enjoy the benefit of the trust income. Harrison v. Schaffner, supra.Still further removed are situations like those involved in Helvering v. Clifford, supra, where the owner of property places it in trust for a relatively short term, with himself as trustee, retains broad powers of management and over distribution of income, with a reversion to the grantor. A gift in trust for the benefit of another, but with reserved power to modify or revoke, results in taxation of the trust income to the settlor. This is on the ground that "taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed -- the actual benefit for which the tax is paid." Corliss v. Bowers, 281 U.S. 376">281 U.S. 376.}

The attribution of income from property to the owner of the property was emphasized by the tax committees of the House of Representatives and of the Senate in their consideration of the family partnership provisions that became section 340 of the Revenue Act of 1951. ^{*166 necessarily indicated by powers retained by the transferor as a managing partner or in any other fiduciary capacity when considered in the light of all of the circumstances. *167 to the years involved in these proceedings. Nevertheless, the basic principle of taxing income from property to the owner of the property was the law in the earlier years as fully as it is today. A proper appraisal of the evidence is convincing that the trusts in these proceedings were the owners of the property held by them. Petitioner T. H. Brodhead irrevocably parted with a 50 per cent interest in his business property when he created the first trust. The second trust became the owner of that interest by purchase. The corpus has not reverted to him, and it cannot. The income has not been used for the benefit of the settlors but is held intact for the beneficiaries. Such powers as Brodhead had over the corpus by use in his business were no more than those of a managing partner, and in the exercise thereof he was required to act in a fiduciary capacity. After a gift is once complete and title has passed to the donee, the fact that the donor subsequently has possession of it does not affect its validity. Garrison v. Union Trust Co., 164 Mich. 345">164 Mich. 345, 129 N.W. 691">129 N. W. 691; Adams v. Hagerott, 34 F. 2d 899.}

This is not a case like Ralph C. Hitchcock, 12 T. C. 22, where a father purported to make gifts to minor children of interests in his business, had himself appointed guardian, and charged their purported distributive shares with the cost of their board and keep. Here we have independent trustees who received the full distributive share of the trusts for the benefit of the children.

We fail to see wherein the restrictions on the limited partner were such as to invalidate the partnership. The prohibition against transaction of partnership business by the special partner is a normal provision of limited partnership agreements, and in fact is usually provided for by law where limited partnerships are recognized. See Theodore D. Stern, supra, where we said that retained control in the general partner "is of no particular significance since limited partners normally have no part in the control or management of the business." 15 T. C. at p. 527.

No question is raised in these proceedings as to whether under the laws of Hawaii a trust may be a member of a special partnership. Neither the statutes of Hawaii nor Internal Revenue Code section 2797 prohibits a trust from being a partner, and we have recognized that trusts can be members of partnerships. See Louis R. Eisenmann, 17 T.C. 1426">17 T. C. 1426, and Theodore D. Stern, supra.See also Greenberger v. Commissioner, 177 F.2d 990">177 F. 2d 990.

The "Clifford" Case.

We hold that the decision in the case of Helvering v. Clifford, supra, is not controlling in these cases. The factual differences are so great as to obviate any need for extended discussion. Here we have long term trusts -- the first was to continue until 20 years after the death of the settlor, and the second until the youngest beneficiary attained the age of 33 years. The settlors in these proceedings were not the trustees. They had no discretion as to distribution of income. There could be no reversion of corpus to the settlors.

The respondent makes an argument that the petitioner Thomas H. Brodhead could control the amount of income of the trusts through siphoning off partnership income as compensation for his services. There is no indication that the compensation of Brodhead was more than a reasonable sum for services rendered. Moreover, any compensation taken by him in excess of a reasonable amount would be inconsistent with the purpose for which the respondent charges the trusts and partnership were created, namely, to avoid taxation of income of the business to Brodhead. Also, we have here independent trustees who had available and who, it must be assumed, would use means of preventing the general partner from depriving the trustees' wards of their rightful share of partnership income. A partner does not stand only as such in partnership matters; he occupies a fiduciary relationship to the other partners in all partnership matters and the utmost good faith is required of each in their relations to each other. 68 C. J. S., Partnership, section 76; Stem v. Warren, 161 N. Y. S. 247. Here the outcome of the partnership operations, mentioned above, indicates as a practical matter entire good faith on the part of the general partner in his dealings with the special partner which inured to the benefit of the trust beneficiaries.

By amended answer, the respondent invokes the provisions of section 275 (c) of the Internal Revenue Code to avoid the operation of the statute of limitations against assessment for the year 1943. This question would require decision only in the event that the trust-partnership income were properly taxable to the petitioners, and if that income were in excess of 25 per cent of reported gross income. As we have held that such income was not income of the petitioners, we do not decide the limitations issue.

Decisions will be entered under Rule 50.

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Footnotes

• 1. Revised Laws of Hawaii, 1935, as amended, ch. 225, sec. 6881.↩

• 2. In the case of an inter vivos↩ trust where the settlor retains power to control the trustee in some respects in the administration of the trust, the settlor is ordinarily under a fiduciary duty to the beneficiary in respect to the exercise of the power. Scott, The Law of Trusts, sec. 185.

• 3. H. Rept. No. 586, 82d Cong., 1st Sess.; 1951-2 C. B. 357, 380. The Senate Finance Committee issued a report in the same language as the Ways and Means Committee Report. See S. Rept. No. 781, 82d Cong., 1st Sess.; 1951-2 C. B. 458↩, 485.

• 4. "Not every restriction upon the complete and unfettered control by the donee of the property donated will be indicative of sham in the transaction. Contractual restrictions may be of the character incident to the normal relationships among partners. Substantial powers may be retained by the transferor as a managing partner or in any other fiduciary capacity which, when considered in the light of all the circumstances, will not indicate any lack of true ownership in the transferee. In weighing the effect of a retention of any power upon the bona fides of a purported gift or sale, a power exercisable for the benefit of others must be distinguished from a power vested in the transferor for his own benefit." (H. Rept. No. 586, supra↩.)