Oakman v. Commissioner

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT., TRUSTEE, PETITIONER, v.

Oakman v. Commissioner

Docket No. 42917.

United States Board of Tax Appeals

24 B.T.A. 84; 1931 BTA LEXIS 1693;

September 22, 1931, Promulgated

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Held that the trust involved meets the requirements of section 704(b) of the Revenue Act of 1928 and that the income thereof, whether distributed or not, is taxable to the beneficiaries.

J. Marvin Haynes, Esq., and C. J. McGuire, Esq., for the petitioner.

Arthur Carnduff, Esq., for the respondent.

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VAN FOSSAN

This proceeding was brought for the redetermination of deficiencies in income taxes for the years 1924 and 1925 amounting, respectively, to $23,069.40 and $45,153.04.

The petitioner alleges the following grounds of error:

(1) That the respondent erred "in that he has not considered the petitioner as a trust, the income of which is taxable (whether distributed or not) to the beneficiaries, in accordance with the provisions of section 704(b) of the Revenue Act of 1928."

In the alternative the petitioner alleges the following errors:

(2) The respondent erred in not allowing as a deduction from petitioner's gross income amounts properly paid or credited to the beneficiaries of a certain trust.

(3) The respondent erred by including in petitioner's gross income profit realized from real estate, lot, house and mortgage contract computed on the basis of cost to the grantor of the trust, Robert Oakman, rather than on the basis of market value as of January 16, 1924, the date of the gift of certain trust property by Robert Oakman to the 13 beneficiaries designated in the trust agreement.

(4) The respondent erred by not allowing the deduction from pletitioner's gross income in the year 1924 of interest payable which accumulated mulated at January 16, 1924, and which was paid during the year 1924.

(5) The respondent erred by including in the petitioner's gross income interest accumulated as of January 16, 1924, on lot, house and mortgage contracts and collected during the year 1924.

(6) The respondent erred in not allowing the deduction from petitioner's gross income in either of the years 1924 or 1925 of amortization of bond discounts in the respective amounts of $32,088.03 and $21,546.33.

In his brief the petitioner abandoned the alternative allegation of error numbered 3.

The parties entered into a stipulation of facts, reserving therein the right to introduce other evidence. From this stipulation and the exhibits attached thereto, together with evidence introduced at the hearing, we find the facts as follows:

FINDINGS OF FACT.

The petitioner is a fiduciary, with its principal office in the Union Trust Building, Detroit, Mich., and is acting as trustee in pursuance of the terms of the instruments hereinafter referred to.

On April 14, 1922, one Robert Oakman and Mamie R. Oakman, his wife, entered into an indenture with the Union Trust Company of Detroit, Mich., which indenture is entitled "Declaration of Trust and Security Agreement." Mamie R. Oakman joined with her husband in the execution of the indenture solely for the purpose of binding whatever right of dower she might have in the real estate described in the instrument.

This indenture recited, among other things, that Robert Oakman had determined to issue his gold bonds in the amount of $2,500,000, of which $1,250,000 were to be immediately issued, and that this issue of Robert Oakman's gold bonds was to be secured by the declaration of trust and security agreement contained in the instrument upon the property and assets, real and personal, specifically set forth therein and the income therefrom. These bonds, both the immediate issue of $1,250,000 and the balance of $1,250,000 as provided in the instrument, were to mature on the first day of March, 1932, unless sooner redeemed and were to bear interest at the rate of 7 per cent per annum. The provisions of the bonds referred to together with the provisions of interest coupons are specifically set forth in the indenture.

Article I of the indenture contains the individual covenants of Robert Oakman with reference to the property transferred by the indenture to the trustee as security for the payment and redemption of the bonds referred to.

Article II contains the trustee's declaration of trust. In this article the property conveyed by Robert Oakman to the trustee as security is fully described. It consisted of a large number of parcels of land situated in Wayne County, State of Michigan, some of which was improved and some unimproved.

Article III of the indenture is as follows:

Terms and Conditions of Trust.

First: Until default shall be made in the payment of the principal or interest of said bonds, or any of them, or in the payment of taxes, assessment, or insurance, as herein provided, or until default shall be made in respect to something by these presents required to be done by the said Robert Oakman, the said Union Trust Company shall continue to possess, manage, and operate the property herein described and intended so to be, to improve and develop the same, to sell said lands or any part thereof, to enforce all contracts for the sale of the same, or any part thereof, to convey any of said lands free from the lien hereof, to plat and subdivide unplatted lands, if any, to undertake such building operations thereon as in the judgment of the Trustee are desirable, and to take all steps which it may deem advisable for the financing incidental to all of such powers, including the financing of individual contractors, and in general to care for and operate said lands as a going liquidating real estate business.

Second: All collections from land contracts, sales, mortgages or otherwise, from said properties, are to be made by the said Trustee who shall separate interest and principal collections as received, and deal with and enter them as follows:

(a) Interest Collections. After paying the collection charge and incidental expenses, if any, involved in the collection of interest, the Trustee will establish out of said interest collections a sinking fund to which are to be credited in monthly instalments, amounts sufficient to meet the next maturing series of bond coupons. This sinking fund shall bear interest at three (3) per cent, computed on even thousands of dollars. After provision for this sinking fund has been duly made, the balance of interest collections are to be subject to withdrawal by the said Robert Oakman. Should the interest collections at any time be insufficient to provide said monthly instalments for said sinking fund, the said Trustee shall make up such deficiency from collections on account of principal frm said lands, their sales' contracts and mortgages.

(b) Principal Collections.

1. All amounts of principal of such sales, land contracts and mortgages, shall be collected by said Trustee, and from the amounts so collected, there shall first be paid all collection fees and expenses of administration, including taxes and all selling expenses and salesmen's commissions, and reasonableness of which two latter items shall be determined solely be the Trustee.

2. Beginning September 1, 1923, the Trustee will credit from said principal collections monthly to a principal sinking fund, one-twelfth of ten (10) per cent of the par value of the maximum amount of bonds at such time outstanding, said sinking fund so created to be used for the redemption of bonds as hereinafter set forth, interest to be allowed on this sinking fund at the rate of three (3) per cent per annum on even thousands of dollars.

3. The balance of principal collections not applied as provided in the foregoing paragraph (b), or not required to meet a deficiency as set forth in the foregoing paragraph (a), shall be devoted by the Trustee, in its sole judgment and discretion as to amounts and purposes, as follows:

A. Improvements. The Trustee may devote said balance of principal collections for the construction of sewers, water pipes and facilities, sidewalks, pavements and general beautification and development, including the platting and grading of unplatted lands, if any, and the general care and maintenance of the properties so held in trust; or,

B. Indebtedness. The Trustee may pay from said balance of principal collections, underlying liens and indebtedness on such further properties of the same general nature and in the same general location, as the properties herein held in trust for the purpose of subjecting the same to the provisions of this trust when and if it is deemed desirable by the Trustee so to do.

C. Advances. The Trustee may, from said balance of principal collections, advance sums for building operations on properties now or hereafter covered hereby, or on other Oakman properties of the same general nature and in the same general location, either directly or through the financing of independent builders, taking from them, if the Trustee should deem desirable, first or second mortgages on improved property or land contracts, as payment or security for such advances.

D. Application of Balance. Any balance of principal receipts or collections not applied as provided aforesaid, may be used by the Trustee, in addition to the said principal sinking fund, in its sole discretion, in the further purchase or redemption of bonds in the manner set forth in ensuing Article IV of this Indenture.

Article IV provides for the redemption or purchase by the trustee of the bonds issued. Among other things, this article provides that:

The said Robert Oakman further reserves the right to redeem on March 1, 1924, or on any interest date thereafter, all of the then outstanding bonds, by payment of the principal thereof, all interest accrued to the date of redemption, and the current call price premium as set forth in said bonds. Upon deposit with the Trustee of sufficient funds to so redeem all of such bonds and upon performance of all of his undertakings in this indenture provided, and at such time remaining unperformed, the said Robert Oakman shall be entitled to a release of this indenture and a re-conveyance of the properties covered hereby.

Article V provides for the issuance of the additional bonds.

Article VI provides for the execution and registration of the permanent bonds under the indenture.

Article VII provides for the foreclosure by the trustee of the properties in the event of the default of Robert Oakman to fulfill the agreements and covenants on his part to be performed. It also provides that, in the event of foreclosure, any surplus over and above the amount necessary to pay the principal and interest of the bonds and expenses of the foreclosure shall be paid to Robert Oakman.

Article VIII recites the special rights of the bondholders.

Article IX relates to the rights of the trustee.

On January 16, 1924, a second instrument was entered into between the said Robert Oakman and the said Union Trust Company. This latter instrument is in part as follows:

AGREEMENT, Made this 16 day of January, one thousand nine hundred and twenty-four, between ROBERT OAKMAN, of Detroit, Michigan, party of the first part, and the UNION TRUST COMPANY, a corporation of the same place, party of the second part,

WITNESSETH:

WHEREAS, the parties hereto are the parties to a certain indenture of trust, dated April 14, 1922, but as of March 1, 1922 and recorded May 3, 1922 in Liber 1086 of Mortgages, Page 415 Wayne County Registry, wherein said first party is the grantor and said second party is the grantee and trustee, a major part of the properties included thereunder having been sold on contract, the collections thereon being made by said second party, and

WHEREAS, the party of the first part hereto has heretofore borrowed from the party of the second part hereto, in addition to all funds secured under said indenture of trust, the sum of Two hundred eighty thousand ($280,000.00) dollars secured by the properties covered by the above mentioned indenture of trust, subject to the prior lien thereof, and

WHEREAS, it is the desire of said first party to made (sic.) a gift at this time of his interest in all of the properties covered by said indenture of trust, subject however, to the lien, terms and conditions of the same, and further subject to the said loan of Two hundred eighty thousand ($280,000.00) dollars, (the lien of which, and any and all extensions and renewals thereof, if made, upon all of said properties and the collections thereon, subordinate only to the lien of said trust indenture, is hereby confirmed) to his wife, Mamie R. Oakman, and to his nephews and nieces, so that they may presently have property which they may dispose of by will or otherwise to such relations, parties charitable organizations and religious or other persons as they may see fit, and until such disposition by them or any of them, enjoy the same and the proceeds thereof.

Now, THEREFORE, IT IS HEREBY AGREED:

1. That said party of the second part shall continue to collect the payments receivable on the properties and assets covered by said indenture of trust, and shall manage, handle and administer the same as a going liquidating real estate business, for the account firstly, of the holders of bonds or other parties in inerest under said indenture of trust, according to all the terms, conditions and provisions thereof; secondly, of the holder or holders of said loan of $280,000.00 and any and all renewals and extensions thereof, paying the interest and principal thereof as funds for the purpose become available after satisfying the requirements of said indenture of trust and expenses and charges hereunder and thereafter in the interest and for the account of the beneficiaries hereunder according to the terms and conditions hereof, it being understood that in matters of general policy under said indenture of trust the same courses and practices shall continue to be pursued by said Trust Company as heretofore, especial reference being had to the improvement and development of the properties covered hereby, by the encouragement and financing of building operations and otherwise, out of surplus collections, with a view to the conservation and firm establishment of the trust estate held hereunder, which said purposes and policies are hereby declared to be of paramount interest and importance in determining the amount of any current distribution to be made to the beneficiaries hereunder.

2. All of the net funds and avails realized in liquidation of said land contracts and properties under said trust indenture in excess of the requirements of the same and of said loan of Two hundred eighty thousand ($280,000.00) dollars and interest thereon, shall be paid over as follows:

To said Mamie R. Oakman, wife	one-third
of said first party
To the children of Maggie Gilbert,
sister of said first party, viz:
Clara Gilbert	Two-thirty thirds
Roy J. Gilbert	Two-thirty thirds
Walter Gilbert	One-thirty third
To Carol Ruth Gilbert, daughter of	one-thirty third
said Walter Gilbert
To the daughter of Joseph Oakman,	two-thirty thirds
brother of said first party, viz:
Florence Oakman,
To the children of Lizzie Baylis
sister of said first party, viz:
Sybella Baylis	two-thirty thirds
Normile Baylis	two-thirty thirds
Freda Baylis	two-thirty thirds
To the children of Charles H. Oakman,
brother of said first party, viz:
Ruth Oakman	two-thirty thirds
Charles Oakman	two-thirty thirds
To the children of Milton Oakman,
brother of said first party, viz:
Dorothy Oakman	two-thirty thirds
Helen Oakman	two-thirty thirds

provided however, that no principal funds arising herefrom shall be turned over to any beneficiary hereunder who shall be less than twenty-one years of age, in lieu whereof such sums so accruing to such beneficiary shall be held by said Trust Company in trust for his or her account and invested in mortgages or good income producing securities, the income of which, less expenses of administration, shall be turned over to said beneficiary in convenient instalments, and the principal of the trust fund shall be turned over to the said beneficiary, when he or she shall reach the age of twenty-one years, or in event of his or her prior death, to his or her heirs, legal representatives and assigns.

3. This agreement shall be irrevocable by the parties hereto.

4. To effectuate the security created hereby and to give the trusts herein set forth immediate effect, the party of the first part does grant, bargain, sell, assign and convey unto the party of the second part, its successors and assigns, all of his right, title and interest in and to said land contracts and other properties covered by said trust indenture, and all of his equity thereunder, to hold the same in trust for the purposes of this agreement, and to continu as trustee in the collection and liquidation of all of said properties covered by said trust indenture until the purposes thereof and of the trusts herein created be accomplished and all of said properties turned into cash or the equivalent thereof and distributed as herein provided.

The trust created by the agreements dated April 14, 1922, and January 16, 1924, was operated in accordance with the respective provisions thereof.

For each of the taxable years 1924 and 1925 petitioner, as trustee under the two instruments eferred to, filed a return of the trust under which it was operating. Neither in the year 1924 nor in the year 1925 was a return filed by the trust as an association.

On September 15, 1925, the petitioner, the Union Trust Company, filed with the respondent a duly executed "notice of election by trustee to have income of trust taxed to beneficiaries." By this notice petitioner notified respondent, among other things, that it elected to have the income of the trust now in question for the years 1924, 1925, 1926 and 1927 taxed to the beneficiaries thereof pursuant to the provisions of section 704(b) of the Revenue Act of 1928. This notice was filed within one year after the enactment of section 704(b) of the Revenue Act of 1928.

During the year 1924 the trustee paid or credited to the beneficiaries the sum of $1,500 and also paid or credited to the beneficiaries during the year 1925 the sum of $16,068.43. The maximum amount of interest collections which could have been distributed by the trustee to the beneficiaries in 1924 under the provisions of the instruments already referred to was $41,398.24 and in 1925 an additional amount of $58,313.02.

The interest which was receivable and accumulated as of January 16, 1924, but which was collected subsequently during the year 1925, was reported and included in the taxable income of the petitioner as $37,598.12.

The interest payable and accumulated in the sinking fund as provided in the two instruments referred to is the sum of $29,166.68, as at January 16, 1924. This sum was paid during the year 1924 and was among the deductions made by the petitioner, the Union Trust Company, from its gross income in its return for that year, but such deduction was not allowed by the respondent.

Under the indenture dated April 14, 1924, the total amount of bonds issued was $1,250,000. The date of their issue was March 1, 1922, they were redeemable ten years after such date, and sold at a discount of 10 per cent.

At January 16, 1924, the date of the second instrument hereinbefore referred to, the unamortized discount on said bonds amounted to $101,562.50. The unamortized discount at December 31, 1924, amounted to $69,473.67. The petitioner claimed that the difference between these two amounts, namely, $32,088.83, is deductible from gross income for the year 1924. The respondent disallowed the claim.

At January 1, 1925, the unamortized discount amounted to $69,473.67. At December 31, 1925, the unamortized discount amounted to $47,927.34. The petitioner claimed that the difference between the amount of the unamortized discount at January 1, 1925, and the unamortized discount at December 31, 1925, i.e., $21,546.33, is deductible from gross income for 1925, but the respondent disallowed the deduction.

Bonds of a par value of $280,600 were retired in 1924 and bonds of a par value of $192,200 were retired in 1925.

The petitioner claimed that the income resulting from the operations of the trust herein during the years 1924 and 1925 was taxable to the beneficiaries under the trust. The respondent, however, disallowed the claim on the ground, in effect, that the trust created by the instruments herein referred to is not within the terms of section 704(b) of the Revenue Act of 1928.

The beneficiaries, Carol Ruth Gilbert and Helen Oakman, had not attained legal age and were minors during the years 1924 and 1925. The other beneficiaries were of legal age during 1924.

OPINION.

VAN FOSSAN: The primary question for determination is whether or not petitioner is a trust the income of which is taxable to the beneficiaries thereof pursuant to section 704(b) of the Act of 1928. That section is as follows:

For the purpose of the Revenue Act of 1926 and prior Revenue Acts, a trust shall, at the option of the trustee exercised within one year after the enactment of this Act, be considered as a trust the income of which is taxable (whether distributed or not) to the beneficiaries, and not as an association, if such trust (1) had a single trustee, and (2) was created and operated for the sole purpose of liquidating real property as a single venture (with such powers of administration as are incidental thereto, including the acquisition, improvement, conservation, division, and sale of such property), distributing the proceeds therefrom in due course to or for the benefit of the beneficiaries, and discharging indebtedness secured by the trust property, and (3) has not made a return for the taxable year as an association.

The two instruments dated, respectively, April 14, 1922, and January 16, 1924, which are substantially set forth in the findings of fact, must be read together and, so read, their provisions are determinative of the characteristics of the trust involved in this proceeding. Except as to the provisions of Article III the instrument of April 14, 1922, is an ordinary deed of trust to secure bondholders which, in legal effect, created between Robert Oakman and the Union Trust Company the relationship of mortgagor and mortgagee. ; ; ; ; ; . So far as the relationship of mortgagor and mortgagee is concerned, the trust created as a passive trust and not a taxable entity. But Article III of the trust indenture, which is set forth in full in the findings of fact, created an active trust, which is taxable. That article provides, among other things, that until Robert Oakman shall default in the payment of principal or interest of the bonds issued by him, as stated in the instrument, or in any other covenant or agreement by him to be performed, the Union Trust Company shall continue to possess, manage, operate and develop the lands conveyed to it by the instrument, to plat and subdivide unplatted lands, to undertake such building operations as in its judgment might be desirable and "in general to care for and operate said lands as a going liquidating real esate business." Article III of the instrument dated April 14, 1922, also provides for the disposition by the trustee of interest and of principal funds collected from land contracts, mortgages, and sales of the property conveyed in trust, and it further provides that any interests not necessary fo the requirements of the sinking fund created by the terms of the article are to be subject to withdrawal by Robert Oakman.

The agreement dated January 16, 1924, executed by Robert Oakman and the Union Trust Company, the petitioner, is supplemental to the deed of trust dated April 14, 1922. It recited that the major portion of the properties conveyed to the Union Trust Company by Robert Oakman by the trust indenture of April 14, 1922, had been sold on contract, that an additional loan of $280,000 had been made by the Union Trust Company to Robert Oakman, secured by the properties conveyed by the first instrument, and that Robert Oakman desired to make a gift to his wife and to certain nephews and nieces of all his interest in such trust properties. Robert Oakman's interest under the trust indenture of April 14, 1922, which he desired to transfer to his wife and certain nieces and nephews was his equity in the property conveyed in trust and his right to certain excess interest. The second instrument, namely, that of January 16, 1924, in explicit terms directs the trustee to continue to "manage, handle and administer" the properties conveyed by the first instrument "as a going liquidating real estate business" and to continue the same general policy of operation as theretofore in force with a view to the conservation and firm establishment of the trust estate. These purposes and policies are declared to be of paramount importance in determining the "amount of any current distribution to be made to the beneficiaries hereunder." The second agreement further directs that all of the net funds and avails realized in liquidation of the land contracts and properties in excess of the requirements of the trust indenture of April 14, 1922, and of the requirements of the additional loan of $280,000 shall be paid to the beneficiaries named in the agreement in specified proportions, except that no principal funds shall be paid to any beneficiary who is a minor and that any minor's distributive share of principal funds shall be held in trust by the Union Trust Company for such minor's benefit and account until he minor reaches his or her majority. In order fully to effectuate the purposes of the agreement Robert Oakman granted, sold, assigned and conveyed to the trustee, the petitioner herein, all his right, title and interest to the properties and land contracts covered by the trust indenture of April 14, 1922, and all his equity thereunder and the trustee was directed to continue the collection and liquidation of the properties until the purposes of the trust indenture and "of the trusts herein created be accomplished and all of said properties turned into cash or the equivalent thereof and distributed as herein provided."

It is apparent from the provisions of the two instruments under discussion that the properties conveyed by the trust indenture dated April 14, 1922, constituted what is commonly called a "real estate development," and the purpose of the active trust created by Article III of the trust indenture was to continue the development of the properties by the methods described in that article to the end that pending the maturity of the bonds secured by the properties conveyed those properties might be turned into cash or its equivalent as expeditiously and advantageously as possible for distribution under the terms of the indenture. All the provisions of both instrument with reference to the handling or investment of surplus principal funds are subordinate and incidental to this main purpose. It is also apparent that under the indenture of April 14, 1922, the Union Trust Company, the petitioner herein, had two capacities, namely, that of a mortgagee for the benefit of bond owners and that of managing and operating a going liquidating real estate business as trustee. Under the first of these capacities no taxable entity was created. The active trust, however, is a taxable trust.

The instrument dated January 16, 1924, which is supplemental to and became a part of the first instrument, does not in any way alter the characteristics of the active trust created by such first instrument. The second instrument shows that the major portion of the trust properties had been sold on land contracts and were, therefore, in process of due liquidation. It also extended the benefit of the security to the holders of an additional loan. But it did not effect any material change in the purposes of the active trust. On the contrary it ratified and continued those purposes. In ultimate effect it simply changed the beneficial ownership of the equity arising under the trust indenture and directed distribution of the surplus of principal funds and interest to the new beneficial owners. It is true that the second instrument directs that any amount of principal funds distributable to beneficiaries who were minors, of whom there were two, should be held in trust for the benefit of such minors until they, respectively, arrived at majority. But this direction related simply to the method of distributing principal funds. It had no effect upon the characteristics of the trust in question.

In our opinion the trust created for the beneficiaries named in the second instrument is within the conditions and limitations of section 704(b) of the Revenue Act of 1928. That trust has a single trustee who, within a year after the passage of the statute referred to, exercised the option therein provided by notifying the respondent that it elected to have the trust considered as a trust, the income of which is taxable (whether distributed or not) to the beneficiaries thereof. The trust has not made a return as an association for the respective taxable years. It was created and operated for the sole purpose of liquidating real property as a single venture. The powers of administration as set forth in the instruments creating the trust are incidental to its purpose and the trustee is authorized to distribute the proceeds of the trust properties to or for the benefit of the beneficiaries and to discharge the indebtedness secured thereby.

Therefore, for the taxable years in question, the income of the trust involved in this proceeding, whether distributed or not, is taxable to the beneficiaries and not to the petitioner. In view of this decision of the principal issue, it is unnecessary to discuss the alternate issues alleged by the petitioner.

Reviewed by the Board.

Decision will be entered under Rule 50.