MADORIN v. COMMISSIONER Docket No. 28963-81.
84 T.C. 667 (1985)
BERNARD AND JOYCE MADORIN, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
United States Tax Court.
Filed April 11, 1985.
Stephen N. Engberg and Michael A. Klein, for the petitioners.
Judy Jacobs, for the respondent.
DAWSON, Chief Judge:
Respondent determined a deficiency of $27,618 in petitioners' Federal income tax for the taxable year 1978. The issues for decision are: (1) Whether section 1.1001-2(c), example (5), Income Tax Regs., should be declared invalid as an unwarranted extension of sections 671, 674, and 1001;
This case was submitted fully stipulated pursuant to Rule 122.
Petitioners Bernard and Joyce Madorin were residents of Chicago, Illinois, at the time they filed their petition in this case. On December 19, 1975, Bernard Madorin (petitioner), as grantor, established four separate irrevocable trusts: the Miles Trust; the Mark Trust; the Melanie Trust; and the Bernard Descendant's Trust. The trust agreement designated Richard Coen (Coen) as the trustee of each of the four trusts. Coen was at all times a "nonadverse party" as defined by section 672(b). Further, he was not a "related or subordinate" party as defined by section 672(c). A provision in the trust agreement gave the trustee the power to add one or more section 501(c)(3) charitable organizations as beneficiaries to any of the trusts. As a result of this provision, petitioner, the grantor, was
On or about December 19, 1975, petitioner funded each of the trusts with $5,075 in cash. Petitioners filed United States Quarterly Gift Tax Returns (Forms 709) with respect to the gifts. The $5,075 gift to each trust was its only funding.
On December 19, 1975, each of the four trusts contributed $5,010 to Metro Investment Co. (Metro), an Illinois partnership. The trusts each acquired a one-ninth interest in Metro. On or about December 22, 1975, Metro contributed $45,000 to Saintly Associates (Saintly), a partnership involved in servicing the production of motion pictures. Of the $45,000 invested, approximately $20,000 was attributable to the contributions made by the four trusts. On October 17, 1975, Saintly had entered into an agreement with Warner Bros., Inc., to perform all services necessary to produce a motion picture. To finance the performance of these services, Saintly obtained a nonrecourse loan of $3,270,000 from Security Pacific National Bank.
On petitioners' 1975 through 1977 Federal income tax returns they reported the following losses and income from the four trusts:
1975 ............ Loss .......... ($50,709.60) 1976 ............ Loss .......... (20,753.92) 1977 ............ Income .......... 1,544.28
On January 1, 1978, Coen, the trustee of the four trusts, irrevocably renounced his power to add beneficiaries to each trust. As a result, the trusts ceased to be grantor trusts and petitioner, the grantor, was no longer considered the owner of the trusts under section 674(a). Petitioners reported no gain or loss from the trusts on their 1978 return.
In August 1981, respondent sent petitioners a notice of deficiency. Relying on section 1.1001-2(c), example (5), Income Tax Regs. (hereinafter referred to as example (5) or the regulation),
I. Validity of the Regulation
Petitioners contend that example (5) is invalid as an unreasonable interpretation of sections 671, 674, and 1001. Petitioners argue that the grantor of a trust should be "treated as the owner" only for the limited purpose of attributing to him items of income, deductions, and credits. This contention embodies petitioners' argument that (1) the trust should be treated as the partner and owner of the partnership interest,
It is well established that regulations "must be sustained unless unreasonable and plainly inconsistent with the revenue statutes." Commissioner v. South Texas Lumber Co., 333 U.S. 496, 501 (1948). Section 7805(a) gives the Commissioner broad authority to promulgate needful regulations. See United States v. Correll, 389 U.S. 299, 306 (1967). As such, regulations "should not be overruled except for weighty reasons." Bingler v. Johnson, 394 U.S. 741, 750 (1969), quoting Commissioner v. South Texas Lumber, Co., supra at 501.
We note, however, that "Regulations must, by their terms and in their application, be in harmony with the statute. A regulation which is in conflict with or restrictive of the statute is, to the extent of the conflict or restriction, invalid." Citizen's National Bank of Waco v. United States, 417 F.2d 675, 679 (5th Cir. 1969), quoting Scofield v. Lewis, 251 F.2d 128, 132 (5th Cir. 1958).
The Supreme Court has ruled that statutory terms should be given their "usual, ordinary and everyday meaning." Old Colony Railroad Co. v. Commissioner, 284 U.S. 552, 561 (1932). We agree with respondent's contention that defining "owner * * * of a trust" under section 674 (and section 671) to mean owner of the trust's assets is consistent with the usual, ordinary, and everyday meaning of the word. Application of the grantor trust provisions generally results in nonrecognition of the trust (or a portion thereof) as an entity separate from the grantor. See Estate of O'Connor v. Commissioner, 69 T.C. 165, 174 (1977).
Petitioners set forth several arguments toward establishing that "owner" as defined in example (5) is inconsistent with the intended meaning of section 671. First, they appeal to the language of section 671. Section 671 states in part:
Where it is specified in this subpart that the grantor or another person shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the
Petitioners assert that the plain language of section 671 limits the attributes of ownership to the imputation of income, deductions, and credits only. We disagree. There is nothing on the face of the statute which tells us that that is the exclusive attribute of ownership. Section 671 specifies one result of being an "owner," but it does not specifically limit the meaning to that result.
Second, petitioners point to the legislative history of section 671. Petitioners assert that the Senate and House committee reports
We find petitioners' argument to be unpersuasive. The authorities cited in support of petitioners' argument do not specifically state that "owner" was used solely as a device to include items of deductions, losses, and other allowances.
Third, petitioners argue that a grantor trust maintains its existence as a transactional entity separate and distinct from its grantor for Federal income tax purposes. In support of their contention, petitioners direct us to several cases. Petitioners' reliance upon these cases is misplaced.
Petitioners rely heavily upon W & W Fertilizer Corp. v. United States, 208 Ct. Cl. 443, 527 F.2d 621 (1975), in which the Court of Claims addressed the issue of whether a corporation's subchapter S status was automatically terminated when a shareholder transferred his stock into a grantor trust of which he was the grantor. The Commissioner contended that when the shareholder transferred his stock to the trust, the subchapter S election terminated because having a trust as a shareholder disqualified the corporation as a "small business corporation."
In W & W Fertilizer Corp., the court rendered its decision on the basis of the congressional policy inherent in restricting the ownership of subchapter S corporations to individuals and estates. The intent was to provide a narrow benefit to certain classes of taxpayers. A specific requirement of form was established. Hence, when the grantor trust was examined, its specific form rather than the substance was accepted. The court wrote:
The "grantor trust rules" treat the grantor as if he were the owner in cases where he has reserved to himself some of the powers normally attendant to
We, therefore, think that W & W Fertilizer Corp. has limited applicability. It is an exceptional example where form of ownership controls in order that congressional intent be carried out. We are not concerned in the instant case with a statute that requires that a specific form be satisfied. Moreover, the effect of the decision in W & W Fertilizer Corp. is not that the grantor is not considered the owner of the trust corpus for other tax purposes but that there is a disqualification from a benefit that was not intended to be bestowed upon a particular form of ownership.
Petitioners also cite Swanson v. Commissioner, 518 F.2d 59 (8th Cir. 1975), affg. T.C. Memo. 1974-61, and Estate of O'Connor v. Commissioner, 69 T.C. 165 (1977). We agree with respondent, however, that these cases more aptly support respondent's position than that of petitioners.
In Swanson v. Commissioner, supra, life insurance policies on the grantor's life were transferred to grantor trusts for valuable consideration. The Commissioner contended that pursuant to section 101(a)(2) each of the trusts was required to recognize as gross income a proportionate amount of the proceeds of the policies that matured upon the grantor's death. The taxpayer claimed that the transfer was to the grantor/insured, and therefore, an exception to section 101(a)(2) had been met. At issue in Swanson was whether the trusts and the grantor/insured were the same entity per the definition of "owner" under section 671. While this Court did not directly address this issue, the Eighth Circuit, in its affirmance of our opinion held that "owner" under section 671 meant "owner" in the legal sense of the word, and held that the policies had in fact been transferred to the grantor/insured. The Eighth Circuit declared:
Estate of O'Connor v. Commissioner, supra, involved a testamentary marital trust in which the decedent's wife held certain rights which made the trust a grantor trust. Subsequent to the establishment of the trust, the decedent's wife assigned all of her interest in the trust to a section 501(c)(3) charitable foundation. One issue in Estate of O'Connor was whether the estate was entitled to a distribution deduction under section 661(a) for amounts passed through the marital trust to the foundation. The resolution of that issue turned upon whether the foundation/grantor should be treated as the "owner." If the foundation were treated as the "owner," then the trust entity would be ignored, and the estate would be deemed to have made its distributions directly to the foundation and not through the trust. This Court held that the trust was not a recognizable tax entity, and disallowed the estate's deduction.
When a grantor or other person has certain powers in respect of trust property that are tantamount to dominion and control over such property, the Code "looks through" the trust form and deems such grantor or other person to be the owner of the trust property and attributes the trust income to such person. See secs. 671, et seq. By attributing such income directly to a grantor or other person, the Code, in effect, disregards the trust entity. [69 T.C. at 174.]
Petitioners also rely upon Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984), wherein the issues were whether the grantor of irrevocable trusts was (1) entitled to a new cost basis when he purchased shares of corporate stock from the trusts, which he originally contributed to the trusts, and (2) entitled to a deduction for interest paid to the trustee on the promissory note used to purchase the stock. The Commissioner contended that the step-up in basis and the interest deduction should be disallowed because the grantor/owner had in effect purchased
Section 671 makes it plain that it was not Congress's intention that the taxation of grantor/"owners" be governed by what might otherwise seem the sensible general principle that a taxpayer may not have meaningful dealings with himself. Rather, the statute envisions (1) that the income and deductions of the grantor and the trust will be computed in the normal fashion, the trust being treated as a fully independent tax-paying entity, and (2) that the relevant "items of income, deductions, and credits against tax" that would ordinarily appear on the trust's return will instead "be included in computing the taxable income and credits of the grantor." * * * Consistently with the objective of Clifford to prevent high-bracket taxpayers from shifting income to low-bracket trusts over which they retain or exercise excessive controls, § 671 dictates that, when the grantor is regarded as "owner," the trust's income shall be attributed to him—this and nothing more. [735 F.2d at 709; fn. ref. omitted.]
We need not comment on the result reached by the Second Circuit in Rothstein, nor on the rationale applied by the court in reaching such result.
This scheme of taxation is frustrated here if petitioners are allowed to escape recapture through a formalistic, piecemeal application of the law. The trusts were created with a built-in defect, causing them to be grantor trusts. The trusts then invested in a limited partnership interest that produced significant paper losses for the grantor. At the "cross-over" point, when the partnership began to generate income, the defect in the trusts was cured, and the tax burden was placed on the lower bracket beneficiaries. A formalistic approach, as suggested by petitioners, would result in a finding that ownership never changed hands—since the trusts have technically been the owners of the partnership interests—which would then allow petitioners to escape recapture.
Although Edgar v. Commissioner, 56 T.C. 717 (1971), was not cited by either party, we think it necessary to comment upon that opinion in light of the instant case. In Edgar, we held that a grantor who was also the income beneficiary of a grantor trust could not be treated as the owner of the corpus portion of the trust. Accordingly, we held that the loss generated by a partnership interest owned by the trust was not deductible on the grantor's individual tax return, because the loss belonged to the corpus portion of the trust, while the grantor was owner only of the income portion. The key issue in Edgar was the definition of "portion" in section 677. In Edgar, was determined that under section 677 a grantor who was also an income beneficiary could only "own" the income portion of the trust. We did not imply in Edgar that it was not possible to own the entire trust, i.e., income and corpus. Our previous
The grantor shall be treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party.
Because the trustee, the nonadverse party, has a power of disposition over all of the corpus and income, the grantor must be considered owner of the whole trust, both income and corpus. Edgar, therefore, is distinguishable from the instant case.
Petitioners also contend that even if the grantor is the owner of the trust assets, a mere change in the trust's status is not a disposition triggering the recognition of gain. On brief, petitioners argue that a sale or other disposition did not occur, noting that no transfer documents were ever executed, nor was there any other method of conveyance at the time of trust perfection. While this is true in form, a different event took place in substance.
The situation at hand is analogous to cases dealing with part-sale, part-gift transactions. Under section 1.1001-1(e), Income Tax Regs., if a transfer of property is in part a sale and in part a gift, the transferor must recognize gain to the extent his amount realized exceeds his adjusted basis in the property. This doctrine has been applied by the courts to situations where the transferred gift property is subject to a debt. To the extent the debt assumed by the transferee exceeds the transferor's adjusted basis in the property, a disposition is deemed to occur, and a corresponding gain must be recognized by the transferor. Estate of Levine v. Commissioner, 634 F.2d 12 (2d Cir. 1980), affg. 72 T.C. 780 (1979); Johnson v. Commissioner, 495 F.2d 1079 (6th Cir. 1974), affg. 59 T.C. 791 (1973). See Diedrich v. Commissioner, 457 U.S. 191 (1982). Here, the grantor's proportionate share of the partnership's nonrecourse liability exceeded his adjusted basis in the partnership interest. Therefore, a disposition is deemed to have occurred, and gain must be recognized.
We do not agree with respondent's contention that an examination of the ownership test of the family partnership rules is inappropriate in a grantor trust situation. Section 1.671-1(c), Income Tax Regs., provides, in part, as follows:
Except as provided in such subpart E, income of a trust is not included in computing the taxable income and credits of a grantor or another person solely on the grounds of his dominion and control over the trust. However, the provisions of subpart E do not apply in situations involving an assignment of future income, whether or not the assignment is to a trust. * * * Nor are the rules as to family partnerships affected by the provisions of subpart E even though a partnership interest is held in trust. * * * [Emphasis added.]
In addition, this Court has noted that the language of section 704(e) is sufficiently broad to cover nonfamily partnership situations even though section 704(e) is primarily directed towards "family partnerships." Carriage Square, Inc. v. Commissioner, 69 T.C. 119, 126 n. 4 (1977), citing Evans v. Commissioner, 54 T.C. 40, 51 (1970), affd. 447 F.2d 547 (7th Cir. 1971).
We do agree, however, with respondent that the grantor trust provisions result in the grantor's being treated as the owner of the partnership interest. We do not accept petitioners' contention that the application of section 704(e) and the regulations thereunder overrides the grantor trust provisions and necessitates the opposite conclusion.
II. Retroactive Application of the Regulation
Petitioners argue that if example (5), is upheld, it should not be applied retroactively. Section 1.1001-2, Income Tax Regs., was promulgated on December 11, 1980, while the grantor trust in the instant case was perfected in 1978.
In the Treasury explanation accompanying the regulation, the Government stated that the regulation would have retroactive effect by reasoning that "these amendments merely clarify the existing regulations by setting forth the long-established ruling and litigating position of the Internal Revenue Service." T.D. 7741, 1981-1 C.B. 430, 431. Petitioners dispute this by pointing out that while the rest of section 1.1001-2, Income Tax Regs., may represent the Government's long-standing litigating position, example (5) does not. Petitioners argue that (1) no previous regulation addressed the issue; (2) in several previous cases,
Generally, regulations are applied retroactively unless the Secretary provides otherwise. Sec. 7805(b); Helvering v. Reynolds, 313 U.S. 428 (1941); Wendland v. Commissioner, 79 T.C. 355 (1982), affd. per curiam 739 F.2d 580 (11th Cir. 1984), affd. sub nom. Redhouse v. Commissioner, 728 F.2d 1249 (9th Cir. 1984). The Secretary's failure to limit the retroactive effect of a regulation may not be disturbed unless it amounts to an abuse of discretion. See Automobile Club of Michigan v. Commissioner, 353 U.S. 180 (1957); Beneficial Life Insurance Co. v. Commissioner, 79 T.C. 627 (1982).
We find no abuse of the Secretary's discretion in the instant case. This is not a case where the regulation in question alters settled prior law upon which the taxpayer justifiably relied and the alteration causes the taxpayer to suffer inordinate harm. See Helvering v. R.J. Reynolds Tobacco Co., 306 U.S. 110 (1939); Wilson v. United States, 588 F.2d 1168, 1172-1173 (6th Cir. 1978). In fact, respondent's position on the issue in the instant case was published in Rev. Rul. 77-402, 1977-2 C.B. 222, in the year prior to the year in issue. Petitioners were thus aware of respondent's position at the time the trusts were perfected. Accordingly, we uphold the retroactive application of example (5).
III. Capital Gain Versus Ordinary Income
As previously noted, the trusts invested in Saintly via another partnership, Metro. Metro did not have any unrealized receivables or substantially appreciated inventory. Saintly, however, did have unrealized receivables.
Petitioners argue that because the trusts' investments were in Metro, and not in Saintly, directly, the disposition that
Section 741 provides that in the case of a sale or exchange of an interest in a partnership, gain shall be recognized to the transferor and it shall be considered as gain from the sale or exchange of a capital asset, except as provided in section 751. Section 751(a) generally requires ordinary income treatment for the portion of the gain attributable to unrealized receivables or inventory items of the partnership.
Legislative intent in enacting section 751 was "to prevent the conversion of potential ordinary income into capital gain by virtue of transfers of partnership interests."
Decision will be entered for the respondent.
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