American Participations-Trust Co. v. Commissioner

American Participations-Trust, City National Bank and Trust Company, Trustee, Petitioner, v. Commissioner of Internal Revenue, Respondent American Participations-Trust Co. v. Commissioner Docket No. 17110 United States Tax Court 14 T.C. 1457; 1950 U.S. Tax Ct. LEXIS 148; June 30, 1950, Promulgated *148 Decision will be entered for petitioner. Held, since there were no powers granted to or exercised by the trustee, or depositor, or both combined, beyond those which are incidental to the preservation of trust property, the collection of income therefrom and its distribution to the holders of trust certificates, the trust involved is not an association taxable as a corporation within the meaning of section 3797 of the Internal Revenue Code. Andrew B. Young, Esq.,*149 for the petitioner. William B. Springer, Esq., for the respondent. Hill, Judge. HILL *1458 The respondent determined deficiencies in petitioner's income and declared value excess profits taxes and 25 per cent delinquency penalties as follows: Income tax Declared value excess profits tax Year ended July 31 Deficiency 25% penalty Deficiency 25% penalty [1937] $ 166.24 $ 41.56 $ 246.81 $ 61.70 [1938] 273.51 68.38 363.83 90.96 [1939] 436.87 109.22 419.40 104.85 [1940] 840.45 210.11 610.33 152.58 [1941] 932.40 233.10 811.92 202.98 [1942] 1,465.88 366.47 885.60 221.40 [1943] 1,820.56 455.14 938.94 234.74 [1944] 2,464.82 616.21 1,277.53 319.38 [1945] 6,670.56 1,667.64 960.11 240.03 Certain adjustments made by respondent are not contested. The question for determination is whether petitioner is an Association taxable as a corporation, as contended by respondent, or taxable as a trust as urged by petitioner. An issue was raised by the pleadings concerning the penalties determined. However, on brief, petitioner stated "There is no issue as to penalties -- if the Respondent prevails, there is no question that Forms 1120 have not been *150 filed." FINDINGS OF FACT. Part of the facts have been stipulated and they are so found. The City National Bank & Trust Company (formerly City Bank & Trust Company) is a national bank with offices in Kansas City, Missouri. It will hereinafter be referred to as trustee. It is trustee of a trust indenture executed May 21, 1932, by it and American Participations, Inc. (hereinafter sometimes referred to as the depositor), a Missouri corporation with its separate office in Springfield, Missouri. Registered holders of trust certificates issued under the trust indenture from time to time are also parties to the indenture and are bound by its terms. American Participations-Trust was established by indenture dated May 21, 1932. Article Eleven of that indenture contains the following definitions: #11.03. The term "Beneficiary" shall mean the person in whose name the Certificate is registered in the Beneficiary Account. * * * * #11.08. The term "maintenance allowance" shall mean the allowance to the Trustee for its fees, charges and expenses, as in #6.05 and #9.02 hereof described. * * * * *1459 #11.11. A "Portfolio Unit" shall mean the units of common stocks of the thirty-four companies*151 described in this Indenture; each "Portfolio Unit" being composed of one share each of the thirty-four stocks described herein. #11.12. A "Participation" shall mean the fractional part of a "Portfolio Unit" into which the "Portfolio Unit" is divided to ascertain the fractional parts of a "Portfolio Unit" applicable to the investment of the funds of the Beneficiary through his payments and distributions. #11.13. The word "Distributions" shall mean dividends which shall be paid from time to time on the different stocks to the Trustee; the proceeds from the sale of stock dividends and split-ups and/or any profits that many accrue to the Beneficiaries. Pursuant to the terms of the indenture, the depositor of the trust plan solicited funds from the public for the purchase of an interest in designated stocks deposited, or to be deposited with the trustee. The plan provides for the issuance of certificates which, when properly authenticated and registered by the trustee, are conclusive evidence of the certificate holder's right to participate in the benefits provided by the indenture. There are four plans of investment: (1) Trust Plan A -- insured, (2) Trust Plan B -- uninsured, (3) Fully*152 Paid Plan -- accumulative type, and (4) Fully Paid Plan -- distributive type. The first two plans call for the payment by the certificate holder to the trustee of periodic payments over a stated period designated on the certificate. The last two plans provide for the deposit in a single sum of the face amount of the certificate at the time of issuance. Under the first three plans, the certificate holder designates the trustee as his agent to collect periodic distributions from trust property for his account and use the same for the purchase of additional participations. Most of the certificates were issued under the first and third plans. To become a certificate holder, an application accompanied by a sum representing the first payment is turned over to the depositor. The depositor prepares the certificate and sends it and the first payment to the trustee, and the trustee enters on its records the name and address of the certificate holder, records the amount of payment and the type of plan, and causes the certificate to be authenticated and registered. The certificates are transferable by the registered certificate holders upon surrender to the trustee of the properly assigned*153 and endorsed certificate, but only upon the written consent of the depositor and registration of the assignment upon the beneficiary account maintained by the trustee and the issuance of a new certificate. There is limited liability of the beneficiaries to the property embarked in the undertaking. The depositor was required to deposit initially and maintain with the trustee at all times an amount in cash, or security units, or participations therein equal to one and one-half times the current value of one portfolio unit. This fund established by and belonging to the *1460 depositor is known as the "Revolving Fund" and includes, in addition, the depositor's service charges deducted from time to time by the trustee and paid into such fund. A portfolio unit, as shown by the definitions set forth above, consisted originally of one share of common stock of each of 34 different corporations designated in the indenture. There was provision in the indenture for elimination of securities in certain circumstances. Through elimination of three issues, the number of corporations whose shares constituted a unit was reduced to 31. Each unit of deposited property, in turn, consists of *154 10,000 undivided equitable interests or "participations" in the unit, each identical with every other undivided equitable interest in any and every unit of deposited property. The original or initial payment is normally given by the certificate holder to the depositor by means of a check payable to the trustee. The depositor sends out notices of installments due on the certificates and the certificate holders send their payments to the trustee which issues a receipt to the certificate holder and prepares a "ticket" as to each such receipt. This establishes the basis for entries to be posted to an individual certificate holder's ledger card reflecting his payments and the participations credited to his account. These transactions were handled by a cashier in the "cage" of the trustee's trust department, who took care, in addition to these receipts, of mortgage payments, bond coupon payments, and other trust department functions for accounts unrelated to American Participations-Trust. The trustee then makes the appropriate deductions for fees of 7 1/2 per cent to 12 per cent payable to the depositor, the trustee, and for insurance, if any, and the balance of the net payment is available*155 to purchase participations in the fixed portfolio of designated common stock. When moneys constituting the net payment are available at the end of the day, a clerk in the trust department of the trustee determines the number of participations to be purchased with such net cash by taking the current market price of the participations calculated as of the close of the preceding market day, which is determined by a broker for the depositor, and dividing that figure into the net payments. Cash is then transferred to the revolving fund established in order to facilitate investments, and the trustee transfers from the revolving fund to itself as trustee for the certificate holder the number of participations purchasable with such cash. These participations are then credited by a clerk to the individual accounts of the various certificate holders to the extent they had supplied the net payment and a summary of these account entries was furnished to the depositor daily. *1461 A clerk in the trustee's trust department, as a matter of daily routine, keeps account of the securities in the revolving fund, and whenever the balance is low, as compared with the daily demand of the trust for*156 participations, he orders that one or more portfolio units be purchased by brokers for the account of the depositors' revolving fund out of the cash balance of such fund. These purchases of securities are made without consulting the depositor, although the depositor receives a copy of the purchase confirmation from the broker. The equity in the revolving fund belonging to the depositor could be withdrawn by the depositor, on demand, so long as the balance of cash or participations amounted to at least one and one-half portfolio units. The trustee retains as currently distributable funds all cash received as dividends or distributions with respect to the deposited property and as agent or attorney in fact reinvests for the certificate holder semi-annually, such distributable funds less authorized deductions in a manner similar to the original investment of net payments except in those cases where no instructions to reinvest is given. In that case the amount available less authorized deductions is distributed semi-annually. A certificate holder's share of distributable funds is determined exclusively by his relative share of participations outstanding as shown by the books of the*157 trustee. Concerning distributions and reinvestment, Article Four, #4.08 of the indenture, provides as follows: #4.08. The trustee shall sell all split-ups in excess of one share of each stock in each "Portfolio Unit" and also all rights and stock dividends of each stock in the "Portfolio Units" and shall re-invest the proceeds from any and all such sales as provided in paragraph #4.05 of this section. Said sales shall be made on the New York Stock Exchange if said stock is listed on said Exchange, and if not listed on said Exchange, it may be sold on any Exchange on which it may be listed. If not listed on any Exchange, it may be sold in any manner deemed best by the Trustee. A certificate holder is entitled, upon surrender of his certificate before maturity, to receive, in kind, from the trustee the number of whole portfolio units credited to his account and receive the cash value of participations that amount to less than a whole unit or, in the alternative, the certificate holder may receive in cash the market value of his account in accordance with terms specified in the trust indenture. On these occasions, cash is secured for distribution to the liquidating certificate holder*158 through the operation of the revolving fund. Concerning the elimination of any stock in the portfolio unit Article Seven of the indenture provides as follows: #7.01. From time to time the Company, acting in consonance with the opinion of two or more reputable investment counsels, may certify to the Trustee in writing *1462 signed by its President or any Vice-President that in its opinion from the viewpoint of an investment to be held until the maturity of Certificates issued hereunder and solely for the purpose of protecting and preserving the quality of the investment of holders of Certificates all or any part of any stock then held by the Trustee as Deposited Property should be eliminated then and in that event the Trustee shall use its discretion in the manner of eliminating anyone or more stocks held as Deposited Property as certified by the Company and in the event any one or more stocks are eliminated the proceeds received therefor shall be invested by the Trustee in Portfolio Units from which the eliminated stock or stocks have been removed. The Trustee shall notify each Beneficiary of such eliminations. #7.02. The Trustee shall have no duty in respect of any elimination*159 of stocks under this section unless and until it receives the certification and opinion of the Company, referred to in #7.01 hereof, and under no circumstances shall the Trustee be held liable for its action in eliminating any stock or stocks. #7.03. Neither the Trustee nor the Company shall be liable for any action taken or omitted in good faith under this section. #7.04. In the event any practical difficulties arise in the matter of stock dividends, splits or any change in the status of any corporation or number of shares held in any corporation the Company may certify to the Trustee in writing signed by its President or any Vice-President its opinion as to the manner of handling such difficulties in the interest of the holders of Certificates, and the Trustee may act on such certification or may use its own discretion even to the extent of liquidation. The Trustee and the Company shall not be liable for any action taken or omitted by it in good faith under this section. Common stock of Drug Incorporated, Standard Brands, Incorporated, and The United Gas Improvement Company were completely eliminated from the portfolio units on the following dates: Drug Incorporated, August 25, *160 1933; Standard Brands, Incorporated, and The United Gas Improvement Company, November 8, 1943. Drug Incorporated stock was sold because the stock was split up. Standard Brands, Incorporated, stock was sold because in September 1943 it was split backwards, and one share was offered for every four shares held. In August 1943 The United Gas Improvement Company distributed stock in Philadelphia Electric Company and Public Service Company of New Jersey to the holders of The United Gas Improvement Company stock. The trustee sold the distributed stock and then, with those stocks eliminated, the trustee decided that The United Gas Improvement Company stock did not have the investment quality it previously had and thus sold it. Neither the trustee nor the depositor has any discretion in, nor has either of them ever exercised any control in, the choice of stocks in which units are invested or the number of shares of a particular security. Concerning modification of the trust indenture, Article Ten of the indenture provides in part as follows: #10.08. If at any time during the life of this Indenture it shall appear to the Company [American Participations, Inc.] there are practical difficulties*161 *1463 or unnecessary hardships, working or likely to work to the disadvantage of the Beneficiaries, then, and in each and every such event, a certificate setting forth said difficulty or hardship, together with the provisions of the Indenture contributing to the same and with a specific proposal for modification of this Indenture for the purpose of meeting the same (such certificate to be duly executed by the President or any Vice-President and the Secretary or Treasurer of the Company in its name), shall be filed with the Trustee, and if the Trustee, by writing filed with the Company, shall approve thereof, this Indenture shall be deemed modified or amended accordingly. Neither the Company nor the Trustee shall, in any such event, be under any liability to anyone for anything done or omitted under the provisions of this section, except each for its own deliberate bad faith. Notice of all such modifications of this Indenture shall be given as herein provided. The Company shall send a copy thereof to each Beneficiary at his respective address as the same appears on the Beneficiary Account. The trust, according to the indenture, terminates on May 21, 1982, except that the trustee*162 giving notice to the beneficiaries may terminate it sooner, if the trustee resigns and the Company, prior to the date fixed in the notice of resignation for such resignation to take effect, fails to appoint a successor trustee, or in the event that the trustee does not apply to a court of competent jurisdiction for the appointment of a successor trustee, or if upon such application the trustee so appointed fails to qualify under the indenture. After termination the trustee is required to convert the deposited property into cash and make distribution to the beneficiaries. The market value of portfolio units outstanding as at the end of the periods shown below was as follows: Period: May 22, 1932 to September 30, 1933 $ 18,466.50 October 1, 1933 to March 31, 1935 79,074.82 April 1, 1935 to June 30, 1936 259,470.00 Fiscal years ended July 31: [1937] 431,543.25 [1938] 527,806.18 [1939] 681,358.54 [1940] 695,125.50 [1941] 767,369.25 [1942] 701,488.00 [1943] 990,492.69 [1944] 1,046,803.81 [1945] 1,133,178.17 On October 1, 1946, fiduciary income tax returns, Form 1041, were filed by petitioner for the respective fiscal years ending July *163 31, 1937, through 1945. The returns were filed with the collector of internal revenue for the sixth district of Missouri. No Federal income tax returns other than the aforesaid fiduciary income tax returns filed on October 1, 1946, have ever been filed by or for American Participations-Trust for the taxable years involved in this proceeding. *1464 In the statement attached to the notice of deficiency respondent stated as follows with respect to the amounts involved: Inasmuch as your returns were not filed within the time prescribed by law, 25 per centum of the tax has been added thereto in accordance with the provisions of Section 291 of the Internal Revenue Code and of prior Revenue Acts. It is held that you are taxable as a corporation, as that term is defined in Section 3797 of the Internal Revenue Code and corresponding provisions of the prior applicable Revenue Acts. There were no powers granted to or in fact exercised by the trustee, the depositor, or both combined, beyond those which are incidental to the preservation of trust property, the collection of income therefrom and its distribution to the holders of trust certificates. OPINION. The respondent contends that American*164 Participations-Trust is an association taxable as a corporation within the meaning of section 3797 1 of the Internal Revenue Code and the sections of the revenue acts applicable to the years before us. He argues specifically that this case is not distinguishable from Commissioner v. North American Bond Trust Co., 122 Fed. (2d) 545, certiorari denied, 314 U.S. 701, because #7.01 of the trust indenture, which is set forth in full in our findings, "confers on the Trustee the power to reinvest proceeds from the sale of undesirable stocks in proportions other than those originally specified in the trust indenture" or, in other words, it gives the trustee the power to vary the investment within the meaning of the above case and Regulations 111, section 29.3797-2, 2 as amended by T. D. 5468. *166 The petitioner, on the other hand, urges that the trust in question is not so taxable because there are "* * * no powers in any party or combinations of powers in any parties beyond those which are *1465 necessary incidents to the preservation of trust property, the collection of income therefrom and its distribution to the accounts of the beneficiaries." It relies principally upon the case of Commissioner v. Chase National Bank of City of New York, 122 Fed. (2d) 540, affirming 41 B. T. A. 430. The petitioner argues that #7.01 should be construed together with #11.11, which is set forth in our findings. It then states: The plain meaning of sections 7.01 plus 11.11 would appear to be that the word "thirty-four" in paragraph 11.11 is altered by action taken under section 7.01 of the Indenture by inserting in lieu thereof such lesser number as may be appropriate. Such would appear to be the necessary effect of section 7.01 where it speaks of "Portfolio Units" from which the eliminated stock or stocks have been removed. Nowhere does section 7.01 require or justify a change, in fact, of the provision of section 11.11 *167 which describes Portfolio Units as consisting of "one share each" of the stocks remaining authorized for purchase by the Trustee. It further argues in support of its position that the respondent's interpretation would make the indenture as a whole unworkable for "* * * in the case of a withdrawal in kind, the trust would be impossible to administer unless all the underlying units of securities were identical." In Morrissey v. Commissioner, 296 U.S. 344, the Supreme Court said that a business trust was a taxable association when it had (1) a continuing entity throughout a trust period; (2) centralized management; (3) continuity of the trust uninterrupted by death among the beneficial interests; (4) means for transfer of beneficial interests; and (5) limitation of personal liability of participants to property embarked in the undertaking. See discussion of the Morrissey case in Commissioner v. City National Bank & Trust Company, 142 Fed. (2d) 771, certiorari denied, 323 U.S. 764. The powers granted by the trust indenture to the trustee, and not the extent*168 to which these are used, determine whether or not it constitutes an association taxable as a corporation. Morrissey v. Commissioner, supra;Helvering v. Coleman-Gilbert Associates, 296 U.S. 369. The powers and duties of the trustee should be added to those of depositor in appraising the full amount of management activities and trust objects. Commissioner v. Chase National Bank, supra. The United States Court of Appeals for the Second Circuit in Chase National Bank, supra, relying on the Morrissey case, supra, by a divided court, held that when the power of the trustee, or the trustee *1466 and the depositors combined, is to determine only that certain securities should be weeded out of a portfolio unit whenever they become unsound for investment and retain the remainder, the trust was not organized and administered in such a way as to be an association taxable as a corporation under the revenue statutes. Reinvestments there were forbidden, the proceeds of all sales being distributed. See 41 B. T. A. 430, 441.*169 The Court determined that in that instance the trustees and the depositor, or both combined, were not doing business, but instead were merely holding and preserving trust property. The Court, however, on the same day it handed down the decision in the Chase National Bank case, held, again by a divided court, that if the depositor or trust, or both combined, have the power to vary the existing investments of all certificate holders at will, and in this way "* * * take advantage of the market variations to improve the investments, it is an association taxable as a corporation." Commissioner v. North American Bond Trust, supra.See Mertens, Law of Federal Income Taxation, section 43.24. We believe that the respondent's determination is erroneous. We agree with petitioner that the provisions of #7.01 should be considered together with those of #11.11, which defines a portfolio unit as consisting of one share each of the specified corporations. In view of #11.11 of the trust indenture we can not hold that the depositor or the trustee, or both combined, had any authority to increase the number of shares of any portfolio unit so that any unit would*170 comprise more than one share each of any of the authorized securities. Although, as above pointed out, the granted powers in the trust indenture and not the extent to which they are used determine whether or not it constitutes an association taxable as a corporation, we nevertheless believe that here the conduct of the trustee and/or depositor is of material aid in determining the authority they had under the trust indenture. Neither the trustee nor the depositor ever reinvested in the portfolio units from which the undesirable securities were removed. They did not because, as their officers testified, it was felt there was no authority under the trust indenture so to do. After the undesirable securities were removed, the portfolio units consisted only of one share each of the remaining 31 approved corporations. In support of his position, the respondent cites Commissioner v. North American Bond Trust, supra, and Commissioner v. City National Bank & Trust Company, supra. The North American Bond Trust case is not applicable since, as we have pointed out above, there is no power in the trustee or depositor *171 here to vary the investment. In City National Bank & Trust Company, the Court stated that that case was distinguishable from Chase National Bank, supra.The instant case is not so distinguishable. In the Chase National Bank case, the Court of Appeals said in part as follows: *1467 In determining the character of these trusts the powers and duties of the trustee should be added to those of the depositor in order to arrive at the full amount of permitted managerial activity and its object. When that is done we find the permitted activities could, and the actual activities did, affect the property held in trust only by weeding out whatever became unsound for investment and retaining the remainder. That, we think, prevented the trusts from being, or becoming, more than what are sometimes called strict investment trusts. What they were when created is determinable from the trust agreements and the application of the principles set forth in Morrissey v. Commissioner, 296 U.S. 344, 56 S. Ct. 289, 80 L. Ed. 263, leads to the conclusion, in support of the Board's decision, that *172 the trust property was to be held for investment and not to be used as capital in the transaction of business for profit like a corporation organized for such a purpose. This distinction is what makes the difference tax-wise. Sears, Trustee, v. Hassett, 1 Cir., 111 F. 2d 961. Though what was actually done controls, Ittleson v. Anderson, 2 Cir., 67 F. 2d 323, it was found that nothing was done to change the original character of the trusts. The latter involves questions of fact as to which the Board's findings are conclusive if supported by the evidence. Helvering v. National Grocery Co., 304 U.S. 282, 58 S. Ct. 932, 82 L. Ed. 1346. The Board, on ample evidence, found that there was no exercise by the trustee, the depositor, or both combined of "any powers beyond those which are necessary incidents to the preservation of trust property, the collection of income therefrom and its distribution to the holders of trust shares." That being so, these trusts do not fall within the statute upon which the Commissioner relies. The Court of Appeals in that*173 case affirmed our decision therein. We adhere to that decision and accordingly hold for the petitioner here. In view of our holding on the principal issue, we also hold that petitioner is not liable for any penalty under the provisions of section 291 (a) of the Internal Revenue Code and corresponding provisions of the Revenue Acts of 1936 and 1938 for failure to file returns for the years in question. Decision will be entered for petitioner. Footnotes 1. SEC. 3797. DEFINITIONS. (a) When used in this title where not otherwise distinctly expressed or manifestly incompatable with the intent thereof -- * * * * (3) Corporation. -- The term "corporation" includes associations, joint-stock companies, and insurance companies. * * * *↩ Section 901 (a) (2) of the Revenue Act of 1938 and section 1001 (a) (2) of the Revenue Act of 1936 contain similar language. The applicable regulations are: Regulations 111, sections 29.3797-1, 29.3797-2 and 29.3797-3; Regulations 101, article 901-2; Regulations 94, article 1001-2. 2. REGULATIONS 111. * * * * Sec. 29.3797-2. Association. -- The term "association" is not used in the Internal Revenue Code in any narrow or technical sense. It includes any organization, created for the transaction of designated affairs, or the attainment of some object, which, like a corporation, continues notwithstanding that its members or participants change, and the affairs of which, like corporate affairs, are conducted by a single individual, a committee, a board, or some other group, acting in a representative capacity. It is immaterial whether such organization is created by an agreement, a declaration of trust, a statute, or otherwise. It includes a voluntary association, a joint-stock association or company, a "business" trust, a "Massachusetts" trust, a "common law" trust, an interinsurance exchange operating through an attorney in fact, a partnership association, and any other type of organization (by whatever name known) which is not, within the meaning of the code, a trust or an estate, or a partnership. An "investment" trust of the type commonly known as a management trust is an association, and a trust of the type commonly known as a fixed investment trust is an association if there is power under the trust agreement to vary the investment of the certificate holders. (See Commissioner v. North American Bond Trust, 122 Fed. (2d) 545, certiorari denied, 314 U.S. 701↩).