Lehmann v. Commissioner

EDWARD J. LEHMANN, OTTO W. LEHMANN, AND EDITH M. BEHR, AS TRUSTEES OF THE FAIR STOCK TRUST, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Lehmann v. Commissioner Docket No. 32137. United States Board of Tax Appeals 21 B.T.A. 664; 1930 BTA LEXIS 1815; December 12, 1930, Promulgated *1815 1. Where trustees have discretion to accumulate or distribute the income of the trust, the beneficiaries are taxable upon the amount distributed and the trustees upon the amount undistributed. Sec. 219, Revenue Act of 1921. 2. Income distributed by trustees in the exercise of a discretion lodged in them by the trust instrument is income distributed pursuant to such instrument. Herbert Pope, Esq., and E. Barrett Prettyman, Esq., for the petitioner. Bruce A. Lowe, Esq., and Leslie H. Rushbrook, Esq., for the respondent. PHILLIPS *664 Respondent has determined a deficiency in income tax for the year 1922 in the amount of $194,718.94. It is alleged that respondent erred (1) in determining that petitioners as trustees under the provisions of The Fair Stock Trust might in their discretion distribute the income of the trust or accumulate it, and that such income fell within the provisions of article 342 of Regulations 62; (2) in determining that said article was a valid regulation; and (3) in taxing to the petitioners as trustees the income of said trust for the year 1922 instead of taxing such income to the beneficiaries to whom it*1816 had been distributed. Shortly before the hearing of this proceeding respondent filed an amended answer in which he sought to increase the deficiency to the sum of $4,194,718.94, on the ground *665 that petitioners had received additional income in the year 1922 either as a dividend or as capital gain. Respondent at the hearing failed to prove the affirmative allegations of his answer and on motion of petitioners decision was entered for petitioners on all said affirmative allegations in the answer. FINDINGS OF FACT. The petitioners are trustees under the terms of an indenture of trust executed on February 2, 1914, between Augusta Lehmann and Edward J. Lehmann, Otto W. Lehmann, and Augusta Lehmann as trustees. The petitioners have their principal office and each resides within the first internal revenue district of Illinois. Said indenture of trust, so far as here material, reads as follows: This Indenture made this Second day of February, A.D. 1914, by and between Augusta Lehmann, the widow of Ernst J. Lehmann, deceased, party of the first part, and Edward J. Lehmann, Otto W. Lehmann and Augusta Lehmann, as Trustees hereunder, all of the City of Chicago, County of*1817 Cook and State of Illinois, parties of the second part, hereinafter, for convenience, referred to as the Trustees, Witnesseth: That Whereas, the said party of the first part is the owner of all of the capital stock of the corporation known as The Fair, organized and existing under the laws of the State of Illinois, and doing a general dry goods and mercantile business in the City of Chicago, and capitalized for the sum of one million dollars, consisting of ten thousand shares of the par value of one hundred dollars each, and Whereas the said business of said corporation has been carried on for several years last past under the management, and largely under the direction of the said Edward J. Lehmann, and the said Otto W. Lehmann, the said Edward J. Lehmann having had the general management thereof, and the said Otto W. Lehmann having assisted the said Edward J. Lehmann in the conduct of said corporation in carrying on its said business, and Whereas, said business has been a prosperous one, and has grown into large proportions, and the said party of the first part recognizes the fact that its present prosperous condition is, in a large measure, due to the business management*1818 of said Edward J. Lehmann and the said Otto W. Lehmann, and Whereas, the said party of the first part, feeling the burdens and responsibilities resting upon her, as the sole owner thereof, and realizing that the experience of said Edward J. Lehmann and Otto W. Lehmann in the successful management of said business in the past will justify her in entrusting the future management of the same to them, and being convinced that their control and management will not only be advantageous to her, but will also be for the best interests of all her children who will eventually profit by a successful business career of said corporation, and Whereas, the party of the first part being desirous of putting the control and management of said corporation, and its said business, in the said trustees, and in order to carry out and effectuate such purposes, she, the said party of the first part, has decided to convey the said capital stock of the said corporation to the said trustees, the parties of the second part herein. *666 Now, Therefore, For and in consideration of one dollar and other good and valuable considerations to said first party moving from the said second parties, as such*1819 trustees, the receipt of which is hereby acknowledged, and for the purpose of accomplishing the objects herein set forth, said party of the first part has sold, assigned, transferred and set over, and does hereby sell, assign, transfer and set over, unto the said parties of the second part, as such trustees, and to their successor or successors in the trust hereby created, all the right, title, interest or demand whatsoever, which the said party of the first part, the said Augusta Lehmann, in her own right, now has, in and to all the capital stock of The Fair, a corporation organized and existing under and by virtue of the laws of the State of Illinois, consisting of ten thousand shares of the par value of one hundred dollars each, together with all rights appertaining thereto and connected therewith, and has also placed in the hands of said trustees the sum of fifty thousand dollars ($50,000.00) as working capital, which is to become a part of this trust and administered by said trustees as other moneys belonging to said Trust Fund. To Have and to Hold the same upon the following trusts, uses and purposes, to wit: First: To take and hold the title to said capital stock of The Fair*1820 in their names, as such trustees hereunder, with all the rights, privileges and appurtenances thereunto belonging, as fully to all intents and purposes, as the said party of the first part hereto, now has, as the absolute owner of the same, and with all the powers usually bestowed upon stockholders of like corporations. * * * Third: The said trustees shall manage, control, and administer all the property at any time held by them in trust hereunder, in such manner as they in their own unfettered judgment may think for the best interests of the trust estate, and shall have full power and authority to do all acts and things which they may in their own discretion deem necessary and proper in so managing and administering such trust property, it being the intention of this instrument to confer upon the said trustees, in addition to the powers hereinafter specifically conferred upon them, as full power in the management and administration of the property, and every part thereof, at any time belonging to the trust hereby created, as though they were the absolute owners thereof. Said trustees shall collect all the income, rents and profits of the property at any time belonging to the*1821 trust hereby created, and out of them, when so collected, as such trustees, they shall from time to time, first pay all taxes and special assessments, or special taxes, on each and every part of such trust property, and all necessary and proper operating expenses of the same, including the expense of repairs, and also any and all other necessary or proper costs, charges or expenses, of any and every description, connected with, or growing out of the management or administration of the trust property, or in the execution of the trusts hereby created, as well as by the exercise of any and all of the powers conferred upon said trustees by this instrument. Fourth. During the continuance of the trusts hereby created and until the termination of the same as herein provided, the trustees hereunder, shall, in executing each and all of the trusts created in and by this instrument, have in addition to the powers hereinbefore conferred upon them, each and all the following powers, but it being the intention of this instrument that the conferring and enumeration of the following powers shall not be held or construed to in any manner, degree or respect whatsoever, limit, abridge, or affect*1822 the scope, extent or operation of any of the powers hereinbefore conferred on the said trustees. Fifth. The trustees shall have power at any time, and from time to time, to sell all or any of the property, real or personal, then belonging to the trust hereby created, either at public auction or by private contract, for cash or *667 on credit, or part for cash and part on credit, and to execute and deliver all good and sufficient deeds, bills of sale, instruments of transfer, and any and all other writings, necessary or proper, to convey the property so sold, and the proceeds of any sale so made shall be held by said trustees, upon, and subject to the same trusts which the property so sold was held by said trustees. Sixth. Said trustees shall have power at any time, and from time to time, to invest the moneys, and convert the property, real and personal, belonging to the trust hereby created into money, and invest the same in such Government or Municipal bonds or securities, stocks or bonds of corporations created under the laws of the United States or of the State of Illinois, or of any other State, bonds or notes secured by mortgage or pledge of either real or personal*1823 property, or other interest-bearing or income-producing securities, or in incomeproducing real estate, or in certificates, receipts, or any other papers, executed or issued by any trustee or trustees holding the title to real estate situated anywhere in the United States, and evidencing any interest in such real estate or in the income or proceeds of sale thereof, as said trustees may, in their sole discretion see fit. SINKING FUND. Thirteenth. It at any time, during the term of this trust, the trustees shall feel that they should establish a sinking fund to protect against extraordinary expenses or demands, in operating said business, or in expanding and enlarging the same, they shall have the right and power so to do, from the funds or ready securities in their hands, to be used in such extraordinary expenses and demands, and the said trustees shall have the power to add to and withdraw from such sinking fund, any and all sums that in their judgment may be necessary to be used by the Directors of The Fair in carrying on its said business and in meeting such emergencies and extraordinary demands, and their judgment shall not be questioned by any person in this regard. HOW*1824 TRUST MAY BE TERMINATED. Fifteenth. This trust agreement and the trust hereby created, May be terminated at any time prior to the death of the said Augusta Lehmann, in the following manner: 1. By all of the three trustees herein mentioned joining in a written agreement revoking and canceling the said trust, the same, however, to be acknowledged as deeds are required to be acknowledged in the State of Illinois. 2. If either the said Edward J. Lehmann or Otto W. Lehmann shall not be acting at the time such revocation or cancellation of this agreement is sought to be made, then the said party of the first part, the said Augusta Lehmann, joining with whichever of the said trustees (Edward J. Lehmann or Otto W. Lehmann) may be acting, may cancel the trust by a similar agreement. 3. If neither the said Edward J. Lehmann or said Otto W. Lehmann shall be acting as trustees hereunder, then and in that event, the said Augusta Lehmann shall have full power and authority to cancel and revoke this agreement by giving written notice to the trustee or trustees acting with her, of her desire or determination to terminate this trust. 4. And in case of a revocation or cancellation*1825 of this trust agreement at any time prior to the death of the said Augusta Lehmann, as herein and in this paragraph provided, all of the said property and estate then in the hands of the said trustees shall immediately revert to and be vested in the said Augusta Lehmann, and by proper and sufficient deeds of conveyance, bills of sale or assignments be immediately conveyed to the said Augusta Lehmann and she shall have and retain the same as her own absolute property as though this agreement had not been made. *668 VACANCIES IN TRUSTEESHIP - HOW FILLED. Sixteenth. Whenever any vacancy occurs in the Trustee-ship created by this instrument, by reason of the death, resignation, refusal or inability to act, of any of the trustees for the time being hereunder, then and in such case a successor to fill such vacancy shall be appointed as follows, to wit: * * * 3rd. If such vacancy shall occur after the death of said Augusta Lehmann, or by her death, then the other two trustees acting at that time shall appoint the third to fill such vacancy. Seventeenth. Any person or persons appointed as a successor or successors in trust to any trustee or trustees under this instrument, *1826 shall, on such appointment, without any further act, deed or conveyance, become and be trustee or trustees hereunder, with all the estate, trusts, rights, powers and duties of the trustee or trustees in whose place he or they shall have been so appointed, except as limited under and by virtue of the specific terms of this trust agreement. * * * Twentieth. This trust shall terminate at the end of twenty years after the death of first party, the said Augusta Lehmann. Twenty-first. Said trustees shall have the power, in addition to the powers heretofore given them, to sell said capital stock of The Fair, or any part or portion thereof, and also all the estate and property belonging to said trust, as to them may seem best, and upon such terms as they may, in their discretion, think for the best interest of said trust estate, and when sold, the proceeds of such sale shall pass into their hands as such trustees, and be held by them under the terms of this trust. Twenty-second. None of the parties hereinafter designated as beneficiaries hereunder shall have the right or power to anticipate the said income, or any part thereof, or the principal of said trust estate, or to alienate*1827 in any manner whatsoever, or encumber the same, or any part thereof at any time during the continuance of the trusts hereby created, nor shall such trustees be obliged to pay said income, or principal, to any of said beneficiaries hereinafter named except upon the personal receipt of the person entitled thereto. Twenty-third. Said trustees shall pay to said first party the sum of Twenty Thousand Dollars ($20,000.00) for each and every calendar month, payable on the last day of each and every month during her natural life, and in case of a failure to make such payments for a period of sixty days shall give first party the right to terminate this agreement, and by giving written notice to the other trustees of the fact of the default in such payments, and that by reason of such default she is desirous of terminating such trust, she shall have the power to reassign said capital stock of The Fair to herself and thereafter she shall own and control the same with all the estate and property in the hands of said trustees at that time, and re-possess the same as if this agreement had not been made. Twenty-fourth. When the said party of the first part purchased of Otto Young one-half*1828 of the capital stock of The Fair, as part payment therefor she gave her note for one million dollars, dated August 1st, 1905, due on or before ten years after its date and secured the same by trust deed to John P. Wilson, Trustee, which was recorded in the Recorder's Office of Cook County, Illinois as Document 3731546, and recorded in Book 9125 of Records, page 317, conveying the property therein described belonging to the said Augusta Lehmann, it being the intention that upon the execution of this trust agreement the trustees herein and hereby are to assume, and do hereby assume *669 and agree to pay, the balance due upon the said note, with interest, said balance amounting at the present time to about the sum of seven hundred thousand dollars of principal, and interest from and after February 1st, 1914, and save the said Augusta Lehmann harmless from said obligation, and cause the balance of said note, with interest, to be paid and her said property covered by said trust deed to John P. Wilson to be released and discharged of record from the lien of said trust deed. DISTRIBUTION OF INCOME Twenty-sixth. During the term of this trust it shall be discretionary with said*1829 trustees, as to what portion of the income from said trust estate over and above the monthly payments to Augusta Lehmann, hereinbefore provided for, shall be distributed, but when distributed, such income shall be divided into six equal parts and be distributed as follows: * * * DISTRIBUTION OF PRINCIPAL AND ACCUMULATIONS Twenty-seventh. At the termination of this trust, all of the trust estate, and the accumulations, shall be divided into six (6) equal parts and paid over, conveyed and disposed of as follows: (Here follow detailed provisions for the distribution of the trust property among the six beneficiaries and their descendants.) It is expressly covenanted and agreed that except as hereinbefore provided, this instrument, and the trusts hereby created, shall not, either in whole or in part, be revocable or determinable in any manner whatsoever, but shall be absolutely binding on the grantor herein and on the trustee hereunder. Augusta Lehmann died on November 16, 1918. On December 27, 1918, the surviving trustees pursuant to the provisions of clause sixteenth of the trust instrument appointed petitioner Edith M. Behr as contrustee to succeed Augusta Lehmann. From*1830 said date to and including the calendar year 1922 petitioners Edward J. Lehmann, Otto W. Lehmann, and Edith M. Behr were the duly appointed qualified and acting trustees of The Fair Stock Trust. At all times from November 16, 1918, to November 4, 1927 (the date of the filing of petition herein), Edward J. Lehmann, Emilie W. Peacock, Augusta E. Lehmann, Edith M. Behr, Otto W. Lehmann and Ernst E. Lehmann have been the beneficiaries of The Fair Stock Trust. From the inception of the trust to and including the year 1922 the trustees received and expended or distributed the following amounts of income: — 1914 — Receipts Disbursements Dividends $240,000.00 Mrs. Lehmann $220,000.00 Interest on bank 538.61 Other beneficiaries 30,000.00 balances Interest on mortgage 14,000.00 Total 240,538.61 Attorney's fees 1,405.00 Total 265,405.00 — 1915 — Dividends $1,000,000.00 Mrs. Lehmann $220,000.00 Interest on bank 631.36 Other beneficiaries 60,000.00 balances Interest on 25,666.67 Total 1,000,631.36 Payment of mortgage 700,000.00 Total 1,005.666.67 — 1916 — Dividends $340,000.00 Mrs. Lehmann $260,000.00 Interest on bank 511.81 Other beneficiaries 90,000.00 balance Total 340,511.81 Total 350,000.00 — 1917 — Dividends $540,000.00 Mrs. Lehmann $240,000.00 Interest 1,205.19 Other beneficiaries 300,000.00 Expenses 50.00 Total 541,205.19 Total 540,050.00 — 1918 — Dividends $480,000.00 Mrs. Lehmann $210,000.00 Interest 482.91 Other beneficiaries 275,000.00 Expenses 35.00 Total 480,482.91 Total 485,035.00 — 1919 — Dividends $340,000.00 Beneficiaries $344,000.00 Interest 490.31 Expenses 35.00 Attorney's fees 245.00 Total 340,490.31 Total 344,280.00 — 1920 — Dividends $140,800.00 Beneficiaries $144,000.00 Interest 1,278.49 Expenses 35.00 Total 142,078.49 Total 144,035.00 — 1921 — Dividends $448,800.00 Beneficiaries $444,000.00 Interest 2,291.38 Expenses 128.75 Total 451,091.38 Total 444,128.75 — 1922 — Dividends $440,794.27 Beneficiaries $444,000.00 Interest 6,517.96 Expenses 35.00 Tax exempt interest 3,902.30 Total 451,214.53 Total 444,035.00 *1831 *671 On January 12, 1920, the trustees sold to The Fair 1,200 shares of its capital stock and The Fair paid them therefor the sum of $1,200,000. The Fair on its books charged this stock to treasury stock. Practically the whole amount received by the trustees was used by them to pay the Federal estate tax on the transfer of the estate of Augusta Lehmann and the balance, if any, was included in the corpus of the trust and invested. The surplus of The Fair amounted on August 1, 1914, to $3,356.734.19 and on February 1, 1920, to $10,501,398.67. On March 14, 1923, petitioners, as trustees, filed in the office of the collector of internal revenue at Chicago, Ill., an income-tax return for the year 1922 on Form 1040, showing that the net income of the Fair Stock Trust for 1922 amounted to $447,277.23 and that the income tax calculated thereon would amount to $194,718.94. At the same time that this return was filed there was filed by petitioners, pinned to the return, a claim for the abatement of the entire amount of $194,718.94 on the ground that under the Revenue Act of 1921 (as well as under the Revenue Act of 1918) the entire "net income of the trust should be taxed to*1832 the beneficiaries and not to the trustees." Respondent rejected said claim for abatement and determined the deficiency against petitioners in the amount of tax returned. OPINION. PHILLIPS: Before filing his answer to this proceeding respondent moved to dismiss the petition, on the ground that he had not determined a dificiency within the meaning of the provisions of the Revenue Act of 1926, and pointed out that the amount of the tax determined was precisely the amount shown on the return. Petitioners contended that when the return was read in connection with the claim for abatement which had been made part of it, the whole disclosed that no tax was due and, therefore, that the tax determined was in excess of the tax returned, which was zero. This motion was overruled on Authority of , and . The issue presented is whether the income of the trust is taxable to the trustees, and involves the application of the provisions of section 219 of the Revenue Act of 1921, the pertinent parts of which read: (a) That the tax imposed by sections 210 and 211 shall apply to the*1833 income of estates or of any kind of property held in trust, including - * * * (2) Income accumulated in trust for the benefit of unborn or unascertained persons or persons with contingent interests; (3) Income held for future distribution under the terms of the will or trust; and *672 (4) Income which is to be distributed to the beneficiaries periodically, whether or not at regular intervals, and the income collected by a guardian of an infant to be held or distributed as the court may direct. (b) The fiduciary shall be responsible for making the return of income for the estate or trust for which he acts. The net income of the estate or trust shall be computed in the same manner and on the same basis as provided in section 212, except that (in lieu of the deduction authorized by paragraph (11) of subdivision (a) of section 214) there shall also be allowed as a deduction, without limitation, any part of the gross income which, pursuant to the terms of the will or deed creating the trust, is during the taxable year paid or permanently set aside for the purposes and in the manner specified in paragraph (11) of subdivision (a) of section 214. In cases in which there*1834 is any income of the class described in paragraph (4) of subdivision (a) of this section the fiduciary shall include in the return a statement of the income of the estate or trust which, pursuant to the instrument or order governing the distribution, is distributable to each beneficiary, whether or not distributed before the close of the taxable year for which the return is made. (c) In cases under paragraphs (1), (2), or (3) of subdivision (a) or in any other case within subdivision (a) of this section except paragraph (4) thereof the tax shall be imposed upon the net income of the estate or trust and shall be paid by the fiduciary * * *. (d) In cases under paragraph (4) of subdivision (a) * * * the tax shall not be paid by the fiduciary, but there shall be included in computing the net income of each beneficiary that part of the income of the estate or trust for its taxable year which, pursuant to the instrument or order governing the distribution, is distributable to such beneficiary, whether distributed or not * * *. (e) In the case of an estate or trust the income of which consists both of income of the class described in paragraph (4) of subdivision (a) of this section*1835 and other income, the net income of the estate or trust shall be computed and a return thereof made by the fiduciary in accordance with subdivision (b) and the tax shall be imposed, and shall be paid by the fiduciary in accordance with subdivision (c), except that there shall be allowed as an additional deduction in computing the net income of the estate or trust that part of its income of the class described in paragraph (4) of subdivision (a) which, pursuant to the instrument or order governing the distribution, is distributable during its taxable year to the beneficiaries. In cases under this subdivision there shall be included, as provided in subdivision (d) of this section, in computing the net income of each beneficiary, that part of the income come of the estate or trust which, pursuant to the instrument or order governing the distribution, is distributable during the taxable year to such beneficiary. It is urged by the petitioners that, since there was no express provision for accumulation of income, the trustees were without authority to accumulate and, further, that the trustees by their actions in distributing all of the income have given this construction to the trust*1836 instrument. The Commissioner counters with the statement that the receipts in 1917, 1921, and 1922 exceeded the distributions, that in 1915 income of $700,000 was used to pay off a mortgage and that in 1920 income was received from redemption of stock which was not distributed. The petitioners answer by pointing out that *673 the total amounts distributed at the end of any year exceeded the total income to that date, by reason of the fact that in its first year the trust distributed more income than it received, using for that purpose the $50,000 fund which was deposited as part of the trust fund for use as "working capital." They further point out that $700,000 used in 1915 was paid pursuant to article twenty-fourth of the trust instrument. Also, they urge that the amount received in 1920 from the redemption of capital stock was not income to be distributed to the beneficiaries, but moneys to be held as a part of the principal of the trust fund. Upon this basis the petitioners seek to show that they were required to and did distribute all income of the trust, while the respondent contends that the trustees might accumulate or distribute income in their discretion, that*1837 they exercised their discretion to accumulate in some instances, and that by reason thereof all income is taxable to the trustees whether or not distributed. The petitioner urges further that if the trustees did have discretion to accumulate or distribute the income, as the respondent contends, the beneficiaries are taxable upon the amount distributed and the trustees only upon the amount undistributed. This point seems to us to be well taken. In a long line of decisions of this Board and the courts it has been pointed out that the various revenue acts required that the beneficiaries report income which was distributed or distributable under the instrument or order governing distribution and that income distributed in the exercise of a discretion imposed by a trust instrument is income distributed pursuant to such instrument. ; ; affd., ; ; *1838 ; ; ; ; . In those decisions the contention of respondent, which is repeated in his brief now before us, that paragraph (4) of subdivision (a) should be construed to read: "Income which is required by the terms of the trust to be distributed * * *" was rejected. We conclude that petitioners are not liable to tax upon the income distributed by them to the beneficiaries. Although the amount of income received was in excess of that distributed in the taxable year, substantially all arises from dividends which are not subject to the normal tax. For this reason the amount of undistributed income does not exceed the credits and exemptions allowed by law and there is no tax. It therefore becomes unnecessary to determine the effect, if any, of distributions in prior years in excess of receipts. Decision will be entered for petitioners.