Investment Trust of Mut. Inv. Co. v. Commissioner

INVESTMENT TRUST OF MUTUAL INVESTMENT COMPANY, EMPIRE TRUST COMPANY, TRUSTEE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Investment Trust of Mut. Inv. Co. v. Commissioner Docket No. 54695. United States Board of Tax Appeals 27 B.T.A. 1322; 1933 BTA LEXIS 1202; April 28, 1933, Promulgated *1202 The petitioner holds the legal title to securities belonging to many beneficiaries. At the behest of a "managing company" it makes purchases and sales of securities. The income and profits are distributed to the beneficiaries upon the order of the managing company. Held, that the petitioner is an association within the contemplation of the Revenue Act of 1928. Herbert J. Lyall, Esq., for the petitioner. C. A. Ray, Esq., for the respondent. SMITH *1322 This is a proceeding for the redetermination of a deficiency in income tax for 1928 in the amount of $5,564.56. The allegation of error stated in the petition is, "the assessment of the petitioner as an association instead of its exemption as a strict trust or fiduciary." *1323 FINDINGS OF FACT. The petitioner is the holder of the legal title of funds belonging to certain subscribers to a so-called investment trust. It was organized April 1, 1926, under an indenture of that date by and between the Mutual Investment Company, hereinafter sometimes referred to as the "managing company" (a joint stock association formed in March, 1926, under the General Association Laws of the*1203 State of New York), as party of the first part; the Empire Trust Company, a New York corporation as party of the second part; and "all present and future registered holders" of Class A and Class B certificates issued in accordance with the provisions of the indenture and representing the holders' participation in the venture, as parties of the third part. The purpose of the organization, as stated in the indenture, is: * * * to furnish a means whereby investors, especially those with limited capital may establish an Investment Fund for their own benefit and by uniting with others secure diversification of their investments, obtain the benefit of informed judgment and continuous watchfulness, receive greater security through the subordinate investment of the Managing Company in the Investment Fund and compensate the Managing Company for its investment and service only by sharing with it in those earnings of the Investment Fund which are in excess of the 6% cumulative distributions on the Class A certificates, * * * During 1928, the petitioner's operations were carried on in accordance with the indenture dated April 1, 1926, as amended July 8, 1926, December 31, 1926, and January 12, 1928. *1204 In this instrument the Mutual Investment Company is designated as the party to "manage, supervise and control and to invest and reinvest" the investment fund. The Empire Trust Company is designated as the trustee to "hold legal title to all cash, securities, funds and property" at any time transferred to it or conveyed to it for the account of the investment fund, subject, however, at all times to the order of the managing company, but without liability respecting the propriety of any order emanating from the managing company. The investment fund is to be composed of common and preferred stocks, bonds, etc., as determined by the managing company under certain restrictions, and the beneficiaries' interests are to be represented by Class A and Class B certificates having a face value of $100 each and $10 each, respectively. For every $100 paid to the investment fund by those desiring to participate for which a Class A certificate shall be issued, the managing company agrees to pay $10 for which it shall be issued a Class B certificate. All certificates are to be prepared and executed by the managing company and authenticated and issued by the petitioner *1324 and funds raised*1205 from the sale of these certificates are to be invested in securities. The managing company, through its board of directors, has complete discretion as to the investment and reinvestment of these funds, subject only to certain restrictions designed to afford proper diversification. It is authorized to borrow money and encumber the investment fund up to two-thirds of its market value. The expenses to be borne by the managing company and those chargeable against the investment fund are specified in the indenture. It is specifically provided that neither the certificate holders nor the officers or directors of the managing company shall be subject to any personal liability with respect to the investment fund and that the trustee shall be subject to no personal liability except for its individual gross negligence or willful neglect. The trustee may be removed at any time by vote of the holders of 15 per cent of the outstanding Class A certificates. In the case of the resignation or removal of the trustee the successor shall be selected by the managing company, subject to a provision that the shares of any Class A certificate holder not agreeing to the amendment shall be redeemed*1206 by the managing company. The Class A certificate holder is entitled (1) to cumulative distributions upon the face value of his certificate accruing from the date thereof at the rate of 6 per cent per annum payable quarterly, but only out of the net income derived from the investment fund as defined in the indenture, unless the board of directors of the managing company shall cause such distributions to be made out of other monies in the investment fund and, (2) to such additional pro rata distributions (on a parity with Class B shares), on the number of shares of each certificate as the board of directors of the managing company may determine, subject to the limitations provided in the indenture. "Net income" is defined by the indenture, section I, subdivision 3, as follows: 3. The term "Net income" shall mean cash receipts and accrued interest from any loans, securities or other investments of the Investment Fund including cash dividends whether ordinary or extraordinary, but not stock dividends and not increment in principal or profit from increase in value of, or sale of, such securities or other investments, (and likewise without consideration of depreciation or losses*1207 in principal), less Fixed Expenses as hereinafter in Paragraph 4 of this Section I defined. The Class A certificates of any holder are redeemable on the first day of any business month at the option of either the holder or the managing company. Class B certificates are issued to no one other than the managing company. Whenever Class A certificates are redeemed, but at no other time, an equal number of Class B certificates *1325 are likewise redeemed. Section VIII of the indenture provides in part that all certificates shall be fully registered; that - Certificates shall not be transferable, but the right of the registered holder of any Certificate to cause such Certificate to be redeemed * * * may be assigned * * *. The assignee * * * may cause such Certificate to be redeemed * * *. Such distributive share may be paid over * * * against receipt of a new Certificate of the same class, face value, and number of shares as the Certificate so redeemed * * * in such event, the charges for redemption payable to the Managing Company as provided in subdivision (c) of Section XVIII shall be wholly abated. In accordance with the provision of the indenture the managing company, *1208 on or before February 15, 1929, mailed to each of the certificate holders a report showing his or her proportionate part of the income and profits for the year 1928 analyzed for use in connection with his or her Federal income tax return. The certificate holders of the investment fund have no board of directors; no officers; no by-laws; no vote on anything; no veto on changes in the indenture; no power by cooperative action to do anything except to remove the passive trustee; and are without power to appoint a successor or to remove or control the managing company. The operations of this organization increased rapidly and during the year 1928 its gross income and expenses were as follows: Interest on bank deposits, notes and corporation bonds, etc $6,467.58 Interest on tax-free covenant bonds upon which a tax was paid at source 5,432.88 Profit from sale of stocks and bonds: Date acquired, 1926-7-8 Amount received $611,948.64 Cost 569,622.47 Net profit 32,326.17 Dividends on stock domestic corporations 14,926.17 Total income 69,152.80 DEDUCTIONS Interest paid $6,458.60 Other deductions - trustees' fees 1,396.73 Total deductions 7,855.33 Excess of gross income over deductions 61,297.47 *1209 During the year 1928 the total purchases of securities by the petitioner amounted to $823,872.45, $398,882.39 of which was obtained from the sale of trust certificates, and $424,990.06 represented the reinvestment of old capital. The average capital and surplus for the year was $656,066. *1326 The quarterly record of growth since organization furnished the certificate holders shows that the surplus had increased from zero on April 1, 1926, to $180,806 on December 31, 1928. The par value of Class A certificates outstanding had increased from $146,000 on April 1, 1926, to $636,070 on December 31, 1928. The par value of Class B certificates outstanding increased from $14,600 on April 1, 1926, to $63,607 on December 31, 1928. The Class A certificate holders have increased from six as of April 1, 1926, to 389 as of December 31, 1928. The balance sheet furnished the Class A certificate holders as of December 31, 1928, showed the assets of the petitioner to be as follows: Securities owned and held by trustee (Cost $691,237.69) at market value $809,917.77 Accrued interest and dividends receivable 6,370.05 Cash in hands of trustee 80,118.26 Total 896,406.08 *1210 Of the original issue of 1,732 shares of the Mutual Investment Company, 1,140 shares were owned by two of the organizers who neither then nor thereafter owned any Class A certificates of the investment fund. Of the five directors constituting the board of the managing company during the first part of 1928, three owned no Class A certificates, and, out of the seven directors constituting the board after September 13, 1928, five owned no Class A certificates. The petitioner filed a fiduciary return of income for 1928 on Form 1041, which showed a gross income (including $42,326.17 profit from the sale of securities, and $14,926.17 representing dividends on stock of domestic corporations) of $69,152.80 and deductions therefrom of interest paid $6,458.60, trustees' fees $1,396.73 (total $7,855.33), and a net income of $61,297.47 which it claimed was distributable income and taxable to beneficiaries. The respondent in the determination of the deficiency held that the petitioner was an association subject to the corporation income tax for 1928 upon a taxable net income of $46,371.30, or the amount of the net income reported less dividends received from domestic corporations. *1211 OPINION. SMITH: The question presented by this proceeding is, first, whether the petitioner is an association taxable as a corporation under the provisions of the Revenue Act of 1928; and, second, if so, whether the operations of the Mutual Investment Company, the managing company, should be consolidated with it for the purpose of computing taxable net income. *1327 Section 701 of the Revenue Act of 1928 provides in part as follows: (a) When used in this Act - * * * (2) The term "corporation" includes associations, joint-stock companies, and insurance companies. Articles 1312 and 1314 of Regulations 74 are as follows: ART. 1312. Association. - Associations and joint-stock companies include associations, common law trusts, and organizations by whatever name known, which act or do business in an organized capacity, whether created under and pursuant to State laws, agreements, declarations of trust, or otherwise, the net income of which, if any, is distributed or distributable among the shareholders on the basis of the capital stock which each holds, or, where there is no capital stock, on the basis of the proportionate share of capital which each has or*1212 has invested in the business or property of the organization. A corporation which has ceased to exist in contemplation of law but continues its business in quasicorporate form is an association or corporation within the meaning of section 701. ART. 1314. Association distinguished from trust. - Where trustees merely hold property for the collection of the income and its distribution among the beneficiaries of the trust, and are not engaged, either by themselves or in connection with the beneficiaries, in the carrying on of any business, and the beneficiaries have no control over the trust, although their consent may be required for the filling of a vacancy among the trustees or for a modification of the terms of the trust, no association exists, and the trust and the beneficiaries thereof will be subject to tax as provided by sections 161-170 and by article 861-891. If, however, the beneficiaries have positive control over the trust, whether through the right periodically to elect trustees or otherwise, an association exists within the meaning of section 701. Even in the absence of any control by the beneficiaries, where the trustees are not restricted to the mere collection*1213 of funds and their payment to the beneficiaries, but are associated together with similar or greater powers than the directors in a corporation for the purpose of carrying on some business enterprise, the trust is an association within the meaning of the Act. The line of demarcation between a trust taxable as an association and one taxable under sections 161 to 169 of the Revenue Act of 1928 is not sharply drawn. The situation under the 1928 Act is similar to that which was involved in the case of , under the Revenue Act of 1918, wherein the Supreme Court stated: We think that the word "association" as used in the Act clearly includes "Massachusetts Trusts" such as those herein involved, having quasi-corporate organizations under which they are engaged in carrying on business enterprises. What other form of "associations," if any, it includes, we need not, and do not, determine. Since the pronouncement of the above cited decision in 1924, the courts and this Board have many times had occasion to pass upon the question of whether a given trust is taxable as an association or as a strict trust. *1214 *1328 As pointed out in Morris Realty Co. Trust No. 1,, there are three tests for determining whether an organization is to be classified as one or the other: (1) business purpose; (2) [ In Ittelson v. Anderson, Feb. 9, 1933, the United States District Court for the Southern District of New York stated: * * * The Supreme Court of the United States in the case of , emphasized the test of business purpose and operation rather than that of structure; that is, the control or lack of control exercised by the beneficiaries. In Ittelson v. Anderson, Fed.(2d) , Feb. 9, 1933, the United States District Court for the Southern District of New York stated: Under the opinion from which the foregoing excerpts have been quoted, there appear to be three elemental requisites to a trust which, under the capital stock tax statutes, is to be regarded as an "association." (1) It should have a "quasi-corporate form;" (2) its trustees should be "associated together in much the same manner as the directors in a corporation;" and (3) the trustees must be engaged in carrying on a business. * * *1215 * * * * trusts have been held to be taxable as "associations" wherever they carried on active commercial enterprises. (C.C.A.-1st), cert. den. ; (C.C.A.-3rd); (C.C.A.-9th); ; ; ; ; . The only trusts engaging in business activity, which have not been classified as "associations" have been those formed for the liquidation of concerns or estates. (, (C.C.A. 1st); *1216 , (C.C.A. 5th); ), and real estate trusts where it was deemed that the trustees were merely holding property for the collection of income (, (C.C.A. 1st); , and were not actively engaged in managing the property or buying and selling real estate. See , cf. , (C.C.A. 7th). Apparently, the judicial emphasis has been placed upon the third element of the test set forth in the Hecht case, - namely, that the trustees be engaged in carrying on a business, as distinguished from winding up a business or merely holding property and receiving and distributing its income. The question of whether the trust had a "quasi-corporate form" or whether the directors were associated together like "the directors of a corporation" has been subordinated by the courts to the consideration of whether they should regard*1217 the control of the beneficiaries over the trustees, or the business activities of the trustees, as the decisive consideration. Results have been reached on both theories. See, for example, , in the First Circuit, where there was no control in the beneficiaries and the purpose of the trust was to liquidate a business. The majority of the court there held that the trust was not an association, because its function was not to carry on a business enterprise, but to bring about its liquidation. Bingham J. concurred on the ground that the organization under analysis was a strict *1329 trust under Massachusetts law, and not an association, the beneficiaries having no control over the actions of the trustees. On the whole, it would appear that the weight of authority has regarded the business activity of the trustees as the controlling factor. * * * The petitioner does not deny that the indenture entered into on April 1, 1926, had behind it a business purpose. It contends, however, that the Mutual Investment Company was the entity which was to transact the business; that the petitioner was simply to hold the legal title to securities*1218 and was not to engage in business operations. We are not impressed by this argument. The organization of the petitioner was an integral part of the whole scheme. It held the legal title to the securities and it was the only one that could purchase and sell securities. The income of the entire operation was to be the income of the petitioner in the first instance, and that income was to be derived in part from trading in securities. In a very real sense the petitioner was organized for a business purpose. We also think that it was engaged in a business operation. The petitioner argues that it was not doing business within the meaning of the decisions of the courts which have held the transaction of business a factor of importance in the classification of an organization of the character of the petitioner. In its brief the petitioner states: While the buying and selling of securities may become a business, as the Bureau held, such changes in investment as an active trustee reasonably makes in the trust funds in his care to meet the continually changing important economic and financial conditions is investment and not business, and we most emphatically maintain we*1219 are doing no more than a wide-awake Trustee should do. We can not agree that the investment of funds by an entity organized for that purpose does not constitute the doing of business. The evidence of record shows that the petitioner intended to take advantage of wide swings in the market and, in point of fact, a large percentage of the petitioner's net income for 1928 was from profit on the sale of securities. The petitioner was doing the business for which it was organized; The fact that most of the work was performed by the managing company and paid for by that company does not make it that the petitioner was not doing business. In numerous decisions of the courts one of the criteria for determining whether a trust is taxable as an association is the extent of the authority which the beneficial certificate holders have over the trustees. Here the evidence is to the effect that when 15 per cent of the Class A certificate holders indicate in writing that they are dissatisfied with the trustee it will be removed and a new one appointed. The certificate holders themselves do not have the power of appointment of a new trustee, but the managing company has that *1330 *1220 power. It is nevertheless the fact that the certificate holders have a measure of control over the trustee. The form of organization of the petitioner is not that of a corporation, except that its capital is divided into shares. In , the Board said: Quasi-corporate form is not an indispensable element of an "association." . But business purpose and activities are criteria which clearly bring the petitioner within the category of associations. Willis v. Commissioner, Fed.(2d) (C.C.A., 9th Cir., May 2, 1932), affirming . Cf. . The petitioner also makes the point that under the laws of the State of New York and under the provisions of the indenture the certificates of beneficial interest are not transferable. It is to be noted, however, that a certificate holder may assign his right to redeem and the assignee may under the provisions of the indenture turn in the acquired certificate and have reissued to him a certificate in his own name. The*1221 provision of the indenture, therefore, that the certificates may not be transferred is of no consequence in the determination of this issue. It was apparently the intention of Congress to tax as corporations, associations of men, other than copartnerships, organized for the purpose of carrying on a business. We think that where men associate themselves together and contribute money to a common fund to be held by one or more trustees for a business purpose, the profits thereof to inure to them, the entity thus created is properly classifiable as an association, regardless of the power of control held over the trustee by the associates; of their authority freely to transfer their shares of beneficial interests; or of any provision for meetings of the certificate holders. Upon the entire record we are of the opinion that the petitioner was an association taxable as a corporation for 1928. With respect to the second contention of the petitioner, that if it is held to be an association there should be consolidated with it for the purpose of computing its net income the operations of the Mutual Investment Company, we are of the opinion that there is no authority in the law for such*1222 consolidation. The shareholders of the Mutual Investment Company are different from those of the petitioner. The expenses of the Mutual Investment Company are not the expenses of the petitioner. The provision in the indenture that the managing company shall receive a share of the profits of the petitioner to compensate it for its services in furnishing investment advice in no wise affects the net income of the petitioner. Reviewed by the Board. Judgment will be entered for the respondent.