Trust A, 3586 v. Commissioner

TRUST A, #3586, FOR THE BENEFIT OF SARAH ESTELLE KNAPP RUSSELL AND LOUISE RUSSELL, UNDER DEED AND AGREEMENT DATED MAY 10, 1922, BY LOUISE SAVAGE KNAPP, DECEASED, CENTRAL HANOVER BANK AND TRUST COMPANY, TRUSTEE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. TRUST B, #3587, FOR THE BENEFIT OF SARAH ESTELLE KNAPP RUSSELL AND PHEBE RUSSELL, UNDER DEED AND AGREEMENT DATED MAY 10, 1922, BY LOUISE SAVAGE KNAPP, DECEASED, CENTRAL HANOVER BANK AND TRUST COMPANY, TRUSTEE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. TRUST C, #3588, FOR THE BENEFIT OF SARAH ESTELLE KNAPP RUSSELL AND ISABEL RUSSELL, UNDER DEED AND AGREEMENT DATED MAY 10, 1922, BY LOUISE SAVAGE KNAPP, DECEASED, CENTRAL HANOVER BANK AND TRUST COMPANY, TRUSTEE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Trust A, #3586 v. Commissioner Docket Nos. 101753, 101754, 101755. United States Board of Tax Appeals 46 B.T.A. 846; 1942 BTA LEXIS 801; April 7, 1942, Promulgated *801 In 1922 Louise Knapp created three trusts to each of which she gave 1,000 shares of X corporation stock. By the terms of the trust instrument the trustee was under severe restrictions as to investments after the death of the primary beneficiary. In 1923 George Knapp, husband of Louise Knapp, executed a "deed of gift" to the same trustee covering 2,000 shares of X corporation stock for the benefit of the same beneficiaries with a provision that the terms of the trust instrument executed by his wife should apply. The trustee added this stock to the corpora of the three trusts created by Louise Knapp so that each trust was treated as owning 3,000 shares. This stock was later split three for one and other stock was bought pursuant to "rights." George Knapp intended to create three new trusts, none of which were to have provisions restricting the trustee as to investments. Upon learning that his intentions had not been carried out, George Knapp brought an action for reformation in the Supreme Court of New York. After issue had been joined and after a hearing on the merits, the court in 1937 granted the reformation asked and in effect decreed that there had been six trusts instead*802 of three. In 1936 and before judgment had been entered in the reformation action the trustee sold 11,100 shares of X stock held by the three trusts. After the decree in the reformation action the trustee reconstructed its accounts to show six trusts and allocated two-thirds of the stock sold to the three new trusts. In an action by the trustee before the State Supreme Court to have its accounts thus reconstructed taken as stated, the court approved and confirmed these accounts. Held: (1) On the question whether there were six trusts making sales instead of three, the Board is bound by the judgment of the state court in the reformation action. Hugh D. Rhodes et al., Administrators,41 B.T.A. 62; affd., 117 Fed.(2d) 509; George N. Spiva,43 B.T.A. 1174. (2) On the question of how much stock was sold from each of the six trusts, the facts found by the state court in the accounting action will be considered as establishing prima facie the amount of stock sold by each trust. Edgar M. Carnrick,21 B.T.A. 12, distinguished. Charles W. Crawford, Esq., for the petitioners. Clay C. Holmes, Esq.*803 , for the respondent. KERN *847 The above entitled cases were consolidated for hearing and opinion. Respondent has determined deficiencies in the amount of $581.48 in income taxes for the year 1936 in each case. From these determinations the petitioners have brought this appeal. In addition, petitioners assert that there were overpayments for the taxable year 1936 in the following amounts: Docket No. 101753 $25,407.83 Docket No. 101754 25,400.10 Docket No. 101755 25,400.11 The deficiencies in each case arose by reason of respondent's adjustments in the basis of certain stocks sold by petitioners in 1936. Petitioners concede that these adjustments were correct, but contend that *848 there were no deficiencies, but, on the other hand, large overpayments because the stock involved was sold by six trusts instead of three. The major portion of the evidence in these proceedings is contained in a stipulation of the parties and the facts as stipulated are adopted as the findings of this Board. In so far as deemed material, those stipulated facts are now set forth, together with the pertinent facts which we find from the evidence*804 presented at the hearing herein. FINDINGS OF FACT. On or about May 10, 1922, Louise Savage Knapp, deceased, wife of George O. Knapp, executed a trust instrument conveying 1,999 shares of common stock of the Union Carbide & Carbon Corporation to the Central Union Trust Co. of New York, as trustee. The Central Union Trust Co. of New York, by virtue of a merger and consolidation with the Central Hanover Bank & Trust Co. on May 15, 1929, was succeeded by the latter organization as trustee under the May 10, 1922, instrument. For the sake of brevity both trust companies are hereinafter referred to as petitioner. The trust instrument dated May 10, 1922, provided for three trusts, A, B, and C, which are the three trusts involved herein. Trust A consisted originally of 667 shares of Union Carbide stock and was primarily for the benefit of the settlor's daughter, Sarah Estelle Knapp Russell, during the daughter's life and thereafter for the benefit of a grandchild, Louise Russell, for life. The grandchild was given a testamentary power of appointment. On December 11, 1922, the settlor added 333 shares of the same stock to this trust, making a total of 1,000 shares contributed*805 by her. Trust B consisted originally of 666 shares of the same stock and contained like provisions except that the secondary life beneficiary was a different granddaughter, Phebe Russell. On December 11, 1922, the settlor added 334 shares of the same stock to this trust, making a total of 1,000 shares contributed by her. Trust C consisted originally of 666 shares of the same stock and contained like provisions except that the secondary life beneficiary was a third granddaughter, Isabel Russell. On December 11, 1922, the settlor added 334 of the same stock to this trust, making a total of 1,000 shares contributed by her. The provisions of all three trusts above referred to contained alternative and default clauses to take effect in the event of the secondary life beneficiaries predeceasing the primary life beneficiaries, failure to appoint, etc., which are not material to the present consideration. All of the beneficiaries named in the provisions are still alive. The following provision on disposition and reinvestment was contained in all three trusts as set up by Louise Savage Knapp, deceased: *849 THIRTEENTH: That the Trustee may in the exercise of its best*806 judgment and discretion (but in each instance during the lifetime of said Sarah Estelle Knapp Russell only with her consent or direction in writing) sell at any time or times any or all of the securities then constituting any part of said respective Trust Funds; and the Trustee shall with all reasonable promptness after receipt, invest and re-invest the proceeds of any and all such sales and any and all cash collected as payment of the principal of any notes and/or bonds and/or for the retirement of any preferred stock at any time held in trust under any of said respective Trust Funds, and any and all cash which may from time to time hereafter be deposited hereunder in any of said Trust Funds. Such investments and re-investments shall in each instance during the lifetime of said Sarah Estelle Knapp Russell be made in such securities as she may by her instrument in writing direct or approve, and shall after the death of said Sarah Estelle Knapp Russell, be made in bonds of the United States Government and/or of any State, County and/or Municipality therein issued by authority of the taxing power of such respective Government, State, County and/or Municipality. On June 29, 1923, George*807 O. Knapp, husband of the settlor, Louise Savage Knapp, executed a "deed of gift and agreement" with petitioner and on the same day executed another "deed and gift of agreement" with petitioner. He had instructed his attorney, now deceased, to prepare two trust deeds, each to have three subdivisions and to resemble with regard to beneficiaries the 1922 deed of his wife, except that Sarah Russell should be the primary life beneficiary under one deed and her husband, Benjamin Russell, under the other. He further instructed that both deeds should give the primary beneficiaries control over investments during their lives and thereafter allow the trustee the broadest possible investment powers. This was done with regard to the trust deed under which Benjamin Russell was beneficiary. However, despite these instructions, the attorney did not draw up the deed for the benefit of Sarah Russell according to the wishes of George O. Knapp. The deed which he drew up and which George O. Knapp executed, after referring to the agreement of May 10, 1922 (the Louise Knapp trust instrument), and a clause therein (article tenth), allowing contributions to corpus to be made by anyone, said: FIRST: *808 That pursuant to the provisions of said article Tenth of said Instrument the said Grantor hereby agrees to deposit and does hereby deposit with the said Trustee as Trustee under said Instrument of May 10th, 1922, [The deed then added 2,000 shares of Union Carbide stock to each of the three prior trusts created by the deed of May 10, 1922, with the provision that they:] hereupon immediately become and be a part of said Trust Fund, [A, B and/or C], and shall be subject to all of the trusts applicable to said Trust Fund [A, B and/or C] as set forth in said instrument. Then, under item "Second", it was further provided: It is agreed by the parties hereto that all of the provisions of said Instrument of May 10th, 1922, shall apply to the said shares of stock described in and covered by this Instrument, and to all other property and/or cash added thereto *850 or substituted therefor or any part thereof, in each and every respect and with the same force and effect as if the said property * * * had originally been respective parts of the said respective trust funds described in said Instrument of May 10th, 1922, * * * In 1936 petitioner's books of account for trusts A, *809 B, and C under the deed of Louise Savage Knapp showed the following holdings and acquisitions of Union Carbide stock: Trust A: Shares 5/10/22 [667] 12/11/22 [333] Subtotal 1,000 6/29/23 2,000 Subtotal 3,000 The stock was subsequently split 3 for 1 9,000 There was a further accretion by subscription on "rights" after sale of a portion of such rights to raise funds therefor [235] Subtotal 9,235 4/15/30 less two shares sold [2] Total 9,233 Trust B: Shares 5/10/22 [666] 12/11/22 [334] Subtotal 1,000 6/29/23 2,000 Subtotal 3,000 The stock was subsequently split 3 for 1 9,000 There was a further accretion by subscription on "rights" after sale of a portion of such rights to raise funds therefor [235] Subtotal 9,235 4/15/30 less two shares sold [2] Total 9,233 Trust C: Shares 5/10/22 [666] 12/11/22 [334] Subtotal 1,000 6/29/23 2,000 Subtotal 3,000 The stock was subsequently split 3 for 1 9,000 There was a further accretion by subscription on "rights" after sale of a portion of such rights to raise funds therefor [235] Subtotal 9,235 4/15/30 less two shares sold [2] Total 9,233 Total for trusts A, B, and C 27,699 *810 *851 As a result of discussions with Benjamin Russell and William Knapp and advice received from investment counsel and petitioner, George O. Knapp became aware for the first time in 1934 that the stock conveyed by him under his deed for Sarah Russell was being treated as if it constituted an addition to the three trusts already created by his wife. This was alarming to him because such had not been his intention, and he had not wished to restrict the trustee in matters pertaining to reinvestment of corpus. It was pointed out to him that if shares in the Sarah Russell trusts were sold for the purpose of reinvesting in securities with a greater yield, and Sarah Russell should die before reinvestment of the funds realized, then the petitioner would be restricted to reinvestment in low yield Government and municipal bonds. Although George O. Knapp had hoped that Sarah Russell would retain the Union Carbide stock in the trusts, there was no intention to force her to do this. George O. Knapp requested legal advice and was advised by his attorney that a reformation action should be brought to rectify the mistake before laches might become a bar to possible relief. On or*811 about November 13, 1935, George O. Knapp commenced an action in the Supreme Court of the State of New York in and for the County of Westchester for the reformation of the deed for the benefit of his daughter executed June 23, 1923, to conform to his intentions. In his complaint in that action George O. Knapp stated that he executed both deeds without knowing that the deed for the benefit of his daughter was in form a supplement to his wife's deed; that he thought it established independent trusts and related to his wife's deed only for brevity's sake. He also stated that he did not examine his wife's deed at the time he executed the deed for his daughter and that he did not know that its investment provisions were contrary to the directions given his attorney. Had he known of these restrictions, he stated, he would not have executed the deed. He also stated that he thought the deed for his daughter was similar to that for his son-in-law. The latter trust instrument did not restrict the trustees to reinvestments in Government and municipal bonds after the death of the primary beneficiary. Parties defendant were the petitioner and all of the beneficiaries under the trusts. *812 *852 On January 31, 1936, a guardian ad litem was appointed by the court to defend the interests of the infant defendants to the action. Issue was joined on February 8, 1936, and by court order the action was, on January 27, 1937, referred to an official referee to hear and determine the issues. The action came to trial on March 22, 1937. At the trial, George O. Knapp testified by deposition that it was his understanding that the deed signed by him for his daughter's benefit would subject the trustee to no restrictions in relation to sales and investments except to make them subject to her approval during her lifetime. He stated that he thought the reference to his wife's deed was merely to identify the beneficiaries and their various estates. In addition, the testimony of two other witnesses was heard. The guardian ad litem rendered his report, which concluded that a mistake had been established and the requested relief should be granted; and on May 3, 1937, the referee's decision was rendered. On June 25, 1937, the judgment of the Supreme Court of New York was rendered, granting the reformation sought. The order and decree reads in part as follows: *813 ORDERED, ADJUDGED AND DECREED, that the deed of trust made, executed and delivered under date of June 29th, 1923 by plaintiff George O. Knapp as grantor, to Central Union Trust Company of New York, * * * as grantee, purporting to convey to said grantee certain shares of the capital stock of Union Carbide & Carbon Corporation to be held by said grantee as Trustee subject to certain trusts described in a prior deed dated May 10th, 1922, from Louise Savage Knapp to said Central Union Trust Company of New York, * * * be and the same hereby is reformed, as of the date of execution thereof, June 29, 1923, * * * The official referee found as a fact that George O. Knapp executed the deed as written in the belief that his instructions were being carried out and that the deed provided for separate trusts without the restriction of his wife's agreement. Neither George O. Knapp nor his attorney had tax advantages in mind when bringing the reformation action. There was no fraud or collusion in the reformation action. During the pendency of this action and in the period from September 28 through October 7, 1936, petitioner sold 11,100 shares of Union Carbide stock out of the 27,699 shares*814 above referred to, and individual sales were apportioned to the three trusts on petitioner's books in thirds as evenly as possible. The gains from these sales constitute the income in question in these proceedings. At this time and at all times theretofore the accounts of petitioner reflected only three trusts, namely, trusts A, B, and C, created on May 10, 1922. Consent to the sales of the 11,100 shares and endorsement of a reinvestment program were given by Sarah Estelle Knapp Russell, as required by article thirteenth of the trust instrument of May 10, *853 1922, executed by Louise Savage Knapp. This investment program, recommended by investment counsel in 1936, contemplated the diversification of the corpus of three trusts (only three were then thought to be in existence) by the sale of approximately 80 percent of the Union Carbide stock held by those trusts. There was no necessity for a reformation of the three trusts in order to permit the sales and reinvestments recommended, since endorsement of the program by Sarah Estelle Knapp Russell was the sole requirement. The investment clause of the 1922 instrument did not prohibit an investment in any security desired*815 in 1935 or 1936, since the primary beneficiary was still alive in those years. While not necessary, a reformation was, nevertheless, desirable in view of the restrictions which would have been imposed on the trustee with regard to investments in the event of Sarah Russell's death. On or about March 15, 1937, petitioner filed 1936 income tax returns on Form 1040 with the collector of internal revenue for New York City, as trustee of the Louise Savage Knapp trusts, A, B, and C, accounting in each return for the gain from one-third of the sales of the 11,100 shares of stock. Following rendition of judgment in the reformation action on June 25, 1937, petitioner reconstructed its records and divided the assets held in the three trusts and received from Louise Savage Knapp and George O. Knapp so as to reflect the existence of three trusts under the wife's deed from May 10, 1922, and three separate and distinct trusts under the husband's deed from June 29, 1923. In this reconstruction of accounts the total assets were treated as having been received one-third from the wife and two-thirds from the husband. In this manner, instead of one-third of the sales of the 11,100 shares being*816 attributed to each trust under the wife's deed, the fraction attributed was one-ninth, and two-ninths were attributed to each of the trusts under the husband's deed. Petitioner then instituted an action in the Supreme Court of the State of New York in and for the County of New York to have its revised accounts taken as stated; its acts and proceedings ratified, approved, and confirmed by the court; and its accounts, as revised and submitted, judicially settled and allowed, and it named as parties defendant all of the beneficiaries of the several trusts. These accounts, attached to the stipulation of facts in the present proceedings, assert, inter alia, the following transactions made by the trustee on behalf of six trusts: 1. Sales of 1,233 1/3 shares in 1936 on behalf of each of the three trusts under Louise Knapp's 1922 deed at the following net amounts (less commissions and taxes): Trust A, $120,203.31; trust B, $120,187.10; and trust C, $120,187.12. *854 2. Sales of 2,466 2/3 shares in 1936 on behalf of each of three trusts under George Knapp's 1923 deed at the following net amounts (less commissions and taxes): Trust A, $240,407.63; trust B, $240,374.20; *817 and trust C, $240,374.25. The accounts do not disclose certificate numbers of shares deposited in the various trusts or certificate numbers of shares sold. The complaint in this action was verified on January 7, 1938. In April 1938 the court appointed a guardian ad litem to defend and protect the interests of the infant defendants to this action. The guardian ad litem rendered a report on May 18, 1938, recommending approval of the accounts. No objection was lodged to the accounts by any of the parties. On motion of the attorneys for petitioner, judgment was entered July 12, 1938, which ratified, approved, and confirmed in all respects the petitioner's accounts. There was no fraud or collusion in this accounting action. On or about February 7, 1939, petitioner filed 1936 income tax returns on Form 1040 as trustee of the three George O. Knapp trusts declared to have been set up under his deed of June 29, 1923, showing liability for profits on the sales (two-thirds of total sales) which petitioner contends in these proceedings were not allocable to the Louise Savage Knapp trusts. If petitioner, as trustee of the Louise Savage Knapp trusts A, B, and C, is held*818 to be liable for tax in the case of each trust on the income from the sale of one-ninth of the 11,100 shares of Union Carbide stock, instead of one-third as originally reported and as now contended by respondent, then petitioner concedes that, as trustee of the three trusts set up under the deed of George O. Knapp as reformed, it is liable for tax in the case of each of those trusts on the income from the sale of two-ninths of the 11,100 shares. Petitioner concedes that the basis determined by respondent for computing capital gain is correct. This determination by respondent gives rise to the deficiency determined in the ninety-day letter. OPINION. KERN: Respondent argues that the decision of the state court reforming the deed of George O. Knapp dated June 29, 1923, is not binding on this Board or the Federal courts when applying a Federal tax statute. We do not agree with this contention. The record discloses an action between adverse parties and a hearing on its merits. It is well settled that the decision of a state court of competent jurisdiction upon property rights, rendered in an adversary proceeding after a hearing upon the merits, is conclusive upon the Federal*819 courts until it is reversed or overruled. ; ; . *855 That the decision of the state court in the reformation proceeding involved herein is a decision coming within the rule above stated is settled by ; affd., , and . The court decided that there had existed at all times since the execution of George Knapp's instrument in 1923 six separate trusts, not three. We consider ourselves bound to honor this decree. Respondent argues ingeniously that, even accepting the state court's decree and recognizing the existence of six trusts, nevertheless, there were only three taxable entities. With such an argument he is attempting to bring this case within the exception recognized in cases such as , and *820 , where this Board refused to give application to the state court's decree solely because Congress had established its own criterion as to what claims and expenses are properly deductible for Federal tax purposes. We do not believe that Congress has ever established its own criteria for trusts to the extent of excluding as a separate taxable entity any relationship declared by state law to constitute a true trust. Consequently, the rationale of the Forst and Morris cases, supra, has no application whatsoever to the present controversy. Respondent, foreseeing the possibility of the conclusions at which we have already arrived, has advanced a further argument which, if accepted, would have the effect of disallowing in part the petitioner's claims of overpayments. Respondent asserts that the evidence is not sufficient to show that two-thirds of the gain derived from sales by the trustee of the Union Carbide stock resulted from sales of shares held as a result of the original contribution of 2,000 shares made by George Knapp, pointing out that there is no proof before us to distinguish which of the shares sold*821 was a part of those physically transferred under the 1922 instrument and which was a part of those transferred under the 1923 instrument. Inasmuch as the burden of proof lies with the petitioner in a claim such as this, respondent contends that we must hold that the sales were made out of the corpus of the trusts set up by Louise Knapp in 1922. Where evidence on behalf of the taxpayer is lacking, we would be forced to this conclusion. In the present proceedings this would mean that all of the corpora of the original trusts was sold, since those trusts contained a total of 9,233 shares, and 11,100 shares were sold. Consequently, 9233/11100 of the gain from the sales would be taxable in equal proportions to the three original trusts, instead of all the gains from all the shares sold. This position of respondent is predicated on the proposition that we can not consider those facts found by the Supreme Court of *856 New York in its decree entered in the accounting action brought by the trustee against the beneficiaries of the six trusts. We would be impressed with this argument of respondent if the accounts in question were mere formal accounts rendered in a court administering*822 a running trust and the court's approval was entered ex parte. See . In the instant proceeding, however, the trusts were not testamentary trusts and thus administered under the jurisdiction of the Surrogate's Court; it was necessary for the trustee to bring an action in the Supreme Court of New York to have its accounts taken as stated and its acts and proceedings as trustee ratified and confirmed. This was not a routine formality, for the trustee was faced with the unusual situation of having administered in the form of three trusts what had been judicially determined to have been six trusts. This it had done in good faith but, as the event proved, in error; and, since the restrictions upon the powers of the trustee with regard to investments differed in the George Knapp trusts from those in the Louise Knapp trusts, it was a matter of great importance to the trustee and the beneficiaries to have definitely determined by court action what constituted the corpus of each trust in view of the actions of the trustee in regard thereto over the many years before the decree in the reformation action, and to have determined the question*823 whether the trustee had acted correctly in reconstructing his accounts to show two-ninths of the stock sold from each of the George Knapp trusts and one-ninth from each of the Louise Knapp trusts. Accordingly, the trustee brought the action in the Supreme Court and made the beneficiaries parties defendant. After the service of summonses a guardian ad litem was appointed for the infant defendants, who subsequently filed a report. Upon the verified complaint and accounts of the trustee and the report of the guardian ad litem, the Supreme Court entered its decree approving and confirming the trustee's accounts, which, among other things, found that two-ninths of the Union Carbide & Carbon stock had been sold by the trustee from each of the George Knapp trusts. Under the peculiar facts of this case we can not feel justfied in disregarding this decree. As we have shown above, it was entered in an accounting action specially brought, adversary in nature, and involving important property rights, and after a through investigation by the guardian ad litem appointed by the court.In addition we may point out that the trustee is of necessity subject to the jurisdiction of the*824 state courts in the administration of the various trusts. Those courts have determined that there were six trusts during the taxable year and that the securities sold were properly allocable one-ninth to each of the three petitioner trusts, and two-ninths to each of three other trusts. Unless these determinations *857 are recognized by us, the trustee faces a situation not only in the taxable year, but also in all later years, whereby it is bound by the state court decrees to administer a certain corpus in a certain trust, and yet with regard to its Federal tax liability as to each trust it is subject to the uncertainty of the respondent's determination, for it is apparent that a physical identification of each share that went into the several trusts is impossible. After the transfers of the stock to the trustee by both settlors the stock was divided three for one and new certificates necessarily issued, and a considerable number of shares was acquired pursuant to "rights." Under these circumstances, if the respondent determined, for example, that all of certain stock which the trustee purported to sell from each of the six trusts was, in reality, a part of the corpus of*825 two trusts created by George Knapp, the trustee would not be able to overcome this determination by tracing back into each trust the certificates which were sold. It is apparent to us that the state court in the accounting action gave a fair and equitable answer to the problems raised in the administration of the trusts by the decree in the reformation action. It is further apparent to us that, the decree in the accounting action being binding upon the trustee and the beneficiaries in the administration of the various trust properties, it should be accepted by the Federal taxing authorities as determining the interests of the various trusts subject to tax. This result, demanded by justice and public policy, may be reached by considering as evidence herein those facts found in the decree of the state court entered in the accounting action; and this we do for the reasons set forth above. Accordingly, we hold that the petitioner trusts are each taxable on one-ninth of the gains derived from the sale of Union Carbide & Carbon Co. stock during the taxable year. Decisions will be entered under Rule 50.