Ellsworth M. Statler Trust v. Commissioner of Internal Revenue

FRIENDLY, Circuit Judge: This petition to review a decision of the Tax Court, 43 T.C. 208 (1964), on capital gains and deductions as applied to the income taxation of trusts, raises a novel question of the construction to be given the Internal Revenue Code of 1954. In 1920 Ellsworth M. Statler executed an indenture conveying large amounts of stock of Hotels Statler Company, Inc., in trust for the benefit of his descendants. The indenture provided that separate trusts be established for each of Mr. Statler’s children, though in all significant aspects the trust estate was to be administered as a single fund. The trustees were directed to make charitable gifts of not less than 15% nor more than 30% of the net income in each year; the charities were to be chosen by majority vote of the trustees and Mr. Statler’s children, but only the trustees were to determine the precise percentage, within the stated limits, to be expended from the income of each trust. By 1954, the year to which this controversy relates, the trustees were obligated to pay all the income remaining after the charitable set-aside to persons who were of full age; upon their death the corpus passes to other individuals, with no charity having an interest therein. In 1954, the trusts owned 217,088 shares of Statler stock, which they had held for many years. Under a series of agreements they and other large Statler shareholders sold their stock to Hilton Hotels Corporation pursuant to a plan whereby the assets of Statler would be sold and the company liquidated. The trustees received some $50 per share, of which approximately $47 was long-term capital gain. Initially they allocated the entire proceeds to principal, but income beneficiaries contested the propriety of this under New York trust law. A compromise agreement between the trustees, the income beneficiaries, the Attorney General of New York representing the undesignated charitable beneficiaries, and a special guardian representing an infant and unknown contingent beneficiaries, was executed in November 1955 and approved by the Supreme Court, Erie County, in December. This provided that $15.50 per share should be allocated to income, that 15% of this sum less commissions of 2% should be paid to charities in accordance with the indenture, that the balance of the $15.50 should be distributed to the other beneficiaries, and that the rest of the proceeds should be added to corpus. On December 30, 1955, the trustees made payments of some $367,000 to charities qualifying for exemption under the Internal Revenue Code.1 The trustees filed their 1954 federal income tax returns prior to the execution of the compromise but evidently in anticipation of its terms. Deductions other than the charitable contributions under the compromise agreement sufficed to offset income other than long-term capital gains. The returns reported the capital gain, subtracted the payments to the charities, and computed the tax on the balance under the alternative tax provided in § 1201(b) of the 1954 Code.2 [130] The issue, decided against the trusts by the Tax Court, is whether the payments to the charities were properly subtracted. It will be useful to begin by dissipating any obscurities caused by the delayed execution of the compromise agreement and the resulting form of the tax returns. The Commissioner does not dispute that the issue is to be determined as if the correct allocation had been determined and payments made in 1954. See Rev. Ruling 62-147 and cases under earlier Revenue Acts there cited, 1962-2 Cum. Bull. 151. It is agreed also that if the settlement had been concluded before the tax returns were filed, the entire amount of the gain distributed to the non-charitable income beneficiaries, approximately $13 per share, would have been deductible by the trustees under § 661(a), and each non-charitable beneficiary, in computing his tax on such gain, would have been entitled under § 662(b) to avail himself of the alternative tax. Hence nothing turns on the fact that the trustees here paid the capital gains tax attributed to the amounts dsitributable to these beneficiaries and deducted this from the amount the beneficiaries would otherwise receive. The case concerns only two items, the capital gain added to corpus, some $31.56 per share, and the portion distributed to charity, some $2.28; the issue is whether the alternative tax is to be computed on the former figure alone, as the trustees insist, or on the sum of the two, $33.84, as the Commissioner and the Tax Court have ruled. It will be easier to understand the issue if we take a hypothetical case and assume that, after payments to non-charitable income beneficiaries of their share of the gain, the remaining gain is $500,-000, the required income payment to charities is $40,000 and the trust has no other income or expense, so that, apart from taxes, $460,000 would be added to corpus. The parties agree that, the trust having already deducted the payments to the non-charitable income beneficiaries, we next turn to § 1202, which allows it to deduct 50% of the gain other than amounts includible by the income beneficiaries, to wit, $250,000. They agree also that § 642(c) allows a deduction for half of the $40,000 paid to charities, or $20,000 — the remaining half having been already deducted under § 1202 — thereby leaving taxable income of $230,000, all representing long-term capital gain. We thus arrive at the computation of the alternative tax under § 1201(b), see fn. 2. The Commissioner computes this as follows: (1) Partial tax on taxable income, $230,000, reduced by 50% of long-term capital gains of $500,000, or $250,000, to wit, minus $20,000 = 0. (2) 25% of long-term capital gains of $500,-000 = 125,000. $125.000. The trustees say that § 1201(b) (2) must be read as excluding long-term gain they were required to pay the charities as current income, and that the correct tax is 25% of the $460,000 added to corpus, or $115,000. The Commissioner insists that in referring simply to “net long-term capital gain,” § 1201(b) (2) does not contemplate any deduction for charitable contributions and is on its face clear and unambiguous. He argues there is no un [131] fairness in literal application of the statute because the alternative tax is still less than the regular rate, and relies on Weil v. C. I. R., 229 F.2d 593 (6 Cir. 1956), which held that an individual taxpayer may not use an excess of deductions over ordinary income to reduce long-term capital gains before applying the 25% rate. The trustees answer that the Code sections on capital gains cannot be read without taking account of the trust provisions in Subchapter J, which by § 641(b) were declared to prevail over inconsistent sections on treatment of individual taxpayers; that these provisions treat the trust as a mere conduit; and that the so-called “separate basket” theory of Weil is inapplicable to income which the trust never owned. Certainly this case raises a different question from Weil. That case held only that, in terms of the present statute, “the excess of the net long-term capital gain over the net short-term capital loss” cannot fairly be read as equivalent to “the excess of the net long-term capital gain over the sum of (a) the net short-term capital loss and (b) the excess of deductions (other than that provided in § 1202) over other income”; the court had no occasion to consider whether net long-term gain belonging to a charitable income beneficiary may be excluded by a trust in computing the alternative tax. The Commissioner replies to all this with § 663(a) (2), which forbids the inclusion, as a distribution deduction to the trust under § 661(a) or as an item in the income of a beneficiary under § 662 (a), of any charitable distribution qualifying for the deduction provided in § 642(c). Federal income taxation of trusts and their beneficiaries has long been based on the principle that the trust “is in general treated as a conduit through which income passes to the beneficiary.” H.R.Rep. No. 1337, 83d Cong., 2d Sess., 1954 U.S.Code Cong. & Ad.News 4017, 4087. The general scheme of the 1954 Code, like that of its predecessors, is to treat currently distributable income “not as the trust’s income, but as the beneficiary’s,” whose “share of the income is considered his property from the moment of its receipt by the estate.” Freuler v. Helvering, 291 U.S. 35, 41-42, 54 S.Ct. 308, 310-311, 78 L.Ed. 634 (1934).3 Consistently with this the Commissioner does not suggest that § 1201(b) should be construed as requiring inclusion of long-term gain distributable to non-charitable beneficiaries, although a strictly literal reading would lead to that conclusion and neither § 661(a) nor § 662 nor any other section expressly dictates the contrary. He says,. however, as already indicated, that even when a distribution of gain to a charity must be made by a trustee as from current income, so that from a trust accounting point of view the charity stands no differently than any other income beneficiary, the tax result is otherwise because the Code lumps all payments to charities as a deduction under § 642(c) and § 663 (a) (2) forbids the treatment of such payments as amounts to be deducted from the trust income under § 661(a) or to be included in the income of a beneficiary under § 662(a). The argument stresses the form at the neglect of substance; the letter of § 1201(b) must yield when it would lead to an unfair and unintended result. See Read v. United States, 320 F.2d 550 (5 Cir. 1963). Congress considered charitable contributions from capital gains to be generally within the conduit principle, as demonstrated by their inclusion in the definition of distributable net income in § 643(a) (3).4 Amounts [132] paid or permanently set aside for charity were dealt with separately in § 642(c) apparently because Congress did not wish charitable gifts by trusts to be subject to the percentage limitations imposed on individuals in § 170(b). Having authorized this broad deduction in § 642(c), Congress enacted § 663(a) (2) to prevent the trust from having a double deduction and a beneficiary from claiming a charitable deduction already taken by the trustee. See H.R.Rep. No. 1337, supra, 1954 U.S.Code Cong. & Ad.News 4344; Sen.Rep., id. at 4621. None of this speaks to the point whether Congress meant that gains required to be paid to a charity as distributable income should be included in computing the alternative tax under § 1201. The increase in the tax due to including such distributable gains in computing the alternative tax would have to be borne by either the charities or the remaindermen. If, as the compromise agreement here authorized, the trustee takes from the charities a quarter of the amount otherwise distributable to them on the theory that the charitable gifts required to be made out of income should not increase the tax burden on the remaindermen, there is an indirect incursion on the exemption afforded the charities by § 501. On the other hand, to place the burden on the remaindermen would subject them to a higher tax than if the settlor had not included charities among the income beneficiaries.5 Such a situation is quite different from that in Weil where the taxpayers in effect made charitable gifts of gains they themselves realized during the year. Thus the literal reading of § 1201(b) urged by the Commissioner would not only be inconsistent with the general scheme of trust taxation but would bring about adverse results with respect to charitable gifts that Congress is unlikely to have intended. The Supreme Court’s observation in Helvering v. Bliss, 293 U.S. 144, 150-151, 55 S.Ct. 17, 20-21, 79 L.Ed. 246 (1934), although on a different problem, seems singularly apt: “The exemption of income devoted to charity and the reduction of the rate of tax on capital gains were liberalizations of the law in the taxpayer’s favor, were begotten from motives of public policy, and are not to be narrowly construed.” See also United States v. American Trucking Ass’ns, Inc., 310 U.S. 534, 543-544, 60 S.Ct. 1059, 84 L.Ed. 1345 (1940); J. C. Penney Co. v. C. I. R., 312 F.2d 65, 68 (2 Cir. 1962). We decide only that long-term capital gain required to be treated by a trust as distributable income to charities need not be included in “the excess of the net long-term capital gain over the short-term capital loss” under § 1201(b) (2); we are not required to determine what the result here would have been if the trustees had exercised their power to make a charitable distribution greater [133] than the 15% required by the trust agreement. Reversed. Footnotes [1] This figure represents only payments from the three trusts involved in this appeal. In addition, the trustees paid out and set aside some $75,000 from a fourth trust administered as a part of the overall estate. [2] Section 1201 provides: ‘“(b) Other Taxpayers. — If for any taxable year the net long-term capital gain-of any taxpayer (other than a corporation) exceeds the net short-term capital loss, then, in lieu of the tax imposed by sections 1 and 511, there is hereby im [130] posed a tax (if such tax is less than the tax imposed by such sections) which shall consist of the sum of— (1) a partial tax computed on the taxable income reduced by an amount equal to 50 percent of such excess, at the rate and in the manner as if this subsection had not been enacted, and (2) an amount equal to 25 percent of the excess of the net long-term capital gain over the net short-term capital loss.” Since § 1202 authorizes deduction of 50% of the excess of net long-term capital gain over net short-term capital loss, the entire excess is eliminated in computing the partial tax under § 1201(b) (1) and the excess is taxed at the 25% rate provided in § 1201(b) (2). [3] “The novelty of the 1954 Code was in creating a new concept to distinguish between taxable and tax-free distribution-distributable net income — which is based on the trust’s taxable income (with appropriate adjustments), rather than on income as defined by state law * * Bittker, Federal Income and Estate Taxation 362 (3d ed. 1964). [4] The Senate Report on this provision declared : “In order to implement the conduit theory in a satisfactory manner, it is necessary to include in the measure [132] items of income and deductions -which are not reflected in taxable income. The hill adopts the concept of ‘distributable net income* as the measure * * * ” Sen.Fin.Comm.Rep., 83rd Cong., 2d Sess., 1954 U.S.Code Cong. & Ad.News 4621, 4715. The Conference Committee Report sustaining the Senate amendment to the section stated: “This amendment changes the definition of distributable net income to insure that where capital gains must be or are added to principal, they will be taxed to the estate or trust. But where capital gains are paid, credited, or required to be distributed to any beneficiary, or paid, permanently set aside, or to be used for the purposes specified in section 642(c), such gains are to be included in the computation of distributable net income.” H.R.Rep.No. 2543, id. at 5314 (emphasis added); see also, Sen.Fin.Comm.Rep., supra at 4984. [5] Although the amount in this instance is' small in proportion to the gain, the same principle would have to apply if our hypothetical case were altered so that the payment to charity was $150,000 rather than $40,000. On that assumption the tax on a $350,000 increment to corpus would be $125,000 under the Commissioner’s theory, as against $87,500 on the taxpayers’.