Opinion
Docket Nos. 15727 15728.
1949-06-21
HELEN C. BROWN, PETITIONER, V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.EARL M. BROWN, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
George E. H. Goodner, Esq., and Scott P. Crampton, Esq., for the petitioners. J. Harrison Miller, Esq., for the respondent.
Petitioners, husband and wife, are engaged as partners in the general contracting and coal-mining business. In 1943 petitioners acquired a 35-acre tract of coal land, and another tract upon which was located a railroad siding which petitioners were then using in their coal-mining operations. Petitioners devised a plan under which these properties were to be conveyed to a trustee of two trusts for their minor children, who was to lease the properties back to petitioners for the purpose of carrying on their partnership coal operations. The necessary legal documents putting into effect the plan were duly executed. Pursuant to the lease agreements, petitioners paid to the trustee in the taxable year 1944 the amount of $10,278.90 as ‘royalties‘ for the coal lands and $10,203.38 as ‘rental‘ for the siding. Petitioners received from a third party the sum of $26 in 1944 for the use of the siding. This amount was paid over to the trustee by petitioners. Held:
(1) The payments of the so-called ‘royalties‘ and ‘rentals‘ to the trusts were in fact merely gifts of partnership income to the trusts and therefore constituted neither royalties, nor rentals, nor ordinary business expenses of the partnership within the meaning of section 23(a)(1)(A) of the Internal Revenue Code.
(2) Petitioners have not shown error in respondent's determination that the sum of $26 constituted income of the partnership. George E. H. Goodner, Esq., and Scott P. Crampton, Esq., for the petitioners. J. Harrison Miller, Esq., for the respondent.
These consolidated proceedings involve deficiencies in income tax for the calendar year 1944, as follows:
+------------------------------------+ ¦Taxpayer ¦Docket No.¦Deficiency¦ +--------------+----------+----------¦ ¦ ¦ ¦ ¦ +--------------+----------+----------¦ ¦Helen C. Brown¦15727 ¦$6,027.77 ¦ +--------------+----------+----------¦ ¦Earl M. Brown ¦15728 ¦15,088.41 ¦ +--------------+----------+----------¦ ¦ ¦ ¦ ¦ +------------------------------------+
The issues presented are (1) whether the respondent properly disallowed deductions in the amount of $10,278.90, as royalties, and the amount of $10,203.38, as wheelage and siding rental paid in the taxable year 1944 by a partnership composed of the petitioners to the trustee of two trusts created by petitioners for the benefit of their two minor sons; and (2) whether the amount of $26 received in 1944 as rental for use of the railroad siding represents taxable income to petitioners. An additional assignment of error respecting respondent's disallowance of a deduction of $1,000 claimed by the partnership in the purchase of a bulldozer blade was abandoned by petitioners at the hearing.
The deficiency originally determined against Earl M. Brown, for the taxable year as set forth in the respondent's notice was $13788.26. By amended answer respondent alleges that in his income tax return Earl M. Brown overstated the amount paid on account of estimated tax by the amount of $1,300.15, so that the correct deficiency in income tax for 1944 is $15,088.41. The controversy between the parties in relation to the $1,300.15 has been settled by stipulation and they have agreed that appropriate adjustments will be made on the basis of agreed figures in a computation under Rule 50.
FINDINGS OF FACT.
Petitioners are husband and wife, residing in Clearfield, Pennsylvania. Their individual tax returns for the calendar year 1944 were filed on the cash receipts and disbursements basis, with the collector of internal revenue for the twenty-third district of Pennsylvania.
In 1943 the business of petitioners was growing. They owned a large equity in equipment worth about $150,000. They owned several coal properties which were then being operated. In their mining operations petitioners made use of a railroad siding for loading coal, then owned by H. F. Bigler, Jr. This railroad siding consisted of a single track, with a ramp or tipple from which coal could be loaded from trucks into railroad cars. This siding connected with the Baltimore & Ohio Railroad and was capable of holding approximately 30 coal cars. The petitioners paid a wheelage charge of $2.50 per car, regardless of the amount of coal loaded. The amount of coal held by one coal car ranges from 50 to 70 tons.
By deed dated June 7, 1943, petitioners acquired, as husband and wife, title to 8.9 acres of land from H. F. Bigler, Jr., and wife, for a consideration of $4,500. The land was located just outside the borough limits of Clearfield, Pennsylvania. Among the improvements thereon was the aforesaid railroad siding.
By deed dated September 29, 1943, petitioners acquired for $3000 a 35-acre tract of coal land located about three miles north of Clearfield and known as the Kephart tract. Testings had been made on this tract and evidences of coal discovered. Prior to January 3 1944, petitioners had commenced or were about to commence mining operations on this tract.
Sometime prior to January 3, 1944, petitioners discussed with their attorneys, Harry Boulton and his son, Harold J. Boulton, the matter of the future financial security of their two sons, Robert Earl Brown, born August 10, 1941, and Allan Murray Brown, born July 2, 1943. Harry Boulton suggested the creation of a trust. A plan was agreed upon whereby the title to the 8.9-acre tract upon which the railroad siding was located and to the 35-acre coal land was to be transferred to a trustee, with the understanding that the properties were to be leased to petitioners, who were, as was always intended, to continue to operate them under their partnership agreement.
Under date of January 3, 1944, petitioners formally executed two irrevocable trust agreements, under each of which they conveyed to Harold J. Boulton, as trustee, an undivided one-half interest in the aforesaid tracts for the benefit of the petitioner's two sons. The trust agreements are identical except as to the names of the beneficiaries. Each trust contained, inter alia, the following provisions:
1. During the continuance of the Trust, The Trustee shall have the absolute right, in his sole discretion, to operate, manage, sell, convey, transfer, lease, assign and convey any and all, or any part of the said Trust Estate, and to make, execute and deliver good and sufficient deeds, indentures or other written instruments to the purchaser or lessee at whatever price and upon whatever terms may to him seem wise; and the Trustee shall have the right to consent to assignments by lessees and modify or cancel lease contracts for any part of the trust estate, if power and occasion should be reserved or arise under the terms of the lease agreement or agreements.
3. The income from the Trust Estate shall be held and accumulated by the Trustee for the duration of the Trust but not exceeding twenty-one years after the death of the survivor of the grantors nor longer than the minority of the beneficiaries; and he shall have the right at all times to pay out of the income at his discretion such sums as he may deem necessary for the support, maintenance and education of any of the beneficiaries who at the time of such payment would be entitled to receive all or part of the Trust Estate as though it were then terminated, and it is specifically authorized that the Trustee may invest any part or all of the income, or of the principal if converted into cash, in additional real estate or in leases of additional real estate. The income, after the dates fixed for accumulation thereof shall be paid from time to time to those entitled as though the trust had at the date of such payments been terminated.
4. The first beneficiary of the Trust Estate hereby created is ALLAN MURRAY BROWN, a minor child of the Grantors herein, subject to he hereinafter stated terms and conditions of the Trust; but if the said ALLAN MURRAY BROWN should die before attaining the age of twenty-five years, his surviving children in the first place, or if the said ALLAN MURRAY BROWN shall not have children to survive him, then his surviving brothers and sisters in the second place, in the order named, are substituted as beneficiaries.
5. The Trust Estate shall terminate upon the first beneficiary arriving at the age of twenty-five years; if the first beneficiary shall die prior to the date fixed for the termination of the Trust, the duration of the Trust Estate shall, nevertheless, so far as concerns the principal of the Trust Estate, continue until the youngest of the respective substituted beneficiaries shall arrive at the age of twenty-one years, and the Trust shall continue for such substituted term with the same powers as herein set forth. Upon the termination of the Trust Estate, the Trustee shall execute sufficient conveyances and assignments in fee simple as to real estate and absolutely as to personalty, to the beneficiary or beneficiaries of all the corpus of the Trust Estate, including income which may have accumulated.
Under date of January 4, 1944, petitioners entered into a written agreement with Harold J. Boulton, as trustee, whereby petitioners were granted the exclusive right and privilege to occupy and use the aforementioned railroad siding for a period of 10 years, upon the payment of a rental of seven cents per ton for each and every ton of coal or clay loaded upon the premises in railroad cars and shipped over the siding. In addition, the lessees were to keep the railroad siding and equipment in good repair, and were to save harmless and indemnify the lessor and the railroad from any loss, damage or expense by reason of injury to persons or property arising from use or occupation of the described premises, including any appurtenant sidewalks or driveways. The lease also provides for the payment of a minimum rental of $25 per month; prohibits the assignment or subletting without lessor's consent; and gives the lessor certain redress in case of default.
Under the same date of January 4, 1944, petitioners entered into another written agreement with Harold J. Boulton, as trustee, whereby petitioners were granted, for a period of 5 years, the right to mine and take for their own use and benefit all the coal and fire clay upon the 35-acre tract acquired by petitioners on September 29, 1943, upon the payment of the sum of 25 cents per ton for coal mined and 10 cents per ton for clay produced from said premises. The agreement also provided for the payment of a minimum rental of $50 per month, for which credit was to be given upon the royalty paid. it prohibited the assignment or subletting without lessor's consent. and it gave the lessor certain redress in case of default.
The 25 cents per ton paid by the petitioners to the trustee for coal mined on the 35-acre tract and the 7 cents paid by petitioners to the trustee for each ton of coal loaded over the railroad siding constituted reasonable royalties and rentals for the use of the facilities leased.
The transfers of the coal acreage and railroad siding by petitioners to the trustee of the trusts for petitioners' children were integrated steps in one transaction.
In 1944 petitioners paid to Harold J. Boulton, as trustee of the two trusts, the sum of $10,278.90, representing royalties on coal mined on the 35-acre tract, and the sum of $10,203.38 representing rentals for the use of the railroad siding. On the partnership return for 1944, the petitioners claimed those amounts as deductions, which amounts the respondent disallowed.
The only person other than petitioners who made use of the railroad siding during 1944 was H. F. Bigler, Jr., for which use he paid petitioners the sum of $26. This amount was paid over by petitioners to the trustee. Petitioners did not report this $26 in their partnership return of income for 1944. The respondent has included this amount as income in computing the income from business taxable to petitioners.
OPINION.
LEECH, Judge:
The principal issue is whether petitioners are entitled to deduct the amounts paid in 1944 to two trusts, either as rents or royalties, or as ordinary and necessary expenses of their partnership business under the provisions of section 23(a)(1)(A) of the Internal Revenue Code.
Petitioners contend that the respective amounts are deductible under the rationale of Skemp v. Commissioner, 168 Fed.(2d) 598, reversing 8 T.C. 415. The respondent's position is that the plan devised and executed by petitioners, under which they transferred certain properties to a trustee for the benefit of their minor sons on the condition that these properties were to be leased back to petitioners in consideration of the payment of ‘royalties‘ and ‘rentals‘ for use of such properties, constituted in fact an assignment or allocation by them of their partnership profits to their two minor sons, and that the amounts of those ‘royalties‘ and ‘rentals‘ are, therefore, not deductible as such or otherwise as a business expense, under section 23(a)(1)(A) of the Internal Revenue Code.
Sec. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions:(a) EXPENSES.—(1) TRADE OR BUSINESS EXPENSES.—(A) In General.— All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business; and rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.
Where transactions, such as these, involve the members of an intimate family group, ‘the question is always whether the transaction under scrutiny is in reality what it appears to be in form.‘ Johnson v. Commissioner, 86 Fed. (2d) 710, affirming 33 B.T.A. 1003.
Neither the mechanics employed nor the legal designations, i.e., ‘rents‘ and/or ‘royalties,‘ are controlling. The issue is simply whether the transactions under consideration, i.e., the ‘gift‘ and ‘lease‘ upon ‘rents‘ and/or ‘royalties,‘ were, in fact, an assignment or allocation by petitioners of their partnership income to the trusts for the children in the amount of the ‘royalties‘ and ‘rents‘ paid by petitioners. If the answer to that question is in the affirmative, then, of course, the amounts so paid to the trusts are not expenses at all and are, therefore, not deductible under section 23(a)(1)(A) of the Internal Revenue Code. And, in arriving at the correct answer to the question, the fundamental inquiry is whether the ‘gift‘ by petitioners to the trusts for the children and the ‘lease‘ of the subject matter of the ‘gift‘ by the trusts to the petitioners were, for present purposes, separate transactions or integrated steps in a single transaction. Thus, for income tax purposes, if A purports to give B $10,000, with the understanding that B will buy 100 shares of X stock from A, and B does so, the ‘gift‘ and ‘purchase‘ are not separable. A single integrated transaction occurred and that was not a gift of $10,000 from A to B, but a gift of 100 shares of X stock. Since the parties, before the transfer of the $10,000, agreed that the ‘donee‘ should use the ‘gift‘ to buy the stock from the ‘donor,‘ the ‘gift‘ and the following ‘purchase‘ are integrated steps in the same single transaction and, when so treated, A, in fact, never actually gave away the $10,000. All that happened was a gift by A to B of 100 shares of X stock. Manning v. Gagne, 27 Fed.Supp. 286; affd., 108 Fed.(2d) 718; Smith v. Hoey (unreported officially, Dist. Ct. N.Y.), 34 A.F.T.R. 1704; affd., 153 Fed.(2d) 846; Percy C. Madeira, 36 B.T.A. 456; reversed, 98 Fed.(2d) 556.
What does the record here reveal? Petitioners, as partners were engaged in mining coal from several properties. In carrying on those operations they had acquired a large amount of appropriate equipment. For some time they had made use of a railroad siding for loading the coal for shipment, for which they paid rental on a tonnage basis. In June 1943 they acquired title to the acreage upon which the railroad siding was located. On September 29, 1943; they acquired title to an additional 35 acres of coal property. These properties were acquired by petitioners with the purpose and intent of using them, as well as their other property and equipment, in the coal-mining operations of the partnership. In fact, to have separated such properties from the partnership coal business would have materially interfered with the conduct of that business and also curtailed the use of their large investment in equipment.
Petitioners, so far as the record reveals, did not intend that any benefit, advantage, or consideration should result to or be received by the partnership in its business by the arrangement under scrutiny. Nor does the evidence disclose that such was a result. No such contentions were even made. Cf. Catherine G. Armston, 12 T.C. 539. But, petitioners did have at least two major purposes. These purposes were to provide financial security for the petitioners' children and, at the same time, leave the partnership coal business and the properties used therein undisturbed under the continued management and control of the partnership consisting of petitioners. The plan of the ‘gift‘ and ‘lease,‘ adopted and carried out, met those purposes. The ‘gift‘ to the trusts would not have occurred except upon the condition that the ‘lease‘ back to petitioners of the subject matter of the ‘gift‘ would follow. Obviously, we think, as found as a fact, the ‘gift‘ and ‘lease‘ were interdependent, and they constitute but a single transaction for present purposes. Petitioners never intended to and in fact never did part with their right to mine the coal from the acreage and load and ship the same from the siding, which they transferred to the trusts. They merely intended and made a gift of their partnership income in the amounts of the contested ‘rents‘ and ‘royalties‘ to the trusts for their children. It follows that these amounts are, therefore, neither ‘rents,‘ nor ‘royalties,‘ nor ordinary or necessary expenses of the business carried on by the petitioners within the provisions of section 23(a)(1)(A) of the Internal Revenue Code, nor deductible as such. The respondent's disallowance of the deductions as such is sustained. Ingle Coal Corporation, 10 T.C. 1199; affd., 174 Fed.(2d) 569; Granberg Equipment, Inc., 11 T.C. 704; A. A. Skemp, 8 T.C. 415; Paul G. Greene, 7 T.C. 142; Catherine G. Armston supra.
Petitioners rely upon the reversal of this Court in the Skemp case, supra, by the Circuit Court of Appeals for the Seventh Circuit. In Catherine G. Armston, supra, however, we took note of that action of the Circuit Court and, after due consideration, respectfully refrained from following it. We adhere to that position.
The second issue involves the question as to the treatment to be accorded the receipt of the sum of $26. This sum represents moneys paid to petitioners by H. F. Bigler, Jr., for the use of the railroad siding. Petitioners had the exclusive right to occupy and use the siding and were using it in the production of income. We think the payment was incidental to such use and was business income of petitioners. No contention is made that petitioners' receipt from a third party of such insignificant amount constituted a subletting in violation of the lease. For lack of proof, we sustain respondent's determination that the $26 was business income of petitioners in the taxable year 1944.
Reviewed by the Court.
Decisions will be entered under Rule 50.
ARUNDELL, J., dissenting:
The evidence in this case establishes that the petitioners unconditionally and irrevocably conveyed a coal lease and the lease to a railroad siding to two trusts established for the benefit of their minor children. Immediately thereafter the trustee, who was an independent trustee, leased these properties to petitioners on a royalty basis, which was reasonable in amount. The Commissioner does not contend that the trusts were not bona fide but that the royalties paid by petitioners to the trusts do not constitute ordinary and necessary expenses within the meaning of section 23(a)(1)(A) of the Internal Revenue Code. The majority opinion takes the view that the agreement between petitioners and the trusts constituted a gift of partnership income, although the evidence is clear that the sums paid by petitioners to the trusts by way of royalties were in nowise dependent upon the earning of any income on the part of petitioners, and petitioners were legally liable to the trusts for the royalties, even if their operations had resulted in a loss.
In my opinion, the undisputed facts bring this case within the principle stated by the Seventh Circuit Court of Appeals in Skemp v. Commissioner, 168 Fed.(2d) 598, in which opinion the court stated:
The Commissioner argues that the payments as rent were not required because the taxpayer had voluntarily entered into the transaction. While the taxpayer voluntarily created the situation which required the payments of rent, the fact remains that the situation created did require the payments. In this case we have a valid, irrevocable trust, wholly divesting the taxpayer of any interest in the trust property, and an agreement by the taxpayer to pay the trustee a reasonable rental under a valid lease. The income from the property is not claimed in this proceeding to be that of the taxpayer. We have here only a question of deduction of rental from gross income. There can be no question but what rent required to be paid is properly deductible. The trustee was duty bound to exact rent of the taxpayer and the taxpayer was legally bound to pay it, just as much as if the taxpayer had moved across the street into the property of a third party.
The majority relies on Ingle Coal Corporation, 10 T.C. 1199, which case was affirmed by the Court of Appeals for the Seventh Circuit, the same court which reversed our decision in A. A. Skemp, 8 T.C. 415. It is significant to note that in affirming Ingle Coal Corporation the appellate court adhered to its holding in Skemp v. Commissioner, supra, and pointed out what it considered to be the fundamental distinction between the two cases, viz., that ‘In the case before us (Ingle Coal) the transfer of property was not to an independent third party but to a corporation which the same stockholders controlled, and who had it within their power to change or erase the overriding royalty obligations at any time that they chose to do so,‘ while in the Skemp case there was a change in the taxpayer's economic status and he could only occupy the building by paying the rent fixed by the trustee. As already stated, the facts in the instant case in my opinion bring it within the principle of Skemp, supra, and distinguish it from Ingle Coal, supra.
I can detect no sham in the transaction entered into by petitioners with the two trusts. As already stated, there was an absolute and unconditional conveyance of all right and title in the properties from the petitioners to the trustee which completely divested petitioners of all interest therein. Whatever interest the petitioners subsequently acquired was obtained by virtue of valid leases which provided for the payment of reasonable rentals and royalties. The royalties and rentals paid by petitioners to the trustee of the two trusts, to paraphrase the language of section 23(a)(1)(A), were royalties or other payments required to be made as the condition to the continued use or possession, for the purpose of the trade or business, of property to which the taxpayers had not taken and were not taking title or in which they had no equity.
I think the petitioners should prevail.
VAN FOSSAN, MURDOCK, BLACK, TYSON, and LeMIRE, JJ., agree with this dissent.