JOHNSON

1. GIFT TAX.— In ascertaining the net value of gifts to a trust for gift tax purposes, wherein the trustee was required to pay the future income tax of the settlor-beneficiary, the gross value of the gift may be reduced by the present worth of future income tax payments.

2. GIFT TAX.— In determining the net value of gifts to a trust, wherein the trustee agreed to pay the gift tax, the settlor excluded the gift tax incurred in the transfer. Held, the gift tax may be deducted from the gross value of the gifts in determining the net value of the transfer subject to gift tax. Hover T. Lentz, Esq., and F. Tillman Brownne, C.P.A., for the petitioner. Marvin E. Hagen, Esq., for the respondent.

Respondent determined a deficiency in gift tax of $10,566.68 for the year 1947. By amended answer respondent asks that the deficiency be increased to the amount of $24,313.81.

The questions here present are whether in determining for gift tax purposes the present net value of gifts given to two trusts there may be excluded from the gross value of the gifts (1) the present worth of petitioner-settlor's future income tax payments which are to be paid by the trustee under the terms of the trusts, and (2) petitioner-settlor's gift tax payments made by the trustee under the terms of a parol agreement.

Some of the facts were stipulated.

FINDINGS OF FACT.

The facts stipulated are hereby found.

Petitioner is an individual and was at all times prior to 1947 a resident of Albuquerque, New Mexico. She filed an original and an amended gift tax return for the calendar year 1947 with the collector of internal revenue for the district of New Mexico, at Albuquerque. Petitioner was 50 years of age on September 17, 1947.

On September 2, 1947, petitioner obtained a final decree of divorce from Raymond Leyden Harrison in the District Court of Bernalillo County, New Mexico. The divorce decree set aside to petitioner as her share of community property 11 parcels of business real estate located in Albuquerque, negotiable promissory notes of R. L. Harrison payable to petitioner in the aggregate amount of $200,000, the family home, and an automobile. On the same day the divorce decree was granted, September 2, 1947, petitioner transferred to Albuquerque National Trust & Savings Bank, as trustee, an undivided one-half interest in the above 11 parcels of business real estate, and one-half of the promissory notes in the aggregate amount of $100,000, such total one-half interest of notes and property having an aggregate value of $267,500. This trust was described as the ‘Sarah Helen Harrison Living Trust No. 1.‘ The trust instrument provided in part as follows:

ARTICLE I

Section 1. The Trustee shall pay to Settlor in monthly, quarterly or other convenient installments the sum of Twelve Thousand Dollars ($12,000) per annum, for and during the remainder of her life. Such payments shall be paid out of net income and, if necessary, out of corpus. The Trustee, in its sole discretion, may make additional payments out of net income and, if necessary, out of corpus to Settlor during the remainder of her life to meet any hardship of hers that may arise from time to time due to changed or unusual economical conditions or an emergency of any kind.

The Trustee s all also pay and discharge out of net income and, if necessary, out of corpus, each year during the remaining lifetime of Settlor, her entire liability for Federal and State income taxes.

Section 3. Upon the death of Settlor, the Trustee shall divide the trust estate into equal shares as follows: one share for each of the then living of said children of Settlor, and one share for the then living children of each of said children of Settlor who may be deceased.

Also on September 2, 1947, petitioner transferred to the above bank, as trustee, the other undivided one-half interest in the business real estate and R. L. Harrison notes payable in the aggregate amount of $100,000. This trust was described as the ‘Sarah Helen Harrison Living Trust No. 2.‘

The trust instrument provided in part as follows:

ARTICLE I

Section 1. The Trustee shall immediately divide the Trust Estate into four equal shares, one share for each of the said children of Settlor.

Both trust instruments provided that the trustee had wide discretionary powers in the management of the trusts, and were in all respects irrevocable from and after the date of their execution and delivery. In addition, both trust instruments contain the following provision:

ARTICLE III

Section 1. To carry out the purpose of the trust, the Trustee shall have the following powers in addition to those now or hereafter conferred by law affecting the trust and the Trust Estate:

1. To pay out of corpus any gift, inheritance or succession taxes due or to become due or levied by reason of the execution of this instrument or the death of Settlor.

Petitioner transferred the bulk of her assets consisting of her share of community property to these two trusts, retaining for herself the family home, its furnishings, the automobile, and an annual income of $12,000 tax free.

The following table indicates the gross value of the gifts and the deductions toward net value:

+-----------------------------------------------------------------------------+ ¦ ¦Petitioner's ¦Determined ¦ +----------------------------------------------+--------------+---------------¦ ¦ ¦amended ¦in deficiency ¦ +----------------------------------------------+--------------+---------------¦ ¦ ¦return ¦notice ¦ +----------------------------------------------+--------------+---------------¦ ¦ ¦ ¦ ¦ +----------------------------------------------+--------------+---------------¦ ¦Gross value of gifts to Trusts No. 1 and 2 ¦$535,000.00 ¦$535,000.00 ¦ +----------------------------------------------+--------------+---------------¦ ¦Less: Present value of annuity ($12,000 ¦152,367.36 ¦152,367.36 ¦ ¦annually) ¦ ¦ ¦ +----------------------------------------------+--------------+---------------¦ ¦Present worth of income tax payments ¦55,306.19 ¦None ¦ +----------------------------------------------+--------------+---------------¦ ¦Liability for gift tax ¦46,713.02 ¦57,279.70 ¦ +----------------------------------------------+--------------+---------------¦ ¦Total deductions ¦$254,386.57 ¦$209,647.06 ¦ +----------------------------------------------+--------------+---------------¦ ¦Total gifts ¦$280,613.43 ¦$325,352.94 ¦ +-----------------------------------------------------------------------------+

Negotiations extending over more than three years preceded the divorce decree, the division of community property and the execution of these trusts. There were numerous discussions from time to time between petitioner, her attorney, petitioner's husband, and his attorney, the trust officer of the bank, and two accountants for the purpose of planning the division of community property and the ultimate disposition of petitioner's share. This was done to protect petitioner's interest because she was a housewife without business experience.

An oral agreement was made, prior to the divorce proceedings, whereby petitioner would receive income property in lieu of shares in her husband's business as her share of the community property. It was agreed this income producing property was to be placed in two trusts, one for petitioner's benefit, and the other for the children's benefit. It was further agreed that the gift tax would be paid out of the promissory notes rather than by sale of the real property, and that the trustee would be obligated to pay petitioner's gift tax out of those notes. In furtherance of this agreement, petitioner's husband executed the required promissory notes. It was the intention of the parties that an amount equal to petitioner's gift tax would be transferred to the trustee to hold solely for the payment of petitioner's gift tax liability.

On March 15, 1948, petitioner filed an original gift tax return for 1947 reporting the aggregate gifts in trust at a value of $210,400. She claimed an exemption of $30,000 and reported a gift tax liability of $33,615.

On April 14, 1948, petitioner filed an amended gift tax return for 1947 reporting the aggregate net value of gifts in both trusts in the amount of $238,613.43. She claimed specific exemption of $30,000 and an annual exclusion of $12,000 (4 X $3,000). A gift tax liability of $46,713.02 was reported and paid.

In computing her estimated future income tax of $55,306.19 petitioner estimated that the net income from the trust would be $16,000 each year. This estimate was based upon the rentals in effect in 1947, and the income from the notes. Petitioner computed the estimated Federal and state income taxes to be $4,370 a year on the basis of the rates in effect at December 31, 1947. The estimated annual Federal and state income taxes of $4,370 were then capitalized by using the factor 12.47032 and the factor 1.01488 as found in Table A, Regulations 108, section 86.19. These figures were then extended and resulted in the value of $55,306.19 as the present worth of future income tax payments. The factor 12.47032 is the present value of $1 during the life of a person age 50; the factor 1.01488 is the amount of increase in the present value if these payments are to be made quarterly.

In her amended gift tax return for 1947 petitioner deducted the gift tax liability of $46,713.02 from the value of the property transferred in arriving at the value of the gifts subject to gift tax.

On or about March 15, 1948, the Albuquerque National Trust & Savings Bank, as trustee, paid the collector of internal revenue for the district of New Mexico the gift tax shown on petitioner's original return in the sum of $33,615. About a month later, the trustee paid an additional gift tax, as shown on her amended return, in the amount of $13,098.02. Discretionary acts performed by the trustee were usually preceded by a conference with the trustee, the beneficiaries and the remaindermen in attendance. However, the trustee paid the gift tax, as per the oral agreement, without a prior conference.

The present worth of the future income tax payments to be made by the trustee under article I, section 1, of Trust No. 1, was $50,623. An estimate of the annual net income of the trust, considering past income of the real property, the notes, and the prospective rental income, is $16,000.

Respondent, in his notice of deficiency, allowed a deduction of the asserted gift tax liability of $57,279.70 in lieu of $46,713.02, which had been paid by the petitioner. The increase in gift tax liability resulted from the disallowance of a present worth of the future income tax payments as estimated by petitioner. Respondent filed an answer to the petitioner and later, in an amended answer, claimed an increased deficiency in the amount of $13,747.13, alleging that he erred in allowing a reduction of $57,279.70, or any amount in arriving at the value of the gifts subject to gift tax.

OPINION.

JOHNSON, Judge:

In the first issue, petitioner alleges respondent erred in disallowing the exclusion of the present worth of future income tax payments from the gross value of gifts in determining the net value of petitioner's gifts subject to gift tax. Respondent contends that the present value of petitioner's right to have her future income tax paid by the trustee may not be deducted from the gross value of the gifts to the trusts, since the value of the right could not be ascertained by recognized actuarial methods.

By the provision in Trust No. 1, that the trustee ‘shall also pay and discharge * * * , each year during the remaining lifetime of Settlor, her entire liability for Federal and State income taxes,‘ petitioner reserved or retained a valuable and enforceable right in this trust. Cf. Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 729. The payment of petitioner's income tax is not discretionary; but rather, as spelled out in the trust agreement, the payment is an enforceable obligation of the trustee.

Respondent does not deny that the payment of petitioner's income tax is a retained interest, but he takes the position under the theory of Robinette v. Helvering, 318 U.S. 184, affirming 129 F.2d 832, and 44 B.T.A. 701, that such an interest could not be ascertained by any recognized actuarial methods. It is, of course, impossible to foretell with mathematical accuracy the amount of the future Federal and state income tax payments which have to be paid under the terms of the trust agreement within the lifetime of petitioner. However, of a certainty, we know that some tax payments will be required. Since the adoption of the Sixteenth Amendment to the Constitution, Federal income taxes have become a permanent and growing part of our economy, and there is no likelihood, that such taxes will not continue to be imposed throughout the life expectancy of petitioner.

Even though difficult to ascertain, an estimate of petitioner's present right to have her future income tax paid should be made. We note the words of Judge Learned Hand, as expressed in Commissioner v. Maresi, 156 F.2d 929, affirming 6 T.C. 582, wherein a Tax Court evaluation was sustained:

We are dealing with speculation as to the future on a subject which at best admits of no accurate determination. * * * The one sure way to do injustice in such cases is to allow nothing whatever upon the excuse that we cannot tell how much to allow. It is true that in earlier times the law preferred inaction to uncertainty, being sensitive to all that disturbed possession; although the certainty with which it was satisfied, was even then factitious in numberless situations which had no more than the sanction of custom. However, although the demand for certainty has become less exacting, we agree that there is still a limit; indeed, Robinette v. Helvering, supra, 318 U.S. 184, * * * is authoritative to the contrary. * * contrary. * * *

Our case, like the Maresi case, has not approached the Robinette limit. In the Robinette case the taxpayer attempted to evaluate a contingent reversionary remainder. The possibility of the reversion to the settlor was highly remote, and the courts found that the value of this interest could not be ascertained. In the instant case petitioner's right is a present interest with an immediate and substantial value, as distinguished from the contingent interest in the Robinette case. There, the contingency was based upon the highly speculative uncertainty as to whether or not a woman would marry, and whether children, if born, will reach 21 years of age. In the instant case Federal income tax liability may be uncertain as to amount, but it is reasonably sure, if not definite, that the income the petitioner will receive from the trust will require the payment of such a tax.

Having decided that petitioner does have a valuable and enforceable right, our remaining task, as to the first issue, is to evaluate the right to receive $12,000 each year tax free. There is no dispute as to the present worth of the $12,000 each year for the life of petitioner, so we direct our attention to the present worth of the future income tax on $12,000 each year.

We do not accept petitioner's estimate of $55,306.19 as the most reasonable estimate of the present worth of the future tax payments. From a consideration of all the evidence we find and so hold the present value of the future income tax payments to be $50,623.

The second issue involves the exclusion of a gift tax payment from the gross value of the gift in determining the net value of the gifts subject to gift tax. Respondent has amended his answer and claimed that he erroneously allowed a deduction in the deficiency notice for gift taxes; his amended answer, therefore, claimed a deficiency exceeding that in the original deficiency notice. The burden of proof is upon the respondent in respect to any new matter pleaded in his answer. Rule 32, Tax Court's Rules of Practice.

Petitioner contends that incident to the creation of the trusts and as a condition thereof, the trustee was under a contractual obligation to pay petitioner's gift tax liability resulting from the creation of the trusts, and, therefore, the gross value of the property given to the trusts should be reduced by the amount of the gift tax which was to be paid by the trustee. Respondent contends that the gift tax was paid pursuant to the trustee's discretionary powers; therefore, the value of the gift should not be reduced by the amount of the gift tax.

Respondent and the petitioner both rely, for different reasons, on our holding in Estelle May Affelder, 7 T.C. 1190. We do not think that the Affelder case decided the issue which we have here. In that case we found that no prior agreement existed whereby the trustee was obligated to pay the gift tax, and hence we were not required to decide whether if such agreement had been made as a condition or obligation to the making of the gift the amount so paid could be excluded in determining the net value of the gift to the trust.

In the present case we have found that the trustee was obligated by an agreement, between donor and trustee, wherein the trustee was to assume the liability of the donor in the payment of the gift tax. We are not called upon for the first time to decide whether the value of that gift tax as a retained interest by the donor may be excluded from the gross value of the gifts in determining the net value of the gift subject to gift tax. Relying on the rationale, as set forth in the first issue, that the donor has retained an interest in the property to the extent that the trust is obligated to pay petitioner's income tax during the remainder of her life, we hold that the amount of the gift tax may be excluded, as a retained interest, from the gross value of the gifts in determining the net value.

The unimpeached testimony adduced in behalf of petitioner proves unquestionably that an oral agreement existed, prior to the execution of the trusts, whereby the trustee would be obligated to pay the gift tax liability incurred by petitioner in establishing the trusts. Further, the conferences prior to the divorce, the small amount of property retained by petitioner after the divorce settlement, petitioner's inexperience in business matters, and the trustee's actual payment of the gift tax, indicate that the unequivocal intention of the parties was to obligate the trustee rather than leave payment of the gift tax to the discretion of the trustee or petitioner. Because the trustee had been obligated to pay the gift tax, and since these obligations were incurred as a condition to the making of the gift, the property transferred by petitioner was the value of the property at the time of the gift less the interest retained by petitioner for the payment of the gift tax.

Respondent asserts that gift tax ‘is measured by the value of the property passing from the donor.‘ Regulations 108, section 86.3. This is true if the property passes from the donor with all the elements of a gift. Cf. Commissioner v. Hogle, 165 F.2 352, 353, affirming 7 T.C. 986. One of the essential elements of a gift is the donor's intention to make the gift. Petitioner did not intend that the amount of the value of the property necessary for the gift tax liability would be a gift to the trust. Therefore, in the absence of an intent to give, this amount was not effective as property passing from the donor, and not taxable as a gift.

Respondent objects to be introduction and the consideration of testimony with respect to the oral agreement obligating the trustee, but his objection is not well founded. Parol evidence is admissible when the controversy is not between the parties to the instrument. Cf. Scofield v. Greer, 185 F.2d 551. We also recognize that the courts are not rigidly bound by formal written documents in determining questions in the field of taxation, since it is the substance and the realities of the transaction that must govern. Cf. Helvering v. Lazarus & Co., 308 U.S. 252.

In determining the net value of petitioner's gifts the present worth of the future income tax payments is the amount of $50,623. This amount and the gift tax computed as herein directed shall be excluded from the gross value of the gifts as retained interests in determining the net value. The exclusion for gift tax should not be in an amount greater than the gift tax liability recomputed after allowing the exclusion of the present worth for future income tax payments.

Reviewed by the Court.

Decision will be entered under Rule 50.