Opinion
Docket No. 3695.
1945-11-21
HERBERT A. LOEB, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Arnold R. Baar, Esq., for the petitioner. Gerald W. Brooks, Esq., for the respondent.
X was indebted to Y in the sum of approximately $750,000. He owned stock of a corporation which was pledged to a broker to secure his account in the sum of approximately $250,000 and the account of a business associate. In 1935 X and Y entered into a contract whereby Y was given a lien upon this stock and was entitled to the payment of a certain share of the dividends thereon for 10 years. Y also received certain choses in action from X which, when credited on his indebtedness, reduced it to approximately $500,000. If at the end of 10 years this latter amount had not been paid by the application of the dividends on the stock, the stock was to be sold and the proceeds applied to the payment of the balance. In consideration of X's obligations under this contract Y discharged X from any further personal obligation on this indebtedness. In 1939 X created two trusts, of which his sons were beneficiaries and to which he transferred the stock, subject to the pledge and to Y's lien. The trustees were given the power to spend any of the trust income to reduce the liens and encumbrances against the stock. In 1939 and 1940 balances on the account with the broker and the amount due to Y remained unpaid. Held, dividends on this stock received by the two trusts in 1939 and 1940 constituted taxable income to X. Arnold R. Baar, Esq., for the petitioner. Gerald W. Brooks, Esq., for the respondent.
The Commissioner determined deficiencies in petitioner's income tax for the calendar years 1939 and 1940 in the respective amounts of $77,953.32 and $21,785.16, by reason of his alleged liability for the payment of tax on dividends paid in those years on corporate stock previously transferred by petitioner in trust for his sons, subject to liens of pledges in favor of third persons, or, in the alternative as to 1939, on account of capital gains realized in that year upon the transfers in trust.
FINDINGS OF FACT.
Petitioner filed his individual income tax returns for 1939 and 1940 with the collector for the first district of Illinois, at Chicago.
The facts have, in part, been stipulated, and we find them to be as stipulated and set them out here, together with other facts derived from the record, to the extent necessary for an understanding of the issues.
Petitioner is secretary-treasurer of Hillman's, Inc., a corporation engaged in the food business. On January 12, 1935, he owned 1,026 of a total of 5,000 shares of common stock outstanding of the H-H Corporation, predecessor of Hillman's, Inc.
Prior to January 12, 1935, petitioner had become indebted over a period of years to Max Adler in an amount then determined to be $782,236.05. On that date they entered into a written contract by the terms of which Adler was given a lien on 1,026 shares of common stock of H-H Corporation owned by petitioner and upon a share of the dividends to be paid thereafter on the stock for the initial period of 10 years, to secure the payment of the amount set out above, less the value of certain choses in action transferred by petitioner to Adler. The net amount to be secured by the lien was $499,615.08.
The contract provided also that:
It is understood and agreed that said Max Adler accepts this contract and the agreements therein contained in full settlement of the indebtedness above described due him from said Herbert A. Loeb, and hereby discharges him from any further personal liability therefor, said Max Adler accepting in full satisfaction of said indebtedness his right to receive the dividends from said stock and the right to cause the stock and securities remaining in the hands of the Trustee to be sold at the times and under the terms and conditions hereinabove set forth.
The contract recited that 1,000 of the shares covered thereby were at that time pledged to George Pick & Co., investment bankers, along with other collateral, to secure the payment of the amount of $239,910.22 owed by petitioner and $262,965.93 owed by Martin Burns, a business associate of petitioner, which petitioner had guaranteed. It provided that the 26 shares which were in petitioner's possession should be immediately endorsed with a legend reading: ‘This certificate is held subject to the terms and provisions of a certain agreement dated January 12, 1935, between Max Adler and Herbert A. Loeb, and any transferee hereof shall take the same subject to the terms and provisions of said agreement,‘ and should be endorsed in blank and delivered to Abraham Greenspan, as the trustee named in the Adler contract. The 1,000 shares pledged to Pick & Co. were to be similarly endorsed and delivered upon their release by Ick & Co.
It was further provided that 75 percent of all cash dividends declared and paid upon the stock should be paid to Adler and applied in reduction of the indebtedness, unless the amount of income tax payable by Herbert A. Loeb by reason of his receipt of those dividends and certain other income should be in excess of 25 percent of the aggregate amount of such income, in which case the percentage payable to Adler would be reduced to the extent that such tax exceeded 25 percent of the income. Provision was made for the release of stock in blocks of 25 shares by reason of the payment of dividends to Adler, with the proviso that the dividends paid on such released shares would continue to be subject to the contract, whereas dividends paid on shares released by payment from other sources were not to continue subject to the contract.
At the expiration of ten years, if the entire amount had not been paid, the trustee was given full power to sell the shares remaining in his possession, after notice, at public sale, the proceeds to be applied on the unpaid amount of the indebtedness, any surplus to be paid to petitioner; but in case of any deficit, there was expressly declared to be no personal obligation on petitioner for the payment thereof.
The H-H Corporation's assets consisted exclusively of 5,000 shares of common stock of Hillman's, a separate corporation.
In December 1936 Hillman's declared a dividend of $14 per share, payable $5 in cash and $9 in one-year notes. The H-H Corporation then declared a dividend of $13.50 per share, and paid $4.50 in cash and transferred to its stockholders the one-year notes received from Hillman's. Petitioner received as a dividend on his H-H Corporation stock $4,617 in cash and $9,234 in one-year notes of Hillman's. He also owned 102.6 shares of Hillman's stock and on that he received $513 cash dividend and $923.40 in one-year notes. About December 31 of 1936 petitioner transferred to Adler all of the notes received by him from H-H Corporation and from Hillman's, totaling $10,157.40.
On December 26, 1936, H-H Corporation changed its name to Hillman's, Inc., and liquidated certain subsidiaries, whose assets it acquired. On December 27, 1938, a dividend of $15 per share was paid on its stock. Petitioner received $15,390 as dividends on the stock owned by him and paid to Max Adler $10,523.50, in accordance with the contract.
On December 15, 1939, Hillman's, Inc., effected a recapitalization, as a result of which the 1,026 shares owned by petitioner were replaced by 10,260 shares.
On December 19, 1939, petitioner executed two trust agreements, one naming his son, Herbert A. Loeb, Jr., and Leon Ramis, a business associate of petitioner, as trustees for the benefit of Edward Loeb, another son, and the other naming Edward Loeb and Ramis as trustees for the benefit of Herbert, Jr. The trusts were substantially similar in terms. To each petitioner transferred 5,000 shares of stock in Hillman's, Inc., subject to the pledge thereof to Pick & Co. and subject also the Adler contract. Each trust was to last for 10 years, during which time the trustees had the power to vote the stock, to retain and accumulate the net income, or to spend all or any part of it to reduce the liens and encumbrances against the stock, or to pay any part or all of it to the beneficiary. After the payment of all liens and encumbrances against the trust estate, the trustees could then, in their discretion, transfer all or any part of the principal to the beneficiary. Upon the expiration of 10 years, if the beneficiary were alive, the trust should terminate and the remainder of the trust property should be transferred to the beneficiary. If the beneficiary were dead, provision was made for the continuance of the trust for the benefit of children of the beneficiary until each attained the age of 25 years, when he would be entitled to his share of the trust estate. Petitioner retained no powers whatever with respect to either the trust property or the conduct of the trustees, nor could the trust property ever revert to the petitioner under any provision of the trust instrument. The beneficiaries of the trusts were adult sons of petitioner, financially independent of him, married, and maintaining separate households.
At the time of the creation of the trusts the unpaid balance of the Adler lien was $478,400.92.
On December 28, 1939, Hillman's, Inc., paid a dividend of $2 per share. The dividends on the 10,000 shares which had been transferred of record to the trustees were paid to the trustees by the corporation, in the amount of $20,000. The trustees reported the receipt of that amount for taxation, and paid the tax thereon. They paid to Adler the amount of $15,000 in accordance with the terms of the contract.
On December 27, 1940, Hillman's Inc., paid a dividend of $4 per share. The trustees received and paid tax on $40,000 on the stock held in trust, and paid over to Adler the sum of $30,000.
Petitioner received the dividends paid on the 260 shares retained by him and paid to Adler from those amounts the sums of $374.40 in 1939 and $582.40 in 1940.
On December 31, 1939, the balance due on petitioner's indebtedness to Pick & Co. was $176,244.35, and collateral held by the company as security therefor, other than the Hillman's, Inc., stock, had a market value of $137,014.06.
On December 31, 1940, the balance due on the Pick indebtedness was $142,348.88 and was secured by collateral, other Hillman's, Inc., stock, of a then market value of $124,303.13.
Prior to the creation of the trusts in 1939, Pick & Co. had requested additional collateral for the Loeb account, stating that there was no market for Hillman's, Inc., stock and, since they did not wish to enter the grocery business, it was of no value to them as security. Instead of supplying additional collateral, petitioner entered into an agreement with Pick & Co. by the terms of which he agreed to pay $12,500 every six months on his account until it was reduced to the value of the marketable securities held as security for it. Pursuant to this agreement, and to oral assurances given his sons at the time the trusts were created that he would satisfy the Pick debt, petitioner did make substantial payments on that account, and satisfied it entirely by 1943. The Hillman's, Inc., stock which had been held by Pick was then delivered to Greenspan, as trustee under the Adler agreement, in accordance with its terms.
Martin Burns, whose debt to Pick & Co. was guaranteed by petitioner, died October 1, 1939, before the creation of the trusts. Shortly thereafter his indebtedness to Pick was liquidated.
Petitioner reported the gifts to the trusts in 1939 and paid gift tax thereon.
The dividends paid on the stock in Hillman's, Inc., which was transferred to the trusts in 1939 and 1940 are taxable as income to petitioner to the extent to which they were paid to Adler pursuant to petitioner's contract with Adler, and to the extent to which they constituted the net income of the trusts.
OPINION.
KERN, Judge:
Respondent has made alternative and inconsistent determinations, first, that the petitioner received income in 1939 and 1940 consisting of dividends paid on the stock involved here after it was transferred to the trusts created by him, or, second, that he realized capital gain by reason of the transfers of the stock to the trusts.
Considering first the contention that the dividends received by the trusts constituted taxable income to petitioner, respondent relies on sections 22(a), 166, and 167 of the Internal Revenue Code.
It is respondent's view that the dividend's are taxable to petitioner under the broad sweep of section 22(a) under the doctrine of constructive receipt and because the beneficiaries of the trusts were his sons, the trusts were of short duration, and he had previously pledged the stock first, with other and marketable collateral to secure the payment of a debt, and later to another creditor under an agreement by the terms of which his personal liability on the debt owed to this creditor was extinguished in consideration of the pledge of the stock and his agreement to pay to this creditor 75 percent of the dividends thereafter paid on the pledged shares. Respondent regards this contract as constituting in legal effect an assignment of 75 percent of the income from the stock, and the later transfer of the stock itself to the trusts as a mere assignment of the remaining 25 percent. The applicability of section 166 is urged because the stock was pledged for the Pick debt, which respondent views as equivalent to a power to revest, and respondent also urges the applicability of section 167(a)(2) because of the discretionary power of trustees having no adverse interest to use the income to discharge legal obligations of the petitioner.
Petitioner strenuously urges his theory that, since he was not personally liable on the Adler debt, payments made thereon pursuant to the 1935 contract did not discharge any legal liability of his; and, since the stock when released from the lien of the debt belonged not to petitioner, but to the trusts, whatever economic benefits resulted from the payments accrued to the trusts alone, and not to petitioner; and that, therefore, the income applied to that use can not under any theory be taxed to him.
We can not agree with the respondent's contention that the 1935 contract amounted to a present assignment of future income, but we do agree that the dividends paid pursuant thereto are taxable as constructively received by petitioner.
It is true, as petitioner claims, that he was not, after the execution of the 1935 contract, personally liable on his old debt, since that liability was specifically and effectively extinguished. But he secured his release from that liability by the expedient of assuming for his own benefit a new and different obligation— the obligation to pay over the stipulated percentage of the dividends to Adler. This obligation was to continue during the life of the contract, which expressly required that any transfer of the stock be made subject thereto. The transfers to the trusts involved here were in fact made specifically subject to the requirements of petitioner's contract with Adler. The payments made to Adler out of the dividends after the transfer were therefore made at his direction in satisfaction of petitioner's obligation, assumed for his own economic advantage. This is true not because the payments were credited to the old debt, but because they were made pursuant to and in satisfaction of a valid and existing contractual obligation of petitioner.
Under this view of the facts, there can be little doubt that petitioner is taxable on the part of the income so applied.
Petitioner argues that the trusts are properly taxable because they own the stock which produces the income and because they are the practical beneficiaries of the arrangement.
It is true, of course, that title to the stock is in the trusts and also that ordinarily the income would belong to and be taxable to them. But the transfers here were made subject to the preexisting right of Adler arising out of his contract with petitioner to receive part of the dividends. The trusts, therefore, never at any time had any right to that income for their own unqualified use. The moment it came into their hands it was impressed with the requirements of the Adler contract. As to such amounts, the trusts were mere conduits through which they passed. See J. Gregory Driscoll, 3 T.C. 494.
It is also true that the trusts would ultimately benefit to some indeterminate degree from the carrying out of the Adler contract. But that result accrues not by reason of the terms of the contract, but by reason of the wholly unrelated transactions of the gifts. It is an incidental and secondary effect of the payments made by reason of the contract. The primary advantage of the Adler contract, to secure which the obligations of the contract were undertaken, benefited Loeb himself, as we have seen. Since they were obligations of Loeb himself, undertaken primarily for his own economic advantage, the payments made pursuant thereto at his direction constitute income to him, notwithstanding the fact that the trusts derive some resultant benefits because of later gifts to them.
There remains for our consideration that part of the income from the stock which was not required to be paid under the Adler contract. The trust instrument provides, as we have seen, that:
* * * said Trustees may retain and accumulate the net income or may spend all or any part thereof for the reduction of liens or encumbrances against the trust estate * * * .
Section 167(a)(2) of the Internal Revenue Code provides that:
Where any part of the income of a trust * * * may, in the discretion of the grantor or of any person not having a substantial adverse interest in the disposition of such part of the income, be distributed to the grantor; * * * then such part of the income of the trust shall be included in computing the net income of the grantor.
It seems clear that that share of the dividends, roughly 25 percent, which was not required by the Adler contract to be paid on the Adler lien, might, in the discretion of the trustees, after payment of the trust expenses, be paid in reduction of either the Adler or the Pick lien. There is no dispute that petitioner remained personally liable on the Pick debt throughout the tax years and no contention that the trustees had any adverse interest in the distribution of the trust income. Any payment which they might thus have made on the Pick debt would have discharged petitioner's obligation to that extent. The Adler contract constitutes no impediment to that use of that portion of the dividends.
There seems to be no escape from the conclusion that petitioner is taxable, therefore, on the entire amount of the dividends, less the expenses of the trusts.
In view of this conclusion it is unnecessary to enter to an extended discussion of the applicability of section 166, or to consider further the alternative contention advanced by respondent.
Decision will be entered under Rule 50.