Opinion
Docket Nos. 5150 5151.
1947-01-31
JANE COOPER HEMPHILL, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.RALPH HEMPHILL, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
A. W. Hutchinson, C.P.A., for the petitioners. R. E. Maiden, Jr., Esq., for the respondent.
In 1938 petitioner and his wife created irrevocable trusts, of which he was trustee and of which each corpus consisted of 5,000 shares of stock of Aero Industries Technical Institute, Inc. (later merged into Aero-Crafts Corporation). The two minor children of petitioner were beneficiaries, one of each trust. Thereupon, petitioner held a minority of the stock of Industries. Petitioner became president and a director of Aero-Crafts on December 9, 1940. Under an agreement dated November 14, 1941, petitioner was required to resign as such president and director. Later, with the support of minority stockholders, he was reelected president and director. The trust instrument provided that all net income and earnings should be accumulated and added to corpus during the lives of the grantors, or the survivor thereof, and prior to the attainment of the beneficiary's majority. It recited that the trust estate was for the exclusive use and benefit of the beneficiary and that if the beneficiary should require financial aid because of accident, sickness, or other unforeseen emergency, the trustee might use the income or corpus to meet such needs. It further provided that upon the beneficiary's becoming 21 years of age all the net income and earnings should be paid to him until he became 25 years of age, when one-fourth of the trust estate should be distributed. Thereafter, at intervals, fractional parts of the estate were so distributable until he should become 40 years of age, when he would receive the remainder of the corpus and the trust would terminate. The beneficiary was given the absolute power of appointment, from the date on which he should become 18 years of age until the termination of the trust. Should he die before exercising such power, distribution would be made to his sister (or brother, in the case of the trust in which the daughter was beneficiary) or her issue. If she should die without issue, distribution would be made under the laws of succession of California. The trustee was granted the usual broad powers od administration. He kept a strict account of his transactions as trustee. Neither income nor corpus of the estates has ever been used by the trustee for the education, support, and maintenance of the beneficiaries. All income from both trusts has been added to the corpora. Held, that the trust income is not taxable to the petitioners under section 167 or section 22(a) of the Internal Revenue Code. A. W. Hutchinson, C.P.A., for the petitioners. R. E. Maiden, Jr., Esq., for the respondent.
The respondent determined deficiencies in the income tax of each of the petitioners, Ralph Hemphill and Jane Cooper Hemphill, as follows:
+-------------+ ¦1939¦$298.59 ¦ +----+--------¦ ¦1940¦909.61 ¦ +----+--------¦ ¦1941¦222.93 ¦ +-------------+
The sole issue is the taxability of the income from certain trusts created by the petitioners for the benefit of their minor children, Calvin Ralph Hemphill and Audrey Jane Hemphill, respectively.
FINDINGS OF FACT.
The facts were stipulated. Such portions thereof as are material to the issue are as follows:
Ralph Hemphill and Jane C. Hemphill are, and have been at all times herein material, husband and wife, residing either in Los Angeles or Glendale, California. Ralph Hemphill will be referred to hereinafter as the petitioner. Their income tax returns were filed with the collector of internal revenue for the sixth district of California for the years 1939, 1940, and 1941 on the community property basis and disclosed net incomes of $22,774.90, $13,859.31 and $8,919.86, respectively, for each petitioner.
Under date of December 29, 1938, the petitioner and his wife executed two trust indentures naming Ralph Hemphill as trustee, one in favor of their son, Calvin Ralph Hemphill, who was born March 4, 1925, and the other in favor of their daughter, Audrey Jane Hemphill, who was born November 7, 1931. The trusts were identical in form and were declared to be for the exclusive use and benefit of their children. The corpus of each trust was 5,000 shares of Aero Industries Technical Institute, Inc. (now Aero-Crafts Corporation), hereinafter called Industries, a Delaware corporation having its office and principal place of business at 5245 San Fernando Road, Los Angeles, California. All net income was to be added to corpus during the majority by the beneficiaries. In case of accident, sickness, or other unforeseen emergency, the trustee might devote income or corpus to the needs of the beneficiaries. Upon the beneficiary's becoming 21 years of age, all income was distributable to him until he should become 25 years old, when he was to receive one-fourth of the trust estate. Similar conditions controlled the payment of current income and the distribution of the estate at 30, 35, and 40 years of age. At the last named age the entire remainder of the trust estate was to be distributed.
At the age of 18 years the beneficiary was given the absolute power of appointment of the undistributed estate. Should the beneficiary die before receiving final distribution of the corpus and not having exercised the power of appointment, distribution was to be made to his surviving issue, if any, by right of representation, and if no issue survived, to the sister or brother, or issue. If no such issue survived, the trust estate was to be distributed to the heirs at law of the beneficiary according to the laws of succession of the State of California.
The trustee was empowered to hold any property received in the trust as long as he might deem it advisable; to manage, control, sell, exchange, improve, repair, etc., the corpus; to borrow money as he deemed advisable and to mortgage and encumber the corpus; to invest the principal and income in approved securities, except those owned or for sale by him; and to advance his own funds to the trust, to be repaid first out of income or principal. He was also granted all powers and discretions of an absolute owner and was charged with the payment of taxes, fees, and expenses incurred in the administration of the estate.
At the time of the creation of these trusts the petitioner and his wife owned, on a community property basis, 53,500 shares of the capital stock of Industries out of a total of 100,000 shares of the corporation's capital stock outstanding at that date, representing a 53 1/2 per cent ownership therein. Such shares were registered and held in the name of Ralph Hemphill.
Industries was incorporated under the laws of the State of Delaware on January 4, 1937. It was engaged exclusively in the business of a technical trade school for the training of aircraft mechanics and engineers. The petitioner, who had for many years prior to the organization of the corporation been engaged in the operation of technical trade schools such as that carried on by the corporation, was active in the organization of the corporation. During its entire existence, to wit, from January 4, 1937, to July 1, 1941, he was never president or an executive officer, but was a member and the chairman of its board of directors.
At the time of the execution of the trust indentures the petitioner and his wife transferred to each trust 5,000 shares of the capital stock of Industries. This stock represented the sole corpus of each trust and no additions were made to the corpus of either of the trusts during the taxable years 1939, 1940 and 1941, or at any time since then, by either of the grantors.
Aero-Crafts Corporation, hereinafter called Aero-Crafts, was incorporated on December 9, 1940, under the laws of the State of California. It acquired all of the assets and assumed the liabilities of Industries by a merger on July 1, 1941. There was no change in the business operations, Aero-Crafts continuing the school for the training of aircraft mechanics and engineers formerly conducted by Industries. The corporate change was primarily made for the purpose of changing the organization from a Delaware to a California corporation. At the time of the merger the stockholders received five shares of stock in Aero-crafts for each share of stock in Industries. Ralph Hemphill became president and a member and chairman of the board of directors of the new corporation. He held these official positions continuously until November 14, 1941, at which time he resigned all his offices. On June 1, 1942, he was elected president and a member of the board of directors, and, except during the period from November 14, 1941, to June 1, 1942, during which the petitioner held no official position with Aero-Crafts, he has been the active and chief executive officer of the corporation.
During the taxable years 1939, 1940, and 1941, in addition to Ralph Hemphill and the two trusts, there were approximately 300 stockholders of the capital stock of Industries, the average holding of the remaining stockholders being less than 1,000 shares. The capital stock of the corporation issued and outstanding during the taxable years 1939 and 1940 and part of 1941 was 100,000 shares, par value $1 per share. In 1941 an additional 20,000 shares were issued.
At all times material hereto, Aero-Crafts had 600,000 shares of stock outstanding, of which at the time of the merger 180,000 shares were issued to Ralph Hemphill and 25,000 shares were issued to each of the trusts. In addition to Ralph Hemphill and the two trusts, there were approximately 300 stockholders of the capital stock of Aero-Crafts, the average holding of the 300 stockholders being less than 1,000 shares.
On December 29, 1938, the petitioner and his wife held as community property 43,500 shares of Industries. On March 20, 1939, they held 49,800 such shares. Thereafter they held various amounts ranging from 39,800 on April 24, 1939 to 29,800. On July 1, 1941, they held 36,000 such shares, which they exchanged for 180,000 shares of Aero- Crafts out of 600,000 shares of that corporation outstanding. They retained practically that number of shares through the remainder of the year 1941.
The trust assets and net income for the taxable years were as follows:
+-----------------------------------------------------------------------------+ ¦ ¦Assets at December 31- ¦Net income ¦ +--------------------+----------------------------+---------------------------¦ ¦ ¦1939 ¦1940 ¦1941 ¦1939 ¦1940 ¦1941 ¦ +--------------------+---------+----------+-------+---------+---------+-------¦ ¦Calvin Ralph ¦$6,505.25¦$10,973.14¦$11,716¦$1,505.25¦$4,532.81¦$965.24¦ ¦Hemphill ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------------+---------+----------+-------+---------+---------+-------¦ ¦Audrey Jane Hemphill¦6,505.25 ¦10,973.14 ¦11,716 ¦1,505.25 ¦4,534.10 ¦987.05 ¦ +-----------------------------------------------------------------------------+
All stocks owned by the trusts were at all times held and registered in express trust capacity. Separate bank accounts were kept for the income of the trusts during the taxable years by an account #2500 in the Bank of America National Trust & Savings Association, Glendale, California, in the name of ‘Calvin Ralph Hemphill Trust,‘ and account #3037 in the same bank in the name of ‘Audrey Jane Hemphill Trust.‘ During 1940 and 1941 some of the income of the trusts was deposited in the personal account of the petitioner. He was indebted to the Calvin Ralph Hemphill trust in the amount of $797.65 at December 31, 1940, and in the amount of $1,170.81 at December 31, 1941. He was likewise indebted to the Audrey Jane Hemphill trust in the amount of $902.24 at December 31, 1940, and in the amount of $1,645.10 at December 31, 1941. Books were not kept for the trusts, but the petitioner maintained complete double entry personal books and on these books any income belonging to the two trusts which was deposited in his personal bank account was credit to an ‘Accounts Payable‘ with the trusts and was not credited to his income account. All funds owed to the trusts by the petitioner prior to 1943 were transferred to the trusts' bank accounts in 1943 and the status of the two trusts at December 31, 1943, was as follows:
+-------------------------------------------------------------+ ¦AUDREY JANE HEMPHILL TRUST ¦ +-------------------------------------------------------------¦ ¦ ¦ ¦ +---------------------------------------------------+---------¦ ¦Cash in Bank of America-Savings Account #3037 ¦$2,328.35¦ +---------------------------------------------------+---------¦ ¦Cash in Bank of America-Savings Account #556 ¦5.39 ¦ +---------------------------------------------------+---------¦ ¦Cash in Glendale Federal Savings & Loan Association¦1,118.25 ¦ +---------------------------------------------------+---------¦ ¦Stock-25,000 shares Aero-Crafts Corporation ¦5,000.00 ¦ +---------------------------------------------------+---------¦ ¦Stock-10 shares Bankers & Shippers Insurance Co ¦1,042.50 ¦ +---------------------------------------------------+---------¦ ¦Stock-15 shares Security Insurance Co ¦478.13 ¦ +---------------------------------------------------+---------¦ ¦Half interest in Balboa property ¦3,522.56 ¦ +---------------------------------------------------+---------¦ ¦ ¦13,495.18¦ +---------------------------------------------------+---------¦ ¦Less advance by Ralph Hemphill for trust expenses ¦125.60 ¦ +---------------------------------------------------+---------¦ ¦Net assets of trust ¦13,369.58¦ +---------------------------------------------------+---------¦ ¦ ¦ ¦ +-------------------------------------------------------------+
CALVIN RALPH HEMPHILL TRUST Cash in Bank of America Savings Account #2500 $2,318.66 Cash in Glendale Federal Savings & Loan Association 1,118.25 Stock-25,000 shares of Aero-Crafts Corporation 5,000.00 Stock-10 shares Bankers & Shippers Insurance Co 1,042.50 Stock-15 shares Security Insurance Co 478.13 Half interest in Balboa property 3,522.56 13,480.10 Less advance by Ralph Hemphill for trust expenses 105.61 Net assets of trust 13,374.49
On March 5, 1940, at a total cost of $7,045.12, one-half of the cost being charged to each trust, the petitioner purchased a beach house and lot located at Balboa, California. The title to the beach house was taken and is held even now in the name of Ralph Hemphill, with no disclosure that it is trust property. This beach house was occupied by Ralph Hemphill and family, including the beneficiaries of the instant trusts, from May 1 to September 30, 1940, and from May 1 to September 30, 1941. The property was first rented to strangers on April 6, 1942, and remained rented to strangers until February 14, 1944.
The fiduciary income tax returns for the taxable years 1939, 1940, and 1941 did not reflect any rental income received by the trusts from the beach house. Rental for the time the property was occupied by Ralph Hemphill and his family was not paid to the trusts until some time in 1943, following advice of counsel.
On March 20, 1940, and on April 8, 1941, at a cost of $104.59 and $369.70, respectively, Ralph Hemphill purchased with funds belonging to the Calvin Ralph Hemphill trust two boats for the use of Calvin Ralph Hemphill.
In connection with the said beach house and boats, counsel for Ralph Hemphill wrote a letter dated March 18, 1943, to Harry A. Linendoll, Internal Revenue Agent, in which the following appeared:
Mr. Hemphill has already advised us that he has reimbursed the trusts for the money expended for the purchase of the boats, and has also paid to the trusts a reasonable rental for the use of the beach house for the months of May, June, July, August and September, 1940 and for the same months of 1941, which was the time the property was occupied by the family for personal use. This reimbursement will increase the taxable income of the trusts for the calendar year 1940, by the amount of $300.00, less depreciation for the property and will make a similar change in the trust returns for the calendar year 1941.
At all times when occasions arose, the petitioner voted the stocks of the trusts consistent with the vote of his own stock in Industries and Aero-Crafts.
Unless that part of the stipulation referring to the beach house and the boats is construed otherwise by the Court, none of the income or corpus of these trusts has ever been used by the trustee for the education, support, and maintenance of the beneficiaries of the trusts, and all the income derived from the property of the trusts has been accumulated and reinvested and no distributions of either income or corpus have ever been made from the trusts' property either to the beneficiaries of the trusts or to any other person.
Under date of November 14, 1941, the petitioner executed an agreement between himself and Aero-Crafts. Under this agreement the petitioner agreed to purchase from Aero-Crafts that portion of its business known as the ‘Plastics Division‘ for a total consideration of $102,108.95, on terms as set forth in the agreement, and as security to endorse in blank certificates evidencing 112,500 shares of stock of Aero-Crafts and deliver them to Bank of America National Trust & Savings Association, Gateway Branch, Glendale, California, as pledgeholder. He further agreed to and did execute a general proxy with respect to these 112,500 shares, to Robert E. Gross, James L. McKinley, John K. Northrop, Bruce V. Reagan and C. A. Van Dusen, as voting trustees, to vote such shares, and concurrently therewith, was required to resign as president and a director of Aero-Crafts.
Prior to the next annual meeting of the shareholders of Aero-Crafts, which was held on June 1, 1942, the petitioner marshaled his supporters and was able to secure enough votes to have himself again elected to the board of directors and president of Aero-Crafts. This was accomplished with the assistance and cooperation of Bruce V. Reagan, of Reagan & Co. investment bankers, Pasadena, California, a firm which had been largely instrumental in the sale of shares in Aero-Crafts to the general public. The firm was consequently in touch with many of the larger minority stockholders and was able to secure proxies to a substantial number of shares. The petitioner's election to the board of directors at the stockholders' meeting on June 1, 1942, and his election by the board of directors as president were accomplished only with the cooperation of minority stockholders, and in spite of the fact that the 112,500 shares held by the Bank of America National Trust & Savings Association were voted against him by the trustees.
Ralph Hemphill did not regain control of the stock held by the Bank of American National Trust & Savings Association until November 2, 1942, when his indebtedness to Aero-Crafts, under the agreement dated November 14, 1941, was completely liquidated. During the period from November 14, 1941, to November 2, 1942, his continuance in office was dependent upon the cooperation of the minority stockholders.
OPINION.
VAN FOSSAN, Judge:
With respect to the issue under section 167, Internal Revenue Code, the basic facts here presented are quite similar to those found in Arthur L. Blakeslee, 7 T.C. 1171. In that case we first discussed the applicability of section 167 and cited David Small, 3 T.C. 1142, reaffirmed in Estate of O. M. Banfield, 4 T.C. 29, as authority for holding that income not actually used for the support of the beneficiary was not taxable to the grantor. We do not construe the terms of the trust before us as permitting the petitioner, the trustee, to devote the trust income and corpora to the discharge of his parental obligation to support and maintain his infant children, as argued by the respondent. On the contrary, the provision specifically states that only in the event of ‘accident, sickness or unforeseen emergency,‘ can the trust income or corpus be so expended.
The power given to the trustee thus to use the funds of the trust is to be exercised only if the parent is unable to fulfill parental obligation to his children. It does not supersede that duty or relieve the parent of his obligation. During the taxable period before us no such accident occurred and no emergency arose. Consequently, no expenditures were made under the quoted provision. Therefore, section 167 is not applicable to the cases at bar.
We now turn to the taxability of the income under the provision of section 22(a). At the outset, the respondent's counsel contends that the taxability of the trust income to the grantors must ‘depend on an analysis of the terms of the trust and of circumstances attendant upon its creation and operation. ‘ (Clifford v. Helvering, 309 U.S. 331.) We agree that this principle is fundamental in determining the applicability of section 22(a) under the Clifford rule. Arthur L. Blakeslee, supra. We have only to apply it to the facts of each case.
There is here no factual controversy, since the facts have been stipulated. Therefore, the decision rests on the reasonable inferences that may be drawn from those facts. We consider first the facts relating to the creation of the trust and then those surrounding its operation.
The trusts were created for the exclusive use and benefit of the beneficiaries. That purpose is so stated in the trust instrument. The petitioner was engaged in the somewhat hazardous occupation of training aircraft mechanics and engineers.
The petitioner owned 53,500 of the 100,000 outstanding shares of Industries, of the par value of $1 per share. On December 29, 1938, the petitioner and his wife created the two trusts for their children's benefit and transferred to each trust 5,000 shares of Industries as its corpus. The corpora of both trusts constituted less than one-fifth of the stock owned by the petitioner. After April 24, 1939, the petitioner's own stock, plus that owned by the trusts, constituted a minority of the stock of both Industries and Aero-Crafts.
In view of the relatively small value of the trust estates, the uncertainty of receiving dividends from the stock, the lack of stock control of the corporations, the comparatively small fraction of the petitioner's stock transferred to the trusts, and other circumstances of record, we have no ground for concluding that the trusts were created to provide a means of continuing the control of the corporation, originally held by the petitioner, for his own personal and pecuniary gain. The economic ownership of the trust stock was not retained by him.
The terms of the trust make clear the facts that the trust income was definitely and irrevocably set aside for the children's use and enjoyment and that the petitioner and his wife could receive no immediate or ultimate benefit therefrom. As trustee, the petitioner was given broad powers of management, but, as has been held often, such powers in themselves do not impute to him economic ownership of the corpus or of the income therefrom. Frederick Ayer, 45 B.T.A. 146; Alma M. Myer, 6 T.C. 77; Ward Wheelock, 7 T.C. 98. Thus, in the trust itself and from the events concurrent with its creation, we find no reason to invoke the Clifford rule. United States v. Morss, 159 Fed.(2d) 142.
There remains for consideration only the respondent's contention that the operation of the trusts brings the situation within the Clifford rule. He asserts that ‘the trust property was actually used for the economic benefit of the grantor.‘ He builds his argument largely on (1) the alleged use of the trusts' stock to further his own interests and to secure salary increases and, (2) the petitioner's alleged transgressions of the strict terms of the trust in the purchase of the beach house at Balboa and of the two boats.
The stipulated facts do not support the respondent's contentions. The petitioner received his salary, dividends, and other compensation directly from Industries and its successor, Aero-Crafts. The amount and condition of such payments to him had no relation whatever to the trusts' ownership of stock in the corporation and could not have been affected by that circumstance. The majority of the stock was held by others, who recognized pecuniarily the value of the petitioner's services to the company. His reelection to office in June 1942 (a date subsequent to the taxable years) was accomplished by the aid of minority stockholders, organized by Reagan & Co., without whose assistance he could not have been reelected. Any economic benefit gained by him on that occasion came solely from that source and was not due to his holding or voting the trust stock.
The respondent charges that the petitioner's purchase and use of the beach house and the boats evidence a personal benefit and gain to him. The record shows that the beach property was purchased as an investment of the trusts and was so treated on the books of the trustee. A one-half interest therein was listed as an asset of each trust. No rent was paid currently for the occupancy of the house by the petitioner's family during 1940 and 1941, but this error was rectified sometime prior to March 18, 1943, upon advice of the petitioner's counsel. We attach no significance to the petitioner's holding title in his own name. Apparently it was so placed to avoid complications in case of sale, since the children were infants. The petitioner declared it to be trust property on his books and so holds it.
The petitioner also repaid to the Calvin Ralph Hemphill trust the cost of the boats. Whether or not this repayment was necessary we do not say, but obviously it was made from abundance of caution. We do not hold that these minor irregularities, if such they were, on the part of the petitioner as trustee, transform an income otherwise taxable to the trusts into income taxable to him individually. The intent and purpose of the creation of the trusts were solely for the benefit of the children and we see in the petitioner's treatment of the trust property, in his capacity as its trustee, nothing to contravene that fundamental fact. See Cushman v. Commissioner, 153 Fed.(2d) 510.
Reviewed by the Court.
Decisions will be entered under Rule 50.