Harold Rothstein and David M. Rothstein as Executors of the Estate of Alexander Rothstein, Deceased, and Reba Rothstein v. United States

735 F.2d 704, 54 A.F.T.R.2d (RIA) 5072, 1984 U.S. App. LEXIS 22295

• Court: Court of Appeals for the Second Circuit
• Decided: May 21, 1984
• Docket: 519, Docket 83-6198
• Status: Published

Opinions

FRIENDLY, Circuit Judge:

Harold and David M. Rothstein, as executors of the estate of Alexander Rothstein, and Reba Rothstein, his widow,' appeal from a judgment of the District Court for Connecticut, which dismissed their action for a tax refund after trial before Judge Eginton and an advisory jury, 574 F.Supp. 19. Appellants urge two grounds for reversal. One involves the interpretation of §§ 453, 671 and 675 of the Internal Revenue Code (“IRC”); the other relates to the judge’s having sua sponte stricken from the jury panel eleven veniremen solely because they had some experience with rental property or connection with closely held corporations. In the view we take of the case only the first requires statement and discussion.

The district court found the facts to be as follows: In 1951 decedent Alexander Rothstein (“taxpayer”) and Abraham Savin formed a real estate holding company known as Industrial Developers, Inc. (“IDI”). They purchased, at a cost of $30,-000 each, a parcel of land in East Hartford, Connecticut, which they conveyed to the corporation, each receiving 300 shares of IDI stock. The corporation constructed, at a cost not disclosed in the record, warehouses which were used as rental property.

On February 18, 1957, taxpayer contributed his 300 shares of IDI to an irrevocable trust he established for the benefit of his three children, Harold, David and Edna. Taxpayer’s wife Reba was the trustee. Although the trust was required to distribute any dividends received on the IDI stock, which was its sole asset, to the beneficiaries at least semi-annually, no dividends were ever paid.

In October 1964, taxpayer bought Savin’s 300 shares of IDI for $500,000, agreeing to pay the purchase price at a later date. On November 13, 1964, he purchased from his wife as trustee the trust’s 300 shares for $320,000. Payment was made by an unsecured promissory note bearing an interest rate of 5% per annum, payable semi-annually beginning May 13, 1965. These payments were duly made. Principal payments were scheduled to be made as follows: $25,000 on or before November 13, 1969; $25,000 on or before November 13, 1970; $50,000 on or before November 13, 1971; and $50,000 on or before November 13 of each calendar year thereafter until the full sum of $320,000 had been paid.

In January 1965, taxpayer, having become owner of all of IDI’s stock as a result of the transactions with Savin and. the trust, dissolved IDI and had all its assets transferred to himself. He then refinanced the property, replacing an existing mortgage of less than $200,000 with a new $700,000 mortgage to Equitable Life Insurance Company and using the approximately $500,000 excess of the new mortgage over the old to discharge his debt to Savin. On February 8, 1965, he gave a second mortgage of $320,000 to his wife as trustee to secure the promissory note of that amount given in exchange for the trust’s IDI shares three months before.

In their joint federal income tax return for 1965 taxpayer and his wife claimed deductions for (1) $16,000 in interest paid to the trust on the promissory note, and (2) a short-term capital loss of $33,171 on the liquidation of IDI, determined as follows:

fair market value of property received upon liquidation $1,054,580

Less:

IDI liabilities assumed $267,751

Cost of stock acquired from Savin 500,000

Cost of stock acquired from trust 320,000

Gain (loss) realized $1,087,751 ($33,171)

The Commissioner, however, asserted a deficiency of $56,664 based on his disallowance of the interest deduction and his determination that taxpayer had in fact realized a substantial gain on the liquidation of IDI. As now presented by the Government, the Commissioner's theory was that, under IRC § 675(3)

1 the taxpayer was to be treated as the “owner” of the trust assets and that this crucially affected the tax consequences of the events described above. On this view, transactions involving trust assets were to be re-analyzed after substituting the taxpayer (as the “owner” of those assets) for the trust. Thus, the Commissioner disallowed the $16,000 interest deduction, since the taxpayer was not entitled to a deduction for amounts paid to himself as “owner” of the promissory note held by the trust. Similarly, in computing taxpayer’s gain on the' liquidation of IDI, the Commissioner reduced taxpayer’s basis in the shares acquired from the trust from $320,000 to $30,000. His rationale, apparently, was that the taxpayer could not claim a full “cost” basis in stock acquired in a sale that involved nothing more than a transfer of the property from the taxpayer (as “owner” of the stock) to himself.

2

In July 1967, taxpayer paid the asserted deficiency, together with interest of $2,470. In February 1969 Mr. and Mrs. Rothstein filed a claim for a refund in the amount of $57,942.12. After this was denied, the Rothsteins filed a protest, which the IRS held for’ more than five years, during which time Alexander Rothstein died. The protest was finally disallowed and Rothstein’s executors and widow brought this refund suit against the United States under 28 U.S.C. § 1346(a)(1).

Although both sides were entitled to a jury trial, 28 U.S.C. § 2402, the case was tried by the judge with an advisory jury. After denying motions by both sides for a directed verdict, the judge put four interrogatories to the jury. The questions and answers were as follows:

1. Was the sale by the Trustee, Reba Rothstein, to the grantor, Alexander Rothstein of 300 shares of IDI stock for $320,000 for adequate consideration?

Yes.

2. Was the trustee, Reba Rothstein, subservient to the grantor, Alexander Rothstein, when she accepted a note from Alexander Rothstein in the amount of $320,000 in exchange for the 300 shares of IDI stock from the trust?

3. Was adequate security provided by Alexander Rothstein for the $320,000 note given by him in November, 1964 to Reba Rothstein as trustee?

No.

4. Did the note for $320,000 from Alexander Rothstein to Reba Rothstein, as trustee for the children, provide for an adequate rate of interest?

The judge then made findings of fact and conclusions of law pursuant to F.R.Civ.P. 52(a). He ruled that the 1964 sale of the IDI stock involved a borrowing of trust funds under the first sentence of IRC § 675(3) and, in accordance with the advisory jury’s answers with respect to lack of adequate security and subservience, that it did not fall within the exception created by the second sentence. Without further discussion, the judge entered judgment for the Government, presumably because he agreed with the Commissioner that, if § 675(3) applied, this would entail disallowance of taxpayer’s interest deduction and reduction of his basis in the shares of IDI acquired from the trust.

DISCUSSION

Taxpayer’s principal argument on the merits is that his purchase, on credit, of the 300 shares of IDI did not involve a “borrowing” from the trust and therefore did not come within IRC § 675(3), which applies only when the grantor “has directly or indirectly borrowed the corpus or income and has not completely repaid the loan, including any interest, before the beginning of the taxable year”. The image most immediately conveyed by the statutory language is that of a grantor who has obtained an asset from the trust, whether money or otherwise, in exchange for a promise to return the same asset at some future time. Taxpayer is correct in noting that a transaction like that here in question — a sale of a trust asset on credit — involves no borrowing of the asset sold. However, the Commissioner’s argument is that what was “directly or indirectly borrowed” was not the IDI stock but money in the amount of the purchase price. On the Commissioner’s view, the trust’s extension of credit was a “loan” within the- meaning of § 675(3), notwithstanding that the loan “proceeds” were immediately used to pay for the shares.

Whether an extension of credit in a sale should be deemed a “loan” for purposes of § 675(3) is not easily answered on the basis of the language of the statute alone. On the one hand, Black’s Law Dictionary 844 (5th ed. 1979) defines “loan” quite narrowly as the “[djelivery by one party to and receipt by another party of [a] sum of money upon agreement, express or implied, to repay it with or without interest”. This definition suggests that an extension of credit is not a loan unless there is actual delivery of loan proceeds to the obligor. A similar distinction appears to underlie the numerous decisions holding that, for purposes of a usury statute, a sale on credit is not a loan. See, e.g., Bartholomew v. Northampton Nat’l Bank, 584 F.2d 1288,1295 (3 Cir.1978) (Pennsylvania law). On the other hand, it is common enough to conceive of a credit sale as involving a loan, as witness the many statutes referred to as “truth-in-lending” laws, see, e.g., Consumer Credit Protection Act, 15 U.S.C. § 1601 et seq. (“Truth in Lending Act”), although one hardly says that the purchaser has borrowed the property purchased.³

More important in deciding whether § 675(3) should apply in the instant ease is the object which the statute was intended to serve. As is well known, the purpose of IRC §§ 671-79 and the regulations that preceded them was to bring order out of the chaos that has been created by the decision in Helvering v. Clifford, 309 U.S. 331, 60 S.Ct. 554, 84 L.Ed. 788 (1940), that a grantor’s continued domination of a trust might render trust income taxable to him. This led to over a hundred decisions in the courts of appeals, some holding Clifford to be applicable and others holding the contrary, with little difference in the facts, see 1 Surrey & Warren, Federal Income Taxation 1340 (1972 ed.). The purpose of the regulations, originally issuéd in 1945, amended in 1947, and codified in 1954, was “to establish a definite line separating ‘Clifford trusts’ where income is taxable to the grantor from trusts falling under the general trust sections [where income is taxable to the trust or its distributees].” Id. at 1341. The statute directs that the grantor shall be treated as “owner” of a portion of a trust not only when a reversionary interest “will or may reasonably be expected to take effect in possession or enjoyment within 10 years commencing with the date of the transfer of that portion of the trust," § 673(a), but in many other instances where, although the trust was expected to have a longer duration, the grantor’s powers or acts were thought by the Commissioner and later by Congress to indicate that he remained in effective control.

Section 675, entitled “Administrative powers”, is a subset of the many provisions dealing with the retention of substantial interests in and powers over a trust. Broadly speaking, it requires that the grantor be treated as “owner” of a trust when he could engage or has engaged in certain transactions with the trust without providing adequate consideration. In particular, § 675(3) addresses those situations in which the grantor has exercised “dominion and control” over a trust by borrowing from it at less than an adequate rate of interest or without giving adequate security for his promise to repay the loan. Indeed, § 675(3)’s determination to prevent a grantor’s treating a trust as his private bank without paying the tax consequences is so strong that the grantor is to be treated as “owner” even if the rate of interest and the security are adequate, unless the loan is made by a trustee other than the grantor or “a related or subordinate trustee subservient to the grantor”.

There can be no doubt that the extension of credit in the present case, made without adequate security by a subservient trustee, would fall within the scope of the statute should we deem it a “borrowing” or “loan” under § 675(3). We think it is consistent with the overall purpose of Congress to do so. First, in view of the fact that the statute is to apply to any grantor who has “borrowed” from the trust, whether “directly or indirectly’’ (emphasis supplied), we cannot attach much weight to the distinction, mentioned above, between (1) an extension of credit in which the proceeds are actually delivered to and received by the obligor, and (2) one in which they are immediately applied to the purchase of an asset from the obligee. Second, we must consider the consequences of a decision that an extension of credit like this is not within the scope § 675(3). A grantor wishing to obtain a loan from a trust while steering clear of the statute could always do so by arranging for the trust tp purchase, for example, marketable securities with a value equal to the amount of the contemplated loan, which the grantor would then purchase from the trust in exchange for his note. The grantor could then sell the securities on the market, leaving him with cash and the trust with his note — just as if it had made him a conventional loan. The only difference would be that § 675(3) would not apply, since the extension of credit in the sale did not involve actual delivery of loan proceeds to the grantor. Accepting taxpayer’s argument would in effect largely annul § 675(3). We therefore adopt the district court’s conclusion that the extension of credit here was, at least “indirectly”, a “borrowing” within the meaning of the statute.3a

While we thus agree with the Government that the taxpayer’s purchase of the IDI stock in exchange for his installment note involved a “loan” under § 675(3), we disagree with its contention that this requires a complete recharacterization for tax purposes of transactions involving the taxpayer and the trust. If § 675(3) stood alone, we might agree that taxpayer’s “ownership” of trust assets should prevent his claiming a deduction for interest paid on the note or a full cost basis in the shares acquired from the trust. However, § 675 is only one of a battery of provisions, see §§ 673-74, 676-79, requiring that the grantor or another person be treated as the “owner” of trust assets. All of these provisions are subject to § 671, in which Congress expressly stated the consequences of such “ownership”:

Where it is specified in this subpart [§§ 671-79] that the grantor ... shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor ... those items of income, deductions, and credits against tax which are attributable to that portion of the trust to the extent such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual. Any remaining portion of the trust shall be subject to subparts A through D [§§ 641-68].

Section 671 makes it plain that it was not Congress’s intention that the taxation of grantor/“owners” be governed by what might otherwise seem the sensible general principle that a taxpayer may not have meaningful dealings with himself.⁴ Rather, the statute envisions (1) that the income and deductions of the grantor and the trust will be computed in the normal fashion, the trust being treated as a fully independent tax-paying entity, and (2) that the relevant “items of income, deductions, and credits against tax” that would ordinarily appear on the trust’s return will instead “be included in computing the taxable income and credits of the grantor”. Nowhere does § 671 direct that the grantor’s basis in property purchased from the trust be deemed any different from what it would otherwise be, namely, his cost in acquiring it — in this case $320,000, the amount of taxpayer’s note. Nor does the statute contain1 anything authorizing the Commissioner to disallow an interest deduction on the ground that grantor’s payments were made to the trust. Consistently with' the objective of Clifford to prevent high-bracket taxpayers from shifting income to low-bracket trusts over which they retain or exercise excessive controls, § 671 dictates that, when the grantor is regarded as “owner”, the trust’s income shall be attributed to him — this and nothing more.

In some instances the result of applying § 671 as written will be identical with what would have obtained under the Government’s approach of recharacterizing the transaction. Here, for example, application of § 671 would mean that the trust’s $16,-000 annual interest income on the promissory note would be included in computing taxpayer’s gross income, but would be offset by an equivalent deduction for the interest paid — with the same net result as under the Government’s approach, where the taxpayer would be neither entitled to the deduction nor required to treat as income the payments received. But in other instances, the two approaches can yield quite different results. Here, for example, if the full amount of the note had been paid in 1965, the trust would have realized a gain in the amount of $290,000 (the excess of $320,000 over the trust’s $30,000 carryover basis in the shares transferred to it in 1957, see § 1015(a)). Under § 671 this gain would be ineludible in the taxpayer’s income, whereas under the Government’s approach, which would “disregard” the sale for tax purposes, no one would realize taxable income unless and until the taxpayer sold the stock.

The Government’s grievance apparently derives from the fact that, here, in contrast to the hypothetical where the precise application of § 671 would work to its advantage in the year 1965, neither the taxpayer nor the trust had reported a capital gain on the sale of the IDI shares in 1964.⁵ This, however, is simply a consequence of the provisions of § 453, governing installment sales. We disagree with the district court’s contention that § 453 supplies little aid to the taxpayer here because it' was “designed to alleviate a hardship on the seller by permitting an installment seller to report a proportionate share of the gain during each year in which he receives proceeds from the sale” (emphasis in original). Under § 671 the income of the seller (the trust) is to be computed as in the case of an individual, and as the Government concedes in its brief “the transaction under consideration in this case may properly be characterized as an installment sale, and ... the seller, here the trust, may elect to recognize its income proportionately over the period of the payment schedule” (emphasis in original). It is that income, if any there he in the taxable year, which § 671 directs shall be imputed to the grantor in cases where, under other sections, he is to be treated as owner of a portion of the trust. Because the trust had no reportable gain in 1965, application of § 675(3) to the taxpayer should not increase his tax liability on account of the trust’s sale of IDI stock. The reason why taxpayer realized no gain in the liquidation of IDI is not, as the dissent argues, that we are allowing him “to take advantage of the trust’s prior election to receive a portion of its proceeds from the taxpayer/grantor on an installment basis”, but that the taxpayer obtained a new basis of $320,000 as a' consequence of his purchase from the trust and that this resulted in his realizing a loss on his subsequent disposition of the IDI shares.- Nothing in § 671 says that a grantor shall not be entitled to his usual cost basis in property purchased from a trust of which other sections direct he shall be treated as “owner”; it says only, so far as here relevant, that if his purchase results in taxable gain to the trust, he is taxable on the gain. But here the trust, having properly taken advantage of the opportunity to account for .its gain on the installment basis, had no reportable income on the sale to the taxpayer that could be imputed to him under § 671. The dissent simply refuses to recognize that the consequences of violating § 675(3) are those and only those specified in § 671. It is immaterial whether the statutory scheme envisioned by Judge Oakes would achieve better results; we are governed by the statute as it is. Congress specified the consequences of violating § 675(3) and similar provisions in § 671; we are not at liberty to enlarge upon it.

The judgment dismissing taxpayer’s claim is reversed and the cause remanded to the district court for the entry of a judgment in favor of the taxpayer consistent with this opinion.

1 . This provides:

§ 675. Administrative powers

The grantor shall be treated as the owner of any portion of a trust in respect of which— (3) Borrowing of the trust funds

The grantor has directly or indirectly borrowed the corpus or income and has not completely repaid the loan, including any interest, before the beginning of the taxable year. The preceding sentence shall not apply to a loan which provides for adequate interest and adequate security, if such loan is made by a trustee other than the grantor and other than a related or subordinate trustee subservient to the grantor.

2 . The $30,000 basis asserted by the Commissioner seems to reflect either a carry-over of the trust’s basis in the shares or perhaps, as suggested in the Government’s brief, taxpayer’s original basis in the shares that he transferred to the trust — the two being here identical by virtue of IRC § 1015(a). Using this reduced figure as taxpayer’s basis and an appraisal that the property received was worth $950,000, the Commissioner determined that the taxpayer had realized a capital gain of approximately $152,000 on the liquidation of IDI. The Commissioner’s gross adjustment — some $184,000 — represents the recomputed gain plus the allegedly erroneously computed loss that appeared on taxpayer's return. After the 50% allowable deduction, this yielded a net increase in taxable income of approximately $92,000, to which was added $16,000 representing the disallowance of the deduction for interest paid to the trust. The resultant deficiency was $56,664, plus interest.

3 . It could be further contended on behalf of the taxpayer that Congress dealt with the subject of purchases from a trust in § 675(1) (regarding certain powers "to purchase, exchange, or otherwise deal with or dispose of the corpus or the income therefrom for less than an adequate consideration”), thus arguing for a narrower interpretation of § 675(3). Against this is the fact that § 675(1) applies only to powers permitting purchases for inadequate consideration, whereas § 675(3) applies, irrespective of a previously existing power, where the loan is either inadequately secured or made by "a related or subordinate trustee subservient to the grantor".

. Our ruling does not rest on any conclusion that the transaction here in question was a "sham”, as Chief Judge Feinberg seems to suggest. We do not question the authenticity of the sale by the trust but adhere to the not very novel proposition that the trust's extension of credit to enable Rothstein to finance the sale was a "borrowing” for purposes of § 675(3).

We also note that the hypothetical in the text, which Chief Judge Feinberg would dispose of as a "sham”, describes only the most egregious case. One can readily imagine situations in which the asset in question would be one already held by the trust or something other than a marketable security, but would nonetheless be an item of value for which the grantor would gladly give his unsecured 'note. It is unclear how such cases would be dealt with under Chief Judge Feinberg’s proposal, notwithstanding that they are as much the target of § 675(3) as the example in the text.

4 . It should be observed that most of the provisions of §§ 673-79 mandate "ownership" treatment in circumstances in which there may have been no transaction between the grantor and the trust. In those instances, § 671 must operate by imputing tax items to the grantor, not by recharacterizing his dealings with the trust.

5 . The record does not show whether the trust paid capital gains tax beginning in 1969 when principal payments became taxable under the installment sale provision, IRC § 453(b). Neither the taxpayer’s nor the Government's counsel was able to respond to our inquiries at argument on this score. The Government’s brief tells us only that ”[t]he Government has not made any assertions whatever regarding the realization of gain by the seller in this case."