Edgar v. Commissioner

*719 Respondent determined deficiencies in petitioners' income tax and additions to tax under sections 6651(a)² and 6653(a) as follows:

The issues presented for decision are:

(1) Whether members of the Strain family (docket Nos. 2911-68 through 2915-68) or, in the alternative, trusts created by them (docket Nos. 2916-68 through 2922-68) had recognizable capital gain from the sale or exchange of stock in 1964.

*720 (2) Whether William Russell Strain ³ and his wife, Frances Strain ⁴ (docket No. 2911-68), and Harriet Strain (docket No. 2912-68) or, alternatively, the William Russell Strain Trust No. CR-1 (docket No. 2916-68) and the Arthur W. Strain Trust No. CR-1 (docket No. 2918-68) had recognizable gain in 1964 as the result of the sale of stock subject to certain liens.

(3) *107 Whether Glenn E. Edgar realized taxable income in 1964 as the result of a bargain purchase of stock which G & E Trust No. CR-7007, created by him, was allowed to make on condition that he arrange the sale of the stock of the Strain corporations; if so, whether the amount of such income is to be computed by reference to annuity tables (docket No. 2923-68); alternatively, whether G & E Trust No. CR-7007 realized short-term capital gain on the sale of the stock (docket No. 2924-68).

(4) Whether Glenn E. Edgar realized taxable income which is to be computed by reference to annuity tables as the result of transfers of cash and a duplex residence to Brigham Young University (docket No. 2923-68); alternatively, whether the Glenn E. Edgar Trust No. CR-2002 realized long-term capital gain on the sale of the duplex residence to Brigham Young University (docket No. 2925-68), and whether the Glenn E. Edgar Trust No. CR-3003 realized ordinary income in consideration of services performed by Glenn E. Edgar, the grantor of the trust (docket No. 2926-68).

(5) Whether Russell Strain (docket No. 3340-67) and Harriet Strain, on the joint return of herself and her deceased husband (docket No. 3341-67), *108 are entitled to charitable contribution deductions for the remainder values of the stock in Strain Brothers, Inc., which they transferred to trusts in 1963.

(6) Whether Glenn E. Edgar is entitled to charitable contribution deduction for the remainder values of various items of property and cash which he transferred to trusts during 1962, 1963, and 1964 (docket Nos. 3237-67 and 2923-68).

(7) Whether Russell Strain (docket No. 2911-68) and Harriet Strain (docket No. 2912-68) are entitled to charitable contribution deductions for amounts paid to certain privately controlled foundations during 1964.

(8) Whether Harriet Strain (docket No. 2912-68) is entitled to a charitable contribution deduction for 1964 for the value of a salary continuation agreement which she relinquished in connection with the sale of the stock of the Strain corporations to Brigham Young University.

*721 (9) Whether Russell Strain (docket No. 3340-67) and Harriet Strain (docket No. 3341-67) realized a constructive dividend in 1963 as a result of the transfer of the Strain Ranch to certain privately controlled foundations.

(10) Whether Raymond P. Murphy and Mary Jean Murphy (docket No. 2914-68) have established that they suffered *109 a capital loss during 1964.

(11) Whether Glenn E. Edgar, as grantor and income beneficiary of the Glenn E. Edgar Trust Nos. CR-1 and CR-2, is entitled to deductions for 1962, 1963, and 1964 for losses incurred by partnerships in which the trusts were limited partners (docket Nos. 3237-67 and 2923-68).

(12) Whether the trust petitioners' failure to file timely income tax returns for 1964 was "due to reasonable cause and not due to willful neglect" within the meaning of section 6651(a)(1); and

(13) Whether the underpayment of income tax by Glenn E. Edgar and Elva Edgar for 1964 was due to "negligence or intentional disregard of rules and regulations" within the meaning of section 6653(a).

FINDINGS OF FACT

Petitioners' legal residences or their principal places of business at the time they filed their petitions and the places where they filed their Federal income tax returns are as follows:

For many decades prior to 1960, Russell Strain and his brother, Arthur Waldo Strain, ⁵ managed successful business enterprises, owned by three family corporations, in downtown Great Falls, Mont. The three corporations were Strain Brothers, Inc. (hereafter Strain Brothers), *111 Monarch Loan & Mortgage Co., and Monarch Warehouses, Inc. These corporations are herein sometimes referred to collectively as the Strain corporations.

In 1960, Russell and Arthur were in their sixties. Russell had suffered a stroke, and Arthur's health was not good. Together, they owned a majority of the stock of Strain Brothers, but they lacked voting control of Monarch Loan & Mortgage Co. and Monarch Warehouses, Inc. They feared that, on the death of either one of them, the stock of the Strain corporations would pass into the hands of strangers or uncooperative relatives and that the survivor would thereby lose management control of the companies.

Russell and Arthur started looking for a way to preserve control of the corporations and to plan the future handling of their estates. To assist them, they retained Glenn E. Edgar (hereafter Edgar), a lawyer and business consultant, and Herman L. Wood (hereafter Wood), a certified public accountant. The first meeting with Edgar and Wood took place in October of 1961. At this meeting and at numerous *112 subsequent meetings, Russell and Arthur outlined the management and estate problems they were facing. During these discussions, Arthur firmly rejected any possibility of selling the Strain corporations, and that possibility was not pursued. Arthur was hopeful that his son would eventually become manager of the corporations.

With the help of Wood, Edgar developed a plan designed to place control of all the Strain corporations in the hands of Russell and *723 Arthur, to minimize their estate taxes, and to avoid probate of their estates. This plan envisioned the creation of numerous trusts of which Russell and Arthur were to serve as trustees; various members of the Strain families were to be designated as life beneficiaries; two private foundations, one to be controlled by Russell's family and the other by Arthur's family, were to be created, and one of the foundations was to be named remainderman of each of the various trusts. The plan further called for salary continuation agreements to provide life income for the widows of Russell and Arthur. Late in 1962, Russell and Arthur approved this plan and directed Edgar and Wood to take steps to put it into effect.

For 2 weeks, early in June *113 of 1963, Edgar and Wood worked with Russell and Arthur, reviewing the papers required for the creation of the trusts. On June 6, 1963, the William Russell Strain Foundation and the Arthur W. Strain Foundation were organized as nonprofit corporations; certificates of incorporation were issued for these foundations by the State of Nevada on July 9, 1963. On June 17, 1963, members of the Strain family who held stock in the Strain corporations created irrevocable charitable remainder trusts, designating successive life beneficiaries and remainderman as follows:

*114 *724 In each trust instrument, ⁶ Russell and Arthur were named as cotrustees, and in this capacity they were given power to change the designated remainderman by naming "either a hospital, church or school, which is a tax exempt organization under the Federal Tax laws, to receive * * * [the] corpus upon the death of" the last income beneficiary.

Each trust provided that the "entire annual net income of the Trust Estate shall be distributed" to the designated life income beneficiaries. The trust instruments further provided that:

All capital gains and losses of the Trust, extraordinary stock dividends and capital gain dividends of investment companies *115 shall be considered principal. Any other determination of what is principal or income of the Trust Estate and the apportioning and allocating of receipts and disbursements between these accounts shall be governed by Federal Income Tax laws then in effect.

Each trust instrument further provided for the selection of trustees as follows:

The original Trustees, * * * [Russell and Arthur] or the survivor of them, may at all times while serving hereunder vary and determine the number of Trustees required to serve this Trust and they may at all times while serving hereunder appoint and discharge any of them.

If said survivor should become unwilling, unable or decline to continue to act as Trustee, the number and members of the board of trustees thereafter shall be as determined by an instrument in writing made by said survivor and delivered to the then remaining trustees (or to any beneficiary hereunder if for any reason there shall be no trustee then serving). Said survivor shall at all times while serving hereunder have the right to revoke, withdraw, modify or amend such instrument.

If at any time there is no Trustee serving hereunder and no provision is otherwise made herein to fill such *116 vacancy, a court of proper jurisdiction shall appoint either an individual or corporation to act as sole Trustee during said period.

The trustees were also given the power to retain or sell the stock in the Strain corporations and to vote it for any purpose.

All the outstanding shares of stock of the Strain corporations were transferred to these seven trusts (hereafter the Strain trusts) with the exceptions of two shares of Strain Brothers stock owned by Marie Hegener and S. A. Lerum, redeemed by the corporation in October of 1963; 343 shares held in an oral trust for Richard Hurd; 342 shares held in an oral trust for Kathleen Strain Hurd; and 186 shares held by G & E Trust CR-7007.

*725 All the documents required for the creation of the trusts were properly executed; all the stock was transferred on the books of the corporations; and a separate file for each trust was set up in the office of the trustees. The trusts became effective June 17, 1963.

On June 10, 1963, prior to the creation of the trusts, Russell and Arthur received $ 24,000 and $ 41,000, respectively, from Strain Brothers. To document these receipts, Russell and Arthur each signed a promissory note, which bore no interest *117 and was payable to the order of Strain Brothers on a date 75 years thereafter. Stock of Russell and Arthur in Strain Brothers was pledged to secure the payment of these notes, and liens were endorsed on the stock certificates. The stock certificates issued to William Russell Strain Trust CR-1 and to Arthur W. Strain Trust CR-1 stated that they were subject to those liens, but the trusts did not assume the liability on the notes.

During 1962, Edgar was given checks totaling $ 10,000 which fully compensated him for his services in planning the trusts.

During the 2 weeks in June of 1963, when the trusts were being established. Russell and Arthur again discussed with Edgar and Wood the possibility of selling the stock in the Strain corporations. Arthur was not at this time enthusiastic about selling it, but the Strains agreed that Edgar and Wood would explore the possibilities of a sale. To compensate Edgar for his services, Russell and Arthur each agreed to sell 93 shares of Strain Brothers stock, having a fair market value at the time of $ 28,125, to Edgar's G & E Trust CR-7007 for $ 50.

On June 10, 1963, Edgar created G & E Trust CR-7007 and transferred $ 110 in cash to it for the *118 purpose of purchasing the stock in Strain Brothers. The terms of this trust were similar, in principle, to those of the Strain trusts. Under the declaration of trust, he and Wood were designated as trustees. Edgar reserved all the income for his life and that of his wife, and provided that the remainder was to go to the Primary Children's Hospital of Salt Lake City, Utah. However, Edgar reserved for the trustees the power to substitute some other tax-exempt hospital, church, or school as the remainderman.

The purchase agreement between the trustees of G & E Trust CR-7007 and Russell provided:

Notwithstanding the foregoing W. R. Strain [i.e., Russell] shall have the option to purchase said shares of stock from said Trustees at any time or times within a period of 18 months after the date of execution of this agreement upon paying to said Trustees the sum of $ 50.00 in cash; provided, however, should W. R. Strain within said period of time sell to a third party any of his remaining shares of common capital stock of Strain Bros. said option shall terminate and said Trustees shall have the right to sell said 93 shares of stock to said third party at a price to be agreed upon by said *119 Trustees and said third party.

The agreement between Arthur and G & E Trust CR-7007 was identical except for the name of the seller.

*726 Prior to June 17, 1963, there were no existing contracts of sale, prior understandings, or commitments of any kind with respect to the sale of the assets or stock of the Strain corporations. No contacts of any kind had been made by any person connected with the Strain family or G & E Trust CR-7007 with anyone regarding such sale.

On about June 19, 1963, a few days after Edgar and Wood were asked to investigate the possibility of a sale, Graham Doxey (hereafter Doxey) visited Wood's office on some personal business. During this visit, Edgar and Wood talked with him about the stock. Doxey thought that Zion Securities Corp. (hereafter Zion Securities) might be interested in purchasing it. Shortly thereafter, at an executive committee meeting, he proposed that the company purchase the stock. After consideration and investigation, the proposal was rejected.

In late August of 1963, the proposal which had been rejected by Zion Securities was communicated to the Corporation of the President of the Church of Jesus Christ of Latter-Day Saints and through it to *120 representatives of Brigham Young University (hereafter BYU). Ben E. Lewis, vice president of BYU, contacted Wood for details.

After extended negotiations, an agreement with BYU was reached for the purchase and sale of the stock, and the transaction was completed in January of 1964. The total purchase price agreed upon was $ 1,394,587.60 for all the outstanding stock in the three Strain corporations. Each of the Strain trusts and G & E Trust CR-7007 executed a separate agreement with BYU with respect to its stock.

All of the agreements of purchase and sale were basically the same, except for numbers of shares sold and amounts to be paid. Each agreement provided for the principal amount to be paid after 75 years, but BYU was given the option to accelerate this payment after the death of the last life income beneficiary. In the interim, interest was payable quarterly. The annual interest rates were 10 percent for all the Strain Trusts CR-1 and G & E Trust CR-7007; 3.78 percent for the Arthur W. Strain Trust CR-2; and 7.75 percent for the William Russell Strain Trust CR-2 until Russell's death and, thereafter, 3.42 percent. Each agreement also provided:

The *121 Notices of Breach of Warranty. There shall be deducted from the purchase price such amounts as may be specified in any written notices of breach of warranty given by Buyer to Seller and approved on behalf of Seller by such persons who under the terms of the instrument establishing Seller have interests as lifetime beneficiaries and have reached their majority. Such notices of breach of warranty must specify the breach of one or more of the warranties or representations set forth in this agreement and the amount estimated by Buyer as the damage resulting, or which may result, from the breach thereof.

In the event the said lifetime beneficiaries of Seller shall not approve in writing the amount specified in such notices of breach of warranty, the respective rights of the parties hereunder shall be determined by arbitration, each *727 party, Buyer and Seller, to choose one arbitrator and the two arbitrators so chosen to appoint a third arbitrator and the decision of any two of said three persons to be final and binding upon both Buyer and Seller. The purchase price, as well as the interest payments provided for in Paragraph 2(b) hereof shall be adjusted to reflect the decision of the arbitrators *122 and a copy of the arbitrators' decision shall be annexed to and become a part of this agreement. In the event a claimed breach of warranty or representation cannot be resolved by arbitration as herein provided, recourse may be had to the courts.

Included in all the agreements were warranties that corporate balance sheets attached thereto were accurate and that "The title of Seller to said shares is free of any lien, charge or encumbrance and Buyer, on the closing date, will receive good and absolute title thereto free of any liens, charges or encumbrances thereon." However, the agreements with William Russell Strain Trust CR-1 and the Arthur W. Strain Trust CR-1 contained an exception to the latter warranty with respect to the liens securing the repayment of the loans by Strain Brothers to Russell and Arthur in the respective amounts of $ 24,000 and $ 41,000, evidenced by the promissory notes dated June 10, 1963. The agreement with Russell's CR-1 trust provided:

should the said promissory note be due and payable on the date Buyer is obligated to pay the principal amount due hereunder, Buyer may at its option and upon giving written notice of exercise reduce the amount of its principal *123 payment by an amount equal to the amount of said note.

A similar provision appeared in the agreement with Arthur's CR-1 trust.

The element of the transaction which was most attractive to BYU was its designation as the charitable remainderman of each of the trusts. All the agreements provided:

Designations. (a) Trustee hereby agrees to designate Buyer as the Charitable Remainderman of Seller, such designation to take effect in the future upon the death of Trustee or upon a date which is ninety (90) days from the closing date. The Trustee shall deliver to Ray, Quinney & Nebeker, on the closing date a valid, enforceable and irrevocable designation of Buyer for delivery, in accordance with the terms of the instrument creating Seller when said designation becomes effective.

(b) Trustee agrees to irrevocably appoint Buyer or Buyer's nominee as sole Trustee of Seller. Said designation to be made and become effective ninety-five (95) days from the closing date, unless Trustee's death occurs prior to the expiration of the 95-day period. Trustee hereby and herewith irrevocably designates and appoints Buyer as the sole Trustee of Seller upon Trustee's death, if such death should predate a date *124 which is 95 days from the closing date. Buyer agrees that it will not charge any fee for its services as Trustee of Seller and that it will not select a nominee or successor trustee unless such nominee or successor agrees in writing to serve as trustee without remuneration from Seller.

(c) Trustee warrants that he has the right and authority as sole Trustee of Seller to make the designations and appointments set forth in Sections (a) and *728 (b) of this paragraph 12. Trustee and Seller specifically agree that a failure of either of the two said designations and appointments shall give Buyer a right to declare a breach of this agreement and thereby relieve itself of its obligation under the terms of this agreement and entitle it to recover its costs and expenses, including reasonable attorney's fees.

At the insistence of Russell and Arthur, the obligations of BYU under the agreements were guaranteed by the Corporation of