Estate of Sidles v. Commissioner

*873 OPINION

Respondent determined deficiencies of $ 160,203 and $ 2,197 in petitioners' Federal income taxes for the taxable years ended May 31, 1969, and May 31, 1970, respectively.

Some issues have been conceded by petitioners. The primary issue for our decision is whether a liquidating distribution received by the Estate of Harry B. Sidles from Bi-State Distributing Corp. constituted "income in respect of a decedent" within the meaning of section 691(a)(1). ¹ If this distribution is *874 determined to be "income in respect of a decedent," then we must decide whether the deduction provided by section 691(c) is to be offset only against section 691(a) income.

All of the facts are stipulated. The stipulation of facts and the exhibits attached thereto are adopted as our findings. The relevant facts are summarized below.

Harry B. Sidles (herein referred to as *172 the decedent) was born on May 2, 1903, and died testate in Omaha, Nebr., on June 12, 1968. During his lifetime the decedent was a cash basis taxpayer.

Daniel J. Monen, Jr., and Janice P. Sidles, the petitioners herein, are the duly appointed and qualified coexecutors of the Estate of Harry B. Sidles (herein referred to as the estate). When the petition was filed herein the legal residence of Daniel J. Monen, Jr., was Omaha, Nebr., and that of Janice P. Sidles was Scottsdale, Ariz.

The estate's fiduciary income tax return (Form 1041) for the taxable year beginning June 12, 1968, and ending May 31, 1969, was filed with the Internal Revenue Service Center at Kansas City, Mo. Subsequently, two amended returns were filed for that year. The estate's fiduciary income tax return for the taxable year ending May 31, 1970, was filed with the District Director of Internal Revenue at Omaha, Nebr.

Bi-State Distributing Corp. (herein referred to as Bi-State) was originally incorporated under the laws of Nebraska in 1930 as the H.E. Sidles Co. On October 17, 1947, the name of the corporation was changed to Bi-State Distributing Corp.

From January 3, 1956, until his death on June 12, 1968, the decedent *173 owned all the outstanding common stock (500 shares) of Bi-State. At his death decedent's adjusted basis in these shares was $ 29,701.04.

As of June 12, 1968, Bi-State's board of directors consisted of three individuals: the decedent (nominated and elected January 20, 1933), Janice P. Sidles (nominated and elected on January 3, 1956), and Areta L. Kelly (nominated and elected on June 26, 1962). Janice P. Sidles and Areta L. Kelly were the decedent's wife and mother-in-law, respectively. On July 22, 1968, Margaret DeVore was nominated and elected to serve the balance of the decedent's term as a director. She was an employee of Bi-State and was not related to the decedent or to either of the other two directors.

*875 At a special meeting held on February 28, 1968, Bi-State's board of directors adopted a plan of complete liquidation and dissolution pursuant to section 337 of the Internal Revenue Code of 1954, and section 21-2083 of the Nebraska Business Corporation Act. On the same day this plan of complete liquidation was approved by the decedent as Bi-State's sole shareholder.

On February 29, 1968, Bi-State filed with the Nebraska secretary of state a statement of intent to dissolve.

Bi-State*174 owned 11,025 shares of Sidles Co. stock. On March 26, 1968, Sidles Co. made an offer to purchase these shares. The purchase agreement provided that Bi-State would receive cash of $ 13,429 and a 20-year, 6-percent promissory note from Sidles Co. in the face amount of $ 899,000. On the same day Bi-State accepted this purchase offer. Bi-State's basis in the 11,025 shares of Sidles Co. stock at the time of sale was $ 86,344.84.

Bi-State owned certain real and personal property at 4827 Dodge Street in Omaha, Nebr., and from November 1964 until November 1968 was actively engaged in the operation of a gift shop, Areta's, at that location. The gift shop was managed by Areta L. Kelly, decedent's mother-in-law.

After the decedent's death, Bi-State took no action to distribute any of its assets pursuant to the previously adopted plan of liquidation until November 29, 1968, when its board of directors adopted a resolution to distribute all its real and personal property to the decedent's estate. On that date a warranty deed, transferring the real property located at 4827 Dodge Street, and a bill of sale, transferring the personalty to the estate, were executed.

On November 30, 1968, Bi-State*175 assigned all its right, title, and interest in the Sidles Co. promissory note to the estate.

As of the dates of distribution, November 29 and 30, 1968, the assets distributed in liquidation by Bi-State to the estate had a total net fair market value of $ 702,830.85, being the total fair market value of assets received ($ 731,195.88), less liabilities assumed ($ 28,365.03).

Articles of dissolution were executed by Bi-State on November 30, 1968, and were filed with the Nebraska secretary of state on December 17, 1968. On December 17, 1968, a certificate of dissolution was issued.

At the time Bi-State adopted its plan of liquidation and dissolution, which was by act of the corporation, section 21-2088, *876 Nebraska Business Corporation Act, provided the procedure for the corporate revocation of voluntary dissolution proceedings. ^{2*176 *177}

Pursuant to the provisions of section 337, Bi-State did not recognize its gain on the sale of its assets in liquidation, i.e., the gain on the sale of its Sidles Co. stock, less a $ 204 loss on the sale of a 1968 Buick station wagon.

On the decedent's Federal estate tax return, the executors included the 500 shares of Bi-State stock at a value of $ 702,830.85, valued as of the alternate valuation date (November 30, 1968). This valuation was accepted by respondent following an audit.

In his notice of deficiency dated June 12, 1973, respondent determined that the gain realized from the liquidation of Bi-State constituted income in respect of a decedent. The gain ($ 673,129.81) was calculated by subtracting the decedent's adjusted basis in his Bi-State stock ($ 29,701.04) from the net fair market value of the assets received by the estate as a liquidating distribution ($ 702,830.85). The respondent further determined that a deduction of $ 950 for the taxable year ending May 31, *178 1969, for Federal estate tax attributable to income in respect of a decedent, as claimed by petitioners, was not allowable, but that an estate tax deduction of $ 94,448 was *877 allowable as an offset against income in respect of a decedent totaling $ 674,708 in computing the alternative tax. It was further determined that for the taxable year ending May 31, 1970, the proper deduction for Federal estate tax attributable to income in respect of a decedent was $ 255, rather than $ 686 as claimed on the return.

Petitioners contend that the liquidating distribution received by the estate from Bi-State is not governed by section 691(a) and, even if it did constitute income in respect of a decedent, the deduction provided by section 691(c) should not be limited solely to section 691(a) income items.

The principal issue is whether the liquidating distribution received by the estate from Bi-State constituted "income in respect of a decedent" as that term is used in section 691, which provides, in relevant part, that:

The amount of all items of gross income in respect of a decedent which are not properly includible in respect of the taxable period in which falls the date of his death or a prior *179 period (including the amount of all items of gross income in respect of a prior decedent, if the right to receive such amount was acquired by reason of the death of the prior decedent or by bequest, devise, or inheritance from the prior decedent) shall be included in the gross income, for the taxable year when received, of:

(A) the estate of the decedent, if the right to receive the amount is acquired by the decedent's estate from the decedent; [Emphasis added.]

Section 1.691(a)-1(b), Income Tax Regs., defines "income in respect of a decedent" as:

those amounts to which a decedent was entitled as gross income but which were not properly includible in computing his taxable income for the taxable year ending with the date of his death or for a previous taxable year under the method of accounting employed by the decedent. * * * [Emphasis added.]

Respondent determined that the liquidation proceeds were income in respect of the decedent because, as of the date of his death, the decedent was entitled to and possessed the right to receive the liquidating distribution from Bi-State.

Petitioners argue that the criterion for determining whether an item constitutes "income in respect of a decedent" *180 within the meaning of the Code and regulations sections quoted above is that the decedent must be entitled to the item in the sense that he had a right to the income at the time of his death, which right had been earned during his lifetime. Petitioners further contend that neither the adoption of the plan of liquidation nor *878 decedent's activities or economic efforts created the requisite right to income under section 691 and the regulations thereunder. They argue that the decedent had no right and was not entitled to the liquidation proceeds until the distribution had been authorized by Bi-State's board of directors.

Income in respect of a decedent is defined only in the regulations and not in the statute. An attempt to add such a definition to the Code in 1959 failed. H.R. 3041, 86th Cong., 1st Sess. (1959). However, some guidelines can be gleaned from an examination of congressional intent as reflected in the legislative history of section 691 and its antecedents.

Prior to 1934 an accrual basis taxpayer was required to pay income tax on those amounts accrued but not received as of the date of his death. However, neither a cash basis taxpayer nor his estate was required to pay *181 a Federal income tax on such amounts because they were considered corpus rather than income. Nichols v. United States, 64 Ct. Cl. 241 (1927), cert. denied 277 U.S. 584 (1928). Furthermore, no income tax liability arose when capital assets were transferred after death since the estate's basis in such assets was fair market value at date of death and the amounts received generally did not exceed this amount. ³

Congressional concern with this discrimination between taxpayers and loss of revenue led to the enactment of section 42 of the Revenue Act of 1934. This section required all income accrued to the date of death but not otherwise properly includable in income for that period or any prior period to be included in decedent's income tax return for the period ending with his death regardless of his method of accounting. See S. Rept. No. 558, 73d *182 Cong., 2d Sess. 28 (1934).

While this section achieved an equality between cash and accrual basis decedents, it resulted in bunching of income since amounts which would have been received over several years and taxed at lower rates were required to be reported in the year of death. This situation was aggravated by the imposition of war surtaxes and by the realization that taxpayers might be taxed on substantial sums which they had not yet received or might never receive. See S. Rept. No. 1631, 77th Cong., 2d Sess. 100-105 *879 (1942), 1942-2 C.B. 504, 579-583. Furthermore, the decision of the Supreme Court in Helvering v. Enright, 312 U.S. 636 (1941), greatly expanded the meaning of "accrued" as used in section 42. In that case, the Supreme Court, after giving the reasons for the enactment of section 42, explained that it was endeavoring to effectuate the legislative objective of ensuring that income, which would have been taxable had decedent lived to receive it, should not escape income taxation by reason of his death.

Accruals here are to be construed in furtherance of the intent of Congress to cover into income the assets of decedents, earned during their life and unreported as income, *183 which on a cash return, would appear in the estate returns. Congress sought a fair reflection of income. [312 U.S. at 644-645.]

Section 134 of the Revenue Act of 1942 added section 126 of the 1939 Internal Revenue Code. This section, the predecessor of section 691 of the Internal Revenue Code of 1954, eliminated the undesirable pyramiding effects of the prior law through formulation of the concept of "income in respect of a decedent." Under this section income accruing to a decedent because of his death was not to be included in his final return, but was to be treated as income and reported as such by the person receiving such income. As noted in Commissioner v. Linde, 213 F. 2d 1, 5-6 (9th Cir. 1954), cert. denied 348 U.S. 871 (1954):

there is nothing in the legislative history or in the text of Sec. 126 to indicate that it was intended to be anything other than an improved device to accomplish the general purpose of the internal revenue code that all income should pay a tax and that death should not rob the United States of the revenue which otherwise it would have had. We think it clear that the intent of Congress continued to be as stated in the Enright case "to cover into income *184 the assets of decedents, earned during their life and unreported as income". * * * [Fn. ref. omitted.]

* * *

it is our view that section 126 was but an improved method adopted by Congress in aid of its continuing effort to avoid the loss of tax upon income merely because of the death of the decedent who would have paid a tax upon the same economic returns had he lived to receive them.

Section 691 includes in gross income "all items of gross income in respect of a decedent which are not properly includible" in the taxable year ending with the date of his death or prior period. This reflects the same general congressional intent to tax all items which can constitutionally be considered income, but which are not exempted from taxation, as that underlying section 61 which defines gross income. However, for income to be *880 considered "income in respect of a decedent," section 691 requires that the decedent possess a right to that income as of his date of death. ^4*186 This is a question of fact and each case depends upon its "subsisting facts." Trust Co. of Georgia v. Ross, 392 F. 2d 694, 695 (5th Cir. 1967), cert. denied 393 U.S. 830 (1968). One of the factors to be considered is whether the *185 income received after death resulted from the decedent's activities and economic efforts during his lifetime. ⁵ But this right must be distinguished from the activity which created it. No matter how great the activity or effort, there can be no income in respect of a decedent under section 691 unless the decedent possessed a right to receive such income on his date of death. Trust Co. of Georgia v. Ross, supra at 695. Our point of inquiry must be whether the transaction had sufficiently matured as of decedent's death so as to create in him a right to receive the income when it was subsequently realized.

The facts and circumstances of this case lead us to the conclusion that the amounts received by the decedent's estate on the liquidation of Bi-State constituted income in respect of a decedent within the meaning of section 691.

On February 28, 1968, the board of directors of Bi-State Distributing Corp., consisting of Harry *187 B. Sidles, Janice P. Sidles, and Areta L. Kelly, passed a resolution calling for the complete liquidation and dissolution of the corporation. The sole *881 stockholder of Bi-State, Harry B. Sidles, approved the resolution that same day.

The liquidating distribution had its source exclusively in decedent's actions. His affirmative vote for liquidation created a right to receive that distribution, which right existed at his death. Although decedent had the power to rescind the transaction creating such a right, he had not attempted to do so before his death. Had the decedent lived to receive the liquidating distribution, it would have constituted income to him, and consequently such amounts constitute income in respect of a decedent when received by the estate.

There can be no doubt that the estate acquired the right to receive the liquidation distribution from the decedent. The estate's right to such proceeds derived solely from decedent's death and not from its own efforts. Whatever actions the estate took were of no material significance here.

Furthermore, the actions of Bi-State's board of directors which remained to be done at the time of decedent's death do not derogate decedent's *188 right to receive the liquidating distribution. The resolution of November 29, 1968, to distribute the assets in liquidation to decedent's estate, the declaration of the liquidating dividend and the filing of articles of dissolution were mere formalities; ministerial acts necessary to complete the liquidation under State law. On the date of his death the decedent had performed enough substantive acts within his control to perfect his right to receive the liquidating distribution for purposes of section 691. ^6*189 Cf. Hudspeth v. United States, 471 F. 2d 275 (8th Cir. 1972); Kinsey v. Commissioner, 477 F. 2d 1058 (2d Cir. 1973), affg. 58 T.C. 259 (1972).

In Keck v. Commissioner, 415 F. 2d 531 (6th Cir. 1969), revg. 49 T.C. 313 (1968), the Commissioner determined a deficiency in the income tax of George W. Keck and Mary Ann Keck, and also asserted transferee liability against Mary Ann Keck, as transferee of the assets of the Estate of Arthur D. Shaw, deceased. *882 The issue there was whether certain amounts received in 1960 by Mary Ann Keck and by the estate, were taxable as income in respect of a decedent under section 691. The deceased, Arthur D. Shaw, owned stock in three affiliated corporations as of March 1, 1956. On that date an agreement was entered into prior to the sale of the assets of the corporation. The sale, however, was contingent upon approval of the Interstate Commerce Commission. The shares of stock were placed in escrow pending such approval.

Mr. Shaw died November 27, 1958. ICC approval was not obtained until May 5, 1960. On July 21, 1960, pursuant to authority granted by the ICC, the three companies were liquidated pursuant to the agreement earlier agreed upon, and the cash received from the sale was distributed *190 in exchange for shares of the stock of the three companies. The executor of the Estate of Mr. Shaw paid over to Mrs. Keck $ 314,328.53 in exchange for 100 shares of one of the companies liquidated. The court there held that at the time of the decedent's death, his stock had not been converted into section 691 income in respect of a decedent. The Court of Appeals agreed with the dissenting opinion of Judge Featherston in George W. Keck, 49 T.C. 313 (1968), that the sale was subject to a number of contingencies which operated to prevent the cash from becoming income in respect of a decedent: (1) The sale was subject to approval of the ICC, which approval did not come until 18 months after decedent's death; (2) as of the time of decedent's death, neither decedent nor the other stockholders were contractually committed to the plan to liquidate the corporation; (3) the majority stockholder (who in this case was not decedent) might have decided not to liquidate the corporation; and (4) the decedent's own stock was not committed to vote for the plan until May 23, 1960, when the proxies were signed and delivered.

The Keck case is clearly distinguishable on its facts. Unlike Keck , the decedent, *191 as Bi-State's sole shareholder, possessed the power to compel payment of the liquidating distribution, as well as the right to that payment, when he died. His right to the liquidation distribution was not subject to the many contingencies involved in Keck. The transaction was not subject to the approval of any Government agency; there was no other stockholder who could vote not to liquidate the corporation. The distribution made to the Estate of Harry B. Sidles, was clearly *883 "income in respect of a decedent" within the meaning of section 691.

The second issue we must decide is whether the estate tax deduction provided in section 691(c) can be offset only against related section 691(a) items. Petitioners argue that the 691(c) deduction is not limited to deductions from or offsets against income items in respect of a decedent but may be used in the way that is most advantageous to them. They have first taken the 691(c) deduction against ordinary income (which was not income in respect of a decedent) and then applied the remainder against the capital gain income in respect of a decedent which engendered the deduction.

Section 691(c) provides that when a taxpayer includes an amount *192 of "income in respect of a decedent" in his gross income, he "shall be allowed" a deduction. This deduction is limited to the portion of the estate tax imposed upon the decedent's estate which is attributable to the inclusion of that amount of income in respect of a decedent in the decedent's gross estate. Sec. 691(c)(1)(A). Neither the statute nor its legislative history expressly restricts the 691(c) deduction to 691(a) income items. The purpose for providing this deduction was to prevent subsequent income taxation of an item of income in respect of a decedent which had already been taxed for estate tax purposes. S. Rept. No. 1622, 83d Cong., 2d Sess. 87-89 (1954); H. Rept. No. 1337, 83d Cong., 2d Sess. 64-65 (1954).

Based on our conclusion on the first issue, the estate had income in respect of a decedent of $ 674,708. The estate tax attributable to the income in respect of a decedent (and thus the amount of the section 691(c) deduction) was $ 94,448. The estate also had other taxable income for 1969 of $ 29,284. It took the 691(c) deduction first against ordinary income, and, after completely using that amount, took the remaining deduction as an offset against capital gains *193 before making the alternate tax computation provided by section 1201(b).

In his statutory notice of deficiency the respondent allowed the 691(c) deduction only as an offset against the 691(a) items (capital gain) and not from ordinary income. Respondent's computation in the notice of deficiency was as follows: *884

Petitioners' method results in a tax savings because the deduction was first taken against ordinary income, which is taxable at a higher rate than the capital gains.

Respondent relies on Read v. United States, 320 F. 2d 550 (5th Cir. 1963). In that case the income in respect of a decedent consisted of long-term capital gain against which the estate offset the section 691(c) deduction before computing the alternative tax. The *194 Government argued that the 691(c) deduction must be taken against ordinary income and could not be offset against capital gains because "there is no express provision making the deduction applicable in alternative tax computations," Read v. United States, supra at 552. In other words, a deduction is not an offset. The Court of Appeals for the Fifth Circuit found for the estate, reversing the decision of the District Court and remanding the case. It noted that the adoption of the Government's position would result in the imposition of both estate and income tax on amounts of income with respect to a decedent where the alternative computation was used, contrary to the congressional intent in enacting section 691(c). The court also referred, at page 553, to the legislative history which noted that recipients of income in respect of decedent are to be "allowed an offsetting deduction" for the estate tax attributable to the inclusion of income in respect of a decedent in the decedent's gross estate, citing S. Rept. No. 1622, 83d Cong., 2d Sess. 87 (1954).

In Read, the 691(c) deduction obviously exceeded the amount of ordinary income and would have been lost unless it could be offset against *195 the capital gain income in respect of a decedent item. The Government's position would have forced the estate to *885 forego the alternative tax in order to fully utilize the 691(c) deduction.

The Court of Appeals, after allowing the offset, noted that:

The offsetting is a pro tanto cancelling out. It works a reduction in the amount of the particular kind of income which is to be subject to taxation. There is equal purpose to be served and a like reason for allowing the deduction where the alternative tax computation is used as where it is not. * * * [Read v. United States, supra at 553; emphasis added.]

Respondent argues that this language requires us to sustain his position in this case because this will result in a proper matching of the deduction with its related income consistent with congressional intent.

We do not find Read to be on point because the holding in that case was that the 691(c) deduction could be used as an offset where the alternative tax is used. Respondent does not dispute petitioners' right to an offset here.

The issue confronting us in this case was not before the court in Read and, accordingly, we have only considered those portions of that case which discussed *196 the statutory purpose of section 691(c). Furthermore, we think that the failure of the estate in Read to use the section 691(c) deduction in the most advantageous way should not be deemed to be a conclusive determination that the credit must be offset solely against income in respect of a decedent.

The scope of the 691(c) deduction has been explored in three subsequent cases. Meissner v. United States,