Estate of O'Connor v. Commissioner

*166 OPINION

Respondent determined the following deficiencies in the petitioners' Federal income taxes:

The issues before us are:

(1) Whether the decedent's estate properly claimed distributions deductions in respect of amounts received by a charitable foundation on the grounds either (a) that such amounts constituted*38 distributions to a marital trust created under decedent's last will and testament or (b) that, since the foundation succeeded to the interests in the marital trust, such amounts should be treated as distributions to a beneficiary under said last will and testament;

(2) If the estate is entitled to such distributions deductions on the ground that they were made to the marital trust, whether *167 the marital trust is entitled to distributions deductions in respect of the amounts received by such charitable foundation;

(3) Whether certain distributions by the estate to the beneficiaries of residuary trusts under the decedent's last will and testament were required distributions of current income and, in any event, the amount of such distributions includable in gross income by such beneficiaries; and

(4) Whether a portion of the executors' commissions paid by the decedent's estate are allocable to tax-exempt income and, therefore, nondeductible.

Respondent concedes that any assessment against the marital trust for the taxable year ended December 31, 1969, is barred by the statute of limitations.

This case was submitted to the Court upon a full stipulation of facts, which, together*39 with the exhibits, is incorporated herein by this reference.

A. Lindsay O'Connor (decedent) died on May 9, 1968, a resident of Delaware County, N. Y. His last will and testament, dated December 11, 1957, was admitted to probate by decree of the Surrogate's Court, County of Delaware, N. Y., dated May 20, 1968, and letters testamentary and letters of trusteeship were issued to Dermod Ives and United States Trust Co. of New York authorizing them to act as executors and trustees under the will. A joint petition was filed herein by Dermod Ives and United States Trust Co. of New York as executors and trustees and by Olive B. Price, Robert L. and Lucille S. Bishop, and Donald F. and Edna G. Bishop, individually. The United States Trust Co., a corporation organized under the banking laws of the State of New York, maintained its principal office in New York, N. Y., at the time of filing said petition. ¹

*40 The executors filed an estate tax return on June 24, 1969. They elected a fiscal year ending October 31 for income tax reporting purposes. A short-period income tax return was filed by the estate for the period from the date of decedent's death to October 31, 1968. Thereafter, income tax returns for the estate were duly filed for the taxable years ending October 31, 1969, October 31, 1970, and October 31, 1971. The trustees elected the calendar year for income tax purposes and duly filed forms 1041 *168 for the marital trust and for each of the other trusts for 1969, 1970, and 1971.

The dispositive provisions of the decedent's will basically provided for the division of his estate into two shares. ² The first share, consisting of one-half of the entire net estate, was bequeathed in trust (marital trust) for his widow, Olive B. O'Connor, who was given the income therefrom, coupled with a general testamentary power of appointment over corpus in favor of "such persons and/or corporations as she may appoint" and a power to withdraw at any time (including the year of death) any or all of the corpus by a written election to be filed with the trustees. As to the second share, *41 the decedent made some specific pecuniary bequests and directed that the balance be divided into three equal parts, to be held in trust, with income from each part to be paid or applied for the benefit of Olive B. Price, Donald F. Bishop, and Robert L. Bishop (niece and nephews of the widow), respectively.

On May 23, 1968, the decedent's widow, Olive B. O'Connor (Mrs. O'Connor), notified the executors and trustees in writing that she elected to have all of the principal of the marital trust paid to her. By instrument, executed the same day and entitled "Gift Assignment of Interest in Estate of A. Lindsay O'Connor," Mrs. O'Connor assigned all of her right, title, and interest to the marital trust, together with any income from such property, to the A. Lindsay and Olive B. O'Connor Foundation (hereinafter the foundation). The foundation had been created by Mrs. O'Connor in 1965 and was, at all times material herein, recognized by the*42 Internal Revenue Service as a charitable foundation within the meaning of section 501(c)(3). ³ For the year 1968, Mrs. O'Connor filed a gift tax return in which she reported the assignment of her interest in the marital trust to the foundation; the value of such interest in both income and corpus was estimated to be $ 25 million.

With respect to its 3 taxable years involved herein, the parties have stipulated that "the estate made the following distributions to the beneficiaries thereof": *169

*43 *170 The total value of such distributions in each case exceeded the distributable net income of the estate as reflected in its income tax returns for each of its taxable years in issue. The parties further stipulated that the marital trust distributed all that it received from the estate to the foundation shortly after receipt. ⁴

The parties*44 have further stipulated that the administration of the estate continues pending the outcome of this proceeding; that the trustees continue to administer the marital trust, receiving estate assets from time to time, and in general turning over the assets received to the foundation shortly after receipt by the trust; that a small balance of principal cash is now maintained by the trust; and that, when the controversies involved in this proceeding are finally determined and the trustees have received from the executors all property passing under the will to the marital trust (which must be distributed to the trustees, despite Mrs. O'Connor's assignment, under New York law), they will make a final judicial accounting to the Surrogate's Court and only after that accounting proceeding is completed and all assets remaining in their possession thereafter have been distributed can the administration of the trust be considered completed.

For its taxable years at issue, the estate claimed distributions *171 deductions under section 661(a)(2)⁵ against its reported distributable net income as follows:

For its taxable years in question, returns were filed for the marital trust on which the amounts distributed from the estate and passed through ⁶ to the foundation in accordance with the election and assignment executed by Mrs. O'Connor were reported and deducted under section 661(a).

*46 As noted in the above table, the estate also made income distributions directly to the beneficiaries of the residuary trusts prior to the transfer of the underlying assets to such trusts. On the premise that such distributions were not required to be made currently by the estate, each of the individual beneficiaries computed his respective tax liability in accordance with section 662(a)(2). ⁷

*47 *172 On its income tax return for the taxable year ending October 31, 1971, the estate claimed a deduction for the payment of executors' commissions in the amount of $ 55,674.04. The commissions were computed on the basis of the estate's aggregate gross income earned from the date of death to May 8, 1970 (the intermediate accounting period), or $ 1,391,851.25. Of this amount, $ 703,759.65 was tax-exempt income. No tax-exempt income was earned in the taxable year ending October 31, 1971.

Respondent made three primary determinations in respect of the above-outlined distribution plan:

(1) The marital trust was not a recognizable tax entity because it was a passive trust under New York law;

(2) Section 661(a) does not permit a deduction to an estate or trust for distributions to charitable entities where such distributions do not qualify for deduction under section 642(c); and

(3) The income paid to the residuary trust beneficiaries was required to be distributed currently by the residuary trusts.

The frame of reference for issues posed by respondent's determinations can be simply stated: Who is taxable, and to what extent, on income earned and distributed by the decedent's estate*48 during its period of administration? Resolution of the issues is not as simply divined.

The core questions with respect to the amounts received by the foundation are (a) to what extent should the marital trust be recognized for the purposes of this proceeding; (b) should section 1.663(a)-2, Income Tax Regs., ⁸ be given effect; and (c) if the regulation is not given effect, should the foundation be treated as a "beneficiary" for the purposes of the distributions deduction?

*49 *173 Before turning to these questions, we deem it appropriate to deal with an addendum to one of petitioners' briefs in which an attempt is made to support the proposition that the distributions to the foundation qualify for the charitable deduction provided for in section 642(c). One of the critical requirements of that section is that the amount in question be paid "pursuant to the terms of the governing instrument." Petitioners seek to bring the payments to the foundation within section 642(c) by latching on to the provision in the decedent's will granting Mrs. O'Connor a general power of appointment "to such persons and/or corporations" as she sees fit. Aside from the fact that Mrs. O'Connor in form never exercised her power of appointment in favor of anyone, the mere reference to "corporations," even if coupled with decedent's knowledge of the existence of the foundation, simply does not meet the test of section 642(c), namely, that the governing instrument (in this case, decedent's will) must contain some manifestation of charitable intent. See Ernest & Mary Hayward Weir Found. v. United States, 362 F.Supp. 928, 939 (S.D.N.Y. 1973), affd. *50 per curiam 508 F.2d 894 (2d Cir. 1974). Cf. Estate of Pickard v. Commissioner, 60 T.C. 618, 622 (1973), affd. without opinion 503 F.2d 1404 (6th Cir. 1974). Accordingly, we now turn to the core questions.

We first direct our attention to the estate's claimed distributions deductions for amounts passed through the marital trust to the foundation. This issue involves an initial determination of whether the marital trust should be recognized for purposes of this proceeding. ⁹

Although respondent has, by virtue of various parts of the stipulation of facts, conceded that the marital trust existed in the sense that distributions from the estate were required, *51 by virtue of New York law, to be made to and through the trustees, he nevertheless contends that the trust was passive under section 7-1.2, New York Estates, Powers & Trusts Law, and is not recognizable for tax purposes.

We find it unnecessary to resolve the status of the marital trust for State law purposes. Even assuming arguendo that throughout the years in question a valid trust ¹⁰*52 existed for *174 purposes of State law, it does not follow that it was a recognizable tax entity. Indeed, we think that by virtue of the operation of section 678 it was not. ¹¹

When a grantor or other person has certain powers in respect of trust property that are tantamount to dominion and control over such property, the Code "looks through" the trust form and deems such grantor or other person to be the owner of the trust property and attributes the trust income to such person. See secs. 671, et seq. By attributing such income directly to a grantor or other person, the Code, in effect, disregards the trust entity. ¹² Income is deemed, therefore, to have been received by the "owner" of the property.

*53 The circumstances in which a person other than a grantor is considered the owner of trust property are set forth in section 678, which provides in part as follows:

SEC. 678. PERSON OTHER THAN GRANTOR TREATED AS SUBSTANTIAL OWNER.

(a) General Rule. -- A person other than the grantor shall be treated as the owner of any portion of a trust with respect to which:

(1) such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself, or

(2) such person has previously partially released or otherwise modified such a power and after the release or modification retains such control as would, within the principles of sections 671 to 677, inclusive, subject a grantor of a trust to treatment as the owner thereof.