Outwin v. Commissioner

*153 In these consolidated cases, respondent determined deficiencies in petitioners' Federal gift tax for the year 1969 as follows:

*187 The only issue presented for decision is whether certain transfers *154 in trust made by each petitioner during 1969 constituted taxable gifts for purposes of section 2501. ¹

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly. The stipulation of facts and accompanying exhibits are incorporated herein by this reference.

Edson S. Outwin (sometimes hereinafter referred to as petitioner) and Mary M. Outwin are husband and wife and resided in Amherst, N.H., when they filed their petitions in these consolidated cases. Each petitioner filed a gift tax return for 1969 with the Internal Revenue Service at Newark, N.J., on April 15, 1970. The petitioners have been married since 1941 and have three sons and one daughter.

In 1945, Edson S. Outwin went to work for C. R. Bard, Inc. (Bard), a company which manufactured and sold urological products. *188 During his association with Bard, the company prospered and became an important supplier of urological products in this country. Petitioner became a major stockholder and a member of the board of directors. Subsequently, serious disputes concerning the operation of the company arose between petitioner and Harris L. Willets, another major stockholder and member of the board of directors. The hostilities grew worse and at a meeting of the board of directors in 1962, petitioner was removed from his position as an officer of Bard. Thereafter, petitioner resigned from the board of directors, and in 1963, he arranged for a sale of all Bard stock owned by him and his family, including stock which he had gifted to his wife and their four children. After income taxes, the sale netted approximately $ 2,500,000. These funds were transferred to the investment firm of Stein, Roe & Farnham and placed in six individual custody accounts, one each for petitioner, his wife, and each of their four children.

Petitioner's investment adviser at Stein, Roe & Farnham was Henry B. Thielbar, who was also a neighbor and a good friend of the Outwin family. Another friend and adviser to petitioner was*189 Morris H. Bergreen, an attorney whom Mr. Thielbar had *155 introduced to petitioner when his differences with Harris L. Willets began to develop. Both Mr. Thielbar and Mr. Bergreen provided counsel and assistance to petitioner during the troubled times which eventually led to the buyout of his interest in Bard.

In the 5 years following the sale of stock in 1963, petitioner made a number of attempts to reenter the urological supply business. Then, in 1968, he abandoned his efforts and began to take a more active role in the management of the Outwin family investments. After considerable discussion with Mr. Bergreen and Mr. Thielbar, petitioner decided to consolidate the funds placed in the six custody accounts at Stein, Roe & Farnham in order to reduce administrative expenses and permit more efficient asset management. At Mr. Bergreen's suggestion, he decided to employ a family investment partnership as the vehicle for consolidation. Mr. Bergreen's plan called for petitioner to create four irrevocable discretionary trusts and transfer to each an undivided 15-percent interest in his investment account at Stein, Roe & Farnham. The remaining undivided 40-percent interest was*190 to be transferred to a revocable trust. Similarly, Mary M. Outwin was to establish an irrevocable discretionary trust and a revocable trust, to which she would transfer undivided interests in her custody account equal to 60 percent and 40 percent, respectively. The four children were to form a partnership in which their capital contributions would be the balance in their respective custody accounts. Finally, the children's partnership, the two revocable trusts, and the five irrevocable discretionary trusts were to form a partnership to which each partner-entity would contribute its interest in the Stein, Roe & Farnham custody accounts. By consolidating the family portfolio in this manner, petitioners and Mr. Bergreen hoped not only to reduce administrative expenses and increase investment yield, but also to save Federal income taxes and avoid probate on the trust assets upon the death of the settlors.

Subsequent to this proposal, Mr. Bergreen and Mr. Thielbar had various discussions with petitioner, his wife, and their children to discuss the legal and financial ramifications of the family investment company. Since Edson Outwin was no longer actively involved in business, both*191 he and his wife felt that the income from the trust funds would be insufficient to meet their needs and that invasions of corpus would be necessary from time to time. Accordingly, Mr. Bergreen and Mr. Thielbar made it *156 clear that the funds to be placed in his irrevocable discretionary trusts would be made available to him automatically upon his request. Mary Outwin received similar assurances regarding the funds to be placed in her irrevocable discretionary trust. To further allay their fears concerning the proposed transfers in trust, Mr. Thielbar and Mr. Bergreen assured the petitioners that, if at any time they became unhappy with the trust arrangements, the trustees would immediately liquidate the trusts by making discretionary distributions to them of the remaining corpus.

The proposed investment plan was implemented on December 24, 1969. On that date, the following trusts were created by petitioner:

Edson S. Outwin Revocable Trust

Edson S. Outwin Trust No. 1

Edson S. Outwin Trust No. 2

Edson S. Outwin Trust No. 3

Edson S. Outwin Trust No. 4

To each of the four discretionary trusts (Trusts Nos. 1, 2, 3, and 4) petitioner transferred property with a value of $ 335,188.60, *192 or a total value of $ 1,340,754.40. The trustees of the discretionary trusts were Henry B. Thielbar, Morris H. Bergreen, and Mary M. Outwin.

Similarly, Mary M. Outwin created the following trusts:

Mary M. Outwin Revocable Trust

Mary M. Outwin Trust No. 1

To her discretionary trust (Trust No. 1), Mary Outwin contributed property with a value of $ 105,874.87. Henry B. Thielbar and Morris H. Bergreen were named trustees.

At the same time, the Outwin children formed a partnership known as the EHCP Holding Co. The EHCP Holding Co., the two revocable trusts, and the five discretionary trusts then transferred all their assets to a partnership called the Outwin Investment Co. (company).

The trust agreements for the Edson S. Outwin Trust Nos. 1 to 4 and the Mary M. Outwin Trust No. 1 (hereinafter referred to collectively as the discretionary trusts) contain parallel provisions. Each provides that the trust is irrevocable and that the grantor is to be the sole potential beneficiary during his or her *157 lifetime. The grantor's rights to distributions of income or principal are specified in the following articles:

First: Disposition of Income During Life of Grantor

A. During the*193 life of the Grantor, the Trustees shall accumulate the net income of the Trust as received, and at the end of each calendar year shall add such accumulated net income to the principal of the trust, to be administered as part of the principal.

B. Notwithstanding the provisions of Paragraph A of this Article First, subject to Articles Third and Eighth, the Trustees shall have the power, at any time or times, during any calendar year, in the life of the Grantor, prior to the addition of that year's net income to the principal, to pay to, or apply for the benefit of, the Grantor, such part, parts or all of such net income as the Trustees shall determine, in the Trustees' absolute and uncontrolled discretion.

Second: Trustees' Power To Distribute Principal During Life of Grantor

Anything to the contrary notwithstanding, subject to Articles THIRD and EIGHTH, the Trustees shall have the power, at any time or times, in the life of the Grantor, to pay to, or apply for the benefit of, the Grantor, such part, parts or all of the principal of the trust as the Trustees shall determine, in the Trustees' absolute and uncontrolled discretion, for any reason whatsoever, notwithstanding that such payments*194 may result in the termination of the trust.

Certain other provisions pertaining to the trustees' discretionary powers are contained in the eighth article, which provides in relevant part:

Eighth: Trustees' Discretionary Powers Over Income and Principal

* * * *

B. Payments and applications may be made without regard to beneficiary's independent resources.

The Trustees, in determining the amount of income or principal to be paid or applied to, or for the benefit of, any beneficiary under applicable Articles First through Sixth of this Agreement, are authorized, in the Trustees' discretion, to disregard or not to take into consideration such beneficiary's other resources, the amount of such beneficiary's independent property, or the extent to which such beneficiary may be entitled to support by a parent or any other person.

Any decision of the Trustees with respect to the exercise of the Trustees' discretionary powers, made in good faith, shall be a full and absolute protection to the Trustees and shall be conclusive and binding upon all persons interested in any trust created under this Agreement.

The third article of each trust agreement*195 provides that no distributions may be made by the trustees pursuant to the first *158 or second articles without the prior written consent of the grantor's spouse in his or her individual capacity. Under the fourth article the grantor's spouse is also named as a second income beneficiary of the trust. In the event the second income beneficiary survives the grantor, he or she becomes entitled to mandatory distributions of the trust income on at least an annual basis. The trust corpus, on the other hand, is to be distributed to such person only in the absolute and uncontrolled discretion of the trustees. In addition, the second income beneficiary is given a special testamentary power of appointment over the corpus remaining at his or her death.

The 20th article of each trust provides for a committee of the trust comprised of the second income beneficiary and up to two additional members whom he or she may designate. The committee is authorized to remove any trustee with or without cause and appoint additional or successor trustees. Upon the death of the second income beneficiary, the committee may also designate a person or persons whose written consent must be obtained prior*196 to any distributions to the grantor under the first or second articles. The foregoing powers vested in the committee are required to be exercised in a fiduciary capacity.

The assets transferred to petitioners' revocable and discretionary trusts consisted primarily of the funds in their investment accounts at Stein, Roe & Farnham. With the exception of their personal residence, some stock, and certain other real estate, virtually all of the petitioners' assets were placed in these trusts.

From 1971 through 1978, petitioner and his wife received salaries from the company in the amounts of $ 38,000 and $ 12,000, respectively. To supplement their income petitioner also withdrew considerable sums from the company in the form of loans. These loans, which averaged at least $ 5,000 per month, plus additional amounts when necessary, were unsecured and bore no interest. All loans were recorded on the books of the company as loans to the Edson S. Outwin Revocable Trust. The trust, in turn, established on its books a liability to the company for the amount of the advances and then distributed the funds to petitioner. During the period from 1970 to 1978, petitioner's withdrawals from the*197 company in this manner were as follows: *159

Since their formation, the Edson S. Outwin discretionary trusts have made no distributions or loans to petitioner. Consequently, Mary M. Outwin has never exercised her veto power over such distributions. Similarly, Mary M. Outwin has received no distributions or loans from her discretionary trust and petitioner has had no occasion to exercise his veto power.

The discretionary trust agreements provide that *198 the trusts are to be administered and construed according to Massachusetts law.

On December 2, 1976, respondent issued statutory notices of gift tax deficiency for 1969 to each petitioner in the amount of $ 167,895.09. In each case, the additional gift tax was determined on one-half of the combined value of the assets contributed to the Mary M. Outwin Trust No. 1 and the Edson S. Outwin Trust Nos. 1 to 4.

OPINION

We must decide whether the transfers by the petitioners to their respective discretionary trusts in 1969 constituted completed gifts subject to tax under section 2501. The gift tax *160 provisions of the Internal Revenue Code do not define the term "completed gift" ² but it is well settled that a conveyance in trust will not be subject to gift tax where the donor retains dominion and control over the property transferred. Estate of Sanford v. Commissioner, 308 U.S. 39 (1939); Burnet v. Guggenheim, 288 U.S. 280 (1933); Estate of Mandels v. Commissioner, 64 T.C. 61 (1975); Hambleton v. Commissioner, 60 T.C. 558 (1973); Estate of Holtz v. Commissioner, 38 T.C. 37 (1962);*199 sec. 25.2511-2(b), Gift Tax Regs. In the present cases, the discretionary trusts are irrevocable under the terms of the written trust agreements. In each instance, the grantor may receive lifetime distributions of trust income or corpus only in the "absolute and uncontrolled discretion" of the trustees. The trustees are empowered to distribute the entire corpus to the grantor even though such distribution results in the termination of the trust. Additionally, the trust agreements require the grantor's spouse to give his or her prior written consent in an individual capacity to any such distributions. Upon the death of the grantor, the surviving spouse acquires the right to mandatory distributions of trust income on at least an annual basis, plus distributions of principal in the unfettered discretion of the trustees. The grantor's spouse is also given a special testamentary power of appointment over the trust corpus. Under these circumstances, we must decide whether petitioners have sufficiently parted with dominion and control over their property so as to qualify the transfers as completed gifts.

*200 Petitioners contend that no completed gifts resulted because the trustees of the discretionary trusts had orally agreed prior to the execution of the written agreements to (1) distribute the trust income or corpus whenever the grantors requested such funds, and (2) terminate the trusts upon their request by making liquidating distributions of all the remaining corpus. Consequently, petitioners maintain that they never relinquished dominion and control over the property transferred. In the alternative, they argue that under Massachusetts law the creditors of a grantor-beneficiary of a discretionary trust can reach the assets of the trust for satisfaction of their claims, *161 notwithstanding the veto power over discretionary distributions vested in the grantor's spouse. Accordingly, they contend that the gifts are incomplete under the principle established in Paolozzi v. Commissioner, 23 T.C. 182 (1954).

Respondent contends that the evidence is insufficient to prove the existence of the oral agreements alleged by the petitioners, and that, even if such agreements did exist between the grantors and the trustees, there was no agreement between the*201 grantors (petitioners) which would restrict the right of either grantor to veto distributions from the other's discretionary trust(s). Respondent further argues that the transfers in trust were completed gifts under sections 25.2511-2(b) and 25.2511-1(g)(2), Gift Tax Regs., ³ since there are no fixed or ascertainable standards enforceable by or on behalf of the grantor which limit the trustees' discretion to make distributions. Finally, respondent *162 contends that under Massachusetts law the assets of a discretionary trust cannot be subjected to the claims of the grantor's creditors where (1) distributions are subject to the approval of the grantor's spouse, who is also a secondary beneficiary, and (2) there are no enforceable standards to limit the trustees' discretion in making such distributions. Thus, respondent maintains that the rule of law in Paolozzi is inapplicable. We hold for petitioners.

*202 Where the trust agreement specifies, as here, that distributions to the settlor are to be made in the absolute discretion of the trustees, with no enforceable standard provided, the transfer is generally held to be complete for gift tax purposes. Herzog v. Commissioner, 116 F.2d 591 (2d Cir. 1941); Rheinstrom v. Commissioner, 105 F.2d 642 (8th Cir. 1939); Estate of Holtz v. Commissioner, 38 T.C. 37, 42 (1962); sec. 25.2511-2(b), Gift Tax Regs. Cf. Commissioner v. Irving Trust Co., 147 F.2d 946 (2d Cir. 1945); Estate of Toeller v. Commissioner, 6 T.C. 832 (1946), affd. 165 F.2d 665 (7th Cir. 1948). A different result obtains, however, where State law permits creditors of the settlor-beneficiary to pierce the trusts for satisfaction of claims.

In Paolozzi v. Commissioner, 23 T.C. 182 (1954), the taxpayer created a trust under the terms of which the trustees were authorized to pay her so much of the trust income as they in their absolute discretion determined to be in her best*203 interest. Upon her death, the trust assets were to be distributed to her issue. She reported a taxable gift when the trust was established in an amount equal to the value of the assets transferred reduced by the value of a life estate for an individual her age. Respondent determined that the amount of the gift should be undiminished by the value of the life estate since her interest in the trust income was at best an expectancy, and not susceptible of valuation by actuarial methods. This Court rejected respondent's determination on the ground that, under Massachusetts law, the creditors of a settlor-beneficiary of a discretionary trust could reach for satisfaction of claims the maximum amount which the trustee could pay to the settlor or apply for her benefit. Thus, we concluded that the taxpayer could at any time obtain the economic benefit of the trust income simply by borrowing and then forcing her creditors to look to her interest in the trust income for a source of repayment. On this basis, we held that the gift was incomplete to the extent of the value of *163 her life estate. Accord, Vander Weele v. Commissioner, 27 T.C. 340, 343-344 (1956),*204 affd. 254 F.2d 895 (6th Cir. 1958) (involving Michigan law). See also Estate of Holtz v. Commissioner, 38 T.C. 37, 42 n. 3 (1962); Herzog v. Commissioner, 116 F.2d 591 (2d Cir. 1941) (reaching a contrary result under New York law); Rev. Rul. 76-103, 1976-1 C.B. 293. Cf. Hambleton v. Commissioner, 60 T.C. 558, 565-566 (1973).

Under the rule of Paolozzi, then, we must determine whether the assets of the Edson S. Outwin and Mary M. Outwin discretionary trusts could be subjected to the claims of the grantor's creditors under Massachusetts law, which governs the interpretation and administration of the trusts.

The general rule in this country regarding the rights of creditors of a settlor-beneficiary of a discretionary trust is expressed in 1 Restatement, Trusts 2d, sec. 156(2) (1959): "Where a person creates for his own benefit a trust for support or a discretionary trust, his transferee or creditors can reach the maximum amount which the trustee under the terms of the trust could pay to him or apply for his benefit." An*205 example of the application of this rule is set forth in E. Griswold, Spendthrift Trusts, sec. 481 (2d ed. 1947):

§ 481. Discretionary trusts. The settlor may attempt to retain a beneficial interest free from the claims of his creditors, by giving his property to a trustee and investing the trustee with complete discretion to decide whether the income shall be paid to him and, if so, how much of it. Thus, A may convey property to T on trust to pay to A during A's life so much of the income as in T's uncontrolled discretion he deems wise, with a provision that on A's death the principal and any accumulated income shall be conveyed to B. The remainder, so far as the principal is concerned, being a present vested remainder in B and not subject to A's control, is beyond the reach of A's creditors, unless the transfer is a fraudulent conveyance. Does the fact that the trustee is given discretion over the disposition of the income exempt the income, likewise, from the claims of creditors? The courts have very properly held that in such a case creditors of the settlor may reach the entire income from the trust property during his life. A person can not settle his own property so that*206 it will be free from the claims of creditors and yet retain the right to receive the income, if it is paid to any one, during his lifetime. [Fn. ref. omitted.]

See also 2 A. Scott, Trusts, sec. 156.2 (3d ed. 1967); G. Bogert, Trusts & Trustees, sec. 228 (2d ed. 1965).

The Supreme Judicial Court of Massachusetts formally adopted this general rule in Ware v. Gulda, 331 Mass. 68, 117 N.E.2d 137 (1954). In that case, the settlor established a trust which *164 provided for payments of income or principal for her support and maintenance in the sole discretion of the trustee. During her lifetime, she was the sole potential beneficiary; upon her death, the property was to go to her two daughters and her son, who was also the named trustee. An attorney brought suit against the settlor for the purpose of collecting past-due legal fees and won a court order directing the Second National Bank of Boston, which became a successor trustee following the death of the settlor's son, to pay the claim out of the trust assets. Following an appeal by the bank, the Supreme Judicial Court upheld the order and offered the following explanation (117 N.E. 2d at 138):*207

The substance of what happened is this. Louise with her own property created a trust of which she was, for her lifetime, to be the sole beneficiary, if there was to be one at all. The decision as to making or withholding payments, as to both principal and income, was to be entirely in the discretion of the trustee. She was to be incapable of making an assignment of any interest in the trust property, which was intended to be beyond the reach of creditors. At the moment there is no amount which the trustee has exercised its discretion to pay to Louise, although in the past it has made payments to her both of principal and of income.

Merely because the trustee has not exercised the discretionary power conferred upon it by Louise seems to us to be an insufficient ground to distinguish this case in principle from the rule of years' standing we recently restated in Merchants National Bank v. Morrissey, 329 Mass. 601, 605, 109 N.E.2d 821, 823: "The established policy of this Commonwealth long has been that a settlor cannot place property in trust for his own benefit and keep it beyond the reach of creditors. Pacific National Bank v. Windram, 133 Mass. 175;*208 Jackson v. Von Zedlitz, 136 Mass. 342; Taylor v. Buttrick, 165 Mass. 547, 551, 43 N.E. 507; Forbes v. Snow, 245 Mass. 85, 89, 140 N.E. 418."

The rule we apply is found in Restatement: Trusts, § 156(2): "Where a person creates for his own benefit a trust for support or a discretionary trust, his transferee or creditors can reach the maximum amount which the trustee under the terms of the trust could pay to him or apply for his benefit." It has substantial support in authority. Greenwich Trust Co. v. Tyson, 129 Conn. 211, 224, 27 A.2d 166; Warner v. Rice, 66 Md. 436, 8 A. 84; Hay v. Price, 15 Pa.Dist.R. 144; Menken Co. v. Brinkley, 94 Tenn. 721, 728-729, 31 S.W. 92; Petty v. Moores Brook Sanitarium, 110 Va. 815, 817, 67 S.E. 355, 27 L.R.A., N.S., 800; Scott, Trusts, § 156.2; Griswold, Spendthrift Trusts (2d ed.) § 481. See Am. Law of Property, § 23.18. Although every exercise*209 of the power might take property away from the remaindermen, that is no objection where the trustee could pay the entire principal to the creator of the trust.

[Emphasis added.]

Thus, the Massachusetts Court held that creditors of the settlor-beneficiary could reach the trust assets despite the fact that under the terms of the trust instrument, distributions by *165 the trustee to, or on behalf of, the settlor were completely within its discretion, and even though the interests of the remaindermen beneficiaries would be adversely affected by such action. See also State Street Bank & Trust Co. v. Reiser, 7 Mass. App. Ct. 633, 389 N.E.2d 768 (1979). The Gulda decision provided the basis for our holding in