Stephenson Trust v. Commissioner

*283 OPINION

These consolidated cases are before us on petitioners' motion for summary judgment pursuant to Rule 121. ¹

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

Christina *44 Bonde Stephenson and Garrick C. Stephenson resided in Virginia and New York, respectively, when they filed the petitions in these cases. Girard Bank maintained its principal office in Pennsylvania when it filed the petitions in these cases.

*284 These cases concern the recognition of multiple trusts as independent taxpaying entities. Two trusts are involved in each case. The respondent determined in each docket, pursuant to section 1.641(a)-0(c), Income Tax Regs. (hereinafter referred to as the consolidation regulation or simply as the regulation), that the two trusts should be consolidated into a single trust.

Petitioners maintain that the consolidation regulation is invalid and that each trust should be respected as an independent entity. They assert that they are entitled to a decision as a matter of law under Estelle Morris Trusts v. Commissioner, 51 T.C. 20 (1968) (Court reviewed), affd. per curiam 427 F.2d 1361 (9th Cir. 1970).

No genuine issue of any material fact is involved in deciding whether the consolidation regulation is valid and whether Morris Trusts applies to these cases. Accordingly, it is proper for us to decide these issues in considering petitioners' motion for summary *45 judgment. Rule 121(b). If we decide that the regulation is invalid and that the Morris Trusts case controls these cases, then the petitioners will be entitled to a decision as a matter of law and their motion for summary judgment will be granted. But if we decide that the regulation is valid, then we must deny petitioners' summary judgment motion because application of the regulation requires review of contested factual issues. Rule 121(b).

By an instrument dated December 14, 1972, Edward L. Stephenson created two trusts: the Edward L. Stephenson Amanda (Amy) Stephenson Trust (hereafter referred to as the Stephenson Simple Trust), and a separate income accumulation trust (hereafter referred to as the Stephenson Accumulation Trust).

The initial corpus of the Simple Trust was 5,000 shares of Procter & Gamble Co. common stock. The Accumulation Trust corpus was composed entirely of distributions received from the Simple Trust and from its own accumulated income.

The trust instrument required the Stephenson Simple Trust to distribute all of its income currently. The trust instrument contained instructions for certain mandatory and discretionary income distributions *46 to Edward L. Stephenson's daughter, *285 Amy Stephenson, and to one other named individual. Income not currently distributed to the named individuals was to be distributed to the Stephenson Accumulation Trust. During the years in issue, the Simple Trust distributed nearly all of its income to the Accumulation Trust.

The trust instrument allowed the Stephenson Accumulation Trust to distribute some or all of its income to Amy Stephenson. Income not distributed to her was added to the Accumulation Trust's principal.

The trustees of both Stephenson Trusts had the power to distribute corpus in certain circumstances. Also, Amy Stephenson was vested with the power to demand and receive, at two specified times, a part of the Simple Trust's corpus. The Accumulation Trust did not contain such a provision. Further, the trust instrument provided for alternative dispositions in case the beneficiaries untimely died. The trustees of both Stephenson Trusts had broad authority to manage the trusts, but the trust instrument directed the trustees to invest primarily in high-grade equities until Amy Stephenson reached age 25.

By an instrument dated June 6, 1969, Mary C. LeBlond created *47 two trusts: the Mary C. LeBlond Procter & Gamble Trust No. 2 (hereafter referred to as the LeBlond Simple Trust), and a separate income accumulation trust (hereafter referred to as the LeBlond Accumulation Trust).

The initial corpus of the Simple Trust was 7,000 shares of Procter & Gamble Co. common stock. The Accumulation Trust corpus was composed entirely of distributions received from the Simple Trust and from its own accumulated income.

The trust instrument required the LeBlond Simple Trust to distribute all of its income currently. The trust instrument contained instructions for certain mandatory and discretionary income distributions to certain of Mary C. LeBlond's grandchildren. Income not currently distributed to the grandchildren was to be distributed to the LeBlond Accumulation Trust. During the years in issue, the Simple Trust distributed most, if not all, of its income to the Accumulation Trust.

The trust instrument allowed the LeBlond Accumulation Trust to distribute some or all of its income to the grandchildren *286 who were named as beneficiaries of the LeBlond Simple Trust. Income not distributed to the grandchildren was added to the Accumulation Trust's principal.

The *48 trustees of both LeBlond trusts had the power to distribute corpus in certain circumstances. Also, the beneficiaries were vested with the power to demand and receive, at two specified times, a part of the Simple Trust's corpus. The Accumulation Trust did not contain such a provision. Further, the trust instrument provided for alternative dispositions in case the beneficiaries untimely died. The trustees of both LeBlond trusts had broad authority to manage the trusts, but the trust instrument directed the trustees to invest primarily in high-grade equities.

Each trust filed a separate return for the years in issue. They reported the following amounts of taxable income and tax liability:

Respondent determined under the consolidation regulation that *49 the separate identity of the accumulation trusts should be disregarded. Accordingly, respondent consolidated the trusts and increased the taxable income and tax liability of the simple trusts as follows:

The Treasury Department promulgated the regulation, under which respondent seeks to consolidate petitioners' trusts, in 1972. T.D. 7204, 1972-2 C.B. 352, 393. The consolidation regulation states:

(c) Multiple trusts. Multiple trusts that have --

(1) No substantially independent purposes (such as independent dispositive purposes),

(2) The same grantor and substantially the same beneficiary, and

(3) The avoidance or mitigation of (a) the progressive rates of tax (including mitigation as a result of deferral of tax) or (b) the minimum tax for tax preferences imposed by section 56 as their principal purpose,

shall be consolidated and treated as one trust for the purposes of subchapter J.

[Sec. 1.641(a)-0(c), Income Tax Regs.]

Petitioners contend that the consolidation regulation is invalid. Petitioners argue that Estelle Morris Trusts v. Commissioner, 51 T.C. 20 (1968)*50 (Court reviewed), affd. per curiam 427 F.2d 1361 (9th Cir. 1970), governs these cases because it held that tax-avoidance motive is irrelevant in determining whether multiple trusts will be recognized for tax purposes.

Respondent maintains that the regulation is valid and that he properly consolidated the multiple trusts in these cases under its authority. Alternatively, if the regulation is held to be invalid, then respondent argues that Morris Trusts is distinguishable from these cases and that we should examine tax-avoidance motive in deciding whether to recognize the multiple trusts as independent entities.

The Commissioner has broad authority to promulgate all needful regulations. Sec. 7805(a); United States v. Correll, 389 U.S. 299, 306-307 (1967). Treasury regulations "must be sustained unless unreasonable and plainly inconsistent with the revenue statutes." Commissioner v. South Texas Lumber Co., 333 U.S. 496, 501 (1948). Regulations, as constructions of the Code by those charged with its administration, "should not be overruled except for weighty reasons." Bingler v. Johnson, 394 U.S. 741, 750 (1969); Commissioner v. South Texas Lumber Co., supra at 501.

*288 Although regulations *51 are entitled to considerable weight, "respondent may not usurp the authority of Congress by adding restrictions to a statute which are not there." Estate of Boeshore v. Commissioner, 78 T.C. 523, 527 (1982). See State of Washington v. Commissioner, 77 T.C. 656 (1981), affd. 692 F.2d 128 (D.C. Cir. 1982). A regulation is not a reasonable statutory interpretation unless it harmonizes with the plain language, origin, and purpose of the statute. United States v. Vogel Fertilizer Co., 455 U.S. 16 (1982); Durbin Paper Stock Co. v. Commissioner, 80 T.C. 252, 257 (1983). Where the statute's provisions are unambiguous, and its directive specific, the Commissioner has no power to amend it by regulation. Koshland v. Helvering, 298 U.S. 441, 447 (1936); Arrow Fastener Co. v. Commissioner, 76 T.C. 423 (1981). ⁴

To evaluate the validity of the consolidation regulation *52 it is essential to review the following developments in the law concerning multiple trusts which preceded the regulation's 1972 promulgation: the use of multiple trusts as permanent income-splitting devices, the 1968 Morris Trusts case which upheld such use of multiple trusts and the 1969 Act which eliminated some, but not all, of the tax benefits associated with multiple trusts. We will review each of these developments in turn.

Generally, trusts are taxed as separate entities under subchapter J of the Internal Revenue Code. Sec. 641(b). However, trusts receive a deduction for amounts distributed or required to be distributed to the beneficiary. Secs. 651, 661. The beneficiary is taxed on amounts received from a trust during a year to the extent of the trust's distributable net income for that year. Secs. 652, 662. Subject to qualifications not relevant here, distributable net income means a trust's taxable income. Sec. 643(a). Therefore, a trust will have no tax *289 liability, and it will exist solely as a conduit, if it distributes or is required to distribute all of its income.

A trust is taxed at its own rates on accumulated income. *53 Sec. 641(a). Under the basic approach of subchapter J (absent application of the throwback rule discussed infra), the following tax consequences occur when a trust makes a distribution which includes some accumulated income: the beneficiary is taxed at his own rates up to the trust's distributable net income for the year of distribution; the beneficiary is not taxed on amounts in excess of the trust's distributable net income. Thus, the accumulated income inures to the beneficiary, tax free. This result allows a permanent income split between the trust and the beneficiary as to the accumulated income. This income split lowers the total tax collected if the trust's effective tax rate is lower than the beneficiary's effective tax rate. Multiple trusts multiply this advantage because they each offer a separate chance to have some income taxed at the lower rates of the progressive rate system.

The 1954 Code enacted the so-called "five-year throwback rule" to modify the basic approach of subchapter J and to lessen the tax advantages of accumulation trusts. See generally Estelle Morris Trusts v. Commissioner, 51 T.C. at 39-40. When applicable, the throwback rule taxed the beneficiary *54 on the receipt of accumulated income as he would have been taxed had he earlier received the income in the year in which the trust received such income. Secs. 665-669.

However, limits and exceptions restricted the throwback rule's effectiveness. The throwback rule only applied to accumulated income earned by the trust during the 5 years immediately preceding the accumulation distribution. Sec. 666(a). Also, the throwback rule did not apply to the following distributions: (1) Income accumulated before the beneficiary attained the age of 21; (2) accumulated income distributed to meet the emergency needs of the beneficiary; (3) the final distribution of the trust if such final distribution was made more than 9 years after the last transfer to the trust; (4) a distribution of accumulated income not exceeding $ 2,000 per year; and (5) certain periodic mandatory distributions under trusts created prior to 1954. Sec. 665(b).

*290 These limits and exceptions made it possible in certain circumstances to avoid the original throwback rule. Accordingly, accumulation trusts remained an effective way to split income, and thus to lower taxes. See, e.g., Friedman & Wheeler, "Effective Use of Multiple *55 Trusts," 16 N.Y.U. Inst. on Fed. Tax. 967, 981-987 (1958). The 1968 Morris Trusts case in effect legitimatized this planning technique by recognizing each multiple trust as a separate taxpaying entity regardless of tax-avoidance motive.

In Morris Trusts, the grantors created 20 trusts by executing 10 instruments. The trusts bought and sold various interests in real property. The dispositive provisions of each trust were identical except for the period for accumulation and termination. Respondent determined that the 20 trusts should be consolidated because the trust instruments did not effectively create 20 separate trusts. Alternatively, the respondent maintained that the multiple trusts should be consolidated under the principle that substance should triumph over form because the grantors created 20 trusts instead of two trusts principally for tax-avoidance purposes. Respondent relied on cases such as Gregory v. Helvering, 293 U.S. 465 (1935), and Knetsch v. United States, 364 U.S. 361 (1960), to support his second argument.

The trust instruments in the Morris Trusts case created 20 separate trusts. We found as a fact that each grantor and trustee was careful *56 to "dot his i's and cross his t's" in respecting the form of 20 separate trusts. 51 T.C. at 45. We held as a matter of law that "a finding of tax-avoidance is simply not enough to invalidate multiple trusts." 51 T.C. at 44. Therefore, we concluded that the separate identity of each of the Morris Trusts would be respected for tax purposes.

Because the Morris Trusts case is central to deciding the cases currently before us, we will carefully review the basis of our holding in that case.

First, we noted that Congress sanctioned income splitting between the beneficiary and a single trust simply by recognizing trusts for tax purposes, generally. We concluded that, in dealing with 20 trusts, we were "concerned here only with a quantitative extension of the advantages of a single trust, a *291 difference in degree; and not with a qualitatively distinct phenomenon, that is a difference in kind." 51 T.C. at 39.

Second, we noted that Congress had not enacted a provision making tax-avoidance motive the touchstone of tax liability in the trust area, although it had done so in other areas such as sections 269, 306, 482, 532 and 1551. "To the contrary," we stated, "since the Revenue Act of 1916, which *57 provided for the first time that trusts would be treated as separate taxable entities, the tax laws have recognized implicitly that trusts may be used as income-splitting devices." 51 T.C. at 39 (fn. ref. omitted).

Third, we determined that motive in establishing and maintaining multiple trusts instead of a single trust was irrelevant for tax purposes. We based this conclusion on the fact that Congress had declined to limit the tax-avoidance utility of multiple trusts despite repeated calls for reform. Following an extensive review of congressional consideration of the multiple trust issue we stated:

In these circumstances the language of the Supreme Court in American Automobile Assn. v. United States, 367 U.S. 687, 697 (1961), is particularly apposite:

"At the very least, this background indicates congressional recognition of the complications inherent in the problem and its seriousness to the general revenue. We must leave to the Congress the fashioning of a rule which, in any event, must have wide ramifications. The Committees of the Congress have standing committees expertly grounded in tax problems, with jurisdiction covering the whole field of taxation and facilities for studying *58 considerations of policy as between the various taxpayers and the necessities of the general revenues. The validity of the long-established policy of the Court in deferring, where possible, to congressional procedures in the tax field is clearly indicated in this case. [n12] * * * [Footnote omitted.]"

See also Commissioner v. Brown, 380 U.S. 563, 578-580 (1965).

We do not intend to imply that we believe congressional inaction here means complete sanction of tax avoidance through multiple accumulation trusts. Rather, we believe the lesson to be learned is that courts should be wary of broad-scale incorporation of the doctrine of "tax avoidance," or "business purpose," or "sham" in an area so fraught with its own particular problems and nuances. At the very least, we are required to limit those judicially developed doctrines to the situations which they were intended to cover.

Given the foregoing legislative background, we think that the "business purpose" test of Gregory and the "economic reality" test of Knetsch, Weller, and Goldstein are inapposite. None of those cases involves a history of detailed consideration by the Congress of the specific problem presented. *292 Indeed, to have *59 allowed the tax benefits sought in those cases would have frustrated the clearly defined legislative purposes of the controlling statutes. Moreover, we know that "business purpose" is often absent in donative dispositions of property through the device of the family trust. Cf. Alden B. Oakes, 44 T.C. 524, 532 (1965). Accordingly, a litmus test of "business purpose" on the part of the grantor will not suffice, and nothing in the legislative history of section 641(b), reviewed above, leads us to believe that tax-motivated trusts necessarily lie outside its plain meaning. Similarly, the continuing individual economic and legal viability of the Morris Trusts preclude the application of the "economic reality" test. Cf. Irvine K. Furman, 45 T.C. 360, 366 (1966), affirmed per curiam 381 F.2d 22 (C.A. 5, 1967).

After careful consideration, we are constrained to reach the conclusion that a finding of tax avoidance is simply not enough to invalidate multiple trusts. * * *

[51 T.C. at 42-44; fn. refs. omitted.]

Fourth, we found support for our conclusion in "the fact that the Supreme Court, in a case decided less than 3 years after Gregory v. Helvering, supra, held that amendments to a trust *60 instrument were effective to create three separate taxable entities despite an express finding by the Board of Tax Appeals that the purpose of the amendments was 'to reduce liability for income taxes on the income of the trust.'" 51 T.C. at 45, citing U.S. Trust Co. v. Commissioner, 296 U.S. 481, 485 (1936).

Based on these four factors we concluded that trusts, like corporations and family partnerships, are not invalidated solely because the creator's principal aim was tax reduction. 51 T.C. at 44. Accordingly, we held that the 20 Morris Trusts would not be consolidated but would be respected as independent taxpaying entities.

The Circuit Court of Appeals in affirming our decision stated: "We adopt the views of the majority of the Tax Court and for the reasons stated in that opinion we affirm the judgments from which these consolidated appeals are taken." 427 F.2d at 1362.

Congress reconsidered the method of taxing trusts and beneficiaries in the Tax Reform Act of 1969, Pub. L. 91-172, 83 Stat. 487 (hereafter referred to as the 1969 Act). The 1969 Act made changes in subchapter J for the following reasons:

The progressive tax rate structure for individuals is avoided *61 when a grantor creates trusts which accumulate income taxed at low rates, and the income in turn is distributed at a future date with little or no additional tax being *293 paid by the beneficiary, even when he is in a high tax bracket. This result occurs because the trust itself is taxed on the accumulated income rather than the grantor or the beneficiary. This means that the income in question, instead of being added on top of the beneficiary's other income and taxed at his marginal tax rate, is taxed to the trust at the starting tax rate. The throwback rule theoretically prevents this result, but the 5-year limitation and the numerous exceptions seriously erode the basic principle that a beneficiary who receives income from property should pay tax on that income at his (rather than the trust's) marginal rates.

This avoidance device is compounded by the use of multiple trusts -- the creation of more than one accumulation trust by the same grantor for the same beneficiary. The splitting of the income among many taxable entities may result in still further reductions of the overall tax burden, since the accumulated income may be taxed to each separate trust at lower rates than would be *62 the case if only one trust were created. ¹Although the use of multiple trusts has been attacked by the Internal Revenue Service, the courts have held that such trusts are valid in some cases.

* * * *

The committee agrees with the House that taxpayers should not be allowed to utilize accumulation trusts to allow the beneficiaries of the trust either to escape paying tax on the income or to substantially minimize their tax on the income. The committee believes that beneficiaries of these accumulation trusts should be taxed in substantially the same manner as if the income had been distributed to the beneficiaries currently as it was earned. Thus, under the House bill and the committee amendments, the beneficiaries of accumulation trusts will be placed in substantially the same tax status as beneficiaries of trusts which distribute their income *63 currently. This approach is essentially the same treatment as has been applicable to foreign accumulation trusts created by U.S. persons since the passage of the Revenue Act of 1962.

See also H. Rept. 91-413, 91st Cong., 1st Sess. (1969), 1969-3 C.B. 200, 258-259; Conf. Rept. 91-782, 91st Cong., 1st Sess. (1969), 1969-3 C.B. 644, 660.

The 1969 Act, among other changes not relevant in this case, eliminated the 5-year limitation and all exceptions to the throwback rule. Sec. 331 of the 1969 Act. As a result, accumulation distributions were to be "treated as if they had been distributed in the preceding years in which income was accumulated, but are includible [on that basis] in income of the *294 beneficiary for the [year of distribution]." H. Rept. 91-413, supra, 1969-3 C.B. at 259; S. Rept. 91-552, supra, 1969-3 C.B. at 505.

The Senate amended the House version of the bill to include an interest charge in the application of the throwback rule. Senate Report 91-552 explains the need for the interest charge as follows:

The committee also modified the House bill to provide an interest charge to cover the tax payments by the income beneficiaries which are deferred by the use of accumulation *64 trusts. This interest charge is based on the additional income tax which the beneficiary would have paid if the income originally had been taxed to the beneficiary instead of the trust. The committee believes that this interest charge is necessary because, otherwise, the deferral of the payment of the additional tax (i.e., from the time the income is taxed to the trust until the time when the remainder of the tax is paid on the accumulation distribution by the beneficiary) amounts, in effect, to an interest-free loan to the beneficiary by the government. [S. Rept. 91-552, supra, 1969-3 C.B. at 504-505. Emphasis added.]

Nonetheless, the conference eliminated the interest charge. Conf. Rept. 91-782, supra, 1969-3 C.B. at 660.

The consolidation regulation was promulgated in 1972 as part of a set of regulations designed to interpret the 1969 Act. T.D. 7204, 1972-