Court Opinion

ID: 4630528
Source: CourtListenerOpinion
Date Created: 2020-11-21 03:07:39.822771+00
Date Added: 2024-06-11T07:59:26.895188
License: Public Domain

SUSAN B. ARMSTRONG, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Armstrong v. CommissionerDocket No. 82552.United States Board of Tax Appeals38 B.T.A. 658; 1938 BTA LEXIS 840; September 29, 1938, Promulgated *840  Petitioner was the life beneficiary of a testamentary trust created by her husband which, in the taxable year in question, received $88,200,35 interest which had been accrued but unpaid on certain notes held by the trust.  The executors of the estate theretofore had received the notes as a principal asset of the estate, and had transferred one of them of the face amount of $25,000, plus interest, for the sum of $26,522.30, which sum was entered in their books and reported by them as income when received.  In lieu of the note thus transferred the executors placed in their principal account an assignment of accrued interest on the remaining notes from income to capital account.  In the executors' accounting, filed with the Surrogate's Court for the City of New York, the $26,522.30 was entered as income and the assignment of accrued interest was accounted for by the executors as part of the principal assets.  Their accounting was judicially settled and approved by the Surrogate's Court.  Upon the receipt of the above mentioned $88,200.35 interest the trustees treated $25,000 thereof as principal and redeemed the assignment.  The trustees' intermediate accounting filed with the New York*841  court of proper jurisdiction included the assignment of $25,000 as a principal asset and showed their redemption thereof.  This intermediate accounting was similarly approved by the court of proper jurisdiction.  Held:(1) The payment in 1932 was, to the extent of $25,000, a restoration of capital and not income to the beneficiary.  (2) The decree of the Surrogate's Court determining the status of the 1932 payment to the extent of $25,000 as a return of capital is conclusive.  Following Freuler v. Helvering,291 U.S. 35">291 U.S. 35; Blair v. Commissioner,300 U.S. 5">300 U.S. 5. George A. Wilson, Esq., and Paul L. Peyton, Esq., for the petitioner.  J. R. Johnston, Esq., for the respondent.  VAN FOSSAN *658  This proceeding was brought to redetermine a deficiency in the income tax of petitioner for the calendar year 1932 in the sum of $14,000.  The sole issue of the case is whether an amount of $25,000 actually received by the trustees of a testamentary trust upon certain notes *659  within the year 1932, as hereinafter set forth, was income to the trust distributable to petitioner, the life beneficiary thereof, *842  and taxable to her as income for the year 1932.  The case was submitted on a stipulation of facts and the introduction of an additional exhibit.  FINDINGS OF FACT.  The facts were stipulated substantially as follows: Petitioner is an individual residing in New York City and is the widow of Frederick S. Armstrong, who died April 16, 1930, a resident of the City, County, and State of New York.  This decedent left a last will and testament, which was duly admitted to probate by the Surrogate's Court, New York County, on May 7, 1930.  Paragraph tenth of the will provides in part as follows: TENTH: All the rest, residue and remainder of my estate of whatsoever nature and wheresoever situate, including any interest which I may have in the estate of another, or with respect to which I may now have or may hereafter have power of appointment, I give, devise and bequeath unto my said wife, Susan B. Armstrong, and the Bankers Trust Company of New York City, to have and to hold the same in trust, however, during the life of my wife Susan B. Armstrong, to and for the uses and purposes hereinafter mentioned, viz: In invest and keep invested the same, and to collect and receive the*843  rents, interest, income, dividends, issues and profits thereof, and, after paying from said income all taxes and lawful expenses, to pay over the said net income to my said wife during her life in quarterly installments, or oftener * * *.  * * * Upon the death of my said wife, I direct that my said trustees divide the capital of the said trust estate into two equal shares and pay over absolutely one of such shares to my daughter Susanne Armstrong and another of such shares to my daughter Mary Elizabeth Armstrong.  In the event that either of my said daughters shall die in the life time of my said wife, then I direct that the share of my said estate, which would have been payable to such daughter had she survived her mother, be paid absolutely, upon my said wife's death, to the issue of such daughter, or in default of such issue to my other daughter, or to her issue if she be not then living.  Petitioner and the Bankers Trust Co., a New York corporation, were named as executors and trustees under the will and duly qualified as such.  At the time of his death Frederick S. Armstrong had a one-third interest in the partnership of L. W. and P. Armstrong which was engaged in business*844  in the city of New York as sugar brokers and commission merchants, and the principal asset of his estate consisted of his interest in that partnership.  The assets which came into the hands of the executors were valued at $1,733,892.30, of which amount $1,029,039.91 represented the value of decedent's interest in the above *660  named partnership.  At the time of Armstrong's death the largest part of the assets of the partnership consisted of an open account receivable from the Fajardo Sugar Co. of Puerto Rico and its affiliated companies, for which notes (hereinafter sometimes referred to as the Fajardo notes) were subsequently given to the partnership on or about July 1, 1930, for the principal sum of $1,327,742.24, being the amount of the account receivable, plus accrued interest thereon to that date.  These Fajardo notes, which were dated July 31, 1930, were payable on demand, bore interest at the rate of 6 percent compounded semiannually, and contained the provision that the notes are "each and all equally and ratably alike secured, without preference or priority among themselves, or of principal over interest or of interest over principal, either by reason of prior issue*845  or negotiation or of prior demand for payment or for any other reason * * *." The Fajardo notes were subordinated to a certain indebtedness owing by the Fajardo Sugar Co. to the National City Bank of New York and could not be paid either as to principal or interest until that indebtedness had been satisfied in full.  At the date of Armstrong's death the partnership of L. W. and P. Armstrong did not have sufficient cash or liquid assets to satisfy in full decedent's interest therein, and the executors did not deem it advisable to continue under any plan which would make them partners in the business of the new partnership of the same name which became successor, upon Armstrong's death, to the old partnership and was composed of the surviving members of the old partnership.  In connection with the liquidation of the interest of Armstrong in the partnership of L. W. and P. Armstrong an agreement in writing was entered into on June 29, 1931, between the executor and trustees, the surviving members of the old partnership, and the members of the new partnership.  This agreement provided, among other things, for the transfer to the executors of 29 of the Fajardo notes, numbered 1 to*846  29, inclusive, in the face amount of $25,000 each, and one numbered 54 in the face amount of $2,742.24, the aggregate face amount of all the notes being $727,742.24.  The transfer so provided for was subsequently made.  The Fajardo notes constituted a substantial portion of the estate of Armstrong and, since the notes could not be paid either as to principal or interest until the indebtedness of the Fajardo Sugar Co. to the National City Bank of New York had been satisfied in full, the executors deemed it imperative, in order to provide the estate with cash which could be distributed as income to the life beneficiary, to work out some arrangement under which the new partnership would be obligated to pay a certain annual amount on account of any interest *661  accrued but unpaid on the Fajardo notes, such payments to continue during the period that the Fajardo Co. itself was unable to make the annual interest payments or until demand had been made for the payment of the notes.  It was, therefore, provided in the agreement that the new partnership would pay to the executors on July 31 of each year, on account of the interest then accrued and then unpaid on the Fajardo notes held*847  by the estate, an amount in cash equal to and which should be measured by the face amount of one of such notes in the sum of $25,000, plus interest thereon to the time of such payment, the first such payment to be made on July 31, 1931.  The agreement further provided that in consideration for each such payment of accrued interest the estate would execute and deliver at the time of such payment an assignment to the new partnership of all right to receive and collect the amount of accrued interest so paid to the estate by the new partnership and any interest on such interest to which the estate was entitled as holder of the Fajardo notes, or, at the option of the new partnership in lieu of such an assignment, to deliver to the new partnership one of the Fajardo notes in the face amount of $25,000, plus accrued interest thereon.  In accordance with the terms of the above mentioned agreement of July 29, 1931, the new partnership paid to the executors of the estate on July 31, 1931, the sum of $26,522.30 on account of interest then accrued and unpaid on the Fajardo notes held by the estate.  In lieu of taking an assignment of accrued interest in that amount from the estate, the new*848  partnership, in accordance with the option given to it under the agreement, elected to and did take from the executors one of the Fajardo notes in the face amount of $25,000 on which interest of $1,522.30 had accrued.  The executors entered this payment of $26,522.30 as income upon their books of account.  As of July 31, 1931, the interest accrued and unpaid on the Fajardo notes held by the executors amounted to approximately $43,664.  On that date the executors executed an assignment transferring and setting over unto the principal account of the estate from income account all interest then accrued and unpaid on the Fajardo notes to the extent of $25,000, the assignment stating that such accrued interest as and when paid by the Fajardo Sugar Co. to the extent of $25,000 thereof should be held as principal and not distributed as income.  The executors established a fiscal year ending March 31 as the accounting period for the estate of Frederick S. Armstrong, deceased, and duly filed a fiduciary return of income for the fiscal year ended March 31, 1932, including therein as income the above mentioned sum of $26,522.30 paid to the executors on July 31, 1931, by the new partnership*849  of L. W. and P. Armstrong.  *662  The gross income collected by the executors, if the amount of $26,522.30 be included, during the period January 1 to November 19, 1931, both dates inclusive, on which latter date substantially all the assets remaining in their hands were turned over to themselves as trustees, was $43,920.38.  During the calendar year 1931 the executors paid to or for the account of petitioner, as beneficiary of the estate of Frederick S. Armstrong, deceased, the sum of $20,359.06.  This amount of $20,359.06 was duly reported by petitioner in her return of income filed for the calendar year 1931.  In the executors' account of proceedings, verified on November 25, 1931, and filed with the Surrogate's Court for the County of New York, the amount of $26,522.30 was entered as income received in the "Statement Showing All Income Collected", as follows: From L. W. and P. Armstrong, on account of interest on notes of Fajardo Sugar Company in accordance with agreement of June 29, 1931 (See Schedule "L") - $26,522.30.  The assignment of accrued interest from income to principal account was accounted for by the executors as part of the principal assets of the*850  estate and the assignment, together with the remaining Fajardo notes, was taken charge of as principal by the executors in their capacity as trustees under the will of the decedent on November 19, 1931.  Under date of December 17, 1931, the duly appointed special guardian for Beverly Randolph Shriver, Jr., an infant grandson of the decedent and contingent remainderman under the will of the decedent, filed his report with the Surrogate's Court in the matter of the judicial settlement of the account of proceedings of the executors under the last will and testament of the decedent, stating that it was "to the best interest of his ward that the Account of petitioners be finally judicially settled; and that all acts of the petitioners - especially with regard to the liquidation of the interest of the decedent in L. W. and P. Armstrong and the agreement in connection therewith, dated June 29, 1931, be approved * * *." All persons having an interest in the estate were duly served with or waived citation.  No objections were made to the account rendered by the executors and the account of proceedings was judicially settled and approved by the Surrogate for the County of New York in his*851  decree of February 10, 1932.  On or about July 30, 1932, the trustees of the trust under paragraph tenth of the will of the decedent as above set out received from the Fajardo Sugar Co. $88,200.35, being the full amount of interest then due and unpaid on the Fajardo notes which had been transferred and delivered to them by the executors on November 19, 1931.  *663  Pursuant to the terms of the assignment and consistent therewith the trustees treated $25,000 of the aforesaid payment as principal and made the following entries in their books of account: ARMSTRONG ESTATE - SUSAN B. ARMSTRONG TRUSTJuly 30, 1932. - Interest at 6% compounded semi-annually from7/31/30 to 7/31/32 on $702,742.24 principal amount of FajardoSugar Co. demand notes dated 7/31/30(Credit income)$88,200.35Aug. 1, 1932. - To redeem assignment from income to principal onaccount of accrued interest unpaid on note of Fajardo Sugar Co. of Porto Rico and Loiza Sugar Co. dated 7/31/30(Charge income)$25,000.00(Credit principal)25,000.00In the trustees' intermediate account of the proceedings, verified on February 5, 1937, and filed with the Surrogate for the County of New York, *852  the assignment of $25,000 was included as a principal asset in the "Statement Showing All Principal Assets Received." Likewise, the redemption of the assignment of $25,000 was shown in the accounting in the "Statement Showing All Principal Assets Sold, Liquidated and Distributed." Under date of March 12, 1937, the duly appointed special guardian for Beverly Randolph Shriver, Jr., and Suzanne Crocker, infant grandchildren of the decedent and contingent remaindermen of the trust, filed his report with the Surrogate's Court for the County of New York in the matter of the judicial settlement of the intermediate account of proceedings of the trustees, approving the accounts of the trustees in so far as the interests of his wards were concerned.  All persons having an interest in the trust were duly served with or waived citation, and the intermediate account of proceedings was judicially settled and approved by the Surrogate for the County of New York in his decree of March 31, 1937.  The trustees established the calendar year as the accounting period for the trust under article tenth of the will of the decedent, and duly filed a fiduciary return of income for the calendar year 1932. *853  The trustees included as income in this return $63,200.35 of the payment of $88,200.35 received as aforesaid from the Fajardo Sugar Co. on July 30, 1932, but did not include as income in this return the balance of the payment, $25,000, credited to principal as above stated.  On the audit of this return, the Commissioner increased the income of the trust by the amount of $25,000.  The return of the trustees for the year 1932 was received in evidence and shows all income as distributed to the beneficiary.  Petitioner duly filed her individual income tax return for the calendar year 1932 and reported as taxable income her distributive *664  share of income from the trust as shown by the fiduciary return for the calendar year 1932.  The respondent increased the amount of petitioner's distributive share of the income from the testamentary trust by $25,000, and included this additional sum in her taxable income for the year in question, thus arriving at the deficiency here contested.  The pertinent statute is shown in the footnote. 1*854  OPINION.  VAN FOSSAN: The sole question presented by the above facts is whether the payment of $25,000 of the sum of $88,200.35 received by the trustees on July 30, 1932, from the Fajardo Sugar Co., represented a return of capital and, therefore, not income to the trust to be distributed currently to petitioner.  Respondent contends that the transaction of July 31, 1931, transferring the $25,000 Fajardo note and accrued interest thereon to the new firm for $26,522.30 in cash was in fact a purchase and sale of this note.  On this premise he urges that the proceedings were highly irregular and totally without the authority of the executors and trustees.  He further urges that the restoration of the sum in question by the redemption of the assignment in the taxable year in question does not in any way affect petitioner's tax liability on the income because the entire amount of the $88,200.35 payment received by the trustee on July 30, 1931, from the Fajardo Sugar Co. was income to the trust distributable to petitioner.  Petitioner's contention with respect to this phase of the case is that the transaction was entirely regular and unquestionably made the payment by the Fajardo*855  Co. a return or redemption of capital to the extent of $25,000.  The nature of the July 31, 1931, transaction becomes important in determining the status of the subsequent redemption of the assignment *665  of accrued interest in 1932, and a short resume of the facts will be helpful.  A substantial part of the assets of decedent's estate was comprised of his interest in the partnership and, in turn, the partnership's largest asset was the account receivable from the Fajardo Sugar Co., for which notes were given in the full amount of the account, plus interest to date.  The estate had no desire to become a member of the new partnership and the partnership did not have sufficient cash to liquidate the estate's interest.  An agreement was therefore entered into whereby a group of the Fajardo notes were transferred to the estate and the new partnership agreed that it would pay the estate annually, on account of the interest then accrued and unpaid on the Fajardo notes held by the estate, cash in an amount equal to the face amount of one of the notes ($25,000), plus interest to the time of payment.  In return the estate either was to make an assignment to the new partnership of*856  the right to receive the interest thus paid, or, at the option of the new partnership, was to deliver one of the Fajardo notes to it.  Upon payment under this agreement on July 31, 1931, the new partnership exercised its option and received one of the notes theretofore held by the estate.  From these facts respondent contends that the transaction between the estate and the new partnership is a purchase and sale; and that the estate has, in effect, sold and distributed a portion of its principal.  The argument is that the cash received from the transaction was cash paid for a principal asset of the estate, a Fajardo note, and that it must necessarily be impressed with the same character.  If this argument presented the entire picture of the transaction, the above conclusion might follow.  There are further considerations, however, which, in our view, alter the situation.  In the first instance, the new partnership was, in effect, guaranteeing the partial payment of interest on the notes; and, secondly, by the agreement and the subsequent treatment and disposition thereof, the cash was paid and received as interest on the notes.  We believe these facts fixed the character of*857  the transaction.  The fact that the partnership exercised its election to take a note in lieu of an assignment of interest does not change the character of the payment to the estate.  The cash did not come into the hands of the executors in lieu of their capital asset, the Fajardo note - the cash came to them as interest.  What came to them as a capital asset in lieu of the note was the assignment to the principal account from income account of all interest then accrued and unpaid on the Fajardo notes to the extent of $25,000.  It was this assignment which took care of the otherwise impaired principal account.  The notes were equally secured as to principal and interest, so the assignment in the principal account of accrued and unpaid interest was of equal dignity to a claim for the face amount of the *666  notes themselves, and the estate in no wise was prejudiced by the transaction.  When viewed in the full light of all the facts the entire transaction speaks of neither a purchase and sale, nor of a borrowing with the posting of collateral.  It is what it purports to be, i. e., a guarantee and payment thereunder of interest accrued and unpaid.  The assignment of accrued*858  interest stood as much a part of the principal of the estate as any other of its assets and it was the duty of the trustees to apply money received on account of interest to the extent of $25,000 to the redemption of the assignment.  Such money had theretofore been impressed with the character of capital and upon its receipt was capital.  Under the circumstances it was not and could not be income distributable to petitioner beneficiary.  Recognizing, as we do, the above status for the interest paid in 1932 to the extent of $25,000, we do not find ourselves in accord with the contention by respondent that petitioner possessed the right to receive the interest to the extent of $25,000 and that the redempti0n in effect was for the benefit of petitioner and in settlement of an obligation on her part to replace the impaired capital.  If there be any doubt as to the above construction of the facts, there is a further reason why petitioner should prevail.  The decrees entered by the Surrogate's Court are conclusive of the issue presented here.  The stipulated facts show that the Surrogate's Court for the County of New York, having jurisdiction of the estate and testamentary trust, has*859  twice approved all the transactions involved in this manner of handling the estate and trust.  By court decree the action of the executors in treating the payment of July 31, 1931, as income when received, and in turning over to the trustees as a principal asset the assignment of accrued interest, was approved.  And subsequently, by court decree, the intermediate accounting of the trustees determining the payment of $25,000 in 1932 to be a receipt of principal, was also approved.  The decrees of that court are final and conclusive of these questions and are binding upon this Board.  It is a well recognized rule that where the question involved is the meaning of a revenue law the will of Congress controls over local law.  The obvious reason for this rule is to effect an interpretation of Federal statutes of uniform application to a nation-wide scheme of taxation.  . Where applicable, this principle is controlling, but when the legislative will is dependent upon facts which can be interpreted only in accordance with a state rule of property, the state rule must then prevail.  Included in this category of state or local determinations*860  which are *667  controlling in Federal tax matters, are rules governing the construction of wills, and administration of estates and testamentary trusts.  In our opinion the present case is within this last mentioned limitation on the rule and the decrees of the Surrogate's Court determining the status of the 1932 payment, to the extent of $25,000, are binding upon this Board.  Respondent strongly urges the contrary because no actual contest was presented to the surrogate.  There is, however, no evidence of collusion in the present case; all interested and necessary parties were represented and from the nature of the proceeding the court's approval and decree must conclude the matter.  The particular subjects now in issue were directly before the court and were specifically discussed in the report of the special guardian for the infant remainderman.  The leading case on the conclusiveness of a determination by a local court concerning the amount distributable to the beneficiaries under a trust, is . It was there held that the decree of the state court was binding.  The Court said: * * * The decision of that court, *861  until reversed or overruled, establishes the law of California respecting distribution of the trust estate.  It is none the less a declaration of the law of the state because not based on a statute, or earlier decisions.  The rights of the beneficiaries are property rights and the court has adjudicated them.  What the law, as announced by that court, adjudges distributable is, we think, to be so considered in applying section 219 of the Revenue Act of 1921.  In that case it was argued that the proceeding in the state court was a collusive one, but this argument was rejected in view of the record in the state court.  The Court said: * * * The case appears to have been initiated by the filing of a trustee's account, in the usual way.  Notice was given to the interested parties, Objections to the account were presented, and the matter came on for hearing in due course, all parties being represented by counsel.  The decree purports to decide issues regularly submitted and not to be in any sense a consent decree.  A case following the principle of *862 , and possibly closer to the present factual situation, is that of  (C.C.A., 9th Cir.), affirming . In that case the trustees filed their account showing therein the sum of over $6,000,000 received by them as trustees during the taxable year and the distribution by them of a sum of over $1,000,000 as net income to the beneficiaries of the trust.  The trustees prayed for and obtained from the local court having jurisdiction over the matter an order "approving, allowing, and settling said account." The Federal court, in arriving at its decision, followed the rule enunciated in the Freuler case, supra, and said: Whether, under the will, income received by the trust was or was not currently distributable, was to be determined, in the first instance, by the *668  trustees themselves and, finally, by the state court having jurisdiction of the trust.  Petitioner and his cotrustees determined that, of the $6,998,888.24 which the trust received from the Holmby Corporation in 1927, $1,185,088.24 was net income currently distributable to the beneficiaries*863  of the trust.  They accordingly made such distribution and so reported to the court in their account heretofore referred to.  The court, after hearing the matter, made its order approving, allowing, and settling the account, thereby finally determining that the $1,185,088.24 was currently distributable to the beneficiaries of the trust, including petitioner.  That order has not been reversed or overruled and is, therefore, conclusive.  . The Supreme Court of the United States, in , adhered to the rule of the Freuler case, supra, and held that a decision of a state court determining a trust there under consideration not to be a spendthrift trust, and further holding that certain assignments of income were valid, was binding upon the Federal courts.  The Court there said: The question of the validity of the assignments is a question of local law.  The donor was a resident of Illinois and his disposition of the property in that State was subject to its law.  By that law the character of the trust, the nature and extent of the interest*864  of the beneficiary, and the power of the beneficiary to assign that interest in whole or in part, are to be determined.  The decision of the state court upon these questions is final. ; , , . It matters not that the decision was by an intermediate appellate court.  Compare . In this instance, it is not necessary to go beyond the obvious point that the decision was in a suit between the trustees and the beneficiary and his assignees, and the decree which was entered in pursuance of the decision determined as between these parties the validity of the particular assignments.  Nor is there any basis for a charge that the suit was collusive and the decree inoperative.  The trustees were entitled to seek the instructions of the court having supervision of the trust.  *865  (C.C.A., 8th Cir.), following the Freuler case, held that where the local state court decided that beneficiaries could not recover amounts retained by trustees from income of a trust for depreciation on trust property and for undepreciated cost of obsolete buildings, the amounts are not distributable to the beneficiaries nor taxable to them.  Respondent's attempt to distinguish the present case from the above cited controlling cases is not convincing.  We conclude and hold, therefore, that the payment to the trustees by the Fajardo Co. in 1932 of interest on its notes was not, to the extent of $25,000, income distributable to petitioner.  Reviewed by the Board.  Decision will be entered for the petitioner.Footnotes1. SEC. 162.  NET INCOME.  [Revenue Act of 1932.] The net income of the estate or trust shall be computed in the same manner and on the same basis as in the case of an individual, except that - * * * (b) There shall be allowed as an additional deduction in computing the net income of the estate or trust the amount of the income of the estate or trust for its taxable year which is to be distributed currently by the fiduciary to the beneficiaries, and the amount of the income collected by a guardian of an infant which is to be held or distributed as the court may direct, but the amount so allowed as a deduction shall be included in computing the net income of the beneficiaries whether distributed to them or not.  Any amount allowed as a deduction under this paragraph shall not be allowed as a deduction under subsection (c) of this section in the same or any succeeding taxable year; (c) In the case of income received by estates of deceased persons during the period of administration or settlement of the estate, and in the case of income which, in the discretion of the fiduciary, may be either distributed to the beneficiary or accumulated, there shall be allowed as an additional deduction in computing the net income of the estate or trust the amount of the income of the estate or trust for its taxable year which is properly paid or credited during such year to any legatee, heir, or beneficiary, but the amount so allowed as a deduction shall be included in computing the net income of the legatee, heir, or beneficiary. ↩