735 F.2d 704 (2nd Cir. 1984), 519, Rothstein v. United States

Docket Nº:519, Docket 83-6198.
Citation:735 F.2d 704
Party Name:Harold ROTHSTEIN and David M. Rothstein as Executors of the Estate of Alexander Rothstein, Deceased, and Reba Rothstein, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.
Case Date:May 21, 1984
Court:United States Courts of Appeals, Court of Appeals for the Second Circuit

Page 704

735 F.2d 704 (2nd Cir. 1984)

Harold ROTHSTEIN and David M. Rothstein as Executors of the

Estate of Alexander Rothstein, Deceased, and Reba

Rothstein, Plaintiffs-Appellants,


UNITED STATES of America, Defendant-Appellee.

No. 519, Docket 83-6198.

United States Court of Appeals, Second Circuit

May 21, 1984

Argued Dec. 16, 1983.

Ira B. Grudberg, New Haven, Conn. (Jonathan Katz, Charles B. Price, Jr., and Jacobs, Grudberg & Belt, P.C., New Haven, Conn.), for plaintiffs-appellants.

Page 705

Thomas M. Preston, Atty. Tax Div., Dept. of Justice, Washington, D.C. (Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, William S. Estabrook, Attys., Tax Div., Dept. of Justice, Washington, D.C., and Alan H. Nevas, U.S. Atty., New Haven, Conn.), for defendant-appellee.

Before FEINBERG, Chief Judge, and FRIENDLY and OAKES, Circuit Judges.

FRIENDLY, Circuit Judge:

Harold and David M. Rothstein, as executors of the estate of Alexander Rothstein, and Reba Rothstein, his widow, appeal from a judgment of the District Court for Connecticut, which dismissed their action for a tax refund after trial before Judge Eginton and an advisory jury, 574 F.Supp. 19. Appellants urge two grounds for reversal. One involves the interpretation of Secs. 453, 671 and 675 of the Internal Revenue Code ("IRC"); the other relates to the judge's having sua sponte stricken from the jury panel eleven veniremen solely because they had some experience with rental property or connection with closely held corporations. In the view we take of the case only the first requires statement and discussion.

The district court found the facts to be as follows: In 1951 decedent Alexander Rothstein ("taxpayer") and Abraham Savin formed a real estate holding company known as Industrial Developers, Inc. ("IDI"). They purchased, at a cost of $30,000 each, a parcel of land in East Hartford, Connecticut, which they conveyed to the corporation, each receiving 300 shares of IDI stock. The corporation constructed, at a cost not disclosed in the record, warehouses which were used as rental property.

On February 18, 1957, taxpayer contributed his 300 shares of IDI to an irrevocable trust he established for the benefit of his three children, Harold, David and Edna. Taxpayer's wife Reba was the trustee. Although the trust was required to distribute any dividends received on the IDI stock, which was its sole asset, to the beneficiaries at least semi-annually, no dividends were ever paid.

In October 1964, taxpayer bought Savin's 300 shares of IDI for $500,000, agreeing to pay the purchase price at a later date. On November 13, 1964, he purchased from his wife as trustee the trust's 300 shares for $320,000. Payment was made by an unsecured promissory note bearing an interest rate of 5% per annum, payable semi-annually beginning May 13, 1965. These payments were duly made. Principal payments were scheduled to be made as follows: $25,000 on or before November 13, 1969; $25,000 on or before November 13, 1970; $50,000 on or before November 13, 1971; and $50,000 on or before November 13 of each calendar year thereafter until the full sum of $320,000 had been paid.

In January 1965, taxpayer, having become owner of all of IDI's stock as a result of the transactions with Savin and the trust, dissolved IDI and had all its assets transferred to himself. He then refinanced the property, replacing an existing mortgage of less than $200,000 with a new $700,000 mortgage to Equitable Life Insurance Company and using the approximately $500,000 excess of the new mortgage over the old to discharge his debt to Savin. On February 8, 1965, he gave a second mortgage of $320,000 to his wife as trustee to secure the promissory note of that amount given in exchange for the trust's IDI shares three months before.

In their joint federal income tax return for 1965 taxpayer and his wife claimed deductions for (1) $16,000 in interest paid to the trust on the promissory note, and (2) a short-term capital loss of $33,171 on the liquidation of IDI, determined as follows:

fair market value of property received upon liquidation $1,054,580 Less: IDI liabilities assumed $267,751 Cost of stock acquired from Savin 500,000 Cost of stock acquired from trust 320,000 ------- $1,087,751 ---------- Gain (loss) realized ($33,171) Page 706

The Commissioner, however, asserted a deficiency of $56,664 based on his disallowance of the interest deduction and his determination that taxpayer had in fact realized a substantial gain on the liquidation of IDI. As now presented by the Government, the Commissioner's theory was that, under IRC Sec. 675(3) 1, the taxpayer was to be treated as the "owner" of the trust assets and that this crucially affected the tax consequences of the events described above. On this view, transactions involving trust assets were to be re-analyzed after substituting the taxpayer (as the "owner" of those assets) for the trust. Thus, the Commissioner disallowed the $16,000 interest deduction, since the taxpayer was not entitled to a deduction for amounts paid to himself as "owner" of the promissory note held by the trust. Similarly, in computing taxpayer's gain on the liquidation of IDI, the Commissioner reduced taxpayer's basis in the shares acquired from the trust from $320,000 to $30,000. His rationale, apparently, was that the taxpayer could not claim a full "cost" basis in stock acquired in a sale that involved nothing more than a transfer of the property from the taxpayer (as "owner" of the stock) to himself. 2

In July 1967, taxpayer paid the asserted deficiency, together with interest of $2,470. In February 1969 Mr. and Mrs. Rothstein filed a claim for a refund in the amount of $57,942.12. After this was denied, the Rothsteins filed a protest, which the IRS held for more than five years, during which time Alexander Rothstein died. The protest was finally disallowed and Rothstein's executors and widow brought this refund suit against the United States under 28 U.S.C. Sec. 1346(a)(1).

Although both sides were entitled to a jury trial, 28 U.S.C. Sec. 2402, the case was tried by the judge with an advisory jury. After denying motions by both sides for a directed verdict, the judge put four interrogatories to the jury. The questions and answers were as follows:

  1. Was the sale by the Trustee, Reba Rothstein, to the grantor, Alexander Rothstein of 300 shares of IDI stock for $320,000 for adequate consideration?


  2. Was the trustee, Reba Rothstein, subservient to the grantor, Alexander Rothstein, when she accepted a note from Alexander Rothstein in the amount of $320,000 in exchange for the 300 shares of IDI stock from the trust?


  3. Was adequate security provided by Alexander Rothstein for the $320,000 note given by him in November, 1964 to Reba Rothstein as trustee?


  4. Did the note for $320,000 from Alexander Rothstein to Reba Rothstein, as trustee for the children, provide for an adequate rate of interest?


    Page 707

    The judge then made findings of fact and conclusions of law pursuant to F.R.Civ.P. 52(a). He ruled that the 1964 sale of the IDI stock involved a borrowing of trust funds under the first sentence of IRC Sec. 675(3) and, in accordance with the advisory jury's answers with respect to lack of adequate security and subservience, that it did not fall within the exception created by the second sentence. Without further discussion, the judge entered judgment for the Government, presumably because he agreed with the Commissioner that, if Sec. 675(3) applied, this would entail disallowance of taxpayer's interest deduction and reduction of his basis in the shares of IDI acquired from the trust.


    Taxpayer's principal argument on the merits is that his purchase, on credit, of the 300 shares of IDI did not involve a "borrowing" from the trust and therefore did not come within IRC Sec. 675(3), which applies only when the grantor "has directly or indirectly borrowed the corpus or income and has not completely repaid the loan, including any interest, before the beginning of the taxable year". The image most immediately conveyed by the statutory language is that of a grantor who has obtained an asset from the trust, whether money or otherwise, in exchange for a promise to return the same asset at some future time. Taxpayer is correct in noting that a transaction like that here in question--a sale of a trust asset on credit--involves no borrowing of the asset sold. However, the Commissioner's argument is that what was "directly or indirectly borrowed" was not the IDI stock but money in the amount of the purchase price. On...

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