Fulk & Needham, Inc. v. United States

• Decision Date: 09 June 1969
• Docket Number: No. 12975.,12975.
• Parties: FULK & NEEDHAM, INC., Appellant, v. UNITED STATES of America, Appellee.
• Court: U.S. Court of Appeals — Fourth Circuit

411 F.2d 1403 (1969)

FULK & NEEDHAM, INC., Appellant, v. UNITED STATES of America, Appellee.

No. 12975.

United States Court of Appeals Fourth Circuit.

Argued May 7, 1969.

Decided June 9, 1969.

Murray C. Greason, Jr., and Leon L. Rice, Jr., Winston-Salem, N. C. (Womble, Carlyle, Sandridge & Rice, Winston-Salem, N. C., on the brief), for appellant.

Howard M. Koff, Atty., Department of Justice (Richard M. Roberts, Acting Asst. Atty. Gen., Lee A. Jackson, Jonathan S. Cohen, Attys., Department of Justice, and William H. Murdock, U. S. Atty., on the brief), for appellee.

Before HAYNSWORTH, Chief Judge, and SOBELOFF and BUTZNER, Circuit Judges.

SOBELOFF, Circuit Judge:

The single question raised in this action for refund of corporate income taxes is whether the appellant-taxpayer, Fulk & Needham, Inc., was eligible for treatment as a small business corporation under subchapter S of the Internal Revenue Code during the years 1960, 1961 and 1962. In order to obtain subchapter S treatment, a corporation must make a valid election to have its income taxed directly to its shareholders.¹ In this case appellant made an election in November, 1958, which, if valid, would be effective for the calendar year 1959 and succeeding years, thus entitling the taxpayer to the refund sought.

For an election to be valid the electing corporation must satisfy the specific eligibility requirements set out in 26 U.S.C. § 1371(a):

(a) Small business corporation. — For purposes of this subchapter, the term "small business corporation" means a domestic corporation which is not a member of an affiliated group (as defined in section 1504) and which does not —

(1) have more than 10 shareholders;

(2) have as a shareholder a person (other than an estate) who is not an individual;

(3) have a nonresident alien as a shareholder; and

(4) have more than one class of stock.

The Commissioner's position, upheld by the District Court, is that Fulk & Needham's election was invalid because certain of its shares were held in trust, and therefore not all were owned by individuals or estates as § (a) (2) requires. We too find that the conditions laid down in § (a) (2) were not met and therefore affirm the District Court's denial of the refund.

The material facts are these: On July 14, 1954, A. P. Fulk, a partner with a one-half interest in the construction firm of Fulk & Needham, died testate. Under the Will his estate passed to a trust wherein his wife was designated life beneficiary. The Will provided that at the wife's death the trust should terminate and the testator's two daughters should take the trust property in fee. Fulk's wife and daughters were named co-executrices of his estate and co-trustees of the trust. The estate consisted in large part of his interest in Fulk & Needham.

Five months after Fulk's death, the partnership was incorporated as Fulk & Needham, Inc. The ownership of the new corporation was divided evenly between the Fulks and the Needhams. Each family transferred its partnership assets to the corporation in return for an ownership interest therein. No stock certificates were ever issued, but the corporation's minutes include a direction to issue 545 shares to the trustees of the A. P. Fulk Estate. The following year the estate was closed, and the widow and daughters signed as co-trustees a document acknowledging receipt of the estate assets from themselves as co-executrices.

The present appeal turns upon the ownership of the 545 shares in question. If they were held in trust, rather than by an individual or estate, then the 1958 election was invalid as the Commissioner determined and the refund was properly denied.

The corporate taxpayer concedes that the Will created a trust and that the corporation's records contain evidence that the shares were to be issued to Fulk's widow and daughters as trustees. The contention made, however, is that the trust should be disregarded as lacking economic reality.² Appellant's argument is predicated upon the fact that Fulk's widow had, without objection from her daughters, treated the 545 shares as her own property ever since the corporation was formed. She was accepted by the corporate management as the representative and authoritative spokesman of the Fulk interests, and in her income tax returns reported not only the distributed but also the undistributed income of Fulk & Needham, Inc. attributable to the 545 shares. No fiduciary returns were ever filed, but neither was any gift of the remainder interests from the daughters to the mother reported or any gift tax paid thereon. It is conceded that no element of tax avoidance is present. The enumerated circumstances have led appellant to the conclusion that the widow, not the trust intended by Fulk, owns the shares. Thus it is reasoned that § 1371 (a) (2) has been satisfied and consequently the election of subchapter S treatment is valid.

Appellant's contention must be rejected. We do not agree with the taxpayer that in the particular circumstances of this case, the Internal Revenue Service's and later the District Court's recognition of the trust as owner of the shares exalts form over substance. To the contrary, it seems to us that adoption of the taxpayer's theory would have that very effect. The events stressed by appellant furnish no ground for disregarding the trust created by the Will.

The objective fact is that under the trust, Fulk's widow was entitled to a life interest in her husband's property, and this is precisely what she has received. The fact that she alone among the trustees represented the Fulk interests in running the corporate business is entirely consistent with the existence of a trust. Under North Carolina law, the vote of one trustee ordinarily is the act of all the trustees where the trust owns shares of corporate stock.³ There is no evidence that Mrs. Fulk appropriated the corpus of the trust to her own use, or otherwise acted in a manner at odds with the continued existence of the remainderman's rights under the testamentary trust. The trust's interest in Fulk & Needham has not been invaded by the life tenant, remains entirely intact, and will be available to the life tenant's daughters at her death, all in strict accordance with the direction in Mr. Fulk's Will. Unquestionably, the daughters, at the termination of their mother's life estate, will not inherit from her, but will take under their father's Will.

It is of some importance to note that we are dealing here with a family situation in which the same persons were named co-executrices, co-trustees, and beneficiaries. It may be assumed that informal administration was contemplated. However, we perceive no reason to disregard the trust merely because it was administered loosely, yet in a manner not diverging from the trust provisions.

It is true that Mrs. Fulk did not always consult with her daughters in matters affecting the business in which the trust held stock. Nevertheless, the fact that the daughters were inactive trustees and were content to allow the co-trustee, their mother, to exercise trustees' prerogatives does not obliterate the trust. Especially is this so since it is conceded that no action taken by the mother conflicted with her prescribed duties as trustee. If she had obtained a formal power of attorney authorizing her to act for her co-trustee daughters, the taxpayer would hardly be before this court urging that the trust is a nullity. To...