American Nurseryman Publ'g Co. v. Comm'r of Internal Revenue

• Decision Date: 17 November 1980
• Docket Number: Docket No. 6150-78.
• Citation: 75 T.C. 271
• Parties: AMERICAN NURSERYMAN PUBLISHING CO., PETITIONER v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

75 T.C. 271

AMERICAN NURSERYMAN PUBLISHING CO., PETITIONER

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 6150-78.

United States Tax Court

Filed November 17, 1980.

In 1969, P made the election to be taxed as a small business corporation under subch. S, I.R.C. 1954. In 1975, K, a shareholder of P, transferred her stock in P to a revocable trust of which she was the sole trustee and sole beneficiary during her lifetime. After her death in 1976, an Illinois court found that the transfer was based on a mistake and held it to be void ab initio. Held:

1. The order of the Illinois court must be disregarded for Federal tax purposes.

2. The election by P was terminated since sec. 1.1371-1(e), Income Tax Regs., provides that such a trust cannot hold stock in an electing small business corporation and since such regulations are valid. Loren E. Juhl, Thomas E. Swaney, and Robert A. Malstrom, for the petitioner.

Allan E. Lang, for the respondent.

OPINION

SIMPSON, Judge:

The Commissioner determined a deficiency of $22,664.55 in the petitioner's Federal income tax for 1975. The only issue to be decided is whether an election by the petitioner to be treated as a small business corporation under subchapter S of the Internal Revenue Code of 1954¹ was terminated when a shareholder transferred her stock to a revocable trust of which she was the trustee and sole beneficiary during her life and when such transfer was later held by an Illinois court to have been void ab initio.

All of the facts have been stipulated, and such facts are so found.

The petitioner, American Nurseryman Publishing Co., an Illinois corporation, had its principal place of business in Chicago, Ill., at the time of filing its petition in this case. It filed its Federal income tax return for 1975 with the Internal Revenue Service Center, Kansas City, Mo.

The petitioner is the publisher of American Nurseryman magazine. On January 1, 1969, the petitioner made a valid election to be taxed as a small business corporation under subchapter S (secs. 1371 et seq.). Since then, it has filed small business corporation income tax returns each year.

On July 11, 1975, Colleen B. Kilner, a shareholder of the petitioner, executed a declaration of trust in which she transferred securities owned by her, including 223 shares in the petitioner, to herself as trustee. The declaration named Mrs. Kilner as the sole beneficiary during her lifetime, empowered her to revoke or amend the instrument at will during her lifetime, and provided for the distribution of the trust assets upon her death. Also, the declaration appointed the Continental Illinois National Bank & Trust Co. of Chicago (the bank) to succeed Mrs. Kilner as trustee on her death. On August 11, 1975, the ownership registration of the 223 shares in the petitioner was changed from Colleen B. Kilner to Colleen B. Kilner, trustee under declaration of trust dated July 11, 1975.

Mrs. Kilner died testate on May 16, 1976. Her will devised all her property, except personal effects and household goods, to the successor trustee, the bank, to be distributed in accordance with her declaration of trust. Her will also appointed the bank as executor of her estate.

Shortly after Mrs. Kilner's death, the bank filed a citation proceeding ² in the Circuit Court of Cook County, Ill., seeking to have declared void Mrs. Kilner's transfer of her stock in the petitioner in trust. As executor and petitioner in the proceeding, the bank alleged that:

Respondent, CONTINENTAL ILLINOIS NATIONAL BANK AND TRUST COMPANY OF CHICAGO, as Trustee of the Colleen B. Kilner Trust dated July 11, 1975, has in its possession and control, personal property belonging to decedent which Respondent should be ordered to deliver to the Petitioner as Executor of this estate.

* * *

(3) Respondent is in possession and control of such property as a result of a transfer made by decedent on July 11, 1975. * * * such transfer was made by decedent as a result of a mistake of law and fact concerning the nature of such property and the consequences of such transfer. Due to her mistake, decedent did not intend the transfer which was made. Accordingly, the transfer should be declared null and void, and such property should be returned to decedent as of the date of such transfer.

In support of its allegations, the bank attached to its petition an affidavit of the attorney who advised Mrs. Kilner to execute the declaration of trust. In such affidavit, the attorney stated that neither Mrs. Kilner nor the petitioner advised him that the petitioner was a small business corporation taxable under subchapter S, that he believed that Mrs. Kilner was unaware that such a corporation may not have a trust as a shareholder, and that if he had known that the petitioner was taxable under subchapter S, he would not have advised her to transfer the stock in the petitioner to the trust.

The bank, as trustee and respondent in the citation proceeding, answered the petition by denying knowledge of any reason why the 223 shares should be transferred to the bank as executor and by demanding “strict proof” of the allegations in the petition. On October 6, 1976, the Circuit Court entered an order in which it found “that decedent's transfer of such shares was due to a material mistake which was not the result of her own negligence and that no persons will be adversely affected by correcting such mistake,” and ordered that “[the bank], as Trustee of the Colleen B. Kilner Trust dated July 11, 1975, shall deliver the 223 shares of American Nurseryman Publishing Co. common stock which are subject to its possession and control to * * * [the bank] as Executor of the Will of Colleen B. Kilner, deceased.”

In its small business corporation income tax return for 1975, the petitioner reported that it was not liable for any tax. In his notice of deficiency, the Commissioner determined that the petitioner's election to be treated as a small business corporation was terminated in 1975 because the trust created by Mrs. Kilner became a shareholder of the petitioner in that year.

If a corporation elects to qualify under subchapter S (that is, becomes a subchapter S corporation), it is not taxable on its income, but such income is taxable to its shareholders. Secs. 1372(b), 1373. An election to become a subchapter S corporation is terminated whenever the corporation ceases to qualify as such. Sec. 1372(e)(3). The issue to be decided in this case is whether the transfer of stock by Mrs. Kilner in trust caused the election by the petitioner to terminate under section 1372(e)(3).

The Commissioner takes the position that as the law stood in 1975, any transfer of stock in trust caused an election under subchapter S to terminate, and he relies on section 1.1371-1(e), Income Tax Regs. He maintains that Mrs. Kilner made a transfer of her stock in trust and that the tax consequences of such transfer cannot be changed retroactively. On the other hand, the petitioner first takes the position that the trust never owned the stock in the petitioner since “the net effect” of the State court order “was that Colleen B. Kilner remained a shareholder of the petitioner in her individual capacity until her death on May 16, 1976.” In the alternative, the petitioner argues that in deciding whether there has been a transfer of stock for purposes of applying the provisions of subchapter S, the courts are guided by the substance of a transaction, not its form, and that in substance, Mrs. Kilner remained the owner of the stock in the petitioner even if we disregard the order of the State court. It urges us to declare the regulations invalid to the extent that they are inconsistent with its position.

At the outset, there is no merit in the petitioner's argument that this Court should give retroactive effect to the State court order voiding Mrs. Kilner's transfer of her stock in trust. There is no dispute that in 1975 Mrs. Kilner desired to transfer her stock in trust, and there is no dispute that in 1975 she actually transferred her stock in a valid and completed transaction. As between Mrs. Kilner and the trust, the State court order may have had retroactive effect, but this Court and the Courts of Appeals have consistently expressed the view that “not even judicial reformation can operate to change the federal tax consequences of a completed transaction.” Van Den Wymelenberg v. United States, 397 F.2d 443, 445 (7th Cir. 1968); see Emerson Institute v. United States, 356 F.2d 824 (D.C. Cir. 1966), cert. denied 385 U.S. 822 (1966); Piel v. Commissioner, 340 F.2d 887 (2d Cir. 1965), affg. a Memorandum Opinion of this Court; Sinopoulo v. Jones, 154 F.2d 648 (10th Cir. 1946); Estate of Hill v. Commissioner, 64 T.C. 867 (1975), affd. in an unpublished opinion 568 F.2d 1365 (5th Cir. 1978); Davis v. Commissioner, 55 T.C. 416, 428 (1970); M. T. Straight Trust v. Commissioner, 24 T.C. 69 (1955), affd. 245 F.2d 327 (8th Cir. 1957); Van Vlaanderen v. Commissioner, 10 T.C. 706 (1948), affd. 175 F.2d 389 (3d Cir. 1949); Daine v. Commissioner, 9 T.C. 47 (1947), affd. 168 F.2d 449 (2d Cir. 1948); Eisenberg v. Commissioner, 5 T.C. 856 (1945), affd. 161 F.2d 506 (3d Cir. 1947), cert. denied 332 U.S. 767 (1947); but see Flitcroft v. Commissioner, 328 F.2d 449 (9th Cir. 1964), revg. 39 T.C. 52 (1962).

In M. T. Straight Trust v. Commissioner, supra, this Court faced the issue of whether a certain instrument had created three trusts or only one trust. By its terms, the instrument had created only one trust, but subsequent to the years in issue, the settlor had sought and received an order of a State court reforming the instrument to create three separate trusts. The order was made retroactive to the time of the execution of the instrument. We held that the order could not be given retroactive effect for Federal tax purposes. We recognized that “There are numerous cases in which the construction or interpretation of an instrument by a...