Estate of Petschek v. C.I.R.

• Decision Date: 21 June 1984
• Docket Number: No. 1020,D,1020
• Parties: 84-2 USTC P 9598 ESTATE OF Ernst N. PETSCHEK, Deceased, Thomas H. Petschek and Asher Lans, Executors, Petitioners-Appellants, v. The COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. ocket 83-4215.
• Court: U.S. Court of Appeals — Second Circuit

Page 67

738 F.2d 67

84-2 USTC P 9598

ESTATE OF Ernst N. PETSCHEK, Deceased, Thomas H. Petschek

and Asher Lans, Executors, Petitioners-Appellants, v. The COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 1020, Docket 83-4215.

United States Court of Appeals, Second Circuit.

Argued April 27, 1984.

Decided June 21, 1984.

Asher B. Lans, New York City (Judith S. Jaffess, Burns, Summit, Rovins & Feldesman, New York City, of counsel), for petitioners-appellants.

Carleton D. Powell, Tax Div., Dept. of Justice, Washington, D.C. (Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, Patricia A. Willing, Tax Division, Dept. of Justice, Washington, D.C., of counsel), for respondent-appellee.

Before KAUFMAN, MESKILL and NEWMAN, Circuit Judges.

MESKILL, Circuit Judge:

This is an appeal from the judgment of the United States Tax Court, Nims, J., 81 T.C. 260, which held that appellants' decedent Petschek failed to report $136,547 of taxable trust income for 1975 and that Petschek was thus deficient in his income tax paid in the amount of $98,222.

We affirm the decision of the tax court.

BACKGROUND

Appellants are the executors of the estate of the decedent Ernst N. Petschek. For many years prior to 1975, Petschek resided in France as a United States citizen. From January 1, 1975 to November 23, 1975, Petschek retained his non-resident citizen status. On November 24, 1975, however, Petschek renounced his United States citizenship and became a citizen of the Republic of France, where he lived for the remainder of 1975.

During 1975, Petschek was the sole income beneficiary of the Ernst Petschek Trust (Trust 5A). Trust 5A was part of an inter vivos trust established in 1955 by Petschek's father. Under the trust terms, the trustee was to distribute Trust 5A's net income at least annually to Petschek. The trustee could invade the corpus of the trust at his discretion for the use of Petschek, his spouse or issue.

Both Petschek and Trust 5A were calendar year, cash basis taxpayers in 1975. During 1975, Trust 5A realized $152,415 net dividend and interest income ($152,482 gross income less $67 actual expenses). No part of this income was derived from sources within the United States, nor was any part connected with the conduct of any business or trade within the United States. During 1975, the trustee distributed only current income. The trust, therefore, was a simple trust for that year within the purview of sections 651 and 652 of the Internal Revenue Act of 1954.

In 1975 Petschek paid $133,500 with respect to his estimated tax liability. Having relinquished his citizenship, however, Petschek reported no income from Trust 5A on his 1975 income tax return and sought a refund of the entire amount paid. The Commissioner issued a statutory notice of deficiency for 1975, contending that Petschek should have reported $136,547 taxable income from Trust 5A. This represented the net income realized by Trust 5A in 1975 prorated over the number of days in 1975 that Petschek was a United States citizen. Appellants petitioned the tax court for a redetermination of the deficiency and a refund of the 1975 taxes retained by the Commissioner. ¹ In his brief to the tax Appellants contend that Petschek received no taxable income in 1975 from Trust 5A while he was a United States citizen and thus was not required to report any income from Trust 5A on his 1975 tax return.

court, the Commissioner claimed that in 1975 Petschek was required to report $136,657 taxable income from Trust 5A, a different amount than was claimed in the deficiency notice. This figure was the trust's income of $136,717, actually received by Trust 5A between January 1, 1975 and November 23, 1975, less stipulated allocable expenses of $60. The Commissioner alternatively claimed that Petschek should have reported at least the $132,841 actual trust income distributed to him during the period in 1975 when he was a United States citizen.

The tax court, in its September 7, 1983 opinion, determined that the beneficiary of a simple trust receives trust income simultaneously with the trust's receipt of income. The court found Petschek liable for taxes on the income Trust 5A received in 1975 prior to Petschek's abandonment of his United States citizenship. Although the court stated that Petschek should have reported $136,657, it noted that the Commissioner failed to make a formal request for an increase of the amount claimed in its notice of deficiency. Under I.R.C. Sec. 6214(a), the Commissioner was bound to the deficiency notice amount of $136,547. The court thus entered judgment for the Commissioner for $98,222, the amount of tax due on additional income of $136,547.

Appellants now claim that the tax court erred in determining that Petschek received taxable income from Trust 5A in 1975. They again argue that Petschek received taxable trust income only after he renounced his United States citizenship on November 24, 1975.

We reject appellants' argument and affirm the decision of the tax court.

DISCUSSION

When an individual changes his status from non-resident United States citizen to non-resident alien during a taxable year, the individual's taxable year is divided into two periods. Treas.Reg. Sec. 1.871-13(a), 26 C.F.R. Sec. 1.871-13(a) (1983). In the period prior to the abandonment of citizenship, the individual is taxed as a non-resident citizen. Id. Generally, a non-resident United States citizen is taxed on his worldwide income. Treas.Reg. Sec. 1.1-1(b), 26 C.F.R. Sec. 1.1-1(b) (1983); Cook v. Tait, 265 U.S. 47, 44 S.Ct. 444, 68 L.Ed. 895 (1924). In the period subsequent to the abandonment of citizenship, the taxpayer is treated for tax purposes as a non-resident alien. Treas.Reg. Sec. 1.871-13(a). A non-resident alien is taxed only on income derived from sources within the United States or effectively connected with the conduct of trade or business within the United States. I.R.C. Sec. 872(a). Treasury Regulation section 1.871-13(c) explains how income is assigned for tax purposes:

(c) Abandonment of U.S. citizenship or residence. Income from sources without the United States which is not effectively connected with the conduct by the taxpayer of a trade or business in the United States is not taxable if received by an alien individual while he is not a resident of the United States, even though he earns the income earlier in the taxable year while he is a citizen or resident of the United States. However, income from sources without the United States which is not effectively connected with the conduct by the taxpayer of a trade or business in the United States is taxable if received by an individual while he is a citizen or resident of the United States, even though he abandons his U.S. citizenship or residence after its receipt and before the close of the taxable year.

26 C.F.R. Sec. 1.871-13(c) (1983) (emphasis added).

None of Trust 5A's income was derived from sources within the United States or was effectively connected with the conduct of a trade or business in the United States. ² Therefore, the only question on appeal is what part, if any, of Trust 5A's income Petschek received as a United States citizen.

Appellants maintain that Petschek received no trust income as a United States citizen. They argue that the amount of trust income to be included in Petschek's taxable income depends on Trust 5A's Distributable Net Income (DNI). Because the amount of the trust's DNI and thus Petschek's taxable income could not be calculated until the end of the trust's tax year, they reason, Petschek could not be deemed to have received income until that time. The end of Trust 5A's tax year was December 31, 1975, when Petschek was no longer a United States citizen.

The Commissioner argues that the conduit theory of trust taxation requires that Petschek be deemed to have received income from Trust 5A throughout 1975. Under the conduit theory, Petschek would "receive" or realize income from Trust 5A at the moment that it was received by the trust. Thus, the Commissioner contends that Petschek received the amount of income Trust 5A actually received while Petschek was a United States citizen in 1975, or $136,657.

We accept the Commissioner's legal position. I.R.C. sections 651 and 652 establish the basic statutory framework for the taxation of simple trusts and their distributions. Under section 652(a), the beneficiary of a simple trust includes as income the lesser of his share of the trust's DNI or his share of the income the trust is currently required to distribute (distributable income). The trust deducts a comparable amount from its income. I.R.C. Sec. 651. The trust income has the same taxable character (capital gains, tax-exempt income, etc.) in the hands of the beneficiary as in the hands of the trust. I.R.C. Sec. 652(b).

The legislative history of the Internal Revenue Act of 1954 indicates that this taxation scheme was based on the conduit theory of trusts:

The bill adheres to the conduit theory of the existing law. This means that an estate or trust is in general treated as a conduit through which income passes to the beneficiary. In order to implement this theory in a satisfactory manner, it is necessary to include in the measure items of income and deductions which are not reflected in taxable income. The bill adopts the concept of "distributable net income" as the measure and adjusts the amount of the distributions deductible by the estate or trust and taxable to the beneficiaries by eliminating not only capital gains and losses but items of income and expenses which do not enter into the computation of taxable income. Thus, the distributable net income of an estate or trust is defined as its taxable income for the current year, excluding capital gains and losses not distributed by the estate or trust, the portion of extraordinary cash dividends and taxable stock dividends allocated to principal (in the case of simple trusts described...