Johnson v. CIR

• Decision Date: 09 April 1974
• Docket Number: No. 73-1908-73-1910.,73-1908-73-1910.
• Citation: 495 F.2d 1079
• Parties: Joseph W. JOHNSON, Jr. and Margaret A. Johnson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. H. Clay Evans JOHNSON and Betty Mead Johnson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. David F. S. JOHNSON and Elsie E. Johnson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

495 F.2d 1079 (1974)

Joseph W. JOHNSON, Jr. and Margaret A. Johnson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

H. Clay Evans JOHNSON and Betty Mead Johnson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

David F. S. JOHNSON and Elsie E. Johnson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

Nos. 73-1908-73-1910.

United States Court of Appeals, Sixth Circuit.

Argued February 12, 1974.

Decided April 9, 1974.

Thomas Caldwell, Jr., Chattanooga, Tenn., for appellants ; Thomas O. Helton. William C. Myers, Jr., Stophel, Caldwell & Heggie, Chattanooga, Tenn., on brief.

Donald H. Olson, Tax Div., Dept. of Justice, for appellee ; Scott P. Crampton, Asst. Atty. Gen., Meyer Rothwacks, Jonathan S. Cohen, Attys. Tax Div., Dept. of Justice, Washington, D. C., on brief.

Before CELEBREZZE, PECK and ENGEL, Circuit Judges.

CELEBREZZE, Circuit Judge.

This case presents the question of a donor's income tax liability upon the transfer to a trust of highly appreciated stock subject to debt, where the proceeds of a loan which the stock secures are received by the donor and a large portion of the proceeds is used to pay the donor's gift taxes on the transfer.

Joseph W. Johnson, David F. S. Johnson, and H. Clay Evans Johnson¹ developed Interstate Life and Accident Insurance Company into a successful enterprise. In March 1965, each taxpayer decided to give a substantial block of Interstate stock to his children. Dr. Joseph Johnson's transactions will be described herein, as the prototype for what all three taxpayers did, with figures rounded off for purposes of simplification.²

On March 9, 1965, Dr. Johnson obtained $200,000 from a bank by signing a note. The note was secured by 50,000 shares of Interstate stock, "without personal liability" of Dr. Johnson. On March 11, he established an irrevocable trust for his children's benefit and transferred to it his rights in the 50,000 shares. His wife and the lending bank were appointed trustees.

On April 8, the trustees executed a note which cancelled Dr. Johnson's note and opened a $200,000 debit account in the trust's name, with the 50,000 shares pledged as collateral.

When these transactions were completed, Dr. Johnson had $200,000 in cash, and the trust had stock worth over $500,000, encumbered by a $200,000 note. Dr. Johnson later paid gift taxes of $150,000, leaving him $50,000 of cash and no obligation on the note.

On August 13, 1969, the Commissioner of Internal Revenue mailed deficiency notices to the taxpayers, asserting that each had realized long-term capital gain in the amount that the loan proceeds exceeded the basis in the stock transferred ($200,000 minus $10,000). Taxpayers contested the deficiencies in the Tax Court, arguing that because the transfer of stock to the trust constituted a "net gift," they "realized" no income upon the transfer.

The Tax Court rejected this argument, relying instead on "the Crane doctrine"—in broad terms, that the shedding of a liability constitutes the realization of income within § 1001, Int.Rev. Code of 1954. To reach this result, the Tax Court felt it necessary to decide whether the transfers of Interstate stock to the trusts were "in part sales and in part gifts" or "merely gifts of the difference between the fair market value of the stock transferred and the loans to which the stock was subject." 59 T.C. at 806. The Tax Court concluded,

"We hold that the transfers in question constituted in part a gift and in part a sale. To the extent that the fair market value of the stock transferred by each of the petitioners exceeded the amount of his loan it was a gift subject only to the payment by him of the gift taxes thereon, which have been paid and are not an issue herein. To the extent the transfers were subject to the loans they were sales and petitioners each realized capital gains in the amount his loan exceeded his basis in the stock." 59 T. C. at 812.

By arriving at its conclusion via this route, the Tax Court distinguished Turner v. Commissioner of Internal Revenue, 49 T.C. 356 (1968) aff'd per curiam, 410 F.2d 752 (6th Cir. 1969). Turner seems to have been interpreted for the proposition that when a donor makes a "net gift" to a recipient and requires the donee to pay his gift tax liability, the payment of the donor's gift tax is not taxable as income to the donor. 49 T.C. at 363.³ In Turner, the donor required the donee to pay his gift tax out of the gift's proceeds. In the instant case the Tax Court found that the transfers were not conditioned on the recipients' payment of gift taxes, that the donors reserved no interest in the trust corpora, and that the loans herein were not to be equated with the gift tax liabilities in Turner (since the loan proceeds significantly exceeded the gift taxes paid). The Tax Court concluded,

"Finally, unlike in the Turner case, we have found, on the basis of all the facts presented and consonant with the authorities hereinbefore discussed, that the transfers here in question were in reality part sales and part gifts." 59 T.C. at 813.

Taxpayers concede on appeal that the Crane doctrine applies to the extent of $50,000 received through Dr. Johnson's transactions, but only to this extent. Asserting the familiar doctrine that "substance controls over form," they argue that their intent and the results of their transactions are identical to the Turner situation, so long as they concede that the $50,000 received in excess of gift tax liability minus the basis of the transferred shares should be taxed as a capital gain. Thus, they argue that the $150,000 which was received and used to pay the gift tax liability should escape income taxation.

Were we to view the Turner case in such broad terms as taxpayers assert, it would be difficult to distinguish this case from Turner. To be sure, the factors which the Tax Court found distinguishing are present. But to the extent the loan proceeds were used to pay the gift tax on the transfer, these features have little distinguishing force. Indeed, to state that in this case the transactions were "in reality part sales and part gifts" is to do nothing more than assert a conclusion. The fact is that these taxpayers, assisted by attentive tax counsel, attempted to raise cash to pay their gift taxes without themselves incurring taxable gain from transactions needed to raise the cash. This is what the Turner taxpayers attempted to do and succeeded in doing. In the murky tax-planning days of the early 1960's,⁴ the Turner lawyers advised one procedure, and the lawyers in this case advised another. For the results to diverge diametrically, we should be forced to this conclusion by the words or policies of the Internal Revenue Code. Because of our approach to this problem, we avoid the need to consider maintaining a distinction in result based on minor variations in tax planning to similar ends.⁵

The substance of a transaction rather than its form must ultimately determine the tax liabilities of individuals. Gregory v. Helvering, 293 U.S. 465, 470, 55 S.Ct. 266, 79 L.Ed. 596 (1935) ; Commissioner of Internal Revenue v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 89 L.Ed. 981 (1945) ; Foresun, Inc. v. Commissioner of Internal Revenue, 348 F.2d 1006, 1008 (6th Cir. 1965). When one overall transaction transferring property is carried out through a series of closely related steps, courts have looked to the essential nature of the transaction rather than to each separate step to determine tax consequences of the transfer. Commissioner of Internal Revenue v. Ashland Oil & Refining Co., 99 F.2d 588 (6th Cir.), cert. denied, 306 U.S. 661, 59 S.Ct. 786, 83 L.Ed. 1057 (1939) ; Kimbell-Diamond Milling Co. v. Commissioner of Internal Revenue, 14 T.C. 74 (1950), aff'd per curiam, 187 F. 2d 718 (5th Cir.), cert. denied, 342 U.S. 827, 72 S.Ct. 50, 96 L.Ed. 626 (1951) ; American Potash & Chemical Corp. v. United States, 399 F.2d 194, 185 Ct.Cl. 161, pet. for rehearing, 402 F.2d 1000, 185 Ct.Cl. 161 (1968). The substance of the transactions in this case was a gift of $500,000 worth of stock in exchange for $200,000, $150,000 of which was used to pay the donor's gift taxes.⁶

Whether we describe this substance as a "part sale and part gift" or a "net gift" has no importance. The fact is that each taxpayer received something of value upon transferring his encumbered stock into trust. Dr. Johnson received $200,000, free and clear of any obligation to repay that amount from any property in his possession. This amount constituted gross income in the year of receipt, under the broad definition set forth in section 61 of the Code —"all income from whatever source derived." It makes no difference to what use the $200,000 was put, whether to pay for food or to pay a gift tax.

The same result would be reached if we describe the $150,000 used to pay the gift taxes on the transfer into trust as equivalent to what happened in Turner (donees' assumption of donor's gift tax liability). If we view the $150,000 receipt as the payment of the donor's gift tax by the donee, then the donor has nonetheless realized income. The gift tax liability is the donor's legal obligation under section 2502(d) of the Code,⁷ and "the discharge by a third person of an obligation to him is equivalent to receipt by the person taxed." Old Colony Trust Co. v. Commissioner of Internal Revenue, 279 U.S. 716, 729, 49 S.Ct. 499, 504, 73 L.Ed. 918 (1929) (taxing as income employer's payment of employee's income taxes). Accord, Safe Harbor Water Power Corp. v. United States, 303 F.2d 928, 157 Ct.Cl. 912 (1962) (payment of income taxes) ; Schaeffer v. Commissioner of Internal Revenue, 258 F.2d 861, 864 (6th Cir. 1958) (net increase in accrual basis taxpayer's reserve account with purchaser) ; Guarantee Title & Trust Co. v. Commissioner of Internal Revenue, 313 F.2d 225, 228 (6th Cir. 1963) ; Malone v....