Ketter v. Comm'r of Internal Revenue , Docket No. 1661-74.
| Decision Date | 09 August 1978 |
| Docket Number | Docket No. 1661-74. |
| Citation | 70 T.C. 637 |
| Parties | MELVIN P. KETTER and MILDRED J. KETTER, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
P operated an accounting practice as a sole proprietorship. During December 1968, P established eight trusts for the benefit of his six children and college alma mater. He transferred to these trusts work in progress of his accounting proprietorship, and employment contracts covering his employees. The trusts formed a partnership to provide accounting services for accountants, transferring the work in progress and the employment contracts to the partnership, and hired P as manager. The partnership performed those services under P's direction with the employees encompassed by the employment contracts transferred to the trusts. The partnership never performed services for anyone but P. Respondent refused to recognize the partnership and taxed its income to P. Held, capital was not “a material income-producing factor,” in the partnership formed by the eight trusts P established. Sec. 704(e)(1). Held, further, the trusts lacked sufficient dominion and control over the partnership interests to be recognized as partners. Sec. 704(e)(1). William J. Shapiro and Charles P. Schleicher, for the petitioners.
John Wendell Paul, for the respondent.
Respondent determined deficiencies in petitioners' Federal income tax as follows:
+--------------------+
¦Year ¦Deficiency ¦
+------+-------------¦
¦ ¦ ¦
+------+-------------¦
¦1968 ¦$6,842.90 ¦
+------+-------------¦
¦1969 ¦3,403.89 ¦
+------+-------------¦
¦1970 ¦254.57 ¦
+------+-------------¦
¦Total ¦10,501.36 ¦
+--------------------+
These deficiencies resulted from respondent's conclusion that a partnership between eight trusts established by petitioner, Melvin P. Ketter, should not be recognized for Federal income tax purposes, and that the partnership income was taxable to him. The issue presented for our determination is whether the partnership should be recognized for Federal income tax purposes under section 704(e).1
Some of the facts have been stipulated and are found accordingly.
Petitioners are Melvin P. Ketter (hereinafter petitioner) and Mildred J. Ketter (hereinafter Mildred), husband and wife, who resided at St. Joseph, Mo., at the time the petition in this case was filed.2 Petitioners filed joint Federal income tax returns for the years 1968, 1969, and 1970 with the Internal Revenue Service Center at Kansas City, Mo. These returns were prepared on the cash receipts method of accounting.
Prior to December 21, 1968, petitioner maintained a certified public accounting practice with offices in St. Joseph and Chillicothe, Mo., in the form of a sole proprietorship. On December 16, 1968, he employed 16 persons in the conduct of this accounting practice.
Petitioner was an alumnus of St. Benedict's College and had taught courses there, with the assistance of his professional staff, in the areas of accounting and Federal taxation.
On December 21, 1968, Melvin created eight irrevocable, inter vivos trusts. These trusts were identified as “MPK Irrevocable Trust numbers 1 through 8.” The beneficiaries of trusts numbers 1 through 6, inclusive, were petitioner's six minor children, with each child the beneficiary of a separate trust. The beneficiary of trusts numbers 7 and 8 was St. Benedict's College, Atchison, Kans., a charitable organization.
The initial trustee of all these trusts was Donald J. Gawatz (hereinafter Gawatz), a resident of St. Joseph, Mo., with 22 years of experience in accounting. Gawatz was Mildred's brother. The First National Bank of St. Joseph, Mo., was designated as the successor trustee for trusts numbers 1 through 6, inclusive. Trusts numbers 7 and 8 designated petitioner's eldest living child who has attained the age of 21 as successor trustee with the First National Bank as alternative successor trustee.
The six trusts created for the benefit of petitioner's children are identical in form, varying only in the designation of the beneficiary. Each of these trusts is irrevocable and cannot be altered, amended, or terminated by the settlor. The trust indentures specifically preclude the settlor from borrowing money therefrom directly or indirectly, without adequate interest or security, and by its terms gives sole control over trust assets to the trustee.
The trustee was given the power to invest and sell trust assets, including the power to borrow or lend money. Additionally, the trustee was authorized to form a partnership to provide to certified public accountants “general accounting, auditing, tax reporting and other services,” and to incorporate such partnership or to terminate the same and wind up its business. The trust income is payable for life to the designated beneficiary after attaining age 21, unless the beneficiary requests in writing that such income be accumulated. The indenture provides that prior to the time each child attains age 21—-
the net income of the Trust Estate shall be paid over to or for the benefit of (such beneficiary), * * * but in no event shall any of the net income be used or applied during the lifetime of the Settlor for the support, education or maintenance of said beneficiary, or otherwise to meet Settlor's legal obligation to support such beneficiary.
The trustee is further granted the sole discretionary right to invade trust corpus to provide for such beneficiary's education, support, and medical maintenance. If the beneficiary of a trust dies, the trust terminates and its assets are payable to the descendants and spouse of the beneficiary pursuant to a limited power of appointment granted to each beneficiary. At the time the trusts were created the six beneficiaries thereof ranged in age from 3 to 14 years.
The terms of the charitable trusts, trusts numbers 7 and 8, provide that the net income shall be accumulated until October 31 of 1978 and 1983, respectively, and thereafter paid at least annually to St. Benedict's College to be used for the general purpose of establishing a professorship in its accounting department. Mildred and a majority of petitioner's children who have attained the age of 21 are empowered to change the beneficiary of these trusts to a nonprofit organization suited to the accomplishment of the trust purpose which is either described under section 170(c)(2) or exempt from taxation under section 501(c)(3).
Pursuant to the indentures, each trust was assigned an undivided one-eighth interest in a portion of the “work in progress” of petitioner's existing accounting firm and the employment contracts held by him with employees of his firm. The “work in progress” was transferred in two separate assignments. The first assignment, concurrent with the creation of the trusts, was reported on petitioner's 1968 gift tax return in the total value of $21,067.74. The gift tax return did not report a separate value for the gift of employment contracts.
The second assignment of “work in progress,” dated December 31, 1969, was reported on petitioner's 1969 gift tax return in the total value of $35,903.54. The assignment document stated that such “work in progress” had a “standard rate value” of $55,139.34, and an “actual market value” of $43,560.08.
By these two transfers, which respondent acknowledges as valid under State law, petitioner transferred to the eight trusts, in equal shares, all of the work in progress of his accounting proprietorship along with the employment contracts containing covenants not to compete of all employees under contract to him.
The employment contracts assigned contained a covenant not to compete under which the employees agreed not to perform services for clients of the employer for a period of 5 years after termination of employment. They were standard form employment contracts petitioner used with his employees and included a penalty for violation of the provision not to compete. Either party could terminate employment at will upon 15 days written notice. After these employment contracts were transferred, petitioner was the only person active in his accounting firm.3
On December 21, 1968, the day the trusts were created, the trustee executed a document forming a partnership among the eight trusts (hereafter the partnership). The partnership was designated as “Melvin P. Ketter, C.P.A.,” although neither petitioner nor his wife were members of the partnership. The “work in progress” and employment contracts transferred on December 21, 1968, to the trusts, were immediately reassigned to the partnership by the trusts when the partnership was formed; there was no formal document to effect the legal assignment to the partnership of the assets transferred to the trusts in 1969.
Neither petitioner, nor the partnership, nor the trusts have recognized, for Federal income tax purposes, the income transferred as a part of the “work in progress.” Originally this income was reported by the partnership for 1968, but the partnership filed an amended return for that year after respondent took the position, during an audit, that this income was taxable to petitioner rather than the partners.
The partnership agreement, which was valid under State law, provided inter alia, that the partners were to have equal management rights, that each partner could withdraw his share of the partnership net profits at the end of the year, and that each partner could withdraw upon giving 90 days' notice. Upon withdrawal, a partner was entitled to the value of his capital account without allowance for intangibles, except such costs incurred in obtaining intangibles as were reflected in the partnership books.
On December 21, 1968, petitioner entered into an agreement with the partnership as an independent contractor, employing the partnership to supply petitioner's accounting proprietorship with accounting services, including personnel,...
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