Madorin v. Comm'r of Internal Revenue, Docket No. 28963-81.

• Decision Date: 11 April 1985
• Docket Number: Docket No. 28963-81.
• Citation: 84 T.C. 667,84 T.C. No. 44
• Parties: BERNARD AND JOYCE MADORIN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

84 T.C. 667
84 T.C. No. 44

BERNARD AND JOYCE MADORIN, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 28963-81.

United States Tax Court

Filed April 11, 1985

Petitioner was the grantor of four trusts. Because the trustee of the trusts had the power to add beneficiaries, the trusts were grantor trusts pursuant to sec. 674(a), I.R.C. 1954. The trusts purchased limited partnership interests in Metro, which in turn purchased a limited partnership interest in Saintly. Petitioner, as grantor, recognized on his joint income tax return the losses generated by Saintly. At the point Saintly began generating income, the trustee renounced his power to add beneficiaries and the trusts ceased to be grantor trusts, i.e., they were perfected. HELD, Sec. 1.1001-2(c), EXAMPLE (5), Income Tax Regs., is a valid interpretation of secs. 671, 674 and 1001, I.R.C. 1954, because the grantor is treated as the owner of the trust property and the perfection of the trusts resulted in a taxable disposition of the trust property by petitioner to the trusts. HELD FURTHER, the Commissioner has authority to apply the regulation retroactively. HELD FURTHER, the gain recognized is ordinary income pursuant to secs. 741 and 751, I.R.C. 1954.

[84 T.C. 668]

JUDY JACOBS, for the respondent.

STEPHEN N. ENGBERG and MICHAEL A, KLEIN, for the petitioners.

OPINION DAWSON, CHIEF JUDGE:

Respondent determined a deficiency of $27,618 in petitioners' Federal income tax for the taxable year 1978. The issues for decision are: (1) Whether section 1.1001-2(c), EXAMPLE (5), Income Tax Regs., should be declared invalid as an unwarranted extension of sections 671, 674 and 1001; ¹ (2) if the regulation is valid, whether the regulation should be applied retroactively; and (3) if the regulation is applied retroactively against petitioners, whether the gain recognized by petitioners should be treated as ordinary income or long-term capital gain.

This case was submitted fully stipulated pursuant to Rule 122. ² The stipulation of facts and the attached exhibits are incorporated herein by this reference. The pertinent facts are summarized below.

Petitioners Bernard and Joyce Madorin were residents of Chicago, Illinois at the time they filed their petition in this case. On December 19, 1975, Bernard Madorin (petitioner), as grantor, established four separate irrevocable trusts: the Miles Trust; the Mark Trust; the Melanie Trust; and the Bernard Descendant's Trust, The trust agreement designated Richard Coen (Coen) as the trustee of each of the four trusts. Coen was at all times a ‘nonadverse party‘ as defined by section 672(b), Further, he was not a ‘related or subordinate‘ party as defined by section 672(c). A provision in the trust agreement gave the trustee the power to add one or more section 501(c)(3) charitable organizations as beneficiaries to any of the trusts. As a result of this provision, petitioner, the grantor, was

[84 T.C. 669]

treated as the owner of the four trusts pursuant to the provisions of section 674(a).

On or about December 19, 1975, petitioner funded each of the trusts with $5,075 in cash. Petitioners filed United States Quarterly Gift Tax Returns (Forms 709) with respect to the gifts. The $5,075 gift to each trust was its only funding.

On December 19, 1975, each of the four trusts contributed $5,010 to Metro Investment Company (Metro), an Illinois partnership. The trusts each acquired a one-ninth interest in Metro. On or about December 22, 1975, Metro contributed $45,000 to Saintly Associates (Saintly), a partnership involved in servicing the production of motion pictures. Of the $45,000 invested, approximately $20,000 was attributable to the contributions made by the four trusts. On October 17, 1975, Saintly had entered into an agreement with Warner Bros., Inc., to perform all services necessary to produce a motion picture. To finance the performance of these services, Saintly obtained a nonrecourse loan of $3,270,000 from Security Pacific National Bank.

On petitioners' 1975 through 1977 Federal income tax returns they reported the following losses and income from the four trusts:

+-------------------------+
                ¦1975¦Loss ¦($50,709.60) ¦
                +----+------+-------------¦
                ¦1976¦Loss ¦(20,753.92) ¦
                +----+------+-------------¦
                ¦1977¦Income¦1,544.28 ¦
                +-------------------------+
                

On January 1, 1978, Coen, the trustee of the four trusts, irrevocably renounced his power to add beneficiaries to each trust. As a result, the trusts ceased to be grantor trusts and petitioner, the grantor, was no longer considered the owner of the trusts under section 674(a). Petitioners reported no gain or loss from the trusts on their 1978 return.

In August 1981 respondent sent petitioners a notice of deficiency. Relying on section 1.1001-2(c), EXAMPLE (5), Income Tax Regs. (hereinafter referred to as example 5 or the regulation), ³ respondent determined that the grantor was the

[84 T.C. 670]

owner of the partnership interests and when the trusts ceased to be grantor trusts there was a disposition of the trusts' assets, i.e., the partnership interests in Saintly via Metro, by the grantor to the four trusts. ⁴

I. VALIDITY OF THE REGULATION.

Petitioners contend that example 5 is invalid as an unreasonable interpretation of sections 671, 674 and 1001. Petitioners argue that the grantor of a trust should be ‘treated as the owner‘ only for the limited purpose of attributing to him items of income, deductions, and credits. This contention embodies petitioners' arguments that (1) the trust should be treated as the partner and owner of the partnership interest

[84 T.C. 671]

and (2) the trust maintains a separate transactional identity. According to petitioners, the interpretation of ‘owner‘ in example 5 to mean owner of the trust's assets is inconsistent with section 671. Respondent contends, however, that example 5 is a valid interpretation of the applicable statutory provisions. We agree with respondent.

It is well established that regulations ‘must be sustained unless unreasonable and plainly inconsistent with the revenue statutes.‘ Commissioner v. South Texas Lumber Co., 333 U.S. 496, 501 (1948). Section 7805(a) gives the Commissioner broad authority to promulgate needful regulations. See United States v. Correll, 389 U.S. 299, 306 (1967). As such, regulations ‘should not be overruled except for weighty reasons.‘ Bingler v. Johnson, 394 U.S. 741, 750 (1969), quoting Commissioner v. South Texas Lumber, supra at 501.

We note, however, that ‘Regulations must, by their terms and in their application, be in harmony with the statute. A regulation which is in conflict with or restrictive of the statute is, to the extent of the conflict or restriction, invalid.‘ Citizen's National Bank of Waco v. United States, 417 F.2d 675, 679 (5th Cir. 1969), quoting Scofield v. Lewis, 251 F.2d 128, 132 (5th Cir. 1958).

The Supreme Court has ruled that statutory terms should be given their ‘usual, ordinary and everyday meaning.‘ Old Colony Railroad Co. v. Commissioner, 284 U.S. 552, 561 (1932). We agree with respondent's contention that defining ‘owner * * * of a trust‘ under section 674 (and section 671) to mean owner of the trust's assets is consistent with the usual, ordinary and everyday meaning of the word. Application of the grantor trust provisions generally results in nonrecognition of the trust (or a portion thereof) as an entity separate from the grantor. See Estate of O'Connor v. Commissioner, 69 T.C. 165, 174 (1977).

Petitioners set forth several arguments toward establishing that ‘owner‘ as defined in example 5 is inconsistent with the intended meaning of section 671. First, they appeal to the language of section 671. Section 671 states in part:

Where it is specified in this subpart that the grantor or another person shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the

[84 T.C. 672]

trust which are attributable to that portion of the trust to the extent that such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual. * * *

Petitioners assert that the plain language of section 671 limits the attributes of ownership to the imputation of income, deductions, and credits only. We disagree. There is nothing on the face of the statute which tells us that that is the exclusive attribute of ownership. Section 671 specifies one result of being an ‘owner,‘ but it does not specifically limit the meaning to that result.

Second, petitioners point to the legislative history of section 671. Petitioners assert that the Senate and House Committee Reports ⁵ indicate that Congress intended to limit the attributes of ownership to the reporting of income, deductions, and credits. Petitioners argue that the stated purpose for enacting sections 671 through 679 was to bring together ‘the rules for determining taxability of trusts falling within the purview of section 22(a) as well as those covered by sections 166 and 167 (of the Internal Revenue Code of 1939) . . . .‘ ⁶ As such ‘(t)hese...