Malone v. United States

• Decision Date: 29 April 1971
• Docket Number: No. DC 6911-K.,DC 6911-K.
• Citation: 326 F. Supp. 106
• Parties: R. C. MALONE and Nettie A. Malone, Plaintiffs, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Northern District of Mississippi

326 F. Supp. 106

R. C. MALONE and Nettie A. Malone, Plaintiffs, v. UNITED STATES of America, Defendant.

No. DC 6911-K.

United States District Court, N. D. Mississippi, Delta Division.

April 29, 1971.

Ben F. Mitchel, Cleveland, Miss., for plaintiffs.

Jack Warren, Justice Dept., Washington, D. C., for defendant.

MEMORANDUM OPINION

KEADY, Chief Judge.

This action was instituted under 28 U.S.C. § 1346(a) (1) by R. C. Malone and Nettie A. Malone against the United States for recovery of $5,706.73 assessed against and collected from them as federal income taxes for the calendar year 1961, plus interest and costs.¹

The case presents three questions: (1) whether plaintiff realized a long-term capital gain in 1961 as the result of a transfer of 546 acres of encumbered farm land to a trust for the benefit of his grandchildren; (2) whether $33.70 paid by plaintiff for legal fees in connection with a mortgage placed on the land in question a few months before creation of the trust represented a non-deductible capital expenditure; (3) whether plaintiff realized ordinary income of $1,784.20 in 1961 as the result of cattle sales in that year. Following briefing by counsel and the submission of a comprehensive pre-trial order stipulating the legal and factual issues, the parties consented to submit the entire case to the court for final judgment upon the pleadings, pre-trial order, exhibits and the deposition of R. C. Malone, without an evidentiary hearing.

As revealed by the pre-trial order and by plaintiff's deposition, the factual background of the case as to questions (1) and (2) above is as follows:

On or about January 25, 1940, plaintiff purchased, for $13,650, 546 acres of farm land, known as the Willis Place, in Bolivar County, Mississippi. On or about February 6, 1956, he obtained a loan of $21,000 from the Federal Land Bank of New Orleans, executing his personal note and deed of trust² on the Willis Place as security. The loan was to be repaid in 21 annual installments, the first to be due and payable on November 15, 1956.

On or about July 28, 1961, after having reduced the initial mortgage debt to $16,000, plaintiff obtained a second loan from the Federal Land Bank, this time procuring an additional $16,000. The second loan was also evidenced by his personal note and secured by deed of trust on the same land; the two loans were consolidated for purposes of payment and were to be repaid in 35 annual installments commencing on January 15, 1962. Plaintiff paid $33.70 as legal fees to obtain the second loan, comprising a $3.70 recording fee and a $30 attorney's fee.

On October 31, 1961, plaintiff established an irrevocable trust, known as the "Malone Trust", for the benefit of his four minor grandchildren and any afterborn grandchildren. On the same date he conveyed the Willis Place, subject to the two mortgages, to the trustees of the Malone Trust. The two trustees, who were plaintiff himself and The Cleveland State Bank of Cleveland, Mississippi, joined as grantees in the execution of the conveyance "to acknowledge and accept the property as trust property" and "to further acknowledge the acceptance and agreement of the terms and conditions expressed in * * * the Trust Agreement." The trust agreement itself provided that the Willis Place was "to be held by said Trustees in Trust, but subject to certain indebtedness to the Federal Land Bank of New Orleans in the amount of $32,000 secured by the Trust Property." This agreement specifically directed the trustees to "hold the lands", and

"manage and invest the Trust Property and shall collect and receive the income thereof; and after deducting all necessary expenses incident to the administration of the Trust and the installments of principal and interest due annually on the loan from the Federal Land Bank of New Orleans and secured by the Trust Property, shall dispose of the principal and income of the Trust as follows * * *" Here follow discretionary directions to pay remaining income to the grandchildren during their minority and mandatory directions to terminate the trust as each grandchild becomes 21 years of age and pay to him his share of the corpus and undistributed income. (Emphasis added).

The evidence reflects that plaintiff did not use the proceeds of either loan to improve or operate the trust property, but to conduct his personal farm operations on other lands and purchase farm machinery for his own use. It is clear that both loans were for plaintiff's personal use unrelated to the establishment or operation of the trust.

Since the formation of the trust in 1961, the trustees have received annual rent of $7,500 upon lease of the trust property and have paid the annual loan installments therefrom. Plaintiff has not been called upon to make any loan payment. The trust has also accumulated an undisclosed sum of money after meeting the annual mortgage payments and other expenses and making certain distributions to the trust beneficiaries.

On June 12, 1962, plaintiffs filed a joint United States gift tax return, reporting the aforesaid conveyance to the Malone Trust and listing its gross market value as $57,485. They listed the net value of the gift as $25,485, after deducting the $32,000 lien thereon; and plaintiffs paid no gift tax by claiming applicable exclusions and exemptions.

Following an audit of plaintiffs' 1961 joint federal income tax return, the Commissioner of Internal Revenue, by a ninety-day letter, gave them statutory notice that: (1) they had realized a long-term capital gain of $18,616.30 in 1961 on account of the transfer to the Malone Trust of the 546 acres of debt-encumbered land; (2) the $33.70 legal fees incurred in procuring the second mortgage were non-deductible capital expenditures and not deductible business expenses;³ and (3) they had realized $1,784.20 in ordinary income on 1961 cattle sales. Based on the Commissioner's determinations, Internal Revenue Service assessed additional taxes of $4,898.48, plus $808.25 interest, totaling $5,706.73, which plaintiffs promptly paid. They timely filed a claim for refund, waived statutory notice of disallowance, and instituted the present action.

I.

Plaintiff contends that the conveyance to the trust was wholly a gift, which resulted in no pecuniary benefit to him, and he therefore realized no gain taxable as income. The government disagrees, arguing that by the trust agreement the trustees assumed the mortgage debt, relieving the plaintiff of primary liability thereon, and since the mortgage debt was greater than his basis, the transaction was part gift and part sale. Conceding that the plaintiff made a valid gift of $25,485, the value of the land in excess of the debt, the government claims plaintiff also made a sale, or other disposition, whereby he realized a long-term capital gain of $18,650, or the difference between the $32,000 debt and $13,350, plaintiff's adjusted basis in the land.

Plaintiff insists that his conveyance to the Malone Trust fulfilled all requirements of law to constitute a valid gift.⁴ Yet, the government urges that the transaction was not wholly gratuitous since plaintiff received a valuable consideration in the form of relief from his primary liability on a $32,000 debt, and that the transaction was, therefore, a partial sale resulting in a substantial taxable gain to plaintiff. This directly raises the question of whether the trust estate merely accepted title subject to the mortgage or assumed responsibility for its payment. It is settled state law "that a mortgagor may convey the mortgaged premises subject to the mortgage in which case the grantee incurs no liability, or he may convey them in such manner that the grantee assumes the payment of the mortgage debt, and thus renders himself personally and primarily liable therefor."⁵

The government argues that the language of the trust instrument, although not cast in terms of a formal assumption, was sufficient under applicable Mississippi law to create an assumption of the taxpayer's debt by the trust. This argument is well-taken, since under the general law no particular form of words is necessary to create a binding assumption, and it is sufficient that the language shows a clear intent on the part of a grantee to assume the liability for paying the mortgage debt.⁶ The general rule above stated was first recognized by the Mississippi court in 1925, and has been followed consistently ever since.⁷ As the court stated in Gilliam, quoting from 3 Pomeroy's Equity Jurisprudence, ¶ 1206:

"The mortgagor may not only convey the premises `subject to' the mortgage; he may also convey them in such a manner that the grantee assumes the payment of the mortgage debt, and thus renders himself personally liable therefor. * * * No particular form of words is necessary to create a binding assumption; it is sufficient that the language shows unequivocally an intent on the part of the grantee to assume the liability of paying the mortgage debt, but this intent must clearly appear. When the deed executed by the grantor contains a clause sufficiently showing such an intent, the acceptance thereof by the grantee consummates the assumption, and creates a personal liability on his part, which inures to the benefit of the mortgagee as though he had himself executed the deed."

Here, plaintiff not only conveyed the lands to the Malone Trust subject to the mortgage, but he also directed that the trustees "deduct" the annual debt installments from the trust income. It is important to note that plaintiff, as settlor, neither reserved any portion of the income from the Willis Place for his own use in paying the debt, nor did he covenant with the trust that he would protect it against paying the mortgage. Necessarily, the directions to the trustees that they deduct from the trust income an amount equal to the annual installments of the loan's principal and interest can mean only a mandate to pay the deducted amount to...