Smith v. United States
| Decision Date | 28 December 1965 |
| Docket Number | Civ. No. 14968,14969. |
| Citation | 248 F. Supp. 873 |
| Parties | Ernest L. SMITH and Margaret B. Smith v. UNITED STATES of America. Ernest L. SMITH, Trustee, E. L. Schmidt Trust v. UNITED STATES of America. |
| Court | U.S. District Court — District of Maryland |
Moshe Schuldinger, Atty., Dept. of Justice, Washington, D. C. (Thomas J. Kenney, U. S. Atty., and Robert W. Kernan, First Asst. U. S. Atty., Baltimore, Md., and Louis F. Oberdorfer, Asst. Atty. Gen., C. Moxley Featherston and David A. Wilson, Jr., Attys., Dept. of Justice, Washington, D. C., on brief) for defendant.
The two actions now before the Court seek refund of federal income taxes and interest for the years 1953 and 1954. One action is brought by individual taxpayers, Ernest L. Smith and his wife, Margaret B. Smith; the other is brought by Ernest L. Smith as Trustee of the E. L. Schmidt Trust, an inter vivos trust created in 1931.
Ernest L. Smith and Eugene A. Smith are the two sons of E. L. Schmidt, who died in 1938. To minimize confusion, they will be referred to herein as "Ernest", "Eugene" and "Schmidt", respectively. Where the reference is to Ernest as Trustee, he will be called "Ernest, Trustee", or simply "the Trustee". Where questions are common to both suits, the plaintiffs will be referred to collectively as "taxpayers".
1. Whether payments made by C & S Realty Corp. to Ernest, Trustee, in 1953 and 1954 constituted (a) ordinary income from collections on certain second trust notes, or (b) capital gain income from a sale or exchange of the notes.
2. Whether the amounts distributed to Eugene by Ernest, Trustee, as a result of the payments made by C & S Realty Corp. were taxable (a) to the Trust or (b) to Eugene. If they were taxable to Eugene, should Ernest, Trustee, be permitted to recover herein for taxes paid by him as Trustee when assessment of such taxes against Eugene is barred by the statute of limitations?
3. Whether the basis of the second trust notes was properly determined; specifically, whether the basis should have included an amount previously deducted by taxpayers without any tax benefit.
Most of the facts are contained in a written stipulation and in oral and written supplements thereto and modifications thereof at the trial. The following statement recites such of the stipulated facts as are necessary to understand the legal issues, and includes a few facts which have been found from depositions of Ernest and another, which were offered in evidence.
In 1931 Schmidt held a note from Eugene A. Smith, Incorporated (Smith, Inc.), in the face amount of $163,000. That note was secured by eleven second trust notes in the amount of $25,000 each, a total of $275,000. The eleven notes were, in turn, secured by a second trust on the Conard Apartment, Washington, D. C. In 1931 the Conard Apartment was owned by Smith, Inc., and that corporation was wholly owned by Eugene. There was no personal liability on the maker of the eleven notes, who was a straw party.
By an indenture dated February 24, 1931, Schmidt, a resident of the District of Columbia, created the Schmidt Trust, with Ernest as Trustee. Schmidt transferred all his assets to the Trust, except some stocks and household effects. Among the assets transferred were the note of Smith, Inc., for $163,000, and the eleven second trust notes on the Conard Apartment, which secured the $163,000 note.
Under the terms of the trust indenture the grantor, Schmidt, was entitled to the income for life. Upon his death, the corpus of the trust was to be divided into two equal parts, one of which was to be "assigned, conveyed, transferred and set over unto Ernest L. Smith, individually, for his absolute use and benefit". The remaining one-half remains in trust during the life of Eugene, who receives the income from that half, but, by reason of certain spendthrift provisions contained in the trust instrument, cannot pledge or otherwise dispose of his interest. On the death of Eugene, his interest is to be paid over to such of the heirs of Schmidt as Ernest may by will appoint or, in default of appointment, to such heirs of Schmidt as would take in accordance with the statutes of distribution of the District of Columbia.
After the death of the grantor in 1938, Ernest, Trustee, continued to treat as part of the trust assets the one-half share thereof to which he was then absolutely entitled, and continued up to and including the taxable years 1953 and 1954 to administer the trust as a single taxable entity with two beneficiaries. This was done for ease of administration, because the assets were not readily divisible. Eugene and Ernest thereafter shared equally in all distributions of the income of the trust. In the administration of the Trust, Ernest as Trustee treated amounts which he believed to be capital gains as distributable income rather than as an increase in corpus, and distributed such amounts currently to Eugene as well as to himself individually.
As early as 1931, Smith, Inc., was in serious financial difficulties. To satisfy its creditors, and in accordance with an agreement dated December 23, 1931, Smith, Inc., conveyed the Conard Apartment and other real property to Washington Apartment Securities Corporation (Securities Corp.), and Smith, Inc., received 4,750 shares of common stock of Securities Corp. Under the terms of the agreement, Securities Corp. was to manage the properties and to apply the rentals to the operation thereof and to the payment of taxes and other obligations due thereon. At the time Securities Corp. took over the Conard Apartment, that property was subject to a first trust of $531,875, which was held by the Metropolitan Life Insurance Company, and to a second trust securing notes totaling $275,000, which were held by Ernest as Trustee of the Schmidt Trust. Securities Corp. did not assume payment on the second trust notes. Smith, Inc., engaged in no further activity after the transaction described in this paragraph, and at some unspecified time thereafter was dissolved. The properties other than the Conard Apartment were subsequently abandoned to the creditors of Smith, Inc.
Securities Corp. recorded upon its books the acquisition of the Conard Apartment and the first mortgage thereon. Although not recorded initially, the second trust notes totaling $275,000 were recorded later on the books of Securities Corp. as "trust notes receivable — pledged".
No payment of any kind was ever made on the $163,000 note of Smith, Inc. In 1938, Ernest, Trustee, acquired ownership of the collateral securing the $163,000 note by giving a $100,000 credit on that note, which was endorsed as follows:
The $63,000 difference between the face value of the note and the $100,000 credit given for the collateral was treated as uncollectible; Ernest, Trustee, wrote the $63,000 off as a bad debt in 1938 and deducted this amount in the 1938 fiduciary income tax return which he filed for the Schmidt Trust. As a result of that deduction, the fiduciary return showed a distributable loss for the taxable year and the distribution of the loss equally between Ernest and Eugene.
Upon audit of that return by a revenue agent it was determined that no part of the loss was distributable to Eugene, but that one-half of the loss was deductible by the Trust and one-half by Ernest. Because of other deductions the tax benefit of this loss to the Trust was only $2,505.71. Ernest and his wife Margaret took as a deduction on their joint income tax return for the taxable year 1938 the sum of $28,945.70, being the portion of the loss reported on the fiduciary return as distributable to Ernest. The tax benefit of this distributed loss to Ernest, as a deduction, was $12,122.47.
Ernest, Trustee, thereafter sought payment of the second trust notes from Securities Corp. When they were not paid, he advised Securities Corp. by letter dated June 15, 1938, that he must insist upon a foreclosure of the collateral securing the second trust notes which he held unless the corporation delivered to him or his nominee a deed to the Conard Apartment. On June 17, 1938, the stockholders of Securities Corp. resolved that the Conard Apartment be conveyed to Ernest, Trustee, or his nominee, without merging his equitable lien with the legal title. At the same meeting it was decided to dissolve Securities Corp.1
By letter dated August 2, 1938, Ernest requested Securities Corp. to execute a deed conveying the Conard Apartment to C & S Realty Corporation subject to the first and second deeds of trust securing debts of $476,000 and $275,000, respectively.2 C & S Realty Corporation (Realty Corp.) was owned and controlled by Ernest individually.
Securities Corp. conveyed the Conard Apartment to Realty Corp. on August 4, 1938, ceased its activities and was subsequently dissolved. At a special meeting of the board of directors of Realty Corp. on August 2, 1938, the directors authorized acceptance of the deed conveying the property, noting that it was subject to a first deed of trust securing Metropolitan Life Insurance Company in the approximate amount of $476,000 and subject to a second deed of trust in the approximate amount of $275,000.
Realty Corp. did not assume the second trust obligation. However, on its balance sheets for fiscal years ending July 31, 1942, through July 31, 1953, Realty Corp. reported the current outstanding balances of both the first and second trusts as representing mortgages payable. Moreover, beginning in the year 1944, Realty Corp. made payments to Ernest, Trustee, of accrued interest on the second trust notes. Eventually, all of the interest due on those notes was paid by Realty Corp. to Ernest, Trustee.
In addition to the interest, Realty Corp. made payments...
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