Third Nat'l Bank v. Comm'r of Internal Revenue (In re Estate of Henry) , Docket Nos. 2926-75

• Decision Date: 06 February 1978
• Docket Number: 2927-75.,Docket Nos. 2926-75
• Citation: 69 T.C. 665
• Parties: ESTATE of DOUGLAS HENRY, DECEASED, THIRD NATIONAL BANK, et al., CO- EXECUTORS, and KATHRYN C. HENRY, SURVIVING WIFE, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENTKATHRYN C. HENRY, PETITIONER v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

69 T.C. 665

ESTATE of DOUGLAS HENRY, DECEASED, THIRD NATIONAL BANK, et al., CO- EXECUTORS, and KATHRYN C. HENRY, SURVIVING WIFE, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENTKATHRYN C. HENRY, PETITIONER

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket Nos. 2926-75

2927-75.

United States Tax Court

Filed February 6, 1978.

Petitioner made gifts of securities to trusts established for the benefit of her grandchildren. The trusts were required to pay all gift taxes resulting from the transfers. The trusts paid such gift taxes, totaling $2,085,967.26, from funds borrowed for that purpose. Held, petitioner did not realize a taxable gain in the amount of the difference between the gift taxes paid and her basis in the securities transferred. Turner v. Commissioner, 49 T.C. 356 (1968), affd. 410 F.2d 752 (6th Cir. 1969), followed; Johnson v. Commissioner, 59 T.C. 791 (1973), affd. 495 F.2d 1079 (6th Cir. 1974), cert. denied419 U.S. 1040 (1974), distinguished. Harlan Dodson, Harlan Dodson III, and Jack H. Putnam, Jr., for the petitioners.

John B. Harper, for the respondent.

FEATHERSTON, Judge:

Respondent determined a deficiency in the amount of $647,934.63 in petitioners' joint Federal income tax for 1971. Alternatively, respondent determined a deficiency in the amount of $699,640.83 in petitioner Kathryn C. Henry's Federal income tax for 1972.

The principal issue for decision is whether petitioner Kathryn C. Henry realized net income as a result of the payment of gift taxes by the trusts to which she had made gifts of certain securities. In the event that income was so realized, we must deal with a second issue as to whether such income was realized in 1971, the year in which the gifts were made, or in 1972, the year in which the gift taxes were paid by the donee. In order to protect his position, respondent has determined deficiencies with respect to the same alleged income in both such years; however, he concedes that the tax will be due only with respect to one of the 2 years, as may be determined herein.

FINDINGS OF FACT

Petitioner Kathryn C. Henry (hereinafter petitioner) is the surviving wife of Douglas Henry, who died on September 3, 1971. Third National Bank in Nashville (Third National) is a Tennessee corporation with offices in Nashville.

Petitioner and Third National were coexecutors under the will of Douglas Henry. Additional executors of the estate of Douglas Henry (hereinafter the estate) were Kathryn Craig Henry, Margaret Henry Joyce, and Douglas Selph Henry, Jr. Petitioner and each of the individual coexecutors resided in Nashville, Tenn., on the date the petition herein was filed.

The estate and petitioner, as surviving spouse, filed a joint Federal income tax return for 1971 with the Director, Internal Revenue Center, Memphis, Tenn. Petitioner filed an individual Federal income tax return for 1972 with the Director, Internal Revenue Center, Memphis, Tenn. During the years in question, petitioner and the estate were cash basis taxpayers.

During 1971 Thomas Cooper (Cooper), an employee of Third National with whom petitioner consulted concerning investments, suggested to petitioner that she consider making certain gifts. Cooper and petitioner consulted with Richard Holton (Holton), an officer in Third National's tax department, concerning the technical tax aspects of the proposed gifts. Holton and Cooper also called in petitioner's personal attorney, Harlan Dodson (Dodson), to discuss the situation.

Among the matters discussed were the possible income tax consequences of a gift made with the requirement that the donee pay all applicable Federal and State gift taxes. Dodson, an attorney with considerable experience and expertise in estate planning and taxation, researched this question thoroughly and concluded that it had been clearly established in several court cases ¹ that such an arrangement did not give rise to income tax consequences to the donor. Accordingly, Dodson advised petitioner to proceed with the proposed gifts. If Dodson had believed that the proposed gift arrangement would have resulted in income tax liability to petitioner, he would not have advised her to proceed in such a manner, and she would not have done so.

Based upon the advice of Cooper, Holton, and Dodson, petitioner on December 20, 1971, created eight irrevocable trusts for the benefit of her eight grandchildren. The trust instruments, which were identical as to all provisions pertinent to the issues in this case, named Third National as trustee and contained the following provisions concerning gift taxes:

ARTICLE III. TAXES

A. Trustee shall promptly pay all federal and state gift taxes which shall arise out of or be attributable to the transfer by this trust agreement.

B. In order to provide funds with which to pay such taxes, the trustee in its sole and absolute discretion may borrow sufficient funds for such purposes from such sources, including itself, as it may deem proper and to pledge or charge any or all of the corpus or income of this trust as security for any such loan.

The foregoing provisions were modeled in part upon certain language in the trust instrument involved in Krause v. Commissioner, 56 T.C. 1242, 1243 (1971), appeal dismissed (nolle pros) (6th Cir. June 27, 1972). That case had been decided on August 31, 1971, and had been relied upon by Dodson as the then most recent court decision. It was consistent with prior decisions in the Sixth Circuit and confirmed his conclusion that such an arrangement for the payment of gift taxes would not result in income to petitioner.

Petitioner transferred the following shares of stock to the eight trusts on December 22, 1971:

+----------------------+
                ¦¦Shares transferred   ¦
                ++---------------------¦
                ¦¦          ¦          ¦
                +----------------------+
                

Trust NLT Corp. Third National Bank  
                A       29,352      3,450
                B       29,352      3,450
                C       19,568      2,300
                D       19,568      2,300
                E       19,568      2,300
                F       19,568      2,300
                G       19,568      2,300
                H       19,568      2,300
                Total   176,112     20,700
                

Petitioner's basis in the transferred shares of stock was $114,940.97. On December 20, 1971, the fair market value of all the shares of stock transferred to the eight trusts was $6,682,572. Neither petitioner nor the trustees intended the transfer, in whole or in part, to be a sale of the stock.

On January 31, 1972, the eight trusts each borrowed sufficient funds from Third National to pay all Federal gift tax liabilities for the fourth quarter of 1971 and Tennessee State gift taxes for 1971. Trust assets (shares of the stock received from petitioner) were pledged as security for the loans. On the same date the trustee paid a total of $2,085,967.26 in Federal and State gift tax liabilities.

In 1972 all of the trusts began making payments on the January 31, 1972, loans from Third National. By 1976 six of the trusts had paid their loans in full. The loans to the other two trusts had not been paid in full as of the date of trial. Virtually all repayments of the Third National loans were made from the net proceeds from sales of the securities received by the trusts in 1971, such proceeds consisting of both income and corpus.

Petitioner did not report any income in connection with her transfers of NLT Corp. and Third National stock in either her 1971 or 1972 Federal income tax returns. Respondent determined that such transfers resulted in a taxable gain to petitioner in 1972, or alternatively in 1971, computed as follows:

+-----------------------------------------------------------------------------+
                ¦Amount realized (gift tax liabilities assumed and paid by the  ¦$2,085,967.26¦
                ¦trusts)                                                        ¦             ¦
                +---------------------------------------------------------------+-------------¦
                ¦Less: basis in stock transferred                               ¦114,940.97   ¦
                +---------------------------------------------------------------+-------------¦
                ¦Long term capital gain                                         ¦1,971,026.29 ¦
                +---------------------------------------------------------------+-------------¦
                ¦Less: sec. 12022   deduction                                   ¦985,513.15   ¦
                +---------------------------------------------------------------+-------------¦
                ¦Unreported taxable income                                      ¦985,513.14   ¦
                +-----------------------------------------------------------------------------+
                

Based upon the foregoing determination of additional income, respondent computed income tax deficiencies of $647,934.63 for 1971 and $699,640.83 for 1972. These deficiencies included a minimum tax in each year; however, respondent has now stipulated that such minimum tax is not applicable, and that the deficiencies now asserted are $637,264.79 for 1971 and $685,949.81 for 1972. Respondent has also conceded that the additional net income, determined as shown above, will not be subject to tax in both 1971 and 1972, but only in the proper year as may be determined herein.

OPINION

In this case we must once again grapple with the issue of the income tax consequences to a donor of appreciated property where the gift is conditioned upon the donee's payment of the gift tax resulting from the transfer. The basic facts are not disputed and are simply stated. Petitioner made gifts of securities which had a fair market value substantially in excess of her basis. One condition of the gifts was that the donees pay all applicable gift taxes, which they eventually did. The gift taxes paid exceeded in total amount the donor's basis in the securities transferred, but neither petitioner nor the trustees intended the transaction to be a sale in whole or in part.

Respondent characterizes the transaction as in part a sale and in part a gift, under the following rationale: Since the gift taxes on the transfer were the legal obligation of the donor,³ the donee's payment of the donor's tax...