Opinion
Docket No. 40005.
1954-06-30
ESTATE OF HAROLD S. DAVIS, DECEASED, MARY DAVIS, EXECUTRIX, AND MARY DAVIS, SURVIVING WIFE, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
John F. Langs, Esq. , for the petitioners. Charles Speed Gray, Esq. , for the respondent.
1. During its taxable year 1942, H. S. D. Co. established a profit sharing plan for its executive employees and its hourly-paid employees and as part of the plan established a separate trust for each of those groups of its employees. During 1948, Harold S. Davis, a participant in the trust for the executive employees, died and thereafter during that year the trustee of that trust distributed in one sum to petitioner, Mary Davis, his interest in the trust. She reported said sum as taxable as gain from the sale or exchange of a capital asset held for more than 6 months. Respondent determined that the executive trust from its creation had been operated so as to discriminate in favor of the stockholders of H. S. D. Co. and its supervisory employees, that therefore the trust was not exempt from tax during the year in which said sum was distributed and held that such sum was taxable as ordinary income. in H. S. D. Co. v. Kavanagh, (C. A. 6) 191 F. 2d 831, the question before the court was whether the trust for the executive employees and that for the hourly-paid employees were exempt from tax for the taxable year 1944. The facts as to the operations of the two trusts from their creation to April 30, 1947, were also before the court. It was there held that there was no discrimination as to any of the contributions or investments in either of the trusts, subsequent to the amendments to section 165(a) of the Internal Revenue Code by the Revenue Act of 1942, making the exemption of profit sharing trusts dependent on their being nondiscriminatory, that the profit sharing plan in question met the requirements of section 165(a) of the Code, as amended, and that the trusts were entitled to exemption. Many of the facts and a number of the legal questions there involved are also involved herein. Held, that while the court's decision as to the status of the trusts for the taxable year 1944 is not conclusive of their status during the year of the distribution involved herein, its holdings with respect to such facts and legal questions as were there involved and are also involved here are persuasive authority and are to be accorded recognition as such.
2. Held, that the trust for executive employees was not operated so as to result in discrimination.
3. During its taxable year 1948 H. S. D. Co. abandoned its profit sharing plan as to the executive trust preliminary to going into liquidation the following year. Held, that the profit sharing plan was not lacking in permanence.
4. Held, that the executive trust was exempt from tax under section 165(a) of the Internal Revenue Code at the time of the distribution to petitioner, Mary Davis, and that under the provisions of section 165(b) the amount of said distribution is taxable as a gain from the sale or exchange of a capital asset held for more than 6 months. John F. Langs, Esq., for the petitioners. Charles Speed Gray, Esq., for the respondent.
The respondent determined a deficiency of $5,759.48 in the petitioners' income tax for 1948. The only issue for determination is whether an amount of $32,948.28 received by Mary Davis during 1948 and which represented the total proceeds of the interest of Harold S. Davis, deceased, in an employees' trust is to be considered as gain from the sale or exchange of a capital asset held for more than 6 months.
FINDINGS OF FACT.
A portion of the facts has been stipulated and is found accordingly.
Mary Davis, sometimes hereinafter referred to as the petitioner, is a resident of Michigan. She is the widow of Harold S. Davis, sometimes hereinafter referred to as the decedent, who died testate and a resident of Michigan on February 27, 1948. The petitioner, the sole executrix and the sole beneficiary of the will of the decedent, filed with the collector at Detroit, Michigan, a joint income tax return for 1948, showing her income for the entire year and the income of the decedent for the portion of the year prior to his death.
The Knight-Morley Corporation, a Michigan corporation, sometimes hereinafter referred to as the corporation, was incorporated on April 1, 1937, to manufacture automobile accessories. It engaged in that business which it carried on until April 30, 1942, when it began the manufacture of airplane parts for war purposes. On November 15, 1944, the corporation sold all of the machinery which it used in the manufacture of airplane parts, put the remainder of its machinery in storage, and thereupon ceased manufacturing. Thenceforth it operated as a selling corporation, doing no manufacturing itself but having certain manufacturing done for it by others. On April 30, 1948, the name of the corporation was changed to H. S. D. Company by amendment of its articles of incorporation. During its fiscal year 1948 the corporation disposed of all of its exhaustible assets, including automobiles and office equipment, and in the following fiscal year went into liquidation. At the time of the hearing in this proceeding liquidation had not been completed. The corporation kept its books and filed its income tax returns on the accrual basis and for a fiscal year ended April 30.
At the time of his death the decedent was, and had been for many years, an officer, director, and stockholder of the corporation. The corporation had two classes of stock, class A and class B. Class A stock had voting rights. Class B stock did not have voting rights but was preferred as to dividends and in liquidation and was convertible into class A stock. Fifty per cent of the class A stock was owned by Charles E. Morley and his wife and 50 per cent by decedent and his wife, the petitioner herein. Also, Morley and the decedent each owned approximately 23 per cent of the class B stock. Morley was president of the corporation during the fiscal years 1943 through 1949.
On April 29, 1942, the corporation established a deferred compensation trust as part of a profit sharing plan for its executive employees, including the decedent. This trust was designated the Knight-Morley Corporation Executive Employees' Trust, sometimes hereinafter referred to as the executive trust. This trust was to continue for a period of 5 years with a possible extension of 5 years at the sole and exclusive direction of the trustee, provided, however, that the trust should terminate upon the death of all the executive employees. As a part of its profit sharing plan the corporation at the same time established, under provisions of section 165(a) of the Internal Revenue Code as it was prior to amendment by the Revenue Act of 1942, enacted October 21, 1942, another trust for its hourly-paid employees. The latter trust was designated the Knight-Morley Corporation Employee's Trust, sometimes hereinafter referred to as the employee trust. This trust was to continue for 10 years, with a possible extension of 5 years by the trustee upon the consent, advice, and direction of the advisory committee provided for therein. A trust agreement for each trust was executed by the corporation with John F. Langs as trustee. At the time of the creation of the trusts there were three executive employees and four hourly-paid employees. The plans were communicated to the respective employees of the corporation. The books and records of the respective trusts were kept and the reports of the trustee were made on the basis of a fiscal year ended April 30.
Subsequent to the amendments of sections 23(p)(1) and 165(a) of the Internal Revenue Code by the Revenue Act of 1942, the executive employees' and hourly-paid employees' profit sharing plans were amended to conform to the regulations prescribed by the respondent.
The general provisions of each plan, as amended, as to management, contributions by the corporation, payment of benefits to employee-participants, and terminations, were the same and were as follows:
The affairs of the trusts were governed by the trustee and an advisory committee consisting of three members, two of whom were to be at all times participating employees. The advisory committee had the duty and responsibility of directing the administration of the plan of which the trust was a part, and the trustee was required to follow the directions of the advisory committee. However, the trustee had general powers of control over handling and investing trust funds and the right to purchase any class of stock or interest in the corporation.
Employees of the corporation entitled to participate in the trust were all employees eligible under the trust who had been in continuous service with the corporation for 1 year or more.
Contributions made by the corporation to the trusts were to be uniform, being 15 per cent of the total basic compensation of all employee-participants, subject to the proviso that such percentage would not reduce the net income of the corporation before Federal taxes below $5,000.
In the event of the termination of the employment of an employee-participant, either voluntarily or involuntarily without cause, at any time after the participant had been in the continuous service of the corporation for 1 year from the date of the trust instrument or from the date of his employment, whichever was later, and prior to the termination of the trust, the participant was to receive 10 per cent of the contributions made on his behalf by the corporation to the trust, and for each additional year he had been in continuous service of the corporation he was to receive an additional 10 per cent for each year until he had accumulated 5 years of continuous service. Thereafter he was to receive for each additional year over 5 years 5 per cent of the contributions made on his behalf to the trust and standing to his credit. An employee-participant entering the military service of the United States or of any allied Government was to be continued as a participant, but the corporation was not to make any contribution on his behalf to the trust while he was in the military service. Upon his return from the military service, and in the event of his reemployment, the corporation again was to make contributions on his behalf to the trust in accordance with the trust agreement. In the event, upon his return from the military service, he was not reemployed by the corporation, he was to receive benefits from the trust in accordance with the above provisions as though his services with the corporation had been terminated in the year he was discharged from military service. Respecting payment by the trustee in case of the death of an employee-participant, the trust agreements, as amended, provided as follows:
In the event of death of an employee beneficiary under the terms of this Trust Agreement, the Trustee shall pay to his or her heirs or personal representatives designated by the employee beneficiary, in accordance with uniform rules and regulations adopted by the Advisory Committee, at the termination of this Trust one hundred per cent (100%) of the contributions made by the Company to the Trust Fund on his behalf, providing however, that between the time of the death of a particular employee beneficiary and the termination of this Trust Agreement the Trustee with the advice and direction of the Advisory Committee, may make such advances or loans against the benefits to which the designated heirs or personal representatives of the deceased may be entitled, but not in excess of the total benefits due and owing by virtue of this Trust Agreement to the designated heirs or personal representatives; and, provided, further, that such loans and advances shall be made only in the event of financial hardship. Respecting payments or distributions the trust agreements, as amended, authorized the trustee to make division or distribution in money or in kind, or partly in money and partly in kind, including undivided interests at fair market values, to be determined by the advisory committee, making the necessary equalization in cash to the beneficiaries of the trust.
The corporation reserved the right to discontinue contributions to the trusts for such reasons as it might believe to be for the best interest of itself. However, the trust was to continue in existence even though the corporation discontinued or failed to make further contributions.
Upon termination of the trusts, distribution of the assets of the trusts was to be made to the employee-participants in accordance with their interest in the trust, such distribution to be at the rate of one-tenth of the amount of such interests each year until the full amount had been distributed. The employee-participants were not to have any right to their respective portions of the trust fund until paid to them.
The trust agreements might be altered or amended by the parties thereto, provided that such alteration or amendment did not alter the duties, powers, and responsibilities of the trustee without his consent, did not affect the substantial rights of any employee-participant or beneficiary under the trust agreements without his written consent and did not vest in the corporation any interest, ownership, or control, directly or indirectly, in any of the assets of the trusts. Under no circumstances were the sums of money or other things of value contributed by the corporation to the trusts or any part of the income or corpus of the trusts to be recoverable by the corporation from the trustee or any employee-participant or beneficiary.
An addition to the executive trust was made by an amendment, dated October 5, 1944, which reads as follows:
That in conformance with the terms of I. T. 3674 recently issued by the Internal Revenue Department, it is hereby provided that amounts allocated to participants under this Trust who individually hold, directly or indirectly, more than 10% of the voting stock of the Company shall not exceed in the aggregate 30% of the total contributions for all participants, and where amounts allocated to such participants under the Trust exceed this limit, the Advisory Committee shall reduce such stockholder participant's allocation proportionately, and equitably, to bring it within said limitations, and notify the Trustee thereof and allocate the amount of said reduction proportionately to the other participants who are not stockholders.
During its fiscal years 1942 through 1944 the corporation made contributions totaling $25,703.44 to the executive trust and $16,836.61 to the employee trust. The corporation sustained net losses for the fiscal years 1945 and 1946. A contribution of $780 was made to the executive trust for the fiscal year 1947. No contribution was made to the employee trust for the fiscal year 1947 since the one active participant in the trust was not employed by the corporation during that year. The corporation's net income for the fiscal year 1948 was $68,391.03 and a contribution of $97.50 was made to the executive trust for expenses. The corporation had a net income of $5,115.05 for the fiscal year 1949, the year in which it went into liquidation. No contribution for that year was made by the corporation to either the executive trust or the employee trust.
The following is a statement of the assets of each of the trusts on April 30 of the indicated years:
+----------------------------------------------------------------------------------------------------------+ ¦EXECUTIVE TRUST ¦ +----------------------------------------------------------------------------------------------------------¦ ¦ ¦1942 ¦1943 ¦1944 ¦1945 ¦1946 ¦1947 ¦1948 ¦1949 ¦ +----------------+----------+----------+----------+----------+----------+-----------+-----------+----------¦ ¦Cash ¦ ¦ ¦$1,098.93 ¦$1,235.74 ¦$379.15 ¦$1,608.12 ¦$26,238.19 ¦$11,015.21¦ +----------------+----------+----------+----------+----------+----------+-----------+-----------+----------¦ ¦Class B stock of¦$10,000.00¦$12,650.00¦18,800.00 ¦48,800.00 ¦12,650.00 ¦12,650.00 ¦12,650.00 ¦ ¦ ¦the corporation ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +----------------+----------+----------+----------+----------+----------+-----------+-----------+----------¦ ¦Vendee's ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦interest in ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦premises 650 ¦ ¦8,551.95 ¦13,351.95 ¦ ¦ ¦ ¦ ¦ ¦ ¦East Hancock ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦Street, Detroit ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +----------------+----------+----------+----------+----------+----------+-----------+-----------+----------¦ ¦Insurance ¦ ¦1,145.30 ¦3,220.76 ¦5,380.11 ¦7,369.86 ¦9,902.51 ¦6,056.53 ¦ ¦ ¦policies ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +----------------+----------+----------+----------+----------+----------+-----------+-----------+----------¦ ¦Factory ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦building, ¦ ¦ ¦ ¦ ¦72,000.00 ¦78,289.87 ¦ ¦ ¦ ¦Richmond, ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦Michigan ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +----------------+----------+----------+----------+----------+----------+-----------+-----------+----------¦ ¦Balance due, on ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦land ¦ ¦ ¦ ¦ ¦ ¦ ¦56,767.87 ¦51,564.21 ¦ ¦contract—factory¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦building ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +----------------+----------+----------+----------+----------+----------+-----------+-----------+----------¦ ¦Total ¦$10,000.00¦$22,347.25¦$36,471.64¦$55,415.85¦$92,339.01¦$102,450.50¦$101,712.59¦$62,579.42¦ +----------------------------------------------------------------------------------------------------------+
+-------------------------------------------------------------------------------------------------+ ¦EMPLOYEE TRUST ¦ +-------------------------------------------------------------------------------------------------¦ ¦ ¦1942 ¦1943 ¦1944 ¦1945 ¦1946 ¦1947 ¦1948 ¦1949 ¦ +-----------+---------+---------+----------+----------+----------+----------+----------+----------¦ ¦Cash ¦ ¦ ¦$73.20 ¦$1,604.51 ¦$1,284.86 ¦$3,236.86 ¦$3,116.86 ¦$13,509.99¦ +-----------+---------+---------+----------+----------+----------+----------+----------+----------¦ ¦Class B ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦stock of ¦$5,000.00¦$5,000.00¦14,850.00 ¦11,200.00 ¦11,200.00 ¦11,200.00 ¦11,200.00 ¦ ¦ ¦the ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦corporation¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+---------+---------+----------+----------+----------+----------+----------+----------¦ ¦Total ¦$5,000.00¦$5,000.00¦$14,923.20¦$12,804.51¦$12,484.86¦$14,436.86¦$14,316.86¦$13,509.99¦ +-------------------------------------------------------------------------------------------------+
The Hancock Street property, consisting of an improved tract of real estate and a building thereon, was purchased by the executive trust on July 30, 1942. This property was the site of the corporation's manufacturing plant and immediately after its purchase by the trust was rented to the corporation at a monthly rental of $500. About a year later the rental was increased to $700 per month. On April 2, 1945, the trust sold the property at a profit of approximately $14,000.
The factory building at Richmond, Michigan, was purchased for $72,000 by the executive trust during the fiscal year 1946. Of the purchase price, the trust assumed payment of a mortgage for $37,150 then on the property, gave a further mortgage thereon for $10,000 and transferred, at an amount of $24,850, 697 shares of class B stock it owned in the corporation. The building was leased to the Damor Company at a rental of $1,000 per month. During the fiscal year 1948 the property was sold on a land contract for $56,767.87.
Prior to the discontinuance of the corporation's manufacturing business in 1944, there were 23 active participating employees in the employee trust. As of April 30, 1945, there was only 1 active participant in the trust, Richard Drozdowski, who was away in the military service. No new participants were added to the trust and Drozdowski has remained as the sole participant in the trust. As of April 30, 1949, his interest in the trust amounted to $5,151.32. There also were in the trust unallocated forfeitures amounting to $8,573.67.
The principal active participants of the executive trust were the decedent and Morley and for the fiscal year 1946 they were the only active participants. At the date of his death the decedent's interest in the trust amounted to $32,948.28 which the trustee paid on November 22, 1948, to the petitioner, Mary Davis, executrix of the estate of the decedent. The interests of the two remaining active participants in the trust, of whom Morley was one, amounted to $54,699.58 as of April 30, 1949. In addition, there were forfeitures allocated to participants in the amount of $7,879.84.
The executive and employee profit sharing plans were submitted to the Bureau of Internal Revenue on two occasions, following amendments to the plans, for ruling as to whether the plans met the requirements of section 165(a) of the Internal Revenue Code, as amended. On October 23, 1944, the Commissioner of Internal Revenue in a letter addressed to the corporation ruled as follows:
Upon consideration of the plan and a review of the related data, it is the opinion of this office that the plan instituted by you meets the requirements of Section 165(a) of the Code; therefore, the trust established thereunder is entitled to exemption under the provisions of Section 165(a) of the Code.
On February 13, 1946, the Commissioner addressed another letter to the corporation containing the following:
Reference is made to letter * * * dated September 19, 1945, submitting a proposed amendment to your Employees' Stock Bonus and Profit-Sharing Plan. There are two trust agreements executed on April 29, 1942 covering two trusts which have been amended as follows:
Executive Employees' Trust
November 12, 1942
October 13, 1943
November 15, 1943
January 31, 1944
October 5, 1944
December 27, 1945
Employees' Trusts
October 12, 1943
November 15, 1943
January 31, 1944
October 5, 1944
December 27, 1945
These two trusts form a part of the profit-sharing plan created by you for the benefit of your employees. A ruling is requested as to whether the plan, as now amended, meets the requirements of Section 165(a) of the Internal Revenue Code, as amended. Under date of October 23, 1944, a favorable ruling letter was issued by this office.
Upon consideration of the plan and a review of the related data, it is the opinion of this office that since the plan has been amended as heretofore stated, it now meets the requirements of Section 165(a) of the Internal Revenue Code, as amended, and that the trusts established thereunder are entitled to exemption under the provisions of that section.
Contributions made to the trusts will be allowed as deductions from gross income in accordance with Section 23(p) of the Internal Revenue Code, as amended, subject, however, to verification upon examination of your return.
The plan specifically permits investment of trust funds in your stock. Prior to making such investment, the date [ sic] required by P. S. No. 49 dated June 16, 1945, should be submitted to the Commissioner of Internal Revenue, Pension Trust Division, Washington 25, D. C. The foregoing P. S. and Section 29.165(a) of Regulations 111 reads in part as follows:
‘No specific limitations are provided in Section 165(a) with respect to investments which may be made by the Trustees of a trust qualifying under Section 165(a). The contributions may be used by the trustees to purchase any investment permitted by the trust agreement to the extent allowed by local law. Where, however, the trust funds are invested in stock or securities of the employer, full disclosure must be made of the reasons for such arrangement and of the conditions under which such investments are made in order that the Commissioner may determine whether the trust serves any purpose other than constituting part of a plan for the exclusive benefit of employee.’
Profit-sharing trust [ sic] providing benefits other than on death, retirement, sickness or disability of the employee require approval under the provision of the Act of October 2, 1942 (Public Law No. 729, 77th Congress, 2nd Session) as amended, and regulations issued thereunder, unless such benefits, which under Salary Stabilization regulations are treated as ‘Salary’ increases, are paid upon the condition that they will not be used in whole or in part as the basis for seeking an increase in price ceilings, or for resisting otherwise justifiable reductions in price ceiling, or in the case of products or services being furnished under contracts with a Federal Procurement Agency will not increase the cost to the United States.
During the first part of 1947 a revenue agent made an investigation of the tax liability of the corporation for the fiscal years 1942 through 1946. In addition to examining the books and records of the corporation, he examined the trustee's records for the executive trust and the employee trust. Deductions taken by the corporation for contributions of the two trusts were allowed with the exception of an amount of $5,000 which it was determined represented a contribution in excess of what was required by the formula contained in the trust agreements. The examination further disclosed a net overassessment of $18,834.11, representing overpayment of excess profits tax for the fiscal year 1944 due to the carry-back to that year under the provisions of the Internal Revenue Code of a net operating loss and an unused excess profits tax credit for the fiscal year 1945. A copy of the agent's report was furnished to the corporation on July 9, 1947.
Thereafter, and without having taken action on a claim for refund of excess profits tax for the fiscal year 1944 previously filed by the corporation, the Commissioner of Internal Revenue, on April 8, 1948, addressed a letter to the corporation containing the following:
Reference is made to the Executive Employees' Trust and the Employees' Trust established under separate trust agreements executed by you on April 29, 1942, and which form a part of your employees' profit-sharing plan. Such Trust agreements have been amended as follows:
Executive Employees' Trust
April 29, 1942
November 24, 1942
October 13, 1943
November 15, 1943
January 31, 1944
October 5, 1944
December 27, 1945
Employees' Trust
April 29, 1942
October 12, 1943
November 15, 1943
January 31, 1944
October 5, 1944
December 27, 1945
The plan, as evidenced by the Trust Agreements and information furnished with respect to computation of the allowable deduction under Section 23(p) of the Internal Revenue Code, as amended, has been considered and this office is of the opinion that such plan does not meet the requirements of Section 165(a) of the Internal Revenue Code, as amended, for the following reasons:
1. The conduct of the trusts has been of such a nature as not to operate for the exclusive benefit of the employees and their beneficiaries as required by Section 165(a) of the Internal Revenue Code, as amended. The trust funds have been invested in stock of the company for no purpose other than for the benefit of the employer.
2. Approximately one-half of the employer's contribution to each trust for F–1943 was returned to the employer. The use of corpus of the trust in this manner is not in accordance with Section 165(a)(2) of the Internal Revenue Code, as amended.
3. The operation of the trust discriminated in favor of the stockholders and supervisory employees which is prohibited by statute. During the four years the Employees' Trust had income of only $73.00 while the Executive Trust more than doubled the contributions it received. Forfeitures and unallocated funds of a considerable amount will eventually inure to the two stockholder participants in the Executive Trust. Interest in the Executive Trust by the two stockholder participants is approximately equal to 60% of the compensation otherwise paid such participants during years for which the employer made contributions to the trust, whereas the corresponding percentage in the Employees' Trust is equal to only 5%.
Accordingly, the opinion expressed by letters dated October 23, 1944 and February 13, 1946, with respect to qualifications of the plan and the exempt status of the trust is revoked and the plan, as amended, will be considered not to have met the requirements of Section 165(a) of the Internal Revenue Code, as amended, retroactively to the inception of the plan and the right of the trusts to exemption has been forfeited as of the time they were instituted.
If you so desire, you may make a written request for a conference at this office, within 15 days from date hereof, in connection with the exceptions herein-above set forth. Unless a request for a conference is received within such time at this office, the case will be closed.
Following a conference on May 4, 1948, between the corporation and representatives of the Commissioner, the Commissioner in a letter to the corporation, dated May 7, 1948, reaffirmed the holding contained in his letter of April 8, 1948, to the corporation.
On May 18, 1948, the corporation filed a complaint in the District Court of the United States for the Eastern District of Michigan, Southern Division, against Giles Kavanagh, Collector of Internal Revenue for the District of Michigan, for the refund of corporation excess profits tax in the amount of $18,834.11 for the fiscal year 1944. In his answer to the complaint, the collector took the position that the corporation was not only not entitled to the claimed refund of excess profits tax but alleged as an affirmative defense that it owed an additional income tax of $5,876.17 for said year as a result of erroneously having taken certain stated deductions for that year, including a deduction of $16,337.39 for payments to the executive and the employee trusts. The case was heard in the District Court on April 19, 1949, at which time evidence was taken. At the trial of the case, counsel for the collector took the position that the corporation's deduction of the $16,337.39 was erroneous because the trust did not comply with section 165(a) of the Internal Revenue Code for the reasons set forth in the Commissioner's letter of April 8, 1948, to the corporation, a copy of which was part of the record before the court. On January 11, 1950, the District Court held that the trusts were not exempt under section 165(a) of the Internal Revenue Code and that the contributions made thereto by the corporation were not deductible by it. Accordingly, the court dismissed the complaint and entered judgment for the collector. H. S. D. Co. v. Kavanagh, 88 F. Supp. 64.
The decision of the District Court was appealed by the corporation to the United States Court of Appeals for the Sixth Circuit. On June 19, 1951, the Court of Appeals reversed the decision, holding that the trusts were exempt under section 165(a) and that the corporation's contributions thereto were deductible, and remanded the case for entry of judgment in accordance with its opinion. H. S. D. Co. v. Kavanagh, 191 F. 2d 831.
In the income tax return filed by her for 1948, the petitioner reported as again from the sale or exchange of a capital asset held for more than 6 months the $32,948.28 paid to her as decedent's interest in the executive trust. In determining the deficiency involved herein the respondent determined that said amount represented ordinary income and explained his action as follows:
Income from Knight-Morley Corporation Executive Trust, reported in tax return as long term capital gain and eliminated as such in adjustment above, is determined as ordinary income.
See adverse ruling by this office for the Commissioner dated April 8, 1948 and May 7, 1948 addressed to Knight Morley Corporation.
The pension plan was not a qualified plan under the provisions of Section 165(a) of the Internal Revenue Code, for the year of 1948 in which the distribution to the taxpayer was made. In the court decision, H. S. D. Company (formerly known as Knight Morley Corporation) 88 F. Supp. 64, 38 A. F. T. R. 1386 reversed, the court did not consider nor was there involved at that time any fiscal year of the employer subsequent to the fiscal year ended April 30, 1944.
The decedent never made any contributions to the executive trust.
OPINION.
WITHEY, Judge:
The single issue for determination is whether the amount received by petitioner on November 22, 1948, as the interest of the decedent in the executive trust is taxable as gain from the sale or exchange of a capital asset held for more than 6 months, as reported by petitioner, r as ordinary income, as determined by respondent. Under the provisions of section 165(b) of the Internal Revenue Code, where the total distributions payable by a trust that is exempt from taxation under section 165(a) with respect to any employee are paid to the distributee within one taxable year of the distributee on account of the employee's separation from the service, the amount of such distribution in excess of the employee's contributions is to be considered a gain from the sale or exchange of a capital asset held for more than 6 months. Pertinent portions of section 165 are set out below.
SEC. 165. EMPLOYEES' TRUSTS.(a) EXEMPTION FROM TAX.—A trust forming part of a stock bonus, pension, or profitsharing plan of an employer for the exclusive benefit of his employees or their beneficiaries shall not be taxable under this supplement and no other provision of this supplement shall apply with respect to such trust or to its beneficiary—(1) If contributions are made to the trust by such employer, or employees, or both, for the purpose of distributing to such employees or their beneficiaries the corpus and income of the fund accumulated by the trust in accordance with such plan;(2) if under the trust instrument it is impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be (within the taxable year or thereafter) used for, or diverted to, purposes other than for the exclusive benefit of his employees or their beneficiaries;(3) if the trust, or two or more trusts, or the trust or trusts and annuity plan or plans are designated by the employer as constituting parts of a plan intended to qualify under this subsection which benefits either—(A) 70 per centum or more of all the employees, or 80 per centum or more of all the employees who are eligible to benefit under the plan if 70 per centum or more of all the employees are eligible to benefit under the plan, excluding in each case employees who have been employed not more than a minimum period prescribed by the plan, not exceeding five years, employees whose customary employment is for not more than twenty hours in any one week, and employees whose customary employment is for not more than five months in any calendar year, or(B) such employees as qualify under a classification set up by the employer and found by the Commissioner not to be discriminatory in favor of employees who are officers, shareholders, persons whose principal duties consist in supervising the work of other employees, or highly compensated employees;and(4) if the contributions or benefits provided under the plan do not discriminate in favor of employees who are officers, shareholders, persons whose principal duties consist in supervising the work of other employees, or highly compensated employees.(5) A classification shall not be considered discriminatory within the meaning of paragraphs (3)(B) or (4) of this subsection merely because it excludes employees the whole of whose remuneration constitutes ‘wages' under section 1426(a)(1) (relating to the Federal Insurance Contributions Act) or merely because it is limited to salaried or clerical employees. Neither shall a plan be considered discriminatory within the meaning of such provisions merely because the contributions or benefits of or on behalf of the employees under the plan bear a uniform relationship to the total compensation, or the basic or regular rate of compensation, of such employees, or merely because the contributions or benefits based on that part on an employee's remuneration which is excluded from ‘wages' by section 1426(a)(1) differ from the contributions or benefits based on employee's remuneration not so excluded, or differ because of any retirement benefits created under State or Federal law.(6) A plan shall be considered as meeting the requirements of paragraph (3) of this subsection during the whole of any taxable year of the plan if on one day in each quarter it satisfied such requirements.(b) TAXABILITY OF BENEFICIARY.—The amount actually distributed or made available to any distributee by any such trust shall be taxable to him, in the year in which so distributed or made available, under section 22(b)(2) as if it were an annuity the consideration for which is the amount contributed by the employee, except that if the total distributions payable with respect to any employee are paid to the distributee within one taxable year of the distributee on account of the employee's separation from the service, the amount of such distribution to the extent exceeding the amounts contributed by the employee, shall be considered a gain from the sale or exchange of a capital asset held for more than 6 months.
Since the decedent made no contributions to the trust and since his interest was paid in one sum, there is no controversy between the parties as to the amount in question qualifying under subsection (b) of section 165 for treatment as gain from the sale or exchange of a capital asset held for more than 6 months if the trust was exempt from tax under subsection (a). The primary question, therefore, is whether the trust was so exempt at the time of the distribution to petitioner in November 1948.
In her original brief, and on the ground that she was in privity with the corporation, as settlor of the trusts, the petitioner took the position that the decision of the United States Court of Appeals for the Sixth Circuit in H. S. D. So. v. Kavanagh, supra, was res judicata of the questions raised by respondent as to the operations of the trusts. However, on reply brief she merely contends that the decision of the Court of Appeals on the issues and facts presented there, which she claims are, in all material respects, identical with those presented here, is authoritative and should be followed. The respondent, on the other hand, takes the position that the decision of the Court of Appeals is not res judicata of the question presented here, namely, the status of the executive trust under section 165(a) of the Code at the time it made the distribution to the petitioner in November 1948 of the decedent's interest therein. Concededly, the principal question before the Court of Appeals was whether the two trusts were exempt under section 165(a) for the fiscal year 1944. Under the principles announced by the Supreme Court in Commissioner v. Sunnen, 333 U. S. 591, if it be conceded that petitioner was in privity with the corporation, the holding of the Court of Appeals that the trusts were exempt during the fiscal year 1944 is not conclusive of the status of either of them for the fiscal year 1949. Although the holding of the Court of Appeals as to status of the trusts in 1944 is not conclusive of the question here, many of the facts involved there are also involved here and a number of the legal questions involved there are likewise involved here. Under the circumstances the Court of Appeals' holdings of such questions are persuasive authority and are to be accorded recognition as such.
While conceding that H. S. D. Co. v. Kavanagh, supra, involved the status of the trusts for the fiscal year 1944, the petitioner points out that the case also involved the correctness of the respondent's ruling of April 8, 1948, wherein it was held that the two trusts had been so operated from their inception in 1942 to the time of the ruling as to forfeit their right of exemption from the time of their formation. Petitioner further points out that the respondent has based the determination here involved upon that ruling. Against this background the petitioner takes the position that, since in H. S. D. Co. v. Kavanagh, supra, the Court of Appeals had before it all the facts relating to the trusts from the time of their inception to April 30, 1947, and concluded therefrom that the trusts were exempt under section 165(a), that since no amendments, not considered by the Court of Appeals, have been made to the trust agreements, and that since no facts or change in operation of the trusts has occurred since April 30, 1947, which would bar exemption of the trusts, we should follow the holding of the Court of Appeals and conclude that the executive trust was also exempt at the time of the distribution of the decedent's interest in that trust.
The respondent recognizes that the correctness of his ruling of April 8, 1948, was involved in H. S. D. Co. v. Kavanagh, supra, that in that case the Court of Appeals had before it the facts relating to the two trusts from the time of their inception to April 30, 1947, and that the Court of Appeals there held that the trusts were exempt for the fiscal year 1944. However, he contends that the trusts were not exempt during their fiscal year 1949 when the distribution in question was made because they were discriminatory in operation and the corporation's plan for sharing profits lacked permanence.
In support of his contention that the trusts were discriminatory in operation, the respondent urges that, as a result of profitable real estate investments of contributions to the executive trust and the investment solely in the stock of the corporation of the contributions to the employee trust, assets of the executive trust as of April 30, 1948, exceeded $100,000 whereas the assets of the employee trust were slightly in excess of $14,000. He further urges that on April 30, 1949, and after the distribution to the petitioner of the $32,948.28 involved herein, the interest of the two remaining participants in the executive trust amounted to $54,699.58, plus forfeitures in the amount of $7,879.84 allocated to participants, and that on the same date benefits paid to about 22 participants of the employee trust amounted to less than $5,000 and that there was only one participant having an interest in trust assets of about $13,500 and that said participant had not been employed by the corporation since 1944.
The foregoing contentions of the respondent as to discrimination are in principle a repetition of the argument made by the collector in H. S. D. Co. v. Kavanagh, supra, and there rejected by the Court of Appeals. The only parcels of real estate in which funds of the executive trust were invested were the Hancock Street property in Detroit, which was acquired on July 30, 1942, and the factory building in Richmond, which was acquired during the fiscal year 1946. The Hancock Street property was sold on April 2, 1945, at a profit of approximately $14,000. The Richmond property was sold during the fiscal year 1948, but the record does not indicate that any profit was realized on the sale. In H. S. D. Co. v. Kavanagh, supra, the Court of Appeals considered the question of whether the profit made by the trust from its dealings in the Hancock Street property and the fact that the larger proportionate contributions were made by the corporation to the executive trust prior to the amendments to the Internal Revenue Code made by the Revenue Act of October 21, 1942, than were made to the employee trust, resulted in the trusts being operated in such a manner as to discriminate in favor of employee-participants of the executive trust and unfavorably to the employee-participants of the employee trust. The court there pointed out that the Hancock Street property had been acquired, and the disproportionate contributions had occurred, before the amendments to the Code on October 21, 1942, prohibiting discrimination. It further pointed out that after said amendments all contributions made by the corporation to the two trusts were based on a uniform percentage of the total basic compensation of all employee-participants. It then concluded that ‘In the instant case, there was no discrimination as to any of the contributions or investments in either of the trusts, subsequent to the amendments [by the Revenue Act] of 1942’ and held that ‘the plan met the requirements of Section 165(a) of the Internal Revenue Code, as amended, and that the trusts are entitled to exemption.’
As a part of his argument that the trusts were operated in a manner that resulted in discrimination, the respondent further contends that in reaching its decision in H. S. D. Co. v. Kavanagh, supra, the Court of Appeals did not consider the acquisition by the executive (rust of the Richmond property during the fiscal year 1946. He urges that since that transaction was substantially the same as the ownership of the Hancock Street property, except for the lessee, and that since the transaction occurred several years after the amendments made to section 165(a) by the Revenue Act of 1942, the transaction alone is proof of discrimination in favor of the employee-participants of the executive trust. Although the court did not specifically mention the Richmond property in its opinion, and while some of the language used by the court tends to support respondent's contention that that court did not consider the acquisition of the property by the executive trust, the evidence in the instant case shows that the fact of such acquisition and ownership was before the court. Since such fact was before the court, and since the court concluded that ‘there was no discrimination as to any of the contributions or investments in either of the trusts, subsequent to the amendments' made to section 165(a) by the Revenue Act of 1942, we think it must be concluded here that the court considered all investments, whether in real estate or otherwise, made after the amendments by the Revenue Act of 1942 and saw nothing in them which it deemed to be discriminatory.
The question of permanence of the corporation's profit sharing plan was raised in this proceeding for the first time by the respondent on brief. No mention of the matter is contained in the respondent's letter of April 8, 1948, on which the notice of deficiency involved herein was based nor was any mention made of the matter at the hearing of the instant proceeding. However, in view of what appears below, this belatedly raised question affords the respondent no aid here.
In support of his position that the corporation's plan for sharing profits lacked permanence, the respondent relies on the following: That the corporation discontinued its manufacturing business in November 1944 and terminated the employment of all of its hourly-paid employees, except the one who was away in the military service, with the result that the plan by which hourly-paid employees and executive employees shared in the corporation's profits was continued in effect for only about 3 years and that after the fiscal year 1945 only executive employees shared under the plan and that the corporation made no contribution to the executive trust for the fiscal year 1948 and apparently in that year abandoned the plan as to the executive employees.
Regulations 111 provide, in part, as follows:
SEC. 29.165–1. EMPLOYEES' TRUSTS.—( a) In general.—* * *
The term ‘plan’ implies a permanent as distinguished from a temporary program. While the employer may reserve the right to change or terminate the plan, and to discontinue contributions thereunder, if the plan is abandoned for any cause other than business necessity within a few years after it has taken effect, this will be evidence that the plan from its inception was not a bona fide program for the exclusive benefit of employees in general. Especially will this be true in the case of a pension plan under which pensions were fully funded for the highly paid employees or others in favor of whom discrimination is prohibited under section 165(a), and which was abandoned soon after the pensions for such favored employees had been provided. The permanency of the plan will be indicated by all of the surrounding facts and circumstances, including the likelihood of the employer's ability to continue contributions as provided under the plan. * * *
Respecting the corporation's discontinuance of its manufacturing business in 1944 and the consequent termination of the employment of its hourly-paid employees and the subsequent effect such action had with respect to the profit sharing plan of the corporation, the evidence herein shows that the facts as to those matters were before the Court of Appeals in H. S. D. Co. v. Kavanagh, supra, and the respondent concedes on brief that those matters were urged on the court by the collector as grounds for holding that the trusts lacked permanency. While in its Opinion the court did not discuss the question of the permanency of the plan, its holding that the trusts were exempt disposed of that question adversely to the collector and to the respondent's position here.
As to the respondent's contention that the corporation made no contribution to the executive trust for the fiscal year 1948 and that in that year it apparently abandoned the profit sharing plan as to the executive trust, the evidence shows that the corporation's only contribution to the trust for the year was $97.50 for expenses. The corporation's income for the year and the profit sharing formula contained in the trust agreement for that trust indicate that a larger contribution possibly should have been made. However, the evidence shows that during the fiscal year 1949 the corporation went into liquidation and further that during the fiscal year 1948 it disposed of all its exhaustible assets, including automobiles and office equipment. Apparently the corporation's disposition of such assets was preparatory to going into liquidation the following year and was dictated by business requirements. In this situation, and since it does not appear that the corporation made any contributions to the trust after the fiscal year 1947, it appears that during the fiscal year 1948 it abandoned the profit sharing plan as to the executive trust.
In E. R. Wagner Manufacturing Co., 18 T. C. 657, where the question of permanency of a profit sharing plan was involved we said:
Congress inserted many requirements in sections 23(p) and 165(a) but did not provide that the plan had to be permanent * * *. A plan involving a single contribution was held permanent enough to exempt the trust under section 165(a) in Lincoln Electric Co. Employees' Profit-Sharing Trust v. Commissioner, 190 F. 2d 326, reversing 14 T. C. 598. * * *
Here the corporation's abandonment of the profit sharing plan as it related to the executive trust occurred after the plan had been in operation for approximately 6 years and apparently was made preliminary to the liquidation of the corporation. Under the circumstances it cannot be said that such abandonment indicates that the plan was lacking in permanence as respondent contends.
In view of what has been said above, we hold that the executive trust was exempt from tax under section 165(a) of the Code at the time of the distribution to the petitioner in November 1948 of the decedent's interest therein. Having reached the foregoing conclusion, it becomes unnecessary to consider the effect here of the holding of the Court of Appeals in H. S. D. Co. v. Kavanagh, supra, that the Commissioner was without authority to revoke, as recited in his letter of April 8, 1948, the rulings of exemption of the trusts theretofore made.
Since under section 165(a) of the Code the executive trust was exempt from tax when the decedent's interest therein was distributed, since decedent had made no contributions to the trust, and since the entire amount of his interest was paid to petitioner during her taxable year 1948, said amount, under section 165(b), is to be considered a gain from the sale or exchange of a capital asset held for more than 6 months.
Decision will be entered under Rule 50.