Docket No. 3623-70.
Charles I. Rosin, for the petitioners. Earl Goldhammer, for the respondent.
A decedent had disposed of property pursuant to an arrangement which was adjudicated to be a long-term installment sales contract bearing an interest rate of 7 percent for purposes of computing the amount of interest received in each installment. Petitioner inherited the decedent's rights under the installment sales contract and received the installments paid thereafter. Held, that amounts received by petitioner pursuant to the installment sales contract were income in respect of a decedent under sec. 691(a), I.R.C. 1954, and were reportable by petitioner in the same manner that the decedent would have been required to treat them had she lived. Held, further, that a Valuation Agreement in respect of the decedent's estate taxation and signed by petitioner in his capacity as executor and beneficiary was not a statutory closing agreement under sec. 7121, I.R.C. 1954, and did not prevent the Commissioner from properly determining deficiencies in petitioner's income taxes. Held, further, that petitioner's spouse, who also signed the joint Federal income tax return, is jointly and severally liable for taxes determined to be due. Charles I. Rosin, for the petitioners. Earl Goldhammer, for the respondent.
The Commissioner determined deficiencies in petitioners' income tax in the following amounts:
+--------------------+ ¦Year ¦Deficiency ¦ +------+-------------¦ ¦ ¦ ¦ +------+-------------¦ ¦1966 ¦$2,233.79 ¦ +------+-------------¦ ¦1967 ¦2,440.30 ¦ +------+-------------¦ ¦1968 ¦2,531.46 ¦ +--------------------+
A decedent had disposed of property pursuant to an arrangement which was adjudicated to be a long-term installment sales contract. In other prior litigation involving the decedent's Federal income taxes this Court, in order to compute the amount of interest included in each installment, made a determination as to the rate of interest applicable to the sale. Petitioner inherited the decedent's rights under the installment sales contract and received the installments paid thereafter. The principal questions presented are: (1) In computing the amount of income in respect of a decedent pursuant to section 691 of the Code attributable to petitioner by reason of the installments received by him, is he entitled to use a lower rate of interest than that determined in the prior litigation; (2) does a Valuation Agreement, by which petitioner accepted a basis in the aforesaid contract in consideration of the Commissioner's acquiescence in his proposed valuation of the contract for decedent's Federal estate tax return, estop the Commissioner from using the decedent's correct basis, as required by section 691(a), in calculating the gain realized by petitioner from each installment payment. A third issue concerns the liability for taxes due from petitioner's wife who joined with him in filing joint income tax returns for the years in issue. Other possible issues based upon allegations of error appearing in the petition were neither raised at trial nor argued on brief and are therefore now deemed to have been conceded.
FINDINGS OF FACT
The parties have stipulated certain facts, which, together with attached exhibits, are incorporated herein by this reference.
At the time they filed their petition, Ray Bert Hedrick and Mary H. Hedrick were husband and wife with their principal place of residence at Pacific Palisades, Calif. For the tax years here in issue, petitioners filed their joint Federal income tax returns with the district director of internal revenue at Los Angeles, Calif.
This case comprises yet another episode in what now consists of more than 20 years of litigation concerning the Federal tax consequences of a certain real estate transaction entered into by Walburga Oesterreich, the former spouse of petitioner Ray Bert Hedrick, in September 1929. At that time Walburga Oesterreich, now deceased, and Wilshire Amusement Corp., the predecessor of of Wilshire Holding Corp., executed what purported to be a lease of certain of her real property to the corporation for a period of 67 years and 8 months to commence on September 1, 1929. The schedule of payments set forth in the contract provided for a ‘Total Rental’ of $679,380, payable in 812 monthly installments of varying amounts. At the conclusion of the lease term Wilshire Amusement Corp. was entitled, upon the further payment of $10, to receive full title to the property.
Despite the form of the transaction, however, the Commissioner determined that the contract had in fact effected a sale of the property, a position sustained in Oesterreich v. Commissioner, 226 F.2d 798 (c.a. 9), reversing 12 T.C.M. 277, as well as in Commissioner v. Wilshire Holding Corporation, 244 F.2d 904 (C.A. 9), certiorari denied355 U.S. 815. The tax result of this holding was that Wilshire Holding Corp. (Wilshire) was not entitled to deduct its periodic payments as rental expense and that Walburga was entitled to treat the same as return of capital and capital gain. No issue relating to whether the periodic payments included an element of interest on the unpaid purchase price was considered in the foregoing litigation. However, in subsequent litigation, Wilshire established that a portion of each installment payment to Walburga was properly allocable to interest on the outstanding balance of the purchase price, in respect of which Wilshire was entitled to an income tax deduction. Wilshire Holding Corporation v. Commissioner, 262 F.2d 51 (C.A.9), reversing18 T.C.M. 62, on remand 28 P-H T.C. Memo. par. 59, 176-A, reversed with directions 288 F.2d 799 (C.A. 9), rehearing denied288 F.2d 799. Likewise, in subsequent proceedings relating to Walburga's estate's liability for her income taxes for the years 1947 through 1960 (Walburga died on April 8, 1961), the Ninth Circuit Court of Appeals concluded that Walburga had received, as a part of each monthly payment from Wilshire, interest income taxable at ordinary rates. Estate of Hedrick v. Commissioner, 406 F.2d 587 (C.A. 9), reversing23 T.C.M. 1374. On remand this Court fixed an interest rate of 7 percent for the reconstructed transaction, Estate of Walburga Hedrick, 28 T.C.M. 1223, and its decision in this respect was affirmed in 457 F.2d 501 (C.A. 9), certiorari denied409 U.S. 1024.
According to the tax schedule which formed the basis of the computations necessitated by that decision, the amounts payable to Walburga during the years here in issue would have been allocated as follows:
+------------------------------------------------+ ¦ ¦Total ¦ ¦ ¦Capital ¦ +----+----------+----------+-----------+---------¦ ¦ ¦payments ¦Interest ¦Principal ¦gain ¦ +----+----------+----------+-----------+---------¦ ¦ ¦ ¦ ¦ ¦ ¦ +----+----------+----------+-----------+---------¦ ¦1966¦$10,977.60¦$8,679.35 ¦$2,298.25 ¦$1,901.80¦ +----+----------+----------+-----------+---------¦ ¦1967¦10,864.20 ¦8,516.76 ¦2,347.44 ¦1,942.51 ¦ +----+----------+----------+-----------+---------¦ ¦1968¦10,750.80 ¦8,350.58 ¦2,400.22 ¦1,986.18 ¦ +------------------------------------------------+
The Commissioner has conceded that Walburga's correct cost basis in the property sold was $24,235.05 rather than $23,428, the figure used in the earlier computations upon which the deficiency notice herein relies. The corrected amounts of capital gain are $1,888.24, $1,928.66, and $1,972.02 in 1966 through 1968, respectively.
Ray Bert Hedrick (petitioner) had been Walburga's business manager at the time of the 1929 transaction, and he continued to guide her in her financial affairs at least to the extent of preparing her income tax returns in subsequent years. In early 1961, shortly before her death on April 8, 1961, Walburga and petitioner were married. By the terms of Walburga's will, petitioner was both the executor and her sole legatee. As her legatee he succeeded to her rights in the installment sales contract and received the monthly payments that would have been payable to her.
Petitioner, as executor, filed a Federal estate tax return on which he reported as a part of Walburga's gross estate the contract of sale to Wilshire valued at $148,391.89. At the time of Walburga's death, the aggregate amount of the remaining payments under the contract was $343,696. Walburga's estate paid $14,158.21 in Federal estate tax with respect to the contract.
In connection with an audit of the estate tax return, the Commissioner prepared a standard estate tax Valuation Agreement for petitioner's signature, the substance of which appeared as follows:
In the event of the acceptance by or on behalf of the Commissioner of Internal Revenue of a proposal of settlement of the Federal estate tax liability of the estate of Walburga Oesterreich Hedrick upon the basis of a contract of sale * * * valued at $148,391.89 and as part of the consideration for such settlement, I hereby agree that my basis for the aforesaid property for Federal income tax purposes will be $148,391.89.
The ‘agreement’ form was printed on a single page in a readily understandable fashion, and it provided space for the signatures of the beneficiary, heirs, administrators, and executors only; there was no place designated for the signature of the Commissioner or his agent. Petitioner alone signed the ‘agreement’ on March 20, 1962, both as executor and beneficiary, and returned it to the Commissioner in whose possession it has since remained.
On their joint Federal income tax returns for the years here in issue, petitioner and his new wife, who is also a petitioner in this case, reported long-term capital gain resulting from the payments received under the contract of sale as follows:
+---------------------------------------------+ ¦ ¦Total payment ¦ ¦Long-term ¦ +----+---------------+---------+--------------¦ ¦ ¦received ¦Basis ¦capital gain ¦ +----+---------------+---------+--------------¦ ¦ ¦ ¦ ¦ ¦ +----+---------------+---------+--------------¦ ¦1966¦$10,877.60 ¦$4,613.20¦$6,264.40 ¦ +----+---------------+---------+--------------¦ ¦1967¦10,760.20 ¦4,563.40 ¦6,196.80 ¦ +----+---------------+---------+--------------¦ ¦1968¦10,750.80 ¦4,607.80 ¦6,143.00 ¦ +---------------------------------------------+
On their returns, they did not allocate any portion of the payments received to interest.
On April 3, 1970, the Commissioner mailed a deficiency notice to petitioners in respect of the taxable years 1966 through 1968. The Commissioner determined that in those years petitioner received $10,977.60, $10,864.20, and $10,750.80, respectively, as anticipated by the schedule of payments prepared in connection with the decision in Estate of Walburga Hedrick, supra. Furthermore, based on the theory that the proceeds of the contract were income in respect of a decedent, the Commissioner determined that ‘payments are to be allocated between principal and interest using a 7% rate’ and that capital gain was to be computed using Walburga's basis, all as appeared in the earlier schedule of payments. The Commissioner has conceded that petitioners are entitled to a yearly credit, not reflected in the deficiency notice, on account of the estate tax paid in respect of the contract according to the provisions of section 691(c), I.R.C. 1954. He has also conceded that Walburga's correct cost basis was $24,235.05, not $23,428 as used in the deficiency notice. See fn. 1 supra.
At the root of this case lies the question whether the payments under the contract of sale, which petitioner received by operation of his deceased wife's will, constitute income in respect of a decedent subject to taxation as provided in section 691, I.R.C. 1954. Pertinent portions of section 691 are set forth in the margin.
SEC. 691. RECIPIENTS OF INCOME IN RESPECT OF DECEDENTS.(a) INCLUSION IN GROSS INCOME.—(1) GENERAL RULE.— The amount of all items of gross income in respect of a decedent which are not properly includible in respect of the taxable period in which falls the date of his death or a prior period * * * shall be included in the gross income, for the taxable year when received, of:* * *(C) the person who acquires from the decedent the right to receive the amount by bequest, devise, or inheritance, if the amount is received after a distribution by the decedent's estate of such right.* * *(3) CHARACTER OF INCOME DETERMINED BY REFERENCE TO DECEDENT.— The right, described in paragraph (1), to receive an amount shall be treated, in the hands of * * * any person who acquired such right * * * by bequest, devise, or inheritance from the decedent, as if it had been acquired by the estate or such person in the transaction in which the right to receive the income was originally derived and the amount includible in gross income under paragraph (1) and (2) shall be considered in the hands of * * * such person to have the character which it would have had in the hands of the decedent if the decedent had lived and received such amount.(4) INSTALLMENT OBLIGATIONS ACQUIRED FROM DECEDENT.— In the case of an installment obligation received by a decedent on the sale or other disposition of property, the income from which was properly reportable by the decedent on the installment basis under section 453, if such obligation is acquired by the decedent's estate from the decedent or by any person by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent—(A) an amount equal to the excess of the face amount of such obligation over the basis of the obligation in the hands of the decedent (determined under section 453(d)) shall, for the purpose of paragraph (1), be considered as an item of gross income in respect of the decedent; and(B) such obligation shall, for purposes of paragraphs (2) and (3), be considered a right to receive an item of gross income in respect of the decedent, but the amount includible in gross income under paragraph (2) shall be reduced by an amount equal to the basis of the obligation in the hands of the decedent (determined under section 453(d)).
The generally operative language of these provisions is contained in (a)(1) wherein it is provided that ‘all items of gross income in respect of a decedent * * * shall be included in the gross income, for the taxable year when received.’ Further, (a)(3) provides that such income in the hands of the successor will be treated in the same manner as it would have been in the hands of the decedent, e.g., capital gain as against ordinary income, etc. And, finally, (a)(4) makes clear that installment obligations are within the general rule. These provisions are complemented by section 1014(c) whereby property which constitutes a right to receive an item of income in respect of a decedent under section 691 is excepted from the general rule of section 1014(a) which otherwise allows a stepped-up basis for property received from a decedent.
SEC. 1014. BASIS OF PROPERTY ACQUIRED FROM A DECEDENT.(a) IN GENERAL.— EXCEPT as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent's death by such person, be the fair market value of the property at the date of the decedent's death, or, in the case of an election under either section 2032 or section 811(j) of the Internal Revenue Code of 1939 where the decedent died after October 21, 1942, its value at the applicable valuation date prescribed by those sections.* * *(c) PROPERTY REPRESENTING INCOME IN RESPECT OF A DECEDENT.— This section shall not apply to property which constitutes a right to receive an item of income in respect of a decedent under section 691.
It is the Commissioner's position that the amounts received by petitioner pursuant to the contract of sale represented income in respect of a decedent, and that they were reportable by petitioner in the same manner that Walburga would have been required to treat them had she lived. As to how Walburga would have treated them, the Commissioner continues, that precise question was finally settled by our decision in the litigation which culminated with Estate of Walburga Hedrick, 28 T.C.M. 1223, affirmed by the Ninth Circuit, the computations for which allocated portions of each future payment to interest and principal, with interest computed at a 7-percent rate.
Petitioner raises two objections to the Commissioner's determination. With respect to the interest component, he contends that the 7-percent rate underlying the Commissioner's calculations is unduly high and should be redetermined at a lower rate in accordance with the provisions of section 483 and the regulations thereunder. Wholly aside from the issue of interest, petitioner also argues that on account of the Valuation Agreement by which petitioner agreed to accept a basis of $148,391.89 in the sale contract, the Commissioner is estopped from applying Walburga's basis in the property in order to compute petitioner's capital gain. We think that petitioner's arguments are without merit.
Section 691 embodies a scheme of taxation intended to perpetuate the potential tax liability attached to that income to which a decedent is entitled at the time of his death but which will not be received until some later taxable period. And section 691(a)(3) plainly required that such income in the hands of the decedent's successor shall be considered to have the same ‘character which it would have had in the hands of the decedent if the decedent had lived and received such amount.’ The critical inquiry of section 691 therefore concerns how the decedent, in this case Walburga Hedrick, would have treated such income. It was to the resolution of precisely this question that the extensive litigation noted above was directed. And the outcome of that litigation was that Walburga was required to treat a portion of each payment as interest, calculated at a rate of 7 percent, the remainder to be applied to principal (which included capital gain). Although the taxable years then before the Court were 1947-60, it is not to be supposed that our decision there left Walburga free, had she survived, to relitigate the question of an appropriate interest rate in each succeeding year. By our decision the construction of the contract was settled, and there has been no change in the ‘legal atmosphere’ which would have permitted Walburga, in a later taxable year, to reopen the matter in court. Commissioner v. Sunnen, 333 U.S. 591, 600. The suggestion that the addition to the Code of section 483, enacted as part of the Revenue Act of 1964, occasioned the necessary change in legal climate which would have permitted Walburga to relitigate this question is no more valid now than when we rejected it in our earlier decision. 28 T.C.M. at 1224. Thus, had she lived, Walburga would have been bound by our prior decision; and by operation of section 691(a)(3), that decision now applies with equal finality to petitioner. It is therefore our conclusion that the portion of each payment received which is allocable to interest, computed at 7 percent in accordance with our earlier decision, is ordinary income in the hands of petitioner.
Petitioner's position in respect of his basis in the contract is also unpersuasive. By operation of section 691(a)(3) and the exception contained in section 1014(c), the Code clearly required that petitioner adopt Walburga's unrecovered cost basis in the contract. This result is not altered by the Valuation Agreement. Despite petitioner's contention to the contrary, by its very terms the Valuation Agreement purports only to prevent petitioner from obtaining the Commissioner's acquiescence in a low valuation for purposes of estate taxation and later claiming a higher value in order to obtain a more favorable basis for himself in the determination of his own subsequent income taxes. The very nature of the agreement, however, presupposes that petitioner is entitled to a stepped-up basis in the contract by virtue of section 1014(a). Section 1014(a), however is inapplicable to petitioner here by reason of section 1014(c). It follows therefrom that the agreement has no bearing on the intended operation of section 691, its effect being to fix a basis only where the Code might otherwise permit. In any event, it is well settled that the Commissioner is not bound by the mistake of his agents but is free to correct an error of law. Automobile Club v. Commissioner, 353 U.S. 180, 183-185; Dixon v. United States, 381 U.S. 68, 72-73; Union Equity Cooperative Exchange v. Commissioner, 481 F.2d 812, 817 (C.A.10), affirming 58 T.C. 397, certiorari denied 414 U.S. 1028; George R. Tollefsen, 52 T.C. 671, 681, affirmed 431 F.2d 511 (C.A. 2), certiorari denied 401 U.S. 908. Accordingly, we hold that for purposes of calculating his capital gain on the proceeds of the contract, petitioner must apply as his basis the unrecovered portion of Walburga's $24,235.05 cost, as required by section 691(a)(3).
See fn. 3 supra.
The situation herein is to be sharply distinguished from one in which the parties have entered into a Closing Agreement under sec. 7121 of the Code whereby the Commissioner may be bound with finality as to the liability of a taxpayer. The Valuation Agreement herein was plainly not intended to be and can by no stretch of the imagination be treated as a Closing Agreement. Not only was it not approved and signed by the Secretary of the Treasury or his delegate as required by sec. 7121(b), Dorl v. Commissioner, 507 F.2d 406 (C.A. 2), affirming 57 T.C. 720; Bank of New York v. United States, 170 F.2d 20 (C.A. 3), but it was also fatally defective as a Closing Agreement since it was not executed on the prescribed Form 866 or Form 906, as required by sec. 301.7121-1(d)(1), Proced. & Admin. Regs., and Statement of Procedural Rules, 26 C.F.R. part 601, sec. 601.202(b). See also Rev. Proc. 68-16, 1968-1 C.B. 770, sec. 6.01-6.03. Cf. H. M. Harrington, Jr., 48 T.C. 939, affirmed 404 F.2d 237 (C.A. 5).
With respect to the liability of Mary H. Hedrick for taxes relating to income from the contract in issue, section 6013(d) imposes joint and several liability upon both husband and wife where, as here, a joint return has been filed. This is so regardless of either party's relationship to the property giving rise to the income. There is no contention here that she is entitled to the benefits of the so-called innocent spouse provisions in section 6013(e), nor would there appear to be any basis for any such contention. It is therefore held that Mary H. Hedrick is jointly and severally liable for all taxes determined to be due hereunder.
In order to reflect the Commissioner's concessions in respect of the proper cost basis of the contract and the credit for estate taxes paid on account of the contract.
Decision will be entered under Rule 155.