Comm'r of Internal Revenue

Tax Court of the United States.Apr 30, 1947
8 T.C. 950 (U.S.T.C. 1947)

Docket No. 8695.



Chester J. McGuire, Esq., and Wm. R. Spofford, Esq., for the petitioner. Karl W. Windhorst, Esq., for the respondent.

The trustee of a Pennsylvania testamentary trust acquired an office building of deed from the owner, who thereby avoided further payment of ground rent. The trustee paid taxes, repairs, and operating expenses in excess of gross rents in the taxable years, using the trust's gross income, which would otherwise have been payable to the taxpayer, life beneficiary. The Commissioner determined the amounts so used distributable and taxable to the taxpayer beneficiary. Held:

(a) Court approval of the 1937 accounts of a trustee who used income to pay carrying charges on trust-held real estate is conclusive of their correctness.

(b) In years when the former rule of apportionment for trust income was being changed by state court decisions, none of which was clearly applicable to the rights of the taxpayer, a life beneficiary, the mere possibility that she could have forced the trustee to depart from the old rule and to pay her income used by him for carrying charges and operating expenses of an unprofitably operated building acquired in a transaction resembling foreclosure is insufficient to support a tax on such income to the beneficiary under theory that it was distributable to her. Chester J. McGuire, Esq., and Wm. R. Spofford, Esq., for the petitioner. Karl W. Windhorst, Esq., for the respondent.

The Commissioner determined deficiencies of $1,964.98, $1,107.02, and $1,641.62 in petitioner's income tax for 1937, 1938, and 1940, respectively, in part by adding to income reported, undistributed portions of the gross income of a testamentary trust of which petitioner was life beneficiary. The trustee applied such income to the payment of taxes, repairs, and operating expenses of a building deeded to the trustee in extinguishment of the transferor's liability for ground rent. Petitioner contends that under Pennsylvania law the expenses were properly paid from income, not corpus, and that the Commissioner erred in determining the amounts so paid distributable and taxable to her.


This case was presented on a stipulation of facts and exhibits, which are hereby adopted by reference as findings. From this evidence it appears that petitioner, a resident of Reno, Nevada, filed her income tax returns, prepared on a cash basis, for 1937, 1938, and 1940 with the collector of internal revenue for the first district of Pennsylvania, at Philadelphia. She is the niece of Nina Lea, who died a resident of Philadelphia, on August 26, 1927, and the life beneficiary of the net income of a trust created by section 17 of Nina Lea's will, which was duly probated in the office of the Register of Wills of Philadelphia County on September 1, 1927. Section 17 of the will provides:

SEVENTEENTH. I now own a ground rent reserved by me and issuing out of premises numbered 511, 513, 515, 517 and 519 North Broad Street, Philadelphia. I also own a bond and mortgage conditioned for the payment of Eighty-five Thousand Dollars ($85,000) and secured upon premises 329 and 331 North Broad Street. I give, devise and bequeath said ground rent and mortgage to my brother, Arthur H. Lea, his heirs, executors, administrators and assigns, IN TRUST, during the lifetime of my niece Marjorie V. Lea Hudson, to pay over to her from time to time the net income therefrom.

IN TRUST, upon her decease leaving descendants her surviving, to assign and convey the same to such descendants * * * .

IN TRUST, upon the decease of my said niece, leaving no descendants her surviving, to pay over, assign and convey said ground rent and mortgage as part of my residuary estate.

If in my lifetime said ground rent or mortgage shall have been reduced or extinguished this legacy shall not be thereby reduced, but in place of said ground rent or mortgage or in addition thereto, as the case may be, there shall be set aside and held for the purposes of this trust, such other securities to me belonging as may be necessary to provide a total annual income from said trust fund equal to the net annual income from said ground rent and mortgage.

Other sections of the will relating to the testamentary trust so created are:

FOURTH. Upon my Executors and upon the Trustee of any legacy * * * I confer * * * the following powers * * * :

1. To alter, vary and change investments and reinvestments without being confined to what are known as ‘legal securities,‘ saving that shares of stock shall not be purchased.

3. To make leases, for such terms as may be deemed proper, of any real estate which may, at any time, belong to the trust; to collect rents; and to make all necessary repairs.

7. To buy any mortgaged premises, subject to mortgage or ground rent, at any judicial sale.

8. To purchase investments at a premium and to charge the premium either against principal or income, or partly against principal and partly against income, as they shall deem best.

NINETEENTH. It is my intention by the seventeenth and eighteenth paragraphs of my Will to create trust estates which shall provide substantially equal incomes for my nieces Marjorie V. Lea Hudson and Katherine Lea Hancock. While this is approximately the case at the present time, I recognize that this situation may change in the future. I therefore direct that if the net income from the two trust estates hereby created shall differ by more than One Thousand Dollars ($1000) per annum at any time before said trust estates are finally set apart and delivered to my Trustees, there shall be added from the income of my residuary estate to the income of that niece who is receiving the less amount, such a sum as shall make her income equal to that of her sister.

And I further direct that at the time such trust estates are so finally set apart there shall be added from my residuary estate to the principal of that trust estate which as originally created is then producing the less net income, such a sum as, invested in securities as in this my Will provided, may be necessary to equalize the income of such trust estates with each other.

On January 2, 1920, Nina Lea, being then the owner of the property known as 511-519 North Broad Street, Philadelphia, sold it to Oscar Isenberg, reserving to herself an annual ground rent of $18,487.50. By the terms of the deed this rent was a charge against the premises, but the purchaser had the right to extinguish liability for it by a payment of $435,000.

In 1932 Isenberg defaulted in payment of the ground rent and offered to deed the property to the trust. The trustee applied to the Orphans' Court of Philadelphia County for authorization to accept the deed in settlement, expressing doubt of his power to do so under the provisions of the will, but pointing out that he had authority ‘to buy any mortgaged premises‘; ‘that the acceptance of such deed would bring about the same identical result as the purchase of said premises at judicial sale on suing out the arrearages of rent‘; and he believed ‘that under existing leases said building can be operated economically but properly so as to yield a substantial amount of net income, although for the present less than the rental reserved under the ground rent deed.‘ Upon consideration of the petition the court authorized the trustee to accept the deed. He did so on December 29, 1932, and the property was continuously owned by the trust until 1945. During the years 1937-1940 the trustee paid for maintenance, repairs, taxes, and other expenses attributable to the operation of the property amounts which exceeded the gross income from it. During the years in controversy the expenses and gross income were as follows:

+--------------------------------------------------+ ¦ ¦1937 ¦1938 ¦1940 ¦ +------------------+---------+----------+----------¦ ¦Repairs ¦$763.56 ¦$13,449.59¦$24,662.32¦ +------------------+---------+----------+----------¦ ¦Operating expenses¦15,949.60¦16,622.12 ¦2,591.36 ¦ +------------------+---------+----------+----------¦ ¦Taxes ¦13,564.31¦6,689.34 ¦9,085.74 ¦ +------------------+---------+----------+----------¦ ¦Total expenses ¦30,277.47¦36,761.05 ¦36,339.42 ¦ +------------------+---------+----------+----------¦ ¦Rent ¦16,671.94¦26,724.82 ¦27,198.42 ¦ +------------------+---------+----------+----------¦ ¦Net loss ¦13,605.53¦10,036.23 ¦9,141.00 ¦ +--------------------------------------------------+

The income of the trust for these years consisted principally of dividends, interest, and rents, and, as the trustee applied the rents and other trust income to expenses and taxes of the building, there was little or nothing left for petitioner as income beneficiary. On the fiduciary returns the following income was reported:

+-----------------------------------------------+ ¦ ¦1937 ¦1938 ¦1940 ¦ +-----------------+---------+---------+---------¦ ¦Dividends ¦$5,586.75¦$2,485.50¦$5,293.00¦ +-----------------+---------+---------+---------¦ ¦Interest ¦4,898.33 ¦946.11 ¦9,014.02 ¦ +-----------------+---------+---------+---------¦ ¦Tax-free interest¦3,370.00 ¦3,325.33 ¦4,515.15 ¦ +-----------------------------------------------+

In her income tax return for 1937 petitioner reported no income as paid to her by the trust. The Commissioner determined that she was taxable on $12,329.73 as distributable to her. In making this computation he eliminated, as charges against principal and not proper deductions from trust income, taxes of $13,564.31 on the building and a loss of $2,541.22, which was computed on the trustee's 1937 fiduciary tax return as follows:

+-----------------------------------+ ¦Gross rents ¦ ¦$16,671.94¦ +--------------+---------+----------¦ ¦Depreciation ¦$2,500.00¦ ¦ +--------------+---------+----------¦ ¦Repairs ¦763.56 ¦ ¦ +--------------+---------+----------¦ ¦Other expenses¦15,949.60¦19,213.16 ¦ +--------------+---------+----------¦ ¦Net loss ¦ ¦2,541.22 ¦ +-----------------------------------+

There were also ‘other adjustments immaterial hereto.‘ For 1938 and 1940 petitioner reported $1,721.02 and $5,190.52 as her income from the trust by a computation similar to that for 1937 the Commissioner determined that she was taxable on trust income of $10,857.08 and $15,896.43, respectively. For each of the three years he allowed petitioner a deduction of $2,500 as depreciation on the trust building.

The first account of the trustee was filed and approved by the orphans' court in May 1938; petitioner waived the filing of a complete income account. The trust beneficiaries have never questioned the trustee's computation of distributable income.



Under the theory that trust income which the trustee applied to the payment of taxes, repairs, and operating expenses of the Broad Street building should have been charged against trust principal, the Commissioner has determined by a computation not fully disclosed that such a charge would release funds for distribution to petitioner as life beneficiary and accordingly has added to the income reported by her $12,329.73 for 1937, $10,857.08 for 1938, and $15,896.43 for 1940, as representing amounts distributable and, hence, taxable to her as trust income under section 162(b) Internal Revenue Code. If such amounts were in fact distributable to her, they should be included in her taxable income for the several years, regardless of her failure to receive them, Malcom v. Commissioner, 97 Fed.(2d) 381, and cases cited, and regardless of their character as income or principal to the trust, Johnston v. Helvering, 141 Fed.(2d) 208; certiorari denied, 323 U.S. 715.

SEC. 162. NET INCOME.(b) (Prior to amendment by section 111(b), Revenue Act of 1942.) There shall be allowed as an additional deduction in computing the net income of the estate or trust the amount of the income of the estate or trust for its taxable year which is to be distributed currently by the fiduciary to the beneficiaries, * * * but the amount so allowed as a deduction shall be included in computing the net income of the beneficiaries whether distributed to them or not. * * *

As the trust was created and administered in Pennsylvania, the law of that state determines petitioner's rights, Blair v. Commissioner, 300 U.S. 5; Freuler v. Helvering, 291 U.S. 35. Prior to 1938 it was unquestioned in Pennsylvania that trust expenses, including carrying charges on unproductive real estate, were payable from trust income. Commissioner v. Lewis (C.C.A., 3d Cir.), 141 Fed.(2d) 221; In re Levy's Estate, 333 Pa. 440; 5 Atl.(2d) 98. The trustee applied that rule, and his accounts for 1937 and prior years were approved by an order of the orphans' court in May 1938. ‘That order has not been reversed or overruled and is, therefore, conclusive.‘ Letts v. Commissioner (C.C.A., 9th Cir.), 84 Fed.(2d) 760. See also Josephine Towne Clegg, 47 B.T.A. 934; Estate of Sallie Houston Henry et al., Executors, 47 B.T.A. 843; Jennie Arrott Adams, 44 B.T.A. 408.

On June 30, 1938, the Supreme Court of Pennsylvania modified the rule, holding in In re Nirdlinger's Estate (No. 2), 331 Pa. 135; 200 Atl. 656, that:

* * * net rents from foreclosed properties, that is gross rents, less taxes, insurance, repairs and other carrying charges, should be paid to life tenants. * * * The carrying charges on unproductive property can be advanced out of principal.

This decision was closely integrated with a prior one, In re Nirdlinger's Estate (No. 1), 327 Pa. 171; 193 Atl. 30 (July 7, 1937), wherein the court awarded to the income beneficiary a portion of the sale proceeds from foreclosed real estate on which the trust held a mortgage, such portion to be computed in accordance with the formula prescribed by the American Law Institute in its Restatement of the Law of Trusts, section 241. And in extending the principle to foreclosed real estate bid in and held by the trustee, it expressly contemplated an eventual sale, viewed each individual property as a separate salvage operation requiring a separate computation, and directed that proper adjustment be made for income paid to the life beneficiary and for advances of carrying charges when the property acquired should be sold and the proceeds apportioned in accordance with the formula. On March 22, 1939, the court made a further modification of the apportionment rule, holding in In re Levy's Estate, supra, that carrying charges on unproductive trust-held real estate could be charged against or divided between income and principal according to the equities in each case. But this decision was applicable only to property which had been held by the grantor or executor and not to property acquired by the fiduciary in a salvage operation, which remained subject to the Nirdlinger rule. In re Crozer's Estate, 346 Pa. 446; 31 Atl.(2d) 147 (Mar. 22, 1943). That rule was later held applicable to collateral other than real estate acquired by the fiduciary, In re Haugh's Estate, 33 Pa.D.&C. 202 (May 13, 1938); In re Keasbey's Estate, 49 Pa.D.& C. 690 (Feb. 18, 1944), and to mortgaged property which the mortgagor voluntarily deeded to the fiduciary in lieu of foreclosure, In re Cope's Estate, 38 Pa.D.&C. 327 (Apr. 12, 1940); In re Pfromm's Estate, 40 Pa.D.&C. 104 (Dec. 20, 1940). But the beneficiary's right to the income distributed before completion of the salvage operation was described as ‘embryonic,‘ Miller's Estate, 43 Pa.D.&C. 565 (Dec. 15, 1941); and in Romberger's Estate, 39 Pa.D.&C. 604 (Dec. 6, 1940), the orphans' court refused to make any anticipatory allocation, saying:

Considerable testimony was taken as to allocation as between principal and income of carrying charges upon unproductive and underproductive real estate held by the trustees, either as mortgagees in possession, or pending liquidation foreclosure. As there is no other fund, except out of rentals, with which to pay such carrying charges, all expenditures necessarily must come out of this common fund, or from voluntary advancements made by the trustees. Until the real estate is actually sold, and a fund is before the court for distribution, there exists no completed salvage operation. Under such circumstances, decisions relating to questions of allocation as between income and principal are most premature. * * * When the salvage operation is finally completed, and upon an accounting when there is a fund before the court for distribution, the parties may then appear and make application for equitable allocation of the funds as between income and principal. Nirdlinger's Estate (No. 2), 327 Pa. 171.

Implicitly the court disapproved the advances which the trustee had made for paying income to the life beneficiaries, for it held: ‘a fiduciary is entitled to receive interest on advances or loans made for carrying charges and improvements, but not for advances on income distributions.‘ Later the Nirdlinger rule was held inapplicable altogether if the salvage operation should result in a profit. Cope's Estate (No. 1), 50 Pa.D.&C. 189 (Apr. 14, 1944); affd., 351 Pa. 514; 41 Atl.(2d) 617 (Mar. 15, 1945).

On May 3, 1945, the Pennsylvania Legislature enacted the Uniform Principal and Income Act, Purden's Pennsylvania Statutes, Annotated, title 20, ch. 11, which makes no distinction between property owned by the grantor or decedent and property acquired by the trustee or executor in a salvage operation, and provides in section 2 that expenses incurred in disposing of or as carrying charges on unproductive real property shall be paid out of principal. By section 12 an unproductive property is defined as one:

(2) * * * which for more than a year * * * has not produced an average net income of at least one per centum * * * , and the trustee is under a duty to change the form of the investment as soon as it may be done without sacrifice of value, * * *

(4). If the tenant has received any income from the property, * * * his share of the delayed income shall be reduced by the amount of such income received * * *.

From the foregoing review it is plain that from 1937 until 1945 the Pennsylvania apportionment rule was in an unsettled process of evolution, and that the trustee's duty was not consistently fixed during the taxable years 1937, 1938, and 1940.

Respondent earnestly argues, however, that the opinion in In re Nirdlinger's Estate (No. 2), supra, requires a decision in his favor here, contending that the trustee's acquisition of the building in extinguishment of ground rent was tantamount to a trustee's acquisition of mortgaged property in the collection of a mortgage debt. We agree that there is substantial analogy, and that after that decision a trustee was under a duty to pay to the life beneficiary the net income from real estate acquired by him in a salvage operation, or if the property so acquired was unproductive, to pay the carrying charges on it from trust principal. But two considerations render an application of that rule to this trust's building at least doubtful.

First, while the trustee's acquisition was a salvage operation in the sense that he was recovering what he could from the trust's right to ground rent, he petitioned the Orphans' Court to approve acquisition because he believed ‘that under existing leases said building can be operated economically but properly so as to yield a substantial amount of net income.‘ Such considerations are compatible only with the purpose of holding the building indefinitely as an income-producing asset. In a salvage operation, and more specifically in one contemplated by the Nirdlinger's Estate, opinion, a subsequent sale is envisaged so that an apportionment of proceeds between life beneficiary and remainderman can be made in accordance with the Institute's formula. In re Nirdlinger's Estate (No. 1), supra, the court found the restatement rule sound:

* * * in that it treats as advances money necessarily used from whatever source in acquiring the property and in holding it, and returns the money in full when the purpose of the advances has been achieved and the property sold.

Second, the Nirdlinger's Estate opinion makes no specific provision for the treatment of operating deficits from salvage property and a fortiori from property held as an investment. It is quite clear that the net income from a salvage property is payable to the life beneficiary and that ‘taxes, insurance, repairs and other carrying charges‘ are to be paid first from the property's gross income. It is equally clear that if a salvage property produces no gross income, the carrying charges ‘can be advanced out of principal,‘ for such property is obviously ‘unproductive.‘ The trust building here produced in 1938 more than enough gross rents to cover taxes and repairs, which qualify readily as carrying charges, but insufficient to cover operating expenses in addition. And while we note that trust-held real estate producing a small amount of rents insufficient to pay carrying charges and other minor expenses has been termed ‘unproductive,‘ without discussion, in opinions involving an application of the Nirdlinger's Estate opinion, Kathryn E. T. Horn, 5 T.C. 597; John Frederick Lewis, Jr., 1 T.C. 449; affd. (C.C.A., 3d Cir.), 141 Fed.(2d) 221; In re Pfromm's Estate, supra, we do not regard them as decisive that a building which produced an annual rent of over $26,000 is to be so classed, especially if the rents can pay the carrying charges. And if it can not be classed as ‘unproductive,‘ Nirdlinger's Estate does not require that carrying charges be paid from principal.

During 1939 and 1940 the trustee used trust income in general to pay trust expenses, as he had done from the beginning. There was no question about his duty to do so prior to 1937, and his accounts through 1938 received court approval in 1938. If the Nirdlinger's Estate decision of 1938 clearly imposed on him the duty to pay the building's carrying charges from principal in 1939 and 1940, we would have the right and the duty to hold petitioner taxable on a corresponding amount of trust income thereby released for distribution. Commissioner v. Lewis, supra. But for reasons above given, we do not think that the decision clearly so required. The trustee obviously did not think so, and petitioner sought no redress. Under such circumstances we adhere to our view expressed in John Frederick Lewis, Jr., supra, that:

* * * the interpretation of a trust by the interested parties should be given great consideration and not to be set aside lightly. Anna M. Chambers, 17 B.T.A. 820; E. L. E. Brenneman, 10 B.T.A. 544; Mary Helen Cadwalader, 27 B.T.A. 1078, 1082. * * * To tax the petitioners upon income which cannot be said to be ‘distributable income‘ with finality and certainty as a matter of local law, would be to penalize the petitioners for their reliance upon the correctness of the trustees' acts. * * *

When the building was sold in 1945, the rule emerging from judicial interpretations of the decisions in Levy's Estate and Nirdlinger's Estate was superseded by the Uniform Principal and Income Act, which fixes precisely petitioner's share of the sale, proceeds, with adjustments to reflect prior charges or distributions, if any, and which does not perpetuate the distinctions herein discussed relating to an application of the former rule. If, as we must assume, a portion of the sale proceeds was awarded and taxed to petitioner in 1945, the computation reflects an adjustment for all taxable years here involved, and she has received income not according to any apportionment rule existing in former years, but according to a formula which has supplanted all former rules. Her rights, therefore, were determined in 1945 as they might have been determined by a prior court order. In Kathryn E. T. Horn, supra, we considered the case of a life beneficiary to whom the Orphans' Court of Philadelphia County, citing Levy's Estate, supra, had awarded in 1940 amounts charged by the trustee to income over a ten-year period, and held her taxable on the whole in that year, contrary to her contention that the amounts were distributable income and hence taxable in prior years. After noting that the beneficiary had made no request for distribution prior to 1940, we said:

* * * Nothing in the record suggests that if such a request had been made the equities of the case would have warranted a court in granting it. See the Lewis case, supra. Therefore, before the order entered by the Orphans' Court in 1940 we are unable to agree with the petitioner that she was entitled of right to have the carrying charges of the unproductive trust real estate paid from trust principal rather than trust income. Not until the state court entered this order in 1940 was the income account of the trust increased by charging these expenses against principal, and not until then were any additional payments on account of trust income distributable to petitioner. * * *

To the same effect is Emily B. Harrison, 7 T.C. 1. So here, we can not say that if petitioner had requested in 1939 and 1940 the amounts on which the Commissioner seeks to tax her, the trustee could have been forced to pay them, and if she had successfully brought suit, the year of the order awarding her the income would have fixed the year of her liability for tax. The possibility that she might have won is not sufficient to support a tax. The Commissioner's determination is reversed.

Reviewed by the Court.

Decision will be entered under Rule 50.