Robert E. Darling and Virginia K. Darling v. the United States, 375 F.2d 843 (Ct. Cl. 1967)

This case was referred to Trial Commissioner Herbert N. Maletz with directions to make findings of fact and recommendation for conclusions of law. The commissioner has done so in a report and opinion filed on January 16, 1967. Defendant has filed no exceptions or brief on this report and the time for so filing pursuant to the Rules of the court has expired. On March 6, 1967, plaintiffs filed a motion that the court adopt the opinion, findings of fact and conclusion of law in this case. Since the court agrees with the commissioner's opinion, findings and recommended conclusion of law, as hereinafter set forth, it hereby adopts the same as the basis for its judgment in this case without oral argument. Plaintiffs are therefore entitled to recover and judgment is entered for plaintiffs with the amount thereof to be determined pursuant to Rule 47(c).

MALETZ, Commissioner:

This case involves section 170(b) (1) (D) of the Internal Revenue Code of 1954 (26 U.S.C. § 170(b) (1) (D) (1958)) which provides in part that no charitable deduction may be taken by the grantor of a trust for the value of any interest in property transferred in trust if the grantor has a reversionary interest in the corpus or income which exceeds five per cent of the value of the property.¹  In issue is whether a grantor who creates irrevocable trusts which require a fixed amount to be paid to charity but which also give the corporate trustee discretion to apply trust income or corpus for the support, maintenance and education of the grantor's children is entitled to charitable contribution deductions for income tax purposes. Resolution of this issue turns on whether the grantor had, within the meaning of section 170(b) (1) (D), a reversionary interest in the trusts which had a value of over five per cent of the property transferred in trust.

The facts are not in dispute. In November 1955, Robert E. Darling (hereafter referred to as plaintiff)²  established six similar irrevocable trusts consisting of two trusts for the ultimate benefit of each of his three then minor children. Plaintiff and a bank (hereafter referred to as the corporate trustee) were named as trustees. Each of these trusts had a corpus of some $52,000 and was to continue until the death of the survivor of plaintiff's wife and the child beneficiary. Upon the death of the survivor, the remainder was to be paid to a designated class of remaindermen.

Each trust had a charitable charge of $11,000 which had to be paid, with interest, either from the income or principal of the trust within 44 years or less, the plaintiff retaining the power to choose the specific charitable donees and the portion of the charge each was to receive.³  Each payment to such donees reduced the charitable charge by the amount of the payment. The trust instrument also gave the corporate trustee the right "in its absolute discretion" to apply "any or all" of the trust income or principal for the use of the plaintiff's minor child-beneficiary's "care, comfort, education and welfare." No distribution could be made, however, if it would reduce the trust funds to an amount less than 150 per cent of the then unsatisfied charitable charge.

The trust provisions allowed the plaintiff to increase the charitable charge upon each trust at any time but only on condition that the amount of his contribution to principal equalled at least 150 per cent of the additional charge for charitable purposes. Pursuant to these provisions, plaintiff in January 1956 transferred stock worth some $45,000 to each of the six trusts, increasing the charitable charge of each trust by $12,000. In December 1956, plaintiff made an additional transfer to each of the trusts of stock worth some $12,000 increasing the charitable charge on each by $1,500. In December 1957, plaintiff created three additional irrevocable trusts, one for the ultimate benefit of each of his three then minor children and his family. These trusts were identical except for the name of the child who was the beneficiary thereof, and their terms and provisions were generally the same as the six trusts created in November 1955. Each of these three trusts had a corpus of stock valued at approximately $114,000 and contained a charitable charge of $27,500.

In their joint income tax returns for the calendar years 1955, 1956 and 1957, plaintiff and his wife claimed charitable contribution deductions under section 170 of the Internal Revenue Code of 1954 for the charitable charges imposed on the trusts for these years. These deductions were denied on the ground that the plaintiff had a reversionary interest in excess of five per cent of the principal or income of the trusts within the meaning of section 170(b) (1) (D) as defined by the regulations thereto;⁴  and a deficiency was assessed.⁵ 

Section 170(b) (1) (D) was a new provision which originated on the floor of the House in 1954 as an amendment to the bill (H.R. 8300) that was subsequently enacted as the Internal Revenue Code of 1954. See 100 Cong.Rec. 3560 (1954). As explained on the floor (ibid): " [I]ts purpose is to plug the loophole which has been in existing law. The loophole was made more apparent at the time the committee adopted the liberalization policy in regard to charitable trusts created for a term of years with revisionary [sic] rights to the grantor. Under existing law, by means of these term charity trusts, a grantor was able in effect to get two deductions, first for the amount which was deducted from his gross income and then again the same amount as a charitable deduction. This amendment simply provides that only one deduction, the deduction from gross income is granted, and the charitable deduction is not granted."⁶  See also S.Rep. No. 1622, 83d Cong., 2d Sess., pp. 208-09 (1954) (3 U.S.Code Cong. & Adm. News, p. 4845 (1954)). Save for these statements of Congressional purpose, the legislative history of the section throws little light upon the scope of its operation, and provides no indication as to what constitutes a reversionary interest⁷  or how it is to be valued. The regulation, however, defines a reversionary interest broadly to include a possibility that the trust property or its income will be subject to a power exercisable by a nonadverse party to use that property or the income for the benefit of the grantor. See note 4. It is the defendant's contention that the discretionary power given to the corporate trustee to distribute principal or income to the plaintiff's minor children is a reversionary interest within the meaning of this regulation. Since the grantor has the legal obligation to support his children,⁸  defendant argues that there is a possibility that the trustee will use trust funds to meet this obligation and thereby use the corpus or income of the trust for the "benefit of the grantor" as these words are used in the regulation. Plaintiff contends that such a discretionary power exercisable by a trustee does not fall within the definition of a "revisionary interest" as that term is used in the statute and regulation, and, in the alternative, that if the regulation covers such a discretionary power, it is invalid as an improper extension of the statute.

Which contention is the correct one need not be decided, for even if it is assumed that such a discretionary support power in the hands of a trustee is a reversionary interest in the grantor for purposes of section 170(b) (1) (D), it is clear from the record that the reversionary interest did not have a value in excess of five per cent of the value of the property transferred in trust. The defendant asserts that the computation of the value of plaintiff's reversionary interest is a simple matter of arithmetic; it merely subtracts the charitable charge from the corpus of the trust to arrive at what it considers to be the value of the reversionary interest.⁹  But such an arithmetic computation merely sets forth the value of the amount the corporate trustee could have distributed to the minor, ignoring the fact that the critical inquiry is not the value of the property that is subject to the reversionary interest but the value of the reversionary interest itself. In other words, defendant's computation tells us only the amount of the trust subject to the trustee's discretion and does not tell us the value of the probability that this discretion will be exercised. And it is the probability that the plaintiff's support obligation will be met from the trust funds that is defined as the reversionary interest.¹⁰  See note 4. Defendant's contention is analogous to valuing a reversion after a life estate by assuming that the life tenant will die immediately rather than at the end of his actuarial life expectancy. Such a computation would only show the greatest amount that could revert to the grantor and not the probable sum that would remain at the expiration of the life estate. In short, what must be valued here is not the amount which the corporate trustee could distribute immediately if it were of a mind to do so, but the probability as of the dates the transfers to the trusts were made that the corporate trustee would exercise its discretion, during plaintiff's lifetime, to make payments to plaintiff's children in discharge of plaintiff's legal support obligation to them.

Viewed in this perspective, it is apparent from the record that the probability that the corporate trustee would exercise this discretionary power was factually so remote as to be negligible. It is quite true that the trust instrument gave the corporate trustee absolute discretion to distribute principal or income to the plaintiff's children for their support, but this discretionary power not only may not be abused (see Scott on Trusts § 187), it must be considered in the context of applicable State law. See e. g., Helvering v. Stuart, 317 U.S. 154, 161-166, 63 S. Ct. 140, 87 L. Ed. 154 (1942). The rule in Connecticut regarding discretionary trusts is that the trustee, in determining whether to expend trust funds for the beneficiary's support, is entitled to take into consideration any other means of support available to the beneficiary. City of Bridgeport v. Reilly, 133 Conn. 31, 47 A.2d 865 (1946); Auchincloss v. City Bank Farmers Trust Co., 136 Conn. 266, 70 A.2d 105 (1949). This, it would seem clear, is what the corporate trustee as a prudent fiduciary would do in the present situation, especially since one of its primary obligations is to conserve the trust property. See Scott, op. cit. supra, §§ 174, 176. In thus taking into account the other means of support available to plaintiff's children, it would be highly unlikely that the trustee would ever distribute trust funds to them in discharge of plaintiff's legal obligation of support. For one thing, plaintiff-grantor's adjusted gross income for each of the years when the transfers to the trusts were made was in excess of $400,000 (of which over $367,000 a year was investment income) so that the probability was obvious that he would be able to support from his own funds those beneficiaries of the trusts to whom he owed the legal obligation of support.¹¹  Under these circumstances, the corporate trustee would not have to use the resources of the trusts for the purpose of discharging plaintiff's obligation to support those beneficiaries. Furthermore, during the years in question, the adjusted gross income of each of the three minor children ranged from some $11,000 to $17,000 a year and was rising each year.¹²  Added to this is the fact that when the transfers to the trusts were made, only a relatively short period remained before the children would reach their majority,¹³  at which time plaintiff's support obligation would come to an end for all practical purposes.¹⁴ 

Moreover, the rule in Connecticut, when considering the propriety of a trustee's use or non-use of his discretionary support power, is to measure the trustee's action by looking to the grantor's intention "in the light of any relevant circumstances." Auchincloss v. City Bank Farmers Trust Co., supra, 136 Conn. at 271, 70 A.2d at 107; Stempel v. Middletown Trust Co., 127 Conn. 206, 220, 15 A.2d 305, 311, 157 A.L.R. 657 (1940); Bridgeport-City Trust Co. v. Beach, 119 Conn. 131, 137-138, 174 A. 308, 311 (1934); City of Bridgeport v. Reilly, supra, 133 Conn. at 38-39, 47 A. 2d at 867-868; Hull v. Holloway, 58 Conn. 210, 217, 20 A. 445 (1889). In the present case the plaintiff-grantor's intention appears clear that the discretionary power was not to be used except in instances of necessity and that action by the corporate trustee contrary to this intention would be unwarranted. In Article Fourth of each trust the plaintiff-grantor states that he "wishes to impress upon the Corporate Trustee in the strongest possible manner, but without abridging the absolute discretion hereinbefore granted to it, that his wife's interests and her comfort and well-being are the * * [grantor's] first consideration and that accordingly it is his strong desire that after his death, if she shall survive him," the corporate trustee pay to or apply to her use as much of the income and principal "as it may deem necessary, taking into consideration her available receipts from other sources and all other circumstances, to enable her to maintain the standards of living which she shall have maintained during the * * * [grantor's] life." After his wife's death, the same recommendations are made with respect to the named child-beneficiary "so that he may maintain the station in life that the * * * [grantor] maintained." Such language indicates that the corporate trustee is to manage the trust funds so as to provide adequately for the plaintiff's wife after his death. Making unneeded distributions to minor children would be contrary to such purpose since it would serve to reduce the funds available for plaintiff's wife — and for the children after the death of the parents.

In addition, it seems obvious that an important reason for establishing the trusts — apart from plaintiff's desire to provide for his wife and children — was to exclude the trust income from plaintiff's high tax bracket.¹⁵  However, any distribution by the corporate trustee which would satisfy plaintiff's support obligation under Connecticut law would be taxable to plaintiff under section 677(b). This would deny the income-shifting benefit as to such distributions that the creation of the trusts was meant to achieve. In such circumstances and considering the financial resources of plaintiff and his children, it would be most unlikely that the corporate trustee would thwart this important objective by distributing trust funds to discharge plaintiff's support obligations.

In summary, the possibility as of the dates the transfers to the trusts were made that the corporate trustee would exercise its discretionary power, during plaintiff's lifetime, to make distributions to plaintiff's children for support purposes was factually so improbable as to be negligible.¹⁶  Accordingly, even if it be assumed that the plaintiff had a reversionary interest in these trusts, it is an interest whose value was not in excess of five per cent of the trust property. Since section 170(b) (1) (D) does not apply to such a reversionary interest, the general rule of section 170(a) of the Code controls and plaintiff is entitled to the claimed charitable contributions deductions for 1955, 1956 and 1957.¹⁷