August J. Fabens, Petitioner-appellant, v. Commissioner of Internal Revenue, Respondent-appellee, 519 F.2d 1310 (1st Cir. 1975)

The parties stipulated that from 1953 to 1969 taxpayer Fabens maintained in a trust account municipal bonds, the income from which was tax-exempt, and other securities the income from which was taxable. The trust also realized capital gains and losses from transactions involving its holdings. Upon termination the fair market value of the trust assets included a considerable amount of unrealized capital appreciation¹  which was reflected in the fiduciary fees paid on termination and computed under local law as a percentage of current market value. Taxpayer deducted the full amount of these commissions as expenses for the production of income under Int.Rev.Code Sec. 212.²  The Commissioner disallowed a portion of this deduction pursuant to Int.Rev.Code Sec. 265(1) prohibiting the deduction of expenses directly or indirectly allocable to the production of tax-exempt income. The fees were disallowed in the ratio of tax-exempt income over the life of the trust to total income (including net capital gains) realized during that period.³ 

 ($740,093 -------- 28.57 percent), ($211,443

and this percentage was applied to the total amount of receiving and paying commissions incurred upon termination of the trust ($50,695) to determine the amount of the termination commissions ($14,484) allocable to tax-exempt income. The Commissioner made a separate allocation with respect to the annual commissions (income and principal commissions) for 1969 in the total amount of $3,241. The Commissioner allocated this commission by computing the total income (taxable and tax exempt) of the trust for 1969 ($24,743), and computing tax-exempt income for 1969 ($9,028), as a percentage of total income

 ($ 9,028 ------- = 36.49 percent). ($24,743

The percentage was applied to the annual commissions ($3,241) for 1969 to determine the amount ($1,183) allocable to tax-exempt income for that year. The total amount ($15,667) allocable to tax-exempt income ($14,484 of the termination charges, plus $1,183 of the annual commissions) was disallowed as a deduction pursuant to the provisions of Section 265 of the Code. The Commissioner allowed the remaining amounts ($38,269) as deductions for 1969.

In the Tax court taxpayer argued that this formula was not reasonable in the light of all the facts and circumstances, Treas.Reg. Sec. 1.265-1(c), because it did not reflect the unrealized appreciation of the trust assets. The court upheld the Commissioner's allocation and taxpayer appeals.

The Commissioner argues there was no evidence that the trust assets were actually managed for capital appreciation; and that to the extent they were so managed, the Commissioner's inclusion in his allocation formula of net capital gains realized over the life of the trust would reasonably reflect this fact. We disagree on both counts. As an initial matter even if achieving appreciation were not a prime goal of the trustee's management, it would remain unclear how fees created solely because of a rise in the value of taxable investments could be considered "allocable" within the statute to the production of tax exempt income. At any rate, while there is no specific evidence as to the trustee's investment objectives, that appreciation was such an objective is inferable from the facts that the trustee apparently insisted on compensation for appreciation when the trust was established, and that appreciation under the trustee's management comprised more than half of corpus value at termination. As to the second point, since the trustee's decision to sell securities (thereby realizing capital appreciation) is dictate by considerations other than that of the trust's termination date, there is no necessary reason to suppose that the net capital gains realized over the life of the trust and included in the Commissioner's formula will fairly reflect the trustee's division of labor between exempt and taxable income-production activities in administering the trust.⁴  Since the value of the property comprising corpus generates the fee, an allocation measure like taxpayer's which somehow reflects that value will seemingly result in a fairer apportionment.⁵  See M. Ferguson, J. Freeland & R. Stephens, Federal Income Taxation of Estates and Beneficiaries 492-93, 644 n. 115 (1970). The Tax Court characterized the appreciation as "ephemeral." but the commissions it produced represented an outlay very tangible indeed.

It is clear as a general matter that expenditures aimed at the production of future capital gains are deductible under Treas.Reg. Sec. 1.212-1(b). It is also clear as a general matter that in the application of Sec. 265, an allocation based on realized income is not mandatory, Rev.Rul. 63-27, and this was true as regards trustees' fees too, at least under the 1939 Code. Edward Mallinckrodt, Jr., 2 T.C. 1128, 1148 (1943). The Commissioner argues, however, that where a trust is involved, the concept of distributable net income, see Int.Rev.Code Sec. 643(a), and the special system of taxation in subchapter J (dealing with trusts and estates) are important components of a "all the facts and circumstances" mentioned in Treas.Reg. Sec. 1.265-1(c). Manufacturers Hanover Trust Co. v. United States, 312 F.2d 785, 795, 160 Ct. Cl. 582 (1963). Trusts are taxable entities which compute their deductions basically as do individuals, though in order to effectuate the "flow-through" scheme of taxation of subchapter J they are allowed a special deduction for distributions to beneficiaries. Int.Rev.Code Sec. 641(b); Treas.Reg. Sec. 1.641(b)-1. This distribution deduction is limited by distributable net income, Int.Rev.Code Sec. 661(a). The statute contemplates that items of deduction like fiduciary fees be allocated exclusively among items of distributable net income. Int.Rev.Code Sec. 661(b); Treas.Reg. Sec. 1.652(b)-3(b). Thus, in Manufacturers Hanover Trust v. United States, supra, and Tucker v. Commissioner, 322 F.2d 86 (2d Cir. 1963), the courts upheld the Commissioner's excluding from the allocation base realized capital gains allocable to corpus not required to be distributed in the current year, hence excluded from distributable net income. Int.Rev.Code Sec. 643(a) (3). Since capital appreciation is never included in distributable net income, the Commissioner contends, it may never be included in the base for allocating commissions between exempt and taxable income.

The Commissioner himself acknowledges that the allocation of termination fees like those involved here may not be subject to the strictures of the distributable net income concept, conceding that the deductions may instead pass to beneficiaries under the general allocation provisions and the excess deduction provisions of Sec. 642(h) (2). We think this is in fact the case. Distributable net income is an annual concept. Int.Rev.Code Sec. 643(a). Manufacturers Hanover Trust and Tucker involved annual commissions and income beneficiaries.⁶  Since income beneficiaries would not be taxed for capital gains (which were allocated to corpus under the trust instrument), the Court of Claims saw no reason to give them the added advantage of a deduction for expenses which would be inflated if it included fees based on such gains--gains which would eventually be a tax burden to another (the remainderman). 312 F.2d at 796. In the present case taxpayer will receive the benefit of the appreciation if anyone does. There is no authority in the code for computing, as the Commissioner in effect wishes, a second, analogous distributable net income based on figures from the entire duration of the trust. Thus the court in Whittemore v. United States, 383 F.2d 824 (8th Cir. 1967), facing the identical issue as we are, seemingly did not feel constrained by Treas.Reg. Sec. 1.652(b)-3 in applying Sec. 642(h) (2).⁷ 

In sum, we agree that the Commissioner's allocation was proper as to the annual fees but conclude it was not reasonable in light of all the facts and circumstances, including taxpayer's proposed allocation, insofar as the termination fees were concerned.

Affirmed in part and reversed in part. Remanded for further proceedings consistent with this opinion.