Sidney B. Stern and Vera L. Stern v. Commissioner of Internal Revenue

ENRIGHT, District Judge,

dissenting:

I respectfully dissent. In my view, the majority decision would elevate form over substance in characterizing these transactions as sales in exchange for annuities rather than transfers in trust. In so doing, sanction is given to a troubling method of improper tax avoidance. In a time when the average individual struggles to meet his or her share of the tax burden, the wrong signal is sent to those who possess the means to circumvent the tax responsibilities we all must bear.

At the risk of reiterating facts already described by the Tax Court and the majority, it is important to highlight the essential features of the transactions at issue here.

With the goal of securing tax benefits as their admitted purpose, the Sterns, through their attorney, caused two foreign situs trusts to be established. As named beneficiaries of the trusts, the Stems and their issue would receive payments from the trust corpus and income. Stern held a lifetime power of appointment over the trust, although he could not name himself, his creditors, or his estate. He could, however, appoint his wife, who was provided with an identical power effective at her husband’s death. Most importantly, both Sterns had the power to remove the trustee, with or without cause, and could appoint a qualified successor. 1 The trustee was given broad powers to distribute trust funds to the beneficiaries, lend them money on an unsecured, interest-free basis, and to invest in common stock or securities with trust assets.

The record indicates that once Stern transferred his Teledyne stock to the trusts pursuant to the “annuity agreements,” he continued to exercise considerable control over the trust assets. He made several investment proposals to the Hylton Trust and eventually convinced the trustee to invest $25,000 in trust funds to finance his reentry into the secondary loan business. He personally interviewed representatives from Weiss, Peck & Greer, the investment firm chosen to manage the trust assets. Upon Stern’s subsequent recommendation, the trustee terminated the relationship with Weiss, and only hired a replacement after consulting with Stern. Eventually, Stern terminated the Hylton trustee and replaced them with an entity of his choice.

These facts must be analyzed in light of the two Ninth Circuit decisions which have attempted to distinguish annuity sales from transfers in trust, Lazarus v. Commissioner, 513 F.2d 824 (9th Cir.1975), and Lafargue v. Commissioner, 689 F.2d 845 (9th Cir.1982). In Lazarus , taxpayers acting in accordance with a pre-arranged estate plan, established an irrevocable trust with independent trustees and the taxpayers’ children as the beneficiaries. They transferred stock to the trust pursuant to an “annuity agreement” which provided for an annual payment to the taxpayers of $75,000. The stock was sold in exchange for a note which was structured to yield $75,000 a year in interest income. The fact that the interest income of the trust was the sole source of the annuity payment, along with other factors “no one of [which] is controlling,” led the court to hold that the transaction was properly characterized as a transfer in trust with a reserved life estate in the trust income. Id. at 829-30 . 2

*562 In Lafargue , this circuit reached the opposite result. There, the taxpayer established a trust with her daughter as the named beneficiary. The taxpayer was neither a trustee nor a beneficiary, and the court expressly stated that she held no power to manage the trust or control the independent trustees. Id. 689 F.2d at 848 . She transferred property worth $335,000 in exchange for annual payments from the trust of $16,502. As the trust corpus was assessable for the annuity payments, there was no “tie-in” between the income of the trust and the payment to the taxpayer. The Lafargue court characterized the transaction as a sale in exchange for an annuity, rather than a transfer in trust. Id. 689 F.2d at 848 .

In ruling in favor of the taxpayer, the Lafargue court focused on much more than whether the annuity payments were a “mere conduit” for the trust income. 3 The court listed several factors which highlight the distinctions between that decision and the case at bar.

First, Lafargue indicates that had the taxpayer there exercised control over the trust assets or trustees, the court might have applied the rationale of Bixby v. Commissioner, 58 T.C. 757 (1972), or Samuel v. Commissioner, 306 F.2d 682 (1st Cir.1962). In both Bixby and Samuel , the taxpayers exerted such a high degree of control over the assets purportedly transferred to trusts that the transactions could not be characterized as sales in exchange for annuities. By way of example, Lafargue notes that the “annuitant” settlor in Bixby could remove the trustee and receive interest-free, unsecured loans from the trust. Lafargue, supra, at 848-49, n. 4 .

Mr. Stern enjoyed precisely this type of control over his trust assets, together with other significant incidents of ownership. Under his power of appointment, he could transfer the trust to his wife or anyone else, save himself or his creditors. He held the power to terminate the trustee without cause, a power he eventually exercised in replacing the Hylton trustee.

At least one court has viewed the power to terminate without cause as the functional equivalent of being the trustee. Corning v. Commissioner, 24 T.C. 907, 915 (1955). Stern exercised considerable control over the management of the trust assets, as evidenced by his selection and termination of the trust’s investment counsel- or.

Short of actually holding the Teledyne stock in his own name, it is difficult to conceive of an arrangement whereby Stern would enjoy greater control over the assets he purported to transfer away. Indeed, on at least one occasion, he represented that those assets were his own. 4

The second factor which distinguishes this case relates to the Sterns’ status as co-beneficiaries of the trust. The Lafargue court supported its decision in favor of the taxpayer by noting that subsequent gains in the trust property would inure to the trust, rather than Mrs. Lafargue, who was not named as a beneficiary. Hence, the early risk of death lay with the taxpayer, as it would in a normal annuity situation. Lafargue, supra, 689 F.2d at 850 .

In contrast, the Sterns face none of the risks normally borne by an annuitant. As beneficiaries, they will reap any increases in the trust corpus. More importantly, they are insured against the risk of early death as the residue of the trust is held for their benefit. The majority’s observation that there is little chance of unexhausted corpus passing to others upon the death of the annuitants misses the point. It makes little difference to the Sterns if the accu *563 mulated value of their annuity payments approximates the fair market value of the stock transferred. Any unexhausted payments resulting from their premature deaths will pass to the surviving spouse or some other beneficiary they have named. Given this arrangement, Sidney and Vera Stern are more appropriately characterized as beneficial owners rather than annuitant-creditors. Lafargue, supra, 689 F.2d at 849 ; Samuel, supra, 306 F.2d at 687 .

In conclusion, I find based on the degree of control and the beneficial enjoyment afforded over the trust assets, these transactions must be characterized as. transfer in trust rather than sales in exchange for annuities. I would further find, based upon the same factors, the Sterns are the true settlors of the trusts and should be taxed under I.R.C. §§ 677(a) and 671. I would affirm the decision of the Tax Court.

. The trust instrument required that the successor trustee have authorized capital of at least $100,000 in Bahamian currency.

. The other factors listed in Lazarus are: 1) the note taken back in the stock sale was the only asset in the trust excluding the $1,000 used to initially fund the trust; 2) the corpus remained' intact for the beneficiaries as it would in a normal trust arrangement; 3) the "sale” did not provide for downpayment, interest, or security for payment; and 4) there was a substantial disparity between the fair market value of the stock transferred and the actuarial value of the annuity payments. Lazarus, supra, at 829 .

. The majority’s reading of Lafargue unduly limits the range of factors considered in that case and in Lazarus . While Lafargue indicates the “mere conduit" test is an important factor, Id. at 848, n. 5 , the extended discussion of the taxpayer’s control (or lack thereof) over trust assets indicates the tie-in test is not determinative of the issue.

. After the transfer of the Teledyne stock to the Hylton Trust, Stern listed those shares as among his personal assets in an application for a California personal property broker's license. 77 T.C. 614, 632 (1981).