Petition — Commissioner v. Quinlivan

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OCTOBER TERM, 1979

COMMISSIONER OF INTERNAL REVENUE, PETITIONER

Vv.

RICHARD R. QUINLIVAN AND ANN M. QUINLIVAN,

ET AL.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR

THE EIGHTH CIRCUIT

WADE H. MCCREE, JR.

Solicitor General

M. CARR FERGUSON

Assistant Attorney General

STUART A. SMITH

Assistant to the Solicitor General

RICHARD FARBER

MARILYN E. BROOKENS

Attorneys

Department of Justice

Washington, D.C. 20530

a eee a ae ann i in a) sree nen

Page

REE A 1

Jurisdiction aati adil Adaiibindéindlennniacininegine 2

EEE aT 2

Statutes and regulations involved .................... 2

EEL LENSES 3

Reasons for granting the petition -................... 8

RR IL ASSES 16

Ee la

EE A 9a

SEES SS 21a

SIE ETE EE EC 22a

CITATIONS

Cases:

Audano v. United States, 428 F.2d 251.... 11, 12

Brooke v. United States, 468 F.2d 1155... 7,12

Brown v. Commissioner, 180 F.2d 926,

cert. denied, 340 U.S. 814 -..................... 7,12

Butler v. Commissioner, 65 T.C. 32'7........ 12

Chace v. United States, 422 F.2d 292........ 12

Corliss v. Bowers, 281 U.S. 376 .............. 14

Engel v. United States, 400 F. Supp. 5,

an ee eee ee 7,12

Felix v. Commissioner, 21 T.C. 794 ........ 12

Finley v. Commissioner, 255 F.2d 128,

aff'd, 265 F.2d 885, cert. denied, 361

i atti scheipenevennenee 11-12

Furman v. Commissioner, 381. F.2d 22... 12

Gregory v. Helvering, 293 U.S. 466 ........ 14

Cente ee ~— Iu thy Supreme Court of the United States

Griffiths v. Commissioner, 308 U.S. 355.... 14 Cceninn Vote 207%

Knetsch v. United States, 364 U.S. 361... 14 ,

Lerner v. Commissioner, 71 T.C. 290...... 12

Mathews v. Commissioner, 61 T.C. 12,

rev'd, 520 F.2d 323, cert. denied, 424 No.

Wes: WHE sainarbeceanneuaiecvesadinaiial 5, 6, 8, 9, 10, 18

Minnesota Tea Co. v. Helvering, 302 U.S. COMMISSIONER OF INTERNAL REVENUE, PETITIONER

RE ES teat 14

Oakes vy. Commissioner, 44 T. C. 524. Sivan 12 v.

Penn v. Commissioner, 51 T.C. 144 ........ 12

Perry v. United States, 520 F.2d 235, RICHARD R. QUINLIVAN AND ANN M. QUINLIVAN,

cert. denied, 423 U.S. 1052....7, 8, 9, 10, 11, 14 ET AL.

Serbousek v. Commissioner, T.C.M. (P-H)

{77,105 (1977) .- ‘ 12

ee eee. ae PETITION FOR A WRIT OF CERTIORARI TO THE

ie Mey v. Commissioner, 841 F.2d UNITED STATES COURT OF APPEALS FOR

, cert. denied, 382 U.S. 814 -.......... 6, 8,9 THE EIGHTH CIRCUIT

White v. Fitzpatrick, 193 F.2d 398, cert.

denied, 343 U.S. 928 . , 12

Wiles v. Commissioner, 491 F.2d 1406... 12

Zumstein v. Commissioner, T.C.M. (P-H) The Solicitor General, on behalf of the Commis- -

73,045 (1978) ------------enneeeeneeeneeeeeneee 12 sioner of Internal Revenue, petitions for a writ of

Statutes and regulation: certiorari to review the judgment of the United

States Court of Appeals for the Eigh ircuit i

Internal Revenue Code of 1954 (26 af Appens for the ign Circuit in

this case.

seer | OPINIONS BELOW

Section 162 (a) (3) .................--- 2, 4, 5, 6, 7, 14 |

RONNIE ictesisia ncbichosnnttintiatnectcte 2, 7-8, 14 | The opinion of the Tax Court (App. A, infra, 1a-

BGFR IMA) ck 9 8a) is not officially reported. The opinion of the

; court of appeals (App. B, infra, 9a-20a) is reported

Miscellaneous: at 599 F.2d 269.

S. Rep. No. 1622, 88d Cong., 2d Sess.

CRRSG) sn ax as 14 (1)

JURISDICTION

The judgment of the court of appeals was entered

on May 24, 1979 (App. C, infra, 21a). By order

dated August 16, 1979, Mr. Justice Blackmun ex-

tended the time for filing a petition for a writ of

certiorari to and including October 21, 1979 (a Sun-

day). The jurisdiction of this Court is invoked

under 28 U.S.C. 1254(1).

QUESTION PRESENTED

Whether respondents are entitled to a business

expense deduction under Section 162(a)(3) of the

Internal Revenue Code of 1954 for purported “rental”

payments made under a prearranged gift and lease-

back transaction having no business purpose other

then to divert income to their children, pursuant to

which they contemporaneously transferred an office

building to short-term trusts for the benefit of their

children and leased the building back from the trustee

throughout the term of the trust, while retaining a

reversionary interest in the property upon the termi-

nation of the trust.

STATUTES AND REGULATION INVOLVED

Section 162(a)(3) and Sections 671 through 678

of the Internal Revenue Code of 1954 (26 U.S.C.) and

Treasury Regulation on Income Tax (1954 Code),

Section 1.671-1(c) (26 C.F.R.) are set forth in

Appendix D, infra, 22a-35a.

STATEMENT

1. The facts were fully stipulated and may be

summarized as follows: Respondents: Richard R.

Quinlivan and Robert P. Quinlivan are attorneys who

practice law in St. Cloud, Minnesota. They began

the practice with their father in the 1950s and con-

tinued as members of the same firm following his

death in 1961 (App. A, infra, 2a; App. B, infra,

10a). In 1963, respondents began construction of an

office building in which each owned an undivided one-

half interest. Upon completion of the building, re-

spondents’ law firm became the sole occupant of the

building (App. A, infra, 2a-3a; App. B, infra, 10a).?

On January 2, 1964, each respondent transferred

his one-half interest in the office building to the

Northwestern National Bank of Minneapolis as trus-

tee under a separate trust for the benefit of his chil-

dren. The trusts were established on the same day

and were irrevocable for a term of ten years and six

months. At the conclusion of the term, the trust prop-

erty was to revert to respondents (App. A, infra,

3a; App. B, infra, 10a-1la).

1The term “respondents” refers to Richard and Roger

Quinlivan. Ann and Joyce Quinlivan are parties solely be-

cause they filed joint federal income tax returns with their

husbands during the years in issue (App. A, infra, 2a; App.

B, infra, 10a, note 2).

2 At this time, respondents were the only members of the

law firm. Subsequently, at some time prior to the years in

issue, another partner joined the firm (Exs. 7-G, 12-L).

Shortly after the establishment of the trusts, the

trustee and respondents’ law firm entered into a

written lease under which the firm leased back the

building that respondents had transferred to the

trusts.* The initial lease was for three years and

contained a renewal option at the expiration of the

term “at a rental and terms to be agreed upon” (App.

A, infra, 3a; App. B, infra, 1la). Subsequent agree-

ments increased the rent and continued the law

firm’s tenancy; each subsequent lease contained the

same renewal option provision (App. B, infra, 11a).

After the termination of the trusts and the reversion

of the building to respondents on July 2, 1974, the

law firm leased the office space from respondents for

an amount that was not less than the highest rent

paid to the trustee during the period it held the

property (App. A, infra, 3a-4a).

2. In computing their net income from the law

practice for each of the years at issue, respondents

claimed business expense deductions for “rentals”

under Section 162(a)(3) of the Internal Revenue

Code of 1954 equal to their aliquot partnership share

of the payments made by the law firm to the trustee

pursuant to the leaseback arrangement. On audit, the

Commissioner of Internal Revenue disallowed the

rental deductions, increased respondents’ share of

their law firm’s income, and accordingly determined

deficiencies (App. A, infra, 2a; App. B, infra, 12a).

8’ The term of the lease commenced as of January 2, 1964;

however, the lease was executed by the parties three weeks

later (Ex. 12-L).

In the Commissioner’s view, the rentals were not an

ordinary and necessary business expense because the

obligation to pay such rentals arose out of a trans-

action serving no business purpose and having the

sole objective of tax avoidance (App. B, infra, 12a).

In this suit brought by respondents for redetermi-

nation of the deficiencies, the Tax Court held that

respondents’ payments to the trustee were deductible

under Section 162(a)(3) as “rentals or other pay-

ments required to be made as a condition to the con-

tinued use or possession, for purposes of the trade

or business, of property to which the taxpayer has

not taken or is not taking title or in which he has

no equity.” Pursuant to the Tax Court’s analysis,

respondents’ gift and leaseback satisfied the four-

part test it announced in Mathews v. Commisioner,

61 T.C. 12 (1973), rev’d, 520 F.2d 323 (5th Cir.

1975), cert. denied, 424 U.S. 967 (1976). First, the

Tax Court concluded that respondents did not retain

substantially the same control over the property that

they had before they made the gift because they em-

ployed an independent trustee. Second, the lease-

back was in writing and required the payment of a

reasonable rental. Third, the court ruled that the

leaseback (as distinguished from the gift) had a

bona fide business purpose because respondents’ con-

tinued use of the building was essential to the con-

duct of their law practice. Fourth, the court con-

cluded that respondents’ reversionary interest in the

property was not a disqualifying “equity” within

the meaning of Section 162(a)(3) (App. A, infra,

5a-8a).

3. The court of appeals affirmed on three inde-

pendent grounds (App. B, infra, 9a-20a). It first

concluded that respondents’ payments met the literal

requirements for deductibility as “rentals” under Sec-

tion 162(a)(3) because: (1) the payments were

required to be made for the continued use or posses-

sion of the property; (2) respondents’ continued use

or possession of the property was for purposes of

their trade or business; (3) respondents had not

taken and were not taking title to the property; and

(4) respondents had no equity in the property (App.

A, infra, 18a-15a). As the court of appeals saw the

matter, “[i]t is clear that application of the plain

meaning of section 162(a)(3) to the facts of this

case justifies the deduction” (id. at 15a).

As a second ground for affirmance, the court of

appeals approved the four-part test applied by the

Tax Court and concluded that it complemented its

own analysis based upon the literal meaning of

Section 162(a) (3). In so holding, the court rejected

the rationale of the decisions of the Fifth and Fourth

Circuits upholding the government’s position that a

business deduction for rent is allowable only if there

is a business purpose for the entire transaction, in-

cluding the transfer of the property from the tax-

payer and the leaseback. See, e.g., Van Zandt v.

Commissioner, 341 F.2d 440 (5th Cir.), cert. denied,

382 U.S. 814 (1965) ; Mathews v. Commissioner, 520

F.2d 323 (5th Cir. 1974), cert. denied, 424 U.S. 967

(1976); Perry v. United States, 520 F.2d 235 (4th

Cir. 1975), cert. denied, 423 U.S. 1052 (1976).

While the court of appeals acknowledged that “for

tax purposes the overall nature of a transaction must

be considered” (App. B, infra, 17a), it observed that

“in addition to all recent cases of the Tax Court not

appealable to the Fifth Circuit, several courts have

adopted positions inconsistent with the Commission-

er’s contentions and consistent with our holding in

this case” (App. B, infra, 15a). See Brooke v. United

States, 468 F.2d 1155 (9th Cir. 1972); Brown v.

Commissioner, 180 F.2d 926 (8d Cir.), cert. denied,

340 U.S. 814 (1950) ; Engel v. United States, 400 F.

Supp. 5 (W.D. Pa. 1975), aff’d by an equally divided

en bane court, 562 F.2d 41 (3d Cir. 1977). As its

second basis for affirmance, the court of appeals con-

cluded that “to the extent that there may be a split

in the courts on this issue, we adopt the majority

view as applied by the Tax Court below” (footnote

omitted) (App. B, infra, 17a-18a).

Even if it had not held that Section 162(a) (3)

expressly authorized respondents’ deductions or

adopted “the majority view as applied by the Tax

Court * * *” (App. B, infra, 17a-18a), the court of

appeals would nevertheless have affirmed on the third

independent ground that the income from the trusts

was taxable to the beneficiaries under the grantor

trust rules of Sections 671-678, App. D, infra, 22a-

35a (App. B, infra, 18a-20a). In the court of ap-

peals’ view, the rental deduction provision of Section

162(a)(3) and the grantor trust rules of Sections

671-678 must be read in pari materia. It accordingly

ruled that the taxation of the income of the trusts

to the beneficiaries and not to respondents necessarily

required the conclusion that respondents were entitled

to the rental deduction for the payments to the trust

(App. B, infra, 20a).

REASONS FOR GRANTING THE PETITION

The decision below holding that respondents are

entitled to a business expense deduction for “rentals”

paid to a trustee of a short-term trust for the benefit

of their children in a gift and leaseback arrangement

conflicts with Van Zandt v. Commissioner, 341 F.2d

440 (5th Cir.), cert. denied, 382 U.S. 814 (1965);

Mathews v. Commissioner, 520 F.2d 323 (5th Cir.

1975), cert. denied, 424 U.S. 967 (1976); and Perry

v. United States, 520 F.2d 235 (4th Cir. 1975), cert.

denied, 423 U.S. 1052 (1976). In those cases, the

Fourth and Fifth Circuits have rejected similar at-

tempts by taxpayers to split their income with their

children by creating rental deductions for the use of

business property by means of gift and leaseback

arrangements with short-term trusts. This Court

should resolve the conflict and establish a national

rule with respect to this type of transaction.

1. The typical gift and leaseback device contains

the following elements: The grantor-taxpayer owns

a building which he occupies in the conduct of his

trade or business. He transfers the building to a

trust with a term slightly in excess of ten years for

the benefit of his children, with a reversion to him

upon termination of the trust. Simultaneously with

the transfer, the grantor leases the building back

from the trust, for a total period that is usually

coextensive with the term of the trust. The grantor

thereafter claims business expense deductions for the

“rentals” paid to the trust, thereby reducing his high-

bracket taxable income, and shifting the taxation of

the “rentals” to his children, who are typically low-

bracket taxpayers. If the arrangement is given effect —

for tax purposes, the gift and leaseback device enables

high-bracket taxpayers owning realty that they put

to business use to reduce their taxable income by

what are in fact non-deductible payments to the natu-

ral objects of their bounty.

Contrary to the decision below, the Fifth and

Fourth Circuits have refused to permit business ex-

pense deductions for purported rentals in similar

arrangements. Those courts have upheld the Com-

missioner’s position that “rentals” paid pursuant to

a gift and leaseback transaction are not deductible

business expenses unless the taxpayer shows a busi-

ness purpose for the transaction as a whole. Thus,

in Van Zandt v. Commissioner, supra, which involved

a similar trust device for diverting income to the tax-

payer’s children, the Fifth Circuit emphatically re-

jected the notion, adopted by the court below, that

it is sufficient if there is a business purpose for the

leaseback. In holding that the taxpayer’s payments

to the trust were not deductible, Van Zandt concluded

that (341 F.2d at 443) “inevitably we must look at

the original conveyance of the property together with

the execution of the lease-back as a single transaction.

Thus reviewing it, we conclude that the obligation to

pay rent resulted not as an ordinary and necessary

incident in the conduct of the business but was in

fact created solely for the purpose of permitting a

division of the taxpayer’s income tax” (emphasis in

original).

Although the taxpayer in Van Zandt named him-

self trustee, the Fifth Circuit subsequently held in

Mathews v. Commissioner, supra, 520 F.2d at 323,

that “[t]he outcome would not have differed had there

been an outside independent trustee” (id. at 325). In

ruling in favor of the government in a case involving

an independent trustee, the court in Mathews em-

phasized that the “[t]axpayers’ effective control of

the property for the duration of the term was prac-

tically assured, notwithstanding the trustee’s inde-

pendence * * *. In short, before the trust’s creation

Taxpayer operated his business on and with necessary

property—all under his complete control. The same

was true afterward—except he hoped some of his in-

come had been siphoned off to his children. As in

Van Zandt what was carefully planned to achieve a

total result cannot be split into separate parts”

(ibid.). Accord: Perry v. United States, supra, 520

F.2d at 239.

Thus, as matters now stand, respondents’ transac-

tion, employing an independent trustee, would pass

muster in the Eighth Circuit but not in the Fourth

or Fifth Circuits. There is accordingly a square con-

flict between the decision below and Mathews and

Perry.‘

Finally, the question presented is important to the

proper administration of the revenue laws. It has

produced substantial litigation in recent years and it

is expected that the number of cases will increase

unless the conflict among the circuits is resolved. The

deductibility of rental payments arising out of gift

and leaseback arrangements has been involved in at

least 19 decided cases." Moreover, we are advised by

* Although the court of appeals stated that “to the extent

that there may be a split in the courts on this issue, we adopt

the majority view as applied by the Tax Court below” (App.

B, infra, 17a-18a), it also expressed doubt as to whether

“there exists a true split among the courts of appeals” (App.

B, infra, 17, note 4). The court there recognized that the

Fifth Circuit’s Mathews decision conflicts with its own and

is unpersuasive in suggesting that the pre-Mathews Fifth

Circuit decision in Audano v. United States, 428 F.2d 251,

which also held for the government, somehow suggests that

“the real conflict may be among cases in the Fifth Circuit.”

Moreover, the court’s attempted reconciliation of Perry with

what it characterized as the “majority view’ on the basis of

the “tightly drawn leases” in Perry ignores the Fourth Cir-

cuit’s own analysis in that case. In Perry, the court observed

that “[w]le think our cases are indistinguishable from Van

Zandt, that the latter was correctly decided, and that it should

be applied here” (520 F.2d at 237). The court there further

rejected the bifurcation of the overall transaction (id. at 238-

239) upon which the decision below relies (App. B, infra,

14a, 16a). See pages 12-14, infra. There is thus a clear con-

flict between Van Zandt, Perry and Mathews, on the one hand,

and the decision below.

5 Skemp v. Commissioner, 168 F.2d 598 (7th Cir. 1948) ;

Brown Vv. Commissioner, supra; Brooxe v. United States,

supra; Van Zandt v. Commissioner, supra; Perry v. United

States, supra; Mathews v. Commissioner, supra; Engel v.

United States, supra; Finley v. Commissioner, 255 F.2d 128

the Internal Revenue Service that there are currently

15 docketed cases pending in the Tax Court and 45

additional cases pending at various administrative

levels in the Service presenting the issue.

2. The fundamental error by the court below, as

well as by the decisions in Brooke v. United States,

468 F.2d 1155 (9th Cir. 1972); Brown v. Commis-

sioner, 180 F.2d 926 (3d Cir.), cert. denied, 340 U.S.

814 (195c); Engel v. United States, 400 F. Supp. 5

(W.D. Pa. 1975), affd. by an equally divided en banc

court, 562 F.2d 41 (3d Cir. 1977); and Skemp v.

Commissioner, 168 F.2d 598, upon which it relied

(App. B, infra, 15a-16a), was to bifurcate these

integrated gift and leaseback devices into two un-

related transactions of gift and leaseback having

separate and independent status. After breaking

down the transaction into separate components, the

court below concluded the grantor’s rental pay-

ments served a business purpose because they were

required to be made to permit the continued use of

the building for his business.

(10th Cir. 1958), aff’d, 265 F.2d 885, cert. denied, 361 U.S.

834 (1959) ; Audano v. United States, supra; Wiles v. Com-

missioner, 491 F.2d 1406 (5th Cir. 1974); Chace v. United

States, 422 F.2d 292 (5th Cir. 1970); Furman v. Com-

missioner, 381 F.2d 22 (5th Cir. 1967); Felix v. Commis-

sioner, 21 T.C. 794 (1954); Oakes v. Commissioner, 44

T.C. 524 (1965) ; Penn v. Commissioner, 51 T.C. 144 (1968) ;

Butler v. Commissioner, 65 T.C. 327 (1975); Zumstein v.

Commissioner, T.C.M. (P-H) {73,045 (1973); Serbousek

v. Commissioner, T.C.M. (P-H) {77,105 (1977); Lerner

v. Commissioner, 71 T.C. 290 (1978), appeal pending, No. 79-

4129 (2d Cir.). Cf. White v. Fitzpatrick, 198 F.2d 398 (2d

Cir. 1951), cert. denied, 8343 U.S. 928 (1952).

But splitting the transaction into separate com-

ponents blinks at the reality inherent in these cases

that the gift and leaseback are integral parts of a

prearranged plan. Unlike the situation where two

independent parties enter into a lease arrangement

pursuant to which rent is paid in exchange for the

occupation of realty, here the taxpayers have them-

selves temporarily created the obligation to pay rent

on property that they themselves owned outright and

will continue to own outright after the termination

of the trust. As the Fifth Circuit succinctly put it in

Mathews v. Commissioner, supra, 520 F.2d at 325,

“Ti]f we stood at the top of the world and looked down

on this transaction—ignoring the flyspeck of legal

title under state law—we would see the same state of

affairs the day after the trust was created that we

saw the day before.”

Since respondents’ short-term trusts and the lease

were essential elements of a prearranged plan,° there

is no basis for the bifurcation of the overall trans-

action by the decision below. Indeed, this Court long

® Although the Tax Court stated in its opinion that “the

leaseback” was not prearranged (App. A, infra, 7a), it made

no finding to this effect and the fully stipulated facts do not

support such an inference. To the contrary, the close prox-

imity in time between the gift and leaseback, coupled with

the fact the building housed respondents’ law practice, sup-

ports the conclusion that respondents intended to lease back

the property at the time they conveyed it to the trusts. In-

deed, in affirming the Tax Court, the court of appeals did not

adopt its conclusion that there was no prearrangement but

relied upon Brown and Skemp in which the fact of prear-

rangement was undisputed.

ago established the fundamental principle that trans-

actions designed and executed as integral parts of a

single plan will not be given independent tax signifi-

cance but will be regarded together in determining

the tax consequences of the overall transaction. See,

e.g., Gregory v. Helvering, 293 U.S. 465, 469-470

(1935); Minnesota Tea Co. v. Helvering, 302 U.S.

609, 613-614 (1938) ; Griffiths v. Commissioner, 308

U.S. 355, 357-358 (1939). See also Corliss v. Bowers,

281 U.S. 376, 378 (1939) ; Knetsch v. United States,

364 U.S. 361 (1960). “To hold otherwise would be to

exalt artifice above reality and to deprive the statu-

tory provision in question of all serious purpose.”

Gregory v. Helvering, supra, 293 U.S. at 470.

3. The decision below also erred in concluding, as

its third ground of decision, that the fact that the

income of the trusts was taxable to the beneficiaries

and not to respondents under the grantor trust rules

of Sections 671-678 justified respondents’ rental de-

duction under Section 162(a)(3) (App. B, infra,

18a-20a). There is, however, no necessary correlation

between the taxation of the income from the trusts

and the deductibility of the payments to the trusts.

Indeed, in enacting the grantor trust provisions, Con-

gress specified that they were to have “no applica-

tion in determining the right of a grantor to deduc-

tions for payments to a trust under a transfer and

leaseback arrangement.” S. Rep. No. 1622, 83d Cong.,

2d Sess. 365 (1954). See Perry v. United States,

supra, 520 F.2d at 237, n. 2. In ruling that the

grantor trust rules and Section 162(a) (3) are to be

construed in pari materia (App. B, infra, 20a), the

court of appeals disregarded the clearly expressed

intent of Congress.’

In sum, viewing the creation of the trust and the

leaseback as a single integrated transaction, it is

plain that respondents’ “obligation to pay rent” was

not an ordinary and necessary incident to a transac-

tion with a real business purpose. Hence, they were

not entitled to a business expense deduction for such

payments.

™The decision below found the statement in the Senate

Report not authoritative because it was not also set forth in

the House Report (see App. B, infra, 19a). But the Senate

considers revenue measures after the House and the two

bodies thereafter confer on such legislation. There is accord-

ingly no justification for the court of apeals’ conclusion that

the views expressed in the Senate Finance Committee Report

do not represent the intent of Congress.

CONCLUSION

The petition for a writ of certiorari should be

granted.

Respectfully submitted.

WADE H. McCrEE, Jr.

Solicitor General

M. CARR FERGUSON

Assistant Attorney General

STUART A. SMITH

Assistant to the Solicitor General

RICHARD FARBER

MARILYN E. BROOKENS

Attorneys

OCTOBER 1979

APPENDIX A

T. C. Memo. 1978-70

UNITED STATES TAX COURT

Docket Nos. 8921-75

8922-75

Filed February 23, 1978

RICHARD R. QUINLIVAN and ANN M. QUINLIVAN,

PETITIONERS

Vv.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

ROGER P. QUINLIVAN and JOYCE E. QUINLIVAN,

PETITIONERS

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Clinton A. Schroeder and Frederick J. Gerhart, for

the petitioners.

Dale L. Newland, for the respondent.

MEMORANDUM OPINION

Fay, Judge: Respondent determined the following

deficiencies in petitioners’ Federal income taxes:

Dkt. No. Petitioner Year Deficiency

8921-75 Richard R. 1967 $5,919.89

and Ann M. 1968 7,011.31

Quinlivan 1969 8,640.70

8922-75 Roger P. and 1967 8,809.91

Joyce E. 1968 4,987.97

Quinlivan 1969 3,580.34

These cases were consolidated for purposes of trial,

briefing, and opinion. Richard R. Quinlivan and

Roger P. Quinlivan will be hereinafter referred to

individually as Richard or Roger and referred to

collectively as the petitioners.

Petitioners are lawyers and were members of the

same law firm during all relevant times herein. Un-

til its incorporation as a professional association in

1969, the law firm operated as a partnership.

Due to concessions, the remaining issue for decision

is whether in computing petitioners’ share of income

from their law practice, a rental expense deduction

under section 162(a) (3), should be allowed for pay-

ments made for the use of property which petitioners

had previously transferred to two short-term trusts.

All of the facts in this case have been stipulated

and are so found.

At the time their petitions in this case were filed,

petitioners and their wives resided in St. Cloud, Minn.

Each petitioner and his spouse filed a joint Federal

income tax return for 1967, 1968, and 1969 with the

Internal Revenue Service Center in Kansas City, Mo.

In 1962 petitioners were engaged in the active

practice of law. In that year, they began construc-

tion of a building designed for general purpose office

space. Richard and Roger each owned an undivided

one-half interest in the building which, upon its com-

pletion, contained some 8,275 square feet of office

space. In April 1963 the law firm of which petition-

* Unless otherwise indicated, all statutory references are

to the Internal Revenue Code of 1954, as amended.

ers are members became the sole occupant of the

building.

On January 2, 1964, Richard and Roger each

executed, as grantors, a 10-year 6-month irrevocable

Trust Agreement creating two trusts for the benefit

of their respective children. Richard and Roger each

retained a reversionary interest in their respective

trusts.

On that same day, Richard and Roger, as grantors,

together with their wives, conveyed the realty to the

Northwestern National Bank of Minneapolis, trustee.’

After the creation of the trusts, the law firm, as

lessee, and the trustee, as lessor, entered into a lease

of the realty held by the trusts. The initial lease was

for a three-year term and was dated January 2, 1964.

At the end of the three-year term, the lessee had the

option of renewing the lease “at a rental and terms

to be agreed upon.” *

Throughout the existence of the trusts, the law

firm remained as the sole tenant of the building.

During the years in issue, the rent paid by the law

firm was reasonable in amount and represented the

fair rental value of the office space. After the termi-

nation of the trusts on July 2, 1974, the law firm

leased the office space from petitioners for an amount

2 Petitioners were not in any way connected with the

trustee bank as a shareholder, officer, depositor, or employee

during any of the years involved.

3 Subsequent to the initial term, the law firm and the

trustee periodically negotiated new written leases of the office

space. For each of the years in issue, a one-year written

lease was agreed upon.

which was not less than the highest rent paid to the

trustee during the period it held the property.

The following is a summary of the rent paid by the

law firm during the years in issue:

Taxable Monthly Yearly

Year Ended Payment Total

December 31, 1967 $ 925 $11,000

December 31, 1968 950 11,400

October 31, 1969 + 1,000 10,000

Upon receipt of the monthly payments, the trustee

allocated one-half the rental income to each trust.*

The issue presented is whether the rental payments

made pursuant to the lease during the years in issue

may be deducted as an ordinary and necessary busi-

ness expense under section 162(a) (3).°

4 After its incorporation in 1969, the law firm elected to

be governed by the provisions of subchapter S of the Code. It

also adopted a fiscal year ending October 31.

5 None of the rent paid by the law firm to the trustee was

ever expended either for the benefit of Richard or Roger or

for the support of any of the beneficiaries of the two trusts.

All of such rent was invested for the sole benefit of the

beneficiaries. :

* Sec. 162(a) (3) provides:

(a) In General.—There shall be allowed as a deduction

all the ordinary and necessary expenses paid or incurred

during the taxable year in carrying on any trade or

business, including—

(3) rentals or other payments required to be

made as a condition to the continued use or posses-

sion, for purposes of the trade or business, of

property to which the taxpayer has not taken or is

not taking title or in which he has no equity.

In Mathews v. Commissioner, 61 T.C. 12 (1973),

revd. 520 F.2d 323 (5th Cir. 1975), cert. denied 424

U.S. 967 (1976), we set forth our view as to the

appropriate test for deductibility of rental payments

by the grantor in a gift and leaseback arrangement.

In so doing, we held that such payments are deduct-

ible if the following requirements are met: (1) “The

grantor must not retain ‘substantially the same con-

trol over the property that he had before’ he made the

gift.” (2) “The leaseback should normally be in

writing and must require payment of a reasonable

rental.” (3) “The leaseback (as distinguished from

the gift) must have a bona fide business purpose.”

(4) In addition, the taxpayer must not possess a

disqualifying “equity” in the property within the

meaning of the statute.’

Based on a careful examination of the facts as

presented, we find these requirements have been met.

First, a fundamental prerequisite to the deducti-

bility of rental payments in a gift and leaseback

arrangement is the relinquishment by the grantor of

a quantum of control over the property which is not

7 Respondent urges, in essence, that we abandon the require-

ments set forth in Mathews v. Commissioner, 61 T.C. 12

(1973), revd. 520 F.2d 328 (5th Cir. 1975), cert. denied, 424

U.S. 967 (1976), in favor of an overall business purpose

test. Specifically, respondent argues that there must be a busi-

ness purpose for the gift as well as the leaseback. We have

previously considered and rejected this contention, and see

no compelling reason to alter our position at this time. See

Serbousek v. Commissioner, T.C. Memo. 1977-105, appeal to

the Eighth Circuit dismissed per stipulation of the parties

(Jan. 12, 1978).

insignificant in comparison to the control that he

enjoyed prior to making the gift. In this regard, we

stated in Mathews that this requirement “is usually

met through a transfer to an independent trustee who

has the right and the opportunity to negotiate regard-

ing the leaseback and who acts for the primary bene-

fit of the beneficiaries, rather than the grantor.”

In the instant case, it is undisputed that the trusts

were valid and irrevocable under Minnesota law.

The trustee was a corporate entity in which the

petitioners were not in any way connected as a share-

holder, director, officer, depositor, or employee. Nor

was the leaseback prearranged. Coupling these fac-

tors with the fiduciary obligations imposed upon

local law, we conclude that the trustee acted inde-

pendently of the petitioners-grantors. Moreover, un-

der the terms of the trusts, the trustee had broad

powers and, of particular import, it had the un-

fettered power to “sell, lease, exchange or otherwise

dispose of the property” held in the trusts, including

the building. We believe the evidence sufficient to

infer that the trustee carried out its fiduciary duties

in accordance with these broad powers granted to it

under the trust agreements. Nor does respondent

seriously dispute this. Furthermore, as in Mathews,

the trustee periodically renegotiated the lease of the

property which was renewable only under mutually

agreeable terms. Specifically, for each of the years

in issue, the trustee negotiated a one-year written

lease of the office building in what we, based on the

evidence, believe were arm’s-length transactions. In

addition to negotiating renewals, the trustee collected

the rents due under tne lease and applied the net in-

come of the trusts for the benefit of the income

beneficiaries. In light of these facts, we cannot say

that the trustee’s functions and independence were

illusory. See Penn v. Commissioner, 51 T.C. 144

(1968); Van Zandt v. Commissioner, 40 T.C. 824

(1963), affd. 341 F.2d 440 (5th Cir. 1965), cert.

denied 382 U.S. 814 (1965). Thus, we hold that pe-

titioners relinquished sufficient control over the realty

to satisfy the first requirement in Mathews.

As to the second requirement, the lease in question

was in writing, and the parties have agreed that the

rent thereunder was reasonable for the property.

Petitioners likewise satisfy the third requirement:

a business purpose for the lease. Petitioners’ con-

tinued use of the realty was essential to their law

practice. After the petitioners conveyed the realty to

the trustee, their continued possession of the premises

was wholly conditioned upon the payment of rent.

Under such circumstances, the execution of the lease

was a matter of business necessity. Oakes v. Com-

missioner, 44 T.C. 524 (1965); compare Wiles v.

Commissioner, 59 T.C. 289 (1972), affd. 491 F.2d

1406 (5th Cir. 1974).

With respect to the fourth requirement in Mathews

we cannot agree with respondent’s contention that

petitioners possessed an equitable interest or “equity”

in the realty within the meaning of section 162(a)

(3). Briefly stated, petitioners’ reversionary interest

was not derived from the lease or the lessor and

would only become possessory after the termination

of the trusts. Therefore, such interest is not within

the prohibition of section 162(a)(3). Mathews v.

Commissioner, supra, at 23.

Accordingly, on the basis of the particular facts

and circumstances involved herein, we hold the rental

payments in question are deductible as ordinary and

necessary business expenses.

Decisions will be

entered under Rule 155.

APPENDIX B

UNITED STATES COURT OF APPEALS

FOR THE EIGHTH CIRCUIT

No. 78-1653

RICHARD R. QUINLIVAN and ANN M. QUINLIVAN,

ROGER P. QUINLIVAN and JOYCE E. QUINLIVAN,

APPELLEES

Vv.

COMMISSIONER OF INTERNAL REVENUE, APPELLANT

Appeal from the United States Tax Court

Submitted: February 14, 1979

Filed: May 24, 1979

Before GIBSON, Chief Judge, HENLEY, Circuit Judge,

and HANSON, Senior District Judge.*

* The Honorable William C. Hanson, Senior United States

District Judge, Southern District of Iowa, sitting by desig-

nation.

10a

GIBSON, Chief Judge.

The Government appeals from a decision of the

Tax Court* holding that Richard and Roger Quin-

livan * are entitled te deduct rental payments made to

a short-term, so-called Clifford trust set up in accord-

ance with sections 671 through 678 of the Internal

Revenue Code of 1954, 26 U.S.C. §§ 671-678. The

payments were made for the use of an office building

previously owned by the taxpayers and transferred

by them to a trustee for the benefit of the taxpayers’

children. After carefully considering the arguments —

of the parties and the pertinent statutory and case

authority, we affirm.

Richard and Roger Quinlivan are attorneys who

reside in St. Cloud, Minnesota. They began the prac-

tice of law with their father in the 1950s and con-

tinued as members of the same. firm following his

death in 1961. In 1963, the firm moved into an office

building owned by the two brothers as tenants in

common. Then on January 2, 1964, each taxpayer

transferred his one-half interest in the property to

Northwestern National Bank of Minneapolis as trus-

tee under separate trusts for the benefit of the chil-

dren of each taxpayer.

1 The Honorable William M. Fay, United States Tax Court.

? Ann M. Quinlivan and Joyce E. Quinlivan are the wives

of Richard and Roger, respectively. They are involved in this

action by virtue of their having filed joint income tax returns

with their husbands. References to “taxpayers” in this

opinion mean Richard and Roger, whose legal business gen-

erated the challenged deductions.

lla

The trust documents were executed January 2,

1964, and were irrevocable for a period of ten years

and six months; at the end of that time trust property

reverted to the grantor-taxpayers. Neither the tax-

payers nor their wives were connected with the trus-

tee during the years here involved as a shareholder,

director, officer, depositor, or employee. All parties

agree that under sections 671 through 678 of the

Internal Revenue Code of 1954, the income of the

trusts was properly taxed to the beneficiaries. Nor

is there any question that the taxpayers treated the

establishment of the trust properly under the gift tax

laws and the laws of Minnesota.

Shortly after January 2, 1964, the trustee and the

taxpayers’ law firm entered into a written lease of

the premises to the law firm. The initial lease was

for three years and contained a renewal option “at a

rental and terms to be agreed upon.” Subsequent

agreements increased the rent and continued the law

firm’s tenancy; each agreement contained the same

renewal option. It is stipulated that reasonable rental

payments were made to the trustee. During the

1967, 1968, and 1969 taxable years involved in this

case, the law firm was composed of Richard and

Roger Quinlivan and Gerald Williams.’ The law

firm deducted from its income the rental payments

made to the trustee.

* During 1967 and 1968 the law firm was a partnership.

In 1969, it was converted to a corporation and chose a tax-

able year ending October 81, 1969.

12a

In 1975, the Commissioner issued notices of de-

ficiency to the taxpayers and their wives. This was

based in part on computation of an increased dis-

tributive share of law firm income for each taxpayer

after the Commissioner disallowed the rental deduc-

tions. Petitions contesting the deficiency notices were

filed in the Tax Court. After other issues were

settled, the rent deduction issue was submitted to the

court on an agreed statement of facts. The Tax Court

held the rent deductions were allowable. The Com-

missioner appeals, positing the issue of “whether the

rentals paid are a necessary and ordinary business

expense notwithstanding the fact that the obligation

to pay such rentals arose out of a transaction serving

no business purpose and having tax avoidance as its

sole objective.”

In analyzing the correctness of the conclusions of

the Tax Court, we first look at the statutory basis for

this deduction. Section 162 of the Internal Revenue

Code of 1954 provides, in pertinent part:

(a) In general—There shall be allowed all

the ordinary and necessary expenses paid or in-

curred during the taxable year in carrying on

any trade or business, including—

* * * *

(3) rentals or other payments required to

be made as a condition to the continued use or

possession, for purposes of the trade or busi-

ness, of property to which the taxpayer has not

taken or is not taking title or in which he has

no equity.

13a

In applying tax statutes, including the Internal

Revenue Code, the literal meaning of the words chosen

by Congress is most important. Masonite Corp. v.

Fly, 194 F.2d 257, 260-61 (5th Cir. 1952). Mr.

Justice Douglas noted and elaborated on this concept

when he wrote:

Congress may be strict or lavish in its allowance

of deductions or tax benefits. The formula it

writes may be arbitrary and harsh in its appli-

cations. But where the benefit claimed by the

taxpayer is fairly within the statutory language

and the construction sought is in harmony with

the statute as an organic whole, the benefits will

not be withheld from the taxpayer though they

represent an unexpected windfall.

Lewyt Corp. v. Commissioner, 349 U.S. 237, 240

(1955).

Examining section 162(a)(3) from this perspec-

tive, we find that Congress has expressly provided for

the deduction of rental expenses where:

(1) the payments are required to be made for

the continued use or possession of the prop-

erty;

(2) the continued use or possession of the prop-

erty is for purposes of the trade or busi-

ness;

(3) the taxpayer has not taken and is not

taking title to the property; and

(4) the taxpayer has no equity in the property.

l4a

If all four requirements are met, the law firm is

entitled to the deduction and the Tax Court’s decision

must be affirmed.

It is clear that the first requirement has been

established. The law firm was required to pay rent

under the written leases for the years in question.

Had the payments not been made, it is undisputed

that the bank as trustee would have been under a

fiduciary obligation to evict the law firm and rent

the property to others or to sue the law firm for the

rent. The trusts were valid and enforceable under

Minnesota law. There is no reason to believe that

the independent trustee in this case would have vio-

lated its fiduciary duties and permitted the law firm

to remain in the building without paying rent.

Similarly, it is clear that the continued use of the

property was for the purposes of the law firm’s busi-

ness. It could not function without the office space

it rented. In like manner, the third requirement is

met by title being in the trustee; certainly the law

firm was not purchasing the office building.

The fourth requirement in section 162(a) (3) is

that the taxpayer have no equity in the property.

On appeal, the Government has not argued that the

taxpayers have a disqualifying equity here. The Tax

Court noted the taxpayers’ “reversionary interest was

not derived from the lease or the lessor and would

only become possessory after the termination of the

trusts. Therefore, such interest is not within the

prohibition of section 162(a)(3).” Memorandum

opinion at 9. We agree. The prohibition on equitable

15a

interests seems designed to fill the gaps around the

third requirement dealing with title to the property.

Taken together, they were intended to prevent the

taxpayer from receiving or improperly benefiting

from the deducted rental payments.

It is clear that application of the plain meaning

of section 162(a)(3) to the facts of this case jus-

tifies the deduction. This is a sufficient basis for

affirmance of the Tax Court.

Despite the clear application of the statute, the

Government has contended for many years that rental

deductions should not be allowed where the leased

property was previously owned by the lessee and

given by him to the lessor. The Government urges

that a deduction is allowable only if there was a

“business purpose” for the “entire transaction,” in-

cluding the transfer of the property from the tax-

payer and the leaseback. Years of litigation has re-

sulted in a few cases adopting the Government’s

rationale. See, e.g., Mathews v. Commissioner, 520

F.2d 323 (5th Cir. 1974), cert. denied, 424 U.S. 967

(1976); Perry v. United States, 520 F.2d 285 (4th

Cir. 1975), cert. denied, 423 U.S. 1052 (1976); Van

Zandt v. Commissioner, 341 F.2d 440 (5th Cir.),

cert. denied, 382 U.S. 814 (1965). On the other

hand, in addition to all recent cases of the Tax Court

not appealable to the Fifth Circuit, several courts

have adopted positions inconsistent with the Commis-

sioner’s contentions and consistent with our holding

in this case. Brooke v. United States, 468 F.2d 1155

(9th Cir. 1972); Brown v. Commissioner, 180 F.2d

16a

926 (3d Cir.), cert. denied, 340 U.S. 814 (1950);

Skemp v. Commissioner, 168 F.2d 598 (7th Cir.

1948) ; Engel v. United States, 400 F. Supp. 5 (W.D.

Pa. 1975), aff'd by evenly divided en banc court,

No. 76-1889 (3d Cir. Aug. 3, 1977).

Following the decisions in Brown and Skemp, the

Tax Court has taken the lead in developing a con-

sistent body of law in this area. In the present case

the Tax Court stated four requirements which it had

previously applied in Mathews v. Commissioner, 61

T.C. 12 (1973), rev’d, 520 F.2d 328 (5th Cir. 1975),

cert. denied, 424 U.S. 967 (1976). The four require-

ments were:

(1) “The grantor must not retain ‘substan-

tially the same control over the property that he

had before’ he made the gift.” (2) “The lease-

back should normally be in writing and must

require payment of a reasonable rental.” (3)

“The leaseback (as distinguished from the gift)

must have a bona fide business purpose.” (4)

In addition, the taxpayer must not possess a dis-

qualifying “equity” in the property within the

meaning of the statute.

Memorandum opinion at 6.

These tests complement the statutory standards

discussed above. They provide a specific approach

for application of the statute in gift-leaseback situa-

tions. We are satisfied that any expenditure which

fails these requirements would also fail the statutory

standards.

17a

We recognize that for tax purposes the overall

nature of a transaction must be considered. Cer-

tainly in these situations of gifts and leasebacks, the

gift aspect is a relevant factor to consider in several!

respects. If no independent trustee is present, then

the existence of a gift brings into question whether

there was in fact any “requirement” that rent be

paid and also suggests the possible existence of a

disqualifying equity. However, the Congress has

specified that the business purpose test is concerned

with the “continued use or possession” of the prop-

erty. There is no justification for adding an in-

quiry into the origin of the lessor’s title in applying

this requirement.

In short, to the extent that there may be a split

in the courts on this issue,* we adopt the majority

4It is not clear that there exists a true split among the

courts of appeals. The Government primarily relies on

Mathews, Perry, and Van Zandt involved a situation in which

the settlor-taxpayer was also the trustee. Similarly, in Perry,

the Fourth Circuit found that the trustee’s independence was

illusory due to tightly drawn leases; this result may have

been consistent with the majority view. Mathews did take a

position more hostile to taxpayers in a similar situation. Van

Zandt and Mathews were decided by the Fifth Circuit as

was Audano v. United States, 428 F.2d 251, (5th Cir. 1970).

Audano held for the Government in a similar situation but

carefully considered traditional tests, including the reason-

ableness of the rental payments. 428 F.2d at 256-57. Audano

was decided after Van Zandt but before Mathews, and has

not been overruled. Thus the real conflict may be among

cases in the Fifth Circuit.

18a

view as applied by the Tax Court below. This is a

second basis for affirmance.

III

Even if we were not convinced that section 162

(a) (3) expressly authorizes the taxpayers’ position

and that the majority view adopted by other courts

is correct, we would still affirm the Tax Court. There

is an interplay between section 162 and sections 671-

678 of the Internal Revenue Code of 1954. The latter

sections provide detailed rules governing the taxation

of income to the beneficiary of donative trusts; typi-

cally this means less tax is paid than would be other-

wise. If these rules are carefully followed, the

grantor of a trust will not be taxed on the income

generated by the gift; instead the beneficiaries will

bear that burden.

As we noted above, the trusts in this case were

valid and resulted in the income of the trusts being

taxed to the beneficiaries. The interplay with section

162 occurs because a deduction for rental payments

is essential if the grantor-taxpayers are to gain any

tax benefit from the arrangement. It is the Govern-

ment’s essential position that the law firm’s payments

to the trust amounted to gifts but that it was taxable

income to the beneficiaries.

Following the Government’s approach, sections 671-

678 would produce a benefit only in cases where in-

vestment property—not used in the grantor’s trade

or business—is placed in trust. Persons whose as-

sets consist largely of business property would be

19a

excluded from a tax benefit clearly provided by

Congress.°®

The Government defends this result by relying on

a single sentence contained in a Senate committee

report dealing with the 1954 Code. Referring to

sections 671-678, the report stated: “This subpart

also has no application in determining the right of a

grantor to deductions for payments to a trust under

a transfer and leaseback arrangement.” S. Rep. No.

1623, 83rd Cong., 2d Sess., pp. 364-72, reprinted in

[1954] U.S. CopE Conc. & Ap. News 4621, 5006.

Obviously, this statement, contained in a lengthy com-

mittee report and not paralleled in the House report,

aids the Government’s case but is of questionable

weight.

If we accept this strand of legislative history as

conclusive, we implicitly assume that in enacting the

1954 Code, Congress considered the propriety of de-

ductions similar to those involved in this case. Mak-

ing that assumption, we are immediately faced with

the fact that the two leading cases deciding this

issue before 1954 were Brown v. Commissioner, 180

F.2d 926 (3d Cir.), cert. denied, 340 U.S. 814 (1950),

and Skemp v. Commissioner, 168 F.2d 598 (7th Cir.

1948). Both of those cases favored the taxpayers.

* Presumably, the Government’s position would permit an

office building to be placed in trust under these sections so

long as the grantor didn’t occupy any of the premises. Thus

an elaborate pian of a gift of vacated office space followed

by rent of other office space would satisfy the Government,

although the substance of the transaction would be identical

with that involved here.

20a

Since Congress was rewriting the entire Code and

made no pertinent change in the section dealing with

business deductions, we can only conclude that it ap-

proved the result in Brown and Skemp.

We are left with a firm conviction that if section

162(a)(8) and sections 671-678 are considered in

pari materia, the taxpayers are entitled to the rent

reduction. On the other hand, if the sections are not

considered together due to legislative history, we can

only conclude that Congress wished to continue the

law existing in 1954. In either event, the judgment

of the Tax Court must be affirmed.

As noted by the Supreme Court: “The legal right -

of a taxpayer to decrease the amount of what other-

wise would be his taxes, or altogether avoid them, by

means which the law permits, cannot be doubted

* * *” Gregory v. Helvering, 293 U.S. 465, 469

(1935). See also Knetsch v. United States, 364 U.S.

361 (1960). The law permits the method of tax

minimization chosen by the Quinlivans.

Judgment affirmed.

A true copy.

Attest:

Clerk, U.S. Court of Appeals, Eighth Circuit.

21a

APPENDIX C

UNITED STATES COURT OF APPEALS

FOR THE EIGHTH CIRCUIT

No. 78-1653

September Term, 1978

[Filed May 24, 1979]

RICHARD R. QUINLIVAN; ANN M. QUINLIVAN,

ROGER P. QUINLIVAN; JOYCE E. QUINLIVAN,

APPELLEES

vs.

COMMISSIONER OF INTERNAL REVENUE, APPELLANT

Appeal from the United States Tax Court

JUDGMENT

This Cause came on to be heard on the record of

the United States Tax Court, appendix and briefs of

the respective parties and was argued by counsel.

On Consideration Whereof, it is now here ordered

and adjudged by this Court that the judgment of the

Tax Court be and is hereby affirmed in accordance

with opinion of this Court.

Costs taxed in favor of Appellees: May 24, 1979

Costs of printing 10 copies

of brief: $64.00

Total costs of Appellees for

recovery from Appellant: $64.00

22a

APPENDIX D

Internal Revenue Code of 1954 (:26 U.S.C.) :

SEC. 162. TRADE OR BUSINESS

EXPENSES.

(a) In General.—There shall be allowed as a

deduction all the ordinary and necessary expenses

paid or incurred during the taxable year in

carrying on any trade or business, including—

* * * *

(3) rentals or other payments required

to be made as a condition to the continued

use or possession, for. purposes of the trade

or business, of property to which the tax-

payer has not taken or is not taking title or

in which he has no equity.

* * * *

SEC. 671. TRUST INCOME, DEDUCTIONS,

AND CREDITS ATTRIBUTABLE

TO GRANTORS AND OTHERS AS

SUBSTANTIAL OWNERS.

Where it is specified in this subpart that the

grantor or another person shall be treated as the

owner of any portion of a trust, there shall then

be included in computing the taxable income and

credits of the grantor or the other person those

items of income, deductions, and credits against

tax of the trust which are attributable to that

portion of the trust to the extent that such items

would be taken into account under this chapter in

computing taxable income or credits against the

tax of an individual. Any remaining portion of

EE ee ae ee ee

23a

the trust shall be subject to subparts A through

D. No items of a trust shall be included in com-

puting the taxable income and credits of the

grantor or of any other person solely on the

grounds of his dominion and control over the

trust under section 61 (relating to definition of

gross income) or any other provision of this title,

except as specified in this subpart.

SEC. 672. DEFINITIONS AND RULES.

(a) Adverse Party.—For purposes of this sub-

part, the term “adverse party” means any person

having a substantial beneficial interest in the

trust which would be adversely affected by the

exercise or nonexercise of the power which he

possesses respecting the trust. A person having

a general power of appointment over the trust

property shall be deemed to have a beneficial in-

terest in the trust.

(b) Nonadverse Party.—For purposes of this

subpart, the term “nonadverse party” means any

person who is not an adverse party.

poses of this subpart, the term “related or sub-

ordinate party” means any nonadverse party who

(1) the grantor’s spouse if living with the

grantor;

(2) any one of the following: The

grantor’s father, mother, issue, brother or

sister; an employee of the grantor; a cor-

poration or any employee of a corporation

in which the stock holdings of the grantor

and the trust are significant from the view-

point of voting control; a subordinate em-

24a

ployee of a corporation in which the grantor

is an executive.

For purposes of section 674 and 675, a related

or subordinate party shall be presumed to be

subservient to the grantor in respect of the exer-

cise or nonexercise of the powers conferred on

him unless such party is shown not to be sub-

servient by a preponderance of the evidence.

(d) Rule Where Power Is Subject To Condi-

tion Precedent.—A person shall be considered to

have a power described in this subpart even

though the exercise of the power is subject to a

precedent giving of notice or takes effect only on

the expiration of a certain period after the exer-

cise of the power.

SEC. 673. REVERSIONARY INTERESTS.

(a) General Rule——The grantor shall be

treated as the owner of any portion of a trust

in which he has a reversionary interest in either

the corpus or the income therefrom if, as of the

inception of that portion of the trust, the interest

will or may reasonably be expected to take effect

in possession or enjoyment within 10 years com-

mencing with the date of the transfer of that

portion of the trust.

(b) [Repealed].

Death of Income Beneficiary.—The grantor shall

not be treated under subsection (a) as the owner

of any portion of a trust where his reversionary

interest in such portion is not to take effect in

possession or enjoyment until the death of the

25a

person or persons to whom the income therefrom

is payable.

(d) Postponement of Date Specified for Re-

acquisition.—Any postponement of the date speci-

fied for the reacquisition of possession or enjoy-

ment of the reversionary interest shall be treated

as a new transfer in trust commencing with the

date on which the postponement is effected and

terminating with the date prescribed by the post-

ponement. However, income for any period shall

not be included in the income of the grantor by

reason of the preceding sentence if such income

would not be so includible in the absence of such

postponement.

SEC. 674. POWER TO CONTROL BENE-

FICIAL ENJOYMENT.

(a) General Rule—The grantor shall be

treated as the owner of any portion of a trust in

respect of which the beneficial enjoyment of the

corpus or the income therefrom is subject to a

power of disposition, exercisable by the grantor

or a nonadverse party, or both, without the ap-

proval or consent of any adverse party.

(b) Exceptions for Certain Powers.—Subsec-

tion (a) shall not apply to the following powers

regardless of by whom held.

(1) Power to apply income to support a

dependent.—A power described in section

677(b) to the extent that the grantor would

not be subject to tax under that section.

(2) Power affecting beneficial enjoyment

only after expiration of 10-year period.—

26a

A power, the exercise of which can only af-

fect the beneficial enjoyment of the income

for a period commencing after the expira-

tion of a period such that a grantor would

not be treated as the owner under section

673 if the power were a reversionary inter-

est; but the grantor may be treated as the

owner after the expiration of the period un-

less the power is relinquished.

(3) Power exercisable only by will.—A

power exercisable only by will, other than

a power in the grantor to appoint by will the

income of the trust where the income is

accumulated for such disposition by the

grantor or may be so accumulated in the

discretion of a grantor or a nonadverse

party, or both, without the approval or con-

sent of any adverse party.

(4) Power to allocate among charitable

beneficiaries—A power to determine the

beneficial enjoyment of the corpus or the

income therefrom if the corpus or income is

irrevocably payable for a purpose specified

in section 170(c) (relating to definition of

charitable contributions).

(5) Power to distribute corpus.—A power

to distribute corpus either—

(A) to or for a beneficiary or bene-

ficiaries or to or for a class of bene-

ficiaries (whether or not income bene-

ficiaries) provided that the power is

limited by a reasonably definite stand-

ard which is set forth in the trust in-

strument; or

eR eT Ee ee ee ee ee Te eae

27a

(B) to or for any current income

beneficiary, provided that the distribu-

tion of corpus must be chargeable

against the proportionate share of cor-

pus held in trust for the payment of

income to the beneficiary as if the cor-

pus constituted a separate trust.

A. power does not fall within the powers

described in this paragraph if any person

has a power to add to the beneficiary or

beneficiaries or to a class of beneficiaries

designated to receive the income or corpus,

except where such action is to provide for

after-born or after-adopted children.

(6) Power to withhold income tempo-

rarily.—A power to distribute or apply in-

come to or for any current income bene-

ficiary or to accumulate the income for him,

provided that any accumulated income must

ultimately be payable—

(A) to the beneficiary from whom

distribution or application is withheld,

to his estate, or to his appointees (or

persons named as alternate takers in

default of appointment) provided that

such beneficiary possesses a power of

appointment which does not exclude

from the class of possible appointees

any person other than the beneficiary,

his estate, his creditors, or the creditors

of his estate, or

(B) on termination of the trust, or

in conjunction with a distribution of

corpus which is augmented by such ac-

28a

cumulated income, to the current in-

come beneficiaries in shares which have

been irrevocably specified in the trust

instrument.

Accumulated income shall be considered so

payable although it is provided that if any

beneficiary does not survive a date of dis-

tribution which could reasonably have been

expected to occur within the beneficiary’s

lifetime, the share of the deceased benefi-

ciary is to be paid to his appointees or to

one or more designated alternate takers

(other than the grantor or the grantor’s

estate) whose shares have been irrevocably

specified. A power does not fall within the

powers described in this paragraph if any

person has a power to add to the beneficiary

or beneficiaries or to a class of beneficiaries

designated to receive the income or corpus

except where such action is to provide for

after-born or after-adopted children.

(7) Power to withhold income during dis-

ability of a beneficiary.—A power exercis-

able only during—

(A) the existence of a legal disabil-

ity of any current income beneficiary,

(B) the period during which any in-

come beneficiary shall be under the age

of 21 years,

to distribute or apply income to or for such

beneficiary or to accumulate and add the

income to corpus. A power does not fall

within the powers described in this para-

29a

graph if any person has a power to add to

the beneficiary or beneficiaries or to a class

of beneficiaries designated to receive the in-

come or corpus, except where such action

is to provide for after-born or after-adopted

children.

(8) Power to allocate between corpus and

income.—A power to allocate receipts and

disbursements as between corpus and in-

come, even though expressed in broad lan-

guage.

dent Trustees.—Subsection (a) shall not apply

to a power solely exercisable (without the ap-

proval or consent of any other person) by a

trustee or trustees, none of whom is the grantor,

and no more than half of whom are related or

subordinate parties who are subservient to the

wishes of the grantor—

(1) to distribute, apportion, or accumu-

late income to or for a beneficiary or bene-

ficiaries, or to, for, or within a class of

beneficiaries ; or

(2) to pay out corpus to or for a bene-

ficiary or beneficiaries or to or for a class

of beneficiaries (whether or not income

beneficiaries).

A power does not fall within the powers described

in this subsection if any person has a power to

add to the beneficiary or beneficiaries or to a

class of beneficiaries designated to receive the

income or corpus, except where such action is to

provide for after-born or after-adopted children.

(d) Power to Allocate Income if Limited by a

Standard.—Subsection (a) shall not apply to a

30a

power solely exercisable (without the approval

or consent of any other person) by a trustee or

trustees, none of whom is the grantor or spouse

living with the grantor, to distribute, apportion,

or accumulate income to or for a beneficiary or

beneficiaries, or to, for, or within a class of

beneficiaries, whether or not the conditions of

paragraph (6) or (7) of subsection (b) are

satisfied, if such power is limited by a reasonably

definite external standard which is set forth in

the trust instrument. A power does not fall with-

in the powers described in this subsection if any

person has a power to add to the beneficiary or

beneficiaries or to a class of beneficiaries desig-

nated to receive the income or corpus except

where such action is to provide for after-born or

after-adopted children.

SEC. 675. ADMINISTRATIVE POWERS.

The grantor shall be treated as the owner of

any portion of a trust in respect of which—

(1) Power to deal for less than adequate and

full consideration—A power exercisable by the

grantor or a nonadverse party, or both, without

the approval or consent of any adverse party

enables the grantor or any person to pur-

chase, exchange, or otherwise deal with or dis-

pose of the corpus or the income therefrom for

less than as adequate consideration in money or

money’s worth.

(2) Power to borrow without adequate inter-

est or security.—A power exercisable by the

grantor or a nonadverse party, or both, enables

3la

the grantor to borrow the corpus or income di-

rectly or indirectly, without adequate interest or

without adequate security except where a trustee

(other than the grantor) is authorized under a

general lending power to make loans to any per-

son without regard to interest or security.

(8) Borrowing of the trust funds.—The

grantor has directly or indirectly borrowed the

corpus or income and has not completely repaid

the loan, including any interest before the be-

ginning of the taxable year. The preceding sen-

tence shall not apply to a loan which provides for

adequate interest and adequate security, if such

loan is made by a trustee other than the grantor

and other than a related or subordinate trustee

subservient to the grantor.

(4) General powers of administration.—A

power of administration is exercisable in a non-

fiduciary capacity by any person without the ap-

proval or consent of any person in a fiduciary

capacity. For purposes of this paragraph, the

term “power of administration” means any one

or more of the following powers: (A) a power

to vote or direct the voting of stock or other

securities of a corporation in which the holdings

of the grantor and the trust are significant from

the viewpoint of voting control; (B) a power to

control the investment of the trust funds either

by directing investment or reinvestment, or by

vetoing proposed investments or reinvestments,

to the extent that the trust funds consist of

stocks or securities of corporations ix which the

holdings of the grantor and the trust are signifi-

eant from the viewpoint of voting control; or

32a

substituting other property of an equivalent

value.

SEC. 676. POWER TO REVOKE.

(a) General Rule—The grantor shall be

treated as the owner of any portion of a trust,

whether or not he is treated as such owner under

any other provision of this part, where at any

time the power to revest in the grantor title to

such portion is exercisable by the grantor or a

non-adverse party, or both.

(b) Power Affecting Beneficial Enjoyment

Only After Expiration of 10-Year Period.—Sub-

section (a) shall not apply to a power the exer-

cise of which can only affect the beneficial en-

joyment of the income for a period commencing

after the expiration of a period such that a

grantor would not be treated as the owner under

section 673 if the power were a reversionary in-

terest. But the grantor may be treated as the

owner after the expiration of such period unless

the power is relinquished.

SEC. 677. INCOME FOR BENEFIT OF

GRANTOR.

(a) General Rule——The grantor shall be

treated as the owner of any portion of a trust,

whether or not he is treated as such owner

under section 674, whose income without the

approval or consent of any adverse party is, or,

in the discretion of the grantor or a nonadverse

party, or both, may be—

(1) distributed to the grantor or the

grantor’s spouse;

33a

(2) held or accumulated for future dis-

tribution to the grantor or the grantor’s

spouse; or

(3) applied to the payment of premiums

on policies of insurance on the life of the

grantor or the grantor’s spouse (except

policies of insurance irrevocably payable for

a purpose specified in section 170(c) (relat-

ing to definition of charitable contribu-

tions) ).

This subsection shall not apply to a power the

exercise of which can only affect the beneficial

enjoyment of the income for a period commenc-

ing after the expiration of a period such that the

grantor would not be treated as the owner under

section 673 if the power were a reversionary 1n-

terest; but the grantor may be treated as the

owner after the expiration of the period unless

the power is relinquished.

(b) Obligations of Support.—Income of a

trust shall not be considered taxable to the

grantor under subsection (a) or any other pro-

vision of this chapter merely because such in-

come in the discretion of another person, the

trustee, or the grantor acting as trustee or Co-

trustee, may be applied or distributed for the

support or maintenance of a beneficiary (other

than grantor’s spouse) whom the grantor is

legally obligated to support or maintain, except

to the extent that such income is so applied or

distributed. In cases where the amounts so ap-

plied or distributed are paid out of corpus or out

of other than income for the taxable year, such

amounts shall be considered to be an amount

34a

paid or credited within the meaning of para-

graph (2) of section 661(a) and shall be taxed

to the grantor under section 662.

SEC. 678. PERSON OTHER THAN

GRANTOR TREATED AS

SUBSTANTIAL OWNER.

(a) General Rule—A person other than the

grantor shall be treated as the owner of any por-

tion of a trust with respect to which:

(1) such person has a power exercisable

solely by himself to vest the corpus or the

income therefrom in himself, or

(2) such person has previously partially

released or otherwise modified such a power

and after the release or modification retains

such control as would, within the principles

of sections 671 to 677, inclusive, subject a

grantor of a trust to treatment as the owner

thereof.

(b) Exception Where Grantor Is Taxable.—

Subsection (a) shall not apply with respect to a

power over income, as originally granted or

thereafter modified, if the grantor of the trust

or a transferor (to whom section 679 applies) is

otherwise treated as the owner under the pro-

visions of this subpart other than this section.

(ce) Obligations of Support.—Subsection (a)

shall not apply to a power which enables such

person, in the capacity of trustee or co-trustee,

merely to apply the income of the trust to the

support of maintenance of a person whom the

holder of the power is obligated to support or

85a

maintain except to the extent that such income

is so applied. In cases where the amounts so

applied or distributed are paid out of corpus or

out of other than income of the taxable year,

such amounts shall be considered to be an amount

paid or credited within the meaning of para-

graph (2) of section 661(a) and shall be taxed

to the holder of the power under section 662.

(d) Effect of Renunciation or Disclaimer.—

Subsection (a) shall not apply with respect to

a power which has been renounced or disclaimed

within a reasonable time after the holder of the

power first became aware of its existence.

* * * *

Treasury Regulations on Income Tax (1954 Code),

Section 1.671-.1.

Likewise, these sections have no application in

determining the right of a grantor to deductions

for payments to a trust under a transfer and

leaseback arrangement.

~ * + *

ow. 8. covmanment printine orrics; 1979 302660 100

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.