Miles v. Commissioner , 41 T.C. 165 ( 1963 )

Egbert J. Miles, Jr., and Jean N. Miles, Petitioners, v. Commissioner of Internal Revenue, Respondent

Miles v. Commissioner

Docket No. 89906

United States Tax Court

41 T.C. 165; 1963 U.S. Tax Ct. LEXIS 25;

November 8, 1963, Filed

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Decision will be entered for the respondent.

Acting pursuant to a prearranged integrated plan, a corporation which owned both domestic and foreign rights in certain patents, purportedly "sold" its foreign patent rights for an inadequate consideration to five Bermuda trusts which had been newly created for the benefit of children of the corporation's senior executives; on the same day, these Bermuda trusts purportedly "granted" the use of these same patent rights to a newly organized partnership, composed of the junior executives of the above-mentioned corporation, under an arrangement whereby the partnership would pay over to the trusts 90 percent of its net proceeds from the exploitation of such rights; and thereafter, the partnership claimed deductions for the amounts so paid over to the trusts, as ordinary and necessary business expenses. The principal purpose of this integrated plan was to channel substantially all the net income from the patent rights into the Bermuda trusts, and thereby avoid the imposition of United States taxes on such income.

1. Held, that the Bermuda trusts were employed merely as conduits for passing the foreign patent rights from the corporation to the newly organized partnership; that all income derived from the use of the rights was earned by the partnership; and that the portions of such income which the partnership paid over to the trusts do not qualify for deduction as ordinary and necessary business expenses of the partnership.

2. Held, further, that the amounts so paid over by the partnership to two of the trusts which had been established for the benefit of the petitioners herein, constitute part of the principal petitioner's distributive share of the partnership's net incomes for the taxable years involved; and that said amounts should have been included by the petitioners in the income from partnerships which they reported on their joint income tax returns.

George E. Cleary and Walter S. Rothschild, for the petitioners.

Albert R. Doyle, for the respondent.

Pierce, Judge.

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PIERCE

Respondent determined deficiencies in the income taxes of the petitioners for the calendar years 1957 and 1958 in the amounts of $ 5,472.39 and $ 5,684.35, respectively.

The issues for decision are:

(1) Did the Commissioner err in determining that the amounts of $ 11,779.40 and $ 14,146.25, which were paid in the respective taxable years by Hum International (a partnership of which petitioner Egbert Miles was a member) to two Bermuda trusts established for the benefit of the petitioners, constitute taxable income to the petitioners under the provisions of the 1954 Code?

(2) In the alternative, if it is decided that petitioners are not so taxable, should the allowable foreign tax credit in respect of certain foreign income, which said Hum International partnership received and paid over in major part to five Bermuda trusts (including the two trusts established for petitioners), be attributed to the partnership only to the extent of that part of such credit which is applicable to the portion of said foreign income which the partnership retained; or should the entire amount of said foreign tax credit be attributed to the partnership, and thereby be made available to its partners (including petitioner Egbert Miles) for use in computing their individual income tax liabilities?

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulation of facts and all exhibits identified therein are incorporated herein by reference.

The petitioners, Egbert Miles, Jr., and Jean Miles, are husband and wife residing in Woodbridge, Conn. They filed a joint Federal income tax return for each of the taxable years here involved, with the district director of internal revenue at Hartford. It has been stipulated that the issues involved in this case are not foreclosed by the closing agreement referred to on the face of said returns.

Sarong, Inc., was at all times material a corporation organized under the laws of Connecticut and having its principal office in West Haven, Conn. It was formerly named "I. Newman & Sons." The principal business of said corporation was the manufacture and wholesaling of women's foundation garments, including girdles and brassieres. The corporation's capital stock was at all times closely held. Over 99 percent of the shares of its common capital stock (which was the only class of stock issued and outstanding) was owned by members of three families: The Usher family, the Hine family, and the Northup-Miles family. On September 12, 1955 (the date of certain transactions hereinafter described), the shareholders of record of all said outstanding shares of stock were as follows:

			Record
		Number	shareholdings
		of shares	per
Stockholders of record		held	family
Usher family:
	Harry C. Usher, Sr	182
	Myrtis Usher (wife)	1,968
	Harry C. Usher, Jr. (son)	326	2,476
Hine family:
	P. W. Hine	937
	Charles W. Hine (son)	1,767	2,704
Northup-Miles family:
	Daniel W. Northup	2,279
	Egbert J. Miles, Jr. (son-in-law and petitioner
	herein)	40	2,319
Ira Levy (employee of the corporation; no kinship to
other stockholders)		50	50
	Total	7,549	7,549

Also, the beneficial ownership of all said shares corresponded with the record ownership, with one exception: Of the 2,279 shares held of record by Daniel W. Northup, 400 shares were deposited with a bank pursuant to a 1936 agreement between said Northup and said Charles W. Hine, under which the latter was to become both the record and beneficial owner thereof upon Northup's death.

The executive officers of the Sarong corporation on September 12, 1955 (as classified in the petition herein, between "senior" executives and "junior" executives), were:

Senior executives:

D. W. Northup, president

H. C. Usher, Sr., treasurer

P. W. Hine (official position not shown by the evidence)

Junior executives:

H. C. Usher, Jr. (official position not shown by the evidence)

Egbert J. Miles, Jr., secretary

Charles W. Hine, vice president

These senior and junior executives were also the members of the corporation's board of directors.

The greater portion by far of the corporation's business activity and its income consisted of and was derived from the manufacture and sale of its products within the continental United States. During 1954 and approximately the first 8 1/2 months of 1955, the corporation also derived substantial amounts of income from royalties paid to it by foreign manufacturers which it had licensed to use certain of its patents and trademarks ($ 30,472.18 in 1954 and $ 71,231.75 in 1955).

Among the several patents, applications for patents, and trademarks which Sarong at that time owned, used in its own business, and licensed to foreign companies, were: A patent covering an invention of Maude C. Fridolph (to whom it paid royalties) for a girdle of criss-cross design which it marketed as one of its principal products under the registered trademark name of "Sarong"; a patent application covering an invention of Leona Lax for another girdle, called a "pantie girdle"; and various trademarks which were either registered or under application for registration, embodying the names "Sarong," "Panix," and "Snapparong."

The foreign licensing operations, a relatively new phase of its business, were managed principally by one of the junior executives, Charles W. Hine. Besides seeking out licensees and working out licensing arrangements for the above-mentioned patents and trademarks, it was also necessary to see to the registration of the patents and trademarks in foreign countries, and to combat infringements upon the patent and trademark rights. The senior executives, to whom the foreign rights phase of the business was something new and unfamiliar, were content to leave the management of the same to the younger Hine; but they nevertheless insisted on reports being made to them, and upon being consulted when decisions were made regarding the rights. The younger Hine was compelled to expend considerable time and effort on the details and negotiations respecting the foreign rights. The senior executives were not entirely satisfied with this substantial expenditure of time, for they were more concerned with maintaining and expanding the corporation's domestic business operations.

Accordingly, to eliminate the frictions and tensions occasioned by the presence of the foreign rights business within the corporation, to lessen the corporation's Federal income tax burden which was expected to increase with an anticipated upswing in foreign royalty income, and also to provide economic security for the children of the senior executives, a plan of action was worked out in the early part of September 1955. The principal features of such plan were: The senior executives would create trusts for the benefit of their children, with the trustees being located outside the jurisdiction of the United States taxing statutes; the corporation's foreign patent and trademark rights would be "sold" to the trustees, and the latter would immediately "grant" to a newly created partnership to be composed of the corporation's junior executives (who also would be included among the trusts' beneficiaries), all of the foreign rights "purchased" by the trusts; and the partnership would then in turn manage the foreign rights business and turn over to the trustees as "compensation" for the use of such rights, 90 percent of the partnership's net proceeds from royalties received from foreign business concerns using such foreign rights.

On September 12, 1955, the following several related transactions and events occurred, in implementation of the foregoing plan.

Creation of Bermuda Trusts

On said date of September 12, 1955, Daniel W. Northup, P. W. Hine, and Harry C. Usher, Sr. (being all of the above-mentioned senior executives of the Sarong corporation), separately executed one or more agreements with the Bank of N. S. Butterfield & Son, Ltd., of Hamilton, Bermuda, as trustee -- under which there were created five separate but substantially identical trusts. Two of these five trusts were created by said Daniel W. Northup, as grantor -- under one of which petitioner Jean Miles (daughter of said grantor) was named the primary beneficiary, and under the other of which petitioner Egbert J. Miles, Jr. (Jean's husband and Northup's son-in-law), was named the primary beneficiary. Another of said five trusts was created by said P. W. Hine, as grantor -- under which the above-mentioned Charles W. Hine (son of the grantor) was named the primary beneficiary. And the other two of these five trusts were created by said Harry Usher, Sr., as grantor -- under which the grantor's sons, John C. Usher and H. C. Usher, Jr., were named the respective primary beneficiaries. The agreements covering these five separate trusts were identical, except for the names of the grantors and the beneficiaries, and except also as to the amounts of corpus contributed by the several grantors.

Northup contributed $ 500 corpus to each of the two trusts he created; Usher, Sr., contributed the same amount as corpus to each of the two trusts he created; and P. W. Hine contributed double said amount, or $ 1,000, as corpus for the one trust he created. In addition and on the same day, Northup loaned to each of the two trusts he created, the sum of $ 2,416.67, evidenced by a promissory note of the trustee bearing interest at the rate of 5 percent; Usher, Sr., loaned an identical amount, evidenced by a similar promissory note, to each of the two trusts he created; and P. W. Hine loaned approximately double said amount or $ 4,833.32, evidenced by a similar promissory note, to the one trust he created. A summary of all the amounts so contributed and loaned by the several grantors is as follows:

	Cash	Cash
	contributed	loaned	Total
	as corpus
Trusts created by D. W. Northup:
Trust for Jean Miles	$ 500	$ 2,416.67	$ 2,916.67
Trust for Egbert J. Miles	500	2,416.67	2,916.67
Trusts created by H. C. Usher, Sr.:
Trust for John C. Usher	500	2,416.67	2,916.67
Trust for H. C. Usher, Jr	500	2,416.67	2,916.67
Trust created by P. W. Hine for
Charles W. Hine	1,000	4,833.32	5,833.32
Aggregates for all five trusts	3,000	14,500.00	17,500.00

The provisions of the several trust agreements covering said five Bermuda trusts (which, as before stated, were substantially identical) may be summarized so far as here material, as follows:

Until September 30, 1965 (being 10 years and 18 days after the creation of each trust), or until the prior death of the named primary beneficiary, the trustee was to pay to or apply for the benefit of such beneficiary, so much of the net income of the trust as the trustee, in its sole and unreviewable discretion, might deem expedient or advisable; and the trustee in its discretion was to retain, accumulate, and reinvest any "undistributed" balance of such income. Thereafter, commencing on October 1, 1965, and continuing until the termination of the trust in the manner hereinafter mentioned, the trustee was to pay to or apply for the benefit of said beneficiary, if he or she were then living, all the net income of the trust.

The trust was to terminate: On September 30, 1965, if the primary beneficiary died prior thereto; or upon the death of said primary beneficiary if he or she died after September 30, 1965; or upon the written request of said beneficiary delivered to the trustee after September 30, 1965, while said beneficiary was still living. And upon any such termination, the trustee was to dispose of the principal of the trust together with any accumulated or undistributed income, either to the primary beneficiary if living, or otherwise in the manner provided.

The trustee was authorized to receive any additional property which might be transferred or made payable to it, either by the grantor or by any other person or persons; and any such property was thereupon to be added to the corpus of the trust.

Any adult beneficiary, or a majority of the adult beneficiaries if there were more than one, was granted the right in his or their sole and unreviewable discretion, to remove the trustee and appoint a successor; provided that such successor would have to be a corporate trustee, located outside the United States, and having a capitalization of not less than $ 100,000.

Under section Tenth of each trust agreement, the trustee was given broad powers with respect to the administration of the trust; subject however to the limitations contained in paragraph K of said section, which read as follows:

K. Any foregoing provision of this Article (Tenth) to the contrary notwithstanding, prior to the purchase or sale of any property, real or personal, and prior to the making of any investment or reinvestment of any of the assets of the Trust fund, the Trustee shall submit in a Letter of Notification details of the proposed transaction, investment or reinvestment to the members of the Investment Advisory Committee hereinafter named. Upon receipt in writing of the consent of a majority of the members of the Investment Advisory Committee to the proposed transaction, investment or reinvestment, or, if no objection in writing by any members of said Committee to such transaction, investment or reinvestment is received by the Trustee within a period of thirty (30) days from the date of mailing of the aforesaid Letter of Notification, the Trustee may enter upon and consummate the transaction, investment or reinvestment therein described, but in so doing shall adhere strictly to the terms and conditions as set forth in the Letter of Notification. The Trustee is also authorized to accept the advice of a majority of the members of the Investment Advisory Committee as to the propriety or desirability of any particular investment or investments, and in respect of such investments the Trustee shall be relieved of all liability and responsibility. [Emphasis supplied.]

The persons appointed to be the members of the above-mentioned investment advisory committee, in the case of each and all the five trusts, were:

Charles W. Hine

Harry C. Usher, Jr.

Egbert J. Miles, Jr.

Harry D. Butterfield

Each trust was declared to be irrevocable, and to be governed by the laws of the Islands of Bermuda.

The total assets of said five trusts immediately prior to the other transactions of September 12, 1955, which are hereinafter described, consisted solely of the above-mentioned amounts of cash contributed and loaned thereto by the several grantors, aggregating $ 17,500.

Agreements re Foreign Rights to Sarong Patents and Trademarks

On the same date that said five trusts were created (September 12, 1955) Sarong, Inc., acting pursuant to resolutions that previously had been adopted by its directors and stockholders on September 7 and 8, 1955, executed a single written agreement with the trustees of the five trusts, acting separately but collectively -- which agreement may be summarized so far as here material, as follows:

Sarong, Inc., agreed that it "hereby sells, assigns and transfers" to the trustee of each of said five Bermuda trusts, severally, a "fractional share" in all its rights, title, and interest in specified foreign countries, for certain of its patents, applications for patents, and trademark registrations and applications (including those covering the above-mentioned inventions of Maude C. Fridolph and of Leona Lax), and also the "entire good will" of the business of Sarong, Inc., relating to said rights and interests for all parts of the world ¹ except for the United States and its possessions. The rights and interests for the United States and its possessions were expressly retained by the Sarong corporation.

It was agreed that the fractional share "sold" to each of the five trusts, and the consideration paid by each, was as follows:

		Fractional	Consideration
		share	paid
Trusts created by D. W. Northup:
	Trust for Jean Miles	1/6	$ 2,916.67
	Trust for Egbert J. Miles, Jr	1/6	2,916.67
Trusts created by H. C. Usher, Sr.:
	Trust for John C. Usher	1/6	2,916.67
	Trust for H. C. Usher, Jr	1/6	2,916.67
Trust created by P. W. Hine for Charles W. Hine		1/3	5,833.32
	Total for all five trusts		17,500.00

The trustees of the several trusts agreed to perform all obligations imposed on Sarong, Inc., under its agreements covering the rights and interests mentioned (including the payment of royalties to the inventors), and to hold Sarong, Inc., harmless in respect of the same.

The agreement was to continue until the expiration of the several patents and trademark rights, unless sooner terminated by uncorrected default of any party to any other party. And in the event of termination for default on the part of the trustee for any of the trusts, then the property and rights granted and assigned to such trustee would automatically revert to Sarong, Inc.

The agreement would be assignable by any party only upon written agreement of all the other parties; and any assignment would not relieve the assigning party of its obligations under the agreement.

No trustee of any one of the several trusts would be subject to individual liability for any payment to be made or for any obligations to be performed under the agreement.

The agreement stated that it was made at Hamilton, Bermuda, and was to be interpreted under the laws of Bermuda.

The trustees did not seek or obtain the consent of the investment advisory committee provided for in section Tenth (K) of the trust agreements, before "purchasing" the foreign patent rights from the Sarong corporation.

The Court finds as an ultimate fact that the fair market value of the foreign patent rights agreed to be sold for $ 17,500, was not less than $ 300,000 on September 12, 1955.

Also on September 12, 1955 (the same date on which the five trusts were created, and the same date on which Sarong executed the above-mentioned agreement), the trustee of each and all the trusts, acting separately but collectively, executed a written agreement with a partnership named Hum International. This partnership had been organized 12 days previously, on September 1, 1955, for the purpose of acquiring patents, patent rights, inventions, trademarks, and licensing agreements in the field of ladies' foundation garments. The members of the partnership were: Petitioner Egbert Miles, Jr., H. C. Usher, Jr., and Charles W. Hine (being all the above-mentioned junior executives of Sarong, Inc.). Each of these partners contributed an equal amount of $ 500 to the firm as its capital. Partnership profits and losses were to be shared equally by the three partners. Said agreement with the partnership may be summarized so far as here material, as follows:

It was agreed that the trustee of each and all of the above-mentioned Bermuda trusts thereby "granted" to the partnership: The exclusive power and right to sell, assign, use, or grant lawful licenses under the identical foreign patents, patent applications, and trademarks which were referred to in the previously mentioned agreement that Sarong, Inc., had executed on that same day with said five trusts; to receive royalties and other compensation in respect thereto from foreign licensees; and to prosecute and settle actions against infringers or contracting licensees -- all subject however to the obligations which the partnership assumed, that had theretofore been imposed on Sarong, Inc., in connection with its previous acquisition of such patents and trademark rights.

In compensation for said "grant," the partnership promised "To report and pay to" the trustee of each of the five trusts "Ninety (90%) per cent of the net proceeds which the Partnership derives from said grant, after deducting all expenses incurred by the Partnership in exercising said grant, including, for example but without limitation, all expenses of the Partnership, not otherwise reimbursed, for royalties * * * [and] taxes." And said percentage (the 90 percent of net proceeds) was to be divided among the five trusts, as follows:

		Percent of net
		proceeds derived
		by partnership
		minus expenses, etc.
Trusts created by D. W. Northup:
	Trust for petitioner Egbert J. Miles, Jr	15
	Trust for petitioner Jean N. Miles	15
Trusts created by H. C. Usher, Sr.:
	Trust for John C. Usher	15
	Trust for Harry C. Usher, Jr	15
Trust created by P. W. Hine for Charles W. Hine		30

It was agreed that "Payment of the Trustees' share of said net receipts" would be due at the time of the written reports that were to be rendered by the partnership to the trustees at 3-month intervals.

The agreement was to continue during the life of the patents and trademarks, unless sooner terminated in one of the following ways: By mutual agreement of all the parties; by uncorrected default of either party; upon dissolution of the partnership without a successor; or upon termination of the trusts or of the power of any trustee to act thereunder. And upon any such termination of the agreement "the rights and powers hereby granted shall revert" to the trustees of the five trusts unless they were in default; and in case they were in default, then "all the property, rights and powers" of the trustee for the several trusts would pass to the partnership "as agent for the beneficiaries if the Trust be terminated, or for the Trustee, so long as the Trust be in effect."

The agreement stated that it was made in Bermuda, and was to be interpreted in accordance with the laws of Bermuda.

The trustees did not seek or obtain the consent of the above-mentioned investment advisory committee before "granting" the foreign patent rights to the Hum International partnership.

Operation of the Partnership Subsequent to September 12, 1955

During the period from September 12, 1955, to January 28, 1960, the partners managed the foreign patent rights in the same manner as the same had been managed when they were held by the Sarong corporation. The partnership had its office in that of a New Haven accounting firm which served as the partnership's accountants. The partnership granted new licenses to manufacturers in Germany, Norway, South Africa, and Switzerland; worked out revisions in some of the licensing agreements that had been in existence at September 12, 1955; collected royalties from the foreign manufacturers; paid all amounts due the inventors, and also all foreign taxes on the income which it received; and maintained surveillance to detect infringements. The following tabulation shows the income and expenses of the partnership, as reported on the partnership information returns which it filed for each of the years 1956, 1957, and 1958:

		1956	1957	1958
Royalties received		$ 40,624.22	$ 83,168.58	$ 109,199.20
Less: Expenses --
	Accounting		300.00	250.00
	Bank service charge	3.47
	Legal fees	902.26	10,065.80	12,277.44
	Office expenses		242.77	111.05
	Stationery and printing	40.39		46.74
	Royalties paid	33,483.87	49,851.37	65,555.12
	Total expenses	34,429.99	60,459.94	78,240.35
Net income from royalties		6,194.23	22,708.64	30,958.85
Add: Other income (gain on foreign
exchange)		290.03	1,443.62	625.63
	Partnership net income	6,484.25	24,152.26	31,584.48

The amounts of "royalties paid," as set forth among the partnership's expenses in the foregoing income statements, included both the overriding royalties paid to the inventor Fridolph with respect to the Sarong patent, and also the amounts paid over to the trustees pursuant to the above-described agreement between them of September 12, 1955. For 1957 and 1958, the total amounts so paid over to the trustees of the five trusts aggregated $ 35,338.20 and $ 42,438.72, respectively.

On January 28, 1960, the shareholders of Sarong, Inc., agreed to sell all of their stock in said corporation to Ten Kenton Corp., a subsidiary of International Latex Corp., for $ 3 million. On the same date, the Ten Kenton Corp. entered into a separate agreement with the trustees providing for the purchase by it of all the foreign patent rights which the trustees represented that they had reacquired from the Hum partnership (apparently through termination of the agreement between the trustees and the partnership which is here involved). Under the terms of this agreement, the purchase price to be paid for said rights by the Kenton Corp. was stated to be 50 percent of the net royalties (after taxes and expenses) realized by said Kenton Corp. from licenses granted by it under such rights, subject to a maximum of $ 22,000 per calendar quarter, up to a maximum total purchase price of $ 900,000. There was no minimum royalty payable by the Kenton Corp. under said agreement.

During each of the years 1957 and 1958, the partnership paid income taxes to foreign governments on the royalties which it received from manufacturers in the foreign countries, in the amounts of $ 19,189.89 and $ 26,736.54, respectively. On the partnership's information returns for said years, the partnership reflected these foreign income tax payments in Schedule K ("Partners' Share of Income Credits and Deductions"), column 14 ("Income and profits taxes paid to a foreign country or United States possession"); and the effect of this was that the total amount of foreign tax paid each year was allocated in equal portions to the three partners. The amount so allocated to petitioner Egbert Miles was $ 6,396.63 for 1957, and $ 8,912.18 for 1958. On the joint Federal income tax return which said petitioner and his wife filed for each of said years, they utilized the foreign tax credit so allocated to Egbert by the partnership in computing the credit against their liability for U.S. income taxes.

Pursuant to the provisions of the agreement between Hum International and the trustee, the Jean N. Miles trust and the Egbert J. Miles trust received the following amounts from the partnership in 1957 and 1958:

	Jean Miles	Egbert Miles
	trust	trust
1957	$ 5,889.70	$ 5,889.70
1958	7,073.12	7,073.12

The trustee did not in either 1957 or 1958 distribute any income of either trust, in cash or otherwise, to the named beneficiary of either trust, viz, to petitioner Egbert Miles or to petitioner Jean Miles.

The petitioners, Egbert and Jean Miles, did not report on their joint income tax return for either of the years 1957 or 1958, any of the amounts which the Hum partnership paid in said years to their respective trusts; nor did they report any distribution of income to them from such trusts.

The respondent, in his statutory notice of deficiency, stated:

It has been determined that the amounts of $ 11,779.40 and $ 14,146.25 paid in the taxable years 1957 and 1958 respectively by Hum International to trusts established for your benefit in Bermuda constitute income taxable to you for such years under the provisions of the Internal Revenue Code of 1954. [Emphasis supplied.]

OPINION

The essence of what we have here, when considered with regard to substance, is a carefully prearranged plan to fund trusts for the benefit of the children of the senior executives of the Sarong corporation, through: (1) "Spinning off" the foreign patent rights of said corporation into a partnership composed of the corporation's junior executives (who were beneficiaries of three of the newly created children's trusts); and (2) funneling the bulk of said partnership's income from its use of such foreign rights into said children's trusts. The icing on the cake, so to speak, was that (under such plan) most of the income from said foreign patent rights would never bear the burden of any Federal income taxes, although it would be earned by a domestic partnership. Avoidance of taxes would be achieved by interposing the Bermuda trusts between the corporation and the partnership through: Having the corporation "sell" the foreign patent rights to the trusts; having the trusts concurrently "grant" the partnership the exclusive right to license foreign users; and then having the partnership, as "compensation" for such grant, pay over to the trusts 90 percent of its net proceeds from the exploitation of said foreign rights. Thus, the partnership's net income would, by use of a "deduction" for the amount so paid over to the trusts, be reduced to a relatively insignificant amount; and the trusts (being in Bermuda and beyond the reach of the Federal taxing statutes) would not pay any Federal taxes on the amounts which they would receive from the partnership. Still other features of the plan completed the tax avoidance picture: (1) The trustees, by not distributing to their beneficiaries any of the amounts which they would thus receive from the partnership, would prevent any of said amounts being currently taxable to the beneficiaries; and (2) upon any subsequent termination of the trusts, which could occur at any time after 10 years and 18 days, all principal and accumulated income of the trusts would become available to the beneficiaries, tax free. Also, by having the partnership retain the entire foreign tax credit paid by it with respect to both the portion of the income which it retained and also the portion which it remitted to the trusts, the partners would avoid most of the tax on their retained portions.

We think that the plan, advantageous though it might have appeared to all parties involved, is defective taxwise.

It is necessary, in the first place, to consider what precisely is the issue before us; and whether the petitioners on brief actually have directed their arguments to meeting such precise issue. As we have heretofore pointed out in our Findings of Fact, the particular income which the Commissioner in his notice of deficiency determined to be taxable to the petitioners is the amounts of $ 11,779.40 and $ 14,146.25 which the Hum partnership paid to the trusts in 1957 and 1958. The evidence discloses that the partnership, in paying over these amounts to the trusts, took deductions therefor as ordinary and necessary business expenses, so as to reduce the amounts of the distributive shares of its net income which otherwise would have been available to its partners (including petitioner Egbert Miles); and accordingly, that the amounts of taxable income from partnerships which petitioners Egbert Miles and his wife reported in their joint returns for the years involved, were substantially less than what they would have been if such deductions had not been taken by the partnership. Hence, the determinative factor in deciding whether the Commissioner's determination should be approved is, as we see it, whether the amounts which the Hum partnership paid over to the trusts legally qualify for deduction as ordinary and necessary expenses of the partnership. If they do not so qualify as deductions, then it will follow that the Commissioner's determination must be approved. ²

Thus viewing the case as we do, it seems to us that the situation here presented is merely a variation of a familiar situation, to wit: Where assets used in a business are purportedly "sold," pursuant to a prearranged plan, to a trust for the benefit of family members; where the purported "vendee" thereupon makes a leaseback of the same assets to the "vendor"; and where the "vendor" then seeks to reduce his taxable income by claiming a deduction for the amounts paid over to the "vendee" under the leaseback arrangement. Such a case was recently considered by us in I. L. Van Zandt, 40 T.C. 824">40 T.C. 824. In that case, the taxpayer, who was a physician, owned a building and certain equipment which he used in his medical practice. He created two 10-year irrevocable trusts for the benefit of his children, naming himself as trustee; purported to "sell" to such trusts both the building and the equipment; and then the "vendee" trusts, on the same day, leased back the same properties to the taxpayer, who thereafter continued to use the same in the practice of his profession. The taxpayer thereafter deducted the ostensible rental payments which he made to the trusts under the leaseback arrangement. The Commissioner disallowed the claimed deduction; and we sustained the Commissioner's action. In our opinion in that case, we held that the claimed deduction was not allowable, stating in part:

Moreover, it is well recognized that intra-family transactions resulting in the distribution of income within a family unit are subject to the closest scrutiny. Helvering v. Clifford, 309 U.S. 331">309 U.S. 331 (1940); Commissioner v. Tower, 327 U.S. 280">327 U.S. 280 (1946). Where, as here, the trusts and leasebacks are steps in a prearranged transaction, we think it is necessary to examine the true nature of the transaction and aim our inquiry at seeing if the net effect has been a shift of family income. * * * It would seem that economic reality, rather than the validity of the documents creating the trusts, the transfers and the leases, must serve as the basis upon which the right to the deduction rests.

To hold for the petitioner would be inconsistent with another line of decisions. Where a sale and lease-back does not serve a utilitarian business purpose, but is in reality a camouflaged assignment of income, the expenses have not been considered "ordinary and necessary." See W. H. Armston Co. v. Commissioner, 188 F. 2d 531 (C.A. 5, 1951), affirming 12 T.C. 539">12 T.C. 539 (1949); Unger v. Campbell, 7 A.F.T.R. 2d 547 (N.D. Tex. 1960); and White v. Fitzpatrick, 193 F. 2d 398 (C.A. 2, 1951) certiorari denied 343 U.S. 928">343 U.S. 928. The same result has been reached where the transfer was in the form of a gift. Johnson v. Commissioner, 86 F. 2d 710 (C.A. 2, 1936), affirming 33 B.T.A. 1003">33 B.T.A. 1003 (1936). * * *

In addition to the cases cited in the above quotation, see to the same effect Kirschenmann v. Westover, 225 F. 2d 69 (C.A. 9). See also Rev. Rul. 54-9, 1 C.B. 20">1954-1 C.B. 20.

The variation between the usual leaseback situation represented by the Van Zandt case and the situation in the instant case is that here, instead of having a leaseback to the "vendor" by the trust, we have a "leaseover" to a related organization, i.e., to a partnership whose members were not only children of the senior executives of the "vendor" corporation but who also were themselves stockholders and executives of the "vendor" corporation. This variation presents a situation similar to that involved in Ingle Coal Corporation, 10 T.C. 1199">10 T.C. 1199, affd. 174 F. 2d 569 (C.A. 7).

In this Ingle case, corporation A distributed in liquidation to its stockholders, all its assets (including certain mining leases on which it was paying royalties to the landowner); and these stockholders then, acting pursuant to a prearranged plan, immediately conveyed these same assets to the newly created taxpayer, corporation B, partly for stock and partly for an agreement under which the taxpayer was to pay the stockholders an additional overriding royalty on each ton of coal mined from the properties. The Commissioner disallowed the deduction claimed by corporation B for these overriding royalties. We affirmed such determination, stating in part:

In effect, petitioner received from the old corporation, not its shareholders, just what the old corporation had, namely, the right to continue mining coal under the lease. This is so regardless of the possibly enforceable obligation of the petitioner corporation, as between it and the shareholders, to pay the overriding "royalty." * * * In short, under no aspect of the evidence, have we found or can we find that the petitioner corporation intended to or did receive any actual consideration for agreeing to pay this additional five-cent "royalty." The series of transactions constituted integrated steps in a single plan and must be so considered for tax purposes, which resulted in an unnecessary "obligation" upon the part of petitioner to pay the so-called overriding "royalty." * * * [Citing cases.] We think, under the circumstances, the payment of this additional 5 cents per ton as an overriding "royalty" was a distribution of corporate profits to the stockholders receiving the same and therefore was not a deductible expense, either as a "royalty" or otherwise. * * *

In the instant case, the position of the Bermuda trusts is similar to that occupied by the stockholders in the Ingle case. Both, acting pursuant to a prearranged integrated plan, purported to acquire the income-producing assets of a business; thereupon purported to immediately make these same assets available to a newly created business organization, through contractual arrangements under which both sought to extract a charge from the new business for the latter's use of such assets. Also, the position of the partnership in the instant case is similar to that of the new taxpayer corporation in the Ingle case; for each earned the income that it disposed of under the contractual arrangement, and each claimed deductions for the payments which it made under such arrangement, as ordinary and necessary expenses of its business. Just as both this Court and the Seventh Circuit disallowed the deductions claimed in the Ingle case, we likewise in the instant case conclude that the claimed deductions should be disallowed.

It is our opinion, based on our consideration and weighing of all the evidence herein, that the Bermuda trusts acted merely as conduits through which the foreign patent rights were passed from the Sarong corporation to the Hum partnership. This becomes evident when consideration is given to the following facts revealed in the record.

The integrated plan was all prearranged prior to the creation of the trusts which performed an essential part in the carrying out of the plan. The purported transfer of the foreign patent rights from the Sarong corporation to the trusts was for a grossly inadequate consideration; for such "consideration" was only $ 17,500, notwithstanding that the foreign rights transferred, yielded very large amounts of income both prior and subsequent to the transfer, and also that the fair market value thereof was, as we have hereinabove found, not less than $ 300,000. The amount of even such nominal "consideration" equaled the amount of all assets which the trusts had theretofore acquired, both as corpus and as loans from the grantors. Both the purported purchase of the rights by the trustees, and also the purported retransfer of the same to the partnership, were accomplished without prior notice being given to the trusts' investment advisory committee, as specifically required by paragraph Tenth (K) of the trust agreements. And following these purported transfers, the members of the partnership (one of whom had theretofore handled the foreign patent rights for the Sarong corporation) managed and operated these foreign patent rights, and earned all the income which they produced.

It seems obvious to us that the trusts were never intended to acquire, and did not acquire, and substantial interests in said foreign patent rights; and in the absence of such substantial interest, there was no warrant or true consideration for the partnership paying over to the trusts 90 percent of its net income, under the guise of such payments being ordinary and necessary expenses of producing that income. The Supreme Court's decision in Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179">315 U.S. 179 (a case which the Court of Appeals for the Seventh Circuit cited in affirming the decision of this Court in the Ingle case), provides authority for the principle that "Transitory phases of an arrangement frequently are disregarded under * * * the revenue acts where they add nothing of substance to the completed affair." To the same effect see Gregory v. Helvering, 293 U.S. 465">293 U.S. 465.

We regard the cases of Brown v. Commissioner, 180 F. 2d 926 (C.A. 3), reversing 12 T.C. 1095">12 T.C. 1095; Skemp v. Commissioner, 168 F. 2d 598, reversing 8 T.C. 415">8 T.C. 415; Albert T. Felix, 21 T.C. 794">21 T.C. 794, and John T. Potter, 27 T.C. 200">27 T.C. 200 (in which rentals paid under leaseback arrangements were held to be deductible), to be distinguishable on their facts. There, it was decided that the trusts had acted independently in arm's-length transactions. In the instant case, to the contrary, we are impelled to conclude that the five Bermuda trusts here involved did not function independently in arm's-length transactions, when they participated in carrying out the prearranged integrated plan for shifting the foreign patent rights from the Sarong corporation to the partnership.

We hold that the amounts of $ 11,779.40 and $ 14,146.25, which were paid in the taxable years 1957 and 1958 by the Hum partnership to the two trusts established for the petitioners' benefit, do not qualify for deduction as ordinary and necessary business expenses of the partnership; that said amounts constitute part of Egbert's distributive share of the partnership's net incomes for said taxable years; and that said amounts should have been included by Egbert and his wife in the income from partnerships which they reported on their joint income tax returns for said years.

We sustain the Commissioner's determination that said amounts constitute income taxable to the petitioners for the taxable years involved.

By reason of our above holding, it is unnecessary for us to consider respondent's alternative contention regarding the credits for foreign taxes paid by the partnership.

Decision will be entered for the respondent.

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Footnotes

• 1. These rights and interests will hereinafter for simplicity be referred to as the "foreign patent rights."↩

• 2. Both parties in their briefs appear to have taken an approach to the problem which is different from ours. They seem to have regarded the question to be whether the petitioners, in their capacity as beneficiaries of the trusts, are taxable with undistributed trust income, either because the trusts were illusory or were subject to their "control"; whereas we think it obvious from a reading of the Commissioner's determination that the income sought to be taxed is partnership income↩ which was distributable to Egbert Miles as one of the partners, and hence includable by him and his wife on their joint income tax returns. The Commissioner in his notice of deficiency made no reference whatever to any income in the hands of the trustees, whether distributable or nondistributable.