3 T.C. 929 (1944)

Income received from a trust, even if awarded as a prize, is taxable as income to the beneficiary, regardless of whether the beneficiary has a direct interest in the trust’s principal.

Summary

Malcolm McDermott received the Ross Essay Prize of $3,000 in 1939, which was funded by a trust established under the will of Erskine M. Ross and administered by the American Bar Association. The IRS determined that this prize constituted taxable income. McDermott also claimed a deduction for North Carolina sales tax paid. The Tax Court held that the prize money was taxable income because it was distributed from a trust, and that the sales tax was not deductible because it was levied on the retailer, not the consumer. This case illustrates the principle that income derived from a trust is taxable to the beneficiary, even if received as a prize or award.

Facts

Erskine M. Ross bequeathed $100,000 to the American Bar Association in his will, stipulating that the annual income from the investment of this sum should be awarded as a prize for the best essay on a legal subject. The American Bar Association administered the trust and awarded Malcolm McDermott the $3,000 Ross Essay Prize in 1939. McDermott did not include the prize money in his income tax return. He also paid $22.16 in North Carolina retail sales tax, which he deducted from his gross income.

Procedural History

The Commissioner of Internal Revenue determined a deficiency in McDermott’s 1939 income tax return, adding the $3,000 prize money to his income and disallowing the $22.16 sales tax deduction. McDermott petitioned the Tax Court for a redetermination of the deficiency.

Issue(s)

1. Whether the $3,000 Ross Essay Prize received by McDermott constitutes taxable income.

2. Whether McDermott is entitled to deduct the North Carolina sales tax he paid on purchased merchandise.

Holding

1. Yes, because the prize money represented income from a trust, making it taxable to the beneficiary, McDermott.

2. No, because the North Carolina sales tax was imposed on the retailer, not the consumer, and therefore McDermott could not deduct it.

Court’s Reasoning

The court reasoned that the $3,000 prize originated from the will of Erskine M. Ross, which established a trust administered by the American Bar Association. The court emphasized that McDermott was the designated income beneficiary of the trust for 1939, and the money he received was a distribution of trust income. The court stated, “It is enough to support the taxation of the $3,000 in petitioner’s hands that the $3,000 was trust income and was received by him as such.” The court cited Irwin v. Gavit, 268 U.S. 161, noting that even if a beneficiary has no interest in the corpus, payments from the trust are still considered income. Regarding the sales tax deduction, the court relied on Leonard v. Maxwell, 3 S.E. (2d) 316, where the Supreme Court of North Carolina held that the sales tax was levied on the privilege of doing business as a retailer, not on the consumer. Therefore, McDermott, as a consumer, could not deduct the sales tax.

Practical Implications

This case clarifies that prizes or awards funded by trusts are generally considered taxable income to the recipient. It emphasizes the importance of tracing the source of funds to determine their taxability. Even if the recipient performs some action (like writing an essay) to become eligible for the prize, the ultimate source of the funds as trust income dictates its tax treatment. This case also reinforces the principle that deductions are only allowed for taxes legally imposed on the taxpayer, not taxes merely passed on to them. Later cases have cited McDermott to support the principle that the character of income is determined by its source.