10 T.C. 1126 (1948)

A state court decree confirming the partition of a testamentary trust’s assets into separate trusts for different beneficiaries is recognized for federal income tax purposes from the date of the decree forward, thereby allowing each trust to be taxed separately.

Summary

The John Shertzer Trust disputed the Commissioner’s assessment of deficiencies for 1943 and 1944, arguing that the income from two sub-trusts should not be included in the main trust’s taxable income. A state court had ordered a partition of the original trust into separate trusts for two daughters. The Tax Court held that the state court’s decree was binding for federal tax purposes from the date of the decree. It also disallowed deductions for legal and accounting fees paid in 1944 but claimed in 1943 because the trust was on a cash basis.

Facts

John Shertzer died in 1934, leaving a will that created a trust for his wife and two daughters, Lillian and Marilyn. The will specified different distribution schedules for each daughter. In 1943, the wife petitioned a Texas probate court for a partition of the estate. The daughters entered appearances in the proceeding.

Procedural History

The probate court approved the partition and appointed commissioners who divided the estate’s property, allocating shares to the wife and establishing separate trusts for each daughter. The Tax Court reviewed the Commissioner’s determination including income of the daughter’s trusts to the primary trust.

Issue(s)

1. Whether the state court decree partitioning the trust into separate trusts is binding on the Tax Court for federal income tax purposes.
2. Whether the trust can deduct attorneys’ fees and audit expenses in 1943 when they were not paid until 1944.

Holding

1. Yes, because the state court decree was a valid order creating property rights, and it was not collusive.
2. No, because the trust was on a cash basis, and the expenses were not paid in 1943.

Court’s Reasoning

The Tax Court reasoned that the state court decree was an action <em>in rem</em> and the state court had jurisdiction over the matter and the parties. The procedure was regular and the establishment of the two separate trusts followed the actual partition of the property. The court noted that the decree was not an <em>ex parte</em> attempt to interpret a trust instrument to avoid taxes. Instead, it was a distribution of property subject to two separate trusts pursuant to the decedent’s intent. Because the decree was not entered until November 12, 1943, the court held that the two trusts existed separate and distinct from the petitioner only after that date. Regarding the deductions, the Tax Court stated, “Deductions on account thereof were taken by petitioner, which was on a cash basis, in 1943, while the stipulation shows that these items were not paid until 1944. No claim for these deductions was made as to 1944. We are unable to see the basis for any such claim by petitioner in any year, since the parties have stipulated that these items were paid by persons other than petitioner.”

Practical Implications

This case highlights the importance of state court decrees in determining property rights for federal tax purposes, specifically in the context of trusts. Attorneys should consider the tax implications when structuring trust partitions or modifications. A valid state court decree can effectively create separate tax entities, affecting how income is reported and taxed. Taxpayers using the cash method of accounting must pay expenses before they can deduct them. This case also suggests that tax claims must be properly made for the tax year they occurred.