Bishop v. Commissioner, 4 T.C. 804 (1945)

A beneficiary of a trust can be taxed on the trust’s undistributed income under Section 22(a) of the Internal Revenue Code if they possess substantial control over the income’s disposition, even without directly receiving it.

Summary

Edward and Lillian Bishop, each independently wealthy, created reciprocal trusts naming each other as life beneficiaries with a general testamentary power of appointment. The trustee had discretion to distribute income, but Lillian testified there was an understanding the trustee would pay the income to Edward upon request for the Crawfords benefit. Edward testified his motive was to ensure Lillian’s financial security. Each beneficiary could replace the trustee. The Tax Court held that each life beneficiary’s power to direct income distribution and replace the trustee gave them sufficient control to be taxed on the undistributed income under Section 22(a), irrespective of whether the income was actually distributed.

Facts

• Edward and Lillian Bishop created reciprocal trusts in 1935.
• Each spouse was the life beneficiary of the trust created by the other, and each had a general testamentary power of appointment over the trust corpus.
• The corporate trustee had complete discretion to determine if and when to pay net income to the life beneficiary.
• Lillian Bishop testified that her spouse was given a life estate because she did not want Crawford to get control of the funds should Mrs. Crawford predecease him, and that there was an understanding with the trustee that when Bishop requested the net income to be paid to him the trustee would so pay it, for the use of the Crawfords.
• Edward Bishop testified that one of his motives in creating the trust was to ensure that Mrs. Bishop would have the use of the trust in case she needed it.
• Each life beneficiary had the right to change the trustee to any other corporate trustee at any time.

Procedural History

The Commissioner of Internal Revenue assessed deficiencies against the Bishops for income taxes. The Bishops petitioned the Tax Court for a redetermination of these deficiencies. The Tax Court reviewed the case. The Commissioner argued the undistributed income was taxable under Section 22(a) and Sections 166 and 167 as reciprocal trusts. The Tax Court found for the Commissioner under Section 22(a), making it unnecessary to consider Sections 166 and 167. The court also ruled on certain deductions claimed by Edward Bishop.

Issue(s)

1. Whether the undistributed income of the trusts was taxable to the petitioner-life beneficiaries under Section 22(a) of the Revenue Act of 1938 and the Internal Revenue Code.

Holding

1. Yes, because the beneficiaries had the power to have the income distributed or accumulated, and they possessed significant control over the trust and its income, making them the virtual owners of the income for tax purposes under Section 22(a).

Court’s Reasoning

The court reasoned that the confluence of the trustee’s complete discretion over income distribution, combined with the life beneficiary’s power to replace the trustee, effectively allowed the beneficiary to control the income’s disposition. The court emphasized the substance over form, stating, “Since these provisions are more than they appear to be, we consider actualities only, regarding the substance rather than the form.” The court cited Richardson v. Commissioner and Jergens v. Commissioner, which held that control over income warrants the imposition of the tax incidence upon the person who commands its disposition. The court also referenced Edward Mallinckrodt, Jr., noting that the power to receive trust income upon request is the equivalent of ownership for taxation purposes. The court concluded that the Bishops had retained all the incidents of ownership that were important to them, including the right to the income and the power to change the trustee. The court found it unnecessary to rule on whether the trusts were reciprocal under sections 166 and 167.

Practical Implications

Bishop illustrates that the IRS and courts will look beyond the formal structure of a trust to determine who truly controls the income. Even if a beneficiary does not directly receive the income, the power to control its distribution or to replace the trustee can result in the beneficiary being taxed on that income. This case reinforces the principle that “the power to dispose of income is the equivalent of ownership of it.” This decision serves as a warning to tax planners to carefully consider the degree of control granted to beneficiaries when designing trusts, as excessive control can negate the intended tax benefits. Subsequent cases have cited Bishop to support the proposition that substantial control over trust assets or income, even without formal ownership, can trigger tax liabilities.