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Schulz v. Commissioner of Internal Revenue

July 30, 1982


Consolidated Appeals from the United States Tax Court, Nos. 2358-78 and 2541-78 -- C. Moxley Featherston, Judge, No. 2419-78 -- Howard A. Dwason, Jr., Judge.

Cummings, Chief Judge, Posner, Circuit Judge, and Leighton, District Judge.*fn*

Author: Cummings

CUMMINGS, Chief Judge.

These appeals, which were consolidated by order of this Court, are the tip of an iceberg.*fn1 The common issue is the appropriate treatment, for tax purposes, of so-called family or constitutional trusts. The taxpayers contend that these are bona fide trusts taxable as such.*fn2 The Commissioner argues, and the Tax Court found, that they are ineffective attempts to shift the incidence of taxation by assignment of income under Lucas v. Earl, 281 U.S. 111, 74 L. Ed. 731, 50 S. Ct. 241, and invalid grantor trusts under Sections 671-677 of the Internal Revenue Code, 26 U.S.C. ยงยง 671-677. In the Schulz cases, the taxpayers appeal deficiency findings of $5,167.08 (1972), $9,645.92 (1973), and $4,630.12 (1974); the trust (curiously) appeals the decision that it is entitled to refunds of $754 (1972) and $3,446.17 (1973).*fn3 In the White case, the deficiencies in the individual returns amount to $293.63 (1972), $6,964.98 (1973), and $4,564.44 (1974).*fn4 We affirm the Tax Court decisions in all three cases.

I. The Terms of the Trusts

La Verne Schulz, a Wisconsin dairy farmer and real estate broker, created his trust in 1972. Into it he and his wife Barbara*fn5 conveyed all their real and personal property, including the farming and office equipment Mr. Schulz used to earn a living and Mrs. Schulz' right to receive her salary as an employee in the county courthouse. Everything from the dairy farm acreage to the real estate office's filing cabinets to the family's television set and toaster became the trust res. In return, the Schulzes received shares representing 100% of the beneficial interest in the trust, which they distributed to Barbara (50%), their three children (15% each), and La Verne (5%). The initial trustees were Mr. and Mrs. Schulz and Ena Lundgren, the wife of their bookkeeper; in 1976 one of the Schulzes' daughters replaced Mrs. Lundgren. The terms of the trust called for it to last for 25 years, renewable for another 25-year term with ultimate distribution to the beneficiaries or their heirs or legal representatives. Most actions could be taken by a majority of the trustees, but early termination required unanimous action. La Verne Schulz drew a salary from the trust as its consultant in running the dairy farm and real estate business he had previously conducted, and reported the salary on his individual income tax return. No distributions were made to beneficiaries. The trust paid tax on its net income -- i.e., the accumulations to the trust minus the expenses of administration. In 1972 it had income of $9,321.49 and expenses of $4,930.57; in 1973 income of $25,461.96 and expenses of $11,448.69; the 1974 trust return is missing from the record. Included in the expenses of administration were such items as life insurance premiums on policies insuring La Verne Schulz ($660 in 1973); costs of maintaining and operating the family car; health care expenses for trustees ($680 in 1972 and 1973); gifts and charitable contributions ($1,100 in 1972 and 1973); license fees for a boat and a dog; educational expenses; and the cost of a home in Elkhorn, Wisconsin, allegedly maintained for the convenience of Schulz's employer, the Schulz family trust ($3,000 in 1972 and 1973).*fn6

Russell White set up his family trust in the same manner and in the same year. The trust res consisted of the White family house, stocks, life insurance policies, and assorted personal property. The trust's main asset was a contract entitling it to receive the income payable to Mr. White by his employer, Litho Productions, Inc. The beneficial interests in the trust were parceled out as follows: 20% to Mrs. White, 14% to each of the Whites' five children, 10% to the Russell White Educational Fund, and nothing to Mr. White. Mr. White did, however, receive a manager's fee, determined to be whatever amounts he needed to draw from the trust. Initially the trustees were Mr. and Mrs. White and Mrs. White's brother; the brother resigned immediately after the trust was formed and was never replaced. The duration of the trust and the powers of the trustees were the same as in the Schulz family trust -- a fact that is not surprising since both trusts were drafted according to instructions contained in a prepackaged kit. The tax returns of the White family trust show income of $26,532 and administration expenses of $21,694 for 1973; income of $22,935 and expenses of $16,493 for 1974; the 1972 return is not included in the record. Among the administration expenses listed separately on the returns are health expenses of the trustees ($2,600 in 1973 and 1974), "household expenses" ($5,400 in 1973 and 1974), home and car insurance ($2,200 in 1973 and 1974), and "automobile lease" -- i.e., the trust's lease of the Whites' family car ($7,850 in 1973 and 1974).*fn7

II. The Tax Consequences of the Trusts

It takes no particular acumen in tax law to know that the Schulz and White family trusts cannot be treated like ordinary trusts. The only real question is which of several established doctrines the Internal Revenue Service should use to deny their existence as taxable entities.

A. Attempted deduction of personal consumption expenses

It is fundamental to our income tax regime that personal consumption expenditures -- food, clothing, travel, education, entertainment -- do not generate income tax deductions unless they are somehow inextricably linked to the production of income.*fn8 When taxpayers buy cars, travel, or take out life insurance policies, they make those expenditures out of after-tax dollars. The trust devices here are a transparent attempt to alter that state of affairs by turning all the families' activities into trust activities and all the families' expenses into expenses of trust administration. If this device worked, the Schulzes and the Whites would, unlike the rest of us, make all their consumptive expenditures with pre-tax dollars.

The Internal Revenue Service could disallow most of the administration expenses claimed in these family trust returns. But such an approach would be extremely inefficient; the Service does not have the resources to audit every return, and the chance of avoiding an audit would only encourage this form of tax evasion.

B. Anticipatory assignment of income

A broader-based attack on family trusts of the type described here is possible. Since the seminal case of Lucas v. Earl, 281 U.S. 111, 74 L. Ed. 731, 50 S. Ct. 241, it has been clear that income is taxed to the person who earns it, regardless of what arrangements he makes to divert the payment of it elsewhere.*fn9 This is a rule of imputation that has nothing to do with, and does not affect, the validity of the particular arrangement for purposes other than computing income taxes.*fn10 In the absence of such an imputation rule, taxpayers would be able to defeat the progressivity of the income tax rate structure by directing income to low-bracket recipients. That result would obviously have occurred if Mr. White's or Mr. Schulz' income had actually been distributed to their respective children and wives; but the potential deflation of the brackets exists even where -- as here -- there has been no distribution to the trust beneficiaries. The impact on progressivity is only postponed, owing to a special feature of trust taxation. Although the trust pays taxes on accumulated, undistributed income as if it were an individual taxpayer,*fn11 when accumulated income is finally distributed to the trust beneficiaries (at the latest, when these trusts terminate), it is taxed to the beneficiary as if it had been distributed in the year it was accumulated, and the taxes previously collected from the trust are credited to ...

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