for the value shown in Mrs. Scully's federal estate tax return.
A subsequent review and settlement of the estate taxes resulted
in an increase in the valuation of the farmland.
The Trustees claim that the increase in the valuation
demonstrates that the individual trusts actually sold the land to
the family trusts at a loss. They seek to apply the alleged loss
against ordinary income and to recover resulting tax refunds. The
Internal Revenue Service has disallowed the claim with respect to
all nine of the individual trusts. Having adequately exhausted
their rights to administrative redress, the Trustees seek this
Court's review of their claim for a refund.
This Court is asked to determine whether the trusts involved in
this dispute have a common grantor. If the family and individual
trusts are found to have separate grantors, the Court must
further determine whether the farmland sold was real property
used in a trade or business such that a loss on the sale may be
deducted against income. I.R.C. § 165(a).
In pertinent part, section 267 of the Internal Revenue Code
provides that "no deduction shall be allowed . . . [i]n respect
of losses from sales or exchanges of property . . . between . . .
[a] fiduciary of a trust and a fiduciary of another trust, if the
same person is a grantor of both trusts . . ." I.R.C. §
267(a)(1), (b)(5). The litigants agree that Mr. Scully was the
grantor of the family trusts; they ask this Court to decide
whether, in light of the undisputed facts of this case, Mrs.
Scully's exercise of her power of appointment establishes her as
the grantor of the individual trusts.
In deciding whether Mr. Scully was the grantor of the
individual trusts, the Magistrate, citing three United States
Supreme Court cases, initially determined that the Illinois law
of estates and trusts controlled. See Helvering v. Stuart,
317 U.S. 154, 63 S.Ct. 140, 87 L.Ed. 154 (1942); Morgan v.
Commissioner, 309 U.S. 78, 60 S.Ct. 424, 84 L.Ed. 1035 (1940);
Blair v. Commissioner, 300 U.S. 5, 57 S.Ct. 330, 81 L.Ed. 465
(1937). The gravamen of the Trustees' objection is that the
Magistrate erred in resolving under Illinois law the question of
whether, for the purposes of section 267 of the Internal Revenue
Code, Mr. Scully was the "grantor" of the trusts created by Mrs.
Scully's exercise of her general power of appointment. Rather,
the Trustees contend, the construction of the term "grantor"
should have been determined under a uniform federal law concept
of the term, so that the taxability of the transaction in issue
is not dependent upon the vagaries of local property law.*fn2
The Result Under Illinois Law
As ably pointed out by the Magistrate, Illinois has generally
recognized that upon the exercise of a power of appointment, the
appointment of assets relates back to the time of the power's
creation "as if [the appointment] had been originally contained
in the donor's will." Restatement (First) of Property, p. 1811
(1940). "Property passing pursuant to the exercise of the power
passes under the instrument creating the power, just as though
the appointment were read into the original instrument." In re
Estate of Breault, 29 Ill.2d 165, 174, 193 N.E.2d 824 (1963). In
light of these precedents, Mrs. Scully's exercise of her general
testimentary power of appointment would relate back to Mr.
Scully's creation of the Marital Trust, and Mr. Scully would be
denominated the grantor of the individual trusts.
There is, however, one exception,*fn3 relevant here, to the
general rule that the
exercise of a power of appointment relates back to the donor of
the power: "[P]roperty subject to a general power of appointment
may pass as a part of the estate of the donee of the power if the
donee shows an intention to take such property `out of the
instrument creating the power,' and `to make it his own for all
purposes' . . ." Breault at 174, 193 N.E.2d 824, quoting Cary and
Schuyler, Illinois Law of Future Interests, Sec. 364, p. 491
(1941). The question for this Court is, therefore, whether Mrs.
Scully's will evinces an intention to make the property her own
for all purposes.
In determining whether the testator treated appointive and
personal assets as his own for all purposes, the Breault court
emphasized the treatment of the assets for the purpose of
satisfying charges against the testator's estate. Breault at 177.
The testator in Breault clearly intended to commingle the assets
he held personally and the assets over which he held appointive
power, but his will did not treat the two sets of assets in the
same manner. This difference in treatment, the Breault court
found, prevented the appointive assets from becoming a part of
the testator's personal estate and left the grantor of the
appointive power as the donor of the assets appointed. The same
test may be applied under the present circumstances.
A review of Mrs. Scully's will reveals that she clearly
intended for her personal assets and the Marital Trust assets to
be commingled at some point in time. Article VII of her will
expressly provides that "the property I own at my death . . . be
added to the Marital Trust Estate." The language adopted,
however, implies an intention to pour her personal assets into
the Marital Trust, not an intention to make the Marital Trust
assets her own. Determining into which vehicle the assets were
poured is, as Plaintiffs point out, the sort of ritualistic
formalism that the law would ordinarily do best to abjure. But in
this context, reference to form aids in the devination of intent.
The manner in which Mrs. Scully treated the assets subject to her
control evince an intent to keep the Marital Trust a viable
entity and, no doubt, a shield against unforeseen creditors with
claims on whatever they could characterize as her estate.
This Court need not, however, rest its decision solely on the
manner in which Mrs. Scully combined the assets she controlled.
The Court looks also to the substantive differences resulting
from the manner in which the assets were treated by the will
before the combining or commingling was executed. Here, Mrs.
Scully's will treated her personal assets and the Marital Trust
assets differently for the purpose of satisfying charges against
The will does provide for the satisfaction of all "the expenses
of administration . . . all cash gifts . . . and all estate and
inheritance taxes . . ." out of the assets in the Individual
Trusts to be derived from the Marital Trust, but only in "such
amounts as the trustee shall be liable or may agree to pay."
Article VI, paragraph (c) (emphasis added). Her personal assets,
in contrast, are charged with the payment or arrangement for
payment of these charges "prior to the distribution of [Mrs.
Scully's personal] estate." Article VIII(c). The assets funding
the Individual Trusts, the Marital Trust assets, are only
secondarily responsible for the enumerated expenses should the
trustees of the two trusts so agree. Mrs. Scully's will places
primary responsibility for payment of those charges
incurred or directed as a result of her death on her personal
Article VII's instruction to add the testatrix's personal
estate to the Marital Trust estate could not be carried out until
Article VIII's instructions to pay or arrange for payment of the
enumerated expenses had been accomplished. Like the testator in
Breault, Mrs. Scully appears to have directed the payment of
expenses (or the arrangement for payment) before any blending or
commingling of the assets in her personal estate and the assets
of the Marital Trust estate. See Breault at 177, 193 N.E.2d 824.
This Court cannot find that the testatrix "treated the two
estate as one for all purposes," Breault at 176, 193 N.E.2d 824,
and consequently must find that Mrs. Scully did not appoint the
assets funding the Marital Trust estate to her own estate. The
Marital Trust assets were appointed directly to the Individual
Trusts. Thus, under Illinois law, Mr. Scully, the grantor of the
Marital Trust, would also be the grantor of the Individual Trust;
and any deduction for losses incurred on the sale of assets
between the two trusts would be barred by I.R.C. § 267.
The Trustees, however, object to the Magistrate's application
of Illinois law. They contend that federal law must determine
whether Mr. Scully was the grantor of both trusts for the
purposes of § 267.
Illinois or Federal Law
As the Trustees correctly point out, Congress' intent in
passing the Internal Revenue Code was to provide for the uniform
application of a nationwide scheme of taxation. See Burnet v.
Harmel, 287 U.S. 103, 110, 53 S.Ct. 74, 77, 77 L.Ed. 199 (1932).
Pursuant to this intention, the Court in Burnet held that federal
tax legislation, "in the absence of language evidencing a
different purpose, is to be interpreted so as to give a uniform
application to a nationwide scheme of taxation." Id. Further,
"state law may control only when the federal taxing act, by
express language or necessary implication, makes its own
operation dependent upon state law." Id.
At the same time, however, Congress in drafting the tax code
clearly did not intend to redefine whole areas of legal
relationships created by state property law, but instead sought
to impose a generally uniform system of taxation upon the
existing legal structure. Ernest & Mary Hayward Weir Foundation
v. United States, 362 F. Supp. 928, 932 (S.D.N.Y. 1973), aff'd,
508 F.2d 894 (2d Cir. 1974); Morgan v. Commissioner, 309 U.S. 78,
80-81, 60 S.Ct. 424, 425-26, 84 L.Ed. 1035 (1940). The objectives
to be sought in administering the federal tax code within this
framework of state law, therefore, should be to minimize tax
differences among the states while not encroaching on the
customary role of state law in the federal system. See Note, The
Role of State Law in Federal Tax Determinations, 72 Harv.L.Rev.
1350, 1351 (1959).
State law is not, however, used for tax purposes in the same
manner that it is applied by federal courts exercising diversity
jurisdiction, under which state law furnishes the substantive
rule of decision. Erie R.R. v. Tompkins, 304 U.S. 64, 78, 58
S.Ct. 817, 823-24, 82 L.Ed. 1188 (1938). In tax cases, the
substantive rule is federal, with state law establishing some of
the facts to which the Court applies federal law in order to
reach its conclusions, and whether a particular fact should be
established by means of state law is a matter of legislative
intent. Morgan v. Commissioner, 309 U.S. 78, 80-81, 60 S.Ct. 424,
425-26, 84 L.Ed. 1035 (1940); Burnet v. Harmel, 287 U.S. 103,
110, 53 S.Ct. 74, 77, 77 L.Ed. 199 (1932). As explained in
State law creates legal interests and rights. The
federal revenue acts designate what interests or
rights, so created, shall be taxed. Our duty is to
ascertain the meaning of the words used to specify
the thing taxed. If it is found in a given case that
an interest or right created by local law was the
object intended to be taxed, the federal law must
prevail no matter what name is given to the interest
or right by state law.
309 U.S. at 80-81, 60 S.Ct. at 426. In this case, section 267 of
the Code intends to disallow deductions resulting from losses
from the transfer of property between trusts that have the same
grantor. Thus, this Court must determine whether Congress
intended the term "grantor" in section 267 of the Code to be
determined by reference to state law, or whether a more uniform
federal tax law is determinative. Where, as here, there is no
explicit reference to state law in the statute, the intent of
Congress must be ascertained in accordance with principles
established by a number of Supreme Court cases in this area.
Supreme Court Guidelines
The first general principle enunciated by the Supreme Court and
the principle most often stated by recent decisions is that state
law initially determines the specific consequences of the legal
relationship in issue; those consequences are then applied to
standards established by federal tax law to determine if and when
they should be taxed. Burnet, 287 U.S. at 110, 53 S.Ct. at 77;
Lyeth v. Hoey, 305 U.S. 188, 59 S.Ct. 155, 83 L.Ed. 119 (1938);
Helvering v. Stuart, 317 U.S. 154, 63 S.Ct. 140, 87 L.Ed. 154
(1942). See also, Independence Bank Waukesha (N.A.) v. United
States, 761 F.2d 442, 444 (7th Cir. 1985) ("[a] determination of
the legal rights and interests created by an instrument is a
question of state law."); Brantingham v. United States,
631 F.2d 542, 545 (7th Cir. 1980) (same); Little v. United States,
704 F.2d 1100 (9th Cir. 1983) ("state law controls in determining the
nature of the legal interest which the taxpayer has in the
property sought to be reached by the federal statute."). Thus,
once it is determined that the taxpayer possesses a certain legal
relationship to property recognizable under state law, the
federal tax consequences of such rights are solely a matter of
federal law. As a consequence of this principle, for example,
liens provided by federal statute may not be defeated by state
exemption statutes. United States v. Bess, 357 U.S. 51, 57, 78
S.Ct. 1054, 1058, 2 L.Ed.2d 1135 (1958).
This apparently broad principle, however, has not been
interpreted to mean that every peculiarity and special incidence
of local law controls in applying federal tax law. For instance,
in Lyeth v. Hoey, 305 U.S. 188, 59 S.Ct. 155, 83 L.Ed. 119
(1938), the Supreme Court held that pursuant to section 22(b)(3)
of the Revenue Act of 1932 — permitting an exemption for the
"value of property acquired by bequests, devise or inheritance"
— the plaintiff's status as an heir should be determined by state
law. But once it was established that plaintiff was an heir, "the
question whether what the heir had thus received had been
`acquired by inheritance' within the meaning of the federal
statute necessarily is a federal question. It is not determined
by local characterization." Id. In so holding, the Court
[i]n dealing with the meaning and application of an
act of Congress enacted in the exercise of its
plenary power under the Constitution to tax income
and to grant exemptions from that tax, it is the will
of Congress that controls, and the expression of its
will, in the absence of language evidencing a
different purpose, should be interpreted "so as to
give a uniform application to a nationwide scheme of
Id. at 194, 59 S.Ct. at 158 (quoting Burnet v. Harmel, supra, 287
U.S. at 110, 53 S.Ct. at 77.)
Applying this standard to the facts of Lyeth, the Court held
that in framing the statute in words such as "inheritance,"
"devise" and "bequest," Congress "used comprehensive terms
embracing all acquisitions in the devolution of a decedent's
estate." Id. at 194, 59 S.Ct. at 159. This persuaded the Court to
hold that although a person's status as an heir is determined by
state law, Congress intended a uniform federal meaning to be
given to the phrase "acquired by inheritance."
Another case emphasizing Congress' intent to provide for a
generally uniform application of tax law is Rogers' Estate v.
Helvering, 320 U.S. 410, 64 S.Ct. 172, 88 L.Ed. 134 (1943). In
that case, the Court
held that although state law determines the attributes of a power
of appointment, federal law determines whether the power is
"general" or "special" regardless of the state terminology. Cf.
Morgan, supra, 309 U.S. 78, 60 S.Ct. 424. Again the problem of
attempting to insure a uniform tax structure given a preexisting
structure of state property law was addressed:
Whether for purposes of local property law
testamentary dominion over property is deemed a
"special" or a "general" power of appointment, . . .
whether local tax legislation deems the appointed
interest to derive from the will of the donor or that
of the donee of the power, . . . whether for some
purposes in matters of local property law title is
sometimes traced to the donee of a power and for
other purposes to the donor . . . are matters of
complete indifference to the federal fisc.
Whether by a testamentary exercise of a general
power of appointment property passed under § 302(f)
is a question of federal law, once state law has made
clear, as it has here, that the appointment had legal
validity and brought into being new interests in
property. . . . Were it not so, federal tax
legislation would be the victim of conflicting state
decisions on matters relating to local concerns and
quite unrelated to the single uniform purpose of
federal taxation. . . . In taxing "property passing
under a general power of appointment exercised . . .
by will", Congress did not deal with recondite
niceties of property law nor incorporate a crazyquilt
of local formalisms or historical survivals."
Id. 320 U.S. at 413-14, 64 S.Ct. at 174. (Emphasis added and