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March 14, 1986


The opinion of the court was delivered by: Mills, District Judge:


A question of taxes.

The Trustees of the Scully Trusts filed this action against the United States, seeking refunds of alleged overpayments of tax resulting from a re-valuation of property sold by the trusts. The parties filed cross motions for summary judgment pursuant to Fed.R.Civ.P. 56.

On May 23, 1985, United States Magistrate Charles H. Evans entered a recommendation that the Trustees' motion for summary judgment be denied, and that the Government's motion for summary judgment be granted. In accordance with Fed.R.Civ.P. 72, objections of the Trustees to the recommendation and the Government's response are now before the Court, both supported by the well prepared memoranda of the parties.


The trustees and the Commissioner are in agreement as to the broad outline of the facts. The cause concerns the sale of portions of large tracts of farmland over which the Scully family has exercised ownership and careful stewardship for several generations. In 1959, Thomas A. Scully created two trusts, one for the benefit of his lineal descendants per stirpes through his son, Peter, and one for the benefit of his lineal descendants per stirpes through his son, Michael. Mr. Scully endowed each trust with tracts of farmland and named his two sons co-trustees of both trusts. The trust agreement essentially grants a life estate to all of Mr. Scully's grandchildren with the corpus to be distributed per stirpes ten years after the death of the last person to die among those listed in the trust agreement. The Court will refer to these trusts as the "family trusts." Upon Mr. Scully's death (approximately two years after the creation of the family trusts), Mr. Scully created by his will two more trusts, a "marital trust" and a "residuary trust." His will named his two sons trustees of these two trusts as well.

The disposition of the marital trust is directly at issue here. Mr. Scully's will provided that his wife, Violet (Mrs. Scully), should receive the income from the marital trust's assets for life and should have the power to appoint the disposition of the assets upon her death. In default of appointment by Mrs. Scully, the assets were to be added to the residuary trust and, in accordance with that trust's provision, distributed eventually to Mr. Scully's lineal descendants per stirpes.

Mrs. Scully died in 1976. She exercised her power of appointment by directing the trustees of the marital trust to donate a relatively small amount of land to the Lincoln County Park and Trails Foundation and to divide the remainder of the trust corpus equally between her sons' families, then evenly among her grandchildren in each of the two families. She further directed that her sons, Peter and Michael, serve as co-trustees for each of the resulting nine trusts. The Court will refer to these trusts as the "individual trusts."

This litigation concerns two sets of trusts: the two "family trusts" (one trust for each of the two sons' children as a group) arising during Mr. Scully's lifetime and one set of nine individual trusts (one trust for each of the nine grandchildren) arising at the time of Mrs. Scully's death.

In her will, Mrs. Scully directed the executors of her estate, her sons Peter and Michael, to pay or arrange for payment of administrative expenses, cash bequests, and estate tax liabilities. Mrs. Scully's estate, however, lacked liquid assets sufficient to satisfy the bequests and charges. In order to raise the necessary funds, the executors, acting in their capacity as trustees of the individual trusts, sold land held by the individual trusts to the two family trusts for which they also acted as trustees. The individual trusts sold and the family trusts purchased the farm real estate 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 ...

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