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Pfluger v. Commissioner of Internal Revenue

decided: March 7, 1988.


Appeal from the United States Tax Court, No. 82-30209-Charles P. Simpson, Judge.

Cummings, Cudahy and Posner, Circuit Judges.

Author: Cudahy

CUDAHY, Circuit Judge.

Six years ago this court attempted to thwart the proliferation of "family trusts," tax avoidance devices that have as their central feature the anticipatory assignment of income to a trust controlled by the taxpayer. See Schulz v. Commissioner, 686 F.2d 490 (7th Cir. 1982). In that opinion, Judge Cummings said:

Given the deeply rooted instinct not to pay more taxes than the law requires and the endless changes that can be rung on trust draftsmanship, we do not suppose that any single opinion can put a definitive end to . . . family trusts.

Id. at 497. This case involves an altered version of the family trust device disallowed in Schulz. We find that the new version leads to the same legal conclusions. We also find petitioners' other contentions meritless and affirm the Tax Court's decision upholding a deficiency and negligence penalty.


Petitioner Robert Pfluger,*fn1 a dentist, became disillusioned with the federal income tax system after having to borrow money to pay in 1979 taxes. He undertook extensive research into the tax system and concluded that the federal income tax was an unconstitutional "leveling" device.*fn2 He also attended meetings of individuals interested in reducing their tax burden; at one such meeting he learned about "family trusts."

Dr. Pfluger was intrigued by the potential tax benefits that the family trust arrangement seemed to provide. He was, however, aware that similar devices had been struck down by the courts and the Internal Revenue Service (the "IRS"). Nonetheless, after a brief consultation with his attorney and numerous conversations with the provider of the trust documents, Dr. Pfluger decided to forge ahead.

On February 23, 1980, Dr. Pfluger executed the "Family Trust Indenture of the Robert A. Pfluger Family Trust." Dr. Pfluger was the grantor of the trust. In return for the entire beneficial interest he assigned "the exclusive use of his lifetime services" and certain specified property to the trust. See Petitioners' Exhibit 4 at 3. His wife and brother-in-law were the initial trustees, but within two days of the indenture's execution Dr. Pfluger had replaced his brother-in-law as co-trustee. See Petitioners' Exhibit 5 at 2. Thus, Dr. Pfluger was grantor, co-trustee and sole beneficiary of the family trust.*fn3

Up to this point, the case before us resembled a "typical" family trust case, in which the taxpayer "assigns" his income to the trust and the trust funds are used to cover his personal expenditures, purportedly allowing deduction of those expenditures. See, e.g., Schulz, 686 F.2d at 492-93. This court in Schulz, and every other court to consider the issue in cases too numerous to catalogue, has held that this family trust arrangement is an invalid anticipatory assignment of income under Lucas v. Earl, 281 U.S. 111, 74 L. Ed. 731, 50 S. Ct. 241 (1930). See, e.g., Schulz, 686 F.2d at 493.*fn4 Dr. Pfluger did not follow a straight assignment of income path, however; in fact, he did not attempt to assign his professional receipts directly to the trust. Instead, on February 25, 1980, two days after executing the indenture, he entered into a contract with the trust. The trust was represented in the "negotiations" by Dr. Pfluger and his wife. Under the contract the trust agreed to manage Dr. Pfluger's dental practice*fn5 in return for a management fee, expressed as a percentage of Dr. Pfluger's gross income. The percentage was left blank, to be filled in later by Dr. Pfluger.

After purportedly researching the average business expenses of dentists nationwide, Dr. Pfluger set the management fee at approximately sixty percent of his gross income.*fn6 On their 1980 tax return, the Pflugers reported $159,091 in gross income from the dental practice; they then deducted a "management fee" of $95,000 allegedly paid to the trust.*fn7 They also claimed deductions for office expenses and wages paid directly by Dr. Pfluger, all of which were to be paid by the trust under the February 25 contract. The trust in turn reported income of $95,000 and deductions of $61,280.

The IRS audited the Pflugers. It first determined that the trust should be disregarded for tax purposes. The government therefore sought to redetermine the Pflugers' tax by allowing the couple to directly deduct all substantiated business expenses, ignoring the management fee and treating expenses paid by the trust as expenses paid by the taxpayers. The Pflugers, however, refused to turn over any documents to the IRS. The Service was left with no choice; it disallowed the $95,000 deduction and all other deductions and assessed a deficiency of $42,762 and a negligence penalty under Internal Revenue Code section 6653(a), 26 U.S.C. ยง 6653(a), of $2,138.

The Pflugers petitioned the Tax Court for a redetermination of the deficiency. They then refused the government's repeated discovery requests, turning over only the trust indenture and the February 25 contract. The IRS moved for an order compelling compliance with discovery requests and for sanctions if the Pflugers continued their obstinate conduct. The Pflugers continued to refuse cooperation.

After a hearing on the sanctions motion, the court entered an order that states in part:

[T]he petitioners are prohibited from introducing any of the documents which had been requested by the respondent in his request for production of documents and which had been ordered to be produced by the Court's order of May 25, 1984. The petitioners are also prohibited from attempting to prove ...

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