The Commissioner determined a deficiency of $7,577 in the petitioners’ Federal income tax for 1973. Due to concessions by the parties, the only issue for decision is whether the amounts paid as rent by Dr. May in 1973 to an irrevocable trust created by the petitioners for the benefit of their children constituted an ordinary and necessary business expense under section 162(a) of the Internal Revenue Code of 1954.1
FINDINGS OF FACT
Some of the facts have been stipulated, and those facts are so found.
The petitioners, Lewis H. V. and Nancy C. May, husband and wife, maintained their legal residence in Arcadia, Calif., when they filed their petition in this case. They filed a joint Federal income tax return for 1973 with the Internal Revenue Service, Fresno, Calif.
During the taxable year 1973, Lewis H. V. May was a doctor of medicine engaged in the general practice of medicine at 5807 Temple City Boulevard, Temple City, Calif. The doctor had been conducting his practice in a building situated on such property for some years prior thereto. The petitioners owned, as tenants by the entirety, the land and medical building at 5807 Temple City Boulevard (the medical property), which was encumbered by a mortgage.
In 1970, Dr. May contacted an attorney for the purpose of arranging a transfer of the medical property in trust. The attorney drafted a declaration of trust setting forth that the “Trustors,” the petitioners, “have delivered” to Lewis H. V. May and Harlos Gross, as “Trustees,” all their right, title, and interest in and to the medical property. In the declaration, the trustees acknowledged delivery of the property to them and agreed to hold the property in trust for the benefit of the petitioners’ four children. On January 15,1971, Dr. May and Mr. Gross executed the declaration as trustees, and petitioners, as trustors, executed the following statement, which was attached to the declaration: “We certify that we have read the foregoing Declaration of Trust (Irrevocable), and that it correctly states the terms and conditions under which the Trust Estate is to be held, managed and disposed of by the Trustees. We approve the Declaration of Trust in all particulars, and have requested the Trustees to execute it.” The declaration described the medical property as having a value of $46,504 and encumbered by trust deed notes aggregating $21,619.
The petitioners first became acquainted with Mr. Gross in 1957. Mr. Gross owned the grocery store at which the petitioners shopped, and he became acquainted with the May family. He also participated in various civic organizations with Dr. May. Mr. Gross and his family had, at various times, been patients of Dr. May. Mr. Gross was not related to the petitioners by blood or marriage. Mr. Gross had been a trustee of other trusts and was familiar with the duties of a trustee. He served as trustee of the May trust without compensation.
The declaration of trust creates four separate irrevocable trusts, one for the benefit of each of the petitioners’ children. The income is payable currently, except that during the minority of a beneficiary, his share of the income is accumulated until he reaches age 21. The trustees are given the power to apply either income or corpus for the education, maintenance, medical care, or support of a beneficiary but not in discharge of any parental obligation of petitioners. The trustees are required to distribute any accumulated income and corpus to a beneficiary when he attains age 25.
The trust cannot be amended, altered, or revoked by any person prior to termination. In the declaration of trust, the trustors “relinquish, absolutely and forever, all their possession of, or enjoyment of, or right to or income from, the Trust property” and “expressly renounce for themselves, and for their estates, any and all interest, either vested or contingent, including any reversionary interests or possibility of reverter, in the income or corpus of these Trusts.” The declaration of trust further provides that no part of the corpus or income of the trust should ever be used for the benefit of the trustors nor should it be used to pay premiums on insurance policies on their lives or to satisfy their legal obligations. Trustors relinquish all further right to designate, alter, amend, or in any way change the designation of beneficiaries.
Under the declaration of trust, the trustees are given broad powers to manage the trust property, including the powers to lease the property, to make improvements, to borrow money, and to invest trust assets in both low-risk and speculative ventures. The declaration specifically ^ests the trustees with “all the rights, powers and privileges which an absolute owner of the same property would have.” However, the powers of the trustees are subject “always to the discharge of their fiduciary obligations” and to the exercise of reasonable prudence in making investments. Also, neither the trustors nor the trustees are allowed to deal with or dispose of the corpus or income of the trust for less than an adequate consideration, nor can they borrow all or part of the trust corpus or income without adequate interest or security.
The declaration of trust makes no provisions for resolving disputes which may arise between the two trustees. It designates the individuals to succeed Dr. May and Mr. Gross as trustees, with the limitation that Dr. and Mrs. May shall not serve as trustees at the same time. The original trustees are to receive no compensation, but compensation is to be paid to successor trustees.
The names and birth dates of the petitioners’ children are as follows:
Charles H. V. May .Nov. 30, 1954
Robert Cass May .July 9, 1956
Matthew Franklin May .Feb. 24, 1958
Lewis H. V. May II .Nov. 22, 1960
The trustors executed a deed transferring title to the medical property to the trustees. The deed was acknowledged on September 20, 1973, and was recorded in the official records of Los Angeles, Calif., on October 2, 1973. The deed was actually prepared at the time of the execution of the declaration of trust. Although the deed now bears an execution date of September 20, 1973, the original execution date on the deed had been erased.
After January 15, 1971, the petitioners and the cotrustees proceeded as if all the necessary steps had been taken to establish the trust for the medical property. Dr. May was the sole occupant of such property prior to the execution of the declaration of trust, and thereafter, he continued to be the sole occupant of such property. Gift tax returns were timely filed by the petitioners reflecting the gift of their interests in the property. A fiduciary income tax return was filed by the trust for each of the taxable years 1971, 1972, and 1973, in which deductions were claimed for distributions of income to the beneficiaries. From 1971 through 1973, the trust paid the installments on the mortgage on the medical property.
When the declaration of trust was executed, it was understood that the trustees would enter into a lease with Dr. May for the rental of the medical property whereby he would pay all taxes, insurance, utilities, and other operating expenses, and a rental of $1,000 per month. The petitioners’ attorney prepared a rough draft of the lease. In April 1972, the attorney left private practice and turned the matter over to another law firm. The lease was never executed. During the taxable years 1971 through 1973, Dr. May paid $1,000 per month to the trust as rent; he also paid taxes and other expenses of the property. Mr. Gross assumed that there was an executed lease and that title to the property had been transferred to the trust, but he made no independent investigation to determine whether a lease had been executed and the transfer completed. However, Mr. Gross testified that he “checked the checkbook about four times a year” and “looked to see if the rent had been paid.” A rental of $1,000 per month net to the trust was a reasonable rental for the medical property.
On their Federal income tax return for 1973, the petitioners deducted the payments made by Dr. May as rent. In his statutory notice of deficiency, the Commissioner disallowed the entire deduction. In explanation thereof, the Commissioner stated that:
The deduction claimed of $12,000.00 for rent on business property paid to a family trust is not allowed because it has not been established that these expenses were incurred or, if incurred, were expended for ordinary and necessary business expense. Therefore, your taxable income is increased by such amount.
OPINION
The only issue in this case is whether the payments made by Dr. May as rent in 1973 were ordinary and necessary business expenses under section 162(a). In part, that section provides:
There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including—
Hi * * * % * ‡
(3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.
The Commissioner concedes that the payments were made by Dr. May, that such payments constituted reasonable rental for the medical property, and that such property was used in Dr. May’s medical practice. Nevertheless, the Commissioner contends that the payments are not deductible because the transfer in trust should not be recognized for tax purposes. In the first place, he argues that under California law, a valid trust was not created because there was no effective transfer of the medical property in trust. In the alternative, he argues that even if such transfer took place, the trust should not be recognized for tax purposes because Dr. May never relinquished control of the medical property.
The Commissioner’s alternative argument will be considered first, and for purposes of such consideration, we shall assume that the medical property was transferred in trust before 1973. Yet, such fact by itself does not entitle the petitioners to the deduction for rent. When a taxpayer transfers property to a trust and names the members of his family the beneficiaries and himself the trustee, the transaction must be closely scrutinized to determine whether substance comports with form.2 Helvering v. Clifford, 309 U.S. 331, 335 (1940); Penn v. Commissioner, 51 T.C. 144, 149-150 (1968); Van Zandt v. Commissioner, 40 T.C. 824 (1963), affd. 341 F.2d 440 (5th Cir. 1965), cert. denied 382 U.S. 814 (1965). In Mathews v. Commissioner, 61 T.C. 12 (1973), revd. 520 F.2d 323 (5th Cir. 1975), cert. denied 424 U.S. 967 (1976), this Court drew upon the numerous decisions dealing with whether the grantor of such a trust may deduct payments made by him to the trust as rent, and we set forth the following criteria for deciding whether the deduction is to be allowed:
(1) The grantor must not retain substantially the same control over the property that he had before he made the gift.
(2) The leaseback should normally be in writing and must require payment of reasonable rent.
(3) The leaseback (as distinguished from the gift) must have a bona fide business purpose.3
(4) The grantor must not possess a disqualifying “equity” in the property within the meaning of section 162(a) (3).
Since Mathews, we have continued to rely upon these criteria in deciding cases involving gift-leaseback transactions. E.g., Lerner v. Commissioner, 71 T.C. 290 (1978); Quinlivan v. Commissioner, T.C. Memo. 1978-70, affd. 599 F.2d 269 (8th Cir. 1979), cert. denied 444 U.S. 996 (1979); Serbousek v. Commissioner, T.C. Memo. 1977-105.
Here, during 1973, the petitioners did not have an equity in the medical property in the sense of a property right “which traditionally would have been enforceable by means of an equitable remedy.” Oakes v. Commissioner, 44 T.C. 524, 531 (1965). Under the declaration of trust, the sole equitable owners of the property were the petitioners’ children. Moreover, Dr. May required the property for his medical practice, and therefore, the leaseback had a bona fide business purpose. Lerner v. Commissioner, supra at 302.
Our statement in Mathews that the leaseback should “normally” be in writing reflects our view that the requirement of a written lease is not absolute. See Brooke v. United States, 468 F.2d 1155 (9th Cir. 1972), affg. 300 F. Supp. 465 (D. Mont. 1969). While there was no written lease of the trust property, we are satisfied on the present record that the terms of the lease were clearly understood by the trustees and faithfully observed by the parties. Accordingly, we feel that the requirement of a written lease need not be imposed here.
The requirement that the rent be reasonable finds its roots in the statutory mandate that the rent be “required.” Sec. 162 (a) (3). In seeking to determine whether reasonable rent was paid as evidencing payment of a required rent, courts have sometimes examined the lessor/trustee to determine whether he is independent of the lessee/grantor. Where, as here, the reasonableness of the rent paid is conceded, inquiry into the independence of the lessor is unnecessary to make the requisite determination to satisfy this prong of the Mathews test.
The remaining prong of the Mathews test — that the grantor must not retain substantially the same control over the property that he had before he made the gift — has also caused courts to consider the independence of the trustee in a gift-leaseback situation. As the Ninth Circuit stated: “Many decisions pivot on the issue of the independence of the trustee.” Brooke v. United States, 468 F.2d at 1157.
In the present case, it is noteworthy that the gift of the property by petitioners to the trust was of their entire interest in the property and irrevocable. This distinguishes the instant case from those involving a transfer in trust with a reversion to the grantor. See, e.g., Helvering v. Clifford, supra; Van Zandt v. Commissioner, supra; Penn v. Commissioner, supra.
Nor does the instant case involve a sole trustee who is also the grantor. The trustees herein are Dr. May and Mr. Gross. At the trial, Mr. Gross testified that as trustee he felt independent of Dr. May. Mr. Gross had previously served as a trustee for other trusts, and testified that he was aware of the fiduciary nature of the position and of the statutory liability imposed on trustees by the State of California. Cal. Civ. Code Ann. secs. 2228-2239 (West 1954). See Goodman v. Commissioner, 74 T.C. 684 (1980), and cf. Brooke v. United States, supra. Mr. Gross monitored the rental payments to the trust through examination of the checkbook each quarter.
While Mr. Gross might have expended more time and exercised more detailed supervision of the day-to-day operations of the trust, we are persuaded that, under the present facts, his actions as trustee were sufficient to establish his independence. The management of the trust corpus, due to its size and lack of complexity, required no more. Accordingly, we need not decide whether an independent trustee is required in every gift-leaseback case, for we are satisfied that Mr. Gross is sufficiently independent to meet the tests of Mathews: the rent paid under the lease was reasonable, the leaseback had a bona fide business purpose, the grantors did not possess a disqualifying equity in the property; and the grantors’ control over the property was not substantially the same control possessed before the gift.
Concerning respondent’s first argument — that under California law, a valid trust was not created because there was no effective transfer of the medical property in trust — we find that the trust instrument effectuated a valid transfer. Keogh v. Noble, 136 Cal. 153, 68 P. 579 (Cal. 1902); Olsen v. Cornwell, 134 Cal. App. 419, 25 P.2d 879 (1933); Cal. Civ. Code Ann. secs. 2221, 2222, 1091 (West 1954). In this regard, we need not consider the deed which petitioners alternatively introduced as evidence of the transfer. See Weiner v. Mullaney, 59 Cal. App. 2d 620, 140 P.2d 704 (1943). The declaration of trust adequately declared the trust of the property and accomplished the necessary transfer of petitioners’ entire right, title, and interest in the property to the trust on January 15, 1971. That being the case, and all other criteria for deductibility having been met, we hold that petitioners are entitled to deduct the rental paid by Dr. May for the use of the medical property.
Due to concessions by the parties,
Decision will be entered under Rule 155.
Reviewed by the Court.
Dawson, J., did not participate in the consideration or disposition of this case.All statutory references are to the Internal Revenue Code of 1954 as in effect during 1973.
Whether a transfer of property to a trust is recognized for tax purposes determines not only whether a deduction is allowable to the grantor for the rent paid by him on the leaseback of such property, but also whether the grantor is taxable on the trust’s income. In secs. 671-676, Congress enacted specific rules to determine who is taxable on a trust’s income, but such rules have no bearing on the deduction issue. Penn v. Commissioner, 51 T.C. 144, 150 (1968); Lerner v. Commissioner, 71 T.C. 290, 299 (1978).
The Commissioner vigorously argues that a gift-leaseback is in substance a single transaction, and that unless there is a business purpose for the entire arrangement, the transaction should not be recognized. However, we have considered such argument numerous times and have declined to adopt it. See Lerner v. Commissioner, 71 T.C. 290, 300 (1978); Mathews v. Commissioner, 61 T.C. 12 (1973), revd. 520 F.2d 323 (5th Cir. 1975), cert. denied 424 U.S. 967 (1976); Oakes v. Commissioner, 44 T.C. 524, 532 (1965); see also Skemp v. Commissioner, 168 F.2d 598 (7th Cir. 1948), revg. 8 T.C. 415 (1947); Brown v. Commissioner, 180 F.2d 926 (3d Cir. 1950), revg. 12 T.C. 1095 (1949); compare Perry v. United States, 520 F.2d 235 (4th Cir. 1975), cert. denied 423 U.S. 1052 (1976); Audano v. United States, 428 F.2d 251 (5th Cir. 1970). We perceive no reason to reconsider the matter in this case.