*164 Decisions will be entered under Rule 50 in docket Nos. 91844, 93682, and 91845.
Decision will be entered for petitioners in docket No. 93683.
Under the will of her first husband May Hrobon was entitled to receive all the income of the Clay M. Thomas trust for life with the remainder going to the heirs of Clay M. Thomas upon May's death. The principal asset of the trust consisted of a laundry and linen supply business which had been operated as a proprietorship and which the trustee continued to operate quite successfully as such from the date of Thomas' death in 1938 to date. In November 1955, May entered into an agreement with Emil Hrobon, whom she had married in 1939 and divorced in 1952, whereby she transferred all her right, title, and interest in her life estate in the trust to Emil and Emil agreed to pay her 60 percent of the net annual distributions of the trust. Held:
1. In substance for tax purposes May transferred all her equitable interest in the corpus of the trust, the terminal interest she may have had in the estate, and 40 percent of the distributions of the trust to Emil and retained 60 percent of the net distributions of the trust for herself.
2. The*165 60 percent of the net distributions of the trust received by May during 1956-59 were taxable to her as ordinary income and not as capital gain.
3. May made a taxable gift to Emil in 1955 of the value of the right to receive 40 percent of the distributions of the trust during May's life and certain terminal rights which might belong to the owner of the life interest upon termination of the trust, including an undistributed accumulated income account; which value is found to be $ 900,000.
4. May's failure to file a gift tax return for 1955 was due to reasonable cause and not due to willful neglect. Addition to gift tax not imposed.
5. Emil Hrobon is not taxable on any part of the net distributions of the trust paid to May during the years 1956 and 1957.
*477 The principal issue in these consolidated proceedings is whether the transaction of November 9, 1955, whereby May T. Hrobon, hereinafter referred to as May, purportedly sold her life interest in the Clay M. Thomas trust to Emil M. Hrobon, hereinafter referred to as Emil, for $ 800,000 payable out of 60 percent of the distributable income of the trust, was in fact a sale of a capital asset by May, as contended by petitioners; or was a gift of 40 percent of the income of the trust and certain terminal rights which might*167 inure to the life tenant by May to Emil with a reservation of 60 percent of the income to May, as contended by respondent.
In docket Nos. 91844 and 93682 respondent determined a deficiency in May's income tax for the taxable years 1956 through 1959 in the amounts of $ 64,133.89, $ 74,208.36, $ 81,455.29, and $ 108,341.42, respectively. The explanation of the adjustment for each of those years which is in issue here, differing only with respect to the year and the amount, is set forth in the deficiency notice as follows:
(a) It has been determined that pursuant to the agreement entered into on November 9, 1955 by you and Emil M. Hrobon, you reserved the right to receive from Emil M. Hrobon 60 percent of the net distributions made by the trustee of the Clay M. Thomas trust to the income beneficiary, and such right was to be charged against the income from the trust. Accordingly, 60 percent of the net distribution of income for the calendar year ending December 31, 1956, or $ 117,681.16 is taxable to you as constituting gross income as provided under section 61 of the Internal Revenue Code of 1954.
Should the agreement that was entered into on November 9, 1955 between you and Emil *168 M. Hrobon be considered a sale of the right to receive during your lifetime 60 percent of the net distributions from the Clay M. Thomas trust, it is determined that you realize a capital gain to the extent that the proceeds received during the calendar year ending December 31, 1956 exceeded your adjusted basis in the right to receive 60 percent of the net distributions of income from the Clay M. Thomas trust.
*478 In docket No. 91845 respondent also determined a deficiency in gift tax of May for the year 1955 in the amount of $ 314,539.94, and an addition to tax under section 6651(a), I.R.C. 1954, in the amount of $ 78,634.99, with the following explanation:
It has been determined that you, as donor, on November 9, 1955, made a gift to Emil M. Hrobon, the donee, of 40 percent of your right, as the life tenent [sic], to receive the income distributions from the Clay M. Thomas trust of Columbus, Ohio, plus a gift to him of 100 percent of all other rights, title or interest you had in the trust, including any interest you or your heirs might leave upon your death or upon the termination of the trust, whichever event first occurs.
In docket No. 93683 respondent determined deficiencies*169 in the joint income tax of Emil M. Hrobon and Maxine Hrobon for 1956 and 1957 in the amounts of $ 33,802.75 and $ 41,787.07, respectively, by allowing petitioners to amortize the cost of the life interest only over the life expectancy of May, rather than as the payments were made as claimed on their returns. By amended answer, respondent asserts increased deficiencies in the income tax of Emil and Maxine for 1956 and 1957 in the amounts of $ 34,257.10 and $ 36,153.34, respectively, by allowing petitioners to amortize only that portion of the purchase price determined to be allocable to the wasting asset, i.e., the income of the trust distributable to May during her lifetime. Petitioners, by amended petition, claim an overpayment of tax should the Court determine that petitioners may amortize the cost of the life interest in the trust acquired by Emil over the subjective life expectancy of May, the life tenant, rather than as the payments are made on the purchase of the life interest.
The questions presented for our decision are as follows:
(1) Whether May transferred her entire life interest in a trust to Emil for a consideration of $ 800,000, or whether she reserved the right*170 to receive 60 percent of the net income distributions from the trust.
(2) Whether the amounts received by May after the above transaction are taxable to her as ordinary income or capital gain.
(3) Whether May transferred part of her interest in the trust to Emil as a gift in 1955 and if so, what was the value of the gift subject to gift tax.
(4) If May made a gift to Emil in 1955, whether her failure to file a gift tax return for that year was due to reasonable cause.
(5) If Emil did purchase May's entire life interest in the trust for $ 800,000, whether he may amortize all or part of the purchase price of the life interest so acquired over the life expectancy of May or as the payments are made to May. This question may also require a determination as to the life expectancy of May.
FINDINGS OF FACT
A stipulation of facts and supplemental stipulation of facts, together with numerous exhibits, were filed by the parties and are incorporated *479 herein by this reference. Only those facts which are necessary to an understanding of the issues will be set forth herein.
May T. Hrobon resides at 1969 Chatfield Road, Columbus, Ohio. She filed her Federal income tax returns for the *171 years 1956 through 1959 with the district director, Columbus, Ohio. Emil and Maxine Hrobon now reside at 912 Hall Street, Lancaster, Tex. They filed joint Federal income tax returns for 1956 and 1957 with the district director, Columbus, Ohio. Maxine Hrobon is involved only because she filed jointly with her husband, Emil.
Prior to his death in 1938 May was married to Clay M. Thomas (hereinafter called Thomas). After Thomas' death May married Emil on June 1, 1939. They were divorced in 1952. In 1953, Emil married Maxine.
In 1920, Thomas, with May's help, started a linen supply business known as Atlas Linen Laundry & Supply (hereinafter called Atlas) which business was operated as a proprietorship until Thomas' death, and consisted primarily of supplying clean linen and industrial garments to businesses in the vicinity of Columbus, Ohio. This business was quite successful.
Thomas died on April 14, 1938. His will and codicil created a trust wherein May was designated as life tenant after certain specific income legatees. The latter charges were completely satisfied by 1949. The will, executed January 23, 1936, and codicil, executed April 12, 1938, inter alia, contained *172 the following provisions.
All of the balance of my property, both real and personal, of every kind and description, wheresoever situated, which I may own or have the right to dispose of at the time of my decease, I give, bequeath and devise to my wife, Mae Thomas, in trust, for the benefit and the use of my wife, for and during her life; hereby directing my said trustee, Harry B. Holmes, to pay for her for her use and benefit all the income after the payment of operating expenses and taxes and other charges from my business at the Atlas Linen Laundry and Supply, or any other income that I may have after the payment of the other monthly legacies which I hereinbefore have set out, with full power granted to my said trustee to lease, transfer, or exchange any securities and property belonging to said trust fund for such prices and upon such terms and conditions as he may deem best, and for the best interests of my wife; * * * Upon the death of my said wife, the said trust as herein created shall cease, and the trustee or his successor shall convey and transfer to my legal heirs the balance of the said property, share and share alike, at the time of the death of my said wife.
ITEM VI.
*173 I make, nominate and appoint my attorney, Harry B. Holmes, of Columbus, Ohio, to be the executor and trustee of this, my last will and testament, with full power and authority to conduct and carry on the laundry business now conducted by me, and to do all things necessary or proper in the usual course of said business until such a time as the same can be sold, as a going business for a price which, in the opinion of my said executor, and in the opinion of my said wife, Mae Thomas, is a reasonable value thereof, and with full power and authority to sell and dispose of any or all of my estate * * *
*480 CODICIL TO MY LAST WILL AND TESTAMENT
I further authorize and empower my said trustee, Harry B. Holmes, in the exercise of his discretion, to carry on any and all business conducted by me at the time of my decease, or in which I may then be interested, whether alone or in partnership with others, and to continue the same for such time, as in the judgment of the said trustee, shall be for the best interest of my estate, and to extend or renew any such relationships, or to terminate, as the trustee shall think fit, but it is my wish that the said trustee continue my Linen and Laundry*174 business as long as the same may be profitable.
At the time of his death, Thomas was survived by his wife, May, a brother, Ray Thomas, and two sisters, Millie K. Watson and Clara Mann.
The will and codicil were admitted to probate and Harry B. Holmes qualified as executor of the estate on April 19, 1938. The assets and liabilities of the estate as adjusted for Federal estate tax purposes, consisted of assets valued at $ 391,946.37 and liabilities of $ 201,733.40, or a net estate of $ 190,212.97. Holmes closed administration of the estate on December 31, 1938, whereupon as trustee he commenced management of the trust. The principal assets of the trust consisted of the assets of Atlas which Holmes, acting as trustee, continued to operate until his death in 1958. Under Holmes' management the business of Atlas expanded greatly and continued to be even more successful, as indicated by the income figures related hereafter.
Commencing in 1946 May made certain demands upon the trustee to pay over to her additional income, asserting unauthorized diversion of the profits of Atlas and the income of the trust to pay the specific legacies and to provide capital for Atlas. On October 3, 1946, *175 an action was started in the Probate Court by the trustee seeking a declaratory judgment construing the will. The specific legatees joined with the trustee in the prayer for relief. May's answer denied the allegations and asked for affirmative relief.
The Probate Court appointed a special master commissioner to take testimony. Several volumes of testimony and hundreds of exhibits were submitted at this hearing, which extended over a period of many weeks. The special master commissioner submitted his report, which contained findings of fact and conclusions of law. A judge of the Court of Common Pleas, Franklin County, Ohio, was appointed acting probate judge to determine the matter, and judgment was rendered in the Probate Court on April 19, 1949.
Notice of appeal from the judgment of the Probate Court on questions of law and fact were filed on behalf of the life tenant, May. The Court of Appeals, Franklin County, Ohio, appointed a referee to consider the matter and his report was filed on January 2, 1951. Motions were filed with the court by the trustee and specific legatees to confirm *481 the report of the referee, and by the life tenant to vacate and set aside the report*176 of the referee and grant a new trial.
The Court of Appeals, on April 19, 1951, handed down a 92-page opinion, reported at 93 Ohio App. 1">93 Ohio App. 1, affirming the referee in part and overruling in part. From this judgment two appeals were perfected to the Supreme Court of Ohio; one by the trustee and the other by the specific legatees.
During the pendency of the declaratory judgment proceeding, May brought charges to remove the trustee and to terminate the trust, which applications were denied. Following the decision of the Supreme Court of Ohio, an action was filed on behalf of the life tenant, on June 1, 1953, to disentail a portion of the principal of the trust, which action was subsequently dismissed by the court. Annually, beginning with 1946 and continuing through 1957, with the exception of 1953, exceptions were filed to the trustee's annual report. These exceptions had not been pressed for hearing for the years up to 1955.
The Supreme Court of Ohio, in its decision in the declaratory judgment proceeding held, inter alia, as follows (as quoted from the syllabus):
(a) The trustee has power under such testamentary provisions to continue operation of the*177 business by using a portion of the income derived therefrom as capital for operation, maintenance and expansion of the business consistent with the manner of operation thereof by the testator and consistent with sound business judgment so long as the business is operated profitably and the widow, as life tenant, currently receives a reasonable share of such income.
(b) Such trust is not a static trust but is an active trust in which all the assets which constitute the trust corpus are used in the operation of the business, and the amount of the trust corpus should be shown on the books of account as the initial capital in the hands of the trustee. Such amount representing the corpus must not be reduced as a result of operation of the business, and such use of income by the trustee must not be permitted to result in currently increasing the corpus.
(c) The books of account should be so kept as to reflect currently the total net assets of the trust. The difference between the total net assets and the original amount of the corpus will represent additions to capital, resulting from the trustee's use of income, and the life tenant will be entitled to receive the amount of additional*178 capital so supplied from income upon sale of the business or termination of the trust, but such payment to her shall not reduce the amount of original corpus.
In addition, the court stated as follows, at page 523:
The court is mindful of the fact that upon sale of the business or termination of the trust there may be an item of intangible value, goodwill or going value, not represented by physical assets or cash in the hands of the trustee, the disposition of which may call for the court's determination at that time. No such issue is now before this court and this decision is not to be considered as dispositive of any such question or issues except to the limited extent herein stated.
*482 In accordance with the decision of the Supreme Court of Ohio, a certified public accounting firm prepared a report covering the period from May 1, 1938, through December 31, 1952, which report was filed in and approved by the Probate Court. This report reflected the following information concerning the trust:
| Estate corpus | $ 190,212.97 | |
| Less: Litigation expenses charged to corpus per court decision | 45,459.59 | |
| Net corpus | 144,753.38 | |
| Total income ultimately to be distributed to life tenant | 1,049,413.90 | |
| Less: Income distributed to life tenant | 697,179.29 | |
| Undistributed portion of trust income | 352,234.61 |
*179 The following schedule shows the amount of income of the trust before distribution to specific income legatees and the life beneficiary for the period May 1, 1938, through 1955:
| Period or year | Amount | Year | Amount |
| May 1 to Dec. 31, 1938 | $ 23,004.13 | 1947 | $ 69,440.41 |
| 1939 | 22,522.76 | 1948 | 116,743.25 |
| 1940 | 22,137.25 | 1949 | 110,576.83 |
| 1941 | 22,014.14 | 1950 | 92,733.72 |
| 1942 | 36,806.52 | 1951 | 105,451.65 |
| 1943 | 58,498.69 | 1952 | 133,886.45 |
| 1944 | 61,177.40 | 1953 | 156,542.51 |
| 1945 | 79,277.07 | 1954 | 1 169,081.01 |
| 1946 | 148,943.77 | 1955 | 2 89,837.01 |
The following schedule shows the net income of the Clay M. Thomas trust for income tax purposes before deduction for distributions to specific income legatees and the life beneficiary:
| Period or year | Amount | Year | Amount |
| May 1 to Dec. 31, 1938 | $ 23,004.13 | 1947 | $ 151,362.73 |
| 1939 | 22,522.76 | 1948 | 164,524.32 |
| 1940 | 22,137.25 | 1949 | 151,140.12 |
| 1941 | 22,014.14 | 1950 | 133,784.90 |
| 1942 | 41,522.14 | 1951 | 135,792.88 |
| 1943 | 62,487.67 | 1952 | 134,294.32 |
| 1944 | 62,786.18 | 1953 | 193,577.52 |
| 1945 | 83,614.38 | 1954 | 202,385.35 |
| 1946 | 158,027.36 | 1955 | 165,592.08 |
*180 The following schedule shows the amount of income distributed to or for the life beneficiary of the Clay M. Thomas trust from 1939 through 1955 per accounts filed in Probate Court: *483
| Period or year | Amount | Year | Amount |
| May 1 to Dec. 31, 1938 | 1947 | $ 45,000.00 | |
| 1939 | $ 11,569.73 | 1948 | 60,000.00 |
| 1940 | 8,407.53 | 1949 | 60,000.00 |
| 1941 | 16,267.83 | 1950 | 60,000.00 |
| 1942 | 17,684.99 | 1951 | 76,679.57 |
| 1943 | 28,400.46 | 1952 | 120,000.00 |
| 1944 | 61,244.59 | 1953 | 200,000.00 |
| 1945 | 42,206.04 | 1954 | 1 130,000.00 |
| 1946 | 89,718.45 | 1955 | 135,000.00 |
The following schedule shows the accumulated income fund of the Clay M. Thomas trust which, under the decision of the Supreme Court of Ohio, must ultimately be distributed to the life beneficiary:
| Period or year | Amount | Year | Amount |
| May 1 to Dec. 31, 1938 | $ 16,283.20 | 1947 | $ 173,278.83 |
| 1939 | 22,194.17 | 1948 | 227,622.54 |
| 1940 | 31,234.29 | 1949 | 277,309.96 |
| 1941 | 32,041.66 | 1950 | 309,576.68 |
| 1942 | 46,064.02 | 1951 | 338,348.16 |
| 1943 | 70,217.55 | 1952 | 352,234.61 |
| 1944 | 65,557.85 | 1953 | 308,777.12 |
| 1945 | 97,796.34 | 1954 | 347,858.13 |
| 1946 | 152,902.33 | 1955 | 302,695.14 |
*181 The trust has paid income tax on this undistributed income of the trust.
Under the terms of the will the trust ceases upon the death of May and the corpus is distributable to Clay Thomas' legal heirs, share and share alike. In the latter part of 1953, May, through the efforts of Emil and her counsel, Edwin Tuttle, an attorney in Columbus, Ohio, attempted to acquire the remainder interests from the blood heirs of Thomas. A contract was entered into and submitted to the Probate Court for approval; but May withdrew from the agreement when the trustee instituted a declaratory judgment action to determine whether the contract could be approved by the court without the approval of the trustee.
The executive staff of Atlas in 1954 consisted of the following:
| Fred Comer | Assistant to general manager. |
| Lester Landgrave | Secretary-treasurer. |
| Daryl Williams | Sales manager. |
| Earl Kordell | Chief engineer. |
| Gilbert Barrett | Stock manager and purchasing agent. |
| A. Leroy Houck | Production manager. |
| Richard Castrop | Finance and personnel manager. |
Each of the above individuals was an employee of Atlas at the time of Thomas' death. In 1955, Louis Voisinet was one of the suppliers of linen and industrial*182 garments to Atlas.
*484 On December 27, 1954, a contract was entered into whereby the above-named individuals, including Voisinet, hereinafter called the Atlas group, purchased the remainder interests of Thomas' heirs for a total consideration of $ 750,000, payable as follows: $ 40,000 in cash and installments of $ 1,000 per month until May's death and the balance at a rate of $ 50,000 per annum with interest at 4 percent after May's death. The trustee gave his approval to this transfer.
After the acquisition of the heirs' interests by the Atlas group, May instructed Tuttle, who had been her attorney for a number of years and was entirely familiar with her affairs, to attempt to dispose of her life interest, and Tuttle made several attempts to do so. One offer of $ 500,000 was made for her interest but it was not accepted.
May's decision to sell the life interest was based, in part, on the facts that she was tired of the stress and anxiety of the constant litigation surrounding the Clay M. Thomas trust, that her attorney advised that such litigation would probably continue, and that her physician informed her that unless she eliminated this source of continual high tension, *183 her life would be endangered.
In the fall of 1955 May and Emil discussed the lack of success in May's efforts to sell her life interest in the trust through her attorney. During this conversation the possibility of Emil's purchasing the interest was raised, and it was agreed that Emil would buy the life interest from May. They also agreed to ask Paul Knospe, an accountant in Columbus, Ohio, who was familiar with the business and with the affairs of the trust and in whom both had confidence, to determine a value for the life interest.
This understanding was communicated to Knospe by both parties. The terms of the understanding, as communicated by them to Knospe, were that May had agreed to sell and Emil had agreed to purchase, the life interest; that Knospe was mutually designated to determine and fix a price.
After the understanding had been reached, May informed Tuttle of its terms, requested that he prepare the necessary instrument of transfer, and instructed him to cooperate and provide information to Knospe in determining and fixing a sales price.
Pursuant to this request Tuttle prepared a document entitled "Agreement," and hereinafter referred to as such, which provided as*184 follows:
Agreement
This agreement made and concluded this 9 day of November 1955, by and between May T. Hrobon, hereinafter called the first party and Emil M. Hrobon, hereinafter called the second party,
Witnesseth:
Whereas, first party is the life tenant under and by virtue of the will and codicil of the late Clay M. Thomas and likewise has an invested interest in various assets of the trust created by said will and codicil and,
*485 Whereas, litigation over a protracted period has ensued, causing much concern and considerable expense which litigation is continuing and,
Whereas, it is her desire to receive a specific income and likewise to relieve herself of the burden of personal attention relating to her interest;
Now, therefore, in consideration of mutual promises hereinafter made the parties hereto do agree as follows:
1. All right, title and interest in and to the life estate, vested interest, invested interest, contingent interest, present or future interest, now or later acquired, as first party has or will have for herself or her heirs upon her death or upon the termination of the trust whichever event first occures [sic] is herewith transferred and conveyed *185 to second party.
2. Second party agrees to pay an amount of One ($ 1.00) Dollar and other valuable considerations for said interest, to hypothecate all investments and securities now owned by him as additional security for said money to be paid by him to first party.
3. Default of payments within sixty (60) days of due date agreed according to schedule, may be considered by first party as grounds for cancellation of this contract, reversion of all interest in the trust to her and the right to consider all assets hypothicated [sic] to her as forfeited and applied against money due her by second party.
4. Schedule of assets hypothecated and schedule of payments and amounts due first party are attached hereto and made a part hereof.
5. This agreement is binding upon the heirs, executors, administrators and assigns of both parties hereto.
In witness whereof, the parties hereto do set their hands the date and day first herein written.
(S) Philip Carr.
(S) Wm. Lewis Marshall.
(S) May T. Hrobon.
May T. Hrobon.
(S) Emil M. Hrobon.
Emil M. Hrobon.
State of Ohio,
County of Franklin, ss:
Before me, a Notary Public, in and for said county, personally appeared the above named May T. Hrobon*186 and Emil M. Hrobon, who acknowledged that they did sign the foregoing instrument and that the same is their free act and deed.
In testimony whereof, I have hereunto subscribed my name and affixed my official seal at Columbus, Ohio, the 9 day of November, 1955.
(S) Ellis V. Viner,
Notary Public.
Exhibit "A" to contract for sale of life estatePursuant to the terms of an agreement entered into this 10th day of November, 1955, by and between Emil M. and May T. Hrobon Emil Hrobon agrees to pay 60% of all monies received from the trustee of the trust created under the will and codicil of the late Clay M. Thomas, wherein the said May T. Hrobon was named the life beneficiary, after the payment of necessary legal, auditing and other miscellaneous expenses necessary to the handling of said income, to the said May T. Hrobon, payable without interest during the period of her life, payments to be made at least annually, (monthly if so received), with complete annual audit of all amounts received and disbursed; the first payment to be made not later than December 31, 1956.
Emil M. Hrobon pledges as collateral security for payment all the shares of stock he owns in Troy Laundry*187 & Dry Cleaning Company. (stock attached.)
*486 The agreement was executed by May and Emil on November 9, 1955. Exhibit A was not signed by either party but was attached to the agreement.
It was the understanding of Tuttle, as communicated to him by his client, that the consideration for the sale of the life interest was to be the price determined and fixed by Knospe.
Knospe was informed of the oral agreement between May and Emil with respect to the sale of the life interest in the trust to Emil, in October 1955. He testified that he started to work on his computations of the value of May's life interest in the latter part of October and completed them by the middle of November. He also testified that he arrived at his value of May's interest in the following manner: He assumed that May had a life expectancy of 10 years. He then computed the average annual distributions to May by the trust over the 10-year period from 1945 through 1954 and found it to be $ 97,640. 2 Having concluded that May's life expectancy was 10 years, he used the annuity tables to determine the present cost of an annuity of $ 97,640 for 10 years and thereby arrived at the amount of $ 812,032.82, which*188 he rounded off to $ 800,000.
In making his computation, Knospe gave little consideration to the value of Atlas based on its growth potential or a possible decline in its earnings. He assigned little value to over $ 300,000 of earnings retained by the trust which belonged to the life beneficiary because he thought it would all be used in litigation expenses at the termination of the trust; and he attached little or no value to the right of the life beneficiary of the trust to "float" used in the business as hereinafter related, or goodwill of the business at the termination of the trust.
According to Knospe's testimony, when he had completed his computations he telephoned May and informed her that he had determined the selling price should be $ 800,000. May said she thought the price was fair and she agreed to it. After having communicated the price to May and receiving her acceptance, Knospe*189 immediately telephoned Emil and informed him of the determined price of $ 800,000. Emil stated that this amount was acceptable.
In the course of his determination of the sales price, Knospe contacted another attorney in Detroit who specialized in tax matters. Knospe had frequently worked with the tax attorney on business planning and income tax audit matters and had considerable respect for his legal opinion as to tax matters. The purpose of the contact was to secure a legal opinion as to the tax consequences, to the seller, of the sale of the life interest in the trust. Upon examination of the *487 will and after some legal research, the tax attorney expressed an opinion and was requested by Knospe to prepare a rough draft of a form to be used as the contract of sale. A rough draft was provided to Knospe with the understanding that it would be given to May's attorney, Tuttle, to use or discard. In the meantime, Tuttle had prepared, and the parties had executed, the agreement dated November 9, 1955, so the tax attorney's draft was discarded and never used. Knospe delivered a copy of Tuttle's agreement to the tax attorney, stating that it would be necessary to prepare a*190 payment contract, to be embodied as a part of the agreement, which reflected the price which Knospe fixed and the terms of payment, which called for a minimum payment to May of $ 60,000 per annum. The tax attorney testified that he understood, from his conversations with Knospe, that the payment contract was to be incorporated into and become a part of the agreement dated November 9, 1955. For that reason, in drafting the payment contract, he made reference to and incorporated terms and terminology from the agreement.
The payment contract as prepared by the tax attorney provided as follows:
Pursuant to the terms of an agreement entered into this 10th day of November, 1955, by and between the undersigned and May T. Hrobon, the undersigned hereby promises to pay the sum of eight hundred thousand dollars ($ 800,000.00) to the said May T. Hrobon, payable without interest over a period of not more than ten (10) years in periodic payments, at least annually, of not less than sixty thousand dollars ($ 60,000.00) per year; the first payment to be made not later than December 31, 1956. Any balance owing after payment as herein provided, is to be due and payable not later than November*191 10, 1967.
The undersigned pledges as collateral security for payment of aforementioned $ 800,000.00 the Twenty Five Hundred (2,500) shares of stock of the Troy Laundry and Dry Cleaning Co. attached hereto.
Emil M. Hrobon.
The payment contract was then delivered to Knospe who delivered it to either Emil or Tuttle. The payment contract was signed by Emil. A signed copy of the contract, together with the Agreement and Exhibit A, were delivered to May. May did not sign the payment contract. The first payment to be made by Emil to May was to be made in 1956.
On November 14, 1955, on Tuttle's motion, the Probate Court of Franklin County filed the following entry:
The Court finds that a contract of sale was made of all interest of the life tenant to Emil M. Hrobon.
Wherefore, it is hereby ordered that all income due or paid by the trustee shall be paid Emil M. Hrobon, life tenant.
On November 30, 1955, the trustee moved the Probate Court to vacate the entry on the grounds, among others, that the order was not based upon any recorded evidence of sale of May's interest in the trust and *488 the contract was not a bona fide sales contract. In 1957 an action was filed for the removal*192 of the trustee. The Probate Court, in an opinion dated September 23, 1957, overruled the trustee's motion to vacate, which had been pending for almost 2 years, and ordered removal of the trustee, stating, inter alia:
Notwithstanding the objections of the trustee that the assignment was not a valid one, and particularly notwithstanding his allegation that the reported contract of sale was not a bona fide sale contract, the trustee permitted this motion to lie without any effort to have it heard for a period of more than nineteen months, and during that period of nineteen months paid out to the assignee of the life tenant in the neighborhood of a quarter of a million dollars, apparently acting upon the entry of November 14th. It was the duty of the trustee, or his counsel, to request a hearing on this motion.
At the Court's direction the assignee was called to the stand and sworn and produced his copy of the written assignment or contract by which he became the assignee of the life tenant. The contract or assignment was properly executed.
Counsel for the trustee contend that because the stock pledged as collateral for the payment of the obligation was not physically attached *193 to the executed copy of the contract, it was not sufficient to show an interest in the assignee in the trust sufficient to permit him to file the motion to remove. The evidence clearly showed that the original copy of the contract, properly executed, with the stock attached, is in the possession of the life tenant. We cannot agree with the contention that the assignee of the life tenant did not have a sufficient interest in the trust to permit him to file the motion to remove.
The motion to stay proceedings is, therefore, overruled.
The only contract exhibited to the Probate Court and referred to in its opinion was the Agreement with Exhibit A attached.
The decision of the Probate Court was appealed to the Court of Appeals, Franklin County, Ohio, which appointed a referee to hear the evidence and file a report. After extensive hearings the referee filed his report with the Court of Appeals, which confirmed the referee's report, reversing the decision of the Probate Court insofar as it ordered removal of the trustee. The trustee died before the decision became final and a successor trustee was appointed who has continued to serve up to the date of this trial. In his report which*194 was confirmed by the Court of Appeals, the referee stated:
The evidence discloses that on November 9, 1955, May (Mae) T. Hrobon and Emil M. Hrobon entered into a written agreement by the terms of which May T. Hrobon transferred all her right, title and interest in and to her life estate under the will of her deceased husband to Emil M. Hrobon. * * *
* * * *
It must be concluded that the transfer by May Hrobon was a legal and effective transfer, and Emil Hrobon, as the assignee, had the undoubted right to the income * * *
From the date of the entry of the Probate Court on November 14, 1955, to date, all income distributed by the trust has been distributed *489 to Emil, who, during the years involved, paid 60 percent thereof to May.
Emil was a golf professional at the time he married May. Thereafter he worked in a managerial capacity at Atlas for about a year. He and the trustee did not get along too well. After service in World War II, Emil returned to Columbus and he and May purchased the Troy Laundry, which Emil has operated since. Emil's income tax returns for the years here involved indicate that he and Maxine also owned the Acorn Towel & Linen Supply in Columbus. Those*195 returns report no income from Troy Laundry and a substantial loss from Acorn Towel & Linen Supply for each of those years.
Shortly after his acquisition of May's life interest in the trust Emil discussed with the owners of the remainder interest either a combining of the two interests in a new corporation or a sale of the life interest by Emil to the owners of the remainder interest. No agreement was ever reached. The owners of the remainder interest thought Emil's demands for the life interest were too great. Dollar figures mentioned by Emil in these negotiations were considerably in excess of $ 800,000.
Emil had acted as May's business manager from 1938 to the present time. In 1946 Emil entered into a managerial arrangement with May under which he was to receive 50 percent of the distributable income of the trust. This arrangement was terminated when the agreement for transfer of May's life interest in the trust was entered into. Since November 9, 1955, Emil has continued to act as May's business manager without specific compensation.
In the linen and industrial supply business the term "float" is used to designate the used linens and industrial garments in use by the customer, *196 loaded for delivery, or in the process of laundering in the plant. When any of these items were taken out of inventory by Atlas, they were expensed in computing income for the reason that these items usually had a useful life of less than a year. In 1955 float with a cost of $ 734,841.84 was taken out of inventory. Float used by Atlas would be more valuable to it than to anyone else because many of the items comprising the float bore the name "Atlas." At the end of their useful lives as float, the items comprising float have only a limited value as rags or marked garments.
The question of who would be entitled to the value of the float at the termination of the trust is in dispute as between the owner of the life interest and the owners of the remainder interests. In its opinion dated April 19, 1951, in the declaratory judgment action reported at 93 Ohio App. 1">93 Ohio App. 1, the Court of Appeals, Franklin County, Ohio, said, in part, as follows:
We are in accord with the contention of the life tenant to the extent that the trustee should not be permitted to gradually build up the inventory of such material during the conduct of the trust and charge it to income and*197 at the termination *490 of the trust regard such material in inventory and float as corpus. In respect to float, we fail to find any injustice resulting to the life tenant during the continuation of the trust. It is upon the termination of the trust that an adjustment must be made, otherwise the remaindermen would be unjustily enriched at the expense of the life tenant. Then, too, in the event of the sale of the business, material in inventory and in float would be substantial items in determining the value of the business. It is at that juncture in the relationship of the parties that an adjustment will be required.
The formula used by the Ohio Department of Taxation, Intangible Tax Division, seems to be fair and just. * * * Upon the termination of the trust or in the event of sale of the business, by applying this formula, we arrive at a figure which will represent the value of material in stock and in float at the beginning of the trust, from which the life tenant will no longer derive any use or benefit by way of income. This figure at the end, whatever it may be, will be credited to income and not corpus.
The Supreme Court of Ohio reversed the decision of the Court*198 of Appeals, in part, but does not appear to have specifically answered this question in its opinion reported at 158 Ohio St. 508">158 Ohio St. 508.
May was 62 years of age at the time of the transfer. In accordance with section 1.72-9, Income Tax Regs., Table I, the expected return multiple for an ordinary life annuity for a female aged 62 is 20.3 years; however, respondent in the notice of deficiency determined May's life expectancy to be 13.47 years at the date of the transfer.
May has had a history of fluctuating overweight and high blood pressure -- apparently her blood pressure increased or subsided with an increase or decrease in weight, respectively. On November 27, 1955, she was admitted to a hospital and operated on for varicose veins. She was discharged on November 30, 1955. Her weight at or about the time of the operation was about 210 pounds. However, the hospital records do not show a weight or blood pressure problem at that time. Since March 1956 she has been under the care of a doctor for obesity and hypertension. Her weight when she first saw this doctor was about 250 pounds and her blood pressure was 190 over 115. In November 1956 she was admitted*199 to a hospital for the purpose of losing weight. Her doctor testified at this trial that she presently has "controlled hypertension" which was brought under control in 1956. May was subpoenaed by respondent to testify at the trial. She did not appear. Her doctor testified that if May was called upon to testify in court in this case it would endanger her health, so her testimony was taken by deposition.
The 1956 Federal income tax returns of petitioners Emil and May were prepared by Knospe or someone in his office, and signed by the respective petitioners on October 15, 1957. The 1957 income tax return of Emil and the 1957 and 1959 returns of May were prepared by Knospe's office. May's original 1958 return was prepared by Emil but an amended return was later prepared by the above-identified office.
*491 On her Federal income tax return for the year 1956, May reported the following on Schedule D with respect to amounts received in connection with her assignment to Emil of her interest in the Clay M. Thomas trust:
| Long-Term Capital Gains and Losses -- Assets Held More Than 6 Months | ||||
| Depreciation | ||||
| allowed (or | ||||
| Kind of property | Date | Date | Gross sales | allowable) |
| acquired | sold | price | since | |
| acquisition | ||||
| or Mar. 1, | ||||
| 1913 | ||||
| Life interest in testamentary | 4-14-37 | 1-1-56 | Indeterminate | |
| trust created | ||||
| by will of Clay M. | ||||
| Thomas. | ||||
| Received during the calendar year 1956, $ 117,681.16 as return of capital | ||||
| against her basis for interest received on death of husband. |
| Long-Term Capital Gains and Losses -- Assets Held More Than 6 Months | |||
| Cost or | |||
| other basis | |||
| Kind of property | and cost of | Expense | Gain |
| subsequent | of sale | (loss) | |
| improvements | |||
| Life interest in testamentary | - 0 - | ||
| trust created | |||
| by will of Clay M. | |||
| Thomas. | |||
| Received during the calendar year 1956, $ 117,681.16 as | |||
| return of capital against her basis for interest | |||
| received on death of husband. |
On their joint Federal income tax return for the year 1956, Emil and Maxine reported the following on a schedule attached to the return with respect to income received from the Clay M. Thomas trust:
| Income from trust: | ||
| Income from life interest acquired from May T. Hrobon | $ 215,135.27 | |
| Less: Legal & accounting fees (per agreement) | ||
| E. M. Tuttle | $ 12,500 | |
| R. M. Draper | 6,500 | |
| Total legal and accounting fees | 19,000.00 | |
| Balance | 196,135.27 | |
| Less: 60% paid to May T. Hrobon (per agreement) | 117,681.16 | |
| Net amount to Schedule H -- line 2 | 78,454.11 |
On their joint Federal income tax return for the year 1957, petitioners Emil and Maxine reported the following on a utility schedule attached to the return with respect*201 to income received from the Clay M. Thomas trust:
| Income from trust: | ||
| Income from life interest acquired from May T. Hrobon | $ 220,000 | |
| Less: Legal & accounting fees (per agreement) | ||
| T. J. Cook | $ 350 | |
| J. Childers | 2,075 | |
| T. Applegate | 500 | |
| R. M. Draper | 500 | |
| F. J. Collopy | 10,000 | |
| Total legal and accounting fees | 13,425 | |
| Balance | 206,575 | |
| Less: Paid to May T. Hrobon (per agreement) | 123,945 | |
| Net amount to Schedule H -- line 2 | 82,630 |
*492 On her income tax returns for 1957, 1958, and 1959 May did not report the receipt of any income from the trust and made no mention of the transaction.
Pursuant to the terms of the agreement of November 9, 1955, May received the following amounts from Emil:
| Year | Amount |
| 1956 | $ 117,681.16 |
| 1957 | 123,945.00 |
| 1958 | 132,134.77 |
| 1959 | 196,973.20 |
As of the date of the transaction involved herein, the trustee of the Clay M. Thomas trust had retained income of the trust in the amount of $ 302,695.14, which, under the opinion of the Supreme Court of Ohio in the declaratory judgment action, belonged to the life beneficiary but which was invested in the assets of the trust.
ULTIMATE FINDINGS *202 OF FACT
The actual agreement adopted and acted upon by Emil and May was that embodied in the agreement dated November 9, 1955, and Exhibit A attached thereto.
The value of the equitable interest in the corpus of the trust property and the rights incident thereto, the terminal rights the owner of the life interest might have in the estate, plus the value of the right to receive 40 percent of the distributions of the trust transferred by May to Emil as a gift in 1955 was $ 900,000.
May's failure to file a gift tax return for 1955 was due to reasonable cause and not due to willful neglect.
OPINION
The question upon the answer to which all issues here involved hinge, is what the parties intended and what was actually accomplished by the transaction between May and Emil evidenced by the agreement of November 9, 1955. In tax matters we must look to substance rather than form alone, Helvering v. Clifford, 309 U.S. 331">309 U.S. 331 (1940), and the essence of the transaction is to be determined not by the subtleties of draftsmanship but by its total effect. Commissioner v. P. G. Lake, Inc., 356 U.S. 260">356 U.S. 260 (1958). The transaction here *203 involved seems to us to be one to which that rule is peculiarly applicable.
Docket Nos. 91844 and 93682 -- Capital Gain v. Ordinary Income
Petitioner contends that the transaction was a sale by May of her entire life interest in the Clay M. Thomas trust to Emil for a consideration of $ 800,000, constituting a capital transaction the gain from which is taxable as long-term capital gain. Respondent determined *493 and argues primarily that the transaction resulted in a gift of 40 percent of the income of the trust and 100 percent of all terminal rights the life tenant might have in the trust by May to Emil with a retention by May of 60 percent of the income of the trust, which is taxable to her as ordinary income.
We do not question that the transaction resulted in a transfer of May's equitable interest in the corpus of the trust property to Emil and that this was what it was intended to do. The basic instrument entitled "Agreement," dated November 9, 1955, and signed by both May and Emil would clearly so operate and it was found to have that effect by the courts of Ohio in proceedings which could hardly be said to be uncontested. The question of the validity of the assignment*204 is one of local law. Blair v. Commissioner, 300 U.S. 5 (1937). And we also know from the Blair case that a person who is entitled for life to the net income from property held in trust is the owner of an equitable interest in the corpus of the property, and that such interest is "property" alienable like any other property. And, prior to the Supreme Court decision in Commissioner v. P. G. Lake, Inc., supra (decided April 14, 1958, rehearing denied May 19, 1958), at least, if the entire interest of the life beneficiary in the income and the trust corpus was sold in an arm's-length transaction for a lump-sum consideration, the transaction was considered to be a capital transaction and the consideration received by the transferor was held to be capital gain. Bell's Estate v. Commissioner, 137 F. 2d 454 (C.A. 8, 1943), reversing 46 B.T.A. 484">46 B.T.A. 484 (1942); McAllister v. Commissioner, 157 F. 2d 235 (C.A. 2, 1946), reversing 5 T.C. 714">5 T.C. 714 (1945). See also Gladys Cheesman Evans, 30 T.C. 798">30 T.C. 798 (1958),*205 which was decided at about the same time as the Lake case.
Petitioners claim this case falls squarely within the ambit of the cases last cited above and is controlled by them. However, a close analysis of the evidence in this case to determine just what the complete agreement between May and Emil was, as viewed in the light of their actions as well as their testimony, what the purpose of the transaction was, and what the end result was, convinces us that this transaction is not controlled by the cases last cited above. And we also think this case should be examined under the principle with respect to capital gains established by the Supreme Court in the Lake case, and Commissioner v. Gillette Motor Transport Co., 364 U.S. 130">364 U.S. 130 (1960).
First, we must determine what the complete agreement, as adopted and acted upon by Emil and May, actually was. Was it the basic agreement with only Exhibit A attached, which made no reference to a dollar amount but gave May only a percentage of the income? Or was this modified by the "payment contract" which recited a purchase price of $ 800,000 payable $ 60,000 per year?
*494 Three of petitioners' witnesses, *206 being their accountant, Knospe, their local attorney, Tuttle, and a tax attorney from Detroit consulted by the accountant, Raymond, testified that it was their understanding of the oral agreement between May and Emil that Knospe was to arrive at a fair market value for May's interest in the trust and that this was to become the purchase price for May's entire interest in the trust. Emil testified that the lump-sum figure was to be the purchase price. At the time of this trial, when May had received a large part of the $ 800,000 figure arrived at by Knospe, it would appear to have been to Emil's interest to so testify, but the evidence indicates a considerable reluctance on the part of anyone to exhibit the payment contract prior to that time. May also testified to that effect but her testimony indicates considerably more reliance on the right to receive 60 percent of the trust distributions than on the right to receive $ 800,000. 3
*207 The tax attorney had no firsthand information on this -- he was simply asked by the accountant to prepare a payment schedule using an $ 800,000 total price. We have no doubt that he prepared the payment contract quoted in our findings and delivered it to the accountant during the latter part of 1955, but if he was aware that both Exhibit A, which called for payment of 60 percent of the net distributions from the trust to May with no mention of dollar amounts, and the payment contract, which used dollar amounts only and made no reference to a percentage, were supposed to be a part of the complete agreement, it seems strange that some mention of Exhibit A was not made in the payment contract.
It also seems strange that if a purchase price of a fixed dollar amount was to be used, why some specific reference to such fact was not made in the basic agreement or Exhibit A attached thereto. On its face this document was a complete contract in itself. Furthermore, if the payment contract was later adopted as a part of the agreement it seems strange that in a transaction of this magnitude the entire agreement should not have been revised or tied together in some manner that there could be*208 no doubt about it.
The evidence reveals some confusion as to what happened to the payment contract after it was delivered to the accountant. The accountant's testimony indicates that he gave it to either Tuttle or Emil. Tuttle's testimony indicates that he either received it from the accountant and delivered it to Emil or received a copy thereof signed by Emil which he delivered to May. Apparently no one observed Emil sign the payment contract and there is no suggestion that May signed *495 it, which also seems a little odd in the light of the fact that there apparently was a contract which had previously been signed by both Emil and May which, with Exhibit A attached, was complete in itself and could be considered in conflict with the payment contract. The payment contract does not appear to have been exhibited to the Ohio courts. Petitioners' explanation of this is that in the various proceedings which eventually confirmed the transfer of May's interest to Emil the Ohio courts were interested only in whether Emil had an interest in the property which would entitle him to sue the trustee, which was evidenced by the basic agreement, and the purchase price for which he acquired*209 the property was of no interest to the local courts. There is some conflict in the evidence as to whether agents of the Internal Revenue Service were advised of the payment contract in either 1958 or 1959 when May's returns for the years preceding the years here involved were under investigation. However, a signed copy of the payment contract could not be produced at the time of trial of this case and was not produced until May's deposition was taken several months after the trial had been concluded.
On May's income tax return for 1956, which was prepared by the accountant, this transaction was reported on Schedule D as "Life interest in testamentary trust created by will of Clay M. Thomas," gross sales price, "indeterminate"; reporting $ 117,681.16 as having been received during the calendar year 1956 as return of capital against her basis, although the amount of her basis was not stated. An "indeterminate" sales price is inconsistent with a fixed sales price of $ 800,000. Nothing was shown on May's returns for 1957-59 with respect to this transaction. Emil's returns for 1956 and 1957, also prepared by the same accountant, reported the entire amount distributed by the trust *210 and, after deducting certain legal fees and expenses, deducted from the net amount $ 117,681.16 identified as "60% paid to May T. Hrobon (per agreement)." This also seems more consistent with the payment schedule set out in Exhibit A than with the terms of the payment contract.
The only purposes of this transaction, aside from the tax considerations, would seem to be to place title to the life interest in the trust in Emil so he could bring actions against the trustee in his own capacity rather than having to bring them in May's name, and to give Emil the right to claim the value of the accumulated income account, the float, and the goodwill of the business upon termination of the trust at May's death if he survived her. We recognize that May was probably tired of the continuous litigation with respect to the trust, but doubt that this was the dominant reason for the transfer. May appears to have had numerous attorneys and Emil to insulate her against the rigors of this litigation; the evidence indicates that she testified only once throughout the entire series of cases tried in the local courts.
*496 It seems more likely that May was interested only in receiving enough income*211 from the trust to support herself for the rest of her life and that for some reason she was willing to let Emil have the rest of the income as well as any terminal benefits which might inure to the owner of the life interest on May's death. This is understandable when it is realized that May had apparently been giving Emil 50 percent of the income of the trust prior to this transaction, 4 and it was unlikely that May, personally, would benefit from any of the terminal rights which would probably not mature until her death. But there appears to be no reason why May would be willing to limit her income to a fixed amount which, in all likelihood, she could recover only out of the current distributions of the trust, which she had a right to in any event. There is no evidence that Emil could have paid either the minimum annual amounts or any unpaid balance of the $ 800,000 in the event the trust did not produce sufficient income to meet the annual payments or in the event May died before the $ 800,000 was paid. An additional reason to make us doubt that Emil and May ever adopted the payment contract as a binding part of the entire agreement is the fact, of which they had been advised, *212 that if the payment contract was adopted and May died shortly thereafter Emil would have been obligated to her estate for up to $ 800,000 and the value of this claim would have been an asset in May's estate for estate tax purposes, which would not have been the case had she retained merely a life interest in the trust.
With respect to May's economic position, the end result of the transaction was simply to give May 60 percent of the income to which she had been entitled, prior to the transaction, without running the risk of having her payments to Emil disallowed as a deduction for tax purposes. 5Emil became entitled to 40 percent of the trust distributions, plus any terminal rights the life beneficiary might have in the trust, rather than the 50 percent of the trust distributions he had been receiving from May. The transaction effected no substantial change in the*213 economics of the situation as between May and Emil except with respect to the terminal rights.
In the light of the above we are not convinced that the payment contract ever became a part of the agreement between Emil and May. In our opinion, the agreement they carried out was that contained in the agreement dated November 9 with Exhibit A attached, with the payment contract being held for production only when and if the income tax problem became more pressing than the estate tax problem. In our opinion the realities of the transaction were that May transferred her equitable interest in the trust corpus, all terminal *497 rights the owner of the life interest might have in the trust estate, and the right to receive 40 percent of the distributions of the trust to Emil, but reserved 60 percent of the net trust distributions for herself. This reservation of income to herself was not consideration for the sale or exchange of a capital asset; *214 it was something she was entitled to all along. While under State law Emil became entitled to receive all the distributions from the trust, in economic substance and for tax purposes he was merely a conduit of 60 percent of the net trust distributions to May.
We think this case is distinguishable from Bell's Estate v. Commissioner, McAllister v. Commissioner, and Gladys Cheesman Evans, all supra. In the first two cases the transferor received a lump-sum consideration, and in the latter the transferor was to receive annual payments in fixed amounts regardless of the income of the trust. In none of them was the compensation to be paid dependent upon, or determined as a percentage of, the trust income, nor was the transferor required to look to the trust for production of his compensation. We do not consider Estate of Robert J. Cuddihy, 32 T.C. 1171 (1959), which was an estate tax case, apposite, but the same distinctions would be applicable.
We conclude that the trust distributions received by May were not taxable to Emil but were taxable as ordinary income to May. Even if the amounts received by May were found to be consideration*215 received for transfer of her interests in the trust, we believe the principle established in the recent Supreme Court decisions in Commissioner v. P. G. Lake, Inc., and Commissioner v. Gillette Motor Transport Co., both supra, would support our conclusion here.
In Commissioner v. P. G. Lake, Inc., supra, the question was whether the consideration received for the assignment of an oil payment right was taxable as ordinary income or capital gain. The Supreme Court recognized that under Texas law oil payments were considered interests in land but held that the consideration received for the oil payment was taxable as ordinary income because it found that the transaction did not fall within the intended purpose of the capital gains provisions of the Internal Revenue Code, which were said to be "to relieve the taxpayer from * * * excessive tax burdens on gains resulting from a conversion of capital investments, and to remove the deterrent effect of those burdens on such conversions." The Court found no conversion of a capital investment but found that the lump-sum consideration was a substitute for what would otherwise be received*216 at a future time as ordinary income and was therefore taxable as ordinary income.
In Commissioner v. Gillette Motor Transport Co., supra, the question was whether a sum received by a taxpayer from the United States as compensation for the temporary taking by the Government *498 of its business facilities during World War II represented ordinary income or capital gain. Looking to the precise nature of the property taken and again referring to the purpose for the capital gains provisions of the Code, the Court found that the property right taken for which the compensation was awarded was the right to use the transportation facilities, rather than the fee in the facilities themselves, and that such right, although a valuable property right, was not a capital asset within the meaning of the capital gains provisions. The right taken, said the Court, was not something in which the taxpayer had an investment separate and apart from its investment in the physical assets themselves.
We think that applying the doctrine of the above two Supreme Court cases to the transaction here involved requires us to hold that the income received by May during the*217 years here involved is taxable as ordinary income rather than capital gain. True, we find that there was a transfer of May's equitable interest in the trust corpus but we can find no conversion of that interest for cash insofar as May was concerned. All she was receiving after the transaction was a part of the same income she was receiving prior to the transaction. It is a fact that after the transaction the State court found that Emil was entitled to the entire distributions from the trust and thereafter all distributions were made to Emil, but in reality May was simply receiving a lesser amount of the distribution from the trust than she had previously received and there was no sale or exchange of that right. This does not amount to a "capital transaction" within the meaning of the capital gains provisions of the Internal Revenue Code.
Docket No. 91845 -- Gift TaxWe believe it follows from the above discussion that the value of Emil's right to receive and retain 40 percent of the distributions of the trust and the value of the right to any terminal benefits which might inure to the owner of the life interest upon termination of trust, i.e., the accumulated income account*218 and the claim to float and goodwill, which Emil received in this transaction was a gift from May to Emil in 1955. We can find no consideration passing from Emil to May for these rights. In our view of the transaction, Emil actually paid May nothing; she simply continued to receive 60 percent of the trust distributions. But if it should be found that Emil received from May the right to receive 100 percent of the trust distributions, and paid her 60 percent thereof as consideration for the transfer, we do not see how the consideration could be allocable to anything other than the right to receive 60 percent of the income of the trust. If such were the situation there would be no consideration allocable to the remaining 40-percent income interest and the terminal rights received by Emil. *499 The value of the consideration given by Emil would equal the value of 60 percent of the net income, and the value of the balance received by Emil would be deemed a gift.
Section 2512(b) of the Internal Revenue Code of 1954 provides in part as follows:
Where property is transferred for less than an adequate and full consideration in money or money's worth, then the amount by which the value*219 of the property exceeded the value of the consideration shall be deemed a gift * * *
Section 25.2512-8, Gift Tax Regs., provides in part as follows:
Transfers reached by the gift tax are not confined to those only which, being without a valuable consideration, accord with the common law concept of gifts, but embrace as well sales, exchanges, and other dispositions of property for a consideration to the extent that the value of the property transferred by the donor exceeds the value in money or money's worth of the consideration given therefor. * * *
Petitioners claim that this was not a taxable gift because the rights were obtained by Emil in an arm's-length transaction for a valuable consideration and that there was no donative intent on May's part.
While we find it difficult to believe that May had no donative intent with respect to this transaction, particularly in view of the fact that she appears to have ended up with considerably less than she had to start with, it seems clear that donative intent is not required to make a transfer taxable under the Federal gift tax laws. In Commissioner v. Wemyss, 324 U.S. 303">324 U.S. 303 (1945), the Supreme Court stated:
*220
For purposes of the gift tax it [Congress] not only dispensed with the test of "donative intent." It formulated a much more workable external test, that where "property is transferred for less than an adequate and full consideration in money or money's worth," the excess in such money value "shall for the purpose of the tax imposed by this title, be deemed a gift * * *." And Treasury Regulations have emphasized that common law considerations were not embodied in the gift tax. n1 [Footnote omitted.]
The only exception to the above well-established principle is in the case where there is a genuine business transaction involved. We cannot conclude from the evidence that this was a genuine business transaction between Emil and May negotiated at arm's length. It is obvious from the facts stated in our findings and from the evidence that there was a peculiar relationship existing between Emil and May even after their divorce and Emil's remarriage, that they were on quite friendly terms, that Emil continued to manage most of May's financial affairs, and that May was willing for Emil to have all of the benefits from the trust that she did not need or want for her own support and livelihood. *221 Emil and May both testified that they were willing to be bound by the value arrived at by the accountant without making any estimates of the value of the life interest themselves. Yet the evidence indicates that Emil made considerable efforts to sell the life interest *500 to others soon after the transaction here involved was completed for a price considerably in excess of the value purportedly fixed by the accountant. May had no children and apparently no close relatives to whom she was particularly interested in leaving an estate on her death, and the value of any terminal rights in a trust which might accrue to the life beneficiary would be of little or no benefit to May but might be of considerable benefit to Emil if he survived her. The same might be said with respect to any unpaid balance of the purported $ 800,000 sales price at the time of May's death. May was to receive so much less of value to her personally than the present and potential value of what she transferred to Emil that one would have to be incredulous to believe that May expected to receive full and complete consideration for the actual value of the interests she transferred.
We therefore conclude *222 that May made a taxable gift to Emil of the value of 40 percent of the distributions from the trust, plus the value of any terminal interests in the trust which might accrue to the owner of the life interest upon termination of the trust. Having found that Emil paid no consideration for this transfer, the value of the rights transferred would be the measure of the value of the gift subject to tax.
It would be impossible to determine with any exactitude what the value of the interest transferred to Emil was as of the date of the transfer. There are too many uncertainties, including, inter alia, May's life expectancy, the estimated profits of a competitive business, the amount of that profit or income which the trustee would feel required to put back into the business instead of distributing to the life beneficiary, the fact that if the trustee made distribution from the accrued income account during May's lifetime 60 percent thereof would be payable to May, and the uncertainty of who would be entitled to the float and goodwill of the business upon termination of the trust and the value thereof. We know of no mathematical formula which would take all these uncertainties into consideration*223 but we must do the best we can on the evidence before us. Hugh McK. Jones, 29 T.C. 200">29 T.C. 200 (1957).
Respondent determined the value of the gift of a 40-percent interest in the distributions from the trust and a 100-percent interest in the terminal rights to be $ 1,243,222 in his notice of deficiency. He started with a value for goodwill, plant, and equipment of Atlas, in the amount of $ 3,983,250, which he reduced by a factor based on May's life expectancy, to arrive at the value of the entire life interest ($ 1,530,454), of which he then took 40 percent. This amounted to $ 612,181. To this he added the then balance in the accumulated income account of $ 302,695, and a value for inventory and float presumably owned by the life tenant in the amount of $ 328,346, to arrive at the above total value of the gift. Petitioner offered little *501 evidence to rebut respondent's determination of value of the gift except medical testimony to the effect that because of her obesity and hypertension, May's subjective life expectancy was considerably less than the average life expectancy used in the tables based on age. Petitioners' evidence on this point is *224 not convincing and is of course belied to some extent by the fact that May is still living about 8 years after the critical date.
Respondent's determination is presumptively correct. However, there is sufficient evidence in the record to indicate that some adjustments should be made in respondent's determination.
Respondent's formula for determining the value of the basic life interest (exclusive of any terminal rights) finds support in section 25.2512-5(c), Gift Tax Regs. However, there is no explanation that we can find anywhere in the record of how respondent arrived at his starting value for goodwill, plant, and equipment. The record does indicate that the book value of plant and equipment of the trust as of December 31, 1955, was considerably less than the total figure used by respondent. However, because of the presumption and for reasons hereinafter indicated, we will use respondent's figure as a starting point under the formula used in the regulation. Respondent used a factor based on the age of a life tenant of 61 years. It is agreed that May was 62 years of age on the date of this transaction. If we apply the factor for age 62 to respondent's starting value it results*225 in a value for the life tenancy of $ 1,480,374.86, rather than $ 1,530,454 as determined by respondent. Forty percent of the corrected figure is $ 592,149.94, which would be the indicated value of the right to receive 40 percent of the distributions from the trust throughout May's normal life expectancy.
On the other hand if we determine the value of the right to receive 40 percent of the trust distributions during May's life expectancy by applying the average of the annual trust distributions during the 10-year period 1946-55 ($ 97,640) to the annuity table in paragraph (f) of the above regulations, which was about the method used by petitioners' accountant in determining the value of the life estate, we arrive at a value of $ 422,531 for the income interest. However, if we can use an average of the trust distributions over the preceding 5 years 1951-55 ($ 132,336) this method would produce a value of $ 562,089 for the income interest. This method is based, of course, on the amount of trust distributions rather than trust income. Inasmuch as any undistributed income would add to the accumulated income account, which the Ohio courts indicate the life tenant will eventually be *226 entitled to, these figures may be low. In any event we conclude that there is not enough evidence in this record to overcome the presumptive correctness of respondent's value *502 for the 40-percent income interest, except that May's correct age should be used in the computation. 6
Respondent added to the value of the income interest the agreed upon amount in the trust's accumulated income account at the time of the transaction ($ 302,695). It seems pretty clear from the opinion of the Ohio Supreme Court in the declaratory judgment action that the owner of the life interest will be entitled to the amount in this account upon termination of the trust, so this would be an additional item of value transferred to Emil. However, we do think this item should be discounted to some extent for the probable delay in receiving it.
Respondent*227 also adds the sum of $ 328,346 as the value of inventory and float to which the life tenant will presumably be entitled upon termination of the trust. We have no explanation of how respondent arrived at this figure. There would seem to be considerable doubt whether the life tenant will be entitled to any part of the float and goodwill upon termination of the trust. In addition whatever value these doubtful rights might have as of the date of the transfer should also be discounted for the probable delay in receipt thereof. Consequently, we cannot attach too much value to this item in trying to determine a value for the interests transferred to Emil as a gift.
Taking all the above factors and the attendant uncertainties into consideration, in our judgment a fair market value for the 40-percent income interest and the terminal rights transferred by May to Emil as a gift would be $ 900,000, and we have so found as an ultimate fact. May's gift tax liability should be computed under Rule 50, using that figure as the value of the gift, and allowing the annual exclusion and her specific exemption as claimed in her petition.
Addition to Gift Tax for Failure to File a ReturnRespondent*228 determined that May is liable for an addition to tax for failure to file a gift tax return for 1955 under section 6651, I.R.C. 1954. 7
*229 *503 May relied entirely on the advice of counsel concerning this entire transaction and upon the advice of her accountant with respect to the necessity for filing a gift tax return. It seems to us that under the facts and circumstances of this case both May and the accountant were justified in believing that the transaction could be considered a sale in toto, cf. Estate of Michael Collino, 25 T.C. 1026">25 T.C. 1026 (1956), and that the failure to file the gift tax return was due to reasonable cause and not due to willful neglect. We therefore conclude that no addition to tax is due from May.
Docket No. 93683 -- Emil's Income TaxThe only issue in this docket number is whether Emil is entitled to amortize and deduct the entire 60 percent of the net trust distributions he paid over to May in 1956 and 1957. He reported the entire amounts distributed by the trust in each of those years as income.
Our conclusions on the above issues point to the conclusion that there is no deficiency in Emil's income tax for the years 1956 and 1957 resulting from deducting the amounts distributed to May in those years. In the first place we do not think he acquired the right*230 to receive the 60 percent of the distributions from the trust which went to May for tax purposes. He was simply the conduit of that income from the trust to May and it was taxable to May, not Emil. In the second place if he did acquire the right to receive that income for tax purposes and it was taxable to him as ordinary income, we believe he would be entitled to amortize and deduct the entire amount paid to May in these years because the amount paid would be consideration for 60 percent of the entire distributions of the trust which he acquired from May, all of which is allocable to the cost of that wasting asset. Bell v. Harrison, 212 F. 2d 253 (1954).
Decisions will be entered under Rule 50 in docket Nos. 91844, 93682, and 91845.
Decision will be entered for petitioners in docket No. 93683.
Footnotes
1. Proceedings of the following petitioners are consolidated herewith: May T. Hrobon, docket Nos. 91845, 93682, and Emil M. Hrobon and Maxine Hrobon, docket No. 93683.↩
1. The 1954 figure is computed after a deduction of $ 30,000 in legal fees paid by the trust on behalf of the life beneficiary and which was income to the life beneficiary for Federal income tax purposes.↩
2. The figure for 1955 is arrived at after subtracting $ 69,346.07 in Federal income taxes of the trust and interest thereon, with respect to the years 1942 through 1952, which is a nonrecurring item.↩
1. Although the life beneficiary distribution for 1954 was only $ 130,000, the trust paid another $ 30,000 in legal fees on behalf of the life beneficiary, which, for Federal income tax purposes, are considered as income to the life beneficiary.↩
2. He apparently meant for the years 1946 through 1955 because only in those 10 years did the distributions average $ 97,640.↩
3. Unfortunately, May's testimony was taken by deposition and the Court did not have the opportunity to observe her as a witness. A reading of her deposition indicates such a reluctance on her part to give complete answers to the questions asked that the deposition is as much that of her attorney as of May herself, and cannot be given too much weight.↩
4. The evidence with respect to this arrangement was vague and if there was any written agreement with respect thereto, it was not offered in evidence.↩
5. Respondent had attacked these deductions in her prior years' returns.↩
6. We do not vouch for the accuracy of our computations above, but inasmuch as they are used for illustrative purposes only we believe they are sufficiently accurate for our purpose.↩
7. SEC. 6651. FAILURE TO FILE TAX RETURN.
(a) Addition to the Tax. -- In the case of failure to file any return required under authority of subchapter A of chapter 61 (other than part III thereof), of subchapter A of chapter 51 (relating to distilled spirits, wines, and beer), or of subchapter A of chapter 52 (relating to tobacco, cigars, cigarettes, and cigarette papers and tubes), or of subchapter A of chapter 53 (relating to machine guns and certain other firearms), on the date prescribed therefor (determined with regard to any extension of time for filing), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the amount required to be shown as tax on such return 5 percent of the amount of such tax if the failure is for not more than 1 month, with an additional 5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25 percent in the aggregate.↩