*207 Decision will be entered under Rule 50.
Petitioner was settlor and life beneficiary of a trust with remainders over. He, as well as the trustee of the trust, was a resident of Pennsylvania, and the trust assets included certain securities and Pennsylvania real estate. Among the securities were capital stock shares in two personal holding companies. At the beginning of 1945 the capital of both companies was substantially impaired because of previous capital losses. During the taxable year they sustained further capital losses in excess of their income. Since such losses are not deductible when computing Subchapter A (section 500, I. R. C., et seq.) net income, both companies had some Subchapter A net income. From this source were declared and paid certain dividends. Held: The source from which these dividends were paid constituted income only for the purposes of Subchapter A and not for the purpose of determining the proper allocation to be made as between corpus and distributable income. For this purpose state law is controlling, and since the payments further impaired the capital of the paying companies, they should be allocated to the corpus of the trust in accordance*208 with Pennsylvania law. Not being distributable to petitioner, they are not taxable to him.
*956 This proceeding involves a deficiency in income tax determined by respondent for the taxable year 1945 in the amount of $ 9,193.03. It is attributable to respondent's inclusion in petitioner's 1945 gross income*209 of certain dividends received by a trust of which petitioner is life beneficiary. The only issue is whether such dividends are properly so includible.
FINDINGS OF FACT.
The facts, which have been stipulated, are so found and made a part hereof.
Petitioner is a resident of Bryn Mawr, Pennsylvania, and filed his income tax return for the year in question with the collector of internal revenue for the first district of Pennsylvania, at Philadelphia.
*957 In 1932 petitioner created an irrevocable trust (hereinafter sometimes called "The Trust"), the corpus of which was made up of land in Pennsylvania and certain securities. He was designated as beneficiary for his own life with remainders over. The trustee was Ethel Brown Foerderer, petitioner's wife, who was also a resident of Pennsylvania.
Throughout 1945 the assets of The Trust included, among other things, 3,005 shares of the outstanding stock of Robert H. Foerderer Estate, Inc.; a one-half interest in a partnership known as Caroline F. Artman Trust; and 1,717 shares, out of a total of 2,167 outstanding, of the capital stock of a corporation known as Percival E. Foerderer, Inc.
Robert H. Foerderer Estate, Inc., a Delaware*210 corporation, was, in 1944 and 1945, a personal holding company within the meaning of section 501, Internal Revenue Code. It had net operating losses in 1937 and in all subsequent years, except 1941. At the end of 1944 its capital was impaired to the extent of $ 469,787.35. In 1945 it had Subchapter A net income as defined in section 505, Internal Revenue Code, of $ 19,331.41, and net capital losses not deductible in the computation of Subchapter A net income amounting to $ 19,489.54. Despite this continued impairment of capital, it declared and paid during 1945, pursuant to the resolution of its board of directors on January 8, 1945, a monthly dividend amounting to 30 cents per share of stock outstanding. This stock was held throughout 1945 as follows:
| Florence F. Tonner | 3,005 shares |
| Caroline F. Artman Trust | 3,005 shares |
| Percival E. Foerderer Trust (u/a May 18, 1932) | 3,005 shares |
Payments made to the Percival E. Foerderer Trust (u/a May 18, 1932) in 1945, pursuant to the above resolution, aggregated $ 10,818.
The Caroline F. Artman Trust was a partnership, or joint account, in which the Percival E. Foerderer Trust (u/a May 18, 1932) owned a 50 per cent interest.
Percival*211 E. Foerderer, Inc., a Delaware corporation, was, in 1944 and 1945, a personal holding company within the definition contained in section 501, Internal Revenue Code. It had net operating losses in the years prior to 1944 and at the end of 1944 its capital was impaired to the extent of $ 151,934.52, despite a profit of $ 257.22. Its capital was further impaired in 1945 for which year it had a Subchapter A net income of $ 5,650.54, and net capital losses, not deductible in the computation of Subchapter A income, amounting to $ 10,110.40. Its outstanding stock was held throughout 1945 as follows:
| Ethel Brown Foerderer, trustee of three trusts for her children | 450 shares |
| Percival E. Foerderer Trust (u/a May 18, 1932) | 1,717 shares |
*958 On December 28, 1945, it paid $ 6,009.50 to the Percival E. Foerderer Trust, pursuant to the resolution of its board of directors passed December 20, 1945.
Ethel Brown Foerderer, as trustee of The Trust (u/a May 18, 1932), filed a fiduciary return on Form 1041 for 1945 in which she reported a taxable income of $ 3,990.03. This amount did not include anything on account of dividends from Robert H. Foerderer Estate, Inc. received either*212 directly or indirectly through the Caroline F. Artman Trust. Neither did it include anything on account of dividends from Percival E. Foerderer, Inc. Petitioner, in his income tax return for 1945, did not include in taxable income any part of the dividends paid in 1945 by Robert H. Foerderer Estate, Inc. or Percival E. Foerderer, Inc.
Respondent, in his notice of deficiency, added to petitioner's 1945 income $ 11,792.60 for dividends of Robert H. Foerderer Estate, Inc., and $ 4,075.54 for dividends of Percival E. Foerderer, Inc. These amounts were part of an item that respondent determined to be "Income from fiduciaries" in the amount of $ 23,673.49. The correct amount of taxable dividends paid to The Trust (u/a May 18, 1932) from Robert H. Foerderer Estate, Inc. was $ 9,665.71, and from Percival E. Foerderer, Inc. $ 4,477.14, amounting to a total of $ 14,142.85. This amount received by The Trust (u/a May 18, 1932) constituted taxable income. If it is taxable to petitioner as beneficiary it is deductible to The Trust (u/a May 18, 1932) under section 162 (b), Internal Revenue Code. Petitioner is taxable on the dividends of $ 14,142.85 if they were distributable to him.
Petitioner*213 concedes the correctness of respondent's determination in increasing his income for the year 1945 by the amount of $ 3,221.28 as income received from the Ethel Brown Foerderer trust.
OPINION.
Petitioner is settlor and life beneficiary of an irrevocable trust with remainders over. As a part of its corpus, the trust holds, among other things, 1,717 shares of the outstanding stock of Percival E. Foerderer, Inc., a Delaware corporation, which is a personal holding company. Further, it holds directly and indirectly a total of 4,507.5 shares of the capital stock of Robert H. Foerderer Estate, Inc., another Delaware corporation, which is also a personal holding company. At the beginning of the taxable year the capital of these corporations was impaired to the extent of $ 151,934.52 and $ 469,787.35, respectively. During the taxable year both corporations suffered further capital losses in the amounts of $ 10,110.40 and $ 19,489.54, respectively. Since such losses were not deductible when computing the Subchapter A net income of either corporation ( Section *959 505, Internal Revenue Code), both corporations had Subchapter A net income in the amounts of $ 5,650.54 and $ 19,331.41, *214 respectively. Despite this continued impairment of capital these corporations, during the year here involved, declared and paid taxable dividends to The Trust amounting to a total of $ 14,142.85. The parties are agreed that this amount constitutes taxable income and that if it is distributable to petitioner as beneficiary of The Trust, it is taxable to him and deductible by The Trust in accordance with section 162 (b), Internal Revenue Code. 1 Therefore, stripped of non-essentials, the issue is whether the amount so received by The Trust is or is not distributable to petitioner.
*215 Legal interests and rights in the administration of trusts are essentially matters of local law. Helvering v. Stuart, 317 U.S. 154">317 U.S. 154, 161. The determination of whether or not income is distributable to a particular beneficiary depends upon the terms of the trust and the applicable state law. Blair v. Commissioner, 300 U.S. 5">300 U.S. 5, 9; Freuler v. Helvering, 291 U.S. 35">291 U.S. 35, 43-45; Henricksen v. Baker-Boyer National Bank, 139 F. 2d 877. Once this determination is made, the pertinent Federal revenue act then attaches to designate to whom such income is taxable. Helvering v. Stuart, supra.Here, The Trust was created in Pennsylvania. Its trustee, as well as its life beneficiary, is a resident of that state. Accordingly, the determination of whether the income which it received was distributable to petitioner during the taxable year should be made in accordance with the law of the Commonwealth of Pennsylvania.
Where a trust has been created and its trustee is directed by the trust indenture to pay the income therefrom to*216 a certain beneficiary for life and upon his death to pay the principal to designated remaindermen, the trustee is under a duty so to administer the trust as to protect the interests of both the life tenant and the remaindermen. 2 Scott on Trusts § 232. Accordingly, when a dividend is received on stock held as a part of the trust res, he must determine whether such dividend should be treated as accruing to the corpus and held for the remaindermen or constitutes income distributable to the life beneficiary. The authorities are in substantial agreement on the proposition that a dividend which represents a reduction or impairment of capital belongs to corpus and not to income. Vinton's Appeal, 99 Pa. 434">99 Pa. 434, 44 Am. Rep. 116">44 Am. Rep. 116; Gray v. Hemenway, 268 Mass. 515">268 Mass. 515, 168 *960 N. E. 102; Hite v. Hite, 93 Ky. 257">93 Ky. 257, 20 S. W. 778; 24 A. L. R. 92. And any impairment of the trust assets must be made good before anything is awarded to income. Cf. McKeown's Estate, 263 Pa. 78">263 Pa. 78, 106 A. 189">106 A. 189.*217
Here, the corporations from which The Trust received the dividends in question had suffered capital losses in the years preceding the one under review to the extent that their capital structure had been substantially impaired. During the taxable year they sustained further capital losses in excess of their income. However, they were personal holding companies, and such losses were stipulated not to be deductible in the computation of their Subchapter A net income. Consequently, for tax purposes they had current income. And it was from this source that the dividends were paid. If we look to the substance of the situation, we find that had the corporations been allowed to deduct their capital losses, they would have had no income from which to pay these dividends. The funds from which the payments were made constituted income only for the purposes of Subchapter A and not for the purpose of determining the proper allocation to be made of such payments as between corpus and distributable income. These payments further impaired the capital of the corporations, and should be allocated to corpus. To hold otherwise would be to defeat the purposes of the trust instrument by giving *218 petitioner, the life beneficiary, access to the principal of the trust fund, thereby totally defeating the gift over to the remaindermen.
Accordingly, we hold that the dividends received by the trustee from Robert H. Foerderer Estate, Inc., and Percival E. Foerderer, Inc., should not be awarded to income to be distributed to the life beneficiary but, to the contrary, should be allocated to corpus with The Trust paying the taxes thereon.
Decision will be entered under Rule 50.
Footnotes
1. SEC. 162. NET INCOME.
* * * *
(b) There shall be allowed as an additional deduction in computing the net income of the estate or trust the amount of the income of the estate or trust for its taxable year which is to be distributed currently by the fiduciary to the legatees, heirs, or beneficiaries, but the amount so allowed as a deduction shall be included in computing the net income of the legatees, heirs, or beneficiaries whether distributed to them or not. As used in this subsection, "income which is to be distributed currently" includes income for the taxable year of the estate or trust which, within the taxable year, becomes payable to the legatee, heir, or beneficiary. * * *↩