UNITED CALIFORNIA BANK v. UNITED STATES
Legal provision: Internal Revenue Code
Argument of Ronald E. Gother
Chief Justice Warren E. Burger: Well hear arguments next in United California Bank against the United States.
Mr. Gother you may proceed whenever you’re ready.
Mr. Ronald E. Gother: Yes, Mr. Chief Justice and may it please the Court.
The facts of this case involved the estate of Walt Disney.
Under Mr. Disney’s will, he provided that 45% of the residue of his estate was to pass to the Disney Foundation where it was to be held for certain charitable and educational purposes primarily for the support of California Institute of the Art, a school which he helped to found.
During 1967 and 1968, the executors of his estate sold stock of Walt Disney Productions at a substantial gain.
In computing its tax for those years in which the gain was incurred, the state excluded from tax 45% of the gain, being the gain, which was permanently set aside for and would ultimately pass to the charity, and paid tax therefore on only 55% of its gain.
Such 55% passed basically to taxable taxpayers, a trust for the family of Walt Disney.
The IRS has taken the position that if the estate wanted to exclude 45% of the gain which was passing to charity, that in computing it’s tax on the 55% of the gain passing to taxable beneficiaries, it had to compute such gain -- it could not use I should say, it could not use in computing the tax on such gain the alternative tax rate which during those years placed a 25% limit on the amount of tax on capital gains.
What the Internal Revenue Service said was that if you wanted to use the 25% tax rate, that tax rate must be applied against 100% of the gain, including the 45% of the gain that passed to charity.
While the facts in the case are easy to understand, unfortunately, the law is not, and this is due to some very complex style of legislative drafting and also to the interrelationship of several different code sections.
I believe that the taxpayer has accurately interpreted these code sections and put together the puzzle of these code sections in a way that carries out the intent of Congress and makes sense.
And I would say that the correctness of our interpretation must be judged against the two basic intents of Congress which are quite evident from this particular fact pattern.
Justice Harry A. Blackmun: Mr. Gother in your primary brief you didn’t say it Foster Lumber?
Mr. Ronald E. Gother: No, we do not.
Justice Harry A. Blackmun: You cited it in or rather collaterally in your reply brief.
Do you feel that Foster Lumber has no significance in this case at all?
Mr. Ronald E. Gother: I believe it has no significance for a couple of reasons.
The first is that it was dealing with entirely different set of code sections.
We were not -- it was not dealing with the charitable set aside deduction.
Justice Harry A. Blackmun: That’s conceded --
Mr. Ronald E. Gother: It was not dealing with the taxation of within an estate, which is I think a major factor here.
It was dealing with the carrying back of a loss carrying back to a prior year during which the taxpayer calculated his tax using the alternative tax rate.
Justice Harry A. Blackmun: But isn’t the -- we know a lot, isn’t the general principle the same however, here is the fairly -- here’s a statute that seems to say one thing and they conceded intent of Congress the other way.
And I just wondered whether your failure to cite is indicative of the fact that maybe it’s against you?
Mr. Ronald E. Gother: I don’t believe so Your Honor at all.
I think also that our interpretation of the code is a literal one in that we are literally interpreting our code section correctly and that the Government is not.
Justice Harry A. Blackmun: What we get down to then and your approach is, it is whether the estate is a conduit, nothing more?
Mr. Ronald E. Gother: In part there, in part and whether that conduit system is applicable to the 1201 (b) (2) alternative tax rate calculation, yes.
Foster Lumber is no different than the Weil case in essence that you had an excess of an ordinary deduction which you couldn’t use against your alternative tax rate and that was a regular ordinary loss carry forward deduction.
I’m saying that our charitable set aside deduction is an entirely different animal.
That it is not an ordinary deduction that an individual taxpayer individual or corporate such as in Foster Lumber had, but it is a different type of deduction and it is more of a manifestation of this conduit theory.
Also in Foster Lumber the issue was the definition of taxable income.
Well, if there’s anything that is relatively clear in the Internal Revenue Code is the definition of taxable income and I don’t believe that that is in issue here at all.
We say there are two basic intents of Congress here that are evident.
One is that there is to be no tax imposed on that part of any capital gain which an estate realizes or any income, which an estate realizes, be it ordinary or on capital gain, which passes ultimately to a charity.
642 (c) of Internal Revenue Code says that any gain, any income, any item of income gain or ordinary income which is permanently set aside for charity is entitled to a 100% deduction, even though it’s not paid out.
So that we have a 100% deduction, whether we pay it or don’t pay it out in the particular year.
It’s referred to as the set aside deduction.
It's perfectly clear from that that intent of Congress was to exempt from tax that part of income realized by a fiduciary.
The second intent of Congress, which is perfectly evident, is that capital gains were to be taxed in those years at a maximum of 25%.
Now you’ve got these two intents and I believe they are perfectly reconcilable in our case and in due -- and our interpretation carries both to those out.
The Government's does -- the Government’s interpretation does violence to one if not both of those.
The basic issue which separates our self and the Government is best explained in the question of whether the capital gains tax base for computing the alternative tax rate under Section 1201 (b) 2 includes the gain going to the charity.
This is by far the biggest area of disagreement between ourselves and the Government.
Section 1201 (b) is set forth on pages 8 (a) and 9 (a) of the appendix of the Government brief.
Before getting into the specific language of those sections, I think it’s essential to take -- stand back just a bit and take a look at what is the over all concept of the taxation of estates and trusts.
We have a peculiar system of taxation here because we have interposed a fiduciary, a third party here.
We don’t have a taxpayer and his tax.
We have a fiduciary and the system, the basic system for taxation of estates or trusts is first you determine what part of the income that the fiduciary realizes is either required to be distributed or will be distributed or is distributed to a taxable beneficiary and that’s one set of income and you put that of to a side.
The next is that you look to see if there is any income permanently set aside for charity, under 642 if it is, you set that aside.
You're then left with a third group, a third body of income that is taxed to the fiduciary and then the question is what tax rate applies to that tax income.
Now you go to Section 1201.
1201 (b) says that if you have some capital gains in that year, you compute your tax in a two-step approach.
You divide this taxable income that I have over here into its component parts.
The first part being ordinary income, the second part being capital gain, and you do that by taking the taxable income that you had here and deduct out the part that is capital gain and on the remaining part you compute your tax at your ordinary income rate, that’s your ordinary income.
The part that is capital gain, you then tax at a maximum of 25%.
Now our position is that if you look at 1201 and apply it literally to what is the taxable income of the estate, our interpretation is as literal as any interpretation can be of that code section that the capital gains referred to in that section, the long-term capital gain is the long-term capital gain that’s in this part taxable to the estate.
It’s not in the part that’s going out to the taxable beneficiaries.
It’s not the gain that’s in the part over here for charity and the best way I think I can --
Justice John Paul Stevens: Can I interrupt you Mr. Gother.
Do you take the position that the Weil case is wrong?
Mr. Ronald E. Gother: No.
Justice John Paul Stevens: You don’t.
Mr. Ronald E. Gother: It’s just not in a fiduciary context.
Justice John Paul Stevens: Then you take the position that the word excess of a long-term gain over net short-term capitalized means thing for a fiduciary and another thing for an individual tax --
Mr. Ronald E. Gother: I believe that’s correct.
Because we have a fiduciary.
Justice John Paul Stevens: And how do you reconcile that with the fact that 1201 (b) refers to any taxpayer?
Mr. Ronald E. Gother: Any taxpayer?
Justice John Paul Stevens: Yes.
Mr. Ronald E. Gother: Well I think you’re talking about the taxable income of that taxpayer.
If you look at 1201 (b) 1 --
Justice John Paul Stevens: 1201 (b) starts out, if for any taxable year then that long-term capital gain of any taxpayer and it goes on and I would read it as prescribing the same procedure for individual taxpayers as for fiduciary.
But you -- I’m just questioning your literal argument now?
Mr. Ronald E. Gother: Well, my literal argument says that -- of any taxpayer is, it presupposes that you’re talking about the taxable income of that taxpayer not in the fiduciary context.
So that in the fiduciary context that is literally being applied to this other part of income that’s over here, not to these.
And I think another way of emphasizing then is look at 1201 (b) 1 which now talks about the computation of the partial tax.
The partial tax is computed on taxable income.
Well again, that has got to be the taxable income that is taxed to the taxpayer.
It can’t be some taxable income that’s sitting over that’s taxed to somebody else.
It seems to me we are applying it as literally.
Let me show you that the Government doesn’t apply that literally.
It doesn’t even come close to applying it literally in the context of gain which is set aside or a gain which is to be distributed or is distributed to a taxable taxpayer.
Remember I’ve got that gain sitting over here.
If we had gain that is to being distributed to a taxpayer, a taxable taxpayer, it’s sitting over in this other pile.
The Government doesn’t contend that when you compute the 1201 tax that this reference to the excess of capital gains of excess long-term capital gain includes that taxable gain that goes over the taxpayer.
No, that is already out.
Justice Byron R. White: So they wouldn’t take that out of the fiduciaries?
Mr. Ronald E. Gother: They would.
Justice Byron R. White: Part of capital gain.
Mr. Ronald E. Gother: And yet if you want to read that as literal as the Government seems to read it literally that shouldn’t happen, that the tax should be on 25% of the 100% of the gain.
Justice Byron R. White: Or at least you’re saying that it ought to be the same for both thoughts for both the charity and for the --
Mr. Ronald E. Gother: That’s exactly my position, yes sir.
Justice Byron R. White: And the Government says that they can be different.
Mr. Ronald E. Gother: That’s correct.
Justice Harry A. Blackmun: I take it to the Government not only does not object but it actually concedes that with respect to a taxable distributee, this is the correct method under the statute?
Mr. Ronald E. Gother: I haven’t seen that in their briefs but we have computed, we have given a exhibit in our reply brief of the instructions in computing your tax under 1041 and in the example of working it out in the form.
The Court in Statler made the same observation and I don’t anticipate that the Government would refute that.
So they’re not applying it literally.
They’re not even applying it literally in another context and that’s in the context of the 691 deduction.
691 deduction is a for the amount of the state tax attributable to income in respect of a decedent item.
There are series of cases which says that that deduction if it relates to capital gain taxable to an estate, that deduction, the word it is a deduction, works as an exclusion from the capital gains tax base and the Government itself in (Inaudible) case argued that that 691 deduction reduced the capital gains tax based from a 100% to something less than a 100%.
So clearly the literal interpretation is not one which is there for the Government.
Our interpretation it seems to me is -- as literal as theirs and ours does no offense to the basic contents.
Justice Byron R. White: But the Government position doesn’t reduce the amount distributable to the charity, does it?
Mr. Ronald E. Gother: Well, that’s correct that’s their position here is that no the charities are somehow different.
Justice Byron R. White: It’s just that there’s not much and there’s just less money in the estate, I mean you pay out more tax.
Mr. Ronald E. Gother: You pay out more tax.
Justice Byron R. White: But it doesn’t reduce the amount distributable to the charity?
Mr. Ronald E. Gother: That would depend upon how the tax is allocated under your will, how the tax burden is allocated.
They are either taxing --
Justice Byron R. White: Well how about in this case, does the charity hurt?
Mr. Ronald E. Gother: Yes, any tax payable out in the residue of this estate is going to reduce the amount going to charity under the terms of Mr. Disney’s will.
Justice William J. Brennan: The will was specific in that respect?
Mr. Ronald E. Gother: The will is specific and that the charity shared in the net residue, 45% of the net residue this would be a residue charge.
Justice Harry A. Blackmun: Is the will in the record incidentally --
Mr. Ronald E. Gother: Yes it is Your Honor.
One of the -- getting to the conduit argument, one other point that I want to emphasis very much is that the Ninth Circuit and the Government both contend that this conduit principle doesn’t apply to the amount going in this part over here in the charity and they cite as example of that Section 643 (a) 3.
Now 643 (a) 3 has a very complex section, but the position they take is that that section provides that capital gains that are in the pot going to charity are included or added to distributable net income.
That is absolutely wrong, absolutely wrong.
If you read through 643, 643 starts with the concept of taxable income.
You have some taxable income now and you want to determine how much of that taxable income is going to be taxed to a taxable beneficiary.
So, taxable income already has a distributions deduction off, already has a charitable deduction off and so you’ve got to get -- you’ve got to kind of gross this back up to see how much is going to be taxed to the beneficiary.
And in the process of grossing up, one of the things that they gross up, or one of the things they do is that 643 (a) 3 says you exclude all capital gains.
So you -- they were in taxable income but now you got to take them out.
When you take them out, if you take out a 100% of capital gain, you already -- you would take out also those capital gains which are going to charity which would mean -- but they are already out of taxable income so you will be taking them out twice if you did that so the statute has a double negative in there and they said no, no, don’t take out all the capital gains, leave in their the capital gains that are going to stay in the trust and are going to be taxable to the trust and the gains that are permanently set aside for charity, those having already been deducted above.
So you cannot contend that distributable net income includes any capital gains passing to charity.
It’s a basic error in the Ninth Circuit’s opinion, a basic error in the Government’s brief.
As example of that -- the Ninth Circuit then goes on to say another example of why the conduit theory doesn’t apply to this part of gain going -- setting aside for charity over here is that Section 663 (a) 2 says that in -- 662 (a) 2, says that when you are going to allocate distributable net income in a particular circumstance among taxable beneficiaries, you take distributable net income and then it says (and add to it) the amount of the deduction that you have taken for charity under 642 (c).
Well obviously distributable net income therefore doesn’t include anything going to charity for the limited purpose of 662 they add -- have that added back.
So basic error that 643 does not provide that distributable net income includes an amount going to charity.
The limited purpose of this add back in 662 of the 642 charitable deduction has nothing to do with estates as such.
The very solemn could apply to the estates has something to do with taxable income of trusts and has to do with this concept of a tier beneficiaries that they wanted to make sure, Congress want to make sure that the income tax -- that the taxable beneficiary for whom income was required to be distributed would pay the tax on the maximum taxable income not reduced by anything that was permanently set aside for charity and it just sets up an order of priorities as we see it of this policy.
Justice Byron R. White: What does the -- in this case what is the basis for saying that current income is distributable to a charity?
Mr. Ronald E. Gother: Excuse me, I’m not sure I followed the question.
Justice Byron R. White: Well, the question is what’s the estates income tax for a year, is that right?
For particular year, is that the question in the case?
Mr. Ronald E. Gother: Keep going again, I’m still --
Justice Byron R. White: Is this an income tax case?
Mr. Ronald E. Gother: Yes it is.
Justice Byron R. White: Is it a question about the income tax of an estate?
Mr. Ronald E. Gother: Yes.
Justice Byron R. White: For a year?
Mr. Ronald E. Gother: For a year.
Justice Byron R. White: That’s -- now we're together.
Mr. Ronald E. Gother: Okay.
Justice Byron R. White: What’s the basis in this case for saying that the income that was earned in the years in question was distributable to a charity?
Mr. Ronald E. Gother: The terms in the will provide that 45% of our --
Justice Byron R. White: Of all current income?
Mr. Ronald E. Gother: That would include current income.
That just a matter of state law, 45% of the current income, 45% of the principle --
Justice Byron R. White: That’s what I meant, the will say currently distribute this year’s income to a charity or was it just a question of saying whenever you call the estate give the -- 45% of the residue to the charity.
Mr. Ronald E. Gother: It’s the latter.
Justice Byron R. White: So if I die and I have a business in my -- I tell my executor operate my business until you can sell it, then sell it, sell all my stocks and bonds and then take the cash that’s all left and give it to a charity.
Do -- say it’s everything to a charity.
Now is there -- does the estate pay any income tax?
Mr. Ronald E. Gother: No it does not Your Honor, never.
That’s the essence of the 642 (c), 642 (c) charitable deduction is an unlimited deduction and it --
Justice Byron R. White: And even though the charity gets only the residue you can’t take out of the residue, any income earned before you distribute?
Mr. Ronald E. Gother: That’s correct.
Justice Byron R. White: Is that law?
Mr. Ronald E. Gother: That’s the law, the law would say that all of the in --
Justice Byron R. White: Is there any argument about that law?
Mr. Ronald E. Gother: No, all of the income earned during the course of the estate proceeding, in an estate where the will provides that ultimately, all of the assets are to pass to charity, all of the income, even if that estate were open ten years would be free of tax.
Justice Byron R. White: Now there’s now question about that?
Mr. Ronald E. Gother: No question about that.
Chief Justice Warren E. Burger: What you’re saying when you say that is that the tax exempt entity is the de facto owner from that instant of death, are you not?
Mr. Ronald E. Gother: We are, we’ve even cited the probate code section in California which embodies that concept that in an estate proceeding, the assets of an estate really title vest in the beneficiary subject only.
Chief Justice Warren E. Burger: And you are saying that Congress has indicated that in these statutes that that exemption should attached from the outset and it continue wherever it goes?
Mr. Ronald E. Gother: Exactly.
That’s exactly --
Justice Byron R. White: So in this case you were saying that the Government’s position in effect reduces the amount distributable to the charity contrary to will of Congress, has it?
Mr. Ronald E. Gother: It has to, yes Your Honor.
I’d like to reserve whatever time I have remaining for --
Justice John Paul Stevens: If you help me in one problem I have with the whole case.
One way of stating the issue for the year 1967 would be I think to say that you are contending that the word excess in 1201 (b) 1, the alternative tax computation, this $275,000.00.
The Government contends its $500,000.00 because you take the 45% out first?
Mr. Ronald E. Gother: That’s right.
Justice Byron R. White: And do you make the same contention with respect to the word excess in 1202?
Mr. Ronald E. Gother: Identical.
Justice John Paul Stevens: You contend its $275,000.00 in either case.
Mr. Ronald E. Gother: That’s correct.
Justice John Paul Stevens: But you did not so compute it when you stipulated what the ordinary tax would be, that’s one thing that puzzled me.
You treated this $500,000.00 in your statement of why you have to use this -- the 1201 (b) procedure to get the lower tax, you agree to the Government’s computation under 1202?
Mr. Ronald E. Gother: Not when we get to the computation of the alternative tax?
Unknown Speaker: No, no in the computation of the normal method of computing.
You agreed, when you get your comparison deciding which one to use, you did the normal tax by treating $500,000.00 as the excess and you stipulated that was the right way to do it?
Mr. Ronald E. Gother: Only because that was the way the form is set up.
We were not doing it because we were saying that --
Justice John Paul Stevens: But you didn’t follow the text form on your computation?
Mr. Ronald E. Gother: No we did not, we couldn’t.
We had to -- the computation that we use, we had to exclude at some point this 45% of the gain go into charity.
Justice John Paul Stevens: You see what my problem is?
I think you stipulated there was $500,000.00 under 1202 and you’ve argued that it’s 275 under 1201 (b) and I don’t know how you can have it both ways?
Mr. Ronald E. Gother: Well, that’s because --
Justice John Paul Stevens: Maybe you’ve made an unwise stipulation I don’t know but I think it is?
Mr. Ronald E. Gother: Perhaps I’m not sure, but maybe the confusion is with the 1202 section itself, the amount that passes to charity in the capital gain situation really gets deducted the way the code sets it up in two categories.
A half of that capital gain gets deducted in the 642 (c) charitable deductions and the other half in the 1202.
Now those two inter relate in 643 -- 642 has a cross reference to the 1202 but you’re taking it both places.
Justice John Paul Stevens: I think your return is $500,000.00 for that purpose by now?
Mr. Ronald E. Gother: Pardon, excuse me?
Justice John Paul Stevens: I think your return used $500,000.00 for that purpose?
Mr. Ronald E. Gother: What we have -- because we had to get all of the game going out to charity deducted out in two places.
Justice John Paul Stevens: You could have precluded the 275 from the very beginning it seems to me and had quite different figures?
Mr. Ronald E. Gother: Yes we could have.
As a matter of fact, this came up in the Ninth Circuit argument.
We could have in the very basic capital gain schedule when we had 500, we could have deducted 45% there and then went on with the calculation.
Justice John Paul Stevens: The fact that you didn’t suggest it to me that you thought the word “excess” had a different meaning in the two different sections.
Now you say that really isn’t you’re the theory --
Mr. Ronald E. Gother: If you did one, I prepared the tax return I changed my mind at this point in time.
Thank you Your Honor.
Argument of M. Carr Ferguson
Chief Justice Warren E. Burger: Very well.
Mr. M. Carr Ferguson: Mr. Chief Justice and may it please the Court.
I’m afraid our differences are more basic than I had originally anticipated from reading the briefs.
The Government simply does not accept the basic premise that there are three pots or three conduits or three shells, whatever they are.
Chief Justice Warren E. Burger: What would you say Mr. Ferguson about Justice White’s hypothetical case, if the entire state you were given to the University of California or some totally recognizable tax entity that was exempt, income on these earnings during the period of probate proceedings?
Mr. M. Carr Ferguson: Sir I would have to say that first of all, the estate is nonetheless a tax payer, a private tax payer under the provisions of the code as it would be in any other case.
Chief Justice Warren E. Burger: You mean until distribution, the entity takes on the cloak of the decedent and not the cloak of the legatee?
Mr. M. Carr Ferguson: I think that is one way of looking at it.
Chief Justice Warren E. Burger: Isn’t it just that simple in the long run?
Mr. M. Carr Ferguson: I think it is that simple.
Justice Byron R. White: Does it pay -- does it pay taxes or doesn't it, on its current income?
Mr. M. Carr Ferguson: It depends upon whether or not the provisions with respect to the ultimate distribution to a charity qualify as a charitable deduction for the state.
Justice Byron R. White: Let’s assume it does.
Mr. M. Carr Ferguson: If it does then the charitable deduction would eliminate any taxable income assuming --
Justice Byron R. White: While the state, while the estate is open?
Mr. M. Carr Ferguson: That is correct.
Justice Byron R. White: So that essentially you agree with your brother’s answer?
Mr. M. Carr Ferguson: I agree.
Justice Byron R. White: With the qualification that it's a qualified charitable deduction?
Mr. M. Carr Ferguson: I agree that as long as it’s a charitable deduction which qualifies and the amount of that deduction equals the gross income there would be no net tax due from the estate.
Chief Justice Warren E. Burger: In other words, it has the same status under that theory as though the decedent had made an inter vivos gift on the last day of his life?
Mr. M. Carr Ferguson: Exactly.
There are certain limitations on the charitable deduction which applied to an estate which would not have applied to the decedent and there are likewise certain benefits or allowances which would not have been permitted to the decedent during his life.
Chief Justice Warren E. Burger: But you seem to agree that that was the basic intent of Congress to put the ultimate legate to the legatee, the ultimate distributee in the shoes of the -- just who made the gift inter vivos?
Mr. M. Carr Ferguson: No Your Honor I don’t, I think that the ultimate intent of Congress was to treat the estate as a tax payer separate and apart from the decedent on the one hand and separate and apart from the distributees and beneficiaries on the other hand.
Chief Justice Warren E. Burger: If I hear you correctly you’ve answered the same question in two different ways now Mr. Ferguson?
Mr. M. Carr Ferguson: Your Honor your example posited a particular kind of estate, one in which the entire residue was to go to charity.
In that case I would assume that the provisions of the estate would be sufficient to satisfy the conditions of the charitable deduction and leave no net taxable income.
For that reason I answered your first question that there would be no net taxable income.
In response to your last question which was whether there is a general intent of Congress to exempt all income going ultimately to charities, as my learned friend suggested, I must disagree with that.
I think that the clear intent of Congress was to strain all items of gross income coming in to the custody and management of the estate through the estate’s gross income and through the deductions which are allowable.
So as to make sure that any amounts which are paid out or set aside to charity, meet the conditions of the charitable deduction and if they do not then the estate has a tax, a tax which it pays and which obviously, ultimately becomes a burden on that part of the residual estate indicated by the will to bear the burden of the tax.
Justice Harry A. Blackmun: Mr. Ferguson in the government’s view, who held title to this share of the residue?
Mr. M. Carr Ferguson: We do not dispute that under the provisions of California law, title to all parts of the residue personality and realty was vested as of the moment of death in the ultimate takers, charitable and non-charitable.
Justice Harry A. Blackmun: So you do concede that legal result?
Mr. M. Carr Ferguson: Oh! Indeed we think however, that is irrelevant.
In fact, I had not thought that there was a significance to that.
The tax payer did not contest on brief that the estate was a tax payer with respect to the property which it was administering.
Even this ingenuous argument which is suggested because of some dicta in Bowers versus Slocum does not go so far as to suggest that the gross income arising from the sales which the estate made was not gross income of the estate.
Indeed it is gross income of the estate, all of it.
There is a case not cited in the party's briefs in which the tax court considered the effect of California law and that case is Estate of Kahn, 8 Tax Court 784.
The tax court followed the general rule which had been followed in many other earlier cases that title to property does not define the gross taxable assets in the estate.
The estate for sub-chapter (j) purposes, sub-chapter (j) being those sections dealing with the income taxation of estates is defined in Section 641 to include all income arising from assets within the custody, management and control of the executor.
These assets, the shares of stock in Walt Disney Productions were clearly assets of the estate and when those assets where sold, they generated gross income for the estate.
The estate indeed is Bowers versus Slocum pointed out at page 351 of that Second Circuit’s opinion and I quote from page 351 “cannot escape from taxation except by taking the deductions provided therefore in the statutory scheme.
So, I think that the question properly framed is whether the payments here in question constitute a deduction which is allowable under 1201 (b) in the calculation of the alternative tax.
Justice William H. Rehnquist: This maybe elementary Mr. Ferguson, but I take it the Government’s submission is and perhaps as conceded by both parties that for income taxation an estate is treated as an entity in a way that it is not in a way, in most states for purposes of decedents' estates where you have the executor as an individual and the distributee as an individual, but the estate is simply an accumulation of assets for income taxation an estate is an entity?
Mr. M. Carr Ferguson: Yes sir that is correct.
Sub-chapter (j) I think makes it clear that in estate like a trust is a taxable entity which is taxable as if it were an individual according to Section 641 with the various modifications in that general scheme is set forth.
One of the modifications which is critical here is the different kind of charitable deduction permitted.
An individual for example can take a charitable deduction by giving property to a charity, an estate may not.
An estate may only claim a charitable deduction if it can establish that the amount paid to charity was out of its gross income.
There is no dispute here that the capital gains which were set aside for the charity were out of the estate's gross income.
I have not thought there was such a dispute anyway.
The 45% of the residue of the estate which was earmarked for qualified charities meant that 45 % of the capital gains generated by the estate, its capital gains qualified for the charitable deduction set aside in arriving at the estates taxable income.
And I think that’s where we must begin as Judge Sneed in the Ninth Circuit by pointing out that in the normal computation of an estate's taxable income, it’s capital gains are first computed, including all of the sale of these shares of stock, the 1202 deduction, the deduction of 50% of the capital gains is then computed on the full amount of those gains which would include the 45% as tax payer's first position had indicated and then the balance left in taxable income after an appropriate adjustment for the fact that there has been a 1202 deduction already for part of those capital gains, is then permitted as a deduction under Section 642 (c) as long as it meets the conditions of that section, that is they must be permanently set aside for charity.
The set aside deduction is really a rather special deduction because it involves allowing an estate to take a deduction for an amount not actually paid out.
There is obviously a room for abuse for sheltering income which will be going to the private beneficiaries of the trust and for that reason they’ve set aside deduction like the rest of the charitable deduction in 642 (c) as restricted to gross income items.
Now, if I may proceed from that basic point which I think is the statutory scheme that the estate must report and take into account all of the gross income which it generates by sale of estate assets?
Justice Potter Stewart: Because there is no really no argument about any of these?
Mr. M. Carr Ferguson: I had not thought so.
I had not thought so.
Justice Potter Stewart: I have not thought so either.
Mr. M. Carr Ferguson: We come now to the question of whether the estate in computing its -- its tax on its net taxable income can achieve a lower rate by using the so-called alternative tax under 1201 (b) by combining this deduction for charitable contributions with the 1201 (b) alternative lower tax rate by off setting it against capital gains.
I think that the reasoning of the Weil case, the reasoning of judge Sneed below, and the reasoning of the tax court in the Statler Trust case which was reversed by the Second Circuit, all are perfectly consonant with the assumption which this Court made both the majority and the dissenting opinions in Foster Lumber that the alternative capital gains tax is a tax upon all of the capital gains of the taxpayer, unreduced by deductions which as my learned friend has described them are taken into account in arriving a taxable income, so-called ordinary deductions, ordinary income deductions.
Justice Thurgood Marshall: But the Ninth didn't follow this in the circuit.
Mr. M. Carr Ferguson: I beg your pardon.
Justice Thurgood Marshall: Isn’t it true that the Ninth didn’t follow Judge Friendly’s opinion in the circuits?
Mr. M. Carr Ferguson: That’s quite true Your Honor.
The Ninth Circuit agreed with the tax court decision in Statler Trust which the Second Circuit by a divided vote reversed.
So the -- it seems to me that the -- if I can refer to it this way, the line up of authorities directly on point would be the Statler Trust tax court decision, the Ninth Circuit’s opinion below in this case and the Sixth Circuit’s decision on the Weil case and of course the dissenting opinion of Judge Dooling in the Second Circuit against the majority opinion in Statler Trust.
Justice John Paul Stevens: Mr. Ferguson is that quite fair to treat the Weil case because that wasn’t’ an estate case obviously?
Mr. M. Carr Ferguson: The Weil case was a charitable deduction case involving an individual.
Justice John Paul Stevens: An individual so it really didn’t’ present this problem?
Mr. M. Carr Ferguson: I think that's correct.
Justice John Paul Stevens: And if you’re right that in the alternative tax computation 1201 (b), you do not reduce capital gains by deductions which maybe taken against ordinary income.
How do you respond to the argument in their reply brief about reducing the capital gain for deductions or distributions to non-charitable beneficiaries?
Mr. M. Carr Ferguson: That Your Honor is a place where we do depart from the literal language of the statute.
However, I would suggest that the statutory scheme which we must look at is 1201 and 1202 together.
1202 which is the normal method of tax, if the alternative computation is not used, specifically provides that capital gains which are distributable to beneficiaries under 662 and 661 which do not include charities.
These are the so-called private or taxable beneficiaries, are not taken into account in making the capital gains computation of the estate or trust.
That is because the statutory scheme of sub-chapter (j), as we have heard from the taxpayer, treats the taxable entity of the estate or of the trust as essentially sharing in the income with its taxable beneficiaries to the extent the income is currently distributed.
Now, to the extent the income is currently distributed, the conduit rule which has been taken out of context and used for the charitable deduction, but the conduit rule as Congress explained it in the committee reports is appropriate to treat the estate income currently paid out as carrying with it a share of all of the various categories of income, including capital gain.
Since the individual beneficiaries will receiving it, a part of the capital gain currently of the estate, will each make their own election, whether they use 1202 or 1201 (b), I really shouldn’t call any election, that’s an alternative tax computation requirement.
Justice Potter Stewart: That’s a requirement?
Mr. M. Carr Ferguson: Right, that’s a requirement, but since each will make their own individual computation, the applicability of 1202 or 1201 (b) to each beneficiary will be separately determined.
It would have been clearer if a similar sentence had also appeared in 1201 (b) with respect to taxable beneficiaries.
Justice Byron R. White: What -- if in this case the income had been currently distributable in these years to a charity, would you agree then that the charity should be treated like the taxable distributees?
Mr. M. Carr Ferguson: Your Honor, there are two cases below which involved just --
Justice Byron R. White: I would have thought you would have said yes from your description?
Mr. M. Carr Ferguson: No.
The answer is no because a charity and the two cases which have reached this question in the Court of claims in the Mott case and the tax court very recently in the O’Conner case, have both held that the charity cannot be a distributee of DNI under any circumstances.
It is not a beneficiary within the 661, 662 scheme.
In fact Section 663 as Judge Sneed to point it out specifically holds out charities from the scheme.
Justice Potter Stewart: And it’s that difference Mr. Ferguson that makes you say that the administrative practice with respect to non-charitable distributees described in your petitioner’s reply brief is not inconsistent -- under which you basically do follow the conduit concept, is not inconsistent with the arguments you’re making in this case?
Mr. M. Carr Ferguson: That’s right Your Honor because --
Justice Potter Stewart: And it’s that difference?
Mr. M. Carr Ferguson: That is the difference.
Justice Potter Stewart: That a charity cannot be a beneficiary or is not a statutory beneficiary?
Mr. M. Carr Ferguson: Right and distributees are.
Justice Potter Stewart: And distributees are.
Mr. M. Carr Ferguson: So that a charity -- that the allowance for a charity is the charitable deduction which is a true deduction from taxable income.
Now the 691 (c) cases which deal with a -- with what is clearly a deduction I think under 691 (c) are by their terms not deductions in arriving a taxable income.
It’s a special deduction, as indeed the Micener case made this point and it distinguished the tax court’s decision in Stratford or in the Stratford trust case and also distinguished the Weil case and it said those cases involved deductions in arriving at taxable income.
Justice Potter Stewart: Real deductions?
Mr. M. Carr Ferguson: Real deductions.
And it said that 691 (c) in some pickwickian sense perhaps was like a credit.
It was like an offset to the capital gain.
Justice Potter Stewart: But it’s called the deduction?
Mr. M. Carr Ferguson: Indeed it is and as you know the United States had a great deal of difficulty in accepting that line of cases but the cases themselves distinguished the 691 (c) deduction from the deduction which we are here considering and I think properly so.
I think that the cases here flow from the same or the decision below is consonant with both opinions in Foster Lumber, in that the decisions do recognize that the 1201 (b) computation relates to all capital gains without subtraction for deductions in arriving at taxable income.
The special 691 (c) deduction I think can be explained as an off set in the nature of the credit to make sure that items which were taxable were subject to the estate tax are not again subject to an income tax which might duplicate and indeed exceed the principle amount of the item itself.
There are special considerations there which I think just are not present in any of the so-called ordinary deductions described in the tax.
Chief Justice Warren E. Burger: Mr. Ferguson earlier I said you seemed to answer the same question two different ways and I realized that in this exchanges here a word here or there can make the difference and let me try again, even if there is an over simplification.
Taking Mr. Justice White’s hypothetical case, Mr. Disney left everything, his entire estate after the expenses with the administration to this tax exempt entity charitable.
Do I understand you to concede no income tax during the pendency of the probate proceeding, no income tax after the date of death, is that right?
Mr. M. Carr Ferguson: Assuming, Your Honor if I may add one more fact I can agree with you, assuming that the gross income of the estate could be off set by a deduction under 642 (c) which met the various requirements of that deduction section I would agree.
Chief Justice Warren E. Burger: In other words, the tax exempt ultimate to distributees takes hold at the instant of death, rather than having the executors stand in the shoes of the decedent?
Mr. M. Carr Ferguson: Well, Your Honor again I have to disagree.
Perhaps I can offer another illustration of why we’re having trouble coming to a common agreement as the nature of the taxable estate.
Let us suppose that the executor had the duty to make payments from income or corpus as necessary to provide for the comfort and well being of Mrs. Disney and the children, but that any amount not so expended would then be left in its entirety to charity.
In that case, because of the discretion, the conditions in 642 (c) would not be met, the amount going to charity would not be guaranteed and the estate would be fully taxable on all that income, there would be no refund for the amount -- excuse me, ultimately determined to go to charity.
The charity indeed would take the amount which it will take here as a residuary legatee reduced by whatever expenses, including income tax as the estate encounters during the course of administration.
I think that in every case even the extreme case you have suggested of an estate left outright to charity, the estate must file an income tax return, report its gross income and demonstrate that the income earned does qualify for the charitable set aside deduction.
Justice Potter Stewart: But if it does in the Chief Justice’s question even though the entire income is capital gains income, you wouldn’t need the alternative tax, you would just make the deduction which --
Mr. M. Carr Ferguson: Clearly in that case, the lower tax would be the regular tax and there would be a zero rate.
Justice Potter Stewart: Regular tax without the alternative tax, without any you’re required to figure the alternative tax I guess but you’d figured and discard it.
Mr. M. Carr Ferguson: Clearly.
Justice Thurgood Marshall: I am surprised that had nothing to do with the estate law at all?
Mr. M. Carr Ferguson: No Your Honor we don’t feel it does, we think that that has been decided long ago that the placement of title is irrelevant to custody and management of the assets which is the activity generating tax liability and the reason that Congress has seen fit to treat the estate as a tax payer.
Now the -- if I may return for one moment to the so-called confusion as to the development of the charitable deduction, I think that the preoccupation of the Second Circuit and of counsel for the tax payer on Section 643 and the computation of DNI is irrelevant.
I think for purposes of this argument, we would be willing to concede that tax payer's version of the computation of distributable net income and its attack on the example which we set out in our brief is correct, but we do submit that that is just utterly irrelevant.
You come to the question of distributable net income only after you have arrived at taxable income and in the course of that, the taxable income of the estate has started out with gross income which includes all of the capital gains and then has been diminished by that part of a charitable deduction which or that part of a set aside for charity which comes out of gross income.
And it’s only at that point after you’ve arrive at taxable income that the DNI or distributable net income adjustments become relevant.
We suggest that the only point of looking at the distributable net income scheme is to demonstrate as Judge Sneed did that the only conduit theory, the only distribution theory of sub-chapter (j) has to do with private beneficiaries who share in the tax load to the extent there is a current distribution of income.
To the extent the income is retained that remains taxable to the estate regardless of how it is ultimately distributed and the charitable set aside deduction of 642 (c) is simply one of the deductions in arriving a taxable income.
When you go to look at the alternative tax in 1201 (b), we suggest that there’s no more reason for pulling out the charitable deduction than there would be for pulling out the executors commissions which maybe deductions in looking at the way, the computation of net capital gains is to be made.
We suggest the Court was quite correct in its assumptions and both opinions in Foster Lumber that net capital gains means net capital gains for purposes of the alternative tax.
Thank you very much.
Rebuttal of Ronald E. Gother
Chief Justice Warren E. Burger: Very well Mr. Ferguson.
You have a few minutes left Mr. Gother.
Mr. Ronald E. Gother: Thank you Your Honor, just one quick point.
Don’t be misled by the use of the word “deduction” in 642.
642 speaks of it in terms of a deduction and I think Government is emphasizing that word more than need be.
642 provides for an unlimited deduction and it provides that it is available even if there is not a distribution.
You put those two concepts together and you got something other than a deduction.
Justice Potter Stewart: Well, some deductions are unlimited?
Mr. Ronald E. Gother: Some deductions are unlimited --
Justice Potter Stewart: And there are limitations for another.
Mr. Ronald E. Gother: -- but only if you pay them out.
Justice Potter Stewart: Yes but your second point is --
Mr. Ronald E. Gother: My second point is that you don’t even have to pay it out, but it’s on.
Justice Potter Stewart: And that’s contrary to the ordinary concept of a deduction?
Mr. Ronald E. Gother: Also, the deduction that you get for distributing amounts to a taxable beneficiary under 661 to a taxable beneficiary is worded as a deduction.
Same word “deduction,” but it works to take that capital gain out as an exclusion.
So don’t be misled by the words deduction.
Thank you Your Honor.
Justice Potter Stewart: What do you have to say just before you sit down Mr. Gother about then Mr. Ferguson’s explanation of the administrative practice pointed out in your reply brief that you assert is inconsistent with his -- the position of the Government takes in this case.
You know what I’m talking about?
Mr. Ronald E. Gother: No.
Justice Potter Stewart: The government's treatment of non-charitable devices, legatees, distributees is said to be in your -- administratively as said to be in your reply brief inconsistent with the argument that the Government is making in this case in that, that administrative treatment of non-charitable distributees seems to rely upon or recognize the conduit theory and now you heard Mr. Ferguson’s explanation of the difference, i.e. that charities are not beneficiaries within the meaning of the statute and that that explains the difference in practice which he concedes does not follow the literal terms of the statute with the respect to non-charitable distributees but what --
Mr. Ronald E. Gother: The answer to that is that the charitable entity doesn’t need this deduction, this distribution.
It is not a -- it doesn’t need to be a distributee to get the deduction.
The taxable beneficiary needed that and that’s the conduit which carries the taxable amount off to the taxable beneficiary.
The charity because of the fact that it gets this deduction without a distribution just didn’t -- just wasn’t unnecessary to deal with a charitable entity as being a distributee.
Chief Justice Warren E. Burger: Is that to avoid double taxation of the taxable distriburtee in part, that deduction allowance?
Mr. Ronald E. Gother: No I don’t think it relates to the double tax issue.
Chief Justice Warren E. Burger: Well if it's tax in your estate as income and then taxed again to the distributee as income?
Mr. Ronald E. Gother: Oh yes that‘s right, you need the distribution out to cause -- to eliminate the double tax on that and in the case of the charity, you don’t have that, you’re not eliminating a double tax.
Thank you, Your Honor.
Chief Justice Warren E. Burger: Thank you gentlemen.
The case is submitted.