Ray D. Bateman and Helen C. Bateman v. United States of America, Dow R. Bateman and Elaine C. Bateman v. United States

employees Dow Bateman were as well as Dept, Paup (argued), Michael L. S.U. partners, and the court found their sala- Ugast, Acting of Justice —Fred B. Asst. employees ries as to be reasonable. Gen., Atty. Div., Crampton, Tax Scott P. years question, Prior to the tax in Rothwacks, Atty. Meyer Gen., and Asst. Ray and Dow Bateman Dept, Justice, both created Washington, D. U. S. for trusts the benefit C., of their children Brooks, Lawrence W. Asst. U. S. Ray and acquired, Atty., as sole own Angeles, Cal., Los for defendant- er, corporate shell, Group Administra appellant. tors, (GAI). corpo Inc. The and trusts Millikan, (argued), Millikan, E.C. Jr. assigned part ration were then Montgomery Cal., Pasadena, Olafson, & nership interests and BBC received plaintiffs-appellees. . government income The WRIGHT, and Before HUFSTEDLER contends the trusts were not real RENFREW,* Judges, Circuit Dis and purposes for tax under the fam Judge. trict ily partnership provisions of the Internal Code, Revenue and U.S.C. § further corporation contends that OPINION disregarded. was a sham and should be RENFREW, Judge: District We first consider the trusts as appeals The United from a de- States partners. 704(e)(1), Section permitting taxpayers recovery cision .section of the Code U. paid additional taxes assessed and provides: (1)), S.C. § companion taxpayers two cases. The person recognized “A shall be aas part- transferred interests a limited purposes of this subtitle if nership to themselves as trustees for the part- he owns a interest corpo- benefit of their children and to a nership in which is a material solely ration by owned one of the tax- * * income-producing factor *.” payers. The basic issue is in- paid corporation come and trusts BBC maintained its books on the cash may be taxed to these accounting entities should basis method of which did properly be considered income to the re- not reflect accounts receivable and spective taxpayers. Having carefully will owned partnership. Based points gov- upon prices considered the paid by raised par- unrelated third ernment, purchase we affirm. ties for in- * Renfrew, sought only The Honorable Charles B. United 2. Dow Bateman a refund for the Judge, year States District Northern District of calendar 1965. California, sitting by designation. “persons” 3. Trusts are Ray 704(e)(1). (e) (2) Reference to Bateman and Dow Bate- See 26 C.F.R. § 1.704-1 respective (vii). man as includes their spouses. terests, the matter tried to the court below found the same conclusion were us not the It is not will of a value of between issue before us. BBC have during appellate $463,200 rev $405,00.0 the fiscal the function of an court to Corp. years ending 1963, iew evidence de novo. Zenith 1964 and 1965. Hazeltine, 100, 123, found that the trusts and court also GAI law, There were valid under 23 L.Ed.2d 129 California support each during evidence of record to owned a BBC finding,4 clearly period, time it is not erroneous the relevant income-pro- that ducing a matter of law. during peri- factor BBC question There that for od. non-family personal partner service ship, may capi be treated as a government challenges tal asset. See 26 U.S.C. finding grounds. First, court’s on two States, 736(b)(2)(B); Rees v. United urges good personal it that the will was F.Supp. (D.Or.1960), affirmed represented taxpayers merely to the per curiam, 1961). 295 F.2d 817 Cir. present the value of their future earn government urges, however, The that ings. good the Thus will of BBC was good differently will treated should be capital meaning not within the of 26 U. personal family partnership in a service any 704(e)(1), S.C. and therefore personal non-family than in a service partnership transfer of a in partnership. Such a distinction has nei anticipatory assign BBC would be an logic ther a in nor in basis law and we ment of income condemned under Hel reject government it. The failed to vering Horst, point any legislative history out of the 75.(1940). Second, 85 L.Ed. it family partnership (§ section urges that the trusts were not (e)(1)), supports which its conten- since the remained true own any. tion nor do we find Indeed, both assigned ers of the interests 704(e)(1) applicable reg- and the to the trusts. by indicate ulations that reference good belonged toAs whether here will personal to all facts of the each case a finding accept to BBC, we must below the family partnership may service have persuaded unless we are that it was capital income-pro- which a material “clearly 52(a) erroneous”. Rule of Fed- ducing Here, factor. there was evidence eral Rules of Civil Procedure. We have good of the value of the will of BBC including below, the record the reviewed upon party pur- based unrelated third reporter’s transcript testimony chases of In interests. ad- witnesses, persuaded. the and are not so dition, donor-taxpayers’ salaries in we years Whether would reached question in were found to be entity. Capital 4. BBC was a substantial income-producing a material years question, During portion in limited it had 8 gross factor if a substantial partners other than the Batemans as well as income of the business is attributable employees. employment capital 28 to additional The salaries in the business paid by to the Batemans were reasonable i>artnership. general, conducted capital were less than one-third of the amount of income-producing is not a material paid employees. Finally, salaries other factor where the income of the business purchase by principally un- fees, interests commissions, consists finding parties supports compensation personal third related or other services good performed by employees will of not to the BBC was members or partnership. Batemans. hand, On the other ordinarily income-producing a material regulations family partnership 5. The operation factor of the business re provide: section quires substantial inventories a substan 704(e)(1), “For of section plant, machinery, tial in investment or oth determination as whether is a ma- equipment.” (e) er income-producing 26 C.F.R. § 1.704-1 terial be made must factor (1) (iv). (emiphasis supplied) to all each case. reference facts powers fi- emphasized directed to exercise their duciary in reasonable, a factor they agree manner, as indeed were al- 704(e)(2).6 regulations We and § ready obligated general part- Wright’s do as ex- Judge dissent with dealing part- person- ners their been will tent had 15509(1); Cal.Corp.Code in- Wind Batemans, ners. the transfers of al to the Herbert, Cal.App.2d 8 Cal. re- v. not have to the trusts would terest Abraham, (1960); Rptr. recognition. cir- Nelson those tax Under ceived very 177 P.2d 931 29 Cal.2d substan- without cumstances, longer partner- BBC, trusts’ duration than ten was owned tial will only years. ques- trusts which Not were the one in ship not have been would permissible within the tion drafted framework, here, However, no evidence the facts but there was under factor. owned BBC fact the Batemans acted outside found that the court below government in effect con- contends that while which it. upon po- here, Based abuse asset. there there was stituted tential, appears in- the Batemans and therefore the trusts facts, these However, transferring personal income valid. abuse, absence of were not such being no basis the trusts must receive the treating good There trusts. differently recognition.8 non-family partner- partnerships Ray corporation, Bateman’s ships, as a matter no error we find GAI, per the of a cent owner 21 findings the court below. in law the interest, partnership presents a closer government govern next contends question than the trusts. The the the true owners that ment that donors contends was a sham. GAI very the be taxed on question the and should a trusts This is close and were challenge court, is based trial trust income. This we a we would have been donors, government’s positions sympathetic to on the Batemans’ as more the trustees, However, may and remaindermen view. we not substitute judgment partners. the Batemans our for that of be While the court gone permissible question corpora control brink of low. a genuine ownership, they it. have not crossed tion is or a and Congress sham is one of fact. (9 require C.I.R., 992, strict Noonan

has established v. 451 F.2d 993 1971), Company duration trust. ments for valid limited Cir. Construction a Shaw Regulations (26 (9 C.I.R., F.2d The Clifford U.S.C. 321 Cir. § 1963), provide seq.) et framework and we are limited here the a “clearly proper procedure Ray and Bate- erroneous” the rule. trust up stayed it. The Bate- testified that GAI used to mans have within build retiring prohibited buy from a cash fund the trustees reserve to out man trusts any powers partnership interests, exercising or of the enumerated deceased not to taxes, avoid in cause to be and the court so found. which would -them trial though parties stipulated trustees were Even treated owners.7 The provides: capital. 704(e)(2) 6. donor’s The distributive share partnership earnings any partner- interest a in “In the case of of ship of the by gift, share of be ab- created distributive shall not diminished because of military agreement shall donee sence due to service.” under except income, gross in his be includible prohibited 7. The Dow Bateman further trusts such share determined extent any exercising powers the trustee from compensa- allowance of reasonable without Subpart Subehapter (§ E, in enumerated J tion services rendered to seq.) et of the Code. except donor, extent portion shown, share attributable a trust of such When such abuse greater Kuney proportionately recognition. its loses tax See donated 1962). Frank, attributable F.2d share the donor Cir. (9th op- per curiam, investments, passive GAI aff’d 295 F.2d 817 other than 1961), rejecting businesses,9 tes- in the distinction be- and Bateman erated good would be tween will associated with the busi- bill tified that he knew good corporation, not ness itself and associated with we are smaller with the partners. Rees, individual a dentist a “definite and firm conviction left with profitable relationships client sold that a mistake has committed.” been practice. Gypsum Co., interest his United States permitted 364, 395, The court the dentist to treat L.Ed. proceeds from the sale his capital gain. Affirmed. normally Good will would follow Judge WRIGHT, EUGENE A. Circuit partner- dentist who from withdrew (dissenting): ship competed nearby location. respectfully I re- dissent. I would Under the test that I have proposed, judgment verse district court normally dentist’s will would not and remand the case for further factual findings. 704(e), yet the Rees court held sale capi- dentist’s will was a sale I. Therefore, appears tal asset. that the The district court found that proposed test is inconsistent with our trusts were valid under Int. holding in Rees. Rev.Code since the trusts Rees, however, considered whether the partner- owned “a proceeds personal good from the sale ship Brokerage [Bateman which Co.] capital gain ordinary will are income. ais material ability Section deals with the factor.” The part district court relied spread income and avoid partnership’s good will, on the progressive very tax rates. These are the form of established client relation- problems, meaning different ships, finding support capital to its “capital interest” this case must be income-producing was a material factor. determined with reference to the back I would hold that will in the form ground purpose 704(e). relationships cap- of established client ital for 704(e) only of to § spreading among family Income mem the extent that it is with the associated progressive bers to avoid tax rates has merely par- business itself and not with judicial received considerable attention. ticular individually. In order to ability restrict of tax payers applied routinely The test progressive be should to avoid through family splitting will would taxation remain income penalizing with the business or gifts, follow without the individu- bona fide partner Supreme al developed Court withdrew from the distinction competed gifts gifts business and it. between of income itself and income-producing Since district apply property. court did not of though Al findings gift this test or right make of fact that to in receive so, would allow this court do come to does not shift case the tax burden from person should be income, remanded for fac- who further earns the Lucas tual determination. Earl, 111, 241, 281 v. U.S. 50 S.Ct. 74 majority (1930); Helvering Horst, L.Ed. 731 relies on v. v. Rees United States, F.Supp. (D.Or.1960), 187 924 112, 144, 311 U.S. 61 S.Ct. 85 L.Ed. 75 separate, 9. The rule Corporation is that abe Hoey, tional Investors v. 144 F. entity, corporation engage taxable (2 1944) ; Properties must 2d 466 Cir. Moline v. activity. some Coram’r, 436, Noonan 1132, 87 C.I.R., 1971) ; v. 451 F.2d (1943). 992 Na- L.Ed. 1499

555 “spe- Thus, 704(e) prop overruled (1940), gift § of “original capital” services” to the do cial erty the tax burden does shift 5, had es- rules Tower and Commissioner, Culbertson U.S. nee, 300 Blair v. partnership interests, ad- (1937). tablished for 330, 81 L.Ed. 465 S.Ct. 57 mittedly nature, capital do- that were devices for they attractive are Since family nated to members. members, family spreading income Nothing history subjected in the partnerships § family were however, Supreme indicates that standards special scrutiny Court Earl, Helvering Horst, partnership in v. Lucas v. donated even where longer Blair, v. clearly in nature. were no Commissioner were terests applicable determining, pur- Following Supreme decision Court’s 280, poses spreading, Tower, whether a of income v. 327 U.S. Commissioner (1946), it trans- interest had in been fact L.Ed. 670 S.Ct. Indeed, principles those widely ferred. “that one whose believed acquired explicitly approved by the au- cases were 704(e): gift, contri thors the result as a or as gift, acquired as a property bution governing principles Two attribu- controlled busi from relative who long accept- tion income been par not, in the absence ness would (1) proper- ed income from basic: management and ticipation con in the ty is attributable to owner performance or the trol of the business (2) from property; income recognized services, of other vital person services is attributable rendering Mertens, partner.” of Federal Law There is no the services. Commentary Taxation, Code Income 704.10, p. 33; princi- applying reason ples different F. g., e. Sand see Edwin H.Rep. partnership income. implica berg, (1947). The T.C. 423 Cong., Sess., 1st 1951-2 No.586, 82d mitigated somewhat tions of Toiver were Bialock, Harry quoted in L. C.B. 357 Culbertson, U.S. Commissioner [Em- T.C. 3n. (1949), 93 L.Ed. S.Ct. phasis added.] services” and held that the “vital which principles referred The two “original merely capital” in tests were Report from House are derived Lucas than conclusive. But dicative rather Earl, Helvering Horst, and Commis- gifts Culbertson, after even Thus, v. Blair. it is sioner clear partnership interests to members the drafters of did not intend presumptively for tax ineffective cases, to overrule those but rather purposes. they merely Tower intended to overrule and Culbertson. Tower, and In the of Culbertson wake Congress passed predecessor the of § An of Lucas v. Earl re- examination 704(e). purpose spread “to insure that Its was veals that income cannot be sim- by ply generated part properly it is a because the income attributable to good personal case, partnership In that at- capital in a ac- an interest will. torney attempted gift spread quired to his taxed to the half of would be through agree- of income to his if the owner such wife an donee he were real regardless whereby equally ment each the motive share interest of Certainly prompting him re- the income of the other. transfer and the attorney gardless from same not the business benefited of or personal participation sort re- his in its of client will benefited from capi- lationships Mertens, that were found profits.” of Tax- be Law Federal 33; Nevertheless, 704.10, p. ation, tal in Rees. Commentary interest Code § Cong. Sess., p. taxpayer prohibited spreading from H.Rep.No.586, 82d 1st see extending Treas.Reg. (e) By addition, In his wife. 1.704-1 § income (l)(v) spreading sit- provides: Rees to income holding personal thereby uation purposes 704(e), cap- For the of § “capital un- will can interest” ital interest means permits majority 704(e), der § part- an in the of the interest assets very type spreading that was of income nership, which is distributable to Earl. condemned Lucas v. capital upon of the owner interest his withdrawal from the or personal good The conclusion upon liquidation partnership. of the “capital interest” under is not a § right participate The mere 704(e) supported by two of the is also earnings profits regulations. Treas.Reg. Commissioner’s capital part- not a is 1.704-l(e)(1)(iv) provides: nership. purposes 704(e)(1), For company Good will associated with the capital is determination to whether captured upon itself can be dissolution income-producing factor a material partnership, of the re- by all the must be made reference to dissolving intact, by any mains Capital a mate- facts of each case. partners who choose to continue their rial factor if a sub- participation in the business. Personal gross portion income of stantial good will, however, captured only can be em- the business attributable to the by the individual with whom ployment capital in the business is associated. gen- partnership. conducted eral, capital is not material income- course, Of it is desirable that terms producing where the income factor meaning art throughout used are with a uniform principally the business consists the Internal Revenue Code. compensa- fees, commissions, or other personal That will was held to be personal performed tion services persuasive in Rees is a reason to employees part- or members provi- hold that it is under other nership. hand, capital On the other sions of the Code. To good hold ordinarily income-produc- purpose will is of § ing operation if factor busi- would however, be inconsistent requires ness inventories with Lucas v. Earl. We should define principal plant, or a investment in ma- way under that is chinery, equipment. or other [Em- Supreme consistent with the de- Court’s phasis added.] cision in Lucas v. Earl rather than with our own decision in Rees. Brokerage The income of Bateman Co. principally fees, “consists sions, commis- “cap- Good should be defined as a compensation person- or other ital interest” for performed by al services members 704(e) only to the extent that it is asso- partnership.” employees of the Under ciated with business itself rather Treas.Reg. 1.704-l(e)(1)(iv), there- .§ merely partners. I individual fore, Brokerage type Co. is judgment would reverse the of the dis- that, general,” of “in business does not trict court and remand for a de- factual income-pro- as according termination to this standard. ducing 704(e). factor under I would § excepts personal hold that II. “general” company service from the rule Treas.Reg. 1.704-l(e)(1)(iv) only of The district court found also personal company Group Administrators, when the service has Inc. was a valid Brokerage of associated Co. and company corporation’s itself. the income of attributable partnership interest tax- corporation than to the rather America, UNITED STATES payers. Appellee, ownership Corporate recognized not be need interests RUFFIN, Appellant. Thomas J. corporation sham is a America, purpose of tax avoidance. UNITED STATES

created Appellee, Commissioner, F.2d Noonan v. 1971); Co. Construction (9th Shaw (9th Cir. Commissioner, F.2d Ralph Appellant. RUFFIN, S. corporation created 1963). Whether 73-1379, Nos. 73-1380. purpose legitimate is a business for a Appeals, United States Co-urt may finding fact that sham Eighth Circuit. “clearly only un- erroneous” if reversed Submitted Nov. 1973. 52. Id. der F.R.Civ.P. Decided Jan. Group found that district court Administrators, for a was created Inc. purpose:

legitimate the crea- business fund from which

tion of reserve withdrawing interests purchased to ensure

partners could be

continuity partnership. The cre- for the legiti- reserve fund is a

ation of such a purpose, but fund can

mate business

easily within be created personal or within the funds

funds taxpayers partners. The of-

one why purpose explain no fer business under the shell of

the fund was created Although separate corporation. legitimate fund had a reserve business separate corpora-

purpose, of a the use pur- fund no

tion to had establish

pose tax avoidance. other than it- purpose fund reserve If the legitimate business

self can serve as purpose corporate use of the

form, spread in- partnership can its many corporations it has into as come require I reserve to create. would funds legitimate taxpayers provide a purpose creating re-

business separate the shell fund under serve creating

corporation re- rather partnership or

serve fund within

within the partners. funds of one provided legitimate purpose. There-

such

fore, reverse, “clearly I errone- would finding

ous,” the court’s district

Group Administrators, Inc. a valid purposes. for tax

Case Details

Case Name: Ray D. Bateman and Helen C. Bateman v. United States of America, Dow R. Bateman and Elaine C. Bateman v. United States

Court Name: Court of Appeals for the Ninth Circuit

Date Published: Dec 4, 1973

Citation: 490 F.2d 549

Docket Number: 71-2894, 71-2895

Court Abbreviation: 9th Cir.