The Commissioner determined deficiencies in income tax for the taxable year 1941 in the following amounts: Petitioner Docket No. Deficiency Frank T. Knowles ............................. 4016 $1,175.12 Arthur R. and Renee M. Jensen ................ 4017 2,418.14 The petitioner in each docket claims an overpayment.
These proceedings, which have been consolidated for hearing and disposition, raise the general question as to whether certain amounts received by the petitioners upon the dissolution of the teachers' retirement fund of the Hebrew Technical Institute, in excess of their contributions thereto, represent taxable income under section 22 of the Internal Revenue Code.
FINDINGS OF FACT.
Petitioner Frank T. Knowles is a resident of Middletown, Connecticut. He filed his income tax return for 1941 with the collector for the first district of New York. Petitioners Arthur R. Jensen and Renee M. Jensen are husband and wife, and reside at Flushing, New York. They filed a joint income tax return for 1941, also with the collector for the first district of New York.
The Hebrew Technical Institute, hereinafter called the "Institute," is a charitable corporation organized in 1884 under the laws of New York, for the purpose of teaching boys useful trades. It operated a school for technical education for many years. The institute was held to be exempt from Federal income tax on March 24, 1942, under section 101 (6) of the Revenue Act of 1938, and the Internal Revenue Code, as an organization organized and operated exclusively for educational purposes. It was so informed on January 14, 1943, by a letter over the signature of a Deputy Commissioner of Internal Revenue.
Various of the teachers and officials of the Institute had given thought to the establishment of some kind of retirement fund for the teachers. Dr. Morris Loeb, who had been a director of the institute from 1892 to 1912 and had served as president thereof during part of that time, was interested in seeing such a fund brought into existence. On or about December 12, 1906, he donated $1,000 to the institute, to be used by the teachers of the institute for retirement purposes in accordance with the provisions of a fund which was then in process of formation. One condition of the gift was that the principal could be used for payment of benefits during the first three years, but that after December 12, 1909, any unexpended principal was to remain intact and the income alone was to be made available for payment of benefits. In his letter to the institute accompanying the payment of $1,000 Loeb stated:
While this gift is not for the direct use of the Hebrew Technical Institute, I trust that it may prove acceptable; because it tends to remove one of the disadvantages against which a sectarian institution has to contend, when the Carnegie Fund comes into full operation, and because such a mutual benefit will make for more permanent loyalty of the teachers to our Institute. * * *
In January 1907 a group of the teachers employed by the institute voluntarily joined together to form the teachers' retirement fund of the Hebrew Technical Institute, hereinafter called the fund.
The constitution of the fund provided that the object was to furnish life annuities for the members under conditions contained in the articles of the constitution. The articles, as amended, provided that the fund should be founded upon regular payments by the members and that additions to the fund could be made by others interested in the welfare of the institute. The fund was to consist of two parts, a "reserve fund" and a "working fund." The reserve fund was to consist of funds specifically designated for that purpose by the donors and only the interest thereof was to be applied in payment of annuities. The working fund, consisting of interest from any source, payments of members, and nonspecific donations, was to be used for payment of annuities and expenses. In their discretion the trustees were authorized to transfer some portion of the working fund to the reserve account. Eligibility to receive an annuity was based on the time of service at the institute and the number of years as a paying member of the fund. Membership was open to all qualified employees of the institute upon written application and unanimous vote of the paying members. Teachers in the service of the institute over 45 years of age at the time of the adoption of the constitution could retire after 12 years of active service with full retirement benefits. Each member authorized the deduction by the treasurer of the institute of $50 per year, one-twelfth to be deducted monthly, for payment to the fund. Such authorization was irrevocable except for withdrawal provided for in the constitution. In case a member severed his connection with the institute prior to his regular retirement, he could withdraw the amount of his contributions, plus simple interest thereon at the rate of 2 1/2 percent per annum. In the event of the death of a member before his retirement, his designee was entitled to the amount of his contribution, plus interest at the rate of 2 1/2 percent per annum, but not less than the sum of $400. If a member left no living relative or designee, the money reverted to the fund as part of the reserve. At a member's death after retirement, the widow or minor children were to receive a sum equal to the difference between his contribution, plus 2 1/2 percent interest, and the annuities paid during his retirement, plus 2 1/2 percent interest. In no event was such payment to be less than the amount of the annuity paid him the previous year. Retirement was optional at the age of 55 years, provided the member had been 25 years in the employ of the institute. At the age of 60 or more any employee who had been a member of the fund less than 20 years could retire at that fraction of the normal pension whose numerator is his years of membership and whose denominator is 20. A member becoming disabled during his term of service could become a beneficiary without regard to his length of service or length of time as a paying member. The amount of the annuity to which a beneficiary would be entitled was to be fixed by the trustees. It was understood that it was the aim of the fund to provide an amount at least equal to one-half of the beneficiary's average annual salary during the 5 years immediately preceding his retirement. Annuities were payable monthly. There were 5 trustees of the fund, 2 from the board of directors of the institute and 3 selected by the teachers. The treasurer of the institute was the treasurer of the fund.
On January 9, 1907, the institute turned over to the fund the $1,000 gift it had received from Loeb. No part of the principal of such gift was used for payments or benefits prior to December 12, 1909, so that the principal thereafter became unavailable for payment of benefits. At no time subsequent to January 9, 1907, and prior to liquidation of the fund, did the assets of the fund fall below $1,000, the amount of the Loeb gift.
Petitioner Frank T. Knowles joined the fund on December 1, 1911. Petitioner Arthur R. Jensen joined the fund in 1916, but left the institute thereafter to join the armed services and rejoined the fund on September 11, 1920.
On or about October 8, 1912, Morris Loeb died, leaving a last will and testament, which was duly admitted to probate by the Surrogate's Court of New York County, on or about February 11, 1913. The will provided, in part, for a bequest to the institute of $25,000, less amounts given by the testator during his lifetime. The principal of this fund was to be kept intact and the income to be used for the benefit of the teachers of the institute. The institute was empowered to deliver the amount of the bequest to any properly constituted organization having as its object the welfare of the teachers. The institute received $21,500 in full payment of the legacy and on the date of its receipt by the institute, October 8, 1913, the amount was turned over to the fund. At no time after October 8, 1913, and prior to liquidation of the fund, did the assets ever fall below the sum of $22,500. The Loeb money totaling $22,500 was recorded on the books of the fund in a separate "bequest" account and was kept in such separate account until the liquidation of the fund in 1941. Except for the Loeb gift and bequest, all donations received by the fund were paid directly to it and not to the institute.
From the date of its organization the fund kept separate books of account, consisting of a cash book and ledger, and maintained its own bank account. The assets of the fund were invested in such securities as were legal investments for trust funds in New York, and investments were made in accordance with advice rendered by an attorney consulted for that purpose.
The alumni of the school were actively interested in furthering the retirement fund project, and, beginning in about 1920, it became their practice to give donations to the fund.
The institute discontinued its teaching activities on June 20, 1939, as a result of the withdrawal of financial support by the Federation of Jewish Philanthropic Societies. The reason for such withdrawal of support was that a group in the federation felt that the work of the institute, although worthy, was being satisfactorily performed by New York City public vocational schools. As the result of the termination of teaching activities, all but three of the institute's employees were discharged. Prior to the closing of the school the directors of the institute had known of the decision to withdraw support and they were concerned over the prospective discharge of the employees, many of whom were advanced in years. In February 1939 the directors of the institute voted to give severance pay to the employees who would be discharged. When the teaching staff was dismissed severance payments were made by the institute to discharged employees who were entitled to retirement benefits from the fund, as well as those discharged employees who were not members of the fund. The amount of the severance payments was determined by length of service and other factors. The minimum payment to any employee was 3 months' salary and the maximum to any employee was 18 months' salary. In determining the amounts to be paid to the various employees the directors took into consideration the fact that some of the employees were qualified to receive retirement benefits from the fund. The directors decided that the maximum severance payment to be made to an employee entitled to retirement benefits from the fund should be 12 months' salary rather than 18 months. The highest teacher's salary at the time the institute discontinued its teaching activities was approximately $4,500 a year. Petitioners Frank T. Knowles and Arthur R. Jensen each received 12 months' salary as severance pay and the institute treated the severance payments as salaries on its books.
Pursuant to the provisions of the fund constitution, it was determined that, of the members of the fund who were discharged in June 1939, 9 individuals, including petitioners Jensen and Knowles, were entitled to retirement benefits. To this number was subsequently added Marie M. Smith, who was employed for a short time after the school was closed. Two other employees, Foster and Jackson, had previously been retired. The number of beneficiaries was thus 12. Neither Marie Smith, Foster, nor Jackson had been voted severance payments in the spring of 1939.
The average age of the 12 employees entitled to retirement benefits from the fund was over 65 in 1940. The assets of the fund, including the Loeb gift and bequest, would have been completely exhausted in 5 years or less if payments had been made to retired members in an amount equal to one-half of their average annual salaries for the 5 years preceding their retirement. The directors of the institute became aware of the fact that the simultaneous qualification for retirement of the group of 9, later 10, members, in addition to the 2 who had previously retired, would soon exhaust the fund and, after discussion, they decided that the employees should be advised to dissolve it and that the institute would make a payment to the fund to make possible a more suitable amount for distribution to the members. In 1940 an attorney was retained to investigate the legal questions presented in the matter. The attorney reported that the complete dissolution of the fund could not be accomplished without first obtaining judicial approval of the distribution of the Loeb gift and bequest, in view of the restrictions which had been imposed on them. He further reported that the institute was not empowered by its charter to make a payment of the character proposed, so that legislative authority would have to be obtained for such use of its funds. The report was brought to the attention of all concerned and thereafter the directors authorized the attorney to draft a plan of dissolution; to take the steps necessary to obtain judicial approval of the distribution of the Loeb gift and bequest, and to draft a proposed legislative authorization for the payment by the institute to the fund.
Early in 1941 an action was instituted in the Supreme Court of the State of New York for a declaratory judgment that the principal of the Loeb gift and bequest could be distributed pursuant to the plan. This action was brought in the name of the treasurer of the fund and of the institute against the Attorney General of the State of New York. The complaint alleged every connection between the institute and the fund. Among other matters it was alleged that:
21. The existence of the Fund has been used by the Institute as an inducement in the hiring of competent teachers and has been of material assistance in obtaining a competent teaching staff.
22. The activities of the Fund throughout the period of its existence have been charitable, benevolent and educational in nature and have contributed directly to the furtherance of the charitable, benevolent and educational functions of the Institute. * * *
The action was brought to a conclusion and judgment granting the relief prayed for was entered on May 24, 1941. A statute authorizing the institute to make "a payment of pension, retirement allowance or other sums" to its former employees was enacted by the New York State Legislature and approved by the Governor.
The plan of dissolution provided for two groups of employees. The first group consisted of the retired or retiring employees, that is, those who were entitled to retirement benefits from the fund. The other group consisted of the two employees who remained on the pay roll after the school had been closed. Petitioners Knowles and Jensen were in the first group. As originally proposed, the plan provided for lump sum payments to the retired employees, based on salaries and life expectancies. This plan was rejected by the directors of the institute because they thought that it would give the largest benefits to the younger employees, who were presumably least in need. To remedy what was termed an injustice it was provided that the lump sum payable to each retired employee under the original plan should be averaged with an amount computed by multiplying the amount of the employee's last monthly pay check by the number of years of service rendered by him or her. In this way it was thought that the members who were older and were less employable would receive larger shares of the total. The plan of dissolution, which amended the constitution, was executed by all members of the fund, by the fund, and by the institute. Among other things, it provided that the retired or retiring employees should accept a lump sum payment in the amount set opposite their names in the plan in lieu of any and all claims against the fund. The members further agreed to accept any payment by way of annuity, pension, or otherwise which may have been received by way of annuity, pension, or otherwise from the fund or the institute after February 1, 1941, as payment in reduction of the lump sum set opposite their names. The present employees agreed to accept, in lieu of all claims against the fund for annuities, pensions, or otherwise, the amount of their contributions, plus simple interest to the date of payment, computed at the rate of 2 1/2 percent per annum and the additional sum set opposite their names. The fund agreed to make payments according to the schedule to each of the members, and the institute agreed to contribute to the fund out of its income or capital, or both, a sum, which when added to the then assets of the fund, would enable the fund to make the payments as per the schedule. The plan was approved and all conditions to its effectiveness were satisfied July 7, 1941. General releases were obtained from all of the members to avoid any claims by them against the fund, the institute, or its directors.
The amounts which had been contributed to the fund by its members aggregated $15,007.83. The amounts which had been donated to the fund by various benefactors aggregated $65,605.91. At the date of its dissolution the fund had assets aggregating $81,950.66. The schedule of payments pursuant to the plan amounted to a total of $140,515.50. On July 7, 1941, the institute delivered to the fund its check in the amount of $58,000. On that same date final payments were made to the retired members. On November 13, 1941, the institute delivered to the fund a check in the amount of $564.84, and on the same date the fund delivered its check to Madeline Menke and Irving Metz, the retained employees, for the balance of the amounts to which they were entitled under the plan. The reason that the institute's payment was made in two separate checks was because the exact amount to be available from the liquidation of the fund's assets was not known on July 7, 1941. The fund was completely liquidated on November 13, 1941. The payments made by the institute were recorded on its books in a separate "retirement fund" account, although the sum was charged on the books as an expense of operation. Under the method of accounting followed by the institute, no charges were ever made directly to surplus.
The institute intended its payment to be a gift to the members of the fund. From the institute's gift Frank Knowles received the sum of $5,394.11 and Arthur Jensen received $7,019.86. Although those amounts were coupled with the payment received by them in settlement of contractual rights in the fund, they were intended as gifts by the institute to the individual members and were so received.
The plan of dissolution did not earmark the sources of the lump sum payment to be received by the employees. From February 1 to June 30, 1941, Frank T. Knowles received from the fund $794.05 in monthly checks of $158.81, which was charged against the lump sum payment due him under the plan of dissolution. On July 7, 1941, he received a check from the fund in the amount of $12,106.93, making a total of $12,900.98. Petitioner Knowles had paid in to the fund in contributions a total of $1,438.65. From February 1 to June 30, 1941, petitioner Arthur R. Jensen received from the fund $840.85 in monthly checks of $168.17, which was charged against the payment due him under the plan. On July 7, 1941, he received the sum of $15,948.41 in three checks from the fund, which represented the balance due him under the plan. He received a total of $16,789.26 under the plan of dissolution. The total amount contributed to the fund by him was $1,000.80.
Frank Knowles, in the calendar year 1941, reported an income tax liability of $411.45, which amount he paid. Arthur R. Jensen reported an income tax liability of $1,090.67, which amount he paid, and on or about January 3, 1944, after the mailing of the deficiency notice herein, petitioner Jensen paid additional income tax of $2,418.14. Each petitioner claims an overpayment.
The respondent in his notice of deficiency determined that the entire amounts received by the petitioners over and above the amounts of their contributions represented taxable income.
OPINION.ARUNDELL, Judge:
These proceedings raise a question as to whether donations made to the teachers' retirement fund by various benefactors constitute ordinary income in the hands of the members on distributions to them, or whether the gift characteristic carries through and the amounts received by the members which are attributable to the gifts are to be excluded from income by virtue of section 22 (b) (3) of the Internal Revenue Code. The petitioners take the position that the receipts derived from the Loeb gift and bequest and from the institute payment come within the meaning of that section and do not represent taxable income in their hands. The Commissioner has determined that the amounts received by the petitioners in excess of the contributions to the fund constitute ordinary income under section 22 (a).
SEC. 22. GROSS INCOME.
* * * * * * *
(b) EXCLUSIONS FROM GROSS INCOME. — The following items shall not be included in gross income and shall be exempt from taxation under this chapter:
* * * * * * *
(3) GIFTS, BEQUESTS, DEVISES, AND INHERITANCES. — The value of the property acquired by gift, bequest, devise, or inheritance. There shall not be excluded from gross income under this paragraph, the income from such property, or, in case the gift, bequest, devise, or inheritance is of income from property, the amount of such income. For the purpose of this paragraph, if under the terms of the gift, bequest, devise, or inheritance, payment, crediting, or distribution thereof is to be made at intervals, to the extent that it is paid or credited or to be distributed out of income from property, it shall be considered a gift, bequest, devise, or inheritance of income from property.
A group of teachers organized a fund for their mutual benefit. Its primary purpose was to provide pensions or benefits termed "annuities" for its members upon their retirement. At the time the institute discontinued the services of the teachers a total of 10 of the 12 members of the fund were eligible for retirement. Membership contributions, donations received, and a small amount of earnings brought the fund's assets to a total of just under $82,000. Thereafter it was agreed that if a plan providing a more satisfactory amount for distribution to each member could be formulated the institute would make a payment in an amount sufficient to cover the excess of the amount payable thereunder over and above the amount of the fund's assets. Payments of some $58,000 were made by the institute to the fund and the agreed upon amounts were distributed to the members, all of whom executed general releases of any rights they may have had.
Over the years 1907 to 1940 various of the institute alumni classes and individuals, exclusive of the Loeb gift and bequest, donated to the fund sums aggregating about $42,000. The money thus received was not designated to be of benefit to specific individual members of the fund, but was available for utilization in carrying out the general purpose of the fund and for meeting the expenses of its operation. The then members of the fund would have shared its benefits upon their retirement, but, had the institute maintained its teaching staff over a longer period, so might other teachers who were not then members. In these circumstances, we think it is clear that the gift characteristic does not follow through the fund into the hands of the members. The benefits of the pension fund were not available without consideration being furnished by the members. They had to comply with the terms of the constitution, which included a payment of $50 a year to the fund. They also had to continue teaching at the institute until they became eligible for retirement. By such participation the members earned their rights to fund benefits. Hence, the amounts received by the members which were attributable to the alumni donations were in the nature of compensation to the extent that they exceeded the members' contributions. William J. R. Ginn, 47 B. T. A. 41.
The principal of the Loeb gift and bequest amounting to about $22,500 constituted a trust fund. The question has been raised as to whether that sum stands on a different footing in the hands of the members. We think not. From the date of its receipt by the fund, income therefrom had been used for general purposes of the fund. By the removal of the trust restriction it merged into other fund assets and passed with those assets under the settlement agreement. In the hands of the members it occupies the same status as the alumni donations.
We think a different treatment must be accorded the receipts attributable to the institute payments. It is apparent that the institute intended to make a gift to the members of the fund. While it is true that the members were all former employees of the institute, the fact remains that the payments were not intended as additional compensation to them. Two years earlier the institute had made severance payments to its employees who were being discharged, including the members of the fund. The institute was under no legal or moral obligation to do more. The fact that the payments made to fund members were somewhat less than those paid comparable employees who were not members does not deprive this later payment of its gift character. In determining the amount of severance payments to be made to the respective employees, the institute was free to take into account whatsoever factors it deemed appropriate. Moreover, a gift is none the less a gift because inspired by gratitude for past faithful service of the recipient. Bogardus v. Commissioner, 302 U.S. 34.
After the institute had decided that it would like to make the gifts in question, it became necessary to obtain special approval by the state legislature. There is no indication that any such action was required before the severance payments were made. We do not think that the fact that the gifts were made through the fund to the members deprives the payments of their character in this instance. The situation is entirely different from the Loeb money and alumni donations. Here the institute intended the payments for specific individuals and in transmitting the gifts they were paid through the fund only for the purpose of adding the amount to that being paid the same individuals by the fund. The treasurer of the institute was the treasurer of the fund. The institute made its payment to the fund on July 7, 1941, and on that same date the fund delivered the payment to the members. We have found that the sum of $7,019.86 received by petitioner Jensen and the sum of $5,394.11 received by petitioner Knowles were resultant from the institute's gift, and, accordingly, we hold that those sums are not to be included in the gross income of the respective petitioners.
We find no particular merit in the petitioners' contention that the transaction amounted to a tax free distribution of trust principal or that it resulted as a long term capital gain from a distribution in complete liquidation under section 115 (c) of the Internal Revenue Code.
The constitution of the fund contemplated the payment of retirement benefits termed "annuities." In lieu of the monthly sums due and payable on retirement and in lieu of any other benefits given them under the constitution, the members agreed to accept lump sum payments which completely exhausted the assets of the fund. Such a settlement of the contractual rights of its members is not a distribution within the intendment of section 115 (c). Nor is the gain on the transaction to be subjected to the capital gains provisions. It represents ordinary income. George A. Hellman, 33 B. T. A. 901; Frank J. Cobbs, 39 B. T. A. 642; petition for review dismissed, 111 Fed. 2d 644; Ralph Perkins, 41 B. T. A. 1225; affd., 125 F.2d 150.
We conclude that the petitioners are entitled to exclude from their gross income the amounts of their respective contributions to the fund and the amounts received by them as a gift from the institute.
Reviewed by the Court.
Decisions will be entered under Rule 50.
Comments