Michael J. Scully and Peter D. Scully, as Trustees of the Paula Alyce Scully Trust, John Frederick Scully Trust, David Lewis Scully Trust, Merida Jane Scully Trust, Richard Peter Scully Trust, Nadine Gay Scully Trust, Kirsten Maya Scully Trust, Thomas Peter Scully Trust and Michael James Scully Trust v. United States

Citation: 840 F.2d 478Docket: 87-1100

Court: Court of Appeals for the Seventh Circuit; March 22, 1988; Federal Appellate Court

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Michael J. Scully and Peter D. Scully, as trustees of multiple family trusts, filed a lawsuit against the United States seeking a refund of $274,583 in income taxes, claiming a loss from the sale of 980 acres of real estate. The district court granted summary judgment to the government, ruling that section 267(b)(5) of the Internal Revenue Code disallowed the loss. On appeal, the government shifted its argument, stating that section 267(b)(6) applied instead. The appellate court remanded the case for the trustees to seek relief under Rule 60(b) of the Federal Rules of Civil Procedure. Upon remand, the district court maintained its position on section 267(b)(5) and denied the trustees' motion. The trustees then appealed this denial, which was consolidated with their earlier appeal. The appellate court upheld the district court’s ruling, affirming that the loss was properly disallowed, but based its decision on section 165 of the Code rather than section 267(b)(5).

The Scully family history is rooted in land management practices established by William Scully in the 1850s, who purchased 46,000 acres in Illinois and leased them under conditions that allowed tenants to maintain and improve the property. This "Scully Tradition" continues today, managed by Michael and Peter Scully, ensuring the land remains within the family and that tenants' investments are protected.

In 1959, Thomas Scully held title to land and established two trusts (the Buying Trusts) for the benefit of his sons Michael's and Peter's children, appointing Michael and Peter as co-trustees. The trusts allocated equal shares to each child and mandated that two-thirds of annual income be distributed to them at age 21, with the remaining third added to the trust corpus. The trusts would terminate ten years after the last of the children alive in 1959 passed away, with descendants inheriting any deceased child's share per stirpes. 

Thomas died in 1961, leaving half of his estate in a marital trust for his wife, Violet, who had a general power of appointment over the trust assets. Upon her death in 1976, Violet directed the majority of the marital trust land to be divided into new trusts (the Selling Trusts) for Michael's and Peter's children, with similar provisions to the Buying Trusts, except all income was to be distributed to the children after age 21, and the termination date was adjusted to reflect the additional children born between 1959 and 1961.

Violet's will required the Selling Trusts to cover estate taxes and administrative costs, but they lacked sufficient cash, leading Michael and Peter to sell 980 acres from the Selling Trusts to the Buying Trusts at $1,550 per acre, based on a prior appraisal. No other sales were made to preserve the Scully Tradition. In 1977, the Selling Trusts reported no gain or loss from this transaction. However, an IRS audit in 1980 re-evaluated the property at $2,075 per acre, leading Michael and Peter to file claims for tax refunds based on this new valuation, asserting a loss of $525 per acre. The IRS denied their refund claim, resulting in subsequent litigation.

In the district court, the trustees and the government filed cross-motions for summary judgment regarding the Selling Trusts' claimed loss, which the government argued was disallowed under sections 267(a)(1) and 267(b)(5) of the Internal Revenue Code. Section 267(a)(1) prohibits deductions for losses from property sales between related parties, and section 267(b)(5) defines fiduciaries of different trusts with a common grantor as related parties. The government asserted that Thomas Scully was the common grantor of both the Selling and Buying Trusts under Illinois law, which identifies the donor of a general power of appointment as the grantor.

Conversely, the trustees contended that federal law, which identifies the donee of a general power of appointment as the grantor for trusts created by that power, should apply. They also argued that, under Illinois law, the donee should be considered the grantor of any trusts they create. Additionally, the government argued that the sale lacked the necessary arm's length character under section 165, which allows deductions for qualifying losses. The trustees countered by asserting that the sale was conducted at a fair price and was part of the Selling Trusts' business, lacking any tax avoidance motive.

The district court ruled in favor of the government, determining that Illinois law governed the definition of a grantor and concluded that Thomas Scully was the grantor of both sets of trusts. The court applied the "relation back" doctrine in Illinois, which posits that property passing through a power of appointment is treated as if it were included in the original trust instrument. The Scullys appealed, and during the appeal, the government shifted its stance, claiming that the district court had misapplied the law regarding the definition of a grantor and requested a remand for further consideration.

Upon remand, the trustees sought to reopen the judgment, which the government opposed, urging adherence to the original ruling but on different grounds. The government introduced an argument based on section 267(b)(6), which disallows losses in transactions between fiduciaries and beneficiaries of the same trust, asserting that the transaction was indirectly covered by this section. The government also renewed its claim that the transaction did not constitute a recognizable loss under section 165.

The trustees argued that the government's reliance on section 267(b)(6) was unfounded, claiming the government had waived this argument by not presenting it earlier in the district court. They asserted that section 267(b)(6) did not apply because the transaction between the trusts did not involve a fiduciary of a trust and a beneficiary of the same trust. Regarding the government’s argument under section 165, the trustees maintained that the Selling Trusts engaged in a valid trade or business and that the transaction was conducted at arm's length for a fair price.

The district court denied the trustees' motion, primarily stating that neither party provided sufficient authority to alter the original decision, which determined that section 267(b)(5) barred the Selling Trusts from recognizing any losses from the transaction. The court ruled that the government had waived its section 267(b)(6) argument by failing to raise it earlier and deemed it meritless even if it had been timely. Given the ruling on section 267(b)(5), the court did not consider the applicability of section 165.

The case presents a unique situation as the government shifted its focus from section 267(b)(5) to sections 267(b)(6) and 165 for disallowing the deduction. The court emphasized a narrow interpretation of whether section 267(b)(6) applied, acknowledging that the sale was not directly between a fiduciary and a beneficiary. The court referenced precedent, cautioning against an overly restrictive reading of "indirectly," while also avoiding any interpretation that would effectively amend the statute.

Congress has clearly defined the scope of section 267(b) concerning transactions involving trusts, establishing an irrebuttable presumption against taxpayers claiming losses from certain specified transactions. In the case of Widener v. Commissioner, it was noted that Congress explicitly disallowed losses when a trust is involved. This particular transaction does not fall under the prohibited categories outlined by Congress, and thus, the trust entities involved should not be disregarded in interpreting section 267.

Additionally, section 165 must also be assessed in relation to the transaction. This section allows for the deduction of losses incurred within the taxable year, provided they are evidenced by completed transactions and fixed by identifiable events. The government argues that the transaction lacked bona fide economic loss since it did not alter the beneficiaries' economic situation, viewing the transaction as a mere shift of money. They further claim that transactions between family members frequently attract scrutiny under section 165.

In response, the trustees assert that they acted in good faith and fulfilled their fiduciary duties, emphasizing that the sale price was determined by an independent appraisal and that the transaction was conducted at arm's length to raise funds for estate taxes, not to evade taxation. They argue they were unaware of any potential loss until the government reevaluated the property two years post-sale. Furthermore, the trustees maintain that the property sold was part of their valid trade or business activities in property management. The case is currently under review following the district court's summary judgment in favor of the government.

Rule 56(c) requires summary judgment when a party fails to provide sufficient evidence to establish an essential element of their case, which they must prove at trial. In such cases, there is "no genuine issue as to any material fact," as a lack of proof on a critical element renders other facts irrelevant. The moving party is entitled to judgment as a matter of law if the nonmoving party does not present necessary facts to prove a bona fide loss. The burden of proof lies with the trustees to demonstrate the legitimacy of the claimed loss. To assess whether the trustees have met their burden, their evidence must be evaluated against the relevant legal standards. Losses associated with transactions that do not change control or the flow of economic benefits are not permissible. Taxpayers cannot claim losses simply by transferring assets while retaining ultimate ownership or control over them. The actual circumstances of the situation, rather than merely legal structures, must be considered to determine if control has shifted or economic benefits have changed.

The trustees failed to meet their burden of proving that the claimed loss was legitimate. While they presented evidence indicating that the transaction aimed to raise cash rather than evade taxes, and that the sale occurred at a fair price within a genuine business context, they could not demonstrate an actual operational separation of the trusts or any real economic loss. The trusts were managed by the same trustees, who are brothers, with all beneficiaries being their children. The primary purpose of the sale was to keep the real estate within the family and to operate the land as a single economic entity, which does not reflect a genuine economic loss. This situation parallels the Northern Pacific Railway case, where a transaction designed to maintain control did not result in a recognized loss. The court affirmed that there was no genuine economic loss despite the trustees' good faith intentions to manage estate taxes and preserve family assets. Additionally, the court ordered that a legal issue raised by the government should be addressed by the district court, leading to a stay of proceedings in the appeal. A small portion of the land was donated to a foundation, and the trustees were not mandated by the will to pay certain taxes from the Selling Trusts' assets.

Under Code Sec. 1014, a taxpayer's basis in property obtained from a decedent is typically the fair market value at the date of death. The Selling Trusts claimed a basis of $1,550 per acre for their 980 acres, resulting in no gain or loss from the transaction. Section 267(a)(1) prohibits deductions for losses from the sale of property between specified related parties, including fiduciaries of the same grantor's trusts. Section 165 allows deductions for losses not covered by insurance. The court emphasized Congress's intent for a uniform national tax system, stating that state law influences only when federal law explicitly relies on it. However, it clarified that state law initially determines legal consequences, which are then evaluated under federal tax standards. The court identified the term "grantor" as significant for understanding legal and economic ramifications under state law. An exception exists if the donee of a power of appointment treats the property as their own, but the court found this exception inapplicable based on Violet Scully's request for the trustees to pay all expenses from trust assets, indicating she did not consider them her own. Consequently, under Illinois law, Thomas Scully was deemed the grantor of the Selling Trusts. The court also clarified that the term "indirect" in tax sections is broader than merely involving a strawman. Section 267(b) outlines relationships that are considered related for tax purposes, including various fiduciary and beneficiary relationships involving trusts.

Treasury Regulation Section 1.267(a)-1 clarifies that Section 267 is not the only basis for disallowing deductions for losses or unpaid expenses from transactions that lack bona fides. The legislative history of the Revenue Act of 1937 indicates Congress intended to allow for disallowance of losses in trust-related transactions beyond the scope of Section 267, particularly when a transaction does not exhibit good faith or finality. In a prior summary judgment motion, the government argued that the bona fide loss requirements under Section 165 were unmet, a claim the trustees contested. Although the district court initially ruled in favor of the government based on Section 267(b)(5), further proceedings saw the issue of Section 165 raised again, leading to an appeal by the trustees.

The document references several cases, including Wickwire v. United States and Widener v. Commissioner, to illustrate differing outcomes based on factual distinctions. In Widener, trusts with related grantors engaged in stock transactions to generate tax losses, which the court deemed bona fide. However, substantial differences in trust structures and beneficiary control differentiated Widener's case from the present one. In contrast to Widener, the Selling Trusts and Buying Trusts in the current case share identical fiduciaries, beneficiaries, and similar long-term projections, with only minor differences regarding potential termination and income distributions. These distinctions were deemed insufficient to change the transaction's nature.