On Petition for Review of Decision of the United States Board of Tax Appeals.
Before MARIS, JONES, and GOODRICH, Circuit Judges.
In computing, for federal tax purposes, the net estate of Arthur D. Forst, Sr., who died testate on April 2, 1934, resident in Trenton, New Jersey, the Commissioner of Internal Revenue disallowed as a deduction a claim made by a son of the decedent against the latter's estate which the executors paid with the approval and at the request of all of the living and sui juris beneficiaries under the decedent's will. The executors took credit for the payment in their final account and the account was approved in due course by the Orphans' Court of Mercer County, New Jersey, which had jurisdiction of the administration and distribution of the estate.
The Commissioner concluded that the merits of the claim had not been passed upon by the court of distribution in the manner necessary to constitute it, ipso facto, a legally deductible claim against the estate and that the son did not have a valid claim against the father. Accordingly, the Commissioner assessed a deficiency tax appropriate to the augmentation of the net estate by reason of the disallowance of the claim. On petition from the Commissioner's action, the Board of Tax Appeals, 40 B.T.A. 876, sustained the deficiency assessment. The decision of the Board is now here for review on the petition of the executors.
Forst, Sr., being the owner of a majority of the outstanding common and preferred no par stock of a New Jersey manufacturing corporation, entered into a written agreement with his son, Daniel P. Forst, on February 8, 1929, whereby the son agreed to purchase from the father 1,500 shares of the no par common stock at the book value thereof as of December 31, 1928, and to pay therefor with his promissory note bearing interest at six per cent. annually. The note was payable on demand but subject both as to demand and payment to the terms of the written agreement then entered into by the father and the son. The agreement provided that the stock should be transferred on the books of the company to the son, to whom certificates were to issue which he should thereupon endorse in blank and deposit with the father as collateral security for the payment of the note. The stock was to be released from the pledge in hundred sharelots when the payments on account of principal aggregated, from time to time, an amount equal to the proportionate purchase price of 100 shares.
The greement then provided: "The said note representing the purchase price of the said stock shall be paid and satisfied s olely from dividends which shall in the future be declared and paid upon said stock, the amount of the dividends so paid to the * * * [father] shall be first credited to the payment of interest on said note and the balance, if any, shall be credited by the * * * [father] on the principal amount of said note and notations of principal and interest shall be made on the note. * * * "
It is the foregoing provision plus the son's subsequent action in respect of his note obligation which gives rise to the present question. No dividends on the stock were received by the son from September 30, 1929, to April 2, 1934 (the date of the father's death). Nevertheless, the son, notwithstanding the agreement, from time to time between July 1, 1929, and January 2, 1934, paid the father on account of interest on the note a total of $26,957.06, on part of which, as the son correctly avers, had been received by him as dividends on the stock. It was for this amount that the son made claim against the father's estate, alleging in the proof which he filed with the executors that he had made the payments under a mistake of fact as to the terms of the agreement.
The executors contend that the approval by the Orphans' Court of Mercer County of their final account in which they took credit for their payment of the son's claim conclusively determined a valid liability of the father to the son subsisting at the time of the father's death which is deductible in determining the net estate of the father subject to tax.
Unquestionably, a claim against a decedent's estate which is allowed by the laws of the jurisdiction under which the estate is administered is deductible in determining the net estate subject to federal tax. The Revenue Act applicable to the instant case specifically so provides. Sec. 303(a)(1) of the Revenue Act of 1926, 44 Stat. 9, as amended by Sec. 805 of the Revenue Act of 1932, c. 209, 47 Stat. 169, 26 U.S.C.A. Int. Rev. Acts, pages 232 & 643.*fn1
However, to entitle a claim to deduction under the federal taxing statute on the ground indicated, it is necessary that the claim be established as a valid charge against the decedent's estate under the laws of the state. That is what the Revenue Acts contemplate and therefore require. Ordinarily, the decision of a state court, having jurisdiction of a decedent's estate, that such is the status of a particular claim is determinative of the validity of the claim. In such case, its deductibility from the gross estate for federal tax purposes follows automatically under the provisions of the Revenue Act. But, that is so only because the state court has passed upon the merits of the claim and has adjudicated its validity according to the laws of the state. The pertinent Treasury Regulation,*fn2 Art. 30 of Regulations 80 (1934 ed.), correctly and competently applies the congressional intent, as expressed in Sec. 805(1)(C) of the Revenue Act of 1932, in its recognition of the effect of a state court's allowance of a claim against a decedent's estate. The operation of the federal taxing act thus depends upon state law to the extent Congress so intended. Lyeth v. Hoey, 305 U.S. 188, 194, 59 S. Ct. 155, 83 L. Ed. 119, 119 A.L.R. 410; Burnet v. Harmel, 287 U.S. 103, 110, 53 S. Ct. 74, 77 L. Ed. 199. But, Congress did not intend that a claim which could not be established on its merits as a valid liability of a decedent's estate should be accorded deduction for federal tax purposes merely because a state court approved, pro forma, the executors' payment of the claim, no sui juris interested party objecting. United States v. Mitchell, 7 Cir., 74 F.2d 571, 573. See also Buck v. Helvering, 9 Cir., 73 F.2d 760, 765, and Smith v. United States, D.C., 16 F.Supp. 397, 402.
The cases cited by the appellants confirm rather than reprobate the pertinent rule. Each of them was an instance where a state court had heard the merits and on that basis determined and settled property rights. Thus, in Freuler v. Helvering, 291 U.S. 35, 54 S. Ct. 308, 78 L. Ed. 634, the state court considered and thereupon determined what was corpus and what was distributable as income; in Blair v. Commissioner, 300 U.S. 5, 57 S. Ct. 330, 81 L. Ed. 465, the state court likewise adequately considered and etermined the validity of an assignment of the beneficiary's interest in a spendthrift trust; and in Sharp v. Commissioner, 303 U.S. 624, 58 S. Ct. 748, 82 L. Ed. 1087, the state court considerately concluded that certain property belonging to a trust estate created by a decedent in his lifetime and not to his estate.
Here, there was never an adjudication of the son's claim on its merits. The Orphans' Court of Mercer County had no alternative under the circumstances but to approve and confirm the executors' account. The only persons interested in the balance for distribution shown by that account were the beneficiaries under the decedent's will, by which the decedent's widow took a life interest in the residual estate with remainders over to the decedent's surviving children and their issue, per stirpes. The widow and children formally approved, and requested the executors to make, the payment. This, they might do, even though the claim was not legally enforceable, but their so doing cannot affect the tax liability of the estate. United States v. Mitchell, supra, 74 F.2d at page 573. The fact that no interested parties*fn3 objected to the executors' payment of the claim could not serve to give it the certain validity under the laws of the state which the Revenue Acts require as a prerequisite to a claim's deduction from a decedent's gross estate.
We have, then, to consider the claim on its merits. The son contends that in making the payments of interest on his note from funds not derived from dividends on the stock, he acted under a mistaken conception of the terms of the agreement between him and his father. The Board of Tax Appeals said in its opinion [40 B.T.A. 881], - "We do not think it can be seriously contended that Daniel P. Forst made these payments under a mistake of fact and could recover them for that reason, because the terms of the agreement and the note are clear and unambiguous and not susceptible of misunderstanding". The finding therein contained that the son did not make the payments under a mistake of fact is fully supported by the evidence. The terms of payment, conditioned upon the son's receipt of dividends, as specified in the agreement, are clear and unambiguous. The son could not be in default in his obligation under the note so long as dividends on the hypothecated stock were not paid. But it does not follow that the son was thereby precluded from otherwise discharging his note obligation to his father if he so chose. And that is precisely what the son did choose to do and what the father must have knowingly understood the son was doing when, without the son's receipt of ...