## Facts

- A 1935 Texas trust for Caroline Hunt authorized distributions of “net profits or net earnings” to the life beneficiary but prohibited distributions that would invade trust corpus.
- The trust became a limited partner in ZH Associates, a securities-trading partnership that generated substantial realized capital gains.
- The trust’s accounting credited the partnership’s capital gains to the trust’s principal (capital) account.
- During the tax year ending June 30, 1987, and a short period July 1–December 31, 1987, the trust distributed approximately $4.5 million and $1.6 million, respectively, to the life beneficiary.
- On its returns, the trust included the partnership’s capital gains in distributable net income (DNI) and deducted the full distributions as amounts distributed to the beneficiary.
- After audit, the IRS excluded the capital gains from DNI, limited the trust’s distribution deductions accordingly, and assessed roughly $3 million in additional tax, penalties, and interest.
- The trustee paid the assessment and sued for a refund; the case was decided on cross-motions for summary judgment.

## Issues

1. Under the trust instrument and Texas trust law, were the partnership’s realized capital gains allocable to trust income (distributable) or to corpus (principal)?
2. If the gains were allocable to corpus, could they nonetheless be included in DNI to support a deduction for distributions to the beneficiary under the Internal Revenue Code and regulations?

## Decision

- Summary judgment was entered for the United States, and the refund claim was denied.
- The court held the partnership capital gains were allocable to corpus under the trust instrument and Texas law.
- Because the gains were not allocated to income and were not paid, credited, or required to be distributed as income, they were not includible in DNI.
- The IRS properly reduced the trust’s distribution deductions and taxed the excess distributions at the trust level; no overpayment was shown.

## Legal Principles

- For trusts and estates, capital gains are generally excluded from DNI unless they are (1) allocated to income under the governing instrument or local law, or (2) paid, credited, or required to be distributed to beneficiaries.
- State trust law and the governing instrument control whether a receipt is principal or income for DNI purposes when federal tax rules turn on that classification.
- A trustee’s tax-return characterization cannot convert principal into income when the instrument, local law, and the trust’s own accounting treatment classify the item as corpus.
- Provisions barring invasion of corpus weigh against construing general “profits/earnings” language to permit routine distribution of capital gains to a life beneficiary absent clear direction.

## Conclusion

The court held that the trust’s partnership capital gains belonged to corpus under Texas law and the trust instrument, so they could not be included in DNI to justify full distribution deductions; the IRS’s assessment stood and the trust was not entitled to a refund.


Crisp v. United States, 34 Fed. Cl. 112 (Fed. Cl. 1995)