## Facts

- In 1963, Victor W. Krause created three irrevocable trusts for his children and transferred Wolverine Shoe & Tanning Corp. stock to each trust (12,000 shares to one trust; 8,000 shares each to two trusts).
- Each trust instrument required trustees to pay federal gift taxes attributable to the stock transfers and authorized trustees to sell trust assets or borrow funds to meet those tax obligations; trust income was to be applied first to such taxes and related expenses.
- Victor and his wife elected gift-splitting, treating the 1963 gifts as made one-half by each spouse.
- In 1964, trustees borrowed $134,500 from a bank and used the loan proceeds to pay $134,331.65 in gift taxes for Victor and his wife.
- For the trust year ending August 31, 1964, the trusts received dividend income of $7,650 and $5,100 (for each of the other two trusts).
- From 1964 through 1970, the trusts used dividend income to make payments on the bank loans.
- The IRS determined a 1964 income tax deficiency for Victor and his wife, asserting that trust income used (or obligated to be used) to satisfy their gift-tax liability was taxable to Victor and that an additional amount was taxable upon satisfaction of the alleged “income interest.”

## Issues

1. Whether trust dividends (and related loan proceeds) used under the trust instruments to pay gift taxes attributable to the trust-funded gifts were taxable income to the donor.
2. Whether satisfying the gift-tax obligation (and related debt) constituted a “purchase in liquidation” of an alleged donor income interest, producing additional taxable income to the donor.

## Decision

- The Tax Court held for the petitioners and rejected the IRS’s asserted deficiency on these theories.
- Trust dividend income was not taxable to Victor merely because the trusts were obligated to pay gift taxes attributable to the transfers.
- Payment of gift taxes with borrowed funds, and later repayment of the loans with trust income, did not constitute taxable income to Victor.
- The court rejected the “purchase in liquidation” theory because Victor did not possess a separable retained income interest that could be liquidated by the trusts’ tax payments.

## Legal Principles

- A trust’s assumption and satisfaction of gift taxes attributable to a transfer to the trust does not, without more, create a retained income interest in the donor for income tax purposes.
- Payment of the donor’s gift tax with loan proceeds incurred by the trust does not itself generate taxable income to the donor when the trust, not the donor, is the debtor.
- Using trust income to service trust-incurred debt used to pay gift taxes is treated as an expenditure of trust income, not as income constructively received by the donor, absent a continuing right in the donor to such income.
- A “liquidation” or “purchase” theory cannot apply where the predicate retained income interest is not established by the trust instruments and surrounding facts.

## Conclusion

The Tax Court concluded that irrevocable trusts that borrowed to pay gift taxes attributable to funded gifts, and later repaid that borrowing from trust dividends, did not thereby cause the donor to be taxed on the trusts’ income or to recognize additional income upon satisfaction of the gift-tax-related obligation, because the arrangement did not confer on the donor a retained right to trust income.


Krause v. Commissioner, 56 T.C. 1242 (1971)