## Facts

- A will created a $100,000 testamentary trust paying income to John McAllister for life, then (if John died without children) to John’s wife, Mrs. McAllister, for her life, with remainder to other family members.
- After John’s death, disputes arose and funds were needed to address debts and end litigation.
- Mrs. McAllister sued in New Jersey Chancery seeking termination of the trust; the parties reached a settlement approved through the court process.
- Under the settlement, the remainderman agreed to pay Mrs. McAllister $55,000 (plus accumulated income and interest to payment date) in exchange for her release of all interests in the trust and consent to its termination.
- Mrs. McAllister received the $55,000 in 1940 and executed a written release terminating her life interest.

## Issues

1. Whether the $55,000 received for surrendering a life interest in trust income was taxable as ordinary income under I.R.C. § 22(a) or as proceeds from the sale or exchange of a capital asset under I.R.C. § 117.
2. Whether a life estate in trust income constitutes a “capital asset,” and whether a complete relinquishment of that interest is a sale or exchange rather than an advance payment of income.

## Decision

- The Second Circuit reversed the Tax Court.
- The court held that the taxpayer’s life interest in the trust was a capital asset within § 117(a)(1).
- The $55,000 payment was consideration for the sale or exchange of that capital asset because the taxpayer fully surrendered her entire interest and the trust was terminated.
- The payment was not treated as a commutation or advance payment of future income taxable as ordinary income under § 22(a).
- The case was remanded for further proceedings consistent with capital gains/loss treatment.

## Legal Principles

- A life estate in trust income is a transferable property interest that may qualify as a “capital asset” under the capital-asset definition unless a statutory exception applies.
- When a taxpayer disposes of the entire underlying property interest (rather than merely directing future income while retaining the property), the transaction is characterized as a sale or exchange of property for federal income tax purposes.
- A lump-sum payment received in exchange for complete surrender of a life interest incident to trust termination is generally treated as capital-transaction consideration, not ordinary income from a continuing income right.

## Conclusion

The court treated the taxpayer’s court-approved surrender of her entire life interest in a trust, in exchange for a lump-sum payment, as a sale or exchange of a capital asset taxable under the capital gain/loss provisions rather than as ordinary income.


McAllister v. Comm’r of Internal Revenue, 157 F.2d 235 (2d Cir. 1946)