## Facts

- Alexander Rothstein co-founded Industrial Developers, Inc. (IDI), a real-estate holding corporation, and owned 300 shares.
- In 1957, Rothstein created an irrevocable trust for his three children, transferred his 300 IDI shares to the trust, and named his wife (Reba Rothstein) as trustee; dividends were required to be distributed but none were paid.
- In 1964, Rothstein acquired the other 300 IDI shares from his partner for $500,000 with deferred payment.
- In 1964, Rothstein bought the trust’s 300 IDI shares for $320,000 by delivering an unsecured promissory note to Reba as trustee; he paid interest on the note as scheduled.
- In 1965, Rothstein dissolved IDI, took the assets personally, refinanced with a $700,000 mortgage to pay the partner, and gave the trust a second mortgage to secure the $320,000 obligation.
- On the 1965 return, the Rothsteins claimed an interest deduction for payments made to the trust and reported a capital loss tied to the IDI transactions.
- The IRS disallowed the interest deduction and rejected the claimed stepped-up basis from the trust “sale,” asserting that grantor-trust rules treated Rothstein as the owner of the trust portion involved.
- The estate and widow pursued a refund action; the district court entered judgment for the United States, and the taxpayers appealed.

## Issues

1. Whether Rothstein’s acquisition of the trust corpus in exchange for an unsecured note to his spouse as trustee constituted an indirect borrowing that made him the trust’s owner under IRC §§ 671 and 675.
2. If Rothstein was treated as the trust’s owner, whether the stock “sale” could be respected for tax purposes to produce a stepped-up basis and related loss under IRC § 453.
3. If the trust was not a separate taxpayer as to the relevant portion, whether “interest” paid to the trust was nondeductible as a payment to oneself.

## Decision

- The Second Circuit affirmed judgment for the United States.
- The court upheld treating Rothstein as the owner of the relevant trust portion under the grantor-trust rules, based on the unsecured obligation to a related trustee.
- Because Rothstein and the trust were not treated as separate parties for income tax purposes as to that portion, the purported sale did not produce a stepped-up basis or recognized loss.
- The claimed interest deduction was properly denied because the payments were treated as interest paid to oneself.
- The court did not reach the asserted jury-selection error because the statutory issue was dispositive.

## Legal Principles

- Under IRC §§ 671 and 675, a grantor may be treated as the owner of trust property when the grantor directly or indirectly borrows trust corpus or income without meeting statutory conditions (including adequate security and independence from a related, subservient trustee).
- When the grantor is treated as the owner of a trust portion, the trust is not treated as a separate taxpayer as to that portion; transactions between the grantor and the trust are generally disregarded for income tax purposes.
- A grantor cannot deduct “interest” paid to a trust to the extent the grantor is treated as paying interest to himself due to grantor-trust ownership.
- A purported sale between a grantor and a trust that is treated as grantor-owned does not support a stepped-up basis or recognition of gain or loss as between separate parties.

## Conclusion

The court held that Rothstein’s unsecured note to his spouse as trustee brought the transaction within the grantor-trust ownership rules, so the trust and grantor were not separate parties for tax purposes; the stock “sale” was disregarded and both the interest deduction and claimed stepped-up basis (and related loss) were denied.


Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984)