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District Court of Appeal, First District, Division 2, California.


Civ. 13001.

Decided: November 19, 1946

Hugh K. McKevitt and Jack M. Howard, both of San Francisco, for appellant. Philip S. Ehrlich, Albert A. Axelrod and R. J. Hecht, all of San Francisco, for respondents.

This is an appeal by Mae Percival Traung from an order of the probate court approving the third account of respondents as testamentary trustees under the will of Charles F. Traung, deceased. Appellant is the widow of Charles F. Traung, deceased, and is the life tenant entitled to the income from certain property left by his will to the trustees, respondents herein. A part of the property so left in trust was 45,324 shares of Traung Investment Company, which represented approximately 20.16% of the outstanding stock of that company. At the time of the death of the testator Traung Investment Company owned 94% of the capital stock of Mt. Tivy Winery, Inc., and this stock was its only asset.

Charles F. Traung died on February 6, 1940 and this date is the date of the commencement of the trust. Estate of Pratt, 21 Cal.2d 343, 131 P.2d 825. As of December 28, 1942 all of the stockholders of Traung Investment Company sold all of their stock to Joseph E. Seagram and Sons, Inc., and Carstairs Bros. Distilling Co., Inc. This sale was expressly conditioned upon the sale including all of the issued and outstanding stock of Traung Investment Company and the total purchase price was based upon the difference between the value of the assets and liabilities of Mt. Tivy Winery, Inc., as shown by a balance sheet appended to the agreement of sale.

The second account of respondent trustees showed the receipt by the trustees on account of this sale of $74,440.28. All of this was allotted to the corpus of the trust and the account so allotting it was settled without objection.

The third account showed the receipt by the trustees of $17,750.51 on account of said sale. This amount was allotted to the corpus of the trust in the third account and appellant objected to the settlement of the account on the ground that this sum represented earnings which had accrued after the death of the trustor and should have been allocated to income.

While there is some dispute as to the proper construction and effect of the evidence (a matter which we will examine later) it is appellant's position that Mt. Tivy Winery, Inc., earned very substantial income between the date of the trustor's death and the date of the sale of the Traung Investment Company's stock, that this income enhanced the value of the assets of the corporation upon which the sale price was calculated, and that the proportion of the sale price attributable to these earnings was in law income from the corpus of the trust estate which should be paid to the appealing life tenant.

Without elaborating upon the three rules current in the several courts of the United States with regard to the allocation between life tenants and remaindermen of the fruits of corporate investments, and which are known respectively as the Massachusetts, Kentucky and Pennsylvania rules, we are content to note that the Supreme Court of this state is committed to the so-called Pennsylvania rule. Estate of Duffill, 180 Cal. 748, 183 P. 337; Estate of Gartenlaub, 185 Cal. 375, 197 P. 90, 24 A.L.R. 1. That rule is summarized in Estate of Gartenlaub, 185 Cal. at pages 383, 384, 197 P. at page 93: ‘The doctrine generally adopted by the courts of America, and recoganized by this court in Estate of Duffill, 180 Cal. 748, 183 P. 337, is that, where corporate stock forms a part of a trust estate, the income of which is to be paid to one for life with remainder to another, what the remainderman is entitled to is the value of the stock as of the date of the creation of the trust—that is, the testator's death. Any accumulations beyond that date are distributable as profits.’

This rule, in the jurisdictions where it prevails, is limited to the case of extraordinary dividends or profits, no attempt being made to apportion regular or ordinary dividends. 2 Scott on Trusts, sec. 236.1, p. 1293 et seq.; 4 Bogert, Trusts and Trustees, § 844, p. 2445 et seq.; note in 130 A.L.R. p. 494 et seq. It finds its most frequent application in the case of extraordinary dividends, whether in cash or stock, in which cases the courts following the Pennsylvania rule apportion the earnings between life tenant and remainderman so as to preserve the intact value of the stock at the date of the creation of the trust to the corpus of the estate (i. e. that portion of the extraordinary dividend earned before the creation of the trust is allocated to the corpus of the trust and that portion earned after the creation of the trust is paid to the life-tenant). Estate of Duffill, supra, 180 Cal. pages 756, 757, 183 P. 337; Estate of Gartenlaub, supra, 185 Cal. pages 383, 384, 197 P. 90, 24 A.L.R. 1; 2 Scott on Trusts, sec. 236.3, p. 1300; 4 Bogert, Trusts and Trustees, sec. 843, p. 2443, sec. 848, p. 2456; note in 130 A.L.R. p. 538 et seq. The distinguishing feature of the Pennsylvania rule lies in the fact that the courts following that rule attempt to do exact justice between the life tenant and remainderman (in every case except that of regular or ordinary dividends where the amount involved is deemed too unimportant to justify the burden which would be imposed upon the court by attempting an allocation) by preserving the intact value of the corpus of the trust for the remainderman and distributing all income actually earned after the creation of the trust to the life tenant. On the other hand the Massachusetts and Kentucky rules attempt no apportionment of earnings but adopt mechanistic rules of thumb, the only justification for which is found in simplicity of administration by trustees and a lightening of the burden of the courts which are not called upon under either of those rules to inquire into the source of the dividend or to ascertain the intact value of the corpus of the trust at the date of its creation. Cf. 4 Bogert, Trusts and Trustees, § 857, p. 2483 et seq. Since our Supreme Court is committed to the Pennsylvania rule no purpose can be served by examining further into the relative merits of the conflicting rules.

Accepting, as we must, the Pennsylvania rule as governing the decision of this case the primary question presented to us for decision may be simply stated: Where all of the stockholders in a corporation join in a sale of all of its capital stock, the aggregate purchase price being determined by subtracting its total liabilities from the total value of its assets, is the life tenant entitled to the proportion of the purchase price so arrived at which is attributable to earnings realized by the corporation since the creation of the trust? (In so stating the question we ignore for the moment the separate corporate identities of Traung Investment Company and Mt. Tivy Winery.)

Generally in jurisdictions which follow the Pennsylvania rule upon such a liquidation of a portion of the assets of the trust the courts have apportioned to the life tenant the portion of the receipts of the liquidation which are attributable to earnings during the trust's existence. In re McKeown's Estate, 263 Pa. 78, 106 A. 189; United States Trust Co. v. Heye, 224 N.Y. 242, 120 N.E. 645; In re Sherman Trust, 190 Iowa 1385, 179 N.W. 109; In re Heaton's Estate, 89 Vt. 550, 96 A. 21, L.R.A.1916D, 201; Simpson v. Millsaps, 80 Miss. 239, 31 So. 912; Wallace v. Wallace, 90 S.C. 61, 72 S.E. 553.

In United States Trust Co. v. Heye, supra, the New York Court of Appeals said, 224 N.Y. 242, 120 N.E. 645, 648: ‘The fundamental principle involved in these questions is whether there has been a distribution or division of the earnings, profits, or accumulations of the corporation. Until there has been such division, the life tenant is not entitled to any increase in the value of the principal of the trust fund, or the capital and assets of the corporation, shares of which constitute the trust fund. But when there has been a division of the corporate property, no matter what form it may take, that part thereof which consists of accumulated profits or earnings belongs to the life tenant and that which is capital to the remainderman.’

The case most nearly in point, and a leading authority in jurisdictions following the Pennsylvania rule, is In re McKeown's Estate, supra. There, as in our case, there was a sale of stock by the trustees in conjunction with all other understanding shares of stock to a single purchaser. The court held that the portion of the sale price attributable to earnings since the creation of the trust should go to the life tenant. The conclusion of the court is found in 106 A. at page 192: ‘When a corporation is liquidated, those entitled to the income of the trust are to be awarded so much of the sums received for the stock as they show was income accruing after their right to income began, and the balance goes to the principal; and this is so although the course pursued takes the form of a sale of the stock.’

We are satisfied that where the Pennsylvania rule is followed these cases reach the correct result. It is the essence of the Pennsylvania rule that substance is not to be sacrificed to form; that the corpus of the trust estate is to be preserved intact for remaindermen and the earnings in whatever manner received by the trustee are to go to the life tenants.

The purpose of the sale here involved might have been equally accomplished by first distributing the earnings accumulated since the creation of the trust by way of dividend and then selling the stock of Traung Investment Company to the purchasers. In that case the dividend on the shares of stock held in trust would clearly go to the life tenant and only the purchase price, reduced pro tanto by the dividend, would go to the corpus. The accident of procedure by which the sale was effected should not be allowed to change the result.

The fact that there were two corporations here involved is not important. Traung Investment Company owned and controlled Mt. Tivy Winery, Inc., and the shares which it held in Mt. Tivy Winery constituted its only asset. Earnings of Mt. Tivy Winery were in essence earnings of Traung Investment Company and under the circumstances the court should regard substance rather than form and disregard the separate corporate entities. Stark v. Coker, 20 Cal.2d 839, 846, 129 P.2d 390; Conway v. Citrus Belt Land Co., 94 Cal.App. 533, 538, 271 P. 525; Civ.Code sec. 3528. The very manner of the sale demonstrates how artificial is respondents' argument based on the separate corporate entities. The purchasers desiring to acquire the assets of Mt. Tivy Winery, Inc., did so by purchasing the stock of the Traung Investment Company. The purchase price of the stock of Traung Investment Company was expressly based on the net value of the assets of Mt. Tivy Winery. Those assets were enchanced in value by Mt. Tivy Winery's earnings and those earnings in turn enchanced the value of Traung Investment Company's stock. Our courts will not close their eyes to the realities of a situation simply because they are clothed in the legal trappings of one or a series of corporate forms. Corporations are made to serve men, not men to serve corporations, and in no case should courts allow corporate forms to overshadow the realities of the human beings who have created them. If the trustees had owned and operated the Mt. Tivy Winery properties without the interposition of two corporate entities the rights of appellant to the earnings of those properties which accrued after the creation of the trust would be obvious. The corporate shadows are not so opaque as to conceal from the court the intrinsic facts which underlie them.

It is argued also that the settling of the second account of the trustees, in which the total instalment receipts from the sale of the Traung Investment Company were allocated to the corpus of the trust, is res judicata of the question here presented. It is the theory of the Pennsylvania rule that the corpus of the trust should first be preserved intact before any earnings are paid to the remainderman. Where the purchase price is paid in instalments, as here, the first payments under this rule should go to preserve the corpus until its intact value is completely conserved and the failure to object to an earlier instalment being credited to corpus should not estop the life tenant from asserting that a later instalment should be paid wholly, or in part, to the life tenant. In any event the determination of the application of one payment should not be considered res judicata of the proper application of another unless the question controlling the application of the later payment has been actually presented to the court and adjudicated in connection with the earlier one. Estate of Blake, 157 Cal. 448, 456, 108 P. 287; English v. English, 9 Cal.2d 358, 70 P.2d 625, 128 A.L.R. 467.

We find no substance in the point that under the express provisions of the will and the decree of distribution following it the payment of earnings received in this manner to the life tenant is forbidden. Respondents rely on the following language of the will and the decree: ‘(1) My trustee or trustees shall apply the entire net income of all securities held by it hereunder to the use of the beneficiaries hereof, irrespective of the price paid for said securities, or irrespective of their market value at any time, it being intended hereby that no part of such income shall be applied as a sinking fund or otherwise to offset the gradual loss of premium upon the market value or purchase price of such securities. (2) All stock dividends and amounts received upon the sale of rights to subscribe for stocks or any profits accruing from the exercise of such rights, shall be credited to principal and added to the trust estate and be held as a part thereof.’

Neither of the quoted provisions applies to the situation here presented. The decree provides that the ‘trustees shall pay the net income, revenue and profit of the trust estate to Mae Percival Traung, wife of Charles F. Traung, deceased, so long as she shall live * * *’ in which respect it follows a like provision of the will. The testator indicated in the two particulars specified, and only in those particulars, an intention to modify the general direction for the payment of ‘the net income, revenue and profit of the trust estate’ to the life tenant. Under the familiar rule of expressio unius exclusio alterius no other modifications of the direction to pay net income can be added to those which the testator saw fit expressly to provide.

This brings us to a consideration of the evidence produced before the probate court. The weighing of the evidence and the conclusions to be drawn therefrom, are peculiarly for the trial court and we shall pursue our inquiry no further than to determine whether the evidence showed substantial earnings during the trust period which were reflected in the purchase price. The evidence shows a net profit of Mt. Tivy Winery for the fiscal year ending July 31, 1942 of $45,201.22 after payment of income taxes and a net profit from August 1, 1942 to December 28, 1942, § 29,160.39 after payment of income taxes, or a total for the period August 1, 1941 to the date of the sale of $74,361.61. It further shows an operating profit from August 1, 1940 to July 31, 1941 of $28,448 and a loss from the sale of capital assets of $37,999, making a net loss in total assets for the year of $9,551. The loss from the sale of capital assets falls upon the corpus of the trust. ‘The fluctuations in market value after purchase by the trustee are merely changes in the value of the assets of the trust estate, which are to be wholly disregarded in any accounting between life tenant and remainderman for funds from the trust estate invested in income-bearing property.’ Estate of Gartenlaub, 185 Cal. 648, 652, 198 P. 209, 210, 169 A.L.R. 520; Estate of Gartenlaub, 198 Cal. 204, 215, 244 P. 348, 48 A.L.R. 677; Restatement Trusts, sec. 233 and comment b. The property involved in the sale was income bearing property, vineyard and ranch lands, and the loss entailed was a capital loss and not an operating one.

Respondents attempt to reduce these earnings to the vanishing point by reference to various matters appearing in the testimony. They call attention to evidence that Traung Investment Company just prior to the sale had a capital deficit of $113,000. How or when this deficit was created does not appear, but it does appear clearly that during the entire life of the trust Traung Investment Company engaged in no business and had no assets except the shares of stock of Mt. Tivy Winery, Inc. It seems clear that this deficit must have been created before the inception of the trust and cannot be charged against the earnings which were accumulated during the trust's life. The other matters, adjustment and allocation of income taxes, claimed redemption of preferred shares and dividends paid to preferred stockholders, even on respondents' calculations are not sufficient to wipe out the earnings. We express no opinion on the amount, if any, of the deductions from gross income which the probate court should make on their account. Those are questions in the first instance for the probate court any may be more fully established, explained or refuted on a further hearing.

Finally respondents call attention to the fact that there are contingent liabilities of Mt. Tivy Winery approximating $24,500 which may have to be met. The probate court may properly delay the distribution of income until it is ascertained whether it will be needed to meet contingent liabilities. It cannot allocate income to corpus on any such ground.

The order appealed from is reversed.

DOOLING, Justice.

NOURSE, P. J., and GOODELL, J., concur.