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The honorable chief justice and justices of the Supreme Court of Ohio

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					Supreme Court of Ohio
Date: 06/06/2006
Case Number: 05-2084
                                                 -1–

The next case is 05-2084, David Knust versus William Wilkins, the tax commissioner.

>> I'd like to reserve two minutes for rebuttal. Good morning. May it please the court I'm
Steve Nechemias. I'm here representing David Knust, a husband and wife who filed a
joint Ohio income tax return. This case is in Ohio income tax case involving their 2000
Ohio tax liability. It generally involves principles of federal income tax law. In general
the starting point for computing is federal adjusted gross income. And this case is really
about the federal adjusted gross income of the appellants. Trusts are taxpayers and
individuals are taxpayers among others. In the year 2000 trusts were not subject to Ohio
income tax. Their income did not become taxable until in the year -- effective in 2002.
The general assembly determined to impose the income tax on trusts as well as on
individuals. In this particular case, the appellants created trusts in 1998, transferred shares
of stock of their family-owned business. They were the only two shareholders to the trust
in 1998. And at that time the trust filed elections with the internal revenue service to be
treated as what are called electing small business trusts or what tax lawyers sometimes
refer to as ESBITs as the acronym. Under the federal income tax law the income is
taxable to the trust and not to the beneficiary. Under the federal scheme generally, trust
income is sometimes taxable to the trust and that's usually when it's not distributed to the
beneficiary but is taxable to the beneficiary and not the trust if the income is distributed.
However, the scheme for an electing small business trust or ESBIT is a unique scheme
that applies only in the situation where the trust holds stock of an S corporation. A special
kind of corporation for federal income tax purposes and in this case the family-owned
business, the stock that was transferred into the trust, that of precision packaging and
service, was in fact an S corporation and that had to be true in order for the ESbit election
to be made.

>> In an S corporation aren't they required to take certain amount of money each year.

>> All of the income is taxable to the shareholder directly. It a pass-through entity. In this
case the shareholder was the trust and indeed the reason we are here --

>> it was still an S corporation?

>> Yes. This is a trust that is allowed to be an S corporation shareholder. Prior to 1997,
many types of trusts were not permitted under federal tax law to be S corporation
shareholders. In 1997, there was a change in federal law, several, involving S
corporations, one of which was to create this new type of entity called an electing small
business trust. So, yes. The income of the S corporation passes through to the
shareholder. In this case, the shareholder was the electing small business trust and the
reason that we are here today is that the trusts then reported the income on their federal
fiduciary income tax return, form 1041 in this case. The federal returns were filed

Transcripts of oral arguments before the Supreme Court of Ohio are produced by National Captioning
Institute, which has contracted with Ohio Government Telecommunications to provide closed-captioning of
all broadcasts of Supreme Court oral arguments since January 10, 2006. These text files are not official
records of the Supreme Court, and the Court does not vouch for their accuracy. Video of all oral
arguments at the Court since March 2004 is available at the Court’s Web site,
www.supremecourtofohio.gov .
Supreme Court of Ohio
Date: 06/06/2006
Case Number: 05-2084
                                                 -2–

reporting the income in question. It is the tax commissioner's position here that that
income should have been reported not by the trusts but by the beneficiaries and of course
the tax commissioner's position would result in an increase in the beneficiaries' federal
adjusted gross income and resulting in an Ohio tax liability.

>> But you say this is not true because of the change in the law?

>> Correct. This is not true because under the law enacted in 1997, if this particular type
of trust that could elect to be taxed this way, the income would be taxed at the trust or
fiduciary level and that is in fact how the income at issue was reported by the taxpayers
in this case.

>> Because the state income tax keys off of the adjusted gross of the taxpayer, they had a
situation in which income which would have ordinarily been taxed at the taxpayer level
or if it was not sub chapter S would have been taxed at the corporation level is now
diluting state taxation for income purposes?

>> That is correct, Your Honor.

>> And the legislature saw that and closed that gap?

>> They did in 2002.

>> So what was the delay between the change in the federal law and the --

>> I can't speak for the general assembly, Your Honor. You will see --

>> I mean, how long a period of time?

>> Excuse me?

>> How long a period of time? How long did this gap as you see it exist?

>> Four taxable years, '98, '99, 2000, 2001. I'm sorry. 5. 2002. There is attached to our
brief in the appendix copies of bills that were introduced into the general assembly prior
to the taxable year at issue that for whatever reason were not enacted. So the general
assembly was aware of the situation. And I should say that the Ohio income tax was
enacted in 1971 on individuals and estates. So in reality, 30 years went by before it was
determined that the income tax should apply to trusts. And the creation of the electing
small business trust wasn't the only situation in which income was taxed federally at a
trust level and did not leak out, if you will, to the beneficiaries. The creation of the

Transcripts of oral arguments before the Supreme Court of Ohio are produced by National Captioning
Institute, which has contracted with Ohio Government Telecommunications to provide closed-captioning of
all broadcasts of Supreme Court oral arguments since January 10, 2006. These text files are not official
records of the Supreme Court, and the Court does not vouch for their accuracy. Video of all oral
arguments at the Court since March 2004 is available at the Court’s Web site,
www.supremecourtofohio.gov .
Supreme Court of Ohio
Date: 06/06/2006
Case Number: 05-2084
                                                 -3–

ESBIT only made that apply to S corporations but it had been generally through
previously that if a trust did not distribute income to a beneficiary, then the income is
what tax lawyers would call trapped at the trust level and would not have been subject to
Ohio income tax until 2002. I would say the federal creation of the ESBIT expanded the
universe of the type of trust that was not taxable in Ohio but certainly wasn't the first
instance that that occurred. Now, in this case, the Board of Tax Appeals erroneously
determined that in fact the income of the trusts should have been reported by the
beneficiaries.

>> Wasn't that because they determined that it was a grantor trust? You haven't used that
term yet but isn't that the reason you are here?

>> Yes, that is correct. They did. They looked at code section 671, which provides --
which is a different type of trust, not an ESBIT trust. A trust described in section 671 is a
trust where in fact the income of the trust is taxable to the beneficiary.

>> Isn't that an overriding first stage to look at, whether a trust is a grantor trust or not
and then an ESBIT can be a subsection within this grantor trust?

>> That is what the Board of Tax Appeals held, Your Honor, but it is our position that
that is wrong, that 671, to put it one way, does not in fact trump the code provisions
relating to ESBITs.

>> Counsel, is there a specific section that you can point to that says that ESBITs are not
grantor trusts, that they are different animal all together?

>> Two sections, Your Honor. First, an ESBIT is designed in section 1363 E of the code.
1363 E says that any, it uses the word any trust can elect to be an ESBIT. Now, as we all
know, tax laws are never any. There are always exceptions. In fact, there are some
exceptions to the any right in the statute. For example, a pension trust, a charitable trust.
But the important point is that even though there is a list of exceptions in 1563, grantor
trust is not listed.

>> 671 isn't controlling. 641 C is the code section that describes how an ESBIT is taxed
at the trust level. And 641 C contains --

>> that's the federal code now?

>> I'm in the federal code, yes. 641 C contains -- opens with a statement for purposes of
this chapter. And then goes on to describe how an ESBIT trust is taxed. For purposes of
this chapter. Well, 641 is in the same chapter as 671. So 671 doesn't have any language

Transcripts of oral arguments before the Supreme Court of Ohio are produced by National Captioning
Institute, which has contracted with Ohio Government Telecommunications to provide closed-captioning of
all broadcasts of Supreme Court oral arguments since January 10, 2006. These text files are not official
records of the Supreme Court, and the Court does not vouch for their accuracy. Video of all oral
arguments at the Court since March 2004 is available at the Court’s Web site,
www.supremecourtofohio.gov .
Supreme Court of Ohio
Date: 06/06/2006
Case Number: 05-2084
                                                 -4–

comparable to that. So we believe the Board of Tax Appeals in overlooking both 1363 E
and 641 C and the language, the express language, one of them saying any trust can elect
and the other saying for purposes of this chapter that the board stubbed its toe, if you will,
in deciding that in fact 671 was the controlling provision. There is no provision in 671
itself that would bring one to that conclusion. So we believe the board erred. We believe
the court should find that the appellant's federal fiduciary tax returns, 1041s for these
trusts which reported this gain income and paid the federal tax were correct as filed. I see
I'm down to my two minutes.

>> Thank you. Mr. Hubbard.

>> May it please the court -- in fact, the section that he relies on, section 641 C does not
conflict with the grantor trust provision of section 671. It incorporates that provision. We
know that when we look at the actual text of section 641 C. Let's take a look at it. The
first thing that section 641 C provides is that portion of electing small business trusts
attributable to sub chapter S shares shall be treated or deemed as a separate trust. And
then it goes on. Next it says the taxable income of that deemed separate trust shall be
determined, the amount of tax shall be the amount imposed by this chapter subject to the
express modifications in subparagraph B of section 641 C. So the starting point -- under
this chapter means the entire Internal Revenue code. So the starting point for determining
the taxable income of this deemed separate trust is the rest of the Internal Revenue code
other than section 641 C which includes section 671 of the Internal Revenue code, the
grantor code provisions justice Lanzinger. It's not taxed to the grantor trust itself but
taxed to the owner which is also the beneficiary because the grantor is the beneficiary in a
grantor trust.

>> So counsel are you saying that the appellants here inappropriately filed the fiduciary
return?

>> Absolutely, Your Honor, at the federal level because all that income under section
671, the starting point for determining the separate taxable income in this deemed portion
of the electing small business trust attributable to sub chapter S shares, that income is
taxed at the owner of the grantor trust level, the beneficiary level. Those are the
individuals who filed a joint 1040. All that income for federal purposes should have been
reported on the 1040. Now, I said the starting point was outside section 641 C. Then the
next step under 641 C is to look at the express modifications set forth in paragraph 2
thereof. Now, in their brief they don't even quote that portion. But it's significant when
you look at it because none of those provisions, the express modifications to the existing
starting point, none of them relate to section 671. None of them modified section 671.
More interestingly for us tax geeks, the situation is that when you look to the
modifications in section 641 C2 you will see there is a zeroing out of another exception.

Transcripts of oral arguments before the Supreme Court of Ohio are produced by National Captioning
Institute, which has contracted with Ohio Government Telecommunications to provide closed-captioning of
all broadcasts of Supreme Court oral arguments since January 10, 2006. These text files are not official
records of the Supreme Court, and the Court does not vouch for their accuracy. Video of all oral
arguments at the Court since March 2004 is available at the Court’s Web site,
www.supremecourtofohio.gov .
Supreme Court of Ohio
Date: 06/06/2006
Case Number: 05-2084
                                                 -5–

55 D of the Internal Revenue code that provides an exemption from the alternative
minimum tax calculation. The first $22,500 of trust income is exempt under section 55 D.
The effect of the modification in 461 C 2 of zeroing out that exemption is now all that
trust income is subject to tax. So including the first $22,500 worth. Congress knew how
to provide an express zeroing out of an exemption. They did that with respect to 55 D.
They didn't with respect to the exception in sex shun 471. That's the plain reading of the
statute. That's what the Board of Tax Appeals followed.

>> In that situation, federal income tax purposes under the permanent REG, it's to the
beneficiary of the trust and not the grantor trust itself. Their argument in their brief is that
that permanent REG, the effective date is after the taxable year here. They are wrong.
The end of the taxable year is December 31 st , 2000 and it became effective on
December 29 th . Even if that weren't the case. Let's suppose the effective date here
was after the close of the taxable year. We are still left then with the statute itself. That's
what the Board of Tax Appeals relied on. That's what the permanent REG is based on.
There was no regulation contrary to the regulation promulgated. The effective date was
the promulgation rate which couldn't have been prior to that date.

>> Counsel, so they filed the 1041. You say that's in error but the IRS doesn't say that's in
error.

>> I'm glad you asked that.

>> Wait a minute. That wasn't my question. That was a statement.

>> I'm ready for that one.

>> That was an observation on my part.

>> Yes.

>> Okay. So let me ask you. You say as of December 31 st , 2000, that was the end of
their taxable year. They did this sale or transfer in February of 2000. Was the trust in
existence subsequent to the February 2000.

>> well, the answer to that question, the record reflects according to the testimony of one
of the two witnesses, one didn't know and the other said the trust continued in existence
until late December 2000 or early 2001. So the answer is yes, it clearly was in existence
after the sale date.



Transcripts of oral arguments before the Supreme Court of Ohio are produced by National Captioning
Institute, which has contracted with Ohio Government Telecommunications to provide closed-captioning of
all broadcasts of Supreme Court oral arguments since January 10, 2006. These text files are not official
records of the Supreme Court, and the Court does not vouch for their accuracy. Video of all oral
arguments at the Court since March 2004 is available at the Court’s Web site,
www.supremecourtofohio.gov .
Supreme Court of Ohio
Date: 06/06/2006
Case Number: 05-2084
                                                 -6–

>> Had it been sold and liquidated and terminated, the trust terminated in February,
would you still be arguing that December 31 st , 2000 date affects them or was the end
of their taxable year the date they terminated the trust, that portion of the year?


>> That's with respect to whether the permanent REG is effective. It doesn't relate to the
statute in effect all the way back starting in 1997. So yes. With respect to the permanent
REG, our position would be still the taxable year is the end of the year and that's because
the trust year generally is the calendar year. The fact they sold the shares of their S Corp.
And didn't change the taxable year of the trust. But getting to the point about the IRS, for
federal income tax purposes, whether they filed -- put all the income in their jointly filed
return for federal purposes, their 1040 as opposed to putting all their other income
besides sub chapter S income on their 1040 and filing a separate 1041 for the trust, their
federal income tax is exactly the same. The IRS said there is no refund and no
assessment. Under their supposition the sub chapter S income is taxed at the trust level
and not the beneficiary level.

>> So the bottom line is the IRS doesn't look at this as part of their adjusted gross
income?

>> Well, the IRS does. I'm saying under the permanent REG in effect they would. For
federal income tax purposes, whether it's treated as the federal adjusted gross income of
the trust or of the individuals filing a joint return, the liability is the same because they
are at the highest marginal rate.

>> I understand. And so you are saying that there was no motivation for the IRS to take a
look at it and say because they got their money either way.

>> Right.

>> But the language for the Ohio tax is predicated upon the adjusted gross income. It
doesn't say the adjusted gross income of the trust or the -- I mean, we are talking about
the individual's adjusted gross income.

>> The individual adjusted gross income is what their federal justed gross income is,
correct. What I'm saying is, even without the statute, even without the permanent REG,
you know, the consequence if the REG had been effective wouldn't be the law means the
opposite of what it says prior to the effective date. There was no prior.

>> Your point is it clarifies the statute.


Transcripts of oral arguments before the Supreme Court of Ohio are produced by National Captioning
Institute, which has contracted with Ohio Government Telecommunications to provide closed-captioning of
all broadcasts of Supreme Court oral arguments since January 10, 2006. These text files are not official
records of the Supreme Court, and the Court does not vouch for their accuracy. Video of all oral
arguments at the Court since March 2004 is available at the Court’s Web site,
www.supremecourtofohio.gov .
Supreme Court of Ohio
Date: 06/06/2006
Case Number: 05-2084
                                                 -7–

>> Absolutely.

>> So if you don't have the regulation you are urging us to apply the statute.

>> Exactly. That's what the Ohio revised code requires Ohio's tax commissioner to apply
what the federal income tax code means, what the terms mean. That term, those terms are
clear from reading the statute itself. There would be an absurd result to say that the tax
commissioner is bound to the opposite result of what a REG says prior to the effective
date of the REG.

>> Even if the IRS in this case -- my understanding is it ignored their own REG in
looking at the classification or characterization of this income and you are asking the --
you are saying at that point the Ohio tax authority has to look at the REG and apply it for
our purposes of computation.

>> I'm not saying they ignored their REG. I'm saying they didn't audit the return because
there was no liability. The law is what the statute said. The REG simply clarifies that or
applies it. Another point I'd like to make is that his brief constantly states any trust can
elect to continue S corporation status if they become a shareholder except for certain
exceptions. That only gets into the point where the income isn't taxed at the corporate
level. But then the question becomes what level is it taxed at, the grantor trust level or at
the owner of the grantor trust level. That's the question that is answered by a plain
reading in the statutes involved here and the REG simply confirms that. If there are any
further questions I would be glad to entertain them.

>> You have saved two minutes of your time.

>> Thank you. Tax commissioner's counsel stated on a number of occasions in the last
couple of minutes the federal statutes were clear this income should be included in the
federal adjusted gross income of the taxpayers. At page 102 is a copy of the taxpayers
return here. This is the form IT 1040 for Ohio for 2000. As you would expect, line 1 of
the return on the front page is federal adjusted gross income. Now, if you go to the
second page of the return, you will see at line 30 add income from an electing small
business trust. Now, if the income was in the federal adjusted gross income, why do we
need to add it to federal adjusted gross income? These additions on the second page,
everyone except the ESBIT income are supported by specific statutory provisions. The
general assembly has provided for adjustments to federal adjusted gross income for Ohio
purposes. This wasn't one of them. So if it was clear, I guess I'm wondering why we need
to add it back if we are seeing it was in there any way. The second point I'd like to make
quickly is with regard to when the trust terminated. Section 641 C says that an ESBIT


Transcripts of oral arguments before the Supreme Court of Ohio are produced by National Captioning
Institute, which has contracted with Ohio Government Telecommunications to provide closed-captioning of
all broadcasts of Supreme Court oral arguments since January 10, 2006. These text files are not official
records of the Supreme Court, and the Court does not vouch for their accuracy. Video of all oral
arguments at the Court since March 2004 is available at the Court’s Web site,
www.supremecourtofohio.gov .
Supreme Court of Ohio
Date: 06/06/2006
Case Number: 05-2084
                                                 -8–

trust holding stock of an S corporation is a separate trust and regulations provide that
when the trust -- and these are cited in our reply brief.

>>When an ESBIT ceases to hold S corporation stock as was the case here when the
company was sold, the taxable year of the trust terminates. Now, I must concede that
those regulations, like the ones that the tax commissioner is arguing in favor of, were also
issued in 2002 but the fact is if we are going to say these regulations are supported by law
and these aren't, the fact is these regulations, 1.1361-M 52 I provide that when this stock
was sold, the ES bit as a separate trust terminated for federal tax law purposes in
February of 2000, before December 29 of 2000. And the fact that the taxpayers when
they were at the board of tax appeals and they were asked when did the trust terminate, if
they didn't know, they didn't know, but the answer is that was a matter of law that they
wouldn't be able to testify to any way.

>> So that's the end of the tax year?

>> It terminated on the date of sale.

>> Thank you. The case is submitted. You will be advised of our pin why you. Marcia
will please adjourn court.

>> All rise. Here ye, here ye, here ye. This open session of the honorable Supreme Court
of Ohio now stands adjourned.




Transcripts of oral arguments before the Supreme Court of Ohio are produced by National Captioning
Institute, which has contracted with Ohio Government Telecommunications to provide closed-captioning of
all broadcasts of Supreme Court oral arguments since January 10, 2006. These text files are not official
records of the Supreme Court, and the Court does not vouch for their accuracy. Video of all oral
arguments at the Court since March 2004 is available at the Court’s Web site,
www.supremecourtofohio.gov .

				
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