CLASSIFICATION OF TAXPAYERS AND TAXATION OF THEIR INCOME

Trusts

Mr. David created an irrevocable trust in favor of his two minor grandchildren. The trust stipulates that 50% of the net income should be distributed yearly to the grandchildren, share and share alike, the balance to accumulate for eventual distribution to the grandchildren at the age 25. The income for 2002 was P1 million.
a) How will the income of the trust be taxable?
b) Will your answer remain the same if the trust established by Mr. David is revocable?
c) When is a trust considered revocable? (1980)

a) The net income of the irrevocable trust amounting to P1 million should be reduced by the following:

1) The income given to the beneficiaries (Sec. 61 (A), NIRC of 1997);
2) P20,000.00 exemption (Sec. 62, Ibid)
After the allowable deductions mentioned above, the taxable income shall be subjected to the same tax rates as individuals. (Sec. 61, Ibid.)

b) No, because the income of such part of an irrevocable trust shall be included in computing the net income of Mr. David, the grantor. (Sec. 63, Ibid.)
c) A trust is considered as revocable where at any time the power to revest in the grantor title to any part of the corpus of the trust is vested

1) In the grantor either alone or in conjunction with any person not having a substantial adverse interest in the disposition of such part of the corpus or the income therefrom, or
2) In any person not having a substantial adverse interest in the disposition of such part of the corpus or the income therefrom. (Sec. 63, Ibid.)

Oro, a millionaire with a wife and five (5) minor children has the following assets:
Asset Amount
a) Cash in money market P500,000 P75,000
or 15% return
b) Stock investment in ABC Corp. P500,000 P100,000
or 20% return
c) Stock investment in XYZ Corp. P500,000 P50,000
or 10% return
d) Real Estate properties P1,500,000 P180,000
or 12% return
TOTAL P3,000,000 P405,000
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Oro thus earns an annual gross income of P405,000. He comes to you and says: “I want you to lessen the taxes my estate will have to pay, as well as lessen my current income tax. However, until my children reach 21 years of age. I don’t want them to control any of my properties. At my age, I need a gross income of only P75,000 annually.” What would you do to reduce Oro’s estate taxes and his current income tax, and at the same time prevent his children from obtaining control of a substantial portion of his properties until they reach the age of 21? (1974)

I would suggest the creation of an irrevocable trust over all the assets of Mr. Oro, except the cash in money market which earns P75,000.00, administered in the Philippines, registered with and approved by the Bureau of Internal Revenue subject to the following conditions: (a) The share of the children in the properties shall be transferred to each of them when they reach the age of 21; (b) All the income from the properties constituted into the trust, amounting to P330,000.00 should be divided among his five children, and no part of the income should go to Mr. Oro.

The tax to be collected on the return from cash in money market, and the stack investments would be the same whether Mr. Oro constitutes a trust or not. All of these incomes would be subject to final taxes. However, there would be tax savings with respect to the P180,000.00 return from the real properties.

If Mr. Oro does not constitute a trust, the P180,000.00 shall be taxed on the portion above P140,000.00 in the amount of P22,500.00 and the excess over P140,000.00 shall be taxed at the rate of 25% or P40,000 x .25 = P10,000.00. The total tax due from Mr. Oro is P32,500.00.

On the other hand, if an irrevocable trust is so constituted as above –mentioned, the income of P180,000.00 shall be divided among the five (5) children who shall each have income subject to tax in the amount P36,000.00. Each child shall pay an income tax on his share computed on the basis of P2,500.00 on the amount that does not exceed P30,000.00 and 15% on the excess over P30,000.00 or P6,000.00 x .15 = P900.00. Thus, the tax due from each child is P2,500.00 + P900.00 = P3,400.00. The total tax due from all the five (5) children is P3,400.00 x 5 = P17,000.00. The savings is computed as: tax paid by Mr. Oro on the P180,000.00 income from real properties is P32,500 LESS taxes to be paid by his five (5) children amounting to P17,000.00 = P15,500.00

Corporations

Define or explain the meaning of corporation for income tax purposes? (1971)

Corporation for income tax purposes includes partnership, no matter how created or organized, joint stock companies, joint accounts (cuentas en participacion) associations or insurance companies. It does not include general professional partnerships, joint venture or consortium formed for the purposes of undertaking construction projects engaging in petroleum, coal, geothermal, and other energy operations, pursuant to an operation of consortium agreement under a service contract with the Government. [1st sentence, Sec. 22 (B), NIRC of 1997]

Partnerships Taxed as Corporations

E died in December 2000 leaving to his three (3) sons A, B, and C an apartment building. They decided not to partition the property and just divided the rentals among themselves for the year 2001. Was a partnership formed which id subject to the corporate income tax for the year 2001?

In 2002, A, B and C did not divided the income from the apartment building; instead they invested the same in the purchase of a house to be rented out. What is the status of their enterprise for income tax purposes for the year 2002? Explain your answer. (1972)

There was no partnership formed subject to the corporate income tax for the year 2001, when the three (3) sons did not partition the apartment they inherited. However, with respect to the house they purchased in 2002 from the common fund, there was formed a partnership.

Co-heirs who own properties which produce income should not automatically be considered partners of an unregistered partnership, or a corporation, within the purview of the income tax law. To hold otherwise, would subject the income of all co-ownership of inherited properties to the tax on corporations resulting in oppressive taxation and confirm the dictum that the power to tax involves the power to destroy. This eventuality should be obviated.

Article 1769(3) of the Civil Code provides that “ the sharing of gross returns does not of itself establish a partnership, whether or not the persons sharing them have a joint or common fight or interest in any property from which the returns are derived”. There must be an unmistakable intention to form a partnership or joint venture. (Obillos, Jr. v. CIR, 139SCRA 440).Such is not present in the case at bar.

For tax purposes, the purchase of a house t be rented out is in fact a contribution of the incomes of A, B and C to a common fund for the purposes of dividing the rentals earned among themselves. With respect to the purchase of a house, a partnership was thus formed in 2002, subjecting them to corporate income tax rates. (Evangelista v. Collector, 102 Phil 140)

Mrs. Carmen Reyes died in 1996 leaving as heirs her husband, Pedro Reyes, and six (6) children. She left real properties in Manila, Pasay City and Quezon City, with a total value of P50,000.00. The husband was appointed administrator of the estate. In 2001 the project of partition was approved by the court and upon satisfaction that the estate and inheritance taxes had already been paid, the special proceedings on the estate of the deceased was closed and terminated. However, Mr. Reyes continued to administer the properties with the consent of his children. He leased some of the properties, the rental income of which he accumulated and later used in the purchase of other properties. By 2002, he and his children had acquired real property with a total value of P2,000,000.00.

Investigation revealed that during the period 2001 to 2002, the annual rental income of the properties administered by Mr. Reyes was P120,000.00. He reported half of said annual income in his income tax return, while each of his children added to his income the amount of P10,000.00, as his share in the rental income of the properties.

If you were the Commissioner of Internal Revenue, how would you tax the yearly rental income of P120,000.00? What in your opinion should be the tax status of Mr. Reyes and his children? Explain, citing the legal basis for your conclusion. (1973)

As the Commissioner of Internal Revenue, I would determine which portion of the yearly income of P120,000.00 is attributable to the inherited properties and the portion coming from the properties from the accumulated rentals of the inherited properties.

The income from the inherited properties should be taxed as income from the separate properties of Mr. Reyes and his children. They should be taxed separately as they are merely co-owners of the properties.

The income from the properties purchased from the rental income of the properties is partnership income taxable like corporations. With respect to the purchased properties, the tax status of Mr. Reyes and his children is a taxable partnership.

Co-heirs who own properties which produce income should not automatically be considered partners of an unregistered partnership, or a corporation, within the purview of the income tax law. To hold otherwise would subject the income of all co-ownership of inherited properties to the tax on corporations resulting in oppressive taxation and confirm the dictum that the power to tax involves the power to destroy. This eventually should be oviated.

Article 1769(3) of the Civil Code provides that “the sharing of gross returns does not of itself establish a partnership, whether or not the persons sharing them have a joint or common fight or interest in any property from which the returns are derived.” There must be an unmistakable intention to form a partnership or joint venture. (Obillos, Jr. v. Commissioner of the Internal Revenue, 139 SCRA 440) such is not present in the instant case.

For tax purposes the purchase income generating real property is in fact, a contribution of the incomes of Mr. Reyes and his children to a common fund for the purpose of dividing the rentals earned among themselves. Thus, a partnership was thus formed in 2002, subjecting them to corporate income tax rates. (Evangelista c. Collector, 102 Phil.)

Rosa Arroyo died in 2000. His heirs executed a project partition of her estate which was approved by the Court. However, Rosa’s estate was not actually distributed among the heirs but remained under the management of their father (widower-spouse) who used the properties in business and so their value increased yearly. The profits were credited on the books of account of the common fund to the heirs in proportion to their respective hereditary shares. The heirs allowed their father to continue using their shares for his ventures, although they paid income taxes on their respective shares of the profits of their common business. Is there a partnership here subject to corporate income tax under the Tax Code? Why? (1975)

There was no partnership formed subject to the corporate income tax, when her widower-spouse and heirs did not partition the estate they inherited from Rosa. However, when the heirs allowed their father (the widower spouse) to continue using their shares for his ventures, resulting in a common business, there was formed partnership.

Article 1769(3) of the Civil Code provides that “the sharing of gross returns does not of itself establish a partnership, whether or not the persons sharing them have a joint or common fight or interest in any property from which the returns are derived.” There must be an unmistakable intention to form a partnership or joint venture. (Obillos, Jr. v. Commissioner of the Internal Revenue, 139 SCRA 440) such is not present in the instant case.

EL, GL, and XL all of legal age, inherited from their parents, who both died in a car accident on January 1, 1997, a ten (10) door apartment building situated on a 2,500 square meter lot (apartment building) in Pasay City. The estate proceedings with the Regional Trial Court (RTC) of Pasay City were terminated on 31 December 1998 with the three (3) sisters remaining equal and pro-indiviso co-owners of the apartment building. The rent was divided equally among the three sisters after deducting the expenses (like real estate taxes and major repairs) on the apartment building. The three sisters then reported their shares of the net income in their individual income tax returns from 1999 to 2002. Now, a buyer has offered to purchase the apartment building for P10 million.
a. Were the three sisters correct in reporting their shares of said net income in their respective tax returns from 1999 to 2002? Explain.
b. If the three sisters decide to sell the apartment building, how will they be taxed on the sale? Explain (1990)

a. Yes. Co-heirs who inherited properties which produce income should not automatically be considered as partners of an unregistered partnership or corporation subject to tax. The reason is that sharing of gross returns does not by itself establish a partnership. There must be an unmistakable intention to form a partnership or joint venture. There is no contribution or investment of additional capital to increase or expand the inherited properties, merely continuing the dedication of the property to the use to which it had been put by their forebears. (Obillos, Jr. v.CIR, 139 SCRA 436)

b. They shall be taxed on their ordinary income from the sale. The properties are not capital assets because they are used in trade or business.

Mr. Santos died intestate in 2000 leaving his spouse and five children as the only heirs. The estate consisted of a family home and a four-door apartment which was being rented to tenants. Within the year, an extrajudicial settlement of the estate was excuted among the heirs, each of them receiving his/her due share. The surviving spouse assumed administration of the property. Each year, the net income from the rental of the property was distributed to all, proportionaely, on which they paid respectively, the corresponding tax.

In 2003, the income tax returns of the heirs were examined and deficiency income tax assessment were issued against each of them for the years 2000 to 2002, inclusive, as having entered into an unregistered partnership. Were the assessment justified? (1997)

No. Co-heirs who inherited properties which produce income should not automatically be considered as partners of an unregistered partnership or corporation subject to tax. The reason is that sharing of gross returns does not by itself establish a partnership. There must be an unmistakable intention to form a partnership or joint venture. There is no contribution or investment of additional capital to increase or expand the inherited properties, merely continuing the dedication of the property to the use to which it had been put by their forebears. (Obillos, Jr. v.CIR, 139 SCRA 436)

Roberto Ruiz and Conrado Cruz bought three(3) parcels of land from Rodrigo Sabado on 4 May 1994. Then on 8 July 1995, they bought two(2) parcels of land from Miguel Sanchez. In 2000, they sold the first three parcels of land to Central Realty Inc. In 2002, they sold the two parcels to Jose Guerrero. Ruiz and Cruz realized a net profit of P100,000 for the sale in 2000 and P150,000 for the sale in 2002. The corresponding capital gains taxes were individually paid by Ruiz and Cruz.

On 20 September 2002 however, Ruiz and Cruz received a letter from CIR assessing them deficiency corporate income taxes for the years 2000 and 2002 because, according to the CIR, during said years they as co-owners in the real estate transactions formed an unregistered partnership or joint venture taxable as a corporation and that the unregistered partnership was subject to corporate income tax, as distinguished from profits derived from the partnership by them, which is subject to individual income tax.

Are Roberto Ruiz and Conrado Cruz liable for deficiency corporate income tax?

No. Roberto Ruiz and Conrado Cruz have not formed a partnership subject to corporate tax rates. Mere sharing of gross returns does not of itself establish a partnership (Art. 1769-3, Civil Code).

There must be an unmistakable intention to form a partnership or joint venture. (Obillos, Jr. v.CIR, 139 SCRA 436). There is no showing that the joint purchase was for the purpose of earning profits to be divided among them.

Noel Langit and his brother, Jovy, bought a parcel of land which they registered in their names as pro indiviso owners (Parcel A). Subsequently, they formed a partnership duly registered with the SEC, which bought another parcel of land (Parcel B). Both parcels of land were sold, realizing a net profit of P1,000,000 for Parcel A and P500,000 for Parcel B.
a. The BIR claims that the sale of Parcel A should be taxed as a sale of an unregistered partnership. Is the BIR correct?
b. The BIR also claims that the sale of Parcel B should be taxed as a sale by a corporation. Is the ABIR correct? (1994)

a. No. The brothers have not formed a partnership subject to corporate tax rates. Mere sharing of gross returns does not of itself establish a partnership (Art. 1769-3, Civil Code).

b. Yes, because the Parcel B was brought after the brothers have formed a taxable partnership. Registration of the partnership with the SEC is a manifest showing of the brother’s intention to engage in business together and divide the profits.

General Professional Partnerships

Distinguish the income tax liability of X, a general professional partnership engaged in the practice of law, and Y, a general partnership engaged in the operation of logging concession. (1981)

A general professional partnersip is formed by persons for the sole purpose of exercising their common profession, no part of the income of which is derived from engaging in any trade or business while a general partnership is formed by persons for the sole purpose of engaging in any trade or business.

A general professional partnership is not a taxable entity hence its income is not taxable as such while a general partnership is considered as a corporation hence a taxable entity and its income is taxable as such.

A general professional partnership not being a taxable entity does not need to file an income tax return but an information return while a general partnership being a taxable entity should file an income tax return.

The partners in a general professional partnership are not subject to double taxation being taxed only once while a general partnership is taxed once on its income and the share in the profits of the partners are again taxed as dividends.

X, Y, Z & Associates is a partnership of new lawyers belonging to the same law class and fraternity. The BIR District Officer is requiring them to register their firm name with the Bureau of Domestic Trade before the Revenue Distrcit Office will allow the registration of books, receipts and other records of the law firm.

Is the law firm subject to pay income tax as well as the requirement to file an income tax return? Explain (1988)

The firm is not subject to pay income tax as it is a general professional partnership for the sole purpose of exercising their common profession, no part of the net income of which is derived from engaging in any trade or business. The parties shall be liable for income tax only in their individual capacity.

The firm is required to file in duplicate a return of its income, except income exempt under Sec 32 (B) of the NIRC of 1997 (exclusion from gross income), setting forth the items of the gross income and deductions allowed and the names, TINs, addresses and shares of each of the partners. (Sec. 55, NIRC of 1997)

A partner in a general law partnership incurs expenses that are not passed on to the partnership such as: he buys his own law books; he entertains clients without passing the bills to the partnership; he pays his own dues to professional organization; and he buys a car for use in law practice. The partnership does not advance the purchase price or take title to the car. May he deduct the above-mentioned expenses from his distributive share in the net profits of said partnership? Why? (1999)

No, because these are incurred in the exercise of the profession which are properly deductible by the general professional partnership in order to arrive at the net distributive shares of the individual partners.

Atty. MA and Atty. PL were classmates in law school. After passing the bar in 1999, they joined separate law firms in Makati. In 2000, they resigned from their respective law firms and formed a law partnership under the firm name of A & L, with office address at Ayala Avenue, Makati City. In January, 2002, being particularly a good year, the partnership anticipates a net income of P2.0 million.
a. Is the said law partnership a taxable entity for income tax purposes? Explain.
b. If the two partners decide to reinvest P1.5 million into the partnership to buy an office condominium and distribute as dividends only P0.50 million, how much of the partnership’s 2002 net income will be subject to income tax? Explain. (1990)

a. No, because it is a general professional partnership organized for the conduct of a profession. (Sec. 22 (B) and 26, NIRC OF 1997)
b. None, because the net income of a general professional partnership is not subject to income taxation.