[Emphasis added.]

The focal point of the dispute before us is1980 U.S. Tax Ct. LEXIS 24">*30 the application of the parenthetical clause "(other than the deductions allowed under subsections (b) or (c))." Section 642(b) permits a $ 600 personal exemption deduction and section 642(c) permits a deduction for amounts paid or permanently set aside for a charitable purpose.

Like many simple rules, the rule contained in section 642(h)(2), when applied to a concrete set of facts, creates an enigma. We are told that no part of the charitable deduction may be included in "excess deductions," but we are not told how to determine whether, on facts such as ours, the excess of deductions over income actually includes any charitable deduction.

Respondent contends that section 642(h)(2) invokes a simple one-step procedure in which all deductions are totaled, except for the personal exemption and charitable contribution, and that 75 T.C. 304">*307 figure is given first priority in reducing gross income to determine whether there are any excess deductions. ³

1980 U.S. Tax Ct. LEXIS 24">*31 Petitioner reads the section 642(h)(2) parenthetical clause as excluding the section 642(c) deduction, not from total deductions calculated under section 642(h)(2), but only from the amount determined to be the excess. Arithmetically, this translates into a two-step calculation: the first step is to determine the amount by which total deductions exceeds gross income, and the second step is to determine what amount of this excess consists of deductions other than the section 642(b) and (c) deductions. In essence, says petitioner, the amount by which total estate deductions exceed gross income is an excess deduction under section 642(h)(2) to the extent that the estate has deductions other than a section 642(c) deduction. ⁴

1980 U.S. Tax Ct. LEXIS 24">*32 From the above it is apparent that, regardless of the arguments made to support the respective positions, each party is simply asking us to afford priority to a preferred type of deduction in reducing estate gross income. If, under petitioner's theory, gross income is first to be reduced (but not below zero) by the charitable deduction, the excess deductions allowable to the trust, and ultimately in fact to petitioner, must perforce consist of allowable deductions. Under respondent's theory, the reverse would be true.

There can be little argument that respondent's construction 75 T.C. 304">*308 follows more comfortably the literal dictates of the statute. Petitioner asks the Court to look beyond a literal construction of the statute and to read section 642(h) in the context of the entire statutory scheme of subchapter J. Petitioner argues that her interpretation preserves the integrity of the section 642(c) charitable deduction and also balances the goal of section 642(h) to ameliorate wastage of deductions with what she perceives as the purpose of the parenthetical in section 642(h)(2) to prevent any charitable deduction from being passed from an estate or trust to a noncharitable beneficiary.

1980 U.S. Tax Ct. LEXIS 24">*33 Section 642(h) is only one part of a tightly woven and intricate statutory scheme. Before turning to the specifics of this case, we need to review the basic provisions and underlying principles of subchapter J of the Code, which deals with the taxation of estates, trusts, beneficiaries, and decedents, generally. We have couched this overview in terms of the tax treatment of estates; but the rules of subchapter J apply with equal force, with appropriate modifications, to trusts as well.

Subchapter J sets forth the rules for determining the proper amount of estate income subject to tax as well as the rules for determining whether the beneficiary or estate should bear the burden of this tax. ⁵ Simply stated, subchapter J is built on the "conduit principle" of taxation; i.e., estate income is taxed only once, either to the estate or to the beneficiaries, or partly to each. The estate is treated as a taxable entity and is taxed, in general, on income which it realizes but does not distribute to its beneficiaries. Income distributed to a beneficiary is not taxable to the estate but instead is taxable to the beneficiary. This result is accomplished by permitting the estate a deduction1980 U.S. Tax Ct. LEXIS 24">*34 for the amount of the distribution.

The device that serves as the linchpin for this statutory scheme is the concept of distributable net income (D.N.I.). D.N.I., which is defined in section 643 and is essentially the 75 T.C. 304">*309 estate's taxable income (with some modifications), serves generally as a ceiling on the combined tax liability1980 U.S. Tax Ct. LEXIS 24">*35 of the estate and beneficiary. D.N.I. is allocated between the estate and beneficiaries in accord with the distribution rules of sections 661-663.

When distributions to beneficiaries exceed D.N.I., the tier structure of section 662 determines who among the beneficiaries are deemed to have received taxable distributions out of income and who have received nontaxable distributions out of corpus. D.N.I. is allocated under section 662(a)(1) first to beneficiaries who have a right to income that is "required to be distributed currently to such beneficiary," and the distribution to those beneficiaries is taxable to that extent. Sec. 1.662(a)-2(a), Income Tax Regs. All distributions within that tier are treated ratably should D.N.I. be less than total first-tier distributions. Any remaining D.N.I. is allocated pursuant to section 662(a)(2) among all other taxable beneficiaries, so called second-tier beneficiaries, and distributions to those beneficiaries are taxable to that extent. Sec. 1.662(a)-3(a), Income Tax Regs.

Section 661 complements section 662 by providing the estate a deduction up to the estate's D.N.I. for amounts distributed to its beneficiaries.

The rules of subchapter1980 U.S. Tax Ct. LEXIS 24">*36 J become more complex when charitable beneficiaries are involved. In lieu of the charitable deduction allowed under section 170, section 642(c) in general allows an estate an unlimited charitable deduction for amounts of "gross income" which, pursuant to the governing instrument, are paid, permanently set aside, or to be used for charitable purposes.

On the estate side of the equation, the charitable contribution authorized by section 642(c) is simply one of numerous deductions that may be claimed in computing the estate's taxable income. To avoid duplicating deductions, section 663(a)(2) provides that distributions qualifying for the charitable deduction under section 642(c) are not included for purposes of calculating the estate's section 661 distribution deduction.

On the beneficiary side, however, the effect of the section 642(c) charitable distribution depends upon whether the beneficiary is a first- or second-tier beneficiary. Section 662(a) is 75 T.C. 304">*310 structured so that first-tier beneficiaries do not benefit from the charitable deduction. ⁶1980 U.S. Tax Ct. LEXIS 24">*38 Conceptually, section 662 accomplishes this by factoring charitable distributions into the tier system of priorities in such a 1980 U.S. Tax Ct. LEXIS 24">*37 way that the pool of income that can potentially be taxed to the beneficiaries (potentially taxable income) ⁷ is deemed to flow first to first-tier beneficiaries. It is only if the pool of potentially taxable income exceeds first-tier distributions that the distribution to charitable beneficiaries is deemed to come out of that pool. In effect, the section 642(c) charitable distribution is an "intermediate tier" ⁸ between tier-one and tier-two beneficiaries. We say intermediate tier because section 662(a)(2) is designed so that tier-two beneficiaries ⁹ benefit from the section 642(c) charitable distribution deduction: the pool of potentially taxable income for determining the amount of a distribution that is taxable to tier-two beneficiaries is reduced by the section 642(c) charitable distributions (as well as the tier-one distributions). Section 662(a) and (b).

Finally, we reach section 642(h)(2), which allows estate beneficiaries to take a deduction on their individual return for certain excess deductions of the estate in the year of termination. Section 642(h) had no counterpart in the 1939 Internal Revenue Code. Prior to 1954 excess deductions of an estate could not be passed onto beneficiaries. The problem was particularly acute in the estate's final year when the windup expenses of estate administration are generally heaviest and the deductions for those expenses often are greater than income. Congress, as part of a general effort to prevent wastage of deductions, ¹⁰1980 U.S. Tax Ct. LEXIS 24">*39 ameliorated this problem through the enactment of section 642(h)(2). ¹¹

1980 U.S. Tax Ct. LEXIS 24">*40 75 T.C. 304">*311 III

Petitioner has drawn on two themes present in subchapter J in an attempt to show her construction of section 642(h)(2) best implements policy considerations underlying subchapter J. One is the familiar axiom that Congress seeks to encourage charitable contributions and foster charitable organizations and that this policy is manifested in section 642(c). The second is that unused deductions for expenses incurred in the year of termination should be passed on to beneficiaries.

While these themes are present in subchapter J, countervailing considerations surface in section 642(h)(2). Charitable deductions are allowed "without limitation" on the estate side only for purposes of calculating the estate's taxable income. On the beneficiary side, the section 662(a) tier system imposes a substantial limitation by barring first-tier beneficiaries from gaining any tax benefit from the presence of a section 642(c) charitable distribution deduction. ¹² The structure of section 662 reflects a distinct lack of concern on the part of Congress for 75 T.C. 304">*312 "wastage" of charitable deductions insofar as determining the tax liability of income beneficiaries.

1980 U.S. Tax Ct. LEXIS 24">*41 In the instant case all the deductions, other than the section 642(b) personal exemption and the section 642(c) charitable deduction, have already been taken into account in determining the pool of income potentially taxable to beneficiaries. The only deduction that has been wasted here, i.e., that does not operate to reduce the income beneficiary's tax liability, is the section 642(c) deduction for charitable distributions. Given the lack of concern evinced by Congress in section 662 for wasted charitable deductions, we are not troubled by a reading of section 642(h)(2) which allows these deductions to go unused. Mathematically, this result is accomplished by excluding altogether the section 642(c) charitable deduction from the section 642(h)(2) computation, which is the construction of the statute called for by respondent.

Under the circumstances, we reject petitioner's argument that the policy considerations underlying subchapter J are best implemented by her reading of section 642(h)(2). In summary, we hold that to determine whether there are excess deductions available to beneficiaries under section 642(h)(2), deductions exclusive of the personal exemption under section 642(b)1980 U.S. Tax Ct. LEXIS 24">*42 and the charitable deduction under section 642(c) are to be totaled and matched against the gross income of the terminating estate or trust. If the deductions so computed in fact exceed such gross income, then, and only then, will there be excess deductions as contemplated by section 642(h)(2).

To reflect concessions made by the parties on other issues,

Decision will be entered for the respondent.