Opinion
Docket No. 82241.
1962-03-7
A. A. HELWIG AND EVA S. HELWIG, PETITIONERS, V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Monroe F. Marsh, Esq., for the petitioners. Alfred L.Margolis, Esq., for the respondent.
Monroe F. Marsh, Esq., for the petitioners. Alfred L.Margolis, Esq., for the respondent.
Held, purported interest payments made in connection with so-called annuity transactions, similar to those involved in Knetsch v. United States, 364 U.S. 361, and Amor F. Pierce, 37 T.C. 1039 (decided this day), are not deductible, notwithstanding the interposition of an immediate bank loan found herein to be lacking in substance.
Respondent has determined a deficiency in petitioners' income tax for the taxable year 1955 in the amount of $23,404.38. The sole remaining issue is whether petitioners may deduct as interest certain payments made in 1955 to the All Service Life Insurance Corporation and to the Farmers and Stockmens Bank, both of Phoenix, Arizona.
FINDINGS OF FACT.
The facts stipulated by the parties are incorporated herein by this reference.
Petitioners, husband and wife, presently residing at 404 North Roxbury Drive, Beverly Hills, California, formerly resided in Chicago, Illinois, and filed a joint income tax return for the calendar year 1955 with the district director of internal revenue at Chicago, Illinois. A. A. Helwig will hereinafter be referred to as petitioner.
In 1955 petitioner was chairman of the board of the Standard Railway Equipment Manufacturing Company with an annual salary of $60,000. He was 63 years old. His net worth amounted to several million dollars.
In December of 1955 petitioner traveled to Phoenix, Arizona, for the purported purpose of arranging to purchase 10 annuity contracts from the All Service Life Insurance Corporation of Phoenix, hereinafter referred to as All Service. The events which, in form, occurred on or about December 29, 1955, are set forth in the paragraphs that follow.
Petitioner applied to All Service for the issuance of 10 retirement life annuity contracts with 10 years' payments certain. The consideration specified for each contract consisted of eight annual premiums of $20,000 each, or an aggregate for the 10 contracts of $200,000 per annual installment.
As payment of the first annual installment, petitioner signed 10 nonrecourse demand promissory notes payable to All Service in the total amount of $200,000.
All Service accepted petitioner's application and issued to him 10 retirement life annuity contracts with 10 years' payments certain, each dated December 20, 1955, and numbered A-426 through A-435. Payments to petitioner as the named annuitant under each contract were to commence on the anniversary of the issue date nearest petitioner's 75th birthday and were to be in the amount of $1,534.32 per contract per month. Petitioner's estate was designated as the death benefit beneficiary in each contract.
All Service agreed to lend petitioner $200,000 pursuant to 10 contract loan agreements, each in the amount of $20,000, signed by petitioner on December 29, 1955. As sole security for the loans, petitioner assigned the 10 annuity contracts to All Service. Each contract loan agreement called for 6 years' interest to be paid in advance at the rate of 3.75 percent per annum, with interest paid for more than 1 year in advance discounted at the rate of 2.75 percent per annum, compounded annually. The total interest payable to All Service on December 29, 1955, was $42,094.40. All Service applied the proceeds of these contract loans to discharge the $200,000 nonrecourse demand notes which petitioner had signed in payment of the first annual consideration.
On the same day petitioner applied to the Farmers and Stockmens Bank of Phoenix, Arizona, for 10 loans in the amount of $3,488 each or for an aggregate loan of $34,880. The bank made such loans on All Service's contract loan agreement forms and the 10 annuity contracts were designated as the sole security therefor. As in the case of the contract loans made directly with All Service, petitioner agreed to pay the bank 6 years' interest in advance at the rate of 3.75 percent per annum, with interest paid for more than 1 year in advance discounted at the rate of 2.75 percent per annum, compounded annually. The total interest thus payable to the bank by petitioner amounted to $7,341.20, which petitioner paid to the bank on December 29, 1955, by check drawn on his account at the Continental Illinois National Bank & Trust Co. of Chicago, Illinois.
At the same time petitioner opened a new checking account at the Farmers and Stockmens Bank by depositing a check drawn to his own order on his account at the Continental Illinois National Bank & Trust Co., of Chicago, Illinois, in the amount of $7,700. He instructed the Farmers and Stockmens Bank to deposit the $34,880 proceeds of his loan to this new checking account and then to forward his check on his new account in the amount of $42,094.40, also signed on December 29, 1955, to All Service. The bank complied with petitioner's instructions by depositing petitioner's check in All Service's account at the bank.
Under date of January 4, 1956, Farmers and Stockmens Bank wrote to petitioner to inform him that it had assigned, without recourse, his 10 contract loan agreements in the total amount of $34,880 to All Service.
In their joint Federal income tax return for 1955, petitioners claimed deductions for interest paid to All Service in the amount of $42,094.40 and to Farmers and Stockmens Bank in the amount of $7,341.20. The respondent has disallowed these deductions.
All Service was incorporated under the laws of Arizona as a fraternal benefit society on February 13, 1952, and commenced business on March 11, 1952. On December 31, 1952, its total assets consisted of $3,674.75 and its liabilities and reserves amounted to $5,913.73, leaving a deficit of $2,238.98. All Service's balance sheet as of December 31, 1955, showed total assets of $9,267,344.22 (of which $9,038,010.62 consisted of ‘Policy Loans') and a ‘Surplus' of $8,000.90 (resulting from the difference between the deficit in ‘accumulated earnings' of $105,103.07 and ‘non-ledger assets-contra’ of $113,103.97). From the date of incorporation through December 31, 1956, the net income of All Service resulted solely from the difference in the rate of interest charged on contract loans and the rate of interest allowed on annuity considerations paid. Income from other sources, including the sale of other forms of insurance, was exceeded by the expenses incurred in the production of that income.
Sometime in 1954 representatives of All Service approached officers of the Farmers and Stockmens Bank concerning the establishment of a ‘loan program’ in which the bank would purportedly make loans to holders of All Service's annuity contracts, on the security of such contracts, for the purpose of paying interest due on contract loans to All Service. Under the plan adopted All Service specifically agreed to accept the assignment of all such loans, by a charge to its account at the bank, 1 working day after the loans were purportedly made by the bank. Since the annuity holder opened up an account at the bank in which he deposited the proceeds of the purported loans before transferring them to All Service, the money supposedly involved in such ‘loans' from the bank never left the bank's control. For its services the bank was paid a service charge of $10 per annuity contract plus the interest for the 1 or 2 days or more that the ‘loans' were on its books prior to their assignment to All Service.
All Service prepared all the necessary papers for such ‘loans' from the bank in a packet which included the annuity holder's application for the ‘loan,‘ a letter for the signature of an officer of the bank to All Service that such application had been received, a letter from All Service to the bank informing the bank of the purported value of the annuity contracts if certain amounts were paid and of All Service's willingness to accept an assignment of any ‘contract loan agreements' made by the bank, and a final letter from the bank to All Service informing the latter of the assignment of the ‘loan agreements' to its account and the charges connected therewith. In addition, the purported loans from the bank to the annuity holder were made on All Service's contract loan agreement forms.
At the time this ‘loan program’ between All Service and the Farmers and Stockmens Bank began, the bank received a legal opinion from its counsel regarding the legality of such purported loans. This opinion, dated November 16, 1954, read in part as follows:
It is my understanding that All Service Life Insurance Corporation and United Guarantee Life Society contemplate writing annuities, that premiums will be paid by the execution of promissory notes by the annuitants to the insurance companies, that the annuitants will borrow from the Farmers and Stockmens Bank sums to pay advance interest on said notes, that the insurance companies will make a commitment to the Bank to purchase the obligations of the annuitants to the Bank. This program has been initiated by the insurance companies for the purpose of enabling the annuitants to avoid income taxes. We are not asked for nor are we prepared to give an opinion as to whether or not the program will accomplish its purpose.
It is our opinion that the loans by the Bank to annuitants and the purchase of such obligations by the insurance companies from the Bank will not constitute the engaging in illegal activities by the Bank. Assuming that the Bank has a firm commitment from the insurance companies to purchase obligations created by the Bank's loans to the annuitants and further assuming that the Bank is satisfied with the financial responsibility of the insurance companies, we believe that the Bank would be justified in making the loans.
The officers of Farmers and Stockmens Bank always worked with representatives of All Service when the purported loan transactions were being made, and in about 50 percent of such instances no officer of the bank ever dealt with or met the purported borrower. Although the bank in the ordinary course of its business would customarily open a credit file and would obtain and verify a financial statement when it lent money to a borrower, no credit file was ever started at the bank respecting the All Service ‘borrowers' and the bank did not investigate the financial strength or credit standing of such ‘borrowers.’ The bank relied on the commitment of All Service to accept an assignment of such ‘loans' 1 working day after they had been made. The bank carried these ‘loans' on its loan records as an indirect revolving line of credit to All Service under the name of All Service and under the name of the customer of All Service. In no case did a customer of All Service ever repay his ‘loan’ to the bank. If such ‘loans' were repaid, they were repaid directly to All Service.
The Farmers and Stockmens Bank would not have ‘lent’ money on the security of All Service's annuity contracts absent the fact that All Service had its deposit account at the bank and that All Service was committed to take over the so-called loans promptly. Absent these considerations, All Service's financial circumstances would not have justified the bank extending credit on the security of its annuity contracts.
The aforementioned ‘loan program’ between the bank and All Service continued from 1954 until approximately September of 1957.
When petitioner was in Phoenix, Arizona, late in December 1955, in order to arrange the purchase of the annuity contracts from All Service presently under consideration, he attended a luncheon meeting with representatives of All Service and an officer of the Farmers and Stockmens Bank. The bank officer attended at the request of All Service. At this meeting the bank officer explained to petitioner the arrangements existing between the bank and All Service. He specifically told petitioner that any ‘loan’ made by the bank on the security of All Service's annuity contracts would be assigned by the bank to All Service the following day by agreement with All Service. At the same meeting the subject of the tax consequences to petitioner of taking out the annuity contracts and borrowing money thereon was discussed ‘quite extensively.’
In other discussions with All Service representatives prior to signing for the annuity contracts, petitioner was told that he would be able to dispose of the annuity contracts and the indebtedness thereon at any time.
Petitioner, at the time of entering the annuity transaction, obtained a written release of obligation from All Service which acknowledged that he would not be liable personally for any of All Service's debts and that All Service would look only to the annuity contracts for repayment of all contract loans.
The indebtedness against each of the 10 annuity contracts here involved at the end of 1955 was $20,000 plus $3,488, or a total of $23,488. The $20,000 was the annual premium that allegedly was borrowed from All Service and the $3,488 was the purported indebtedness to the bank. The loan value of each policy at the end of the first contract year (December 1956) was $20,509. The cash surrender value of each policy at the end of the first contract year (December 1956) was $20,529.40.
The total indebtedness against the 10 annuity contracts at their inception in December of 1955 was $234,880. The total loan value of the contracts at the end of the first contract year (December 1956) was.$205,090. total cash surrender value of the contracts at the end of the first contract year (December 1956) was $205,294.
Petitioner's out-of-pocket expense in the annuity transaction in 1955 amounted to $14,555.60, consisting of the $7,341.20 paid to the Farmers and Stockmens Bank as purported interest and the $7,214.40 of his own funds paid to All Service as purported interest. The net cash value of the 10 annuity contracts as on the end of 1955, including the refundable portion of prepaid interest on contract loans, was $11,041.60. Thus, but for tax considerations, petitioner's purported investment in the 10 annuity contracts resulted in a net economic loss of $3,514 ($11,041.60 net cash value minus $14,555.60 net cost) in 1955.
The events which have occurred, in form, with respect to the 10 annuity contracts since the taxable year in issue are set forth in the paragraphs that follow.
In December of 1956 petitioner did not pay the annual premium then due on each of the 10 annuity contracts nor did he make any payments on the indebtedness secured by the annuity contracts. In February of 1957, he requested an extension of time ‘in order to more fully study the matter of the continuation of the annuities.’ In December of 1957 petitioner applied to All Service to reinstate the 10 annuity contracts by signing new contract loan agreements covering the second annual consideration (due in December 1956) and the third annual consideration (due in December 1957). As a result petitioner borrowed an additional $399,199 on the 10 annuity contracts and signed new contract loan agreements covering all the borrowing to date in an aggregate amount of $634,079. Based on the cancellation of the prior contract loan agreements, All Service agreed to refund to petitioner $515.19 of the prepaid interest on such prior agreements. Petitioner instructed All Service to apply this refund to the annuity premiums then due. He sent All Service a check in the amount of $285.81 which together with the prepaid interest refund of $515.19 and the new contract loans of $399,199 made up the $400,000 due for the second and third annual premiums.
On his 1957 Federal income tax return, petitioner reported the $515.19 prepaid interest refund from All Service as interest income.
In December 1958, an agent of petitioner informed All Service that petitioner wanted to sell his annuity contracts. Petitioner expressed a desire not to have the contracts canceled but rather to sell them to a purchaser. On December 16, 1958, All Service wrote to petitioner's agent advising him that W. Lee Cole of Phoenix, Arizona, probably would be interested in purchasing petitioner's annuities.
On or about December 19, 1958, petitioner sold 9 of the 10 annuity contracts to W. Lee Cole, the latter agreeing to assume loans against the contracts in the total amount of $569,106. Cole paid petitioner $1 for each of the nine contracts as consideration for the assignment, thus resulting in a total payment of $9.
On or about December 18, 1959, petitioner sold the last of the 10 annuity contracts to Cole, and Cole assumed loans against the contract of $64,973. Cole paid petitioner $1 for his interest in the contract.
With the exception of the annuity transaction described herein, petitioner has never before nor since done business with All Service or the Farmers and Stockmens Bank.
In 1955 petitioner's purported purchase of the 10 annuity contracts from All Service, borrowing of funds from All Service and from the Farmers and Stockmens Bank, and payment and prepayment of interest to All Service and the bank on such borrowing, were lacking in substance. During the taxable year, the steps taken had no economic or commercial substance apart from an intended tax benefit.
OPINION.
RAUM, Judge:
While in form the transactions here involved differ somewhat from the transactions considered in Amor F. Pierce, 37 T.C. 1039, decided this day, we think they are the same in fact. The inclusion in this case of a purported 1-day loan from a commercial lending institution, the Farmers and Stockmens Bank of Phoenix, Arizona, adds not one jot of substance to this case. It is clear on this record that at most the bank lent petitioner the use of its name, not its funds, and that in reality petitioner neither borrowed money from nor paid interest to either the bank or the All Service Life Insurance Corporation. Thus, as in the Pierce case, we think that the respondent's disallowance of petitioner's claimed interest deductions must be upheld on the authority of Knetsch v. United States, 364 U.S. 361. Cf. William R. Lovett, 37 T.C. 317.
Petitioner would have us believe that for an out-of-pocket cost of $14,555.60 in 1955 he purchased 10 retirement life annuity contracts with an aggregate annual premium of $200,000, borrowed $234,880 on the security of such contracts, and paid some $49,435.60 interest in advance on the resulting loans. In form, this is exactly what he did do— all on December 29, 1955. In fact, however, petitioner purchased no annuities and borrowed no funds. He willingly paid $14,555.60 as so-called interest payments to All Service and the bank as the ‘fee for providing the facade of ‘loans“ (Knetsch v. United States, supra at 366) whereby he hoped to reduce his Federal income tax.
The bank's participation herein was merely commercial window dressing. By prearrangement with All Service, the bank had agreed to go through the ritual of making ‘loans' to All Service's annuity holders and then assigning such ‘loans' to All Service 1 working day later. Petitioner was fully informed of this system prior to entering the transaction. In substance, the bank made no loans to customers of All Service such as petitioner and risked none of its money. For a small service charge, it permitted the use of its name in such transactions and served as a conduit of the so-called interest payments to its depositor, All Service. In these circumstances, the $7,341.20 paid by petitioner to the bank on December 29, 1955, does not qualify as ‘interest paid * * * on indebtedness' under section 163 of the 1954 Code any more than does the $42,094.40 paid by petitioner to All Service on the same day.
We heard testimony regarding the supposed economic reality of these transactions, suggesting that petitioner had a bona fide intention to acquire these annuities for genuine business reasons. The short answer is that we do not believe it.
We do not reach the question, raised by the parties on brief, whether section 264 of the 1954 Code would prevent the deduction of the so-called interest payments in issue, assuming these transactions had not been lacking in substance.
Decision will be entered for the respondent.