Opinion
Docket No.88086.
1962-01-5
ESTATE OF GERTRUDE H. CROCKER, DECEASED, WILLIAM G. PARROTT, JR., ADMINISTRATOR, AND WILLIAM W. CROCKER, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Franklin C. Latcham, Esq., for the petitioners. Donald G. Daiker, Esq., for the respondent.
Franklin C. Latcham, Esq., for the petitioners. Donald G. Daiker, Esq., for the respondent.
Gain, predominantly composed of previously earned investment income, realized on transfer for consideration to third person of insurance policies on petitioner's life, held ordinary income notwithstanding transaction may have incorporated sale of a capital asset. Harry Roff, 36 T.C. 818 (1961), followed; Percy W. Phillips, 30 T.C. 866 (1958), distinguished.
Respondent determined a deficiency in income tax for the year 1955 in the amount of $14,178.67. The issues remaining for decision are (1) whether the petitioners made a bona fide sale of life insurance policies and (2), if so, whether the increment or profit realized upon the sale of these policies is taxable as ordinary income.
FINDINGS OF FACT.
Petitioners are a surviving husband and the estate of his deceased wife. A joint income tax return for the calendar year 1955, the period here involved, was filed with the district director of internal revenue at San Francisco, California.
William W. Crocker (hereinafter sometimes referred to as petitioner) is now and has been for many years, including the year 1955, an officer and director of Crocker-Anglo National Bank (formerly Crocker First National Bank of San Francisco), with main offices in San Francisco, California. During the year 1955, petitioner was chairman of the board of directors of Crocker First National Bank. He also was, and is, a director of a number of other corporations.
During the year 1955, petitioner was the owner of the following eight policies of life insurance on his own life:
+-----------------------------------------------------------------------------+ ¦ ¦ ¦Cash value¦Increase ¦Face ¦Premiums ¦“Dividends”¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦Policy and ¦Cost ¦at ¦in value ¦amount ¦paid ¦ ¦ ¦date ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦of issue ¦ ¦assignment¦ ¦of ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦policy ¦ ¦ ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦Pacific Mutual¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦401107, July ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦4, 1920 ¦$12,450.00¦$16,365.50¦$3,915.50¦$25,000¦$12,450.00¦ ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦Pacific Mutual¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦445690, Dec. ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦28, 1921 ¦15,100.00 ¦16,568.41 ¦1,468.41 ¦25,000 ¦17,194.75 ¦$2,094.75 ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦Pacific Mutual¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦621007, June ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦11, 1926 ¦6,690.00 ¦6,546.20 ¦(143.80) ¦10,000 ¦7,772.60 ¦1,082.60 ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦Travelers ¦ ¦ ¦ ¦1 ¦ ¦ ¦ ¦775167, Dec. ¦15,630.00 ¦22,525.25 ¦6,895.25 ¦34,150 ¦15,630.00 ¦ ¦ ¦28, 1921 ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦Aetna ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦N-258386, July¦11,920.00 ¦16,367.50 ¦4,447.50 ¦25,000 ¦11,920.00 ¦ ¦ ¦11, 1920 ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦Aetna ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦N-305807, Dec.¦12,140.00 ¦16,249.50 ¦4,109.50 ¦25,000 ¦12,140.00 ¦ ¦ ¦28, 1921 ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦Aetna ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦P-581619, June¦5,691.40 ¦6,564.70 ¦873.30 ¦10,000 ¦6,647.70 ¦956.30 ¦ ¦18, 1926 ¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦Metropolitan ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦1363420A, Dec.¦ ¦ ¦ ¦ ¦ ¦ ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦28, 1921 ¦17,996.23 ¦19,194.57 ¦1,198.34 ¦39,691 ¦22,840.61 ¦4,844.38 ¦ +--------------+----------+----------+---------+-------+----------+-----------¦ ¦Total ¦97,617.63 ¦120,381.63¦22,764.00¦193,841¦106,595.66¦8,978.03 ¦ +-----------------------------------------------------------------------------+
None of the policies matured until petitioner's death and all of the policies, except the Metropolitan Life Insurance Company policy, were 20-payment life policies, that is, premiums were payable for a period of 20 years beginning with the year in which the policy was issued. The Metropolitan Life Insurance Company policy provided for payment of premiums throughout the life of the policy.
Petitioner received so-called dividends, either in the form of credits against premiums or of direct cash payments. Pacific Mutual Life Insurance Company and Metropolitan Life Insurance Company are mutual insurance companies. Aetna Life Insurance Company is a stock company but issues participating as well as nonparticipating policies. The Aetna Life Insurance Company policy No. P-581619 was a participating policy upon which dividends were paid to petitioner. The Travelers Insurance Company is a stock company and dividends were not payable on the policy issued to petitioner.
Each of the policies provided that, after payment of a certain number of full annual premiums, usually two, the insured would have three options. The insurance companies would pay a cash amount on surrender of the policy by the insured, term the ‘cash surrender value.’ In the alternative, the insured had the option of taking ‘paid-up life insurance’ or ‘paid-up term insurance’ in lieu of the cash surrender value. A typical example of these options is that set out in the policy written by the Pacific Mutual Life Insurance Company, No. 401107:
+-----------------------------------------------------+ ¦ ¦Cash loan ¦ ¦Paid-up term ¦ +-----------+--------------+------------+-------------¦ ¦ ¦value or ¦Paid-up life¦insurance ¦ +-----------+--------------+------------+-------------¦ ¦End of year¦cash surrender¦insurance ¦ ¦ +-----------+--------------+------------+-------------¦ ¦ ¦value ¦ ¦Years ¦Days ¦ +-----------+--------------+------------+------+------¦ ¦3 ¦$875 ¦$2,625 ¦4 ¦214 ¦ +-----------+--------------+------------+------+------¦ ¦4 ¦1,350 ¦3,925 ¦7 ¦71 ¦ +-----------+--------------+------------+------+------¦ ¦5 ¦1,825 ¦5,250 ¦9 ¦362 ¦ +-----------+--------------+------------+------+------¦ ¦6 ¦2,350 ¦6,575 ¦12 ¦339 ¦ +-----------+--------------+------------+------+------¦ ¦7 ¦2,875 ¦7,875 ¦15 ¦317 ¦ +-----------+--------------+------------+------+------¦ ¦8 ¦3,400 ¦9,200 ¦18 ¦226 ¦ +-----------+--------------+------------+------+------¦ ¦9 ¦3,975 ¦10,525 ¦21 ¦28 ¦ +-----------+--------------+------------+------+------¦ ¦10 ¦4,575 ¦11,850 ¦23 ¦80 ¦ +-----------+--------------+------------+------+------¦ ¦11 ¦5,175 ¦13,150 ¦25 ¦28 ¦ +-----------+--------------+------------+------+------¦ ¦12 ¦5,825 ¦14,475 ¦26 ¦256 ¦ +-----------+--------------+------------+------+------¦ ¦13 ¦6,475 ¦15,800 ¦28 ¦54 ¦ +-----------+--------------+------------+------+------¦ ¦14 ¦7,175 ¦17,100 ¦29 ¦172 ¦ +-----------+--------------+------------+------+------¦ ¦15 ¦7,875 ¦18,425 ¦30 ¦267 ¦ +-----------+--------------+------------+------+------¦ ¦16 ¦8,625 ¦19,725 ¦32 ¦7 ¦ +-----------+--------------+------------+------+------¦ ¦17 ¦9,400 ¦21,050 ¦33 ¦168 ¦ +-----------+--------------+------------+------+------¦ ¦18 ¦10,200 ¦22,350 ¦35 ¦76 ¦ +-----------+--------------+------------+------+------¦ ¦19 ¦11,025 ¦23,675 ¦37 ¦255 ¦ +-----------+--------------+------------+------+------¦ ¦20 ¦11,900 ¦(1) ¦(1) ¦(1) ¦ +-----------------------------------------------------+
Due to payment of maximum annual premium.
was absent in Percy W. Phillips, supra; and it is not accident that under the facts there, a time could never arrive prior to maturity when, as in the instant case, the surrender value would exceed the total premiums. This circumstance seems to us to assimilate this situation to that in Harry Roff, supra, where ‘an interest rate of 3 1/2 percent, compounded annually’ and ‘a rate of 3 1/4 percent, compounded annually’ were applied ‘to the effective rate of premium payments, i.e., total annual premium of $1,000 as reduced by $125 for administrative costs * * * (and) $1,000 less $170 for administrative cost.’ We find here, as was stated there, that ‘Because of the interest provided for by the contracts, the cash surrender values thereof * * * at the dates of the sales * * * were in excess of the total premiums called for by the policies.’
In the Roff case, we held, as to respondent's second contention, that, although the transaction was to be treated as a sale of a capital asset, ‘the gains reaped by petitioner on the sales of the contracts, are attributable to interest accumulated under the contracts at fixed and predictable rates.’ Accordingly, we determined that ‘petitioner received the equivalent of interest on the sales of the contracts,‘ commenting in the course of the Opinion that ‘upon surrender of the policy * * * petitioner would have been taxed on the gain as ordinary income. Sec. 72, I.R.C. 1954 * * *,'
1Fully paid.
The cash surrender values set out in the policies represented the amounts of reserves, less surrender charges, if any, set up by the companies to fulfill the obligations called for by the contracts of insurance. These amounts were calculated by actuaries who assumed in these calculations, inter alia, that the mortality rate among their insureds would accord with the American Experience Table of Mortality and that the earnings of the company to be credited would be at the rate of 3 percent or 3 1/2 percent compounded annually. Provision for an assumed cost of administration (i.e., assumed administrative cost to be incurred by the company) was computed at a fixed amount at the time the annual net premium for each policy was determined and was added to the annual net premium to establish the annual gross premium. The amount of the premium allocated to cost of administration was not considered in determining the cash surrender value of the policies. The reserve established for the cash surrender value of each policy was increased each year by an amount represented by the sum of the net annual premium, plus an addition to the total value of the reserve computed by a 3 percent or 3 1/2 percent factor, less the cost of mortality computed according to the American Experience Table of Mortality and set aside by the company to cover expected deaths in that year of all insured persons of the same age as petitioner.
The amount of the reserves calculated upon these actuarial assumptions is a theoretical amount conservatively computed for the purpose of providing for the solvency of the company and the soundness of its insurance protection. It is hoped and expected, and in actual practice it frequently happens, that the rate of mortality among the company's insureds will be less than that assumed, that its earnings will be greater than those assumed, and that the cost of administration will be less than that assumed. If, as a result of any or all of these occurrences, either a mutual insurance company issuing participating policies, finds that, after setting aside the reserves required under its actuarial computations and after creating other additional voluntary reserves for contingencies, its premium receipts are in excess of the amounts needed for the conduct of its business, neither class of insurer increases the cash value of its participating policies but it frequently declares ‘dividends' to the holders of such participating policies of a part of the premiums collectible under its policies, thus in effect reducing the cost of insurance below that contracted for in the policies.
Petitioner has a substantial income but, because of corresponding expenditures for living expenses and for charitable contributions which he makes each year, he needs cash from time to time. Petitioner was is need of cash in the fall of 1955.
At that time, petitioner consulted with his financial adviser, Emmett G. Solomon, and a review of petitioner's investment account was made with the purpose of determining which of his holdings might be liquidated so as to raise cash to meet required expenditures. Petitioner's insurance policies were selected for liquidation because they were not valuable from the standpoint of income production during his lifetime nor were they attractive investments in his estate because they would be taxed in the highest estate tax brackets and there was the possibility of creating a transaction on which capital gain would be involved as against ordinary income.
After negotiations between petitioner and Dean Witter & Company (hereinafter called the company), petitioner transferred the policies to the company for a cash consideration of $118,731.63, $1,650 less than the cash surrender value of the policies. The transfer was effectuated in November 1955 by an absolute assignment of all interest of any kind in each of the policies to the company. At the time of the transfer, the premiums on all the policies were fully paid except for the Metropolitan policy which required payment of premiums for the insured's entire life. After the transfer, the policies remained in full force and effect while owned by the company.
In January 1956, the company surrendered the policies to the respective insurers involved for a total consideration of $121,779.59.
The company is a partnership engaged in the stock brokerage and investment banking businesses. Petitioner had no connection whatsoever with the company in 1955 nor has he ever had any such connection.
Petitioner has never been and is not now in the business of selling insurance policies, including life insurance policies, or securities of any kind.
Petitioner had not before the year 1955, and has not at any time since 1955, made any transfers of insurance policies, including life insurance policies. Such policies are not stock in trade of petitioner or other property of a kind properly includible in inventory of petitioner or property held by petitioner primarily for sale to customers in the ordinary course of his trade or business.
In determining the deficiency, respondent treated as ordinary income $21,384, representing the difference between the amount received by petitioner from the company, $118,731.63, and the assumed cost of the policies, $97,347.63. It is now stipulated that the amount of gain included a ‘clerical error’ and that the cost of the policies was $97,617.63 and the gain derived was $21,114.
OPINION.
OPPER, Judge:
As in Percy W. Phillips, 30 T.C. 866 (1958), and Harry Roff, 36 T.C.818 (1961), on appeal (C.A. 3, Nov. 20, 1961), we have before us two opposing theories as to the treatment of the excess which petitioner here received over the stipulated cost of a contract with an insurance company. Respondent contends first that the ‘sale’ by petitioner should be disregarded because of its obvious motivation purely for tax purposes; and second, that even if a sale took place, the excess received by petitioner over his cost represented an item of ordinary income, such as interest, which had already attached to the property and which was sold with it; and that accordingly, whether or not the transaction was a sale or exchange, the gain must be taxed as ordinary income.
The same two contentions were made by respondent in Percy W. Phillips, supra, and in both respondent was unsuccessful. But there, ‘If the premiums called for by the policy had been paid annually there would have been no excess of cash value over cost.’ Here, as the parties have stipulated and as our findings show, the cash surrender value on the date of sale was greatly in excess of the premiums provided in the policy. The total ‘cash value’ of all the policies at the time of assignment was over $120,000, whereas the total gross premiums due were but $106,595, and the net cost even smaller. We know also from the same source that ‘The reserve established for the cash surrender value of each policy was increased each year by an amount represented by the sum of the net annual premium, plus an addition to the total value of the reserve computed by a 3% or 3 1/2% factor.’
The element of a guaranteed and predictable interest factor added to the premiums