Opinion
Docket No. 1361.
1945-01-16
WILLIAM E. FREEMAN AND HELEN A. FREEMAN, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
John W. Burke, Jr., Esq., for the petitioners. Scott A. Dahlquist, Esq., for the respondent.
GROSS INCOME— COMPENSATION FOR SERVICES— ANNUITIES.— The cost of annuity contracts purchased for an employee and received by him in satisfaction of his employer's promise to pay compensation for services is taxable income to the employee in the year of receipt, following Richard R. Deupree, 1 T.C. 113, and Renton K. Brodie, 1 T.C. 275. John W. Burke, Jr., Esq., for the petitioners. Scott A. Dahlquist, Esq., for the respondent.
The Commissioner determined a deficiency of $18,391.31 in income tax for the calendar year 1939 solely as a result of adding $80,000 to income. The correctness of this adjustment is the only issue.
FINDINGS OF FACT.
The petitioners are husband and wife. Their joint return for the taxable year was filed with the collector of internal revenue for the second district of New York. They were married at all times material hereto. William E. Freeman, hereinafter referred to as the petitioner, was born on July 29, 1864, and his wife was born on March 6, 1870.
The petitioner is a certified public accountant. He devoted all of his time for many years to the estate of Anthony N. Brady. This work began in 1914 and continued until March 1930. The estate was worth many millions of dollars. Nicholas F. Brady, a son of Anthony, was one of the executors and trustees. His brother and a bank were the other executors and trustees. The petitioner had constant contact with Nicholas while he performed this work. The petitioner received $15,000 a year as compensation from the estate.
The petitioner was not satisfied with compensation and discussed the matter with Nicholas in 1927 and thereafter. Nicholas and his brother recognized that something should be done and promised to work out some plan. Finally, Nicholas wrote the following letter to the petitioner on March 7, 1929:
N. F. BRADY 80 Broadway, New York, March 7/29.
W. E. FREEMAN, ESQ.,
MY DEAR MR. FREEMAN: This note is to confirm our understanding that from Jan 1/30 I am to pay you twelve thousand dollars ($12,000) a year as consulting accountant as long as you live and in case Mrs. Freeman survives you to pay her eight thousand dollars ($8,000) per year for the balance of her life.— In case, however, Mrs. Freeman should pre-decease you I (or my estate) am to have the option of reducing the amount paid you by four thousand dollars ($4,000) per year from the time of her death.— The consideration for this agreement is your services past, present and future which I hereby duly acknowledge and look forward to.
Yours,
N. F. BRADY.
Nicholas made payment pursuant to that letter for a short time. He died on March 27, 1930. He left an estate worth about $1,800,000. The petitioner filed a claim against that estate and the widow, as executrix, continued the payments to the petitioner pursuant to the letter of March 7, 1929, until August 1938. The widow died on November 24, 1938, and the successor executor, a bank, discontinued the payments altogether.
The only explanation in the record for this action is an allegation in the original petition that the bank contended that the letter of March 7, 1929, was not binding since there was no consideration for the promise made therein. This allegation was denied in the answer.
The petitioner objected to this action. The bank, as executor, sought and obtained permission of the Surrogate's Court to compromise and settle the claim of the petitioner. It offered him $80,000 in cash, but he refused on account of the tax consequences. Finally, the matter was settled in June 1939. A court order states that for a full release the claim was to be settled as follows:
1. By purchase for the said William E. Freeman and Helen Arms Freeman of a joint life and survivor annuity on the lives of William E. Freeman and Helen Arms Freeman and the survivor of them, in the maximum amount that a single payment premium of $50,839.20 will purchase, issued by such life insurance company and containing such terms and conditions as the Freemans in their discretion may determine;
2. By purchase for William E. Freeman and Helen Arms Freeman of a straight annuity on the life of William E. Freeman in the maximum amount that a single payment premium of $20,500 will purchase, issued by such life insurance company and containing such terms and conditions as the Freemans in their discretion may determine;
3. By the payment of $8,660.80 in cash to the said William E. Freeman and Helen Arms Freeman jointly.
The cash represented payments of $1,000 per month from November 1938 to the date of settlement. This settlement was carried out in 1939.
The petitioners reported on their return for 1939 that they had received $2,505.15 in that year from the companies which issued the annuities and that $891.75 was taxable income and the balance nontaxable. They did not report any other amount representing the settlement.
The Commissioner, in determining the deficiency, added to taxable income the entire $80,000 paid to or on behalf of the petitioners in settlement of their claim.
The petitioners in prior years had never reported as taxable income any amount representing payments received pursuant to the letter of March 7, 1929, but had made statements on those returns that the amounts, although received, were ‘in the nature of an annuity‘ and ‘exempt from tax.‘ They never reported any amount as taxable income representing the promise contained in the letter of March 7, 1929.
OPINION.
MURDOCK, Judge:
The petitioner contends that nothing received in the settlement represented income for 1939 and the Commissioner, was therefore, in error in including any part of the $80,000 in taxable income. He argues that there was at that time merely the substitution of one annuity for another— in fact, a smaller annuity for a larger one, so that, if anything, there was a loss. He also argues that he was on an accrual basis and should have accrued in 1929 or 1930 the then value of the annuity represented by the letter of March 7, 1929. He points out that the Commissioner was informed from year to year of the situation and the error can not be corrected by including any lump sum in income for 1939.
The result in this case does not depend upon what method the petitioner has used for reporting income, but, as a matter of fact, in returns prior to 1936 he had reported that he was using a cash basis. Therefore, although he stated in later returns and in his testimony that he was on an accrual basis, nevertheless, the record does not justify a finding that he was using an accrual basis in 1929 and 1930.
The petitioner worked for many years for the Brady estate. Apparently he did whatever work the Bradys told him to do. He asked for additional compensation for his services. Nicholas, in consideration of his ‘services past, present and future,‘ agreed to pay him as consulting accountant $12,000 a year for the petitioner's life. It is nowhere suggested that this was unearned for a gift. Nothing was reported as taxable income prior to 1939. No amount was reported in 1929 or 1930 representing the cost or value of an annuity contract. No annuity was purchased at that time. The letter represented a contract of employment under which the petitioner might receive payments for life provided he fulfilled his part of the bargain. No regular and unconditional annuity was purchased. It would appear that no amount was taxable at that time under the principles announced later in Renton K. Brodie, 1 T.C. 275, but whatever he received in payments would be taxable income as received. Nothing was ever reported in prior years, so it is clear that he had no cost or basis for income tax purposes which should be recovered tax-free. The reduction in annual receipts did not represent any loss for tax purposes. It meant only that his taxable income would be less. Where a man has a prospect of receiving $12,000 a year which would be taxable income as received, he certainly has no loss for income tax purposes when the amount actually received is less.
A change took place in 1939, the taxable year. The petitioners at that time received and accepted the equivalent of $80,000, $8,660.80 of this was in cash and the balance was used to purchase annuity contracts as might be selected by the petitioners. Clearly, the cash was all taxable income under section 22(a). It represented monthly payments of $1,000 for several preceding months, all of which was compensation for services rendered. The petitioners were offered the balance in cash, but they refused and agreed, instead, that the balance should be used to purchase annuities for them from an insurance company. Under such circumstances the entire amount used to purchase the annuity contract is taxable income. See Richard R. Deupree, 1 T.C. 113; cf. George Matthew Adams, 18 B.T.A. 381. Furthermore, these contracts of the insurance company to pay annuities were quite a different thing from the petitioners' rights under the letter from Nicholas Brady dated March 7, 1929. They represented the absolute right to receive the annuities, with no conditions whatsoever, whereas the Brady letter was a mere promise to pay compensation under the circumstances described in the letter. It was simply a letter from the employer and not an absolute contract or annuity. The amount paid for the annuities is taxable income under the principle of the Brodie case, supra, and would be so even if the petitioners had not been offered the full amount in cash and had not been allowed to select the annuities themselves. We hold that the cost of annuities purchased to compensate the petitioner for services is income in 1939 under the circumstances here present. Payments under the annuity contracts may be reported properly under section 22(b)(2), and for that purpose $71,339.20 will represent their cost.
Reviewed by the court.
Decision will be entered for the respondent. KERN, J., dissenting: By the contract of March 7, 1929, embodied in the letter of Nicholas Brady to Freeman, petitioners were entitled to the payment of $12,000 a year during the life of Freeman, and of $8,000 a year during the life of Mrs. Freeman if she should survive her husband. This was more than ‘a prospect of receiving $12,000 a year‘; it was a contractual right against a solvent obligor, and can only be described as a right to an annuity. Whether that annuity was a retirement annuity or an annuity given to Freeman as compensation is immaterial, since the tax year before us is 1939 and not 1929. The question in this proceeding is not whether petitioners were subject to tax upon the receipt of this right in 1929, but whether they are subject to tax upon the receipt in 1939 of two annuity contracts and an amount of cash taken by them in compromise of the rights under the 1929 contract. It is also immaterial that this right of Freeman under the 1929 contract might have been conditional in 1929 or 1930 upon his rendering services to Brady as a consulting accountant upon Brady's request. This condition was removed by Brady's death in 1930.
The important fact is that in 1930, at the death of Brady, Freeman had a valid unconditional right to an annuity for himself and his wife as against Brady's estate. He filed a claim based thereon against the estate and its validity was acknowledged by the executrix and a deduction on account thereof was allowed to the estate by respondent in computing estate taxes due. This deduction was in the sum of $112,513.20. Payments were made to Freeman for many years by Brady's estate. In 1938 a successor executor was appointed for Brady's estate. He pointed out to the Surrogate's Court that the estate could not be closed until the death of the survivor of petitioners unless some settlement could be made with petitioners for their rights under the annuity contract made by Nicholas Brady. If an insurance company were to be substituted as the obligor under the annuity contract held by petitioners the cost to the executor, as pointed out by it in its petition to the court, would be approximately $142,700.
The executor, faced with that situation, decided to stop making the payments to petitioners called for under its decedent's annuity contract and to dicker with petitioners with regard to a settlement of their claims under that contract. The executor dickered successfully from the standpoint of the estate. Instead of having to purchase substitute annuity contracts from an insurance company at a cost of $142,700, the executor was able to persuade petitioners to give up their rights under the 1929 annuity contract executed by Brady, which, according to the executor's petition to the court, had a value in 1939 of $130,070, and to accept in return for the relinquishment of those rights two annuity policies issued by an insurance company at a cost to the executor of $71,339.20, plus $8,660.80 in cash, the latter sum being a little in excess of the unpaid monthly installments due under the 1929 contract up to the date of settlement.
The net result of the transaction from the standpoint of the executor was that it could close the estate of its decedent and at a cost of $80,000 instead of $130,070; while from the standpoint of the petitioners they had given up an annuity calling for the payment during their joint lives of $12,000 a year and during the life of the survivor of $8,000 a year, and now had, instead of such an annuity payable by an estate having net assets of approximately $1,800,000, annuity contracts executed by an insurance company, one calling for the payment of $3,610.32 a year during their joint lives and thereafter to the survivor and the other calling for the payment during the life of William E. Freeman of $2,402.04 a year. In addition they received in cash $8,660.80
It requires no reference to actuarial tables to conclude that the value of the annuities received by petitioners in 1939 was far less than the value of the annuity to which they were entitled under the Brady contract of 1929. However, if one does refer to the actuarial table set out in Regulations 105, p. 31, this conclusion may be verified. The difference in value is considerably greater than the $8,660.80 received by petitioners in cash.
It is to these facts that the majority opinion applies the doctrine of Richard R. Deupree, 1 T.C. 113, and Renton K. Brodie, 1 T.C. 275.
As we pointed out in the Brodie case, the taxpayer in the Deupree case was ‘in the position to go to the company and say: 'You have some money which, under the special remuneration plan adopted, I am entitled to receive in cash. However, I would prefer to have * * * that cash invested in an annuity contract.’‘ In the instant case Freeman was not entitled to receive $80,000 in cash as special remuneration for his services during the taxable year. He was entitled to annual payments of $12,000 for life which had no reference to services performed during the taxable year but constituted an annuity given to him 10 years before as a retirement pension or as compensation for services ended in 1930, or, perhaps, as both pension and compensation for work performed long prior to the taxable year. The fact that Freeman was offered in compromise for this right the sum of $80,000, which offer was refused, can not support a conclusion that he constructively received this amount. Freeman wanted annual payments and was entitled to receive annual payments. A rejected offer to compromise his rights to annual payments by the payment of one lump sum can not make him taxable on the lump sum by any doctrine of constructive receipt.
The Brodie case was one in which the annuity was purchased as extra compensation for the employee's services rendered during the taxable year there involved, and was ‘intended as extra compensation for services performed in the taxable year,‘ as we pointed out in Charles L. Jones, 2 T.C. 924, 931. In the latter case we reviewed the administrative rulings with regard to the taxation of annuities and the plain inference of that case is that the rule of the Brodie case will be applied only to cases having the same unusual facts, since, in the ordinary case, the administrative rulings have already set up equitable and fair methods for taxing annuities.
Nevertheless, the majority opinion extends the rule of the Brodie case to the instant proceeding in which an annuity was not purchased as extra compensation for the employee's services rendered during the taxable year and was not intended as extra compensation for such services, but was purchased as part of a compromise of previously existing rights to an annuity.
The practical results of the majority opinion are startling. Petitioners were entitled during the taxable year to receive $12,000 annually for the life of Freeman. They took in compromise of this right $8,660.80 in cash and two annuity contracts calling for the payment of $6,012.36 a year for the life of Freeman. These annuity contracts had no cash surrender or loan value. If the compromise transaction had occurred in 1945 instead of 1939, the tax upon petitioners would have been in excess of $50,000. This tax of $50,000 would have been the result of a transaction by which petitioners had given up more than they received in cash only $8,660 plus two annuity contracts which they could not sell and against which they could not borrow.
It is an understatement to say that such a result is unfortunate. Since it is also contrary to the system for the taxation of annuities set up by administrative regulations and rulings, and is not required by any of the decided cases, I respectfully dissent from the majority opinion.