Smith v. Comm'r of Internal Revenue

Full title: HAROLD W. SMITH AND CAROLINE H. SMITH, PETITIONERS v. COMMISSIONER OF…

Court: United States Tax Court

Date published: May 12, 1971

56 T.C. 263 (U.S.T.C. 1971)

Opinion

Docket Nos. 5330-68 3489-69.

1971-05-12

HAROLD W. SMITH AND CAROLINE H. SMITH, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENTHELEN C. SMITH, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Harold S. Voegelin and Richard F. Oetting, for the petitioners. Michael J. Christianson, for the respondent.

RAUM

Harold S. Voegelin and Richard F. Oetting, for the petitioners. Michael J. Christianson, for the respondent.

In 1961 the taxpayers (husband and wife) sold their controlling stock interest in American Gas to Union Oil under an installment sale contract payable over a 5-year period. They properly elected to report their gain on the installment method under sec. 453, I.R.C. 1954. In 1964, when over $700,000 in gain remained yet to be reported, the taxpayers and their advisers devised a plan whereby the taxpayers undertook to transfer the installment contract to their two children, the children undertook to pay annuities to the parents, and each child executed an instrument establishing a trust designed to fund the annuities. The sole corpora of both trusts consisted of the funds representing the entire balance of the installment contract, which Union Oil had meanwhile paid.

1. Held, the taxpayers disposed of the installment contract ‘otherwise than by sale or exchange’ and must therefore include in their 1964 gross income that portion of their gain which had not theretofore been recognized to the extent required by sec. 453(d)(1)(B). Held, in the alternative, the taxpayers actually received payment in full of the outstanding installment obligation in 1964 and must therefore account in that year for the remaining unreported gain on the sale of their stock in accordance with sec. 453(a) and (b).

2. Held, the taxpayer's daughter made no deductible interest payments to them under her annuity contracts with them. Sec. 163, I.R.C. 1954.

The Commissioner determined deficiencies in petitioners' income tax as follows:

+---------------------------------------------------------------------------+ ¦ ¦Calendar ¦ ¦ +---------------------------------------------------+----------+------------¦ ¦Petitioner ¦year ¦Deficiency ¦ +---------------------------------------------------+----------+------------¦ ¦Harold W. and Caroline H. Smith, docket No. 5330-68¦1964 ¦$178,543.76 ¦ +---------------------------------------------------+----------+------------¦ ¦Helen C. Smith, docket No. 3489-69 ¦1967 ¦4,708.21 ¦ +---------------------------------------------------------------------------+

These cases involve the tax consequences of certain transactions in 1964 whereby (1) Harold W. and Caroline H. Smith, the owners of an installment obligation, undertook to transfer it to their son and to their daughter, petitioner Helen C. Smith, (2) the sone and daughter each undertook the pay annuities to their parents, and (3) the proceeds of the installment obligation, which had meanwhile been paid by the obligor, were placed in trusts in which the son and daughter appeared as settlors, and in which the trustees were instructed to pay the annuities to the parents out of the assets of the trusts. Particularly in question is whether the parents are chargeable with taxable income in 1964 under section 453(d)(1), I.R.C. 1954, in respect of the theretofore unreported gain reflected in the installment obligation, which they had elected to report on the installment basis in an earlier year. Also in issue is whether petitioner Helen C. Smith may deduct as interest a portion of the payments made to her parents by the trustees of her trust purportedly in discharge of her obligation under the so-called annuity agreements.

FINDINGS OF FACT

The parties have stipulated certain facts, which, together with the attached exhibits, are incorporated herein by this reference.

Petitioners Harold W. and Caroline H. Smith (Harold and Caroline) are husband and wife. They filed a joint Federal income tax return for the calendar year 1964 with the district director of internal revenue at Los Angeles, Calif., and resided at 2449 Ridgeway Road, San Marino, Calif., at the time their petition herein was filed. Their return was prepared on the basis of a cash method of accounting. Petitioner Helen C. Smith (Helen) is the daughter of petitioners Harold and Caroline Smith. She filed an individual Federal income tax return for the calendar year 1967 with the district director of internal revenue at Los Angeles, Calif., and resided at 2449 Ridgeway Road, San Marino, Calif., at the time her petition herein was filed.

Harold was born on April 20, 1901, and Caroline was born on October 22, 1913. They are the parents of one daughter, Helen, and one son, Harold W. Smith, Jr. (Harold, Jr.).

Helen was born on November 3, 1944. From September 1962 until June 8, 1966, she was a full-time student at the University of California at Santa Barbara. During the years in question her home address was the same as that of her parents. However, during the first, second, and fourth years of her college career, she resided at Santa Barbara during the school year. From the latter part of August of 1964 until July of 1965, Helen studied at the University of California ‘Extension, junior year abroad program,‘ at Goettingen, Germany. From February 20, 1967, to November 30, 1968, she was employed as a librarian. During this latter period she lived ‘at home’ for approximately 4 or 5 months and then moved into an apartment in Pasadena, Calif. Helen was married in November of 1969 and acquired the married name of Helen C. (Smith) Hurst.

Harold, Jr., was born on October 8, 1937. In June of 1963 he graduated from the University of Colorado at Boulder, and enlisted in the U.S. Air Force for 5 years. From the fall of 1963 until August of 1964 he was engaged in flight training at Craig Air Force Base at or near Selma, Ala. After graduation from flight school in August of 1964, he was stationed at Bunker Hill Air Force Base in Indiana. Upon receipt of his honorable discharge from the Air Force in 1968, he was employed by Continental Air Lines as a commercial airline pilot, flying primarily Pacific and Far Eastern flights. At the time of the trial herein, he resided at Dana Point, Calif., and continued to be employed by Continental Air Lines as a commercial Pilot.

On June 1, 1961, Harold and Caroline entered into a ‘purchase agreement’ with Union Oil Co. of California (Union Oil). Under the agreement, the Smiths agreed to sell to Union Oil 9,839 1/4 shares (out of a total of 10,500 issued and outstanding shares) of the capital stock of American Liquid Gas Corp. (American Gas). The purchase agreement, which identified the Smiths as ‘Sellers' and Union Oil as ‘Buyer,‘ made the following provision with regard to payment for the stock:

1. The purchase price to be paid by Buyer to Sellers for the Stock shall be the sum of ONE MILLION, EIGHT HUNDRED AND THIRTY-NINE THOUSAND, ONE HUNDRED AND EIGHT DOLLARS ($1,839,108.00) subject to adjustment upward or downwards in accordance with the provisions of paragraph 5 hereof. An amount equal to twenty-five per cent (25%) of the purchase price shall be paid not later than Tuesday, June 20, 1961, at 10:00 o'clock A.M. in Los Angeles Clearinghouse funds at the principal offices of the Buyer, Union Oil Center, Los Angeles, California. Such time and date is sometimes referred to herein as the ‘time of closing.’ The balance of the purchase price shall be paid in five equal annual installments commencing on the 1st day of July, 1962, or may be prepaid at the option of Buyer, except that no portion of such balance of purchase price shall be paid prior to January 1, 1962. Buyer agrees to pay interest semi-annually on the unpaid balance at a rate equal to the prime rate of interest being charged by New York City banks (currently 4 1/2 per cent) on the interest payment date. * * *

The purchase agreement was subsequently modified on two occasions in 1961, first on June 20, the closing date, to increase the total purchase price to $1,839,248.50, and finally on December 14, 1961, to reduce the total purchase price to $1,786,994.75.

On June 20, 1961, pursuant to the purchase agreement, Union Oil paid the Smiths $459,812.12 (approximately 25 percent of $1,839,248.50, the total purchase price as modified on that date) as the first installment of the purchase price. At the time of the sale, the Smiths' basis in the American Gas shares which were sold was $170,770.12. The selling expenses incurred by them which were attributable to the sale amounted to $10,102.28. On their joint Federal income tax return for 1961, the Smiths properly elected to report their gain from the sale of the American Gas stock on the installment method under section 453, I.R.C. 1954. Accordingly, in 1961 they reported income of $413,271.79 from the sale of the stock.

¹

1 The Smiths' return disclosed the following computations:
Selling price . . . . . $1,786,994.75
Less: Basis in stock . . . . . ($170,770.12 Selling expenses . . . . . ($10,102.28
Gain . . . . . $1,606,122.35
Gross profit percent ($1,606,122.35 % $1,786,994.75) . . . . . $89.8784%
Amount received in 1961 . . . . . $459,812.13
Installment profit 1961 ($459,812.13 x 89.8784% . . . . . $413,271.79

In each of the years 1962 and 1963, Union Oil paid the Smiths the annual installment of principal due in the amount of $265,436.53 (equal to approximately one-fifth of the difference between $1,786,994.75, the final aggregate purchase price, and $459,812.13, the first installment payment made in 1961) as well as the interest due on the unpaid balance. However, the payment due on July 1, 1962, was made on July 23, 1962, approximately 3 weeks late, as the result of Harold's oral request that Union Oil delay such payment. Union Oil did not pay the Smiths the added interest which accrued as the result of the late payment. On their joint Federal income tax returns for 1962 and 1963, the Smiths reported the 1962 and 1963 payments on the installment method in accordance with their election to do so in 1961; the income from the sale of the stock reported each year was $238,570.11 (89.8784 percent of the annual payments of $265,436.53).

Thus, at the end of 1963, the unpaid balance of the total purchase price due from Union Oil was $796,309.56, and of that amount $715,710.28 represented gain to be reported by the Smiths in the future in accordance with the installment method.

At the time of the trial herein, neither Harold nor Caroline had ever been a member of the board of directors of Union Oil or a major stockholder in Union Oil. Furthermore, apart from a period of no more than 10 months immediately following the sale of the American Gas stock, when Harold was employed by Union Oil as a consultant,

² neither had been an employee of that corporation.

2 During this period Harold also had the title of chairman of the board of one of the Union Oil subsidiaries to which the assets of American Gas had been transferred.

After the sale of the American Gas stock in 1961, Harold began to consider or plan the disposition of his estate. At one time, Stanford University or someone acting on its behalf proposed an estate plan under which Stanford would be the beneficiary of at least a substantial portion of the estate. However, Harold turned down the proposal because ‘It would look like we would get very little out of it.’

Subsequently, while in Florida in April of 1964, Harold had discussions with a Mr. Hardy, a mutual fund salesman who purported to have extensive estate-planning experience. Hardy proposed a plan whereby Harold would transfer certain assets to his children in exchange for their agreement to provide him, and possibly also his wife, with annuities. The plan also contemplated that the assets transferred to the children would be placed in trust and that the trust corpus would be invested in mutual funds. Harold was initially receptive to the proposal, and Hardy had an attorney draft a number of documents to carry out the plan.

Harold left Florida to return to California in April of 1964, bringing with him the unexecuted documents which had been prepared by Hardy and his attorney. On his trip back to California, he stopped off to see his son, Harold, Jr., who was then at flight school in Alabama. At that time Harold discussed the proposed plan, including the proposed annuities and trusts, with his some. After their discussion, Harold, Jr., signed the documents calling for his signature.

On his return to California, Harold consulted his attorney, Harold Voegelin, with regard to the proposed plan. he gave Voegelin the documents which had been prepared by Hardy and his attorney and recounted to Voegelin the substance of his conversations with Hardy in Florida. Already somewhat uneasy about dealing with Hardy, whom he had known for only a relatively brief period of time, Harold decided to have the matter handled by Voegelin and an accountant, Martin Samuelson, both of whom he had known for a number of years.

Harold sought an estate plan which would ensure him and his wife of adequate incomes for the remainder of their lives, which would also ensure that their children would be well taken care of thereafter, and which would minimize the amount of estate tax imposed at their deaths. Moreover, an engineer by training, Harold disliked the responsibilities of financial planning and management; in the past he had granted his brokers management powers over his securities accounts and had made Samuelson generally responsible for his financial affairs. Thus in planning his estate, he also decided a financial program which would continue to require little participation on his part.

Voegelin and Samuelson ultimately developed a plan which in general followed the outlines of Hardy's proposal, but differed therefrom in a number of details. In form, the plan contemplated that Harold and Caroline would assign to their children their interests in the purchase agreement with Union Oil and that in return the children would agree to pay annuities to their parents for the rest of their lives. The plan further contemplated that the children would establish trusts, that the purchase agreement or payments made by Union Oil in satisfaction of its obligation under the agreement would be placed in the trusts, and that the trusts would periodically pay to Harold and Caroline the amounts due to them as annuities.

As of late June 1964, it appeared that the series of transactions planned by Voegelin would not be fully consummated by July 1, 1964, the date when the third annual payment of $265,436.53 was due from Union Oil. Harold and Caroline wanted that payment to be included in Voegelin's plan, without first passing through their hands where the gain reflected therein would be subject to tax. They requested Union Oil to defer the payment by letter dated June 29, 1964. That letter read in pertinent part as follows:

With reference to that certain Purchase Agreement dated June 1, 1961 by and between Harold Smith and Caroline Smith, as Sellers, and Union Oil Company of California (Union), as Buyer, the undersigned hereby request that Union refrain from making the payment on the purchase price for the stock purchased under the terms of said agreement which would otherwise be due on the first day of July, 1964; and the undersigned hereby release Union from any and all liability for default in the making of said payment on July 1, 1964.

It is agreed, however, that interest on the amount of principal which would otherwise have been paid to the undersigned on July 1, 1964 shall cease to accrue as of July 1, 1964, and the undersigned hereby waive payment of any interest on the amount of such installment for the period from and after July 1, 1964 until said installment is paid.

The undersigned will advise Union when they wish to have said installment paid to them.

The prime rate of interest charged by New York City banks, which was the applicable rate of interest under the contract with Union Oil, was 4 1/2 percent in July of 1964. Union Oil would have made the installment payment on or before July 1, 1964, had it not been for the Smith's request to defer the payment. At the time the letter was written, Harold expected the assignments of contract, annuity contracts, and trust instruments to be executed in ‘due time.’

Prior to their execution of any of the instruments called for by the plan, Helen and Harold, Jr., each had some discussion with their father about the nature of the plan. Harold's discussions with Helen were less detailed than those with his son; she was a minor at that time, more interested in academic pursuits than in financial transactions, and was ‘willing to go along with anything that was proposed by Mr. Voegelin's office and Mr. Samuelson who had handled our (Harold's and Caroline's) affairs for a good many years.’ The children did not retain counsel of their own in connection with their role in the plan and relied primarily on the advice of Voegelin and Samuelson.

Three sets of documents were prepared by Voegelin and Samuelson's advice or guidance to carry out the plan. They were dated respectively, June 30, 1964, July 1, 1964, and August 1, 1964. They were in fact executed at some time or times during the period from late June to early August 1964, and were interdependent parts of a single integrated plan. They were not necessarily executed on the dates that they bear. They were as follows:

1. The Assignments of Contract.— The first two documents were both entitled ‘Assignment of Contract.’ One was signed by Harold and the other by Caroline. Both were dated June 30, 1964. Harold was identified as ‘Assignor’ in the document signed by him and Caroline was identified as ‘Assignor’ in the document signed by her. Harold, Jr., and Helen were identified as ‘Assignees' in both documents. Each document purported to convey to Harold, Jr., and Helen, in equal shares, all the rights that the respective assignor (Harold or Caroline) might have in the Union Oil contract. The operative provisions of both documents were identical and read in full as follows:

Said Assignor hereby transfers, sells, assigns, conveys and sets over to Assignees free and clear of any claims, liens or encumbrances whatsoever, in equal shares as to each, all the Assignor's right, title and interest, legal and equitable, in and to that certain contract dated June 1, 1961, called ‘Purchase Agreement’ by and between HAROLD W. SMITH and CAROLINE H. SMITH, and the UNION OIL COMPANY OF CALIFORNIA, as amended.

The intent hereof is to transfer to Assignees all of the contract rights and interest which the Assignor ownes or possesses, now or hereafter, and to confer upon Assignees full right and power in their absolute discretion to hold or dispose of said contract or their respective interests therein at any time without any notice to the Assignor.

As of July 1, 1964, the Union Oil contract had a fair market value of $796,308.

2. The Annuities.— Four documents, each captioned ‘Annuity Contract,‘ were dated July 1, 1964. In two of them Harold, Jr., appeared as the ‘undersigned promisor.’ In one of those he undertook to pay his father $21,000 per year, at the $1,750 a month beginning August 1, 1964, purportedly in consideration of the assignment of his father's one-half interest in the Union Oil contract. The introductory paragraph and operative provisions of that document were as follows:

WHEREAS, HAROLD W.SMITH has on this date assigned to the undersigned promisor an undivided one-half interest in and to all the right, title, and interest which the said HAROLD W. SMITH has in a certain contract, more particularly described as ‘Purchase Agreement’ between HAROLD W. SMITH and CAROLINE H. SMITH and THE UNION OIL COMPANY OF CALIFORNIA, dated June 1, 1961, as amended;

NOW THEREFORE, in consideration of such assignment, (the value of which is hereby stipulated to be $199,077) the undersigned promisor hereby covenants and agrees to pay to HAROLD W. SMITH Twenty-one Thousand Dollars ($21,000.00) per year, payable monthly beginning August 1, 1964 in the amount of One Thousand Seven Hundred Fifty Dollars ($1,750.00) and each and every month thereafter during said HAROLD W. SMITH's lifetime. Provided, however, that if at the time of HAROLD W. SMITH's death the total amount of the payments made hereunder to HAROLD S. SMITH shall not equal the amount of the consideration paid ($199,077), then the undersigned promisor shall continue making the annuity payments, as herein provided, to such person or persons as HAROLD W. SMITH shall designate by an instrument in writing filed with the promisor during said HAROLD W. SMITH's lifetime. The last such written instrument filed with the promisor shall govern and any such instrument so filed shall be deemed valid unless at the time of execution thereof the said HAROLD W. SMITH shall have been adjudicated an incompetent by a court of competent jurisdiction. The annuity payments to such designee shall continue until such time as the total of all the annuity payments made to HAROLD W. SMITH and his designee shall equal the amount of the consideration paid ($199,077) for this contract. In the absence of such designation, such payments shall be made to the estate of the said HAROLD W. SMITH.

It is mutually understood and agreed by and between the parties to this Annuity Contract that the interest factor in this contract shall be equal to that amount of any payments made to HAROLD W. SMITH pursuant to the terms hereof which is required by applicable Federal Income Tax laws to be included in the taxable income of HAROLD W. SMITH as ordinary income. It is further understood that this interest factor as so stated shall be in lieu of any other provisions or requirements for interest payments on the part of the promisor.

The second ‘annuity contract’ signed by Harold, Jr., was for the benefit of his mother and was substantially identical with the first ‘annuity contract’ except that it provided for an annuity of only $15,000 a year ($1,250 a month).

The other two documents of this group were executed by Helen as the ‘undersigned promisor,‘ one undertaking to provide an annuity for her father the other for her mother. The operative provisions of each were substantially identical with those of the corresponding instrument executed by Harold, Jr. None of the four ‘annuity contracts' contained a provision for collateral of security for the payments required by the agreements.

As of July 1, 1964, the value of each annuity to be received by Harold, computed pursuant to Federal Gift Tax Regulations section 25.2512-5(f), was $218,894.35, while the value of each annuity to be received by Caroline, computed under the same regulations, was $221,122.16. So calculated, the aggregate value of the four annuities was $880,033.02 on July 1, 1964.

3. The Trusts.— Two substantially identical trust instruments were executed, one by Harold, Jr., as settlor and the other by Helen as settlor. Each was dated August 1, 1964, and the corpus of each trust consisted of one-half of the funds obtained from Union Oil in discharge of its liability under the so-called purchase agreement, as hereinafter set forth. By July 31, 1964, Union Oil had been advised by or on behalf of Harold and Caroline that payment (which had theretofore been held in abeyance) might be made under the purchase agreement. Union Oil, whether on its own initiative or in response to a request by Harold, in fact made payment on July 31, 1964, not merely of the installment due in 1964 but also of the entire remaining principal amount for which it was liable under the contract plus interest accrued up to that time. On July 31, 1964, Union Oil thus delivered to Harold a check in the amount of $798,333.51, payable to Harold, Jr., and Helen. The components of that amount and the manner in which the proceeds of the check were transferred to the two trusts about to be more fully described will be set forth hereinafter.

Each trust instrument named Voegelin and Samuelson as trustees and each stated that the trust corpus would consist of $399,166.75 (one-half of the total amount of the funds received from Union Oil). Part ‘Second’ of each instrument stated the purpose of the trust and provided for payments by the trustees as follows:

(a) WHEREAS, the Settlor herein for a valuable consideration has contracted to pay to HAROLD W.SMITH and CAROLINE H. SMITH certain annuities as specified in Schedule B attached hereto; the purpose of this trust is to insure orderly payment and management of the annuity in the event of death or disability of the Settlor and the maintenance of separate accounts during the said Settlor's life as well as a disposition of the trust assets after the termination of this trust.

(b) TRUSTEES shall pay to HAROLD W. SMITH and CAROLINE H. SMITH such amounts as are called for in the annuity contracts attached hereto as Schedule B. Such payments shall be made from principal or income as the Trustees deem appropriate in their discretion. However, neither the trustees nor the Settlor shall have any obligation to secure the payment and obligations of the annuity contracts.

In addition, paragraph (c) authorized the trustees in their discretion to pay trust income to the settlor, spouse of the settlor, or children of the settlor, and also to expend amounts from principal for the benefit of such persons where needed for ‘proper care, maintenance, support or education.’

Each instrument declared the trust irrevocable:

the trust under this instrument cannot be altered, amended, revoked, or terminated by the Settlor and he retains no beneficial interest, vested or contingent, hereunder * * *

The Harold W. Smith, Jr. Trust was to terminate under the following conditions:

FIRST: This trust shall terminate upon the death of HAROLD W. SMITH, CAROLINE H. SMITH or HAROLD W. SMITH, JR., whichever is the later. But, if HAROLD W. SMITH, JR. should survive HAROLD W. SMITH and CAROLINE H. SMITH, then this trust shall terminate upon HAROLD W. SMITH, JR.‘s death or attaining the age of forty (40) years, whichever occurs first.

On termination of the trust, the trust corpus and accumulated income were to be distributed as follows:

THIRD: Upon termination of this trust, as provided in the FIRST paragraph, the Trustees are to distribute all of the trust estate and accumulated income therefrom to the following:

(a) HAROLD W. SMITH, JR., absolutely and forever, as his own separate property, but if he should not then be living, then to the lawful issue of HAROLD W. SMITH, JR. surviving to the date of such distribution, upon the principle of representation, subject to the continuation in trust as to the share of any such issue as may then be under the age of twenty-one (21) years as hereinafter provided.

(b) If no such issue of HAROLD W. SMITH, JR. should survive to the date of distribution and termination of this trust, then all such property shall go to the Trustees of the trust created on the same date hereof by the Settlor's sister, HELEN CAROLINE SMITH to be held by such Trustees according to the terms of such HELEN CAROLINE SMITH TRUST. In the event no such trust is then in existence, then this trust estate shall be distributed to HELEN CAROLINE SMITH outright if she is then living, or if she should not so survive, then to the lawful issue of HELEN CAROLINE SMITH surviving to the date of such distribution, upon the principle of representation.

(c) If no issue of HAROLD W. SMITH, JR. should survive to the date of distribution and termination of this trust, and the HELEN CAROLINE SMITH TRUST should not be then in existence, and HELEN CAROLINE SMITH should not so survive and no issue of HELEN CAROLINE SMITH should so survive, then all such trust property and accumulated income therefrom shall be distributed as follows:

(1) Thirty per cent (30%) thereof shall be held in trust for the benefit of FRANC(I)S M. SMITH and his wife, CATHERINE, or the survivor, presently of Bradenton Beach, Florida; the entire net income thereof to be distributed to or used for the benefit of such beneficiaries during their lifetime and the lifetime of the survivor. Upon the death of the survivor, or at the time distribution would have been made by the trust estate for their benefit had they been living, this portion of the trust estate shall be distributed to their then living lawful issue.

(2) Ten per cent (10%) outright to MRS. LOU RODAUCH, presently of Canton, Ohio, or if she is not living, to her then living lawful issue.

(3) Ten per cent (10%) to MRS. VERONA HELM, presently of Windsor, Ontario, Canada, or if she is not then living, to her husband, WILLIAM HELM; if both of such persons are not then living, their share shall be added to the share distributable to MRS. LOU RODAUCH, or to her then living lawful issue under subparagraph (c)(2) above.

(4) Fifteen per cent (15%) outright to EDWARD CHARLES HAUSER, JR., presently of Chico, California, or if he is not then living, to his then living lawful issue.

(5) Fifteen per cent (15%) outright to MRS. MARIE HAUSER, stepmother of CAROLINE H. SMITH, presently of Sacramento, California, or if she is not then living, such share shall be added to the share distributable to EDWARD CHARLES HAUSER, JR., or to his then living lawful issue under subparagraph (c)(4) above.

(6) Any remaining balance not otherwise disposed of hereunder shall be distributed one-half to the CHILDREN'S HOME SOCIETY OF CALIFORNIA, and one-half to the STANFORD RESEARCH INSTITUTE.

FOURTH: Notwithstanding the preceding provisions, in the event HAROLD W. SMITH, JR. should survive both CAROLINE H. SMITH and HAROLD W. SMITH, then if HAROLD W. SMITH, JR. should die before attaining the age of forth (40) years, the Trustees shall pay the trust estate and accumulated income therefrom, if any, to such person or persons in such amounts and proportions as said HAROLD W. SMITH, JR. may designate and appoint in the last unrevoked written instrument other than a Will executed by him and on file with the Trustees at the time of his death, such persons to be limited to his spouse, his lawful issue, his sister, HELEN CAROLINE SMITH, and the lawful issue of HELEN CAROLINE SMITH; provided, however, should the said HAROLD W. SMITH, JR. leave lawful issue surviving his death, then not more than one-half of the trust estate may be appointed to his spouse and any amount in excess thereof shall go instead to such issue of his. To the extent he shall not have exercised the limited power of appointment set forth herein, such trust estate shall be distributed in accordance with paragraph THIRD above, subject to the continuation in trust of the share of any such issue as may then be under the age of twenty-one (12) years, as hereinafter provided. * * *

The Helen Caroline Smith Trust was to ‘terminate upon the death of HAROLD W. SMITH, CAROLINE H. SMITH or HELEN CAROLINE SMITH, whichever is later.’ Unlike her brother's trust, which could terminate upon his attaining the age of 40, there were no provisions in Helen's trust for accelerating termination prior to her death. On termination of the trust, the trust corpus and accumulated income were to be distributed as follows:

THIRD: Upon termination of this trust, as provided in the FIRST paragraph, the Trustees are to distribute all of the trust estate and accumulated income therefrom to the following:

(a) The lawful issue of HELEN CAROLINE SMITH surviving to the date of such distribution, upon the principle of representation, subject to the continuation in trust as to the share of any such issue as may then be under the age of twenty-one (21) years as hereinafter provided.

(b) If no such issue of HELEN CAROLINE SMITH should survive to the date of distribution and termination of this trust, then all such property shall go to the Trustees of the trust created on the same date hereof by the Settlor's brother, HAROLD W. SMITH, JR., to be held by such Trustees according to the terms of such HAROLD W. SMITH, JR. TRUST. In the event no such trust is then in existence, then this trust estate shall be distributed to HAROLD W. SMITH, JR. outright if he is then living; or if he should not so survive, then to the lawful issue of HAROLD W. SMITH, JR. surviving to the date of such distribution, upon the principle of representation.

(c) If no issue of HELEN CAROLINE SMITH should survive to the date of distribution and termination of this trust, and the HAROLD W. SMITH, JR. TRUST should not be then in existence, and HAROLD W. SMITH, JR. should not so survive, and if no issue of HAROLD W. SMITH, JR. should so survive, then all such trust property and accumulated income therefrom shall be distributed as follows:

(Subpars. (c)(1) through (c)(6) were identical to the corresponding subparagraphs in the Harold W. Smith, Jr. Trust, quoted above.)

FOURTH: Notwithstanding the preceding provisions, in the event HELEN CAROLINE SMITH, should survive both CAROLINE H. SMITH and HAROLD W. SMITH, then on the death of said HELEN CAROLINE SMITH, the Trustees shall pay the trust estate and accumulated income therefrom, if any, to such person or persons in such amounts and proportions as said HELEN CAROLINE SMITH may designate and appoint in the last unrevoked written instrument other than a Wi-l executed by her and on file with the Trustees at the time of her death, such persons to be limited to her spouse, her lawful issue, her brother, HAROLD W. SMITH, JR., and the lawful issue of HAROLD W. SMITH, JR.; provided, however, should the said HELEN CAROLINE SMITH leave lawful issue surviving her death, then not more than one half of the trust estate may be appointed to her spouse and any amount in excess thereof shall go instead to such issue of hers. To the extent she shall not have exercised the limited power of appointment set forth herein, such trust estate shall be distributed in accordance with paragraph THIRD above, subject to the continuation in trust of the share of any such issue as may then be under the age of twenty-one (21) years, as hereinafter provided. * * *

Each trust instrument contained the following provision which was designed to make it at least more difficult for creditors to reach the trust assets:

SEVENTH: The interest of each beneficiary in the income or principle of a trust under this instrument shall be free from the control of interference of any creditor of a beneficiary or of any spouse of a married beneficiary and shall not be subject to attachment or susceptible of anticipation or alienation. Nothing contained in this paragraph shall be construed as restricting in any way the exercise of any power of appointment granted hereunder.

Each trust instrument also required the trustees to RENDER an account of the administration of the trust' annually to Harold, Jr., and Helen, respectively, while living.

The individual beneficiaries in Third (c)(1) through (5) of the trust instruments were all close relatives of either Harold or Caroline or were persons in whom Harold or Caroline were particularly interested. Thus, Francis Smith was Harold's brother. Mrs. Lou Rodauch and Mrs. Verona Helm were cousins of Harold; he never had any sisters, but these cousins, who were very nearly of the same age as his own, were very close to him when he was young, and he regarded them as sisters. Edward Charles Hauser, Jr., was a brother of Caroline, and Marie Hauser was her stepmother. As to the charitable beneficiaries named in subparagraph (6), Harold had a special interest in Stanford Research Institute and Caroline appears to have had an interest in the Children's Home Society of California. Prior to the time when the trust instruments were drafted, Voegelin had prepared a will for Harold and Caroline which governed property other than their rights under the Union Oil contract. Most, if not all, of the beneficiaries named in the foregoing paragraph (c) were also named as beneficiaries under the will.

The execution of the trust agreements was the last step in creating the legal mechanism for Harold's desired estate plan. It was an integral and indispensable part of the plan. These trusts provided for the disposition of property (the Union Oil contract) previously owned by Harold and Caroline in accordance with the wishes and plans of Harold and Caroline. Harold, Jr., and Helen do not appear to have exercised any independent judgment in this connection. Harold and Caroline were in truth and in fact the real settlors; Harold, Jr., and Helen were settlors in form only.

Neither Helen nor Harold, Jr., had previously granted an annuity. Harold, Jr., admitted that his net worth was less than $2,000, and indicated that his principal resource was his salary as a second lieutenant. He was about to graduate from the Air Force flight school, and both he and his father understood that he would remain in the Air Force for at least 4 more years. Helen had no significant financial resources of her own. She was 19 years old in the summer of 1964, unmarried, and a full-time college student, about to leave for Germany on a junior year abroad program. Neither Helen nor Harold, Jr., had any prior experience with regard to investment and management of capital. It was contemplated both by the parents and the children when the former executed the assignments of the Union Oil contract that, pursuant to Voegelin's plan, the proceeds of the assignments would be placed in a trust or trusts which would fund the annuities.

As previously noted, Union Oil, on July 31, 1964, delivered to Harold a check in the amount of $798,333.51, payable to Harold, Jr., and Helen. That amount represented the entire outstanding principal balance on the installment contract of $796,309.56 (including the annual installment payment of $265,436.53 which had been deferred a month earlier pursuant to Harold's request), plus interest in the amount of $2,013.95. The $2,023.95 interest payment represented $99.54 in interest for 1 day, July 1, 1964, on $976,309.56, and $1,924.41 in interest for the period July 2, 1964, through July 31, 1964, on $530,873.04. In accordance with Harold's letter of June 29, 1964, Union Oil did not pay interest which may otherwise have accrued by virtue of the deferred payment of the installment due on July 1, 1964.

The following schedules reflect all payments of principal and interest made by Union Oil under the purchase agreement:

PRINCIPAL

+-----------------------------------------------------------------------------+ ¦ ¦Amount of ¦ ¦Balance due ¦ +------------+-----------+--------------------------------------+-------------¦ ¦Date of ¦principal ¦Payee ¦from Union ¦ ¦payment ¦ ¦ ¦ ¦ +------------+-----------+--------------------------------------+-------------¦ ¦ ¦payment ¦ ¦Oil ¦ +------------+-----------+--------------------------------------+-------------¦ ¦ ¦ ¦ ¦$1,786,994.75¦ +------------+-----------+--------------------------------------+-------------¦ ¦June 20, ¦$459,812.13¦Harold W. and Caroline H. Smith ¦1,327,182.62 ¦ ¦1961 ¦ ¦ ¦ ¦ +------------+-----------+--------------------------------------+-------------¦ ¦July 23, ¦265,436.53 ¦Harold W. and Caroline H. Smith ¦1,061,746.09 ¦ ¦1962 ¦ ¦ ¦ ¦ +------------+-----------+--------------------------------------+-------------¦ ¦June 28, ¦265,436.53 ¦Harold W. and Caroline H. Smith ¦796,309.56 ¦ ¦1963 ¦ ¦ ¦ ¦ +------------+-----------+--------------------------------------+-------------¦ ¦July 31, ¦796,309.56 ¦Harold W. Smith, Jr., and Helen ¦0 ¦ ¦1964 ¦ ¦Caroline Smith ¦ ¦ +-----------------------------------------------------------------------------+

INTEREST

+-----------------------------------------------------------------------------+ ¦Date of ¦Period interest ¦Payee ¦Amount ¦ ¦payment ¦accrued ¦ ¦ ¦ +--------------+---------------------+-----------------------------+----------¦ ¦Dec. 28, 1961 ¦6/20/61 to 1/1/62 ¦Harold W. and Caroline H. ¦$31,602.72¦ ¦ ¦ ¦Smith ¦ ¦ +--------------+---------------------+-----------------------------+----------¦ ¦Jan. 5, 1962 ¦Adjustment ¦Harold W. and Caroline H. ¦83.77 ¦ ¦ ¦ ¦Smith ¦ ¦ +--------------+---------------------+-----------------------------+----------¦ ¦July 23, 1962 ¦1/1/62 to 7/1/62 ¦Harold W. and Caroline H. ¦29,861.61 ¦ ¦ ¦ ¦Smith ¦ ¦ +--------------+---------------------+-----------------------------+----------¦ ¦Dec. 28, 1962 ¦7/1/62 to 1/1/63 ¦Harold W. and Caroline H. ¦23,889.29 ¦ ¦ ¦ ¦Smith ¦ ¦ +--------------+---------------------+-----------------------------+----------¦ ¦June 28, 1963 ¦1/1/63 to 7/1/63 ¦Harold W. and Caroline H. ¦23,889.29 ¦ ¦ ¦ ¦Smith ¦ ¦ +--------------+---------------------+-----------------------------+----------¦ ¦Dec. 30, 1963 ¦7/1/63 to 1/1/64 ¦Harold W. and Caroline H. ¦17,916.97 ¦ ¦ ¦ ¦Smith ¦ ¦ +--------------+---------------------+-----------------------------+----------¦ ¦July 31, 1964 ¦1/1/64 through 6/30/ ¦Harold W. and Caroline H. ¦17,817.43 ¦ ¦ ¦64 ¦Smith ¦ ¦ +--------------+---------------------+-----------------------------+----------¦ ¦July 31, 1964 ¦7/1/64 through 7/31/ ¦Harold W. Smith, Jr., and ¦ ¦ ¦ ¦64 ¦Helen ¦ ¦ +--------------+---------------------+-----------------------------+----------¦ ¦ ¦ ¦Caroline Smith. ¦2,023.95 ¦ +-----------------------------------------------------------------------------+

Union Oil made the $798,333.51 check (embodying its final principal and interest payments) payable to Harold, Jr., and Helen at Harold's request. The record does not clearly disclose the reason for Union Oil's decision to prepay the outstanding balance.

After receiving the check Harold took it home and had Helen endorse it. ‘Immediately’ after Helen endorsed the check, Harold and Caroline left for Selma, Ala., to visit Harold, Jr., who was then about to graduate from flight school. Upon obtaining Harold, Jr.‘s endorsement on the check, Harold mailed it to Voegelin in California.

On August 5, 1964, a savings account was opened at the Crocker- Citizens National Bank, Los Angeles, by Voegelin and Samuelson as trustees for the Harold W. Smith, Jr. Trust. On the same date a like account was opened at the same bank for the Helen C. Smith Trust. At this time one-half of the amount of the check from Union Oil, or $399,166.76, was deposited in the account for the Helen C. Smith Trust, and the remaining funds, $399,166.75, were deposited in the savings account for the other trust.

By a letter dated September 1, 1964, Voegelin and Samuelson as trustees instructed the Crocker-Citizens National Bank to disburse fixed monthly amounts out of the two trust accounts to Harold and Caroline:

In accordance with Annuity Contracts dated August 1, 1964, payable by each of the above trusts, payment should be made by the above trusts commencing September 1, 1964, and the first day of each month thereafter, as follows:

+----------------------------------------------+ ¦By Harold W. Smith, Jr. Trust: ¦ ¦ ¦ +--------------------------------+------+------¦ ¦To Harold W. Smith ¦$1,750¦ ¦ +--------------------------------+------+------¦ ¦To Caroline H. Smith ¦1,250 ¦ ¦ +--------------------------------+------+------¦ ¦Total ¦ ¦$3,000¦ +--------------------------------+------+------¦ ¦Savings Account No. 0021330 ¦ ¦ ¦ +--------------------------------+------+------¦ ¦By Helen Caroline Smith Trust: ¦ ¦ ¦ +--------------------------------+------+------¦ ¦To Harold W. Smith ¦1,750 ¦ ¦ +--------------------------------+------+------¦ ¦To Caroline H. Smith ¦1,250 ¦ ¦ +--------------------------------+------+------¦ ¦Total ¦ ¦3,000 ¦ +--------------------------------+------+------¦ ¦Savings Account No. 0021348 ¦ ¦6,000 ¦ +----------------------------------------------+

Such payments should continue until further notice in writing and are to be forwarded to the Smiths' at 2449 Ridgeway Road, San Marino, California.

Harold and Caroline also maintained a personal joint account at the Crocker-Citizens National Bank. By a letter dated February 12, 1965, Harold instructed the bank to deposit the monthly disbursements from the two trust accounts, totaling $6,000, in the joint account.

From the date when the trust accounts were opened in August of 1964, until February 1, 1966, the source of all additions to the trust accounts (apart from the initial deposits) was the accrual of interest thereon which was automatically deposited by the bank in the accounts. During the same period, apart from two unexplained exceptions,

³ the only disbursements from each trust account were those made by the bank in accordance with the trustees' instructions to pay $3,000 per month to Harold and Caroline.

3 The quarterly statements for the accounts disclose two unexplained withdrawals of $7,500 and $2,500 from each account on Jan. 3, 1966.

Each of the four annuity contracts stated that the monthly annuity payments were to commence on August 1, 1964. However, the first monthly payments were not made until September of 1964 because the trusts had not yet been established at the time of the first monthly payments were due.

On February 1, 1966, $350,000 was withdrawn from each trust account, and the balance appearing in each account was then approximately $6,096.

⁴ On February 2, 1966, the trustees opened two additional savings accounts, one in the name of each trust, at the First Western Bank at San Marino, Calif. The initial deposit made in each account on that date was the $350,000 previously withdrawn from each trust account at the Crocker-Citizens National Bank. Harold and Caroline also maintained a joint commercial account at the First Western Bank. And on the date the trust accounts were opened, the First Western Bank was authorized by Samuelson and Voegelin to disburse $3,000 per month from each trust account, and was also authorized by Harold and Caroline to deposit the aggregate of $6,000 per month in their joint commercial account at the bank.

4 The parties have stipulated that the balance in each account was approximately $8,000. The discrepancy is unexplained. From Feb. 2, 1966, through Mar. 25, 1970, there were no disbursements from the Helen C. Smith Trust account, apart from an unexplained withdrawal of $31.20 on June 4, 1969. The source of all additions to the account during this period was the accrual of interest on the balance, which amounted to $8,272.82 on Mar. 26, 1970. During the same period there were no disbursements whatever from the Harold W. Smith, Jr. Trust account, and the source of all additions to the account was the accrual of interest on the balance, which amounted to $8,655.69 on Mar. 26, 1970.

From 1966 until the time of the trial herein, the deposits and withdrawals for the two trust accounts at the First Western Bank were in general

⁵ identical. During this period the bank has in general⁵ continued to transfer automatically $6,000 per month from the children's trust accounts to the parents' joint commercial account. Prior to December 1, 1966, there were no withdrawals from either of the trust accounts apart from the automatic monthly withdrawals. On December 1, 1966, $200,000 was withdrawn from each account and invested and subsequently reinvested in commercial paper, until on July 17, 1969, $209,750.20 was placed in an investment account for each trust. From September 26, 1969, to April 30, 1970, the funds were invested principally in common stock, as well as U.S. Treasury Bills and time deposits. From time to time interest earned on the commercial paper was deposited in the appropriate trust account at the First Western Bank.

5 The only exception, which is unexplained, appears to have occurred during the last 3 months of 1969. See fn. 6 infra.

At the time of the trial herein, all payments made to Harold and Caroline under the annuity contracts had been made by the trusts.

⁶ Although the trust instruments provided that the trustees were entitled to receive compensation for their services, neither Vogelin nor Samuelson received such compensation from the trusts from 1964 through 1969. Each trust instrument also provided that the trustees were to render to the settlor an annual account of the administration of the trust. However, Harold, Jr., did not receive an annual report during the years when he was in the Air Force. The record does not disclose whether Helen Has ever received an annual report from the trustees.

6 However, the bank statements for the trust accounts disclose that in contrast to the regular withdrawals of $3,000 per month in the past, only one withdrawal (in the amount of $1,100) was made from the Harold W. Smith, Jr. Trust account during the last 3 months of 1969, and that during the same period, only one $1,100 withdrawal and one $3,000 withdrawal were made from the Helen Caroline Smith Trust account.

Helen became 21 years of age on November 2, 1965. On December 9, 1965, she executed a document entitled ‘Ratification Agreement,‘ wherein she acknowledged that she had executed the trust instrument and the annuity contracts while a minor, ratified her prior actions, and agreed to fulfill the terms of the instruments she had executed.

Fiduciary Federal income tax returns were filed on behalf of each of the trusts for the years 1964 through 1969, inclusive. The amounts reported on the returns as the trusts' annual total income were, with one minor exception,

⁷ identical in each year:

7 The $11.84 difference in 1969 is wholly attributable to the fact that during 1969 the Harold W. Smith, Jr. Trust received $11.84 more in interest than did the Helen C. Smith Trust. With the exception of 1969, the income reported on the returns was exclusively interest income. In 1969, $315 of dividend income, in addition to interest income, was reported on each return.

+------------------------------------------+ ¦ ¦Harold W. Smith, ¦Helen Caroline ¦ +------+------------------+----------------¦ ¦Year ¦Jr. Trust ¦Smith Trust ¦ +------+------------------+----------------¦ ¦1964 ¦$5,759.08 ¦$5,759.08 ¦ +------+------------------+----------------¦ ¦1965 ¦15,170.19 ¦15,170.19 ¦ +------+------------------+----------------¦ ¦1966 ¦12,182.20 ¦12,182.20 ¦ +------+------------------+----------------¦ ¦1967 ¦12,470.32 ¦12,470.32 ¦ +------+------------------+----------------¦ ¦1968 ¦20,524.69 ¦20.524.69 ¦ +------+------------------+----------------¦ ¦1969 ¦14,863.27 ¦14,851.43 ¦ +------------------------------------------+

Each fiduciary return reported all income from the trusts as chargeable to either Harold, Jr., or Helen as the ‘grantor’ of the trust in question. Each Federal income tax return filed by Harold, Jr., and Helen for the years 1964 through 1967 included in gross income all of the net income reported in the appropriate fiduciary return for that year.

On each of her Federal income tax returns for the years 1964 through 1968, Helen also claimed a deduction for interest expenses incurred under her annuity contracts with her parents. The amount of the claimed deduction on her 1967 return was $18,936. That amount was equal to precisely one-half of the amount which her parents reported on their 1967 joint return as ordinary income from their four annuity contracts with the children. See table at p. 281 infra. In the Commissioner's notice of deficiency against Helen he determined that she was not entitled to the interest deduction claimed on her 1967 return.

On each of his Federal income tax returns for the years 1964 through 1967, Harold, Jr., claimed interest deductions attributable to the annuity contracts which were equal in amount to the deductions claimed by Helen during those years. The following table summarizes the interest deductions claimed by Helen and Harold, Jr., from 1964 through 1967, attributable to the annuity contracts:

+-----------------------------------+ ¦ ¦Deduction ¦Deduction ¦ ¦ +----+----------+-----------+-------¦ ¦Year¦claimed by¦claimed by ¦Total ¦ +----+----------+-----------+-------¦ ¦ ¦Helen ¦Harold, Jr.¦ ¦ +----+----------+-----------+-------¦ ¦1964¦$6,312 ¦$6,312 ¦$12,624¦ +----+----------+-----------+-------¦ ¦1965¦18,936 ¦18,936 ¦37,872 ¦ +----+----------+-----------+-------¦ ¦1966¦18,936 ¦18,936 ¦37,872 ¦ +----+----------+-----------+-------¦ ¦1967¦18,936 ¦18,936 ¦37,872 ¦ +-----------------------------------+

On their joint Federal income tax return for 1964, Harold and Caroline included in gross income a portion of the annuity payments received from their children under the annuity contracts. The included portion of the payments was computed on the basis of ‘exclusion ratios' (authorized by section 72, I.R.C. 1954, with respect to the receipt of annuity payments), and was treated as ordinary income.

⁸ Harold and Caroline also reported as capital gain income a percentage of the remaining (and otherwise unincluded) portion of the annuity payments. That amount was computed by multiplying the remaining portion by 89.8784 percent (the profit ratio previously used by Harold and Caroline in reporting Union Oil's payments on the installment method under section 453). The following table summarizes the manner in which the 1964 return reflected the receipt of the annuity payments:

8 The ‘exclusion ratios' were computed on the basis of (1) a total investment in the four contracts of $732,603.36 (the fair market value of the Union Oil contract on the date it was assigned to the children—reduced by $63,704.64 to reflect the guaranteed refund feature of the annuity contracts), and (2) ‘multiples' of 16.9 years for Harold and 28.7 years for Caroline. So computed, the exclusion ratios were 49.9 percent for Harold and 43.9 percent for Caroline. The multiple for Harold was apparently selected on the basis of the mistaken assumption that he was 62 years old rather than 63 as of the annuities' starting date.

+-----------------------------------------------------------------------------+ ¦ ¦Harold ¦Caroline¦Total ¦ +-------------------------------------------------+-------+--------+----------¦ ¦(a) Total annuity payments received during 1964 ¦$14,000¦$10,000 ¦$24,000.00¦ +-------------------------------------------------+-------+--------+----------¦ ¦(b) Portion of (a) excluded under annuity ¦49.9% ¦43.9% ¦ ¦ ¦provisions (exclusion ratio) ¦ ¦ ¦ ¦ +-------------------------------------------------+-------+--------+----------¦ ¦(c) Amount excluded under annuity provision [(a) ¦$6,986 ¦$4,390 ¦$11,376.00¦ ¦x (b)] ¦ ¦ ¦ ¦ +-------------------------------------------------+-------+--------+----------¦ ¦(d) Amount included as ordinary income [(a) - ¦$7,014 ¦$5,610 ¦$12,624.00¦ ¦(c)] ¦ ¦ ¦ ¦ +-------------------------------------------------+-------+--------+----------¦ ¦(e) Amount reported as long-term capital gain ¦ ¦ ¦ ¦ +-------------------------------------------------+-------+--------+----------¦ ¦[(c) multiplied by 89.8784% (the profit ¦ ¦ ¦ ¦ +-------------------------------------------------+-------+--------+----------¦ ¦ratio under installment sale provisions)] ¦ ¦ ¦$10,224.57¦ +-------------------------------------------------+-------+--------+----------¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------+

Harold and Caroline reported no gain on their 1964 return from the disposition of Union Oil's installment obligation during that year.

On each of their returns for the years 1965 through 1967, Harold and Caroline reported the receipt of a total of $72,000 under the annuity contracts. They treated those amounts in the same manner as that applied on their 1964 return. The following table summarizes the manner in which each return reflected the receipt of each year's total annuity payments:

+-----------------------------------------------------------------------------+ ¦ ¦Harold ¦Caroline¦Total ¦ +-------------------------------------------------+-------+--------+----------¦ ¦Total annuity payments received during year ¦$42,000¦$30,000 ¦$72,000.00¦ +-------------------------------------------------+-------+--------+----------¦ ¦Amount included as ordinary income under annuity ¦21,042 ¦16,830 ¦37,872.00 ¦ ¦provisions ¦ ¦ ¦ ¦ +-------------------------------------------------+-------+--------+----------¦ ¦Amount reported as long-term capital gain ¦ ¦ ¦30,673.70 ¦ +-------------------------------------------------+-------+--------+----------¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------+

In the Commissioner's notice of deficiency against Harold and Caroline for 1964 he determined that the portion of the Smith's gain on the sale of the American Gas stock to Union Oil which had not yet been recognized and which had until then been deferred under the installment method should be recognized as long-term capital gain:

In the year 1964, installment sale payments aggregating $796,309.56 were paid by the obligor, the Union Oil Company, to your assignees, Harold W. Smith, Jr. and Helen Caroline Smith. It is determined that said payments were actually received by you in 1964 within the meaning of section 453 of the Internal Revenue Code and that the proportion of said installment payments representing deferred or unrecognized installment gain amounted to $715,710.29. It is further determined that the $715,710.29 is includible in your 1964 taxable income as long-term capital gain. Since your included in your 1964 taxable income installment sale gain of only $10,224.57, your long-term capital gain income is increased by $705,485.72, taxable to the extent of 50 percent, or $352,742.86.

For the year 1965, the gain of $30,673.70 reported in connection with the installment sale to Union Oil Co. is eliminated since the entire balance of gain is included in 1964. * * *

None of the members of the Smith family filed a Federal gift tax return as a result of any of the transactions described herein.

OPINION

RAUM, Judge:

1. In 1961 Harold and Caroline Smith sold their American Gas stock to Union Oil. The sale price finally agreed upon was $1,786,994.75, of which 459,812.13 was paid in 1961 and the balance was to be paid in annual installments over a 5-year period. On their 1961 joint Federal income tax return, the Smiths properly elected to report their gain from the sale on the installment method under section 453.

⁹ By the end of 1963, the unpaid balance of the total purchase price due from Union Oil was $796,309.56, and of that amount $715,710.28 represented gain to be reported by the Smiths in the future under the installment method. At Harold's request, Union Oil deferred the annual installment payment due on July 1, 1964. At approximately the same time, the Smiths' entered into the following series of transactions with their children, Helen and Harold, Jr.: Harold and Caroline transferred their interests in the Union Oil contract to Helen and Harold, Jr.. The children agreed to provide each parent with an annuity. Each child thereafter executed an instrument establishing a trust designed to fund the annuities. At about the same time Union Oil delivered a check to Harold payable to Helen and Harold, Jr., in payment of the entire outstanding balance under the installment contract. The proceeds of the check were then deposited in two savings accounts opened on behalf of the two trusts. As of the time of the trial herein, all of the payments made to Harold and Caroline under the annuity contracts have been made by the trusts.

9 SEC. 453. INSTALLMENT METHOD.
(a) DEALERS IN PERSONAL PROPERTY.—
(1) IN GENERAL.— Under regulations prescribed by the Secretary or his delegate, a person who regularly sells or otherwise disposes of personal property on the installment plan may return as income therefrom in any taxable year that proportion of the installment payments actually received in that year which the gross profit, realized or to be realized when payment is completed, bears to the total contract price.
(2) TOTAL CONTRACT PRICE.— For purposes of paragraph (1), the total contract price of all sales of personal property on the installment plan includes the amount of carrying charges or interest which is determined with respect to such sales and is added on the books of account of the seller to the established cash selling price of such property. This paragraph shall not apply with respect to sales of personal property under a revolving credit type plan or with respect to sales or other dispositions of property the income from which is, under subsection (b), returned on the basis and in the manner prescribed in paragraph (1).
(b) SALES OF REALTY AND CASUAL SALES OF PERSONALTY.—
(1) GENERAL RULE.— Income from—
(A) a sale or other disposition of real property, or
(B) a casual sale or other casual disposition of personal property (other than property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year) for a price exceeding $1,000, may (under regulations prescribed by the Secretary or his delegate) be returned on the basis and in the manner prescribed in subsection (a).

On their joint Federal income tax return of 1964 Harold and Caroline reported no gain from the disposition of their interests in the Union Oil contract or from Union Oil's final payment of principal in respect of that contract. However, on their returns for 1964 and years subsequent, they included in gross income a portion of the annuity payments received in each year. Part of the included portion was computed by applying the method authorized by section 72, I.R.C. 1954, to the annuity payments and treating the amount includable thereunder as ordinary income. The remainder of the included portion was computed by applying the installment method authorized by section 453 to the portion of the annuity payments which had not been included under section 72 and treating that amount as capital gain. By reporting their gain in this manner, Harold and Caroline would not include the full amount of their gain in gross income until 1987, assuming that the guaranteed refund provisions had not yet been triggered.

¹⁰ In any event, the date would probably be much later than July 1, 1966 (which would have been the date of Union Oil's final payment if its payments had been made as originally planned), and certainly later than July 31, 1964 (when the total outstanding balance due under the contract was paid).

10 Harold and Caroline reported $10,224.57 as long-term capital gain in 1964 and $30,673.70 as long-term capital gain in each subsequent year. Assuming that the annual payments in the aggregate amount of $72,000 continued, not until 1987 would they have reported a total long-term capital gain of $715,710.28.

The Commissioner contends that Harold and Caroline should have included in their 1964 gross income that portion of their gain on the sale of the American Gas stock to Union Oil which had not yet been recognized and which had until then been deferred under the installment method. On brief he relies primarily upon section 453(d):

¹¹

11 In his notice of deficiency, however, the Commissioner referred merely to sec. 453 without specifying any paragraph thereof, but the explanation in that notice would seem to indicate reliance upon par. (a) which is made applicable to this case by par. (b). The theory involving these latter provisions will be considered, infra pp. 291-292.

SEC. 453. INSTALLMENT METHOD.

(d) GAIN OR LOSS ON DISPOSITION OF INSTALLMENT OBLIGATIONS.

(1) GENERAL RULE.— If an installment obligation is satisfied at other than its face value or distributed, transmitted, sold, or otherwise disposed of, gain or loss shall result to the extent of the difference between the basis of the obligation and

(A) the amount realized in the case of satisfaction at other than face value or a sale or exchange, or

(B) the fair market value of the obligation at the time of distribution, transmission, or disposition, in the case of the distribution, transmission, or disposition otherwise than by sale or exchange.

Any gain or loss so resulting shall be considered as resulting from the sale or exchange of the property in respect of which the installment obligation was received.

(2) BASIS OF OBLIGATION.— The basis of an installment obligation shall be the excess of the face value of the obligation over an amount equal to the income which would be returnable were the obligation satisfied in full.

The Commissioner urges that in 1964 Harold and Caroline disposed of Union Oil's installment obligation ‘otherwise than by sale or exchange’ and that therefore, pursuant to section 453(d)(1)(B), the difference between the basis of the obligation and ‘the fair market value of the obligation at the time of * * * disposition’ should be included in the Smiths' 1964 gross income. In the alternative, the Commissioner argues that even if the disposition were by ‘sale or exchange,‘ the fair market value of the annuities at the time of the disposition is ascertainable and that such amount, less the Smiths' basis in the Union Oil contract, is includable in their 1964 gross income pursuant to section 453(d)(1)(A).

Petitioners agree that section 453(d) governs their disposition of the Union Oil contract. However, they contend that the disposition was a ‘sale or exchange’ within the meaning of section 453(d)(1) and that therefore subparagraph (A), not subparagraph (B), provides the applicable measure of the amount of gain: the difference between the basis of the obligation and ‘the amount realized.’ Petitioners urge that what was realized, the annuities, had no ascertainable fair market value in 1964 and that therefore recognition of gain was properly deferred under the combined application of sections 72 and 453.

The installment method of reporting income for Federal tax purposes was first authorized by statute in section 212(d) of the Revenue Act of 1926, 44 (pt.2) Stat. 23. It was designed to permit recipients of certain installment payments to report their gain ratably over the period during which the installments were received and thereby avoid the hardships of ‘bunching’ the gain in 1 year or a relatively few years, often prior to the receipt of a substantial portion of the anticipated proceeds. S. Rept. No. 52, 69th Cong., 1st Sess., p. 19 (1926); H. Rept. No. 356, 69th Cong., 1st Sess., pp. 32-33 (1926); Burnet v. S. & L. Bldg. Corp., 288 U.S. 406, 413-414; Nuckolls v. United States, 76 F.2d 357, 359 (C.A. 10); Everett Pozzi, 49 T.C. 119, 126; Lewis M. Ludlow, 36 T.C. 102, 107-108; Thomas F. Prendergast, Executor, 22 B.T.A. 1259, 1262. The effect of reporting sales proceeds under the installment method is thus deferral or postponement of much of the tax stemming from the gain on the sale. Accordingly, the installment method provisions have been customarily regarded as ‘relief’ measures, and ‘exceptions' to the general tax accounting rules. Their availability has therefore been considered a ‘privilege’ for which the statutory requirements must be strictly construed. Everett Pozzi, 49 T.C. 119, 127; Cappel House Furnishing Co. v. United States, 244 F.2d 525, 529 (C.A. 6); Blum's, Incorporated, 17 B.T.A. 386, 389.

After the installment method became available in 1926, a number of taxpayers electing to report gain under that method subsequently disposed of their unpaid installment obligations and claimed that recognition of the gain represented by the unpaid installment obligations should continue to be deferred or should be bypassed altogether. See Nuckolls v. United States, 76 F.2d 357, 359-360 (C.A. 10); Nebraska Seed Co. v. United States, 116 F. Supp. 740, 743-744 (Ct. Cl.), certiorari denied 347 U.S. 1012; Hegra Note Corp. v. Commissioner, 387 F.2d 515, 517-518 (C.A. 5), affirming a Memorandum Opinion of this Court. In response Congress enacted section 44(d) of the Revenue Act of 1928, 45 (pt. 1) Stat. 806,

¹² which was designed to terminate the privilege of reporting gain on the installment method where a taxpayer who had elected installment method treatment subsequently disposed of unpaid installment obligations. The House and Senate committee reports explained the objectives of the 1928 legislation in identical language (H. Rept. No. 2, 70th Cong., 1st Sess. p. 16 (1927); S. Rept. No. 960, 70th Cong., 1st Sess. p. 24 (1928)):

12 SEC. 44. INSTALLMENT BASIS.
(d) Gain or loss upon disposition of installment obligations.— If an installment obligation is satisfied at other than its face value or distributed, transmitted, sold, or otherwise disposed of, gain or loss shall result to the extent of the difference between the basis of the obligation and (1) in the case of satisfaction at other than face value or a sale or exchange— the amount realized, or (2) in case of a distribution, transmission, or disposition otherwise than by sale or exchange— the fair market value of the obligation at the time of such distribution, transmission, or disposition. The basis of the obligation shall be the excess of the face value of the obligation over an amount equal to the income which would be returnable were the obligation satisfied in full.

Subsection (d) contains new provisions of law to prevent evasion of taxes in connection with the transmission of installment obligations upon death, their distribution by way of liquidating or other dividends, or their disposition by way of gift, or in connection with similar transactions. The situations above specified ordinarily do not give rise to gain and yet at the same time it is urged that they permit the recipient to obtain a greatly increased basis in his hands for the property received, except in the case of gifts. It therefore seems desirable to clarify the matter. The installment basis accords the taxpayer the privilege of deferring the reporting at the time of sale of the gain realized, until such time as the deferred cash payments are made. To prevent the evasion the subsection terminates the privilege of longer deferring the profit if the seller at any time transmits, distributes, or disposes of the installment obligations and compels the seller at that time to report the deferred profits. The subsection also modifies the general rule provided in subsection (a) for the ascertainment of the percentage of profit in the deferred payments, in those cases in which the obligations are satisfied at other than their face value or are sold or exchanged. The modification permits a compensating reduction in the percentage of profit in case the obligations are satisfied at less than their face value, or are sold or exchanged at less than face value.

Whether or not the gain or loss realized under the section is recognized for tax purposes, depends upon general principles of law embodied in the income tax provisions the exchange of installment obligations in connection with tax-free exchanges, for instance, being cared for by section 112.

The general purpose of the 1928 legislation was thus to require a taxpayer who had elected to defer recognition of gain under the installment method to recognize previously unrecognized gain when he disposed of the installment obligations of the purchaser. Nebraska Seed Co. v. United States, 116 F.Supp. 740, 744 (Ct. Cl.); Ralph Dessauer, 54 T.C. 327, 330, on appeal (C.A. 8). The significant language of the 1928 legislation has been preserved, substantially unchanged, in the 1954 Code. The statute provides two different standards for measuring the amount of the proceeds from the disposition of an installment obligation. One, ‘the amount realized,‘ is applicable in the case of a sale or exchange or a satisfaction of the obligation at less than face value. The other, ‘the fair market value of the obligation at the time of distribution, transmission, or disposition,‘ is applicable in the case of all other dispositions.

Petitioners concede that there was a ‘disposition’ of an installment obligation in 1964 calling for the application of section 453(d)(1). However, their position— that the disposition qualifies as a ‘sale or exchange’ under section 453(d)(1)(A), that the ‘amount realized’ had no ascertainable value in 1964, and that therefore recognition of gain ought to be deferred beyond the period originally authorized by section 453— flies in the face of the general purpose of section 453(d): to terminate the privilege of deferred recognition on the disposition of an installment obligation.

¹³ And in deciding whether or not the Smiths' disposition of their interests in the Union Oil contract qualifies as a ‘sale or exchange,‘ we have borne in mind the general purposes of section 453(d).

13 Of course, as indicated by the final paragraph of the committee reports quoted above, statutory nonrecognition provisions (e.g., in the case of corporate reorganizations) may in some cases authorize nonrecognition of gain described by sec. 453. See regs. secs. 1.453-9(a) and 1.453-9(c); Nebraska Seed Co. v. United States, 116 F.Supp. 740, 742-743 (Ct. Cl.), certiorari denied, 347 U.S. 1012. No such provision has been called to our attention that is applicable here.

¹⁴

14 Cf. Hegra Note Corp., 25 T.C.M. 479, 486, P-H. Memo. 66-538, 66-546, affirmed 387 F.2d 515 (C.A. 5):
‘If installment notes were transferred for so nebulous a right that nothing with an ascertainable fair market value might be said to have been received therefor, it would be questionable whether an exchange as distinguished from other disposition of the notes had occurred within the meaning of section 453(d)(1). The clear import of the statute is that upon disposition in any manner of installment obligations, other than certain tax free exchanges, the portion of the gain deferred when the installment method of reporting the gain was elected which has not previously been included in income becomes includable therein.’

We conclude that Harold and Caroline's disposition of their interests in the Union Oil contract in 1964 was a ‘disposition otherwise than by sale or exchange’ within the meaning of section 453(d)(1)(B) and that therefore they realized gain in 1964 to the extent of the difference between the basis of the contract and its fair market value at the time of the disposition. The record makes abundantly plain that the so-called assignments did not in fact represent any bona fide ‘sale or exchange.’ Rather, the evidence convincingly shows that they were simply component elements of an overall plan which embraced the trusts as well as the annuities— a plan that merely provided for periodic payments to petitioners during their lifetimes to be made out of the proceeds of the Union Oil contract, followed by disposition of the remainder of their children or other objects of their bounty, all in accord with a carefully preconceived and integrated ‘estate plan,‘ prepared, conducted, and dominated by Harold and his advisers. Among other materials in the record we take particular note of the following.

In April of 1964, Harold seriously considered and nearly accepted a proposal which generally paralleled the plan he adopted some 2 months later. That he did not accept this proposal appears to have stemmed from his uneasiness about its promoter, and not from any objection he had to the basic elements of the scheme. Thus, from the outset, the assignments, annuities, and trusts were all regarded as interdependent components of a prearranged plan.

By instruments dated June 30, 1964, Harold and Caroline purported to assign their interests in the Union Oil contract to Helen and Harold, Jr., and by instruments dated July 1, 1964, the children in return purported to undertake to furnish their parents with annuities. The annuity contracts were unsecured, notwithstanding a number of considerations which made the absence of collateral or security extremely risky: Helen was then a college student, with little interest in financial affairs and no significant financial resources of her own apart from her interest in the Union Oil contract; she was a minor, only 19 years old, no guardianship was established through which her liability might have been fixed, and she could have disavowed her ‘obligation’ upon attaining her majority; Harold, Jr., was then about to graduate from Air Force flight school and was expected to remain in the Air Force for 4 more years; neither child had prior experience with investment and management of capital or with annuities; and neither expected to be in a position in the near future to manage the assets which had been assigned or to fulfill the annuity obligations out of assets other than those assigned.

Harold and Caroline requested Union Oil to defer the installment payment otherwise due on July 1, 1964, because the planned series of transactions had not been consummated at that time. Not until July 31, 1964, when the trust instruments were ready for the children's signatures, did Harold receive the deferred payment from Union Oil. We note that it was to Harold that Union Oil delivered the check, notwithstanding the fact that it was payable to Helen and Harold, Jr. Plainly, it was he with whom Union Oil dealt. Immediately thereafter Harold personally brought the check to Helen and Harold, Jr., and had each child endorse the check at approximately the same time that each executed the appropriate trust instrument. Then Harold (not one of his children) mailed the check to Voegelin who deposited the proceeds in the trust accounts. Neither of the children appears to have had any control over the check or the proceeds therefrom for any period of time.

Furthermore, notwithstanding that the annuity contracts required payments to begin as of August 1, 1964, they did not in fact commence until September 1 of that year because the trusts had not been established by August 1. Although the failure to make the August 1 payments may perhaps be characterized as a mere detail which petitioners contend was ‘overlooked,‘ it is a detail of great significance in the context of this case. If the obligations of the children to pay the annuities were bona fide personal obligations that were assumed in exchange for the Union Oil contract, the August 1 payments required by the specific terms of the annuity contracts should have been made regardless of the establishments of the trusts. Such August payments were substantial ($6,000 in the aggregate), and the casual manner in which the failure to make those payments was accepted makes it all too plain that no real personal obligation was ever intended to be imposed upon the children. To the contrary, we are convinced that the annuities and the trusts represented in substantial part merely an attempted gradual payout to petitioners of the proceeds of the Union Oil contract over a period of years, comparable to the ‘technically elegant arrangement’ referred to in Griffiths v. Commissioner, 308 U.S. 355, 357, which was described as having been ‘devised’ by a ‘lawyer's ingenuity.’ There was no bona fide ‘sale or exchange’ here.

Throughout the roles played by Helen and Harold, Jr., were passive. They were kept informed of the plan as it developed, but the record reveals only peripheral participation in planning and no semblance of arm's-length bargaining prior to the time the plan was carried out. Although completely inexperienced in such matters, the children retained no counsel of their own and relied simply on the advice of Voegelin and Samuelson, who had planned the entire scheme on behalf of their parents. Moreover, the record discloses no participation by the children in the arrangement after the trusts had been established. Indeed, the record strongly suggests that their daily lives were largely unaffected by the entire affair. If the trusts for any reason had been unable or had failed at any time to make the annuity payments we have no doubt that the parents would not have taken any steps against the children to require them personally to make the payments. We think that no such personal liability was in fact intended, and the actions (or nonaction) of the parties in respect of the August 1, 1964, payments speak much louder to us in this connection than the testimony of Harold, Jr., who indicated that he felt personally bound by the instruments which he signed.

Similarly, the series of transactions has caused remarkably little change in the position of Harold and Caroline with regard to their wealth. The trustees selected to manage the investment of the proceeds of the Union Oil contract were Voegelin and Samuelson, the same persons who had been advising the Smiths over the years in the management of their affairs. The use of the irrevocable trust device simply carried out Harold's estate plan to ensure himself and his wife of adequate incomes for the remainder of their lives, to attempt to minimize estate taxes, to avoid the responsibilities of managing his family's financial affairs, and to ensure that his children would be well taken care of particularly after he and his wife had passed on. The trusts accomplished these purposes, and they clearly reflect the intentions and desires of the parents, rather than those of the children, who appear in form as settlors. Thus, after the death of both parents, the entire corpus and accumulated income of Harold, Jr.‘s trust were to be distributed to him upon his becoming 40 years of age; in contrast, no such provisions permitted like terminal distributions to Helen at any time out of her trust. In his testimony before us Harold referred to this situation as ‘the way we wanted it’— i.e., to Harold, Jr., ‘after a certain period of time,‘ but in the case of Helen, who was then unmarried, ‘we did not know who she was going to marry, or if he would try to get everything away from her’. Obviously, the trusts represent the parents' disposition of their own property in accordance with their own desires and do not reflect dispositions made by the children. Confirmation of this conclusion, if confirmation were thought to be necessary, may be found not only in the fact that the contingent beneficiaries were persons or institutions in which the parents, rather than the children, had some particular interest, but also in the further fact that Harold had made similar dispositions in a will which he had theretofore executed. Moreover, we are fully satisfied that the highly restrictive nature of the special powers purportedly reserved to Harold, Jr., and Helen in paragraph Fourth of their respective trusts reflect the will of the parents rather than that of the children; we do not believe that the children would have tied their own hands so early in life in respect of their control over the remainder interests, particularly where no tax advantage would appear to accrue to them in thus limiting their power to dispose of the remainder interests. The true explanation lies, of course, in the fact that Harold, Jr., and Helen were not the real settlors of these trusts, and that the provisions in question carry out the will of their parents rather than their own desires.

It is our conclusion that the children were but passive intermediaries in a circuitous scheme, that although they were settlors in form the true settlors were the parents themselves, and that this case presents a peculiarly apt occasion to apply the oft-quoted language of Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613: ‘A given result at the end of a straight path is not made a different result because reached by following a devious path.’ That the true settlor of a trust may be someone other than the one who appears in form as the settlor has been well established in a long line of cases beginning at least as far back as Lehman v. Commissioner, 109 F.2d 99 (C.A. 2), certiorari denied 310 U.S. 637, which finally received the stamp of approval by the Supreme Court in United States v. Estate of Grace, 395 U.S. 316. Although those cases frequently involved the reciprocal trust device, the central point is substantially the same, and the same principles have been considered applicable in a wide variety of other situations. Df., e.g., Estate of Dora N. Marshall, 51 T.C. 696, 700-702; Estate of Grace D. Sinclair, 13 T.C. 742, 746; Estate of Cornelia B. Schwartz, 9 T.C. 229, 237-239; Estate of George W. Hall, 6 T.C. 933, 939.

¹⁵ Throughout this line of cases is the underlying concept, articulated in 2 Scott, Trusts, sec. 156.3, pp. 1201-1202 (3d ed. 1967), that ‘A person who furnishes the consideration for the creation of a trust is the settlor, even though in form the trust is created by another person.’ Cf. Restatement, Trusts 2d, sec. 156, comment f at p. 327 (1959). And as we evaluate the evidence in the record before us the parents in fact furnished the assets that became the corpora of the trusts. That central fact is not to be obscured by the intervening formalism of separate transfers and annuity contracts. Those steps were but component parts of a single, integrated transaction, in which the parents must be regarded as the real settlors of the trusts.

15 The cited cases were decided under the estate tax provisions of the internal revenue laws. Petitioners urge that such decisions have little relevance to a case arising under the income tax provisions. We disagree. While the ‘language and considerations ingrained in the gift and estate tax statutes' do not impede us in deciding questions under certain income tax provisions, cf. United States v. Davis, 370 U.S. 65, 69, fn. 6, we should hardly be reluctant to look to them for guidance where we think them relevant. See, e.g., Samuel v. Commissioner, 306 F.2d 682, 688-689 (C.A. 1), affirming 36 T.C. 641. This is particularly true when relying upon a doctrine of such general applicability as that of ‘substance over form.’ Compare Commissioner v. P. G. Lake, Inc., 356 U.S. 260, 265-267; Commissioner v. Court Holding Co., 324 U.S. 331, 334; Griffiths v. Commissioner 308 U.S. 355; Higgins v. Smith, 308 U.S. 473; Gregory v. Helvering, 293 U.S. 465, with United States v. Estate of Grace, 395 U.S. 316, 321-325; Lehman v. Commissioner, 109 F.2d 99, 100 (C.A. 2), certiorari denied 310 U.S. 637, and Estate of Dora N. Marshall, 51 T.C. 696, 701-702.

Petitioners' contention that they fulfilled legitimate estate-planning purposes and that there was thus no ‘sham’ or absence of ‘business purpose’ is beside the point. Of course, we accept the view that petitioners engaged in ‘estate planning’; indeed, that is basic to our decision. The point is that they were the real settlors in attempting to achieve such purpose, and that the use of the annuity device coupled with trusts intended to pay the annuities serves only to camouflage the true nature of the transaction. In form there may have been a sale or exchange; in substance there was none.

Petitioners have placed considerable reliance upon Gladys Cheesman Evans, 30 T.C. 798. Whatever may be thought of the Court's evaluation of the evidence before it in that case, our conclusion in the present case rests upon our appraisal of the evidence now before us. And on that evidence we do not find that the children were given the Union Oil contract free and clear, to do with it as they pleased, merely in consideration of their unsecured promises to pay annuities. To the contrary, we find that the creation of the trusts, which carried out the parents' estate plan, not that of the children, was an integral and indispensable part of the transaction. When the smoke cleared away all that really remained (except for formal individual promises of the children to pay the annuities which we have found were not intended to be binding) were two trusts in which the parents provided for themselves during their lifetimes with appropriate provisions also taking care of their children and certain contingent beneficiaries who were the objects of their bounty.

Although we sustain the Government's position argued on brief that the deficiency may be supported under section 453(d)(1)(B) as opposed to petitioners' contention that there was a ‘sale or exchange’ of the installment obligation under section 453(d)(1)(A) in return for annuities which had no ascertainable fair market value in 1964,

¹⁶ we think that the 1964 deficiency determined against the Smiths may be approved upon the more fundamental ground set forth in the notice of deficiency.

16 The Commissioner has urged in the alternative that even if there were a ‘sale or exchange’ of an installment obligation, the annuities had an ascertainable fair market value at the time of the exchange and that such amount, less the Smiths' basis in the Union Oil contract, is includable in their 1964 gross income pursuant to sec. 453(d)(1)(A). However, in view of our disposition of the case, we do not reach this contention.

¹⁷ See p. 281, supra. In that notice, the Commissioner determined that the 1964 payment made by Union Oil to petitioners' assignees (Harold, Jr., and Helen) was ‘actually received by you in 1964 within the meaning of section 453.’ While that determination did not specify any particular paragraph of section 453, it obviously referred to paragraph (a) which is made applicable to this case by paragraph (b)(1)(B). See fn. 9, supra p. 282.

17 Indeed, even if this ground had not been set forth in the notice of deficiency it would still be open to us to base our decision upon it, for, as we recognized in Wilkes-Barre Carriage Co., 39 T.C. 839, 845-846, affirmed 332 F.2d 421 (C.A. 2), ‘the rule is well established that a deficiency may be approved on the basis of reasons other than those relied upon by the Commissioner or even where his reasons may be incorrect. Blansett v. United States, 283 F.2d 474, 478-479 (C.A. 8); Bernstein v. Commissioner, 267 F.2d 879, 881-882 (C.A. 5); Acer Realty Co. v. Commissioner, 132 F.2d 512, 514-515 (C.A. 8); Alexander Sprunt & Son v. Commissioner, 64 F.2d 424, 427 (C.A. 4); Crowell v. Commissioner, 62 F.2d 51, 53 (C.A. 6); J. & O. Altschul Tobacco Co. v. Commissioner, 42 F.2d 609, 610 (C.A. 5); Hughes v. Commissioner, 38 F.2d 755, 757 (C.A. 10); John I. Chipley, 25 B.T.A. 1103, 1106; Edgar M. Carnrick, 21 B.T.A. 12, 21; cf. Helvering v. Rankin, 295 U.S. 123, 132-133.’

The various materials in the record which support the Government's position on brief in respect of section 453(d)(1)(B) furnish even greater support to the theory of the deficiency notice that the funds paid by Union Oil in 1964 were actually received by the parents, or at the very least were paid out at their direction. If we accept the Government's argument, as we have, that the various steps involved were but component parts of a single transaction, the conclusion is irresistable that the Union Oil payment, although made in form to the children, was in fact made to the parents, who became the true settlers of the trusts before us. The children were merely intermediaries in the transaction. In that view of the record, the parents must be treated as having actually received payment in full of the outstanding installment obligation in 1964, and they therefore must account in 1964 for the remaining unreported gain then realized on the installment sale of their stock.

¹⁸

18 Petitioners have contended that they may not be charged with either actual or constructive receipt of Union Oil's payment of July 31, 1964, on the ground that prior to that date they had assigned their entire interest in the purchase agreement to their children. Cf. Blair v. Commissioner, 300 U.S. 5. However, as we indicated in our Findings of Fact, the record before us does not clearly establish the precise chronology of the transactions which occurred between late June and early August of 1964. The burden of proof is upon the petitioners and in our judgment they have failed to establish by satisfying evidence just when the so-called assignments were executed in relation to the payment by Union Oil, or in any event in relation to the accrual of the right to receive the July 1 installment. Cf. Helvering v. Horst, 311 U.S. 112; Helvering v. Eubank, 311 U.S. 122. More fundamentally, Blair v. Commissioner is of no assistance to petitioners simply because petitioners did not make genuine assignments of their rights under the Union Oil contract but in substance retained control over it and its proceeds.

2. The second issue for decision is whether, pursuant to section 163.

¹⁹ Helen may deduct $18,396 as interest paid to her parents in 1967 under her annuity contracts with them. Each contract made the following provision for ‘interest’:

19 SEC. 163. INTEREST.
(a) GENERAL RULE.— There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.

It is mutually understood and agreed by and between the parties to this Annuity Contract that the interest factor in this contract shall be equal to that amount of any payments made to HAROLD W. SMITH (CAROLINE H. SMITH) pursuant to the terms hereof which is required by applicable Federal Income Tax laws to be included in the taxable income of HAROLD W. SMITH (CAROLINE H. SMITH) as ordinary income. It is further understood that this interest factor as so stated shall be in lieu of any other provision or requirements for interest payments on the part of the promisor.

Helen, of course, did not make the ‘interest’ payments herself. The monthly payments were made, purportedly on her behalf, by the Helen Caroline Smith Trust. Although she has not spelled it out, Helen apparently claims the deduction on the theory that since she as included all of the trust's income in her gross income under the ‘grantor trust’ provisions of the Code, deductible expenditures made by the trust on her behalf are similarly attributable to her.

Her contention is adequately answered by our disposition of the first issue in this case. The claimed interest expenditures purportedly represent interest payments on the deferred purchase price paid for one-half of her parents' interests in the Union Oil contract. But while the transaction was cast in the form of a sale, in substance no sale occurred. Helen was but a passive intermediary in a complex scheme whereby her parents retained income interests in the proceeds of the Union Oil contract. Interest, within the meaning of section 163, has been defined to be compensation for the use of borrowed funds or for postponing collection of funds otherwise due. See Old Colony R. Co. v. Commissioner, 284 U.S. 552, 560; Deputy v. DuPont, 308 U.S. 488, 497-498; Autenreith v. Commissioner, 115 F.2d 856, 858 (C.A. 3). Yet Helen neither borrowed from her parents nor deferred the payment of funds owed to them; her parents simply retained income interests in assets which they held from the outset. There was consequently no necessity for Helen to make interest payments to them.

Indeed, in substance, Helen made no payments of any kind to her parents. The sole source of the payments to them was, as intended, the trust and its assets, the proceeds of the Union Oil contract. Of course, one-half of her parents' interests in the contract were formally ‘assigned’ to Helen before they were placed in trust. But the assignments were simply part of a circuitous scheme whereby the proceeds were placed in trust on behalf of the parents, not on behalf of Helen. We conclude, therefore, that Helen made no interest payments to her parents and that she is not entitled to the claimed deduction.

²⁰

20 In view of our conclusion that Helen is not entitled to the claimed interest deduction, it would seem to follow that she should not be charged with any income from the trust. No such issue has been raised, but if a motion to amend the pleadings in this respect should be filed, we would be inclined to give favorable consideration to it in order that the deficiency may be computed on a consistent theory.

Decisions will be entered under Rule 50.