Docket No. 70676.
Filed March 7, 1962.
Held, certain amounts paid in 1954 to an insurance company in the form of interest on purported annuity contract loans are not deductible. Knetsch v. United States, 364 U.S. 361, followed.
Thaddeus Rojek, Esq., for the petitioners.
Charles F. Quinlan, Esq., for the respondent.
The respondent has determined a deficiency in petitioners' income tax for the calendar year 1954 in the amount of $11,502.18. The sole issue is whether petitioners may deduct as interest a payment made in 1954 in the amount of $24,718 to the All Service Life Insurance Corporation of Phoenix, Arizona.
FINDINGS OF FACT.
The facts stipulated by the parties are incorporated herein by this reference. In addition, the record in Estate of Charles G. Polacek, Deceased, Carolyn M. Polacek, Executrix, and Carolyn M. Polacek v. Commissioner of Internal Revenue, Docket No. 83919, is incorporated herein by stipulation of the parties.
Petitioners, husband and wife, residing at 15547 Valley Vista Boulevard, Van Nuys, California, filed a timely joint income tax return for the calendar year 1954, prepared on the cash basis, with the district director of internal revenue, Los Angeles, California. Amor F. Pierce will hereinafter be referred to as petitioner.
Sometime prior to December 13, 1954, petitioner and All Service Life Insurance Corporation of Phoenix, Arizona, hereinafter referred to as All Service, agreed that petitioner and All Service would enter into certain transactions in December of 1954 which, in form, were as set forth in the paragraphs that follow.
On December 13, 1954, petitioner applied to All Service for the issuance of six deferred annuity contracts. The consideration specified for each contract was $100,000, payable in six annual installments of $16,666.67, or a total for the six contracts of $100,000 per annual installment.
All Service accepted petitioner's nonrecourse 6-percent demand promissory note in the face amount of $100,000 on December 13, 1954, as payment of the first annual consideration.
On December 13, 1954, All Service accepted petitioner's application and issued to him six deferred annuity contracts, each dated December 1, 1954, and numbered A-356 through A-361. Petitioner's daughter, 10 years of age at the time, was designated as the annuitant in three of the contracts and petitioner's son, 1 year of age at the time, was designated as the annuitant in the other three contracts. Annuity payments under each contract are to begin on the contract anniversary date at which the named annuitant's age at nearest birthday is 65 years. Petitioner is the contract owner and death benefit beneficiary in each contract.
On December 13, 1954, All Service agreed to lend petitioner a total of $117,441 pursuant to six contract loan agreements, each in the amount of $19,573.50. As sole security for the loans, petitioner assigned the six annuity contracts to All Service. Petitioner was able to borrow $117,441 on the annuity contracts on December 13, 1954, because the contracts provided that the net loan value shall be computed "as of the end of any period through which interest on such loan and all prior loans have been paid in advance." Since petitioner agreed to pay interest on the loans for 6 years in advance, the net loan value was computed as of the end of the 6th year, i.e., as of December 1, 1960.
On December 28, 1954, All Service delivered its check in the amount of $17,441 to Farmers and Stockmens Bank in Phoenix, Arizona, for credit to petitioner's account, which had been opened for the purpose of this transaction. The balance of the loan was applied by All Service against, and in discharge of, the $100,000 nonrecourse demand note which petitioner had delivered in payment of the first annual consideration. The note was returned to petitioner with an acknowledgment thereon by All Service of payment as of December 28, 1954.
On December 28, 1954, petitioner paid to All Service the sum of $24,718 as interest on the loan of $117,441 for 6 years in advance, at the rate of 3.75 percent per annum, with interest paid for more than 1 year in advance discounted at the rate of 2.75 percent per annum, compounded annually. Petitioner paid $17,441 of such interest by a group of six checks drawn on his account at the Farmers and Stockmens Bank, thereby offsetting the deposit of the same day from the All Service loan and reducing his balance in such account to $1. The remaining $7,277 was paid by petitioner's checks on two California banks.
As of the end of 1954, according to the books and records of All Service, the net cash value of the six annuity contracts was $5,520. Such net cash value was determined by subtracting $97,127 (the difference between the $117,441 indebtedness on the contracts and the $20,314 refundable portion of the prepaid interest) from the $102,647 cash surrender value of the contracts. Petitioner's out-of-pocket cost for the six annuity contracts as of the same time was $7,277, the difference between the $24,718 payment made as interest and the $17,441 borrowed from All Service. But for tax considerations, petitioner's purported investment in the six annuity contracts resulted in a net economic loss of $1,757 ($5,520 net cash value minus $7,277 net cost) in 1954.
On their joint Federal income tax return for the calendar year 1954, petitioners claimed a deduction in the amount of $24,718 as interest paid to All Service. The respondent has disallowed this deduction.
The events which have occurred, in form, with respect to the six annuity contracts since the taxable year in issue are set forth in the paragraphs that follow.
In each of the following 5 years (December 17, 1955; December 12, 1956; December 8, 1957; December 3, 1958; December 7, 1959), additional new loans were made with the annuity contracts being assigned as the sole collateral security therefore and $100,000 of the proceeds of such contract loans was applied each year either to the payment of promissory notes which had been tendered in payment of the annual consideration then due or directly to the payment of the annual consideration then due. The remaining balance of the loan proceeds was delivered to petitioner or to his bank for credit to his account. In each of the years from 1955 through 1959 petitioner paid interest on the then existing indebtedness for 1 additional year in advance and on the newly created indebtedness for 5 or 6 years in advance. As of the end of the year 1959, the total outstanding indebtedness created by the previously described transactions was $734,702.04.
In December 1960, an additional new loan in the amount of $20,202 was made with the six annuity contracts being assigned as the sole collateral security. Consequently, the total outstanding indebtedness secured by the six annuity contracts as of the end of 1960 was $754,904.04. As of the same time, petitioner had paid interest on the then outstanding indebtedness in advance through and to December 1, 1965. The net cash value of the six annuity contracts, including the net refundable interest paid in advance on contract loans, was $30,878 as of the end of 1960.
Petitioner's participation in the transactions with All Service from 1954 through 1960 may be summarized as follows:Amount Net proceeds Out-of-pocket Yearly Yearly Year paid as of loans costs increase net economic interest cash values loss 1954 ....... $24,178 $17,441 $7,277 $5,520 $1,757 1955 ....... 29,243 20,669 8,574 6,697 1,877 1956 ....... 27,104 19,145 7,959 4,674 3,285 1957 ....... 27,104 19,145 7,959 3,285 4,674 1958 ....... 38,670 27,396 11,274 5,154 6,120 1959 ....... 43,580 30,906 12,674 5,474 7,200 1960 ....... 26,421 20,202 6,219 74 6,145 _________ ______________ ___________ _____________ ___________ Total ... 216,840 154,904 61,936 30,878 31,058 On September 16, 1959, pursuant to a joint motion filed by the parties, the present case was continued generally awaiting the outcome of the case of Knetsch v. United States, then pending before the Court of Appeals for the Ninth Circuit. The decision in that case was handed down on November 16, 1959, and is reported at 272 F.2d 200. Certiorari was applied for by the taxpayer and was granted. 361 U.S. 958. The Supreme Court affirmed the decision of the Court of Appeals for the Ninth Circuit in an opinion promulgated on November 14, 1960, and reported at 364 U.S. 361.
Some few weeks prior to February 20, 1961, petitioner met in Los Angeles, California, with the president of All Service, Robert Dixon Wood, and discussed and reviewed petitioner's position with respect to the six annuity contracts. The present pending litigation in this Court was discussed at that time, and petitioner expressed a desire "to put some substance into the contracts" by making some additional payments. Petitioner concluded that an additional investment would have a favorable effect on the present litigation.
At this meeting a projection of the results of such an investment over a 20-year period was reviewed by Wood in detail with petitioner, based on the amount of money which petitioner indicated to Wood that he had available for investment in the contracts. Wood explained to petitioner his rights under the annuity contracts if such an additional investment were made. Petitioner was assured that he could withdraw his investment at any time from All Service. Petitioner asked Wood if it would be possible to convert the annuity contracts into retirement annuities for himself. Subsequently, Wood obtained an opinion from All Service's legal counsel that petitioner might elect to so convert the annuity contracts under the terms of the annuities and the applicable Arizona law.
On February 20, 1961, All Service received a check from petitioner drawn on the account of Investors Stock Fund, Inc., payable to the order of petitioner, and properly endorsed to All Service in the amount of $132,596.11. On February 23, 1961, All Service received a properly endorsed cashier's check from petitioner in the amount of $34,360.19. Pursuant to petitioner's instructions, All Service applied these two remittances totaling $166,956.30 to the partial repayment of the then existing indebtedness secured by the six annuity contracts. Such indebtedness was thereby reduced to $587,947.74. As a result of this reduction in indebtedness, $39,767 of the previously paid interest became refundable and was applied to the repayment of the outstanding indebtedness, reducing it still further to $548,180.74.
On March 28, 1961, All Service received from petitioner a properly endorsed cashier's check in the amount of $23,663.77, which remittance was applied to the partial repayment of the then existing indebtedness, reducing it to $524,516.97. As a result of this reduction in indebtedness, $3,955 of the previously prepaid interest became refundable and was applied to the further repayment of the then existing indebtedness, thereby reducing the indebtedness to $520,561.97.
As of the date of trial of the present case, the outstanding indebtedness secured by the six annuity contracts was approximately $520,562, and the net cash value of the six annuity contracts, including the net refundable interest paid in advance on contract loans, was approximately $220,140.
Sometime during the period February 20, 1961, to March 28, 1961, for the first time the annual increase in the net cash value of the annuity contracts began to exceed the annual interest charges on the indebtedness secured by the contracts.
Potential future profits from the six annuity contracts, based on petitioner's investment therein as of the date of trial (primarily, the funds paid to All Service early in 1961) and certain specified contingencies, are set forth in the subparagraphs that follow:
(a) If petitioner makes no further payments in reduction of the indebtedness secured by the annuity contracts, but does pay I year of interest in advance each year hereafter through the year 1975 and thereafter lets the prepaid interest earn itself out through December 1, 1980, the net cumulative earnings of the contracts will exceed their net cumulative cost sometime during the period December 1, 1967, to December 1, 1968, and the net profit from the annuity transaction as of the year 1980 will approximate $134,353.
(b) If petitioner makes no further payments in reduction of the indebtedness secured by the annuity contracts, allows the prepaid interest to earn itself out through December 1, 1965, and thereafter makes a payment of 1 year of interest in advance each year through December 1, 1979, the net cumulative earnings of the contracts will exceed their net cumulative cost sometime during the period December 1, 1968, to December 1, 1969, and the net profit from the annuity transaction as of the year 1980 will approximate $108,268.
(c) If the remaining indebtedness secured by the annuity contracts were repaid by the application thereto of a part of the cash surrender value of the six annuity contracts and the remaining net reserve value of $220,060 allowed to accumulate to maturity in accordance with the terms of the contracts, a monthly annuity would be payable to petitioner's son at his age 65 in the amount of $3,176.89 for the remainder of his life with 10 years' payments guaranteed and a similarly guaranteed monthly annuity would be payable to petitioner's daughter at her age 65 in the amount of $2,200.23. If the optional retirement benefit of a monthly annuity for 10 years certain were exercised at maturity, petitioner's son would receive a monthly annuity of $4,828.45 and petitioner's daughter would receive a monthly annuity of $3,782.43. Under such option, the net profit from the annuity transaction would approximate $780,750.
In 1954 petitioner's purported purchase of the six annuity contracts from All Service, borrowing of funds from All Service, and payment and prepayment of interest to All Service on such borrowing, were lacking in substance. During the taxable year the steps taken had no economic or commercial substance apart from an intended tax benefit.
The basic similarity of the present case with Knetsch v. United States, 364 U.S. 361, affirming 272 F.2d 200 (C.A. 9), was recognized by the parties hereto when, while the Knetsch case was still pending in the Ninth Circuit, they filed a joint motion to have the instant case continued until after the conclusion of that litigation. The motion was granted, and the present trial was accordingly postponed until after the Supreme Court's decision in Knetsch. Now that the trial has taken place and we have had an opportunity to compare "what was done" in the instant case with "what was done" in Knetsch, we think that the determination in Knetsch is controlling. We have found that during the taxable year 1954 there was the same lack of substance in petitioner's purported annuity purchases, loans, and interest payments as was found in Knetsch. We conclude, therefore, that respondent's disallowance of petitioners' claimed interest deduction was proper. William R. Lovett, 37 T.C. 317; cf. Weller v. Commissioner, 270 F.2d 294 (C.A. 3), affirming 31 T.C. 33 and W. Stuart Emmons, 31 T.C. 26, certiorari denied 364 U.S. 908; Diggs v. Commissioner, 281 F.2d 326 (C.A. 2), affirming a Memorandum Opinion of this Court, certiorari denied 364 U.S. 908.
Petitioners now contend that the instant case is distinguishable from Knetsch because the annuity contracts are still outstanding in this case and because a substantial part of the alleged indebtedness on such contracts was, in form, repaid as of the date of trial herein. They urge, therefore, that the economic and commercial substance found missing in Knetsch in fact exists on this record. A similar argument was raised and recently rejected in William R. Lovett, supra at 325. The purported loan repayments made to All Service early in 1961 — more than 6 years after the taxable year here in issue, only a few months after the Supreme Court had declared the Knetsch transaction "a sham," and less than 6 months before the trial herein — are in no way persuasive of the economic reality of the transactions presently under consideration. Such payments, obviously made with a view to influencing the outcome of this very case, can hardly impart retroactive vitality to a transaction that was a sham in 1954. If these 1961 payments have any significance for our inquiry, they merely underscore the absence of a comparable investment in the annuity transaction in 1954.
At first glance, even prior to 1961, it may appear that petitioner's investment in the annuities here involved was somewhat greater than the $1,000 cash surrender value which the Supreme Court designated as a "relative pittance" in Knetsch. In fact, quite the opposite was true. Although the books of All Service showed that petitioner's annuities had an aggregate "net cash value" of $5,520 at the end of 1954, this value was based on payments made in the form of "prepaid interest" on "contract loans," which were refundable prior to the time that they were "earned." In fact, at the end of 1954 petitioner had in form borrowed $117,441 on the six annuity contracts, which together had a gross cash surrender value of only $102,647; thus, but for petitioner's purported prepayment of interest on contract loans, the annuities would have had a minus net cash value for the taxable year. As it was, the "net cash value" of $5,520 on All Service's books was $1,757 less than petitioner's out-of-pocket expenses in the annuity transaction of $7,277 in 1954. Accordingly, the Supreme Court's conclusion in Knetsch is equally applicable here: "it is patent that there was nothing of substance to be realized * * * from this transaction beyond a tax deduction." 364 U.S. at 366. In such circumstances, we hold that the claimed tax deduction must fall, too.
Because we have concluded that the entire annuity transaction was lacking in substance during the taxable year, we do not reach the respondent's alternative position that even if there had been economic substance to the transaction the claimed interest payment would not be deductible under the provisions of section 264 of the 1954 Code.
Decision will be entered for the respondent.