William K. Carpenter and Frances K. Carpenter v. Commissioner of Internal Revenue, 322 F.2d 733, 3rd Cir. (1963)
William K. Carpenter and Frances K. Carpenter v. Commissioner of Internal Revenue, 322 F.2d 733, 3rd Cir. (1963)
2d 733
The matter came before the Tax Court on stipulations of fact, exhibits annexed
thereto, and the testimony of the petitioner and one other witness. The relevant
The petitioner purchased from the Old Republic Life Insurance Company an
annuity policy which provided for monthly payments to him slightly in excess
of $10,000, the said payments to commence when he reached seventy years of
age. At the time of the purchase, in January of 1954, the petitioner was not yet
thirty-five years of age and had a life expectancy of approximately thirty-nine
years. He was a man of considerable wealth and the recipient of substantial
yearly income from a series of trusts,3 the corpora of which would become
distributable upon the death of his mother, who was then seventy years of age.
Aside from other payments made by the petitioner, with which we are not here
concerned, the single premium in the amount of $500,000 was paid as follows:
$8,000 from the personal funds of the petitioner, and $492,000 from the
proceeds of a loan in the said amount advanced by the Philadelphia National
Bank under circumstances hereinafter described.
Pursuant to prearrangement, the petitioner deposited with the Bank his personal
check in the amount of $8,000, payable to the Insurance Company, and
contemporaneously therewith applied to the Bank for a loan in the amount of
$492,000. The loan was granted and the proceeds thereof, together with the
proceeds of the check, were credited to the account of the Insurance Company.
This loan was evidenced by a personal note and was secured by a pledge of the
annuity policy. Thereupon the petitioner made application to the Insurance
Company for a loan in an amount equal to the full loan value of the policy, and
contemporaneously therewith deposited with the Bank his personal check in the
sum of $19,680, payable to the Insurance Company and representing the
prepayment of interest on the anticipated loan for the first year.
The latter application was granted, and at the direction of the petitioner the
proceeds of the loan were paid directly to the Bank in repayment of its loan.
The loan from the Insurance Company was evidenced by the usual annuity loan
agreement, under the terms of which the petitioner agreed to repay the loan,
together with interest thereon at the rate of 4% per annum. The agreement
provided that there was no personal liability on the petitioner for the repayment
of the loan and that the sole recourse of the Insurance Company was against the
annuity contract which was pledged as collateral. The details of the
transactions, outlined in the Tax Court's memorandum, are of no relevance
here. The loan was never repaid.
The petitioner, joined by his wife, filed an income tax return for the year 1954,
therein claiming a deduction in the amount of $189,834.33, representing the full
amount of the interest paid on the purported indebtedness to the Insurance
Company. The deduction was disallowed by the Commissioner and the
disallowance resulted in the assessment of a tax deficiency in the amount of
$168,952.57. The assessment and the interest thereon were paid, and the
proceeding before the Tax Court followed.
The Tax Court found that the loan transactions lacked commercial substance of
economic benefit to the petitioner apart from the intended tax advantage. This
finding of fact, upon which the ultimate decision of the Court rested, is herein
challenged as clearly erroneous. The question for determination is whether the
transactions in question, entered into in the taxable year of 1954, created an
indebtedness within the meaning of 163(a) of the Internal Revenue Code,
supra. The answer is clearly in the negative. Knetsch v. United States, and
Weller v. C.I.R., both supra.
The cited section of the code provides that there "shall be allowed as a
deduction all INTEREST PAID * * * within the taxable year on
INDEBTEDNESS." (Emphasis added). The term "`interest on indebtedness'
means compensation for the use or forbearance of money." Deputy v. du Pont,
308 U.S. 488, 498, 60 S.Ct. 363, 368, 84 L.Ed. 416 (1940). The prepayments
made by the petitioner do not meet the accepted definition. The petitioner had a
right, under the "Loan Provisions" of the annuity contract, to "borrow" an
amount equal to the cash surrender value of the policy without incurring any
personal liability for the repayment of the loan.
10
The transactions, although in the form of loans and treated as such by the
Insurance Company, were in substance advance payments against reserves for
which the Company obtained a proportionate discharge of its obligations under
the contract. Orleans Parish v. New York Life Ins. Co., 216 U.S. 517, 30 S.Ct.
385, 54 L.Ed. 597 (1910); Williams v. Union Central Life Ins. Co., 291 U.S.
170, 179, 54 S.Ct. 348, 78 L.Ed. 711 (1934). These advances, under the facts
and circumstances hereinabove summarized, did not create an "indebtedness"
within the meaning of the statute. Weller v. C. I. R., supra. Absent such an
indebtedness, the transactions lacked the commercial substance essential to a
deduction under the statute.
11
It seems obvious that apart from the tax advantage the overall transaction was
of no economic value to the petitioner. He paid to the Insurance Company a
total of $689,834.33, representing premium and interest, and immediately
withdrew $605,000, the full cash surrender value of the policy. The Company
retained $84,834.33, the surplus. The petitioner received in return an annuity
contract, the economic benefits of which were immediately exhausted by the
advances. He purchased nothing more than a potential tax deduction having a
cash value of $168,952.57, an amount equal to the deficiency assessment. The
net gain to the taxpayer, if the claimed deduction had been allowed, would
have been $84,118.44. The only economic benefit derived from the transaction
was the possible tax reduction.
12
13
The petitioner contends that the disallowance of the deduction was arbitrary,
capricious and discriminatory, and therefore should be nullified by this Court.
The contention rests on evidence that the purchase of the annuity contract and
the ensuing loan transactions were induced by the representations of the
insurance broker, supported by rulings issued to taxpayers other than the
petitioner, that interest payments on policy loans would be deductible. The
question raised was heretofore considered by this Court and decided adversely
to the petitioner's contention. Weller v. C.I.R., supra. The invitation of the
petitioner to reconsider the question must be rejected.
14
Notes:
1
See also Diggs v. C. I. R., 281 F.2d 326 (2nd Cir. 1960), cert. den. 364 U.S.
908, 81 S.Ct. 271, 5 L.Ed.2d 224; Pierce v. C. I. R., 311 F.2d 894 (9th Cir.
1962)