Emeloid Co. v. Commissioner

The Emeloid Co., Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent Emeloid Co. v. Commissioner Docket No. 15898 United States Tax Court 14 T.C. 1295; 1950 U.S. Tax Ct. LEXIS 155; June 27, 1950, Promulgated *155 Decision will be entered under Rule 50. 1. No jurisdiction for determination of overpayment of income taxes held to exist where respondent in a deficiency notice for year 1944 determined a deficiency in excess profits tax and an overassessment in income tax. Difco Laboratories, Inc., 10 T. C. 660, followed. 2. Indebtedness incurred by petitioner to purchase single premium payment life insurance policies on the lives of its two principal stockholders and officers determined incurred for reasons personal to them and not for business purposes of petitioner. Such indebtedness held not includible in petitioner's borrowed invested capital under section 719, Internal Revenue Code, and Regulations 112, section 35.719-1. Sydney A. Gutkin, Esq., for the petitioner. Maurice S. Bush, Esq., for the respondent. Arundell, Judge. ARUNDELL *1295 Respondent has determined a deficiency in the amount of $ 3,446.26 in petitioner's excess profits tax liability for the taxable year ended June 30, 1944. Petitioner claims an overpayment of excess profits taxes for said year in the amount of $ 160.72, and further claims an overpayment of its income*156 tax for the taxable year ended June 30, 1944, in the amount of $ 1,377.09. The only issue involved is whether respondent, in computing petitioner's excess profits credit based on invested capital, erred in excluding from borrowed invested capital an amount borrowed by petitioner to purchase single premium life insurance policies on the lives of its two principal stockholder-officers. FINDINGS OF FACT. Petitioner is a New Jersey corporation, with its principal office at Arlington, New Jersey. Its excess profits tax return for the period here involved was filed with the collector of internal revenue for the fifth district of New Jersey. The principal officers of petitioner are Myron P. Leeds and Edward K. Madan. At all times material herein they owned in equal amounts all the outstanding common stock of petitioner and a substantial portion of the outstanding, nonvoting callable preferred stock. Leeds and Madan alternate each year as president and secretary-treasurer of petitioner. Petitioner is engaged in the manufacture and sale of plastics. Its business is divided into four departments: (1) advertising specialties; (2) instruments for the architectural engineering field; (3) *157 contract parts for other manufacturers; and (4) goods distributed to syndicate department stores for resale purposes. Leeds *1296 and Madan each supervise the production and sales activities of two of the departments. Petitioner showed the following profits for the respective fiscal years ended on June 30: Net profit before Net profit before Year officers' salaries Officers' salaries Federal income and Federal tax income tax — 1936 — $ 30,506.17 $ 28,000.00 $ 2,506.17 — 1937 — 35,869.38 30,000.00 5,869.38 — 1938 — 21,458.80 20,000.00 1,458.80 — 1939 — 28,868.25 25,000.00 3,868.25 — 1940 — 32,493.39 30,000.00 2,493.39 — 1941 — 45,779.49 32,000.00 13,779.49 — 1942 — 146,838.99 55,961.94 90,877.05 — 1943 — 170,871.89 54,628.73 116,243.16 — 1944 — 133,634.89 50,000.00 83,634.89 As of June 30, 1941, petitioner's financial position was as follows: Assets Current assets $ 98,191.78 Fixed assets 95,465.74 Deferred charges, good will and patents 25,136.93 Total assets 218,794.45 Liabilities Current liabilities $ 67,942.84 Other liabilities 13,877.16 Net worth: Capital stock $ 88,060.00 Surplus 48,914.45 136,974.45 Total liabilities and net worth 218,794.45 *158 Petitioner's sales began to increase materially in 1941 due to the impetus given by the war. Petitioner received Government contracts to make precision instruments and calculating devices in the war period. In 1929 life insurance policies in the amount of $ 15,000 on each life were taken out on the lives of Leeds and Madan with petitioner as beneficiary. These policies were taken out at the instance of petitioner's creditors to protect their interests in granting petitioner additional time to pay its outstanding obligations. The policies were term insurance. They were continued in effect until the obligations they secured were ultimately discharged in 1935. Petitioner carried no insurance on the lives of its principal officers, Leeds and Madan, from 1935 to 1942. In the first few months of 1942, the following policies were effected on the lives of Leeds and Madan with petitioner named as beneficiary: Insurance carrier Leeds Madan John Hancock Mutual Life Ins. Co $ 25,000 $ 25,000 Massachusetts Mutual Life Ins. Co 40,000 40,000 Connecticut Mutual Life Ins. Co 25,000 25,000 National Life Ins. Co. 10,000 10,000 Total 100,000 100,000 These policies were*159 single premium payment life insurance policies. The insurance agent who sold the policies suggested that the single *1297 premium payment policies could be financed to a great extent by a bank loan secured by the insurance policies, that the cash surrender value of the policies at the maturity of the loan would be in excess of the amount of the loan, plus the small investment by petitioner, and that the interest paid on the loan would be deductible for tax purposes. Prior to these policies in which petitioner was named beneficiary, the agent had sold in 1941 to each of Leeds and Madan a $ 50,000 single premium payment life insurance policy in the Mutual Benefit Life Insurance Co. for their personal estates with trusts named as beneficiaries. The total premium cost for the eight policies taken out in 1942 amounted to $ 115,455.90. To finance these policies, two six-year loans in the total amount of $ 97,500, with interest at 2 1/4 per cent, were obtained from the Central Hanover Bank & Trust Co. of New York. The insurance policies were assigned to the bank as collateral. A renewal loan for an additional five-year period was secured in 1946 before the expiration of the original*160 loans. Deduction of interest paid on the loans was claimed by petitioner in its income tax return for the year ended June 30, 1944, but was disallowed by respondent. On January 14, 1946, a trust was created with the National State Bank of Newark as trustee, providing, inter alia, that Leeds and Madan would deposit their stockholdings in petitioner with the trustee and that the trustee would purchase the stock of the first to die of Leeds or Madan at a stipulated price per share, paying the proceeds to the decedent's representative. Following such payment, the shares deposited by the survivor would be returned to him and the trust would terminate. It was provided that funds for the purchase would be made available by assignment to the trustee of two groups of life insurance policies on the lives of Leeds and Madan: (a) The above single premium payment policies, totaling $ 200,000 and subject to the $ 97,500 indebtedness due the Central Hanover Bank; and (b) the following policies in possession of the National State Bank, the trustee, and issued on the lives of Leeds and Madan: Insurance carrier Leeds Madan Prudential Insurance Co $ 50,000 Massachusetts Mutual Life Ins. Co $ 50,000 25,000 Equitable Life Assurance Society 50,000 25,000 Total 100,000 100,000 *161 The trust agreement recited that these policies had been effected by petitioner to make available the funds necessary for such stock purchase. The trust was declared to be revocable at any time by written notice given to the trustee either by Leeds or Madan. The insurance policies were purchased to further the personal interests of Leeds and Madan. *1298 OPINION. Before proceeding to the only issue argued by the parties, we shall dispose of petitioner's claim of overpayment of its income tax for the fiscal year ended June 30, 1944. No determination of a deficiency in income taxes has been made by respondent that would confer jurisdiction upon this Court whereby it could find an overpayment of income taxes. Since the income tax and excess profits tax are separately imposed, a determination of a deficiency in the latter will not give this Court jurisdiction of a determination of an overassessment in the former. Difco Laboratories, Inc., 10 T. C. 660. See also Pioneer Parachute Co., 4 T. C. 27. Accordingly, petitioner's claim for overpayment of income taxes for 1944 is dismissed for lack of jurisdiction. Concerning*162 the excess profits tax deficiency determined by respondent, the only issue raised by petitioner is whether the $ 97,500 borrowed by petitioner in 1942 for the sole purpose of purchasing single premium life insurance policies of face amount of $ 100,000 each on the lives of Leeds and Madan, its two principal stockholders and officers, may properly be included in petitioner's borrowed invested capital as defined by section 719, Internal Revenue Code. 1 *163 Respondent's Regulations 112, section 35.719-1, 2 provides that to be includible in borrowed invested capital, an indebtedness must be (1) bona fide and (2) incurred for business reasons. Petitioner attacks the regulations as an invalid exercise of the respondent's authority going beyond the unambiguous terms of the statute. We regard this contention of petitioner's as foreclosed by our decision in Hart-Bartlett-Sturtevant Grain Co., 12 T. C. 760, 769; affd., 182 Fed. (2d) 153 (CA-8, May 5, 1950), where we sustained the validity of the cited regulations. See also Globe Mortgage Co., 14 T. C. 192. *164 *1299 It is indisputable that the indebtedness which petitioner incurred to purchase the insurance policies was bona fide. The debt was in the form of promissory notes given to a New York bank and was secured by the policies themselves. The only question which confronts us is whether the indebtedness satisfies the second requirement of respondent's regulations, viz., that it be insured for business reasons. In determining whether the money borrowed solely to purchase single premium life insurance policies on the lives of petitioner's two principal officers was borrowed for business reasons of petitioner, we much bear in mind that these two officers owned all of the common stock of petitioner. They determined and controlled all of petitioner's actions. When the transactions of such a closely held corporation become involved in tax litigation, its activities must be examined with a realistic eye to decide whether a similarly situated, diversely held corporation would pursue a like course of action or whether instead the corporate cloak is used to achieve discriminatory tax advantages for the controlling stockholders. We do not mean to imply, however, that a corporation, *165 even when closely held, may not legitimately choose from two or more possible methods the one which will result in the lesser tax. It is not the province of the Commissioner to then say that a different method should have been adopted because it would have increased the Government's take. The line separating legitimate tax-minimizing corporate activities from tax-evading transactions utilizing the corporate guise may be difficult to draw as a generalization, but it becomes much easier when applied to a particular situation. Here, the evidence is convincing, and we have found as a fact, that the insurance policies were purchased for reasons personal to Leeds and Madan rather than to benefit the petitioner. By the terms of the trust created in January, 1946, the petitioner transferred these policies to the trustee in order to provide funds for the purchase of the stockholdings in petitioner of the first to die of Leeds and Madan. These provisions make it abundantly evident that the true purpose of the insurance policies, and thus likewise the indebtedness incurred to purchase them, was to provide available funds at the death of either Leeds or Madan, so that the survivor would be*166 readily enabled to purchase his deceased associate's interest. The benefit to the petitioner of such a transaction appears highly remote. Instead of being supplied with funds to tide it over a period of adjustment upon the death of a key employee, petitioner, under the trust agreement, would be compelled to use the life insurance proceeds to purchase and retire the stockholdings of its decedent-officer. It may be noted that the trust arrangement was not indispensable to the insurance-stock purchase scheme worked out by Leeds and Madan. The trust provisions simply bring into clearer focus the *1300 real purpose of the insurance. Without the trust, the survivor of Leeds and Madan at the death of his associate could have caused petitioner to apply the proceeds of the policies on the decedent's life to retire the stock owned by the decedent. Since retirement of the decedent's one-half of the common stock would leave the survivor as sole owner of all the outstanding common stock, the net effect would be to give him as full ownership and control as though he had purchased the decedent's stock directly from the decedent's estate. The only advantage of the trust arrangement was*167 that Leeds and Madan could thereby agree in advance to the price at which the decedent's shares would be purchased and thus obviate the possibility of any bargaining difficulties between the survivor and the decedent's estate. Further, they could do so without irrevocably binding themselves to the price initially set out in the trust instrument, since the price fixed in the trust was declared subject to change by agreement of the parties. Also, the trust could be terminated at will by either Leeds or Madan during their joint lives by written notice to the trustee and parties. All of these provisions emphasize the manner in which any possible interest of petitioner in insuring the lives of key employees was subordinated to the interest of its two common stockholders, Leeds and Madan. As petitioner was committed under the trust agreement to use the proceeds of the policies to purchase the holdings of the first to die of Leeds and Madan, it is evident that the indebtedness which it incurred to purchase the policies would never enter into petitioner's working capital so long as the reason for the policies was the necessity of their inclusion in the stock purchase plan. As was said*168 in Hart-Bartlett-Sturtevant Grain Co. v. Commissioner, 182 Fed. (2d) 153: Petitioner's argument fails to convince that its actions have brought it under the wording of Section 719 or Regulation 112, supra. We note that the statute does not provide for a credit based on a taxpayer's total asset value, but only upon invested capital. And while the sums borrowed by petitioner do constitute borrowed capital they do not constitute borrowed invested capital. The sums borrowed were never actually invested as a part of petitioner's working capital, they were never utilized for the earnings of profits and they were never subject to the risk of petitioner's business. Cf. La Belle Iron Works v. United States, 256 U.S. 377, 388, 389; Commissioner v. South Texas Co., 333 U.S. 496, 497-498; West Construction Co. v. Commissioner, 7 T. C. 974, 978; Player Realty Co. v. Commissioner, 9 T. C. 215, 218. Concluding, as we must from the evidence before us, that the policies here were purchased as part of a stock purchase *169 plan for the personal interests of petitioner's two common stockholders and not for any business purpose of petitioner itself, we must approve the respondent's determination. Decision will be entered under Rule 50. Footnotes 1. SEC. 719. BORROWED INVESTED CAPITAL. (a) Borrowed Capital. -- The borrowed capital for any day of any taxable year shall be determined as of the beginning of such day and shall be the sum of the following: (1) The amount of the outstanding indebtedness (not including interest) of the taxpayer which is evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, or deed of trust, plus, * * * * (b) Borrowed Invested Capital. -- The borrowed invested capital for any day of any taxable year shall be determined as of the beginning of such day and shall be an amount equal to 50 per centum of the borrowed capital for such day.↩ 2. Sec. 35.719-1 Borrowed Invested Capital -- The borrowed invested capital for any day of the taxable year is 50 per cent of the borrowed capital for such day determined as of the beginning of such day. Borrowed capital is defined to mean: (a) Outstanding indebtedness (other than interest, but including indebtedness assumed or to which the taxpayer's property is subject) of the taxpayer which is evidenced by a bond, a promissory note, bill of exchange, debenture, certificate of indebtedness, mortgage, or deed of trust, plus * * * * In order for any indebtedness to be included in borrowed capital it must be bona fide. It must be one incurred for business reasons and not merely to increase the excess profits credit. If indebtedness of the taxpayer is assumed by another person it ceases to be borrowed capital of the taxpayer. For such purpose an assumption of indebtedness includes the receipt of property subject to indebtedness.↩