Lovett v. Commissioner

William R. Lovett and Agnes D. Lovett, Petitioners, v. Commissioner of Internal Revenue, Respondent Lovett v. Commissioner Docket No. 71565 United States Tax Court 37 T.C. 317; 1961 U.S. Tax Ct. LEXIS 29; November 22, 1961, Filed *29 Decision will be entered for the respondent. Held, under the facts, payments of "interest" on "loans" from an insurance company ostensibly used to purchase deferred annuity contracts, which were the sole security for the "loans," are not deductible. Douglas W. McGregor, Esq., Edward McCarthy, Esq., and John M. Markley, Esq., for the petitioners. Harold Friedman, Esq., for the respondent. Black, Judge. BLACK *317 Respondent has determined deficiencies in the income tax of petitioners for the years 1954 and 1955 in the amounts of $ 70,994.26 and $ 139,795.28, respectively, and an addition to tax*30 for 1954 under section 294(d)(2) of the 1939 Code in the amount of $ 5,260.87. In the determination of the deficiency for 1954, the Commissioner added to the taxable income reported on the joint return filed by petitioners for 1954 "(a) Interest expense $ 92,407.50." This adjustment was explained in the deficiency notice as follows: (a) In the return filed by you for the year 1954 a deduction is claimed for interest paid on notes to Sam Houston Life Insurance Company in the amount of $ 92,407.50. It is determined that the deduction claimed does not come within the provisions of section 163(a) of the Internal Revenue Code of 1954. Accordingly, the deduction claimed is disallowed. The deficiency for 1955 is determined in the same manner as above except the comparable adjustment is $ 188,279.83 which was added to the taxable income disclosed by the original return. The explanation in the deficiency notice of this adjustment is substantially the same as was made for the year 1954 and need not be repeated here. Petitioners by appropriate assignments of error contest the foregoing adjustments made by the Commissioner. The sole issue, therefore, presented is whether petitioners may deduct*31 as interest certain payments made to the Sam Houston Life Insurance Company of Houston, Texas, in 1954 and 1955 in the amounts of $ 92,407.50 and $ 188,279.83, respectively. *318 FINDINGS OF FACT. Many of the facts in this proceeding have been stipulated and the stipulation of facts, together with the exhibits attached thereto, is incorporated herein by this reference. Petitioners William R. and Agnes D. Lovett, husband and wife, residing in Jacksonville, Florida, filed joint income tax returns for the taxable years 1954 and 1955 with the district director of internal revenue, Jacksonville. For convenience William R. Lovett will hereinafter be referred to as petitioner. In response to certain newspaper advertisements which claimed that tax savings could be achieved through the purchase of a "Copyrighted Annuity" with borrowed money, petitioner opened negotiations in 1954 with representatives of the Sam Houston Life Insurance Company, hereinafter referred to as Insurance, relative to the matter. The culmination of these negotiations was that in December 1954, Insurance and petitioner entered into three agreements entitled "Annuity" and known as "Form No. A-18." The substance*32 of those agreements was in material parts, as follows: The company agrees to pay petitioner a life annuity of $ 504,725.51 per month commencing on the 30th anniversary of the policy if petitioner is living and the policy is in force. If petitioner dies after the commencement of the annuity payments and prior to the time the annuity payments equal the net cash value of the policy at the commencement of the annuity payments, the company will continue said payments to the beneficiary until said net cash value is paid. If both petitioner and the beneficiary die before such time, the present value of the remaining payments shall be paid to the executors, administrators, or assigns of the last to die. If petitioner dies before the commencement of the annuity, the company will pay the beneficiary, who is named as Agnes D. Lovett, wife, if living, otherwise to the executors, administrators, or assigns of petitioner, a death benefit as computed under the terms of the policy. The cash value of the policy on original maturity date is $ 46,951,210. The contract is issued at age 64, in consideration of the payment of the first annual premium of $ 1 million. At any time during the first 29 years*33 of the policy, petitioner may convert the net cash value of the policy to an immediate refund annuity by electing an optional maturity date, payments under such an immediate refund annuity to be made in accordance with a table of payments set forth in the contract which lists the monthly payment per thousand dollars of net cash value if conversion takes place at male ages 5 to 85 years. Petitioner may surrender the policy at any time prior to the first annuity payment for the lump-sum payment of the net cash value. *319 The death benefit is equal to the sum of all premiums paid less all indebtedness, but in no event an amount less than the cash value of the policy less indebtedness. The contract further provides: 11. CASH LOANS. At any time prior to the due date of the first Annuity Payment provided by the terms of this Contract, the Company will make loans on proper assignment of this Contract and on its sole security. The loan may be for an amount not exceeding the cash or loan value (shown herein in the Table of Cash or Loan Values), for the end of the current Contract year. All existing indebtedness on this Contract and any unpaid premiums for the balance of the current*34 Contract year shall be deducted from the loan. Interest shall be payable in advance to the end of the current contract year and annually in advance thereafter. The rate of interest shall not exceed 3 3/4% per annum. The Company shall have the right to defer making any loan for a period not exceeding ninety days. If interest is not paid when due, it shall be added to the existing loan provided the total indebtedness on the Contract will not be more than its loan value. The indebtedness thus created shall bear interest at the same rate. The whole or any part of the loan may be repaid at any time prior to the death of the Annuitant and the due date of the first Annuity Payment provided by the terms of this Contract except that such loan may not be repaid after five years following the date of termination of this Contract. Failure to repay any indebtedness or to pay interest shall terminate this Contract when the total indebtedness equals or exceeds the cash value of this Contract. 12. AUTOMATIC PREMIUM LOAN. This Automatic Premium Loan provision shall become operative if requested in the application for this Contract, or whenever written request by the Annuitant is received by*35 the Company at its Home Office before any premium is in default beyond the grace period. It shall become inoperative as to premiums not yet paid, upon receipt by the Company at its Home Office of written request by the Annuitant to that effect. The request for this Automatic Premium Loan provision shall be deemed a proper assignment of the Contract to the Company to secure all automatic premium loans. While this Automatic Premium Loan provision is operative the Company will effect a loan, provided such loan satisfies all the terms of the Cash Loans provision of this Contract, and pay any premium in default and not otherwise paid. The amount of such loan shall be the amount of the premium so paid plus any existing indebtedness together with interest on the loan from the due date of such premium. If the Cash or Loan Value is insufficient for a loan to be made as provided above, no Automatic Premium Loan shall be made and Non-Forfeiture Option 2 shall apply. 13. CASH VALUE. At the end of each Contract year prior to the due date of the first Annuity Payment provided by the terms of this Contract, if premiums have been paid in full and this Contract is in full force, this Contract *36 shall have a Cash Value. The Cash Value at the end of any such Contract year shall be computed in accordance with the Basis of Computation stated in the following TABLE OF CASH OR LOAN VALUES. The Cash value at any date within a Contract year after the first shall be the Cash Value at the end of such Contract year, less interest thereon at the effective rate of 2 3/4% per annum from said date to the end of such Contract year. This Contract shall have no Cash Value prior to the end of the first Contract year, nor after the due date of the first Annuity Payment. *320 TABLE OF CASH OR LOAN VALUES BASIS OF COMPUTATION. The Cash Values shown in this Table are for the end of the Contract years stated and are for a premium unit of $ 1,000.00. As this Contract is based on 1,000 premium units, each as specified and described in the preceding sentence, the Cash Values hereunder are 1,000 times the Cash Values shown in this Table. The Cash Value per premium unit, specified and described in the first sentence of this paragraph, at the end of any Contract year is equal to the then reserve for each such premium unit. Cash Value at the End of the Contract years indicated per $ *37 1,000.00 of Annual Premium, provided premiums have been paid in full for the number of years shown. End of Contract Cash or Loan Year Value [1] 1,027.50 [2] 2,083.26 [3] 3,168.05 [4] 4,282.67 [5] 5,427.94 [6] 6,604.71 [7] 7,813.84 [8] 9,056.22 [9] 10,332.76 [10] 11,644.42 [11] 12,992.14 [12] 14,376.92 [13] 15,799.79 [14] 17,261.78 [15] 18,763.98 [16] 20,307.49 [17] 21,893.44 [18] 23,523.01 [19] 25,197.40 [20] 26,917.83 [21] 28,685.57 [22] 30,501.92 [23] 32,368.22 [24] 34,285.85 [25] 36,256.21 [26] 38,280.75 [27] 40,360.98 [28] 42,498.40 [29] 44,694.61 [30] 46,951.21 Net cash value of the policy means "the Cash Value of this Contract (determined in accordance with the provision entitled 'Cash Value') on the date as of which it is being computed and decreased by the amount of any indebtedness to the Company against this Contract." A nonforfeiture provision gives petitioner the option during any grace period after the first premium, either to surrender the policy for its net cash value, or to allow the net cash value to accumulate at 2 3/4 percent interest, compounded annually, to the original maturity date and then be applied to the purchase of an annuity in a lesser amount. In the event petitioner*38 does not elect the first option and the automatic loan provision is not in effect, the second option applies. If the net cash value of the policy upon maturity differs from the specified cash value, the amount of the annuity payments shall be altered proportionately. The policy provides for four different settlement options which may be exercised either by the annuitant or the beneficiary under described circumstances. Two of the policies, Nos. A-15890 and A-15891, were issued on December 22, 1954, while No. A-15876 was issued on December 10, 1954. This last-named policy was identical with the other two, except that its term was 20 rather than 30 years, its cash value on maturity, *321 $ 26,917,830 rather than $ 46,951,210, and the monthly annuity payments were $ 279,137 instead of $ 504,725.51. Simultaneous with the issuance of the policies, petitioner issued checks to Insurance for $ 1,000 on each policy and gave an "Annuity Loan Note and Assignment of Annuity" in the amount of $ 999,000 for each policy. These documents provided in material part, as follows: IN CONSIDERATION OF the sum of *NINE HUNDRED NINETY-NINE THOUSAND* DOLLARS advanced by SAM HOUSTON LIFE INSURANCE*39 COMPANY of Houston, Texas, which sum the Company is hereby authorized and directed to apply to pay the remaining premiums required by the terms of said Annuity, and receipt whereof is hereby acknowledged, as a loan on the sole security of and in accordance with the provisions contained in Annuity Number [the appropriate number] on the life of WILLIAM RADFORD LOVETT issued by the said Company, I hereby assign said Annuity and all sums of money now due or hereafter to become due thereunder, including benefits at death, to said Company as security for the repayment of the said loan and interest thereof. Interest shall be payable in advance at the rate and at the time and in the manner provided in the said Annuity. It is agreed that any interest which is not paid when due shall be added to the principal of the loan, and shall become a part thereof and shall bear interest at the same rate and on the same conditions as the loan. It is also agreed that the principal of the said loan together with any interest due and accrued thereon shall become due and payable whenever the said Annuity shall become due and payable, or whenever the total indebtedness on said Annuity shall equal or exceed*40 the guaranteed cash value of the said Annuity. If at any time the entire indebtedness evidenced by this loan, together with any other indebtedness on said Annuity, shall equal or exceed the guaranteed cash value of the said Annuity, the Company's liability under the said Annuity shall automatically terminate. If the said Annuity shall lapse or become forfeited in any manner, the amount of the said loan with any interest accumulated or accrued thereon shall be deducted from any cash surrender value of said Annuity as provided in the Cash Values privilege of said Annuity. * * * * It is understood that there is no personal liability upon the makers of this note for the payment thereof, the sole recourse being against the said Annuity. This note is to cover the balance of the first annual premium only. At the same time petitioner issued checks to Insurance for "prepaid interest" on each of the "loans," as follows: Policy No. Amount A-15876 $ 32,467.50 A-15890 29,970.00 A-15891 29,970.00 Total 92,407.50 At the end of the first year the contracts were in force, each contract was to have a "cash or loan value" of $ 1,027,500. On November 16, 1955, petitioner received*41 from Insurance "supplemental loans" in the amount of $ 27,500 on each policy, or a total of $ 82,500. At the same *322 time petitioner paid and was credited on the books of Insurance with payment of "supplemental interest" on the policies in the total amount of $ 278.58. In December 1955, petitioner executed an "Annuity Loan Note and Assignment of Annuity" relative to each policy, each in the amount of $ 1,999,000, representing the total of $ 999,000 (the amount of the original notes which were canceled) and $ 1 million (the "second annual premium"). For the years 1954 through 1960, the "premiums" per the policies, "premium interest," "supplemental interest," net annual changes in "premium loans," and "supplemental loans or repayments," per the books of Insurance, the total "disbursements" and "receipts," and the net disbursements or receipts made or received by petitioner were as follows: "Premium "Supplemental Total "disbursements" Year Policy "Premium" interest" interest" No. A-15876 $ 1,000,000 $ 32,467.50 $ 1,032,467.50 [1954] A-15890 1,000,000 29,970.00 1,029,970.00 A-15891 1,000,000 29,970.00 1,029,970.00 3,092,407.50 A-15876 1,000,000 64,967.50 $ 1,117,71 1,066,085.21 [1955] A-15890 1,000,000 59,970.00 1,127.31 1,061,097.31 A-15891 1,000,000 59,970.00 1,127.31 1,061,091.31 3,188,279.83 A-15876 1,000,000 89,970.00 1,089,970.00 [1956] A-15890 1,000,000 89,970.00 1,089,970.00 A-15891 1,000,000 89,970.00 1,089,970.00 3,269,910.00 A-15876 1,000,000 120,000.00 4,500.00 1,124,500.00 [1957] A-15890 1,000,000 120,000.00 4,500.00 1,124,500.00 A-15891 1,000,000 120,000.00 4,500.00 1,124,500.00 3,373,500.00 A-15876 1,000,000 150,000.00 7,725.00 1,157,725.00 [1958] A-15890 1,000,000 150,000.00 7,800.00 1,157,800.00 A-15891 1,000,000 150,000.00 7,875.00 1,157,875.00 3,473,400.00 A-15876 1,000,000 180,000.00 12,810.62 1,192,810.62 [1959] A-15890 1,000,000 180,000.00 12,858.90 1,192,858.90 A-15891 1,000,000 180,000.00 12,783.90 1,192,783.90 3,578,453.42 A-15876 1,000,000 210,000.00 18,075.00 1,228,075.00 [1960] A-15890 1,000,000 210,000.00 18,000.00 1,228,000.00 A-15891 1,000,000 210,000.00 17,925.00 1,227,925.00 3,684,000.00 23,659,950.75 *42 "Supplemental "Premium loan Total Net disbursements Year loan" (repayment)" "receipts" (receipts) $ 999,000 $ 999,000 $ 33,467.50 [1954] 999,000 999,000 30,970.00 999,000 999,000 30,970.00 2,997,000 95,407.50 1,000,000 $ 27,500 1,027,500 38,585.21 [1955] 1,000,000 27,500 1,027,500 33,597.31 1,000,000 27,500 1,027,500 33,597.31 3,082,500 105,779.83 1,000,000 (27,500) 972,500 117,470.00 [1956] 1,000,000 (27,500) 972,500 117,470.00 1,000,000 (27,500) 972,500 117,470.00 2,917,500 352,410.00 1,001,000 150,000 1,151,000 (26,500.00) [1957] 1,001,000 150,000 1,151,000 (26,500.00) 1,001,000 150,000 1,151,000 (26,500.00) 3,453,000 (79,500.00) 1,000,000 107,500 1,107,500 50,225.00 [1958] 1,000,000 110,000 1,110,000 47,800.00 1,000,000 112,500 1,112,500 45,375.00 3,330,000 143,400.00 1,000,000 165,000 1,165,000 27,810.62 [1959] 1,000,000 160,000 1,160,000 32,858.90 1,000,000 155,000 1,155,000 37,783.90 3,480,000 98,453.42 1,000,000 180,000 1,180,000 48,075.00 [1960] 1,000,000 180,000 1,180,000 48,000.00 1,000,000 180,000 1,180,000 47,925.00 3,540,000 144,000.00 22,800,000 859,950.75 *43 *323 On October 21, 1957, petitioner paid the full "premium loan" of $ 2,999,000 on Policy No. A-15876, and on October 22 obtained a "premium loan" of $ 3 million. On October 23 and 24, 1957, he repeated the same procedure as to Policy No. A-15890 and on October 25 and 26, 1957, again repeated the procedure as to Policy No. A-15891. One week before hearing in this case, petitioner repaid all "supplemental loans" on the policies in the amount of $ 1,800,000, as well as $ 1,200,000 of the "premium loans" in the total amount of $ 21 million. The cumulative total of the "premium loans" and the percentage of the cumulative "premiums" represented by the "premium loans" at the close of the years 1954 through 1960 on each of the policies issued to petitioner were as follows: Percentage "Premium of "premium" On or about Dec. 31 -- loan" represented by "premium loan" [1954] $ 999,000 99.9 [1955] 1,999,000 99.999 [1956] 2,999,000 99.999 [1957] 4,000,000 [1958] 5,000,000 [1959] 6,000,000 [1960] 7,000,000 [100] During the years 1954 through 1960, petitioner paid to Insurance "interest" or "supplemental interest" on all three policies*44 in the total amount of $ 2,659,950.75. As of the close of the contract years ending in 1960 the three policies had "cash values" in excess of "total premiums" in the total amount of $ 1,814,130, and as of the close of the contract years ending in 1961 will have "cash values" in excess of "total premiums" in the total amount of $ 2,441,520. Petitioner reported adjusted gross income for 1954 in the amount of $ 237,926.14 and for 1955 in the amount of $ 222,326.60. OPINION. The sole question presented is whether petitioner may deduct during the years in issue amounts paid to the Sam Houston Life Insurance Company as "interest" on "premium" and "supplemental loans." Petitioner contends that the amounts paid constituted interest on indebtedness incurred in the purchase of three annuity policies, and that such interest is deductible under section 163(a) of the 1954 Code. 1*45 Respondent, on the other hand, contends that the entire transaction relative to the purchase of the policies *324 lacks economic substance, and that under the rule of law announced in Knetsch v. United States, 364 U.S. 361 (1960), the deductions must be disallowed. 2 The Knetsch case involved the issue of the deductibility of "interest" payments made by a taxpayer in connection with the purchase of a single-premium annuity with funds largely "borrowed" from the same Sam Houston Life Insurance Company. The taxpayer argued in that case that it was the intent of Congress that such interest be deductible. When we examine "what was done" in the instant case, we find that in form, petitioner, at age 64 3 undertook to purchase two 30-year and one 20-year deferred annuity policies for total annual premiums of $ 3 million so that commencing in his 84th year he would begin to receive monthly payments of $ 279,137.90 and in his 94th year, total monthly payments of $ 1,288,588.92. In form, petitioner borrowed $ 2,997,000 from Insurance in 1954 to pay all but $ 3,000 of the first year premium of $ 3 million and prepaid interest on the loans in the*46 amount of $ 92,407.50, while in 1955 he borrowed the full $ 3 million and paid interest thereon, as well as on the $ 2,997,000, and on $ 82,500 which he had borrowed against an increase in cash surrender value in the total amount of $ 188,279.83. In form, what petitioner did in the first 2 years in which the policies were in force was repeated in succeeding years, with the amounts of loans and interest increasing each year, as set forth in our Findings of Fact. In form, petitioner paid Insurance during the years 1954 through 1960 a total of $ 21 million in premiums and an additional $ 2,659,950.75 in interest. When we examine "what was done" in fact, we discover that petitioner entered into a transaction with Insurance involving various steps over the years, in each of which years there were various debits and credits made on the books of Insurance, and in which various checks were passed between petitioner*47 and Insurance, but the net effect of which was that during the years 1954 through 1960, petitioner paid to Insurance those net amounts set forth in our Findings of Fact. Petitioner reported adjusted gross income during the years in issue which averaged about $ 230,000 per year. Although, in form, petitioner paid $ 2,659,950.75 in "interest" and received "supplemental loans" of $ 1,800,000 during the years 1954 through 1960, "what he was ostensibly 'lent' back was in reality only the rebate of a substantial part of the so-called 'interest' payments. The * * * difference retained by the company was its fee for providing the facade of 'loans' *325 whereby petitioners sought to reduce their * * * taxes * * *." Knetsch v. United States, supra at 366. Over the period of years from 1954 through 1960, petitioner in fact established a pattern of "borrowing" all of the "premiums" for the policies and approximately 99 percent of the "increases in cash or loan values." If such a trend continued to the maturity of the policies (the increasing "interest" burden indicates the strong probability of such a course of action), the combined cash value*48 of the 30-year policies would be approximately $ 340,000, or 0.0362 percent of the indicated cash value of $ 93,902,420. Monthly payments upon maturity would be about $ 3,650 instead of the $ 1,009,451.02 indicated on the face of the policies. On the 20-year policy, the constant borrowing of "premiums" and "increases in cash or loan value" would reduce the face value on maturity to approximately $ 69,200, or 0.0257 percent of the indicated maturity value of $ 26,917,830. Similarly, the monthly payments would be about $ 720, instead of the $ 279,137.90 stated in the policy. Of course, if conversion of the policies to immediate refund annuities were effected prior to maturity, the payments would be further reduced. While these sums are more substantial than those involved in the Knetsch case, supra, where the similar percentage was 0.000125, when compared to the large sums ostensibly involved, they are, as the Supreme Court described them, "a relative pittance." Although petitioner contends that the transaction had the economic substance which the Supreme Court found lacking in the Knetsch case, we believe that the two transactions, while different in form, are indistinguishable*49 in principle. Petitioner received no aspect of life insurance by the policies. Neither he nor his beneficiary would receive more than was paid in, plus low-rate interest. 4 There is no persuasive evidence that either the initial policies or any conversion thereof were, or would be, issued at rates more favorable than petitioner might otherwise have secured. Although petitioner contends that the fact that he has "repaid" part of the "loans" gives substance to the transaction, the steps taken in 1957 appear as nothing more than an integrated set of maneuvers by which he successfully managed to get back from Insurance the only portion ($ 3,000) of the "premiums" which he had ever paid in. In the light of these earlier acts and of its proximity to trial herein, the "repayment" of $ 3 million 1 week before trial in 1961 is not persuasive of the economic reality of the transactions with Insurance in 1954 and 1955. *50 *326 In short, we believe that, as the Supreme Court said in the Knetsch case, 364 U.S. 361, 366 (1960), "it is patent that there was nothing of substance to be realized by [petitioner] from this transaction beyond a tax deduction." As this Court said in W. Stuart Emmons, 31 T.C. 26, 31-32 (1958), affd. 270 F. 2d 294 (C.A. 3, 1959): We might well characterize petitioner's activities here as an operation having no business or annuity or borrowing purpose -- a mere device which put on the form of a loan as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan, not to borrow money (or purchase an annuity) but to create a deduction for income tax purposes. We hold, therefore, that petitioner may not deduct the claimed "interest" payments paid to Insurance during 1954 and 1955. Other issues raised by the petition have been abandoned. Decision will be entered for the respondent. Footnotes 1. SEC. 163. INTEREST. (a) General Rule. -- There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.↩ 2. See also Weller v. Commissioner, 270 F. 2d 294 (C.A. 3, 1959), affirming 31 T.C. 33 and W. Stuart Emmons, 31 T.C. 26↩. 3. At age 64, petitioner had a life expectancy of 15.6 years, Income Tax Regs., sec. 1.72-9↩, Table I. 4. Although one piece of evidence indicates that the "death proceeds" payable to the beneficiary would exceed amounts paid in, the policy and the records of Insurance clearly indicate that the proceeds upon death during the first year would be only $ 3,000, not $ 91,435.91. The difference, which at first blush looks like a life insurance benefit, apparently is nothing more than the return of unused prepaid "interest" on the "loans."↩