Preston v. Commissioner

WILLIAM P. T. PRESTON, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Preston v. Commissioner Docket No. 101762. United States Board of Tax Appeals 44 B.T.A. 973; 1941 BTA LEXIS 1250; July 10, 1941, Promulgated *1250 On October 18, 1934, petitioner borrowed $125,000 from trust company A and delivered that amount to trust company B, as trustee, to be held under a trust indenture for the benefit of a sister-in-law. The trustee was authorized under the trust indenture to lend that entire amount to petitioner on his bond. On October 19, 1934, petitioner delivered to the trustee his bond under seal, in which he covenanted to pay $125,000 in 20 years with interest at 4 percent per annum; the trustee delivered $125,000 to petitioner, and petitioner used that amount to satisfy his loan from trust company A. Under the law of New York, where the bond was executed and delivered, the seal was only presumptive evidence of a sufficient consideration, which might be rebutted as if the bond were not sealed. In 1937, the taxable year, petitioner made payments, denominated interest, totaling $5,000 to the trustee. Held, that the bond was not a legally enforceable obligation and that petitioner is not entitled to a deduction for interest paid on indebtedness with respect to the payments made to the trustee in the taxable year. Allin H. Pierce, Esq., for the petitioner. Allen T. Akin, Esq.*1251 , for the respondent. HARRON *974 Respondent determined a deficiency of $124.21 in income tax for the year 1937. The sole question is whether petitioner is entitled to a deduction of $5,000 for interest paid on indebtedness within the taxable year under section 23(b) of the Revenue Act of 1936. FINDINGS OF FACT. Petitioner is a resident of New York City. He filed his income tax return for the year 1937, the taxable year, with the collector of internal revenue for the second district of New York. Under the will of petitioner's father, Ralph J. Preston, who died on October 25, 1919, four trusts were created, one for the benefit of each of his four children, Evelyn, Jerome, Louis, and petitioner. The Guaranty Trust Co. of New York was the trustee of each trust. Under each trust the trustee was to pay the income to the child named as beneficiary for life and upon his or her death to transfer the corpus to his or her issue, or, in default of issue, to the surviving children of Ralph J. Preston. Jerome died on May 28, 1934. He left surviving his wife, Alice, but no issue. In July 1934 the corpus of the trust for Jerome was distributed in equal shares*1252 to the three surviving children. As the result of such distribution each of the three surviving children received property of the value of $123,222.51. On July 23, 1934, Evelyn transferred the property which she had received as the result of such distribution to the Guaranty Trust Co. in trust for the benefit of Alice. On October 18, 1934, the Gentral Hanover Bank & Trust Co. of New York made a demand loan to petitioner in the amount of $125,000, with interest at 6 percent, and delivered to him a treasurer's check in that amount payable to his order. On October 18, 1934, a trust indenture was entered into between petitioner, as grantor, and the United States Trust Co. of New York, as trustee. Petitioner endorsed the treasurer's check of the Central Hanover Bank & Trust Co. in the amount of $125,000 to the order of the trustee. The proceeds of the treasurer's check were to be held by the trustee as the corpus of the trust. The trustee was to pay the income to petitioner's sister-in-law, Alice, until her death or remarriage, and after Alice's death or remarriage to petitioner's wife for her life. Upon the death of petitioner's wife the trustee was to transfer the corpus to*1253 such of the issue of petitioner and his wife as she should appoint by will; and in default of such appointment, to the issue then living of petitioner and his wife; or if no such issue survived his wife, to the issue then living of petitioner; or if no issue of petitioner survived his wife, then to him. If at the time of Alice's death or remarriage petitioner's wife should not be living, the trustee was to transfer the corpus to him. *975 Paragraph third of the trust indenture provided in part as follows: * * * and the trustee is hereby expressly authorized in its absolute discretion from time to time to loan money to the grantor on either his unsecured note maturing not more than twenty years after the date thereof or his unsecured personal bond maturing as aforesaid or to purchase at par the unsecured note or notes or personal bonds of the grantor in such amount or amounts and bearing interest at such rate or rates and maturing at such time or times but not more than twenty years after the date thereof and upon such terms and conditions as the trustee in its absolute discretion shall deem proper and to pay or exchange in payment therefor all or part of the * * * [$125,000*1254 transferred by petitioner to the trustee] and to renew any such notes or bonds for periods of not more than twenty years after the maturity thereof, and in case the trustee shall make any such loans or purchase any such bond or bonds, then the trustee is hereby expressly authorized to hold such note or notes, bond or bonds or renewals thereof until the maturity thereof and to accept such payments on reduction of the principal amount or amounts due thereunder as the grantor pursuant to the terms thereof shall make from time to time. * * * It is contemplated and expected that the trustee will from time to time loan money to the grantor on his unsecured bond or note and under no circumstances shall such action on the part of the trustee constitute a breach of trust and the trustee shall be under no liability except for actual or wilful fraud to any person or persons interested or claiming to be interested in the trust fund by reason of the purchase in its absolute discretion of any unsecured personal note or bond of the grantor and the trustee shall not be required to undertake the enforcement of any such note or bond in the event of any default thereunder unless (a) the trust fund*1255 shall then contain cash or property other than the said note or bond sufficient in the opinion of the trustee to meet the reasonable expense of the trustee in undertaking such enforcement or (b) unless the the trustee shall first be furnished with indemnity to it satisfactory in form and amount to meet the reasonable expense of the trustee in undertaking such enforcement. On October 19, 1934, petitioner executed and delivered to the trustee a written instrument in which he acknowledged himself to be indebted to the trustee in the amount of $125,000 and covenanted to pay that amount to the trustee on October 15, 1954, with interest at 4 percent per annum payable on December 15, 1934, and quarterly thereafter. The instrument stated that petitioner had set his seal thereunto; and after his signature appeared the letters "L.S." On October 19, 1934, the trustee delivered to petitioner its check in the amount of $125,000, payable to his order. On the same date he endorsed the check to the order of the Central Hanover Bank & Trust Co. and delivered the check so endorsed to that trust company in full payment of the demand loan in the amount of $125,000 made by it to him on October 18, 1934. *1256 Petitioner also paid to the Central Hanover Bank & Trust Co. $20.83 as 6 percent interest on the demand loan for one day. Petitioner filed a gift tax return for the year 1934 on which he reported a gift of $125,000 to the United States Trust Co., as trustee. The return disclosed a liability of $2,179.17 for gift tax. On March *976 15, 1935, petitioner paid that amount of gift tax to the collector of internal revenue for the second district of New York. On October 18, 1934, petitioner instructed the Guaranty Trust Co. to pay to the United States Trust Co. out of the income of the trust created for his benefit under the will of his father "the moneys necessary to meet my obligation to United States Trust Co. of New York for interest on a bond which I executed today." In accordance with these instructions the Guaranty Trust Co. paid to the United States Trust Co. $777.78 on December 15, 1934, and $5,000 per annum in quarterly payments of $1,250 each during the period from December 15, 1934, to December 15, 1940, inclusive. The payments made by the Guaranty Trust Co. were entered as "interest" payments by the United States Trust Co. on the cash receipts and disbursements*1257 account which it kept for the trust. In the taxable year the Guaranty Trust Co. paid a total of $5,000 to the United States Trust Co. in accordance with petitioner's instructions. The United States Trust Co., as trustee, reported the receipt of $5,000 as "interest" on a fiduciary income tax return for the taxable year. The return showed that $125.25 had been expended for commissions and other expenses; that the balance of $4,874.75 had been distributed to petitioner's sister-in-law, Alice; and that there was no liability for income tax. OPINION. HARRON: The sole question is whether petitioner is entitled to a deduction for interest paid on indebtedness with respect to the payments totaling $5,000 which were made by him in the taxable year to the United States Trust Co. The deduction in question was not taken by petitioner on his return for the taxable year, but was claimed by him in his petition. Under section 23(b) of the Revenue Act of 1936 a deduction is allowed for all interest paid within the taxable year on indebtedness. The term "indebtedness", as used in section 23(b), is not defined in the revenue acts. The Board and the courts have defined "indebtedness", *1258 as used in section 23(b), as "an unconditional and legally enforceable obligation for the payment of money." See Paul Autenreith,41 B.T.A. 319; affd., 115 Fed.(2d) 856; William Park,38 B.T.A. 1118; affd., 113 Fed.(2d) 352; W. S. Gilman,18 B.T.A. 1277; affd., 53 Fed.(2d) 47. In the present case, the basic question is whether or not the so-called bond in which petitioner covenanted to pay $125,000 to the United States Trust Co. was a legally enforceable obligation. The law of New York, where the bond was executed and delivered, is in large part determinative of this question. See Wiliam Park, supra, at p. 1120. In the final analysis, the answer to this question depends upon *977 whether or not the bond was supported by sufficient consideration. Petitioner argues, first, that the bond was supported by an actual consideration of $125,000 loaned to him by the United States Trust Co. and, second, that in any event the seal affixed to the bond conclusively imported a consideration under New York law. In support of his second argument he cites *1259 Cochran v. Taylor,273 N.Y. 172; 7 N.E.(2d) 89, and William Park, supra.Respondent argues, first, that the United States Trust Co. did not loan $125,000 to petitioner and that the bond was not supported by any actual consideration; and, second, that under New York law the seal affixed to the bond was only presumptive evidence of the sufficiency of the consideration and that the record clearly overcomes the presumption of sufficiency. He cites Johnson v. Commissioner, 86 Fed.(2d) 710, and Guaranty Trust Co. of New York v. Commissioner, 98 Fed.(2d) 62, in support of his first argument and Alexander v. Equitable Life Assurance Society,233 N.Y. 300; 135 N.E. 509, in support of his second argument. In our opinion, the bond was not a legally enforceable obligation under the law of New York. On October 18, 1934, petitioner borrowed $125,000 from the Central Hanover Bank & Trust Co. and delivered that amount to the United States Trust Co., as trustee under the trust indenture for the benefit of his sister-in-law, Alice. *1260 On October 19, 1934, the very next day, petitioner executed and delivered the bond, the United States Trust Co. paid him $125,000, and he used that amount to satisfy his loan from the Central Hanover Bank & Trust Co. These various steps were taken at the same time and as part of one transaction. See Johnson v. Commissioner, supra;Guaranty Trust Co. of New York v. Commissioner, supra.The only reasonable inference to be drawn from the various steps taken and the carefully drafted provisions of paragraph third of the trust indenture is that it was agreed between petitioner and the United States Trust Co. that the $125,000 which he delivered to the trust company was to be returned to him almost immediately as a "loan." See Johnson v. Commissioner, supra;Guaranty Trust Co. of New York v. Commissioner, supra.The payment to petitioner "of money which he himself supplied to the trustee for the very purpose can not be a loan to him or furnish consideration for his" bond. See *1261 Johnson v. Commissioner, supra.The practical effect of what was done was to set up a trust composed solely of petitioner's bond. See Johnson v. Commissioner, supra. It is true that petitioner's bond was under seal. The letters "L.S." appeared opposite his signature on the bond. This was sufficient to constitute a seal under New York law. See New York General Construction Law, sec. 44. However, under the New York law which was in effect at the time when the bond was executed and delivered, the seal was "only presumptive evidence of a sufficient consideration", which might be rebutted as if the bond were not sealed. See New *978 York Civil Practice Act, sec. 342; Cochran v. Taylor, supra;Alexander v. Equitable Life Assurance Society, supra;Harris v. Shoral,230 N.Y. 343; 130 N.E. 572; In re Greene, 45 Fed.(2d) 428; Jessie W. Donahue,44 B.T.A. 329. The record clearly shows that petitioner's covenant contained in the bond was a wholly gratuitous promise. Thus the presumption as to sufficiency of consideration was amply*1262 rebutted. See Alexander v. Equitable Life Assurance Society, supra;In re Greene, supra.Cochran v. Taylor, supra, is distinguishable because in that case the sufficiency of the consideration was not in question. See Helmick v. Probst,170 Misc. 284; 9 N.Y.S.(2d) 975. William Park, supra, is not in point because in that case the question of whether or not there was a legally enforceable obligation was determined by Pennsylvania law, rather than New York law. See Julius G. Day,42 B.T.A. 109. Petitioner's gratuitous promise contained in the bond was "unenforceable either by the trustee or by the beneficiary" and was "no more than a promise to make a gift in the future." Johnson v. Commissioner, supra.The payments totaling $5,000 which were made by petitioner in the taxable year to the United States Trust Co. were simply gratuitous payments for the benefit of his sister-in-law, Alice. It follows that petitioner is not entitled to a deduction for interest paid on indebtedness with respect to such payments. *1263 Johnson v. Commissioner, supra. Petitioner concedes that respondent correctly determined that the amount of petitioner's distributive share of the taxable net income of a partnership was understated on his return by the amount of $1,276.76. Respondent concedes that petitioner is entitled to a deduction, which was not taken on his return, in the amount of $152.16 for taxes paid by him to the State of New York in respect to unemployment insurance. Effect will be given to these concessions on computation under Rule 50. Decision will be entered under Rule 50.