33 T.C. 511 (1959), 64451, Kaye v. C. I. R.

Docket Nº:64451, 64452.
Citation:33 T.C. 511
Opinion Judge:HARRON, Judge:
Party Name:DANNY KAYE AND SYLVIA KAYE, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. CY HOWARD, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Attorney:Bernard Speisman, Esq., and George V. Delson, Esq., for the petitioners. Emil Sebetic, Esq., for the respondent.
Case Date:December 16, 1959
Court:United States Tax Court

Page 511

33 T.C. 511 (1959)

DANNY KAYE AND SYLVIA KAYE, PETITIONERS,

v.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

CY HOWARD, PETITIONER,

v.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Nos. 64451, 64452.

United States Tax Court.

December 16, 1959

Bernard Speisman, Esq., and George V. Delson, Esq., for the petitioners.

Emil Sebetic, Esq., for the respondent.

INTEREST DEDUCTIONS.- Transactions whereby each principal petitioner purported to purchaser with borrowed funds time deposit certificates in the principal amount of $687,500, but received no money or economic benefit except contemplated tax savings from interest deductions, held, shams; there were not in substance borrowings totaling $687,500; and interest paid on the purported loans at the rate of 10 per cent per annum is not deductible.

OPINION

HARRON, Judge:

The respondent determined deficiencies in income tax for the taxable year 1952 as follows:

Docket No. Petitioners Deficiencies
64451 Danny Kaye and Sylvia Kaye $19,667.66
64452 Cy Howard 33,452.93

Each deficiency results from the respondent's disallowance of a deduction for payment of alleged interest in 1952. The amount deducted as interest by Sylvia Kaye is $23,750. The amount deducted as interest by Cy Howard is $38,750. Each petitioner individually entered into a series of separate transactions with the same broker which purported to be for the purchase, on margin, of certificates of deposit issued by various banks. Each transaction was carried out with borrowed funds and culminated in purported resales of the certificates of deposit. The chief question is whether payments made by each petitioner in 1952 represented interest within the purview of section 23(b) of the 1939 Code. All of the chief facts have been stipulated. The facts are found as stipulated; the stipulation of facts is incorporated herein by this reference. Sylvia and Danny Kaye reside in Beverly Hills, California. They filed a joint income tax return for the calendar year 1952 on a cash basis with the collector of internal revenue for the sixth district of California in Los Angeles. Cy Howard, a resident of California, filed his individual income tax return for the calendar year 1952, on a cash basis, with the collector of internal revenue for the sixth district of California in Los Angeles. Danny Kaye is a well-known entertainer of the stage, screen, radio, Page 512 and television. Sylvia Kaye, his wife, is an advisor of and business agent for Danny Kaye. Since the issue in the Kaye's case relates to Sylvia, only, she is referred to hereinafter as the petitioner. Cy Howard is a well-known writer and producer in the entertainment business. Both the Kayes and Cy Howard used the following business address in their respective income tax returns: ‘ c/o Lefkowitz and Berke, 9130 Sunset Blvd., Los Angeles 46, California.’ The foregoing is an abbreviation of the name of an accounting firm, Lefkowitz, Berke, Parker & Freedman, hereinafter referred to as the Lefkowitz accountants. That firm has another office at 465 South Beverly Drive, Beverly Hills, California. It furnished the Kayes and Howard accounting and auditing services and prepared for them financial statements and their respective income tax returns. The returns for 1952 of all of the petitioners were prepared by that firm. Cantor, Fitzgerald & Co., Inc., hereinafter called CanFitz is an investment brokerage firm, an underwriter and distributor of investment securities, and a broker-dealer in listed securities and in over-the-counter securities. It is registered with both the Securities and Exchange Commission and the National Association of Security Dealers (of which it is a member) as a broker-dealer and it is subject to audits by and the regulations of both agencies. It has offices in Beverly Hills, San Francisco, and New York. Sylvia Kaye and Cy Howard each, in their individual capacities, entered into transactions in 1952 with CanFitz which involved time certificates of deposit obtained by CanFitz in 1952. According to Regulation D, as amended, of the Board of Governors of the Federal Reserve System, effective September 16, 1948, a time certificate of deposit is evidence of a time deposit in a bank (other than a demand deposit) which is to be held by the bank for a specified length of time of not less than 30 days after the date of deposit. A time certificate of deposit and the time deposit it evidences have a maturity date. It may be a nonnegotiable or a negotiable instrument which provides on its face that the amount of such deposit is payable to bearer, or to any specified person or to his order. It is payable in all cases only upon presentation and surrender. Regulation D defines time certificates of deposit as follows:

(c) Time certificates of deposit.- The term ‘ time certificate of deposit’ means a deposit evidenced by a negotiable or non-negotiable instrument which provides on its face that the amount of such deposit is payable to bearer or to any specified person or to his order- (1) On a certain date, specified in the instrument, not less than thirty days after the date of deposit, or (2) At the expiration of a certain specified time not less than thirty days after the date of the instrument, or

Page 513

(3) Upon notice in writing which is actually required to be given not less than thirty days before the date of repayment, and (4) In all cases only upon presentation and surrender of the instrument.

In the case of Sylvia Kaye, transactions with CanFitz were entered into by her which involved 2 certificates of deposit. In the case of Cy Howard, transactions were entered into by him with CanFitz which involved 8 certificates of deposit. All of the certificates of deposit were unregistered negotiable instruments, which did not bear interest, which were issued in 1952 by various banks in California and Texas. All of the transactions of both petitioners with CanFitz were entered into in 1952. The parties have agreed upon an explanation of a commercial practice through which a business concern may borrow capital to be kept on deposit for a stated period at its bank in order to maintain a ‘ compensating minimum deposit balance’ to sustain its revolving fund line of credit with its bank. Finance companies avail themselves of this method of borrowing capital. The arrangements which give rise to a bank's issuance of a certificate of deposit may be illustrated by the following example:[1]

Beverly Finance Company has a line of credit with the Anglo-California National Bank. The bank requires Beverly Finance Company to maintain a compensating minimum balance in its account of $150,000. Resolute Insurance Company will make a deposit of $150,000 in the Anglo-California Bank for Beverly, for a fee or a charge to Beverly of 2 1/2 per cent interest per annum, upon the request of Beverly.[2] Beverly requests Resolute to make such deposit to its account. Resolute transfers $150,000 to Anglo-California Bank which issues to Resolute a certificate of deposit in the amount of $150,000, payable at

Page 514

the expiration 1 year after notice of intended withdrawal shall have been given to the bank and upon the surrender of the certificate properly endorsed. Anglo-California Bank does not pay interest on the amount of $150,000.

Resolute may retain the certificate of deposit for the period of the deposit, or it may sell the certificate, or otherwise deal with it in the same way as may be done with any other negotiable security. The amount of the fee charged by Resolute, or some other firm which engages in a transaction for the acquisition of a certificate of deposit, generally varies according to the prevailing interest rate charged on the money market. Cantor, Fitzgerald & Co., Inc., in 1951, entered into a business practice (in addition to its other business activities) of making funds available to clients for deposit in a bank evidenced by the bank's time certificate of deposit, and it also dealt in time certificates of deposit. For convenience, a certificate of deposit is sometimes referred to hereinafter as a CD. During 1952, CanFitz suggested to the Lefkowitz accounting firm that high-bracket taxpayers might realize tax savings by acquiring non-interest-bearing certificates of deposit by the use of borrowed funds. CanFitz suggested a pattern of procedure, as follows: A taxpayer would purchase from CanFitz, acting as a dealer, a certificate of deposit of the type described above. The purchase price to the taxpayer would be an amount equal to about 5.25 per cent less than the face amount of the CD, or a discount of such per cent. However, the taxpayer would not be obliged to make any cash payment in any amount for the CD or give his note. The purchase would be made under a margin account with CanFitz; CanFitz would make a ‘ loan’ to the purchaser; and the purchaser would pay in advance interest on the loan at the rate of 10 per cent. The amount of the loan would be the face amount of the CD. Since the amount of the loan would exceed the purchase price at a discount, CanFitz would pay to the ‘ borrower,‘ in cash, the difference between the two amounts. The CD would not be delivered to the purchaser but would be held by CanFitz or whoever might receive it as a pledgee of CanFitz. CanFitz could pledge the CD. After 6 months and before the maturity of the CD, the CD would be sold for the taxpayer's account. He could report the gain realized (if any) as long-term capital gain, and he would claim a deduction, as interest expense, for the amount of the ‘ interest’ paid on the loan. The above plan can be illustrated as follows: Canfitz has a client (a finance company) which wants a time deposit made for it at its bank, Anglo-California, in the amount of $150,000 on October 21, 1952, for 210 days until May 19, 1953. CanFitz, as a broker, arranges Page 515 with Cleveland Trust...

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