Dean v. Commissioners of Internal Revenue

• Decision Date: 30 March 1961
• Docket Number: Docket No. 75523.
• Citation: 35 T.C. 1083
• Parties: J. SIMPSON DEAN AND PAULINA DUPONT DEAN, PETITIONERS, v. COMMISSIONERS OF INTERNAL REVENUE, RESPONDENT.
• Court: U.S. Tax Court

35 T.C. 1083

J. SIMPSON DEAN AND PAULINA DUPONT DEAN, PETITIONERS,

v.COMMISSIONERS OF INTERNAL REVENUE, RESPONDENT.

Docket No. 75523.

Tax Court of the United States.

Filed March 30, 1961.

1. In 1955 petitioners each obtained loans on insurance policies which each held on the other's life. Soon thereafter, petitioners each assigned the insurance policies involved to their children. After the assignments, petitioners continued to pay the interest on the insurance loans during the remainder of 1955 and all of 1956. Held, petitioners may not deduct interest paid or accrued on insurance loans after the date of assignment of the beneficial ownership of the insurance policies to their children. Cf. Agnes I. Fox, 43 B.T.A. 895.

2. During 1955 and 1956 petitioners had outstanding interest-free loans in excess of $2 million which they had obtained from a corporation controlled by them. Held, petitioners realized no taxable income attributable to the free use of the borrowed money. Laurence Graves, Esq., for the petitioners.

Edward L. Newberger, Esq., for the respondent.

OPINION.

RAUM, Judge:

The Commissioners determined deficiencies in income tax against petitioners for 1955 and 1956 in the amounts of $13,875.61 and $16,383.86, respectively. Petitioners are husband and wife; they filed joint returns for 1955 and 1956 with the director of internal revenue at Wilmington, Delaware. To the extent that the deficiencies still remain in controversy they raise the question whether petitioners were entitled to deduct as interest the amounts of $9,243.38 in 1955 and $26,912.02 in 1956 representing interest on loans on life insurance policies which had accrued and which was paid by them after they had made irrevocable assignments of such policies to their children. An amended answer filed by the Commissioner claims increases in the deficiencies already determined by adding thereto the amounts of $105,181.50 and $119,796.78 for 1955 and 1956, respectively. Such increases raise a single issue, unrelated to the original deficiencies, namely, whether petitioners realized taxable income to the extent of the alleged economic benefit derived from the interest-free use of funds which they had borrowed from a family corporation controlled by them. The facts have been stipulated.

Issue 1. Interest Deduction.

The stipulation of facts, as it relates to the original issue presently in controversy, is in its entirety as follows:

2. In 1937 petitioner J. Simpson Dean created an irrevocable trust to which he transferred life insurance policies theretofore obtained by him on the life of petitioner Paulina duPont Dean, having an aggregate face value of $2,145,017. In 1937 petitioner Paulina duPont Dean created an irrevocable trust to which she transferred life insurance policies theretofore obtained by her on the life of petitioner J. Simpson Dean having an aggregate face value of $1,125,391. Each of these trusts had the power to sell and assign to any person or persons the policies of insurance held thereunder, or any of them, for not less than the cash surrender value.

3. Early in 1955 petitioner J. Simpson Dean purchased from the trustee certain of the life insurance policies transferred by him to the trust created by him in 1937 at their cash surrender value on the date of the purchase, which was considered to be the fair market value of the policies so purchased. Immediately after this purchase said petitioner applied for and obtained loans from the respective insurance companies on the policies so purchased to the extent of their cash surrender values. The money so obtained was applied by said petitioner to his personal use. Shortly after securing such loans said petitioner assigned and transferred ownership of said policies to the children of himself and petitioner Paulina duPont Dean by executing forms required by the respective insurance companies.

4. Early in 1955 petitioner Paulina duPont Dean purchased from the trustee certain of the life insurance policies transferred by her to the trust created by her in 1937 at their cash surrender value on the date of the purchase, which was considered to be the fair market value of the policies so purchased. Immediately after this purchase said petitioner applied for and obtained loans from the respective insurance companies on the policies so purchased to the extent of their respective cash surrender values. The money so obtained was applied by said petitioner to her personal use. Shortly after securing such loans said petitioner assigned and transferred ownership of said policies to the children of herself and petitioner J. Simpson Dean by executing forms required by the respective insurance companies.

5. In connection with the assignments to the beneficiaries, the children of the petitioners, each of the companies used their own special forms for assignment and change of ownership of the policies. Examples of the forms used by the insurance companies for the above purpose, are Exhibit 1-A, the form used by the Bankers Life Insurance Company, and Exhibit 2-B, the form used by the United States Life Insurance Company.

6. Approximately one-half of the notices for payment of the interest due and the amounts of interest due in the years 1955 were addressed to petitioners. The other one-half were addressed to the assignee children of the petitioners.

All the interest regardless of to whom the bills were addressed was pay by the petitioners and deductions were claimed in their joint income tax returns filed by them for the years 1955 and 1956, in the following amounts:

+----------------+
                ¦1955¦$14,102.41 ¦
                +----+-----------¦
                ¦1956¦26,912.02  ¦
                +----------------+
                

7. Of the $14,102.41 claimed above as interest by the petitioners on their 1955 income tax return, $4,859.03 is attributable to interest accrued and/or paid by the petitioners prior to the assignment of the insurance policies. This latter amount is allowable as a deduction. The balance of the interest claimed, $9,243.38, represents interest paid and accrued after the assignments, and is the amount in controversy for 1955. All the interest claimed in 1956 has been disallowed, and is the amount in controversy for that year.

Petitioners seek to deduct the amounts in controversy as ‘interest paid * * * on indebtedness.’ Sec. 163(a),I.R.C. 1954. The Commissioner defends his disallowance of the deduction by relying upon the familiar rule that ‘The statutory provision allowing deduction for interest on indebtedness means interest on an obligation of the taxpayer claiming it; payments made on obligations of others do not meet the statutory requirement.’ Chester A. Sheppard, 37 B.T.A. 279, 281-282. Cf. Helen B. Sulzberger, 33 B.T.A. 1093; William H. Simon, 36 B.T.A. 184; Agnes I. Fox, 43 B.T.A. 895. An analysis of the insurance loans here involved persuades us that the Commissioner correctly applied the foregoing well-established rule to the facts of this case.

Insurance policy loans are unique because the borrower assumes no personal liability to repay the principal or to pay interest on the amount borrowed. Such loans are based on the reserve value of the insurance policies involved. If either the principal or the interest is not repaid, it is merely deducted from the reserve value of the policy. Since the insurance company ‘never advances more than it already is absolutely bound for under the policy, it has no interest in creating a personal liability.’ Orleans Parish v. N.Y. Life Ins. Co., 216 U.S. 517, 522.

We have held that interest on an insurance policy loan may be deducted so long as it is actually paid or accrued by the policyholder. If such interest is not paid but is allowed to be added to the principal amount of the loan, the amount of the interest is not deductible. Nina Cornelia Prime, 39 B.T.A. 487; Albert J. Alsberg, 42 B.T.A. 61.

Here, the respondent has stipulated that the interest paid or accrued by the petitioners on the insurance policy loans prior to the assignment of the insurance policies to their children is a proper deduction. True, the petitioners were not personally liable to pay this interest. But by making the loans involved, the petitioners had become obligated in a sense to pay interest thereon. Although the petitioners could never be sued for this interest, the ‘obligation’ was sufficient to qualify it as deductible interest for income tax purposes because such interest was in fact and in law a charge against their rights in the policies. The essential question for purposes of this case is whether the ‘obligation’ to pay interest survived the assignment of the policies involved to others. We think it did not. It follows that after the assignment, interest paid by the petitioners was paid for the benefit of the assignees and is not deductible by petitioners. Cf. Helen B. Sulzberger, supra.

In Agnes I. Fox, 43 B.T.A. 895, it was held that the assignee of an insurance policy subject to a loan made prior to the assignment could deduct interest on that loan paid or accrued after the assignment but not interest accrued and unpaid prior to the assignment. We there noted that it was the assignor who had borrowed on the policies and ‘it was he who had the obligation to pay interest and the obligation continued until the date of assignment to petitioner. Proration must be made as of that date.’ 43 B.T.A. 895, 899. Although that case dealt with the reverse situation from the instant case (i.e., the deduction of interest by the assignee rather than the assignor), it seems obvious that the same principles must apply to both. The assignor has a right to deduct the interest paid or accrued prior to the date of the assignment of the underlying insurance policy; the assignee has such right after. Here, under the rule of the Fox case, it was petitioners' children, the assignees, who could deduct the interest on the insurance policy loans after the assignment, assuming that they paid such interest. When the...