Nichols v. Comm'r of Internal Revenue

• Decision Date: 17 January 1962
• Docket Number: Docket Nos. 81752-81755.
• Citation: 37 T.C. 772
• Parties: PERRY A. NICHOLS AND INEZ NICHOLS, ET AL.,1 PETITIONERS, V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: U.S. Tax Court

37 T.C. 772

PERRY A. NICHOLS AND INEZ NICHOLS, ET AL.,1 PETITIONERS, V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket Nos. 81752-81755.

Tax Court of the United States.

Filed January 17, 1962.

Cyrus A. Neuman, Esq., for the petitioners.

Kenneth G. Anderson, Esq., for the respondent.

In December 1955, petitioners, partners in a successful Miami law firm, were approached by L about a tax-saving plan involving the purported purchase of United States Treasury notes with borrowed funds. L ‘assured’ petitioners that there would be no ‘short sale’ of the pledged Treasury notes by the lender under his plan. Petitioners then entered a transaction which, in form, included ordering an aggregate of $6-million-face-amount United States Treasury notes from L, borrowing the purchase price of the Treasury notes from a finance company supplied by L, repaying the interest on these loans with approximately 80 percent funds lent them without interest by L and with the remaining 20 percent from their own funds, receiving an option from L to sell the Treasury notes back to L in 9 months at a price slightly above par, and exercising this option in September 1956. L charged petitioners no fees or commission for the purported purchases, sales, options, and loans. Held, that, in substance, petitioners did not purchase Treasury notes, borrow funds, or pay interest which is deductible under section 163 of the 1954 Code. Eli D. Goodstein, 30 T.C. 1178,affirmed267 F.2d 127 (C.A. 1), followed.

In these consolidated cases the Commissioner determined deficiencies in income taxes of the petitioners for the taxable year 1955 in amounts as follows:

+----------------------------------------------------------------+
                ¦Petitioners                             ¦Docket No.¦Deficiencies¦
                +----------------------------------------+----------+------------¦
                ¦Perry A. Nichols and Inez Nichols       ¦81752     ¦$69,017.15  ¦
                +----------------------------------------+----------+------------¦
                ¦William C. Gaither and Elaine B. Gaither¦81753     ¦50,663.07   ¦
                +----------------------------------------+----------+------------¦
                ¦Walter C. Beckham and Ethel K. Beckham  ¦81754     ¦15,530.03   ¦
                +----------------------------------------+----------+------------¦
                ¦William S. Frates and Jean Frates       ¦81755     ¦14,960.59   ¦
                +----------------------------------------------------------------+
                

The principal issue is whether petitioners paid interest on indebtedness to Corporate Finance and Loan Corporation of Boston, Massachusetts, within the meaning of section 163 of the Internal Revenue Code of 1954. If this issue should be decided in petitioner's favor, the Commissioner by amendment to his answer in each of these cases raises the alternative question whether petitioners realized taxable income in 1955 when they received purported loans from Livingstone & Company.

FINDINGS OF FACT.

The facts stipulated by the parties are incorporated herein by this reference.

Perry A. and Inez Nichols, William C. and Elaine B. Gaither, Walter H. and Ethel K. Beckham, and William S. and Jean Frates were husbands and wives, respectively, residing in Miami, Florida, during the taxable year 1955. Each couple filed a joint Federal income tax return for the calendar year 1955 on the cash basis method with the district director of internal revenue at Jacksonville, Florida. For convenience, the male petitioners will individually be referred to hereinafter as Nichols, Gaither, Beckham, and Frates, and will be collectively referred to as petitioners.

Petitioners and William C. Green were attorneys by profession and were engaged in the private practice of law in Miami, Florida, during the years 1952 through 1960 under the partnership firm name of Nichols, Gaither, Green, Frates, and Beckham. Under their partnership agreement dated March 1, 1955, the members of the partnership, insofar as practicable, limited their practice of law to the specialty of negligence cases, civil trials, and workmen's compensation cases.

None of petitioners were dealers in securities nor had any of the petitioners purchased or sold Government securities in substantial amounts prior to December of 1955.

During the year 1955 each of the petitioners derived and received substantial earnings principally from the private practice of law. In their joint Federal income tax returns for the taxable year 1955, petitioners reported adjusted gross income in amounts as follows: Nichols, $176,078.37; Gaither, $112,264.69; Beckham, $59,569.69; Frates, $58,401.60. On the same tax returns petitioners claimed deductions for amounts allegedly paid as interest to Corporate Finance and Loan Corporation of Boston, Massachusetts, in amounts as follows: Nichols, $100,546.88; Gaither,$80,437.50; Beckham, $30,164.06; Frates, $30,164.50. The present cases stem from the Commissioner's denial of these claimed interest deductions.

M. Eli Livingstone was a security dealer in Boston, Massachusetts, doing business in the form of a sole proprietorship under the name of Livingstone & Company, referred to hereinafter as Livingstone. Livingstone developed an ‘investment plan’ whereby high income taxpayers theoretically would realize substantial ‘tax savings' by means of a large ‘interest’ deduction on funds ‘borrowed’ to finance the ‘purchase’ of Government securities.

Petitioners firse learned of Liningstone's tax reduction program on or about December 1, 1955, from a Chicago, Illinois, lawyer named Gerald G. Bolotin. Bolotin was a salesman for Livingstone,receiving a commission or ‘finder's fee’ for his services. Bolotin's initial contact with petitioners came at a convention of trial attorneys in Miami Beach, Florida, on or about December 1, 1955. Bolotin was introduced to Frates at that convention by a mutual friend, James Dooley, a lawyer from Chicago, Illinois. Frates referred Bolotin to Gaither who was then serving as office manager of petitioners' law firm. Bolotin went to see Gaither at the latter's office and outlined Livingstone's tax reduction program to him. Gaither then arranged for Bolotin to see Arthur Hemmings, a certified public accountant and petitioners' tax adviser.

Bolotin had a conference with Hemmings and explained to him the Livingstone program which he proposed petitioners enter. At this meeting Hemmings expressed concern that the transaction was similar to one set out in Revenue Ruling 54-94, 1954-1 C.B. 53, in which the Internal Revenue Service held that an interest deduction would not be allowable. Bolotin then showed Hemmings a memorandum prepared by a Chicago law firm which purported to distinguish the revenue ruling in question from the type of transaction which Bolotin said he had in mind for petitioners. In particular, he assured Hemmings that under the Livingstone program there would be no ‘short sale’ of the Government securities by the lending institution as there was under the facts in the revenue ruling.

On the following day a conference took place at petitioners' offices attended by petitioners, their partner Green, Hemmings, Bolotin, and Livingstone. None of petitioners had met Livingstone prior to this occasion. At this conference Bolotin and Livingstone outlined Livingstone's Treasury note ‘purchase plan’ for the entire group. Livingstone indicated that his brokerage firm would sell the Treasury notes to petitioners with 1 year's interest coupons detached and that he had access to numerous large banks and commercial lending institutions in New York, Boston, and Canada from which he could arrange for petitioners to borrow the full purchase price of the Treasury notes ordered. Livingstone did not specify which bank or lending institution would be used if petitioners decided to enter the program nor did he specify the rate of interest which would be charged. Since the interest on such loans would be payable in advance, Livingstone stated that his brokerage firm would lend petitioners without interest a substantial portion of the funds necessary to pay such interest. Livingstone also stated that his firm would grant petitioners a ‘put’ or option to sell the Treasury notes back to Livingstone at a price somewhat above par. Livingstone told petitioners that if the market acted favorably there was a possibility of economic profit and that the plan as outlined had the advantage of protecting against loss.

Petitioners then asked Hemmings for his opinion of the tax consequences of the proposal. Hemmings mentioned the pertinent revenue ruling and stated that if Livingstone's transaction involved a sale by the lending institution of the Treasury notes held as collateral, he could not recommend to petitioners that they enter it. Livingstone assured Hemmings and petitioners that he was aware of the revenue ruling, that there would be no ‘short sale’ of the collateral by the lending institution under his plan, and that his plan was similar to the one set out in the legal memorandum by the Chicago law firm which Bolotin had showed Hemmings the previous day. With these assurances, Hemmings expressed the opinion to petitioners that he believed the interest they paid to the lending institution would be deductible for Federal income tax purposes, that the gain from any subsequent sale of the notes would be capital gain, and that he, therefore, approved of the proposed transaction as outlined by Livingstone and Bolotin.

Petitioners and their law partner Green thereafter, on or about December 5, 1955, decided to enter the Livingstone-planned transaction for the primary purpose of reducing their federal income taxes. The detailed steps of this transaction, in form, were as set forth in the following paragraphs.

Livingstone was to arrange the purchase of United States Treasury 2 7/8-percent notes due March 15, 1957, with interest coupons payable March 15, 1956, and September 15, 1956, detached, on behalf of each of petitioners and their law partner Green, in face amounts as follows: Nichols,...