77 T.C. 173 (1981), 9657-78, Franklin v. C.I.R.

Docket Nº:9657-78.
Citation:77 T.C. 173
Opinion Judge:CHABOT, Judge:
Party Name:H. C. FRANKLIN and MARJORIE FRANKLIN, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
Attorney:Hubert D. Johnson, for the petitioners. William P. Hardeman, for the respondent.
Case Date:August 04, 1981
Court:United States Tax Court
 
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Page 173

77 T.C. 173 (1981)

H. C. FRANKLIN and MARJORIE FRANKLIN, PETITIONERS

v.

COMMISSIONER of INTERNAL REVENUE, RESPONDENT

No. 9657-78.

United States Tax Court

August 4, 1981

On Mar. 9, 1972, petitioner-husband borrowed $2,250,000 from bank A. Bank A sold participations in the loan to other banks.

On Mar. 9, 1973, (1) the $2,250,000 loan was renewed; (2) petitioner-husband borrowed $120,124.99 from bank A, which deposited the proceeds into his otherwise minimally used account at bank A; (3) petitioner-husband wrote a check for interest of $120,124.99 payable to bank A, which, in turn, distributed some of the interest to the other banks. Bank A sold participations in the $2,250,000 renewal loan (but not the $120,124.99 loan) to other banks.

On Mar. 9, 1974, (1) the $2,250,000 loan was again renewed; (2) the $120,124.99 loan was renewed; (3) petitioner-husband borrowed $217,491.27 from bank A, which distributed a portion thereof to the other banks as interest on the $2,250,000 loan. Held :

1. Petitioners have not proven they were on any other than the cash method of accounting;

2. Petitioner-husband did not pay interest to the other banks and owed neither principal nor interest to them;

3. Petitioners are not entitled to deduct $120,124.99 for 1973 as interest paid to bank A;

4. Petitioners are not entitled to deduct $217,491.27 for 1974 as interest paid to bank A; and

5. Petitioners are not entitled to require respondent to change their accounting method to an accrual method.

Hubert D. Johnson, for the petitioners.

William P. Hardeman, for the respondent.

CHABOT, Judge:

Respondent determined deficiencies in Federal individual income tax against petitioners for 1973 and 1974 in the amounts of $61,293.85 and $111,465.77, respectively. In connection with issue (2) infra, petitioners claim overpayments for both years. The issues for decision are as follows:

(1) Whether petitioners are entitled to deduct $120,124.99 and $206,414.49 [1] as interest paid for 1973 and 1974, respectively,

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under section 163,[2] as a consequence of petitioner-husband's transactions with a bank; and

(2) Whether, if petitioner-husband's transactions do not result in his being treated as having paid interest, petitioners' method of accounting should be changed to permit interest deductions.

FINDINGS OF FACT

Some of the facts have been stipulated; the stipulation and the stipulated exhibits are incorporated herein by this reference.

When the petition in this case was filed, petitioners H. C. Franklin (hereinafter sometimes referred to as Franklin) and Marjorie Franklin, husband and wife, resided in Dallas, Tex.

Franklin and Camille Franklin, his then wife of many years, were divorced on March 10, 1972. As an incident to that divorce and the related property settlement, on March 9, 1972, Franklin borrowed $2,250,000 evidenced by his promissory note (hereinafter sometimes referred to as the 1972 principal note) of the same date, payable to the Capital National Bank in Austin (hereinafter sometimes referred to as Capital National), at Austin, Tex. On that same date, Franklin opened a demand deposit account at Capital National (hereinafter sometimes referred to as the account), which was credited with the $2,250,000 thus borrowed. This $2,250,000 amount was much larger than any previous borrowing by Franklin; up to that time the most Franklin had owed at any one time had been between $300,000 and $400,000. Franklin drew a check dated March 13, 1972, on the account for $1,869,289.67 payable to Camille Fryar Franklin.

The 1972 principal note was payable to Capital National on or before March 9, 1973. The note states that it or " any renewal or extension thereof or participation therein" is secured (1) by Franklin's pledge of 8,000 shares of common stock of Lone Star Co. (hereinafter sometimes referred to as Lone Star) registered in Franklin's name; [3] and (2) by a " Take

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Out Commitment" between Capital National and Lone Star, as follows:

Recitation

Contemporaneously herewith, [Capital National], Austin, Texas, has loaned and advanced to [Franklin], of Dallas County, Texas, the sum of Two Million Two Hundred Fifty Thousand Dollars ($2,250,000.00). Such indebtedness is evidenced by a promissory note dated March 9, 1972, bearing interest at the rate provided therein, is due on or before one year from date and is secured by the pledge of 8,000 shares of the common stock of [Lone Star] owned and registered in the name of [Franklin]. [Capital National] has sold, and in the future may sell, participations in such loan and indebtedness to other banks and financial institutions. It is hereby agreed to by [Lone Star] that any such banks or other financial institutions which may at any time own any part of such indebtedness shall be protected by this agreement and share the benefits, including the right of enforcement, pro rata in accordance with their respective shares of ownership of such debt.

Commitment

[Lone Star], which hereby avoids the legal obligation to buy at book value any shares of its common stock tendered to it by its stockholder, [Franklin], in accordance with the terms of agreement set forth on its stock certificates and in the minutes and by-laws of such corporation, and in consideration of [[[Capital National] and its participants making such loan or purchasing participations therein, and to secure payment thereof by the execution and delivery hereof, has agreed and hereby agrees:

1. That [Lone Star] will purchase at maturity or upon default of [Franklin] in any manner the promissory note above described, or any renewal or extension thereof or participation therein, at par in an amount equal to the unpaid balance of principal and interest thereon, within thirty days following written demand by the undersigned bank to so purchase.

2. That [Lone Star] will notify [Capital National] in writing ten days in advance of any proposed corporate reorganizations or changes affecting the stock pledged hereunder.

[Capital National], for itself and on behalf of its participants, agrees that it will notify [Lone Star] of any default (or of any assertion by said bank that a default has occurred) of [Franklin] on any obligation or duty he may have pertaining to the indebtedness described herein, or the collateral securing its payment before taking any action with respect to such collateral.

EXECUTED this 9th day of March, 1972.

In March 1972, Capital National sold participations in the 1972 principal note to various banks (hereinafter sometimes

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collectively referred to as the participating banks) in Texas, and made partial repurchases of some of those participations, as shown in table I.

TABLE I
Sales
Date Amount Bank Date Amount Bank
Mar. 9 $625,000 Frost National Bank, San Antonio Mar. 15 $125,000 Frost National Bank, San Antonio
Mar. 9 625,000 Continental Bank, Houston Mar. 15 125,000 Continental Bank, Houston
Mar. 10 75,000 First National Bank, San Augustine Mar. 15 5,000 First National Bank, San Augustine
Mar. 10 150,000 San Benito Bank & Trust Co., San Benito
Mar. 15 500,000 Fort Worth National Bank, Fort Worth
Thereafter, from March 15, 1972, until March 9, 1973, the participations in the $2,250,000 loan to Franklin were as shown in table II.
TABLE II
Bank Amount
Capital National $530,000
Frost National Bank, San Antonio 500,000
Continental Bank, Houston 500,000
Fort Worth National Bank, Fort Worth 500,000
San Benito Bank & Trust Co., San Benito 150,000
First National Bank, San Augustine 70,000
2,250,000
Each of the participating banks received a certificate of participation in the following form from Capital National: Re: Gentlemen: This certificate evidences your participation with us in a $ note to dated . Said note matures with interest payable at maturity at the rate of % from . We have this date sold to you a participation in the amount of $ [at] % with accrued interest . The execution of this participation agreement shall not limit or affect our discretion in exercising or refraining from exercising without notice to you any and all rights afforded to us by the above mentioned note or any other Page 177 paper or document relating thereto, our sole responsibility to you being to exercise the same care that we exercise in the making and handling of loans for our own account and to account to you for your pro rata share of the net amount of all payments actually received by us with respect to the said note. The right to repurchase all, or any part of this Participation is reserved to [Capital National], Austin, Texas. The ledger sheet maintained by Capital National relating to the loan to Franklin, for the period from March 9, 1972, through March 13, 1973, shows a running balance, as well as debit and credit entries reflecting the sales and repurchases of participations, respectively.[4] When the 1972 principal note matured, on March 9, 1973, the unpaid interest then owed on it equaled $120,124.99. On that date, Franklin borrowed $120,124.99 from Capital National, executing a promissory note (hereinafter sometimes referred to as the 1973 interest note) for that amount payable on or before 1 year from that date to Capital National. The terms of the 1973 interest note are similar to those of the 1972 principal note, including the provision regarding possible participation and the pledge of stock with its related agreement, described supra . The 1973 interest note also...

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