Barnett v. Comm'r of Internal Revenue, Docket No. 92538.

• Decision Date: 28 May 1965
• Docket Number: Docket No. 92538.
• Citation: 44 T.C. 261
• Parties: MAX BARNETT AND ESTHER BARNETT, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

44 T.C. 261

MAX BARNETT AND ESTHER BARNETT, PETITIONERS,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 92538.

Tax Court of the United States.

Filed May 28, 1965.

George V. Delson and William P. Miller, for the petitioners.

Lee A. Kamp, for the respondent.

Taxpayer purportedly borrowed money from Gibralter Financial Corp. to buy U.S. Treasury certificates of indebtedness. Gibralter did not have the funds to loan to petitioner nor the certificates. Gibralter arranged for the purchase of the certificates which were pledged as collateral with a bank to secure the bank's loan to Gibraltar, which funds were applied to the purchase. The certificates were sold by Gibraltar within 30 days and the proceeds of the sales were applied by Gibraltar in repayment of the bank's loan. Held: An amount paid by petitioner to Gibraltar in December 1957, designated as ‘prepaid interest,‘ is not deductible under section 163(a), 1954 Code. As a payment of interest, the transaction between taxpayer and Gibraltar was a sham.

HARRON, Judge:

Respondent determined a deficiency in income tax for 1957 in the amount of $16,189.36. The question is whether petitioner is entitled to a deduction in 1957 of $30,850.49 under section 163(a), 1954 Code, as interest paid on indebtedness.

FINDING OF FACT

Most of the facts have been stipulated. The stipulated facts are found accordingly.

Petitioners are residents of Merrick, N.Y. They filed a joint return for 1957 with the district director of internal revenue in Brooklyn, new York, on the basis of a calendar year and cash method of accounting. Since the issue relates only to Max Barnett, he is referred to herein as the petitioner.

Petitioners' 1957 return is signed by petitioners and, also, by Milton Zipper, as the person who prepared the return, and it bears a rubber stamp reading ‘Milton Zipper, Certified Public Accountant, 37 East Main Street, Oyster Bay, New York.’ Petitioners filed a joint return for 1958, a copy of which is evidence, on which a rubber stamp is affixed with the notation, ‘Milton Zipper, C.P.A.’

Petitioner did not appear at the trial of this case. He did not testify.

From the 1957 and 1958 returns, it is evident that Zipper is petitioners' accountant and that he prepared the returns. From several exhibits it is also evident that Zipper was known to Gibraltar, since in the account of the books of Gibraltar, opened on December 23, 1957, for the transaction in dispute, the name and style of the account is ‘Mr. Max Barnett, c/o Milt Zipper, Esquire, 37 Main Street, Oyster Bay, New York.’

In 1957, petitioner received $50,000 as a prize as the winner of a contest conducted by a newspaper, the Journal-American in New York City; he reported the $50,000 in income on his 1957 return.

Petitioner reported on his 1957 return, income from salary in the amount of $7,825, paid by a corporation, Island Radio Dist(ributor), Inc., Hempstead, N.Y. He reported on the 1957 return, adjusted gross income in the amount of $65,845, and taxable income of $18,847.71. Included in the deductions taken is $30,850.49. It was deducted as ‘interest’ paid to Gibraltar. Respondent disallowed the claimed deduction of $30,850.49. The reason given in the deficiency notice is that ‘the amount does not represent interest within the purview of section 163 of the Internal Revenue Code of 1954 and that the transaction allegedly giving rise to said claimed deduction is a transaction lacking in substance.’ This determination of the respondent is in issue here.

On the 1957 return, petitioner deducted $1,500 as expense connected with the preparation of the return. Respondent disallowed the deduction, but he now concedes error and agrees that this deduction can be allowed.

Gibraltar, during the pertinent period, was a dealer in municipal, State, and Federal bonds, having its offices in New York City. It maintained a checking account with Irving Trust Co. (Irving Trust) in the same city. Irving Trust maintained on its books for Gibraltar a ‘securities clearance’ account, which is defined in the stipulation of facts as one where—

a broker, acting without sufficient cash, may purchase stock or bonds and sell them almost immediately, making a profit or commission on the transaction. He is not able to pay for the security purchase, and he, therefore, employes his bank or possibly some other broker to pay for an receive the same, and then make(s) delivery to the purchaser; the difference between the purchase and selling prices less the clearing charges to be paid to the first broker. At the time of purchasing, a broker may say to the seller, ‘Doe & Co. will clear for me’, meaning that the seller is expected to make delivery to Doe & Co. for the broker's account; the broker, in the meantime, instructing Doe & Co. as to the transaction.

The assets, liabilities, and net worth of Gibraltar as of the end of its fiscal years ending on November 30, 1956, 1957, and 1958, were as follows:

+---+
                ¦¦¦¦¦
                +---+
                

 Nov. 30, 1956 Nov. 30, 1957 Nov. 30, 1958
                

Assets  
                Cash in banks    $24,401    $32,475    $65,202
                Receivable 1     69,599,555 61,551,150 56,506,071
                Securities, long 22,614,933 11,403,774 0
                Other assets     7,571      6,416      8,590
                Total            92,246,460 72,993,815 56,579,863
                

Liabilities  
                Loans payable 2          109,000    91,800     583,500
                Accounts payable         3,932      21,304     18,874
                Securities borrowed      92,214,703 73,010,967 56,299,601
                Accrued expenses payable 17,825     0          0
                Capital stock            2,000      2,000      2,000
                Deficit                  (101,000)  (132,256)  (324,112)
                Total                    92,246,460 72,993,815 56,579,863
                

On Friday, December 20, 1957, petitioner and Gibraltar entered into an arrangement whereby petitioner purportedly bought from Gibraltar and Gibraltar purportedly sold to petitioner on margin $750,000 face amount of 3 3/4-percent short-term U.S. Treasury certificates of indebtedness (certificates) issued on November 26, 1957, and due on December 1, 1958; and on that date petitioner purportedly placed an order with Gibraltar to make that ‘purchase’ for his new account, settlement date December 23; and on that date Gibraltar mailed him a ‘sale confirmation’ slip confirming a ‘sale’ to him of the certificates at 100-23/32 in the principal amount of $755,390.63, plus accrued interest for 22 days, from December 1, of $1,699.86, or a total of $757,090.49. An account was opened on Gibraltar's books in petitioner's name, care of Zipper, on December 23, 1957, designated ‘Special Loan,‘ and under that date the account was ‘charged’ with the ‘purchase’ for the account of the certificates in the amount of $757,090.49. The arrangement (i.e., the steps that were taken) was that the special loan account was opened on Gibraltar's books to reflect a purported loan by Gibraltar to petitioner for the purchase of the certificates in the net amount of $747,890.63; petitioner gave Gibraltar his check for $9,199.86 as ‘margin’; he executed a promissory note payable to Gilbraltar 9 months later in the above net amount, which recited that he deposited and pledged the certificates with Gibraltar as collateral security, and that it could repledge the collateral security; and he made a second payment to Gibralter of $30,850.49, which purportedly was a ‘prepayment’ of all of the ‘interest’ on the note for 9 months. Thus, petitioner made two payments to Gibraltar totaling $40,050.35. The details are set forth infra. However, on December 20 and 23, 1957, Gibraltar did not have its own cash in the amount of $757,090.49, or $747,890.63, and it did not have the certificates in its inventory.

On December 20, 1957, Gibraltar (hereinafter sometimes referred to as G) placed an order with the First Boston Corp., a dealer in Government bonds, for the purchase of $750,000 of the certificates described above at the price of 100-22/32, to be delivered on Monday, December 23, to Irving Trust against payment; and G took the following additional steps on the same day: G sent a letter to the Cleveland Trust Co. (Cleveland Trust) in Cleveland Ohio, requesting that it should instruct its correspondent bank in New York City, the Chemical Corn Exchange Bank (Chemical), to receive on December 23 from Irving Trust the $750,000 of certificates for G's account, and to pay Irving Trust $740,000. G sent to Cleveland Trust, with the letter, G's promissory note for $740,000 payable on demand, bearing interest at the rate of 4 percent, and G requested Cleveland Trust to charge G's account for the cost of handling the transaction. G also sent a letter dated December 20, 1957, to Irving Trust, attention of its securities clearance department, to deliver on December 23 to Chemical against payment of $740,000, the $750,000 of certificates for G's account with Cleveland Trust. All of the instructions were carried out, as follows.

Boston mailed G its confirmation slip dated December 20, 1957, settlement date December 23, showing a sale to G of $750,000 certificates at the price of 100-22/32, in the principal amount of $755,156.25, plus 22 days' accrued interest $1,699.86, or a total price of $756,856.11, delivery to be made to Irving Trust against payment of the total amount on December 23; and First Boston recorded the transaction on its books as a sale, and G recorded it on its books as a purchase. On December 23, 1957, First Boston, through its agent, Manufacturers Trust Co. in New York City, delivered the certificates to Irving Trust, which paid $756,856.11 to First Boston through its agent. Irving Trust mailed to G its debit advice showing that it had received the certificates from First Boston for redelivery against payment of funds (to Chemical); had charged G a clearance charge of $7.50; and had debited G's checking account in the amount of $756,863.61. Irving Trust, on December 23, debited G's checking account in the latter amount.

On December 23, 1957, Irving Trust delivered the certificates...