Calloway v. Comm'r of Internal Revenue

• Decision Date: 08 July 2010
• Docket Number: No. 8438–07.,8438–07.
• Citation: 135 T.C. 26,135 T.C. No. 3
• Parties: Lizzie W. and Albert L. CALLOWAY, Petitioners v. COMMISSIONER of INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

135 T.C. 26
135 T.C. No. 3

Lizzie W. and Albert L. CALLOWAY, Petitioners
v.
COMMISSIONER of INTERNAL REVENUE, Respondent.

No. 8438–07.

United States Tax Court.

July 8, 2010.

[135 T.C. 26]

In August 2001 P entered into an agreement with Derivium whereby P transferred 990 shares of IBM common stock to Derivium in exchange for $93,586.23. The terms of the agreement characterized the transaction as a loan of 90 percent of the value of the IBM stock pledged as collateral. The purported

[135 T.C. 27]

loan was nonrecourse and prohibited P from making any interest or principal payments during the 3–year term of the purported loan. The terms of the agreement allowed Derivium to sell the stock, which it did immediately upon receipt. At maturity P had the option of either paying the balance due and having an equivalent amount of IBM stock returned to him, renewing the purported loan for an additional term, or satisfying the “loan” by surrendering any right to receive IBM stock. At maturity in August 2004 the balance due was $40,924.57 more than the then value of the IBM stock. P elected to satisfy his purported loan by surrendering any right to receive IBM stock. P was not required to and did not make any payments toward either principal or interest on the purported loan.

1. Held: The transaction between P and Derivium in August 2001 was a sale. P transferred all the benefits and burdens of ownership of the stock to Derivium for $93,586.23 with no obligation to repay that amount.

2. Held, further, the transaction was not analogous to the securities lending arrangement in Rev. Rul. 57–451, 1957–2 C.B. 295, nor was it equivalent to a securities lending arrangement under sec. 1058, I.R.C.

3. Held, further, Ps are liable for an addition to tax under sec. 6651(a)(1), I.R.C., for the late filing of their 2001 Federal income tax return.

4. Held, further, Ps are liable for the accuracy-related penalty pursuant to sec. 6662, I.R.C.

Brian G. Isaacson, for petitioners.

Daniel J. Parent, for respondent.

RUWE, Judge:

Respondent determined a $30,911 deficiency, a $6,583 addition to tax under section 6651(a)(1) ¹ for failure to timely file, and a $6,182.20 accuracy-related penalty under section 6662(a) in regard to petitioners' 2001 Federal income tax. The issues we must decide are: (1) Whether a transaction in which Albert L. Calloway (petitioner) transferred 990 shares of International Business Machines Corp. (IBM) common stock to Derivium Capital, L.L.C. (Derivium), in exchange for $93,586.23 was a sale or a loan; (2) whether the transaction qualifies as a securities lending arrangement; (3) whether petitioners are liable for an addition to tax under section 6651(a)(1) for failure to timely file; and (4) whether

[135 T.C. 28]

petitioners are liable for an accuracy-related penalty pursuant to section 6662(a).

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulated facts and the attached exhibits are incorporated herein by this reference. At the time the petition was filed, petitioners resided in Georgia.

After petitioner graduated from college in 1964, he began a successful career with IBM. While employed at IBM petitioner purchased shares of IBM stock.

During 2001 petitioner's financial adviser, Bert Falls, introduced him to Derivium and its 90–percent–stock–loan program.² Under that program Derivium would purport to lend 90 percent of the value of securities pledged to Derivium as collateral. Derivium was not registered with the New York Stock Exchange or the National Association of Securities Dealers/Financial Industry Regulatory Authority. Charles D. Cathcart was president of Derivium.

On or about August 6, 2001, Derivium sent to petitioner a document entitled “Master Agreement to Provide Financing and Custodial Services” (master agreement) with attached “Schedule D, Disclosure Acknowledgement and Broker/Bank Indemnification” (schedule D). The master agreement provides, in pertinent part:

This Agreement is made for the purpose of engaging * * * [Derivium] to provide or arrange financing(s) and to provide custodial services to * * * [petitioner], with respect to certain properties and assets (“Properties”) to be pledged as security, the details of which financing and Properties are to be set out in loan term sheets and attached hereto as Schedule(s) A (“Schedule (s) A”).

The schedule D to be executed in connection with the master agreement states that the transaction was to “Provide Financing and Custodial Services entered into between Derivium * * * and * * * [petitioner]”. Paragraph 3 of schedule D, relating to the pledge of securities, provides, in pertinent part:

[135 T.C. 29]

[Petitioner] understands that by transferring securities as collateral to * * * [Derivium] and under the terms of the * * * [master agreement], * * * [petitioner] gives * * * [Derivium] the right, without notice to * * * [petitioner], to transfer, pledge, repledge, hypothecate, rehypothecate, lend, short sell, and/or sell outright some or all of the securities during the period covered by the loan. * * * [Petitioner] understands that * * * [Derivium] has the right to receive and retain the benefits from any such transactions and that * * * [petitioner] is not entitled to these benefits during the term of a loan. * * * [Emphasis added.]

Derivium also sent to petitioner a document entitled “Schedule A–1, Property Description and Loan Terms” (schedule A 1), which sets forth the essential terms of the transaction. Schedule A–1 provides:

This Schedule A * * *, dated August 6th, 2001, is executed in connection with the Master Agreement to Provide Financing and Custodial Services entered into between Derivium * * * and [petitioner] * * * on 8/6/01.

1. Property Description: 990 shares of International Business Machines Corporation (IBM).

2. Estimated Value: $105,444.90 (as of 8/6/01, at $106.51 per share).

3. Anticipated Loan Amount: 90% of the market value on closing, in part or in whole.

4. Interest Rate: 10.50%, compounded annually, accruing until and due at maturity.

5. Cash vs. Accrual: All Dividends will be received as cash payments against interest due, with the balance of interest owed to accrue until maturity date.

6. Term: 3 years, starting from the date on which final loan proceeds are delivered on the loan transaction.

7. Amortization: None.

8. Prepayment Penalty: 3 year lockout, no prepayment before maturity.

9. Margin Requirements: None, beyond initial collateral.

10. Non–Callable: Lender cannot call loan before maturity.

11. Non–Recourse: Non-recourse to borrower, recourse against the collateral only.

12. Renewable: The loan may be renewed or refinanced at borrower's request for an additional term, on the maturity date, within * * * [Derivium's] prevailing conditions and terms for loans at the time of renewal or refinancing. On the renewal or refinancing of any loan for which 90% of the collateral value at maturity does not equal or exceed the payoff amount, there will be a renewal fee, which will be calculated as a percentage of the balance due at maturity of this loan. The percentage will vary according to the market capitalization of the securities at the time of the renewal or refinancing, as follows: Large Caps at 4.5%, Mid Caps at 5.5%, Small Caps at 6.5%.

[135 T.C. 30]

13. Closing: Upon receipt of securities and establishment of * * * [Derivium's] hedging transactions.

Before entering into the agreement with Derivium, petitioner reviewed a memorandum dated December 12, 1998, from Robert J. Nagy, who claimed to be a certified public accountant, to Mr. Cathcart regarding the “Tax Aspects of First Security Capital's 90% Stock Loan” that was requested by Mr. Cathcart. In the memorandum Mr. Nagy describes a potential client as one who owns publicly traded stock with a low basis, which if sold would result in significant gain to the client. Mr. Nagy describes the primary issue as whether the 90–percent–stock–loan transaction is a sale or a loan and opines that, although there is no “absolute assurances that the desired tax treatment will be achieved”, there is a “solid basis for the position that these transactions are, in fact, loans.” Petitioner relied on Mr. Nagy's memorandum to Mr. Cathcart in deciding whether to enter into the agreement. Petitioner testified that a loan versus a sale transaction made economic sense to him because the loan proceeds given to him were 90 percent of the value of the IBM stock whereas if he had sold the stock he would have had to pay 20 percent for taxes.

Petitioner decided to enter into the 90–percent–stock–loan program (transaction) with Derivium. Petitioner signed the master agreement, the schedule D, and the schedule A–1 on August 8, 2001. Charles D. Cathcart, as president of Derivium, signed the master agreement and the schedule A–1 on August 10, 2001.

On or about August 9, 2001, petitioner instructed Brian J. Washington of First Union Securities, Inc., to transfer 990 shares of IBM common stock (IBM stock or collateral) to Morgan Keegan & Co. (Morgan Keegan) and to credit Derivium's account. On August 16, 2001, Morgan Keegan credited Derivium's account with the IBM stock transferred from petitioner. The following day, August 17, 2001, Derivium sold the 990 shares of IBM stock held in its Morgan Keegan account for $103,984.65 (i.e., $105.035 per share of IBM common stock). The net proceeds from Derivium's sale of the IBM stock were $103,918.18 (i.e., $103,984.65 minus a $3.47 “S.E.C. Fee” and a $63 “Commission”). On August 22, 2001, the net proceeds from the sale of the IBM stock settled into Derivium's Morgan Keegan account.

[135 T.C. 31]

On or about August 17, 2001, Derivium's operations office sent to petitioner two documents. The first document, entitled “Valuation Confirmation”, indicates that Derivium had received the IBM stock into its Morgan Keegan account valued at $104,692.50 (at a “Price per Share for Valuation” of $105.75). Thus, Derivium projected the...