FAYLOR v. Commissioner, Docket No. 65255.
| Decision Date | 16 July 1963 |
| Docket Number | Docket No. 65255. |
| Citation | 1963 TC Memo 190,22 TCM (CCH) 918 |
| Parties | William O. Faylor and Kathryn Faylor v. Commissioner. |
| Court | U.S. Tax Court |
Norman A. Peil, Jr., and Michael Kivko, 430 Market St., Sunbury, Pa., for the petitioners.
Dennis C. DeBerry and Max J. Hamburger for the respondent.
Memorandum Findings of Fact and Opinion
Respondent has determined a deficiency in petitioners' income tax for the calendar year 1953 in the amount of $82,828.80. Certain minor adjustments have not been contested, and the issues remaining for decision are: (1) whether petitioners are entitled to deduct as interest certain payments made during 1953 to Republic National Life Insurance Company in the total amount of $91,806.72; and (2) whether the limestone mined by petitioners' partnership in its fiscal year ending in 1953 qualified for the 15 percent depletion rate provided for "chemical grade limestone" and "metallurgical grade limestone."
Some of the facts have been stipulated and are so found.
William O. Faylor and Kathryn Faylor are husband and wife and are residents of Middleburg, Pennsylvania. They filed a joint Federal income tax return for the year 1953 with the director of internal revenue at Philadelphia, Pennsylvania.
During the year 1953 petitioner William O. Faylor (hereinafter referred to as Faylor) was an executive of Middlecreek Paving, Inc., and Middlecreek Construction Company in Middleburg, Pennsylvania. During the same year petitioners, Faylor and Kathryn Faylor, were copartners engaged in the business of quarrying and processing limestone for sale under the name of Faylor Lime & Stone Company.
In the spring of 1953, Faylor conferred with an insurance agent who discussed with him the desirability of purchasing annuities which could be financed through borrowing. The agent pointed out the tax benefits to be obtained through the deduction of interest paid on such borrowings and showed Faylor copies of a number of favorable unpublished internal revenue letter rulings relating to the deduction of interest paid on loans to be used to obtain annuities. None of these rulings was addressed to Faylor, but all were addressed to other taxpayers whose names were deleted.
The possibility of providing for the future of his three children, all of whom were teenagers, appealed to Faylor. He felt that the program outlined by the agent fitted his situation well because it could be commenced with a minimum cash investment on his part and therefore would not jeopardize his businesses by taking from them cash needed in their operation. Although not the only consideration, the assumed deductibility for Federal tax purposes of "interest" payments on "loans" was a crucial factor in a decision made by Faylor to proceed with the program suggested to him.
Pursuant to said decision, Faylor executed applications late in October of 1953 for the purchase of three separate annual-premium nonparticipating deferred annuity contracts, in the face amount of $250,000 each, to be written by the Republic National Life Insurance Company of Dallas, Texas (hereinafter referred to as Insurance Company). Each of Faylor's three children, Sara L. Faylor, William O. Faylor, Jr., and Elizabeth K. Faylor, who were 14, 13, and 13 years of age, respectively, was to be designated as the annuitant under one of the three contracts. Faylor, who was 42 years of age at the time, was to be named the owner of each contract, reserving all rights under the same.
The applications, accompanied by Faylor's personal check dated October 29, 1953, in the amount of $30,000, were sent to the insurance agent, who in turn forwarded them to Insurance Company's general agent. The $30,000 represented one year's advance premium of $10,000 on each of the annuity contracts.
Pursuant to said applications Insurance Company issued three annuity contracts dated November 6, 1953, as follows:
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First Monthly
Contract Payment Life Annuity
No. Annuitant to Annuitant Provided
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112002 Sara L. Faylor ............. Nov. 6, 1994 $2,798.16
112003 William O. Faylor, Jr. ..... Nov. 6, 1994 2,949.34
112004 Elizabeth K. Faylor ........ Nov. 6, 1994 2,764.11
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Faylor was named the owner of the contracts, all of which were forwarded to Philadelphia National Bank (hereinafter referred to as PNB) as agent for Insurance Company in handling the transaction.
A number of steps were thereafter taken to complete the program outlined to Faylor by the insurance agent. All of the steps were part of an integrated and pre-conceived plan considered by Faylor to be a "package proposition."
On December 1, 1953, Faylor borrowed the sum of $710,565 from PNB at 4 percent interest, giving his personal demand note therefor. He authorized PNB to pay the proceeds of said loan directly to Insurance Company.
Faylor assigned to PNB as collateral security for said loan the three annuity contracts for which he had applied.
The proceeds of the loan were deposited the same day by PNB directly to Insurance Company's account with PNB. Said proceeds were used by Faylor to prepay 40 annual premiums in full, on a discounted basis, on each of the three annuity contracts.
Upon the payment of the $30,000 for the first year's premiums, plus the $710,565 for the following 40 years' premiums, all the annuity contracts were paid up. At that time the total of their cash or loan values was $760,392.
On or before December 1, 1953, Faylor had applied to Insurance Company to borrow the full $760,392 of cash values. He requested that $710,565 of that amount be paid directly to PNB and that the balance of $49,827 be paid to him.
By loan agreements with Insurance Company executed by Faylor and dated December 1, 1953, Faylor promised to pay Insurance Company the total of $760,392, with interest payable in advance for each year on the anniversary date of the annuity contracts at the per annum rate of 4 percent. Assignments of the annuity contracts to Insurance Company as security for such payment were incorporated in the loan agreements, and it was provided that Faylor's obligations under the agreements could be enforced by Insurance Company only out of said contracts.
As requested by Faylor, $710,565 of the resulting loans from Insurance Company was paid directly to PNB on December 1, 1953, and applied as and for full payment of the loan PNB had made to Faylor in that amount. PNB charged Faylor $78.95 as interest for one day on its loan, plus clearance charges of $473.71.
Faylor received from Insurance Company the remaining total of $49,827 of the proceeds of the loans made against the cash values of the annuity contracts.
On December 1, 1953, Faylor also paid Insurance Company the sum of $59,141.61. This amount was denominated as "prepaid interest" from November 6, 1953, to November 6, 1955, on the loans made by Insurance Company. One-third of this amount was applied to each of the annuity contracts involved. In like manner Faylor paid Insurance Company an additional $32,665.11 on December 26, 1953, denominated as "prepaid interest" from November 6, 1955, to November 6, 1956.
Petitioners claimed an interest deduction on their income tax return for the year 1953 for the total amount of $91,806.72 paid Insurance Company by Faylor during December of 1953 as "prepaid interest."
As a result of the payments of "prepaid interest" on December 1 and 26, 1953, the cash values of the annuity contracts increased in amounts totaling $19,692 over the initial $760,392 total which had been borrowed by Faylor against the contracts. On December 28, 1953, Faylor borrowed $19,689 of said increase from Insurance Company, executing new loan agreements identical in all material respects to the initial loan agreements (which they replaced) except for the new requirement of payments totaling $780,081.
On December 28 of the following year, Faylor paid Insurance Company the sum of $66,971.04 as "prepaid interest" from November 6, 1956, to November 6, 1958, on the loans totaling $780,081. As a result of said payment in 1954, there was a further increase in the cash values of the annuity contracts in the total amount of $40,290.
On December 28, 1954, Faylor borrowed from Insurance Company a total of $29,919 of the $40,290 increase in cash values generated by his payment of that date. Again he executed new loan agreements identical in all material respects to the previous loan agreements, except for the new requirement of payments totaling $810,000, the total amount of his outstanding loans from Insurance Company as of that date. Faylor did not borrow the full amount of the increase in cash values at that time because he wanted to create equities in the annuity contracts for his children.
The following table shows the total cash values of the contracts and the total amounts of the loans made against said policies as of the times indicated:
Total Cash Total
Date Values Loans
December 1, 1953 ... $760,392 $760,392
December 28, 1953 ... 780,084 780,081
December 28, 1954 ... 820,374 810,000
Faylor made no further "prepayments of interest" to Insurance Company after 1954 because, as a result of an examination of petitioners' income tax return for the taxable year 1953, he became aware that the Commissioner questioned the deductibility of the payments of "prepaid interest." If Faylor had believed in 1953 that the "prepaid interest" payments would not be...
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