Lynch v. CIR

• Decision Date: 17 December 1959
• Docket Number: 149,Docket 25821,25822.,No. 148,148
• Citation: 273 F.2d 867
• Parties: George G. LYNCH and Marian T. Lynch, Petitioners-on-Review, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-on-Review. Leslie JULIAN and Pearl A. Julian, Petitioners-on-Review, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-on-Review.
• Court: U.S. Court of Appeals — Second Circuit

273 F.2d 867 (1959)

George G. LYNCH and Marian T. Lynch, Petitioners-on-Review, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-on-Review.

Leslie JULIAN and Pearl A. Julian, Petitioners-on-Review, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-on-Review.

Nos. 148, 149, Docket 25821, 25822.

United States Court of Appeals Second Circuit.

Argued November 19, 1959.

Decided December 17, 1959.

Leland T. Atherton, Hartford, Conn. (Henry L. Shepherd, Hartford, Conn., and Shepherd, Murtha & Merritt, Hartford, Conn., on the brief), for petitioners-on-review.

Grant W. Wiprud, Washington, D. C. (Charles K. Rice, Asst. Atty. Gen., Lee A. Jackson and J. Dwight Evans, Jr., Washington, D. C., on the brief), for respondent-on-review.

Before MEDINA, MOORE and FRIENDLY, Circuit Judges.

FRIENDLY, Circuit Judge.

These are petitions to review two decisions of the Tax Court, 31 T.C. 990 and 998, adverse to the taxpayers. Both cases arise out of a plan for reducing income taxes by deductions for the alleged payment of interest on loans to finance the purchase of Government bonds, which was devised by M. Eli Livingstone. Decisions favorable to the government in cases at least broadly similar have been rendered by the Court of Appeals for the First Circuit in Goodstein v. Commissioner, 1958, 267 F.2d 127 and Sonnabend v. Commissioner, 1 Cir., 1958, 267 F.2d 319, affirming respectively 30 T.C. 1178 and 1958 P-H T. C. Memorandum Decisions, par. 58,178, and by the Court of Claims in Broome v. United States, 1959, 170 F.Supp. 613. Taxpayers contend that these cases were wrongly decided and also that an important distinction of fact exists. In addition they advance an alternative contention that does not appear to have been raised in Broome, namely that even if their claims for interest deductions under § 23(b) of the Internal Revenue Code of 1939, 26 U.S.C.A. § 23(b) (Int.Rev.Code of 1954, § 163(a), 26 U.S.C.A. § 163(a)) should be held to have been properly denied, the same amounts ought to have been allowed as deductions under § 23(a) (2) as "ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income." Although we have come to the same conclusion as the Tax Court, the First Circuit and the Court of Claims, we shall state our views, in response to taxpayers' request that we do so and also because other variations on the Livingstone theme may arise in this Circuit.

Taxpayers were co-owners and principal executives of the Bristol Machine Tool Company in Bristol, Connecticut. Lynch's function was "to run the shop completely, including sales and everything else that goes with it." Julian did "engineering, office work, taxes and so forth." In 1953 Lynch received salary and dividends from the Company totaling $134,435.32 and had other income of $2,240.04; Julian received salary and dividends of $134,867.32 and had other income of $4,737.90.

M. Eli Livingstone was a security dealer in Boston doing business under the name of Livingstone & Company. He developed a plan that offered high income taxpayers the enticing prospect of reducing or indeed almost eliminating income taxes, at relatively modest cost to themselves and at a pleasant profit to Livingstone. An essential part of this plan was the making of loans from various so-called finance companies. Gail Finance Corporation was one of these. It was organized on October 30, 1953 with a total capital contribution of $1,000. It and five similar companies had their quarters in the Boston law office of Harry N. Cushing, a longtime friend and former law partner of Livingstone. Cushing was president or treasurer of all of them. None had telephone or address listings.

Julian testified that in 1953 he was discussing the possibility of a pension plan for his Company with his lawyer, Judge Frederick W. Beach, of Bristol, who recommended consulting Gustave Simons, an attorney and business consultant of New York City. Discussions with Simons, Beach and taxpayers' accountant, Howard L. Page, led to the series of actions hereinafter described:

(1) On or about December 2, 1953, Livingstone & Company loaned each taxpayer $80,000. The loans were unsecured and non-interest-bearing. The Tax Court found the loan to Julian was not evidenced by any written document, and we see nothing to indicate there was any written document to evidence the loan to Lynch.

(2) On December 3 Livingstone sent each taxpayer confirmations of the sale to the taxpayer at 86 7/8 of $650,000 face value United States Treasury 2¾% Notes due September 15, 1961 with March 15, 1959, and subsequent coupons attached.¹ The purchase price in each case was $564,687.50. Livingstone charged no commission on the sale.

(3) On the same day, December 3, each taxpayer executed a non-recourse promissory note to Gail for $653,250, payable September 15, 1958, secured by the Treasury Notes described in item (2). The promissory note recited that interest in the amount of $117,677.11 had been prepaid. The maker had the right to anticipate payment in whole or in part; in that event he was to receive back a prorated portion of the collateral but was to be charged interest at the rate of 1% prorated against the amount paid by anticipation.

(4) On the same date, December 3, each taxpayer drew a check to Gail for $117,677.11. The funds for this were provided by the $80,000 loan from Livingstone, item (1), and, at least in Lynch's case, by a $40,000 loan from his Company.

(5) On the same date, December 3, each taxpayer instructed Livingstone & Company to deliver the Treasury Notes to Gail against payment of $653,250, the stated proceeds of taxpayer's "loan" from Gail, to reimburse itself in the amount of $564,687.50 and to remit the difference, $88,562.50, to taxpayer.

(6) When Gail purported to "loan" each taxpayer $653,250 it had only $1,381.65 cash on hand. It purportedly raised most of the funds required for the "loans" by selling short, to or through Livingstone & Company, the identical type and amount of Treasury Notes petitioners had purchased from Livingstone and pledged with Gail, for the same price, $564,687.50, that petitioners had agreed to pay.² In fact, no Treasury Notes were ever delivered by Livingstone to Gail for petitioners' account. Neither were any amounts ever paid by Livingstone to Gail on Gail's "short sale" of Treasury Notes or by Gail to Livingstone to cover petitioners' purchase. This was because Livingstone owed Gail $564,687.50 on the "short sale" whereas Gail was bound to pay Livingstone the same amount out of the "loans" made by Gail to petitioners. Similarly, Gail was bound at some time to deliver Treasury Notes to Livingstone to cover the "short sale" whereas Livingstone was obligated to deliver to Gail the same amount of Treasury Notes allegedly sold to petitioners. The various liabilities thus cancelled each other.

(7) On or about December 7, Gail sent each taxpayer a check for $88,562.50. See item (5).

(8) On or about December 10, each taxpayer repaid Livingstone the $80,000 referred to in item (1).

When the week's work was completed, what was left was this: Each taxpayer was out of pocket in the sum of $29,114.61, the excess of the alleged prepayment of $117,677.11 "interest," item (4), over the repayment of $88,562.50 by which the "loan" exceeded the purchase price of the Notes, item (7). Each taxpayer had a contractual right to require Gail to deliver the $650,000 of Treasury Notes described in item (2) against payment of $653,250, with a further right to anticipate payment on the terms stated in item (3). In other words taxpayers for their payment of $29,114.61³ had obtained a call on Gail for these Notes. What they also thought they had were deductions for prepaid interest which reduced Lynch's income tax liability from $83,947.48 to $4,066.16 and Julian's from $83,132.46 to $3,605.94. Whether they in fact obtained these deductions is the issue here.

The government urges that the interest deductions are forbidden by Gregory v. Helvering, 1935, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596, which the government construes as establishing a doctrine forbidding generally the recognition for tax purposes of transactions entered into for the sole purpose of tax avoidance. The taxpayers counter with a contention that the principle of Gregory v. Helvering does not apply to the deduction of interest under § 23(a) (2) of the 1939 Code, since § 23(a) (2) permits the deduction of interest paid or incurred for personal as well as for business purposes. And while they concede that tax avoidance was an important motive for the transactions, they deny it was the sole one and claim they were also interested in the possibility of appreciation in the Treasury Notes.

Taxpayers' contentions meet serious obstacles. We said in C. I. R. v. Transport Trading & Terminal Corp., 2 Cir., 1949, 176 F.2d 570, 572, certiorari denied 1950, 338 U.S. 955, 70 S.Ct. 493, 94 L.Ed. 589 that the doctrine of Gregory v. Helvering is not limited to cases of corporate reorganizations. Of course any application of the doctrine of Gregory v. Helvering to § 23(b) would have to recognize that the interest deduction extends to...