McLane v. Comm'r of Internal Revenue, Docket Nos. 4697-63

• Decision Date: 29 April 1966
• Docket Number: 4698-63.,Docket Nos. 4697-63
• Parties: W. LESS McLANE, JR., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENTNOLA MCLANE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

46 T.C. 140

W. LESS McLANE, JR., PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENTNOLA MCLANE, PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket Nos. 4697-63

4698-63.

Tax Court of the United States.

Filed April 29, 1966.

Thaddeus Rojek, for the petitioners.

Francis J. Cantrel, for the respondent.

1. Held, legislative history of statutory prohibition against deduction of interest on loans to purchase multiple-premium annuities does not allow a deduction arising from transaction occurring prior to effective date of such legislation, where the transaction lacks economic substance.

2. Held, further, there was no unjust discrimination arising from petitioner's alleged reliance on earlier rulings issued to others by respondent and public statements by respondent.

TANNENWALD, Judge:

Respondent determined deficiencies in the 1958 Federal income tax of petitioner W. Lee McLane, Jr., of $10,073.19 and in the 1958 Federal income tax of petitioner Nola McLane of $10,075.86. The cases were consolidated for trial. The only issue for decision is whether certain amounts paid during 1958 are deductible as interest.

FINDINGS OF FACT

Some facts are stipulated and are found accordingly.

Petitioners were husband and wife and resided in Phoenix, Ariz., during the year in issue. Their Federal income tax returns were prepared on the cash method of accounting and timely filed with the district director of internal revenue, Phoenix, Ariz. Since Nola is a party herein only by reason of Arizona's system of community property, any subsequent reference to petitioner shall mean W. Lee McLane, Jr.

From 1946 through 1958 petitioner was an attorney with a practice limited to tax matters.

In 1952 petitioner was first retained to give advice regarding the deductibility for Federal income tax purposes of interest payments on loans obtained pursuant to purchase of certain annuities. Subsequently, he represented several taxpayers involved in similar transactions (including the taxpayers in Knetsch v. United States, 364 U.S. 361 (1960), before the Supreme Court). He became aware of ‘private,‘ but nevertheless well-publicized, rulings issued by respondent in 1952 to two separate taxpayers stating that interest paid and/or prepaid on certain loans used to purchase single-premium and multiple-premium annuities was deductible in the year of payment for cash basis taxpayers. In 1954 respondent publicly changed his position on single-premium annuities and ruled, in Rev. Rul. 54-94, 1954-1 C.B. 53, that interest paid on loans used for such purchase was not deductible. In another well-publicized private ruling issued that same year, respondent stated that Rev. Rul. 54-94 did not apply to the facts of the 1952 private ruling dealing with multiple-premium annuities.

Petitioner engaged in certain transactions with All Service Life Insurance Corp. (hereinafter referred to as All Service), which, in form, are as set forth in subsequent paragraphs.

On December 29, 1958, petitioner applied to All Service for the issuance of six ‘Retirement Life Annuities with Ten Years Payment Certain.‘ The premium for each annuity was $210,000, payable $35,000 each year for 6 years. Petitioner's certified check in the amount of $1,200 accompanied the applications, representing payment of $200 on account of the first annual premium of $35,000 for each policy.

On three of the policies, the annuitant was petitioner's daughter Martha Ann, who was just short of 11 years of age, having been born on February 16, 1948. On the other three policies, the annuitant was petitioner's daughter Susan Lee, who was just shor of 7 years of age, having been born on February 9, 1952. Petitioner's wife, Nola, was the contingent beneficiary on all six policies.

All Service accepted the applications and on December 29, 1958, issued the six policies.

Also on December 29, 1958, pursuant to six loan agreements, All Service agreed to loan petitioner a total of $208,800, or $34,800 on each policy, with interest payable in advance at a rate of 3 percent per annum but discounted at the rate of 2.25 percent per annum, compounded annually, for interest paid more than 1 year in advance. Pursuant to petitioner's instructions, All Service applied the proceeds of each loan to payment of the balance of the first annual premium due on each of the six policies. At the same time, petitioner delivered to All Service a certified check in the sum of $35,576.10 in accordance with the provisions of the agreements requiring prepayment of 6 years' interest.

At the time that petitioner entered into the transactions with All Service in December 1958, he contemplated systematic borrowing of part or all of the cash values of the policies and use of the borrowed funds to meet the premiums thereon as they came due.

The cash surrender value of the six policies after payment of the first year's premiums was $215,588.70.

The reserve value of the six policies at the end of the first policy year was $215,775.

One week later, on January 5, 1959, All Service agreed to loan to petitioner a total of $37,824 (or $6,304 on each policy), pursuant to six loan agreements, each requiring the prepayment of 6 years' interest at the rate of 3 percent per annum, with interest paid for more than 1 year in advance discounted at the rate of 2.25 percent per annum, compounded annually. In accordance with petitioner's instructions, the entire proceeds of the loan were paid to him. Petitioner was able to borrow an amount in excess of the cash surrender value because of the credit to which he was entitled under the loan agreements for interest prepaid for the years subsequent to the first year.

On January 5, 1959, petitioner paid to All Service, by certified check, the sum of $6,422.76, representing prepaid interest on the loan of $37,824.

On November 19, 1959, All Service's books showed a credit to petitioner's account, as a consequence of the prepayment, of unearned, refundable interest in the amount of $34,622.04. On the same date, and less than 11 months after the policies were issued to him, petitioner surrendered all six policies to All Service for cancellation. All Service applied the cash surrender value of the policies in reduction of petitioner's loans secured by the policies. The remaining unpaid liability of petitioner was satisfied out of the unearned, refundable interest due him, and the remaining balance of the unearned, refundable interest, amounting to $3,557.22, was paid to him by All Service.

As of November 19, 1959, the date of the cancellation of the six policies, petitioner was ‘out of pocket‘ $1,817.64 as a result of these transactions.

At no time was petitioner or Nola McLane personally liable for either the payments of any premiums due on the six policies or for the payment of any funds allegedly borrowed to pay premiums and/or interest.

On the individual Federal income tax return filed by him for the calendar year 1958, petitioner claimed a deduction in the amount of $17,788.05 as ‘interest‘ paid to All Service. On the individual Federal income tax return filed by her for the calendar year 1958, petitioner Nola McLane claimed a deduction in the amount of $17,788.05 as ‘interest‘ paid to All Service. Respondent disallowed both of said claimed deductions.

In 1958 petitioner's purported purchase of the six policies from All Service, borrowing of funds from All Service, and payment of interest to All Service on such loans lacked substance and constituted sham transactions.

OPINION

With refreshing candor, petitioner appears to concede that the transactions involved herein lacked substance¹ and that in this respect this case is controlled by Knetsch v. United States, 364 U.S. 361 (1960), and Amor F. Pierce, 37 T.C. 1039 (1962), affirmed per curiam 311 F.2d 894 (C.A. 9, 1961), certiorari denied 373 U.S. 912. He argues, however, that, notwithstanding the absence of substance, Congress evidenced an intent to allow the deduction for interest under the circumstances involved herein for transactions entered into prior to August 7, 1963. Respondent asserts that the absence of substance is determinative. The parties have also locked horns on petitioner's claim that respondent has unfairly discriminated between him and other taxpayers similarly situated.

In order to justify his deduction for interest, petitioner has developed his arguments with the skill of a tightrope artist. Perhaps if petitioner were merely seeking to have us repair a hole in his safety net, his arguments would have some merit. We will not, however, manufacture the entire net, as petitioner would have us do.² The glove of Knetsch and Pierce fits petitioner's hand perfectly.

The history of the provisions dealing with the deductibility of interest on indebtedness incurred or continued to carry insurance reflects the constant ‘push‘ by Congress to keep abreast of the ‘pull‘ of ingenious schemes to take advantage of loopholes.³ Congress spoke confidently in 1942 of closing a ‘loophole‘ through the enactment of the predecessor of section 264,⁴ see H. Rept. No. 2333, 77th Cong., 2d Sess., p. 47, 194202 C.B. 372, 410, but it later found that taxpayers were accomplishing through the use of single-premium annuities what the 1942 provision had rendered unattainable through the use of single-premium life insurance and endowment contracts. See H. Rept. No. 1337, 83d Cong., 2d Sess., p. 31 (1954); S. Rept. No. 1622, 83d Cong., 2d Sess., p. 38 (1954). Thus, in subsection (a)(2) of section 264, Congress in 1954 ended the tax benefit which had been obtainable through the use of single-premium annuities. Again, as in 1942, the ‘loophole-closing‘ of 1954 sired another loophole, this time in the form of multiple-premium annuities, and by 1956 Congress realized that the barn door had not been closed on this loose horse. Press Release, Subcommittee on Internal Revenue Taxation, House Committee on Ways and Means, Nov. 7, 1956; Hearings before...