Sandor v. Comm'r of Internal Revenue

• Decision Date: 03 July 1974
• Docket Number: Docket No. 7791-72.
• Citation: 62 T.C. 469
• Parties: ANDREW A. SANDOR AND JEANNE SANDOR, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

62 T.C. 469

ANDREW A. SANDOR AND JEANNE SANDOR, PETITIONER

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 7791-72.

United States Tax Court

Filed July 3, 1974.

Robert D. Alban, for the petitioners.

George McDonald, for the respondent.

Petitioners, cash basis taxpayers, borrowed $100,000 from a bank to purchase shares in two mutual funds. The loan was evidenced by a note dated Dec. 31, 1968, payable on demand, or if no demand was made, then 5 years after date, with interest at 7 1/2 percent per annum from date until maturity. Petitioners prepaid the interest for the entire 5-year term on Dec. 27, 1968, and deducted the prepaid interest on their 1968 tax return. Respondent disallowed the deduction under sec. 446, I.R.C. 1954, because such deduction would materially distort taxable income for 1968. Held, respondent did not abuse his authority under sec. 446 by disallowing a deduction of the prepaid interest in order to clearly reflect petitioners' income for 1968. Rev. Rul. 68-643, 1968-2 C.B. 76, considered.

DRENNEN, Judge:

Respondent determined a deficiency in petitioners' income tax for the year 1968 in the amount of $27,090.

Petitioners accounted for their income on the cash basis. The deficiency determined by respondent in the notice of deficiency resulted from the disallowance of a deduction for prepaid interest in the amount of $38,021 and disallowance of part of a claimed loss from a partnership. The partnership loss issue has been conceded by petitioner and is not before the Court. The reason stated for disallowance of the prepaid interest deduction was that it was ‘not allowable under section 446 since such deduction would materially distort taxable income for 1968.’

In their petition petitioners allege as error the disallowance of the deduction for interest and also ‘The question of the legality of Revenue Ruling 68-643.’ In his answer respondent simply denied that he had erred as alleged in the petition. The parties stipulated that the issues remaining for the Court's determination are:

(1) Whether petitioners' deduction of 5 years' prepaid interest should be disallowed pursuant to Rev. Rul. 68-643, 1968-2 C.B. 76.

(2) Whether Rev. Rul. 68-643 was a proper exercise of the rule-making authority of the Commissioner.

The parties directed their arguments on brief primarily toward the issues as posed in the stipulation, and we will approach the issues on the same basis, keeping in mind, however, that what we are called upon to decide is whether petitioners may deduct the prepaid interest in 1968 under the law, rather than the abstract question of whether Rev. Rul. 68-643 is valid.

FINDINGS OF FACT

Certain facts have been stipulated and are found accordingly.

Petitioners Andrew A. Sandor and Jeanne Sandor are husband and wife. The petitioners resided in Corona Del Mar, Calif., when the petition herein was filed. They filed a joint Federal income tax return for the taxable year 1968 on the cash method of accounting. Jeanne Sandor is a party solely because she signed the joint return; therefore, Andrew A. Sandor will be referred to as petitioner.

Andrew A. Sandor is a doctor of medicine who specializes in an eye, ear, nose, and throat practice. Besides his medical practice, petitioner was also extremely active in the stock market; he entered buy-and-sell transactions on a daily basis. As a result of this concentrated investment activity, petitioner was eventually forced to curtail his medical practice so he could devote more time to his investment activities. Finally, petitioner reached the point where he was dividing his time equally between his medical practice and his investment activities. Petitioner's tax return for 1968 showed, under the schedule for capital gains and losses, that he entered into approximately 1,500 stock transactions during that year. Petitioner's activity in the stock market was quite profitable in 1968; on his tax return for that year he reported net short-term capital gains from market activities in the amount of $198,829.87 and net long-term capital gains in the amount of $104,166.48.

Petitioner has on numerous occasions borrowed money to help finance his various market activities. He has obtained in excess of 50 loans from the Manufacturers Bank in Los Angeles over the years, and at one time had a line of credit with that bank in the amount of $100,000. The first loan transaction between the petitioner and that bank occurred sometime in 1963.

Manufacturers Bank (hereinafter referred to as the bank) was founded in 1962, and the petitioner was one of its initial shareholders. All of petitioner's dealings with the Manufacturers Bank were through Ronald Hicks. Hicks has been a vice president and commercial loan officer with Manufacturers Bank since its founding in 1962.

Sometime prior to November 26, 1968, petitioner contacted Hicks by telephone concerning a $100,000 loan. It was standard procedure for petitioner to telephone Hicks when he wanted to obtain a loan. Hicks had aided petitioner in obtaining all his loans from Manufacturers Bank, and, therefore, Hicks was well aware that petitioner used the funds for the purpose of entering into stock transactions.

During this telephone conversation, Hicks gave an oral commitment on behalf of the bank for the $100,000 loan to petitioner. The only terms of the loan that were discussed were the amount, $100,000; the duration of the loan, established as 5 years; the rate of interest on the loan; and an understanding that petitioner would prepay in 1968 the entire 5 years of interest. The securities which petitioner purchased with the borrowed funds would constitute the collateral for the loan. However, since petitioner had not chosen the actual securities at the time of this telephone conversation, the parties did not reach an actual agreement that securities purchased with the borrowed funds would be sufficient collateral until sometime subsequent to this initial conversation.

After the oral commitment from Hicks, petitioner commenced investigating possible investments by sending for various mutual fund prospectuses. He reviewed these materials for 4 to 6 weeks and finally selected the Smith Barney Equity Fund, Inc., and the First Multifund of America, Inc., as the two funds in which he intended to invest.

On December 16, 1968, Hicks initialed a standard loan approval form used by Manufacturers Bank authorizing the processing of a loan to petitioner in the principal amount of $100,000 at 7 1/2-percent interest. According to this form, the loan was payable on demand or in 5 years; however, the interest on the note was to be prepaid and a minimum of 90 days' interest was guaranteed. The approval form also required the guarantee of petitioner's wife, stock powers of the First Multifund of America, Inc., and of Smith Barney Equity Fund, Inc., as collateral for the loan, and a request for a current financial statement from petitioner.

Thereafter, petitioner executed a promissory note to the bank in the amount of $100,000 which was dated December 31, 1968, and interest on the note started on that date. The note was payable on demand or, if no demand was made, then 5 years after the date of the note. The entire interest, which was at a rate of 7 1/2 percent per annum, was payable in advance. Petitioner paid the interest for the entire 5-year term of the note in the amount of $38,041.61 by a personal check to Manufacturers Bank, dated December 27, 1968. A notation on this check stated ‘Prepay interest on loan.’

It was normal procedure in loan transactions between petitioner and the bank for the bank to mail the necessary papers to petitioner. None of the paperwork for this loan was executed until December 1968. After the loan approval form was initialed by Hicks on December 16,1968, it was delivered to the loan processers, and they typed the necessary documents and prepared them for the borrower's signature. Petitioners signed what was sent to them by the bank and returned the documents to the bank.

The bank never loaned funds unless a promissory note and additional documents were signed by the borrower. Petitioner never received a loan from Manufacturers Bank without having to sign a promissory note. Had petitioner advised the bank that he did not want the loan at any time prior to the time petitioners executed the note, the bank would have done nothing to force him to take it. If petitioner prepaid the principal of the note at any time prior to its due date, the bank would refund to him the unearned portion of the prepaid interest, except for a minimum of 90 days' interest. The bank considered the prepaid interest as additional collateral to assure repayment of the loan.

By an authorization dated December 19, 1968, petitioner authorized the Manufacturers Bank to forward cashier's checks in the amount of $50,000 each to the Bank of New York and to the Chase Manhattan Bank. Pursuant to this authorization, Manufacturers Bank executed a cashier's check to Chase Manhattan Bank, custodian for First Multifund of America, Inc., in the amount of $50,000, dated December 31, 1968, and a cashier's check to the Bank of New York in the amount of $50,000, dated December 31,1968. The Chase Manhattan Bank purchased $50,000 in shares of First Multifund of America, Inc., for petitioner's account, and the Bank of New York purchased $50,000 in shares of the Smith Barney Equity Fund, Inc., for petitioner's account. First Multifund of America, Inc., confirmed petitioner's purchase of $50,000 worth of its shares by a receipt dated January 6, 1969. Similarly, Smith Barney Equity Fund, Inc., confirmed petitioner's purchase of $50,000 worth of its shares by a receipt dated January 8, 1969.

On their income tax return for 1968 petitioners deducted a total of $38,359 for interest paid to Manufacturers Bank, which included the $38,041.61 paid on December 27, 1968, in connection with this transaction. Respondent disallowed $38,021 of the...