Golsen v. Commissioner

*743 The Commissioner determined a deficiency of $ 2,918.15 in petitioners' income tax for 1962. The only issue is whether a $ 12,441.40 payment made by petitioner Jack E. Golsen to the Western Security Life Insurance Co. is deductible as an interest payment pursuant to section 163, I.R.C. 1954.

FINDINGS OF FACT

The parties have stipulated *168 certain facts, which, together with the attached exhibits, are incorporated herein by this reference.

Petitioners Jack E. and Sylvia H. Golsen are husband and wife. They filed a joint Federal income tax return for the calendar year 1962 with the district director of internal revenue, Oklahoma City, Okla., and resided in Oklahoma City at the time the petition was filed in this case.

During the latter part of 1961 and during 1962, Jack E. Golsen (Golsen) served as president of Hart Industrial Supply Co. and several affiliated corporations. The corporations were privately owned and did business in Texas and Oklahoma. By the end of 1961 the corporations had incurred indebtedness to banks in the aggregate amount of about $ 1.75 million, and Golsen had personally guaranteed all of it. Golsen was also personally indebted to a bank in the amount of $ 15,000. Moreover, during 1961 he had purchased 50 percent of the stock of the L & S Bearing Co. for approximately $ 625,000.

In December of 1961, Golsen carried about $ 230,000 in life insurance protection. In addition, several of the corporations whose loans he had guaranteed had taken out insurance on his life. However, in view of the size *169 of his potential liabilities and his relatively illiquid financial position in late 1961, Golsen thought that he ought to purchase additional life insurance to protect his family in the event of his unexpected death.

On or about December 28, 1961, an application was made to Western Security Life Insurance Co. of Oklahoma City (hereinafter sometimes referred to as Western or the insurance company) for insurance on Golsen's life. The application requested insurance in the total amount of $ 2 million to be embodied in 40 "executive special" policies of $ 50,000 each, with Mrs. Golsen as the beneficiary and the couple's three children as contingent beneficiaries. No cash was submitted with the application.

Subsequently, on or before January 31, 1962, Western issued to Golsen such life insurance in the amount of $ 1 million embodied in 20 "executive special" policies, each with a face amount of $ 50,000 and *744 an effective date of December 28, 1961. ^1*170 On the date of issue Golsen was 33 years old and had a life expectancy of 35.15 years.

The "executive special" policies appeared on their face to be whole life policies, providing for aggregate premiums of $ 68,180 a year for the first 20 years and $ 18,180 (reflecting a reduction of $ 50,000) a year thereafter. The premiums during the first 20 years were substantially higher than were actuarially required, and consequently the aggregate amount payable on death ("death benefits") as well as the cash surrender and loan values increased substantially during each of the first 20 years. The following table shows by policy year, the total death benefits, cash or loan values, and the net death benefits remaining if loans in the maximum permissible amounts were made against the policies:

Interest on policy loans was payable at the rate of 4 percent a year.

The "executive special" policies implemented an insurance program embodying the following principal elements: First, the insured would "borrow" ² from Western the entire amount of the first-year loan value, which he would use simultaneously to pay the greater part of the first year's premium. Second, he would at the same time "borrow" a much larger sum from Western, and with most of the proceeds of the "loan" he would simultaneously establish a so-called "prepaid *745 premium fund" in the amount of the present value of the aggregate annual premiums for the following 4 years, discounted at an annual rate of 3 percent. Western would undertake to pay interest on the "prepaid premium fund" at the rate of 3 percent a year, and that fund, when supplemented by the interest increments paid by Western, would be sufficient at each of the next four anniversary dates of the policies to pay the annual aggregate premium of $ 68,180. Third, at the beginning of the first year, the insured would simultaneously pay in advance that *172 year's 4 percent "interest" on the sums he "borrowed." Fourth, as the "prepaid premium fund" was reduced each year thereafter by the purported payment of premiums therefrom for such year, the insured would in turn "replenish" the fund by a "prepayment" in respect of the premiums to become due 4 years thereafter. The amount thus to be added to the fund each year was $ 60,577.90, which, at 3-percent compound interest was expected to increase to $ 68,180 4 years thereafter and accordingly be sufficient to pay the premiums falling due at that time. Fifth, each year after the issuance of the policies, the insured would "borrow" the full amount of the increase in the loan value of the policies for that year, which would be greater than the $ 60,577.90 added to the "prepaid premium fund" (see col. 3 of table p. 744 supra), and he would simultaneously use part of the proceeds of such "loan" to pay the full amount of $ 60,577.90 to be added to the "prepaid premium fund" and would use the balance to pay part of the annual "interest" charges on his growing indebtedness to Western. Sixth, thus, after the first year, no part of the insured's out-of-pocket costs would be allocable to premiums, *173 and, as a consequence of treating the "interest" as deductible, the insured's actual cost of the insurance purchased by him would either be comparatively nominal or result in a net profit to him. The insured would never be personally liable on any of his "loans," the policies would never in fact have any cash surrender value as a result of the "loans," and the death benefits would be those shown in the last column of the table at page 744 supra.

Prior to acquisition of the policies Golsen was furnished with a schedule (based upon assumed insurance in the amount of $ 100,000) outlining the mechanics of the "executive special" plan. The schedule showed that under the plan there would be no net cash premium outlay after the first year and that if the "interest" payments were *174 treated as deductible for income tax purposes, the actual net cost of the insurance over the first 20 years to the taxpayer at an assumed tax bracket would be a comparatively nominal amount, and in some years there might even be a net profit. That schedule (when multiplied by 10 so as to conform to the $ 1 million insurance involved herein) in general reflects the plan which Golsen and Western ultimately adopted. It is set forth below: *746

*175 *747 In terms of the particular data appearing thereon the schedule was based upon a plan purporting to provide for a whole life policy with the following features:

(1) increasing death benefits for the first 20 years (col. (9));

(2) an increasing "guaranteed cash value" which would be available for "borrowing" or cash surrender by the insured (col. (2));

(3) establishment in the first policy year of a "prepaid premium fund" (col. (3));

(4) maintenance thereafter of a level "prepaid premium fund" by annual prepayment of a premium four years in advance (col. (3));

(5) availability of the prepaid premium fund, as a supplement to the "guaranteed cash value" of the policy, for additional "borrowing" by the insured (col. (4));

(6) annual "borrowing" by the insured of amounts sufficient to exhaust the total amount available for loans (the sum of the prepaid premium fund and the guaranteed cash value) (cols. (4) and (5));

(7) allocation of a portion of each annual "loan" to the insured's annual premium prepayment and use of the remainder of such "loan" to offset in part his annual "interest" payments on his outstanding "loan" (cols. (5) and (10) and fig. (a));

(8) annual payments by the insured which, *176 after the first year, were to be designated exclusively as "interest" payments on the then outstanding "loan" (cols. (6) and (7)); and

(9) deductibility of the insured's annual payments as interest payments for Federal income tax purposes (col. (8)). ³

As previously stated, Western issued 20 "executive special" policies, or contracts of insurance, to Golsen in the aggregate face amount of $ 1 million. Pursuant to the "executive special" plan, the following occurred on or about January 31, 1962, i.e., on the first date on which any payments were made in respect of the policies.

(1) Golsen issued a check in the amount of $ 321,611.90 to Western purportedly in payment of the first year's premium of $ 68,180 for the policies, plus a "prepayment" of $ 253,431.90 to create the "prepaid premium fund" which, when supplemented by the 3-percent interest accumulating thereon, would be sufficient to pay the next four annual premiums on the policies.

(2) Golsen "borrowed" *177 from Western the full cash value of each policy, or a total of $ 50,000.

(3) Golsen also "borrowed" an additional $ 261,033.90 from Western making a total of $ 311,033.90 "borrowed" from Western. ⁴ "Interest" *748 was payable on this entire "indebtedness" at the rate of 4 percent a year.

(4) In accordance with (2) and (3), Western issued a check to Golsen in the amount of $ 311,033.90.

(5) Golsen "paid" Western $ 12,441.40 by check, purportedly as four percent "interest" on the aggregate of $ 311,033.90 *178 "borrowed" from Western.

(6) The foregoing $ 12,441.40 check cleared the bank on February 2, 1962.

On the date Golsen's $ 321,611.90 check was written, there were not sufficient funds in petitioners' bank account to cover the check; payment thereof was dependent on the deposit of Western's $ 311,033.90 check.

Golsen's actual out-of-pocket expense in regard to this transaction was $ 10,578 of amounts designated as "premiums" or "advance premiums" plus the $ 12,441.40 "interest" which is here in issue.

Attached to each contract were two form documents entitled "Receipt and Prepayment of Premiums Agreement" (prepayment Agreement) and "Loan Agreement and Assignment of Policy" (Loan Agreement). The Prepayment Agreement form was executed by the president and secretary of Western and provided in part as follows:

Western Security Life Insurance Company acknowledges the receipt of $ 12,671.59 as prepayment of premiums under this policy.

It is hereby agreed that in the event of the death of the Insured or application for any of the non-forfeiture benefits of said policy, all premiums paid beyond the current policy year will be commuted at 3% per annum compound interest. Such commuted amount will *179 be paid as a part of the proceeds of the policy in the event of death or in the event of the application for non-forfeiture benefits will be returned to the owner of the policy.

For the purpose of making loans on the policy, it is understood and agreed that the Company will include the present value of the prepaid premiums as a part of the loan, cash surrender, and reserve value of this policy.

Any indebtedness applicable to this Agreement will be deducted in any settlement due the beneficiary or the owner of this policy.

The Loan Agreement form had been executed by Golsen on December 28, 1961, and provided in part as follows:

LOAN AGREEMENT AND ASSIGNMENT OF POLICY

Pursuant to the provisions of Policy Number * * * issued by WESTERN SECURITY LIFE INSURANCE COMPANY of Oklahoma City, Oklahoma, on the life of Jack E. Golsen (The Insured), in consideration of a loan of Three Hundred Eleven Thousand Thirty Three and 90/100 Dollars ($ 311,033.90) by said Company, the receipt of which is hereby acknowledged, the undersigned hereby pledges, assigns, and transfers to said Company, its successors and assigns, said Policy and all rights and benefits thereunder, to secure the payment of said loan *749 *180 and the interest thereon and any other indebtedness to the Company on said Policy.

AUTOMATIC PREMIUM LOAN FOR PREPAYMENT OF PREMIUMS: The insured requests the Company, on each anniversary of the above numbered policy, to advance so much of the net cash value as is available at that time towards the prepayment of the next unpaid annual premium and agrees that any sum so advanced towards prepayment of said premium shall be an additional loan on said policy; provided, however that any sum advanced toward the prepayment of any premium or premiums due one or more years from such anniversary shall be maintained by the Company as deposit for the payment of such premiums when due and the said deposit, or balance thereof, will be credited with interest on each subsequent anniversary at the rate of three percent (3%) per annum, compounded annually.

It Is Hereby Agreed by the Undersigned:

First -- That interest shall be paid to said Company in advance at the beginning of each policy year, at the rate of 4% per annum on the amount of said loan, and that said interest, if not paid when due, shall be added to the principal and bear interest at the same rate and under the same conditions.

The $ 311,033.90 *181 "loan" referred to in the foregoing agreement was composed of $ 50,000, the full first-year loan value of the policies, plus $ 261,033.90 purportedly borrowed by Golsen from Western, as previously described.

On each subsequent year thereafter until the time of the trial herein, Golsen purported to borrow the entire amount of the annual increase in the cash value of the insurance policies as soon as it became available for borrowing each year. Thus at no time did any of the policies have a cash surrender value. The purported annual borrowing took the form of "loans" to prepay the annual insurance premiums in accordance with the Loan Agreement and a "loan" of the remaining cash value directly to Golsen. A schedule of the approximate total cash values and "loans" on the policies over the policies' first 20 years is set out below: