1962 U.S. Tax Ct. LEXIS 219">*219 Decision will be entered under Rule 50.
Gain, predominantly composed of previously earned investment income, realized on transfer for consideration to third person of insurance policies on petitioner's life, held ordinary income notwithstanding transaction may have incorporated sale of a capital asset. Harry Roff, 36 T.C. 818">36 T.C. 818 (1961), followed; Percy W. Phillips, 30 T.C. 866">30 T.C. 866 (1958), distinguished.
37 T.C. 605">*605 Respondent determined a deficiency in income tax for the year 1955 in the amount of $ 14,178.67. The issues remaining for decision are (1) whether the petitioners made1962 U.S. Tax Ct. LEXIS 219">*220 a bona fide sale of life insurance policies and (2), if so, whether the increment or profit realized upon the sale of these policies is taxable as ordinary income.
37 T.C. 605">*606 FINDINGS OF FACT.
Petitioners are a surviving husband and the estate of his deceased wife. A joint income tax return for the calendar year 1955, the period here involved, was filed with the district director of internal revenue at San Francisco, California.
William W. Crocker (hereinafter sometimes referred to as petitioner) is now and has been for many years, including the year 1955, an officer and director of Crocker-Anglo National Bank (formerly Crocker First National Bank of San Francisco), with main offices in San Francisco, California. During the year 1955, petitioner was chairman of the board of directors of Crocker First National Bank. He also was, and is, a director of a number of other corporations.
During the year 1955, petitioner was the owner of the following eight policies of life insurance on his own life:
| Cash value | Increase | ||
| Policy and date of issue | Cost | at assignment | in value |
| Pacific Mutual 401107, July 4, | |||
| 1920 | $ 12,450.00 | $ 16,365.50 | $ 3,915.50 |
| Pacific Mutual 445690, Dec. 28, | |||
| 1921 | 15,100.00 | 16,568.41 | 1,468.41 |
| Pacific Mutual 621007, June 11, | |||
| 1926 | 6,690.00 | 6,546.20 | (143.80) |
| Travelers 775167, Dec. 28, 1921 | 15,630.00 | 22,525.25 | 6,895.25 |
| Aetna N-258386, July 11, 1920 | 11,920.00 | 16,367.50 | 4,447.50 |
| Aetna N-305807, Dec. 28, 1921 | 12,140.00 | 16,249.50 | 4,109.50 |
| Aetna P-581619, June 18, 1926 | 5,691.40 | 6,564.70 | 873.30 |
| Metropolitan 1363420A, Dec. 28, | |||
| 1921 | 17,996.23 | 19,194.57 | 1,198.34 |
| Total | 97,617.63 | 120,381.63 | 22,764.00 |
| Face | Premiums | "Dividends" | |
| Policy and date of issue | amount | paid | |
| of policy | |||
| Pacific Mutual 401107, July 4, | |||
| 1920 | $ 25,000 | $ 12,450.00 | |
| Pacific Mutual 445690, Dec. 28, | |||
| 1921 | 25,000 | 17,194.75 | $ 2,094.75 |
| Pacific Mutual 621007, June 11, | |||
| 1926 | 10,000 | 7,772.60 | 1,082.60 |
| Travelers 775167, Dec. 28, 1921 | 1 34,150 | 15,630.00 | |
| Aetna N-258386, July 11, 1920 | 25,000 | 11,920.00 | |
| Aetna N-305807, Dec. 28, 1921 | 25,000 | 12,140.00 | |
| Aetna P-581619, June 18, 1926 | 10,000 | 6,647.70 | 956.30 |
| Metropolitan 1363420A, Dec. 28, | |||
| 1921 | 39,691 | 22,840.61 | 4,844.38 |
| Total | 193,841 | 106,595.66 | 8,978.03 |
None of the policies matured until petitioner's death and all of the policies, except the Metropolitan Life Insurance Company policy, were 20-payment life policies, that is, premiums were payable for a period of 20 years beginning with the year in which the policy was issued. The Metropolitan Life Insurance Company policy provided for payment of premiums throughout the life of the policy.
Petitioner received so-called dividends, either in the form of credits against premiums or of direct cash payments. Pacific Mutual Life Insurance 1962 U.S. Tax Ct. LEXIS 219">*222 Company and Metropolitan Life Insurance Company are mutual insurance companies. Aetna Life Insurance Company is a stock company but issues participating as well as nonparticipating policies. The Aetna Life Insurance Company policy No. P-581619 was a participating policy upon which dividends were paid to petitioner. The Travelers Insurance Company is a stock company and dividends were not payable on the policy issued to petitioner.
Each of the policies provided that, after payment of a certain number of full annual premiums, usually two, the insured would have 37 T.C. 605">*607 three options. The insurance companies would pay a cash amount on surrender of the policy by the insured, term the "cash surrender value." In the alternative, the insured had the option of taking "paid-up life insurance" or "paid-up term insurance" in lieu of the cash surrender value. A typical example of these options is that set out in the policy written by the Pacific Mutual Life Insurance Company, No. 401107:
| Cash loan | Paid-up term | |||
| value or | Paid-up | insurance | ||
| End of year | cash surrender | life insurance | ||
| value | Years | Days | ||
| 3 | $ 875 | $ 2,625 | 4 | 214 |
| 4 | 1,350 | 3,925 | 7 | 71 |
| 5 | 1,825 | 5,250 | 9 | 362 |
| 6 | 2,350 | 6,575 | 12 | 339 |
| 7 | 2,875 | 7,875 | 15 | 317 |
| 8 | 3,400 | 9,200 | 18 | 226 |
| 9 | 3,975 | 10,525 | 21 | 28 |
| 10 | 4,575 | 11,850 | 23 | 80 |
| 11 | 5,175 | 13,150 | 25 | 28 |
| 12 | 5,825 | 14,475 | 26 | 256 |
| 13 | 6,475 | 15,800 | 28 | 54 |
| 14 | 7,175 | 17,100 | 29 | 172 |
| 15 | 7,875 | 18,425 | 30 | 267 |
| 16 | 8,625 | 19,725 | 32 | 7 |
| 17 | 9,400 | 21,050 | 33 | 168 |
| 18 | 10,200 | 22,350 | 35 | 76 |
| 19 | 11,025 | 23,675 | 37 | 255 |
| 20 | 11,900 | (1) | (1) | (1) |
The cash surrender values set out in the policies represented the amounts of reserves, less surrender charges, if any, set up by the companies to fulfill the obligations called for by the contracts of insurance. These amounts were calculated by actuaries who assumed in these calculations, inter alia, that the mortality rate among their insureds would accord with the American Experience Table of Mortality and that the earnings of the company to be credited would be at the rate of 3 percent or 3 1/2 percent compounded annually. Provision for an assumed cost of administration (i.e., assumed administrative cost to be incurred by the company) was computed at a fixed amount at the time the annual net premium for each policy was determined and was added to the annual net premium to establish the annual gross premium. The amount of the premium allocated to cost of administration was not considered in determining the cash surrender value of the policies. The reserve established for the cash surrender value of each policy was increased each year by an amount represented by the sum of the net annual premium, plus an addition to the total value of the reserve computed1962 U.S. Tax Ct. LEXIS 219">*224 by a 3 percent or 3 1/2 percent factor, less the cost of mortality computed according to the American Experience Table of Mortality and set aside by the company to cover expected deaths in that year of all insured persons of the same age as petitioner.
37 T.C. 605">*608 The amount of the reserves calculated upon these actuarial assumptions is a theoretical amount conservatively computed for the purpose of providing for the solvency of the company and the soundness of its insurance protection. It is hoped and expected, and in actual practice it frequently happens, that the rate of mortality among the company's insureds will be less than that assumed, that its earnings will be greater than those assumed, and that the cost of administration will be less than that assumed. If, as a result of any or all of these occurrences, either a mutual insurance company issuing participating policies, or a stock insurance company issuing participating policies, finds that, after setting aside the reserves required under its actuarial computations and after creating other additional voluntary reserves for contingencies, its premium receipts are in excess of the amounts needed for the conduct of its business, 1962 U.S. Tax Ct. LEXIS 219">*225 neither class of insurer increases the cash value of its participating policies but it frequently declares "dividends" to the holders of such participating policies of a part of the premiums collectible under its policies, thus in effect reducing the cost of insurance below that contracted for in the policies.
Petitioner has a substantial income but, because of corresponding expenditures for living expenses and for charitable contributions which he makes each year, he needs cash from time to time. Petitioner was in need of cash in the fall of 1955.
At that time, petitioner consulted with his financial adviser, Emmett G. Solomon, and a review of petitioner's investment account was made with the purpose of determining which of his holdings might be liquidated so as to raise cash to meet required expenditures. Petitioner's insurance policies were selected for liquidation because they were not valuable from the standpoint of income production during his lifetime nor were they attractive investments in his estate because they would be taxed in the highest estate tax brackets and there was the possibility of creating a transaction on which capital gain would be involved as against ordinary1962 U.S. Tax Ct. LEXIS 219">*226 income.
After negotiations between petitioner and Dean Witter & Company (hereinafter called the company), petitioner transferred the policies to the company for a cash consideration of $ 118,731.63, $ 1,650 less than the cash surrender value of the policies. The transfer was effectuated in November 1955 by an absolute assignment of all interest of any kind in each of the policies to the company. At the time of the transfer, the premiums on all the policies were fully paid except for the Metropolitan policy which required payment of premiums for the insured's entire life. After the transfer, the policies remained in full force and effect while owned by the company.
In January 1956, the company surrendered the policies to the respective insurers involved for a total consideration of $ 121,779.59.
37 T.C. 605">*609 The company is a partnership engaged in the stock brokerage and investment banking businesses. Petitioner had no connection whatsoever with the company in 1955 nor has he ever had any such connection.
Petitioner has never been and is not now in the business of selling insurance policies, including life insurance policies, or securities of any kind.
Petitioner had not before the1962 U.S. Tax Ct. LEXIS 219">*227 year 1955, and has not at any time since 1955, made any transfers of insurance policies, including life insurance policies. Such policies are not stock in trade of petitioner or other property of a kind properly includible in inventory of petitioner or property held by petitioner primarily for sale to customers in the ordinary course of his trade or business.
In determining the deficiency, respondent treated as ordinary income $ 21,384, representing the difference between the amount received by petitioner from the company, $ 118,731.63, and the assumed cost of the policies, $ 97,347.63. It is now stipulated that the amount of gain included a "clerical error" and that the cost of the policies was $ 97,617.63 and the gain derived was $ 21,114.
OPINION.
As in Percy W. Phillips, 30 T.C. 866">30 T.C. 866 (1958), and Harry Roff, 36 T.C. 818">36 T.C. 818 (1961), on appeal (C.A. 3, Nov. 20, 1961), we have before us two opposing theories as to the treatment of the excess which petitioner here received over the stipulated cost of a contract with an insurance company. Respondent contends first that the "sale" by petitioner should be disregarded because 1962 U.S. Tax Ct. LEXIS 219">*228 of its obvious motivation purely for tax purposes; and second, that even if a sale took place, the excess received by petitioner over his cost represented an item of ordinary income, such as interest, which had already attached to the property and which was sold with it; and that accordingly, whether or not the transaction was a sale or exchange, the gain must be taxed as ordinary income.
The same two contentions were made by respondent in 30 T.C. 866">Percy W. Phillips, supra, and in both respondent was unsuccessful. But there, "If the premiums called for by the policy had been paid annually there would have been no excess of cash value over cost." Here, as the parties have stipulated and as our findings show, the cash surrender value on the date of sale was greatly in excess of the premiums provided in the policy. The total "cash value" of all the policies at the time of assignment was over $ 120,000, whereas the total gross premiums due were but $ 106,595, and the net cost even smaller. We know also from the same source that "The reserve established for the cash surrender value of each policy was increased each year by an amount represented by the sum of the1962 U.S. Tax Ct. LEXIS 219">*229 net annual premium, plus an 37 T.C. 605">*610 addition to the total value of the reserve computed by a 3% or 3 1/2% factor."
The element of a guaranteed and predictable interest factor added to the premiums 1 was absent in 30 T.C. 866">Percy W. Phillips, supra; and it is not accident that under the facts there, a time could never arrive prior to maturity when, as in the instant case, the surrender value would exceed the total premiums. This circumstance seems to us to assimilate this situation to that in 36 T.C. 818">Harry Roff, supra, where "an interest rate of 3 1/2 percent, compounded annually" and "a rate of 3 1/4 percent, compounded annually" were applied "to the effective rate of premium payments, i.e., total annual premium of $ 1,000 as reduced by $ 125 for administrative costs * * * [and] $ 1,000 less $ 170 for administrative cost." We find here, as was stated there, that "Because of the interest provided for by the contracts, the cash surrender values thereof * * * at the dates of the sales * * * were in excess of the total premiums called for by the policies."
1962 U.S. Tax Ct. LEXIS 219">*230 In the Roff case, we held, as to respondent's second contention, that, although the transaction was to be treated as a sale of a capital asset, "the gains reaped by petitioner on the sales of the contracts, are attributable to interest accumulated under the contracts at fixed and predictable rates." Accordingly, we determined that "petitioner received the equivalent of interest on the sales of the contracts," commenting in the course of the Opinion that "upon surrender of the policy * * * petitioner would have been taxed on the gain as ordinary income. Sec. 72, I.R.C. 1954 * * *," 2 and that "Even though the property falls within the general definition of a capital asset, the sale under scrutiny may include the sale of certain ordinary income portions which will be taxed at ordinary rates."
1962 U.S. Tax Ct. LEXIS 219">*231 Another distinction from 30 T.C. 866">Percy W. Phillips, supra, is that, except in one instance, the policies had all been paid up for some time. We are not advised when the "dividends" on these policies were credited, but the burden was on petitioner and we must assume that they were 37 T.C. 605">*611 all collectible after the policies became paid up. In that event they were --
"* * * dividends declared in the case of a full-paid participating policy, wherein the policyholder has no further premium payments to make. Such payments having been duly met, the policy has become at once a contract of insurance and of investment. The holder participates in the profits and income of the invested funds of the company." * * * [Emphasis added.]
* * * *
* * * But in level-premium life insurance, while the motive for taking it may be mainly protection, the business is largely that of savings investment. The premium is in the nature of a savings deposit. Except where there are stockholders, the savings bank pays back to the depositor his deposit with the interest earned less the necessary expense of management. The insurance company does the same, the difference being merely1962 U.S. Tax Ct. LEXIS 219">*232 that the savings bank undertakes to repay to each individual depositor the whole of his deposit with interest; while the life insurance company undertakes to pay to each member of a class the average amount (regarding the chances of life and death); * * *
* * * *
* * * On the other hand, the service performed in level-premium life insurance is both protection and investment. Premiums paid -- not in the tax year, but perhaps a generation earlier -- have earned so much for the cooperators, that the company is able to pay to each not only the agreed amount but also additional sums called dividends; and have earned these additional sums, in part at least, by transactions not among the members, but with others; as by lending the money of the cooperators to third persons who pay a larger rate of interest than it was assumed would be received on investments. The fact that the investment resulting in accumulation or dividend is made by a cooperative as distinguished from a capitalistic concern does not prevent the amount thereof being properly deemed a profit on the investment. * * *
Penn Mutual Co. v. Lederer, 252 U.S. 523">252 U.S. 523, 252 U.S. 523">529, 252 U.S. 523">531-532, 252 U.S. 523">534 (1920).1962 U.S. Tax Ct. LEXIS 219">*233
When to that it is added that all of the "dividends" were composed to some extent of the investment profits of the company, see 30 T.C. 866">Percy W. Phillips, supra, it seems to us evident that the ordinary income character of the entire increase in value is so predominant that little basis exists for attributing some probably infinitesimal portion of petitioner's gain to "an increase in the value of the income-producing property." Commissioner v. P. G. Lake, Inc., 356 U.S. 260">356 U.S. 260, 356 U.S. 260">266 (1958). Since perhaps most significantly of all, neither of the parties suggests that any such allocation should or could accurately be made, we deal with the total gain -- that is, the difference between the stipulated "cost" and the amount received -- as partaking of the nature of its overwhelmingly predominant characteristic -- that of ordinary income.
We consequently regard the present circumstances as more nearly like those appearing in 36 T.C. 818">Harry Roff, supra, than in 30 T.C. 866">Percy W. Phillips, supra, and, accordingly, on the authority of the Roff case, we conclude that respondent must be sustained1962 U.S. Tax Ct. LEXIS 219">*234 in his effort to have the gain received by petitioner taxed at ordinary income rates.
Petitioner makes much of the fact that in life insurance, as distinguished 37 T.C. 605">*612 from annuities, the policy incorporates a benefit -- payment in case of the insured's death -- which is entirely different from the investment or interest-earning element. See 36 T.C. 818">Harry Roff, supra. The difficulty is that what obviously gave value to these policies, not perhaps to petitioner personally, but as the subject matter of a sale to a third person, was their cash value, 3 and, indeed, the purchaser kept them in effect for only a short time.
Petitioner insists that the situation here is comparable to that in Bell's Estate v. Commissioner, 137 F.2d 454 (C.A. 8, 1943), reversing 46 B.T.A. 484">46 B.T.A. 484 (1942); and McAllister v. Commissioner, 157 F.2d 235 (C.A. 2, 1962 U.S. Tax Ct. LEXIS 219">*235 1946), certiorari denied 330 U.S. 826">330 U.S. 826, reversing 5 T.C. 714">5 T.C. 714 (1945), and that, accordingly, what petitioner here sold was an asset accompanied by the right to receive future income upon it rather than to transfer that right without at the same time releasing the income-producing property, as in such cases as Hort v. Commissioner, 313 U.S. 28">313 U.S. 28 (1941); and 356 U.S. 260">Commissioner v. P. G. Lake, Inc., supra.We regard the distinction so attempted as beside the point. Granting that petitioner parted completely with all his interest in the property transferred, which necessarily carried with it as part of its value all income to be earned in the future, cf. Helvering v. Horst, 311 U.S. 112">311 U.S. 112 (1940); Helvering v. Clifford, 309 U.S. 331">309 U.S. 331 (1940); Helvering v. Eubank, 311 U.S. 122">311 U.S. 122 (1940), and accepting the effectiveness of the transaction as the sale of a capital asset, 36 T.C. 818">Harry Roff, supra, we are, nevertheless, dealing here with the receipt as part of1962 U.S. Tax Ct. LEXIS 219">*236 the purchase price -- and in addition to any payment attributable to the property sold -- of an amount representing income which has already been earned and which would have been ordinary income if and when received by the vendor. Tunnell v. United States, 259 F.2d 916 (C.A. 3, 1958). Such cases as the sale of a partnership interest including accumulated income, United States v. Snow, 223 F.2d 103 (C.A. 9, 1955), certiorari denied 350 U.S. 831">350 U.S. 831, the sale of a bond with accrued but unpaid interest, Simon Jaglom, 36 T.C. 126">36 T.C. 126 (1961), on appeal (C.A. 2, Aug. 30, 1961), the sale of stock with a declared dividend, Brundage v. United States, 275 F.2d 424, 427 (C.A. 7, 1960), certiorari denied 364 U.S. 831">364 U.S. 831; Herman M. Rhodes, 43 B.T.A. 780">43 B.T.A. 780 (1941), affd. 131 F.2d 50 (C.A. 6, 1942), and the redemption of a certificate of indebtedness carrying unpaid interest, Richard B. Gibbons, 37 T.C. 569">37 T.C. 569 (1961); Rosen v. United States, 288 F.2d 6581962 U.S. Tax Ct. LEXIS 219">*237 (C.A. 3, 1961), are comparable. It was on that theory, as we understand it, that the Tax Court's conclusion in 30 T.C. 866">Percy W. Phillips, supra, was reversed (275 F.2d 33, C.A. 4, 1960). It is also on that theory that it was concluded in 36 T.C. 818">Harry Roff, supra, that that part of the amount received from the sale of an annuity policy, which exceeded 37 T.C. 605">*613 cost and which represented interest already earned, must be treated as ordinary income and not capital gain.
Although a part of the total increment received by petitioner here may have been due to "dividends" rather than to a specified percentage of interest earned on the reserve attributable to his policy, it is clear that the greatest portion must have been due to the latter. 4 As we have said, neither party suggests that we should attempt to allocate the net amount received, in excess of cost, between the two sources, or that they differ as to their taxable quality. We accordingly conclude, as in 36 T.C. 818">Harry Roff, supra, that the amount received above the cost of the policy is ordinary income in its entirety and not capital1962 U.S. Tax Ct. LEXIS 219">*238 gain, and that this excess is to be computed by subtracting, from the amount received, petitioner's cost as stipulated by the parties.
It is unnecessary here, as it was in 36 T.C. 818">Harry Roff, supra, to determine whether as between the Tax Court and the Court of Appeals, 30 T.C. 866">Percy W. Phillips, supra, was correctly decided. The Tax Court's position was founded on the situation there, which is different from that now before us; that except for dividends and certain prepayments, the surrender value of the policies would never have exceeded the amounts paid in by petitioner; and that, consequently, the proceeds of the sale were not attributed to interest earned on the policy. The Court of Appeals, to the contrary, regarded the situation as one where, to the property sold, there was added a right to receive 1962 U.S. Tax Ct. LEXIS 219">*239 income already accrued. The issue, as presented by the parties here, renders it unnecessary to determine, in this proceeding, which approach would have been correct had the present facts appeared in the Phillips case.
In order to take account of a clerical error in determining the deficiency,
Decision will be entered under Rule 50.
Footnotes
1. Due to payment of maximum annual premium.↩
1. Fully paid.↩
1. While the stipulation follows generally the form of the Percy W. Phillips findings, this one statement is naturally missing from the Phillips↩ case.
2. Sec. 72(e)(1), I.R.C. 1954, reads: SEC. 72, ANNUITIES; CERTAIN PROCEEDS OF ENDOWMENT AND LIFE INSURANCE CONTRACTS.
(e) Amounts Not Received as Annuities. --
(1) General rule. -- If any amount is received under an annuity, endowment, or life insurance contract, if such amount is not received as an annuity, and if no other provision of this subtitle applies, then such amount --
(A) if received on or after the annuity starting date, shall be included in gross income; or
(B) if subparagraph (A) does not apply, shall be included in gross income, but only to the extent that it (when added to amounts previously received under the contract which were excludable from gross income under this subtitle or prior income tax laws) exceeds the aggregate premiums or other consideration paid.
For purposes of this section, any amount received which is in the nature of a dividend or similar distribution shall be treated as an amount not received as an annuity.↩
3. Cf. cash value ($ 120,381.63) with sale price ($ 118,731.63).↩
4. We are given no information as to the extent to which the dividends themselves may also have been attributable to an income factor, such as favorable investments.↩