*194 Decision will be entered under Rule 50.
1. In 1955 petitioners each obtained loans on insurance policies which each held on the other's life. Soon thereafter, petitioners each assigned the insurance policies involved to their children. After the assignments, petitioners continued to pay the interest on the insurance loans during the remainder of 1955 and all of 1956. Held, petitioners may not deduct interest paid or accrued on insurance loans after the date of assignment of the beneficial ownership of the insurance policies to their children. Cf.
2. During 1955 and 1956 petitioners had outstanding interest-free loans in excess of $ 2 million which they had obtained from a corporation controlled by them. Held, petitioners realized no taxable income attributable to the free use of the borrowed money.
*1083 OPINION.
The Commissioner determined deficiencies in income tax against petitioners for 1955 and 1956 in the amounts of $ 13,875.61 and $ 16,383.86, respectively. Petitioners are husband and wife; they filed joint returns for 1955 and 1956 with the director of internal revenue at Wilmington, *196 Delaware. To the extent that the deficiencies still remain in controversy they raise the question whether petitioners were entitled to deduct as interest the amounts of $ 9,243.38 in 1955 and $ 26,912.02 in 1956 representing interest on loans on life insurance policies which had accrued and which was paid by them after they had made irrevocable assignments of such policies to their children. An amended answer filed by the Commissioner claims increases in the deficiencies already determined by adding thereto the amounts of $ 105,181.50 and $ 119,796.78 for 1955 and 1956, respectively. Such increases raise a single issue, unrelated to the original deficiencies, namely, whether petitioners realized taxable income to the extent of the alleged economic benefit derived from the interest-free use of funds which they had borrowed from a family corporation controlled by them. The facts have been stipulated.
Issue 1. Interest Deduction.
The stipulation of facts, as it relates to the original issue presently in controversy, is in its entirety as follows:
2. In 1937 petitioner J. Simpson Dean created an irrevocable trust to which he transferred life insurance policies theretofore obtained*197 by him on the life of petitioner Paulina duPont Dean, having an aggregate face value of $ 2,145,017. In 1937 petitioner Paulina duPont Dean created an irrevocable trust to which *1084 she transferred life insurance policies theretofore obtained by her on the life of petitioner J. Simpson Dean having an aggregate face value of $ 1,125,391. Each of these trusts was for the benefit of the petitioners' children. The trustee of each of these trusts had the power to sell and assign to any person or persons the policies of insurance held thereunder, or any of them, for not less than the cash surrender value.
3. Early in 1955 petitioner J. Simpson Dean purchased from the trustee certain of the life insurance policies transferred by him to the trust created by him in 1937 at their cash surrender value on the date of the purchase, which was considered to be the fair market value of the policies so purchased. Immediately after this purchase said petitioner applied for and obtained loans from the respective insurance companies on the policies so purchased to the extent of their cash surrender values. The money so obtained was applied by said petitioner to his personal use. Shortly *198 after securing such loans said petitioner assigned and transferred ownership of said policies to the children of himself and petitioner Paulina duPont Dean by executing forms required by the respective insurance companies.
4. Early in 1955 petitioner Paulina duPont Dean purchased from the trustee certain of the life insurance policies transferred by her to the trust created by her in 1937 at their cash surrender value on the date of the purchase, which was considered to be the fair market value of the policies so purchased. Immediately after this purchase said petitioner applied for and obtained loans from the respective insurance companies on the policies so purchased to the extent of their respective cash surrender values. The money so obtained was applied by said petitioner to her personal use. Shortly after securing such loans said petitioner assigned and transferred ownership of said policies to the children of herself and petitioner J. Simpson Dean by executing forms required by the respective insurance companies.
5. In connection with the assignments to the beneficiaries, the children of the petitioners, each of the companies used their own special forms for assignment and*199 change of ownership of the policies. Examples of the forms used by the insurance companies for the above purpose, are Exhibit 1-A, the form used by the Bankers Life Insurance Company, and Exhibit 2-B, the form used by the United States Life Insurance Company.
6. Approximately one-half of the notices for payment of the interest due and the amounts of interest due in the years 1955 and 1956 were addressed to petitioners. The other one-half were addressed to the assignee children of the petitioners.
All the interest regardless of to whom the bills were addressed was paid by the petitioners and deductions were claimed in their joint income tax returns filed by them for the years 1955 and 1956, in the following amounts:
| 1955 | $ 14,102.41 |
| 1956 | 26,912.02 |
7. Of the $ 14,102.41 claimed above as interest by the petitioners on their 1955 income tax return, $ 4,859.03 is attributable to interest accrued and/or paid by the petitioners prior to the assignment of the insurance policies. This latter amount is allowable as a deduction. The balance of the interest claimed, $ 9,243.38, represents interest paid and accrued after the assignments, and is the amount in controversy for 1955. *200 All the interest claimed in 1956 has been disallowed, and is the amount in controversy for that year.
Petitioners seek to deduct the amounts in controversy as "interest paid * * * on indebtedness."
Insurance policy loans are unique because the borrower assumes no personal liability to repay the principal or to pay interest on the amount borrowed. Such loans are based on the reserve value of the insurance policies*201 involved. If either the principal or the interest is not repaid, it is merely deducted from the reserve value of the policy. Since the insurance company "never advances more than it already is absolutely bound for under the policy, it has no interest in creating a personal liability."
We have held that interest on an insurance policy loan may be deducted so long as it is actually paid or accrued by the policyholder. If such interest is not paid but is allowed to be added to the principal amount of the loan, the amount of the interest is not deductible.
Here, the respondent has stipulated that the interest paid or accrued by the petitioners on the insurance policy loans prior to the assignment of the insurance policies to their children is a proper deduction. True, the petitioners were not personally liable to pay this interest. But by making the loans involved, the petitioners had become obligated in a sense to pay interest thereon. Although the petitioners*202 could never be sued for this interest, the "obligation" was sufficient to qualify it as deductible interest for income tax purposes because such interest was in fact and in law a charge against their rights in the policies. The essential question for purposes of this case is whether the "obligation" to pay interest survived the assignment of the policies involved to others. We think it did not. It follows that after the assignment, interest paid by the petitioners was paid for the benefit of the assignees and is not deductible by petitioners. Cf.
In
Petitioners, in order to avoid this result, argue that their obligation to pay interest on the borrowed money must have survived the assignment of the insurance policies because, although the assignees received policies subject to a loan, they did not assume the indebtedness nor the interest thereon by accepting*204 the assignment. But petitioners' conclusion is not required by their premise. Granted that petitioners' children did not "assume" the obligation to pay the interest on the insurance loans by accepting the policies, this does not necessarily mean that petitioners' obligation continued. Since petitioners' obligation was never a personal liability and since the insurance companies always looked to the policies themselves for repayment, it is not inconsistent to conclude that petitioners' particular obligations in regard to the repayment of the loans and the interest thereon were extinguished upon irrevocably parting with the beneficial ownership of the policies. Petitioners' children received the policies subject to the loans; if they wanted to protect the value of these policies, they could pay the interest on the loans as it came due and under the Fox case they would be permitted to deduct such payments. Although they were in no way required to pay this interest, their ownership interest in the underlying policies which were subject to the indebtedness was sufficient to qualify any interest paid for the statutory deduction. The specific holding in the Fox case, that the*205 assignor's "obligation continued until the date of the assignment" (emphasis supplied), defeats the petitioners' view that either the assignors or the assignees may pay and deduct the interest after the date of assignment.
Finally, petitioners argue that even if they were under no obligation to pay the interest, they are nevertheless entitled to the contested *1087 deductions on a principle of equitable liability since they "benefited" 1 from the loans involved, citing
*207 Issue 2. Income From Interest-Free Loans.
The Commissioner's amended answer charged petitioners with income equal to interest at the alleged legal rate in Delaware (6 percent) with respect to loans which they had obtained upon non-interest-bearing notes from their controlled corporation, Nemours Corporation, and which were outstanding during 1955 and 1956. The theory of the amended answer was that the petitioners realized income to the extent of the economic benefit derived from the free use of borrowed funds from Nemours, and that such economic benefit was equal to interest at the legal rate in Delaware, alleged to be 6 percent per annum. However, the Commissioner's brief has reduced the amount of his additional claim so that the income thus attributed to petitioners is measured, not by the legal rate of interest, but by the prime rate, since it is stipulated that petitioners could have borrowed the funds at the prime rate. As thus reduced, the additional income *1088 which the Commissioner seeks to charge to petitioners is $ 65,648.79 for 1955 and $ 97,931.71 for 1956. The facts in relation to this issue have been stipulated as follows:
9. Prior to December 17, 1954*208 the entire issued and outstanding capital stock of Nemours Corporation, hereinafter referred to as Nemours, organized under the laws of the State of Delaware with principal office in Wilmington, Delaware, consisting of 36,172 shares of no par common, was owned by the petitioners, as follows:
| J. Simpson Dean | 7,249 shares |
| Paulina duPont Dean | 28,923 shares |
10. On December 17, 1954 each of the petitioners made a gift of 2,000 shares of the stock of Nemours to the above-mentioned trusts created by them in 1937 for the benefit of their children. In the years 1955 and 1956 the petitioners owned 32,172 shares of no par common of Nemours.
11. For the taxable year 1955 Nemours was a personal holding company under
12. For the taxable year 1956 Nemours filed its Federal income tax return as a regular business corporation. By notice of deficiency dated March 2, 1960, respondent determined that Nemours was a personal holding company for the year 1956. An appeal from such determination was taken by Nemours and the matter is now pending before this Court in Docket No. 86863, entitled Nemours*209 Corporation v. Commissioner of Internal Revenue.
13. Petitioner J. Simpson Dean owed Nemours on non-interest bearing notes the following amounts:
| Period | Amount |
| January 1, 1955 to January 10, 1955 | $ 302,185.73 |
| January 11, 1955 to December 31, 1955 | 223,861.56 |
| January 1, 1956 to December 31, 1956 | 357,293.41 |
14. Petitioner Paulina duPont Dean owed Nemours on non-interest bearing notes the following amounts:
| Period | Amount |
| January 1, 1955 to December 31, 1955 | $ 1,832,764.71 |
| January 1, 1956 to December 31, 1956 | 2,205,804.66 |
15. The following are the prime rates of interest and the dates on which changes were made in such rates at which the petitioners could have borrowed money during the years 1955 and 1956:
| January 1, 1955 | 3% |
| August 15, 1955 | 3 1/4% |
| October 20, 1955 | 3 1/2% |
| April 20, 1956 | 3 3/4% |
| September 1, 1956 | 4% |
| December 31, 1956 | 4% |
16. Interest computed at the prime rates shown in the preceding paragraph on the non-interest bearing notes of the petitioners for the taxable years 1955 and 1956 would be as follows:
| Year 1955: | Amount |
| J. Simpson Dean | $ 7,203.98 |
| Paulina duPont Dean | 58,444.81 |
| Total | $ 65,648.79 |
| Year 1956: | |
| J. Simpson Dean | $ 13,651.59 |
| Paulina duPont Dean | 84,280.12 |
| Total | $ 97,931.71 |
*210 *1089 [Paragraph 17 of the stipulation, objected to by respondent as to relevancy, 2 states that if petitioners had paid interest to Nemours, the corporation would have made dividend distributions to petitioners equal to the amount of such interest, and further sets forth the effect, taxwise and otherwise, upon petitioners, Nemours, and the trusts, based upon that hypothesis as well as certain other assumptions.]
The theory of the Commissioner's amended answer, as modified in his brief, undoubtedly had its origin in a statement by this Court in a Memorandum Opinion involving certain gift taxes of these taxpayers,
Viewed realistically, the lending of over two million dollars to petitioners without interest might be looked upon as a means of passing on earnings (certainly potential*211 earnings) of Nemours in lieu of dividends, to the extent of a reasonable interest on such loans. * * *
The amended answer herein was filed within several months after the foregoing Memorandum Opinion had been promulgated. The statement quoted above was mere dictum and we have not been directed to any case holding or even suggesting that an interest-free loan may result in the realization of taxable income by the debtor, or to any administrative ruling or regulation taking that position. Although the question may not be completely free from doubt we think that no taxable income is realized in such circumstances.
In support of its present position, the Government relies primarily upon a series of cases holding that rent-free use of corporate property by a stockholder or officer may result in the realization of income.
We have heretofore given full force to interest-free loans for tax purposes, holding that they result in no interest deduction for the borrower,
*215 Decision will be entered under Rule 50.
Opper, J., concurring: The necessity is not apparent to me of deciding more on the second issue than that there can be no deficiency. If petitioners were in receipt of some kind of gross income, possibly comparable to that dealt with in such cases as
Suppose, for example, that in such a case as
Or suppose the facts showed that the indebtedness was "incurred * * * to purchase or carry obligations * * * the interest on which is wholly exempt from * * * taxes."
This being apparently a case of first impression, the present result seems peculiarly unfortunate in deciding a point that need not be passed on. To make matters worse, the burden here is on respondent, since the issue was first raised by his answer; 1 and thus in this leading case all factual conclusions and inferences must be favorable to petitioners. Cf., e.g.,
*217
Bruce, J., dissenting: I respectfully dissent from the opinion of the majority with respect to the second issue. In my opinion the present case is not distinguishable in principle from such cases as
I agree with Judge Opper in his concurring opinion that "the statement that 'an interest-free loan results in no taxable gain to the borrower' is much too broad a generalization to make here." I do not wish to infer that the interest-free loan of money should be construed as resulting in taxable income to the borrower in every instance. *1092 However, it is difficult to believe that the interest-free loan of in excess of $ 2 million*218 ($ 2,563,098.07 throughout 1956) by a personal holding company to its majority stockholders (its only stockholders prior to December 17, 1954) did not result in any economic benefit to the borrower.
In my opinion, the statement that "had petitioners borrowed the funds in question on interest-bearing notes, their payment of interest would have been fully deductible by them under
No deduction shall be allowed for --
* * * *
(2) Interest. -- Interest on indebtedness incurred or continued to purchase or carry obligations * * * the interest on which is wholly exempt from the taxes imposed by this subtitle.
It is recognized that the burden with respect to the issue here presented by his amended answer is upon the respondent. This burden, however, was, in my opinion, discharged by the stipulated facts presented. It was incumbent upon the petitioners, if such were the facts, to plead and establish that had they been required to pay interest on the loans in question they would have been entitled to deduct such interest from their gross income. They have done neither. It is well established that deductions are matters of legislative grace and must be clearly established.
On the record presented herein, I do not agree that "had petitioners borrowed the funds in question on interest-bearing notes, their payment of interest would have been fully deductible by them under
Footnotes
1. Petitioners' contention in effect is that they should be treated equitably as the obligors since the proceeds of the loan were used for their benefit. Apart from the conclusion which petitioners thus seek to have us draw, we are by no means satisfied on this record that the factual assumption as to benefit may be taken as correct. Although the stipulation of facts does indeed state that the "money [proceeds of loan] so obtained was applied by said petitioner to his [or her] personal use," other portions of the stipulation indicate that such was true only in a highly technical sense and that the net effect of the transaction as a whole was that there was no benefit whatever to the petitioners. For, it must be remembered that the policies in question were owned by irrevocable trusts created in 1937, that petitioners in 1955 purchased these policies from the trusts at their cash surrender value, and that they immediately thereafter obtained the loans in question to the extent of the cash surrender value of the policies. Thus, the loan proceeds merely replaced in petitioners' hands, almost simultaneously, the amounts which they had expended to buy the policies from the trusts. In substance, it was a wash transaction, and it is misleading to state that the loan proceeds were applied for petitioners' benefit without at the same time noting that such proceeds merely replaced other funds of petitioners that presumably would similarly have been available for petitioners' personal use.↩
2. We find it unnecessary to rule upon that objection, since we reach the result herein without reliance upon paragraph 17.↩
3. As recently as 1955, this was also the view of the Commissioner. In
Rev. Rul. 55-713, 2 C.B. 23">1955-2 C.B. 23↩ , in sanctioning the so-called split-dollar insurance scheme, it is said at page 24: "In the instant case, the substance of the insurance arrangement between the parties is in all essential respects the same as if Y corporation makes annual loans without interest, of a sum of money equal to the annual increases in the cash surrender value of the policies of insurance taken out on the life of B. The mere making available of money does not result in realized income to the payee or a deduction to the payor."1. See, e.g.,
Rainbow Gasoline Corporation, 31 B.T.A. 1050↩ (1935) , decided partly for petitioner and partly for respondent entirely on the question of burden of proof.