Kornfeld v. Commissioner

F I L E D
United States Court of Appeals
Tenth Circuit
PUBLISH
MAR 3 1998
UNITED STATES COURT OF APPEALS
PATRICK FISHER
Clerk
TENTH CIRCUIT

JULIAN P. KORNFELD,

Petitioner-Appellant,

v. No. 96-9016

COMMISSIONER OF INTERNAL
REVENUE,

Respondent-Appellee.

APPEAL FROM THE UNITED STATES TAX COURT
(T.C. No. 13169-95)

Submitted on the briefs:

Tom M. Moore and Clarke L. Randall of Kornfeld Franklin Renegar & Randall,
Oklahoma City, Oklahoma, for Petitioner-Appellant.

Richard Farber and Thomas J. Sawyer, Attorneys, Tax Division, Department of Justice,
Washington, D.C., for Respondent-Appellee.

Before SEYMOUR, Chief Judge, LOGAN and MURPHY, Circuit Judges.

LOGAN, Circuit Judge.
 This appeal presents the question whether the Tax Court correctly relied on the

substance over form doctrine in determining that Julian P. Kornfeld (taxpayer) was not

entitled to a federal income tax deduction for amortization of a life interest in bonds that

he purportedly jointly purchased with his daughters and secretary, who took remainder

interests.

The legal right of a taxpayer to decrease the amount of what otherwise
would be his taxes, or altogether avoid them, by means which the law
permits, cannot be doubted. . . . But the question for determination is
whether what was done, apart from the tax motive, was the thing which the
statute intended.

Gregory v. Helvering, 293 U.S. 465, 469 (1935).1

I

When a taxpayer purchases a bond the normal rule is that the security is not

depreciable or amortizable for federal income tax purposes.2 5 J. Mertens, Law of

Federal Income Taxation § 23A.93 (1990). Instead the taxpayer has a cost basis in the

bond and when the bond matures or is called or sold the money received is treated as a

nontaxable return of capital to the extent of that basis. The interest paid while the

taxpayer holds the bond is taxable income unless, as here, it is tax exempt. See Internal

1
After examining the briefs and appellate record, this panel has determined
unanimously to grant the parties’ request for a decision on the briefs without oral
argument. See Fed. R. App. P. 34(f); 10th Cir. R. 34.1.9. The case is therefore ordered
submitted without oral argument.
2
In the case of a taxable--not a tax-exempt--bond, the amount of the amortizable
bond premium for the tax year may be allowed as a deduction. IRC § 171.

2
Revenue Code (IRC) § 1001. If the taxpayer owns the bond at his death its value is

included in his estate for federal estate tax purposes. Id. § 2033. If during his lifetime he

should transfer ownership of the bond by gift reserving income for his life the entire value

of the bond would still be included in his estate for federal estate tax purposes. Id.

§ 2036. Additionally, because the gift would be of a future interest the $10,000 per donee

annual gift tax exclusion of IRC § 2503(b) would not apply.

Taxpayer, an experienced tax attorney, apparently believed he found a way to

structure purchases of tax-exempt bonds to give him other income and estate and gift tax

benefits. His method was to enter into agreements (through a revocable trust he created)

with his daughters, Nancy and Meredith, to jointly purchase the bonds with taxpayer

buying a life estate and his daughters buying the remainder interests in the following

manner: Taxpayer ordered bonds from Prudential-Bache Securities Inc. which billed his

trust. Under the agreements with the remaindermen taxpayer determined the value of his

life estate based on Internal Revenue Service (IRS) estate and gift tax actuarial tables.

Taxpayer’s trust paid Prudential-Bache the value of his life estate interests. Taxpayer

contemporaneously sent checks to his daughters in the amount of the purchase price of

their shares. The daughters would then pay Prudential-Bache for the sum representing

their remainder interests.3

3
After the first transaction taxpayer became concerned about his daughter
Meredith’s precarious financial situation and he did not want her interests to be attached
(continued...)

3
 After taxpayer executed two agreements, Congress amended the Code to provide

that “[n]o depreciation deduction shall be allowed . . . to the taxpayer for any term interest

in property for any period during which the remainder interest in such property is held

(directly or indirectly) by a related person.” IRC § 167(e). A “term interest in property”

is defined to include a life estate, and “related persons” includes taxpayers’ children. Id.

§§ 167(e), 267, 1001(e)(2). Taxpayer modified the later agreements so that rather than

purchase the entire remainder interest Nancy would purchase a second life estate to take

effect after taxpayer’s death; taxpayer’s secretary, Patsy Permenter, purchased the final

remainder interest with funds given her by taxpayer. Taxpayer reported the gifts to

Nancy, Meredith and Permenter on belatedly filed gift tax returns, claiming the $10,000

annual exclusion for each donee and using his lifetime exemption (unified credit) to avoid

paying any tax. See IRC §§ 2010 and 2505. The tax-exempt bonds at issue here had a

combined face value of $1,510,000. The actuarial value of taxpayer’s life estate based on

IRS tables was about $1,262,000.

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(...continued)
by her creditors. Thus the second, third, and fourth agreements included Nancy but not
Meredith.

The bonds apparently were held in street name with no indication of the division of
ownership between the life tenant and the remaindermen. The agreements also provided
that evidence of ownership “may also be held by the First Interstate Bank of Oklahoma, as
custodian” in such names or forms “as the custodian shall deem appropriate and
convenient.” Ex. 4-D. The parties agreed to sell, assign, or pledge only on joint direction
of all parties, and to give to each other a right of first refusal at the valuations established
by the IRS regulations in the event any one sought to dispose of his or her interest.

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 We have only an income tax question before us. Taxpayer’s federal income tax

returns for the years 1990 and 1991 reflected tax-exempt interest income on the bonds of

$118,972 and $122,974, respectively. Taxpayer also claimed an amortization deduction

on his life estate in the bonds of $56,203.94 for each year. After an audit the

Commissioner disallowed the amortization deductions. Taxpayer petitioned the Tax

Court for a redetermination of the deficiency and before trial the parties stipulated to the

facts and presented the case on that fully stipulated record.

Relying on the substance over form doctrine, the Tax Court found that the taxpayer

had acquired the entire ownership interest in the bonds and then made a gift of the

remainder interests to his daughters and Permenter. Thus, the Tax Court upheld the

Commissioner’s determination that taxpayer was liable for income tax deficiencies of

$11,803 for 1990 and $13,122 for 1991.

II

Taxpayer first asserts we must review the Tax Court’s decision de novo because

the parties submitted the case to the Tax Court on a fully stipulated record, citing ABC

Rentals of San Antonio, Inc. v. Commissioner of Internal Revenue, 97 F.3d 392 (10th Cir.

1996). In ABC Rentals, we stated that “given the stipulated facts, the question of whether

the [rental] inventory fits into the exception [] presents a legal issue regarding application

and interpretation of [the applicable statute],” 97 F.3d at 395. We went on to note,

however, that even if the facts had not been stipulated, that case presented “a mixed

5
question of law and fact in which the legal issues predominate.” Id. at 395-96. In

contrast, in a case involving whether a transfer of contract rights was genuine, we said

that findings “as to what is substance in a transaction are to be treated as questions of

fact,” Wisebart v. Commissioner, 564 F.2d 34, 37 (10th Cir. 1977), and thus reviewed

under the clearly erroneous standard. See Anderson v. City of Bessemer, 470 U.S. 564,

574 (1985) (“Where there are two permissible views of the evidence the factfinder’s

choice between them cannot be clearly erroneous. . . . This is so even when the district

court’s findings do not rest on credibility determinations, but are based instead on

physical or documentary evidence or inferences from other facts.”). In the instant case,

although the facts were stipulated, the Tax Court was still charged with making ultimate

findings of fact as to the substance of the transaction. We do not need to determine which

standard of review is applicable here, however, because under either standard we hold the

Tax Court correctly disallowed the amortization deduction.

III

The taxation scheme set out in the Internal Revenue Code is complicated and the

tax consequences of many transactions depend on form, how the transaction is structured.

At the same time it has long been held that “[t]he incidence of taxation depends upon the

substance of a transaction. . . . To permit the true nature of a transaction to be disguised

by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the

effective administration of the tax policies of Congress.” Commissioner v. Court Holding

6
Co., 324 U.S. 331, 334 (1945). Ascertaining the “true nature” of the transaction while

adhering to neutral principles of statutory construction is often difficult. That is

exemplified by the instant case, in which the Tax Court opinion and the two others closest

factually--one relied on by taxpayer and the other by the Commissioner--were authored by

the same judge. Compare Gordon v. Commissioner, 85 T.C. 309 (1985) (where taxpayer

gave family trust funds to purchase remainder interests in bonds for which he purchased a

life estate, and claimed amortization deduction, Tax Court determined that in substance

taxpayer purchased the bonds and gave remainder to trust) with Richard Hansen Land,

Inc., 65 T.C.M. (CCH) 2869 (1993) (distinguishing Gordon because although corporation

was source of funds for shareholders’ purchase of remainder interests, the corporation

that purchased a term interest did not use shareholders’ bank accounts as “mere stopping

place” for funds).

There would be no doubt of taxpayer’s right to annual amortization deductions had

he acquired only a limited interest in the bonds in arm’s length commercial transactions in

which the remainder interests had been retained, or independently acquired, by persons

having no connection to taxpayer. A taxpayer may amortize a limited interest in property

if the “intangible asset is known from experience or other factors to be of use in the . . .

production of income for only a limited period, the length of which can be estimated with

reasonable accuracy.” Treas. Reg. § 1.167(a)-3. Here, however, one hundred percent

ownership of the bonds was acquired from or through Prudential-Bache in a market

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transaction; but taxpayer presented no evidence that any brokerage firm would sell only a

life estate in the bonds. The division of the interests between taxpayer’s life estate and

the remainders was made by the separate agreements between taxpayer and his daughters

and secretary; the valuations were not determined by market forces but in accordance

with IRS valuation tables formulated for estate and gift tax purposes. The broker sent one

bill to taxpayer’s trust, and taxpayer calculated the respective shares based on the IRS

tables, and then immediately gave the remaindermen gifts of nearly the exact amounts

they needed to pay their shares. The parties stipulated that “[t]he purpose of these [gift]

checks was to provide Meredith and Nancy with sufficient monies to pay their respective

proportionate shares of the purchase price.” Doc. 14 at 7.

Taxpayer tries to focus the question before us on the cash nature of the gifts to the

daughters and secretary. He argues that they had sufficient independent assets to make

their proportionate payments, and that they were not legally obligated to use the money

gifted to them to make the payments for which they were obligated under their

agreements. Thus he would have the court treat the gifts as separate from the purchases

of the bonds, and he would have the court regard the remainder purchases in the bonds as

independent investor decisions.

The government has applied, and the Supreme Court expressly sanctioned, a step-

transaction doctrine to deal with purportedly separate transactions that the government

believes should be treated as integrated. See Commissioner v. Clark, 489 U.S. 726, 738

8
(1989). “Under this doctrine, interrelated yet formally distinct steps in an integrated

transaction may not be considered independently of the overall transaction. By thus

linking together all interdependent steps with legal or business significance, rather than

taking them in isolation, federal tax liability may be based on a realistic view of the entire

transaction.” Id. (quotation and citation omitted). In Associated Wholesale Grocers, Inc.

v. United States, 927 F.2d 1517 (10th Cir. 1991), we identified three step transaction

tests: “end result,” “interdependence,” and “binding commitment.”

Taxpayer essentially argues that the facts here meet the “binding commitment” test

because his daughters and secretary were not legally obligated to use his gifts to purchase

the bonds. But in Associated Wholesale Grocers we stated that this test is seldom

applied. See id. at 1522 n.6. We thus examine the facts under the other step transaction

tests. The “end result” test amalgamates into a single transaction separate events which

appear to be component parts of something undertaken to reach a particular result. Id. at

1523. The instant case would appear clearly to satisfy the “end result” test. The

“interdependence test” focuses on the relationship between the steps, whether under a

reasonably objective view the steps were so interdependent that the legal relations created

by one of the transactions seem fruitless without completion of the series. Id. Although

the gifts here could stand on their own without relation to the investments, it is difficult to

conceive that the parties would have made the investments as they did, or that they would

9
have agreed to the valuations between life estates and remainders, in the absence of the

gifts taxpayer made. Thus this case would seem to satisfy the “interdependence” test.

We conclude that the Tax Court properly characterized the transactions in the

instant case as impermissible attempts to create amortizable term interests out of

nondepreciable property. We agree with the Gordon opinion that “it is important to note

that what is involved in this case is a simultaneous joint acquisition of income interests

and remainder interests where the consideration moved to a third party who was not in

any way concerned with the arrangements between the joint acquirers. . . . [and that] it is

appropriate to take into account the fact that the participation of the acquirer of the

remainder interest is an essential element in affording the acquirer of the income interest

the opportunity to obtain the tax benefit of an amortization deduction.” 85 T.C. at 325.

We also agree with the Gordon opinion that where, as here, the “parties to the

transactions in question are related, the level of skepticism as to the form of the

transaction is heightened, because of the greater potential for complicity between related

parties in arranging their affairs in a manner devoid of legitimate motivations.” Id.

(quotation and citation omitted).4 Complicity among the parties is further supported by

the following: the parties established their respective purchase obligations by IRS tables

4
Although Permenter is not a natural object of taxpayer’s bounty in the same sense
as his daughters, she is his long time secretary, cotrustee of his revocable trust, and
taxpayer made contemporaneous gifts to her to enable the purchases of her remainder
interests. In such circumstances it is not inappropriate to treat her in the same category as
a related party.

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that are only periodically adjusted and which reflect market values only in a general way;

the parties committed to acting jointly in disposing of their interests, agreeing that if one

wanted to sell he or she must offer to the others at the IRS table valuations; and that there

is no external manifestation of their separate ownerships (as would be the case of

recorded real estate deeds specifying term interests) to permit marketing of a limited

interest to outside parties. Cf. Schultz v. United States, 493 F.2d 1225 (4th Cir. 1974)

(brothers’ gifts of shares in closely held corporation to each other’s children were

reciprocal transactions made to enlarge gifts to own children and thus gift tax exclusion

was properly disallowed).

Finally, although there was no legal requirement that remaindermen would use the

gifts of money to purchase the bonds, taxpayer stipulated that his intention in making the

gifts was to enable the donees to make the purchases. We question the financial capacity

of at least some donees, noting taxpayer ceased making daughter Meredith a party for fear

her creditors might attach her interests. And there is no reason these remaindermen

would question making the investments when taxpayer was giving them the funds to

make their purchases. Expressed colloquially, one does not look a gift horse in the

mouth.

AFFIRMED.

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