Hall v. Commissioner

Grace R. Maxson Hall, Petitioner, v. Commissioner of Internal Revenue, Respondent

Hall v. Commissioner

Docket No. 11090

United States Tax Court

12 T.C. 419; 1949 U.S. Tax Ct. LEXIS 242;

March 24, 1949, Promulgated

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Decision will be entered under Rule 50.

Life Insurance. -- Under certain life insurance contracts which matured and became payable by reason of death of the insured, petitioner elected to receive, for a period of years and so long thereafter as she lived, periodic payments computed with reference to her life expectancy. As to the portions of such payments which are attributable solely to her being the designated beneficiary of the net proceeds of the policies, the parties have stipulated that they are entirely tax-exempt under section 22 (b) (1), I. R. C. As to the portions of such payments which (although payable under the policies by reason of death of the insured) are attributable to petitioner's payment of decedent's debts secured by those policies, held that petitioner is a transferee of interests of decedent's creditors in those policies for a valuable consideration and is entitled to recover her cost tax-free, pursuant to the third sentence of section 22 (b) (2) (A), I. R. C.

Edward Hale Julien, Esq., for the petitioner.

Leonard A. Marcussen, Esq., for the respondent.

Tyson, Judge. Hills, J., concurs only in the result. Murdock, J., dissenting.

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TYSON

Respondent has determined against petitioner an income and victory tax deficiency of $ 498.65 for the calendar year 1943 and by affirmative pleading has asserted claim for an increased deficiency of $ 8.49 for that year. The year 1942 is also involved in this proceeding because of the forgiveness feature of section 6 of the Current Tax Payment Act of 1943.

Two of petitioner's assignments of error have been settled by stipulation as follows: (1) That respondent did not err in disallowing petitioner's claimed deduction for personal exemption of $ 1,200 as head of a family for the calendar years 1942 and 1943, and (2) that respondent erred in determining that petitioner realized taxable income in the total amount of $ 489.22 representing a portion of the benefits received under certain policies of insurance upon the life of her deceased husband, by reason of the fact that she exercised elections under optional modes of payment provisions of the policies whereby she received payments of insurance benefits in installments rather than in one lump sum. Effect to such stipulation will be given in the recomputation under Rule 50.

The question raised by the one remaining assignment of error by petitioner as to respondent's inclusion in income of certain insurance proceeds and also by the respondent's affirmative pleading of error in his failure to include in income certain other insurance proceeds, is essentially the same, namely, whether the portions of periodic payments received by petitioner as the beneficiary under several policies of insurance on the life of her deceased husband, but which are attributable to her paying off the decedent's debts secured by those policies, constitute insurance proceeds which are entirely exempt from tax or constitute payments taxable as an annuity, as determined by respondent.

This proceeding has been submitted upon the pleadings, testimony, and a stipulation of facts, including exhibits attached thereto. The stipulation is included herein by reference as part of our findings.

FINDINGS OF FACT.

Petitioner is an individual whose residence is in San Francisco, California. She filed her income tax returns for the years involved with the collector or internal revenue for the first district of California.

Herbert Gardner Maxson (hereinafter sometimes referred to as the insured or the decedent) died intestate on August 24, 1936, a resident of the State of California. His widow, Grace R. Maxson Hall, petitioner herein, was appointed administratrix of his estate and at the date of decedent's death she was 41 years of age.

At the time of his death the decedent's life was insured with the Mutual Life Insurance Co. of New York (hereinafter referred to as the insurance company) under certain policies of life insurance of which seven are involved herein.

Four similar life insurance policies, designated "Life Income" policies, which were taken out in 1919 and 1924 and were grouped under the insurance company's claim settlement contract No. 43185 with petitioner, had a total commuted value as of the date of decedent's death of $ 113,054.76 and were payable to petitioner as the original beneficiary in specified amounts of "monthly income" for twenty years certain and for as long thereafter as she should live, under designation by the insured when the policies were taken out. Each policy reserved to the insured the right to change the beneficiary and in connection therewith provided that if the insured designated another beneficiary instead of the original beneficiary (petitioner here) the income after the insured's death would "be paid for twenty years certain only." (Italics supplied.) Each policy further provided that "If the age of the Insured or of the Original Beneficiary has been misstated, the income payable hereunder shall be such as the premium paid hereon would have purchased at the correct ages." (Italics supplied.) During his lifetime the decedent borrowed certain sums of money from the insurance company and assigned the four policies to the company as sole security for the loans, upon which there remained owing at date of death the sum of $ 14,737.20. In 1936, after decedent's death, petitioner paid off those loans and from August 24, 1936, including the taxable year 1943, she received the periodic payments due under the policies in monthly payments in the total amount of $ 5,220 per year. Respondent determined that $ 442.12 of the latter amount, representing 3 per cent of the $ 14,737.20 loans paid off by petitioner, constitutes taxable income to her as annuities under section 22 (b) (2) of the Internal Revenue Code.

Two similar life insurance policies, designated "Ordinary Life" policies, which were taken out in 1909 and were grouped under the insurance company's claim settlement contract No. 43187 with petitioner, had a face value as of the date of decedent's death of $ 10,056.42. Each of such policies provided for the payment at the insured's death of specified benefits to the petitioner as the named beneficiary, either in a lump sum or in accordance with one of three optional modes of settlement. After the decedent's death, and after repayment by petitioner of the loans hereinafter mentioned, petitioner, as beneficiary, exercised option No. 3 set forth in each insurance policy, which provided for the beneficiary receiving payment in equal annual payments, in amounts determined in accordance with the table included in the policy and based upon the age of the beneficiary at death of the insured, for a period of twenty years certain and for as long thereafter as she should live. During his lifetime the decedent borrowed a sum of money from the insurance company and assigned those two policies to the company as sole security for the loans, upon which there remained owing at his death the amount of $ 2,689.61. In 1936, after decedent's death, petitioner paid off those loans and from August 24, 1936, including the taxable year 1943, she received the full amount of the periodic payments due under those policies in monthly payments in the total amount of $ 508.32 per year. Respondent determined that $ 80.69 of the latter amount, representing 3 per cent of the $ 2,689.61 loans paid off by petitioner, constitutes taxable income to her as annuities under section 22 (b) (2) of the Internal Revenue Code.

One life insurance policy, No. 4577695, which was taken out in 1932 and came under the insurance company's claim settlement contract No. 43184 with petitioner, had a specified face value of $ 25,000, payable at death to the insured's "executors, administrators or assigns." The premiums on that insurance policy were paid from the community funds of the decedent and petitioner. Under the law of California, petitioner, as the surviving spouse, was entitled to receive and did receive the entire rights in and to the benefits accruing under that policy.

During his lifetime decedent borrowed a sum of money from the Canadian Bank of Commerce of San Francisco, California, (hereinafter referred to as the bank) and assigned policy No. 4577695 to the bank as security for repayment of the loan, upon which there remained due and payable as of the date of decedent's death the sum of $ 17,110.25. The latter sum, plus $ 106.03 interest thereon from date of death to October 23, 1936, making a total of $ 17,216.28, was paid by petitioner to the bank on October 23, 1936, on which date the bank relinquished to petitioner any rights it had in that insurance policy.

Under date of November 19, 1936, petitioner notified the insurance company of her election to receive the benefits accruing under policy No. 4577695 in accordance with the terms of option 3 of the optional modes of settlement set forth therein, namely, equal monthly payments for twenty years certain and as long thereafter as she should live, in amounts determined in accordance with the table included in the policy and based upon the age of the beneficiary at death of the insured. Petitioner's election was honored by the insurance company and since August 24, 1936, including the taxable year 1943, petitioner has received the full amount of the payments due under that policy at the rate of $ 108 per month or $ 1,296 per year. By affirmative pleading respondent claims that $ 516.49 of the $ 1,296 petitioner received each year under the policy, representing 3 per cent of the $ 17,216.28 loan paid off by petitioner, constitutes taxable income to her as annuities under section 22 (b) (2) of the Internal Revenue Code.

The periodic payments involved here and provided for in all the above seven policies were computed with reference to the age and life expectancy of the payee, petitioner here.

The value as of the date of decedent's death of each of the seven policies involved herein was reported in the decedent's Federal estate tax return and was included as a part of the decedent's gross estate for Federal estate tax purposes. Deductions from the decedent's gross estate of the respective amounts, $ 14,737.20, $ 2,689.61, and $ 17,110.25 representing the amounts of decedent's indebtedness to the insurance company or to the bank as of the date of death, were allowed on settlement of decedent's Federal estate tax liability.

The petitioner paid off the decedent's debts, as above mentioned, out of the proceeds of other insurance on the life of the decedent which were paid to her in a lump sum. Such other insurance proceeds were also reported in decedent's Federal estate tax return and were included in the decedent's gross estate for Federal estate tax purposes.

The amount of the periodic payments accruing to and received by the petitioner as the beneficiary under each of the seven life insurance policies involved herein would have been proportionately reduced by the insurance company if the claims against those policies standing as collateral security for the loans made to the decedent had not been satisfied by the petitioner's repayment of such loans.

OPINION.

In asserting the deficiency involved, respondent determined that petitioner received as taxable annuities the entire amounts of the periodic payments made under the seven life insurance policies as to which petitioner-beneficiary, after the insured's death, exercised an option to receive the insurance benefits in such periodic payments. By stipulation and on authority of Katharine C. Pierce, 2 T. C. 832; affd., 146 Fed. (2d) 388; and Law v. Rothensies, 155 Fed. (2d) 13, respondent concedes that the beneficiary's mere exercise of such option does not bring such periodic payments within the category of taxable annuities and, as a consequence, concedes error in his determination with respect to those portions of the periodic payments which are attributable solely to the net proceeds payable to the beneficiary under the policies at date of death after diminution by the decedent's debts outstanding and secured by those policies at date of death. Accordingly, the controversy here involves only those portions of the periodic payments which are attributable to petitioner's having paid off the decedent's debts secured by the policies. The applicable statute is section 22 (b) of the Internal Revenue Code, ^{*424 of decedent's death in 1936, and the broad issue presented is whether such payments are entirely exempt within the meaning of paragraph (1) of section 22 (b), supra, and, if not, whether the first, second, or third sentence of paragraph (2) (A) of section 22 (b) is controlling.}

Petitioner contends that her payment of decedent's debts secured by the policies did not constitute premiums or a consideration paid by her for the purchase of annuity contracts; that the only contracts involved herein are life insurance policies on which the premiums were paid during the lifetime of the deceased insured; that the entire amounts of the periodic payments received by her from the insurance company (including the portions attributable to her paying off the decedent's debts) accrued to her as emanating directly from the decedent's life insurance contracts pursuant to the original provisions contained therein and by reason of the insured's death; and that the entire amounts of such periodic payments constitute "Amounts received under a life insurance contract paid by reason of the death of the insured, whether in a single sum or otherwise" and, therefore, are specifically exempted from tax by section 22 (b) (1), supra.

Respondent contends that, by reason of an election either by the insured prior to his death or by the petitioner after the insured's death and under the specific terms of each of the seven policies, the amounts of the periodic payments received by petitioner are payable to her in the form of annuities; that such periodic payments do not emanate directly or at least entirely from the seven life insurance policies, but also from the insurance company's claim contracts made in settlement with petitioner under those policies after the insured's death; that only the stipulated portions of the periodic payments fall within the tax exemption under the Pierce and Law cases, supra; that the portions of the periodic payments which are attributable to petitioner's paying off the decedent's debts do not constitute amounts received "by reason of the death of the insured," but, instead, constitute annuities which the insurance company under its claim or settlement contracts agreed to pay to petitioner in consideration of her payment of decedent's debts; that the substance of petitioner's transactions in paying off decedent's debts to secure periodic payments larger than otherwise obtainable under the net proceeds of the policies at date of death was the purchase of annuity contracts; and that to the extent attributable thereto the periodic payments received by petitioner constitute "Amounts received as an annuity under an annuity * * * contract" within the meaning of the second sentence of section 22 (b) (2) (A), supra.

There is no question between the parties, and on the facts there can be no doubt, that the entire amounts of the periodic payments received by petitioner from the insurance company pursuant to each of the seven policies and the settlement contracts thereunder constituted payments in the form of annuities, namely, a specified sum of money payable annually or at other periodic intervals for a time longer than one year in return for a fixed consideration and computed with regard to the life expectancy of the payee. Manne v. Commissioner, 155 Fed. (2d) 304, which involved annuity contracts; and George H. Thornley, 2 T. C. 320 (reversed on another issue, 147 Fed. (2d) 416) which involved endowment contracts. It is now well settled by the Pierce and Law cases, supra, and the various authorities therein cited, which involved life insurance contracts, that even though paid in the form of an annuity, periodic payments which constitute "Amounts received under a life insurance contract paid by reason of the death of the insured" fall within the exemption granted in section 22 (b) (1), supra. Accordingly, the mere form of the payments is not alone a criterion for determining whether Congress intended to embrace within that exemption or to exclude therefrom the portions of the periodic payments attributable to the petitioner's paying off the decedent's debts secured by the policies. In our opinion, the form of the payment is not a matter deserving of the emphasis which respondent seems to place upon it.

Section 22 (b), supra, expressly deals with "Exclusions from Gross Income," and paragraphs (1) and (2) (A) thereof deal with such exclusions in whole or in part with regard to insurance proceeds received under life insurance, endowment, or annuity contracts. Paragraph (1) of that section deals with "Amounts received under a life insurance contract paid by reason of the death of the insured," whether in a single sum or otherwise, such as in the form of an annuity, and grants an exemption as to the entire amounts so received, Pierce and Law cases, supra, except for the limitation that the exemption shall not be in excess of cost in cases where the interest in the life insurance contract was acquired by "transfer for a valuable consideration," as provided by the third sentence of paragraph (2) (A) of that section, Charles E. Lambeth, 38 B. T. A. 351. Cf. Alcy Sivyer Hacker, 36 B. T. A. 659, and Haverty Realty & Investment Co., 3 T. C. 161. The first sentence of paragraph (2) (A) of that section deals with "Amounts received * * * under a life insurance or endowment contract" other than by reason of the death of the insured as embraced in the preceding paragraph (1) and other than an annuity as embraced in the next succeeding second sentence of paragraph (2) (A) and grants an exemption of the amounts so received until they "exceed the aggregate premiums or consideration paid," when the excess shall be included in gross income. (Italics supplied.) The second sentence of paragraph (2) (A) of that section deals with "Amounts received as an annuity under an annuity or endowment contract" and provides a formula for computing the percentage of such amounts which shall be excluded from gross income. (Italics supplied.) The third sentence of paragraph (2) (A) of that section deals with cases where an interest in a "life insurance, endowment, or annuity contract" has been acquired by "transfer for a valuable consideration, by assignment or otherwise" and provides that "only the actual value of such consideration" and premiums or other sums subsequently paid by the transferee shall be exempt under paragraphs (1) and (2) (A). (Italics supplied.)

It is clear that section 22 (b), supra, makes a distinction in the exemption or exclusion granted in the case of life insurance contracts, on the one hand, and endowment and annuity contracts, on the other hand. The limitation expressed in the third sentence of paragraph (2) (A) with reference to a transfer for a valuable consideration is made applicable to all three of the named classes of contracts. Except for such limitation, amounts received under life insurance contracts are treated of only in paragraph (1) and the first sentence of paragraph (2) (A) of that section, and under the former are not taxed at all and under the latter are taxed only when the receipts begin to exceed the aggregate premiums or consideration paid, but in no event are amounts received under life insurance contracts made taxable under the 3 per cent formula prescribed, since that formula applies solely to "Amounts received as an annuity under an annuity or endowment contract." (Italics supplied.)

On the facts herein, it is clear that no annuity contract is involved unless, as contended by respondent, the petitioner's transactions in paying off decedent's debts (to obtain receipt of periodic payments, under the settlement contracts, larger than would be otherwise obtainable under the life insurance contracts at date of death) in substance constituted the purchase of an annuity under an annuity contract. In our opinion the petitioner did not purchase an annuity under such a contract from the insurance company, for here no consideration in the sense of a premium or purchase price was paid by petitioner under such a contract. The amounts received by petitioner, and heretofore referred to (for want of a better descriptive expression) as attributable to her paying off decedent's debts, accrued to her under the provisions of the existing life insurance policies and not under any separate contract for a premium or other consideration paid to the insurance company for the purchase of an annuity; for with respect to one policy the insurance company received nothing from petitioner, who merely repaid a sum owed to the bank, which stood in the position of the decedent's creditor, secured by that policy, and with respect to the other six policies the insurance company likewise stood in the position of the decedent's creditor and also received nothing from the petitioner except the repayment of the loans secured by the policies. Furthermore, the settlement contracts between petitioner and the insurance company established no new contractual relationship, but were merely collateral to the life insurance policies in setting forth the company's obligation to the beneficiary under the terms of those policies, which had matured and become payable by reason of the death of the insured.

We conclude that the entire amounts received by petitioner under all seven policies constituted "Amounts received under a life insurance contract paid by reason of the death of the insured" within the meaning of section 22 (b) (1), supra. However, we further conclude that, as to those portions of such amounts which are attributable to petitioner's payment of decedent's debts, we have presented "the case of a transfer for a valuable consideration" of interests in insurance policies within the meaning of the third sentence of section 22 (b) (2) (A), supra, which imposes a limitation on the exemption granted by section 22 (b) (1); Charles E. Lambeth, supra. At date of the insured's death, the petitioner had an interest in each of the seven policies as the beneficiary of the net proceeds thereof after diminution by the decedent's debts secured thereby, and at the same time with respect to one policy the bank had an assignee's interest therein to the extent of the decedent's debt due it, and with respect to each of the six other policies the insurance company likewise had an assignee's interest to the extent of the amount of the debts due it. After the insured's death such assignees' definite matured interests in the policies were transferred to petitioner in consideration of her payment of decedent's debts due them, respectively. At the time the petitioner entered into the settlement contracts with the insurance company for periodic payments, as elected by her pursuant to options provided for in the policies, her interest in each of the policies was that of a designated beneficiary as to a portion of the insurance proceeds, and as to the balance of such proceeds she was a transferee of a beneficial interest for a consideration paid by her.

With respect to those portions of the amounts received by petitioner under each of the seven policies which are attributable to petitioner's payment of decedent's debts, we hold that petitioner is entitled to receive such amounts tax-free until they begin to exceed the actual value of the consideration so paid by her, whereupon the excess becomes taxable income; and, further, that respondent erred in taxing such amounts as taxable annuities.

Under the facts herein it would seem that up to and including the taxable years petitioner had not recovered the cost to her of her transferee's interest in each of the seven policies and that no tax is due on account of the periodic payments received in the taxable years, but whether this is true or not is a matter of mathematical computation which can be resolved in the recomputation under Rule 50.

Decision will be entered under Rule 50.

MURDOCK

Murdock, J., dissenting: I agree with the contention of the respondent as set forth in the third paragraph of the majority opinion.

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Footnotes

• 1. SEC. 22. GROSS INCOME.

  * * * *

  (b) Exclusions from Gross Income. -- The following items shall not be included in gross income and shall be exempt from taxation under this chapter:

  (1) Life Insurance. -- Amounts received under a life insurance contract paid by reason of the death of the insured, whether in a single sum or otherwise (but if such amounts are held by the insurer under an agreement to pay interest thereon, the interest payments shall be included in gross income);

  (2) Annuities, etc. --

  (A) In General. -- Amounts received (other than amounts paid by reason of the death of the insured and interest payments on such amounts and other than amounts received as annuities) under a life insurance or endowment contract, but if such amounts (when added to amounts received before the taxable year under such contract) exceed the aggregate premiums or consideration paid (whether or not paid during the taxable year) then the excess shall be included in gross income. Amounts received as an annuity under an annuity or endowment contract shall be included in gross income; except that there shall be excluded from gross income the excess of the amount received in the taxable year over an amount equal to 3 per centum of the aggregate premiums or consideration paid for such annuity (whether or not paid during such year), until the aggregate amount excluded from gross income under this chapter or prior income tax laws in respect of such annuity equals the aggregate premiums or consideration paid for such annuity. In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance, endowment, or annuity contract, or any interest therein, only the actual value of such consideration and the amount of the premiums and other sums subsequently paid by the transferee shall be exempt from taxation under paragraph (1) or this paragraph.↩