Estate of Bell v. Commissioner

60 T.C. No. 52, 60 T.C. 469, 1973 U.S. Tax Ct. LEXIS 101

• Court: United States Tax Court
• Decided: June 26, 1973
• Docket: Docket No. 8176-71
• Status: Published

Opinions

Quualy, Judge:

Respondent determined the following deficiencies in petitioners’ income tax:

Year Deficiency

1968 _$1, 931. 91

1969 _ 2, 926.11

Some of the facts have been stipulated by the parties and are incorporated herein by reference. As a result of concessions made by the parties, the following issues remain for decision:

(1) The determination of petitioners’ “investment in the contract” in the years 1968 and 1969 for purposes of the exclusion ratio provided for imder section 72 (b);¹

(2) To the extent that petitioners’ “investment in the contract” exceeds their adjusted basis of the stock transferred, the manner of accounting for such excess.

An adjustment to petitioners’ medical deduction for 1968 and 1969 is also involved, but is dependent on the outcome of the issues presented.

FINDINGS OF FACT

Petitioners are the Estate of Lloyd G. Bell, deceased, William Bell as executor, and Grace Bell, the surviving spouse of Lloyd G. Bell. The legal residence of petitioners at the time of the filing of the petition was Rockford, Wash.

Lloyd and Grace Bell filed timely joint Federal income tax returns for the calendar years 1968 and 1969 with the Western Service Center of the Internal Revenue Service at Ogden, Utah. Lloyd Bell died on September 8,1970.

Pursuant to an “Annuity Agreement” dated December 6, 1967, Lloyd and Grace Bell transferred community property consisting of 82214 shares of Bell & Bell, Inc., capital stock and 2,034 shares of Bitterroot, Inc., capital stock to William and Beverly Bell and Calvin A. and Betty Bell Reinertson in exchange for a promise by the transferees to pay them $1,000 per month for so long as either shall live. The stock was placed in escrow as security for the promise of the transferees. As further security, the agreement provided for a cognovit judgment against the transferees in the event of a default. William Bell and Betty Bell Beinertson are the son and daughter, respectively, of Lloyd and Grace Bell.

Bell & Bell, Inc., and Bitterroot, Inc., are both closely held farming corporations. Neither is traded on a stock exchange. Both corporations were formed in 1965 by Lloyd Bell and his son, William Bell, as successors to an informal partnership carried on between father and son.

Lloyd Bell owned one-third of the stock of Bell & Bell, Inc., and two-thirds of the stock of Bitterroot, Inc. William Bell owned the balance of the stock in these corporations.

At the time of the transfer, Lloyd and Grace Bell’s basis in the stock of Bell & Bell, Inc., was $9,559.94, and the basis of their stock in Bitterroot, Inc., was $11,497.63, or a total of $21,057.57. The total fair market value of such stock was $207,600.

Lloyd Bell was 72 years of age and Grace Bell was 68 years of age at the time of transfer. They had a joint life expectancy of 18.7 years. The expected return from the annuity, based upon such life expectancy, was $224,400. The discounted value of the annuity at the time of the transfer was stipulated to be either $142,573 or $126,200.38, depending upon whether the Court finds the correct method of valuation to be the representative cost of a comparable commercial annuity, as petitioners contend, or the tables under section 20.2031-7, Estate Tax Begs., as respondent contends.

Pursuant to the “Annuity Agreement” of December 6,1967, Lloyd and Grace Bell received payments totaling $13,000 during 1968 and $12,000 during 1969.

OPINION

Lloyd Bell and his son, William Bell, formed and operated two closely held farming corporations. Lloyd Bell owned two-thirds of the stock of one and one-third of the stock of the other. His son owned the balance. Pursuant to an “Annuity Agreement” executed December 6, 1967, Lloyd and Grace Bell transferred all their stock in these corporations, owned as community property, to their son and daughter and their respective spouses in exchange for their promise to pay them $1,000 per month for so long as either shall live. The stock transferred was placed in escrow to secure the promise of the transferees. As further security, the agreement provided for a cognovit judgment against the transferees in the event of default. Lloyd and Grace Bell received payments of $13,000 and $12,000, respectively, in the taxable years 1968 and 1969.

The rules for the inclusion in income of said payments are prescribed in section 72. Insofar as material herein, that section provides:

SEO. 72. ANNUITIES; CERTAIN PROCEEDS OF ENDOWMENT AND LIFE INSURANCE CONTRACTS.

(a) General Rules for Annuities. — Except as otherwise provided in this chapter, gross income includes any amount received as an annuity (whether for a period certain or during one or more lives) under an annuity, endowment, or life insurance contract.

(b) Exclusion Ratio. — Gross income does not include that part of any amount received as an annuity under an annuity, endowment, or life insurance contract which hears the same ratio to such amount as the investment in the contract (as of the annuity starting date) bears to the expected return under the contract (as of such date). * * *

(e) Definitions.—

(1) Investment in the contract. — For purposes of subsection (b), the investment in the contract as of the annuity starting date is—

(A) the aggregate amount of premiums or other consideration paid for the contract, minus

(B) the aggregate amount received under the contract before such date, to the extent that such amount was excludable from gross income under this subtitle or prior income tax laws.

The respondent argues that petitioners’ “investment in the contract,” as defined in section 72(c), is petitioners’ adjusted basis for the stock transferred in consideration of the transferees’ promise of an annuity. Rev. Rul. 69-74, 1969-1 C.B. 43. The petitioners argue that their investment in the contract” is the fair market value of the stock transferred, relying on Rev. Rul. 239, 1953-2 C.B. 53, which applied to a similar computation under section 22(b) (2) of the Revenue Act of 1939. Petitioners further contend that the fair market value of the stock was not less than $207,600.

In our opinion, we need not pass on the applicability of either Rev. Rul. 239 or Rev. Rul. 69-74, sufra, since both involve “unsecured” private annuities.² Here, we are dealing with an annuity which is amply secured, not only by the property transferred, but also by a cognovit judgment that would subject all the property of the transferees to attachment without court proceedings.

Section 72(c) (1) defines “investment in the contract” as “the aggregate amount of premiums or other consideration paid for the contract.” Section 22(b) (2) of the 1934, 1936, and 1939 Revenue Acts, predecessors to section 72, contained similar language.³ Under such Acts, this language has uniformly been construed to mean the amount required to purchase the annuity, which in an arm’s-length transfer, is the fair market value of the property transferred. F. A. Gillespie, 38 B.T.A. 673 (1938); Hill’s Estate v. Maloney, 58 F. Supp. 164 (D. N.J. 1944); Jane J. de Can izares, 32 T.C. 345 (1959). Nothing in the statute, the legislative history, or the regulations interpreting section 72 indicates that “consideration paid” on our facts should have a different meaning than it had under section 22(b) (2) of the prior Acts. Here the consideration paid consisted of stock of two closely held farming corporations having an aggregate fair market value of $207,600.

In determining the “consideration paid,” however, the statute presupposes a transaction between unrelated parties dealing at arm’s length. The petitioners claim that the consideration paid for the annuity amounted to $207,600, while at the same time petitioners concede that the discounted value or cost of a commercial annuity providing for the same payments was $142,573. We can only account for such excess as being attributed to the family relationship between the annuitants and the transferees. Such excess, therefore, whether predicated upon the cost of a commercial annuity, as contended for by the petitioners, or upon the annuity tables under section 20.2031-7(f), Estate Tax Kegs., as contended for by the respondent, must be deemed to be a gift. In Commissioner v. Wemyss, 324 U.S. 303, 306 (1945), the Supreme Court makes this clear:

Congress chose not to require an ascertainment of what too often is an elusive state of mind. For purposes of the gift tax it not only dispensed with the test of “donative intent.” It formulated a much more workable external test, that where “property is transferred for less than an adequate and full consideration in money or money’s worth,” the excess in such money value “shall for the purpose of the tax imposed by this title, be deemed a gift * * * * * [Sec. 2512(b).]

See also Anna L. Raymond, 40 B.T.A. 244 (1939), affd. 114 F. 2d 140 (C.A. 7, 1940); Maud Gillespie, 43 B.T.A. 399 (1941), reversed on other grounds 128 F. 2d 140 (C.A. 9, 1942); Bowden v. Commissioner, 234 F. 2d 937 (C.A. 5, 1956).

Our determination that the transfer was a partial gift is further buttressed by the fact that the annuitants did not seek to ascertain the price at which they could have purchased a similar annuity from an insurance company. Nor did the transferees investigate whether the obligation, which they were assuming, was more or less than the value of property received. Their concern was merely whether they could pay the required monthly amounts. The consideration paid for the annuity under these circumstances, therefore, is limited to the commuted value of the annuity contract irrespective of the fair market value of the property transferred.

The parties further disagree on the correct method of valuing the annuity. Petitioners have valued it at $142,573, using the representative cost of a comparable commercial annuity. Respondent, on the other hand, has valued it at $126,200.38, using the Table I under section 20.2031-7 (f), Estate Tax Regs., as provided by section 1.101-2 (e) (1) (iii) (b) (3), Income Tax Regs.

Respondent’s determinations are presumptively correct. To overturn his use of the estate tax tables, petitioners must prove that their use under the circumstances is arbitrary and unreasonable. John C. W. Dix, 46 T.C. 796 (1966), affd. 392 F. 2d 313 (C.A. 4, 1968).

Petitioners object to the actuarial table used by respondent because it is based on the life expectancies of the general population in 1939-41, which does not reflect the longer longevity of the population in 1967, the year of the transfer. Nor does it provide separate tables for men and women, experience indicating that the latter live longer.

Petitioners contend that the cost of a comparable commercial annuity would be a more correct indication of the value of the transferees’ promise. Respondent, however, has presented an expert witness who testified that the rates charged by commercial life insurance companies are affected by factors not present in private annuity transfers. For instance, the commercial price contains a “loading factor” for anticipated expenses and expected profits. Commercial annuitants, as a self-selected class, have a longer life span than the general population. These factors operate to increase the cost of a commercial annuity. So does the fact that commercial companies, being regulated by the State, are restricted in their investments and required to maintain sufficient reserves to assure annuity payments can be made. All these factors have been recognized in prior cases which have rejected using the cost of a commercial annuity to value a private annuity. John C. W. Dix, supra; McMurtry v. Commissioner, 203 F. 2d 659 (C.A. 1, 1953); Estate of Abraham Koshland, 11 T.C. 904 (1948), affd. 177 F. 2d 851 (C.A. 9, 1949); Estate of Koert Bartman, 10 T.C. 1073 (1948); Estelle May Affelder, 7 T.C. 1190 (1946).

The petitioners have presented no evidence to show that the longer life expectancy of commercial annuitants should be attributed to the annuitants in this case, Lloyd and Grace Bell. Indeed, the record indicates that Lloyd Bell died less than 3 years after the transfer. The fact that the table used by the respondent does not distinguish between males and females is of itself not sufficient to prove the use of such tables was arbitrary and unreasonable. John C. W. Dix, supra.

On the basis of the evidence presented, the petitioners have failed to show that respondent’s use of the table under section 20.2031-7 (f), Estate Tax Regs., to Avalué the annuity promise of the transferees was arbitrary and unreasonable. We therefore adopt the respondent’s determination of $126,200.38 as the Avalué of the annuity promise at the time of transfer.

Finally, having determined that the consideration paid by the petitioners for the annuity within the meaning of section 72(c) amounted to $126,200.38, the petitioners must likewise be deemed to have realized a taxable gain on the transfer, measured by the difference between petitioners’ adjusted basis in the stock and the fair market value of the annuity.

Petitioners argue that they should be able to use the cost recovery approach of J. Darsie Lloyd, 33 B.T.A. 903 (1936), before having to report any gain since the value of the promise received is too contingent to be valued for purposes of section 1001. See also Frank C. Leering, 40 B.T.A. 984 (1939); Hill's Estate v. Maloney, supra; Commissioner v. Kann's Estate, 174 F. 2d 357 (C.A. 3, 1949).

We think that petitioners’ reliance on Lloyd is misplaced. That case involved the transfer of certain appreciated stock by a father in exchange for his son’s unsecured promise to make certain annuity payments to him for life. In permitting the father to recover his basis first before having to report any capital gain, the Court held that the son’s promise was too contingent to value for purposes of section 111(c) (now 1001) due to “the uncertainty as to whether or not the one agreeing to make payments will be able to make them as agreed when the time for payment actually arrives.” Cf. Burnet v. Logan, 283 U.S. 404 (1931).

The facts in this case are clearly distinguishable from Lloyd and the cases cited by petitioners. Both petitioners and respondent have elected to treat the exchange of stock for an annuity as a viable transaction for income tax purposes. The annuity was amply secured not only by the stock transferred but also by an agreement providing for a cognovit judgment against the transferees in the event of a default. It was agreed that the stock transferred by Lloyd and Grace Bell had a value of $207,600. It was further agreed that the annuity promise received in return had a substantial value, ranging from $126,200.38, as contended by respondent, to $142,573, as contended by petitioners. This Court has sustained the respondent’s determination with respect to that value.

We thus have a transfer of stock in exchange for a consideration, subject only to a lien to secure payment thereof. Under the laws of the State of Washington, as well as prevailing tax law, this constituted a completed sale. Low v. Colby, 137 Wash. 476, 243 P. 18 (1926); Rockwood v. Green, 179 Wash. 138, 36 P. 2d 61 (1934); cf. Uniform Commercial Code—Sales, Wash. Kev. Code sec. 62A.2-401 (effective July 1, 1967) ;⁴ Pacific Coast Music Jobbers, Inc., 55 T.C. 866 (1971). In fact, except for tbe uncertainty as to tbe ultimate amount payable under the contract, it is no different than any other installment sale. Tbe actuarial tables provide a recognized basis for determining tbe value of the consideration received notwithstanding such uncertainty. John C. W. Dix, supra. Under such circumstances, we find no grounds for tbe application of the cost recovery rule in Burnet v. Logan, supra.

It would be manifestly inconsistent to find that tbe annuity contract bad a fair market value for purposes of determining a taxpayer’s cost or investment in the contract under section 72 (c), and yet to bold it bad no determinable value for purposes of section 1001.

Since the transfer occurred prior to tbe taxable years before tbe Court, no part of tbe amounts received are taxable as gain realized during tbe years before tbe Court.

Reviewed by tbe Court.

Decision will ~be entered wnder Bule 50.

1 All statutory references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated.

2 In fact, some commentators define a “private annuity” as a “transfer of property to a transferee (obligor), who lias not from time to time written annuities, in consideration of tbe transferee’s unsecured promise to make periodic payments of money, for a specified time, to the transferor of the property (annuitant).” Raiborn & Watkins, “Critical Analysis of Private Annuity Taxation,” 50 Taxes 11 (1972).

3 Sec. 22(b) (2), 1939 Code, provided, in pertinent part, as follows :

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 ye,ax), 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. * » *

4 Although sales of stock are excluded from the operation of sec. 62 A.2, Uniform Commercial Code — Sales, Wash. Bev. Code (effective July 1, 1967), there is authority for applying its rules by analogy. Agar v. Orda, 264 N.Y. 248, 190 N.E. 479 (1934), where the Uniform Sales Act, the predecessor to sec. 62 A.2, supra, was extended to the sale of stock. See also Corwin v. Grays Harlior Washingtonian, 151 Wash. 585, 276 P. 902 (1929). In any event, the result reached under the statute on our factB is the same as under common law.