The opinion
Jerome B. Rosenthal and Ruth Rosenthal 1 v. Commissioner.
Rosenthal v. Commissioner
Docket Nos. 67848, 77923-77925, 93832, 1986-62, 1392-64, 1393-64.
United States Tax Court
T.C. Memo 1970-332 ; 1970 Tax Ct. Memo LEXIS 28 ; 29 T.C.M. (CCH) 1521 ; T.C.M. (RIA) 70332 ;
November 30, 1970 , Filed.
*28 Issue 1: Government Bonds Transactions. (a) Held, upon the facts: That in each one of the four transactions involving $1,000,000 Federal Land Bank bonds, $100,000 U.S. Treasury bonds, $100,000 Treasury bonds, and $750,000 Treasury notes, respectively, the petitioner, Jerome B. Rosenthal, did not enter into a bona fide transaction in each instance on February 17, 1953, February 26, 1954, March 1, 1954, and December 23, 1955, respectively, for the purchase of the securities which purportedly were involved; that each transaction was without substance and reality and was a sham transaction; that none of the transactions can be recognized for tax purposes; that in reality petitioner did not puchase the securities referred to in each transaction; that petitioner did not borrow and was not indebted for, in the respective transactions, $1,052,000, $105,000, $105,000, $712,500 (note to Gibraltar), and $37,500 (note to CHK); and that the amounts paid by petitioner during the years involved in each transaction, pursuant to his several "notes", were not interest paid on indebtedness and, therefore, the payments were not deductible under section 23(b), 1939 Code, and section 163(a), 1954 Code. *29
(b) Held: That since each transaction was a sham, there shall be excluded from taxable income, under Rule 50, for the taxable years before theCourt, the respective amounts included in income as "interest received" on the Government securities, and the so-called "capital gains" from the purported sales of the securities. deductions are not allowable for petitioner's out-of-pocket costs as losses from transactions entered into for profit under section 117(g)(2), or as losses from failures to exercise options under section 1234, 1954 Code.
Issue 2: Income in 1953 from BRNM Law Partnership. Held, upon the facts: That Rosenthal did not realize unreported income in 1953 from the BRNM law partnership in the amount of $4,134.81, and that his share thereof did not exceed $25,222.29; respondent's determinations were incorrect.
Issue 3: Deductions for Legal Expenses. Held: That deductions are not allowable under section 212 for legal fees and costs paid in 1960 and 1061; held, further, that the expenditures were personal expenses of Jerome B. Rosenthal and are not deductible under section 262.
Issue 4: Docket Nos. 77923, 77925, Increased Deficiencies for 1955. Held: That the assessment and collection *30 of increases in the deficiencies for 1955, claimed by the respondent, are not barred by the statute of limitations, section 6214(a).
Jerome B. Rosenthal, pro se, * Los Angeles, Calif. Eli Blumenfeld and Myron Weiss,
1522
*10 INDEX
Page Numbers
1. Preliminary Matters 1522-1523
2. Findings of Fact 1523-1555
Issue 1 - Interest Deductions 1523-1550
(a) Transaction 1 1525-1534
(b) Transaction 2 1534-1540
(c) Transaction 3 1540-1544
(d) Transaction 4 1544-1550
Issue 2 - Income, BRNM Law Partnership 1550-1553
Issue 3 - Expenditures, 1960, 1961, Divorce 1553-1554
Issue 4 - Statute of Limita- tions 1554-1555
3. Ultimate Findings of Fact 1555-1558
4. Opinion
Issue 1 - Interest Deductions 1558-1580
Issue 1 - Alternative Deduc- tions 1558-1580
Issue 2 - Income, BRNM Law Partnership 1580-1581
Issue 3 - Deductions, Legal Expenses, Divorce 1581-1589
General Matters 1589
Issue 4 - Statute of Limita- tions 1589-1590
HARRON
Memorandum Findings of Fact and Opinion
HARRON, Judge: Respondent determined deficiencies in income taxes in the *31 total amount of $122,896.84 for the years of 1953, 1955-1958, 1960, and 1961; (the years 1954 and 1959 are not before the Court). For 1955, in his amended pleading (the amended answers), he made a determination denying a deduction of $7,723.67 claimed as an interest deduction, and he made claims for increased deficiencies under section 6214 (a). For 1960, with respect to the separate return in the name of Ruth Rosenthal, he determined a 25 percent penalty, an addition to tax, of $866.38 under section 6651(a). The determinations are as follows (J.R. refers to the petitioner, Jerome B. Rosenthal, and R.R. refers to Ruth Rosenthal): Year Docket No. Deficiency Section6651(a)
1953 67848 $ 26,385.43
1955 77923 R.R. 17,434.80
Increase 2,780.52
77925 J.R. 17,302.80
Increase 2,780.52
1956 77924 21,795.89
1957 93832 18,527.07
1958 1986-62 3,759.04
1960 1392-64 R.R. 3,309.57 $866.38
1393-64 J.R. 3,273.58
1961 1392-64 R.R. 2,782.80
1393-64 J.R. 2,764.82
$122,896.84 $866.38
The taxable years 1954 and 1959 are not before the Court.
The issues are:
1. Whether there was a real and bona fide indebtedness owed by the petitioner, Jerome B. Rosenthal, in each one of four transactions involving Government bonds; or whether each transaction lacked *32 substance or was a sham, so that payments in each of the taxable years were not interest on indebtedness within the meaning of section 23(b), 1939 Code, and section 163(a), 1954 Code. The petitioner made payments, ostensibly as interest, in the taxable years in the following total amounts, for which he took deductions, which were disallowed by respondent: Year Sum Paid and De- ducted as Interest
1953 $ 39,111.01
1955 63,464.62
1956 34,921.41
1957 36,063.61
1958 19,689.77
1960 5,625.00
Total $198,875.42
Because separate returns were filed for 1955 and 1960, deductions of one-half of the payments made in each of those years were deducted on the returns of the petitioner, Ruth B. Rosenthal.
Whether, in the alternative, deductions are allowable for the cost or net out-of-pocket expense, if any, spent in connection with each transaction (a) as losses from transactions entered into for profit, under section 23(e)(2), 1939 Code, or section 117(g)(2), 1954 Code; or (b) as losses resulting from the failure to exercise privileges or options to buy or sell property, under section 165(c), 1939 Code, or section 1234, 1954 Code.
2. Whether Rosenthal's income for 1953 from a former law partnership was more than *33 $25,222.29, as reported in his return.
3. Whether deductions for 1960 and 1961 are allowable under section 212 for legal fees and costs paid in connection with the divorce in 1964 of the petitioners. 1523
4. Whether respondent's claim for increased deficiencies for 1955 is barred by the statute of limitations.
In Docket No. 1392-64, the respondent has conceded that there should not be a 25 percent addition to the tax for 1960 under section 6651(a).
Recomputations of the amounts of the deficiencies for all or some of the taxable years, under Rule 50, are required.
Findings of Fact
Petitioners were residents of Los Angeles and Beverly Hills, California, when their tax returns were filed and their petitions in these cases were filed. All of the returns were filed with the district director of internal revenue at Los Angeles. They were prepared on the cash basis, for calendar years. Joint returns were filed for 1953, 1956, 1957, and 1958; separate returns were filed for 1955, 1960, and 1961.
Jerome B. Rosenthal is referred to herein as the petitioner because all of the income reported in the tax returns resulted from his activities, and the issues involve his transactions. Ruth B. Rosenthal, *34 petitioner's spouse during the taxable years, is a petitioner only because joint returns and separate returns in her name were filed.
Petitioner has practiced law since 1946, and he also engaged in various business activities. He is a member of the Bar of California. In connection with his law practice he advised some of his clients about their business matters and investments.
Petitioner, in the taxable years, did not regularly engage in purchasing and selling securities, on his own account or as an occupation or business.
Issue 1: Federal Land Bank Bonds and Treasury Bonds and Notes: Deductions for Payments of Alleged Interest
During the period of years involved in these cases, petitioner entered into four separate transactions and arrangements. The ostensible purpose of each transaction was the purchase and sale of Government bonds or notes. Petitioner claims that in each transaction he borrowed a large amount of money to finance his claimed purchase of securities. He executed an interest-bearing note in each transaction, which purportedly was security for the claimed borrowing of money, and he made payments of money ostensibly as interest on each note. A schedule of the total *35 sums paid each year, of the alleged interest payments, the deductions of which are in issue, have been set forth in the above statement of the issues to be decided. That schedule is incorporated here instead of repeating it.
Rosenthal's law firm, Rosenthal and Norton, was located at 242 North Canon Drive, Beverly Hills, during the earlier years involved, and later at 250 North Canon Drive. That law firm no longer exists.
Cantor, Fitzgerald Co., referred to herein as Cantor-F, or as C-F, is a firm in Beverly Hills which was engaged in the taxable years as a broker and dealer in securities. Its president was B. Gerald Cantor. John Fitzgerald was a vice-president of C-F from 1947 to 1953. Jack Bernstein was employed by C-F prior to January 1953 when he became employed by Gibraltar Financial Corporation located in New York City. Petitioner, Jerome Rosenthal, was acquainted with B. Gerald Cantor.
Gibraltar was incorporated in New York State in about December 1952. The initial capital invested in Gibraltar was $2,000. From the time of its organization up to 1956, no additional funds were invested in Gibraltar. Jack Bernstein received the capital stock of Gibraltar in exchange for $2,000. *36 He was an employee of Gibraltar from January 1953 to April 1956; he was a director and vice president of Gibraltar; and he directed its operations. Having been employed by Cantor-F before going to Gibraltar, he was re-employed by C-F in Beverly Hills after leaving Gibraltar in about April 1956. Later he became a vice president of Cantor-F, and he was in charge of its New York office when it was opened.
John Fitzgerald became the vice president of Gibraltar in 1953, and he held that office until the business of Gibraltar was terminated, which was at some time in 1959 or 1960. Thereupon, Fitzgerald returned to Cantor-F as a vice president.
Gibraltar had only three or four employees during the period 1952-1956. Included in its business were the type of transactions involved in these cases. It was not subject to any regulatory control. During the years of at least 1953-1956, Cantor-F was Gibraltar's correspondent, and as such C-F was Gibraltar's agent. B. Gerald Cantor discussed the organization of Gibraltar with Bernstein. A major part of Gibraltar's transactions were referred to it by Cantor-F, and B. Gerald Cantor arranged or referred the transactions to Gibraltar. 1524
All of the *37 transactions of Rosenthal with Gibraltar which are in issue in these cases were arranged and referred by B. Gerald Cantor. Gerald Cantor arranged numerous transactions of other individuals which were referred to Gibraltar. Gibraltar received more business from Cantor-F than from other sources. Cantor-F, at its California office, received money from clients for Gibraltar and transferred it to Gibraltar's account.
Gerald Cantor discussed with Bernstein the rate of the charge to be made by Gibraltar, as "interest", at the time transactions were arranged for clients, which were referred to Gibraltar; and that was done with respect to each one of the four transactions of Rosenthal, involved here. Also, Rosenthal discussed with Gerald Cantor, or some one else, the rate of "interest" to be charged by Gibraltar in each transaction.
Irving Trust Company was Gibraltar's clearance agent in New York City. Ordinarily a clearance agent's services include receiving or delivering securities for a client "against payment" of funds provided by the clearance agent, for which service a fee is charged to the client, who maintains an account with the clearance agent. In its services as a clearance agent *38 of Gibraltar, in the transactions in issue here, Irving made charges on its books, and credits, in a reciprocal account between Gibraltar and Irving, and except for amounts to balance this account, no monies ever went from Gibraltar to Irving.
In the transactions of Rosenthal with Gibraltar, there is not evidence that Rosenthal had sufficient funds of his own to actually purchase the total amount of securities involved in the particular transactions in issue. Gibraltar did not have sufficient money to actually "loan" the money to Rosenthal which might have been involved in the transactions in issue. Irving Trust Co. acted as Gibraltar's clearance agent in the Rosenthal transactions in issue, and as such Irving utilized the reciprocal account on its books in the name of Gibraltar.
Gibraltar's method of handling transactions, such as those in issue, was such (with the services of its clearance agent) that Gibraltar did not physically receive securities involved; so that in the Rosenthal transactions, Gibraltar did not physically receive the securities referred to in the written records and documents. Also, Rosenthal never had physical possession of any of the securities referred to in *39 each of the transactions.
In its operations, in general, Gibraltar required that Government securities would be the "collateral" to secure every "loan". In the trade, the term "equivalent securities" means that different items of same issue and same amount are used having different serial numbers than an original lot of securities.
It was provided in the form of each note executed by Rosenthal, made "payable" to Gibraltar, that Gibraltar had the right to borrow, use, and rehypothecate securities "pledged" as collateral for the note.
Rosenthal was not acquainted with Gibraltar's financial condition at any time during the periods of his transactions with Gibraltar. Rosenthal did not recall ever submitting a loan application to Gibraltar for any of the alleged "loans", or his financial statement.
C.F. Childs & Co. was considered to be one of the largest dealers in United States Government securities. Arthur Ehlenberger & Co. was a broker dealing in U.S. Government securities.
B. Gerald Cantor, Irving Hoffstein, and Burt Kleiner at one time formed a partnership, for which the initials of their last names provided the partnership's name, CHK Company. All of these men were connected with *40 the Cantor, Fitzgerald office. Their partnership was formed and used for the purpose of making investments of their own money. CHK was involved in one of the Rosenthal transactions, Transaction 4. There were 4 transactions which purportedly involved "purchases and sales" of Government securities. The following is a list of the transactions, the security "involved", and the dates of the beginning and end of each transaction:
Transaction 1: $1,000,000 Federal Land Bank bonds, bearing 1 3/4 percent interest, due October 1, 1957. This transaction began on February 11, 1953, and was concluded on September 6, 1957.
Transaction 2: $100,000 U.S. Treasury bonds bearing 2 3/4 percent interest, due September 15, 1961. This transaction began on February 25, 1954, and ended on September 14, 1961.
Transaction 3: $100,000 U.S. Treasury bonds bearing 2 3/4 percent interest, due September 15, 1961. The transaction began 1525 on Feb. 26, 1954, and ended September 14, 1961.
Transaction 4: $750,000 U.S. Treasury notes, bearing 1 1/2 percent interest, due April 1, 1960. The transaction began on December 23, 1955, and ended April 1, 1960.
Transaction 1: $1,000,000 Federal Land Bank Bonds
1. The first *41 transaction involved, purportedly, $1,000,000 Federal Land Bank bonds, 1 3/4 percent interest, due October 1, 1957, with interest payable April 1 and October 1, amounting to $17,500 a year, or $8,750 semi-annually.
The evidence about steps followed by Gibraltar with respect to the "purchase" of $1,000,000 of bonds on February 11, 1953, and Gibraltar's handling of the beginning of this transaction is incomplete because the custodian of Gibraltar's records for 1953 could not produce in compliance with respondent's requests the copies of instructions of Gibraltar to its clearance agent, Irving Trust Co., relating to the particular item, of $1,000,000 Land Bank bonds handled on February 11, 1953. Respondent called Jack Bernstein as his witness to testify about Gibraltar's customary procedures, and many matters relating to the four transactions attributed to the petitioner, Rosenthal, in issue here. Also, Gibraltar's records were impounded and held by a custodian, for the purposes of the trial of these cases, pursuant to a motion of respondent which was granted by this Court.
Bernstein, vice president and a director of Gibraltar from January 1953 to April 1956, directed and managed the *42 operations of Gibraltar, and he was personally acquainted with the letters and instructions sent out by Gibraltar in its operations. Respondent subpoenaed him to appear and give testimony in these cases. His testimony established general and specific facts about Gibraltar's customary procedures in transactions of the kind which are involved here in which Rosenthal was a client of Cantor, Fitzgerald Co., and through it, of Gibraltar. For example:
The initial and only capital of Gibraltar was the $2,000 paid in when it was organized and no additional amount of money was paid in to Gibraltar thereafter. On or about February 11, 1953, Gibraltar did not have funds of its own against which it could write a check for $1,000,000, or $961,611. Accordingly, it did not have in February 1953 its own funds with which to pay for a "purchase" of $1,000,000 Land Bank bonds.
Bernstein testified that in general, in a transaction such as the one purportedly involving $1,000,000 Land Bank bonds for its account, for the account of Rosenthal, Gibraltar did not physically take possession of and hold such securities. Instead, its clearance agent, Irving Trust, would receive the securities from a dealer against *43 payment and would debit Gibraltar's bank account with Irving, upon receiving instructions from Gibraltar; and then Irving Trust would redeliver the securities, on the same or next day, to a dealer to whom Gibraltar had sold the securities, against payment, crediting Gibraltar's account with the amount of the proceeds of the sale. Gibraltar would instruct Irving to redeliver against payment by a dealer to cover the first step when the securities were received and taken "In" for Gibraltar's account.
No funds would be borrowed by Gibraltar from Irving because the sale, almost simultaneously, of the securities to a dealer who would pay the proceeds to Irving when the securities went "Out", under the redelivery, would provide a credit to Gibraltar's acount which would cover and offset all, or substantially all, of the debit to the account. This procedure can be described as an "In and Out" mechanics handled by Irving as clearance agent, upon instructions from Gibraltar.
Although Bernstein could not produce, under respondent's subpoena, any copies of Gibraltar's instructions to Irving Trust relating to $1,000,000 of Land Bank bonds attributed to a transaction in February 1953, by Gibraltar *44 and Cantor, Fitzgerald for the account of Rosenthal, he testified that in every transaction in which Rosenthal was the client, namely in the transactions in issue here, there was a sale of Government securities "purchased" for the account of Rosenthal, and described in a promissory note of Rosenthal to Gibraltar as the collateral "pledged" to secure the note. He testified that the customary procedure of Irving was that when Irving received (against payment) some securities for Gibraltar's account, and charged the account and notified Gibraltar of the receipt of the securities, Gibraltar then would instruct Irving to redeliver the same or equivalent securities (against payment) to a dealer to whom Gibraltar would immediately sell the securities which had just been received by Irving for Gibraltar's account. This "In" and "Out" mechanics 1526 handled by Irving as clearance agent for Gibraltar resembled a "short sale" procedure, although strictly speaking the mechanics represented simply Irving's taking securities "In", in Gibraltar's account, and almost at once sending securities "Out" of the account to a dealer to whom Gibraltar had sold them.
The foregoing explains the mechanics employed *45 with respect to $1,000,000 Land Bank bonds, purportedly involved in the first transaction in issue here, if there was in fact an actual purchase thereof by Cantor, Fitzgerald as was represented in C-F's slip to confirm a "purchase". There is no evidence establishing that C-F in fact made a purchase of the bonds apart from its slip.
2. Cantor, Fitzgerald sent Rosenthal its confirmation slip dated February 11, 1953, stating that it had purchased for his account $1,000,000 Land Bank bonds, 1 3/4 percent, due October 1, 1957, at 95 1/2, for $955,000, with $6,611.11 accrued interest, for the total charge of $961,611.11; no commission was charged.
Rosenthal did not make any payment to C-F, and he did not receive delivery of the bonds. He signed letters to C-F, directing it to "deliver" the bonds to Gibraltar against payment of the above charge, and to Gibraltar to "receive" the bonds from C-F and make payment. Gibraltar sent Rosenthal a letter acknowledging "receipt" of the bonds, listing bond numbers.
There is no evidence that C-F actually purchased the bonds; there is not in evidence any slip of a dealer in Land Bank bonds showing a purchase thereof by C-F; and there is no evidence that *46 C-F held any Land Bank bonds in an inventory which it could sell to Rosenthal.
If C-F in fact did purchase the bonds, as represented by C-F's slip, then they were delivered to Irving for Gibraltar's account, against payment; and Gibraltar sold them to a dealer on or about February 17, 1953, and Irving delivered them to the dealer against payment; and Gibraltar's account with Irving was debited and credited, accordingly.
3. If in fact any Land Bank bonds were involved, no money was borrowed by Gibraltar to pay for the bonds as the procedures of Irving, and the book debits and credits to Gibraltar's account with Irving, in an "In" and "Out" transaction on about the same day covered the matter.
No money was in fact loaned by Gibraltar to Rosenthal, and none was borrowed for his account.
4. Rosenthal sent Gibraltar, with his letter dated February 11, a note executed by Rosenthal, dated February 17, 1953, in the amount of $1,052,000, payable to Gibraltar on October 1, 1955. The provisions of the note are set forth later, some of which stated that Rosenthal had "pledged" $1,000,000 Land Bank bonds with Gibraltar, and that Gibraltar had "withheld and reserved" $90,388.90 as security for the *47 payment of interest on the note. The amount of the note, $1,052,000, represented the total of $961,611.11, plus the so-called "reserve" of $90,388.90, less one cent. No part of $961,611.10 was paid to Rosenthal, and Gibraltar did not pay that amount to any payee, out of its own funds, for Rosenthal. As set forth above, the money to pay for the charge for the bonds was derived from funds from the sale on the market of the same bonds. Facts about the reserve of $90,388.90 are set forth later.
5. Under date of February 17, 1953, Gibraltar opened on its books, in the name of Rosenthal, a "Secured Account" in which a debit entry was made of $1,052,000, described as a "Secured Loan", with the explanation that Gibraltar had "Bought or Received" the $1,000,000 Land Bank bonds due October 1, 1957, which bonds were held "Long".
This charge to Rosenthal's account reflected Gibraltar's receipt of Rosenthal's note in the amount of $1,052,000, payable to Gibraltar.
6. Rosenthal executed a printed note of Gibraltar dated February 17, 1953, in the amount of $1,052,000, payable to Gibraltar on October 1, 1955, bearing 3 1/2 percent interest, payable in monthly installments on the dates and in the amounts *48 typed on the note. This note was security for the purported "loan" by Gibraltar to Rosenthal of the above amount, and it was stated on the note that the note was secured by the pledge to Gibraltar of the $1,000,000 Land Bank bonds.
The provisions of the note included the following: That Gibraltar had the right to borrow, re-hypothecate, use, or transfer the pledged bonds for any purpose whatsoever, and to use the pledged bonds "to cover delivery of any securities of similar kind which may have been sold to others by the Gibraltar Financial Corporation, as 1527 principal and for its own account." The note provides further that at the option of Gibraltar, the pledged bonds or collateral "of like kind" can be turned over to the signer of the note upon the payment of the principal of the note, together with interest due on October 1, 1955. In addition, the note provided that petitioner could obtain the return of the collateral (the bonds) or collateral of like kind prior to September 1, 1955, but only upon payment of a penalty, in addition to payment of the principal amount of the note. The penalty was a payment of 1 1/2 percent per year on $1,052,000 from the date of prepayment of the *49 note until October 1, 1955, the due date of the note. Notice of 10 days was required for such prepayment of the note and such prepayment could not be made after September 1, 1955.
The note provides that the bond interest due on the pledged bonds shall be applied to the principal amount of the note; and that the signer of the note shall not be entitled to a refund of any interest paid arising from the reduction of the principal.
The note was renewable for the unpaid balance of principal on October 1, 1955, and could be extended to October 1, 1957. The renewal note was to bear interest for the additional period of time of 1 3/4 percent, payable on the first day of April and October.
It was stated on the original note of February 17, 1953, that the 3 1/2 percent interest was to be paid in installments of specified amounts on the dates and in the amounts typed on the note, namely, $19,555.51 on February 17, 1953, and $9,777.75 on August 17 and October 19, 1953, a total sum of $39,111.01 in 1953; $9,777.75 on January 18, 1954, and $2,444.44 per month beginning on February 15, 1954, through December 15, 1954, a total of $36,666.59 for 1954; and $2,444.44 monthly on January 15, 1955, through *50 August 15, 1955, and on September 15, 1955, $2,444.39, or a total of $21,999.91 for 1955. The sum of all of the periodic payments of "interest" on the original note, as typed on the note, was $97,777.51. However, the note also provided that Gibraltar would pay $90,388.90, to be paid in equal installments to Rosenthal on the dates when Rosenthal was to pay the stated "interest" to Gibraltar, upon the condition that the interest payments were made by Rosenthal. The way in which this provision of the note was carried out is set forth hereinafter.
The total charge by C-F for the bonds was $961,611.11, but the note of Rosenthal to Gibraltar was for $1,052,000, which was $90,388.89 more than the charge for the bonds. The printed note executed by Rosenthal states that as "security" for the payment of interest on the note Gibraltar had withheld $90,388.90 of the principal amount of the note as a "reserve", and that Gibraltar would release and pay to Rosenthal the "reserve" in equal installments on the interest due dates set forth in the note upon the condition that the interest payments would be paid by Rosenthal.
The terms of Rosenthal's note to Gibraltar specifying Rosenthal's periodic payments *51 to Rosenthal out of the so-called "reserve", were carried out by Rosenthal and Gibraltar, respectively. Gibraltar mailed notices to Rosenthal stating that the payment of an installment of "interest" would be due, as provided in the note. Rosenthal wrote checks payable to Gibraltar for each installment of "interest". Gibraltar, in turn, mailed its checks Rosenthal in amounts representing Gibraltar's "release" of parts of the "reserve". During the period February 17, 1953, to September 14, 1955, Rosenthal's checks to Gibraltar for note "interest" totaled $97,777.56. Gibraltar's checks to Rosenthal totaled the amount of the reserve, $90,388.85, leaving a balance of 5 cents in the "reserve". Gibraltar credited the 5 cents to Rosenthal so that it paid him the $90,388.90. (See p. 15 [page 1529], infra.) In effect, Gibraltar refunded $90,388.90 to Rosenthal, so that he paid Gibraltar from his own funds only the net sum of $7,388.66, but he took deductions for $97,777.56. The following schedules for 1953-1955 set forth the respective amounts of Rosenthal's payments to Gibraltar, and Gibraltar's payments to Rosenthal in their exchange of checks: 1528 PAYMENTS OF ROSENTHAL (R) TO GIBRALTAR (G); PAYMENTS OF GIBRALTAR TO
ROSENTHAL; AND NET SUM PAID BY ROSENTHAL
* 10 1953
Check Dates Net Paid
byRosenthal
2/11/53 R to C-F $ 19,555.51
2/21/53 G to R 18,077.78
Net paid by R $ 1,477.73
8/12/53 R to C-F 9,777.75
8/16/53 G to R 9,038.89
Net paid by R 738.86
10/ 9/53 R to C-F 9,777.75
10/13/53 G to N 9,038.89
Net paid by R 738.86
Summary - 1953
Total paid Rosenthal to $39,111.01
Gibraltar
Total paid Gibraltar to 36,155.56
Rosenthal
Net paid Rosenthal to $ 2,955.45
Gibraltar
1954
1/13/54 R to G $ 9,777.75
1/18/54 G to R 9,038.89
Net paid by R $ 738.86
2/12/54 R to G 2,444.44
2/16/54 G to R 2,259.72
Net paid by R 184.72
3/12/54 R to G 2,444.44
3/16/54 G to R 2,259.72
Net paid by R 184.72
4/11/54 R to G 2,444.44
4/18/54 G to R 2,259.72
Net paid by R 184.72
5/12/54 R to G 2,444.44
5/19/54 G to R 2,259.72
Net paid by R 184.72
6/11/54 R to G 2,444.44
6/19/54 G to R 2,259.72
Net paid by R 184.72
7/12/54 R to G 2,444.44
7/18/54 G to R 2,259.72
Net paid by R 184.72
8/13/54 R to G 2,444.44
8/20/54 G to R 2,259.72
Net paid by R 184.72
9/10/54 R to G 2,444.44
9/18/54 G to R 2,259.72
Net paid by R 184.72
10/15/54 R to G 2,444. 44
10/19/54 G to R 2,259.72
Net paid by R 184.72
11/15/54 R to G 2,444.44
11/19/54 G to R 2,259.72
Net paid by R 184.72
12/10/54 R to G 2,444.44
12/19/54 G to R 2,259.72
Net paid by R 184.72
Summary - 1954
Total paid Rosenthal to $36,666.59
Gibraltar
Total paid Gibraltar to 33,895.81
Rosenthal
Net paid Rosenthal to $ 2,770.78
Gibraltar
1955
Check Dates Net Paid
byRosenthal
1/15/55 R to G $ 2,444.44
1/15/55 G to R 2,259.72
Net paid by R $ 184.72
2/11/55 R to G 2,444.44
2/19/55 G to R 2,259.72
Net paid by R 184.72
3/11/55 R to G 2,444.44
3/20/55 G to R 2,259.72
Net paid by R 184.72
4/ 8/55 R to G 2,444.44
4/18/55 G to R 2,259.72
Net paid by R 184.72
5/13/55 R to G 2,444.44
5/20/55 G to R 2,259.72
Net paid by R 184.72
6/10/55 R to G 2,444.44
6/20/55 G to R 2,259.72
Net paid by R 184.72
7/15/55 R to G 2,444.44
7/19/55 G to R 2,259.72
Net paid by R 184.72
8/15/55 R to G 2,444.44
8/30/55 G to R 2,259.72
Net paid by R 184.72
9/12/55 R to G 2,444.44
9/15/55 G to R 2,259.72
Net paid by R 184.72
Summary - 1955
Total paid Rosenthal to $21,999.96
Gibraltar
Total paid Gibraltar to 20,337.53
Rosenthal
Net paid Rosenthal to $ 1,662.43
Gibraltar
Summary - 1953-1955
Total paid Rosenthal to $97,777.56
Gibraltar
Total paid Gibraltar to * 90,388.90
Rosenthal
Net paid by Rosenthal, $ 7,388.66
own funds
*52
1529
7. Rosenthal took deductions for "interest" on his income tax returns for the years 1953-1955 in the sum of his payments to Gibraltar under Transaction 1, as set forth above, namely: 1953, $39,111.01; 1954, $36,666.59; 1955, $21,999.96; total deductions $97,777.56.
8. Although the Land Bank bonds had been sold by Gibraltar on or about February 17, 1953, Gibraltar treated that step as a "borrowing" of the bonds, and Gibraltar credited the accrued bond interest to Rosenthal's account, as the bond interest became due, during the period February 17, 1953, to September 5, 1957. During 1956 and 1957, Gibraltar paid accrued bond interest to Rosenthal at the same time as Rosenthal paid "interest" on his second note to Gibraltar, as is set forth later.
Rosenthal reported the accrued interest on the bonds as income on his income tax returns for the years 1953-1957, as is set forth later.
As of February 11, 1953, the accrued interest on the bonds was $6,611.11. Since this amount was part of the total charge 1530 for the bonds, Rosenthal did not report this amount of bond interest in his 1953 income. The accrued interest on the bonds *53 in 1953 was $17,500, which amount, less $6,611.11, was $10,888.89.
9. Gibraltar credited the principal amount of Rosenthal's note with the annual bond interest, $17,500, for 1953, 1954, and 1955. The sum of the credits was $52,500. They reduced the principal amount of the note from $1,052,000 to $999,500, as of October 1, 1955, when the note became due.
The credits to the principal amount of the note were made pursuant to a provision in the note. The note also provided that the note, referred to hereinafter as the first note, could be renewed for a period ending October 1, 1957.
10. Rosenthal executed a second note, dated October 1, 1955, in the principal amount of $999,500, payable to Gibraltar on October 1, 1957, bearing 1 3/4 percent interest (instead of 3 1/2 perecnt, as on the first note). This note is referred to hereinafter as the second note.
The note stated that it was secured by the $1,000,000 Federal Land Bank bonds due October 1, 1957. Some of the provisions of the second note were the same as those of the first note, but there was no provision that part of the principal amount was to be retained by Gibraltar as a "reserve" to secure the payment of interest, and there was *54 no provision for applying any amount, collected by Gibraltar with respect to the pledged collateral, to reduce the principal amount of the note. The note provided that Gibraltar could borrow, rehypothecate, and use the pledged securities. The second note was a different printed note of Gibraltar than the first note, in several respects.
In Rosenthal's account on Gibraltar's books the amount of the purported "loan" of $1,052,000, a debit, was reduced when the credits for the accrued bond interest were entered, so that as of the date of the second note the purported "loan" had been reduced by the credits to $999,500.
The amount and due dates of the "interest" on the second note, as stated thereon, were April 1 and October 1, 1956, $8,891.38 on each date; April 1, 1957, $8,842.80; and October 1, 1957, $8,891.38; total, $35,516.94. The last installment of interest was subsequently reduced by $1,360.38 as of September 5, 1957, to $7,530.93, which reduced the total charge for "interest" to $34,156.49.
11. Rosenthal made payments by check to Gibraltar for the interest on the second note, as prescribed for 1956 and for April 1, 1957. He received a credit for note interest accrued to September *55 5, 1957, as stated later.
The renewal note provided that petitioner could not obtain return of the "pledged" bonds prior to 30 days before October 1, 1957, the due date of the note. Petitioner could "apply the market value of the securities pledged herein * * * to the payment of the note" by giving written notice, but the right could be exercised no earlier than 30 days before the due date of the note and no later than 10 days before the due date.
With respect to the Land Bank bonds (purportedly involved) the above-described privilege was not of any real significance or benefit because the bonds were to mature on October 1, 1957, which also was the due date of the note, and they were to be redeemed at par.
Gibraltar's payments to petitioner (and credits) in the guise of "interest earned" by the Land Bank bonds represented amounts which would have been earned as interest on the bonds if either Gibraltar or petitioner had possession of them. Since no bonds were in fact held by Gibraltar during the entire period of this transaction for petitioner's account, and since none were in fact pledged as collateral with Gibraltar, Gibraltar did not receive any interest paid on any Land Bank bonds. *56 Petitioner reported in his income on his tax returns amounts which allegedly represented "interest earned" on the bonds.
The payments described as "interest" in the second note were slightly more than the amount of the interest on the Land Bank bonds which Gibraltar would have received if it held the bonds. In fact, Gibraltar simply refunded to petitioner most of his payments of "interest" on the note. Thus, on April 2, 1956, petitioner paid Gibraltar $8,891.38 as "interest" on the note, and Gibraltar paid petitioner $8,750 ostensibly as interest earned on the Land Bank bonds, but the $8,750 was in substance a refund of the $8,891.38, except $141.38, petitioner's net payment.
He took deductions for "interest" on the second note on his income tax returns, $17,782.76 for 1956, and $16,373.73 for 1957. 1531 The total sum of the "interest" charged on the second note was $34,156.49, which was deducted.
Gibraltar paid the accrued bond interest to Rosenthal for 1956, $8,750 due April 1 and October 1; and $8,750 due on April 1, 1957; total $26,250. Rosenthal reported the bond interest in his tax returns for 1956 and 1957.
For 1956 and April 1, 1957, Rosenthal paid a total sum to Gibraltar, *57 as note "interest", of $26,625.56; and Gibraltar paid Rosenthal $26,250, as bond interest, so that the net amount paid by Rosenthal from his own funds was $375.56.
12. As of September 5, 1957, Gibraltar purportedly sold $1,000,000 Land Bank bonds, for Rosenthal's account of the same issue of the 1 3/4 percent bonds due October 1, 1957, as set forth hereinafter. The amount of the accrued bond interest to September 5 was $7,534.72. The amount of the "interest" on the second note, accrued to September 5, 1957, was $7,530.93, which was a charge, or debit, to Rosenthal's account on Gibraltar's books. The credit to Rosenthal's account as of September 5 of the entire proceeds of the sale of bonds had the effect of providing a credit of accrued bond interest, $7,534.72, to the charge for accrued note "interest" of $7,530.93, leaving a net credit of $3.79 in Rosenthal's favor. That balance was credited to Rosenthal's account reducing a debit balance from $1,562.45 to $1,558.66, which Rosenthal paid to Gibraltar on October 2, 1957, the amount constituting the balance owing to Gibraltar after bonds were sold on September 5. The net amount of Rosenthal's cash payments of "interest" on the second *58 note from his own funds was $375.56, as follows: *10 Summary of Net Cash "Interest" Payments on Second Note,
1956-1957
Total "interest" payments by Rosenthal $26,625.56
Total bond interest paid by Gibraltar 26,250.00
Net payments by Rosenthal from our funds $ 375.56
13. The following schedule shows Rosenthal's cash payments of "interest" on the second note; Gibraltar's payments to him of accrued bond interest; the net expense to Rosenthal (from his own funds) of note "interest"; and the credit to Rosenthal's account for accrued bond interest on September 5, 1957, which credit on the books was a part of the credit for the proceeds from the sale of bonds. *10 Rosenthal's Second Note, and Gibraltar's Payments to Rosenthal Cash
for Note "Interest"; Cash for Bond "Interest"; Credit
*10 Cash Accounting
Dates Paid by Rosenthal as Paid by Gibraltar as Net Expenseof
Note"Interest" Bond"Interest" Rosenthal
4/2/56 $ 8,891.38 $ 8,750.00 $141.38
10/1/56 8,891.38 8,750.00 141.38
4/1/57 8,842.80 8,750.00 92.80
$26,625.56 $26,250.00 $375.56
*109/6/57 7,530.93 Credit of Bond Interest
to Rosenthal
*10 $34,156.49 Total Interest on
Secondnote of Rosenthal
The net expense to Rosenthal, in cash, with respect to "interest" on his two notes, was *59 $7,764.22, after receiving cash payments from Gibraltar: Note 1 Net cash expense $7,388.66
Note 2 Net cash expense 375.56
Total net cash expense $7,764.22
With respect to Transaction 1, Rosenthal's deductions on his income tax returns for the years 1953-1957 totaled $131,934.05, which represented his cash payments to Gibraltar of purported interest on his two notes, $124,403.12, and Gibraltar's credit on its books to Rosenthal's account of $7,530.93 for accrued bond interest credited to Rosenthal's account when the bonds were sold on September 5, 1957.
14. As of September 5, 1957, the transaction was concluded by a purported sale of $1,000,000 of Land Bank bonds of the same issue as those bought and sold on or about February 11, 1953, namely, 1 3/4 percent bonds due October 1, 1957. Cantor-F (C-F) handled the sale of these bonds on September 5, 1957. The bonds were sold by 1532 Cantor-F as broker, for Rosenthal's account, at the market price of 99-27/32, or $998,437.50, less $500 commission, plus accrued interest of $7,534.72. The Rosenthal transaction was closed about 25 days before the date when the particular issue of Land Bank bonds would become due and would be redeemed at 100, on October *60 1. The mechanics followed to close the transaction were the same as those followed on February 11, 1953, when bonds were "purchased" for Rosenthal's account.
Cantor-Fitzgerald sold on September 5 a new lot of $1,000,000 of the same issue of Land Bank bonds, Gibraltar "purchasing" $1,000,000 of Land Bank bonds on or about September 5 to cover the sale. Gibraltar's clearance agent, Irving, "received" the bonds on September 5 "against payment" and "redelivered" the bonds to Chemical, clearance agent for Cantor-Fitzgerald "against payment" of $1,005,472.22. Irving debited Gibraltar's account when it "received" the bonds "against payment" for Gibraltar, and credited Gibraltar's account $1,005,472.22 when it "delivered" the bonds to Chemical "against payment" of that amount.
No money was borrowed. The "sale" of the bonds, on the same date as the "purchase" of bonds to cover the sale, provided the funds to pay for the charges for the bonds. The mechanics made the "purchase" by Gibraltar to cover C-F's "sale" a wash-out.
Cantor-Fitzgerald issued its statement confirming a sale of the bonds for Rosenthal's account for $1,005,972.22. Cantor charged a commission of $500. Rosenthal's account on *61 Gibraltar's books was credited $1,005,472.22, which represented the following: Sold $1,000,000 bonds at 99-27/32 $ 998,437.50
Less commission of C-F 500.00
Net selling price $ 997,937.50
Plus bond interest to Sept. 5 7,534.72
Total net proceeds $1,005,472.22
15. In Rosenthal's account on the books of Gibraltar, an adjustment was made of five cents, reducing the amount of Rosenthal's second note from $999,500 to $999,499.95. As of September 6, a debit to his account was made for "interest" accrued on the note to September 6 in the amount of $7,530.93, so that as of September 6, there was purportedly owing to Gibraltar $1,007,030.88. His account was credited with $1,005,472.22, the sale proceeds, which left a balance due of $1,558.66. Gibraltar sent Rosenthal a letter stating the balance due, which Rosenthal paid by check on October 2, 1957, which closed the account in Rosenthal's name.
16. On his 1957 tax return, Rosenthal reported a long-term capital gain from the sale of the Federal Land Bank bonds of $42,937.50, of which 50 percent was taken in account in reporting income from capital gains: 9/ 6/57 Proceeds from sale $997,937.50
2/17/53 Cost 955,000.00
Capital gain $ 42,937.50
17. In fact, the *62 arrangements and the transaction for Rosenthal by Cantor-F and Gibraltar did not yield a real and true gain of $42,937.50. Rather, the whole transaction, apart from the anticipated tax benefits, resulted in a deficit in the account on Gibraltar's books of $1,558.66. The deficit resulted from the fact that the purported "loan" of Gibraltar to Rosenthal included a purported "loan" of $90,388.90, to cover part of the note interest, so that the total purported "loan" of $1,052,000, plus all of the charges for note interest, less all of the credits to principal and note interest, for bond interest, was not fully satisfied by sale of the bonds in 1957, and the account showed an amount still "owing" by Rosenthal of $1,558.66 on the principal amount of the "loan."
18. The schedule set forth later is a summary of the account on Gibraltar's books in the name of Rosenthal which was the book-keeping record of the purported loan in 1953 of $1,052,000. This schedule reflects Gibraltar's charges on its books, in the total amounts, respectively, for interest on each one of the two notes, and the total sum of the credits to the account for bond interest, and note interest. As of September 6, 1957, *63 the debits exceeded credits by $1,558.66, so that the entire transaction, after the sale on September 5, 1957, of $1,000,000 Land Bank bonds (to close the transaction) showed a loss instead of a gain to Rosenthal of $1,558.66, apart from anticipated tax benefits, which was the balance due to Gibraltar, which was paid by Rosenthal.
In his 1957 income tax return, Rosenthal reported a capital gain of $42,937.50 from the sale of the bonds. However, the initial note to Gibraltar was for $1,052,000, and that figure incorporated the "reserve" for note interest of $90,388.89, and bond interest accrued to February 11, 1953, 1533 $6,611.11, or $97,000. Thus, the initial debit to Rosenthal's account included $97,000 more than the "cost" of the bonds in 1953, ($955,000), used in computing "gain" upon the sale of a like amount of bonds in 1957.
The credits, direct or part of some larger credit figure, in the account which offset the debits of $97,000 were credits to capital (rather than to the charges for interest). They totaled $95,441.34, which was $1,558.66 less than the above-described debits. Those credits were the five cents ($0.05) adjustment in reduction of the principal amount of the second *64 note; the credit to the principal of the first note of $52,500 for accrued bond interest for three years, 1953-1955, inclusive; the reported capital gain of $42,937.50; and the credit of $3.79, the excess of accrued bond interest over accrued note interest for the period April 1, 1957, to September 5, 1957.
Excluding expected tax benefits, petitioner could not have made a profit in this transaction, purportedly involving $1,000,000 Land Bank bonds, on the basis of purportedly "borrowing" $1,052,000 from Gibraltar to fund the purchase. to fund the purchase.
19. The following schedule summarizes the debits and credits to petitioner's account on Gibraltar's books and shows the net results: Debits to Rosenthal's Account
2/17/53 Charge for $1,000,000 bonds $ 955,000.00
Accrued bond interest 6,611.11
$ 961,611.11
The "Reserve" 90,388.90
Rosenthal's note less.01 $1,052,000,00
"Interest" charged, Note 1 97,777.56
"Interest" charged, Note 2 34,156.49
Total charges $1,183,934.05
Credits to Rosenthal's Account
1953-1955 "Bond Interest", credit to note $ 52,500.00
Pd., Gibraltar to R, "Reserve" 90,388.90
Net "Interest" pd. by R 7,388.66
1955-1957 "Bond Interest" pd. G to R 26,250.00
Net "Interest" pd. by R 375.56
9/5/57 "Bond Interest" credited by G 7,534.72
1955-1957 Cash and credits, total $ 184,437.84
9/5/57 Credit for "Sale" of bonds 997,937.50
Credit to principal of note .05
Credits $1,182,375.39
Balance owing by R, paid 1,558.66
Total credits $1,183,934.05
*65 20. Rosenthal reported in income on the income tax returns filed for 1953-1957 the following amounts for each year as "interest received" on the Land Bank bonds, in the total amount of $79,673.61. Also, in the return for 1957 he reported capital gain from the "sale" of the bonds of $42,937.50, one-half of which, $21,468.75, was taken into account in reporting taxable income: *10 "Bond
Interest"
Reported
as Income
1953 Credited by G to note $10,888.89
1954 Credited by G to note 17,500.00
1955 Credited by G to note 17,500.00
1956 Paid by G to Rosenthal 17,500.00
1957 Paid by G to Rosenthal $8,750.00
Sales proceeds credit 7,534.72 16,284.72
$79,673.61
21. Respondent conceded at the trial of these cases that if the transaction is held to have been a paper transaction, a sham, then under Rule 50 the "bond interest" and the "capital gain" shall be excluded from taxable income.
22. Net out-of-pocket expense means the excess of cash paid over cash received, without any consideration of possible tax benefits. Rosenthal's net out-of-pocket expense in this transaction was $9,322.88, which was the total sum of his payments from his own funds as "interest" on his notes to Gibraltar, $7,764.22, plus the amount paid as *66 the balance owing to Gibraltar on the note when the account was closed, $1,558.66.
23. There was a net economic loss to Rosenthal in this transaction of $9,322.94 computed as follows: *10 Net Economic Loss
Interest charged on notes $131,934.05
Capital gain $42,937.50
Bond interest reported in income 79,673.61 122,611.11
Rosenthal's net economic loss $ 9,322.94
24. The range of the high and low bid prices for the Land Bank bonds between 1953 and 1957 was: Low * *67 *68 *69 *70 *71 *72 *73 *74 *75 *76 *77 *78 94-16/32 to 99-26/32
High * 95.0 to 99-26/32
7. Although *79 no bonds were held and no earned bond interest was paid to and received by Gibraltar for 1954 and 1955 for coupons attached to the bonds, Gibraltar, on its books, credited to petitioner's account the bond interest which would have been received if the bonds had effectively been purchased and held for his account in the amount of $2,332.18 for 1954, and $2,750 for 1955, a total of $5,082.18. The credits were to note principal reducing it from $105,000 to $99,917.82. (The figure of $2,332.18 for "earned bond interest" for 1954 is $417.82 less than $2,750.00. The adjustment is not explained by the record.) Petitioner did not receive any earned interest on the bonds.
8. As of September 15, 1961, the maturity date of the bonds, Gibraltar credited $100,000 to petitioner's account, which was $82.18 more than the debit balance of $99,917.82. Gibraltar sent petitioner a slip confirming a "purchase" of the bonds from him on Sept. 14, 1961, "X-coupons", for $100,000. Gibraltar paid petitioner $82.18, which closed the account. The "purchase" by Gibraltar as principal was merely a paper transaction consisting of the book credit to petitioner's account which cancelled petitioner's note to Gibraltar *80 and the purported "loan" of $105,000.
9. The following schedule is a summary and explanation of the book debits and credits to petitioner's account: *10 Debits
to R's
Account
2/25/54 Charged for bonds X coupons $ 86,812.50
Charged for accrued interest 828.04
Gibraltar's "reserve" 17,359.46
R's note to G $105,000.00
Note "interest" 21,111.11
Total charges $126,111.11
Credits to R's Account
1954-55 Bond "interest" credited $ 5,082.18
1954-58 G's payments to R 17,359.46
1954-58 Net pd. by R, "interest" 3,751.65
$ 26,193.29
9/15/61 Credit for "purchase" by G 100,000.00
Total credits $126,193.29
9/15/61 Less bal. pd. to R 82.18
$126,111.11
10. On the 1961 tax return, petitioner reported long-term capital gain of $13,187.50: 9/14/61 Sale of bonds $100,000.00
2/25/54 Cost 86,812.50
Long term capital gain $ 13,187.50
11. Petitioner's net out-of-pocket expense in this transaction was $3,669.47: Net amount pd. as note "interest" $3,751.65
Less receipt from G 82,18
Net cost $3,669.47
1539
There was a net economic loss to petitioner in the transaction of $3,669.47 computed as follows: Net Economic Loss
"Interest" charged on note $21,111.11
Less: Capital gain $13,187.50
"Bond interest" 4,254.14 17,441.64
Net economic loss $ 3,669.47
12. Petitioner reported *81 as income in the returns for 1954, 1955, and 1961, bond "interest" of $4,254.14, and the capital gain. There was reported as bond "interest" for 1954, $1,504.14 which was $2,332.18 less $828.04 charged as accrued interest to Feb. 25, 1954. Bond "interest" reported was $1,504.14 plus $2,750.00, $4,254.14.
Respondent agrees that upon our determination that this transaction cannot be recognized for tax purposes, there shall be excluded from the taxable income of the years before the Court here the reported bond interest and capital gain.
13. On the returns filed for 1954-1958, petitioner took deductions for the "interest" set forth on his note to Gibraltar as the amounts to be paid in each year, as follows: 1954 $ 4,222.22
1955 4,222.24
1956 4,222.24
1957 4,222.24
1958 4,222.17
$21,111.11
All of the "interest" charged on the note, which was due Sept. 15, 1961, was prepaid by petitioner by October 13, 1958.
14. Apart from expected tax benefits, petitioner could not have realized or expected to realize a profit from this transaction involving a purported loan of $105,000.
15. The following is a list of the bid prices for Treasury bonds due September 15, 1961, during the period March 31, 1954, to *82 Sept. 1, 1960. The fractions represent the denominator of "32", such as 26/32. The bid prices approached 100 as the dates came closer to Sept. 15, 1961: *10 UNITED STATES
TREASURY BONDS
*10 2 3/4% DUE
9/15/61
*10 WITH COUPONS
ATTACHED
*10 LOW BID PRICES
Year Date Low BidPrice
1954 Mar. 31 103-26
Apr. 1 103-26
May 26 102-30
June 2 103-2
July 27 103-26
Aug. 9 103-18
Sept. 28 103-11
Oct. 25 103-0
Nov. 29 102-19
Dec. 28 102-7
1955 Jan. 17 101-7
Feb. 28 100-25
Mar. 1 100-23
Apr. 26 100-22
May 6 100-19
June 27 99-31
July 29 99-4
Aug. 1 98-29
Sept. 1 99-2
Oct. 5 99-21
Nov. 21 99-10
Dec. 22 99-1
1956 Jan. 3 98-31
Feb. 23 99-28
Mar. 28 98-22
Apr. 16 97-26
May 9 98-7
June 26 98-28
July 31 97-30
Aug. 21 96-24
Sept. 5 96-15
Oct. 29 96-28
Nov. 27 96-4
Dec. 17 95-24
1957 Jan. 2 96-9
Feb. 18 97-8
Mar. 7 97-6
Apr. 30 96-22
May 27 96-2
June 21 95-12
July 22 95-2
Aug. 12 95-4
Sept. 25 95-10
Oct. 31 95-0
Nov. 1 95-6
Dec. 2 98-16
1958 Jan. 6 99-24
Feb. 3 99-30
Mar. 11 100-22
Apr. 2 101-6
May 1 101-22
June 27 101-8
July 29 100-14
Aug. 29 98-0
Sept. 29 97-20
Oct. 1 97-14
Nov. 3 97-30
Dec. 22 97-14
1959 Jan. 19 96-24
Feb. 2 97-2
Mar. 9 97-0
Apr. 21 96-30
May 13 96-26
June 4 96-12
July 28 96-6
Aug. 31 95-28
Sept. 15 95-22
Oct. 2 95-30
Nov. 30 96-10
Dec. 3 95-30
1960 Jan. 6 96-6
Feb. 19 96-24
Mar. 1 97-16
Apr. 12 97-30
May 19 97-28
June 1 98-8
July 8 99-10
Aug. 16 99-24
Sept. 12 99-23
Oct. 10 99-25
Nov. 21 99-25
Dec. 1 99-27
1961 Jan. 9 10 0-0
Feb. 28 99-30
Mar. 1 99-30
Apr. 3 100-0
May 24 100-1
June 2 100-0
July 31 100-1
Aug. 8 100-0
Sept. 1 100-0
*83 1540
Transaction 3: $100,000 U.S. Treasury Bonds
1. On February 26, 1954, settlement date March 1, $100,000 United States Treasury bonds, 2 3/4 percent interest, due September 15, 1961, with the interest coupons payable on March 15, 1956, detached, and also with the subsequent interest coupons detached, were purchased through Joseph Faroll & Co., a dealer in New York City, to be delivered to Irving Trust Co., for the account of Gibraltar, for the account of Rosenthal. The coupon interest on the Treasury bonds was payable on March 15 and September 15, $1,375 on each date, $2,750 annually. The charge for the bonds, with coupons detached, was 86-30/32. The total charge was $87,788.33, including accrued bond interest of $850.83 to February 26, as follows: Purchase price, 86-30/32 $86,937.50
Dealer's commission 0
Accrued bond interest to Feb. 26 850.83
Total purchase price $87,788.33
The bonds were located in New York City. Rosenthal did not make any payment on account of the above charge.
2. On March 1, Faroll delivered the bonds to Irving Trust, clearance agent for Gibraltar, for the account of Gibraltar, against payment of $87,788.33. Irving debited Gibraltar's account for $87,790.83, which *84 included a clearance fee of $2.50.
3. Gibraltar instructed Irving to re-deliver the $100,000 Treasury bonds upon receipt thereof, to C. J. Devine, a dealer, against payment, March 1, because on or about February 26 Gibraltar had placed an order to sell the bonds to Devine. Irving's receipt from Devine of the proceeds from the sale of the bonds covered and paid for Faroll's charge for them. Gibraltar sold the bonds to Devine with all of the coupons attached, for March 15, 1954 and thereafter including those "detached" coupons for March 15, 1956, and thereafter, which was necessary because coupons had to be attached in order to make a good delivery of the bonds. It was unusual to purchase Treasury bonds with some of the coupons detached, as was done in the order to Faroll.
Devine bought the bonds, with all of the coupons attached, at 103-10/32. The sum paid by Devine to Irving Trust was $104,170.92, which included accrued interest to March 1, 1954, of about $1,139.67, assuming that the price of 103-10/32 represented $103,031.25.
The price of 103-10/32 was 16-12/32 more than was charged by Faroll for the bonds, with certain coupons "detached. " Faroll's charge of 86-30/32 was a price *85 discounted for the detached coupons.
Gibraltar evidently was charged separately (at some point) by Irving for the detached coupons. When Irving delivered the bonds to Devine the detached coupons were "re-attached" to the bonds, if in fact they had been detached.
Irving received the bonds from Faroll on March 1, 1954, against payment, and redelivered them to Devine against payment on March 1, 1954. This was an "In" and "Out" transaction in which no funds were borrowed as the sale to Devine substantially covered the charge of Faroll, and a charge for detached coupons. The immediate sale to Devine cancelled the purchase from Faroll in a wash-out. There was not a real "short sale" although the mechanics used resembled one.
In Gibraltar's account with Irving, the proceeds of the sale to Devine were credited, $104,170.92, which exceeded the debit of $87,790.83 by $16,380.09. The difference between Faroll's charge and Devine's payment was $16,382.59. The evidence does not show the details. Presumably the excess amount of the credit covered a charge at some point for the "detached" coupons, presumably a debit to the account, also. If on Irving's books the debits exceeded the credit for the *86 receipt from Devine, that fact is not shown by the evidence but, if so, it was presumably a relatively small amount.
Since this transaction involved a promissory note of petitioner to Gibraltar to mature on September 15, 1961, the same date as the maturity of the Treasury bonds, a profit could be figured on bonds redeemed at 100 only by fixing in advance a "cost" at 1541 a discounted charge, such as 86-30/32 (which was done). Such discounted "purchase price" could be fixed in advance on the basis of purchasing the bonds from Faroll with 12 coupons detached (which was done). This transaction was, therefore arranged so that as of September 14, 1961, there would appear to be a capital gain of $13,062.50, which was the gain reported by petitioner.
In this transaction no money was borrowed by Gibraltar for petitioner, and no funds were loaned to him to fund the purchase of bonds.
4. Rosenthal executed a note dated March 1, 1954, payable to Gibraltar September 15, 1961, the due date of the Treasury bonds, in the amount of $105,000, which represented the sum of the purported "cost" of the bonds, $87,788.33 (Faroll) plus a socalled "reserve" of $17,211.67, to be paid by Gibraltar to Rosenthal. *87 The note carried 2 5/8 interest to be paid in installments, quarterly, to October 15, 1958, only, and no "interest" was to be paid after October 15, 1958. The total amount of the "interest" installments typed on the note was $21,088.15, about $4,217.64 a year to be paid to Gibraltar. Since Gibraltar was to pay $17,211.67 to Rosenthal, his net payments to Gibraltar were to be the difference of $3,876.48. As is shown in schedules hereafter, petitioner and Gibraltar made the reciprocal cash payments to each other, periodically. The "exchanged" checks, and in fact and substance Gibraltar's payments were refunds to petitioner of most of his payments of "interest" on his note.
The note stated that $100,000 Treasury bonds, 2 3/4 percent, due September 15, 1961, with the coupons detached for March 15, 1956, and subsequent coupons, were "pledged" as collateral with Gibraltar.
The note provisions included the following: That the "reserve" of $17,211.67 "with-held" by Gibraltar was to secure the payments of "interest", and that Gibraltar would "release and pay" petitioner the reserve in equal installments on the dates when the note "interest" was due, if paid. After 1954, petitioner's "interest" *88 installments were $1,054.41, and Gibraltar's "reserve" installments were $860.58, so that petitioner's net installments quarterly from his own funds were $193.83, or $775.32 a year (4 quarters).
The note provided that Gibraltar could borrow and re-pledge, use, or transfer the collateral (the Treasury bonds) for any purpose, and to use the collateral to cover delivery of any securities of similar kind.
The note provided for a penalty for prepayment of the principal amount; petitioner could obtain the return of the collateral, or collateral of like kind, upon full payment of the principal on the due date of the note, September 15, 1961, with interest. The "right of prepayment granted" could be exercised on 30 days notice up to March 15, 1961, but only upon payment of 1 1/2 percent per year (the penalty) on $105,000, principal, from the date of prepayment until Sept. 15, 1961.
Since the "collateral" consisted, purportedly of government bonds to be redeemed for $100,000 on Sept. 15, 1961, the "prepayment" right had little significance in this instance. The principal amount of the note was $105,000, or $5,000 more than the principal amount of the Treasury bonds, and it would not have been *89 economical for petitioner to have obtained "the return" of the bonds (even if they had been held by Gibraltar) at the cost of the premium, or penalty, for prepayment. Also, the market prices of the bonds never went higher than 103-26/32 on and after March 31, 1954. Moreover, the purpose of the penalty was to help to avoid prepayment of the note before its due date.
The note provided that interest on the "pledged" bonds would be applied to reduce the principal of the note, but the signer of the note would not be entitled to any refund of note "interest."
Gibraltar did not borrow or pay to petitioner the principal amount of the note, $105,000, and no part thereof was paid, in substance to him. As noted above, Gibraltar's payments of the so-called reserve to petitioner were, in substance, refunds to him of his installment payments of "interest" on his note.
5. As of March 1, 1954, Gibraltar opened on its books a "secured" account in petitioner's name with a debit of $105,000, with the entry that Gibraltar had "bought or received" $100,000 Treasury bonds, which were "held" "long." The debit reflected no more than the receipt of petitioner's note. In fact and substance, the debit entry *90 did not reflect an actual loan to petitioner of $105,000.
6. The following schedules list the reciprocal payments made by petitioner and Gibraltar during 1954-1958 as note "interest", and as releases of the "reserve", respectively: 1542 * 10 PAYMENTS OF
ROSENTHAL (R) TO
GIBRALTAR (G);
PAYMENTS OF
GIBRALTAR TO
ROSENTHAL AND NET
SUM PAID BY
ROSENTHAL
* 10 1954
Check Dates Net Paid
by Rosenthal
3/ 1/54 R to G $4,217.63
3/ 4/54 G to R 3,442.33
Net paid by R $ 775.30
1955
1/19/55 R to G $1,054.41
1/22/55 G to R 860.58
Net paid by R 193.83
4/ 8/55 R to G 1,054.41
4/17/55 G to R 860.58
Net paid by R 193.83
7/15/55 R to G 1,054.41
7/18/55 G to R 860.58
Net paid by R 193.83
10/ 7/55 R to G 1,054.41
10/10/55 G to R 860.58
Net paid by R 193.83
Summary - 1954 and 1955
Total paid Rosenthal to Gibraltar $4,217.64
Total paid Gibraltar to Rosenthal 3,442.32
Net paid Rosenthal to Gibraltar, 1955 $ 775.32
Net paid Rosenthal to Gibraltar, 1954 $ 775.30
1956
1/10/56 R to G $1,054.41
1/14/56 G to R 860.58
Net paid by R $ 193.83
3/31/56 R to G 1,054.41
4/21/56 G to R 860.58
Net paid by R 193.83
7/ 9/56 R to G 1,054.41
7/16/56 G to R 860.58
Net paid by R 193.83
10/15/56 R to G 1,054.41
10/19/56 G to R 860.58
Net paid by R 193.83
Summary - 1956
Total paid Rosenthal to Gibraltar $4,217.64
Total paid Gibraltar to Rosenthal 3,442.32
Net paid Rosenthal to Gibraltar $ 775.32
* 10 1957
1/14/57 R to G $1,054.41
1/18/57 G to R 860.58
Net paid by R $ 193.83
4/ 8/57 R to G 1,054.41
4/12/57 G to R 860.58
Net paid by R 193.83
7/15/57 R to G 1,054.41
7/22/57 G to R 860.58
Net paid by R 193.83
10/14/57 R to G 1,054.41
10/16/57 G to R 860.58
Net paid by R 193.83
Summary - 1957
Total paid Rosenthal to Gibraltar $4,217.64
Total paid Gibraltar to Rosenthal 3,442.32
Net paid Rosenthal to Gibraltar $ 775.32
* 10 1958
1/13/58 R to G $1,054.41
1/17/58 G to R 860.58
Net paid by R $ 193.83
4/ 7/58 R to G 1,054.41
4/11/58 G to R 860.58
Net paid by R 193.83
7/23/58 R to G 1,054.41
7/30/58 G to R 860.58
Net paid by R 193.83
10/13/58 R to G 1,054.37
10/14/58 G to R 860.56
Net paid by R 193.81
Summary - 1958
Total paid Rosenthal to Gibraltar $4,217.60
Total paid Gibraltar to Rosenthal 3,442.30
Net paid Rosenthal to Gibraltar $ 775.30
Summary - 1954-1958
Total paid Rosenthal to Gibraltar $21,088.15
Total paid Gibraltar to Rosenthal * 17,211.59
Net paid by Rosenthal, own funds $ 3,876.56
*91
7. Rosenthal took deductions for "interest" on his income tax returns for the years 1954-1958 and on his wife's return for 1955 in the sum of his payments to Gibraltar under Transaction 3, as set forth above, namely: 1954, $4,217.63; 1955, $4,217.64; 1956, $4,217.64; 1957, $4,217.64; 1958, $4,217.60; total deductions, $21,088.15.
8. Although the Treasury bonds had been sold by Gibraltar on or about February 26, 1954, and no earned interest was received by Gibraltar for 1954 and 1955 for coupons "attached", nevertheless Gibraltar, on its books, credited petitioner's account the bond interest which would have been received if the bonds had been purchased effectively and held. The credits were $2,332.18 for 1954, and $2,750 for 1955, a total of $5,082.18.
Petitioner's note to Gibraltar was in the principal amount of $105,000. The credits 1543 for bond interest of $5,082.18, reduced the amount owing on the note, first by $5,000.00 to $100,000, leaving $82.18 of the credit to be applied to the account. As is stated hereafter, Gibraltar paid petitioner $82.18 in closing the account.
9. On September 14, 1961, Gibraltar *92 sent to petitioner a slip to confirm its "purchase" from him of $100,000 Treasury bonds, 2 3/4 percent, due September 15, 1961. The amount of the credit to petitioner was $100,000, which was credited on the books to petitioner. This credit was represented by the confirmation slip of Gibraltar, only. No bonds were bought and sold.
On the books, the debit balance for the note of petitioner $105,000, had been reduced by the credits for bond interest $5,082.18, to $99,917.82. The credit as of September 15, 1961 (the closing date) of $100,000 left a credit balance due petitioner of $82.18.
Gibraltar wrote a check for $82.18 to clear and close the account, which also contributed to the cancellation of petitioner's note.
10. Petitioner reported a long term capital gain of $13,062.50 for 1961 from the transaction, on the separate returns filed for 1961: 9/14/61 Sale of bonds $100,000.00
2/25/54 "Cost" 86,937.50
Capital gain $ 13,062.50
11. Petitioner's out-of-pocket expense in this transaction was $3,794.38; Net sum paid to G as note interest $3,876.56
Less payment by G to R 82.18
$3,794.38
His out-of-pocket expense may have been $3,794.30. The difference of 8 cents was involved because Gibraltar's payments *93 of the "reserve" to petitioner, the refunds, were $17,211.59, which was 8 cents less than the "reserve" stated in the note of $17,211.67. Gibraltar may have given petitioner a credit for 8 cents.
12. Petitioner's net economic loss from the transaction was $3,794.30: *10 Net Economic Loss
Interest charged by G on note $21,088.15
Capital gain $13,062.50
Bond interest 4,231.35 17,293.85
Net economic loss $ 3,794.30
13. Petitioner reported on his tax returns as income from bond interest the net amount of $4,231.35, which represented accrued bond interest for 1954, $2,332.18; less $850.83, bond interest accrued to Feb. 26, 1954, part of "cost"; leaving $1,481.35 as "interest income" for 1954. He reported as bond-interest-income for 1955, $2,750; which made a total for bond "interest" of $4,231.35.
14. Respondent has agreed that if it is held that this transaction was a sham and is not to be recognized for tax purposes, there shall be eliminated from taxable income, the "capital gain" and the bond "interest" reported in income.
15. The following schedule is a summary of the debits and credits to petitioner's account on Gibraltar's books for this transaction: *10 Debits to
Account
3/1/54 Charge for bonds $ 86,937.50
3/1/54 Bond interest accrued to 2/26/54 850.83
$ 87,788.33
3/1/54 "Reserve" included in note of R 17,211.67
Total amount of Rosenthal's note $ 105,000.00
Total of charges by Gibraltar, "interest" 21,088.15
Total debits $126,088.15
*10 Credits to Account
Bond "interest" '54 credited by G to note principal $ 2,332.18
Bond "interest" '55 credited by G to note principal 2,750.00
Payments to R by Gibraltar, "Re- serve" (with.08) 17,211.67
Net cash paid by R to G as "in- terest" 3,876.48
Credit "purchase" of bonds by G 100,000.00
Total amount of credits $126,170.33
Excess of credits pd. to R to balance 82.18
$126,088.15
16. *94 The following is a list of the market bid prices for Treasury bonds, due Sept. 15, 1961, with all coupons attached. Fractions have the denominator, 32.
Apart from considerations of tax benefits, petitioner could not have realized an actual gain from this transaction. *10 UNITED STATES TREASURY
BONDS
*10 2 3/4% DUE 9/15/61
*10 WITH COUPONS ATTACHED
*10 LOW BID PRICES
Year Date Low Bid Price
1954 Mar. 31 103-26
Apr. 1 103-26
May 26 102-30
June 2 103-2
July 27 103-26
Aug. 9 103-18
Sept. 28 103-11
Oct. 25 103-0
Nov. 29 102-19
Dec. 28 102-7
1955 Jan. 17 101-7
Feb. 28 100-25
Mar. 1 100-23
Apr. 26 100-22
May 6 100-19
June 27 99-31
July 29 99-4
Aug. 1 98-29
Sept. 1 99-2
Oct. 5 99-21
Nov. 21 99-10
Dec. 22 99-1
1956 Jan. 3 98-31
Feb. 23 99-28
Mar. 28 98-22
Apr. 16 97-26
May 9 98-7
May 9 98-7
June 26 98-28
July 31 97-30
Aug. 21 96-24
Sept. 5 96-15
Oct. 29 96-28
Nov. 27 96-4
Dec. 17 95-24
1957 Jan. 2 96-9
Feb. 18 97-8
Mar. 7 97-6
Apr. 30 96-22
May 27 96-2
June 21 95-12
July 22 95-2
Aug. 12 95-4
Sept. 25 95-10
Oct. 31 95-0
Nov. 1 95-6
Dec. 2 98-16
1958 Jan. 6 99-24
Feb. 3 99-30
Mar. 11 100-22
Apr. 2 101-6
May 1 101-22
June 27 101-8
July 29 100-14
Aug. 29 98-0
Sept. 29 97-20
Oct. 1 97-14
Nov. 3 97-30
Dec. 22 97-14
1959 Jan. 19 96-24
Feb. 2 97-2
Mar. 9 97-0
Apr. 21 96-30
May 13 96-26
June 4 96-12
July 28 96-6
Aug. 31 95-28
Sept. 15 95-22
Oct. 2 95-30
Nov. 30 96-10
Dec. 3 95-30
1960 Jan. 6 96-6
Feb. 19 96-24
Mar. 1 97-16
Apr. 12 97-30
May 19 97-28
June 1 98-8
July 8 99-10
Aug. 16 99-24
Sept. 12 99-23
Oct. 10 99-25
Nov. 21 99-25
Dec. 1 99-27
1961 Jan. 9 100-0
Feb. 28 99-30
Mar. 1 99-30
Apr. 3 100-0
May 24 100-1
June 2 100-0
July 31 100-1
Aug. 8 100-0
Sept. 1 100-0
*95 1544
Transaction 4: $750,000 U.S. Treasury Notes
1. This transaction involved $750,000 U.S. Treasury notes bearing 1 1/2 percent interest due April 1, 1960. It was initiated by Gibraltar December 23, 1955, by a purchase on that date through Joseph Faroll & Co., a dealer in New York City. On December 23, 1955, the same day, Gibraltar sold the securities to or through Arthur Ehlenberger, a dealer in Government securities in New York City. Neither Gibraltar nor Rosenthal took possession, as the customary procedure was used by Gibraltar whereby the purchase and sale on the same date were handled by Irving Trust Co., Gibraltar's clearance agent, and the appropriate debits and credits were made by Irving Trust in Gibraltar's account. These securities are referred to hereafter as "bonds" so as to avoid confusing them with "notes" executed by Rosenthal as part of the transaction.
This transaction was closed on Gibraltar's books as of the maturity date of the Treasury bonds, April 1, 1960, by a purported "purchase" of the bonds from Rosenthal by Gibraltar at par, $750,000, the bonds having been sold to Ehlenberger & Co. on December 23, 1955, without any "replacement".
The pattern and mechanics *96 of this transaction were such that Gibraltar did not "borrow" or "lend" any funds to "purchase" the Treasury bonds, which had a cost of $715,546.88. No loan was made to Rosenthal to finance the "purchase" of the bonds. He did not use funds provided by Gibraltar to purchase the Government bonds. As one of the steps followed, Rosenthal executed a note payable to Gibraltar in the amount of $712,500, due April 1, 1960, the maturity date of the Government bonds. The note-form used was one of Gibraltar's printed notes. The note provided for periodic payments of "interest" 1545 on the note to Gibraltar. Most of the duedates for those "interest" payments were the first day of April and October of 1956 to 1960, the same dates as earned coupon interest on the Treasury notes would have been paid if those securities had been effectively purchased and held for petitioner's account with Gibraltar. As is shown hereieafter, by paying purported coupon interest on the purportedly held Treasury notes to petitioner in the same amount as his payments of "interest" on his note to Gibraltar, Gibraltar in effect refunded the "interest" payments to petitioner.
In this transaction, there was a different procedure *97 which was not involved in the other three transactions. It consisted of a purported "loan" of $37,500 to petitioner by the partnership known as CHK. This step was in fact related to and was part of the transaction with Gibraltar as is shown hereinafter.
2. Petitioner reported as income the payments which Gibraltar made to him ostensibly as earned interest on the Treasury notes, in the joint or separate tax returns filed for himself and his then wife, and he reported capital gain from this transaction for 1960 in the amount of $34,453.12. Respondent conceded at the trial that if it is held that the transaction cannot be recognized for tax purposes and the claimed deductions for "interest" are not allowed, then it will follow that no income was realized from interest on the Treasury notes or from capital gain, and such income as was reported will be eliminated from taxable income in the Rule 50 computations to be made after the decision of these cases.
It is noted, also, that in his original determinations, respondent did not "discover" the deduction taken on the separate tax returns for 1955 for "interest" paid to CHK, and so he did not disallow that claimed deduction. However, respondent, *98 in amendments to his pleadings in Docket Nos. 77923 and 77925 has made claims for increases in the deficiencies on the ground that the payment to CHK is not deductible.
3. On December 23, 1955, a purchase was made through Faroll & Co., settlement date the same, of $750,000 U.S. Treasury notes, 1 1/2 percent, due April 1, 1960, at the market price of 95-12/32, for "cash", or $715,312.50. Faroll charged a commission of $234.38. The total charge included accrued interest on the Treasury notes of $2,551.23; and the total charge was $718,098.11, as follows: $750,000 Treasury notes, 95-12/32 $715,312.50
Faroll's commission 234.38
Cost $715,546.88
Accrued interest to 12/23/55 2,551.23
Faroll's total charge $718,098.11
This purchase was entered on Faroll's records as one "in an account with" Jerome B. Rosenthal. However, Faroll issued a statement in that account showing that there were on December 23, 1955, a purchase of $750,000 U.S. Treasury notes due April 1, 1960, and on the same date, delivery of those securities to Irving Trust Co. against payment of $712,500 which was credited to Rosenthal's account; and that on the same date, $5,598.11, cash, was also credited to Rosenthal's account being a *99 deposit of that amount in a bank account of Faroll in Los Angeles in Farmers Merchants National Bank. The credit of the latter amount closed the account with Faroll; it is explained hereinafter.
4. On December 23, 1955, Gibraltar instructed its clearance agent in New York City, Irving Trust, to receive against payment of $712,500, the $750,000 Treasury notes from Faroll, in New York City, account of J. B. Rosenthal.
Gibraltar also instructed Irving Trust on the same date to deliver the securities to another clearance agent, Chemical Corn Exchange Bank, for the account of another dealer in Government securities, Arthur Ehlenberger Co., against payment by Chemical Bank. Irving Trust made that delivery of the securities and received $717,554.36.
Both instructions to Irving Trust had the same office record number, 188. Irving charged Gibraltar a fee of $18.75 for the receipt of the securities from Faroll and the redelivery of them on the same date to Chemical Bank for Ehlenberger. Irving debited and credited Gibraltar's account on its books on December 23, 1955, as follows: Credit (Ehlenberger) $717,554.36
Debit (Faroll) 712,518.75
Credit balance to Gibraltar $ 5,035.61
The Treasury notes, *100 with their accrued interest, cost $717,863.73, without Faroll's commission of $234.38. The record does not explain the difference between Faroll's charge and Ehlenberger's payment for the Treasury notes but the difference of $309.37 probably represented Ehlenberger's commission. 1546
There was a cash payment to Faroll, to its bank correspondent in Los Angeles, on December 23, 1955, of $5,598.11 (explained hereinafter). The credit balance in Gibraltar's favor in its account with Irving Trust ($5,035.61) was $562.50 less than that cash payment to Faroll. The credit balance in the Irving Trust account is accounted for by the cash payment to Faroll's account which was made by Rosenthal, as is later explained.
5. The transaction on December 23, 1955, in $750,000 Treasury notes, was an "In" and "Out" transaction on the same day in which no money was borrowed by Gibraltar, or by Rosenthal, or for Rosenthal. There was a very short use of Gibraltar's clearance account with Irving Trust, for which $18.75 was paid by Gibraltar. The sale to Ehlenberger off-set the purchase on the same day from Faroll and provided the funds which were paid to Faroll. As is shown hereinafter, Gibraltar provided, *101 in shown hereinafter, Gibraltar provided, in effect, the cash paid by Rosenthal to Faroll's account in Los Angeles, $5,598.11. And Gibraltar received back substantially all of that cash advance on the same date in the form of the credit balance in its account with Irving Trust of $5,035.61. Except, therefore, for the small "service" charge to Gibraltar of $18.75, and the broker's commissions noted above, and a cash advance from Gibraltar, through CHK, of the net amount of $562.50 (described above), no money was used in the transaction on December 23, 1955, involving $750,000 face amount of Treasury notes. There was not an actual and bona fide indebtedness owing by anyone for the $750,000 Treasury notes, such as $712,500 or any other amount, and Gibraltar did not make a loan of $712,500, or any other amount to Rosenthal.
In form, and as part of the mechanics used, Rosenthal sent telegrams on December 23, 1955, to Faroll to deliver $750,000 Treasury notes to Gibraltar against payment of $712,500; and to Gibraltar to receive the securities from Faroll against payment of the same amount. Gibraltar sent Rosenthal a confirmation slip with the same date "confirming" its "receipt" for his *102 account, from Faroll, of the Treasury notes against payment of the same amount. The confirmation slip listed the serial numbers of Treasury notes, and their denominations, which had been "received" from Faroll.
6. Rosenthal executed a note dated December 23, 1955, in the amount of $712,500 payable to Gibraltar, due on April 1, 1960, bearing 2 3/8 percent interest payable in installments on the first of April and October from October 1, 1956, to April 1, 1960, in the amount of $5,625 on each date, or $11,250 per year. Also, the note provided for a prepayment of interest on December 23, 1955, of $25,301.11, and $3,073.77 on April 1, 1956, making the total payments $73,374.88.
In the case of this note to Gibraltar, it was not provided that Gibraltar would make payments to Rosenthal of a so-called "reserve" fund, as had been done in other notes to Gibraltar. However, as is stated hereinafter, Gibraltar advanced to Rosenthal, through the CHK partnership, as a "loan", $37,500 on December 23, 1955, for which advance Rosenthal signed a note payable to CHK for $37,500. The amounts of the two notes of Rosenthal totaled $750,000, the principal amount of the Treasury notes which purportedly were *103 involved in this transaction with Gibraltar.
On December 23, 1955, Gibraltar opened a "loan" account on its books in Rosenthal's name charging $712,500 as a "loan secured" by $750,000 Treasury notes, held "Long". That debit entry reflected Rosenthal's note to Gibraltar.
The main provisions of the note to Gibraltar were as follows: That $750,000 Treasury notes, 1 1/2 percent, due April 1, 1960, were pledged by Rosenthal to secure payment of the note and interest; that Gibraltar was given the right to borrow and hypothecate or use the pledged securities for any purpose, including the right to use them to cover delivery of any similar securities "which may have been sold to others by" Gibraltar "as principal and for its own account"; that Rosenthal was entitled to the "return of" the pledged securities or securities of like kind "upon the full payment of the principal and interest at maturity.'
The note further provided that Rosenthal could elect to have the "market value of the securities pledged" applied to the payment of the note, but this election could be made no earlier than 30 days prior to April 1, 1960, the date of the maturity of the note to Gibraltar, and no later than 10 days *104 before April 1, 1960. Under that provision, Rosenthal could not obtain a return of the purportedly pledged Treasury notes 1547 any earlier than April 1, 1960. The note also provided that Gibraltar could collect the interest on the pledged securities and apply it in reduction of the principal amount of the note to Gibraltar. Rosenthal's note was a "full recourse" note binding upon his legal representatives and assigns.
7. It has been noted (p. 7-(c)) that Gerald Cantor, president of Cantor-Fitzgerald, Irving Hofstein, and Burt Kleiner were the members of a partnership called C.H.K. Company, and that Hofstein and Kleiner also were associated with Cantor-Fitzgerald. Gerald Cantor referred to Gibraltar and arranged the four transactions with Rosenthal at issue in these cases, and Cantor Fitzgerald was the correspondent for Gibraltar during the years involved here. All of the "interest" rates which were to be charged petitioner by Gibraltar were discussed by Gerald Cantor and Jack Bernstein, who then was the vice-president and director of Gibraltar and, later, became a vice-president of Cantor-Fitzgerald.
Betty Young was employed by Cantor-Fitzgerald (when these cases were tried) as a stocks *105 cashier; at one time she was one of its bookkeepers; and at another time she was in charge of its accounting department. Before the above employments, she was employed by Gibraltar as a bookkeeper. She testified in these cases about various bookkeeping records of Gibraltar including a loan of Gibraltar to CHK.
CHK borrowed $106,250 from Gibraltar on December 23, 1955, which was entered in a loan account on Gibraltar's books in the name of CHK. Entries were made in CHK's loan account on Gibraltar's books with respect to the loan of $106,250 charging 5 individuals, respectively, with portions thereof, with a notation of a date in December 1955 as follows: 12/23/55 Jerome B. Rosenthal $ 37,500
12/23/55 Samuel P. Norton 25,000
12/23/55 Frank De Vol 12,500
12/23/55 Marvin Miller 12,500
12/23/55 Henry C. Rogers 18,750
$106,250
On December 23, 1955, therefore, CHK borrowed $37,500 from Gibraltar to loan to Rosenthal, which was a part of an advance of $106,250 by Gibraltar to CHK.
8. By its check dated December 23, 1955, the CHK Company paid $37,500, to Rosenthal. Rosenthal signed an unsecured promissory note having the same date, payable to CHK, in the amount of $37,500, due April 1, 1960, bearing 4 3/4 *106 percent interest.
9. Rosenthal made payments on December 23, 1955, totaling $38,622.89, as follows: (a) To Faroll & Co $ 5,598.11
(b) To CHK, prepaid note "interest" 7,723.67
(c) To Gibraltar note "interest" due 12/23/55 25,301.11
$38,622.89
Since Rosenthal had received $37,500 from CHK on the same date as the above payments, it is evident that he provided the difference, $1,122.89, out of his own funds. However, as is shown later, Rosenthal received a payment from Gibraltar on April 1, 1956, of $5,625.00 for purported coupon interest on Treasury notes, which exceeded Rosenthal's payment on March 31, 1956, to Gibraltar for interest on his note to Gibraltar, $3,073.77, by $2,551.23. Therefore, Rosenthal received cash from Gibraltar which more than repaid the $1,122.89 which he had advanced from his own funds on December 23, 1955.
Rosenthal's payments of $38,622.89 were directly related to his transaction with Gibraltar purportedly involving $750,000 Treasury notes, as follows:
(1) He paid $5,598.11 to Faroll & Co. on December 23, 1955, by a deposit to its account with Farmers Merchants National Bank in Los Angeles. His cash payment reduced the amount to be paid by Gibraltar (through Irving Trust) *107 from $718,098.11 to $712,500 (See pages 57-58, supra). Since Irving Trust received $717,554.36 from Ehlenberger, which was credited to Gibraltar's account, and since Irving's debit to that account for its payment to Faroll included only the net amount of $712,500, Gibraltar received back $5,035.61, (via Ehlenberger and Irving Trust) which was the credit balance due Gibraltar in its account with Irving. (See p. 58, supra.)
(2) Rosenthal's note to Gibraltar required an "interest" payment on December 23, 1955, to Gibraltar of $25,301.11. Rosenthal made that payment to Gibraltar, not from his own funds but out of the cash received from CHK, which it had borrowed from Gibraltar. Thus, through CHK, Gibraltar had in fact provided a "reserve" which provided petitioner with cash with which to make the payment of $25,301.11 to Gibraltar. There was, in those steps, a round-robin of cash from and back to Gibraltar, using CHK as a conduit. Petitioner did not have to use his own funds to make the payment of $25,301.11 to 1548 Gibraltar. All of these steps occurred on the same day.
(3) The note for $37,500 payable to CHK was for a period of about 4 years and 3 months, to April 1, 1960. At 4 3/4 *108 percent, the charge for "interest" on that note was $7,723.67. Petitioner paid that amount to CHK on December 23, 1955, as a prepayment of all of the interest on that note.
There is no evidence that CHK retained the payment of $7,723.67, or that CHK did not transfer that amount to Gibraltar, which had provided the $37,500 which CHK had paid to Rosenthal.
10. The coupon interest on $750,000 Treasury notes at 1 1/2 percent would have amounted to $11,250 annually, payable $5,625 on April 1 and October 1, if those securities had been purchased and held for Rosenthal's account by Gibraltar. Since the securities were sold on the same day as the purchase, and were not "replaced" by Gibraltar, it did not receive any coupon interest on Treasury notes.
In the book account in Rosenthal's name, Gibraltar made credits to the account for interest on the Treasury notes, nevertheless, in the amounts which would have been received if they had been bought and held. Gibraltar mailed to petitioner credit advices for Treasury note interest to petitioner; and Gibraltar made cash payments to petitioner in the same amounts as the coupon interest on Treasury notes for the years 1956, 1957, 1958, and 1959. *109 Gibraltar gave petitioner a book credit for interest on the Treasury notes which would have been paid on April 1, 1960, in the amount of $5,625, as is set forth later.
Gibraltar's cash payments to petitioner of the purported interest on Treasury notes was $11,250 for each of the 4 years, 1956-1959, and the sum of those payments was $45,000.
For the 4 years, 1956-1959, Rosenthal's payments to Gibraltar for the prescribed "interest" on his note to Gibraltar, beginning April 1, 1956, totaled $42,448.77. Gibraltar's cash payments to petitioner were $2,551.23 more than petitioner's cash payments to Gibraltar. In fact, Gibraltar refunded to petitioner all of his purported note-interest payments for the 4 years 1956-1959.
It has been stated above that petitioner's payments on December 23, 1955, totaling $38,622.89, exceeded the cash received from CHK, $37,500.00 by $1,122.89; and that Gibraltar's cash payment to petitioner of $5,625 on or about April 1, 1956, exceeded his payment to Gibraltar of $3,073.77, the "interest" on his note by $2,551.23. Petitioner's receipt of $2,551.23 over and above his payment to Gibraltar served to repay the $1,122.89 to him, and he realized a net receipt from *110 Gibraltar of $1,428.34 more than he expended: 4/ 1/56 Rec'd from G,T. note "in- terest" $5,625.00
3/31/56 Pd. to G, "interest" 3,073.77
Surplus rec'd by R $2,551.23
12/23/55 Net pd. by R, own funds 1,122.89
4/ 1/56 Surplus rec'd by R $1,428.34
11. The following schedule shows the cash payments made by Rosenthal as "interest" on his note to Gibraltar; the cash payments received by Rosenthal from Gibraltar as coupon "interest" on Treasury notes; the cash received from Gibraltar through CHK on December 23, 1955; and the excess of Rosenthal's cash receipts over and above his cash payments to Gibraltar out of his own funds. In this transaction, Rosenthal did not make any net cash payments to Gibraltar out of his own funds. Pd. by Gibraltarto Pd. by Rosenthalto Excess pd.by G
Rosenthal Gibraltar to R
12/23/55 $25,301.11(CHK) $25,301.11
4/ 1/56 5,625.00 3,073.77 $2,551.23
10/ 1/56 5,625.00 5,625.00
4/ 1/57 5,625.00 5,625.00
10/ 1/57 5,625.00 5,625.00
4/ 1/58 5,625.00 5,625.00
10/ 1/58 5,625.00 5,625.00
4/ 1/59 5,625.00 5,625.00
10/ 1/59 5,625.00 5,625.00
The note of petitioner to Gibraltar called for a payment by him, as note-interest, of $5,625 on April 1, 1960. On the book account in Rosenthal's name, a charge for that amount was made. *111 Rosenthal did not make a cash payment for that charge. Instead, Gibraltar entered a credit for $5,625, which represented accrued interest on the 1549 Treasury notes which Gibraltar purportedly purchased from petitioner on April 1, 1960, at par, for $755,625, including accrued interest on the Treasury notes.
12. On April 1, 1960, Gibraltar sent petitioner a confirmation slip stating that it had "purchased" $750,000 Treasury notes from him for $750,000, plus $5,625 for accrued interest, for the total sum of $755,625.
In fact, Gibraltar did not make a purchase of $750,000 Treasury notes from petitioner. There was not any entry on Gibraltar's books showing a movement of securities as would have been shown if there had been an actual purchase of securities. The purported "purchase" by Gibraltar was only a bookkeeping entry crediting petitioner's account in the amount of $755,625.
13. The account on Gibraltar's books showed a debit balance owing to Gibraltar of $712,500, the principal amount of petitioner's note, and a charge of $5,625 for "interest" on the note due April 1, 1960. Gibraltar credited $755,625.00 to the account for the purported "purchase". The credit left a credit balance *112 in petitioner's favor of $37,500. On May 17, 1960, Gibraltar paid $37,500 to petitioner by its check, which closed the account, and petitioner's note for $712,500 was cancelled. The closing debits and credits were: 4/1/60 Balance on note of R $712,500.00
4/1/60 Charge for "interest" on note 5,625.00
Total debits $718,125.00
4/1/60 Credit, "purchase" of securi-ties 755,625.00
4/1/60 Credit balance due Rosenthal $ 37,500.00
5/9/60 G. paid Rosenthal 37,500.00
0
14. On May 16, 1960, petitioner paid $37,500 by his check to CHK in payment of his note in that amount to CHK.
15. CHK paid to Gibraltar on May 13, 1960, $106,250.00, which was applied by Gibraltar in the loan account on its books with CHK as credits on May 13, 1960, to the following individuals shown in that account to have been charged with the same amounts on December 23, 1955, as shown in par. 7, supra: Jerome B. Rosenthal $ 37,500
Samuel P. Norton 25,000
Frank De Vol 12,500
Marvin Miller 12,500
Henry C. Rogers 18,750
$106,250
The $37,500 received by Gibraltar from CHK, and designated as for Rosenthal's account, was applied as a credit to a loan dated December 23, 1955, to be made to Rosenthal.
The $106,500 received by Gibraltar from CHK was posted to *113 the CHK loan account on Gibraltar's books as cancelling the loans to CHK on December 23, 1955, totaling $106,250. The amount of $37,500 was posted in that account to cancel a loan of $37,500 to Rosenthal dated December 23, 1955.
16. On the tax returns of Rosenthal, joint and separate, for 1955-1960, inclusive, deductions were taken for "interest" paid on the note to Gibraltar for $712,500, and on the note to CHK for $37,500, as shown in the following schedule. Also there were reported in income "interest" on Treasury notes, as shown in the schedule.
On the separate tax returns for 1960, capital gain of $34,453.12 was reported as the gain from the transaction: 4/ 1/60 Proceeds, sale Treas. notes $750,000.00
12/23/55 Cost 715,546.88
Capital gain $ 34,453.12
The "interest" deductions and the "interest" income reported on the tax returns were: Year "Interest"Deductions Income,Treas, Note"Interest"
1955 $25,301.11 (G) 0
7,723.67(CHK)
1956 8,698.77 $ 8,698.77
1957 11,250.00 11,250.00
1958 11,250.00 11,250.00
1959 11,250.00 11,250.00
1960 5,625.00 5,625.00
$81,098.55 $48,073.77
The evidence does not explain the figure of $8,698.77 which was reported as "interest" income from Treasury notes for 1956 rather than the full *114 amount received from Gibraltar, $11,250.
17. Rosenthal's cash disbursements in this transaction totaled $81,071.66; his cash receipts totaled $82,500.00; and his net cash receipts, or gain, was $1,428.34: Cash Paid Out
1955-1959 "Interest" to Gibraltar $67,749.88
1955 Pd. to Faroll 5,598.11
1955 "Interest" to CHK 7,723.67
$81,071.66
Cash Received
1956-1959 Treas. Note "interest" $45,000.00
1960 Rec'd from G, "purchase" of note 37,500.00
$82,500.00
Net Receipts by Rosenthal $1,428.34 Rosenthal's net economic gain from this transaction was $1,428.34: 1550 *10
Net Economic Gain
Capital gain on "sale", Treas. notes $34,453.12
Treas. notes "interest" rec'd 48,073.77
$82,526.89
"Interest" expense to G & CHK 81,098.55
Net economic gain $ 1,428.34
18. Apart from expected tax benefits, petitioner could not have realized a gain from this transaction of any more than $1,428.34, which gain was realizable only by purportedly holding the Treasury notes for more than 4 years, until maturity, April 1, 1960.
19. The following schedule is a summary of the charges and credits to Rosenthal in the transaction: Charged to Rosenthal's Account
Treas. notes, Faroll $ 5,598.11
Note to Gibraltar 712,500.00
Note to CHK, "reserve" 37,500.00
$755,598.11
Interest, note to G 73,374.88
Interest, note to CHK 7,723.67
$836,696.66
Credits to Rosenthal's Account
Cash pd. by G(CHK) to R $ 37,500.00
Cash pd. by G to R, Treas. notes in-terest 45,000.00
Credit by G, Treas. notes interest 5,625.00
$ 88,125.00
Credit by G, "purchase" Treas. notes 750,000.00
$838,125.00
Excess of credits over debits 1,428.34
$836,696.66
20. *115 The following is a list of the bid prices on the market, for U.S. Treasury notes due April 1, 1960, during the period December 30, 1955, to March 4, 1960. In the list, prices are stated with fractions having a denominator of "32", but the denominator is omitted. Since the Treasury notes were due on April 1, 1960, and were redeemable at par, the bid prices tended to approach 100 as the time before the due date became shorter: *10 UNITED
STATES
TREASURY NOTES
1 1/2% - DUE
4/1/60 - LOW
BID PRICES
Year Date Low BidPrice
1955 Dec. 30 95-8
1956 Jan. 6 95-4
Feb. 3 95-24
Mar. 16 95-6
Apr. 20 94-10
May 11 94-22
June 1 94-30
July 27 94-20
Aug. 31 93-20
Sept. 7 93-16
Oct. 5 94
Nov. 30 93-8
Dec. 7 93
1957 Jan. 4 93-20
Feb. 1 94-20
Mar. 1 94-12
Apr. 26 94-20
May 24 94-18
June 21 94-4
July 19 94
Aug. 16 94
Sept. 6 94-16
Oct. 4 94-20
Nov. 1 95
Dec. 6 97
1958 Jan. 3 97-24
Feb. 7 98-12
Mar. 7 99
Apr. 3 99-4
May 2 99-16
June 27 99-28
July 25 99-18
Aug. 29 97-28
Sept. 5 97-20
Oct. 3 97-20
Nov. 7 97-28
Dec. 19 98-2
1959 Jan. 23 98
Feb. 6 98
Mar. 13 98-4
Apr. 17 98-16
May 22 98-18
June 12 98-14
July 2 98-22
Aug. 7 98-24
Sept. 4 98-16
Oct. 2 98-20
Nov. 13 98-26
Dec. 4 98-30
1960 Jan. 8 99-8
Feb. 5 99-16
Mar. 4 99-18
Issue 2: Docket No. 67848, 1953 Income of BRNM Law Partnership
Rosenthal and Samuel P. Norton were members *116 of a law partnership located in Beverly Hills, Calif., having four members, Brand, Rosenthal, Norton, and Miller, hereinafter called the partnership. There were disputes among the members which led to litigation and delayed the dissolution of the partnership. However, on February 23, 1953, the conduct of the business of the partnership was terminated. Rosenthal and Norton formed their own separate law partnership, but they undertook to watch the winding up of the affairs of the old partnership. One of the problems involved the collection of fees owing to the partnership for services performed before February 23, 1953, which was the cut-off date after which the business of that particular 1551 partnership ended except the procedure of collecting fees and ending the business.
A special bank account was opened by Rosenthal and Norton at Union Bank and Trust Co., apparently located in Beverly Hills, soon after February 23, 1953, for the purpose of holding, receiving, and preserving funds of the partnership. Deposits were made in this bank account of moneys collected after February 23 of money owed to the partnership. The bank account was opened by Rosenthal and Norton as a kind of custodian *117 and trust account in which the four former law partners had an interest; it was called "Rosenthal and Norton Special Account." They transferred all of the remaining funds from the law partnership bank account at the Union Bank to the new Special Account.
The law partnership had its own accounting records. A new accounting record was set up by Rosenthal and Norton for the BRNM partnership in connection with the termination of the business as of February 23, and in connection with the new special bank account at the Union Bank. Entries were made in the new accounting record of collections, receipts, and disbursements after February 23. The new bookkeeping record also was called "Rosenthal and Norton Special Account". One purpose of the new bookkeeping record and special bank account was to keep a record of collections of the billings of the BRNM partnership, and of the payments of the unpaid expenses of the old firm. Another purpose was to make an accounting record to be used in the litigation among the partners; and to preserve the assets; and to prevent improper withdrawals of partnership funds.
One of the issues among the partners related to the amounts of income to which each partner *118 was entitled. As of February 23, 1953, the interest of each partner was as follows: Rosenthal 35 percent; Norton 25 percent; Brand 25 percent; and Miller 15 percent.
The partnership kept its accounts and reported income on a cash basis for a fiscal year beginning November 1 and ending October 31. A partnership tax return for BRNM was filed for the fiscal year ended October 31, 1953. The net income of the partnership which was reported on the return was $72,011.63. There is no dispute about that figure as the net income involved.
One of the problems in this case is whether all of the net income of $72,011.63 was earned prior to February 23, 1953, or whether part was attributable to the period February 24 to October 31, 1953. The respondent made determinations whereby he adjusted the dollar amounts, respectively, of the shares of Rosenthal and Norton in the partnership net income of $72,011.63. The dispute in this case involves respondent's determination of the dollar amount of Rosenthal's share of $72,011.63, the income from the law partnership which was includable in his income for his taxable year 1953. The same question is presented in a separate case, of Samuel P. Norton.
In the *119 partnership tax return filed for the period ended October 31, 1953, the dollar amounts of the distributive shares of the four partners were reported as follows: Rosenthal 35% $25,222.29
Norton 25% 17,989.44
Brand 25% 17,989.44
Miller 15% 10,810.46
Total $72,011.63
In the income tax return of Rosenthal for 1953, he included the above amount, $25,222.29, as his distributive share of the 1953 income of the law partnership, BRNM.
In making his determinations which are in issue here (which also involve Samuel P. Norton in a separate case pending in this Court) the respondent adopted the position that of the total sum of partnership earnings, $72,011.63, $36,215.16 was attributable to the period November 1, 1952, to February 23, 1953, and that the balance of $35,796.47 was attributable to the remaining period February 24 to October 31, 1953; and that with respect to the second period no part of the allocated amount of $35,796.47 represented shares of Brand and Miller, but rather all of that part represented shares of Rosenthal and Norton in equal amounts.
On the above theory respondent determined that the earnings of $72,011.63 were allocable between the two periods before and after February 23, 1953, *120 and among the four individual taxpayers as follows: 11/1/52 2/24/53 Total
to2/23/53 to10/31/53
Rosenthal $11,458.86 $17,898.24 $29,357.10
Norton 9,96 7.80 17,898.23 27,866.03
Brand 9,217.13 0 9,217.13
Miller 5,571.37 0 5,571.37
$36,215.16 $35,796.47 $72,011.63
Respondent's reallocations resulted in increasing the dollar amount of the 1552 partnership income reported by Rosenthal and Norton in their separate and respective income tax returns for 1953 as is shown in the following schedule, so that respondent increased the dollar amount shares of the partnership income attributable to Rosenthal and Norton, respectively, by $4,134.81 and $9,876.59. Respondent's allocations had the effect of reducing the dollar amount shares of the partnership income of Brand and Miller, respectively, by $8,772.31 and $5,239.09: Share Share Increase &Decrease
ofIncomeReported R.Determined
Rosenthal $25,222.29 $29,357.10 $4,134.81
Norto n 17,989.44 27,866.03 9,876.59
Brand 17,989.44 9,217.13 (8,772.31)
Miller 10,810.46 5,571.37 (5,239.09)
The law partnership of BRNM concluded its business operations on February 23, 1953, but thereafter until the dispute among the four partners was settled, the partnership was in a period of winding up its affairs, *121 collecting bills due, and paying obligations. Those matters were handled by Rosenthal and Norton, but they were not engaged in continuing and carrying on the old partnership business. There was only one period to be accounted for, the fiscal period of the BRNM partnership, November 1, 1952, to October 31, 1953. The respondent's theory was incorrect in determining that two periods were involved for tax purposes, such as November 1, 1952, to February 23, 1953, and February 24, to October 31, 1953.
On the other hand, Rosenthal and Norton formed a new and different law partnership after February 23, 1953. The business and earnings of their new partnership were not the business and earnings of the BRNM partnership. The earnings and receipts of the new partnership were accounted for in books and records started for the new partnership by Rosenthal and Norton. The earnings and receipts of the BRNM partnership collected after February 23, 1953, were deposited in the special account at the Union Bank and recorded in the special set of books started to record the receipts and disbursements during the winding up period. No part of Rosenthal and Norton's earnings from their new partnership were *122 deposited to the special account at the Union Bank or reflected in the books of the special account.
Robert Brent, an independent Certified Public Accountant, who had been employed by Rosenthal and Norton as an accountant for several years prior to the trial of this case, testified about the accounting records of the BRNM partnership and the Rosenthal and Norton special account and about what those records reflected. The books and records of the old partnership were kept and reflected entries recorded until the partnership was terminated on February 23, 1953, after which date no entries were made in that set of books. The special account set up by Rosenthal and Norton reflected entries recorded during the winding up period from February 24, 1953, to October 31, 1953. Brent analyzed the two sets of books and records to determine which fees and income were received by the old partnership prior to February 23, and which fees were collected and deposited in the special bank account by Rosenthal and Norton after February 23, 1953. He also analyzed the books to determine whether the fees and income collected and deposited in the special account after February 23, 1953, were earned or attributable *123 to the services performed by the BRNM partnership prior to February 23.
In his analysis, Brent referred to a trial balance sheet (Exhibit 55) to summarize his findings from his review and analysis of the partnership's books and the books of the special account. The trial balance sheet was a report on the earnings of the BRNM partnership for the fiscal year ended October 31, 1953, which showed net income of $72,011.63. Brent checked the amounts in the trial balance with the balances reflected in the accounts in the ledger of the BRNM partnership and in the ledger of the special account.
Of the net income of $72,011.63 of the BRNM partnership for the fiscal year 1953, fees and income received and disbursements made by the old partnership prior to February 24, 1953, accounted for the net amount $47,222.24. The balance, $24,789.39, was accounted for by receipts and disbursements after February 23, 1953, while Rosenthal and Norton were winding up the accounts of the old partnership, which were deposited to and paid from the special account, and were recorded in the books of the special account by Rosenthal and Norton. The net amount of $24,789.39 resulted from gross receipts of approximately *124 $36,000 and disbursements of about $11,200, as reflected in the books of the special account.
There were entries in the legal income and other income accounts in the ledger of 1553 the Rosenthal and Norton Special Account which indicated that amounts collected after February 23 and deposited to the special account were attributable to the period prior to February 23, such as notations describing the income or fee recorded, as "Hedy Lamar - Legal thru 2-23-53"; "Lewis Jaffa - Legal thru 2-23-53"; and "Soriano V. Colby, Legal in full to 2-24-53".
Brent also checked the entries in the ledger accounts of the special account with the cash receipts and disbursements journal from which the entries to the ledger accounts were posted. For every entry in the ledger accounts recording income or fees deposited to the special account, he found a notation in the corresponding entry in the journal that the fees were earned prior to February 23, 1953. In addition, Brent checked the income and fees recorded in the ledger accounts with billings which were made in 1952 by the BRNM partnership, and in several instances he found that the amount of the entry in the ledger account for fees and income collected *125 after February 23, 1953, corresponded exactly with the amount of the billings to clients dated in 1952.
All of the net income, $72,011.63, reported in the BRNM partnership return was earned by the old partnership prior to February 23, 1953. Only the sum of $24,789.39, out of $72,011.63, represented a net sum of items collected after February 23, which were deposited to and paid from the special account at the Union Bank after February 23 and were reflected in the books of the special account.
Rosenthal's distributive share of the net income of the 1953 partnership income was $25,222.29, as reported in the BRNM partnership tax return and in his own return for 1953.
Samuel P. Norton's distributive share of partnership net income was $17,989.44, which was correctly reported in his income tax return for 1953, and in the BRNM partnership return for 1953.
The respondent made incorrect determinations in increasing the dollar amount shares, and the percentage shares, of Rosenthal and Norton in the income of the BRNM partnership for fiscal year 1953 so as to add to their reported shares $4,134.81 and $9,876.59, respectively, and each one is not taxable for such additional amounts, respectively. *126
Rosenthal and Norton did not carry on the business of the BRNM partnership after February 23, 1953; they only managed the winding up of that law business. They formed a new and different law partnership of their own after February 23, 1953. None of the $72,011.63, the earnings of the old partnership, represented or included earnings of the new and separate partnership of Rosenthal and Norton, organized by them after February 23, 1953.
Issue 3: Docket Nos. 1392-64, 1393-64, Deductions for Expeditures in 1960 and 1961
Individual income tax returns were filed by Jerome Rosenthal for 1960 and 1961. Respondent issued one notice of deficiency for both years. For Rosenthal, the petition in Docket No. 1393-64 was filed on the basis of that deficiency notice.
Rosenthal prepared individual income tax returns for 1960 and 1961 in the name of Ruth B. Rosenthal who was then his wife, although their divorce proceedings were instituted in March 1959, and were pending in a Superior Court of California during 1960 and 1961. Rosenthal and Ruth Rosenthal were separated during 1960, 1961, and thereafter. The respondent issued one notice of deficiency for both years on the basis of the two individual *127 returns filed in the name of Ruth. For Ruth Rosenthal, the petition in Docket No. 1392-64 was filed on the basis of the deficiency notice mailed to Ruth Rosenthal.
Issue 3 involves expenditures made by Jerome Rosenthal, $5,867.17 in 1960, and $8,906.61 in 1961. One-half of the expenditures in issue was deducted in the separate returns of Rosenthal and of Ruth for each year. The deductions so taken in Rosenthal's separate returns were $2,933.59 for 1960, and $4,453.31 for 1961. Correspondingly, $2,933.58 was deducted in the return filed for 1960 in the name of Ruth Rosenthal, and $4,453.30 was deducted in the return for 1961 in her name.
Ruth's attorneys in the divorce proceeding were Crowley and Rhoden; Rosenthal's attorneys were Horwin and Caruso. The expenses in issue, which were paid by Rosenthal in 1960 and 1961, were as follows: *10 Fees Paid by J. Rosenthal
1960
Legal fees paid to Crowley and Rhoden $1,000.00
Fees paid for accounting services 50.00
Court costs 4,817.17
$5,867.17
1961
Legal fees paid to Horwin and Caruso $6,500.00
Court costs 1,974.20
Bond for stay of execution 376.76
Messenger services 55.65
$8,906.61
1554
In the statutory notices of deficiencies, the reasons given by respondent *128 for his disallowances of the claimed deductions in the 1960 and 1961 individual returns were that "the deductions for professional fees and costs incurred in connection with divorce and settlement agreement, claimed as other deductions in your returns * * * are unallowable because you have not established that you are entitled to the deductions."
Rosenthal's explanation in the tax returns for the deductions of the above-described expenditures was that they were for professional fees and costs "incurred in connection with divorce and property settlement agreement, incurred to conserve and maintain income-producing property (not including other legal fees and expenses in connection with divorce)."
Prior to 1960, in connection with the suit for divorce filed by Ruth Rosenthal, a stipulation was executed by Rosenthal and Ruth Rosenthal that each party was entitled to a divorce. The stipulation was incorporated into the interlocutory decree of divorce which was entered by the court in the divorce proceedings at some time after 1961. The stipulation removed from the divorce case the issue of marital fault so that the issues in the divorce litigation related to property rights of the spouses *129 and ownership of separate and community property, the division of property, and alimony.
The final decree of divorce was entered on April 3, 1964. The evidence does not show what award of alimony was made by the court to Ruth Rosenthal, if any award of alimony was made. If the court made an award of alimony to Ruth, the evidence does not show what it was, how it was to be paid, or of what it was to consist. No evidence was introduced relating to alimony, the amount thereof, or the way in which it was to be paid. It appears that Ruth was granted the divorce.
The payment of $1,000 in 1960 by Rosenthal to Crowley and Rhoden, who were Ruth's attorneys, was paid pursuant to a court order. However, the evidence does not show what the charges of Crowley and Rhoden were, or what they were for; their statement, or bill, was not produced or offered in evidence. The evidence does not show or establish what relationship there was, if any, of the payment of $1,000 to the matter of alimony (if any).
The payment in 1960 of $4,817.17 was paid pursuant to a court order for court costs in the divorce proceedings.
In 1961, Rosenthal paid $6,000 to Leonard Horwin, and $500 to Paul Caruso, both being *130 his attorneys in the divorce proceedings. There is no evidence showing what the charges were of Horwin and Caruso, or the nature of the services for which their charges were made. No statements or bills of Horwin or Caruso for their respective services were offered or introduced into evidence. They were not called by the petitioner, Rosenthal, to give testimony. There is no proof establishing the nature of the legal services for which Rosenthal paid $6,000 to Horwin and $500 to Caruso.
Ruth Rosenthal did not appear at the trial in this Court of these cases. As far as the record shows, she was not called to give testimony in these cases.
The petitioner, Rosenthal, failed to establish and prove that any of the expenditures in issue were made or were related or attributable to the production or collection of alimony or of income, or that any of the expenditures in issue were ordinary and necessary expenses incurred or paid in connection with the determination, collection, or refund of any tax. The petitioner, Rosenthal, failed to prove that all of the expenditures in issue, which were paid in 1960 and 1961, were not such attorneys' fees, legal fees, court costs, and miscellaneous costs *131 incurred and paid in connection with the divorce proceedings, as are personal expenses connected with a divorce proceeding.
Issue 4: Statute of Limitations
Individual income tax returns for 1955 were filed by and for Rosenthal and Ruth Rosenthal. The taxable year 1955 is involved in Docket No. 77923, Ruth Rosenthal, and Docket No. 77925, Jerome Rosenthal. In the statements attached to the statutory deficiency notices covering the taxable year 1955, the respondent did not disallow deductions taken for payments made in 1955 to CHK as "interest" in connection with Transaction 4 under Issue 1. The total amount of the payment to CHK was $7,723.67. Respondent, by amendment to his answer in each case, made the determination that the 1555 payment of $7,723.67 to CHK was not interest on indebtedness within section 163(a); he disallowed the deductions for that item taken on the individual returns ($3,861.84 on the return in the name of Ruth Rosenthal, and $3,861.83 on the return of Rosenthal); and he made claims under section 6214(a) for increases in the tax deficiencies of $2,780.52 in Docket No. 77923, and $2,780.52 in Docket No. 77925.
Respondent's amendments to his pleadings (answers) *132 and petitioner's replies thereto, were filed 4 years prior to the trial of these cases. Since respondent's claims for increases in the deficiencies were filed "before the hearing" of these cases, this Court has jurisdiction with respect thereto as part of its jurisdiction "to redetermine the correct amount of the deficiency [deficiencies]." Section 6214(a). Respondent's determinations in his amended answers, his claims for the increases in the deficiencies for 1955, and the assessment of the increased deficiencies were not barred by a statute of limitations.
Ultimate Findings of Fact
Issue 1: Transactions in Government Securities
1. Claimed "Interest" Deductions: The following findings relate to each one of the four purported transactions in Government securities.
Each transaction was a paper transaction, and was a sham. In each transaction: No securities were purchased by or for Rosenthal or for his account, except for a day or so because if and when securities were ordered from a dealer, they were delivered to Irving for redelivery to a dealer to whom they were sold in an "In" and "Out" procedure almost immediately; none was held for his account; and no actual bond or note interest *133 on any of the securities purportedly involved was received by Gibraltar or Rosenthal. The closing of Rosenthal's four accounts on Gibraltar's books consisted only of bookkeeping entries; they did not reflect any bona fide sale at the end of any securities which had been "held" for his account under a "pledge" with Gibraltar. No securities were "pledged" with Gibraltar in spite of such statement in the promissory notes of Rosenthal. There were no bona fide and real "short sales" by Gibraltar of any securities "held" for Rosenthal and "pledged" with Gibraltar. The transactions of Cantor-Fitzgerald and of Gibraltar with securities dealers Faroll, Childs, Devine, and Ehlenberger involved sales of securities on or close to the same dates when the same securities had been purchased from a dealer, and they closed each transaction in an "In and Out" procedure almost immediately thereby canceling each purchase and providing the funds with which to pay for each purchase. The transactions were not in reality or in fact "short sales" of securities bought and paid for, and held for Rosenthal. Each "In and Out" transaction through Irving, with dealers, was handled in such way that money was not *134 borrowed by Gibraltar, or by Rosenthal, and no real and bona fide indebtedness was incurred by or for Rosenthal. The securities disposed of to nulify purchases at about the same time, through Irving Trust, were not replaced by Gibraltar. Each "In and Out" procedure involving the temporary delivery and redelivery by Irving Trust of Government securities was no more than a paper device which utilized the routine procedures of clearance agents for the purpose of providing brokers' confirmation slips which would give the appearance of a "purchase" of securities, and the appearance of a long term indebtedness which, in fact, did not come into existence.
Each promissory note executed by Rosenthal, payable to Gibraltar and, in one instance to CHK, was merely a part of a subterfuge and paper transaction; and the promissory notes merely provided the basis for the respective entries on Gibraltar's books, and the appearance of purported "indebtedness" and "interest" payments. None of the promissory notes was evidence of actual indebtedness or of any obligation to make payments for the use of borrowed money. The payments described on each note as "interest" were not in fact and substance interest *135 on indebtedness.
With respect to each note of petitioner, payable to Gibraltar, none was secured, and no securities were in fact "pledged" with Gibraltar. It was not the intention of the petitioner or Gibraltar that petitioner would or could obtain any "return" of the described securities by paying Gibraltar the stated principal amount of the note. The provision in each note that it was secured by "pledged" securities merely provided a basis for the appearance of collections by Gibraltar of coupon interest on such purportedly "pledged" securities, whereas, in fact, no coupon interest was received by Gibraltar, or "owed" by Gibraltar to petitioner. 1556
Each account in petitioner's name on Gibraltar's books was a paper account, and in each instance there was not an actual and bona fide indebtedness of petitioner to Gibraltar for a loan of funds or a bona fide purchase of Government securities for his account. The book entries in each account were part of a paper transaction which was lacking in substance.
Although petitioner made payments to Gibraltar, as specified in each promissory note, and in the stated amounts, Gibraltar in fact refunded to petitioner a substantial part of each *136 payment (or all of it in some instances) under the guise of payments of a "reserve" fund or of coupon interest on purportedly "pledged" securities. The prescribed payments to Gibraltar of "interest" were part of each sham and paper transaction, and they merely provided the appearance for tax deductions in stated amounts.
Petitioner's out-of-pocket expense in transactions 1, 2, and 3 constituted his payment of a charge and fee by Gibraltar for providing a facade for claiming tax deductions. Petitioner's expenses were $9,322.88, $3,669.47, and $3,794.38, respectively, in the first 3 transactions. In transaction 4, petitioner actually received from Gibraltar, in 1956, a cash payment in the net amount of $1,428.34, which represented taxable income for 1960, the end of the transaction.
In transactions 1, 2, and 3, the so-called "reserve" referred to in each original promissory note of petitioner, $90,388.90, $17,359.46, and $17,211.67, respectively, was not in fact a reserve by Gibraltar of its own funds, and Gibraltar did not pay any of those amounts from its own funds. Instead, the payments by Gibraltar to petitioner, in the guise of payments out of a "reserve" fund, were in fact refunds *137 to petitioner of a substantial part of his payments of so-called "interest" on each note.
The closing of each one of the 4 transactions did not involve any actual or bona fide sale of securities for petitioner's account, and no funds were in fact received by Gibraltar from such purported, closing sales. Each transaction was closed merely by a bookkeeping credit to petitioner's account which was part of each sham transaction.
Gibraltar did not have sufficient cash on hand with which to loan petitioner the principal amount stated on each promissory note of petitioner, on or about the date of each note, or at any material date. Gibraltar did not borrow and then loan to petitioner the principal amount of each note in any of the transactions.
Gibraltar did not in fact receive any coupon interest on any Government securities, in each transaction. Credits to the principal amount of a promissory note of petitioner, in the instances where such credits were entered on Gibraltar's books, were merely gratuitous reductions in the principal amount of the note by Gibraltar, and were merely bookkeeping entries, and were part of the sham transaction. In other instances, Gibraltar's cash payments to *138 petitioner of purported coupon interest on Government securities, purportedly "pledged", were in fact refunds to petitioner of all or a substantial part of his payments to Gibraltar of purported note "interest".
In transaction 4, CHK was merely a conduit through which Gibraltar transferred $37,500 to petitioner, and $37,500 was not loaned to petitioner by either CHK or Gibraltar. Petitioner's promissory note to CHK for $37,500 was not evidence of an indebtedness of petitioner, or of a loan to him. In fact, the transfer of $37,500 in cash to petitioner, through CHK, on December 23, 1955, represented the following: a refund to petitioner by Gibraltar of the first payment of so-called "interest", on petitioner's promissory note, in the amount of $25,301.11; a refund to petitioner of $5,598.11 which he paid to Faroll on the same date; and a refund of most of the so-called prepayment of "interest" to CHK on petitioner's note to CHK, of $7,723.67. All of petitioner's expenditures on December 23, 1955, above, totaling $38,622.89, were refunded to petitioner by Gibraltar through the payment by CHK of $37,500 and through Gibraltar's payment of "interest" on Treasury notes of $5,625 on March *139 31, 1956. If "refund" to petitioner is not precisely accurate, then in this financial round robin, petitioner immediately repaid the $37,500 to Gibraltar on December 23, 1955, directly and for Gibraltar's benefit. No loan was made to petitioner of that fund. No interest on indebtedness or for the use of money was paid to CHK by petitioner. Petitioner's payment of $7,723.67 to CHK was not a payment of interest on indebtedness. There was no bona fide indebtedness of $37,500 owing by petitioner to CHK or Gibraltar. 1557
Petitioner failed to prove, in rebuttal, that the $7,723.67 was retained by CHK and was not paid to Gibraltar. Since Gibraltar advanced funds to CHK, which included the $37,500, the reasonable inference is that CHK paid the $7,723.67 to Gibraltar. The finding is made that CHK did so, in the absence of contrary evidence; there is no evidence establishing a reasonable basis for concluding that CHK retained the $7,723.67, and a finding to that effect cannot be made.
Each transaction, 1, 2, 3, and 4, was lacking in any real and substantive economic benefit to petitioner apart from anticipated tax benefits. In Transaction 4, the arithmetic "net economic gain" of $1,428.34 *140 was not a true economic gain but was merely a credit balance in petitioner's favor (which Gibraltar paid to petitioner) arising from Gibraltar's cash payments to him in the guise of coupon interest on Treasury notes.
The bookkeeping balance of $37,500 in petitioner's favor at the end of Transaction 4, on April 1, 1960, was not a bona fide balance owing to petitioner. Rather, it represented Gibraltar's bookkeeping "reserve" and was no more than an integral part of the paper transaction. It was an anticipated balance based upon a "charge" to petitioner under his note of only $712,500, as petitioner's note to Gibraltar did not include the $37,500 "reserve", and "redemption" of the "pledged" notes for $750,000 was anticipated. Gibraltar's payment of $37,500 to petitioner reflected, in fact, a credit to be applied to the account of CHK which received the $37,500 from petitioner and paid it back to Gibraltar in another round robin.
The principal purpose of each transaction, including CHK, was the creation of a facade for claiming tax deductions. Apart from tax purposes, each transaction was devoid of substance and commercial reality, and did not involve any real indebtedness within the meaning *141 of section 23(b), 1939 Code, and section 163(a), 1954 Code. In each transaction, petitioner did not pay any interest on indebtedness to Gibraltar, and none was paid to CHK in Transaction 4. As a transaction for the purchase of securities, each one of the four transactions was a sham. Since each transaction was a sham, not recognizable for tax purposes, petitioner did not realize any taxable income therefrom, except $1,428.34, explained below, and his payments were not interest on indebtedness.
Each transaction was lacking in economic benefit to petitioner, apart from hopedfor tax benefits. The principal purpose of each transaction was not to realize a profit but was to provide a basis for tax deductions.
Petitioner realized taxable income under Transaction 4, even though it was a sham, from Gibraltar's cash payment to him in the net amount of $1,428.34, out of $5,625 on April 1, 1956, because that net amount of $1,428.34 was in excess of petitioner's payments to Gibraltar and of Gibraltar's credits to him as of the end of the transaction on April 1, 1960. The $1,428.34 was income to petitioner in 1960 because it was paid to him out of Gibraltar's funds, it was not a gift, and as of *142 April 1, 1960, it was established by the bookkeeping entries that Gibraltar had paid that amount to petitioner from its own funds.
The steps on December 23, 1955, whereby petitioner received $37,500 and gave his promissory note to CHK in that amount were an integral part of transaction 4 with Gibraltar, and those steps followed by CHK did not constitute a separate transaction between petitioner and CHK. In substance and reality, CHK did not "borrow" $37,500 from Gibraltar to "loan" to petitioner, and there was not a bona fide indebtedness for $37,500 owing by petitioner to CHK or by CHK to Gibraltar. Rather CHK was merely a conduit through which Gibraltar transferred $37,500 to petitioner on December 23, 1955. Since Gibraltar, on the same date, received back, directly or indirectly, $38,622.89 (which included the $37,500) there was a round robin of this fund as between petitioner and Gibraltar which represented either an immediate repayment by petitioner, or Gibraltar's refund to him for his expenditures to or on behalf of Gibraltar. No bona fide indebtedness owing by petitioner to CHK or Gibraltar resulted from this monetary round robin, and petitioner's promissory note to CHK was *143 not evidence of any indebtedness due from him.
2. Alternative Claims for Deductions: Petitioner's out-of-pocket expenses in the transactions and the respective years when each one was concluded were: Transaction Year Ended Expense
1 1957 $9,322.88
2 1961 3,669.47
3 1961 3,794.38
In transaction 1, 2, and 3, there was no economic substance beyond tax deductions. 1558 None of the transactions had substance, and each one was a paper transaction and a sham as a business transaction entered into for profit. In each transaction, the out-of-pocket expense was not incurred in a transaction entered into for profit, and was not cost incurred because of failure to exercise options or privileges to buy or sell property. The out-of-pocket expense, in each of the 3 transactions, in the above amounts, was not a loss from a transaction entered into for profit, and was not a loss attributable to a failure to exercise an option to buy or sell property.
Apart from expected tax deductions and benefits, in each transaction as arranged, purportedly involving certain government securities, and involving so-called "reserves" of Gibraltar and so-called "interest" payments on promissory notes of petitioner in prescribed *144 amounts, a profit could not have been reasonably expected or realized, and each transaction was not entered into for profit.
Issue 2: Income of BRNM Law Partnership
Rosenthal's taxable income for 1953 from the BRNM law partnership, his distributable share thereof was $25,222.29, and no more. There was not income of that partnership earned after February 23, 1953, and it is the only law partnership involved under the issue presented.
Issue 3: Docket Nos. 1392-64, 1393-64, Deductions for Expenditures in 1960, 1961
Rosenthal did not pay any legal fees or other costs "for the production or collection of income; for the management, conservation, or maintenance of property held for the production of income; or in connection with the determination, collection, or refund of any tax" in 1960 and 1961.
Rosenthal's expenditures of $5,867.17 in 1960, and $8,906.61 in 1961 were personal and nondeductible expenses. They were not related or attributable to the production or collection of alimony or of income.
Issue 4: Statute of Limitations
The statute of limitations does not bar the assessment and collection of the increased amounts of deficiencies claimed by respondent for 1955 in dockets numbered *145 77923 and 77925.
Opinion
Issue 1: Four Transactions in Government Securities: Deductions for Payments of Alleged Interest; or, in the alternative, for Loss
A. Deductions Claimed as Interest: The main question under this issue is whether there was in each one of the four transactions in Government securities a bona fide and real indebtedness of Rosenthal to Gibraltar, and also to CHK Company in Transaction 4, evidenced by promissory notes, so that the payments made by Rosenthal pursuant to the notes during the taxable years as "interest" on the purported "loans" constituted interest paid on indebtedness within the meaning of section 23(b), 1939 Code, and section 163(a), 1954 Code. 2
Prior to the trial of these cases the respondent, in his amended answers in Docket Nos. 77923 and 77925, made claims for increases in the deficiencies for 1955 on the ground that deductions taken in the tax returns for 1955 *146 totaling $7,723.67, for payments to CHK Company, were not payments of interest on indebtedness. Respondent had the burden of proof with respect to the issue pleaded in his amended answers. Rule 32, Rules of Practice of this Court.
In the statutory notices of deficiencies for all of the taxable years, respondent disallowed all of the deductions taken for the payments to Gibraltar pursuant to petitioner's promissory notes. Respondent determined that the payments were not payments of interest on indebtedness within the meaning of sections 23(b), 1939 Code, and 163(a), 1954 Code. He determined further that deductions for those payments were not allowable under any Code provision.
With respect to the main question which results from respondent's determinations in the deficiency notices, the petitioner had the burden of proof. Rule 32, Rules of Practice of this Court; and Max Barnett, 44 T.C. 261 , 276 (1965) , affd. 364 F. 2d 742 (C.A. 2, 1966). Petitioner has presented 1559 arguments to the effect that his burden of proof is a limited one. Consideration has been given to those contentions. Our conclusion is that petitioner had the burden of proof in general and with respect to all of the *147 questions involved under the main issue, except with respect to the new question pleaded by respondent in his amended answers, as set forth above.
Additional questions are in issue resulting from petitioner's alternative contention that if it is held that the payments made pursuant to his notes were not interest on indebtedness, then his out-of-pocket expenses are deductible as a loss under either section 117(g)(2), or section 1234. The questions resulting from the alternative contentions are set forth hereinafter.
It is an established rule of law that "interest on indebtedness", as used in the statute, means "compensation for the use or forbearance of money", Deputy v. DuPont, 308 U.S. 488 , 498 (1939) . It has been defined, also, as "the amount which one has contracted to pay for the use of borrowed money." Old Colony R.R. Co. v. Commissioner, 284 U.S. 552 , 560 (1932) . The term "indebtedness", as used in the statute, has been defined as "an unconditional and legally enforceable obligation for the payment of money." Autenreith v. Commissioner, 115 F. 2d 856 , 858 (C.A. 3, 1940); Commissioner v. Park, 113 F. 2d 352 , 354 (C.A. 3, 1940); Gilman v. Commissioner, 53 F. 2d 47 , 50 (C.A. 8, *148 1931).
Upon due consideration of all of the evidence, our conclusion and findings are that Rosenthal did not "contract to pay for the use or forbearance of money." The use of money was never a right of Rosenthal in all of the transactions and arrangements, and no loans were made to him. The elaborate transactions can best be described as shams within the rule of Goodstein v. Commissioner, 267 F. 2d 127 (C.A. 1, 1959), affirming 30 T.C. 1178 ; Lynch v. Commissioner, 273 F. 2d 867 (C.A. 2, 1959), affirming 31 T.C. 990 ; Knetsch v. United States, 364 U.S. 361 (1960) .
These cases, on their facts, are indistinguishable in principle from the substantial number of cases which have held that payments of purported "interest" on alleged "loans" were not interest on indebtedness and, therefore, were not deductible. Knetsch v. United States, supra ; Sammy Cahn, 41 T.C. 858 (1964) , affd. 358 F. 2d 492 (C.A. 9, 1966); Williams v. Commissioner, 323 F. 2d 656 (C.A. 9, 1963), affirming a Memorandum Opinion of this Court; Amor F. Pierce, 37 T.C. 1039 (1962) , affd. 311 F. 2d 894 (C.A. 9, 1962); Danny Kaye, 33 T.C. 511 (1959) , affd. 287 F. 2d 40 (C.A. 9, 1961); Gordon MacRae, 34 T.C. 20 (1960) , remanded *149 on another issue, 294 F. 2d 56 (C.A. 9, 1961), certiorari denied 368 U.S. 955 ; Goodstein v. Commissioner, supra ; Sonnabend v. Commissioner, 267 F. 2d 319 (C.A. 1, 1959), affirming a Memorandum Opinion of this Court; Lifschultz v. Commissioner, 393 F. 2d 232 (C.A. 2, 1968), affirming a Memorandum Opinion of this Court; Benenson v. United States, 385 F. 2d 26 (C.A. 2, 1967); Max Barnett, supra, 44 T.C. 261 (1965) , affd. 364 F. 2d 742 (C.A. 2, 1966), certiorari denied 385 U.S. 1005 ; Kapel Goldstein, 44 T.C. 284 , affd. 364 F. 2d 734 ; Minchin v. Commissioner, 335 F. 2d 30 (C.A. 2, 1964), affirming a Memorandum Opinion of this Court; Jockmus v. United States, 335 F. 2d 23 (C.A. 2, 1964); Becker v. Commissioner, 277 F. 2d 146 (C.A. 2, 1960), modifying a Memorandum Opinion of this Court; Lynch v. Commissioner, supra ; Leslie Julian, 31 T.C. 998 (1959) , affd., 273 F. 2d 867 (C.A. 2, 1959); Carl E. Weller, 31 T.C. 33 (1958) , affd., 270 F. 2d 294 (C.A. 3, 1959), certiorari denied 364 U.S. 908 ; W. Stuart Emmons, 31 T.C. 26 (1958) , affd., 270 F. 2d 294 (C.A. 3, 1959); Joseph H. Bridges, 39 T.C. 1064 (1963) , affd., 325 F. 2d 180 (C.A. 4, 1963); Perry A. Nichols, 37 T.C. 772 (1962) , affd., 314 F. 2d 337 *150 (C.A. 5, 1963); United States v. Roderick, 290 F. 2d 823 (C.A. 5, 1961); Gheen v. Commissioner, 331 F. 2d 470 (C.A. 6, 1964), affirming a Memorandum Opinion of this Court; Knowles Electronics, Inc. v. United States, 365 F. 2d 43 (C.A. 7, 1966); Lewis v. Commissioner, 328 F. 2d 634 (C.A. 7, 1560 1964), affirming a Memorandum Opinion of thit Court, certiorari denied 379 U.S. 821 ; Dooley v. Commissioner, 332 F. 2d 463 (C.A. 7, 1964), affirming a Memorandum Opinion of this Court; Rubin v. United States, 304 F. 2d 766 (C.A. 7, 1962); Rothschild v. United States, 407 F. 2d 404 (C. Cl. 1969) ; Brown v. United States, 396 F. 2d 459 (Ct. Cl. 1968) ; Oritt v. United States, 357 F. 2d 692 (Ct. Cl. 1966) ; Broome v. United States, 170 F. Supp. 613 (Ct. Cl. 1959) ; Carl Shapiro, 40 T.C. 34 (1963) ; A. A. Helwig, 37 T.C. 1046 (1962) ; William R. Lovett, 37 T.C. 317 (1961) ; Morris R. DeWoskin, 35 T.C. 356 (1960) .
Except for immaterial variances as to names, amounts, the securities, and the forms of the transactions, the cases under consideration come within the reasoning of the cases cited above and the holdings that certain transactions were a sham. In Knetsch, supra , it was held that amounts claimed *151 as "interest" could not be deducted where the transaction which gave rise to the claimed deduction was a sham. See Morris R. DeWoskin, supra ; Gordon MacRae, supra ; Rubin v. United States, supra. In these cases considerable attention was given to form, and petitioners rely heavily upon the form of each step taken. However, we do not find any difference in the substance of the transactions in Land Bank bonds, and Treasury bonds and notes in these cases upon making comparisons with the cases cited above. The findings, conclusions, and decisions in the cited cases were arrived at because the substance of each of the respective transactions in issue in each of those cases differed from its form. In these cases, the divergence of substance from form is as great or greater than in the cited cases.
We find no significant difference between the facts of these cases and those of Gordon MacRae, supra , after carefully and fully considering the evidence here, and all of petitioners' assertions, contentions, and arguments in their lengthy briefs.
All of the cases cited by petitioners have been considered. L. Lee Stanton, 34 T.C. 1 , is distinguishable from these cases. In Stanton the Commissioner *152 conceded that the transactions in issue were bona fide and real, and that they created genuine indebtedness. He has not made any of these concessions in these cases. In Stanton this Court concluded that the taxpayer undertook to run the risk of the rise and fall of the market. We cannot make that conclusion here. See Max Barnett, supra, p. 281 .
It is recognized here, as was done in Knetsch v. United States, supra , affirming 272 F. 2d 200 (C.A. 9, 1959), that one of the principles stated in Gregory v. Helvering, 293 U.S. 465 , is that a taxpayer has a right to decrease the amount of what otherwise would be his taxes, or altogether avoid them, if he employs "means which the law permits", and that rule has been considered in these cases. However, the related rule is equally well settled that in instances of the type such as is in issue here "the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended." Gregory v. Helvering, supra. That rule of law requires that we first look beyond the form in which the transaction in question was cast.
Under the statute involved here, the petitioners may prevail "only if the payments in *153 question were in fact and in substance interest, i.e., consideration paid for the use and forbearance of money. Cf. Deputy v. Du Pont, 308 U.S. 488 ." See Gordon MacRae, supra, p. 26 . The statutory provisions involved here, sections 23(b), 1939 Code, and 163(a), 1954 Code, pertain to a type of allowable deduction. Deductions are matters of legislative grace, and to obtain the benefit of a statute permitting a deduction of a specified type, the taxpayer must prove and establish that his claimed deduction comes within the provisions and specifications of the statute. As has been restated recently in Brown, et al. v. United States, 426 F. 2d 355 (May 15, 1970, Ct. Cls.), where a taxpayer "attempts to use the tax system to obtain a benefit or advantage where the only possibility of any real benefit or advantage comes through the tax mechanism itself", and where "there would be no substantial benefit or advantage through the transaction alone, apart from the operation of the particular tax mechanism employed by the taxpayer," the courts should examine carefully such attempts. "Such attempts may not always be rejected per se, but we think that a universal precondition of acceptance for tax *154 purposes is that the taxpayer 'turn square conrners' and fulfill 1561 every legislative requirement of tax law, correctly construed."
Knetsch v. United States, supra , is not favorable to petitioners' claims in these cases but to the contrary supports the respondent's determinations. See Rubin v. United States, supra, p. 770 , where the court noted that Knetsch is not inconsistent with the cases cited by the Government. Cases cited by the petitioners, such as the following, are distinguishable from these cases because in them the courts found the transactions to be in substance what they appeared to be in form and to have commercial reality: Maysteel Products, Inc. v. Commissioner, 287 F. 2d 429 , reversing 33 T.C. 102 ; and Fabreeka Products Co. v. Commissioner, 294 F. 2d 876 , reversing 34 T.C. 290 . See Max Barnett, supra, p. 281 , where the same observation was made.
On the authority of the decisions of the cases cited above (in the long list set forth at the beginning), the general question is decided for the respondent.
In view of the assertions and contentions of the petitioners in their lengthy briefs, it is advisable to discuss the facts, and the substance of the transactions in *155 question, which purported to involve Federal Land Bank bonds and Treasury bonds and notes. Further discussion is necessary because of the diametrically opposite views, of the substance of the purported transactions, of the petitioners and the respondent, respectively, particularly because the petitioners contend that the form and the various steps of each transaction were in substance what they appered to be in form.
The ultimate question and the subsidiary questions are questions of fact.
In parts of the petitioners' assertions on brief, there are several examples of their failure, whether or not deliberate and obtuse, to recognize important facts and distinctions; and there is a tendency, whether or not intentional, to obfuscate the real facts underlying some of the steps employed in the transaction. Moreover, our task in clearly making the findings has been an exceedingly tedious and time-consuming undertaking because the seemingly simple structure of the transactions and of the provisions in the promissory notes given to Gibraltar were far from simple and uncomplicated.
It should be made clear that the many schedules set forth in the findings are the result of this Court's diligent *156 and careful analysis of the relationship of one step to another, and of the necessary comparisons of steps followed by Gibraltar with steps followed by petitioners, particularly with respect to the steps followed by Gibraltar in making payments to Rosenthal, with which, of course, he was entirely cognizant.
The obligation of this Court to look through form in order to ascertain substance, so that the realities and substance of the steps employed as well as of the entire transaction would emerge, has not been an easy task to execute. The design and structure of the underlying plan of each transaction, including the promissory note to Gibraltar which in the principal amount included a so-called "reserve", were in many ways ingenious in their employment of the form of certain commercial and financial procedures. Descriptive labels were used, such as "short sale" which were not real at all in substance. There were no "short" sales of bonds and notes, and to describe what was done as a "short sale" was an artifice and subterfuge in itself. In order to understand the ingenuity of the general plan and of the separate steps employed, there must be an understanding of the evidence and of its *157 significance which reflects understanding of the mechanics and procedures of those who are engaged in executing securities transactions. The fact that Cantor, Fitzgerald (C-F) and Gibraltar were closely related, although separate, entities, that both were dealers in securities, and that each one had as its clearance agent in New York, the Chemical Bank and the Irving Trust Company, respectively, which in their other and major activities are actually engaged in the procedures of clearance agents in real securities transactions, created a trompe l'oeil which at first might fool the eye.
There was a great deal of eye-foolery in the steps which were employed, so that what was nothing at all appeared to have substance and to be a customary procedure in the business of buying and selling securities, of "delivering" them "against payment", and of "borrowing" securities to make a "short sale" of them. The transactions on their face had the appearance of the use and employment of money in substantial amounts, but relatively little money was employed.
Real transactions in the buying and selling of securities involve much paperwork and many bookkeeping entries. In the transactions in dispute, *158 and in the steps 1562 employed, only the paperwork and the bookkeeping entries were real, not the purported use and borrowing of money, and not the purported acquisition of Land Bank bonds and Treasury bonds and notes. That the whole device and framework of each transaction were ingenious is demonstrated by the lengthy Findings of Fact and the many illustrative schedules of figures in the findings, which have been derived from the evidence as the result of a lengthy and tedious examination and analysis of the evidence by this Court, which counsel for the respective parties were not industrious enough to supply.
This Court, having worked out the findings, with the schedules, might find it sufficient to dispose of the questions involved simply by referring to the findings as dispositive of the ultimate question for decision, with the observation that petitioners' assertions and contentions are wholly lacking in merit. But it appears to be advisable to discuss and comment on some of the mechanics used in the transactions, so that the "eye-catching trompe l'oeil", or the deceptions, will not persist. Furthermore, since the petitioners have engaged in the exercise on brief of attempting *159 to distinguish these cases from the decided cases in which the transactions which were not recognized for tax purposes were almost the same or closely similar to the transactions in dispute here, we must laboriously repeat here the analyses in the typical authorities which are controlling, even though in doing so we are obliged to largely quote from them.
Petitioner, Rosenthal, argues that the four transactions here were not "paper transactions", or sham transactions, and that they were not the type which has been described, in general, as Livingstone-type transactions. See Eli D. Goodstein, 30 T.C. 1178 , affd. 267 F. 2d 127 , supra. He argues, also, that these transactions were different from those involved (and not recognized for tax purposes) in the cases relied on by respondent and cited above, such as Max Barnett, Lynch, Rubin, Oritt, Nichols, and Lifschultz, (all supra), because each one of the transactions here was of longer duration (4 and 7 years) than were the shortterm transactions in the cited cases, many of which were held to be merely paper transactions, some of which were for only 15 or 25 days, as in Bornstein v. Commissioner, 334 F. 2d 779 (C.A. 1, 1964); and Ippolito v. Commissioner 364 F. 2d 744 *160 (C.A. 2, 1966). Petitioner contends, further, that in each of the transactions under consideration, he entered into it to make an investment with the expectation of making a profit; that he ran a risk of loss which might result from market fluctuations; and that there was a reasonable possibility of making a profit; and that his motive in each instance was to make a profit. Petitioner contends that these transactions were similar to and should come under the reasoning of L. Lee Stanton, supra. He argues, in addition, that there was a reasonable expectation that in each of these transactions his economic interests would be beneficially affected, apart from any tax considerations.
All of petitioner's contentions have been fully considered. As his contentions do not present any new arguments which, in general, have not been considered in the many cases involving similar transactions, no useful purpose would be served in stating them in any more detail than as set forth above. Moreover, each case must be considered upon its own particular facts. In each case, the issues for decision largely involve fact questions.
Petitioner has observed correctly that in many (or most) of the cases in *161 which similar transactions were in issue the length of time between the beginning and closing of the transaction was one or two years, whereas here the duration of each transaction was about 4 1/2 years, Transaction 1, 4 1/4 years, Transaction 4, and 7 1/2 years, Transactions 2 and 3. But, as has been stated frequently, in considering and deciding the question whether there is an actual indebtedness upon which interest was paid for the use or forbearance of money, the transaction in issue must be considered in its entirety and we may not fragmentize the transaction; neither may we view one factor, without all of the others, as determinative if there is not clear proof that the taxpayer incurred an actual indebtedness. Gordon MacRae, 34 T.C. 20 , 26 , supra.
In MacRae, where the transactions closely resembled those in issue here, only two taxable years were involved, 1952 and 1953. Some of the transactions were closed in later years which were not before this Court. In the transaction purportedly involving Federal Land Bank bonds due October 1, 1957, callable October 1, 1955, the taxpayer's promissory note payable 1563 October 1, 1955, was renewable to October 1, 1957, and if it was *162 extended to that date, the transaction had a duration of 4 1/2 years. With respect to other transactions, we noted at page 24 [page 1533] that they were closed out subsequent to the taxable years, and we did not make findings regarding the dates of the closing of those transactions. It seems evident that in MacRae, this Court did not find it to be a determinative or even a material factor that each transaction was closed three, four, or five years after it was begun, whatever were the facts.
Here, with respect to each transaction, the fact that the duration was either 4 or 7 years, or more, does not contribute to, and is not determinative of, the finding and conclusion that there was no indebtedness incurred or owing by Rosenthal, and that the payments pursuant to each purported promissory note were not payments of interest on an existing indebtedness within the meaning of the applicable statute. Petitioner's point and argument about the length of time involved in each transaction has been considered, and comparisons have been made of these cases with the many others previously decided by this Court and other courts, but on the basis of all of the facts in each transaction here we *163 are unable to ascribe any particular or special weight and significance to the fact that a transaction extended over 4 or 7 years. In each instance, that fact is not helpful to petitioner in view of all of the facts of a transaction, and after taking into account an entire transaction. Furthermore, we think it is significant that in the MacRae case, which so closely resembles these cases, this Court did not find it material or of special significance that some of the transactions extended over a period of more than two years.
We turn now to petitioner's general argument that the instant transactions should be recognized for tax purposes because petitioner allegedly entered into each one for the purpose and with the hope of realizing a profit from an "investment". It is noted first that those general contentions and arguments have been made largely as assertions, per se, without connecting the bare assertions with the evidence. The presentation of bare assertions, unsupported by facts, cannot be given much weight because such unsupported arguments beg the question in issue. The applicable statute requires that the taxpayer shall prove that he incurred an existing indebtedness and that *164 the payments for which interest deductions are claimed were in fact payments of interest on an existing indebtedness.
Petitioner has failed in his arguments to recognize that in the long list of previously decided cases involving claims for deductions of alleged interest on indebtedness, the courts have applied at least two general tests to determine the deductibility of payments which were said to be payments of interest. In Rothschild v. United States, 407 F. 2d 404 (Ct. Cls. 1969) , supra, Judge Skelton made a painstaking review of the decided cases in this area which provides guidance and assistance, in general, and particularly in considering petitioner's arguments here. It was noted in Rothschild, supra, pp. 406-407 , as follows:
One test is commonly called the "business purpose test." According to this, interest is not allowed to be deducted if no economic gain could be realized beyond a tax deduction. Another test, commonly known as the "sham test", is involved in determining whether there is a genuine indebtedness. Here, the courts examine the circumstances surrounding the transaction in order to determine whether the transaction is a sham. If so, then they find that absent *165 any substance to the transaction, there can be no finding of a genuine indebtedness.
In Rothschild, pp. 407-408, the court pointed out that in the cases of Goodstein, Lynch, Broome, and Oritt (all supra), the court, in each case, looked through the form of the transaction "in order to determine the true substance", and where the court found that the transaction did not give rise to an actual indebtedness and there was no true obligation to pay interest, the alleged interest payments are not deductible under section 23(b), 1939 Code, or section 163(a), 1954 Code. The court, in Rothschild, also noted that in the cited cases, the court which decided the particular case looked to the substance of the transaction "without any regard for the tax consequences. Its only interest was to determine whether the transaction was a sham."
In Rothschild, p. 408, the court observed that in the decided cases where the "business purpose test" was applied, those cases did not involve sham situations, but, instead, were concerned with transactions of substance, and dealt primarily with "the problem of whether or not interest [deduction] is to be allowed to a taxpayer in a transaction where he could realize *166 no economic gain apart from a tax deduction."
We resume, now, our considerations of petitioner's arguments. Our first approach 1564 must be to consider whether any or all of the transactions in issue were sham transactions, i.e., whether the so-called "sham test" is to be applied, or the "business purpose test." On this point, the evidence considered as a whole compels us to apply the "sham test". Of course, it is true, as petitioner points out, that M. Eli Livingstone, a Boston broker and dealer, was not involved in any of the instant transactions. See Eli D. Goodstein, 30 T.C. 1178 , 1179 , supra. Nevertheless, in form, the transactions here were of the same general pattern and type as a so-called Livingstone-type transaction.
In these cases, the proper test to be applied is, in our opinion, to look through the form of each transaction in order to determine the true substance. That test has been applied to each transaction; the Findings of Fact represent the application of that test, and we shall now discuss each transaction:
In Transaction 1, in form, there was a sale to Rosenthal of $1,000,000 Land Bank bonds on February 11, 1953, according to a confirmation advice of Cantor, Fitzgerald. *167 There were directions to Gibraltar to "receive" the bonds and pay the charges to C-F. Jack Bernstein's testimony was given to explain the mechanics of this transaction due to his inability to produce, in response to respondent's subpoena, the confirmation advices of Irving Trust (or copies thereof) to Gibraltar which Irving Trust customarily issued as Gibraltar's clearance agent in receiving securities against payment for Gibraltar. Bernstein testified, and the record does not indicate that this testimony should not be regarded as correct, that in every transaction for the account of Rosenthal, namely those in issue here, including Transaction 1, two steps were followed on or about the same day; securities were purchased from a dealer and on or about the same day the same securities were sold back to the same or another dealer by Gibraltar, and that Irving Trust handled the receipt and the redelivery of the same securities for Gibraltar's account, charging the account for the securities received, and crediting the account with the proceeds of the sale thereof. Bernstein testified that this procedure was followed in the transaction involving the $1,000,000 Land Bank
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