Geftman v. Comm IRS ( 1998 )

Opinions of the United
1998 Decisions States Court of Appeals
for the Third Circuit
8-10-1998
Geftman v. Comm IRS
Precedential or Non-Precedential:
Docket 97-7313
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"Geftman v. Comm IRS" (1998). 1998 Decisions. Paper 190.
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Filed August 10, 1998
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 97-7313
JONATHAN B. GEFTMAN,
Appellant
v.
COMMISSIONER OF INTERNAL REVENUE
On Appeal from the United States Tax Court
(T.C. No. 91-22392)
Argued: May 18, 1998
BEFORE: SLOVITER and GREENBERG, Circuit Judges ,
and POLLAK,* Senior District Judge
(Filed: August 10, 1998)
Steven M. Kwartin (argued)
Raoul G. Cantero, III
Adorno & Zeder, P.A.
2601 South Bayshore Drive, #1600
Miami, FL 33133
Attorneys for Appellant
_________________________________________________________________
*Honorable Louis H. Pollak, Senior Judge of the United States District
Court for the Eastern District of Pennsylvania, sitting by designation.
Loretta C. Argrett
Teresa E. McLaughlin (argued)
Ellen Page Delsole
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044
Attorneys for Appellee
OPINION OF THE COURT
GREENBERG, Circuit Judge.
I. INTRODUCTION
Appellant Jonathan Geftman ("Geftman") appeals from a
decision of the United States Tax Court entered March 17,
1997, holding him liable for an income tax deficiency and
for additions to tax due to his failure to report as taxable
income a distribution he received from a trust established
by his late father Raymond Geftman. The Tax Court entered
its decision pursuant to its opinion filed September 30,
1996, as amended by an order of December 23, 1996. The
Tax Court had jurisdiction under 26 U.S.C. #8E8E # 7442,
6213(a) and 6214 based on Geftman's timely filing of a
petition contesting a Notice of Deficiency issued to him on
July 3, 1991, pursuant to 26 U.S.C. S 6212. Appellate
jurisdiction rests on 26 U.S.C. S 7482(a)(1). Venue is proper
pursuant to 26 U.S.C. S 7482(b)(1)(A), as Geftman resided
within this Circuit when he filed his petition contesting the
notice of deficiency. For the reasons that follow, we will
reverse the Tax Court's decision, thus vacating the tax
deficiency and the additions to tax imposed on Geftman.
II. FACTUAL AND PROCEDURAL HISTORY
A. The Trusts
Raymond Geftman died on February 28, 1983, leaving a
will which provided that its "primary purpose" was "to
2
provide for the benefit of " his son Jonathan Geftman, the
taxpayer-appellant in this case, who was 14 years old at
the time of his father's death. The will further provided that
"[n]o action should be taken . . . which would unreasonably
detract from [Geftman's] ability to receive the maximum
income and principal to which he is entitled." The will
established three trusts, designated A, B, and C, to be
funded from the residuary estate with Trust A receiving 40
percent of the residuary estate and Trusts B and C each
receiving 30 percent.
As specified in the will, Geftman was the sole beneficiary
of Trust C and the decedent's fiancee, Edith Kermer, was
the sole income beneficiary of Trust B, while the income
beneficiaries of Trust A included the decedent's accountant
Steven Love, his real estate agent Warren Welt, his
bookkeeper Paul Creedy, and several of their relatives. The
will named Love, Welt and Creedy, along with the
decedent's attorneys, Terrence Russell and Jonathan Beloff,
as personal representatives of the estate ("representatives"),
trustees of the trusts, and directors of Berkley Mortgage
Corporation ("Berkley") and BOP, Inc. ("BOP"), real estate
development enterprises the estate owned.
The will authorized the trustees to make distributions to
Geftman from Trust C's current income or from its
principal, to the extent "necessary for his health, support,
maintenance and education," including higher education
and the cost of establishing him in a business or
profession. Geftman then would receive the remaining
principal of Trust C in installments beginning at age 30 or
upon his admission to the bar, if earlier.
In contrast to these terms governing distributions to
Geftman from Trust C, the will prohibited distributions
from the principal of Trusts A or B, and provided that
Trusts A and B were to make the specified distributions to
their beneficiaries only to the extent that the trusts had
current net income after expenses.1 The remainders of
Trusts A and B after these trusts had made all specified
_________________________________________________________________
1. Several beneficiaries of Trust A were to receive distributions for life
while the others were to receive distributions only until age 25.
3
distributions were to be added to the principal of Trust C
for Geftman's benefit. See app. at 127-30.
B. The Margin Transactions
In August 1983 the estate funded the trusts by
transferring tax-exempt municipal bonds worth
approximately $3 million to brokerage accounts held in the
name of the trusts through the E.F. Hutton and
PaineWebber brokerage firms. See app. at 130-32. Because
the estate had not settled all of its liabilities, the personal
representatives required all beneficiaries of the trusts to
execute consents permitting the estate to recall all trust
assets to the estate as necessary to satisfy the estate's
obligations, even if the recall completely depleted the trusts.2
In December 1983 the estate entered into a Settlement
Agreement resolving lawsuits pending against it. During the
same month, the trusts began brokerage borrowing on
margin at rates of 11.50% to 13.25% using their municipal
bond assets as collateral and transferring the funds
borrowed to the estate. See app. at 178-92; 131. The trusts
borrowed $74,950.97 in December 1983, see app. at 154,
$870,000 on January 5, 1984, see app. at 192, and
$300,000 on January 9, 1984, see app. at 152, for a total
of $1,244,950.97 by January 9. On January 17, 1984, the
representatives met and issued the following memorandum
of their meeting:
The Settlement Agreement . . . was ratified. . . .
The actions necessary to pay or transfer estate assets
needed for the settlement was also ratified, however,
there was lengthy discussion on the issue as to the
ratification of the borrowing from the stockbroker by
using trust assets as collateral as opposed to the sale
of estate assets to pay the sums due for the settlement.
The action which had been taken to borrow was
ratified, however it was acknowledged that Paul Creedy
had dissented from the decision to borrow for purposes
_________________________________________________________________
2. Because Geftman was a minor, his mother executed his consent in her
capacity as his legal guardian.
4
of carrying out the settlement agreement, however Paul
Creedy agreed to the ratification of the action.
App. at 135a. The estate received additional transfers from
the trusts during 1984 for a total of $2,850,408 as of
August 31, 1984, which represented the maximum amount
that could be borrowed on margin against the trusts' $3
million municipal bond collateral. See app. at 131.
The trusts' E.F. Hutton account statements reflected the
monthly interest which the broker charged on the margin
loans. On the statements for the months of April through
July 1984, handwritten notations indicated that a portion
of the margin interest charges was attributable to the
amounts forwarded to the estate while a portion was
attributable to funds which the trusts lent to Edith Kermer.
See app. at 160-99. The loan to Edith Kermer was secured
by a first mortgage in favor of the trusts and was repayable
pursuant to the terms of an installment note which
provided for monthly payments of principal plus interest at
a rate of 1% above the rate charged to the trusts by E.F.
Hutton. See app. at 416.
On four occasions the estate paid the trusts an amount
equal to the notation on the prior month's statement
indicating the amount of margin interest attributable to the
estate. During the period from April through August 1984,
the handwritten notations and corresponding payments
were as follows:
Statement Notation of Estate's Deposit Into
Date Share of Interest Account
4/84 $16,086 --
5/84 $20,538 $16,086
6/84 $21,580 $20,538
7/84 $24,560 $21,580
8/84 -- $24,560
__________________________________________________
total $82,764 $82,764
See Geftman v. Commissioner, 72 T.C.M. 816, 818
(1996); app. at 179, 181, 183, 185, 187.
C. The Mortgage Transactions
The representatives, including those who served as
officers and directors of Berkley and BOP, met on
5
September 5, 1984, regarding Berkley's and BOP's
condominium development ventures, including ventures
known as "La Playa" and "Blue Grass." The representatives
determined that because a financing arrangement for the
La Playa condominium development had fallen through, it
was necessary for the trusts to sell their municipal bonds
and transfer the proceeds to Berkley and BOP. The bonds
were sold for a capital loss of approximately $100,000 and
the proceeds were used to satisfy the margin debt owed to
E.F. Hutton. According to the memorandum of the
September 5 meeting, the remaining proceeds from the sale
of the bonds were transferred to La Playa "as a down
payment for the purchase of all new first mortgages . . . on
the La Playa units." App. at 135a-b.
A memorandum dated February 4, 1985, indicated that
the trusts had acquired the La Playa mortgages, although
Berkley would hold the title to them. The memorandum
stated that,
the prior action[s] taken with regard to Trust A, B and
C . . . were confirmed . . . . Approximately $2,000,000
in first mortgages at LaPlaya have been bought
outright by the Trust . . . . Title to the mortgages[was]
taken in the name of Berkley Mortgage Corp. as
collection agent for the Trust . . . . The balance of Trust
assets for approximately $1,000,000 has been used to
buy mortgages from BOP, Inc. which were also taken in
Berkley's name as collection agent.
App. at 135c. The trusts' books did not reflect a purchase
of the mortgages corresponding to the transaction described
in the February 4, 1985 memorandum. However, "adjusting
journal entries" recorded on June 11, 1985, after the trusts'
tax year ended on February 28, 1985, indicated that the
trusts had received $2,029,390 in La Playa condominium
mortgages from the estate as a "partial debt settlement."
Supp. app. at 40.3
A document entitled "Berkley Mortgage Corp. Accrued
Interest and Principal Collections" set forth cumulative
_________________________________________________________________
3. The estate's tax year ended March 31 while the trusts' ended February
28.
6
totals of the principal and interest which Berkley received
on the La Playa and Blue Grass mortgages for the tax year
ended February 28, 1985, and for the "Ten Months Ended
12/31/85." The document indicated that Berkley had
collected $90,595.81 in payments on mortgages at the La
Playa and Blue Grass developments, and attributed these
amounts to the trusts. See supp. app. at 39. One of the
representatives testified that the document was prepared no
earlier than December 31, 1985, ten months after the end
of the tax year. See supp. app. at 33.
Berkley intermittently transferred funds to the trusts as
follows:
Oct. 17, 1984 $12,000
Nov. 9, 1984 $ 5,000
Jan. 4, 1985 $25,000
Jan. 29, 1985 $ 1,000
Feb. 5, 1985 $14,000
Feb. 14, 1985 $ 1,000
Feb. 20, 1985 $ 1,000
____________________________________
Total $59,000.4
The trusts recorded their receipt of these transfers under
an account entitled "Berkley Mtg. Co." App. at 384-85.
On June 16, 1985, Berkley assigned the La Playa and
Blue Grass mortgages to Ohio Savings Bank to secure a
$1.8 million loan to Berkley and BOP. Berkley represented
that it was the "sole and lawful owner" of the mortgages
"free and clear of any and all claims and liens," and that it
possessed "the full right and lawful authority to deliver,
pledge, assign, grant, convey and transfer" the mortgages
as security for the loan. App. at 390.
On July 30, 1986, Ohio Savings Bank reassigned the
mortgages to Berkley, and on August 15, 1986, Berkley
sold the mortgages to Horowitz Finance Corporation and
_________________________________________________________________
4. In the computerized general ledger the first two payments of $12,000
and $5,000, which were recorded separately in the handwritten journal,
were consolidated into one $17,000 payment. An additional $10,000
payment was recorded and then reversed, as it occurred after the end of
the fiscal year. See app. at 382-88.
7
Fleet National Bank. The closing documents identify
Berkley and BOP as the sellers and Horowitz and Fleet as
the purchasers. Berkley and BOP used the proceeds of the
sale to satisfy the prior loan from Ohio Savings Bank. See
app. at 398-407; 73. In December 1987 the estate formally
exercised its right to recall the assets it had conveyed to the
trusts, and eventually recalled all trust assets due to the
estate's poor cash position. See app. at 135g-i.
D. Distributions and Tax Returns
The estate reported no distributable net income ("DNI")
for fiscal years 1984 and 1985.5 For tax year 1984 the
estate reported negative taxable income of $860,171 and
incurred actual losses of $369,517. For tax year 1985 the
estate reported negative taxable income of $379,955 and
incurred actual losses of $327,946.
The trustees, who were also representatives of the estate,
did not file any Form 1041 Fiduciary Income Tax Returns
and did not report any interest income for the tax year
ended February 28, 1984. For the tax year ended February
28, 1985, the trustees filed a Form 1041 for each of the
trusts, but filed them in February 1986, nine months after
they were due. The Form 1041 for Trust C reported that
Trust C had received $101,890 in DNI during fiscal year
1985, consisting of Trust C's 30% share of the trusts' tax-
exempt municipal bond interest and its 30% share of the
transfers made to the trusts in connection with the E.F.
Hutton margin advances and the La Playa and Blue Grass
mortgage holdings. Although the Form 1041 indicated that
the entire $101,890 had been distributed to Geftman, only
$46,936 actually was distributed while the rest remained in
an E.F. Hutton account to which neither Geftman nor his
legal guardian had access. See app. at 135, 216-20.6
_________________________________________________________________
5. The Distributable Net Income of an estate or a trust determines the
amount that a beneficiary receiving a distribution from the estate or
trust must include in the beneficiary's gross income. See 26 U.S.C.
S 662(a). DNI generally consists of the taxable income of the estate or
trust, subject to certain modifications. See 26 U.S.C. S 643(a).
6. The Schedules K-1 attached to the Form 1041 for Trust A indicated
that Love, Welt, and Creedy each received trust distributions of $13,136.
See app. at 206-08.
8
Geftman, who received only $2,620 in income apart from
the trust distribution, see app. at 126, did not file an
income tax return for 1985. On July 3, 1991, the
Commissioner of Internal Revenue ("Commissioner") issued
Geftman a Notice of Deficiency finding him liable for an
income tax deficiency of $13,043 on the grounds that
$48,693 of the $101,890 distribution reported on the Form
1041 was taxable. The Commissioner also imposed
additions to tax due to Geftman's failure to file a return or
pay estimated tax on the distributions. See app. at 137-39.
Geftman filed a timely petition in the United States Tax
Court contesting the asserted deficiency and additions to
tax. He contended that his entire distribution from Trust C,
which the Commissioner now stipulates totaled $46,936
rather than $101,890, was non-taxable pursuant to 26
U.S.C. S 662(b) and Treas. Reg. S 1.662(b)-1 because,
contrary to the trustees' representations on the Form 1041,
all of the income to Trust C was non-taxable. According to
Geftman, the trustees had mischaracterized the transfers
from the estate as taxable interest income paid to the trusts
in their capacity as creditors in the margin loan
transactions and as holders of the La Playa and Blue Grass
mortgages when in reality those transfers constituted non-
taxable distributions to the trusts as beneficiaries of an
estate which did not have any distributable net income. See
26 U.S.C. S 662(a).
E. The Tax Court Opinion
Following a three-day trial held in December 1995, the
Tax Court issued a Memorandum Opinion dated September
30, 1996, rejecting Geftman's contentions and finding that
the transfers from the estate constituted taxable income to
the trusts. Geftman v. Commissioner, 72 T.C.M. 816
(1996). The court found that the $82,764 transferred to the
trusts in connection with the E.F. Hutton margin borrowing
constituted taxable interest income arising from a bona fide
debtor-creditor relationship between the estate and the
trusts. Id. at 821. The court also found that the $90,596 in
mortgage payments which Berkley collected on the La Playa
and Blue Grass mortgages constituted interest income to
the trusts because the trusts "clearly owned" the La Playa
9
and Blue Grass mortgages. Id. at 821-22. Thus, the court
concluded, because a portion of the income to the trusts
was taxable, a like proportion of the trusts' distribution to
Geftman was taxable. See 26 U.S.C. S 662(b); Treas. Reg.
S 1.662(b)-1.
Geftman filed a timely motion for reconsideration
pursuant to Rule 161 of the Rules of Practice and
Procedure of the Tax Court, pointing out that Berkley had
transferred to the trusts only $59,000 of the $90,596 in
mortgage income it had attributed to the trusts. In an order
dated December 23, 1996, the Tax Court granted the
motion, recognizing that the trusts had received only
$59,000 of the $90,596 which the court had characterized
as mortgage interest income in its September 30, 1996
opinion.
Based on this corrected amount, the Tax Court found
that Trust C had earned $118,251 in distributable net
income and that 36% of this amount, consisting of Trust
C's 30% share of the $82,764 margin loan interest and of
the $59,000 mortgage interest, was taxable while the
remainder was non-taxable interest on the municipal bonds.7
Applying the character rule, which provides that a
distribution from a trust is taxable in the same proportion
that the trust's income is taxable, see 26 U.S.C. S 662(b);
Treas. Reg. S 1.662(b)-1, the court found that 36% of
Geftman's $46,936 distribution was taxable and issued a
final order assessing an income tax deficiency of $2,638.00
and imposing additions to tax totaling $810.50 for
Geftman's failure to file a timely return and pay estimated
_________________________________________________________________
7. The court computed these amounts as follows, based on Trust C's
30% share of the trusts' net assets:
30% x $82,764 taxable margin transaction income = $24,829
+30% x $59,000 taxable mortgage transaction income = $17,700
__________________________________________________ _______
total taxable income $42,529
total taxable income = $42,529
+30% x $252,406 tax-exempt municipal bond income = $75,722
________________________________________________ _______
net income to Trust C = $118,251
$42,529 taxable income ö $118,251 net income = 36%
See app. at 436-37.
10
tax as required under 26 U.S.C. SS 6651 and 6654. See
app. at 436-38.8
Geftman timely filed this appeal. We review the Tax
Court's factual findings for clear error, but exercise plenary
review of its conclusions of law. Fredericks v. Commissioner,
126 F.3d 433, 436 (3d Cir. 1997).9 The taxpayer bears the
burden of proving the error in the deficiency assessed
against him. See Welch v. Helvering, 290 U.S. 111, 115, 54
S. Ct. 8, 9 (1933); Cebollero v. Commissioner, 967 F.2d 986,
990 (4th Cir. 1992).10
_________________________________________________________________
8. Thirty-six percent of Geftman's $46,936 distribution equals $16,897.
The Tax Court calculated Geftman's tax liability on $16,428 but did not
explain the $469 discrepancy. See app. at 436-37. However, the court's
calculation of Geftman's ultimate tax liability is not germane to our
analysis.
9. While the determinations as to whether the transaction gave rise to a
bona fide debt and whether the trusts owned the mortgages could be
considered to be findings of "ultimate fact," we have held that "we no
longer recognize the ultimate fact exception to the standard that factual
findings are reviewed only for clear error." Pleasant Summit Land Corp.
v. Commissioner, 863 F.2d 263, 268 (3d Cir. 1988) (citing American Home
Prods. Corp. v. Barr Labs., Inc., 834 F.2d 368, 370 n.2 (3d Cir. 1987)).
10. Geftman contends, br. at 17, that the burden of proof should have
been shifted to the Commissioner because Geftman demonstrated that
the Commissioner's determination of a deficiency arbitrarily and
erroneously rested on a Form 1041 which inaccurately reported that
Trust C had distributed $101,890 instead of $46,936 to him. See
Cebollero v. Commissioner, 967 F.2d at 990; Portillo v. Commissioner, 932
F.2d 1128, 1133 (5th Cir. 1991); Anastasato v. Commissioner, 794 F.2d
884, 887 (3d Cir. 1986). However, where the burden is shifted to the
Commissioner, the Commissioner only need satisfy a burden of going
forward by presenting some evidence of the taxpayer's liability; the
"ultimate burden of proof or persuasion remains with the Taxpayer."
Anastasato, 794 F.2d at 887. Because the record contains sufficient
evidence to satisfy the Commissioner's burden of going forward, but
more importantly clearly satisfies Geftman's ultimate burden of proving
that the deficiency was assessed in error, we need not address Geftman's
argument that the Tax Court improperly allocated him the burden of
proof.
11
III. DISCUSSION
A. Margin Interest Transactions
The Tax Court's conclusion that a portion of Geftman's
distribution from Trust C was taxable rested in significant
part on its finding that the $82,764 which the estate paid
to the trusts in connection with the margin advances
constituted taxable interest income which the trusts
received in their "capacity as creditor rather than
beneficiary of the estate." Geftman, 72 T.C.M. at 821.
This finding, in turn, rested on the court's determination
that the $2.85 million which the trusts transferred to the
estate gave rise to a bona fide debt owed by the estate to
the trusts. See id.
For "disbursements to constitute true loans there must
have been, at the time the funds were transferred, an
unconditional obligation on the part of the transferee to
repay the money, and an unconditional intention on the
part of the transferor to secure repayment." Haag v.
Commissioner, 88 T.C. 604, 615-16 (1987), aff 'd, 855 F.2d
855 (8th Cir. 1988) (table); accord Saigh v. Commissioner,
36 T.C. 395, 419 (1961). In the absence of direct evidence
of intent, the nature of the transaction may be inferred
from its objective characteristics, see Haag, 88 T.C. 616,
including the presence or absence of debt instruments,
collateral, interest provisions, repayment schedules or
deadlines, book entries recording loan balances or interest
payments, actual repayments, and any other attributes
indicative of an enforceable obligation to repay the sums
advanced. See Fin Hay Realty Co. v. United States, 398
F.2d 694, 696 (3d Cir. 1968).
Where, as here, the transactions occur between related
entities rather than at arms' length, they are "subject to
particular scrutiny because the control element suggests
the opportunity to contrive a fictional debt." In re Uneco,
Inc., 532 F.2d 1204, 1207 (8th Cir. 1976) (citations and
internal quotations omitted). Thus, a transaction must be
measured against "an objective test of economic reality" and
characterized as a bona fide loan only if its"intrinsic
economic nature" is that of a genuine indebtedness. Fin
12
Hay, 398 F.2d at 697. In light of these principles, we must
consider whether the evidence as to the contemporaneous
intent at the time of the transfers and the objective
attributes and economic realities of the transaction between
the trusts and the estate support the Tax Court's
conclusion that the transactions gave rise to a bonafide
debt.
1. Contemporaneous Intent
The Tax Court acknowledged that a transfer will be
characterized as a bona fide loan if " `at the time the funds
were transferred, [there was] an unconditional intention on
the part of the transferee to repay the money, and an
unconditional intention on the part of the transferor to
secure repayment.' " Geftman, 72 T.C.M. at 820
(quoting Haag, 88 T.C. 616). The court found that the
January 17, 1984 memorandum memorializing the lawsuit
Settlement Agreement which referred to "borrowing from
the stockbroker" by "using the trusts assets as collateral"
constituted evidence of the requisite intent. Id . at 821. We
disagree.11
The "determinative fact is the intention as it existed at
the time of the transaction." Saigh, 36 T.C. 420. While
the Tax Court stated that the January 17 memorandum
was "followed by" a transfer of funds from the trusts to the
estate, Geftman, 72 T.C.M. at 821, it did not
acknowledge that by the time of the January 17 meeting,
the trusts already had borrowed almost $1.25 million in
brokerage loans and had transferred funds to the estate
with no statements from either entity as to the intended
nature of those transfers. The Commissioner asserts, br. at
25, that the January 17 meeting merely "ratified" an
intention existing at the time of the initial transfers.
However, the memorandum of that meeting indicates that
the issue of whether to borrow was the subject of"lengthy
discussion" and "dissent" among the estate's
representatives. Although the memorandum states that the
_________________________________________________________________
11. The parties stipulated that this memorandum constitutes the "only
written evidence of indebtedness reflecting any debt due from the Estate
to the Trusts." App. at 134.
13
representatives were able to agree by the end of that
meeting, the ongoing dissent as of January 17 reveals that
the representatives had not formed the requisite
unconditional intention to enter into a debt transaction as
of December 1983 when the transfers began.
Courts have refused to credit statements of intent made
after the time of the transfer even where the statements
consist of formal resolutions establishing the precise terms
of a debt. See Georgiou v. Commissioner, 70 T.C.M.
1341, 1350-51 (1995). In Saigh, 36 T.C. 395, the court
rejected the assertion that there was a debt because funds
had been transferred between a subsidiary and a parent
corporation and, as in this case, "at that time nothing was
said concerning the nature of the transfer." Id. at 419.
Although the transferor's directors then authorized a loan
consisting in part of the sums already transferred and the
transferee then executed a secured note payable to the
transferor on demand at a specified interest rate, the court
found this evidence of intent insufficient as it was not
contemporaneous with the initial transfer. As the court
explained, the parties had been undecided as to the nature
of the transaction at its inception, and this indecision
"affirmatively dismisses the possibility that on the date of
transfer there was an unconditional intention on the part of
the transferee . . . and . . . the transferor to secure
repayment." Id. Similarly, in this case neither the trusts nor
the estate expressed the requisite intent to enter into a loan
transaction at the time of the initial transfer, and the
evidence that the estate's representatives remained
undecided during the following month precludes us from
finding that they had formed an unconditional intention as
the transfers commenced in December 1983.12
_________________________________________________________________
12. The Commissioner asserts that one of the representatives testified
that "a loan . . . was intended from the outset." Br. at 29 (citing app.
at
15, supp. app. at 3-5, 10). The record does not support this assertion.
The cited testimony simply describes the transactions in retrospect as
"loans" and "borrowing" without clarifying whether the intent to borrow
existed at the time the transfers were made. Wefind nothing in the
record suggesting that the intent to create an enforceable debt existed as
of December 1983.
14
The Commissioner contends, br. at 28-29, that this case
is distinguishable from Saigh because any indecision at the
January 17 meeting arose from uncertainty over whether to
proceed with a loan "as opposed to the sale of estate
assets," and therefore involved a debate between two
distinct transactions, whereas in Saigh the parties were
considering two different characterizations of the same
transaction. Thus, the Commissioner argues, in contrast to
Saigh where the parties could have remained undecided
while making the transfer, in this case the very fact of the
transfer reveals that the estate had opted to borrow instead
of selling estate assets. We find this distinction
unpersuasive.
The mere fact that a transfer occurred does not establish
whether that transfer was intended as a bona fide loan with
the requisite unconditional intention to repay. See Haag, 84
T.C. 616. While the transaction clearly did not entail a
sale of estate assets, the fact that it involved a transfer is
not sufficient to establish that the transfer may be
characterized as a bona fide loan for tax purposes. In the
absence of any evidence that the transfer was intended at
its inception to create an unconditional obligation to repay
the sums transferred, we cannot infer that, simply because
there was a transfer, a bona fide indebtedness was created.
Even if the intentions expressed in the January 17
memorandum could be viewed as reasonably
contemporaneous with the initial transfer, those intentions
are not sufficient to support a finding of an intent to create
a bona fide debtor-creditor relationship between the estate
and the trusts. The memorandum's only allusion to
borrowing refers to "borrowing from the stockbroker by
using trust assets as collateral." App. at 135a. This
statement reflects only the undisputed fact that significant
sums were borrowed from the stockbroker, E.F. Hutton,
and then advanced from the trusts to the estate. It does not
illuminate whether the trusts, in transferring the borrowed
sums to the estate, intended those transfers to be bona fide
loans subject to an unconditional obligation to repay or
whether the estate intended to be bound by an
unconditional obligation to repay the advances. The
January 17 memorandum, therefore, cannot be construed
15
as evidence of a contemporaneous, unconditional intent to
create a bona fide debt owed by the estate to the trusts.
Because this document constitutes the only evidence in the
record purporting to express the intent behind the
transactions, and because this document indicates that the
requisite intent had not been formed at the relevant time,
the record cannot support the Tax Court's finding that the
estate and the trusts intended at the time of the initial
transfer to create an unconditional debt.
2. Objective Indicia of Indebtedness
The necessary intent to create a bona fide indebtedness
can be inferred not only from expressions of the parties'
intentions, but also from objective aspects of the
transaction such as the presence vel non of notes or other
debt instruments, security or collateral, interest charges,
repayment schedules or deadlines, book entries recording
loan balances or payments, actual repayments, or any
other factors indicative of an unconditional obligation to
repay. See Fin Hay, 398 F.2d at 696; Haag, 88 T.C. 616.
The Tax Court acknowledged that in transferring $2.85
million to the estate, the trusts did not obtain a debt
instrument or other written promise to repay, did not
require any collateral or security, did not impose any
interest charges, did not establish a repayment schedule or
maturity date, and did not make any entries on their books
treating the transfers as loans. See Geftman, 72 T.C.M.
(CCH) at 820-21. In concluding that the transfers
nonetheless constituted bona fide loans, the court relied
primarily on the fact that the estate had made $82,764 in
repayments to the trusts. See id. at 821. 13 However, upon
analyzing the significance of these repayments and of the
_________________________________________________________________
13. The court also characterized as "objective evidence of indebtedness"
the January 17, 1984 memorandum and a June 11, 1985"adjusting
journal entry" referring to a "partial debt settlement" with the trusts.
Geftman, 72 T.C.M. at 821. However, such"allegedly objective . . .
indicia" which merely represent a party's characterization of the
transaction are unpersuasive "unless supported by objective factors
demonstrating economic reality." Gilbert v. Commissioner, 74 T.C. 60, 65
(1980). Accordingly, we confine our analysis to the objective
characteristics of the transfer which bear on its actual terms.
16
other objective attributes of the transaction, wefind that its
objective characteristics preclude us from upholding the
Tax Court's conclusion that it gave rise to a bonafide debt.
a. Repayments
The Tax Court found that the estate's repayments to the
trusts of $82,764 were indicative of a bona fide debt. While
the court described the repayments as interest "paid to the
trusts . . . on loans from the trusts to the estate," it
recognized that the payments constituted "a portion of the
margin interest charged on the trusts' loan from E.F.
Hutton," as each of the four repayments corresponded to
handwritten notations on the prior month's E.F. Hutton
statement calculating the portion of the E.F. Hutton
interest charges attributable to the sums advanced to the
estate. Geftman, 72 T.C.M. at 821. The fact that the
estate merely reimbursed the trusts for a portion of interest
charges that the trusts incurred from a third party belies
the court's conclusion that the trusts received these
payments in the capacity of a bona fide creditor. See id.14
Even if the trusts had not owed the $82,764 to the third-
party lender that provided the capital in this transaction,
but rather had received that sum from the estate and
retained it as repayment of principal or as payment of
interest charged by the trusts themselves, repayment in
_________________________________________________________________
14. The Commissioner asserts, br. at 34, that the estate was to pay the
trusts enough to allow the trusts to make a profit after paying the
interest charged by E.F. Hutton. The Commissioner concedes that no
documents reflect such an arrangement, and relies solely on testimony
in which one of the representatives initially made the same assertion,
but then, when questioned about the lack of records to that effect,
acknowledged, "I have to be honest with you. . . . My recollection is it
was done at a profit [for the trusts]," but if the records do not so
reflect,
then the trusts were to receive "no less than dollar for dollar" on the
amounts they were charged by E.F. Hutton. App. at 19. This testimony
does not support a finding that the trusts were to earn a profit on the
transactions. While the Tax Court found that the trusts could not have
made their monthly payments to E.F. Hutton unless they had received
the payments from the estate, see Geftman, 72 T.C.M. at 821, this
fact does not elucidate whether the payments properly may be
characterized as interest paid on a bona fide debt.
17
that amount would be insufficient to support afinding of a
bona fide obligation to repay the $2.85 million transferred
to the estate, since repayments which are insubstantial in
relation to the amount transferred are not indicative of a
bona fide debt. In In re Uneco, 532 F.2d 1204, the
transferee repaid $40,000 on a transfer of $193,090;
$26,869 on a transfer of $227,571; and $120,728 on a
transfer of $207,667, representing repayments of
approximately 21%, 12%, and 58%, respectively, for an
aggregate repayment of approximately 30% of the total
amount advanced. The court found these payments
insufficient to establish that the transferee had an
unconditional obligation to repay the principal amount
transferred. See id. at 1204. Thus, a fortiori, the
repayments in this case of $82,764 on a transfer of $2.85
million, representing a repayment of only 3% of the total
amount transferred, cannot be regarded as evidence of a
bona fide obligation to repay the principal amount
transferred.
In Gilbert v. Commissioner, 74 T.C. 60, 65-66 (1980), the
court held that even complete repayment of the amount
transferred was not indicative of a bona fide debt since the
repayment occurred after a long period without
repayments, and thus did not correspond to repayment
terms or schedules established at the outset of the
transaction. The pattern of repayments in this case
similarly does not reveal any established repayment terms
or schedules, as the estate made the repayments only on
four occasions from May through August 1984, making no
other repayments during the period in which it received
transfers from the trusts.
In Georgiou, 70 T.C.M. at 1351, the court found
that repayments were not probative of a bona fide debt as
they not only were "insubstantial in relation to the
advances" but also resulted in "[f]ailure to repay an ever
mounting loan balance." In this case the insubstantial
repayments representing only 3% of the amount transferred
similarly failed to reduce an ever-mounting loan balance
resulting from the fact that the estate received additional
transfers of $746,902 during the months in which it made
the repayments of $82,764. See app. at 184, 178.15 For
_________________________________________________________________
15. The parties stipulated that "[t]he total borrowing on margin as of
August 31, 1984 was $2,850,408.34" and that "[a]ll funds that were
18
these reasons, the repayments of $82,764 cannot be
regarded as evidence of a bona fide debt, in contrast to
repayments that are "regularly made" and result in "an
annual net reduction in the balance" by discharging "all
stated interest charges" and a portion of the principal. See,
e.g., Litton Bus. Sys., Inc. v. Commissioner , 61 T.C. 367,
380 (1973).16 Thus, we find that the Tax Court erred in
characterizing the $82,764 repayments as evidence of a
bona fide debt.
b. Other Objective Factors
The other objective characteristics of the transaction are
equally inconsistent with the existence of a bonafide debt.
While the Tax Court noted that the transfers were not
accompanied by any notes, interest charges, collateral,
repayment schedules, or book entries recording a loan
balance, the court found the absence of these factors
_________________________________________________________________
borrowed on margin from E.F. Hutton . . . were transferred to the Estate
from the Trusts." App. at 131. The E.F. Hutton Statements reflect a
margin loan balance that increased from $2,103,506 as of May 1984 to
$2,850,408 as of August 1984, see app. at 184, 178, for a total increase
of $746,902 during that period. Several courts have refused to
characterize a transfer as a bona fide loan where, as here, the transferor
did not establish a maximum loan amount but continued transferring
funds at the transferee's request. See Haag, 88 T.C. 617; Electric & Neon,
Inc. v. Commissioner, 56 T.C. 1324, 1328-29 (1971), aff 'd, 496 F.2d 876
(5th Cir. 1974) (table); Roschuni v. Commissioner, 29 T.C. 1193, 1202-04
(1958), aff 'd, 271 F.2d 267 (5th Cir. 1959).
16. The Tax Court found that the trusts received additional repayments
when the estate transferred mortgages to the trusts as a "partial debt
settlement." See Geftman, 72 T.C.M. at 821. However, as
discussed more fully below, the trusts never received any beneficial
interest in the mortgages. Even assuming that the trusts had acquired
some interest in the mortgages, the June 11, 1985 document making
adjusting journal entries and characterizing the purported mortgage
transfer as a partial debt settlement was contradicted by
contemporaneous documents describing that purported transfer as a
purchase. See app. at 135c. Thus we find no evidence to support the
assertion that the trusts received additional repayments in the form of a
mortgage transfer, and accordingly confine our analysis of the
repayments to the $82,764 which the trusts actually received.
19
insignificant on the grounds that such features were not
necessary in transactions between related parties. See
Geftman, 72 T.C.M. at 820-21. To the contrary,
however, cases examining transactions between related
parties have found the absence of such factors highly
significant and have characterized transfers as bona fide
loans only where the record contains sufficient objective
evidence of an enforceable obligation to repay and a
reasonable expectation of repayment.
In Baird v. Commissioner, 43 T.C.M. 1173, 1180-
81 (1982), the court recognized a bona fide debt between
related parties because the transferee had executed
promissory notes establishing a payment schedule and
charging interest at a rate of ten percent, and had delivered
the notes to the transferor "prior to . . . receiving the
checks," while the transferor had recorded the
"disbursements on its books as loans." Similarly, in
American Processing & Sales Co. v. United States, 371 F.2d
842 (Ct. Cl. 1967), the court found sufficient evidence of an
"enforceable obligation to repay" and a "reasonable
expectation of repayment" in a transaction between related
corporations, inasmuch as the transferor held a lien on the
transferee's buildings and fixtures and both corporations
recorded consistent, definite amounts due on the debt. See
id. at 845-46, 856-57.
Likewise, in Litton Bus. Sys., 61 T.C. 367, the transferee
corporation adopted a resolution prior to the transfer
authorizing the corporation "to borrow" from its parent
corporation, and at the time of the transfer both the
transferor and transferee recorded the same "opening
balance" of the amount owed by the subsidiary. Moreover,
the "indebtedness and its essential terms" were recorded on
the books of both companies and in "a substantial amount
of correspondence" which set forth "the existence of a debt
obligation, the amount thereof and payments thereon,[and]
the provision for interest." Furthermore, the interest rate
was "reasonable[ ] in light of the prevailing interest rates in
the financial community at that time," the"due date [was]
within the control of the creditors," and there was a
"reasonable expectation, at the inception of the
[transaction], of repayment . . . based on the[transferee's]
established financial history." See id. at 376-80.
20
The Tax Court cited cases such as Baird, American
Processing, and Litton for the proposition that the absence
of certain formalities may be excused when the transferor
and transferee are related entities. See Geftman , 72 T.C.M.
(CCH) at 820-21. The court failed to acknowledge, however,
that although the courts in those cases did not require the
presence of every possible indicium of indebtedness, they
did not recognize a debt in the absence of all objective
indicia, but rather based their recognition of a debt on
numerous objective factors not present in this case. 17
While the foregoing cases demonstrate that the courts
have required objective indicia of an obligation to support
assertions of indebtedness between related parties, perhaps
more significantly, numerous cases, including those relied
upon by the Tax Court, have rejected assertions of
indebtedness between related parties despite the presence
of significant objective evidence that the transfer was
intended as a loan. For instance, in Donisi v. Commissioner,
26 T.C.M. 327 (1967), aff 'd, 405 F.2d 481 (6th Cir.
1968), the court rejected the assertion that a shareholder's
transfers to his closely held corporation were bonafide
loans, although the transferee, prior to the transfers, had
adopted a formal resolution authorizing it to borrow from
the transferor at specified interest rates, had computed and
recorded the interest owed on its books, and had made
several payments designated explicitly as interest owed on
the loans. The court found these factors insufficient,
inasmuch as the transferor did not require any "notes or
other written evidence of indebtedness," and did not
establish a repayment schedule or obtain any collateral
although the transferee had assets "of a kind which
_________________________________________________________________
17. Apart from Baird, American Processing, and Litton, the Tax Court
cited only one case that characterized a transfer between related parties
as a bona fide debt. That case also relied on objective factors not
present
in this case, such as a duly executed promissory note and consistent
treatment of the transfer on the parties' books andfinancial statements
as "loan receivables." See Shaken v. Commissioner, 21 T.C. 785, 793
(1954). However, the Shaken court's conclusion that the transfers were
loan repayments also rested in large part on an analysis of factors which
undermined the Commissioner's assertion in that case that the transfers
constituted dividends, an analysis that is inapposite in this case.
21
normally are considered excellent security." Id. at 330.
Thus, in Donisi, although the parties had manifested an
intent to create a loan through objective factors such as
contemporaneously stated interest rates and book entries
consistent therewith, the court found it significant that the
transferor, like the trusts in this case, did not take readily
available measures, such as obtaining notes or collateral, to
ensure repayment.
In Georgiou, 70 T.C.M. 1341, the court found that
transfers from a corporation to its shareholder were not
bona fide loans, although the corporation had obtained a
security interest in the shareholder's assets, established a
fixed maturity date, charged the shareholder interest,
treated the transfers as loans on its books, and received
funds back from the shareholder which the corporation
explicitly designated as loan repayments. Despite these
objective indicia of indebtedness, the court found that the
transfers did not give rise to a bona fide debt, since there
was no indication that the shareholder intended to"enforce
the debt against himself." Id. at 1351. Thus, contrary to the
Tax Court's finding that the relatedness of the parties
obviated the need for objective evidence of indebtedness,
Georgiou demonstrates that even extensive objective
evidence may be insufficient to establish the existence of a
debt where the close relationship between the transferor
and the transferee leaves the transferor discretion as to
whether to enforce the debt, rendering any obligation to
repay conditional rather than unconditional.
Likewise, in Gilbert, 74 T.C. 60, the court rejected the
assertion that a transfer constituted a bona fide loan
although "the transfer was consistently treated as a loan on
the books . . . and balance sheets of both corporations,"
"the check . . . included a notation that it was a loan," and
the transfer subsequently was repaid in full. Id. at 65. The
court found that the characterization of the transfer as a
loan on these documents was unpersuasive, since the
transferor did not charge interest, obtain a note, require
collateral, impose a repayment schedule, or take other
measures to ensure repayment. Moreover, the transferor
had "borrowed the same money at interest" and had "no
business purpose . . . to have subsidized" the transferee by
22
" `loaning' the same funds without requiring the payment of
at least an equivalent rate of interest." Id. at 66. Finally, the
transferee's financial difficulties, which raised doubts as to
whether the transferee "would have funds available to
repay," demonstrated that the transfer was economically
unreasonable as a loan transaction and precluded the court
from recognizing a bona fide indebtedness. Id. Virtually all
of the factors that weighed against recognition of a debt in
Gilbert are present in this case where the trusts borrowed
funds at interest, transferred them to the estate without
charging an equal rate of interest and obtaining notes,
collateral, or repayment schedules, and without any basis
for believing that the estate would be in a position to repay
the funds transferred.18
The foregoing cases demonstrate that, contrary to the
view adopted by the Tax Court, the mere relatedness of the
parties is not a sufficient basis to support characterization
of a transaction as a debt in the absence of objective
evidence of indebtedness such as notes, collateral,
repayment schedules, interest charges, or other measures
demonstrating an intent to secure repayment. Rather, these
cases demonstrate that transfers between related parties
cannot be characterized as bona fide loans unless the
totality of the objective evidence reveals that the transferee
had an enforceable obligation to repay the sums
transferred. The transactions in this case, which did not
involve any notes, collateral, repayment schedule, interest
charges, or book entries reflecting a loan, bear virtually
none of the objective attributes which denote a bonafide
_________________________________________________________________
18. The Commissioner argues, br. at 26-27, that Gilbert is
distinguishable because in this case the trusts earned $82,764 in
interest whereas in Gilbert the transferor received no interest payments.
This argument is circular, as the $82,764 cannot be characterized as
interest earned by the trusts unless the trusts' $2.85 million transfer to
the estate can be characterized as a bona fide loan based on sufficient
objective indicia of an intent to secure repayment. The argument also is
unsupported by the record, as the trusts did not charge any interest but
merely recovered a portion of the E.F. Hutton interest charges which
they incurred in obtaining funds for the estate. Because the trusts
recovered only a portion of the $133,627 in interest they paid to E.F.
Hutton, see app. at 328, they subsidized the transaction, just as the
transferor did in Gilbert, with no economic advantage to themselves.
23
loan, and closely resemble transfers which the courts have
refused to characterize as a genuine loan because the
transferor failed to take available measures to secure
repayment.19 Accordingly, wefind that the objective
attributes of the transactions between the trusts and the
estate cannot support the Tax Court's conclusion that they
gave rise to a bona fide indebtedness.
_________________________________________________________________
19. The Tax Court cited several other cases which, like those discussed
above, refused to characterize transfers between related parties as bona
fide loans although they bore more objective attributes of a loan than did
the transfers in this case. See In re Indian Lakes Estates, Inc., 448 F.2d
574, 578-79 (5th Cir. 1971) (finding that transfer was not a loan in
economic substance despite issuance of bonds withfixed maturity dates
and interest rates); Wood Preserving Corp. of Baltimore v. United States,
233 F. Supp. 600, 605-07 (D. Md. 1964) (finding that advances were not
bona fide loans, despite notation of debt in ledger, as transferee made no
enforceable promise to repay and could not have obtained such funds
"from any reasonable banker on its own credit"), aff 'd, 347 F.2d 117
(4th Cir. 1965); Electric & Neon, Inc. v. Commissioner, 56 T.C. 1324,
1328-29 (1971) (holding that disbursements, although recorded on
books as balance due and although partially repaid, were not bona fide
loans absent notes, maturity dates or repayment schedules), aff 'd, 496
F.2d 876 (5th Cir. 1974) (table); Astleford v. Commissioner, 33 T.C.M.
(CCH) 793 (1974) (finding that transfers were not bona fide loans despite
interest-bearing promissory notes, notes receivable account entered on
books, and significant repayments), aff 'd , 516 F.2d 1394 (8th Cir.
1975);
Chism Ice Cream Co. v. Commissioner, 21 T.C.M. 25 (1962)
(finding that transfer was not bona fide loan despite ledger account
entitled "note receivable" and eventual repayment of entire balance,
where no promissory notes were executed or delivered, no interest was
charged or paid, and no collateral was given), aff 'd, 322 F.2d 956 (9th
Cir. 1963).
Notably, in each case cited by the Tax Court as well as in virtually
every other case of which we are aware, it was the taxpayer who sought
to establish the existence of a bona fide debt while the Commissioner
contested its existence. In this case, by contrast, the typical positions
are
reversed and it is the Commissioner who seeks to prove the existence of
a genuine indebtedness. The transfer, however, falls far short of the
standards which the Commissioner has advocated and which the courts
have adopted in the cases analyzing whether a transfer constitutes a
debt.
24
c. Economic Reality
Our conclusion that the contemporaneous intent behind
and the objective attributes of the transaction demonstrate
that the transaction cannot be characterized as a bona fide
loan is consistent with the economic realities surrounding
the relationship between the trusts and the estate, as these
realities further demonstrate that the transfers did not give
rise to a reasonable expectation or enforceable obligation of
repayment. As we explained in Fin Hay Realty Co. v. United
States, where "the same persons occupy both sides of the
bargaining table," the form of a transaction"does not
necessarily correspond to the intrinsic economic nature of
the transaction, for the parties may mold it at their will" in
order "to create whatever appearance would be of . . .
benefit to them despite the economic reality of the
transaction." Fin Hay, 398 F.2d at 697. Accordingly, where
the same individuals control both the transferor and the
transferee, the transaction must be scrutinized according to
"an objective test of economic reality" to determine its true
economic nature. Id.20
The Tax Court acknowledged that the " `same persons
occup[ied] both sides of the bargaining table' " in this case
since the same individuals served as both trustees of the
trusts and representatives of the estate. Geftman, 72 T.C.M.
(CCH) at 821 (quoting Fin Hay, 398 F.2d at 697). As one
trustee-representative explained, "[t]rustees, personal
representatives, we did everything as one. I never separated
it." When questioned as to whether the assets held by the
trust belonged to the trusts or the estate, this trustee-
representative testified that he had "no idea." App. at 60-
61. However, having erroneously cited this common control
as a basis for disregarding the absence of objective indicia
of indebtedness, the court did not undertake an analysis of
_________________________________________________________________
20. The rule in Fin Hay accords with the general principle that tax
consequences must be determined not from "the form of the
transaction," but rather from its "true substance." See Diedrich v.
Commissioner, 457 U.S. 191, 195-96, 102 S. Ct. 2414, 2417-18 (1982);
Commissioner v. Hansen, 360 U.S. 446, 461, 79 S. Ct. 1270, 1279 (1959);
Trans-Atlantic Co. v. Commissioner, 469 F.2d 1189, 1193 (1972)
(requiring that transaction amount to "debt in substance as well as in
form").
25
the economic realities surrounding the transaction. See
Geftman, 72 T.C.M. at 821.
In analyzing the nature of the advances from the trusts
to the estate, we cannot ignore the fact that the funds
which the estate purportedly "borrowed" from the trusts
were available only because the estate had funded the
trusts by making the municipal bond transfers just four
months before the transfers back to the estate began. The
courts have refused to characterize transfers as debts
where the purported debtor conveyed its funds to another
entity over which it retained a degree of control only to
"borrow" the same funds back a short time later. See, e.g.,
Wilken v. Commissioner, 53 T.C.M. 965 (1987)
(transfers from trusts to taxpayers who had funded the
trust were not bona fide loans, despite promissory notes
bearing interest and mortgage securing repayment, since
taxpayers had retained control over trust assets and thus
were `borrowing' their own assets in order to generate
deductible interest payments); Ribisi v. United States, 51
A.F.T.R.2d (RIA) 83-961 (N.D. Cal. 1983) (transfers from
trust to taxpayer were not a valid loan, despite promissory
note, because taxpayer had used trust as "conduit" through
which it cycled the funds purportedly borrowed), aff 'd, 746
F.2d 1487 (9th Cir. 1984) (table).
Nor can we disregard the degree of control which the
estate exercised over the trusts' assets by virtue of the fact
that the estate retained the right to reclaim any and all
trust assets for its own purposes at any time. Although the
estate did not directly and formally recall the $3 million
municipal bond portfolio to the estate until 1987, it did so
in economic substance during 1983 and 1984 by having
the trusts borrow over $2.85 million against these assets
worth $3 million and transferring the proceeds to the estate
with no promise to repay or collateral securing repayment.
The Commissioner contends, br. at 32, that the transfers
should not be viewed as a de facto recall of trust assets
because the estate did not issue a formal recall until well
after the transfers were complete. This argument, however,
focuses on the form which the representatives gave to the
transactions rather than their economic reality. Because
the transfers effectively conveyed back to the estate
26
virtually all of the equity in the trusts' assets, so that the
proceeds from the eventual sale of the bonds had to be
used primarily to satisfy the margin debt incurred on behalf
of the estate, the transfers in essence depleted the equity in
the trusts' portfolio and thus amounted to a de facto recall.
While the estate's representatives did not characterize the
transactions as an asset recall, these individuals, who also
controlled the trusts and were beneficiaries of Trust A, had
every incentive to obscure the economic reality that the net
economic effect of the transaction was to return all value of
the trusts' assets to the estate, inasmuch as these
individuals were to receive distributions from Trust A only
to the extent that the trusts generated current net income.
Although these individuals attempted to characterize the
transaction as a profitable endeavor for the trusts in their
capacity as creditors lending funds to the estate, because
these individuals wielded the "power to create whatever
appearance would be of . . . benefit to them despite the
economic reality of the transaction," Fin Hay , 398 F.2d at
697, we cannot accept this characterization which does not
accord with the economic reality that the actual effect of
the transaction was to transfer $2.85 million of the equity
held by the trusts back to the estate with no assurance
that the estate intended to repay these sums to the trusts.
A court may ascertain the true nature of an asserted loan
transaction by measuring the transaction against the
"economic reality of the marketplace" to determine whether
a third-party lender would extend credit under similar
circumstances. Scriptomatic, Inc. v. United States, 555 F.2d
364, 367-68 (3d Cir. 1977); see also Fin Hay, 398 F.2d at
697. It is clear that no reasonable third-party lender would
have extended $2.85 million of credit with no promise of
repayment, no interest charges, no security, no repayment
schedule, and no book entries recording a balance due,
particularly if that entity did not have capital to lend but
rather had to place its assets at risk to borrow the funds at
rates of up to 13.25% in order to transfer them to an entity
that offered no assurance that it would be in afinancial
position to repay the funds. See app. at 178-98. Because
this was not a transaction that "the market would accept as
debt," Scriptomatic, 555 F.2d at 368, wefind that its terms
27
were defined by the relationship between the estate and the
trusts as donor and beneficiary and not as debtor and
creditor.21
The Commissioner argues that E.F. Hutton's willingness
to lend the trusts funds which the trusts then transferred
to the estate demonstrates that the transaction between the
trusts and the estate was economically reasonable as a
debt transaction on the open market. See br. at 33. We
disagree. E.F. Hutton lent funds to the trusts on terms
radically different from the terms on which the trusts
advanced the same funds to the estate. E.F. Hutton
secured its loans to the trusts with $3 million in municipal
bonds as collateral, charged the trusts substantial amounts
of interest, and collected payments monthly. The trusts, by
contrast, made no attempt to obtain a security interest in
any of the estate's assets, although the estate had real
estate holdings that might have served as collateral.
Moreover, the trusts did not charge the estate interest or
require regular payments, but rather received only four
payments in amounts that only partially reimbursed the
trusts for the costs they incurred in borrowing from E.F.
Hutton. Thus, the contrasts between E.F. Hutton's loans to
the trusts, and the trusts' transfers to the estate in fact
demonstrate that the latter transaction did not create a
debtor-creditor relationship.
Moreover, the terms on which the trusts transferred the
funds to the estate differed not only from the terms on
which third parties would lend those funds, but also from
the terms on which the trusts lent funds to other related
parties. Edith Kermer, a trustee and beneficiary of Trust B,
_________________________________________________________________
21. We recognize that credit may be extended between related parties on
terms that differ from those that would exist on the open market. Thus,
while the Commissioner is correct, br. at 33, that a transfer need not be
profitable for the transferor in order to constitute a bona fide loan, in
this case the transfer was not merely unprofitable in the sense that it
did
not generate any interest income for the trusts. Rather, it required the
trusts to incur substantial costs and risks to their assets with no
reasonable expectation that even the principal amount would be repaid.
Under the circumstances, which reveal no obligation to repay and no
expectation of repayment, we cannot characterize the transaction as a
bona fide extension of credit.
28
obtained a loan from the trusts by executing a mortgage on
her home in favor of the trusts and a written agreement to
repay the trusts by certain dates at an interest rate of one
percent above the rate charged to the trusts by E.F.
Hutton. See app. at 416-19. The absence of comparable
terms surrounding the transfers made to the estate further
demonstrates that in economic substance these transfers
were not loans made with a reasonable expectation of
repayment, but rather were a conveyance of trust assets
back to an estate which effectively had exercised its right to
reclaim such assets for its own purposes.
The economic realities surrounding the transaction, the
objective features of the transfer, and the lack of
contemporaneous unconditional intent to create an
enforceable debt all support Geftman's assertion that the
transactions between the trusts and the estate did not give
rise to a genuine indebtedness. In the absence of any
evidence establishing a bona fide debtor-creditor
relationship between the estate and the trusts, we must
reject as clearly erroneous the Tax Court's conclusion that
the $82,764 which the estate paid to the trusts constituted
taxable interest income earned by the trusts in their
capacity as creditors rather than non-taxable distributions
received by the trusts in their capacity as beneficiaries of
an estate that had no distributable net income.
B. Mortgage Transactions
The Tax Court found that the trusts earned additional
taxable income in the form of interest paid on the La Playa
and Blue Grass condominium mortgages. Although Berkley,
one of the estate's wholly owned corporations, held title to
these mortgages and collected all mortgage payments, the
court found that Berkley held the mortgages and processed
these payments merely as an agent or nominee for the
trusts who were the beneficial owners of the mortgages. The
court based its conclusion that the trusts were the
beneficial owners of the mortgages on an "adjusting journal
entry" indicating that Berkley had transferred the
mortgages to the trusts as a "partial debt settlement," and
on a "work paper" attributing to the trusts the $90,596 in
mortgage payments which Berkley collected. See Geftman,
29
72 T.C.M. at 821-22. Based on these documents, the
court found that the "trusts clearly owned the . . .
mortgages," so that the $59,000 which Berkley transferred
to them constituted taxable interest income generated by
those mortgages rather than nontaxable transfers from an
estate with no distributable net income. See id. 22
While it is undisputed that Berkley held title to the
mortgages at all relevant times and did not formally assign
them to the trusts, the true ownership of the mortgages
and the proper attribution of the income derived therefrom
does not depend on legal title, but rather turns on"actual
command over the property" and the right to receive the
"actual benefit" that accrues from ownership. Frank Lyon
Co. v. United States, 435 U.S. 561, 572-73, 98 S. Ct. 1291,
1298 (1978); accord Cepeda v. Commissioner, 67 T.C.M.
(CCH) 2181, 2183-84 (1994), aff 'd, 56 F.3d 1384 (5th Cir.
1995) (table). Accordingly, we must determine whether the
trusts acquired "the benefits and burdens of the incidents
of ownership" of the mortgages based upon "the objective
evidence provided by the . . . overt actions" with respect to
the mortgages. Cordes v. Commissioner, 68 T.C.M.
356, 358 (1994) (citations omitted); accord Frank Lyon Co.,
435 U.S. at 572-73, 98 S.Ct. at 1298.
Upon analyzing these factors, we conclude that, contrary
to the representations in the adjusting journal entry and
the work paper, the objective evidence as to control over the
mortgages and the income derived therefrom clearly
demonstrates that Berkley and BOP retained all incidents
of beneficial ownership of the mortgages, precluding
reliance on the documents cited by the Tax Court.
1. Documentary Evidence
The Tax Court's conclusion that the trusts had acquired
a beneficial interest in the mortgages rested in significant
_________________________________________________________________
22. The court initially found that the trusts received $90,596 in mortgage
interest income, consisting of the entire amount attributed to the trusts
on the work paper, but corrected its finding on reconsideration in light
of the stipulation that only $59,000 had been transferred to the trusts.
See app. at 436-37.
30
part on the June 11, 1985 "adjusting journal entry," which
was prepared over three months after the trusts' tax year
ended on February 28, 1985. The adjusting journal entry
refers only to the La Playa mortgages with no reference to
the Blue Grass mortgages, contrary to the court'sfinding
that this document revealed the trusts' ownership of both
sets of mortgages. See supp. app. at 40. 23
Most significantly, however, records of Berkley and BOP
prepared during the relevant tax year controvert the
adjusting journal entry's representation that ownership of
the mortgages had been transferred to the trusts. A
document entitled "BOP, Inc. et al Schedule of Real Estate
Holdings As of January 31, 1985" identifies BOP as the
owner of the La Playa and Blue Grass mortgages which
were titled to Berkley. See app. at 408-15. The schedule,
which contained numerous footnotes explaining the status
of various properties, contained no notation indicating that
the trusts held an interest in the La Playa or Blue Grass
mortgages. While the Commissioner contends that the"et
al" after BOP's name could be construed to include the
trusts, the Commissioner relies on the testimony of a
representative who conceded that he had no knowledge of
what the "et al" meant. App. at 76-77. We reject the
Commissioner's suggestion that the schedule of BOP
holdings can be construed as comprising assets owned by
the trusts, since the trusts undisputedly held a mortgage
on the home of Edith Kermer, yet the Kermer mortgage was
not identified on the list of BOP's holdings. 24 Accordingly,
we find that this document identifying BOP as the owner of
the mortgages one month before the end of the tax year
precludes reliance on the "adjusting journal entry" which,
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23. The Commissioner contends that the adjusting journal entry is
supported by the minutes of a representatives' meeting held September
5, 1984, stating that the mortgages had been "bought outright" by the
trusts. See app. at 135. While the September 1984 document alludes to
a mortgage transfer, the inconsistency as to whether the mortgages were
purchased or were transferred to settle a debt undermines the
Commissioner's assertion that these documents accurately describe a
transaction that actually occurred.
24. The "et al" apparently refers to BOP's sister corporation Berkley
which held title to some of the properties identified in the document.
31
six months later, asserted that the mortgages had been
transferred to the trusts during that tax year.
2. Objective Incidents of Beneficial Ownership
a. Transactions Involving the Mortgages
Even if Berkley and BOP had recorded consistent,
contemporaneous documents stating that the mortgages
had been transferred to the trusts, such documents would
be insufficient to establish the trusts' ownership of the
mortgages for tax purposes unless the "objective evidence"
as to the "overt actions" with respect to the mortgages,
Cordes, 68 T.C.M. at 358, demonstrated that the
trusts enjoyed "actual command" over the mortgages and
the right to receive the "actual benefit" of owning them.
Frank Lyon Co., 435 U.S. at 572-73, 98 S.Ct. at 1298. The
Tax Court, in relying on documents reflecting the purported
mortgage transfer, did not analyze the significance of the
numerous overt acts in which the mortgages were assigned,
pledged and sold to third parties. The court thus failed to
make the essential determination as to which party
retained actual command over the mortgages and the right
to receive the benefits of owning them. Upon examination of
the overt acts involving the mortgages, it becomes apparent
that, consistent with the schedule reflecting BOP's
ownership of the mortgages, Berkley and BOP retained
actual command over the mortgages and the benefits
flowing therefrom.
Within five days of the June 11, 1985 journal entry
reflecting the purported mortgage transfer, BOP and
Berkley, acting jointly, pledged the mortgages to Ohio
Savings Bank to secure a loan and executed a "Collateral
Assignment" of the mortgages dated June 16, 1985, which
they recorded in public records. In the course of this
transaction, Berkley and BOP held themselves out as the
"sole and lawful owners" of the mortgages"free and clear of
any and all claims" and possessing the "full right and
lawful authority to deliver, pledge, assign, grant, convey
and transfer" the mortgages. Berkley and BOP used the
proceeds of the sums borrowed against the mortgages for
32
their own business activities, completing the process of
hypothecating the mortgages with no participation or
authorization from the trusts. See app. at 389-97, 133, 29-
36, 43, 63-68.
One year later, Ohio Savings Bank reassigned the
mortgages to BOP and Berkley in a written reassignment to
them in their names, which they recorded in the public
records with no mention of the trusts. Shortly thereafter,
Berkley and BOP sold the mortgages to Horowitz Finance
Corporation and Fleet National Bank, again representing
themselves as the sole lawful owners, seeking no
participation from the trusts, and using the proceeds for
their own purposes. See app. at 29-38, 63-68, 41, 90, 398-
407.25
These transactions clearly demonstrate that, despite the
"adjusting journal entry" stating that the trusts owned the
mortgages, Berkley and BOP had full command over those
assets and over the beneficial incidents of owning them,
freely pledging them to obtain credit and selling them to
raise cash for their own undertakings. Courts have refused
to recognize purported asset transfers where the assets
remain within the control of the purported transferor and
remain subject to claims of the purported transferor's
creditors, as was the case here where Berkley and BOP
continued to enter into transactions with respect to the
mortgages and pledged the mortgages to their creditors. See
In re Johnson, 88 T.C. 225, 236-37 (rejecting assertion that
estate had transferred assets where assets remained
sufficiently within control of estate that they"would not be
insulated from the claims of [its] creditors"), aff 'd, 838 F.2d
1201 (2d Cir. 1987); Donisi v. Commissioner, 26 T.C.M.
(CCH) 327, 331 (1967) (disregarding asset transfer recorded
_________________________________________________________________
25. Berkley and BOP used a large portion of the proceeds to satisfy their
debt to Ohio Savings Bank and used the remainder to pursue their real
estate endeavors. While one of the estate's representatives asserted that
the trusts had authorized the various dispositions of the mortgages, he
conceded that all relevant documents referred only to the estate, Berkley
and BOP. See supp. app. at 12-16. In light of the substantial evidence
of transactions carried out exclusively by Berkley and BOP, the record
cannot support a finding that the trusts exercised any control over the
decisions with respect to the mortgages.
33
on books where purported transferor subsequently"took
out two loans using the [assets] as collateral"), aff 'd, 405
F.2d 481 (6th Cir. 1968).26 Because Berkley and BOP
retained all incidents of beneficial ownership including the
power to pledge the mortgages as collateral, sell them to
third parties and retain the proceeds of these transactions
while the trusts did not enjoy any of these incidents of
ownership, we find that the objective evidence of actual
control over the mortgages precludes a finding that the
trusts were the true owners of the mortgages. See Frank
Lyon Co., 435 U.S. at 572-73, 98 S.Ct. at 1298. 27
_________________________________________________________________
26. The Commissioner contends, br. at 38, that this case is
distinguishable from Johnson because Berkley paid the trusts $59,000 of
the income generated by the mortgages, thus providing an objective act
to corroborate the purported transfer of beneficial ownership. We
disagree. The very issue in dispute is whether the $59,000 transferred to
the trusts can be characterized as interest income generated by the
mortgages, since in the absence of evidence that the trusts owned and
controlled the mortgages, the transfers from the estate cannot be
characterized as mortgage interest income. In this case, as in Johnson,
there is no evidence that the trusts assumed the right to control the
mortgages as suggested in book entries. Thus the transfer of $59,000 is
immaterial.
27. The Commissioner argues, br. at 37-38, that the hypothecation and
sale of the mortgages to third parties should be accorded "minimal
weight" because they occurred after the end of the relevant tax year. We
disagree, and find Berkley's and BOP's complete control of the mortgages
as of June 16, 1985, highly probative of the locus of control during the
tax year ended February 28, 1985, especially since the record contains
no indication of any intervening change in the status of the mortgages.
The Commissioner's argument is particularly unpersuasive in light of the
Commissioner's extensive reliance on the journal entry dated June 11,
1985, as evidence bearing on ownership during the tax year ended
February 28, 1985. The Commissioner also asserts that Berkley's and
BOP's dispositions of the mortgages are irrelevant because they involved
"nothing more than transfer of bare legal title." Br. at 38. However, as
the estate's representatives conceded, in pledging the mortgages as
collateral to Ohio Savings Bank, Berkley and BOP placed the value of the
mortgages directly at risk in the event of a default, see app. at 47, 69-
70,
123, 170-71, and in selling the mortgages Berkley and BOP relinquished
all control over them. There is nothing in the record to support the
assertion that these transfers involved only the bare legal title of the
mortgages.
34
b. Control Over Mortgage Income
Berkley's control over the revenues generated by the
mortgages further demonstrates that the trusts did not
hold the incidents of beneficial ownership of the mortgages.
Contrary to the Tax Court's finding that Berkley merely
"serviced" the mortgages by collecting mortgage payments
and forwarding them to the trusts, see Geftman , 72 T.C.M.
(CCH) at 821, the record clearly demonstrates that Berkley
retained exclusive control over the mortgage payments
which it collected without accountability to the trusts. The
only document indicating that Berkley collected the
mortgage payments on behalf of the trusts consists of a
single page, which the court described as a "work paper,"
id. at 822, listing cumulative totals of the payments made
on the La Playa and Blue Grass mortgages through
December 31, 1985, and through the end of fiscal year
1985, and attributing these cumulative amounts to the
trusts. See supp. app. at 39. As one of the estate's
representatives conceded, the cumulative nature of this
document reveals that it could not have been prepared
before December 31, 1985, see supp. app. at 33, ten
months after the close of the trusts' fiscal year.
In contrast to this document retrospectively attributing a
cumulative amount to the trusts, the documents prepared
during the tax year in the ordinary course of Berkley's
business did not attribute to the trusts any of the mortgage
payments which Berkley collected. See app. at 329-34.
These documents accounting for each mortgage payment
received, with no reference to the trusts' purported interest
therein, undermine the Commissioner's assertion that
Berkley "accounted for the interest received on the La Playa
and Blue Grass condominiums as having been received on
account of the trusts." Br. at 37.28 In the absence of any
_________________________________________________________________
28. In support of this assertion, the Commissioner cites only the "work
paper" prepared after the end of the tax year and the testimony of one
of the representatives who conceded that he was"not familiar with the
books" in which Berkley accounted for the mortgage payments it
collected. App. at 78. This evidence cannot support a finding that
Berkley accounted for the mortgage payments as having been received
on behalf of the trusts, particularly since the documents recorded during
the tax year do not reflect such a practice.
35
contemporaneous documents attempting to account for the
trusts' purported mortgage income separately from
Berkley's other income, the single document retrospectively
characterizing a cumulative amount as income to the trusts
fails to establish that the trusts enjoyed a beneficial interest
in that income.
Berkley's handling of the actual funds received further
undermines the Commissioner's assertion that Berkley
merely processed payments belonging to the trusts. While
Berkley collected regular monthly mortgage payments
whose total amount increased steadily as additional
condominium units were sold at the La Playa and Blue
Grass developments, see app. at 99, Berkley's transfers to
the trusts did not correspond to the amounts purportedly
received on their behalf, but rather occurred at irregular
intervals and in haphazard, fluctuating, and sometimes
nominal amounts, which, as Geftman accurately notes,
"bore no reasonable relationship to the regular remittance
of monthly principal and interest payments which would
have been received by a legitimate mortgage servicing
company." Br. at 41.29
Significantly, Berkley forwarded to the trusts only
$59,000 of the $90,596 which it later characterized as
payments collected on behalf of the trusts. As
representative Love explained, Berkley had no obligation to
forward the mortgage payments to the trusts each month,
but rather remitted the money "as we saw fit, as we needed
_________________________________________________________________
29. The transfers occurred as follows:
Oct. 17, 1984 $12,000
Nov. 9, 1984 $ 5,000
Jan. 4, 1985 $25,000
Jan. 29, 1985 $ 1,000
Feb. 5, 1985 $14,000
Feb. 14, 1985 $ 1,000
Feb. 20, 1985 $ 1,000
_______
Total $59,000.
Although the trusts' ledger contained accounts for recording interest
income, the trusts did not record the $59,000 as such, but rather
recorded this sum in an account simply entitled"Berkley Mtg. Corp." See
app. at 384-85.
36
the cash to run the business." App. at 102. This testimony
reveals that Berkley did not function merely as a nominee
or agent processing payments on behalf of its principal, but
rather was free to use the money it collected as it saw fit to
further its own business purposes. Berkley's full control
over the income from the mortgages demonstrates that
Berkley, rather than the trusts, enjoyed this incident of
beneficial ownership.
As the Tax Court acknowledged, "[t]he owner of property
is the one who will reap the benefits of ownership."
Geftman, 72 T.C.M. at 822. In this case, the trusts
did not hold title to the mortgages, did not participate in
transactions pledging them as collateral and selling them,
did not receive any of the proceeds from those transactions,
and did not have control over the monthly mortgage
payments which Berkley collected and retained for its own
business purposes, forwarding funds to the trusts only
when it chose to do so. In light of this evidence that the
trusts did not enjoy any of the incidents of beneficial
ownership of the mortgages and that the mortgages
remained within the exclusive control of Berkley and BOP,
we find that the Tax Court clearly erred in concluding,
based on an adjusting journal entry and a work paper
prepared well after the close of the tax year, that the trusts
were the true owners of the mortgages. Because the trusts
did not hold any beneficial interest in the mortgages, we
must reject the Tax Court's conclusion that the $59,000
transferred to the trusts constituted taxable mortgage
interest income earned by the trusts as owners of the
mortgages rather than non-taxable transfers from an estate
that had no distributable net income.
C. Effect on Appellant's Tax Liability
Section 662(b) of the Internal Revenue Code provides that
income which is taxable in the hands of a trust is taxable
in the hands of the trust's beneficiary. Thus, when a trust
receives both taxable and non-taxable income, the trust's
distributions to its beneficiaries are treated as consisting of
both taxable and non-taxable elements, in the same
proportion as the taxable and non-taxable elements of the
trust's net income. See 26 U.S.C. S 662(b); Treas. Reg.
37
S 1.662(b)-1. The Tax Court found that 36% of the
distribution to Geftman was taxable, based on its
conclusion that 36% of Trust C's net income consisted of
taxable interest income generated by the margin
transactions and the La Playa and Blue Grass mortgages,
while the remainder consisted of tax-exempt income earned
on the trusts' municipal bonds. See app. at 436-38.30
However, for the reasons discussed above, we find that
the Tax Court erred in characterizing the transfers to the
trusts of $82,764 in connection with the E.F. Hutton
margin transaction and $59,000 in connection with the
mortgages as taxable income. Because these amounts were
not paid to the trusts as a bona fide creditor or a bona fide
holder of the mortgages, the transfers can be characterized
only as non-taxable distributions from an estate which had
no distributable net income, rendering all of the trusts'
income, and thus all of the distribution to Geftman, non-
taxable. See 26 U.S.C. S 652(a); Treas. Reg. S 1.652(a)-2(b).
IV. CONCLUSION
For the foregoing reasons, we will reverse the Tax Court's
decision holding Geftman liable for an income tax
deficiency, as the distribution from Trust C which gave rise
to the finding of a deficiency consisted entirely of non-
taxable income. Consequently, we will vacate the Tax
Court's imposition of additions to tax pursuant to 26 U.S.C.
SS 6651 and 6654, as the court's application of these
provisions rested on its finding of an underlying income tax
liability. We will remand the matter to the Tax Court for
entry of a decision in accordance with this opinion and for
such other proceedings as may be appropriate.
A True Copy:
Teste:
Clerk of the United States Court of Appeals
for the Third Circuit
_________________________________________________________________
30. For an explanation of the calculations underlying this 36% figure, see
note 7, supra.
38