69 T.C. 97">*107 The phrase "purposes other than for the exclusive benefit of his employees or their beneficiaries" as used in section 401(a)(2) is defined by section 1.401-2(a)(3), Income Tax Regs., to include "all objects or aims not solely designed for the proper satisfaction of all liabilities to employees or their beneficiaries covered by the trust."

The Code sets forth no specific rules regarding the types of investments which might be considered a use of funds for or diversion of funds to purposes not for the exclusive benefit of employees or their beneficiaries. Section 1.401-1(b)(5)(i), Income Tax Regs., provides that "Generally, the contributions may be used by the trustees to purchase1977 U.S. Tax Ct. LEXIS 36">*57 any investments permitted by the trust agreement to the extent allowed by local law." The only case to which our attention has been directed or that we have found applying the exclusive benefit rule in the context of trust investments is Central Motor Co. v. United States,    F. Supp.    ( D. N.M. 1976, 37 AFTR 2d 76-1001, 76-1 USTC par. 9245). ³1977 U.S. Tax Ct. LEXIS 36">*58 In that case the court found that a trust forming part of an employee plan lost its qualified status because the trust's investments in inadequately secured demand notes of another corporation controlled by the employer were not for the exclusive benefit of the employees. The court reasoned that the "primary purpose of benefitting employees or their beneficiaries must be maintained with respect to investments of the trust funds as well as with respect to other activities of the trust." ⁴ We agree with this reasoning in the Central Motor Co. case.

After considering all the facts and circumstances herein we have concluded that the loan to the trustees of the loan value of the policy on Mr. Feroleto's life and the subsequent loan to Mr. Feroleto were a diversion of the trust assets for a purpose other than the exclusive benefit1977 U.S. Tax Ct. LEXIS 36">*59 of the employees or their beneficiaries in contravention of section 401(a)(2). Admittedly, under section 17.4 of article XVII of the plan, diversion was in fact precluded. 69 T.C. 97">*108 Nevertheless, in our view under the provisions of section 1.401-1(b)(3), Income Tax Regs., we must look not only to the provisions of the trust instrument but also to the operation of the trust by the trustees. On this record we find that the Feroleto Steel Employees Pension Plan and Trust were not qualified under section 401(a) for taxable years 1970 and 1971 as a result of the loan transactions.

Three factors support our conclusion that the loan transactions were not for the exclusive benefit of the Feroleto Steel employees. First, from this record we find that the trustees' actions are inconsistent with their alleged primary intention of safeguarding the plan's investments in Seaboard insurance policies. Had the trustees really been motivated by the desire to protect their investments, in our view they would have taken measures above and beyond the mere borrowing of the loan value of only one insurance policy. Secondly, the low interest rate charged Mr. Feroleto and the substantial economic benefits1977 U.S. Tax Ct. LEXIS 36">*60 he reaped as a result thereof indicate that benefiting the coporation's principal shareholder was a major purpose underlying these loan transactions. Thirdly, we find that these loans were prohibited by the terms of the plan itself and so were not for the employees' exclusive benefit within the provisions of the statute and regulations.

Petitioners' primary argument in response to respondent's contention that the loans violated the exclusive benefit rule is that the transactions were motivated by the trustees' desire to protect their investments on behalf of Feroleto Steel employees in insurance policies of a company experiencing serious financial difficulties. Two of the trustees testified that Seaboard's financial troubles motivated their decision to borrow the loan value of Mr. Feroleto's policy. Neither of these trustees offered any satisfactory explanation as to why lending the proceeds of this loan to Mr. Feroleto at a low interest rate was for the benefit of the Feroleto Steel employees. Nor did either of the trustees offer any satisfactory explanation of why only the proceeds of one policy were borrowed if there were serious questions as to the financial condition of Seaboard.

1977 U.S. Tax Ct. LEXIS 36">*61 The two trustees of the plan who testified and Ralph Smith, adviser to the corporation with respect to the plan, all testified that they decided to borrow only the loan value of the policy covering Mr. Feroleto because it constituted the majority of the 69 T.C. 97">*109 trust assets. They testified that they did not want to borrow on the policies covering the lives of the other plan participants because they did not want to alarm them about the security of their interests in the pension plan. Aside from the policy covering the life of Frank V. Feroleto, the two insurance policies with the highest cash surrender values were those covering Helen Feroleto and Francis V. Feroleto, Jr. It would have been quite easy for the trustees to borrow from Seaboard the loan values of these policies without alarming the rank and file Feroleto Steel employees. Neither of the trustees who testified offered a reasonable explanation as to why this was not done if the trustees felt the trust funds were endangered if they remained with Seaboard. After the trustees borrowed on Mr. Feroleto's policy, some $ 58,000 in trust assets remained with Seaboard. Had the trustees been as concerned about the security1977 U.S. Tax Ct. LEXIS 36">*62 of their investments with Seaboard as they purport to have been, in our view they would have maximized their protection by at least borrowing on the policies covering Mrs. Feroleto and Francis V. Feroleto, Jr. Moreover, by the terms of the plan the trustees were the owners of all the policies on the participants' lives. Consequently, if Seaboard's financial situation was so precarious that it was necessary to take immediate measures to temporarily safeguard their investments in Seaboard policies, in all likelihood the trustees could have gone ahead and borrowed the loan value of all the policies without informing the other participants.

A second reason advanced by petitioners for having borrowed the loan value on only one policy was that the loan value of that policy was approximately equal to the vested interests of all the plan participants. The amount of the vested interest of all employees as of July 1969 could have been readily proved from the records of the trust and Feroleto Steel. Other than statements by the trustees that this was the case, however, no evidence was presented showing that the loan value of the policy on the life of Frank V. Feroleto approximated the vested1977 U.S. Tax Ct. LEXIS 36">*63 interests of all the plan participants. Moreover, no reason was given by the trustees as to why they would not want to protect the nonvested portions of their investments in Seaboard policies as well as the vested portions. Certainly, their duty as trustees required that they protect all the trust investments.

A second factor that demonstrates that the loan transactions were not for the exclusive benefit of the corporation's employees 69 T.C. 97">*110 is the low rate of interest (4.8 percent) on the loan by the trustees to Mr. Feroleto. Given the prevailing rates of interest during the week ended July 12, 1969, we find that 4.8 percent is an unreasonably low rate of interest. The trustees contended that this rate of interest was reasonable because it was the same rate of interest that Seaboard paid on the funds the trustees invested in its policies. The actuary who had determined the proper amount of Feroleto Steel's contributions to the plan had assumed that the policies funding the plan would earn interest at this rate. Investment of the loan proceeds at a higher rate, petitioners allege, would have necessitated a new and expensive actuarial recomputation. We find, however, that1977 U.S. Tax Ct. LEXIS 36">*64 no new actuarial study would have been necessary with regard to the trust funds temporarily invested at a higher rate of interest. Rather, the excess amount received as interest could have been held by the trustees in the suspense account pursuant to article XII of the plan and used by the trustees for subsequent premium payments. Petitioners argue that to have done this would not have benefited the employees but only the employer. In this contention they overlook the benefit to the employees of the extra security of having funds on hand for the premium payments. Such extra funds might well have at some time avoided the necessity of the trustees having to borrow on the policies to pay premiums in accordance with the provisions of section 8.3 of article VIII of the plan. No witness was able to explain why provision for a suspense account was needed if the plan did not contemplate the deposit of funds into the account.

Nor are we willing to overlook the substantial benefits derived by Mr. Feroleto as a result of these loan transactions. The trustees loaned the proceeds of the loan to Mr. Feroleto at an annual interest rate of 4.8 percent. He in turn loaned these funds, together1977 U.S. Tax Ct. LEXIS 36">*65 with some additional money of his own, to the employer corporation at 8.5-percent interest. On their joint individual income tax returns for 1969, 1970, and 1971 Frank and Helen Feroleto listed the sums of $ 2,656, $ 10,625, and $ 13,625, respectively, as interest income from Mr. Feroleto's loan to the corporation. A substantial part of this interest income resulted from Mr. Feroleto's ability to charge the corporation an interest rate which was reasonable but which was appreciably higher than the interest rate charged by the trustees on their loan to him. Moreover, Frank and Helen Feroleto's returns for 1969, 69 T.C. 97">*111 1970, and 1971 reveal no reported dividend income from Feroleto Steel. By loaning funds to his corporation at a higher interest rate than that charged him, Mr. Feroleto was able not only to derive substantial amounts of interest income but also to confer an interest expense deduction on the corporation. Had the corporation paid dividends instead, no deduction would have been allowed.

Mr. Feroleto, Sr., was too ill at the time of trial to testify and has since died. We therefore do not have the benefit of his own statements of his considerations in approving the1977 U.S. Tax Ct. LEXIS 36">*66 borrowing by the trustees of the loan value of his policy and lending the proceeds to him at an interest rate of 4.8 percent. Mr. Feroleto, Jr., testified that while he participated in the decision to borrow the funds from Seaboard, he did not participate in the decision to lend the funds to his father. The other trustee in his testimony did not explain the basis for the decision to lend the funds to Mr. Feroleto, Sr. However, some of his testimony explaining a statement he had made to the respondent's representatives with respect to Mr. Feroleto's inability to meet his repayment schedule is revealing. This witness testified that although Mr. Feroleto was a man of substantial wealth he was at the time extremely short of cash assets. This testimony suggests that the decision to lend the proceeds of the loan from Seaboard to Mr. Feroleto may well have been prompted by his lack of available cash when he desired to make a loan to the corporation. It further suggests that this need for cash by Mr. Feroleto might have influenced the borrowing of the cash surrender value of his policy by the trustees instead of their immediately finding another company with which to place the policies1977 U.S. Tax Ct. LEXIS 36">*67 as they did in December 1971. From the testimony of Mr. Francis V. Feroleto, Jr., it is clear that the views of Mr. Feroleto, Sr., carried great weight with the other two trustees. From this record we conclude that the possibility of garnering substantial economic benefits for Mr. Feorleto, Sr., was an important factor underlying the trustees' decisions to make these loans.

A third basis for our conclusion that these loans were not for the exclusive benefit of the employees is the fact that these transactions were not permitted by the trust agreement as required by section 1.401-1(b)(5)(i), Income Tax Regs. While it is true that the general powers conferred on the trustees by section 4.2 of article IV of the plan were broad, it appears to us that the 69 T.C. 97">*112 specific provisions of section 8.3 of article VIII were intended to narrowly limit the trustees' powers with respect to policy loans. That section provides that the trustees may apply for policy loans whenever the funds furnished by the corporation are insufficient to pay premiums and loan interest and that "any such loan shall be used exclusively to [sic] payment of the premium and loan interest due on the policy on1977 U.S. Tax Ct. LEXIS 36">*68 which it was granted." [Emphasis added.] No provision of the plan sanctions a loan like the one made to Mr. Feroleto. At trial, trustee Arnold Bernstein admitted that the trust instrument did not confer on the trustees the power to engage in a transaction like the one involved herein. He stated that the trustees nevertheless proceeded to borrow on Mr. Feroleto's policy because they did not want to "let Seaboard go down the drain and lose our money." As we have indicated above, while we do not doubt that the trustees were concerned about the financial condition of Seaboard, we do not consider the record as a whole to support a conclusion that their fear of Seaboard's financial collapse was the compelling reason for the loans they made. Had the trustees realistically been in fear of Seaboard's imminent failure, they would have taken further steps to protect their entire investment in Seaboard policies.

Citing Time Oil Co. v. Commissioner, 258 F.2d 237">258 F.2d 237 (9th Cir. 1958), remanding 26 T.C. 1061">26 T.C. 1061 (1956), petitioners contend that disqualification of an employee plan under the exclusive benefit rule is appropriate only when there 1977 U.S. Tax Ct. LEXIS 36">*69 is a showing that the benefits to be received by the beneficiaries were somehow prejudiced. Petitioners argue that because the employees' benefits under the plan were not jeopardized by the transactions involved herein, the rule has not been contravened. The court in Time Oil characterized the deviations from the plan involved in that case as "de minimis" specifically pointing out that no interest advantage inured to the employer since the preferred stock substituted for the non-interest-bearing notes was backdated to the date of the notes. Here, by contrast, the deviations were not de minimis and they were specifically prohibited by the terms of the plan. Also, here the major stockholder of the employer did derive substantial benefits from the deviations. Petitioners' argument to the effect that the exclusive benefit rule is not violated unless the ultimate result of the transaction is that employee benefits are adversely affected would leave trustees 69 T.C. 97">*113 free to engage in virtually any transaction with trust assets, no matter how insecure or speculative, unless as the result of such transactions there were in fact a dilution of employee benefits. Such a narrow construction1977 U.S. Tax Ct. LEXIS 36">*70 of the exclusive benefit rule is unwarranted. The intent of that rule is to protect the fund from unauthorized transactions, whether or not those transactions actually result in a loss of benefits to the employee.

By our holding here, we do not mean to imply that the exclusive benefit rule is contravened whenever a benefit inures to someone other than the employees or their beneficiaries as the result of an investment of the funds of an employee trust. However, under the facts of this case the benefit to the third party is not merely an incidental side effect of an investment of trust assets, but is rather a major purpose of the investment. In these circumstances, we hold that the exclusive benefit rule has not been followed. Accordingly, we find that for the taxable years 1970 and 1971, the Feroleto Steel Co., Inc., Employees Pension Trust was not qualified under section 401(a) and not exempt from tax under section 501(a). It follows that the participants' taxable incomes must be increased in each of these years by the amount of the corporation's contributions to the trust on their behalves to the extent that these contributions are vested and nonforfeitable, pursuant to sections1977 U.S. Tax Ct. LEXIS 36">*71 402(b) and 83. Also, pursuant to section 404(a)(5), the corporation's deductions for contributions to the nonexempt trust must be disallowed to the extent they are forfeitable and not includable in the employees' incomes.

Having concluded that the loan to the trustees and the subsequent loan to Frank Feroleto were not undertaken for the exclusive benefit of the Feroleto Steel employees, we need not consider respondent's alternative arguments that the loan to Mr. Feroleto was a prohibited transaction under section 503.

The basis of respondent's argument that the loan in 1969 by the trustees to Mr. Feroleto was a premature distribution to him by the pension plan, fully taxable in the year of receipt under section 402(b), is unclear. In the notice of deficiency respondent referred to the loan being from a nonexempt trust but on brief argues his contention with respect to a distribution to Mr. Feroleto as an alternative. In any event, although we have found the loan not to have been embarked upon for the benefit of the corporation's employees, the loan was not a sham. Rather, the 69 T.C. 97">*114 parties intended to and did create a bona fide debtor-creditor relationship. The loan was, 1977 U.S. Tax Ct. LEXIS 36">*72 in fact, ultimately repaid. The mere fact that the repayments were not in accordance with the loan schedule does not inexorably lead to the conclusion that no bona fide debtor-creditor relationship ever came into being. We conclude on the basis of this record that Mr. Feroleto borrowed the $ 114,927.88 of trust assets in 1969 and did not receive a distribution in that year of his interest in the pension trust.

Decision will be entered under Rule 155.