56 T.C. 263">*264 The Commissioner determined deficiencies in petitioners' income tax as follows:

These cases involve the tax consequences of certain transactions in 1964 whereby (1) Harold W. and Caroline H. Smith, the owners of an installment obligation, undertook to transfer it to their son and to their daughter, petitioner Helen C. Smith, (2) the son and daughter each undertook to pay annuities to their parents, and (3) the proceeds of the installment obligation, 1971 U.S. Tax Ct. LEXIS 133">*135 which had meanwhile been paid by the obligor, were placed in trusts in which the son and daughter appeared as settlors, and in which the trustees were instructed to pay the annuities to the parents out of the assets of the trusts. Particularly in question is whether the parents are chargeable with taxable income in 1964 under section 453(d) (1), I.R.C. 1954, in respect of the theretofore unreported gain reflected in the installment obligation, which they had elected to report on the installment basis in an earlier year. Also in issue is whether petitioner Helen C. Smith may deduct as interest a portion of the payments made to her parents by the trustees of her trust purportedly in discharge of her obligation under the so-called annuity agreements.

FINDINGS OF FACT

The parties have stipulated certain facts, which, together with the attached exhibits, are incorporated herein by this reference.

Petitioners Harold W. and Caroline H. Smith (Harold and Caroline) are husband and wife. They filed a joint Federal income tax return for the calendar year 1964 with the district director of internal revenue at Los Angeles, Calif., and resided at 2449 Ridgeway Road, 56 T.C. 263">*265 San Marino, Calif., 1971 U.S. Tax Ct. LEXIS 133">*136 at the time their petition herein was filed. Their return was prepared on the basis of a cash method of accounting. Petitioner Helen C. Smith (Helen) is the daughter of petitioners Harold and Caroline Smith. She filed an individual Federal income tax return for the calendar year 1967 with the district director of internal revenue at Los Angeles, Calif., and resided at 2449 Ridgeway Road, San Marino, Calif., at the time her petition herein was filed.

Harold was born on April 20, 1901, and Caroline was born on October 22, 1913. They are the parents of one daughter, Helen, and one son, Harold W. Smith, Jr. (Harold, Jr.).

Helen was born on November 3, 1944. From September 1962 until June 8, 1966, she was a full-time student at the University of California at Santa Barbara. During the years in question her home address was the same as that of her parents. However, during the first, second, and fourth years of her college career, she resided at Santa Barbara during the school year. From the latter part of August of 1964 until July of 1965, Helen studied at the University of California "Extension, junior year abroad program," at Goettingen, Germany. From February 20, 1967, to November1971 U.S. Tax Ct. LEXIS 133">*137 30, 1968, she was employed as a librarian. During this latter period she lived "at home" for approximately 4 or 5 months and then moved into an apartment in Pasadena, Calif.Helen was married in November of 1969 and acquired the married name of Helen C. (Smith) Hurst.

Harold, Jr., was born on October 8, 1937. In June of 1963 he graduated from the University of Colorado at Boulder, and enlisted in the U.S. Air Force for 5 years. From the fall of 1963 until August of 1964 he was engaged in flight training at Craig Air Force Base at or near Selma, Ala. After graduation from flight school in August of 1964, he was stationed at Bunker Hill Air Force Base in Indiana. Upon receipt of his honorable discharge from the Air Force in 1968, he was employed by Continental Air Lines as a commercial airline pilot, flying primarily Pacific and Far Eastern flights. At the time of the trial herein, he resided at Dana Point, Calif., and continued to be employed by Continental Air Lines as a commercial pilot.

On June 1, 1961, Harold and Caroline entered into a "purchase agreement" with Union Oil Co. of California (Union Oil). Under the agreement, the Smiths agreed to sell to Union Oil 9,839 1/41971 U.S. Tax Ct. LEXIS 133">*138 shares (out of a total of 10,500 issued and outstanding shares) of the capital stock of American Liquid Gas Corp. (American Gas). The purchase agreement, which identified the Smiths as "Sellers" and Union Oil as "Buyer," made the following provision with regard to payment for the stock:

1. The purchase price to be paid by Buyer to Sellers for the Stock shall be the sum of ONE MILLION, EIGHT HUNDRED AND THIRTY-NINE THOUSAND, ONE HUNDRED AND EIGHT DOLLARS ($ 1,839,108.00) subject to 56 T.C. 263">*266 adjustment upward or downward in accordance with the provisions of paragraph 5 hereof. An amount equal to twenty-five per cent (25%) of the purchase price shall be paid not later than Tuesday, June 20, 1961, at 10:00 o'clock A.M. in Los Angeles Clearinghouse funds at the principal offices of the Buyer, Union Oil Center, Los Angeles, California. Such time and date is sometimes referred to herein as the "time of closing." The balance of the purchase price shall be paid in five equal annual installments commencing on the 1st day of July, 1962, or may be prepaid at the option of Buyer, except that no portion of such balance of purchase price shall be paid prior to January 1, 1962. Buyer agrees 1971 U.S. Tax Ct. LEXIS 133">*139 to pay interest semi-annually on the unpaid balance at a rate equal to the prime rate of interest being charged by New York City banks (currently 4 1/2 per cent) on the interest payment date. * * *

The purchase agreement was subsequently modified on two occasions in 1961, first on June 20, the closing date, to increase the total purchase price to $ 1,839,248.50, and finally on December 14, 1961, to reduce the total purchase price to $ 1,786,994.75.

On June 20, 1961, pursuant to the purchase agreement, Union Oil paid the Smiths $ 459,812.13 (approximately 25 percent of $ 1,839,248.50, the total purchase price as modified on that date) as the first installment of the purchase price. At the time of the sale, the Smiths' basis in the American Gas shares which were sold was $ 170,770.12. The selling expenses incurred by them which were attributable to the sale amounted to $ 10,102.28. On their joint Federal income tax return for 1961, the Smiths properly elected to report their gain from the sale of the American Gas stock on the installment method under section 453, I.R.C. 1954. Accordingly, in 1961 they reported income of $ 413,271.79 from the sale of the stock. ¹

1971 U.S. Tax Ct. LEXIS 133">*140 In each of the years 1962 and 1963, Union Oil paid the Smiths the annual installment of principal due in the amount of $ 265,436.53 (equal to approximately one-fifth of the difference between $ 1,786,994.75, the final aggregate purchase price, and $ 459,812.13, the first installment payment made in 1961) as well as the interest due on the unpaid balance. However, the payment due on July 1, 1962, was made on July 23, 1962, approximately 3 weeks late, as the result of Harold's oral request that Union Oil delay such payment. Union Oil did not pay the Smiths the added interest which accrued as the result of the late payment. On their joint Federal income tax returns for 1962 and 1963, the Smiths 56 T.C. 263">*267 reported the 1962 and 1963 payments on the installment method in accordance with their election to do so in 1961; the income from the sale of the stock reported each year was $ 238,570.11 (89.8784 percent of the annual payments of $ 265,436.53).

Thus, at the end of 1963, the unpaid balance of the total purchase price due from Union Oil was $ 796,309.56, and of that amount $ 715,710.28 represented gain to be reported by the Smiths in the future in accordance with the installment method.

1971 U.S. Tax Ct. LEXIS 133">*141 At the time of the trial herein, neither Harold nor Caroline had ever been a member of the board of directors of Union Oil or a major stockholder in Union Oil. Furthermore, apart from a period of no more than 10 months immediately following the sale of the American Gas stock, when Harold was employed by Union Oil as a consultant, ² neither had been an employee of that corporation.

After the sale of the American Gas stock in 1961, Harold began to consider or plan the disposition of his estate. At one time, Stanford University or someone acting on its behalf proposed an estate plan under which Stanford would be the beneficiary of at least a substantial portion of the estate. However, Harold turned down the proposal because "It would look like we would get very little out of it."

Subsequently, while in Florida in April of 1964, Harold had discussions1971 U.S. Tax Ct. LEXIS 133">*142 with a Mr. Hardy, a mutual fund salesman who purported to have extensive estate-planning experience. Hardy proposed a plan whereby Harold would transfer certain assets to his children in exchange for their agreement to provide him, and possibly also his wife, with annuities. The plan also contemplated that the assets transferred to the children would be placed in trust and that the trust corpus would be invested in mutual funds. Harold was initially receptive to the proposal, and Hardy had an attorney draft a number of documents to carry out the plan.

Harold left Florida to return to California in April of 1964, bringing with him the unexecuted documents which had been prepared by Hardy and his attorney. On his trip back to California, he stopped off to see his son, Harold, Jr., who was then at flight school in Alabama. At that time Harold discussed the proposed plan, including the proposed annuities and trusts, with his son. After their discussion, Harold, Jr., signed the documents calling for his signature.

On his return to California, Harold consulted his attorney, Harold Voegelin, with regard to the proposed plan. He gave Voegelin the documents which had been prepared by1971 U.S. Tax Ct. LEXIS 133">*143 Hardy and his attorney and recounted to Voegelin the substance of his conversations with Hardy 56 T.C. 263">*268 in Florida. Already somewhat uneasy about dealing with Hardy, whom he had known for only a relatively brief period of time, Harold decided to have the matter handled by Voegelin and an accountant, Martin Samuelson, both of whom he had known for a number of years.

Harold sought an estate plan which would ensure him and his wife of adequate incomes for the remainder of their lives, which would also ensure that their children would be well taken care of thereafter, and which would minimize the amount of estate tax imposed at their deaths. Moreover, an engineer by training, Harold disliked the responsibilities of financial planning and management; in the past he had granted his brokers management powers over his securities accounts and had made Samuelson generally responsible for his financial affairs. Thus in planning his estate, he also desired a financial program which would continue to require little participation on his part.

Voegelin and Samuelson ultimately developed a plan which in general followed the outlines of Hardy's proposal, but differed therefrom in a number of details. 1971 U.S. Tax Ct. LEXIS 133">*144 In form, the plan contemplated that Harold and Caroline would assign to their children their interests in the purchase agreement with Union Oil and that in return the children would agree to pay annuities to their parents for the rest of their lives. The plan further contemplated that the children would establish trusts, that the purchase agreement or payments made by Union Oil in satisfaction of its obligation under the agreement would be placed in the trusts, and that the trusts would periodically pay to Harold and Caroline the amounts due to them as annuities.

As of late June 1964, it appeared that the series of transactions planned by Voegelin would not be fully consummated by July 1, 1964, the date when the third annual payment of $ 265,436.53 was due from Union Oil. Harold and Caroline wanted that payment to be included in Voegelin's plan, without first passing through their hands where the gain reflected therein would be subject to tax. They requested Union Oil to defer the payment by letter dated June 29, 1964. That letter read in pertinent part as follows:

With reference to that certain Purchase Agreement dated June 1, 1961 by and between Harold Smith and Caroline Smith, 1971 U.S. Tax Ct. LEXIS 133">*145 as Sellers, and Union Oil Company of California (Union), as Buyer, the undersigned hereby request that Union refrain from making the payment on the purchase price for the stock purchased under the terms of said agreement which would otherwise be due on the first day of July, 1964; and the undersigned hereby release Union from any and all liability for default in the making of said payment on July 1, 1964.

It is agreed, however, that interest on the amount of principal which would otherwise have been paid to the undersigned on July 1, 1964, shall cease to accrue as of July 1, 1964, and the undersigned hereby waive payment of any 56 T.C. 263">*269 interest on the amount of such installment for the period from and after July 1, 1964 until said installment is paid.

The undersigned will advise Union when they wish to have said installment paid to them.

The prime rate of interest charged by New York City banks, which was the applicable rate of interest under the contract with Union Oil, was 4 1/2 percent in July of 1964. Union Oil would have made the installment payment on or before July 1, 1964, had it not been for the Smiths' request to defer the payment. At the time the letter was written, 1971 U.S. Tax Ct. LEXIS 133">*146 Harold expected the assignments of contract, annuity contracts, and trust instruments to be executed in "due time."

Prior to their execution of any of the instruments called for by the plan, Helen and Harold, Jr., each had some discussion with their father about the nature of the plan. Harold's discussions with Helen were less detailed than those with his son; she was a minor at that time, more interested in academic pursuits than in financial transactions, and was "willing to go along with anything that was proposed by Mr. Voegelin's office and Mr. Samuelson who had handled our [Harold's and Caroline's] affairs for a good many years." The children did not retain counsel of their own in connection with their role in the plan and relied primarily on the advice of Voegelin and Samuelson.

Three sets of documents were prepared by Voegelin with Samuelson's advice or guidance to carry out the plan. They were dated respectively, June 30, 1964, July 1, 1964, and August 1, 1964. They were in fact executed at some time or times during the period from late June to early August 1964, and were interdependent parts of a single, integrated plan. They were not necessarily executed on the dates1971 U.S. Tax Ct. LEXIS 133">*147 that they bear. They were as follows:

1. The Assignments of Contract. -- The first two documents were both entitled "Assignment of Contract." One was signed by Harold and the other by Caroline. Both were dated June 30, 1964. Harold was identified as "Assignor" in the document signed by him and Caroline was identified as "Assignor" in the document signed by her. Harold, Jr., and Helen were identified as "Assignees" in both documents. Each document purported to convey to Harold, Jr., and Helen, in equal shares, all the rights that the respective assignor (Harold or Caroline) might have in the Union Oil contract. The operative provisions of both documents were identical and read in full as follows:

Said Assignor hereby transfers, sells, assigns, conveys and sets over to Assignees free and clear of any claims, liens or encumbrances whatsoever, in equal shares as to each, all the Assignor's right, title and interest, legal and equitable, in and to that certain contract dated June 1, 1961, called "Purchase Agreement" by and between HAROLD W. SMITH and CAROLINE H. SMITH, and the UNION OIL COMPANY OF CALIFORNIA, as amended.

The intent hereof is to transfer to Assignees all of the1971 U.S. Tax Ct. LEXIS 133">*148 contract rights and 56 T.C. 263">*270 interest which the Assignor owns or possesses, now or hereafter, and to confer upon Assignees full right and power in their absolute discretion to hold or dispose of said contract or their respective interests therein at any time without any notice to the Assignor.

As of July 1, 1964, the Union Oil contract had a fair market value of $ 796,308.

2. The Annuities. -- Four documents, each captioned "Annuity Contract," were dated July 1, 1964. In two of them Harold, Jr., appeared as the "undersigned promisor." In one of those he undertook to pay his father $ 21,000 per year, at the rate of $ 1,750 a month beginning August 1, 1964, purportedly in consideration of the assignment of his father's one-half interest in the Union Oil contract. The introductory paragraph and operative provisions of that document were as follows:

Whereas, HAROLD W. SMITH has on this date assigned to the undersigned promisor an undivided one-half interest in and to all the right, title, and interest which the said HAROLD W. SMITH has in a certain contract, more particularly described as "Purchase Agreement" between HAROLD W. SMITH and CAROLINE H. SMITH and THE UNION OIL COMPANY1971 U.S. Tax Ct. LEXIS 133">*149 OF CALIFORNIA, dated June 1, 1961, as amended;

Now Therefore, in consideration of such assignment, (the value of which is hereby stipulated to be $ 199,077) the undersigned promisor hereby covenants and agrees to pay to HAROLD W. SMITH Twenty-one Thousand Dollars ($ 21,000.00) per year, payable monthly beginning August 1, 1964 in the amount of One Thousand Seven Hundred Fifty Dollars ($ 1,750.00) and each and every month, thereafter during said HAROLD W. SMITH's lifetime. Provided, however, that if at the time of HAROLD W. SMITH's death the total amount of the payments made hereunder to HAROLD W. SMITH shall not equal the amount of the consideration paid ($ 199,077), then the undersigned promisor shall continue making the annuity payments, as herein provided, to such person or persons as HAROLD W. SMITH shall designate by an instrument in writing filed with the promisor during said HAROLD W. SMITH's lifetime. The last such written instrument filed with the promisor shall govern and any such instrument so filed shall be deemed valid unless at the time of execution thereof the said HAROLD W. SMITH shall have been adjudicated an incompetent by a court of competent jurisdiction. The1971 U.S. Tax Ct. LEXIS 133">*150 annuity payments to such designee shall continue until such time as the total of all the annuity payments made to HAROLD W. SMITH and his designee shall equal the amount of the consideration paid ($ 199,077) for this contract. In the absence of such designation, such payments shall be made to the estate of the said HAROLD W. SMITH.

It is mutually understood and agreed by and between the parties to this Annuity Contract that the interest factor in this contract shall be equal to that amount of any payments made to HAROLD W. SMITH pursuant to the terms hereof which is required by applicable Federal Income Tax laws to be included in the taxable income of HAROLD W. SMITH as ordinary income. It is further understood that this interest factor as so stated shall be in lieu of any other provisions or requirements for interest payments on the part of the promisor.

The second "annuity contract" signed by Harold, Jr., was for the benefit of his mother and was substantially identical with the first 56 T.C. 263">*271 "annuity contract" except that it provided for an annuity of only $ 15,000 a year ($ 1,250 a month).

The other two documents of this group were executed by Helen as the "undersigned promisor," 1971 U.S. Tax Ct. LEXIS 133">*151 one undertaking to provide an annuity for her father and the other for her mother. The operative provisions of each were substantially identical with those of the corresponding instrument executed by Harold, Jr. None of the four "annuity contracts" contained a provision for collateral or security for the payments required by the agreements.

As of July 1, 1964, the value of each annuity to be received by Harold, computed pursuant to Federal Gift Tax Regulations section 25.2512-5(f), was $ 218,894.35, while the value of each annuity to be received by Caroline, computed under the same regulations, was $ 221,122.16. So calculated, the aggregate value of the four annuities was $ 880,033.02 on July 1, 1964.

3. The Trusts. -- Two substantially identical trust instruments were executed, one by Harold, Jr., as settlor and the other by Helen as settlor. Each was dated August 1, 1964, and the corpus of each trust consisted of one-half of the funds obtained from Union Oil in discharge of its liability under the so-called purchase agreement, as hereinafter set forth. By July 31, 1964, Union Oil had been advised by or on behalf of Harold and Caroline that payment (which had theretofore1971 U.S. Tax Ct. LEXIS 133">*152 been held in abeyance) might be made under the purchase agreement. Union Oil, whether on its own initiative or in response to a request by Harold, in fact made payment on July 31, 1964, not merely of the installment due in 1964 but also of the entire remaining principal amount for which it was liable under the contract plus interest accrued up to that time. On July 31, 1964, Union Oil thus delivered to Harold a check in the amount of $ 798,333.51, payable to Harold, Jr., and Helen. The components of that amount and the manner in which the proceeds of the check were transferred to the two trusts about to be more fully described will be set forth hereinafter.

Each trust instrument named Voegelin and Samuelson as trustees and each stated that the trust corpus would consist of $ 399,166.75 (one-half of the total amount of the funds received from Union Oil). Part "Second" of each instrument stated the purpose of the trust and provided for payments by the trustees as follows:

(a) Whereas, the Settlor herein for a valuable consideration has contracted to pay to HAROLD W. SMITH and CAROLINE H. SMITH certain annuities as specified in Schedule B attached hereto; the purpose of this trust1971 U.S. Tax Ct. LEXIS 133">*153 is to insure orderly payment and management of the annuity in the event of death or disability of the Settlor and the maintenance of separate accounts during the said Settlor's life as well as a disposition of the trust assets after the termination of this trust.

56 T.C. 263">*272 (b) Trustees shall pay to HAROLD W. SMITH and CAROLINE H. SMITH such amounts as are called for in the annuity contracts attached hereto as Schedule B. Such payments shall be made from principal or income as the Trustees deem appropriate in their discretion. However, neither the trustees nor the Settlor shall have any obligation to secure the payment and obligations of the annuity contracts.

In addition, paragraph (c) authorized the trustees in their discretion to pay trust income to the settlor, spouse of the settlor, or children of the settlor, and also to expend amounts from principal for the benefit of such persons where needed for "proper care, maintenance, support or education."

Each instrument declared the trust irrevocable:

the trust under this instrument cannot be altered, amended, revoked, or terminated by the Settlor and he retains no beneficial interest, vested or contingent, hereunder * * *

The 1971 U.S. Tax Ct. LEXIS 133">*154 Harold W. Smith, Jr. Trust was to terminate under the following conditions:

FIRST: This trust shall terminate upon the death of HAROLD W. SMITH, CAROLINE H. SMITH or HAROLD W. SMITH, JR., whichever is the later. But, if HAROLD W. SMITH, JR. should survive HAROLD W. SMITH and CAROLINE H. SMITH, then this trust shall terminate upon HAROLD W. SMITH, JR.'s death or attaining the age of forty (40) years, whichever occurs first.

On termination of the trust, the trust corpus and accumulated income were to be distributed as follows:

THIRD: Upon termination of this trust, as provided in the FIRST paragraph, the Trustees are to distribute all of the trust estate and accumulated income therefrom to the following:

(a) HAROLD W. SMITH, JR., absolutely and forever, as his own separate property, but if he should not then be living, then to the lawful issue of HAROLD W. SMITH, JR. surviving to the date of such distribution, upon the principle of representation, subject to the continuation in trust as to the share of any such issue as may then be under the age of twenty-one (21) years as hereinafter provided.

(b) If no such issue of HAROLD W. SMITH, JR. should survive to the date of distribution1971 U.S. Tax Ct. LEXIS 133">*155 and termination of this trust, then all such property shall go to the Trustees of the trust created on the same date hereof by the Settlor's sister, HELEN CAROLINE SMITH to be held by such Trustees according to the terms of such HELEN CAROLINE SMITH TRUST. In the event no such trust is then in existence, then this trust estate shall be distributed to HELEN CAROLINE SMITH outright if she is then living; or if she should not so survive, then to the lawful issue of HELEN CAROLINE SMITH surviving to the date of such distribution, upon the principle of representation.

(c) If no issue of HAROLD W. SMITH, JR. should survive to the date of distribution and termination of this trust, and the HELEN CAROLINE SMITH TRUST should not be then in existence, and HELEN CAROLINE SMITH should not so survive and no issue of HELEN CAROLINE SMITH should so survive, 56 T.C. 263">*273 then all such trust property and accumulated income therefrom shall be distributed as follows:

(1) Thirty per cent (30%) thereof shall be held in trust for the benefit of [FRANCIS] M. SMITH and his wife, CATHERINE, or the survivor, presently of Bradenton Beach, Florida; the entire net income thereof to be distributed to or used for1971 U.S. Tax Ct. LEXIS 133">*156 the benefit of such beneficiaries during their lifetime and the lifetime of the survivor. Upon the death of the survivor, or at the time distribution would have been made by the trust estate for their benefit had they been living, this portion of the trust estate shall be distributed to their then living lawful issue.

(2) Ten per cent (10%) outright to MRS. LOU RODAUCH, presently of Canton, Ohio, or if she is not living, to her then living lawful issue.

(3) Ten per cent (10%) to MRS. VERONA HELM, presently of Windsor, Ontario, Canada, or if she is not then living, to her husband, WILLIAM HELM; if both of such persons are not then living, their share shall be added to the share distributable to MRS. LOU RODAUCH, or to her then living lawful issue under subparagraph (c)(2) above.

(4) Fifteen per cent (15%) outright to EDWARD CHARLES HAUSER, JR., presently of Chico, California, or if he is not then living, to his then living lawful issue.

(5) Fifteen per cent (15%) outright to MRS. MARIE HAUSER, stepmother of CAROLINE H. SMITH, presently of Sacramento, California, or if she is not then living, such share shall be added to the share distributable to EDWARD CHARLES HAUSER, JR., or to 1971 U.S. Tax Ct. LEXIS 133">*157 his then living lawful issue under subparagraph (c)(4) above.

(6) Any remaining balance not otherwise disposed of hereunder shall be distributed one-half to the CHILDREN'S HOME SOCIETY OF CALIFORNIA, and one-half to the STANFORD RESEARCH INSTITUTE.

FOURTH: Notwithstanding the preceding provisions, in the event HAROLD W. SMITH, JR. should survive both CAROLINE H. SMITH and HAROLD W. SMITH, then if HAROLD W. SMITH, JR. should die before attaining the age of forty (40) years, the Trustees shall pay the trust estate and accumulated income therefrom, if any, to such person or persons in such amounts and proportions as said HAROLD W. SMITH, JR. may designate and appoint in the last unrevoked written instrument other than a Will executed by him and on file with the Trustees at the time of his death, such persons to be limited to his spouse, his lawful issue, his sister, HELEN CAROLINE SMITH, and the lawful issue of HELEN CAROLINE SMITH; provided, however, should the said HAROLD W. SMITH, JR. leave lawful issue surviving his death, then not more than one-half of the trust estate may be appointed to his spouse and any amount in excess thereof shall go instead to such issue of his. To the extent1971 U.S. Tax Ct. LEXIS 133">*158 he shall not have exercised the limited power of appointment set forth herein, such trust estate shall be distributed in accordance with paragraph THIRD above, subject to the continuation in trust of the share of any such issue as may then be under the age of twenty-one (21) years, as hereinafter provided. * * *

The Helen Caroline Smith Trust was to "terminate upon the death of Harold W. Smith, Caroline H. Smith or Helen Caroline Smith, whichever is later." Unlike her brother's trust, which could terminate upon his attaining the age of 40, there were no provisions in Helen's trust for accelerating termination prior to her death. On termination 56 T.C. 263">*274 of the trust, the trust corpus and accumulated income were to be distributed as follows:

THIRD: Upon termination of this trust, as provided in the FIRST paragraph, the Trustees are to distribute all of the trust estate and accumulated income therefrom to the following:

(a) The lawful issue of HELEN CAROLINE SMITH surviving to the date of such distribution, upon the principle of representation, subject to the continuation in trust as to the share of any such issue as may then be under the age of twenty-one (21) years as hereinafter1971 U.S. Tax Ct. LEXIS 133">*159 provided.

(b) If no such issue of HELEN CAROLINE SMITH should survive to the date of distribution and termination of this trust, then all such property shall go to the Trustees of the trust created on the same date hereof by the Settlor's brother, HAROLD W. SMITH, JR., to be held by such Trustees according to the terms of such HAROLD W. SMITH, JR. TRUST. In the event no such trust is then in existence, then this trust estate shall be distributed to HAROLD W. SMITH, JR. outright if he is then living; or if he should not so survive, then to the lawful issue of HAROLD W. SMITH, JR. surviving to the date of such distribution, upon the principle of representation.

(c) If no issue of HELEN CAROLINE SMITH should survive to the date of distribution and termination of this trust, and the HAROLD W. SMITH, JR. TRUST should not be then in existence, and HAROLD W. SMITH, JR. should not so survive, and if no issue of HAROLD W. SMITH, JR. should so survive, then all such trust property and accumulated income therefrom shall be distributed as follows:

[Subpars. (c)(1) through (c)(6) were identical to the corresponding subparagraphs in the Harold W. Smith, Jr. Trust, quoted above.]

FOURTH: Notwithstanding1971 U.S. Tax Ct. LEXIS 133">*160 the preceding provisions, in the event HELEN CAROLINE SMITH, should survive both CAROLINE H. SMITH and HAROLD W. SMITH, then on the death of said HELEN CAROLINE SMITH, the Trustees shall pay the trust estate and accumulated income therefrom, if any, to such person or persons in such amounts and proportions as said HELEN CAROLINE SMITH may designate and appoint in the last unrevoked written instrument other than a Will executed by her and on file with the Trustees at the time of her death, such persons to be limited to her spouse, her lawful issue, her brother, HAROLD W. SMITH, JR., and the lawful issue of HAROLD W. SMITH, JR.; provided, however, should the said HELEN CAROLINE SMITH leave lawful issue surviving her death, then not more than one half of the trust estate may be appointed to her spouse and any amount in excess thereof shall go instead to such issue of hers. To the extent she shall not have exercised the limited power of appointment set forth herein, such trust estate shall be distributed in accordance with paragraph THIRD above, subject to the continuation in trust of the share of any such issue as may then be under the age of twenty-one (21) years, as hereinafter provided. 1971 U.S. Tax Ct. LEXIS 133">*161 * * *

Each trust instrument contained the following provision which was designed to make it at least more difficult for creditors to reach the trust assets:

SEVENTH: The interest of each beneficiary in the income or principal of a trust under this instrument shall be free from the control or interference of any creditor of a beneficiary or of any spouse of a married beneficiary and shall not be subject to attachment or susceptible of anticipation or alienation. Nothing 56 T.C. 263">*275 contained in this paragraph shall be construed as restricting in any way the exercise of any power of appointment granted hereunder.

Each trust instrument also required the trustees to "render an account of the administration of the trust" annually to Harold, Jr., and Helen, respectively, while living.

The individual beneficiaries in Third (c)(1) through (5) of the trust instruments were all close relatives of either Harold or Caroline or were persons in whom Harold or Caroline were particularly interested. Thus, Francis Smith was Harold's brother. Mrs. Lou Rodauch and Mrs. Verona Helm were cousins of Harold; he never had any sisters, but these cousins, who were very nearly of the same age as his own, 1971 U.S. Tax Ct. LEXIS 133">*162 were very close to him when he was young, and he regarded them as sisters. Edward Charles Hauser, Jr., was a brother of Caroline, and Marie Hauser was her stepmother. As to the charitable beneficiaries named in subparagraph (6), Harold had a special interest in Stanford Research Institute and Caroline appears to have had an interest in the Children's Home Society of California. Prior to the time when the trust instruments were drafted, Voegelin had prepared a will for Harold and Caroline which governed property other than their rights under the Union Oil contract. Most, if not all, of the beneficiaries named in the foregoing paragraph (c) were also named as beneficiaries under the will.

The execution of the trust agreements was the last step in creating the legal mechanism for Harold's desired estate plan. It was an integral and indispensable part of the plan. These trusts provided for the disposition of property (the Union Oil contract) previously owned by Harold and Caroline in accordance with the wishes and plans of Harold and Caroline. Harold, Jr., and Helen do not appear to have exercised any independent judgment in this connection. Harold and Caroline were in truth and1971 U.S. Tax Ct. LEXIS 133">*163 in fact the real settlors; Harold, Jr., and Helen were settlors in form only.

Neither Helen nor Harold, Jr., had previously granted an annuity. Harold, Jr., admitted that his net worth was less than $ 2,000, and indicated that his principal resource was his salary as a second lieutenant. He was about to graduate from the Air Force flight school, and both he and his father understood that he would remain in the Air Force for at least 4 more years. Helen had no significant financial resources of her own. She was 19 years old in the summer of 1964, unmarried, and a full-time college student, about to leave for Germany on a junior year abroad program. Neither Helen nor Harold, Jr., had any prior experience with regard to investment and management of capital. It was contemplated both by the parents and the children when the former executed the assignments of the Union Oil contract that, 56 T.C. 263">*276 pursuant to Voegelin's plan, the proceeds of the assignments would be placed in a trust or trusts which would fund the annuities.

As previously noted, Union Oil, on July 31, 1964, delivered to Harold a check in the amount of $ 798,333.51, payable to Harold, Jr., and Helen. That amount represented1971 U.S. Tax Ct. LEXIS 133">*164 the entire outstanding principal balance on the installment contract of $ 796,309.56 (including the annual installment payment of $ 265,436.53 which had been deferred a month earlier pursuant to Harold's request), plus interest in the amount of $ 2,023.95. The $ 2,023.95 interest payment represented $ 99.54 in interest for 1 day, July 1, 1964, on $ 976,309.56, and $ 1,924.41 in interest for the period July 2, 1964, through July 31, 1964, on $ 530,873.04. In accordance with Harold's letter of June 29, 1964, Union Oil did not pay interest which may otherwise have accrued by virtue of the deferred payment of the installment due on July 1, 1964.

The following schedules reflect all payments of principal and interest made by Union Oil under the purchase agreement:

Union Oil made the $ 798,333.51 check (embodying its final principal and interest payments) payable to Harold, Jr., and Helen at Harold's request. The record does not clearly disclose the reason for Union Oil's decision to prepay the outstanding balance.

After receiving the check Harold took it home and had Helen endorse it. "Immediately" after Helen endorsed1971 U.S. Tax Ct. LEXIS 133">*166 the check, Harold and Caroline left for Selma, Ala., to visit Harold, Jr., who was then about to graduate from flight school. Upon obtaining Harold, Jr.'s endorsement on the check, Harold mailed it to Voegelin in California.

On August 5, 1964, a savings account was opened at the Crocker-Citizens 56 T.C. 263">*277 National Bank, Los Angeles, by Voegelin and Samuelson as trustees for the Harold W. Smith, Jr. Trust. On the same date a like account was opened at the same bank for the Helen C. Smith Trust. At this time one-half of the amount of the check from Union Oil, or $ 399,166.76, was deposited in the account for the Helen C. Smith Trust, and the remaining funds, $ 399,166.75, were deposited in the savings account for the other trust.

By a letter dated September 1, 1964, Voegelin and Samuelson as trustees instructed the Crocker-Citizens National Bank to disburse fixed monthly amounts out of the two trust accounts to Harold and Caroline:

In accordance with Annuity Contracts dated August 1, 1964, payable by each of the above trusts, payment should be made by the above trusts commencing September 1, 1964, and the first day of each month thereafter, as follows:

1971 U.S. Tax Ct. LEXIS 133">*167 Such payments should continue until further notice in writing and are to be forwarded to the Smiths' at 2449 Ridgeway Road, San Marino, California.

Harold and Caroline also maintained a personal joint account at the Crocker-Citizens National Bank. By a letter dated February 12, 1965, Harold instructed the bank to deposit the monthly disbursements from the two trust accounts, totaling $ 6,000, in the joint account.

From the date when the trust accounts were opened in August of 1964, until February 1, 1966, the source of all additions to the trust accounts (apart from the initial deposits) was the accrual of interest thereon which was automatically deposited by the bank in the accounts. During the same period, apart from two unexplained exceptions, ³ the only disbursements from each trust account were those made by the bank in accordance with the trustees' instructions to pay $ 3,000 per month to Harold and Caroline.

1971 U.S. Tax Ct. LEXIS 133">*168 Each of the four annuity contracts stated that the monthly annuity payments were to commence on August 1, 1964. However, the first 56 T.C. 263">*278 monthly payments were not made until September of 1964 because the trusts had not yet been established at the time the first monthly payments were due.

On February 1, 1966, $ 350,000 was withdrawn from each trust account, and the balance appearing in each account was then approximately $ 6,096. ⁴ On February 2, 1966, the trustees opened two additional savings accounts, one in the name of each trust, at the First Western Bank at San Marino, Calif. The initial deposit made in each account on that date was the $ 350,000 previously withdrawn from each trust account at the Crocker-Citizens National Bank. Harold and Caroline also maintained a joint commercial account at the First Western Bank. And on the date the trust accounts were opened, the First Western Bank was authorized by Samuelson and Voegelin to disburse $ 3,000 per month from each trust account, and was also authorized by Harold and Caroline to deposit the aggregate of $ 6,000 per month in their joint commercial account at the bank.

1971 U.S. Tax Ct. LEXIS 133">*169 From 1966 until the time of the trial herein, the deposits and withdrawals for the two trust accounts at the First Western Bank were in general ⁵ identical. During this period the bank has in general 5 continued to transfer automatically $ 6,000 per month from the children's trust accounts to the parents' joint commercial account. Prior to December 1, 1966, there were no withdrawals from either of the trust accounts apart from the automatic monthly withdrawals. On December 1, 1966, $ 200,000 was withdrawn from each account and invested and subsequently reinvested in commercial paper, until on July 17, 1969, $ 208,750.20 was placed in an investment account for each trust. From September 26, 1969, to April 30, 1970, the funds were invested principally in common stock, as well as U.S. Treasury bills and time deposits. From time to time interest earned on the commercial paper was deposited in the appropriate trust account at the First Western Bank.

1971 U.S. Tax Ct. LEXIS 133">*170 At the time of trial herein, all payments made to Harold and Caroline under the annuity contracts had been made by the trusts. ⁶56 T.C. 263">*279 Although the trust instrument provided that the trustees were entitled to receive compensation for their services, neither Vogelin nor Samuelson received such compensation from the trusts from 1964 through 1969. Each trust instrument also provided that the trustees were to render to the settlor an annual account of the administration of the trust. However, Harold, Jr., did not receive an annual report during the years when he was in the Air Force. The record does not disclose whether Helen has ever received an annual report from the trustees.

1971 U.S. Tax Ct. LEXIS 133">*171 Helen became 21 years of age on November 3, 1965. On December 9, 1965, she executed a document entitled "Ratification Agreement," wherein she acknowledged that she had executed the trust instrument and the annuity contracts while a minor, ratified her prior actions, and agreed to fulfill the terms of the instruments she had executed.

Fiduciary Federal income tax returns were filed on behalf of each of the trusts for the years 1964 through 1969, inclusive. The amounts reported on the returns as the trusts' annual total income were, with one minor exception, ⁷ indentical in each year:

Each fiduciary return reported all income from the trusts as chargeable to either Harold, Jr., or Helen as the "grantor" of the trust in question. Each Federal income tax return filed by Harold, Jr., and Helen for the years 1964 through 1967 included in gross income all of the net income reported in the appropriate fiduciary return for that year.

1971 U.S. Tax Ct. LEXIS 133">*172 On each of her Federal income tax returns for the years 1964 through 1968, Helen also claimed a deduction for interest expenses incurred under her annuity contracts with her parents. The amount of the claimed deduction on her 1967 return was $ 18,936. That amount was equal to precisely one-half of the amount which her parents reported on their 1967 joint return as ordinary income from their four annuity contracts with the children. See table at p. 281 infra. In the Commissioner's notice of deficiency against Helen he determined that she was not entitled to the interest deduction claimed on her 1967 return.

56 T.C. 263">*280 On each of his Federal income tax returns for the years 1964 through 1967, Harold, Jr., claimed interest deductions attributable to the annuity contracts which were equal in amount to the deductions claimed by Helen during those years. The following table summarizes the interest deductions claimed by Helen and Harold, Jr., from 1964 through 1967, attributable to the annuity contracts:

1971 U.S. Tax Ct. LEXIS 133">*173 On their joint Federal income tax return for 1964, Harold and Caroline included in gross income a portion of the annuity payments received from their children under the annuity contracts. The included portion of the payments was computed on the basis of "exclusion ratios" (authorized by section 72, I.R.C. 1954, with respect to the receipt of annuity payments), and was treated as ordinary income. ⁸ Harold and Caroline also reported as capital gain income a percentage of the remaining (and otherwise unincluded) portion of the annuity payments. That amount was computed by multiplying the remaining portion by 89.8784 percent (the profit ratio previously used by Harold and Caroline in reporting Union Oil's payments on the installment method under section 453). The following table summarizes the manner in which the 1964 return reflected the receipt of the annuity payments:

Harold and Caroline reported no gain on their 1964 return from the disposition of Union Oil's installment obligation during that year.

56 T.C. 263">*281 On each of their returns for the years 1965 through 1967, Harold and Caroline reported the receipt of a total of $ 72,000 under the annuity contracts. They treated those amounts in the same manner as that applied on their 1964 return. The following1971 U.S. Tax Ct. LEXIS 133">*175 table summarizes the manner in which each return reflected the receipt of each year's total annuity payments:

In the Commissioner's notice of deficiency against Harold and Caroline for 1964 he determined that the portion of the Smiths' gain on the sale of the American Gas stock to Union Oil which had not yet been recognized and which had until then been deferred under the installment method should be recognized as long-term capital gain:

In the year 1964, installment sale payments aggregating $ 796,309.56 were paid by the obligor, the Union Oil Company, to your assignees, Harold W. Smith, Jr. and Helen Caroline Smith. It is determined that said payments were actually received by you in 1964 within the meaning of section 453 of the Internal Revenue Code and that the proportion of said installment payments representing deferred or unrecognized installment gain amounted to $ 715,710.29. It is further determined that the $ 715,710.291971 U.S. Tax Ct. LEXIS 133">*176 is includible in your 1964 taxable income as long-term capital gain. Since you included in your 1964 taxable income installment sale gain of only $ 10,224.57, your long-term capital gain income is increased by $ 705,485.72, taxable to the extent of 50 percent, or $ 352,742.86.

For the year 1965, the gain of $ 30,673.70 reported in connection with the installment sale to Union Oil Co. is eliminated since the entire balance of gain is included in 1964. * * *

None of the members of the Smith family filed a Federal gift tax return as a result of any of the transactions described herein.

OPINION

1. In 1961 Harold and Caroline Smith sold their American Gas stock to Union Oil. The sale price finally agreed upon was $ 1,786,994.75, of which 459,812.13 was paid in 1961 and the balance was to be paid in annual installments over a 5-year period. On their 1961 joint Federal income tax return, the Smiths properly elected to report their gain from the sale on the installment method under section 56 T.C. 263">*282 453. ⁹ By the end of 1963, the unpaid balance of the total purchase price due from Union Oil was $ 796,309.56, and of that amount $ 715,710.28 represented gain to be reported by the Smiths1971 U.S. Tax Ct. LEXIS 133">*177 in the future under the installment method. At Harold's request, Union Oil deferred the annual installment payment due on July 1, 1964. At approximately the same time, the Smiths entered into the following series of transactions with their children, Helen and Harold, Jr.: Harold and Caroline transferred their interests in the Union Oil contract to Helen and Harold, Jr. The children agreed to provide each parent with an annuity. Each child thereafter executed an instrument establishing a trust designed to fund the annuities. At about the same time Union Oil delivered a check to Harold payable to Helen and Harold, Jr., in payment of the entire outstanding balance under the installment contract. The proceeds of the check were then deposited in two savings accounts opened on behalf of the two trusts. As of the time of the trial herein, all of the payments made to Harold and Caroline under the annuity contracts have been made by the trusts.

1971 U.S. Tax Ct. LEXIS 133">*178 On their joint Federal income tax return for 1964 Harold and Caroline reported no gain from the disposition of their interests in the Union Oil contract or from Union Oil's final payment of principal in respect of that contract. However, on their returns for 1964 and years subsequent, they included in gross income a portion of the annuity payments received in each year. Part of the included portion was computed by applying the method authorized by section 72, I.R.C. 1954, to the annuity payments and treating the amount includable thereunder as ordinary income. The remainder of the included portion was computed by applying the installment method authorized by section 56 T.C. 263">*283 453 to the portion of the annuity payments which had not been included under section 72 and treating that amount as capital gain. By reporting their gain in this manner, Harold and Caroline would not include the full amount of their gain in gross income until 1987, assuming that the guaranteed refund provisions had not yet been triggered. ¹⁰ In any event, the date would probably be much later than July 1, 1966 (which would have been the date of Union Oil's final payment if its payments had been made as 1971 U.S. Tax Ct. LEXIS 133">*179 originally planned), and certainly later than July 31, 1964 (when the total outstanding balance due under the contract was paid).

The Commissioner contends that Harold and Caroline should have included in their 1964 gross income that portion of their gain on the sale of the American Gas stock to Union Oil which had not yet been recognized and which had until then been deferred under the installment method. On brief he relies primarily upon section 453 (d): ¹¹

SEC. 453. INSTALLMENT METHOD.

(d) Gain or Loss on Disposition of Installment Obligations. --

(1) General rule. -- If an installment obligation is satisfied at other than its face value or distributed, transmitted, sold, or otherwise disposed of, 1971 U.S. Tax Ct. LEXIS 133">*180 gain or loss shall result to the extent of the difference between the basis of the obligation and --

Any gain or loss so resulting shall be considered as resulting from the sale or exchange of the property in respect of which the installment obligation was received.

(2) Basis of obligation. -- The basis of an installment obligation shall be the excess of the face value of the obligation over an amount equal to the income which would be returnable were the obligation satisfied in full.