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United States v. Sullivan

decided: April 10, 1964.


Author: Biggs

Before BIGGS, Chief Judge, and McLAUGHLIN, KALODNER, STALEY, HASTIE, GANEY and SMITH, Circuit Judges

BIGGS, Chief Judge.

The United States brought this action under Section 7403 of the Internal Revenue Code of 1954,*fn1 to foreclose a tax lien on unmatured insurance policies. Defendants in the proceeding below in addition to the delinquent taxpayers, Cornelius W. Sullivan and his wife, Mary E. Sullivan, were the Aetna Life Insurance Company ["Aetna"], and the Manufacturers Life Insurance Company ["Manufacturers"].*fn2 From adverse determinations in the court below, reported at 203 F. Supp. 1 (1962), the Government has appealed.

There is no question that the Commissioner of Internal Revenue can reach the "cash surrender values" of a delinquent taxpayer's unmatured insurance policies and can apply the amounts realized to the satisfaction of the deficiency. The issues raised on this appeal concern the fundamental problem of the means by which the foregoing can be accomplished and the interrelated question of the proper measure of the Commissioner's recovery.

The facts are not in dispute. On November 4, 1952 the Commissioner made an assessment of income taxes with penalties and interest jointly against the Sullivans for deficiencies for the year 1950. On November 5, 1952 the District Collector received the assessment list from the Commissioner and vainly demanded payment from the Sullivans. A lien against the Sullivans' "property and rights to property" automatically arose at this time under Section 3670 of the Internal Revenue Code of 1939.*fn3

Thereafter, between November 8, 1952 and April 6, 1953, and pursuant to Section 3672 of the Internal Revenue Code of 1939,*fn4 notice of lien was filed of public record in various counties.*fn5

The outstanding tax liability of the Sullivans was partially reduced subsequently pursuant to a determination of the United States Tax Court. In addition, some of the amount due was recovered. A balance of $163,486.54 was still outstanding at the time of commencement of the present action.

On May 21, 1953 the Sullivans purchased an insurance policy from Aetna, No. P 975 434, in the face amount of $10,000. On June 17, 1953 the Sullivans purchased an insurance policy from Manufacturers, No. 1 250 226, in the face amount of $15,000.*fn6 Under each of the policies Mrs. Sullivan was the named insured and Mr. Sullivan was the designated beneficiary. Mrs. Sullivan had the right under the policies to change the beneficiary, to exercise all options, and to take part in for present purposes substantially identical dividend sharing plans.*fn7 Mrs. Sullivan elected under both policies to have dividends accumulated at interest.*fn8

The Aetna policy was of the endowment type. It was to mature at the end of twenty-six years at which time Mrs. Sullivan, then having attained the age of sixty-five, was to receive an income of $100.00 a month for life.*fn9 In the event of Mrs. Sullivan's death before the policy's maturity, the proceeds of the policy were to be paid in one lump sum to the beneficiary, Mr. Sullivan.*fn10 The Manufacturers policy was a "whole life policy" with its face amount, $15,000.00, payable to the beneficiary, Mr. Sullivan, on the death of Mrs. Sullivan.

It is unquestioned that the policies were substantially identical in all respects material to this appeal. Generally speaking, at any given time and as to each of the policies, the part of the total premiums paid in on the policy which exceeded the insurer's accrued policy costs plus, for essential purposes, accumulated dividend amounts represented the cash value of that policy.*fn11 The cash value varied throughout the life of the policy. The cash value less any outstanding policy indebtedness previously incurred by the insured to the insurer constituted the cash surrender value of the policy. The cash surrender value was the amount the insured was entitled to receive on election to cancel the policy in accordance with its terms as detailed hereafter.*fn12

The two policies contained a number of substantially identical provisions authorizing various uses of their respective reserves by the insured, Mrs. Sullivan.*fn13 The first of these gave the insured the right to elect to cancel the policy and to receive in settlement its cash surrender value.A condition precedent to the right to recover the cash surrender value was surrender of the policy to the company for discharge. Mrs. Sullivan never took any action to obtain the cash surrender value of either policy other than that implicit in the policy loan transactions with Manufacturers discussed infra

The second of these provisions gave the insured the right to borrow on the security of the policy at five per cent per annum. The Manufacturers policy specifically stated and the Aetna policy provided in effect that all amounts so loaned and interest thereon were to be a first lien on the policy. Under each of the policies there was no specific obligation to repay the amount borrowed; a failure in this regard simply served to bring about a permanent reduction in the cash surrender value. But if the permanent arrearage came to exceed the cash value of the policy, the obligations of the company under the policy were terminated and the policy was thereby cancelled.

The third provision was an optional automatic premium loan clause, revocable at will, which provided in substance that in the event of a default in the payment of premiums, as long as a cash surrender value existed on the policy the company would automatically loan to the insured and apply to premium payment the amount due. The insurance policies prescribed the same terms for these loans as were applicable to general policy loans, i. e., a first lien on the policy to the extent of the loan and an interest charge of five per cent. Mrs. Sullivan elected to have the automatic premium loan provisions of the policies be operative and she did not at any time revoke her elections.*fn14

Finally, a fourth substantially identical clause of significance was contained in the policies. This was a non-forfeiture provision which in substance provided that in the event of default in payment of premiums and at the election of the insured, each policy could be continued to the extent of its cash surrender value as either participating paid-up insurance or non-participating extended term insurance.In the absence of an election on the part of the insured, there was to be an automatic conversion into non-participating extended term insurance.

The non-forfeiture provision mentioned in the preceding paragraph was never operative in the instant case inasmuch as Mrs. Sullivan elected that the automatic premium loan provision of the policies should become operative in the event of premium default. The clause is nevertheless of some relevance in that Mrs. Sullivan could have revoked the applicability of the automatic premium loan provision at any time.*fn15

Aetna and Manufacturers were never served with notice of lien, nor did they receive actual notice of the Government's claim from any source until later served with notice of levy, discussed infra. On July 12, 1955 and on June 24, 1957 Manufacturers granted to Mrs. Sullivan policy loans of the combined principal amount of $714.52. The policy loan amounts were applied to outstanding premiums at the request of Mrs. Sullivan. The automatic premium loan clause of course was in effect at these times, but it had not yet become operative because it made provision for a grace period which had not expired in either instance.

On January 9, 1958 Aetna and Manufacturers were served with an identical "notice of levy" under the purported authority of Sections 6331 and 6332 of the Internal Revenue Code of 1954.*fn16 The notice in pertinent part stated: "You are further notified that demand has been made upon the taxpayer for the amount set forth herein, and that such amount is still due, owing, and unpaid from this taxpayer, and that the lien provided for by Section 6321, Internal Revenue Code of 1954 [the current lien provision, corresponding in substance to Section 3670, Internal Revenue Code of 1939, see note 19 infra], now exists upon all property or rights to property belonging to the aforesaid taxpayer. Accordingly, you are further notified that all property, rights to property, moneys, credits and bank deposits now in your possession and belonging to this taxpayer (or with respect to which you are obligated) and all sums of money or other obligations owing from you to this taxpayer are hereby levied upon and seized for satisfaction of the aforesaid tax, together with all additions provided by law, and demand is hereby made upon you for the amount necessary to satisfy the liability set forth herein, or for such lesser sum as you may be indebted to him, to be applied as a payment on his tax liability."

On January 23, 1958 Manufacturers was served with a "final demand" which in relevant part provided as follows: "Demand is again made for the amount set forth in the notice of levy, $232,215.64, or for such lesser sum as you may have been indebted to the taxpayer at the time the notice of levy was served. If you comply with this final demand within five days from its service, no action will be taken to enforce the provisions of Section 6332 of the Internal Revenue Code. If, however, this demand is not complied with within five days from the date of its service, it will be deemed to be finally refused by you and proceedings may be instituted by the United States as authorized by the statute quoted above." In response to this demand, on January 29, 1958 Manufacturers paid the sum of $196.41 to the Government on account of accumulated dividends.It apparently took no other action in response to the notices served upon it.

The record does not indicate that Aetna was served with any document subsequent to the original notice of levy.

Mrs. Sullivan did not pay premiums on either policy which fell due in 1958 and 1959. Accordingly, pursuant to the automatic premium loan provisions of the policies and notwithstanding the above-mentioned notices served on them, the insurers proceeded in those years to effect automatic premium loans on the respective policies. The automatic premium loans brought about by Manufacturers encompassed a principal amount of $888.90, and those of Aetna totalled $1319.80.

The present action was commenced on October 30, 1958. Prior to judgment and pursuant to a stipulation between the United States and the Sullivans, on January 15, 1960 and January 25, 1960 respectively, Mrs. Sullivan delivered the Aetna policy to Aetna and the Manufacturers policy to Manufacturers and on these same respective dates executed releases to the two companies. The releases, identical in pertinent part, provided that Mrs. Sullivan "agrees that the entire liability of * * * [each of the insurers under its policy] except for the cash value, is hereby discharged and terminated, and the net cash value [i. e., the cash surrender value] shall be determined as of the date of this release and paid to the United States * * *." The Aetna policy had a cash surrender value of $850.36 at the time of surrender and release. The Manufacturers policy no longer had a cash surrender value at that time.

The court below held that the Government was entitled to be paid the cash surrender value under each policy determined as of the date of surrender and release, January 15, 1960 and January 25, 1960 respectively, and that upon payment of the respective amounts, the insurance companies would be wholly discharged from their policy obligations. Accordingly, judgment was entered against Aetna for $850.36 and six per cent interest from January 15, 1960 and judgment was entered in favor of Manufacturers.

On this appeal the amount in dispute as to Manufacturers is the principal sum and interest deducted from the cash value of its policy on account of the two policy loans and two automatic premium loans effected by it.*fn17 The controversy in regard to Aetna covers the corresponding amount deducted with respect to its two automatic premium loans.*fn18

The issues raised on the instant facts with regard to policy loans and automatic premium loans will be treated separately inasmuch as distinct considerations are involved.Before specifically discussing these issues in turn, however, it is necessary to consider the tax lien and ...

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