In re King (424 F. Supp. 117, 1975)

FINDINGS OF FACT, CONCLUSIONS OF LAW AND ORDER ON TAX ISSUES, PHASE ONE AND PHASE TWO

MATSCH, District Judge.

In the course of this proceeding for an arrangement of debts under Chapter XI of the Bankruptcy Act, the debtor, John M. King, applied for a determination of the amount and validity of taxes assessed against him and for tax liens filed pursuant to those assessments. Jurisdiction over these questions was previously determined by a memorandum opinion and order entered on August 15, 1972.

As a result of agreed pre-trial orders, the issues have been divided into three phases for trial. Phase One was heard from March 4, 1974 through March 13, 1974 and Phase Two was heard from July 15, 1974 through July 18, 1974. Counsel have agreed that these two phases should be determined before proceeding with the trial of Phase Three.

FACTUAL CONTEXT FOR PHASE ONE

To understand the specific issues involved in this Phase One litigation, it is first necessary to set forth certain facts establishing the context in which these questions arose.

John M. King entered the oil business as a young man forming Fox-King Oil Company in 1955. Two-years later, he joined with Mr. Stevenson in forming King-Stevenson Oil Company for certain drilling operations which proved to be quite successful. In 1960, Mr. King and Mr. Stevenson formed King-Stevenson Gas and Oil Company, which carried on an oil and gas exploration business in the Midwest and Rocky Mountain Region. These two terminated their business relationship and Mr. King then formed King Resources Company to engage in the same type of business. That company went public in 1967 with the issuance of stock and convertible debentures through Dempsey-Tegler and Company as the underwriter.

With John M. King as chairman of its board of directors, King Resources Company experienced dramatic growth between 1967 and 1970. The scope of its exploration activity expanded with the creation of two new companies to raise public investment funds for such activities through the sale of interests in a series of limited partnerships. Imperial-American Resources Fund, Inc. was created as a Delaware corporation to be the sole general partner in a series of limited partnerships which acquired the beneficial ownership of proven and semi-proven oil and gas properties. Royal Resources Exploration, Inc. was organized as a Delaware corporation to be the general partner in a series of limited partnerships which acquired the beneficial ownership of wildcat oil and gas properties. King Resources Company did much of the actual drilling of exploratory and development wells on these properties.

All of the stock of Imperial-American Resources Fund, Inc. was issued to Imperial-American Management Company, a Delaware corporation, which held title to the Fund properties as the nominee for the limited partnerships and which managed the affairs of the partnerships under contracts providing for receipt by the Management Company of a 25% “net operating profits interest” in each oil and gas lease or other property of such partnerships. All of the stock of Imperial-American Management Company was issued to John M. King, to his wife, Carylyn B. King and to trusts for their children, which trusts are hereinafter described and designated collectively as Trusts No. 1.

All of the stock of Royal Resources Exploration, Inc. was issued to Royal Resources Company, a Delaware corporation owned by Mr. and Mrs. King and Trusts No. 1. The relationship between Royal Resources Company and the Royal Resources partnerships was the same as the relationship between Imperial-American Management Company and the Imperial-American partnerships just described.

In November, 1968, Mr. and Mrs. King and Trusts No. 1 exchanged their stock in Imperial-American Management Company and Royal Resources Exploration, Inc. for stock in a new corporation called The Colorado Corporation. In addition to being a holding company, The Colorado Corporation also engaged in business of the acquisition, sale and development of oil, gas and mineral properties. It also owned the stock of The Denver Corporation which was the broker-dealer for the sale of participation interests in the Royal and Imperial-American limited partnerships as securities offered under registration with the Securities and Exchange Commission.

John M. King personally participated in the investments made by the Royal and Imperial partnerships through a series of joint venture funds parallel to but separate from the limited partnerships.

While each of the Imperial companies, the Royal companies and King Resources Company, as well as The Colorado Corporation, had separate officers and directors, John M. King was active in the management of the entire complex of corporations, particularly in the area of financing. Additionally, an elaborate accounting system was organized and operated for all of these companies through a computer system. The corporate complex engaged in vigorous and aggressive drilling operations in many parts of the world and employed a large number of persons.

The business of the King company complex was greatly influenced by the personality and life style of John M. King. He pursued methods and manners which made him very visible within the industry and to the investing public and he operated flamboyantly, aggressively and with bullish enthusiasm. In his testimony Mr. King estimated that during these years he was travelling constantly throughout the world and that he was able to be in the central offices of the companies in Denver, Colorado, only about 80 days out of the year. He also said that four secretaries and other support personnel were responsible for scheduling his time and travel. Because of the scope of his personal involvement in these complex activities, he relied upon many other persons to implement the broad policies adopted and he freely delegated authority to act for him and for the companies.

The necessary accounting and legal documentation of these activities was always well behind the occurrence of the events. Accordingly, the lawyers and accountants were routinely and consistently preparing papers “as of” a date earlier than their execution. The preparation of such documents was customarily based upon information given to those lawyers and accountants by Mr. King either directly or indirectly.

During the same years that the King companies were experiencing phenomenal growth, another complex of companies underwent rapid expansion. They constituted what shall here be called the IOS Group and engaged in what may be characterized as the offshore mutual fund business obtaining great quantities of money from investments in mutual funds by persons throughout the world. They designed their business to avoid governmental regulation by staying out of countries with laws and agencies such as the securities laws of the United States. The visible leader of the IOS Group was Bernard Cornfeld and Mr. Edward Cowett appeared to be the next most important official for these companies.

Through these mutual funds, IOS controlled great amounts of cash for which it was seeking investment opportunities. The King companies provided those opportunities and by 1970 IOS had become their largest customer for the sale of oil, gas and mineral projects.

Cracks opened in the IOS structure in the spring of 1970. There was an apparent division among those in control. At the same time, there was a collapsing stock market which not only restricted new investment in the mutual funds, but, which also generated a rush of redemptions by the investors.

Mr. King had caused King Resources Company to complete a fairly extensive computer analysis of IOS management and Mr. Cornfeld invited John M. King to attempt to form a consortium to acquire control of IOS. Those efforts are described in the factual context for Phase Two.

Upon the failure of these attempts, John M. King and the companies involved in the King complex developed severe financial difficulties which resulted in various bankruptcy proceedings. An involuntary bankruptcy petition was filed against The Colorado Corporation on April 20, 1971 and after a long contest it was adjudicated bankrupt on September 6, 1974.

John M. King filed his petition under Chapter XI on June 1, 1971. An involuntary Chapter X petition was filed for King Resources Company on August 14,1971 and Imperial-American Resources Fund, Inc. filed for reorganization under that chapter on February 25,1972. All of these proceedings are still pending in this district.

The assessments which create the issues to be decided in this proceeding are jeopardy assessments made on May 1, 1971 and May 31, 1972 for a total of approximately $18,000,000.00. Counsel have agreed that the Court should determine the issues without making any computations of tax, reserving that aspect of the matter for further proceedings.

ISSUE NO. ONE: Gift Tax on Transfer of The Colorado Corporation stock to Trusts No. 2, May, 1970

A gift tax was assessed against John M. King upon the assertion that in May, 1970, he transferred common stock of The Colorado Corporation to domestic trusts for the benefit of his four children for less than an adequate and full consideration. The amount of the tax is contended to be the difference between its then market value and the value of the consideration received.

John and Carylyn King have four children: John M. King, IV, Carylyn Ann King, Sally Ann King and Mark M. King. In 1967 Mr. King established trusts for each of these children with his friend and attorney, Mr. Timothy Lowry, as trustee. Those trusts, which are referred to collectively as Trusts No. 1 throughout this litigation, were designed to exist for the full period permitted by the rule against perpetuities and to benefit not only the children, but the grandchildren and great-grandchildren as well. Accordingly, distribution to the four King children was restricted. Mr. James Bye, a Denver attorney experienced in such matters, prepared the documents creating Trusts No. 1 in 1967 and he was consulted from time to time by John M. King in the area of personal tax planning. During the course of a meeting between them in October, 1969, Mr. Bye was told by Mr. King that he had sold stock of The Colorado Corporation to Timothy Lowry as trustee of a newly created trust for the King children, in an oral transaction at the beginning of 1969, and Mr. Bye was asked to draft the documents for that sale. After obtaining confirmation from Mr. Lowry that such a transaction had taken place, Mr. Bye drafted several documents, dating them “as of January 1, 1969”.

Four of these documents (Exhibits A, B, C and TT) are identical letter agreements between John M. King and Timothy G. Lowry, trustee, for each of four trusts designated as Sally Ann King Trust No. 2, John M. King, IV Trust No. 2, Carylyn Ann King Trust No. 2 and Mark M. King Trust No. 2. For convenience, these trusts are hereinafter collectively called Trusts No. 2. Each agreement shows the date of January 1,1969 and each is for the sale of 400 shares of the stock of The Colorado Corporation with the purchase price stated to be an amount equal to the book value of the assets of that company, excepting the stock in Imperial and American, which price is made payable in eight equal annual installments commencing January 1, 1973, with interest. All of the agreements provide for retention of title to such stock by Mr. King as security for payment of the purchase price and they all include the following language:

. . However, if the fair market value of The Colorado Corporation stock as of the date of this letter is ever determined by the Internal Revenue Service to be greater or less than the fair market value determined in the manner described above, the purchase price shall be adjusted to the fair market value determined by the Internal Revenue Service”.

Attached to each letter agreement is a single page “Declaration of Trust” signed by Timothy G. Lowry, declaring that he holds all rights under each agreement as trustee for each of the respective No. 2 Trusts and that he will execute a formal trust agreement which will set forth the terms and conditions of the trust.

Exhibits H through K are the formal trust agreements for these four trusts. These documents were prepared by Mr. Bye after his October, 1969 discussions with Mr. King and with Mr. Lowry and each document recites as follows:

“THIS AGREEMENT, made as of this 1st day of January, 1969, between Timothy G. Lowry of Chicago, Illinois, (hereinafter called the “Grantor”), and Carylyn B. King of Arapahoe County, Colorado, Timothy G. Lowry of Chicago, Illinois, A. Rowland Boucher of Denver, Colorado, and Edward M. Cowett of Geneva, Switzerland, (hereinafter called the “Trustees”).”

The property granted in each trust agreement is described as:

“All rights and obligations under an agreement dated as of January 1, 1969, between John M. King and Timothy G. Lowry, Trustee, for the purchase of 400 shares of the stock of The Colorado Corporation.”

As previously noted, The Colorado Corporation was organized in November, 1968 to hold the stock of Royal Resources Corporation, Imperial-American Management Corporation, and The Denver Corporation. It acquired that stock from John M. King and from each of the Trusts No. 1 in exchange for its shares. A total of 10,000 shares was issued by The Colorado Corporation with 2,000 going to John King and 2,000 to each of the four trusts of June 30,1967. (Trusts No. 1). The 1600 shares subject to these agreements dated January 1, 1969 with the Trusts No. 2 were from that initial issue of 2,000 shares to John M. King.

The formula used for these agreements with Lowry as trustee was the same as that which had been used for a qualified stock option plan of The Colorado Corporation. Using that formula the stock was valued at $1250.00 per share and the four trusts executed notes for a total of $2,000,000.00. Later, there was a 1,000 for 1 split of The Colorado Corporation stock so the net result was the transfer of 1,600,000 shares at $1.25 per share.

The parties have agreed that this Court will not now attempt to value this stock upon the present record. Part of this same stock was the subject of a purchase agreement dated “as of May 25, 1970” between John King as buyer and the Trusts No. 2 as sellers with a price of $5.00 per share as will later be described in the discussion relating to the annuity agreement issues.

Mr. Bye testified that he inserted the provision for redetermination of the purchase price because there was an uncertainty about the value of stock in The Colorado Corporation because it was closely held and because there had been a few sales of it.

CONCLUSIONS ON THIS ISSUE

The questions presented by these facts are: (1) when did Trusts No. 2 come into existence? (2) when did the transfer of stock to these trusts take place? (3) was there a transfer for adequate consideration? (4) what is the effect of the provision for redetermination of the purchase price for this stock?

The time of creation of the trusts must be considered because there can be no transfer to a trust which does not exist as a legal entity. Among the elements essential for creation of a trust are the settlor’s intent to create the trust, an identifiable trust res, a trustee and identifiable beneficiaries. G. Bogert, Trusts and Trustees § 41 et seq. (2d ed.). A secret intent is not adequate. The settlor must make some objective manifestation of his intent to create the trust. Scott, Abridgment of the Law of Trusts, § 23 at 66 (1960). The confusion inherent in reliance upon a mere verbal declaration of trust is compounded here by the fact that the trust res is the stock sale agreement which is claimed to have been made orally and at the same time as the creation of the trust. Additionally, the only persons participating in the transaction in January, 1969 have an attorney and client relationship as well as a close personal friendship.

The first manifestation of the intent to create a trust shown by the evidence was the affirmation made to Mr. Bye by Mr. Lowry on October 20,1969 after the debtor had requested that Mr. Bye draft the documents for the trust and the transfer to Mr. Lowry as trustee. Accordingly, it is concluded that the Trusts No. 2 were created on October 20, 1969.

That same date is also concluded to be the date of the stock transfer. While the question of the value of the subject shares of stock of The Colorado Corporation has been deferred, for purposes of considering the remaining legal questions it is assumed that on October 20, 1969 the value of those shares was greater than the amount of the notes given by Trusts No. 2, thereby making the transaction subject to gift tax because the transfer was for less than fair and adequate consideration.

What remains, then, is whether the price redetermination provision of the sale agreement avoids the gift tax. The Government urges that such provisions are void because they are contrary to public policy and cites as precedent the decision in Commissioner v. Proctor, 142 F.2d 824 (4th Cir. 1944), cert. denied, 323 U.S. 756, 65 S.Ct. 90, 89 L.Ed. 606 (1944). There an attempt to avoid a gift tax was made by the insertion of the following condition in a transfer agreement:

[I]n the event it should be determined by final judgment or order of a competent federal court of last resort that any part of the transfer in trust hereunder is subject to gift tax, it is agreed by all the parties hereto that in that event the excess property hereby transferred which is decreed by such court to be subject to gift tax, shall automatically be deemed not to be included in the conveyance in trust . . ■ • (p. 827)

The court ruled that the provision could have no validity because it would defeat final judgments of a court of law as well as inhibit the collection of a tax.

The ruling is not persuasive here because there is a substantial difference in the agreements. In Proctor the only apparent purpose of the quoted condition was to negate the transfer entirely if and when gift tax consequences were determined in litigation. In the present case there are proper purposes to be served by the provision for redetermination of price. There is an obvious uncertainty about the valuation of shares in a closely held corporation. That uncertainty is even more apparent for the stock of The Colorado Corporation because of the nature of that company and the assets it held. Additionally, the type of transaction involved with family members can be assumed to generate a tax inquiry. To deny any effect to such an attempt to avoid valuation disputes with Internal Revenue Service agents by removing the incentive to pursue such questions is not contrary to public policy in the absence of a showing of abuse. Upon the record made here, it is concluded that there was an intention to cause the trusts to pay full and fair consideration for the stock and to make an actual adjustment of the price paid upon the event of a determination by the Internal Revenue Service.

ISSUE NO. TWO: The Private Annuity Agreement

A gift tax has been assessed on the transfer from John M. King and Carylyn Becker King to the four Trusts No. 1 of five parcels of real estate, parallel partnership interests, oil and gas property interests, art work and home furnishings, made during 1970 and 1971. The debtor contends that these transfers were all made as of May 25, 1970 in exchange for an annual annuity payment obligation of the Trusts thereby making the transaction one for a valid and adequate consideration with no gift tax consequences.

In early May, 1970, John M. King was engaged in a frantic effort to gain control of IOS and he was in Geneva most of the time. The debtor was then also undergoing a personal liquidity crisis. He had several large loans secured by stock of King Resources Company and because the market value of that stock was declining, the lending banks were demanding more collateral. To obtain that additional collateral, John King went to his children’s trusts.

The documentation of what then happened between the debtor and these trusts is both confusing and conflicting as shown in the following discussion of the exhibits received in evidence.

Exhibit R has two pages. The first page is headed “Annuity Agreement” and bears the signatures of Carylyn B. King and Timothy G. Lowry as trustees together with the signature of John M. King to show his acceptance and approval. The document is undated except that it recites that it is effective as of May 25, 1970. This document reads as follows:

“In consideration of the conveyance to The Carylyn Ann King Trust, The Sally Ann King Trust, The John M. King IV Trust and The Mark M. King Trust, of those certain real and personal properties attached as Schedule A hereto, the undersigned, as Trustees of the aforesaid named Trusts, hereby agree to pay to John M. King during his lifetime and then to Carylyn B. King, during her lifetime if she survives John M. King, each year during their respective lives an amount equal to $157,921.03. Upon the death of the last to die of John M. King and Carylyn B. King, all payments shall terminate.

The Trusts shall have the right to offset the annuity payments due hereunder against any payments which may be due and owing to the Trusts from John M. King to the extent that said annuity payment equals or exceeds the payment due the Trust, regardless of whether said payments arise from promissory note, open account, rent or other obligation.

Should any Court of competent jurisdiction or any other appropriate administrative agency subsequently determine that the appraisals relied upon in ascertaining the value of the properties conveyed were more or less than said values, appropriate adjustments in the annuity payments shall be made accordingly.”

There is no schedule A attached to this exhibit. Exhibit U is a composite of several documents. Two of these documents are identical letters addressed to Mrs. Carylyn B. King and to John M. King, respectively, from Carylyn B. King and Timothy G. Low-ry as Trustees of the four trusts. These letters state:

“This will confirm our agreement with respect to The John M. King IV Trust, The Carylyn Ann King Trust, The Mark M. King Trust and The Sally Ann King Trust as follows:

1. You have agreed to convey to said trusts in equal shares the following properties which have the following estimated fair market values:

(a) an undivided 50% in the King family residence, Cherry Hills Estates, Colorado $750,000.

(b) an undivided 50% in the King family residence at Vail, Colorado $75,000.00.

(c) an undivided 50% in the King family residence at Palm Springs, California $250,000.

(d) an undivided 50% in all furniture, furnishings, paintings, china, silver, bric-a-brac and like articles, and all equipment in or owned and used in connection with said residences $125,000.

2. The said trusts have agreed:

(a)to pay to you each year during your lifetime an amount equal to the total amount of the fair market value of the

property stated above, divided by the estimated number of years of your remaining life.

(b) to give to you as collateral for the

payment of our agreement _com-

mon shares of The Colorado Corporation, which shares you are authorized to pledge in such fashion as you deem proper, but if said collateral is foreclosed the obligation of the trusts to make further payments under this agreement shall cease.

(c) this agreement shall only be assignable to one or more member of your family. If any other assignment is made or attempted by you, or if said agreement is sought to be attached by creditors, the obligation to make further annuity shall cease and you and your assignees shall look only to the collateral for payment.

3.The trusts have agreed to sell to you

and you have agreed to purchase_

common shares of The Colorado Corporation at $7.00 per share to enable the trusts to make the initial payment to you. If this is in accordance with your understanding of our agreement, please accept a copy of this letter and it will service as a present binding agreement, with the understanding that more definitive documents will be prepared and executed to supplement and implement this agreement.”

Also included in Exhibit U is a schedule of oil and gas properties which are interests of John M. King in the partnerships which parallel Imperial-American Resources Fund and Royal Resources Exploration Limited Partnerships. Also as part of this Exhibit are identical letters from Timothy G. Lowry and Carylyn B. King as trustees to The Colorado Corporation for John M. King and Carylyn B. King which read as follows: “I hereby instruct you to issue, in the

name of Carylyn B. King_shares

of Colorado Corporation stock owned by the John M. King IV Trust, the Carylyn Ann King Trust, the Mark M. King Trust, and the Sally Ann King Trust, of whom I am trustee.

The above number of shares to be issued proportionately from each trust.”

The property in Cherry Hills is the subject of a deed from the Kings to the Trusts No. 1 dated August 11, 1970 and recorded August 11,1970. The property in Hawaii is in two parcels which are the subject of deeds from the Kings to these trusts dated September 2, 1970 and September 9, 1970 and recorded on September 4, 1970 and September 9, 1970. The property in Palm Springs, California, is the subject of a deed from the Kings to the trusts dated August 11,1970 and recorded August 11,1970. The property in Vail, Colorado, is the subject of a deed dated August 11, 1970 and recorded August 11, 1970. Exhibits V3 through V6 are identical lease agreements for each of these parcels of real property whereby Timothy G. Lowry and Carylyn B. King as trustees leased to John M. King and Caryl-yn B. King as tenants each of those properties for a term of 15 years commencing May 25, 1970 for stated rentals in annual installments. The leases are dated August 11, 1970 “effective as of May 25, 1970”. The aggregate annual payment on these rentals is $84,000.00 per year. Exhibit S is an agreement between the tenants and trustees for the payment of certain personal property to complete furnishing of these residences by the tenants in lieu of the first years aggregate rental. That agreement is dated August 11, 1970. Also in evidence as Exhibit T is a bill of sale from John M. King and Carylyn B. King to Carylyn B. King and Timothy G. Lowry as trustees to cover furniture, art objects, antiques, guns, paintings etc. to implement the agreements of May 25, 1970. That bill of sale is dated December 7, 1970.

The trusts involved in these documents are the June, 1967 Trusts which have been referred to throughout as the Trusts No. 1. The foregoing documentation appears to support the debtor’s contention that as of May 25, 1970 he and his wife entered into an agreement with the Trusts No. 1 whereby the residential property and the oil and gas interests were valued at $3,191,000.00 and transferred to those trusts in consideration of the trusts’ agreement to pay a private annuity to John M. King for his life at the rate of $157,921.03 per year and then payable to Mrs. King upon the debtor’s death.

Exhibit V9 was submitted as evidence of an additional transaction between the debt- or and the Trusts No. 1 on May 25, 1970. That document is a note and security agreement whereby John King agrees to pay to Carylyn B. King and Timothy Lowry as trustees $4,392,750.00 with interest annually at 1lh%. The note is a demand obligation and the security recited in the document is the pledge of the payments to be received by Mr. King from the Trusts No. 2 as the purchase price for the sale of The Colorado Corporation stock by Mr. King to Trusts No. 2 under the agreement dated “as of January 1, 1969" which is the sale discussed in Issue No. One above. Also pledged as collateral are the annuity payments from Trusts No. 1 under the agreements just described. The testimony was that this $4,392,750.00 note was given to evidence the obligation of John M. King for the purchase of 878,570 shares of Colorado Corporation stock valued at $5.00 per share from Trusts No. 1. The exhibit contains the following language:

“The principal of this note is subject to adjustment in the event any Court of competent jurisdiction or any appropriate administrative agency subsequently determines that the value of the stock sold in exchange for this note was more or less than $5.00 per share.”

The evidence received also includes documents relating to a May 25, 1970 transaction between John M. King and the Trusts No. 2. Exhibit Q-2 is a purchase and sale agreement whereby Mr. King agrees to buy 250,000 shares of The Colorado Corporation common stock for $5.00 per share payable not later than May 25, 1971. That agreement bears the signatures of John M. King as buyer together with Carylyn B. King and Timothy G. Lowry, trustees as sellers, and it recites that it is executed “as of May 25, 1970”. It contains the same language just quoted from the note and security agreement with Trusts No. 1, with reference to redetermination of fair market value of the stock. Exhibit Q-3 is an undated letter from John M. King to the Trusts No. 2 referring to the sale to him by those trusts of 250,000 shares of The Colorado Corporation stock and agreeing to release the pledge of the stock on the indebtedness owing to him under the “agreement of January 1, 1969”. Thus the stock sold to Mr. King in this transaction is a part of that which the Trusts No. 2 acquired in the transactions described under the first issue in this litigation.

These documents were prepared after May 25, 1970 and they were the result of a number of discussions among counsel for Mr. King and for the trusts. Mr. Bye testified that he was in Geneva on King and IOS matters in May, 1970, when he was called by another attorney in his law firm who informed him that either Mr. Coffey or Mr. Lowry had said there was an agreement to transfer assets to the children’s trusts to obtain The Colorado Corporation stock. Mr. Bye further said that when he returned to Denver in June, 1970, he saw a document dealing with a transfer of such stock in exchange for an annuity, and he said he objected to that approach because it involved the pledge of The Colorado Corporation stock to secure the annuity payment resulting in such control by John King as to give rise to a grantor trust with Mr. King incurring liability for the income tax on the trusts’ income. Mr. Bye suggested that it would be far better for Mr. King to have a straight purchase of The Colorado Corporation stock. Mr. Coffey and Mr. Lowry objected to that approach because that would make the trusts liable for a capital gains tax in such an amount as would require the liquidation of trust assets to pay that tax. Both Mr. Lowry and Mr. Coffey did testify in this litigation and each did express that concern about capital gains tax liability.

The testimony of these three witnesses would suggest that the final documentation would have been a combination of the transfer of real estate and partnership interests, the annuity agreement and a stock purchase agreement.

Mr. Lloyd Wade, an attorney employed by King Resources Company was appointed trustee of the Trusts No. 1 in October, 1970. He reviewed these documents and met with the other trustees in November, 1970. Their purpose was to clarify the conflicts in the documents and the result of the meeting was that Mr. Wade drafted what has been received in evidence as Exhibit V. That is headed “Memorandum of Understanding and Agreement” and it is signed by Timothy Lowry, Lloyd Wade, Carylyn B. King, all as trustees and by John M. King and Carylyn B. King, individually. The exhibit recites that the parties wish to confirm and agree that the trusts entered into and consummated in May, 1970 the following transactions. First, that there was conveyed to the trusts real and personal properties in exchange for an annual annuity to be computed on the fair market value of the real estate by Arthur Andersen & Co. based upon appraised values. Second, that the annual annuity payments would be contingent upon receipt by the trustees of money due and owing to the trusts by John M. King. Specifically, if John King defaults in any of his payments the trusts would have the right to offset the annuity payments.

Additionally, the trusts acknowledged the sale to John King of 878,570 Colorado Corporation shares at a price of $5.00 as their fair market value on May 25,1970 and that the purchase price is to be credited with $400,000.00 represented by a with recourse assignment to the trusts of a promissory note made by Lakeshore Associates dated January 2,1970 with the balance evidenced by a promissory note from John M. King. The following paragraph is then in Exhibit V:

“Should any court of competent jurisdiction or any appropriate administrative agency subsequently determine that the value of the stock sold or value of the properties exchanged for the annuity payments was more or less than the value established under this Memorandum, appropriate adjustments shall be made to the promissory note or annuity contract to reflect the effect of any such revaluation.”

It is the acknowledged right to offset payments which provides significance to the way in which these transactions were ultimately structured in the final documentation. The net effect is that John King was able to obtain the Colorado Corporation stock he desperately needed for collateral on his loans without any cash expenditure and the Trusts No. 1 were able to exchange their shares of Colorado Corporation for the real estate and oil and gas interests. Whether the trusts succeeded in avoiding capital gains tax liability in these transactions is not for this Court to decide in this case. All that is to be decided now is whether the gift tax assessment on the annuity transaction is valid.

The Kings never made any payments on the leases and in March or April of 1971 the trustees of Trusts No. 1 terminated those leases for non-payment of rentals. Mr. Wade explained that the trusts had limited cash available and were in the position of having to pay the expenses of these properties without income on them. Neither did John King make any payments on the note for the purchase price of the stock bought from Trusts No. 1. Likewise Trusts No. 1 have never made any payments on the annuity.

CONCLUSIONS

The Government’s contention is that the annuity agreement was, simply, a transfer of substantially all of the real and personal property of John M. King to the Trusts No. 1 for less than adequate and full consideration in money or monies worth. Such a transfer does constitute a gift under 26 U.S.C. § 2512 even without donative intent.

The evidence does show that Mr. Coffey met with Cal Bennett, a CPA with Arthur Andersen & Co., on July 20, 1970 to discuss the stock and the annuity transaction. Another meeting was held by Bennett with Lowry and the trustees in September and possibly October, 1970. At about that time Mr. King changed tax counsel from Mr. Bye to his present attorneys. These accountants recommended the annuity transaction and that it be structured in a way to avoid a gift. The amount of the annuity was to be based on the appraisal of the assets transferred.

With the exception of the house in Arapahoe County, the government has not really attacked the appraised values of these properties. Accordingly, the challenge to the annuity agreement is not that the property conveyed is unrelated to the amount of the annuity; it is that the promise to pay the annuity is not an adequate consideration. It is difficult, though, to separate the annuity transaction from the stock sale. Without the annuity, that sale would not be collateralized excepting for the notes receivable from the Trusts No. 2. Limiting this to the question of a gift tax and ignoring any income tax consequences to the arranging of the offsets, it must be concluded that this transaction did not give rise to the gift tax assessed on it.

There is nothing inherently suspect about the exchange of an annuity, and the practice has been affirmed in a number of cases. See, e. g., K. Bortman, 10 T.C. 1073 (1948); In re Myers, 27 TCM 975 (1968). See also Rev.Rul. 69-74, 1969-1 Cum.Bul. 43. In these cases, and the Revenue Ruling cited, a gift tax was assessed based on the inadequacy of the annuity; but the use of the annuity was not challenged. The above references are not authoritative, but as there are no cases which hold the sale of an annuity to be per se inadequate, the practice is permissible where the annuity is in fact fair consideration for the property transferred.

The Government relies on Updike v. United States, 88 F.2d 807 (8th Cir. 1937) in contending that the annuity cannot be viewed as consideration for the transfer. That reliance is misplaced. Updike dealt with estate taxes and a transfer in contemplation of death, not with the more narrow issue of the validity of an exchange involving an annuity. In Updike the question was whether the substance of the transaction constituted the retention of a life estate, not whether in any circumstances an annuity can be consideration.

Greene v. United States, 237 F.2d 848 (7th Cir. 1956) is equally inapplicable. The Court there held that where an annuity is to be paid from the income of transferred securities, the taxpayer has retained a life estate for purposes of determining the gross estate. That situation is far different from determining whether an annuity is adequate consideration for the remainder interest transferred. The question in estate tax cases is what in substance was transferred. In gift tax cases the question is whatever was transferred, was the consideration received fair. The debtor’s situation is purely a gift tax consideration and estate tax cases are inapposite.

In the annuity agreement, the debt- or provided for an independent and fair appraisal of the property, and for redeter-mination of the price if the amount of the annuity were found to be inadequate. For the purposes of this phase of the litigation, it is sufficient to find that the transaction as structured does not of itself incur gift tax liability. The value of the property and whether an annuity of $157,921.03 per year is large enough to constitute a fair exchange will have to be determined in Phase Three of this litigation.

In that regard, although the annuity agreement is dated as of May 25, 1970, the first evidence of the complete agreement is the series of deeds dated August 11, 1970. This is the proper date of the agreement, and the consideration for the sale should be determined in light of this date.

ISSUE NO. THREE: 1969 Deduction of Ordinary Loss for Abandonment of NOPI

In their joint income tax return for 1969 (Exhibit WW), John King and Carylyn King deducted as an ordinary business loss the amount of $4,543,822.00 for participation in co-owned oil and gas properties operated by The Colorado Corporation. That amount is based upon abandonment in the year of 1969 by The Colorado Corporation of oil and gas leases where John M. King owned a net operating profits interest. In making the assessments, IRS disallowed this deduction, contending that the transactions were without economic substance and constituted a sham designed to provide tax loss deductions.

In their agreements with their respective limited partnerships whose properties they managed, Imperial-American Management Company and Royal Resources Corporation earned participating interests in those properties called “Net Operating Profits Interests”. By definition such interests entitled those companies to payment of 25% of the net income from producing oil and gas properties after the deduction of operating expenses but without deducting any drilling, acquisition or development costs. These companies were wholly owned subsidiaries of The Colorado Corporation, which, therefore, controlled the NOPI. It will be recalled that the funds were engaged in exploratory drilling operations with Royal Resources Funds being the wildcat or most speculative drilling company. Obviously, many of the properties drilled proved to be nonproductive and were abandoned.

Late in 1968 or early in 1969, Mr. Stanley Hallman, a CPA and tax specialist employed first by King Resources Company and later by The Colorado Corporation, discussed with John King the possibility of a sale by The Colorado Corporation of both producing and nonproducing NOPI interests. Mr. Hallman said in his opinion the purchaser of a producing NOPI interest would have income subject to depletion and the owner of a nonproducing interest could take an ordinary loss at the time of abandonment of the underlying property. The sale of NOPI would of course generate cash flow to The Colorado Corporation. Mr. Hallman pointed out to Mr. King that the percentage of dry holes to producing exploratory wells in Royal Resources would be fairly high so that a substantial write-off of the initial acquisition costs would be available to any purchaser of nonproducing NOPI.

In early January, 1969, John King flew to Acapulco and met with Edward Cowett of IOS. Mr. King advised Mr. Cowett that NOPI interests could be made available for purchase by IOS principals. At that time, those principals in IOS who were American citizens were interested in obtaining “tax shelter” investments for two reasons. First, many of them were making very substantial commissions which would be ordinary income, and second, it was then expected that IOS would “go public” on both a new issue basis and a secondary distribution of outstanding shares. The shareholders of IOS would be required to dispose of 10% of their holdings each year for three years upon such a distribution. That requirement would necessitate substantial capital gains for those people and an extensive tax liability under the Internal Revenue Code.

In approaching Mr. Cowett and Mr. Corn-feld about this idea, Mr. King repeated his position that he, personally, would participate in any investments he recommended for them and they became attracted to the proposal.

Again, the documentation lagged.

In February, 1969, Mr. King advised Mr. Lowry that the IOS group had agreed to purchase approximately $20,000,000.00 in NOPI for each of three years, the NOPI to be in a mix of proven and wildcat properties. Mr. Lowry did not begin to draft documents on this subject until March, 1969. At that time he prepared Exhibit CC which consists of two agreements, each dated January 8, 1969, between The Colorado Corporation and John M. King. One agreement is for the purchase by John King of NOPI up to a total purchase price of $6,000,000.00 which NOPI is to be acquired upon the basis of tenders with ten days to reject each tender. The purchase price is to be settled before December 31, 1969 by payment of 25% in cash and 75% in negotiable notes with The Colorado Corporation retaining a security interest in the NOPI to collateralize the notes. The second agreement on the same basis is for the purchase of NOPI to a total of $250,000.00.

Exhibit DD is a similar agreement between The Colorado Corporation and Investors Overseas Bank Limited, for the purchase of $14,160,000.00 in NOPI in 1969. That agreement is also dated January 8, 1969 and it is signed by Edward Cowett for the purchaser. Investors Overseas Bank Limited was an IOS affiliate. That bank entered into the purchase agreement as agent for individuals who were principals in the IOS organization.

Exhibit GG is a letter agreement, dated October 8,1969, between The Colorado Corporation and Investors Overseas Bank, signed by Cowett, confirming an agreement for the bank to purchase, as agent, additional NOPI during 1970 and 1971 up to an aggregate purchase price each year of $15,-000,000.00.

The tenders made under these agreements consisted of oil and gas leases owned by the Royal and Imperial partnerships. Stanley Hallman and another employee prepared the tender letters from their review of these lease files and the tenders were made in the fall of 1969 because of a delay in the implementation of the agreements. The tenders were made on all of the leases committed to drilling programs, according to the testimony of Mr. Hallman. While Mr. King, did, of course, have access to these lease files and could, perhaps, have obtained advance information with respect to the properties subject to the tenders, there is no evidence that he did so. The evidence in this case is consistent with his contention that he purchased upon the same basis as the IOS people, and that he received the same treatment on the tenders as they did. Mr. King paid $1,500,000.00 cash as 25% of the $6,000,000.00 purchase by a check dated December 31, 1969. That $6,000,000.00 was to be the total of his purchase in 1969; but, a vice president of King Resources Company, Bennett King, unrelated to Mr. John King, had agreed to acquire $250,000.00 of NOPI, and he had asked to be released of that obligation. John King took up that obligation personally and paid $62,500.00 as 25% of it in April, 1970.

Mr. King did receive $140,202.00 in March, 1970 as his share of NOPI proceeds collected by The Colorado Corporation for him during 1969. Comparable cash payments were apparently made to the IOS investors.

Many of the leases underlying the NOPI transaction were abandoned and Exhibit KK is a notification to John King from The Colorado Corporation, dated March 20,1970, advising him of the results of exploration activity on the leases in which he held NOPI as the result of this transaction. That exhibit is not sufficiently complete to show all of the abandonments used as the basis for the loss deduction taken in the 1969 income tax return.

By May, 1970, the IOS people had lost their enthusiasm for the NOPI purchase arrangements. By that time, the plan to take IOS public had been abandoned and the IOS empire was collapsing. Those factors combined to eliminate the need for a tax shelter investment and to cause a cash shortage with the persons who were to buy the NOPI. Accordingly, in June, 1970, a representative of those persons arrived in Denver to attempt to renegotiate this arrangement. The result of intensive negotiations was the formation of a new corporation called The NOPI Corporation to which the IOS people transferred all of their NOPI interest in exchange for a release of their future liability. A key bargaining point in those negotiations was the contention that Mr. Cowett did not have authority to bind the principals who were to be the purchasers.

Subsequently, in February, 1971, The Colorado Corporation repurchased all of the NOPI held by John M. King for a note in the amount of $1,400,000.00. At that time, both John M. King and The Colorado Corporation were in default on notes to Continental Illinois National Bank and Mr. King testified that the repurchase of the NOPI was designed to provide an opportunity to refinance The Colorado Corporation’s obligations with that bank. The bank rejected such an offer to refinance.

The end result of the NOPI transaction, viewed retrospectively, is that John King paid out $1,562,500.00 and received $140,-000.00 income, making a net cash investment of $1,422,500.00. For that cash investment he received the tax benefit of a $4,500,000.00 deduction in his 1969 taxes. Additionally, he received a note for $1,400,-000.00 which was never collected by him.

Also a part of the repurchase by The Colorado Corporation of King’s NOPI was the cancellation of the notes from King for the balance of the purchase price. The note to King for $1,400,000.00 and the reassignment are both dated December 31,1970 and are in evidence as Exhibit 51 and 50, respectively.

CONCLUSION

The Internal Revenue Service disallowed this deduction upon the conclusion that the NOPI purchase was a sham without economic substance. It is suggested that from the timing of the preparation of the tenders, which was within the last two months of 1969, and from the relationship of John King to The Colorado Corporation, the necessary inference is that the entire transaction was designed to obtain a tax loss and that the entire matter was controlled by the debtor. While these circumstances do promote suspicion, the Court must accept the uncontradicted testimony of Stanley Hallman as to the manner in which the selection was made and particularly that the tenders were prepared without knowledge of the results of drilling.

Counsel for the Government have cited a number of cases in which deductions were disallowed because the transactions were not entered into for profit. Those cases are not applicable to this situation because they do not involve the oil and gas industry. It is commonplace that in the exploration for oil and gas, more efforts are failures than successes. Accordingly, the statistics for dry holes are such that one is more likely to suffer a loss than a gain in any such transaction. Persons enter into such speculative investment because it does have the possibility of a high return when the efforts are successful and because under the present tax laws there are indeed benefits from failure. What must be said on this record is that while the probabilities favored losses and while it is clear that the parties acquiring the NOPI were motivated by that feature, it was also possible for them to have had substantial revenue produced from these NOPI’s. This is simply another circumstance in which persons who have sufficient tax flexibility to do so can take advantage of the law to enter into transactions in which they will benefit without regard for the economic success or failure of the investment. That is the heart of any tax shelter device and tax shelters are not, per se, unlawful. Upon this record, the taxpayer has met the burden and the deduction should be allowed.

It should also be observed that the transaction cannot fairly be viewed from hindsight. In 1969 it did appear that there would be a merger of King Resources Company and The Colorado Corporation and as has been suggested in the Government’s brief, it would have been advisable to increase the value of The Colorado Corporation’s assets by the sale of NOPI before that merger. By the end of 1970 it was clear that no such merger would take place and the reacquisition of NOPI could well be in the best interests of The Colorado Corporation at that time.

Finally, it should be noted that there were two individuals within the King complex of companies who also participated in the NOPI purchase but who asked for and obtained from John King “put” letters whereby Mr. King offered to repurchase from them the NOPI which they acquired on the basis of their investment less any return which they had received by revenue or tax benefit. I find no significance to those “puts” because that is entirely consistent with Mr. King’s methods of persuading investors to enter into transactions and those “puts” were never exercised insofar as the evidence in this case has disclosed.

Deductions for worthless oil and gas leases are not new or unique aspects of oil and gas taxation. See, e. g., Henley v. United States, 396 F.2d 956, 184 Ct.Cl. 315 (1968); C. C. Harmon, 1 T.C. 40 (1942), aff’d on other grounds, Commissioner v. Harmon, 139 F.2d 211 (10th Cir. 1943), rev’d on other grounds 323 U.S. 44, 65 S.Ct. 103, 89 L.Ed. 60 (1944); Pool v. United States, 119 F.Supp. 202, 127 Ct.Cl. 549 (1954); 5 Mertens, Law of Federal Taxation § 28.20. The only material issues are the worthlessness of the interest, the intent to abandon, and the year in which the interest was abandoned. As stated in Henley, supra, at 962:

“It is the practical worthlessness of the mineral interest . . . not the bare possibility of what might happen at some uncertain time in the future . .

The only evidence of worthlessness presented in the present record is the schedule of income and loss sent to the debtor by letter of March 20, 1970 from The Colorado Corporation, and the Form 927’s submitted to substantiate that loss. It should be noted that some of the properties conveyed by tender letters do not appear on the schedule and roughly one half of the losses claimed in the schedule are not documented by Form 927’s. The failure to document these losses is not fatal to this part of the case as the proper amount of the loss may be determined in Phase Three. What is determined is that in those instances where Form 927’s have been provided, debtor has met his burden of proving worthlessness, and the NOPI transaction as structured here qualifies for a deduction under I.R.C. § 165(c)(2). The only differences between this transaction and those which have been granted deductions in the past, are the name for the interest and the size of the losses generated. This is not enough to deny the deduction.

ISSUE NO. FOUR: Gift tax on Transfer of Furnishings and Artwork To Trusts No. 1

The personal books and records of John M. King reflect that during 1970 furnishings and artwork of the value of $26,213.20 were transferred to children’s Trusts No. 1. A gift tax assessment was made on those transfers because there was no showing of their adequate consideration. The debtor contends that the transfers were made in payment of rent due and owing pursuant to the lease agreement of August 11, 1970.

Little was revealed in the record on this issue. Lloyd Wade testified that no payments of rent were received by the trusts. On this issue the debtor has failed to meet his burden of proof to show that the transfers were accepted as part payment on the rental obligations as well as showing that these lease agreements were effective. Because these transfers cannot be otherwise characterized from the limited evidence available on the point, it is concluded that there was a proper assessment of gift tax on these transfers.

ISSUE NO. FIVE: Gift Tax on 9,450 Shares of King Resources Company Stock

In 1970, Dempsey-Tegler, the firm which had been the underwriter when King Resources Company went public was in financial trouble because of the declining stock market at that time. At that firm’s request, John King agreed that he and his family would place stock of King Resources Company with Dempsey-Tegler as subordinated capital which could be used in improving that firm’s net ratios.

At that time there was a discrepancy among the debtor’s four children in the ownership of shares of King Resources Company. The youngest child, Sally Ann King, had 9,450 shares less than the older three children. That was because the stock which was available to transfer to her was “lettered” stock available only for investment and therefore could not be used in the Dempsey-Tegler transaction. To equalize whatever benefit would result to the children from this transaction, Mr. King placed 9,450 shares of his stock with Dempsey-Te-gler with the benefit to go to his daughter Sally.

While it is clear that Mr. King intended to give Sally these shares when they were free from the investment letter restriction, the record does not show any such transfer. The record also does not reveal what, if any, proceeds or other benefit were obtained from the Dempsey-Tegler transaction. To the extent that there were such benefits resulting from the use of this 9,450 shares, that would be the gift made by the debtor.

CONCLUSION

The assessment made for gift tax on this transaction is limited to the amount of proceeds, if any, received by Sally Ann King from the use by Dempsey-Tegler of 9,450 shares of King Resources Company stock.

FACTUAL CONTEXT FOR PHASE TWO ISSUES

In June, 1968, John M. King created a trust with Mercantile Bank and Trust Company, Freeport, Bahamas, as trustee and Mrs. King as beneficiary. Later, Mrs. King exercised a power of appointment to make their four children the beneficiaries of this trust which will be referred to as the King Bahamian Trust. The trust agreement (Exhibit II-N) was drafted by Mr. Bye and Mr. Lowry with the assistance of a lawyer in New York City, Joel Mallín. Mr. Mallín served as special tax counsel for IOS and its principals from time to time and he was also retained to do special tax work for Mr. King, King Resources Company and The Colorado Corporation on occasions.

The King Bahamian Trust was established with the transfer of $5,000.00. The trust agreement provided for the employment of an investment adviser and while there was no formalization of his role, Mr. Cowett acted in that capacity through an understanding with John King. While it is not clear how he was retained, Mr. Mallín apparently served as an attorney for the trust and he routinely received information and documents about trust affairs from the Mercantile Bank as trustee.

By the end of 1968 there were very substantial business relationships between the King complex and the IOS complex of companies and John King had also established personal relationships with Mr. Cornfeld and Mr. Cowett. The debtor was made aware of the IOS plan to make a public offering of its stock and he learned of the existence of a consent decree which prevented IOS from doing business in the United States. Under the terms of that decree, no American citizen could acquire more than 1% of the outstanding IOS stock which was then 6,000,000 shares.

John King wanted to obtain IOS stock before the public offering, anticipating a sharp rise in its value. At this same time Bernard Cornfeld wanted to reduce his holdings.

There was a preliminary agreement whereby Mr. King was to purchase 55,000 shares of IOS from Mr. Cornfeld. Before that transaction was completed some 40,000 shares of IOS stock became available as a result'of a merger agreement between Lexington Research and Management Corporation and Piedmont Management Company, Inc. and the fact that IOS stock was not to be a part of the merged company’s portfolio. It was decided that Mr. King would purchase those 40,000 shares and only 15,-000 of Mr. Cornfeld’s shares. There is dispute concerning the timing and the legal effect of the transactions and documents involved; but, all of these 55,000 shares eventually became the property of the King Bahamian Trust. That trust also acquired an additional 173,500 shares of IOS stock by purchases made through a broker, G. S. Herbert & Sons during September and October, 1969. The financing of those purchases is also in dispute.

The difficulties caused by a falling stock market, the resulting decline in the value of the securities owned by its mutual funds, the collapse of its sales program and the liquidity drain from increasing redemptions by fundholders produced a crisis in IOS in April, 1970. With the board of directors of IOS engaged in a continuous meeting from day to day, Edward Cowett and Joel Mallín came to John King to propose that he organize a consortium to provide financing and to take control of the IOS complex. They told the debtor that it was necessary to provide an immediate line of credit of $20,000,000.00 with another $20,000,000.00 to be made available later. It was suggested that King Resources Company could be the lead company in the takeover group.

The attitude and position of the Securities and Exchange Commission became a problem because of the existing consent decree. If King Resources Company took an “affiliate” position it could be considered to be in violation of that decree and the result could be a suspension of trading in all of the securities of all of the companies in the King complex. John King reacted quickly to what he perceived to be an enormous opportunity and he accepted the challenge.

He and Timothy Lowry went to Washington, D.C. on May 1, 1970 to inform S.E.C. staff members about this effort and believing that it would meet with approval, the debtor made immediate and most energetic efforts to obtain the required financing. Upon the advice of Edward Cowett tha