T.C. Memo. 1996-281

UNITED STATES TAX COURT

MAX M. AND JOAN E. GREENBERG, Petitioners v

. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 6843-94. Filed June 19, 1996.

Andrew M. Glatt , for petitioners.

Christine V. Olsen , for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

JACOBS, Judge : Respondent determined an $11,644 deficiency in

petitioners’ 1990 Federal income tax, and a $2,329 section 6662(a)

accuracy-related penalty for such year.

The pr incipal issue for decision concerns the proper

characterization of payments petitioners received from or through

an entity known as Pioneer Mortgage in 1990 totaling $44,396 (viz,

whether said payments should be characterized as interest income,-2-

1 G. Naiman operated and controlled the following

(continued...) as respondent contends, or as a return of capital, as petitioners

contend). In the event we accept respondent’s characterization of

these payments, then we must further decide whether petitioners are

liable for the section 6662(a) accuracy-related penalty.

All section references are to the Internal Re venue Code for

the year in issue, all Rule references are to the Tax Court Rules

of Practice and Procedure, and all dollar amounts have been

rounded.

Some of the facts have been st ipulated and are found

accordingly. The stipulation of facts and the attached exhibits

are incorporated herein by this reference.

FINDINGS OF FACT

At the time they filed their petition, petitioners Max M. and

Joan E. Greenberg, husband and w ife, resided in San Diego,

California. They timely filed a joint Federal income tax return

for 1990.

Pioneer Mortgage, Inc.

Pioneer Mortgage, Inc. (Pioneer Mortgage or the company) was

inco rporated by Morrie Naiman (M. Naiman) on July 12, 1967. In

1975, M. Naiman died; thereafter his nephew, Gary Naiman (G.

Naiman) continued the business previously cond ucted by his uncle

(viz, the secondary mortgage market in the San Diego area) using

the Pioneer Mortgage name for several interrelated companies. 1 G.-3-

1 (...continued)

companies under the Pioneer Mortgage umbrella: Naiman Financial

Corp.; Naimpro, Inc.; Naimco-Clairemont, Inc.; Naimco, Inc.;

Alvarado Investment Corp.; and Frontier Service Corp. As used

hereinafter "Pioneer Mortgage" refers to Pioneer Mortgage and its

interrelated companies. Naiman was president and chief exe cutive officer of Pioneer

Mortgage from the mid-1970's until the company filed for bankruptcy

in January 1991.

Pioneer Mortgage originated and serviced real estate loans and

sold investments purported ly related to these loans to third

parties. The loans originated by Pioneer Mortgage generally were

of a short-ter m duration and were secured by real estate. The

loans were commonly known as "equity loans" because they were based

primarily on the borrower's equity in the real estate securing the

loan, as opposed to the borrower’s creditworthiness. The interest

rate and origination fees on equity loans were commensurate to the

relatively high degree of risk involved.

Pioneer Mortgage offered several types of investments related

to the equity loans it originated. The primary investment it

offered was a purported fractionalized interest in a note and deed

of trust fromthe borrower to Pioneer Mortgage. This type of

investment was portrayed to the investor as safe and conservative.

Potential investors were advised that the borrower had sufficient

equity in the collateralized property to support the loan.

Another type of investment offered by Pioneer Mortgage was a

mortgage pool investment known as a Collateral Mortgage Obligation-4-

( CMO). The company bundled different "assets" (such as limit e d

partnership interests and subordinated deeds of trust) and placed

them in a trust account to secure the CMO. Pioneer Mortgage

administered the CMO in vestment. The investor received a CMO

certificate, which represented his proportionate ownership interest

in the bundled assets, as well as a note from Pioneer Mortgage.

For his investment, t he investor received purported monthly

interest payments drawn on Pioneer Mortgage's bank account.

P ioneer Mortgage paid interest at a rate higher tha n that

obtainable from conventional savings accounts, Treasury bills, or

money market accounts. Pioneer Mortgage forwarded monthly payments

to the investors regardless of whether the borrower had at the time

remitted its payment to the company.

The investors and Pioneer Mortgage typically entered into a

loan service agreement pursuant to which the inves tor authorized

Pioneer Mortgage to collect payments on, and otherwise service, the

borrower's note. The loan service agreement provided that Pioneer

Mortgage could grant the borrower an extension of time to remit the

required monthly payments. If the borrower failed to make timely

the interest payment, Pioneer Mortgage could and normally did

advance the borrower an amount equal to that w hich was due. The

loan service agreement f urther provided that if Pioneer Mortgage

ma de a payment to the investor to cover the payment due from the

borrower, such payment would c onstitute an advance and would be-5-

repaid to Pioneer Mortgage upon receipt of the late payment from

the borrower.

Pioneer Mo rtgage was required to inform the investor if any

payment it remitted to the investor came from a source other than

the borrower by designating on the check sent to the investor that

such funds constitute a "loan to the lender". Thus, when Pioneer

Mortgage advanced funds to the investor to cover the bo rrower's

late interest payments, Pioneer Mortgage labeled such payment with

an "L".

As of 1990, over 2,000 persons (many of whom were elderly and

counted on their investments through Pioneer Mortgage to provide a

fixed income reti r ement) had made investments through Pioneer

Mortgage; the amount of these investments totaled approximately

$250 million.

Petitioners’ Investments

Petitioners invested in several fractionalized interests in

notes and deeds of trust through Pioneer Mortgage. They also

invested in a CMO. The following is a list of petitioners’

investments with Pioneer Mortgage:-6-

2 In some documents, this loan is referred to as Loan No.

13567. Loan Loan Date of

Provided To Number Investment Investment Interest Rate

A-440 Enterprises, 13230 $25,000 Sept. 1, 1988 12.75%

Inc. (Foster)

Scott Wellington 13232 25,000 Feb. 10, 1989 12.75%

Rudolph

Avion Properties, 13412 50,000 Aug. 21, 1989 14%

Ltd.

Naimco-Clairemont, 13586 25,000 Aug. 21, 1989 14%

Inc.(Sunnymead)

Hermosa Beach 13566 2 150,000 Aug. 21, 1989 14%

Investment Co.

3.0 CMO

--- 100,000 Aug. 21, 1989 14%

Petitioners received the following payments purportedly as

interest in 1990 from Pioneer Mortgage with respect to the CMO:

Check Date Payments

1/6/90 $1,166.67

2/6/90 1,166.67

3/6/90 1,166.67

4/6/90 1,166.67

5/6/90 1,166.67

6/6/90 1,166.67

7/6/90 1,166.67

8/6/90 1,166.67

9/6/90 1,166.67

10/6/90 1,166.67

11/6/90 1,166.67

Total 12,833.37

Two of the statements for these payments have the notation "L".

Petitioners received the following payments purportedly as

interest in 1990 with respect to their interests in notes and deeds

through Pioneer Mortgage:

Check Date Payments

2/1/90 $3,156.26

3/1/90 3,156.26-7-

3 The bankruptcy court concluded that, contrary to

petitioners' belief, they did not own a direct interest in

borrower notes secured by trust deeds, but rather, petitioners

were unsecured creditors of Pioneer Mortgage. In 1991, all of

the Pioneer Mortgage investors (including petitioners) were

required to relinquish their investments to a new entity called

Pioneer Liquidating Corporation.

4/1/90 3,156.26

5/1/90 3,156.26

6/1/90 3,156.26

6/30/90 3,156.26

8/1/90 3,156.26

9/1/90 3,156.26

10/1/90 3,156.26

11/1/90 3,156.26

Total 31,562.60

The monthly payment statements with respect t o these investments

indicate that the majority of the payme nts included an "L"

notation.

The Demise of Pioneer Mortgage

In late 1990, Pioneer Mortgage acknowledged certain financial

difficulties. In December 1990, Pioneer Mortgage stopped advancing

funds to the borrowers, and failed to make interest payments for

the first time. On January 9, 1991, Pioneer Mortgage and its

interrelated companies filed for Chapter 11 bankruptcy protection. 3

Shortly after Pioneer Mortgage’s bankruptcy filing, the facts

surrou n ding the company’s downfall became public. Apparently

Pioneer Mortgage’s financial difficulties began as a result of the

rapid expansion of the company into new types of products. Before

the mid-1980's, Pioneer Mortgage primarily arranged short-term

loans that were secured by first- or second-trust deeds on single--8-

4 Newspaper articles portray G. Naiman’s activities as a

typical “Ponzi” scheme. Such a scheme involves a pyramiding

technique by which the earlier investors receive their returns

from the principal of their own funds and from the principal of

later investors.

5 Petitioners’ suit was consolidated with some 850 other

lawsuits filed by Pioneer Mortgage investors seeking return of

investment funds and damages in Mertyle H. Owens Trust v. San

Diego Trust & Savings Bank , Consolidated Case No. 633381, in

Superior Court of California, County of San Diego. family residences. Gradually, the company shifted to junior deeds

on larger residential and commercial loans, including h o tels,

resorts, and undeveloped land in California and Arizona.

Accordingly, in 1990, certain borrowers had not been making

their monthly payments; rather than foreclose on the properties or

notify the Pioneer Mortgage investors, G. Naiman used new

investors’ money to fund the continued flow of purported interest

payments. 4 The end result was a financial house of cards dependent

on the influx of new investment dollars. The house of cards could

not survive in the long run.

On January 2, 1992, petitioners filed a civil lawsuit against

G. Naiman and other defendants for, among other things, intentional

misrepresentation, fraudulent concealment, breach of fiduciary

duty, and ai ding and abetting/conspiracy. 5 A jury verdict was

rendered in favor of petitioners on April 30, 1993. The jury also

awarded punitive damages. On May 12, 1994, G. Naiman was indicted

in Federal Court on charges of mail fraud and money laundering. G.

Naiman pleaded guilty to a scheme to defrau d Pioneer Mortgage-9-

6 The parties acknowledge that this amount is $1,853.50

more than the $44,396 petitioners actually received from Pioneer

Mortgage in 1990.

7 The $46,249 comprises the sum total of the amounts

reported on the Forms 1099-INT issued to petitioners for 1990. i nvestors through illegal acts, including mail fraud and mon e y

laundering (promotion and concealment) on October 18, 1994. He is

presently serving a 6-1/2 year prison sentence.

At the time of trial herein, petit ioners had recovered

approximately $25,000 out of their total $375,000 investment with

Pioneer Mortgage.

Forms 1099

In 1991, Pioneer Service Co. (the trustee in bankruptcy)

issued to petitioners two Forms 1099-INT, in the amounts of

$12,833.37 and $33,416.10, 6 with regard to the payments labeled

"interest" on the CMO loan and the remaining loans, respectively.

Petitioners’ 1990 Federal Income Tax Return

Petitioners’ accountant, Kenneth B. Healey, prepared

petitioners' 1990 Fe deral income tax return. Because of the

document matching program that the Internal Revenue Service

employed, Mr. Healey determined that petitioners should report as

interest income the amount ($46,249 7 ) reported on the two Forms

1099-INT from Pioneer Service Co. and wash that amount out by

claiming $46,249 as negative income on line 22 (Other income) of

their 1990 Form 1040.-10-

P etitioners attached a statement to their 1990 tax return

which read:

The taxpayers are holders of notes receivable,

whose princip al repayment is in doubt due to

bankruptcy proceedings; therefore, the taxpayers are

allocating paym e nts received in 1990 to repayment of

principal. The amount of the payments is $46,249.

Notice of Deficiency

Respondent disallowed the $46,249 negative income on

petitioners’ 1990 return on the premise that petitioners failed to

establish "that any amount is deductible under the pro visions of

the Internal Rev enue Code." This disallowance resulted in a

$46,249 increase in petitioners’ 1990 taxable income.

OPINION

Respondent claims that because the trustee in bankrupt c y

labeled the payments to petitioners as interest on Forms 1099-INT,

such payments constitute income. Petitioners posit that the money

they received from Pioneer Mortgage in 1990 does not represent

interest income, but rather payments made to conceal a fraud. As

such, petitioners take the position that the payments constitute a

return of their capital.

The issue involved is purely f actual. In their post-trial

briefs, petitioners argue:

Beginning on or about May 1, 1989 and co ntinuing

until approximately January 9, 1991, G. Naiman and others

devised a scheme to defraud and obtain money and property

from investors by means of false a nd fraudulent

pretenses, representations and promises, and the

concealment of material facts. As part of the scheme to

defraud in the year preceding Pioneer Mortgage's-11-

bankruptcy filing on January 9, 1991, G. Naiman and

others created and maintained the illusion that Pioneer

Mortgage was financially stable when in fact it was not.

Pioneer Mortgage maintained this illusion in order to

attract new investor funds. These new funds were applied

to the monthly interest payments due previou s Pioneer

Mortgage investors, prior financial obligations of the

various Pioneer Mortgage companies and bank over-drafts

at several financial institutions.

Due to the n ature of the fraud perpetrated on

petitioners, there was no agreement between petitioners

and Pioneer Mortgage. Petitioners believed that they

were investing directly in specific promissory notes

which were adequately secured by trust deeds. However,

as the facts in this case clearly indicate, what

petitioners ended up with was instead so me sort of

undivided i nterest as a creditor of Pioneer Mortgage's

successor which is being l iquidated via a bankruptcy

proceeding.

The payments received by petitioners during 1990 did

not originate from investments of a character and quality

in which petitioners believed they had invested. Rather,

the evidence clearly demonstrates that the petitioners

were defrauded as to the character and quali ty of the

investment instruments owned by them.

We agree with petitioners' characterization of the payments

in question. Interest is compensation for the use or forbearance

of money. D eputy v. duPont

, 308 U.S. 488, 498 (1940). We conclude

that the payments petiti oners received through their investment

with Pioneer Mortgage in 1990 were not for the use and forbearance

of t heir money, but rather such payments were made to conceal G.

Naiman's fraudulent misappropriation of petitioners' investment.

Accordingly, the payments represented a return of peti tioners'

investment and should not be included in income as interest simply

because the payments were reported as interest on Forms 1099-INT.

Cf. Burnet v. Logan

, 283 U.S. 404 (1931). The interest label given-12-

8 Were we required to decide this issue, we would rule in

favor of petitioners. to these payments was patently erroneous. Petitioners' money was

not invested in the manner promised by Pioneer Mortgage.

Because the payments petitioners received from or through

Pioneer Mortgage in 1990 represented a return of capital, and not

interest income, respondent's determination that petitioners are

liable for the accuracy-related penalty falls by the wayside. 8

Consequently,

Decision will be entered

for petitioners

.