NEONATOLOGY ASSOCIATES, P.A.
v.
COMMISSIONER OF INTERNAL REVENUE (Tax Court No. 97-1201)
John J. and Ophelia J. MALL
v.
Commissioner of Internal Revenue (Tax Court No. 97-1208)
Estate of Steven Sobo, Deceased and Bonnie Sobo, Executrix, and Bonnie Sobo, Surviving Wife
v.
Commissioner of Internal Revenue (Tax Court No. 97-2795)
Akhileshi S. and Dipti A. DESAI
v.
Commissioner of Internal Revenue (Tax Court No. 97-2981)
Kevin T. and Cheryl McManus
v.
Commissioner of Internal Revenue (Tax Court No. 97-2985)
Arthur and Lois M. Hirshkowitz
v.
Commissioner of Internal Revenue (Tax Court No. 97-2994)
Lakewood Radiology, P.A.
v.
Commissioner of Internal Revenue (Tax Court No. 97-2995)
Neonatology Associates, P.A., John J. and Ophelia Mall, Estate of Steven Sobo, Deceased, and Bonnie Sobo, Executrix, and Bonnie Sobo, Surviving Wife, Akhilshi S. and Dipti A. Desai, Kevin T. and Cheryl McManus, Arthur and Lois M. Hirshkowitz and Lakewood Radiology, P.A., Appellants
No. 01-2862.
United States Court of Appeals, Third Circuit.
Argued: July 11, 2002.
Filed: July 29, 2002.
COPYRIGHT MATERIAL OMITTED Neil L. Prupis, Lampf, Lipkind, Prupis, Petigrow & LaBue, West Orange, NJ, Kevin L. Smith (argued), Hines Smith, Costa Mesa, CA, David R. Levin, Wiley Rein & Fielding, Washington, D.C., for Appellants.
Eileen J. O'Connor, Assistant Attorney General, Kenneth L. Greene, Robert W. Metzler (argued), Attorneys Tax Division, Department of Justice, Washington, D.C., for Appellee.
Steven J. Fram, Archer & Greiner, Haddonfield, NJ, for Amici Curiae Vijay Sankhla, M.D., Yale Shulman, M.D., Boris Pearlman, M.D., Marvin Cetel, M.D. and Barbara Schneider, M.D.
Before: SCIRICA and GREENBERG, Circuit Judges, and FULLAM, District Judge*.
GREENBERG, Circuit Judge.
I. INTRODUCTION
This matter comes on before this court on appeal from decisions of the United States Tax Court entered April 9, 2001, in accordance with its opinion filed July 31, 2000, upholding the determination of the Commissioner of Internal Revenue that contributions made by appellants, two professional medical corporations, Neonatology Associates, P.A. and Lakewood Radiology, P.A., into Voluntary Employees Beneficiary Program (VEBA) plans in excess of the cost of term life insurance were taxable constructive dividends to the physicians owning the corporations and their spouses rather than employer deductible expenses. See Neonatology Assoc., P.A. v. Comm'r,
Our examination of the record convinces us that the contributions at the heart of this dispute were so far in excess of the cost of annual life insurance protection that they could not plausibly qualify as ordinary and necessary business expenses in accordance with I.R.C. § 162. In essence, the physicians adopted a specially crafted framework to circumvent the intent and provisions of the Internal Revenue Code by having their corporations pay inflated life insurance premiums so that the excess contributions would be available for redistribution to the individual shareholders free of income taxes. As correctly recognized by the Tax Court, these contributions were taxable disguised dividends and not deductible expenses. Moreover, as the individual taxpayers could not in good faith avail themselves of the reliance-on-professional defense, the Tax Court duly held them liable for the accuracy-related negligence penalties. Accordingly, for the reasons we elaborate in more detail below, we will affirm the decisions of the Tax Court.
II. BACKGROUND
The evidence at the trial disclosed the following facts. Neonatology is a New Jersey professional corporation owned by Dr. Ophelia J. Mall. Lakewood is a New Jersey professional corporation owned equally at the times material here by Drs. Arthur Hirshkowitz, Akhilesh Desai, Kevin McManus, and Steven Sobo until his death on September 23, 1993. Subsequently Dr. Vijay Sankhla, who is not a party to this action, purchased Sobo's interest. The spouses of the doctors, John Mall, Lois Hirshkowitz, Dipti Desai, Cheryl MacManus, and Bonnie Sobo, are parties to this action as the doctors and their spouses filed joint income tax returns. In addition, Bonnie Sobo is a party as executrix of her husband's estate.
Following the enactment of the Tax Reform Act of 1986(TRA), Pub.L. 99-514, 100 Stat.2085, insurance salesmen Stephen Ross and Donald Murphy formed Pacific Executive Services (PES), a California partnership designed to provides services to retirement plan administrators and employee benefit advisors unfamiliar with the impact of the TRA. See App. at 377. Specifically, Ross and Murphy devised a program to allow closely held corporations to "create a tax deduction for [ ] contributions to [an] employee welfare benefit plan going in and a permanent tax deferral coming out." App. at 2672.
To achieve this end, PES created two voluntary employees' beneficiary associations, the Southern California Medical Profession Association VEBA (SC VEBA) and the New Jersey Medical Profession Association VEBA (NJ VEBA).1 A VEBA, as defined in I.R.C. § 501(c)(9), is a tax-exempt program providing members, their dependents, or designated beneficiaries with life, sick, accident, or other benefits "if no part of the net earnings of such association inures (other than through such payments) to the benefit of any private shareholder or individual."
Under the PES VEBA programs, each participating employer adopts its own plan, maintaining a trust account and designating a trust administrator with exclusive control over all assets. The plan adoption agreement obligates employers to make, whether in the form of group insurance policies or group annuities, contributions towards the life insurance benefits of employees and their beneficiaries, based on a multiple of each employee's annual compensation. Benefits payable under any plan are paid solely from that plan's allocable share of the trust fund, and the participating employer, administrator, and trustee are not liable for any shortfall in the funds required to be paid. Upon termination of a plan, all its remaining assets are distributed to the employer's covered employees in proportion to their compensation. PES enlisted the services of Barry Cohen, a longtime insurance salesman with the Kirwan companies, to market the VEBA programs to medical professionals.
The SC VEBA plans at issue in this case, the Neonatology Employee Welfare Plan and the Lakewood Employee Welfare Plan, shared a common feature: both purchased continuous group (C-group) term policy certificates from the Inter-American Insurance Co. of Illinois, Commonwealth Life Insurance Co., and Peoples Security Life Insurance Co. The C-group product provided routine group term life insurance with an added component, a "special" conversion policy through which a covered employee, under certain circumstances,2 could opt to convert his or her policy to an individual policy, the C-group conversion universalife (UL) policy. By converting from a C-group to an individual UL policy, the employee could access funds paid by the employer to the group policy that exceeded the applicable mortality charge, i.e. the cost of insurance. The excess funds, depending on the year in which the conversion takes place,3 are paid out with interest as so-called "conversion credits."
In addition to being able to access surplus amounts, a policyholder upon conversion to the UL policy may borrow any amounts against his or her policies not required to keep the policies in force.4 When the policyholder dies, the loans are to be repaid from the policy death benefits, which ordinarily are not subject to income tax. See I.R.C. § 101. Of course, by borrowing the money the taxpayer effectively would be withdrawing money the medical corporations paid for the conversion privilege on a tax free basis. Thus, as if by magic, cash derived from the corporations would be withdrawn without tax. Each of the physician taxpayers, other than Dr. Sobo, in fact converted at least one C-group term certificate to a special policy providing conversion credits. See App. at 426-29, 439-41.
Neonatology, on the basis of conversations between its principal, Dr. Mall, and Cohen, established the Neonatology Plan under the SC VEBA on January 31, 1991, effective January 1, 1991. Under the plan, each covered employee was to receive a life insurance benefit equal to 6.5 times the employee's compensation of the prior year. See App. at 434, 1807. John Mall, Dr. Mall's husband, was not a paid employee of Neonatology and thus was not eligible to join the plan. Nevertheless, Dr. Mall and PES, the plan administrator, allowed Mr. Mall to join the plan, making him eligible to receive a death amount commensurate to that payable under life insurance that he had owned outside the plan ($500,000). See Supp.App. at 108-09. The Neonatology Plan purchased three C-group life insurance policies, two on Dr. Mall's life and one on Mr. Mall's life. See App. at 434-39. Neonatology contributed to the Neonatology Plan during each year from 1991 through 1993 and, for each subject year, claimed a tax deduction for those contributions and other related amounts.
Lakewood, on the basis of conversations between its principals and Cohen, established the Lakewood Plan under the SC VEBA on December 28, 1990, effective January 1, 1990. Under the plan, each covered employee was to receive a life insurance benefit equal to 2.5 times his or her prior-year compensation. See App. at 387. Lakewood amended its plan as of January 1, 1993, to increase the compensation multiple to 8.15. The Lakewood Plan purchased 12 C-group life insurance policies on the lives of Drs. Hirshkowitz, Desai, Sobo, McManus, and Sankhla and three group annuities toward future premiums on the policies. See App. at 400-26. Lakewood also purchased three C-group policies outside of the Lakewood Plan. The individual owners on their own behalf determined the amounts contributed by Lakewood to the SC VEBA. See App. at 1015-16, 3674-87. For each subject year, Lakewood claimed a tax deduction for those contributions and other related amounts.
The IRS audited Neonatology's tax returns for calendar years 1992 and 1993 and Lakewood's tax returns for fiscal year 1991 (ending October 31, 1991) and calendar years 1992 and 1993. As a consequence of the audits, the Commissioner made the following determinations. First, with respect to the deductions claimed by Neonatology for amounts paid to the SC VEBA and by Lakewood for amounts paid to the SC VEBA and to the three non-plan C-group policies, he allowed only the cost of annual term life insurance protection and disallowed the excess amounts of $43,615 and $986,826 for Neonatology and Lakewood respectively. See App. at 2265-66, 2283-85. The Commissioner based his disallowance on alternative bases: (1) the excess contributions were not ordinary and necessary business expenses under I.R.C. § 162(a); (2) even if the amounts constituted ordinary and necessary business expenses, they nevertheless were not deductible under I.R.C. §§ 404(a) and 419(a), which limit the deductibility of contributions paid to deferred compensation plans and welfare benefit plans. See App. at 2266, 2285.5
Second, the Commissioner determined with respect to the individual owners that amounts paid to the SC VEBA program increased personal incomes by $39,343 for Dr. Mall and her husband, $219,806 for Dr. Desai, $56,107 for Dr. McManus, $601,849 for Dr. Hirshkowitz, and $101,314 for Dr. Sobo (his estate). See App. at 2271, 2311, 2297, 2320. The Commissioner included the excess contributions as income to the individual taxpayers on alternative bases: (1) the amounts were deposited in the plans for the economic benefit of the individual taxpayers and as such constituted constructive dividends under I.R.C. §§ 61(a)(7) and 301; (2) assuming that the Neonatology and Lakewood Plans constituted deferred compensation plans, the excess contributions were includible under section 402(b). See App. at 2271, 2297, 2311, 2320. Lastly, the Commissioner determined that by reason of the underpayment of taxes the individual taxpayers were subject to penalties under I.R.C. § 6662(a).
Neonatology, Lakewood, and the individual owners petitioned the Tax Court challenging the IRS's determinations. After a bench trial, the court sustained the Commissioner on the ground that:
The Neonatology Plan and the Lakewood Plan are primarily vehicles which were designed and serve in operation to distribute surplus cash surreptitiously (in the form of excess contributions) from the corporations for the employee/owners' ultimate use and benefit.... The premiums paid for the C-group term policy exceeded by a wide margin the cost of term life insurance.... What is critical to our conclusion is that the excess contributions made by Neonatology and Lakewood conferred an economic benefit on their employee/owners for the primary (if not sole) benefit of those employee/owners, that the excess contributions constituted a distribution of cash rather than a payment of an ordinary and necessary business expense, and that neither Neonatology nor Lakewood expected any repayment of the cash underlying the conferred benefit.
Neonatology,
Without addressing the alternative grounds for the Commissioner's conclusions, the court rejected taxpayers' arguments that the possibility of forfeiture in certain situations like policy lapse or death rendered all excess payments into de facto contributions to life insurance protection. Id. at 89-90 ("The mere fact that a C-group term policyholder may forfeit the conversion credit balance does not mean, as petitioners would have it, that the balance was charged or paid as the cost of term life insurance."). The court also rejected the idea that contributions which in fact did not fund term life insurance were paid as compensation for services, rather than dividends, because as a factual matter neither Neonatology nor Lakewood had the requisite compensatory intent when the contributions were made. Id. at 93. Lastly, the court agreed with the Commissioner that the individual taxpayers were in fact negligent and could not circumvent the accuracy-related penalties by asserting a good faith, reliance-on-professional defense nor could they do so by claiming that the case involved tax matters of first impression.
The Tax Court entered its decisions on April 9, 2001. Taxpayers timely appealed on July 6, 2001. We have jurisdiction over this appeal pursuant to I.R.C. § 7482, and the Tax Court had jurisdiction over the petitions pursuant to I.R.C. §§ 6213(a) and 7442.
III. DISCUSSION
There are three principal issues before us on appeal: (1) whether the Tax Court correctly determined that the amounts contributed in excess of the cost of per annum term life insurance were not ordinary and necessary business expenses and therefore not deductible; if yes, (2) whether those amounts constituted dividends, includible as taxable individual income, or compensation to the individual taxpayers; and, (3) whether the individual taxpayers were negligent. Our review of the Tax Court's legal conclusions is plenary and is based on the "clearly erroneous" standard for its findings of fact. See ACM P'ship v. Comm'r,
A. The Deficiencies
Section 162(a) of the Internal Revenue Code7 allows for the deduction of all ordinary and necessary expenses incurred in carrying on a trade or business providing five requirements are met: the item claimed as deductible (1) was paid or incurred during the taxable year; (2) was for carrying on a trade or business; (3) was an expense; (4) was a necessary expense; and (5) was an ordinary expense. See Comm'r v. Lincoln Sav. & Loan Ass'n,
The record amply supports the conclusion that taxpayers paid artificially inflated premiums in a creative bookkeeping ploy conceived by their insurance specialists to exploit what they thought were loopholes in the tax laws. Indeed, we do not see how a court examining this case could conclude otherwise. Charles DeWeese, the Commissioner's expert, testified that amounts paid into the C-group policies exceeded conventional life insurance premiums by nearly 500%. See App. at 804-08, 2156.9 Evidence at trial demonstrated that Dr. Mall knew that term life insurance was substantially more expensive to buy through the SC VEBA than through other plans offered to her under the auspices of the American Medical Association and the American Academy of Pediatrics. She nevertheless opted to form the Neonatology Plan because she believed that it offered her the best tax benefits. See App. at 1025. Dr. Hirshkowitz testified that Lakewood intentionally paid more expensive premiums on the C-group policies than it would have for conventional life insurance protection. See App. at 998. Dr. Desai, another Lakewood owner, testified that his independent personal life insurance cost him substantially less than the policies issued pursuant to the SC VEBA. See App. at 1047. Like Dr. Mall, the Lakewood owners nevertheless invested in the SC VEBA program because of Cohen's representation of tax benefits and cash returns that they could anticipate receiving. See App. at 1014-15.
The record also reveals that excess premium amounts did not pay for actual current year life insurance protection but rather paid for conversion credits. The compliance manager of the Providian Corporation, the parent of the Commonwealth Life Insurance Company which issued policies involved here, stated in a letter to the IRS that the "premiums paid for the term policy are higher than the traditional term policy because of the conversion privilege and the costs of conversion credits." App. at 3690. DeWeese, belying taxpayers' claim that C-group premiums were higher than those under ordinary term life policies because they were calibrated to the higher risks of longer term employees in small markets,10 testified that the bulk of the gross premiums went to accumulate assets for distribution to the individual participants upon conversion. See App. at 2173. In addition, the record supports the conclusion that payments made to the Lakewood Plan for annuities were made not to fund current life insurance protection for employees but rather were made as an investment for the trustee to pay premiums on future C-group premiums. See App. at 976, 993-94, 1041-42.
In sum, the evidence fully supports, indeed compels, the finding that the contributions in excess of the amounts necessary to pay for annual term life insurance protection were distributions of surplus cash and not ordinary and necessary business expenses. Considering the sound reasoning of the Tax Court and our own intensive review of the facts here, we conclude that it is implausible that the owners of Neonatology and Lakewood, educated and highly trained medical professionals, knowingly would have overpaid substantially for term life insurance unless they contemplated receiving an added boon such as a tax-free return of the excess contributions.
Taxpayers advance two arguments to the effect that the court erred by not limiting its consideration to the written plan documents and life insurance contracts rather than relying on extraneous evidence like the plan marketing materials which discuss the availability of conversion credits. First, they maintain that the Neonatology and Lakewood SC VEBA programs were employee benefit plans under the Employee Retirement Income Security Act, 29 U.S.C. § 1001 et seq., (ERISA). Thus, they contend that representations made outside of the plan documents cannot be used to consider rights and obligations arising out of the plans. See Br. of Appellants at 35. Second, they argue that under governing state insurance law, the tax implications of a group term life insurance policy are determined only on the basis of the policy language itself. As the literal provisions of the plans discuss only insurance benefits — that is, a death benefit and an option to convert to an individual policy upon termination of employment — but say nothing about excess contributions returning as conversion credits, taxpayers claim that the Tax Court was compelled to conclude from the strict form of their plans that all contributions in fact went to providing insurance benefits.
Inasmuch as taxpayers did not raise the ERISA issue before the Tax Court, we need not consider it on this appeal. See Visco v. Comm'r,
In any event, even assuming for purposes of argument that the plans were employee benefit plans under ERISA, the fact remains that under well-established tax principles a court is not limited to plan documents in determining the tax consequences of a transaction. See, e.g., Comm'r v. Court Holding Co.,
Moreover, we reject taxpayers' contention that the Tax Court erred by not limiting its evaluation to the plan documents in light of state insurance law. The court did not construe or interpret the terms of the individual taxpayers' life insurance policies, but rather characterized the contributions made towards those policies for purposes of determining tax liabilities. While the former endeavor indeed would implicate state law,14 the latter is singularly a question of federal law. See, e.g., Thomas Flexible Coupling Co. v. Comm'r,
In view of our conclusion that the contributions in dispute were not ordinary and necessary business expenses under I.R.C. § 162(a), we next consider whether the district court erred in determining that the contributions constituted dividends rather than compensation to the individual taxpayers and thus deductible to the corporations on that basis.15 Under I.R.C. § 316(a), a dividend is a distribution of property made by a corporation to its shareholders out of its earnings and profits. See Comm'r v. Makransky,
In this case, the record fully supports the conclusion of the Tax Court that the individual taxpayers were chargeable with constructive dividends. Indeed, Neonatology and Lakewood, by design surrendering any expectation of remuneration, purchased products that generated a considerable economic bounty for their shareholders in the form of conversion credits. Furthermore, nothing in the record illustrates that taxpayers diverted these corporate assets with the requisite "compensatory intent." See King's Ct. Mobile Home Park, Inc. v. Comm'r,
Taxpayers again rely on non-tax ERISA jurisprudence for the exaggerated proposition that payments made pursuant to an employee benefit plan are necessarily compensatory.18 However, the plain language of I.R.C. § 419(a)(2) explicitly contemplates situations where contributions paid or accrued by an employer to a welfare benefit fund are not deductible (deductions allowed only if "they would otherwise be deductible"); see also Treas. Reg. § 1.162-10(a) (contributions to employee benefit plans deductible only if "they are ordinary and necessary business expenses."). To read otherwise inexplicably creates a shelter loophole by allowing taxpayers to transform disbursements into deductible business expenses merely by funneling them through an ERISA plan.
We recognize that it is axiomatic that taxpayers lawfully may arrange their affairs to keep taxes as low as possible.19 Nevertheless, at the same time the law imposes certain threshold duties which a taxpayer may not shirk simply by manipulating figures or maneuvering assets to conceal their real character. See Court Holding Co.,
B. The Penalties
Finally, we must consider the aptness of the penalties assessed by the Commissioner and upheld by the Tax Court. The Internal Revenue Code imposes a 20% tax on the portion of an underpayment attributable, among other things, to negligence or the disregard of rules and regulations. I.R.C. §§ 6662(a) and (b)(1). "Negligence" can include any failure to make a reasonable attempt to comply with the provisions of the Code, to exercise ordinary and reasonable care in the preparation of a tax return, to keep adequate books and records, or to substantiate items properly. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1). Generally speaking, the negligence standard as in the tort context is objective, requiring a finding of a lack of due care or a failure to do what a reasonable and prudent person would do under analogous circumstances. See, e.g., Schrum v. Comm'r,
On the basis of the record, the Tax Court was justified in concluding as a matter of fact that the individual taxpayers were liable for the section 6662 accuracy-related penalties because they did not meet their burden of proving due care. See Hayden v. Comm'r,
Taxpayers argue that their negligence should have been excused because they relied on the advice of professionals. While it is true that actual reliance on the tax advice of an independent, competent professional may negate a finding of negligence, see, e.g., United States v. Boyle,
The Tax Court concluded that taxpayers could not prevail on a reliance-on-professional defense because they received advice only from Cohen, an insurance agent who stood to profit considerably from the participation of Neonatology and Lakewood in the VEBA program, rather than from a competent, independent tax professional with sufficient expertise to warrant reliance. The circumstances here, including the facts that certified public accountants prepared taxpayers' returns, the New Jersey Medical Society — a group with dubious tax code proficiency which in fact received royalties to endorse the SC VEBA20 — purportedly endorsed the program, and the engagement agreement between PES and the employers stated that PES would submit the trust to the IRS for qualification,21 do not suffice for us to disturb the Tax Court's negligence finding on a clear error basis. See Merino v. Comm'r,
In reaching our result, we acknowledge that Dr. Hirshkowitz deviated from the thoroughly head-in-the-sand posture of his fellow taxpayers by soliciting his accountant's opinion of the SC VEBA. See App. at 6666-67. Nevertheless, the record supports the court's finding with respect to Dr. Hirshkowitz, considering that he did not introduce into evidence precisely what information he showed to his accountant, precisely what advice his accountant gave him, and, more generally, the qualifications of his accountant.
We also add the following. When, as here, a taxpayer is presented with what would appear to be a fabulous opportunity to avoid tax obligations, he should recognize that he proceeds at his own peril. In this case, PES devised a program which it marketed as "creat[ing] a tax deduction for the contributions to the employee welfare benefit plan going in and a permanent tax deferral coming out." As highly educated professionals, the individual taxpayers should have recognized that it was not likely that by complex manipulation they could obtain large deductions for their corporations and tax free income for themselves.22
In a final attempt to skirt the additional penalties, taxpayers argue that a finding of negligence could not in fairness arise out of a case resolving tax issues of first impression. In this regard, we point out that the parties have indicated that this case is indeed without direct precedent and that other cases are awaiting our disposition.23 This argument, however, does not sway us for this case does not involve novel questions of law but rather is concerned with the application of well-settled principles of taxation to determine whether certain expenditures made by close corporations are deductible as ordinary and necessary business expenses or taxable as constructive dividends. While the setting in which these principles have come to bear is no doubt unusual with its VEBAs, C-group policies, and conversion credits, the law was nevertheless pellucid that taxpayers should have endeavored to verify the validity of their deductions before claiming them.24 Moreover, they should have been apprehensive when they examined the scheme, for experience shows that when something seems too good to be true that probably is the case. Overall, we are satisfied that taxpayers now must abide the consequences of the Commissioner's audit as sustained by the Tax Court, including the finding of liability for accuracy-related penalties under section 6662.
IV. CONCLUSION
For the foregoing reasons, we will affirm the decisions of the Tax Court.
Notes:
Notes
Honorable John P. Fullam, Senior Judge of the United States District Court for the Eastern District of Pennsylvania, sitting by designation
Notwithstanding what might be regarded as a geographical anomaly, only the SC VEBA is involved here. There was, however, an additional petitioner in the Tax Court, not a party on this appeal, Wan B. Lo, d/b/a Marlton Pain Control and Acupuncture Center, who established a plan under the NJ VEBA
Under the policies, conversion was allowed when group coverage ceased because (1) the employee ceased employment, (2) the employee left the class eligible for coverage, (3) the underlying contract terminated, (4) the underlying contract was amended to terminate or reduce the insurance of a class of insured employees, or (5) the underlying contract terminated as to an individual employer or planSee App. at 1836, 1846.
Under the applicable schedule, none of the conversion credit balance is transferred to the C-group conversion UL policy if conversion occurs in the C-group term policy's first year. However, if conversion takes place in the C-group term policy's fourth year or beyond, 95% of the conversion credit balance is transferred to the C-group conversion UL policy. Policyholders could not receive more than 95% of their conversion credit balance because a five percent commission was paid automatically to the insurance agent upon conversionSee App. at 2161-62, 4710, 4713.
Notably, the interest due on any loan policy was equal to the interest credited on the asset accumulation. In other words, there were no out-of-pocket costs to the debtor-policyholderSee App. at 2164. To hedge the attendant C-group product risks, Inter-American and Commonwealth reinsured with a third party.
Specifically, the Commissioner ruled that as deferred compensation plans, the Neonatology and Lakewood Plans did not satisfy the I.R.C. § 404(a)(5) "separate account" requirement for the contributions to be deductible. If the plans were characterized as welfare benefit funds, I.R.C. § 419(b) limited the deductions as the plans could not qualify for the "10-or-more-employer plans" exception to section 419(b) in I.R.C. § 419A(f)(6)
The burden of proof may be shifted to the Commissioner in certain circumstances for audits conducted after July 22, 1998See I.R.C. § 7491. These modifications to the Internal Revenue Code have no bearing on this case.
The Internal Revenue Code, I.R.C. § 162(a), provides that "[t]here shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business."
Of course, the mere fact that the benefit is a form of deductible compensation does not necessarily mean that it is taxable to the employeeSee I.R.C. § 79. We note that the parties do not treat section 79 as significant here.
It should be noted that the Tax Court made certain credibility determinations, finding DeWeese, an independent consulting actuary, to be a "reliable, relevant, and helpful" witness whose testimony was bolstered by a voluminous record with stipulations to more than 2,000 facts and with more than 1,500 exhibitsSee Neonatology,
See Br. of Appellants at 44 and n. 30.
An amicus brief has been filed in this case on behalf of five physician-participants in the VEBA program who have filed a civil complaint against the insurance companies that wrote the C-group policies,Sankhla v. Commonwealth Life Ins. Co. et al., No. 01-CV-4761 (U.S.D.C.N.J.). Amici have an interest in the outcome of this case because the extent to which we address whether the plans are governed by ERISA could affect resolution of the issue of whether their state law claims against the insurance companies are preempted. See Amicus Br. at 1-2. Rather than needlessly prejudice the rights of litigants in separate proceedings, we do not discuss the applicability of ERISA to the VEBA plans.
Taxpayers, conflating the so-called "substance over-form" doctrine with the "economic substance" or "sham transaction" doctrine, mistakenly argue as well that a court may not disregard the form of an arrangement until it determines that the arrangement lacks any economic substance other than obtaining tax deductionsSee Br. of Appellants at 41 ("If... there is any economic substance to the arrangement apart from the alteration of tax liabilities, then the form of the arrangement must be respected, even if the arrangement was motivated by tax avoidance or minimization."). In actuality, the two doctrines are distinct. The substance-over-form doctrine is applicable to instances where the "substance" of a particular transaction produces tax results inconsistent with the "form" embodied in the underlying documentation, permitting a court to recharacterize the transaction in accordance with its substance. The economic substance doctrine, in contrast, applies where the economic or business purpose of a transaction is relatively insignificant in relation to the comparatively large tax benefits that accrue (that is, a transaction "which actually occurred but which exploit[s] a feature of the tax code without any attendant economic risk," Horn v. Comm'r,
See Br. of Appellants at 29-36 (citing Gruber v. Hubbard Bert Karle Weber, Inc.,
Curiously, taxpayers fail to specify which state's insurance law applies: New Jersey, where all of the physicians reside, or Pennsylvania, where the insurance agents who promoted the VEBA were located
In their brief, taxpayers indicate that the Tax Court erred in characterizing the "disallowed contributions as constructive dividends rather than deductible compensation." Br. at 46 (emphasis added)See King's Ct. Mobile Home Park, Inc. v. Comm'r,
To qualify as deductible compensation, a payment also need be reasonableSee Treas. Reg. § 1.162-7(a). We do not need to address this point, as the Tax Court correctly determined as a matter of fact that taxpayers did not demonstrate compensatory intent.
We are satisfied that the mere fact that Dr. Mall partially diverted the benefits to her husband should not change our result
Taxpayers misreadPediatric Surgical Assoc., P.C. v. Comm'r,
See Gregory v. Helvering,
See App. at 570-71.
Notably, the agreement does not say that the IRS did qualify the plan. In fact, as the government points out, the IRS expressly disavowed any opinion as to whether contributions to the plan were deductibleSee App. at 1410.
It well may be that reliance on the advice of a professional should only be a defense when the professional's fees are not dependent on his opinion. For example, it is not immediately evident why a taxpayer should be able to take comfort in the advice of a professional promoting a tax shelter for a fee. After all, that professional would have an interest in his opinion. Consideration of this point, however, will have to wait for another day
The Tax Court observed that this case is a test case with the result resolving other cases involving SC VEBA and NJ VEBA plans and that the parties in 19 other cases pending before the Tax Court have agreed to be bound by the decision hereSee Neonatology,
We recognize that courts have overlooked negligence penalties in cases of first impression that involve unclear statutory languageSee, e.g., Mitchell v. Comm'r,