Neonatology Associates, P.A. v. Commissioner ( 2000 )

115 T.C. No. 5UNITED STATES TAX COURT
NEONATOLOGY ASSOCIATES, P.A., ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 1201-97, 1208-97, Filed July 31, 2000.
2795-97, 2981-97,
2985-97, 2994-97,
2995-97, 4572-97.
Certain insurance salesmen formed two purported
voluntary employees’ beneficiary associations (VEBA’s)
to generate commissions on their sales of life and
other insurance products purchased through the VEBA’s.
Each employer/participant contributed to its own plan
formed under the VEBA’s, and each plan generally
provided that a covered employee would receive current-
1
Cases of the following petitioners are consolidated
herewith: John J. and Ophelia J. Mall, docket No. 1208-97; Estate
of Steven Sobo, Deceased, Bonnie Sobo, Executrix, and Bonnie
Sobo, docket No. 2795-97; Akhilesh S. and Dipti A. Desai, docket
No. 2981-97; Kevin T. and Cheryl McManus, docket No. 2985-97;
Arthur and Lois M. Hirshkowitz, docket No. 2994-97; Lakewood
Radiology, P.A., docket No. 2995-97; and Wan B. and Cecilia T.
Lo, docket No. 4572-97.
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year (term) life insurance on his or her life.
Premiums on the underlying insurance policies were
substantially greater than the cost of term life
insurance because they funded both the cost of term
life insurance and credits which would be applied to
conversion universal life policies of the individual
insureds. The credits applied to a conversion policy
were “earned” on that policy evenly over 120 months,
meaning that policyholders generally could withdraw any
earned amount or borrow against it with no out-of-
pocket expense.
Held: The corporate employer/participants (N and
L) may not deduct contributions to their plans in
excess of the cost of term life insurance.
Held, further, L may deduct payments made outside
its plan for life insurance on two of its employees to
the extent the payments funded term life insurance.
Held, further, neither M, a sole
proprietorship/participant, nor N may deduct
contributions to its plan to purchase life insurance
for certain nonemployees.
Held, further, sec. 264(a)(1), I.R.C., precludes M
from deducting contributions to its plan to purchase
life insurance for its two employees.
Held, further, in the case of N and L, the
disallowed deductions are constructive dividends to
their employee/owners.
Held, further, Ps are liable for the accuracy-
related penalties for negligence or intentional
disregard of rules or regulations determined by R under
sec. 6662(a), I.R.C.; L also is liable for the addition
to tax for failure to file timely determined by R under
sec. 6651(a), I.R.C.
Held, further, no P is liable for a penalty under
sec. 6673(a)(1)(B), I.R.C.
Neil L. Prupis, Kevin L. Smith, and Theresa Borzelli, for
petitioners.
Randall P. Andreozzi, Peter J. Gavagan, Mark A. Ericson, and
Matthew I. Root, for respondent.
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LARO, Judge: The docketed cases, consolidated for purposes
of trial, briefing, and opinion, represent three test cases
selected by the parties to resolve their disagreements as to
certain voluntary employees’ beneficiary association (VEBA)
plans; namely, the Southern California Medical Profession
Association VEBA (SC VEBA) and the New Jersey Medical Profession
Association VEBA (NJ VEBA).2 The parties in 19 other cases
pending before the Court have agreed to be bound by the decisions
we render herein as to these VEBA issues.
Two of the test cases involve a corporate employer and one
or more employee/owners. These employer/employee groups are the
Neonatology Associates, P.A (Neonatology), group and the Lakewood
Radiology, P.A. (Lakewood), group. These groups relate to two
purported welfare benefit funds formed under the SC VEBA; namely,
the Neonatology Employee Welfare Plan (Neonatology Plan) and the
Lakewood Employee Welfare Plan (Lakewood Plan).3
The third test case involves an individual working as a sole
proprietor and two of his employees. This group is the Wan B.
Lo, Ph.D., D.O., d.b.a. Marlton Pain Control and Acupuncture
2
We use the terms “VEBA” and “plan” for convenience and do
not suggest that any or all of the subject arrangements are
either bona fide plans for Federal income tax purposes or VEBA’s
under sec. 501(c)(9).
3
Petitioners argue that these plans are welfare benefit
funds within the meaning of sec. 419(e). Respondent argues to
the contrary. We do not decide this issue.
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Center (Marlton) group. The Marlton group relates to the Marlton
Employee Welfare Plan (Marlton Plan), a purported welfare benefit
fund formed under the NJ VEBA.4
In regard to each test case, respondent determined that the
employer or sole proprietor could not deduct its or his
contributions to the respective plan and, in the case of
Neonatology and Lakewood, that the employee/owners had income to
the extent that he or she benefited from a contribution.5
Respondent determined that each petitioner was liable for
deficiencies in Federal income tax as a result of the VEBA
determinations and that each petitioner was liable for a related
accuracy-related penalty under section 6662(a) for negligence or
intentional disregard of rules or regulations. In the case of
Lakewood, respondent also determined that it was liable for a 15-
percent addition to tax under section 6651(a) for failure to file
timely its 1992 Federal income tax return and a section 6621
increased rate of interest on its 1991 deficiency as to interest
accruing after July 20, 1995.
Each petitioner petitioned the Court to redetermine
respondent’s determinations. Respondent’s notices of deficiency
4
We do not decide whether this plan is a welfare benefit
fund under sec. 419(e).
5
Respondent also made certain other adjustments of income
and expense. Petitioners concede these adjustments, unless they
are mathematical computations relating to the VEBA issues.
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list the following deficiencies, addition to tax, and accuracy-
related penalties:6
Neonatology Group
Neonatology, docket No. 1201-97
Addition to Tax Accuracy-Related Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)
1992 $1,620 — $324
1993 6,262 — 1,252
John J. and Ophelia J. Mall, docket No. 1208-97
Addition to Tax Accuracy-Related Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)
1992 $6,186 — $1,237
1993 7,404 — 1,481
Lakewood Group
Lakewood, docket No. 2995-97
Addition to Tax Accuracy-Related Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)
1991 $169,437 — $33,887
1991 — — —
1992 71,110 $10,667 14,222
1993 93,111 — 18,622
Estate of Steven Sobo, Deceased, Bonnie Sobo, Executrix, and
Bonnie Sobo, docket No. 2795-97
Addition to Tax Accuracy-Related Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)
1991 $27,729 — $5,546
1992 5,107 — 1,021
1993 3,018 — 604
6
All years refer to the calendar year, except that, in the
case of Lakewood, the first 1991 year is a fiscal year ended on
Oct. 31, 1991, and the second 1991 year is a short taxable year
ended on Dec. 31, 1991.
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Akhilesh S. and Dipti A. Desai, docket No. 2981-97
Addition to Tax Accuracy-Related Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)
1991 $42,047 — $8,409
1992 15,751 — 3,150
1993 25,016 — 5,003
Kevin T. and Cheryl McManus, docket No. 2985-97
Addition to Tax Accuracy-Related Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)
1991 $6,821 — $1,364
1992 6,146 — 1,229
1993 8,214 — 1,643
Arthur and Lois M. Hirshkowitz, docket No. 2994-97
Addition to Tax Accuracy-Related Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)
1991 $82,933 — $16,587
1992 45,233 — 9,047
1993 79,853 — 15,971
Marlton Group
Wan B. and Cecilia T. Lo, docket No. 4572-97
Addition to Tax Accuracy-Related Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)
1993 $41,807 — $8,361
1994 49,970 — 9,994
We decide the following issues:
1. Whether Neonatology and Lakewood may deduct
contributions to their respective plans in excess of the amounts
needed to purchase current-year (term) life insurance for their
covered employees. We hold they may not.
2. Whether Lakewood may deduct payments made outside of its
plan to purchase additional life insurance for two of its
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employees. We hold it may to the extent that the payments funded
term life insurance.
3. Whether Neonatology may deduct contributions made to its
plan to purchase life insurance for John Mall (Mr. Mall), who was
neither a Neonatology employee nor a person eligible to
participate in the Neonatology Plan. We hold it may not.
4. Whether Marlton may deduct contributions to its plan to
purchase insurance for its sole proprietor, Dr. Lo, who was
neither a Marlton employee nor a person eligible to participate
in the Marlton Plan. We hold it may not.
5. Whether section 264(a) precludes Marlton from deducting
contributions to its plan to purchase term life insurance for its
two employees. We hold it does.
6. Whether, in the case of Lakewood and Neonatology, the
disallowed contributions/payments are includable in the
employee/owners’ gross income.7 We hold they are.
7. Whether petitioners are liable for the accuracy-related
penalties for negligence or intentional disregard of rules or
regulations determined by respondent under section 6662(a). We
hold they are.
7
Petitioners concede that the contributions are includable
in the employees’ gross income to the extent that they provided
current-year life insurance protection.
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8. Whether Lakewood is liable for the addition to tax for
failure to file timely determined by respondent under section
6651(a). We hold it is.
9. Whether we should grant respondent’s motion to impose a
$25,000 penalty against each petitioner under section
6673(a)(1)(B). We hold we shall not.
Unless otherwise indicated, section references are to the
Internal Revenue Code applicable to the relevant years, Rule
references are to the Tax Court Rules of Practice and Procedure,
and dollar amounts are rounded to the dollar.
FINDINGS OF FACT
I. Overview of Petitioners
Neonatology is a professional medical corporation wholly
owned by Ophelia J. Mall, M.D. (Dr. Mall). Its principal place
of business was in New Jersey when we filed its petition. Dr.
Mall and her husband, Mr. Mall (collectively, the Malls), resided
in New Jersey when we filed their petition.
Neonatology reports its income and expenses for Federal
income tax purposes using the cash receipts and disbursements
method and the calendar year. It reported the following relevant
amounts on its 1992 and 1993 Federal corporate income tax
returns:
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1992 1993
Total income $282,104 $213,092
Officer compensation 250,000 168,000
Salaries & wages -0- -0-
Pension, profit-sharing, plans -0- -0-
Employee benefit programs 26,000 28,623
Taxable income (loss) (18,881) (20,958)
Income tax -0- -0-
Alt. minimum tax -0- -0-
Lakewood is a professional medical corporation owned equally
by Arthur Hirshkowitz (Dr. Hirshkowitz), Akhilesh Desai (Dr.
Desai), Kevin T. McManus (Dr. McManus), and Steven Sobo (Dr.
Sobo), until his death on September 23, 1993, and by Vijay
Sankhla (Dr. Sankhla) afterwards. When we filed the petitions of
the various members of the Lakewood group,8 Lakewood’s principal
place of business and the residence of each individual (and his
or her spouse) was in New Jersey.
Lakewood reports its income and expenses for Federal income
tax purposes using the cash receipts and disbursements method
and, but for 1991, using the calendar year; its 1991 taxable
years consist of a fiscal year ended on October 31, 1991, and a
short taxable year ended on December 31, 1991. It reported the
following relevant amounts on its Federal corporate income tax
returns for the subject years:
8
The members of the Lakewood group are Lakewood, Drs.
Hirshkowitz, Desai, and McManus, and the Estate of Steven Sobo,
Deceased.
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1993
10/1991 12/1991 1992 (As amended)
Total income $2,303,425 $403,869 $2,411,265 $2,286,460
Officers’ compensation 987,554 350,000 1,171,931 940,895
Salaries & wages 148,750 29,167 200,565 303,750
Pension, profit-sharing, plans 46,907 25,000 132,428 169,170
Employee benefit programs -0- -0- -0- -0-
Other deductions (VEBA contribution) 480,901 -0- 209,869 296,056
Taxable income (loss) 3,664 (103,857) (23,325) (7,796)
Income tax 1,246 -0- -0- -0-
Alt. minimum tax -0- -0- -0- 20,531
It filed its 1992 Federal corporate income tax return untimely on
May 28, 1993.
Marlton is a sole proprietorship owned by Wan B. Lo (Dr.
Lo), and he reports Marlton’s income and expenses on his personal
Schedule C, Profit or Loss from Sole-Proprietor Business, using
the cash receipts and disbursements method and the calendar year.
Dr. Lo reported the following amounts for Marlton on Schedules C
of his joint 1993 and 1994 Federal individual income tax returns:
1993 1994
Gross income $875,477 $868,275
Wages 130,944 124,939
Pension, profit-sharing, plans 16,920 17,396
Employee benefit programs 100,000 120,000
Net profit 406,863 381,122
Dr. Lo and his wife, Cecilia (Ms. Lo) (collectively, the Los),
resided in New Jersey when we filed their petition.
II. The Subject VEBA’s
Pacific Executive Services (PES) was a California
partnership formed by two insurancemen named Stephen R. Ross (Mr.
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Ross) and Donald S. Murphy (Mr. Murphy).9 PES devised the idea
of using a speciously designed life insurance product in the
setting of deviously designed VEBA’s to prosper financially from
the enactment of the Tax Reform Act of 1986 (TRA), Pub. L. 99-
514, 100 Stat. 2085. PES believed that the TRA restricted the
ability of closely held businesses to reduce their tax
liabilities through contributions to retirement and employee
benefit plans. PES believed that the TRA gave PES the
opportunity to market aggressively to owners of such businesses a
novel tax avoidance scheme. PES anticipated that few of the
prospective investors in the scheme would be interested in
purchasing life insurance, the subject matter of the scheme, but
that these persons would purchase the life insurance (C-group
term) product described below in order to get the advertised
benefits.
PES united with Barry Cohen (Mr. Cohen), a longtime
insurance salesman, to market the subject VEBA’s to medical
professionals primarily through the Kirwan Cos. (Kirwan). Mr.
Cohen is an officer, director, and part owner of Kirwan. He is
not an attorney or an accountant. Michael J. Kirwan (Mr. Kirwan)
9
PES dissolved on or about Nov. 11, 1992, and Messrs. Ross
and Murphy each formed a sole proprietorship under the respective
names of Sea Nine Associates and DSM inc. Sea Nine Associates
and DSM inc. divided up the participants in the VEBA’s. For
simplicity, subsequent references to PES may include Sea Nine
Associates and DSM inc.
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is Kirwan’s president and other part owner. Mr. Kirwan is not an
attorney or an accountant.
Kirwan represented to prospective investors during its
marketing of one or both of the subject VEBA’s that the VEBA’s
let an investor make unlimited tax-deductible contributions to
his or her separate plan and that each plan would give a covered
employee significant paid-up life insurance when he or she left
the plan.10 PES represented to prospective investors that each
of the subject VEBA’s gave investors
the ability to park funds for several years while the
funds continue to grow at interest in a tax free
environment. While most people would be happy to take
accumulated funds, pay the tax due at that time at
ordinary rates, [sic] we have created a plan which
provides for a permanent deferral of all the taxes due,
either during ones [sic] lifetime or to the heirs. In
summary, we create a tax deduction for the
contributions to the * * * [VEBA] going in and a
permanent tax deferral coming out.
* * * * * * *
Each individual employer establishes his own level of
benefits and has his own trust account with a third
party trustee * * *. The contribution goes into the
individual trust account for each employer and the
benefits provided under the plan are paid for out of
the individual accounts. Each employer receives
reports which apply only to his account.
The SC VEBA and the NJ VEBA were formed by the Southern
California Medical Profession Association and the New Jersey
10
We use the term “paid-up” in this context to mean that
the insured did not have to make any additional premium payments
on the underlying policy.
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Medical Profession Association, respectively. PES established,
manages, and controls both of these associations, neither of
which is a valid or operating professional association. PES
established both associations for the sole purpose of forming the
subject VEBA’s and of furthering its VEBA scheme by misleading
targeted investor/medical professionals into believing that
respectable, established medical associations were sponsoring an
investment in the VEBA’s. PES named the VEBA’s after the medical
profession to attempt further to legitimize its sale of the
advertised tax benefits with the targeted investors. PES paid an
established medical society, the Medical Society of New Jersey, a
voluntary society of physicians and surgeons operating in the
State of New Jersey, approximately $25,000 to endorse the SC VEBA
as a final attempt to legitimize its scheme. PES represented to
the Medical Society of New Jersey that the SC VEBA provided
medical professionals with tax-deductible payments for high
policy limits of life insurance and the potential to convert some
or all of those payments into annuities or cash value life
insurance which would allow the policyholders ultimately to
withdraw that cash value tax free.
The subject VEBA’s are structured so that each participating
employer establishes its own plan thereunder, executes its own
plan document, and has a plan name that bears its own name. Each
employer, with the aid of an insurance salesman (primarily Mr.
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Cohen), selects its plan administrator, the members of the
committee administering its plan, and the level of benefits
offered under its plan;11 the only employee benefit provided
under the subject VEBA’s is a current-year death benefit payable
at a specified multiple of prior-year compensation. Each
employer generally funds its plan with a limited number of group
insurance policies and/or group annuities owned by its plan for
the benefit of its employees. All group life insurance policies
must provide explicitly that the insured individual may convert
his or her policy, without medical examination, to an individual
policy upon termination of eligibility for coverage.
Each employer has its own trust account maintained under its
plan for its covered employees, and each plan is accounted for
separately. A covered employee has no recourse for benefits
other than, first, from insurance contracts on his or her life
and, second, from any assets held in the employer’s plan.
Employees covered by one plan cannot reach assets of another
plan, and occurrences in one plan do not affect another plan’s
operation. Each plan prepares its own separate summary plan
description, each employer may amend its plan at any time, and
each employer may terminate its plan at any time by delivering
11
The committee members of the Neonatology Plan and the
Lakewood Plan are Messrs. Murphy, Cohen, and Kirwan, and the
committee members of the Marlton Plan are Mr. Ross, Daniel
Sonnelitter, and Timothy S. Lo. PES administered all three plans
at all times relevant herein.
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written notice of termination to the trustee. When an employer
terminates its plan, assets remaining in that plan are
distributed to the employer’s covered employees in proportion to
their compensation.
Independent entities serve as trustees of the respective
trusts underlying the subject VEBA’s, and each trust’s terms are
the same except for the sponsor’s name. Under the trusts’ terms,
each participating employer agrees to make the contributions
required by the administrator to provide benefits under the plan,
and neither the participating employer nor another employer is
liable for a participating employer’s contributions. Any
benefits payable under one plan are paid solely from that plan’s
allocable share of the trust fund, and neither the participating
employer, administrator, nor trustee is liable for the inadequacy
of funds required to be paid. Each plan and corresponding trust
account benefit exclusively the related employer’s covered
employees and their beneficiaries, and no part of that trust
account may be used for, or diverted to, purposes other than the
exclusive benefit of those employees.
III. The Insurance Companies
The Inter-American Insurance Co. of Illinois (Inter-
American) specializes in providing to small, closely held
corporations products such as qualified pension and profit
sharing plans and group life insurance plans. When Inter-
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American was formed in the late 1970’s, it was owned indirectly
by Beaven/Inter-American Cos., Inc. (Beaven/Inter-American), the
wholly owned company of Raymond G. Ankner (Mr. Ankner), who has
worked in the insurance industry for more than 30 years. Inter-
American liquidated on December 23, 1991, pursuant to a court
order to do so, and Beaven/Inter-American changed its name to
Beaven Cos., Inc. Mr. Ankner currently markets the life
insurance products described herein through a company of his
called CJA & Associates.
Capital Holding Agency Group, Inc. (Capital Holding),
underwrites life and health insurance, annuities, and other
insurance products offered for sale through certain of its
affiliated insurance companies; e.g., Commonwealth Life Insurance
Co. (Commonwealth) and Peoples Security Life Insurance Co.
(Peoples Security, sometimes referred collectively with
Commonwealth as Commonwealth). Capital Holding changed its name
to Providian Agency Group, Inc., in 1994, and 3 years later,
AEGON NV acquired Providian Agency Group, Inc., Commonwealth, and
Peoples Security. Commonwealth and Peoples Security merged with
the Monumental Life Insurance Co. in 1998, and all three
companies are currently part of the AEGON USA Insurance Group
(AEGON USA).
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IV. The Life Insurance Products
Inter-American and Commonwealth both issue a virtually
identical conventional group term life insurance product known as
the millennium group 5 (MG-5) policy. Premiums on an MG-5 policy
are generally commensurate with the life insurance risk assumed
by the issuing company and do not present policyholders with
asset accumulation. The MG-5 policies allow policyholders to
convert their policies to 5-year level annual renewable term,
universal or whole life products which do not have any
accumulated value (or “conversion credits” as that term is
described below).
Inter-American and Commonwealth both issue a second
virtually identical innovative life insurance product known as
the continuous group (C-group) product. The C-group product is a
novel product designed by Inter-American (and later adopted by
Commonwealth) to masquerade as a policy that provides only term
life insurance benefits in order to make the product marketable
to targeted investors and to allow Inter-American to make life
insurance purchases from it more attractive than purchases from
its larger competitors. The C-group product is actually a
universal life product consisting of two related policies. The
first policy, the accumulation phase of the C-group product, is a
group term life insurance policy known as the C-group term
policy. The second policy, the payout phase of the C-group
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product, is an individual universal life insurance policy known
as the C-group conversion universalife (UL) policy. The C-group
conversion UL policy is referenced in the C-group term contract
and the C-group conversion UL contract as a “special conversion
policy”.
The C-group term policy provides covered employees with a
life insurance (death) benefit while they work and a cash value
that they may access by converting the term policy to the C-group
conversion UL policy. Commonwealth and Inter-American assumed
that 95 percent of the C-group term policyholders would
ultimately convert their policies to C-group conversion UL
policies, and they priced both policies together as two
components of a single policy. Premiums on the C-group term
policy are paid annually, and these premiums are approximately
four to six times greater than premiums for a conventional life
insurance group term policy (e.g., the MG-5 policy); as discussed
infra, premiums on the C-group term policy fund both
preconversion death benefits and postconversion credits
(conversion credits) anticipated to be applied to the C-group
conversion UL policy. If a premium is not paid timely on the C-
group term policy, the policy terminates; i.e., lapses. Upon its
lapsing, an individual policyholder has a guaranteed right (i.e.,
without evidence of insurability) to convert his or her policy to
an individual policy; e.g., the C-group conversion UL policy. A
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covered employee converts from a C-group term policy to a C-group
conversion UL policy merely by filing an application.
The C-group conversion UL policy was specially designed for
employees converting from the C-group term policy to individual
coverage, and, absent an additional expense, it is issued only to
individuals who convert from the C-group term policy to
individual coverage. An insured employee has the right to
convert, generally without expense, from the C-group term policy
to a C-group conversion policy with equal or less face value if
group coverage ceases because (1) the employee ceases employment,
(2) the employee leaves the class eligible for coverage, (3) the
underlying contract terminates, (4) the underlying contract is
amended to terminate or reduce the insurance of a class of
insured employees, or (5) the underlying contract terminates as
to an individual employer or plan.12 Upon conversion, conversion
credits are transferred from the C-group term policy to the C-
group conversion UL policy in a total amount that would
approximate the cash value that would have been present if a
typical universal life policy had been purchased when the C-group
term policy was first issued. Inter-American and Commonwealth
12
As discussed below, many of the individual petitioners
ultimately received a C-group conversion UL policy by converting
a C-group term policy. Each of these conversions occurred
although none of these five conditions was met. The parties to
the C-group product expected and understood that a C-group term
policy could be converted at any time at the election of the
insured.
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developed and used tables to reference the amount of conversion
credits which would accumulate under the C-group term policy and
be transferred to the C-group conversion UL policy upon
conversion, and the table amounts were referenced in marketing
materials provided to prospective customers; no C-group term
policyholder who converted to a C-group conversion UL policy ever
received anything less than the appropriate amount referenced in
the tables. Upon conversion, the C-group conversion UL policy is
generally fully funded, and C-group conversion UL policyholders
need not pay additional premiums on the C-group conversion UL
policy. A converting policyholder may, if he or she desires, pay
additional premiums on the C-group conversion UL policy. None of
the individual petitioners chose to do so.
Mr. Ankner designed the concept of conversion credits to
allow the C-group term policy to operate in tandem with the C-
group conversion UL policy, while preserving the appearance and
argument that the two policies were separate and distinct.
Conversion credits generally work as follows. With respect to
each premium paid on the C-group term policy, the portion that
exceeds the applicable mortality charge (cost of insurance) is
set aside in a conversion credit account bearing interest at 4.5
percent per annum for transfer to the C-group conversion UL
policy upon conversion thereto. Upon conversion, the conversion
credits which have accumulated up to that time (conversion credit
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balance) are generally transferred to the C-group conversion UL
policy in accordance with a schedule under which (1) 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, (2) 47.5 percent of the conversion credit
balance is transferred to the C-group conversion UL policy if
conversion occurs in the C-group term policy’s second year, (3)
90.25 percent of the conversion credit balance is transferred to
the C-group conversion UL policy if conversion occurs in the C-
group term policy’s third year, and (4) 95 percent of the
conversion credit balance is transferred to the C-group
conversion UL policy if conversion occurs in the C-group term
policy’s fourth or later year.13 Policyholders never receive
more than 95 percent of their conversion credit balance because
the insurance salesperson, upon conversion, is paid a commission
equal to 5 percent of that balance. Conversion credits
transferred from the C-group term policy to the C-group
conversion UL policy are applied to the cash value in the C-group
conversion UL policy (i.e., they are earned by the policyholder
and made available to him or her) in 120 monthly installments,
13
For C-group term policies issued after Jan. 31, 1993, 0
percent of the conversion credit balance is transferred to the C-
group conversion UL policy if conversion occurs in the policy’s
first 4 years, and 95 percent of the conversion credit balance is
transferred to the conversion policy if conversion occurs at any
other time.
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beginning with the month of conversion.14 C-group conversion UL
policyholders may borrow against their policies up to the net
loan value (i.e., cash value less any prior outstanding loans),
and, after the fourth year, any loans are at the same interest
rate as is credited to the conversion credit balance.
Statutory reserves are maintained for the C-group term
policies in an amount that equals the greater of: (1) The
minimum statutory reserve for group term life insurance, which
excludes consideration of the conversion benefits, or (2) the
present value of expected future payments under the policies
(including both death benefits and applied conversion credits)
less the present value of expected future premiums.15 Present
values are calculated using best-estimate assumptions as to
interest, mortality, lapses, and expenses. Inter-American and
Commonwealth reinsured with a third party certain amounts of the
risk associated with the C-group product.
The C-group term policy provides an annual experience refund
to the policyholder. Interest of 4.5 percent per annum is
14
An insurance company usually imposes a surrender charge
upon a policyholder who surrenders his or her policy before the
insurance company recovers its costs as to that policy. The C-
group conversion UL policy was generally designed without
surrender charges by treating portions of the conversion credit
balance as earned and unearned, depending on the number of months
that the policy was held. A policyholder forfeits the unearned
portion upon surrender of the policy.
15
Statutory reserves were maintained separately for the C-
group conversion UL policies.
- 23 -
credited to the conversion credit balance at or about the end of
each certificate year, and, to the extent that the interest on
the funds reflected in the balance actually exceeds the credited
amount, the excess is returned to the policyholder as an
experience refund. The experience refund is credited to the
policyholder as a reduction of the next premium due on the
policy.
V. The Neonatology Plan
Mr. Cohen introduced Dr. Mall to the SC VEBA, and she
decided on her own, without seeking the advice of an independent
knowledgeable professional, to cause Neonatology to invest
therein. Dr. Mall knew that term life insurance was
substantially more expensive to buy through the SC VEBA than
through other plans offered to her by the American Medical
Association and the American Academy of Pediatrics. She believed
that the SC VEBA was the best investment for Neonatology because
it offered her the proffered tax benefits and accumulated value.
Dr. Mall received correspondence on the SC VEBA but generally
chose not to read it before investing in the SC VEBA.
Neonatology established the Neonatology Plan under the SC
VEBA on January 31, 1991, effective January 1, 1991, and the
Malls were the only persons covered by that plan during the
relevant years. Mr. Mall was not a paid employee of Neonatology,
and he was not eligible to join the plan. Dr. Mall and PES, the
- 24 -
plan administrator, allowed Mr. Mall to join the plan, and they
made him eligible to receive a death benefit in an amount
commensurate with the death benefit payable under other life
insurance that he had owned outside the plan. Dr. Mall falsified
and backdated documents in an attempt to legitimize Mr. Mall’s
participation in the Neonatology Plan and to attempt to
legitimize the plan with various governmental agencies and
regulatory bodies.
The Neonatology Plan’s adoption agreement provides that all
employees covered by the plan will receive a death benefit equal
to 6.5 times his or her prior-year “compensation” (defined by the
plan to exclude nontaxable fringe benefit items). Neonatology
paid Dr. Mall compensation of $240,000, $250,000, and $168,000
during 1991, 1992, and 1993, respectively. Neonatology did not
pay Mr. Mall any compensation during those years.
Neonatology contributed to the Neonatology Plan during each
year from 1991 through 1993 and, for each subject year, claimed a
deduction for those contributions and other related amounts. In
1991, Neonatology contributed $10,000 to the plan on behalf of
Dr. Mall. It also paid the plan’s trustee and its administrator
$1,000 each. In 1992, Neonatology contributed $10,000 to the
plan on behalf of Dr. Mall and $10,000 on behalf of Mr. Mall. It
deducted the $20,000 on its 1992 Federal corporate income tax
return as an employee benefit program expense, and it deducted on
- 25 -
that return another $1,000 that was paid to PES for its
administrator services. In 1993, Neonatology contributed $21,623
to the plan on behalf of Dr. Mall and $250 for a “VEBA set-up
fee”. It deducted those amounts on its 1993 Federal corporate
income tax return as an employee benefit program expense, and it
deducted on that return $750 that it contributed to the plan and
$1,000 that it paid PES for its administrator services.
During the relevant years, the Neonatology Plan purchased
three life insurance policies, two on the life of Dr. Mall and
the third on the life of Mr. Mall.16 The attributes of these
policies are as follows.
1. Dr. Mall’s Inter-American C-Group Term Policy
Effective March 15, 1991, Inter-American issued a $650,000
C-group term policy (certificate No. 5076202) on the life of Dr.
Mall, age 45. The first-year premium was $9,906, and the cost of
insuring Dr. Mall for that year was $1,689.85. The Neonatology
Plan paid the first-year premium, and, at the end of that year,
the conversion credit balance was $8,585.88 ($9,906 - $1,689.85 +
$369.73); the $369.73 is the interest of 4.5 percent earned on
the conversion credit balance (($8,585.88 - $369.73) x 4.5% =
$369.73)). None of the conversion credit balance could have been
16
The Neonatology Plan also purchased one annuity during
those years. On or about Mar. 15, 1991, Inter-American issued to
the Neonatology Plan a Plus II Group Annuity (#C15576/91079) for
an initial premium of $69.
- 26 -
transferred at this time to the C-group conversion UL policy,
upon conversion thereto, because the C-group term policy was in
its first year. This policy lapsed on March 15, 1992.
2. Dr. Mall’s Commonwealth C-Group Term Policy
Effective March 15, 1992, Commonwealth issued a $650,000 C-
group term policy (certificate No. 6007725) on the life of Dr.
Mall, age 46. The first-year premium was $10,653.50, and the
cost of insuring Dr. Mall for that year was $1,764.60. The
Neonatology Plan paid the first-year premium, and, at the end of
that year, the conversion credit balance was $9,288.90
($10,653.50 - $1,764.60 + $400); the $400 is the interest of 4.5
percent earned on the conversion credit balance (($9,288.90 -
$400) x 4.5% = $400)). None of the conversion credit balance
could have been transferred at this time to the C-group
conversion UL policy, upon conversion thereto, because the C-
group term policy was in its first year.
The second-year premium, before any experience refund, was
$10,731.50. The policy was credited with an experience refund of
$106.08, and the Neonatology Plan paid the net premium of
$10,625.42 ($10,731.50 - $106.08). The cost of insuring Dr. Mall
for the second year was $1,814.34, and, at the end of that year,
the conversion credit balance was $19,025.33 ($9,288.90 +
$10,731.50 - $1,814.34 + $819.27); the $819.27 is the interest of
4.5 percent earned on the conversion credit balance (($19,025.33
- 27 -
- $819.27) x 4.5% = $819.27)). Of the conversion credit balance,
$9,037.03 could have been transferred at this time to the C-group
conversion UL policy, upon conversion thereto, because the C-
group term policy was in its second year ($19,025.33 x 47.5%).
The Neonatology Plan continued to pay the premiums on this
policy, net of the applicable experience refund, through 1996.
Effective October 15, 1996, Dr. Mall converted this policy to a
fully paid, individually owned C-group conversion UL policy in
the face amount of $71,102. At the time of conversion, the C-
group term policy’s conversion credit balance was $46,508.32, and
$44,182.90 of that amount ($46,508.32 x 95%) was transferred to
the C-group conversion UL policy for potential earning. Dr. Mall
will earn these credits in 120 equal monthly installments,
beginning October 1996. The conversion credit balance of
$46,508.32 equaled the amount referenced in Commonwealth’s table
of conversion credit values for the following variables: (1)
Business issued before February 1, 1993, (2) female, (3) issue
age 46, (4) duration of 4 years 7 months, and (5) $650,000 death
benefit.
3. Mr. Mall’s Commonwealth C-Group Term Policy
Effective March 15, 1992, Commonwealth issued a $500,000 C-
group term policy (certificate No. 6010423) on the life of Mr.
Mall, age 47. The first-year premium was $10,290, and the cost
of insuring Mr. Mall was $2,056.78. The Neonatology Plan paid
- 28 -
the first-year premium, and, at the end of that year, the
conversion credit balance was $8,603.71 ($10,290 - $2,056.78 +
$370.49); the $370.49 is the interest of 4.5 percent earned on
the conversion credit balance (($8,603.71 - $370.49) x 4.5% =
$370.49)). None of the conversion credit balance could have been
transferred at this time to the C-group conversion UL policy,
upon conversion thereto, because the C-group term policy was in
its first year.
The second-year premium, before any experience refund, was
$10,530. The policy was credited with an experience refund of
$98.25, and the Neonatology Plan paid the net premium of
$10,431.75 ($10,530 - $98.25). The cost of insuring Mr. Mall for
the second year was $2,250.45, and, at the end of that year, the
conversion credit balance was $17,643.01 ($8,603.71 + $10,530 -
$2,250.45 + $759.75); the $759.75 is the interest of 4.5 percent
earned on the conversion credit balance (($17,643.01 - $759.75) x
4.5% = $759.75)). Of the conversion credit balance, $8,380.43
could have been transferred at this time to the C-group
conversion UL policy, upon conversion thereto, because the C-
group term policy was in its second year ($17,643.01 x 47.5%).
The Neonatology Plan continued to pay the premiums on this
policy, net of the applicable experience refund, through 1996.
Effective October 15, 1996, Mr. Mall converted this policy to a
fully paid, individually owned C-group conversion UL policy in
- 29 -
the face amount of $67,069. At the time of conversion, the C-
group term policy’s conversion credit balance was $43,304, and
$41,138.80 of that amount ($43,304 x 95%) was transferred to the
C-group conversion UL policy for potential earning. Mr. Mall
will earn these credits in 120 equal monthly installments,
beginning October 1996. The conversion credits of $41,138.80
equaled the amount referenced in Commonwealth’s table of
conversion credit values for the following variables: (1)
Business issued before February 1, 1993, (2) male, (3) issue age
47, (4) duration of 4 years 7 months, and (5) $500,000 death
benefit.
The Neonatology Plan paid no benefits during the relevant
years, and the 1992 and 1993 Forms W-2, Wage and Tax Statements,
that Neonatology issued to Dr. Mall did not report any life
insurance benefits provided to her under the plan. On their
joint 1992 and 1993 Federal individual income tax returns, the
Malls reported $1,626 and $3,654, respectively, as P.S. 58
income.17
17
The term “P.S. 58" refers to the rates deemed by the
Commissioner to be acceptable in determining the cost of life
insurance protection includable in gross income for a participant
covered by a life insurance contract held in a qualified pension
plan. See Rev. Rul. 55-747, 1955-2 C.B. 228; see also sec.
1.72-16, Income Tax Regs.; cf. sec. 1.79-3, Income Tax Regs.
(rules generally used to determine the cost of group term life
insurance provided to employee by employer). See generally sec.
79(a)(1) (employee’s gross income generally does not include the
cost of the first $50,000 of group term life insurance on his or
(continued...)
- 30 -
During the subject years, Commonwealth paid the following
commissions on the C-group products issued on the Malls’ lives:
Period
Beginning Kirwan Mr. Ankner1 Mr. Murphy
3/92 $8,922.94 $709.34 $2,498.67
3/93 852.82 136.88 273.74
1
These commissions were paid to Mr. Ankner either
indirectly through one of his companies or directly.
Kirwan also received, in or about 1996, commissions equal to 5
percent of the conversion credit balances, both earned and
unearned, which were applied to the Malls’ C-group conversion UL
policies. These commissions totaled $4,266.09 (($44,182.90 x 5%)
+ ($41,138.80 x 5%)).
Respondent determined that Neonatology could not deduct its
excess contributions to the Neonatology Plan and increased
Neonatology’s income by $23,646 in 1992 and $19,969 in 1993 to
reflect the following adjustments:
1992 1993
Contributions to the Neonatology Plan $20,000 $22,623
Administrator’s fees 1,000 1,000
1991 NOL from plan contributions 4,272 —
Subtotal 25,272 23,623
Less: P.S. 58 costs included in income 1,626 3,654
Adjustment 23,646 19,969
Respondent determined primarily that the disallowed contributions
were not deductible under section 162(a) because they did not
17
(...continued)
her life).
- 31 -
provide current-year life insurance protection.18 Respondent
determined alternatively that the excess contributions were not
deductible under section 404(a)(5); respondent determined that
the Neonatology Plan was not a “welfare benefit fund” under
section 419(e) but a nonqualified plan of deferred compensation
subject to the rules of section 404. Respondent determined as a
second alternative that, assuming the Neonatology Plan is a
“welfare benefit fund”, any deduction of the excess contributions
was precluded by section 419; for this alternative, respondent
determined that the SC VEBA was not a “10-or-more employer plan”
under section 419A(f)(6) as asserted by petitioners.
As to the Malls, respondent determined they had “other
income” of $19,374 in 1992 (Neonatology’s adjustment of $23,646
less the 1991 NOL of $4,272) and $19,969 in 1993. Respondent
determined that the other income was either constructive dividend
income under section 301 or nonqualified deferred compensation
under section 402(b). As to the latter position, respondent
determined that Dr. Mall was taxable on the disallowed
18
Although respondent’s determination acknowledges that
Neonatology may deduct any contribution that is attributable to
current-year life insurance protection, respondent has not
determined as to the Neonatology group (or the Lakewood group as
discussed infra) the cost of that current-year protection. As to
the Neonatology group, respondent’s determination merely takes
into account the fact that the Malls recognized P.S. 58 income
for the subject years. As mentioned supra note 17, P.S. 58
income relates to life insurance contracts held in a qualified
pension plan.
- 32 -
contributions when they were made, because she received in
connection with services property not subject to a substantial
risk of forfeiture under section 83.
VI. The Lakewood Plan
Mr. Cohen introduced Drs. Hirshkowitz and Desai to the SC
VEBA in 1990. Drs. Hirshkowitz and Desai both knew that the
premiums paid on the C-group product were more expensive than the
cost of term life insurance. They caused Lakewood to invest in
the SC VEBA anyway because, as they understood it, the SC VEBA
ultimately allowed Lakewood’s principals to withdraw the excess
premiums from the plan tax free by way of policy loans. All of
Lakewood’s principals are physicians, and Dr. Hirshkowitz, on the
basis of his conversations with Mr. Cohen, understood that the SC
VEBA allowed policyholders to convert their C-group term policies
to individual policies which allowed the withdrawal of the cash
value at no additional expense. Dr. Desai, on the basis of his
conversations with Mr. Cohen, understood that premiums on the C-
group product covered both term insurance and conversion credits,
and, in his capacity as a member of Lakewood’s board of
directors, would have spoken against the SC VEBA had the
conversion credits not been available. Drs. Hirshkowitz and
Desai both relied on the word of Mr. Cohen as to the validity of
the SC VEBA, seeking no independent competent professional advice
- 33 -
and neither requesting nor reading any of the literature on the
plan.
Lakewood established the Lakewood Plan under the SC VEBA on
December 28, 1990, effective January 1, 1990. The only employees
covered by the plan during the subject years were Drs.
Hirshkowitz, Desai, Sobo, McManus, and Sankhla.19 During the
respective years from 1990 through 1993, Lakewood paid Dr. Desai
compensation of $318,020, $308,279, $297,452, and $275,270, it
paid Dr. Sobo compensation of $330,030 $354,277, $329,185, and
$203,640, it paid Dr. McManus compensation of $218,821, $368,708,
$340,376, and $333,204, and it paid Dr. Sankhla compensation of
$50,000, $127,500, $142,500, and $147,500. During the respective
years from 1990 through 1992, Lakewood paid Dr. Hirshkowitz
compensation of $327,691, $181,994, and $204,918.
Under the terms of the Lakewood Plan, as in effect through
December 31, 1992, a covered employee received a death benefit
equal to 2.5 times his or her prior-year compensation. Lakewood
amended its plan as of January 1, 1993, effective January 1,
1990, to increase the death benefit to 8.15 times prior-year
compensation. Drs. Hirshkowitz, Desai, and McManus each elected
on January 1, 1993, not to accept this additional coverage.
19
Drs. Bharat Patel and Chadru Jain were also employees of
Lakewood. The record indicates that they joined the Lakewood
Plan after the subject years.
- 34 -
No Lakewood employee covered by the Lakewood Plan, if he or
she had died, would ever have received a death benefit equal to
2.5 times or 8.15 times his or her prior-year compensation. Each
of Lakewood’s employee/owners decided the amount that Lakewood
would contribute to the SC VEBA on his or her behalf, and
Lakewood wrote separate checks for each employee/owner’s
contribution, noting on the check the name of the person for whom
the contribution was made.
On its Federal corporate income tax return for its taxable
year ended October 31, 1991, Lakewood claimed a $480,901.49
deduction for VEBA contributions made to the Lakewood Plan for
the following persons’ benefits:
Trustee’s fees........ $1,000.00
Dr. Hirshkowitz.......254,051.49
Dr. Desai.............122,750.00
Dr. Sobo.............. 83,100.00
Dr. McManus........... 20,000.00
480,901.49
On its 1992 Federal corporate income tax return, Lakewood
claimed a $209,869.03 deduction for VEBA contributions made for
the following persons’ benefits:
Dr. Hirshkowitz......$136,678.43
Dr. Desai............ 42,056.44
Dr. Sobo............. 13,213.52
Dr. McManus.......... 17,920.64
209,869.03
This deduction consists of contributions to the Lakewood Plan and
$70,000 that Lakewood paid directly to Peoples Security for C-
group term policies purchased outside of the Lakewood Plan for
- 35 -
Drs. Hirshkowitz and Desai. Of the $70,000 paid to Peoples
Security, $50,000 was attributable to the coverage of Dr.
Hirshkowitz, and $20,000 was attributable to the coverage of Dr.
Desai.
On its 1993 Federal corporate income tax return, Lakewood
claimed a $296,055.90 deduction for VEBA contributions made for
the following persons’ benefits:
Trustee’s fees........ $1,000.00
Dr. Hirshkowitz.......211,119.90
Dr. Desai............. 55,000.00
Dr. Sobo.............. 15,000.00
Dr. Sankhla........... 5,750.00
Dr. McManus........... 18,186.00
296,055.90
1
The Lakewood Plan returned this $5,000 to Lakewood in
October 1993.
This deduction consists of contributions to the Lakewood Plan and
$82,926.23 that Lakewood paid directly to Peoples Security for C-
group term policies purchased outside of the Lakewood Plan for
Drs. Hirshkowitz, Sankhla, and Desai. Of the $82,926.23 paid to
Peoples Security, $57,168.80 was attributable to the coverage of
Dr. Hirshkowitz, $5,750 was attributable to the coverage of Dr.
Sankhla, and $20,007.43 was attributable to the coverage of Dr.
Desai.
During the relevant years, the Lakewood Plan purchased 12
insurance policies on the lives of Lakewood’s principals. The
attributes of these policies are as follows.
- 36 -
1. Dr. Hirshkowitz’ Inter-American C-Group Term Policy
Effective December 31, 1990, Inter-American issued a $1
million C-group term policy (certificate No. 5076058) on the life
of Dr. Hirshkowitz, age 57. The first-year premium was $48,680,
and the cost of insuring Dr. Hirshkowitz for that year was
$9,475.15. The Lakewood Plan paid the first-year premium, and,
at the end of that year, the conversion credit balance was
$40,969.07 ($48,680 - $9,475.15 + $1,764.22); the $1,764.22 is
the interest of 4.5 percent earned on the conversion credit
balance (($40,969.07 - $1,764.22) x 4.5% = $1,764.22)). None of
the conversion credit balance could have been transferred at this
time to the C-group conversion UL policy, upon conversion
thereto, because the C-group term policy was in its first year.
This policy lapsed on December 31, 1991.
2. Dr. Desai’s Inter-American C-Group Term Policy
Effective December 31, 1990, Inter-American issued a $1
million C-group term policy (certificate No. 5076059) on the life
of Dr. Desai, age 45. The first-year premium was $17,390, and
the cost of insuring Dr. Desai for that year was $3,419.48. The
Lakewood Plan paid the first-year premium, and, at the end of
that year, the conversion credit balance was $14,599.19 ($17,390
- $3,419.48 + $628.67); the $628.67 is the interest of 4.5
percent earned on the conversion credit balance (($14,599.19 -
$628.67) x 4.5% = $628.67)). None of the conversion credit
- 37 -
balance could have been transferred at this time to the C-group
conversion UL policy, upon conversion thereto, because the C-
group term policy was in its first year. This policy lapsed on
December 31, 1991.
3. Dr. Sobo’s Inter-American C-Group Term Policy
Effective December 31, 1990, Inter-American issued a $1
million C-group term policy (certificate No. 5076057) on the life
of Dr. Sobo, age 38. The first-year premium was $10,800, and the
cost of insuring Dr. Sobo for that year was $2,374.08. The
Lakewood Plan paid the first-year premium, and, at the end of
that year, the conversion credit balance was $8,805.09 ($10,800 -
$2,374.08 + $379.17); the $379.17 is the interest of 4.5 percent
earned on the conversion credit balance (($8,805.09 - $379.17) x
4.5% = $379.17)). None of the conversion credit balance could
have been transferred at this time to the C-group conversion UL
policy, upon conversion thereto, because the C-group term policy
was in its first year. This policy lapsed on December 31, 1991.
4. Dr. Hirshkowitz’ Commonwealth C-Group Term Policy
Effective October 31, 1991, Commonwealth issued a $150,000
C-group term policy (certificate No. 6000972) on the life of Dr.
Hirshkowitz, age 58. The first-year premium was $7,540.50, and
the cost of insuring Dr. Hirshkowitz for that year was $1,572.75.
The Lakewood Plan paid the first-year premium, and, at the end of
that year, the conversion credit balance was $6,236.30 ($7,540.50
- 38 -
- $1,572.75 + $268.55); the $268.55 is the interest of 4.5
percent earned on the conversion credit balance (($6,236.30 -
$268.55) x 4.5% = $268.55)). None of the conversion credit
balance could have been transferred at this time to the C-group
conversion UL policy, upon conversion thereto, because the C-
group term policy was in its first year.
The second-year premium, before any experience refund, was
$7,720. The policy was credited with an experience refund of
$115.21, and the Lakewood Plan paid the net premium of $7,604.79
($7,720 - $115.21). The cost of insuring Dr. Hirshkowitz for the
second year was $1,665.17, and, at the end of that year, the
conversion credit balance was $12,844.23 ($6,236.30 + $7,720 -
$1,665.17 + $553.10); the $553.10 is the interest of 4.5 percent
earned on the conversion credit balance (($12,844.23 - $553.10) x
4.5% = $553.10)). Of the conversion credit balance, $6,101.01
could have been transferred at this time to the C-group
conversion UL policy, upon conversion thereto, because the C-
group term policy was in its second year ($12,844.23 x 47.5%).
The third-year premium, before any experience refund, was
$7,972.50. The policy was credited with an experience refund of
$176.01, and the Lakewood Plan paid the net premium of $7,796.49
($7,972.50 - $176.01). The cost of insuring Dr. Hirshkowitz for
the third year was $1,798.22, and, at the end of that year, the
conversion credit balance was $19,874.34 ($12,844.23 + $7,972.50
- 39 -
- $1,798.22 + $855.83); the $855.86 is the interest of 4.5
percent earned on the conversion credit balance (($19,874.34 -
$855.83) x 4.5% = $855.83)). Of the conversion credit balance,
$17,935.59 could have been transferred at this time to the C-
group conversion UL policy, upon conversion thereto, because the
C-group term policy was in its third year ($19,874.34 x 90.25%).
The Lakewood Plan continued to pay the premiums on this
policy, net of the applicable experience refund, through 1996.
Effective October 31, 1996, Dr. Hirshkowitz converted this policy
to a fully paid, individually owned C-group conversion UL policy
in the face amount of $44,653. At the time of conversion, the
balance in the C-group term policy’s conversion credit account
was $35,400, and $33,630 of that amount ($35,400 x 95%) was
transferred to the C-group conversion UL policy for potential
earning. Mr. Hirshkowitz will earn these credits in 120 equal
monthly installments, beginning October 1996. The conversion
credit balance of $33,630 equaled the amount referenced in
Commonwealth’s table of conversion credit values for the
following variables: (1) Business issued before February 1,
1993, (2) male, (3) issue age 58, (4) duration of 5 years, and
(5) $150,000 death benefit.
- 40 -
5. Dr. Desai’s Commonwealth C-Group Term Policy
Effective October 31, 1991, Commonwealth issued a $150,000
C-group term policy (certificate No. 6000973) on the life of Dr.
Desai, age 46. The first-year premium was $2,836.50, and the
cost of insuring Dr. Desai for that year was $565.11. The
Lakewood Plan paid the first-year premium, and, at the end of
that year, the conversion credit balance was $2,373.60 ($2,836.50
- $565.11 + $102.21); the $102.21 is the interest of 4.5 percent
earned on the conversion credit balance (($2,373.60 - $102.21) x
4.5% = $102.21)). None of the conversion credit balance could
have been transferred at this time to the C-group conversion UL
policy, upon conversion thereto, because the C-group term policy
was in its first year.
The second-year premium, before any experience refund, was
$2,890.50. The policy was credited with an experience refund of
$44.06, and the Lakewood Plan paid the net premium of $2,846.44
($2,890.50 - $44.06). The cost of insuring Dr. Desai for the
second year was $607.89, and, at the end of that year, the
conversion credit balance was $4,865.74 ($2,373.60 + $2,890.50 -
$607.89 + $209.53); the $209.53 is the interest of 4.5 percent
earned on the conversion credit balance (($4,865.74 - $209.53) x
4.5% = $209.53)). Of the conversion credit balance, $2,311.23
could have been transferred at this time to the C-group
- 41 -
conversion UL policy, upon conversion thereto, because the C-
group term policy was in its second year ($4,865.74 x 47.5%).
The third-year premium, before any experience refund, was
$2,962.50. The policy was credited with an experience refund of
$66.69, and the Lakewood Plan paid the net premium of $2,895.81
($2,962.50 - $66.69). The cost of insuring Dr. Desai for the
third year was $665.36, and, at the end of that year, the
conversion credit balance was $7,485.21 ($4,865.74 + $2,962.50 -
$665.36 + $322.33); the $322.33 is the interest of 4.5 percent
earned on the conversion credit balance (($7,485.21 - $322.33) x
4.5% = $322.33)). Of the conversion credit balance, $6,755.40
could have been transferred at this time to the C-group
conversion UL policy, upon conversion thereto, because the C-
group term policy was in its third year ($7,485.21 x 90.25%).
The Lakewood Plan continued to pay the premiums on this
policy, net of the applicable experience refund, through 1996.
Effective October 31, 1996, Dr. Desai converted this policy to a
fully paid, individually owned C-group conversion UL policy in
the face amount of $22,916. At the time of conversion, the C-
group term policy’s conversion credit balance was $13,143.16, and
$12,486 of that amount ($13,143.16 x 95%) was transferred to the
C-group conversion UL policy for potential earning. Dr. Desai
will earn this amount in 120 equal monthly installments,
beginning October 1996. The conversion credit balance of $12,486
- 42 -
equaled the amount referenced in Commonwealth’s table of
conversion credit values for the following variables: (1)
Business issued before February 1, 1993, (2) male, (3) issue age
46, (4) duration of 5 years, and (5) $150,000 death benefit.
6. Dr. Sobo’s $150,000 Commonwealth C-Group Term Policy
Effective October 31, 1991, Commonwealth issued a $150,000
C-group term policy (certificate No. 6000971) on the life of Dr.
Sobo, age 38. The first-year premium was $1,620, and the cost of
insuring Dr. Sobo for that year was $356.11. The Lakewood Plan
paid the first-year premium, and, at the end of that year, the
conversion credit balance was $1,320.76 ($1,620 - $356.11 +
$56.87); the $56.87 is the interest of 4.5 percent earned on the
conversion credit balance (($1,320.76 - $56.87) x 4.5% =
$56.87)). None of the conversion credit balance could have been
transferred at this time to the C-group conversion UL policy,
upon conversion thereto, because the C-group term policy was in
its first year.
The second-year premium, before any experience refund, was
$1,638. The policy was credited with an experience refund of
$24.48, and the Lakewood Plan paid the net premium of $1,613.52
($1,638 - $24.48). The cost of insuring Dr. Sobo for the second
year was $370.54.
- 43 -
Dr. Sobo died on September 23, 1993. On December 14, 1993,
the Lakewood Plan paid $150,000 to Bonnie W. Sobo (Ms. Sobo) as
the beneficiary of this policy.
7. Dr. McManus’ Commonwealth C-Group Term Policy
Effective October 31, 1991, Commonwealth issued a $2.1
million C-group term policy (certificate No. 6001004) on the life
of Dr. McManus, age 34. The first-year premium was $18,186, and
the cost of insuring Dr. McManus for that year was $4,496.72.
The Lakewood Plan paid the first-year premium, and, at the end of
that year, the conversion credit balance was $14,305.30 ($18,186
- $4,496.72 + $616.02); the $616.02 is the interest of 4.5
percent earned on the conversion credit balance (($14,305.30 -
$616.02) x 4.5% = $616.02)). None of the conversion credit
balance could have been transferred at this time to the C-group
conversion UL policy, upon conversion thereto, because the C-
group term policy was in its first year.
The second-year premium, before any experience refund, was
$18,186. The policy was credited with an experience refund of
$265.36, and the Lakewood Plan paid the net premium of $17,920.64
($18,186 - $265.36). The cost of insuring Dr. McManus for the
second year was $4,465.82, and, at the end of that year, the
conversion credit balance was $29,286.63 ($14,305.30 + $18,186 -
$4,465.82 + $1,261.15); the $1,261.15 is the interest of 4.5
percent earned on the conversion credit balance (($29,286.63 -
- 44 -
$1,261.15) x 4.5% = $1,261.15)). Of the conversion credit
balance, $13,911.15 could have been transferred at this time to
the C-group conversion UL policy, upon conversion thereto,
because the C-group term policy was in its second year
($29,286.63 x 47.5%).
The third-year premium, before any experience refund, was
$18,186. The policy was credited with an experience refund of
$401.32, and the Lakewood Plan paid the net premium of $17,784.68
($18,186 - $401.32). The cost of insuring Dr. McManus for the
third year was $4,433.46, and, at the end of that year, the
conversion credit balance was $44,975.93 ($29,286.63 + $18,186 -
$4,433.46 + $1,936.76); the $1,936.76 is the interest of 4.5
percent earned on the conversion credit balance (($44,975.93 -
$1,936.76) x 4.5% = $1,936.76)). Of the conversion credit
balance, $40,590.78 could have been transferred at this time to
the C-group conversion UL policy, upon conversion thereto,
because the C-group term policy was in its third year ($44,975.93
x 90.25%).
The Lakewood Plan continued to pay the premiums on this
policy, net of the applicable experience refund, through 1996.
Effective October 1, 1996, Dr. McManus converted this policy to a
fully paid, individually owned C-group conversion UL policy in
the face amount of $187,827. At the time of conversion, the C-
group term policy’s conversion credit balance was $78,672.63, and
- 45 -
$74,739 of that amount ($78,672.63 x 95%) was transferred to the
C-group conversion UL policy for potential earning. Dr. McManus
will earn these credits in 120 equal monthly installments,
beginning October 1996. The conversion credit balance of $74,739
equaled the amount referenced in Commonwealth’s table of
conversion credit values for the following variables: (1)
Business issued before February 1, 1993, (2) male, (3) issue age
34, (4) duration of 5 years, and (5) $2.1 million death benefit.
8. Dr. Hirshkowitz’ Commonwealth C-Group Term Policy
Effective December 31, 1991, Commonwealth issued a $1
million C-group term policy (certificate No. 6004482) on the life
of Dr. Hirshkowitz, age 58. The premium for the 10-month period
from December 31, 1991, through October 30, 1992, was $41,891.67,
and the cost of insuring Dr. Hirshkowitz for the 10-month period
was $8,814.60. The Lakewood Plan paid the 10-month premium, and,
at the end of that 10-month period, the conversion credit balance
was $34,317.46 ($41,891.67 - $8,814.60 + $1,240.39); the
$1,240.39 is the interest of 4.5 percent earned on the conversion
credit balance (($34,317.46 - $1,240.39) x 4.5% x 10/12 =
$1,240.39)). None of the conversion credit balance could have
been transferred at this time to the C-group conversion UL
policy, upon conversion thereto, because the C-group term policy
was in its first year.
- 46 -
The premium for the next 12-month period, before any
experience refund, was $51,470. The policy was credited with an
experience refund of $200, and the Lakewood Plan paid the net
premium of $51,270 ($51,470 - $200). The cost of insuring Dr.
Hirshkowitz for the second year was $11,189.96, and, at the end
of that year, the conversion credit balance was $77,954.39
($34,317.46 + $51,470 - $11,189.96 + $3,356.89); the $3,356.89 is
the interest of 4.5 percent earned on the conversion credit
balance (($77,954.39 - $3,356.89) x 4.5% = $3,356.89)). Of the
conversion credit balance, $37,028.34 could have been transferred
at this time to the C-group conversion UL policy, upon conversion
thereto, because the C-group term policy was in its second year
($77,954.39 x 47.5%).
The third-year premium for the next 12-month period, before
any experience refund, was $53,150. The policy was credited with
an experience refund of $1,321.18, and the Lakewood Plan paid the
net premium of $51,828.82 ($53,150 - $1,321.18). The cost of
insuring Dr. Hirshkowitz for the third year was $12,095.03, and,
at the end of that year, the conversion credit balance was
$124,364.78 ($77,954.39 + $53,150 - $12,095.03 + $5,355.42); the
$5,355.42 is the interest of 4.5 percent earned on the conversion
credit balance (($124,364.78 - $5,355.42) x 4.5% = $5,355.42)).
Of the conversion credit balance, $112,239.22 could have been
transferred at this time to the C-group conversion UL policy,
- 47 -
upon conversion thereto, because the C-group term policy was in
its third year ($124,364.78 x 90.25%).
The Lakewood Plan continued to pay the premiums on this
policy, net of the applicable experience refund, through 1996.
Effective October 31, 1996, Dr. Hirshkowitz converted this policy
to a fully paid, individually owned C-group conversion UL policy
in the face amount of $296,937. At the time of conversion, the
C-group term policy’s conversion credit balance was $227,084.21,
and $215,730 of that amount ($227,084.21 x 95%) was transferred
to the C-group conversion UL policy for potential earning. Dr.
Hirshkowitz will earn these credits in 120 equal monthly
installments, beginning October 1996. The conversion credit
balance of $215,730 equaled the amount referenced in
Commonwealth’s table of conversion credit values for the
following variables: (1) Business issued before February 1,
1993, (2) male, (3) issue age 58, (4) duration of 4 years 10
months, and (5) $1 million death benefit.
9. Dr. Desai’s Commonwealth C-Group Term Policy
Effective December 31, 1991, Commonwealth issued a $1
million C-group term policy (certificate No. 6004483) on the life
of Dr. Desai, age 46. The premium for the 10-month period from
December 31, 1991, through October 30, 1992, was $15,758.33, and
the cost of insuring Dr. Desai for this 10-month period was
$3,149.57. The Lakewood Plan paid the 10-month premium, and, at
- 48 -
the end of that 10-month period, the conversion credit balance
was $13,081.59 ($15,758.33 - $3,149.57 + $472.83); the $472.83 is
the interest of 4.5 percent earned on the conversion credit
balance (($13,081.59 - $472.83) x 4.5% x 10/12 = $472.83)). None
of the conversion credit balance could have been transferred at
this time to the C-group conversion UL policy, upon conversion
thereto, because the C-group term policy was in its first year.
The premium for the next 12-month period, before any
experience refund, was $19,270. The policy was credited with an
experience refund of $60, and the Lakewood Plan paid the net
premium of $19,210 ($19,270 - $60). The cost of insuring Dr.
Desai for the second year was $4,064.12, and, at the end of that
year, the conversion credit balance was $29,560.40 ($13,081.59 +
$19,270 - $4,064.12 + $1,272.93); the $1,272.93 is the interest
of 4.5 percent earned on the conversion credit balance
(($29,560.40 - $1,272.93) x 4.5% = $1,272.93)). Of the
conversion credit balance, $14,041.19 could have been transferred
at this time to the C-group conversion UL policy, upon conversion
thereto, because the C-group term policy was in its second year
($29,560.40 x 47.5%).
The third-year premium for the next 12-month period, before
any experience refund, was $19,750. The policy was credited with
an experience refund of $474.65, and the Lakewood Plan paid the
net premium of $19,275.35 ($19,750 - $474.65). The cost of
- 49 -
insuring Dr. Desai for the third year was $4,449.23, and, at the
end of that year, the conversion credit balance was $46,879.92
($29,560.40 + $19,750 - $4,449.23 + $2,018.75); the $2,018.75 is
the interest of 4.5 percent earned on the conversion credit
balance (($46,879.92 - $2,018.75) x 4.5% = $2,018.75)). Of the
conversion credit balance, $42,309.13 could have been transferred
at this time to the C-group conversion UL policy, upon conversion
thereto, because the C-group term policy was in its third year
($46,879.92 x 90.25%).
The Lakewood Plan continued to pay the premiums on this
policy, net of the applicable experience refund, through 1996.
Effective October 1, 1996, Dr. Desai converted this policy to a
fully paid, individually owned C-group conversion UL policy in
the face amount of $151,656. At the time of conversion, the C-
group term policy’s conversion credit balance was $84,397.58, and
$80,177.70 of that amount ($84,397.58 x 95%) was transferred to
the C-group conversion UL policy for potential earning. Dr.
Desai will earn these credits in 120 equal monthly installments,
beginning October 1996. The conversion credit balance of
$80,177.70 equaled the amount referenced in Commonwealth’s table
of conversion credit values for the following variables: (1)
Business issued before February 1, 1993, (2) male, (3) issue age
46, (4) duration of 4 years 10 months, and (5) $1 million death
benefit.
- 50 -
10. Dr. Sobo’s Commonwealth C-Group Term Policy
Effective December 31, 1991, Commonwealth issued a $1
million C-group term policy (certificate No. 6004474) on the life
of Dr. Sobo, age 39. The premium for the 10-month period from
December 31, 1991, through October 30, 1992, was $9,583.33, and
the cost of insuring Dr. Sobo for this 10-month period was
$2,079.88. The Lakewood Plan paid the 10-month premium, and, at
the end of that 10-month period, the conversion credit balance
was $7,784.83 ($9,583.33 - $2,079.88 + $281.38); the $281.38 is
the interest of 4.5 percent earned on the conversion credit
balance (($9,583.33 - $281.38) x 4.5% x 10/12 = $281.38)). None
of the conversion credit balance could have been transferred at
this time to the C-group conversion UL policy, upon conversion
thereto, because the C-group term policy was in its first year.
The premium for the next 12-month period, before any
experience refund, was $11,620. The policy was credited with an
experience refund of $20, and the Lakewood Plan paid the net
premium of $11,600 ($11,620 - $20). The cost of insuring Dr.
Sobo for the second year was $2,588.77.
On February 3, 1994, the Lakewood Plan paid Ms. Sobo $1
million as the beneficiary of this policy. Pursuant to the plan,
Dr. Sobo’s death benefit should have been $2,682,858 (prior-year
compensation of $329,185 multiplied by 8.15). The Lakewood Plan
had assets from which it could have paid Ms. Sobo more than the
- 51 -
$1,150,000 that it did (the $1 million on this policy and the
$150,000 on certificate No. 6000971). The Lakewood Plan retained
those assets for the remaining covered employees.
11. Dr. Sankhla’s Commonwealth MG-5 Policy
Effective December 31, 1991, Commonwealth issued a $150,000
MG-5 policy on the life of Dr. Sankhla, age 38, for a 1-year
premium of $397.50. The policy was renewed for a second year at
a premium of $397.50, and for a third year at a premium of
$397.50. The Lakewood Plan paid all three of these premiums.
12. Dr. Hirshkowitz’ Commonwealth C-Group Term Policy
Effective December 31, 1993, Commonwealth issued a $100,000
C-group term policy (certificate No. 6022354) on the life of Dr.
Hirshkowitz, age 60. The premium for the 10-month period from
December 31, 1993, through October 30, 1994, was $4,496.67, and
the cost of insuring Dr. Hirshkowitz for that 10-month period was
$1,107.84. The Lakewood Plan paid the 10-month premium, and, at
the end thereof, the conversion credit balance was $3,515.91
($4,496.67 - $1,107.84 + $127.08); the $127.08 is the interest of
4.5 percent earned on the conversion credit balance (($3,515.91 -
$127.08) x 4.5% x 10/12 = $127.08)). None of the conversion
credit balance could have been transferred at this time to the C-
group conversion UL policy, upon conversion thereto, because the
C-group term policy was in its first year.
- 52 -
In addition to its purchase of these 12 life insurance
policies, the Lakewood Plan, during the subject years, purchased
three group annuities designated for certain Lakewood employees.
None of these annuities funded the life insurance provided under
the plan. The Lakewood Plan generally purchased these annuities
to accumulate wealth to pay future premiums on the C-group term
policies. The attributes of these annuities are as follows.
1. Plus II Group Annuity
Effective December 31, 1990, Inter-American issued to the
Lakewood Plan a Plus II group annuity (#C15518/C91063). The
Lakewood Plan deposited $78,240 into the annuity on the day it
was effective and $92,700 in 1991. The Lakewood Plan closed the
annuity in April 1997, withdrawing $230,169.02. The $59,229.02
difference between the total deposits ($170,940) and the amount
withdrawn ($230,169.02) represents interest.
2. Commonwealth Sygnet 24 Group Annuity Effective in 1991
Effective October 31, 1991, Commonwealth issued to the
Lakewood Plan a Sygnet 24 group annuity (#D10120/D90039). This
annuity is designed for asset accumulation over a long period of
time and has surrender charges that grade off over 6 years. The
Lakewood Plan deposited $242 into the annuity on the day it was
effective, $143,344.17 in 1992, and $33,664.37 in 1993. The
Lakewood Plan withdrew $76,442.08 from the annuity on November 4,
1994, and $93,301.59 on December 12, 1995, in closing it. The
- 53 -
Lakewood Plan used both withdrawals to pay C-group term policy
premiums for Drs. Hirshkowitz and Desai. The Lakewood Plan paid
$30,153.10 of charges on its deposits and $4,138.44 of surrender
charges on its withdrawals. The $26,784.67 difference between
the (1) total deposits into the account ($177,250.54) and (2) sum
of the charges ($34,291.54) plus total withdrawals ($169,743.67),
represents interest.
3. Commonwealth Sygnet 24 Group Annuity Effective in 1993
Effective December 30, 1993, Commonwealth issued to the
Lakewood Plan a second Sygnet 24 group annuity (#D11794/D90214).
The Lakewood Plan deposited $75,551.50 into the annuity on the
day it was effective and closed the annuity on November 25, 1996,
withdrawing $65,078.20. The Lakewood Plan paid a $15,865.68
charge on its deposit and a $3,436.85 surrender charge on its
withdrawal. The $7,042.45 difference between the (1) deposit
($75,551.50) and (2) sum of the charge ($3,436.85) plus
withdrawal ($65,078.20) represents interest.
Beginning in 1992, Lakewood purchased outside of the SC VEBA
three Peoples Security C-group term policies. Lakewood owned
these policies and deducted the underlying premiums as VEBA
contributions. The attributes of these policies are as follows.
1. Dr. Desai’s Peoples Security C-Group Term Policy
Effective August 15, 1992, Peoples Security issued a
$1,005,000 C-group term policy (certificate No. 7003612) on the
- 54 -
life of Dr. Desai, age 46. The first-year premium was
$19,004.55, and the cost of insuring Dr. Desai for that year was
$3,786.22. Lakewood paid this premium, and, at the end of that
year, the conversion credit balance was $15,903.15 ($19,004.55 -
$3,786.22 + $684.82); the $684.82 is the interest of 4.5 percent
earned on the conversion credit balance (($15,903.15 - $684.82) x
4.5% = $684.82)). None of the conversion credit balance could
have been transferred at this time to the C-group conversion UL
policy, upon conversion thereto, because the C-group term policy
was in its first year.
The second-year premium, before any experience refund, was
$19,366.35. The policy was credited with an experience refund of
$145.33, and Lakewood paid the net premium of $19,221.02
($19,366.35 - $145.33). The cost of insuring Dr. Desai for the
second year was $4,072.87, and, at the end of that year, the
conversion credit balance was $32,600.48 ($15,903.15 + $19,366.35
- $4,072.87 + $1,403.85); the $1,403.85 is the interest of 4.5
percent earned on the conversion credit balance (($32,600.48 -
$1,403.85) x 4.5% = $1,403.85)). Of the conversion credit
balance, $15,485.23 could have been transferred at this time to
the C-group conversion UL policy, upon conversion thereto,
because the C-group term policy was in its second year
($32,600.48 x 47.5%).
- 55 -
Lakewood continued to pay the premiums on this policy, net
of the applicable experience refund, through 1996. Effective
February 15, 1996, Dr. Desai converted this policy to a fully
paid, individually owned C-group conversion UL policy in the face
amount of $106,353. At the time of conversion, the C-group term
policy’s conversion credit balance was $58,141.90, and $55,234.80
of that amount ($58,141.90 x 95%) was transferred to the C-group
conversion UL policy for potential earning. Dr. Desai will earn
these credits in 120 equal monthly installments, beginning
February 1996. The conversion credit balance of $55,234.80
equaled the amount referenced in Commonwealth’s table of
conversion credit values for the following variables: (1)
Business issued before February 1, 1993, (2) male, (3) issue age
46, (4) duration of 3 years 6 months, and (5) $1,005,000 death
benefit.
2. Dr. Hirshkowitz’ Peoples Security C-Group Term Policy
Effective August 15, 1992, Peoples Security issued a
$940,000 C-group term policy (certificate No. 7002550) on the
life of Dr. Hirshkowitz, age 59. The first-year premium was
$48,861.20, and the cost of insuring Dr. Hirshkowitz for that
year was $10,907.54. Lakewood paid this premium, and, at the end
of that year, the conversion credit balance was $39,661.57
($48,861.20 - $10,907.54 + $1,707.91); the $1,707.91 is the
interest of 4.5 percent earned on the conversion credit balance
- 56 -
(($39,661.57 - $1,707.91) x 4.5% = $1,707.91)). None of the
conversion credit balance could have been transferred at this
time to the C-group conversion UL policy, upon conversion
thereto, because the C-group term policy was in its first year.
The second-year premium, before any experience refund, was
$50,440.40. The policy was credited with an experience refund of
$362.35, and Lakewood paid the net premium of $50,078.05
($50,440.40 - $362.35). The cost of insuring Dr. Hirshkowitz for
the second year was $11,830.58, and, at the end of that year, the
conversion credit balance was $81,793.61 ($39,661.58 + $50,440.40
- $11,830.58 + $3,522.21); the $3,522.21 is the interest of 4.5
percent earned on the conversion credit balance (($81,793.61 -
$3,522.21) x 4.5% = $3,522.21)). Of the conversion credit
balance, $38,851.96 could have been transferred at this time to
the C-group conversion UL policy, upon conversion thereto,
because the C-group term policy was in its second year
($81,793.61 x 47.5%).
Lakewood continued to pay the premiums on this policy, net
of the applicable experience refund, through 1995. Effective
October 15, 1995, Dr. Hirshkowitz converted this policy to a
fully paid, individually owned C-group conversion UL policy in
the face amount of $164,406. At the time of conversion, the C-
group term policy’s conversion credit balance was $129,411.70,
and $122,941.12 of that amount ($129,411.70 x 95%) was
- 57 -
transferred to the C-group conversion UL policy for potential
earning. Dr. Hirshkowitz will earn these credits in 120 equal
monthly installments, beginning October 1995. The conversion
credit balance of $122,941.12 equaled the amount referenced in
Commonwealth’s table of conversion credit values for the
following variables: (1) Business issued before February 1,
1993, (2) male, (3) issue age 59, (4) duration of 3 years 2
months, and (5) $940,000 death benefit.
3. Dr. Sankhla’s Peoples Security C-Group Term Policy
Effective January 31, 1993, Peoples Security issued a
$500,000 C-group term policy (certificate No. 7003453) on the
life of Dr. Sankhla, age 39. The first-year premium was $5,750,
and the cost of insuring Dr. Sankhla for that year was $1,245.51.
Lakewood paid this premium, and, at the end of that year, the
conversion credit balance was $4,707.19 ($5,750 - $1,245.51 +
$202.70); the $202.70 is the interest of 4.5 percent earned on
the conversion credit balance (($4,707.19 - $202.70) x 4.5% =
$202.70)). None of the conversion credit balance could have been
transferred at this time to the C-group conversion UL policy,
upon conversion thereto, because the C-group term policy was in
its first year.
During the relevant years, Commonwealth, Inter-American, and
Peoples Security paid Kirwan, Mr. Murphy, and Mr. Ankner (either
indirectly through one of his companies or directly) commissions
- 58 -
of $90,503.82, $6,681.23, and $20,960, respectively, on the C-
group products and Sygnet group annuities sold to the Lakewood
Plan. Kirwan also received, in or about 1996, commissions equal
to 5 percent of the conversion credits, both earned and unearned,
which were applied to the C-group conversion UL policies of Drs.
Hirshkowitz, Desai, and McManus. These commissions totaled
$29,746.93 (($33,630 x 5%) + ($12,486 x 5%) + ($74,739 x 5%) +
($215,730 x 5%) + ($80,177.70) + ($55,234.80) + ($122,941.12 x
5%).
The 1991, 1992, and 1993 Forms W-2 issued by Lakewood to
Drs. Hirshkowitz, Desai, Sobo, McManus, and Sankhla did not
report any taxable life insurance benefits provided to them under
the Lakewood Plan. Dr. Hirshkowitz reported $4,590, $4,590, and
$13,338 as P.S. 58 income on his joint 1991, 1992, and 1993
Federal individual income tax returns, respectively. Drs. Desai,
Sobo, McManus, and Sankhla did not report on their 1991, 1992, or
1993 Federal individual income tax returns any income from the
life insurance benefits provided to them by Lakewood.
Respondent determined that Lakewood could not deduct the
amounts claimed as contributions to the Lakewood Plan in its
October 31, 1991, and its 1992 and 1993 taxable years and
disallowed the related claimed deductions of $480,901, $209,869,
and $296,056, respectively. In contrast with the Neonatology
adjustments, respondent’s Lakewood adjustments do not reflect the
- 59 -
fact that an employee/owner (Dr. Hirshkowitz) reported P.S. 58
income as to the benefits that he received from the Lakewood
Plan. Consistent with the Neonatology determination, respondent
determined primarily that Lakewood’s contributions to its plan
were not deductible under section 162(a) to the extent they did
not provide current-year life insurance protection. Respondent
determined alternatively that the contributions were not
deductible under section 404(a)(5); respondent determined that
the Lakewood Plan was not a “welfare benefit fund” under section
419(e) but a nonqualified plan of deferred compensation subject
to the rules of section 404. Respondent determined as a second
alternative that, assuming that the Lakewood Plan is a “welfare
benefit fund”, any deduction of the contributions was precluded
by section 419; for this purpose, respondent determined that the
SC VEBA was not a “10-or-more employer plan” under section
419A(f)(6) as asserted by petitioners.
As to the petitioning individuals of the Lakewood group,
respondent determined that each group of petitioning individuals
had “additional income” in the following amounts for the
respective years from 1991 through 1993: Dr. and Ms.
Hirshkowitz-–$254,051, $136,678, and $211,120; Dr. and Ms. Desai-
–$122,750, $42,056, and $55,000; Dr. and Ms. McManus-–$20,000,
$17,921, and $18,186; and the Estate of Steven Sobo, Deceased,
- 60 -
and Ms. Sobo-–$83,100, $13,214, and $5,000.20 Respondent
determined that the additional income was either constructive
dividend income under section 301 or nonqualified deferred
compensation under section 402(b). As to the latter position,
respondent determined that the petitioning employee/owners of the
Lakewood group were taxable on their shares of the contributions,
when made, because they received in connection with services
property not subject to a substantial risk of forfeiture under
section 83.
VII. The Marlton Plan
Marlton established the Marlton Plan under the NJ VEBA on
December 31, 1993, effective January 1, 1993. Marlton
contributed $100,000 and $120,000 to the plan during 1993 and
1994, respectively, and Dr. Lo deducted those respective amounts
on his 1993 and 1994 Schedules C as employee benefit program
expenses. Marlton also paid a $2,500 VEBA fee in 1993, which Dr.
20
In summary, respondent determined that the disallowed
contributions were attributable to the following persons:
1991 1992 1993
Dr. Hirshkowitz $254,051 $136,678 $211,120
Dr. Desai 122,750 42,056 55,000
Dr. McManus 20,000 17,921 18,186
Dr. Sobo 83,100 13,214 5,000
Dr. Sankhla — — 5,750
Trustee’s fees 1,000 — 1,000
480,901 209,869 296,056
- 61 -
Lo deducted on his joint 1993 Federal individual income tax
return.
The Marlton Plan provides in relevant part that: (1) Each
person covered by the plan is entitled to a death benefit equal
to eight times his or her prior-year compensation, (2) an
employee’s spouse may not join the plan, and (3) a proprietor may
join the plan only if 90 percent or more of the plan’s total
participants are employees of Marlton on 1 day of each quarter of
the plan year. The only persons covered by the Marlton Plan are
Dr. Lo, Ms. Lo, and Edward Lo,21 and, during 1994, the Marlton
Plan purchased a separate insurance policy on the life of each of
these persons. None of these persons, had he or she died, would
have received a death benefit under the plan equal to eight times
his or her prior-year compensation. Ms. Lo was a Marlton
employee during 1994, and it paid her, ostensibly as employee
compensation, $46,800, $51,600, and $54,000 during the respective
years from 1992 to 1994. Edward Lo was an employee of Marlton
during 1994, and it paid him, ostensibly as employee
compensation, $39,930, $39,358, and $37,918 during the years 1992
through 1994. Dr. Lo was never a Marlton employee, and he was
not eligible to participate in the plan during any of the
21
The record does not reveal Edward Lo’s relationship (if
any) to Dr. Lo.
- 62 -
relevant years. Dr Lo’s participation in the plan was
inconsistent with the terms thereof.
On April 28, 1994, the Marlton Plan purchased from Southland
Life Insurance Co. (Southland) a $3.2 million flexible premium
adjustable life insurance policy (certificate No. 0600008928) on
the life of Dr. Lo, age 52, and it paid Southland a $158,859
premium on the policy during that year.22 Dr. Lo’s death
beneficiary was an irrevocable trust by and between him and Ms.
Lo, as grantors, and Edward Lo as trustee. The policy’s cash
value (i.e., its accumulation value23 less surrender charges)
could be obtained by surrendering the policy, but the product was
designed to access that value by borrowing it through a “wash
loan” (i.e., a loan for which the interest rate charged thereon
equaled the interest rate earned on the policy). The Southland
policy’s accumulated value was $154,483 on December 28, 1994, its
surrender charge for that year was $68,800, and the interest
credited to the policy during that year approximated $5,046.96.
For 1994, a $3.2 million term insurance policy on the life of Dr.
Lo would have cost approximately $9,255.05.
22
Under the terms of the policy, after Southland received
an initial premium payment of $98,859, a minimum monthly premium
payment of $3,738.33 was required to prevent the policy from
lapsing during the first 5 years.
23
The accumulation value equaled the total premiums paid
plus commercial interest less the cost of term insurance and
administrative expenses.
- 63 -
Also during 1994, the Marlton Plan purchased from the First
Colony Life Insurance Co. (First Colony) a $412,800 graded
premium policy on the life of Ms. Lo, age 44, and a $264,008
graded premium policy on the life of Edward Lo, age 45. The
Marlton Plan paid First Colony a $584.26 annual premium on Ms.
Lo’s policy and a $556.34 annual premium on Edward Lo’s policy.
The beneficiary of both policies was the Marlton plan trustee.
The annual premium on these two policies remained constant for
the first 10 years and then increased substantially unless the
policyholder provided evidence of insurability to begin another
10-year period of reduced, level premiums.
The Marlton Plan paid no benefits during the subject years.
On their joint 1993 Federal individual income tax return, the Los
reported no P.S. 58 income. They reported P.S. 58 income of
$4,288 on their joint 1994 Federal individual income tax return.
Respondent determined that Marlton could not deduct its
contributions to the Marlton Plan and increased the Los’ income
by $102,500 in 1993 and $116,212 in 1994 to reflect the following
adjustments:
1993 1994
Contributions to the Marlton Plan $100,000 $120,000
Administrator’s fees 2,500 500
Subtotal 102,500 120,500
Less: P.S. 58 costs included in income -0- 4,288
Adjustment 102,500 116,212
- 64 -
Respondent determined primarily that the contributions were not
deductible under section 162(a). Respondent determined
alternatively that the contributions were not deductible under
section 404(a)(5); respondent determined that the Marlton Plan
was not a “welfare benefit fund” under section 419(e) but a
nonqualified plan of deferred compensation subject to the rules
of section 404. Respondent determined as a second alternative
that, assuming that the Marlton Plan is a “welfare benefit fund”,
any deduction of the contributions was precluded by section 419;
for this purpose, respondent determined that the NJ VEBA was not
a “10-or-more employer plan” under section 419A(f)(6) as asserted
by petitioners. Respondent determined as a third alternative
that any deduction of the contributions was precluded by section
264(a); for this purpose, respondent determined that each life
insurance policy issued under the Marlton Plan covered the life
of a person financially interested in Dr. Lo’s trade or business
and that Dr. Lo was directly or indirectly a beneficiary under
the policy.
OPINION
We must determine the tax consequences flowing from the
subject VEBA’s, which, petitioners claim, are “10-or-more
employer plans” entitled to the favorable tax treatment set forth
- 65 -
in section 419A(f)(6).24 The VEBAs’ framework was crafted by the
insurance salesmen mentioned herein and marketed to professional,
small business owners as a viable tax planning device. The
VEBAs’ scheme was subscribed to by varied small businesses whose
employee/owners sought primarily the advertised tax benefits and
24
The term “10-or-more employer plan” is defined by sec.
419A(f)(6), which provides as follows:
(6) Exception for 10-or-More Employer Plans.--
(A) In general.--This subpart [i.e., the
rules of subpt. D that generally limit an
employer’s deduction for its contributions to
a welfare benefit fund to the amount that
would have been deductible had it provided
the benefits directly to its employees] shall
not apply in the case of any welfare benefit
fund which is part of a 10 or more employer
plan. The preceding sentence shall not apply
to any plan which maintains experience-rating
arrangements with respect to individual
employers.
(B) 10 or more employer plan.--For
purposes of subparagraph (A), the term “10 or
more employer plan" means a plan--
(i) to which more than 1
employer contributes, and
(ii) to which no employer
normally contributes more than 10
percent of the total contributions
contributed under the plan by all
employers.
See generally Booth v. Commissioner, 108 T.C. 524, 562-563
(1997), for a discussion of the tax consequences which flow from
a 10-or-more employer plan vis-a-vis another type of welfare
benefit fund, on the one hand, or a plan of deferred
compensation, on the other hand.
- 66 -
tax-free asset accumulation. The subject VEBA’s were not
designed, marketed, purchased, or sold as a means for an employer
to provide welfare benefits to its employees. Cf. Booth v.
Commissioner, 108 T.C. 524, 561-563 (1997) (designers of welfare
benefit funds intended to provide employees with real welfare
benefits that would not be subject to abuse). The small business
owners at bar (namely, the petitioning physicians) invested in
the VEBA’s through their businesses and caused their businesses
to purchase the C-group product from the insurance salesmen. The
insurance salesmen, guided by the designer of the C-group
product, represented to the physicians that favorable tax
consequences would flow from an investment in the VEBA’s and the
purchase of the C-group product.
Before turning to the issues at hand, we pause to pass on
our perception of the trial witnesses. We observe the candor,
sincerity, and demeanor of each witness in order to evaluate his
or her testimony and assign it weight for the primary purpose of
finding disputed facts. We determine the credibility of each
witness, weigh each piece of evidence, draw appropriate
inferences, and choose between conflicting inferences in finding
the facts of a case. The mere fact that one party presents
unopposed testimony on his or her behalf does not necessarily
mean that the elicited testimony will result in a finding of fact
in that party’s favor. We will not accept the testimony of
- 67 -
witnesses at face value if we find that the outward appearance of
the facts in their totality conveys an impression contrary to the
spoken word. See Boehm v. Commissioner, 326 U.S. 287, 293
(1945); Wilmington Trust Co. v. Helvering, 316 U.S. 164, 167-168
(1942); see also Gallick v. Baltimore & O. R. Co., 372 U.S. 108,
114-115 (1963); Diamond Bros. Co. v. Commissioner, 322 F.2d 725,
730-731 (3d Cir. 1963), affg. T.C. Memo. 1962-132.
Petitioners called eight fact witnesses and one expert
witness. Petitioners’ fact witnesses were Drs. Desai,
Hirshkowitz, and Mall, Messrs. Ankner, Mall, and Ross, and AEGON
USA employees Paula Jackson and Timothy Vance. Petitioners’
expert witness was Jay M. Jaffe, F.S.A., M.A.A.A. (Mr. Jaffe).
Mr. Jaffe is the president and sole consultant of Actuarial
Enterprises, Ltd., and we generally recognized him as an expert
on the characterization of an insurance policy as term insurance.
We recognized him as such but expressed concern as to whether he
was actually an unbiased expert who could help us. Mr. Jaffe
generally testified that the C-group term policy and the C-group
conversion UL policy were separate insurance products with no
interrelationship.
Respondent called two fact witnesses and one expert witness.
Respondent’s fact witnesses were Mr. Cohen and Vincent Maressa,
the latter of whom is the executive director and general counsel
of the Medical Society of New Jersey. Respondent’s expert
- 68 -
witness was Charles DeWeese, F.S.A., M.A.A.A. (Mr. DeWeese). Mr.
DeWeese is an independent consulting actuary, and we recognized
him as an expert on, among other things, the difference between
group term insurance and universal life insurance. Mr. DeWeese
generally testified that the C-group term policy and the C-group
conversion UL policy were one insurance product; i.e., both
policies were parts of a single life insurance product.
We have broad discretion to evaluate the cogency of an
expert’s analysis. Sometimes, an expert will help us decide a
case. See, e.g., Booth v. Commissioner, supra at 573; Trans City
Life Ins. Co. v. Commissioner, 106 T.C. 274, 302 (1996); see also
M.I.C. Ltd. v. Commissioner, T.C. Memo. 1997-96; Proios v.
Commissioner, T.C. Memo. 1994-442. Other times, he or she will
not. See, e.g., Estate of Scanlan v. Commissioner, T.C. Memo.
1996-331, affd. without published opinion 116 F.3d 1476 (5th Cir.
1997); Mandelbaum v. Commissioner, T.C. Memo. 1995-255, affd.
without published opinion 91 F.3d 124 (3d Cir. 1996). We weigh
an expert’s testimony in light of his or her qualifications and
with due regard to all other credible evidence in the record.
See Estate of Kaufman v. Commissioner, T.C. Memo. 1999-119. We
may embrace or reject an expert’s opinion in toto, or we may pick
and choose the portions of the opinion we choose to adopt. See
Helvering v. National Grocery Co., 304 U.S. 282, 294-295 (1938);
Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir. 1976),
- 69 -
affg. T.C. Memo. 1974-285; IT&S of Iowa, Inc. v. Commissioner, 97
T.C. 496, 508 (1991); Parker v. Commissioner, 86 T.C. 547, 562
(1986); see also Pabst Brewing Co. v. Commissioner, T.C. Memo.
1996-506. We are not bound by an expert’s opinion and will
reject an expert’s opinion to the extent that it is contrary to
the judgment we form on the basis of our understanding of the
record as a whole. See Orth v. Commissioner, 813 F.2d 837, 842
(7th Cir. 1987), affg. Lio v. Commissioner, 85 T.C. 56 (1985);
Silverman v. Commissioner, supra at 933; Estate of Kreis v.
Commissioner, 227 F.2d 753, 755 (6th Cir. 1955), affg. T.C. Memo.
1954-139; IT&S of Iowa, Inc. v. Commissioner, supra at 508; Chiu
v. Commissioner, 84 T.C. 722, 734 (1985); see also Gallick v.
Baltimore & O. R. Co., supra at 115; In re TMI Litig., 193 F.3d
613, 665-666 (3d Cir. 1999).
Mr. DeWeese is no stranger to this Court. He testified in
Booth v. Commissioner, 108 T.C. 524 (1997), as an expert on
multiple employer plans. We find him to be reliable, relevant,
and helpful. We credit his opinion as set forth in his report
and as clarified at trial. We rely on his opinion in making our
findings of fact and reaching the conclusions we draw therefrom.
- 70 -
Mr. Jaffe helped us minimally.25 He admitted at trial that
he works with Commonwealth in its everyday business operation,
including helping it develop an innovative term life insurance
product and rendering critical advice to it on an unrelated
litigation matter. An expert witness loses his or her
impartiality when he or she is too closely connected with one of
the parties. See, e.g., Estate of Kaufman v. Commissioner, supra
(the Commissioner’s expert was inherently biased because he was
the Commissioner’s employee). An expert witness also is
unhelpful when he or she is merely a biased spokesman for the
advancement of his or her client’s litigating position. When we
see and hear an expert who displays an unyielding allegiance to
the party who is paying his or her bill, we need not and
generally will not hesitate to disregard that testimony as
untrustworthy. See Estate of Halas v. Commissioner, 94 T.C. 570,
577 (1990); Laureys v. Commissioner, 92 T.C. 101, 129 (1989); see
also Jacobson v. Commissioner, T.C. Memo. 1989-606 (when experts
act as advocates, “the experts can be viewed only as hired guns
of the side that retained them, and this not only disparages
their professional status but precludes their assistance to the
Court in reaching a proper and reasonably accurate conclusion”).
25
In addition to the reasons stated infra, Mr. Jaffe’s
knowledge of critical facts was generally influenced by his
relationship with Commonwealth, he relied incorrectly on
erroneous data to reach otherwise unsupported conclusions, and he
concededly did not review all pertinent facts.
- 71 -
We also do not find the testimony of most of the fact
witnesses to be helpful as to the critical facts underlying the
issues at hand. Drs. Desai, Hirshkowitz, and Mall and Messrs.
Ankner, Mall, and Ross testified incredibly with regard to
material aspects of this case. They all seemed coached and
frequently displayed during cross-examination (or in response to
questions asked by the Court) a loss of memory or hesitation with
respect to their testimony.26 Each of them (with the exception
of Dr. Desai and Mr. Mall) also acknowledged that he or she had
on prior occasions consciously misrepresented material facts in
order to achieve a personal goal. Their testimony, as well as
the testimony of Mr. Cohen, was for the most part self-serving,
vague, elusive, uncorroborated, and/or inconsistent with
documentary or other reliable evidence. Under circumstances such
as these, we are not required to, and we do not, rely on the bald
or otherwise unreliable testimony of these named fact witnesses
to support our decision herein. See Diamond Bros. Co. v.
Commissioner, 322 F.2d 725 at 730-731; see also Tokarski v.
Commissioner, 87 T.C. 74, 77 (1986). We rely mainly on the
testimony of Mr. DeWeese and the voluminous record built by the
parties through their stipulation of approximately 2,167 facts
and approximately 1,691 exhibits.
26
In fact, petitioners’ counsel Neil L. Prupis (Mr. Prupis)
even acknowledged to the Court that the testifying physicians had
selective memories.
- 72 -
We turn to the nine issues for decision and address each of
these issues seriatim.
1. Contributions to the Neonatology and Lakewood Plans
We decide first the question of whether section 162(a)
allows Neonatology and Lakewood to deduct their contributions to
their plans. Section 162(a) generally provides a deduction for
all ordinary and necessary expenses paid or incurred during the
taxable year in carrying on a trade or business. A taxpayer must
meet five requirements in order to deduct an item under this
section. The taxpayer must prove that the item claimed as a
deductible business expense: (1) Was paid or incurred during the
taxable year; (2) was for carrying on his, her, or its trade or
business; (3) was an expense; (4) was a necessary expense; and
(5) was an ordinary expense. See Commissioner v. Lincoln Savs. &
Loan Association, 403 U.S. 345, 352 (1971); Welch v. Helvering,
290 U.S. 111, 115 (1933). A determination of whether an
expenditure satisfies each of these requirements is a question of
fact. See Commissioner v. Heininger, 320 U.S. 467, 475 (1943).
Petitioners argue that Neonatology and Lakewood meet all
five requirements with respect to their contributions to their
plans, and, hence, petitioners assert, those contributions are
fully deductible under section 162(a). Petitioners contend that
the contributions were paid as compensation because, they assert,
the contributions funded a fringe benefit in the form of term
- 73 -
life insurance. Petitioners assert that the contributions all
were made to the plans to pay premiums on term life insurance and
that the premiums entitled the insureds to nothing more.
Respondent argues that section 162(a) does not allow
Neonatology and Lakewood to deduct their contributions in full.
Respondent concedes that Neonatology and Lakewood may deduct
their contributions to their plans to the extent that the
contributions funded term life insurance. See sec. 1.162-10(a),
Income Tax Regs.; see also Joel A. Schneider, M.D., S.C. v.
Commissioner, T.C. Memo. 1992-24; Moser v. Commissioner, T.C.
Memo. 1989-142, affd. on other grounds 914 F.2d 1040 (8th Cir.
1990). As to the excess contributions, respondent asserts, those
amounts are not deductible under section 162(a). Respondent
argues primarily that the excess contributions are distributions
of surplus cash and not ordinary and necessary business expenses.
Respondent points to the fact that the only benefit provided
explicitly under the plans was term life insurance and asserts
that the excess contributions did not fund this benefit.
We agree with respondent that the excess contributions which
Neonatology and Lakewood made to their plans are nondeductible
distributions of cash for the benefit of their employee/owners
and do not constitute ordinary or necessary business expenses.27
27
We need not and do not decide the correctness of
respondent’s alternative determinations disallowing deductions of
(continued...)
- 74 -
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. Although the plans did provide term life insurance to
the employee/owners, the excess contributions simply were not
attributable to that current-year protection. The excess
contributions, which represent the lion’s share of the
contributions, were paid to Inter-American, Commonwealth, or
Peoples Security, as the case may be, to be set aside in an
interest-bearing account for credit to the C-group conversion UL
policy, upon conversion thereto, and it was the holders of these
policies (namely, the employee/owners) who benefited from those
excess contributions by way of their ability to participate in
the C-group products.28 We find incredible petitioners’
assertion that the employee/owners of Neonatology and Lakewood,
each of whom is an educated physician, would have caused their
respective corporations to overpay substantially for term life
insurance with no promise or expectation of receiving the excess
27
(...continued)
these excess contributions.
28
The distributing corporations (Neonatology and Lakewood),
on the other hand, received little if any benefit from the excess
contributions to the plans.
- 75 -
contributions back. The premiums paid for the C-group term
policy exceeded by a wide margin the cost of term life insurance.
We recognize that the conversion credit balance in a C-group
term policy would be forfeited completely were the policy to
lapse and not be converted. Such was the case, for example, when
Neonatology let Dr. Mall’s Inter-American C-group term policy
lapse on March 15, 1992;29 in that case, Dr. Mall forfeited the
conversion credit balance of $8,585.88. Petitioners focus on the
possibility and actual occurrence of such a forfeiture and
conclude therefrom that the premiums are all attributable to
current life insurance protection. We disagree with this
conclusion. 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 current-year insurance
purchased from Inter-American on the life of Dr. Mall cost only
$1,689.85 for the certificate year then ended, and the fact that
Neonatology choose to deposit with Inter-American an additional
$8,216.05 ($9,906 premium less $1,689.85 cost of insurance)
expecting that Dr. Mall would eventually receive that deposit
29
Other C-group term policies which lapsed during the
Neonatology and Lakewood subject years without conversion were
the other two Inter-American C-group term policies; i.e., the
ones owned by Drs. Hirshkowitz and Desai. Although petitioners
do not explain why these policies were allowed to lapse without
conversion, we note that the lapse of these policies occurred
right after Inter-American’s forced liquidation.
- 76 -
with commercial interest does not recharacterize the deposited
funds as the cost of term insurance simply because Neonatology
ultimately decided to abandon the funds. Although it is true
that Neonatology and the insurancemen represented in form that
Neonatology paid the entire $9,906 to Inter-American as a premium
on term life insurance, the fact of the matter is that neither
Neonatology nor Inter-American actually considered the excess
premium to fund the cost of term life insurance. The substance
of the purported premium payment outweighs its form, and, after
closely scrutinizing the facts and circumstances of this case,
including especially the interrelationship between the two
policies underlying the C-group product and the expectations and
understandings of the parties to the contracts underlying that
product, we are left without any doubt that the amount credited
to the conversion account balance was neither charged nor paid as
the cost of current life insurance protection. The parties to
those contracts have always expected and understood that the
conversion credit balance would be returned to the insured in the
future by way of no-cost policy loans.
We also recognize that the conversion credit balance would
not be paid in addition to the underlying policy’s face value
when the insured died, and, if the insured had borrowed from the
balance, that the death benefit would be reduced by the amount of
any outstanding loan. In the case of Dr. Sobo, for example, his
- 77 -
beneficiary, Ms. Sobo, received upon his death only the face
value of the two C-group term policies which were then
outstanding on his life. Neither she nor anyone else was
entitled to, or actually received, the conversion credit balance
on either policy. For the reasons stated immediately above, we
do not believe that this “forfeiture” provision changes the fact
that the amount credited to the conversion credit balance was
simply a deposit that could either grow with interest, or, in the
case of Dr. Sobo, dissipate, and that this deposit was
insufficiently related to the current life insurance protection
to label it as such.30
We conclude that the excess contributions are disguised
(constructive) distributions to the petitioning employee/owners
of Neonatology and Lakewood, see Mazzocchi Bus Co., Inc. v.
Commissioner, 14 F.3d 923, 927-928 (3d Cir. 1994), affg. T.C.
Memo. 1993-43; Commissioner v. Makransky, 321 F.2d 598, 601-603
(3d Cir. 1963), affg. 36 T.C. 446 (1961); Truesdell v.
Commissioner, 89 T.C. 1280 (1989); see also Old Colony Trust Co.
v. Commissioner, 279 U.S. 716 (1929) (individual taxpayer
constructively received income to the extent corporate employer
agreed to pay his tax bill), which means, in turn, that the
30
Neither party has suggested that Dr. Sobo, upon death, is
entitled to deduct a loss equal to the conversion credit balance,
and we do not decide that issue.
- 78 -
distributing corporations cannot deduct those payments.31 The
fact that neither Lakewood nor Neonatology formally declared
these excess contributions as cash distributions does not
foreclose our finding that the excess contributions were
distributions-in-fact. See Commissioner v. Makransky, supra at
601; Truesdell v. Commissioner, supra at 1295; see also Loftin &
Woodard, Inc. v. United States, 577 F.2d 1206, 1214 (5th Cir.
1978); Crosby v. United States, 496 F.2d 1384, 1388 (5th Cir.
1974); Noble v. Commissioner, 368 F.2d 439, 442 (9th Cir. 1966),
affg. T.C. Memo. 1965-84. 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.32 See Noble v.
31
In addition to the deeply ingrained principle that a
corporation may not deduct a distribution made to its
shareholder, the subject distributions neither funded a plan
benefit nor are viewed as passing directly from the corporation
to the plan. See Enoch v. Commissioner, 57 T.C. 781, 793 (1972)
(distributions deemed to have passed from the distributing
corporation to the recipient shareholder and then to the third-
party actual recipient).
32
That the distributing corporations and/or the
employee/owners may not have intended that the excess
contributions constitute a taxable distribution does not preclude
(continued...)
- 79 -
Commissioner, supra at 443; see also Loftin & Woodard, Inc. v.
United States, supra at 1214-1215; Crosby v. United States, supra
at 1388; Magnon v. Commissioner, 73 T.C. 980, 993-994 (1980).
Petitioners argue that the excess contributions were paid to
the employee/owners as compensation for their services. We
disagree. Whether amounts are paid as compensation turns on the
factual determination of whether the payor intends at the time
that the payment is made to compensate the recipient for services
performed. See Whitcomb v. Commissioner, 733 F.2d 191, 194 (1st
Cir. 1984), affg. 81 T.C. 505 (1983); King’s Ct. Mobile Home
Park, Inc. v. Commissioner, 98 T.C. 511, 514-515 (1992); Paula
Constr. Co. v. Commissioner, 58 T.C. 1055, 1058-1059 (1972),
affd. without published opinion 474 F.2d 1345 (5th Cir. 1973).
The intent is not found, as petitioners would have it, at or
after the time that respondent challenges the payment’s
characterization as something other than compensation. See
King’s Ct. Mobile Home Park, Inc. v. Commissioner, supra at 514;
Paula Constr. Co. v. Commissioner, supra at 1059-1060; Joyce v.
Commissioner, 42 T.C. 628, 636 (1964); Drager v. Commissioner,
T.C. Memo. 1987-483. The mere fact that petitioners now choose
32
(...continued)
dividend treatment. Nor is it precluded because the corporations
did not formally distribute the cash directly to the
owner/employees. See Loftin & Woodard, Inc. v. United States,
577 F.2d 1206, 1214 (5th Cir. 1978); Crosby v. United States, 496
F.2d 1384, 1388 (5th Cir. 1974).
- 80 -
to characterize the excess contributions as compensation does not
necessarily mean that the payments were compensation in fact.
The facts of this case do not support petitioners’ assertion
that Neonatology and Lakewood had the requisite compensatory
intent when they made the contributions to their plans. We find
nothing in the record, except for petitioners’ assertions on
brief, that would support such a finding. See Rule 143(b)
(statements on brief are not evidence). Indeed, all reliable
evidence points to the contrary conclusion that we reach as to
this issue. On the basis of our review of the record, we are
convinced that the purpose and operation of the Neonatology Plan
and the Lakewood Plan was to serve as a tax-free savings device
for the owner/employees and not, as asserted by petitioners, to
provide solely term life insurance to the covered employees. To
be sure, some of the plans even went so far as to purchase
annuities for designated employee/owners.
2. Lakewood’s Payments Made Outside of Its Plan
Lakewood made payments outside of the Lakewood Plan for
additional life insurance for two of its employees. Lakewood
argues that these payments are deductible in full under section
162(a) as ordinary and necessary business expenses. We disagree.
For the reasons stated above, we hold that these payments are
nondeductible constructive distributions to the extent they did
not fund term life insurance. The payments are deductible to the
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extent they did fund term life insurance for the relevant
employees.
3. Neonatology Contributions as to Mr. Mall
Neonatology contributed money to the Neonatology Plan for
the benefit of Mr. Mall. Mr. Mall was neither an employee of
Neonatology nor an individual who was eligible to participate in
Neonatology’s Plan. We conclude that these contributions served
no business purpose of Neonatology, and, hence, that they were
not ordinary and necessary expenses paid to carry on
Neonatology’s business. See sec. 1.162-10(a), Income Tax Regs.;
see also Joel A. Schneider, M.D., S.C. v. Commissioner, T.C.
Memo. 1992-24; Moser v. Commissioner, T.C. Memo. 1989-142. The
contributions are nondeductible constructive distributions to Dr.
Mall.33
4. & 5. Marlton Contributions as to Dr. Lo and Its Two Employees
Marlton contributed money to the Marlton Plan to purchase
life insurance on the lives of three individuals; namely, Dr. Lo,
Ms. Lo, and Edward Lo. As to Dr. Lo, he was neither a Marlton
employee nor an individual who was eligible to participate in
Marlton’s plan. We conclude that the contributions made on his
behalf served no legitimate business purpose of Marlton, and,
33
We view Dr. Mall, Neonatology’s sole shareholder, as
having directed her corporation to make these contributions on
behalf of her husband. Accordingly, we view these contributions
as passing first through Dr. Mall on the way to the Neonatology
Plan.
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hence, that they were not ordinary and necessary expenses paid to
carry on Marlton’s business. See sec. 1.162-10(a), Income Tax
Regs.; see also Joel A. Schneider, M.D., S.C. v. Commissioner,
supra; Moser v. Commissioner, supra. In contrast with
Neonatology’s contributions to purchase insurance on the life of
Mr. Mall, which we have just held were a constructive
distribution to Dr. Mall, the contributions which Marlton made on
behalf of Dr. Lo are not a constructive distribution to him
because Marlton is not a corporation.
As to Ms. Lo, she was a Marlton employee. Under section
264(a)(1), however, a taxpayer may not deduct life insurance
premiums to the extent that the taxpayer is “directly or
indirectly a beneficiary” of the underlying policy.34 Sec.
264(a)(1). Respondent argues that section 264(a)(1) applies to
disallow Marlton’s deduction of the contributions that it made to
pay the premiums on Ms. Lo’s term life insurance policy because,
34
Sec. 264(a)(1) provides:
SEC. 264. CERTAIN AMOUNTS PAID IN CONNECTION WITH
INSURANCE CONTRACTS.
(a) General Rule.--No deduction shall be allowed
for–-
(1) Premiums paid on any life insurance
policy covering the life of any officer or
employee, or of any person financially
interested in any trade or business carried
on by the taxpayer, when the taxpayer is
directly or indirectly a beneficiary under
such policy.
- 83 -
respondent asserts, the policy’s beneficiary was a grantor trust
formed by the Los.
We agree with respondent’s conclusion that section 264(a)(1)
prevents Marlton from deducting the contributions which it made
to its plan to pay the premiums on Ms. Lo’s term life insurance
policy. We do so, however, for reasons different from the reason
espoused by respondent. As we see it, Marlton’s deduction of its
contributions for Ms. Lo’s life insurance policy turns on whether
Marlton35 was “directly or indirectly a beneficiary” of that
policy within the meaning of section 264(a)(1). If it was, the
premiums are not deductible, regardless of whether they would
otherwise be deductible as a business expense. See Carbine v.
Commissioner, 83 T.C. 356, 367-368 (1984) (and cases cited
thereat), affd. 777 F.2d 662 (11th Cir. 1985); Glassner v.
Commissioner, 43 T.C. 713, 715 (1965), affd. per curiam 360 F.2d
33 (3d Cir. 1966); sec. 1.264-1(a), Income Tax Regs.
Respondent asserts that the policy’s beneficiary was the
Los’ grantor trust. We are unable to find that such was the
case. As we view the record, and as we found supra, the
beneficiary of Ms. Lo’s term life insurance policy was the
Marlton Plan. Although the trust to which respondent refers was
indeed the beneficiary of Dr. Lo’s policy, we find nothing in the
35
For the purpose of our inquiry, we view Marlton, a sole
proprietorship, as an alter ego of Dr. Lo, the sole proprietor.
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record to suggest that the same trust also was the beneficiary of
Ms. Lo’s policy. Nor has respondent pointed us to any part of
the record that would support such a finding.
We ask whether Dr. Lo is a direct or indirect beneficiary of
Ms. Lo’s term life insurance policy given the fact that the
Marlton Plan is the named beneficiary. We conclude that he is.36
In the event of Ms. Lo’s death, the face value of her life
insurance policy would be paid to the Marlton Plan, for which Dr.
Lo and Edward Lo would be the remaining beneficiaries. Although
Dr. Lo would not be the sole beneficiary of those death benefits,
section 264(a)(1) requires only that he be a beneficiary in order
to render the premiums nondeductible. See Keefe v. Commissioner,
15 T.C. 947, 952-953 (1950). Nor does it matter for purposes of
section 264(a)(1) that he was not expressly listed on Ms. Lo’s
policy as the beneficiary thereof. See Rieck v. Heiner, 25 F.2d
453 (3d Cir. 1928).
Dr. Lo, as opposed to Edward Lo, also stood to gain the most
from the plan assets, were Ms. Lo to have died. Whereas Edward
Lo had a fairly inexpensive term life insurance policy, Dr. Lo
had a fairly expensive universal life policy. Ms. Lo’s life
insurance proceeds also could be used to pay the premiums on the
36
For the same reasons as stated infra, we also conclude
that Dr. Lo is a direct or indirect beneficiary of Edward Lo’s
term life insurance policy, and, hence, that Marlton may not
deduct the contributions that it made to its plan to pay his
premiums.
- 85 -
policies, thus satisfying the obligation of Marlton to do so.
See Rodney v. Commissioner, 53 T.C. 287, 318-319 (1969) (benefit
requirement of section 264(a)(1) is satisfied where the insurance
would ultimately satisfy an obligation of the taxpayer); Glassner
v. Commissioner, supra (same).
6. Disallowed Payments
A corporate distribution is taxed as a dividend to the
recipient shareholder to the extent of the corporation’s earnings
and profits. The portion of the distribution that is not a
dividend is a nontaxable return of capital to the extent of the
shareholder’s stock basis. The remainder of the distribution is
taxed to the shareholder as gain from the sale or exchange of
property. See sec. 301(c); Enoch v. Commissioner, 57 T.C. 781,
793 (1972); see also Commissioner v. Makransky, 321 F.2d at 601.
Petitioners do not challenge respondent’s determination that
Lakewood and Neonatology had sufficient earnings and profits to
characterize the subject distributions as dividends. We sustain
respondent’s determination that all the distributions are taxable
dividends to the recipient employee/owners. See Rule 142(a);
Welch v. Helvering, 290 U.S. at 115.
Petitioners challenge the timing of that income, however,
arguing that it is not taxable to the employee/owners in the year
determined by respondent; i.e., the year in which Neonatology and
Lakewood contributed the excess amounts to their plans or, in the
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three instances where the insurance was purchased directly from
Peoples Security, in the year that Lakewood paid Peoples Security
for that insurance. Petitioners assert that the income is not
taxable to the employee/owners until after the subject years
because the conversion credit balance would be forfeited if the
underlying policy lapsed or if the insured died. Petitioners
observe that the employee/owners’ ability to withdraw the
conversion credit balance was limited to the percentage of that
balance that was transferred to the C-group conversion UL policy.
Petitioners observe that the transferred credits could be reached
by an insured only if a C-group term policy was converted to a C-
group conversion UL policy, and then only in equal increments
over 120 months. Petitioners observe that an insured would
forfeit the transferred credits in the event of his or her death.
Petitioners rely primarily on section 83(a).
Respondent argues that the income is taxable currently.
Respondent asserts that the excess contributions purchased
insurance contracts and annuities for the benefit of the
employee/owners. Respondent asserts that the employee/owners had
the unfettered ability to withdraw the conversion credit balances
at their whim.
We agree with respondent that the dividends are taxable in
the years that he determined. As mentioned supra, we view
Neonatology and Lakewood’s excess contributions to their plans as
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passing first through the employee/owners. We view likewise the
excess payments which Lakewood made directly to Peoples Security.
Accordingly, in both cases, the employee/owners are considered
for purposes of the Federal tax law to have received the excess
contributions (or payments) when the contributions (or payments)
were first made.
Petitioners rely mistakenly on section 83 to argue that the
individual petitioners may not be taxed currently on the excess
contributions.37 Section 83 has no application to a case such as
37
Sec. 83 provides in relevant part:
SEC. 83. PROPERTY TRANSFERRED IN CONNECTION WITH
PERFORMANCE OF SERVICES.
(a) General Rule.--If, in connection with the
performance of services, property is transferred to any
person other than the person for whom such services are
performed, the excess of--
(1) the fair market value of such
property (determined without regard to any
restriction other than a restriction which by
its terms will never lapse) at the first time
the rights of the person having the
beneficial interest in such property are
transferable or are not subject to a
substantial risk of forfeiture, whichever
occurs earlier, over
(2) the amount (if any) paid for such
property,
shall be included in the gross income of the person who
performed such services in the first taxable year in
which the rights of the person having the beneficial
interest in such property are transferable or are not
subject to a substantial risk of forfeiture, whichever
(continued...)
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this where a corporation makes a cash distribution for the
benefit of a shareholder, even when, as is the case here, that
shareholder is also an employee of the distributing corporation.
Section 83 requires a transfer of property in connection with the
performance of services, see sec. 83(a), and, as explained supra,
such a requirement is not met in the case of a distribution.
7. Accuracy-Related Penalties
Respondent determined that each petitioner was liable for an
accuracy-related penalty under section 6662(a) and (b)(1) for
negligence or intentional disregard of rules and regulations.
Petitioners argue that none of them are so liable. Petitioners
assert that they were “approached by various professionals” who
introduced petitioners to the VEBA’s and that they invested in
the VEBA’s relying on “tax opinion letters written by tax
attorneys and accountants and discussions with insurance
brokers”. Petitioners assert that the accountants who prepared
their returns agreed with the reporting position taken as to the
contributions, as evidenced by the fact that the accountants
prepared the returns in the manner they did. Petitioners assert
that many of the issues at bar are matters of first impression,
which, petitioners conclude, means they cannot be liable for an
accuracy-related penalty for negligence.
37
(...continued)
is applicable. * * *
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We disagree with all of petitioners’ assertions as to the
accuracy-related penalties determined by respondent under section
6662(a) and (b)(1). Section 6662(a) and (b)(1) imposes a 20-
percent accuracy-related penalty on the portion of an
underpayment that is due to negligence or intentional disregard
of rules or regulations. Negligence includes a failure to
attempt reasonably to comply with the Code. See sec. 6662(c).
Disregard includes a careless, reckless, or intentional
disregard. See id. An underpayment is not attributable to
negligence or disregard to the extent that the taxpayer shows
that the underpayment is due to the taxpayer’s reasonable cause
and good faith. See secs. 1.6662-3(a), 1.6664-4(a), Income Tax
Regs.
Reasonable cause requires that the taxpayer have exercised
ordinary business care and prudence as to the disputed item. See
United States v. Boyle, 469 U.S. 241 (1985); see also Hatfried,
Inc. v. Commissioner, 162 F.2d 628, 635 (3d Cir. 1947); Girard
Inv. Co. v. Commissioner, 122 F.2d 843, 848 (3d Cir. 1941);
Estate of Young v. Commissioner, 110 T.C. 297, 317 (1998). The
good faith reliance on the advice of an independent, competent
professional as to the tax treatment of an item may meet this
requirement. See United States v. Boyle, supra; sec. 1.6664-
4(b), Income Tax Regs.; see also Hatfried, Inc. v. Commissioner,
supra at 635; Girard Inv. Co. v. Commissioner, supra at 848;
- 90 -
Ewing v. Commissioner, 91 T.C. 396, 423 (1988), affd. without
published opinion 940 F.2d 1534 (9th Cir. 1991). Whether a
taxpayer relies on advice and whether such reliance is reasonable
hinge on the facts and circumstances of the case and the law that
applies to those facts and circumstances. See sec. 1.6664-
4(c)(i), Income Tax Regs. A professional may render advice that
may be relied upon reasonably when he or she arrives at that
advice independently, taking into account, among other things,
the taxpayer’s purposes for entering into the underlying
transaction. See sec. 1.6664-4(c)(i), Income Tax Regs.; see also
Leonhart v. Commissioner, 414 F.2d 749 (4th Cir. 1969), affg.
T.C. Memo. 1968-98. Reliance may be unreasonable when it is
placed upon insiders, promoters, or their offering materials, or
when the person relied upon has an inherent conflict of interest
that the taxpayer knew or should have known about. See Goldman
v. Commissioner, 39 F.3d 402 (2d Cir. 1994), affg. T.C. Memo.
1993-480; LaVerne v. Commissioner, 94 T.C. 637, 652-653 (1990),
affd. without published opinion 956 F.2d 274 (9th Cir. 1992),
affd. in part without published opinion sub nom. Cowles v.
Commissioner, 949 F.2d 401 (10th Cir. 1991); Marine v.
Commissioner, 92 T.C. 958, 992-93 (1989), affd. without published
opinion 921 F.2d 280 (9th Cir. 1991). Reliance also is
unreasonable when the taxpayer knew, or should have known, that
the adviser lacked the requisite expertise to opine on the tax
- 91 -
treatment of the disputed item. See sec. 1.6664-4(c), Income Tax
Regs.
In sum, for a taxpayer to rely reasonably upon advice so as
possibly to negate a section 6662(a) accuracy-related penalty
determined by the Commissioner, the taxpayer must prove by a
preponderance of the evidence that the taxpayer meets each
requirement of the following three-prong test: (1) The adviser
was a competent professional who had sufficient expertise to
justify reliance, (2) the taxpayer provided necessary and
accurate information to the adviser, and (3) the taxpayer
actually relied in good faith on the adviser’s judgment. See
Ellwest Stereo Theatres, Inc. v. Commissioner, T.C. Memo.
1995-610; see also Rule 142(a); Welch v. Helvering, 290 U.S. at
115. We are unable to conclude that any of petitioners has met
any of these requirements. First, none of petitioners has
established that he, she, or it received advice from a competent
professional who had sufficient expertise to justify reliance.38
The “professional” to whom petitioners refer is their insurance
agent, Mr. Cohen. Mr. Cohen is not a tax professional, nor do we
find that he ever represented himself as such. Petitioners’ mere
reliance on Mr. Cohen was unreasonable, given the primary fact
that he was known by most of them to be involved intimately with
38
We note at the start that we heard no testimony from Dr.
McManus or Lo, their respective wives, or Ms. Sobo.
- 92 -
and to stand to gain financially from the sale of both the
subject VEBA’s and the C-group product. Given the magnitude of
petitioners’ dollar investment in the C-group product and the
favorable consequences which Mr. Cohen represented flowed
therefrom, any prudent taxpayer, especially one who is as
educated as the physicians at bar, would have asked a tax
professional to opine on the tax consequences of the C-group
product. The represented tax benefits of the C-group product
were simply too good to be true. Such is especially so when we
consider the fact that the physicians who testified admitted that
they knew that term insurance was significantly less expensive
than the premiums purportedly paid under the C-group product
solely for term insurance.
Petitioners assert on brief that they also relied on tax
opinion letters written by tax attorneys and accountants. We do
not find that such was the case. The record contains neither a
credible statement by one or more of the individual petitioners
to the effect that he or she saw and relied on a tax opinion
letter, nor a tax opinion letter written by a competent,
independent tax professional. In fact, petitioners have not even
proposed a finding of fact that would support a finding that such
a tax opinion letter exists, let alone that any of them ever read
- 93 -
or relied on one. See Rule 143(b) (statements on brief are not
evidence).39
We also are unpersuaded by petitioners’ assertion that they
relied reasonably on the correctness of the contents of their
returns simply because their returns were prepared by certified
public accountants. The mere fact that a certified public
accountant has prepared a tax return does not mean that he or she
has opined on any or all of the items reported therein. In this
regard, the record contains no evidence that, possibly with the
exception of Dr. Hirshkowitz, any of petitioners asked a
competent accountant to opine on the legitimacy of his, her, or
its treatment for the contributions, or that an accountant in
fact did opine on that topic. In the case of Dr. Hirshkowitz,
the record does reveal that he showed his accountant something on
the SC VEBA and that the accountant expressed some reservations
as to the advertised tax treatment of the SC VEBA, but no
reservations which Dr. Hirshkowitz considered “major”, as he put
it. The record does not reveal what exactly Dr. Hirshkowitz
showed his accountant as to the SC VEBA or the particular
reservations which the accountant expressed. Nor do we know
whether a reasonable person would consider those reservations to
39
Because petitioners have failed the first prong of the
three-prong test set forth above, we do not set forth a copious
discussion of our holdings as to the other two prongs. Suffice
it to say that none of petitioners has met his, her, or its
burden of proof as to those prongs.
- 94 -
be “major” from the point of view of accepting Mr. Cohen’s
representations of the tax consequences which flowed from the SC
VEBA.
We also are not persuaded by petitioners’ assertion that the
accuracy-related penalties are inapplicable because, they claim,
the issues at bar are matters of first impression. It is not new
in the arena of tax law that individual shareholders have tried
surreptitiously to withdraw money from their closely held
corporations to avoid paying taxes on those withdrawals. The
fact that the physicians at bar have attempted to do so in the
setting of a speciously designed life insurance product does not
negate the fact that the underlying tax principles involved in
this case are well settled. Nor does the application of the
negligence accuracy-related penalty turn on the fact that this
case is a “test case” as to the tax consequences flowing from a
taxpayer’s participation in the subject VEBA’s. When the
requirements for the negligence accuracy-related penalty are met,
a taxpayer in a test case is just as negligent as the taxpayers
who have agreed to be bound by the resolution of the test case.
We conclude that each of petitioners is liable for the
accuracy-related penalties determined by respondent.
8. Addition to Tax for Failure To File Timely
Lakewood filed its 1992 tax return with the Commissioner on
May 28, 1993. The unextended due date of the return was March
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15, 1993, and Lakewood neither requested nor received an
extension from that date. Respondent determined that Lakewood’s
untimely filing made it liable for an addition to tax under
section 6651(a) equal to 15 percent of the underpayment, and
Lakewood has not shown reasonable cause for its untimely filing.
We sustain respondent’s determination and hold that Lakewood is
liable under section 6651(a) for an addition to tax of 5 percent
for each month during which its failure continued, or, in other
words, a 15-percent addition to tax as determined by respondent.
See sec. 6651(a)(1); see also Rule 142(a).
9. Penalties Under Section 6673(a)(1)(B)
Respondent moves the Court under section 6673(a)(1)(B) to
impose a $25,000 penalty against each petitioner, asserting that
petitioners’ positions in this proceeding are frivolous and
groundless. Respondent asserts that the C-group product is a
“deceptive subterfuge” that was “designed to deceive on its
face”. Respondent asserts that petitioners have not proven the
critical allegations set forth in their petitions as to the
operation of the C-group product and that, at trial, petitioners,
through their counsel, Mr. Prupis and Kevin Smith (Mr. Smith),
contested unreasonably the admissibility of documents that
respondent obtained from third parties as to the workings of the
C-group product. Respondent asserts that petitioners, through
Messrs. Prupis and Smith, failed to comply fully with discovery
- 96 -
requests, “forcing respondent to attempt to obtain the vast
majority of the documentary evidence in this case from third
parties”. Respondent asserts that petitioners were unreasonable
by calling witnesses at trial to testify in support of
petitioners’ proposed findings of fact that the C-group term
policy’s only benefit is current life insurance protection.
Respondent asserts that it was unreasonable for Mr. Smith to
defend against (1) respondent’s motion to compel documents from
AEGON USA, Mr. Smith’s client, and (2) respondent’s offer of
evidence as to certain marketing materials and other evidence.
Petitioners argue that their positions are meritorious.
Petitioners assert that respondent’s motion to impose sanctions
against each of them is frivolous and that the Court should
sanction respondent’s counsel under section 6673(b)(2).
We disagree with respondent’s assertion that we should order
each petitioner to pay a penalty to the Government under section
6673(a)(1)(B).40 Section 6673(a)(1)(B) provides this Court with
the discretion to award to the Government a penalty of up to
$25,000 when a taxpayer takes a frivolous or groundless position
in this Court. The penalty under section 6673(a)(1)(B) is
imposed against each taxpayer, see sec. 6673(a)(1), and a
taxpayer’s position is frivolous or groundless if it is contrary
40
We also decline petitioners’ invitation to sanction
respondent’s counsel.
- 97 -
to established law and unsupported by a reasoned, colorable
argument for change in the law, see Coleman v. Commissioner, 791
F.2d 68, 71 (7th Cir. 1986). Section 6673(a)(2)(B) provides this
Court with the discretion to sanction respondent’s counsel if he
or she “unreasonably and vexatiously” multiples any proceedings
before us.
The mere fact that petitioners are defending the position
that was advertised to them in connection with their investment
in the subject VEBA’s is insufficient grounds to penalize each
petitioner under the facts herein. Petitioners are not directly
responsible for most of the actions listed by respondent in
support of his motion to impose penalties. Those actions are
best traced to petitioners’ counsel, and, given the facts of this
case, we decline to impute the actions of petitioners’ counsel to
petitioners themselves for the purposes of imposing a penalty
under section 6673(a)(1)(B). Petitioners have reasonably relied
on the advice of their trial counsel that their litigating
positions had merit. See Murphy v. Commissioner, T.C. Memo.
1995-76 (section 6673 penalty against taxpayer was inappropriate
where serious failure to present credible evidence at trial was
attributable to her counsel).
We conclude our report directing the parties to prepare
computations under Rule 155 in all but one of the docketed cases,
taking into account the cost of term life insurance for those
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employees who were eligible to receive that protection. In
reaching our holdings we have considered all of petitioners’
arguments for contrary holdings; those arguments not discussed
herein are irrelevant or without merit. We also have considered
respondent’s arguments as to his determinations to the extent
necessary to reject or sustain each determination. We also have
considered all of respondent’s arguments as to his motion to
impose a penalty against each petitioner.
As mentioned supra,
Decision will be entered for
respondent in docket No. 4572-97,
decisions will be entered under
Rule 155 in all other dockets, and
an appropriate order will be issued
denying respondent’s motion to
impose penalties under section
6673(a)(1)(B).