Loan” in connection with insurance funded by corporation was
taxable distribution
Todd, TC Memo 2011-123
The Tax Court has concluded that the supposedly borrowed
amount that the sole shareholder of a corporation received from a welfare
benefit fund, in connection with a life insurance policy funded by the
corporation, was taxable income to the shareholder and not a bona fide loan.
Background. The U.S. Court of Appeals for the Fifth Circuit,
to which an appeal in this case would lie, has held that whether a transaction
constitutes a loan for income tax purposes is a factual question involving
several considerations. The distinguishing characteristic of a loan is the
intention of the parties that the money advanced be repaid. ( Moore v. U.S.,
(CA 5, 1969) 24 AFTR 2d 69-5024 )
In determining whether a distribution is a nontaxable loan,
courts have analyzed the following seven objective factors:
(1) Whether the promise to repay was evidenced by a note or
other instrument;
(2) Whether interest was charged;
(3) Whether a fixed schedule for repayment was established;
(4) Whether collateral was given to secure payment;
(5) Whether repayments were made;
(6) Whether the borrower had a reasonable prospect of
repaying the loan and whether the lender had sufficient funds to advance the
loan; and
(7) Whether the parties conducted themselves as if the
transaction was a loan. (Goldstein, TC Memo 1980-273 )
Facts. Frederick D. Todd, a practicing neurosurgeon, was
employed by his wholly owned corporation, Frederick D. Todd, II, M.D., P.A.
(Corporation). He was also its director and president. Corporation employed
several other individuals as well. Corporation became a member of the American
Workers Master Contract Group (AWMCG), which represented it in labor
negotiations with the union that represented Corporation's employees. Under the
agreement, Corporation would provide its employees with a death benefit only
(DBO) plan organized through a welfare benefit fund established between AWMCG
and the union. The welfare benefit fund, the American Workers Benefit Fund
(AWBF), was later succeeded in a merger by the United Employees Benefit Fund
(UEBF), another welfare benefit fund. AWBF's obligation to pay a death benefit
ceased if Corporation's covered employee was voluntarily or involuntarily
terminated or retired; if Corporation ceased making contributions; or if the
master contract between the union and the master contract group wasn't renewed.
Todd obtained a $6 million universal life insurance on his
life from Southland Life Insurance Co. (Southland) on behalf of AWBF. The
annual premium on the policy was approximately $100,000. The policy was owned
solely by AWBF to provide insurance to fund the death benefits owed by AWBF to
Todd's wife. Corporation made yearly contributions to AWBF on Todd's behalf.
Under the UEBF trust agreement, the employer and employee
trustees had discretionary authority to make loans to a plan participant on a
nondiscriminatory basis upon application and written evidence of an emergency
or serious financial hardship. Todd claimed “unexpected housing costs,” and
obtained a $400,000 loan from UEBF. To effectuate the loan payment, UEBF
reduced the face value of Todd's life insurance policy, rather than pay the
4.76% interest Southland would charge for the loan proceeds.
Todd signed a promissory note for the $400,000 loan some six
months after the payment. Although the agreement required market rate interest
to be paid on a loan, the note charged 1% interest, with loan payments to be
made quarterly. In addition, the note included an alternative means of
repayment (the “dual repayment mechanism”), under which, in the absence of
quarterly payments by Todd, UEBF could instead deduct the outstanding loan
balance from any payment or distribution due from UEBF to Todd or his
beneficiary. Shortly thereafter, Corporation stopped making its annual
contributions to UEBF on behalf of Todd's DBO plan, and UEBF ceased premium
payments on the policy.
While Todd argued that the $400,000 payment was nontaxable,
IRS characterized this “loan” as a taxable distribution.
Court's decision. The Tax Court concluded that $400,000
distribution from UEBF didn't constitute a bona fide loan, and that Todd
improperly failed to report this amount as income.
In reaching this conclusion, the Court analyzed the seven
factors used to determine if a bona fide loan exists. It found that five factors
indicated that the parties didn't intend to establish a debtor-creditor
relationship at the time the funds were advanced (Factors 1, 2, 3, 5, and 7),
while one factor did (Factor 6), and one indicated a possible intent to do so
(Factor 4).
(1) Presence of a note. Despite the requirements in their
agreement, the debt wasn't contemporaneously memorialized when the money was
distributed. Further, the terms of the trust agreement and note weren't
followed: UEBF failed to charge a market rate of interest, and Todd failed to
make quarterly payments;
(2) Interest rate. Todd was charged 1% interest rate by UEBF
on the promissory note, lower than the market rate. In comparison, Southland
charged a rate of 4.76% on a similar loan;
(3) Repayment schedule. UEBF didn't provide Todd with an
amortization schedule reflecting quarterly payments until three months after
the first payment was due under the note's terms, and the note wasn't executed
until almost four months after the first payment was due;
(4) Collateral. At the time of the purported loan, Todd
didn't own the policy (UEBF did), had no access to the cash value of the
policy, and had no rights to the proceeds from the policy. However, the Tax
Court found that the dual repayment mechanism could serve as security between
the parties for the promissory note. The dual repayment mechanism allowed UEBF
to deduct the $400,000 distribution from the death benefit obligation;
(5) Repayments. As of the date of trial, Todd hadn't made
any payments toward the purported loan. The Court rejected Todd's argument that
the dual repayment mechanism served as a valid method of repayment (although it
had accepted that it could serve as security). Because the purported benefits
under the DBO plan were contingent on multiple future events (e.g., Corporation
might cease participation in the UEBF plan, the covered employee might be
terminated or retired, or the master contract group and the union might not
renew their agreement), Todd couldn't reasonably rely on the death benefit as
an alternative payment;
(6) Prospect of repaying. Todd earned a substantial living
as a neurosurgeon, so there was a reasonable prospect of his repaying the
purported loan; and
(7) Parties' conduct. Neither UEBF nor Todd conducted
themselves in a manner indicating that the distribution was a loan. Neither
strictly abided by the note's terms. There was no inquiry into the hardship
justifying the loan. The interest rate was below market. No quarterly payments
were made. UEBF never attempted collection when quarterly payments weren't
made.
Frederick D. Todd, II, et ux. v. Commissioner, TC Memo
2011-123 , Code Sec(s) 61; 6651; 6662; 7491.
FREDERICK D. TODD, II AND LINDA D. TODD, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information:
Code Sec(s): 61;
6651; 6662; 7491
Docket: Docket
No. 26378-06.
Date Issued:
06/6/2011
Judge: Opinion by
HAINES
HEADNOTE
XX.
Reference(s): Code Sec. 61 ; Code Sec. 6651 ; Code Sec. 6662
; Code Sec. 7491
Syllabus
Official Tax Court Syllabus
Counsel
David B. Shiner and Sanjay Shivpuri, for petitioners.
Angela B. Friedman, Jason W. Anderson, and David S. Weiner,
for respondent.
HAINES, Judge
MEMORANDUM FINDINGS OF FACT AND OPINION
After concessions, the issues for decision are: (1) Whether petitioner
Frederick D. Todd II (petitioner) received a taxable distribution of $400,000
from United Employee Benefit Fund (UEBF) in 2002; (2) alternatively, if
petitioner did not receive a taxable distribution from UEBF in 2002, whether
petitioner received $412,973 of discharge of indebtedness income in 2003; (3)
whether petitioners are liable for an addition to tax under section 6651(a)(1)
for 2003; and (4) whether petitioners are liable for a section 6662 penalty for 2002 or 2003. 1
Some of the facts have been stipulated and are so found. The
stipulations of facts and the exhibits attached thereto are incorporated herein
by this reference. At the time they filed their petition, petitioners resided
in Texas.
FINDINGS OF FACT
Petitioner was a practicing neurosurgeon employed by
Frederick D. Todd, II, M.D., P.A. (corporation), a Texas corporation of which
petitioner was the sole shareholder, director, and president. The corporation
also employed a few individuals who worked with petitioner.
On August 18, 1995, petitioner signed an application on
behalf of the corporation to become a member of the American Workers Master
Contract Group (AWMCG), authorizing AWMCG to represent the corporation in
negotiations with the National Production Workers Union Local 707 (Local 707),
the union representing the corporation's employees. The corporation agreed to
provide eligible employees with a death benefit only (DBO) plan organized
through the American Workers Benefit Fund (AWBF), a welfare benefit fund
established between AWMCG and Local 707.
The agreement provided that upon a covered employee's death,
AWBF would provide the employee's designated beneficiary with an amount equal
to eight times the employee's annual income up to $6 million. However, AWBF's
obligation to pay a death benefit ceased if the corporation's covered employee
was voluntarily or involuntarily terminated or retired; if the corporation
ceased making contributions; or if the master contract between the union and
the master contract group was not renewed. As an eligible employee of the
corporation, petitioner enrolled in the DBO plan, designating petitioner Linda
D. Todd as the beneficiary of the $6 million death benefit. A few of
petitioner's fellow eligible employees also participated in the DBO plan.
On September 5, 1995, petitioner submitted an application
for life insurance to Southland Life Insurance Co. (Southland) on behalf of
AWBF. On November 15, 1995, Southland issued a $6 million universal life
insurance policy (policy No. 5160) on petitioner's life to AWBF. The annual
premium on policy No. 5160 was approximately $100,000. The policy was owned
solely by AWBF to provide insurance to fund the death benefit owed by AWBF to
petitioner's wife if petitioner died. The corporation made yearly contributions
to AWBF on behalf of petitioner and his fellow covered employees and deducted
those payments under section 419A(f)(5).
Upon receipt of the corporation's yearly contribution, AWBF paid the premium on
policy No. 5160.
On July 21, 1999, petitioner submitted another application
for life insurance to Southland. On October 1, 1999, Southland issued a $6
million indexed universal life insurance policy (policy No. 8889) on
petitioner's life that required an annual premium of approximately $100,000. On
December 3, 1999, petitioner transferred ownership of policy No. 8889 to AWBF.
On January 28, 2000, AWBF rolled policy No. 5160, which had an accumulation
value of $315,773, into policy No. 8889 pursuant to section 1035, resulting in a single $6
million policy on petitioner's life.
On December 18, 2000, AWBF merged into United Employees
Benefit Fund (UEBF). UEBF was a welfare benefit fund established between
Professional Workers Master Contract Group and the Union of Needletrades,
Industrial and Textile Employees, Local 2411 (Local 2411), to provide a DBO
plan to eligible employees of participating employers. Before November 2001
petitioner's corporation made yearly contributions to AWBF on behalf of
petitioner and his fellow covered employees and deducted those payments as
contributions to AWBF. After receiving notice of the transfer of the insurance
policies on the lives of the corporation's employees from AWBF to UEBF on
November 15, 2001, the corporation made contributions to UEBF, which paid the
premiums on the Southland life insurance policies held on the lives of
petitioner and his covered employees.
Under article 8 of the UEBF Trust Agreement (trust
agreement), the employer and employee trustees had discretionary authority to
make loans to a plan participant on a nondiscriminatory basis. 2 Upon an
application and written evidence of an emergency or serious financial hardship
from the eligible employee, the trustees could make a loan up to the amount of
the present value of the death benefit. 3 David Fensler was a certified
employee benefit specialist and was the employer trustee and administrator of
both UEBF and AWBF. James Skonicki was the employee trustee of UEBF from before
1998 through 2002. On May 20, 2002, Southland notified petitioner's insurance
agent that the maximum available distribution from policy No. 8889 was $400,000
and that any greater distribution would cause the policy to lapse. On July 11,
2002, petitioner submitted to UEBF an application for a loan of $400,000 for
“unexpected housing costs”.
Upon receipt of petitioner's loan application, Mr. Fensler
recommended to Mr. Skonicki that the loan 4 to petitioner be approved. Neither
Mr. Fensler nor Mr. Skonicki made further inquiries into the hardship claimed
by petitioner. On August 26, 2002, Mr. Fensler submitted a policy loan request
to Southland requesting a loan of $400,000 on policy No. 8889. However, after
receiving the loan check, Mr. Fensler decided that the 4.76- percent interest
rate charged by Southland on the loan made the choice of a partial surrender
from policy No. 8889 a better prospect. 5 On August 30, 2002, petitioner agreed
to a distribution, which would reduce the face value of policy No. 8889 to
$5,600,000. On September 18, 2002, Southland reissued a check for $400,000 to
UEBF representing the distribution from policy No. 8889. Upon receipt of the
funds from Southland, UEBF issued a check for $400,000 to petitioner on
September 25, 2002. On October 25, 2002, the corporation made its annual
contribution to UEBF for petitioner's DBO plan, and on January 7, 2003, UEBF
made a premium payment to Southland on policy No. 8889. After 2003, however,
petitioner's corporation stopped making its annual contributions to UEBF on
behalf of petitioner's DBO plan, and UEBF ceased premium payments on policy No.
8889.
The trust agreement provided that a loan from UEBF had to be
secured by a pledge of the actuarially determined present value of the eligible
employee's death benefit and evidenced by an executed promissory note that
provided for payments at least quarterly. The trust agreement also required
that the loan bear a reasonable rate of interest, taking into account the
interest rates charged by persons in the business of lending money for loans
which would be made under similar circumstances.
Six months after the $400,000 check was delivered to
petitioner, and after Mr. Fensler provided an amortization schedule, on March
21, 2003, petitioner signed a promissory note to UEBF in the amount of
$400,000. The stated interest on the note was 1 percent, and the note provided
that petitioner make quarterly installment payments of $20,527 beginning on
November 1, 2002, and continuing until the note was paid.
The note and the trust agreement also included an
alternative means of repayment, referred to by petitioners as a “dual repayment
mechanism”. In the absence of quarterly payments by petitioner, the dual
repayment mechanism allowed UEBF to deduct the outstanding loan balance from
any payment or distribution due from UEBF to the participant or his beneficiary.
According to UEBF, the dual repayment mechanism prevented a participant from
defaulting on his obligation to repay the loan while any payments or
distributions were due to the participant under the terms of the agreement. At
the end of 2002 and 2003, petitioner owed a principal balance of $400,000. As
of the date of trial, petitioner had not made any payments on the note, and
UEBF had taken no action to collect on the note.
The trust agreement required that UEBF hire an auditor to
conduct a certified audit and issue an opinion as to the UEBF financial
statements. An accounting firm conducted a certified audit and, despite the
dual repayment mechanism and its purported protection against default,
determined that the purported loan to petitioner was in default because of the
nonreceipt of payments. For the taxable years 2002 and 2003, the auditor
required UEBF to report the loan as uncollectible or in default in 2002 and
2003 on Schedules G of Forms 5500, Annual Return/Report of Employee Benefit Plan.
UEBF and its trustees issued a statement expressing disagreement with the
auditor, explaining that the dual repayment mechanism prevented the loan from
entering default under the terms of the trust agreement and UEBF's policies and
procedures. The statement likewise explained that the loan was not in default
or uncollectible because petitioner's death benefit owed by UEBF under the DBO
plan would provide the necessary collateral for the payment of the promissory
note.
On July 5, 2005, petitioners filed delinquent 2002 and 2003
Federal income tax returns. On September 21, 2006, respondent issued a notice
determining deficiencies for 2002 and 2003 of $65,237 and $16,719,
respectively, together with section
6662(a) penalties of $13,047 and $3,344, respectively. The deficiencies were
based primarily on unreported dividends from life insurance contributions made
on petitioner's behalf by the corporation and denial of petitioners' claimed
charitable contribution deductions. Petitioners filed a petition with the Tax
Court for 2002 and 2003 on December 21, 2006.
In preparation for trial, respondent discovered petitioner
had received a $400,000 distribution from UEBF in 2002. Arguing that the
distribution was taxable upon receipt, respondent filed an amendment to answer
and asserted an increased deficiency for 2002 of $224,269 and an increased
penalty under section 6662(a) of
$44,854. Respondent alternatively argued that if the $400,000 distribution was
a valid loan, the indebtedness was discharged in 2003 and resulted in a
deficiency for 2003 of $165,596 and a penalty under section 6662(a) of $33,139. Respondent also
asserted an addition to tax under
section 6651(a)(1) of $29,184 for 2003 but none for 2002.
OPINION
I. Burden of Proof As a general rule the taxpayer bears the
burden of proving that the Commissioner's determinations set forth in a notice
of deficiency are erroneous. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111 [12 AFTR 1456] (1933). However,
the Commissioner has the burden of proof as to any new issue or increased
deficiency. Rule 142(a)(1). Respondent concedes that he bears the burden of
proof because the only issues to be decided were raised in the amendment to
answer.
II. Loan or Plan Distribution The parties agree that
petitioner received $400,000 from UEBF on September 25, 2002. Petitioners
maintain that the distribution was a loan which petitioner intended to repay.
Respondent argues that the distribution from UEBF to petitioner was taxable
income. The parties agree that UEBF did not distribute the funds in
satisfaction of its obligation to petitioner's beneficiaries under the DBO
plan.
Section 61(a)
provides the following broad definition of the term “gross income”: “Except as
otherwise provided in this subtitle, gross income means all income from
whatever source derived”. Exclusions from gross income must be narrowly
construed. Commissioner v. Schleier, 515
U.S. 323, 328 [75 AFTR 2d 95-2675] (1995). One such exclusion excepts the
receipt of loan proceeds from gross income because the temporary economic
benefit of income is offset by a corresponding obligation to repay. United
States v. Rochelle, 384 F.2d 748, 751
[20 AFTR 2d 5630] (5th Cir. 1967); Dennis v. Commissioner, T.C. Memo. 1997-275 [1997 RIA TC Memo
¶97,275]. However, for genuine indebtedness to be present there must be both
good-faith intent on the part of the borrower to repay the debt and good-faith
intent by the lender to enforce payment of the debt. Estate of Chism v.
Commissioner, 322 F.2d 956, 960 [12 AFTR
2d 5300] (9th Cir. 1963), affg. Chism Ice Cream Co. v. Commissioner, T.C. Memo. 1962-6 [¶62,006 PH Memo TC];
Wright v. Commissioner, T.C. Memo. 1992-60 [1992 TC Memo ¶92,060].
The U.S. Court of Appeals for the Fifth Circuit, to which an
appeal in this case would lie absent a stipulation otherwise, has held that
whether a transaction constitutes a loan for income tax purposes is a factual
question involving several considerations, and a distinguishing characteristic
of a loan is the intention of the parties that the money advanced be repaid.
Moore v. United States, 412 F.2d 974,
978 [24 AFTR 2d 69-5024] (5th Cir. 1969). Important factors considered by
courts in finding a bona fide debt are whether: (1) The promise to repay was evidenced
by a note or other instrument; (2) interest was charged; (3) a fixed schedule
for repayments was established; (4) collateral was given to secure payment; (5)
repayments were made; (6) the borrower had a reasonable prospect of repaying
the loan, and whether the lender had sufficient funds to advance the loan; and
(7) the parties conducted themselves as if the transaction was a loan. See
Goldstein v. Commissioner, T.C. Memo.
1980-273 [¶80,273 PH Memo TC] (and cases cited therein). We address each factor
in turn.
A. Whether the Promise To Repay Was
Evidenced by a Note or
Other
Instrument
A note or other instrument is indicative of a debtor-
creditor relationship. Teymourian v. Commissioner, T.C. Memo. 2005-232 [TC Memo 2005-232].
However, an instrument will be given little weight when the form of the
instrument fails to correspond with the Provost v. Commissioner, T.C. substance
of the transaction. Memo. 2000-177.
On September 25, 2002, UEBF issued a $400,000 check to
petitioner. Six months later, on March 21, 2003, petitioner signed a promissory
note to UEBF for a loan of $400,000. Despite the requirements within the trust
agreement, the parties failed to contemporaneously memorialize the indebtedness
when the money was distributed to petitioner. Moreover, the record further
reflects that neither petitioner nor UEBF adhered to the terms of the
promissory note or the trust agreement that governed the transaction. UEBF
failed to charge a market rate of interest, petitioner did not make quarterly
payments as required under the promissory note, and UEBF did not attempt to
collect the amount owed or any portion thereof after petitioner defaulted.
For the foregoing reasons, the Court finds that neither
petitioner nor UEBF strictly complied with the terms of the loan agreement or
the promissory note. Thus, the Court gives the promissory note little weight.
This factor indicates the parties did not intend to establish a debtor-creditor
relationship at the time the funds were advanced.
B. Whether Interest Was Charged
The payment of interest indicates the existence of a bona
Welch v. Commissioner, 204 F.3d 1228,
1230 [85 AFTR 2d 2000-1064] (9th Cir. fide loan. 2000), affg. T.C. Memo. 1998-121 [1998 RIA TC Memo
¶98,121]; Teymourian v. Commissioner, supra ; Morrison v. Commissioner, T.C. Memo. 2005-53 [TC Memo 2005-53]. The
trust agreement provided that a reasonable rate of interest should be charged,
taking into account the interest rates charged by persons in the business of
lending money under similar circumstances. Southland charged a rate of 4.76
percent on a similar loan, and petitioner acknowledges that the 1-percent
interest rate charged on the promissory note was lower than the market rate.
The failure of UEBF and petitioner to agree to a reasonable market rate of
interest as dictated by the trust agreement indicates the parties did not
intend to establish a debtor-creditor relationship at the time the funds were
advanced.
C. Whether a Fixed Schedule for Repayment Was Established A
fixed schedule for repayment is indicative of a bona fide loan. Welch v.
Commissioner, supra at 1231; Teymourian v. Commissioner, supra. Evidence that a
creditor did not intend to enforce payment or was indifferent to the exact time
an advance was repaid indicates a bona fide loan did not exist. Gooding
Amusement Co. v. Commissioner, 23 T.C.
408, 418-419 (1954), affd. 236 F.2d 159
[49 AFTR 1973] (6th Cir. 1956); Provost v. Commissioner, supra.
According to the promissory note, petitioner was to make
quarterly installment payments of $20,527 beginning on November 1, 2002, and
continuing until the note was fully paid. Three months after the first payment
was due, UEBF provided petitioner with an amortization schedule reflecting
quarterly payments that should have been paid beginning on November 1, 2002.
Almost 4 months after the first payment was due, the parties finally executed
the promissory note. Petitioner did not make any payments to UEBF, and UEBF
never attempted to collect the amount owed after each default. This factor
indicates the parties did not intend to establish a debtor-creditor
relationship at the time the funds were advanced.
D. Whether Collateral Was Given To Secure Payment Respondent
argues that petitioner provided no collateral because he did not own or have
any rights in the Southland insurance policies purchased on his life. AWBF
secured the potential death benefit obligation by purchasing policy No. 5160
from Southland. On July 21, 1999, petitioner purchased his own policy from
Southland, policy No. 8889. However, on December 3, 1999, petitioner
transferred ownership of policy No. 8889 to AWBF, which rolled the balance of
policy No. 5160 into policy No. 8889. After the merger of AWBF and UEBF in
2000, policy No. 8889 became the property of UEBF. At the time of the purported
loan, petitioner did not own the policy, had no access to the cash value of the
policy, and had no rights to the proceeds from the policy. Thus, respondent
correctly states that the policy cannot be treated as collateral for
petitioner's purported loan.
In response, petitioners claim that the death benefit owed
to them by UEBF under the DBO plan, and not the Southland insurance policies,
provided the necessary collateral for the payment of the promissory note.
Petitioners argue that when combined with the death benefit owed by UEBF, the
dual repayment mechanism served as collateral since any balance remaining on
the loan at the time of petitioner's death would reduce the death benefit
payable by UEBF to his beneficiaries. Thus, petitioner claims he provided the
necessary collateral despite making no payments or relinquishing control over
any property in favor of UEBF.
In our analysis below we find the dual repayment mechanism
does not serve as a valid repayment method for purposes of classifying the
distribution to petitioners as a bona fide loan. However, the mechanism could
serve as security between the parties for the promissory note. For example, if
petitioner died having met all conditions precedent entitling him to death
benefits, UEBF would receive $5,600,000 from Southland and would be obligated
to pay $6 million to petitioner's beneficiary. The dual repayment mechanism
agreed to by petitioners provides security and allows UEBF to deduct the
$400,000 distribution from the death benefit obligation. This factor indicates
the parties possible intent to establish a debtor-creditor relationship at the
time the funds were advanced.
E. Whether Repayments Were Made
Repayment is an indication that a loan is bona fide. Haber
v. Commissioner, 52 T.C. 255, 266
(1969), affd. 422 F.2d 198 [25 AFTR 2d
70-690] (5th Cir. 1970). Although petitioner signed a promissory note obligating
him to make quarterly payments beginning in November 2002, as of the date of
trial petitioner had not made any payments toward the purported loan.
Petitioners argue that the dual repayment mechanism serves as a valid method of
repayment.
For a valid debt to exist for tax purposes, there must exist
an unconditional obligation to repay. Midkiff v. Commissioner, 96 T.C. 724, 734-735 (1991) (”Indebtedness is
`an existing, unconditional, and legally enforceable obligation for the payment
of a principal sum.”, affd. sub nom. Noguchi v. Commissioner, 992 F.2d 226 [71 AFTR 2d 93-1557] (9th Cir.
1993) (quoting Howlett v. Commissioner,
56 T.C. 951, 960 (1971))). If a repayment mechanism is too contingent
and indefinite, the alternative payment method is not recognized. Zappo v.
Commissioner, 81 T.C. 77, 87-88 (1983).
Despite petitioners' characterization of the transaction and
the dual repayment mechanism, there are significant conditions precedent to
petitioners' receipt of a death benefit under the DBO plan from UEBF. If the
corporation ceased participation in the UEBF plan, if the covered employee was
voluntarily or involuntarily terminated or retired, or if the master contract
group and Local 2411 failed to renew their agreement, then UEBF was not required
to pay any benefits. Thus, even if petitioner had rights to a death benefit,
the rights were contingent because if any of the foregoing conditions were
present at the time of his death, his beneficiaries would not receive benefits
from UEBF. Because the purported benefits were contingent upon multiple future
events, petitioner cannot reasonably rely on the death benefit as an
alternative payment method to show that the loan would be unconditionally
repaid. This factor indicates the parties did not intend to establish a
debtor-creditor relationship at the time the funds were advanced.
F. Whether the Borrower Had a Reasonable
Prospect
of
Repaying the Loan and Whether the Lender Had
Sufficient Funds To Advance the Loan
This factor is best determined by looking to whether there
was “a reasonable expectation of repayment in light of the economic realities
of the situation” at the time the funds were advanced. Fisher v.
Commissioner, 54 T.C. 905, 909-910
(1970). A reasonable prospect of repayment at the time the funds were advanced
indicates the existence of a bona fide loan. Welch v. Commissioner, 204 F.3d at 1231 [85 AFTR 2d 2000-1067].
Petitioner earned a substantial living as a neurosurgeon,
and there was a reasonable prospect of petitioner's repaying the purported
loan. This factor favors the existence of a debtor- creditor relationship
between the parties.
G. Whether the Parties Conducted Themselves as if the
Transaction Were a Loan The conduct of the parties may be sufficient to
indicate the existence of a loan. Baird v. Commissioner, 25 T.C. 387, 395 (1955); Teymourian v.
Commissioner, T.C. Memo. 2005-232 [TC
Memo 2005-232]; Morrison v. Commissioner,
T.C. Memo. 2005-53 [TC Memo 2005-53].
Petitioners produced little evidence showing UEBF and
petitioner conducted themselves in a manner indicating that UEBF's distribution
of $400,000 to petitioner was a loan. Although petitioner executed a loan
application and a promissory note, neither party strictly abided by their
terms. First, petitioner failed to provide any written evidence of the
unexpected housing costs that necessitated the loan application, and UEBF made
no further inquiry into the hardship. Second, the interest rate was below
market, petitioner failed to make any quarterly payments as required under the
promissory note, and UEBF never attempted collection. Third, the promissory
note was not executed for almost 6 months after the funds were advanced.
Lastly, petitioner's corporation ceased making contributions to UEBF to fund
petitioner's death benefit shortly after petitioner received the $400,000
distribution from UEBF.
This factor indicates the parties did not intend to establish
a debtor-creditor relationship at the time the funds were advanced.
H. Conclusion
In accordance with our analysis above, respondent has met
his burden of proving that the distribution of $400,000 did not constitute a
bona fide loan. On this record, the Court holds that petitioners improperly
failed to report as income the $400,000 UEBF distributed to petitioner in 2002.
Because of our findings herein, it is unnecessary to address the parties'
arguments regarding a discharge of indebtedness by UEBF or the year in which it
occurred.
III. Penalties and Additions to Tax
A. Addition to Tax Under
Section 6651(a)(1) Section
6651(a)(1) imposes an addition to tax in the case of any failure to timely file
a Federal income tax return unless it is shown that such failure is due to
reasonable cause and not willful neglect. A showing of reasonable cause
requires petitioners to demonstrate they exercised ordinary business care and
prudence and nevertheless were unable to file the return by the due date. Sec. 301.6651-1(c)(1), Proced. & Admin.
Regs.
Petitioners filed their returns for 2002 and 2003 on July 5,
2005. Respondent did not assert a
section 6651(a)(1) addition to tax for 2002. The amount of the section 6651(a)(1) addition to tax is a
computational matter based on the amount of tax due. To the extent respondent
bears the burden of proving an increased
section 6651(a)(1) addition to tax, respondent has met this burden if
petitioners' concessions result in an increased deficiency for 2003. See sec. 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001); Howard v.
Commissioner, T.C. Memo. 2005-144 [TC
Memo 2005-144].
Petitioners admit that they did not have reasonable cause
for their failure to timely file and failed to argue that the addition should
not apply. Accordingly, we conclude that petitioners are liable for an addition
to tax under section 6651(a)(1) for 2003
in an amount to be determined in the Rule 155 computation.
B. Accuracy-Related Penalty Under Section 6662
Petitioners contest the imposition of an accuracy-related
penalty for 2002. 6 Section 6662(a)
and (b)(1) and (2) imposes a 20-percent
accuracy-related penalty upon any underpayment of Federal income tax
attributable to a taxpayer's negligence or disregard of rules or regulations,
or substantial understatement of income tax.
Section 6662(c) defines negligence as including any failure to make a
reasonable attempt to comply with the provisions of the Code and defines
disregard as any careless, reckless, or intentional disregard. Disregard of
rules or regulations is careless if the taxpayer does not exercise reasonable
diligence to determine the correctness of a tax return position that is
contrary to the rule or regulation.
Sec. 1.6662-3(b)(2), Income Tax Regs. Disregard of rules or regulations
is reckless if the taxpayer makes little or no effort An to determine whether a
rule or regulation exists. Id. understatement is substantial if it exceeds the
greater of 10 percent of the tax required to be shown on the return or
$5,000. Sec. 6662(d)(1)(A).
Under section
7491(c), the Commissioner bears the burden of production with respect to
penalties and must come forward with sufficient evidence indicating that it is
appropriate to impose penalties. Higbee v. Commissioner, supra at 446-447. Once
respondent meets his burden of production, petitioners bear the burden of proof
as to substantial authority, reasonable cause, or similar provisions. Id. In an
amendment to answer, respondent asserted an increased penalty based on the
asserted increased deficiency for each year at issue. To the extent respondent
bears the burden of proof for the increased 2002 penalty, we find that
respondent has met that burden. See Bhattacharyya v. Commissioner, T.C. Memo. 2007-19 [TC Memo 2007-19]; Howard
v. Commissioner, supra.
Respondent has proved that petitioners improperly excluded
from income in 2002 the $400,000 distribution from UEBF, which exceeds both 10
percent of the tax required to be shown on the return and $5,000. Respondent
has also shown that petitioners negligently disregarded rules and regulations
by failing to make a reasonable attempt to ascertain the correctness of the
treatment of the distribution. Petitioners arranged for a distribution from the
policy, accepted funds, and made no attempt to make payments on the purported
loan, thus defaulting. Moreover, petitioner provided no evidence that he
discussed his failure to meet the terms of his purported loan with his tax
return preparer or made any attempt to determine the correct treatment of his
failure to report any income associated with the distribution on his income tax
return. This evidence is sufficient to indicate that it is appropriate to
impose a penalty under section 6662(a)
for 2002, except to any portion of the underpayment as to which petitioners
acted with reasonable cause and in good faith. See sec. 6664(c)(1); Higbee v. Commissioner,
supra at 448. The decision as to whether a taxpayer acted with reasonable cause
and in good faith is made on a case-by-case basis, taking into account all of
the pertinent facts and circumstances.
Sec. 1.6664-4(b)(1), Income Tax Regs.
Reliance on professional advice may constitute reasonable
cause and good faith if, under all the circumstances, such reliance was
reasonable and the taxpayer acted in good faith. Freytag v. Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011 [66 AFTR 2d 90-5322] (5th Cir.
1990), affd. 501 U.S. 868 [68 AFTR 2d
91-5025] (1991); sec. 1.6664- 4(b)(1),
Income Tax Regs. However, the taxpayer cannot avoid the penalty merely by
having a professional adviser read a summary of the transaction and offer
advice that assumes the facts presented are true. See Novinger v.
Commissioner, T.C. Memo. 1991-289 [1991
TC Memo ¶91,289]. Moreover, the professional's advice must be based on all
pertinent facts and circumstances; and, if the adviser is not versed in the
nontax factors, mere reliance on the tax adviser See Addington v. United
States, 205 F.3d 54, 58 [85 AFTR 2d 2000-1048]
may not suffice. (2d Cir. 2000); Collins v. Commissioner, 857 F.2d 1383, 1386 [63 AFTR 2d 89-993] (9th
Cir. 1988), affg. Dister v. Commissioner,
T.C. Memo. 1987-217 [¶87,217 PH Memo TC]; Freytag v. Commissioner, supra
at 888, 889.
For a taxpayer's reliance on advice to be sufficiently
reasonable so as to negate possible liability for the accuracy- related
penalty, the Court has stated that a taxpayer must satisfy a three-prong test
by showing: (1) The adviser was a competent professional who had sufficient
expertise to justify reliance; (2) the taxpayer provided the adviser with the
necessary and accurate information; and (3) the taxpayer actually relied in
good faith on the adviser's judgment. Neonatology Associates P.A. v. Commissioner, 115 T.C. 43, 99 (2000), affd, 299 F.3d 221 [90 AFTR 2d 2002-5442] (3d Cir.
2002).
Petitioners claim that they relied on the tax advice of
Jeffrey Oerke, C.P.A., who prepared their 2002 return, and thus reasonable
cause exists. However, there is no evidence that Mr. Oerke had any particular
expertise in employee benefit plans or that petitioners thought he had such
expertise. Furthermore, petitioners failed to show that they provided Mr. Oerke
with all the necessary and accurate information to properly prepare their
returns or evaluate the purported loan. Petitioner testified that although he
provided Mr. Oerke with a copy of the promissory note, he was unsure whether
Mr. Oerke received any documents related to the DBO benefit plan. Finally, the
record indicates that petitioner did not seek or receive an opinion from Mr.
Oerke regarding the validity of the purported loan transaction. Instead, Mr.
Oerke merely prepared petitioners' income tax return for 2002 from the
documents petitioners provided. As we have stated, reliance on the mere fact
that a certified public accountant has prepared a tax return does not mean that
he or she Id. at 100. opined on any or all of the items reported herein. For
all of the foregoing reasons, petitioners are precluded from now arguing that
they relied on the tax advice of Mr. Oerke.
We conclude that petitioners' underpayment for 2002 was the
result of their substantial understatement of income tax and their negligence
and disregard of rules or regulations under
section 6662. We also conclude that petitioners are not entitled to the
reasonable cause and good faith defense under
section 6664 because they did not rely on their accountant. Thus, we
find that petitioners are liable for the accuracy-related penalty for 2002 pursuant
to section 6662 in an amount to be
determined in the Rule 155 computation. We do not impose a section 6662 penalty for 2003.
The Court, in reaching its holdings, has considered all
arguments made, and, to the extent not mentioned, concludes that they are moot,
irrelevant, or without merit.
To reflect the foregoing, Decision will be entered under
Rule 155.
1
Unless otherwise
indicated, section references are to the Internal Revenue Code (Code) as
amended and in effect for the years in issue. Rule references are to the Tax
Court Rules of Practice and Procedure. Amounts are rounded down to the nearest
dollar.
2
The loan
requirements of AWBF and UEBF were the same.
3
The present value of
the death benefit was to be actuarially computed using an assumed interest rate
of 8 percent and an assumed mortality of age 75.
4
Our reference to the
transaction as a loan is made for ease of discussion. This reference is not
dispositive of the status of the transaction, and the determination of whether
the transaction between petitioner and UEBF is a valid debt for tax purposes is
the subject of discussion below.
5
The midterm
applicable Federal rate, applicable to loans with terms of 3 to 9 years, was
3.75 percent for loans originating in September 2002. See sec. 1274(d);
Rev. Rul. 2002- 53, 2002-2 C.B. 427. The long-term applicable Federal
rate for loans originating in September 2002 was 5.23 percent. Rev. Rul. 2002-53, 2002-2 C.B. at 428.
6
Because of the
parties' concessions and our holding that petitioners improperly failed to
report the $400,000 distribution as income in 2002, we find it unnecessary to
address respondent's alternative position regarding the imposition of the
accuracy- related penalty for 2003 or petitioners' response thereto.
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