Neonatology Associates, P.A. v. Commissioner

Opinions of the United

2002 Decisions States Court of Appeals

for the Third Circuit

7-29-2002

Neonatology Assoc v. Commissioner IRS

Precedential or Non-Precedential: Precedential

Docket No. 01-2862

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PRECEDENTIAL

Filed July 29, 2002

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 01-2862

NEONATOLOGY ASSOCIATES, P.A.

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-1201)

JOHN J. and OPHELIA J. MALL

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-1208)

ESTATE OF STEVEN SOBO, DECEASED and

BONNIE SOBO, EXECUTRIX, and

BONNIE SOBO, SURVIVING WIFE

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-2795)

AKHILESHI S. and DIPTI A. DESAI

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-2981)

KEVIN T. and CHERYL MCMANUS

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-2985)

ARTHUR and LOIS M. HIRSHKOWITZ

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-2994)

LAKEWOOD RADIOLOGY, P.A.

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-2995)

Neonatology Associates, P.A., John J.

and Ophelia Mall, Estate of Steven Sobo,

Deceased, and Bonnie Sobo, Executrix,

and Bonnie Sobo, Surviving Wife,

Akhilshi S. and Dipti A. Desai,

Kevin T. and Cheryl McManus,

Arthur and Lois M. Hirshkowitz and

Lakewood Radiology, P.A.,

Appellants

2

On Appeal from the United States Tax Court

(T.C. Nos. 97-1201/1208/2795/2981/2985/2994/2995)

Tax Court Judge: Honorable David Laro

Argued: July 11, 2002

BEFORE: SCIRICA and GREENBERG, Circuit Judges ,

and FULLAM, District Judge*

(Filed: July 29, 2002)

Neil L. Prupis

Lampf, Lipkind, Prupis,

Petigrow & LaBue

80 Main Street

West Orange, NJ 07052

Kevin L. Smith (argued)

Hines Smith

3080 Bristol Street, Suite 540

Costa Mesa, CA 92626

David R. Levin

Wiley Rein & Fielding

1776 K Street, N.W.

Washington, D.C. 20006

Attorneys for Appellants

Eileen J. O’Connor

Assistant Attorney General

Kenneth L. Greene

Robert W. Metzler (argued)

Attorneys Tax Division

Department of Justice

Post Office Box 502

Washington, D.C. 20044

Attorneys for Appellee

_________________________________________________________________

* Honorable John P. Fullam, Senior Judge of the United States District

Court for the Eastern District of Pennsylvania, sitting by designation.

3

Steven J. Fram

Archer & Greiner

One Centennial Square

Haddonfield, NJ 08033

Attorneys for Amici Curiae Vijay

Sankhla, M.D., Yale Shulman,

M.D., Boris Pearlman, M.D., Marvin

Cetel, M.D. and Barbara Schneider,

M.D.

OPINION OF THE COURT

GREENBERG, Circuit Judge.

I. INTRODUCTION

This matter comes on before this court on appeal from

decisions of the United States Tax Court entered April 9,

2001, in accordance with its opinion filed July 31, 2000,

upholding the determination of the Commissioner of

Internal Revenue that contributions made by appellants,

two professional medical corporations, Neonatology

Associates, P.A. and Lakewood Radiology, P.A., into

Voluntary Employees Beneficiary Program (VEBA) plans in

excess of the cost of term life insurance were taxable

constructive dividends to the physicians owning the

corporations and their spouses rather than employer

deductible expenses. See Neonatology Assoc., P.A. v.

Comm’r, 115 T.C. 43 (2000). We refer to the corporations

and individuals collectively as "taxpayers." The

consequences of the decisions were substantial for the

taxpayers inasmuch as the professional medical

corporations were denied deductions they had taken for the

contributions and the individuals were charged with

significant additional taxable dividend income. The court

held further that the individual taxpayers were liable for

accuracy-related negligence penalties under I.R.C.

S 6662(a).

Our examination of the record convinces us that the

contributions at the heart of this dispute were so far in

4

excess of the cost of annual life insurance protection that

they could not plausibly qualify as ordinary and necessary

business expenses in accordance with I.R.C. S 162. In

essence, the physicians adopted a specially crafted

framework to circumvent the intent and provisions of the

Internal Revenue Code by having their corporations pay

inflated life insurance premiums so that the excess

contributions would be available for redistribution to the

individual shareholders free of income taxes. As correctly

recognized by the Tax Court, these contributions were

taxable disguised dividends and not deductible expenses.

Moreover, as the individual taxpayers could not in good

faith avail themselves of the reliance-on-professional

defense, the Tax Court duly held them liable for the

accuracy-related negligence penalties. Accordingly, for the

reasons we elaborate in more detail below, we will affirm

the decisions of the Tax Court.

II. BACKGROUND

The evidence at the trial disclosed the following facts.

Neonatology is a New Jersey professional corporation owned

by Dr. Ophelia J. Mall. Lakewood is a New Jersey

professional corporation owned equally at the times

material here by Drs. Arthur Hirshkowitz, Akhilesh Desai,

Kevin McManus, and Steven Sobo until his death on

September 23, 1993. Subsequently Dr. Vijay Sankhla, who

is not a party to this action, purchased Sobo’s interest. The

spouses of the doctors, John Mall, Lois Hirshkowitz, Dipti

Desai, Cheryl MacManus, and Bonnie Sobo, are parties to

this action as the doctors and their spouses filed joint

income tax returns. In addition, Bonnie Sobo is a party as

executrix of her husband’s estate.

Following the enactment of the Tax Reform Act of 1986

(TRA), Pub.L. 99-514, 100 Stat. 2085, insurance salesmen

Stephen Ross and Donald Murphy formed Pacific Executive

Services (PES), a California partnership designed to

provides services to retirement plan administrators and

employee benefit advisors unfamiliar with the impact of the

TRA. See App. at 377. Specifically, Ross and Murphy

devised a program to allow closely held corporations to

"create a tax deduction for [ ] contributions to [an] employee

5

welfare benefit plan going in and a permanent tax deferral

coming out." App. at 2672.

To achieve this end, PES created two voluntary

employees’ beneficiary associations, the Southern California

Medical Profession Association VEBA (SC VEBA) and the

New Jersey Medical Profession Association VEBA (NJ VEBA).1

A VEBA, as defined in I.R.C. S 501(c)(9), is a tax-exempt

program providing members, their dependents, or

designated beneficiaries with life, sick, accident, or other

benefits "if no part of the net earnings of such association

inures (other than through such payments) to the benefit of

any private shareholder or individual."

Under the PES VEBA programs, each participating

employer adopts its own plan, maintaining a trust account

and designating a trust administrator with exclusive control

over all assets. The plan adoption agreement obligates

employers to make, whether in the form of group insurance

policies or group annuities, contributions towards the life

insurance benefits of employees and their beneficiaries,

based on a multiple of each employee’s annual

compensation. Benefits payable under any plan are paid

solely from that plan’s allocable share of the trust fund,

and the participating employer, administrator, and trustee

are not liable for any shortfall in the funds required to be

paid. Upon termination of a plan, all its remaining assets

are distributed to the employer’s covered employees in

proportion to their compensation. PES enlisted the services

of Barry Cohen, a longtime insurance salesman with the

Kirwan companies, to market the VEBA programs to

medical professionals.

The SC VEBA plans at issue in this case, the Neonatology

Employee Welfare Plan and the Lakewood Employee Welfare

Plan, shared a common feature: both purchased

continuous group (C-group) term policy certificates from the

Inter-American Insurance Co. of Illinois, Commonwealth

_________________________________________________________________

1. Notwithstanding what might be regarded as a geographical anamoly,

only the SC VEBA is involved here. There was, however, an additional

petitioner in the Tax Court, not a party on this appeal, Wan B. Lo, d/b/a

Marlton Pain Control and Acupuncture Center, who established a plan

under the NJ VEBA.

6

Life Insurance Co., and Peoples Security Life Insurance Co.

The C-group product provided routine group term life

insurance with an added component, a "special" conversion

policy through which a covered employee, under certain

circumstances,2 could opt to convert his or her policy to an

individual policy, the C-group conversion universalife (UL)

policy. By converting from a C-group to an individual UL

policy, the employee could access funds paid by the

employer to the group policy that exceeded the applicable

mortality charge, i.e. the cost of insurance. The excess

funds, depending on the year in which the conversion takes

place,3 are paid out with interest as so-called "conversion

credits."

In addition to being able to access surplus amounts, a

policyholder upon conversion to the UL policy may borrow

any amounts against his or her policies not required to

keep the policies in force.4 When the policyholder dies, the

loans are to be repaid from the policy death benefits, which

ordinarily are not subject to income tax. See I.R.C. S 101.

Of course, by borrowing the money the taxpayer effectively

would be withdrawing money the medical corporations paid

for the conversion privilege on a tax free basis. Thus, as if

_________________________________________________________________

2. Under the policies, conversion was allowed when group coverage

ceased because (1) the employee ceased employment, (2) the employee

left the class eligible for coverage, (3) the underlying contract terminated,

(4) the underlying contract was amended to terminate or reduce the

insurance of a class of insured employees, or (5) the underlying contract

terminated as to an individual employer or plan. See App. at 1836, 1846.

3. Under the applicable schedule, none of the conversion credit balance

is transferred to the C-group conversion UL policy if conversion occurs

in the C-group term policy’s first year. However, if conversion takes place

in the C-group term policy’s fourth year or beyond, 95% of the

conversion credit balance is transferred to the C-group conversion UL

policy. Policyholders could not receive more than 95% of their conversion

credit balance because a five percent commission was paid automatically

to the insurance agent upon conversion. See App. at 2161-62, 4710,

4713.

4. Notably, the interest due on any loan policy was equal to the interest

credited on the asset accumulation. In other words, there were no out-

of-pocket costs to the debtor-policyholder. See App. at 2164. To hedge

the attendant C-group product risks, Inter-American and Commonwealth

reinsured with a third party.

7

by magic, cash derived from the corporations would be

withdrawn without tax. Each of the physician taxpayers,

other than Dr. Sobo, in fact converted at least one C-group

term certificate to a special policy providing conversion

credits. See App. at 426-29, 439-41.

Neonatology, on the basis of conversations between its

principal, Dr. Mall, and Cohen, established the Neonatology

Plan under the SC VEBA on January 31, 1991, effective

January 1, 1991. Under the plan, each covered employee

was to receive a life insurance benefit equal to 6.5 times the

employee’s compensation of the prior year. See App. at 434,

1807. John Mall, Dr. Mall’s husband, was not a paid

employee of Neonatology and thus was not eligible to join

the plan. Nevertheless, Dr. Mall and PES, the plan

administrator, allowed Mr. Mall to join the plan, making

him eligible to receive a death amount commensurate to

that payable under life insurance that he had owned

outside the plan ($500,000). See Supp. App. at 108-09. The

Neonatology Plan purchased three C-group life insurance

policies, two on Dr. Mall’s life and one on Mr. Mall’s life.

See App. at 434-39. Neonatology contributed to the

Neonatology Plan during each year from 1991 through 1993

and, for each subject year, claimed a tax deduction for

those contributions and other related amounts.

Lakewood, on the basis of conversations between its

principals and Cohen, established the Lakewood Plan under

the SC VEBA on December 28, 1990, effective January 1,

1990. Under the plan, each covered employee was to

receive a life insurance benefit equal to 2.5 times his or her

prior-year compensation. See App. at 387. Lakewood

amended its plan as of January 1, 1993, to increase the

compensation multiple to 8.15. The Lakewood Plan

purchased 12 C-group life insurance policies on the lives of

Drs. Hirshkowitz, Desai, Sobo, McManus, and Sankhla and

three group annuities toward future premiums on the

policies. See App. at 400-26. Lakewood also purchased

three C-group policies outside of the Lakewood Plan. The

individual owners on their own behalf determined the

amounts contributed by Lakewood to the SC VEBA. See

App. at 1015-16, 3674-87. For each subject year, Lakewood

claimed a tax deduction for those contributions and other

related amounts.

8

The IRS audited Neonatology’s tax returns for calendar

years 1992 and 1993 and Lakewood’s tax returns for fiscal

year 1991 (ending October 31, 1991) and calendar years

1992 and 1993. As a consequence of the audits, the

Commissioner made the following determinations. First,

with respect to the deductions claimed by Neonatology for

amounts paid to the SC VEBA and by Lakewood for

amounts paid to the SC VEBA and to the three non-plan C-

group policies, he allowed only the cost of annual term life

insurance protection and disallowed the excess amounts of

$43,615 and $986,826 for Neonatology and Lakewood

respectively. See App. at 2265-66, 2283-85. The

Commissioner based his disallowance on alternative bases:

(1) the excess contributions were not ordinary and

necessary business expenses under I.R.C. S 162(a); (2) even

if the amounts constituted ordinary and necessary business

expenses, they nevertheless were not deductible under

I.R.C. SS 404(a) and 419(a), which limit the deductibility of

contributions paid to deferred compensation plans and

welfare benefit plans. See App. at 2266, 2285.5

Second, the Commissioner determined with respect to the

individual owners that amounts paid to the SC VEBA

program increased personal incomes by $39,343 for Dr.

Mall and her husband, $219,806 for Dr. Desai, $56,107 for

Dr. McManus, $601,849 for Dr. Hirshkowitz, and $101,314

for Dr. Sobo (his estate). See App. at 2271, 2311, 2297,

2320. The Commissioner included the excess contributions

as income to the individual taxpayers on alternative bases:

(1) the amounts were deposited in the plans for the

economic benefit of the individual taxpayers and as such

constituted constructive dividends under I.R.C.SS 61(a)(7)

and 301; (2) assuming that the Neonatology and Lakewood

Plans constituted deferred compensation plans, the excess

contributions were includible under section 402(b). See

_________________________________________________________________

5. Specifically, the Commissioner ruled that as deferred compensation

plans, the Neonatology and Lakewood Plans did not satisfy the I.R.C.

S 404(a)(5) "separate account" requirement for the contributions to be

deductible. If the plans were characterized as welfare benefit funds,

I.R.C. S 419(b) limited the deductions as the plans could not qualify for

the "10-or-more-employer plans" exception to section 419(b) in I.R.C.

S 419A(f)(6).

9

App. at 2271, 2297, 2311, 2320. Lastly, the Commissioner

determined that by reason of the underpayment of taxes

the individual taxpayers were subject to penalties under

I.R.C. S 6662(a).

Neonatology, Lakewood, and the individual owners

petitioned the Tax Court challenging the IRS’s

determinations. After a bench trial, the court sustained the

Commissioner on the ground that:

The Neonatology Plan and the Lakewood Plan are

primarily vehicles which were designed and serve in

operation to distribute surplus cash surreptitiously (in

the form of excess contributions) from the corporations

for the employee/owners’ ultimate use and benefit . . . .

The premiums paid for the C-group term policy

exceeded by a wide margin the cost of term life

insurance . . . . What is critical to our conclusion is

that the excess contributions made by Neonatology and

Lakewood conferred an economic benefit on their

employee/owners for the primary (if not sole) benefit of

those employee/owners, that the excess contributions

constituted a distribution of cash rather than a

payment of an ordinary and necessary business

expense, and that neither Neonatology nor Lakewood

expected any repayment of the cash underlying the

conferred benefit.

Neonatology, 115 T.C. at 89-91.

Without addressing the alternative grounds for the

Commissioner’s conclusions, the court rejected taxpayers’

arguments that the possibility of forfeiture in certain

situations like policy lapse or death rendered all excess

payments into de facto contributions to life insurance

protection. Id. at 89-90 ("The mere fact that a C-group term

policyholder may forfeit the conversion credit balance does

not mean, as petitioners would have it, that the balance

was charged or paid as the cost of term life insurance.").

The court also rejected the idea that contributions which in

fact did not fund term life insurance were paid as

compensation for services, rather than dividends, because

as a factual matter neither Neonatology nor Lakewood had

the requisite compensatory intent when the contributions

10

were made. Id. at 93. Lastly, the court agreed with the

Commissioner that the individual taxpayers were in fact

negligent and could not circumvent the accuracy-related

penalties by asserting a good faith, reliance-on-professional

defense nor could they do so by claiming that the case

involved tax matters of first impression.

The Tax Court entered its decisions on April 9, 2001.

Taxpayers timely appealed on July 6, 2001. We have

jurisdiction over this appeal pursuant to I.R.C.S 7482, and

the Tax Court had jurisdiction over the petitions pursuant

to I.R.C. SS 6213(a) and 7442.

III. DISCUSSION

There are three principal issues before us on appeal: (1)

whether the Tax Court correctly determined that the

amounts contributed in excess of the cost of per annum

term life insurance were not ordinary and necessary

business expenses and therefore not deductible; if yes, (2)

whether those amounts constituted dividends, includible as

taxable individual income, or compensation to the

individual taxpayers; and, (3) whether the individual

taxpayers were negligent. Our review of the Tax Court’s

legal conclusions is plenary and is based on the"clearly

erroneous" standard for its findings of fact. See ACM P’ship

v. Comm’r, 157 F.3d 231, 245 (3d Cir. 1998); Pleasant

Summit Land Corp. v. Comm’r, 863 F.2d 263, 268 (3d Cir.

1988). Moreover, taxpayers bear the burden of refuting the

IRS’s determinations. See Welch v. Helvering, 290 U.S. 111,

115, 54 S.Ct. 8, 9 (1933).6

A. The Deficiencies

Section 162(a) of the Internal Revenue Code7 allows for

_________________________________________________________________

6. The burden of proof may be shifted to the Commissioner in certain

circumstances for audits conducted after July 22, 1998. See I.R.C.

S 7491. These modifications to the Internal Revenue Code have no

bearing on this case.

7. The Internal Revenue Code, I.R.C. S 162(a), provides that "[t]here shall

be allowed as a deduction all the ordinary and necessary expenses paid

or incurred during the taxable year in carrying on any trade or

business."

11

the deduction of all ordinary and necessary expenses

incurred in carrying on a trade or business providing five

requirements are met: the item claimed as deductible (1)

was paid or incurred during the taxable year; (2) was for

carrying on a trade or business; (3) was an expense; (4) was

a necessary expense; and (5) was an ordinary expense. See

Comm’r v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 352, 91

S.Ct. 1893, 1898 (1971). Beyond peradventure, employee

benefits like life insurance are a form of compensation

deductible by the employer.8 See Treas. Reg. S 1.162-10(a);

see also Joel A. Schneider, M.D., S.C. v. Comm’r, 1992 T.C.

Memo. 992-24, 63 T.C.M. (C.C.H.) 1787. To the extent,

however, that Neonatology’s and Lakewood’s expenditures

did not fund term life insurance, the Tax Court found that

they did not meet the five requirements delineated above

and therefore were not deductible. This factual finding was

not clearly erroneous. See Comm’r v. Heininger , 320 U.S.

467, 475, 64 S.Ct. 249, 254 (1943).

The record amply supports the conclusion that taxpayers

paid artificially inflated premiums in a creative bookkeeping

ploy conceived by their insurance specialists to exploit what

they thought were loopholes in the tax laws. Indeed, we do

not see how a court examining this case could conclude

otherwise. Charles DeWeese, the Commissioner’s expert,

testified that amounts paid into the C-group policies

exceeded conventional life insurance premiums by nearly

500%. See App. at 804-08, 2156.9 Evidence at trial

_________________________________________________________________

8. Of course, the mere fact that the benefit is a form of deductible

compensation does not necessarily mean that it is taxable to the

employee. See I.R.C. S 79. We note that the parties do not treat section

79 as significant here.

9. It should be noted that the Tax Court made certain credibility

determinations, finding DeWeese, an independent consulting actuary, to

be a "reliable, relevant, and helpful" witness whose testimony was

bolstered by a voluminous record with stipulations to more than 2,000

facts and with more than 1,500 exhibits. See Neonatology, 115 T.C. at

86-87. By the same token, the court found that the opinions expressed

by taxpayers’ sole expert, Jay Jaffe, were of minimal help, considering

his close relationship to one of the insurance companies that provided

the C-group product at issue in the case. See id. (experts who act as

advocates, "can be viewed only as hired guns of the side that retained

12

demonstrated that Dr. Mall knew that term life insurance

was substantially more expensive to buy through the SC

VEBA than through other plans offered to her under the

auspices of the American Medical Association and the

American Academy of Pediatrics. She nevertheless opted to

form the Neonatology Plan because she believed that it

offered her the best tax benefits. See App. at 1025. Dr.

Hirshkowitz testified that Lakewood intentionally paid more

expensive premiums on the C-group policies than it would

have for conventional life insurance protection. See App. at

998. Dr. Desai, another Lakewood owner, testified that his

independent personal life insurance cost him substantially

less than the policies issued pursuant to the SC VEBA. See

App. at 1047. Like Dr. Mall, the Lakewood owners

nevertheless invested in the SC VEBA program because of

Cohen’s representation of tax benefits and cash returns

that they could anticipate receiving. See App. at 1014-15.

The record also reveals that excess premium amounts did

not pay for actual current year life insurance protection but

rather paid for conversion credits. The compliance manager

of the Providian Corporation, the parent of the

Commonwealth Life Insurance Company which issued

policies involved here, stated in a letter to the IRS that the

"premiums paid for the term policy are higher than the

traditional term policy because of the conversion privilege

and the costs of conversion credits." App. at 3690.

DeWeese, belying taxpayers’ claim that C-group premiums

were higher than those under ordinary term life policies

because they were calibrated to the higher risks of longer

_________________________________________________________________

them, and this not only disparages their professional status but

precludes their assistance to the court in reaching a proper and

reasonably accurate conclusion") (quoting Jacobson v. Comm’r, T.C.

Memo. 1989-606, 58 T.C.M. (C.C.H.) 645)). The court also found that

some of taxpayers’ fact witnesses "testified incredibly with regard to

material aspects of this case" and that their testimony, for the most part,

was "self-serving, vague, elusive, uncorroborated, and/or inconsistent

with documentary or other reliable evidence." Id. These types of

credibility determinations are ensconced firmly within the province of a

trial court, afforded broad deference on appeal. See Dardovitch v.

Haltzman, 190 F.3d 125, 140 (3d Cir. 1999).

13

term employees in small markets,10 testified that the bulk of

the gross premiums went to accumulate assets for

distribution to the individual participants upon conversion.

See App. at 2173. In addition, the record supports the

conclusion that payments made to the Lakewood Plan for

annuities were made not to fund current life insurance

protection for employees but rather were made as an

investment for the trustee to pay premiums on future C-

group premiums. See App. at 976, 993-94, 1041-42.

In sum, the evidence fully supports, indeed compels, the

finding that the contributions in excess of the amounts

necessary to pay for annual term life insurance protection

were distributions of surplus cash and not ordinary and

necessary business expenses. Considering the sound

reasoning of the Tax Court and our own intensive review of

the facts here, we conclude that it is implausible that the

owners of Neonatology and Lakewood, educated and highly

trained medical professionals, knowingly would have

overpaid substantially for term life insurance unless they

contemplated receiving an added boon such as a tax-free

return of the excess contributions.

Taxpayers advance two arguments to the effect that the

court erred by not limiting its consideration to the written

plan documents and life insurance contracts rather than

relying on extraneous evidence like the plan marketing

materials which discuss the availability of conversion

credits. First, they maintain that the Neonatology and

Lakewood SC VEBA programs were employee benefit plans

under the Employee Retirement Income Security Act, 29

U.S.C. S 1001 et seq., (ERISA). Thus, they contend that

representations made outside of the plan documents

cannot be used to consider rights and obligations arising

out of the plans. See Br. of Appellants at 35. Second, they

argue that under governing state insurance law, the tax

implications of a group term life insurance policy are

determined only on the basis of the policy language itself.

As the literal provisions of the plans discuss only insurance

benefits -- that is, a death benefit and an option to convert

to an individual policy upon termination of employment --

_________________________________________________________________

10. See Br. of Appellants at 44 and n.30.

14

but say nothing about excess contributions returning as

conversion credits, taxpayers claim that the Tax Court was

compelled to conclude from the strict form of their plans

that all contributions in fact went to providing insurance

benefits.

Inasmuch as taxpayers did not raise the ERISA issue

before the Tax Court, we need not consider it on this

appeal. See Visco v. Comm’r, 281 F.3d 101, 104 (3d Cir.

2001). While we recognize that in some exceptional

circumstances an appellate court may review a defaulted

argument, in this case there are compelling reasons

militating against our overlooking procedural norms to

consider whether ERISA governed the SC VEBA programs

as our determination may prejudice persons not parties to

this case.11

In any event, even assuming for purposes of argument

that the plans were employee benefit plans under ERISA,

the fact remains that under well-established tax principles

a court is not limited to plan documents in determining the

tax consequences of a transaction. See, e.g., Comm’r v.

Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 708

(1945) ("The incidence of taxation depends upon the

substance of a transaction."); ACM P’ship, 157 F.3d at 247

("we must look beyond the form of the transaction to

determine whether it has the economic substance that its

form represents") (citations omitted); Lerman v. Comm’r,

939 F.2d 44, 54 (3d Cir. 1991) (Commissioner and courts

have "the power and duty . . . to look beyond the mere

forms of transactions to their economic substance and to

_________________________________________________________________

11. An amicus brief has been filed in this case on behalf of five

physician-participants in the VEBA program who have filed a civil

complaint against the insurance companies that wrote the C-group

policies, Sankhla v. Commonwealth Life Ins. Co. et al., No. 01-CV-4761

(U.S.D.C. N.J.). Amici have an interest in the outcome of this case

because the extent to which we address whether the plans are governed

by ERISA could affect resolution of the issue of whether their state law

claims against the insurance companies are preempted. See Amicus Br.

at 1-2. Rather than needlessly prejudice the rights of litigants in

separate proceedings, we do not discuss the applicability of ERISA to the

VEBA plans.

15

apply the tax laws accordingly.").12 The cases cited by

taxpayers,13 on the other hand, involve only disputes over

_________________________________________________________________

12. Taxpayers, conflating the so-called "substance-over-form" doctrine

with the "economic substance" or "sham transaction" doctrine,

mistakenly argue as well that a court may not disregard the form of an

arrangement until it determines that the arrangement lacks any

economic substance other than obtaining tax deductions. See Br. of

Appellants at 41 ("If . . . there is any economic substance to the

arrangement apart from the alteration of tax liabilities, then the form of

the arrangement must be respected, even if the arrangement was

motivated by tax avoidance or minimization."). In actuality, the two

doctrines are distinct. The substance-over-form doctrine is applicable to

instances where the "substance" of a particular transaction produces tax

results inconsistent with the "form" embodied in the underlying

documentation, permitting a court to recharacterize the transaction in

accordance with its substance. The economic substance doctrine, in

contrast, applies where the economic or business purpose of a

transaction is relatively insignificant in relation to the comparatively

large tax benefits that accrue (that is, a transaction "which actually

occurred but which exploit[s] a feature of the tax code without any

attendant economic risk," Horn v. Comm’r, 968 F.2d 1229, 1236 n.8

(D.C.Cir. 1992)); in that situation, where the transaction was an

attempted tax shelter devoid of legitimate economic substance, the

doctrine governs to deny those benefits. See generally Rogers v. United

States, 281 F.3d 1108, 1113-18 (10th Cir. 2002). The Tax Court in this

case, however, based its decision solely on the substance-over-form

doctrine, finding that the form of the VEBA was not reflective of its

genuine substance. In addition to the evidence we have set forth, the Tax

Court’s determination further is reinforced, inter alia, by the fact that

taxpayers were allowed to convert the C-group term policies to individual

C-group conversion UL policies even though none of the five required

conditions for conversion were present, see Supp. App. at 106, 111-12,

and by the fact that the amount of life insurance taken on the Lakewood

principals did not correspond to the amount of benefits for which they

were eligible under the plan documents. See, e.g., App. at 389, 400-03

(Dr. Hirshkowitz had C-group certificates on his life for over a million

dollars even though he was eligible for life benefits of less than $500,000

-- 2.5 times his 1991 compensation of $181,199.09). Moreover, even

under the economic substance doctrine taxpayers would be hard-pressed

to argue that the transactions involving the excess term life insurance

payments had sufficient economic substance to be respected for tax

purposes.

13. See Br. of Appellants at 29-36 (citing Gruber v. Hubbard Bert Karle

Weber, Inc., 159 F.3d 780 (3d Cir. 1998); Haberern v. Kaupp Vascular

Surgeons Ltd. Defined Benefit Pension Plan, 24 F.3d 1491 (3d Cir. 1994);

Schoonejongen v. Curtiss-Wright Corp., 18 F.3d 1034 (3d Cir. 1994);

Henglein v. Informal Plan for Plant Shutdown Benefits, 974 F.2d 391 (3d

Cir. 1992)).

16

ERISA benefits between private parties, not disputes over

tax liabilities between private parties and the

Commissioner. While the cases lay out certain principles for

determining rights and obligations under an ERISA plan,

including the standard contract theory that the literal

terms of a plan document must guide all analysis, the

cases say nothing about the proper evidentiary protocol for

evaluating the tax ramifications of an employer benefit

plan. In sum, we have no intention of importing ERISA

principles into this tax dispute.

Moreover, we reject taxpayers’ contention that the Tax

Court erred by not limiting its evaluation to the plan

documents in light of state insurance law. The court did

not construe or interpret the terms of the individual

taxpayers’ life insurance policies, but rather characterized

the contributions made towards those policies for purposes

of determining tax liabilities. While the former endeavor

indeed would implicate state law,14 the latter is singularly a

question of federal law. See, e.g., Thomas Flexible Coupling

Co. v. Comm’r, 158 F.3d 828, 830 (3d Cir. 1946).

In view of our conclusion that the contributions in

dispute were not ordinary and necessary business expenses

under I.R.C. S 162(a), we next consider whether the district

court erred in determining that the contributions

constituted dividends rather than compensation to the

individual taxpayers and thus deductible to the

corporations on that basis.15 Under I.R.C. S 316(a), a

dividend is a distribution of property made by a corporation

to its shareholders out of its earnings and profits. See

Comm’r v. Makransky, 321 F.2d 598, 601-03 (3d Cir. 1963).

_________________________________________________________________

14. Curiously, taxpayers fail to specify which state’s insurance law

applies: New Jersey, where all of the physicians reside, or Pennsylvania,

where the insurance agents who promoted the VEBA were located.

15. In their brief, taxpayers indicate that the Tax Court erred in

characterizing the "disallowed contributions as constructive dividends

rather than deductible compensation." Br. at 46 (emphasis added). See

King’s Ct. Mobile Home Park, Inc. v. Comm’r, 98 T.C. 511, 512 (1992)

("The first question is whether the diversion of $58,365 of petitioner’s

income by its controlling shareholder for personal use constitutes the

payment of deductible wages or the distribution of a dividend.") (footnote

omitted).

17

Dividends are taxed as a component of gross income. See

I.R.C. S 61(a)(7). A shareholder, even if the corporation has

dispensed with the formalities of declaration, may be

charged with a disguised or constructive dividend if the

corporation confers a direct benefit on him from available

earnings and profits without expectation of repayment. See,

e.g., Crosby v. United States, 496 F.2d 1388-89 (5th Cir.

1974); Noble v. Comm’r, 368 F.2d 439, 443 (9th Cir. 1966);

see also Magnon v. Comm’r, 73 T.C. 980, 993-94 (1980)

("Where a corporation confers an economic benefit on a

shareholder without the expectation of repayment, that

benefit becomes a constructive dividend, taxable to the

shareholder, even though neither the corporation nor the

shareholder intended a dividend.").

In this case, the record fully supports the conclusion of

the Tax Court that the individual taxpayers were chargeable

with constructive dividends. Indeed, Neonatology and

Lakewood, by design surrendering any expectation of

remuneration, purchased products that generated a

considerable economic bounty for their shareholders in the

form of conversion credits. Furthermore, nothing in the

record illustrates that taxpayers diverted these corporate

assets with the requisite "compensatory intent." See King’s

Ct. Mobile Home Park, Inc. v. Comm’r, 98 T.C. 511, 514-15

(1992) (business expense may be deducted as

compensation only if the payor intends at the time that the

payment is made to compensate the recipient for services

performed).16 Moreover, support for a conclusion, though

certainly not dispositive, that the excess contributions were

not paid as compensation for services rendered is supplied

by the fact that the Neonatology and Lakewood plans were

made available only to those individuals who owned the

corporations and not to their non-equity employees.

Furthermore, Dr. Mall directed Neonatology to purchase the

C-group product on her husband, a non-employee third-

party who did not perform any services for the corporation.17

_________________________________________________________________

16. To qualify as deductible compensation, a payment also need be

reasonable. See Treas. Reg. S 1.162-7(a). We do not need to address this

point, as the Tax Court correctly determined as a matter of fact that

taxpayers did not demonstrate compensatory intent.

17. We are satisfied that the mere fact that Dr. Mall partially diverted the

benefits to her husband should not change our result.

18

In the circumstances, it is therefore not surprising that Dr.

Desai at trial made the matter-of-fact statement that the

money contributed by Lakewood to fund insurance

premiums and conversion credits is "our money. It’s not

Lakewood[‘s]." App. at 1055.

Taxpayers again rely on non-tax ERISA jurisprudence for

the exaggerated proposition that payments made pursuant

to an employee benefit plan are necessarily compensatory.18

However, the plain language of I.R.C. S 419(a)(2) explicitly

contemplates situations where contributions paid or

accrued by an employer to a welfare benefit fund are not

deductible (deductions allowed only if "they would

otherwise be deductible"); see also Treas. Reg. S 1.162-10(a)

(contributions to employee benefit plans deductible only if

"they are ordinary and necessary business expenses."). To

read otherwise inexplicably creates a shelter loophole by

allowing taxpayers to transform disbursements into

deductible business expenses merely by funneling them

through an ERISA plan.

We recognize that it is axiomatic that taxpayers lawfully

may arrange their affairs to keep taxes as low as possible.19

Nevertheless, at the same time the law imposes certain

threshold duties which a taxpayer may not shirk simply by

manipulating figures or maneuvering assets to conceal their

real character. See Court Holding Co., 324 U.S. at 334, 65

S.Ct. at 708 ("[t]o permit the true nature of a transaction to

be disguised by mere formalisms . . . would seriously

impair the effective administration of the tax policies of

Congress."); see also Saviano v. Comm’r, 765 F.2d 643, 654

(7th Cir. 1985) ("The freedom to arrange one’s affairs to

minimize taxes does not include the right to engage in

_________________________________________________________________

18. Taxpayers misread Pediatric Surgical Assoc., P.C. v. Comm’r, 81

T.C.M. (CCH) 1474, 1479 (2001), for the proposition that anything paid

by a corporation for an employee’s benefit is presumed legally to be

compensation. Rather, Pediatric Surgical clearly iterates that intent to

pay compensation "is a factual question to be decided on the basis of the

particular facts and circumstances of the case." Id. at 1480.

19. See Gregory v. Helvering, 293 U.S. 465, 469, 55 S.Ct. 266, 267

(1935) ("The legal right of a taxpayer to decrease the amount of what

otherwise would be his taxes, or altogether avoid them, by means which

the law permits, cannot be doubted.").

19

financial fantasies with the expectation that the Internal

Revenue Service will play along."). Thus, we conclude that

the Tax Court correctly held that the inflated premiums

were not allowable corporate business expenses but rather

allocations in the nature of dividends and thusly taxable.

B. The Penalties

Finally, we must consider the aptness of the penalties

assessed by the Commissioner and upheld by the Tax

Court. The Internal Revenue Code imposes a 20% tax on

the portion of an underpayment attributable, among other

things, to negligence or the disregard of rules and

regulations. I.R.C. SS 6662(a) and (b)(1)."Negligence" can

include any failure to make a reasonable attempt to comply

with the provisions of the Code, to exercise ordinary and

reasonable care in the preparation of a tax return, to keep

adequate books and records, or to substantiate items

properly. I.R.C. S 6662(c); Treas. Reg. S 1.6662-3(b)(1).

Generally speaking, the negligence standard as in the tort

context is objective, requiring a finding of a lack of due care

or a failure to do what a reasonable and prudent person

would do under analogous circumstances. See, e.g., Schrum

v. Comm’r, 33 F.3d 426, 437 (4th Cir. 1994).

On the basis of the record, the Tax Court was justified in

concluding as a matter of fact that the individual taxpayers

were liable for the section 6662 accuracy-related penalties

because they did not meet their burden of proving due care.

See Hayden v. Comm’r, 204 F.3d 772, 775 (7th Cir. 2000)

(the Commissioner’s determination of negligence is

presumed to be correct, and the taxpayer has the burden of

proving that the penalties are erroneous); accord Pahl v.

Comm’r, 150 F.3d 1124, 1131 (9th Cir. 1998) (burden of

disproving negligence on taxpayer); Goldman v. Comm’r, 39

F.3d 402, 407 (2d Cir. 1994) (once the Commissioner

determines that a negligence penalty is appropriate, the

taxpayer bears the burden of establishing the absence of

negligence). The physician-owners caused their

corporations to overpay considerably for term life insurance

knowing that the money could be rerouted circuitously to

their personal coffers with a net tax savings. Yet,

notwithstanding the extraordinary financial implications of

the SC VEBA arrangement, the individual taxpayers did not

20

make a proper investigation or exercise due diligence to

verify the program’s tax legitimacy. See David v. Comm’r, 43

F.3d 788, 789-90 (2d Cir. 1995); see also Pasternak v.

Comm’r, 990 F.2d 893, 903 (6th Cir. 1993) (holding that a

reasonably prudent person should investigate claims when

they are likely "too good to be true") (quoting McCrary v.

Comm’r, 92 T.C. 827, 850 (1989)).

Taxpayers argue that their negligence should have been

excused because they relied on the advice of professionals.

While it is true that actual reliance on the tax advice of an

independent, competent professional may negate a finding

of negligence, see, e.g., United States v. Boyle, 469 U.S.

241, 250, 105 S.Ct. 687, 692 (1985), the reliance itself

must be objectively reasonable in the sense that the

taxpayer supplied the professional with all the necessary

information to assess the tax matter and that the

professional himself does not suffer from a conflict of

interest or lack of expertise that the taxpayer knew of or

should have known about. See Treas. Reg.S 1.6664-4(c);

Ellwest Stereo Theatres, Inc. v. Comm’r, T.C. Memo. 1995-

610, 70 T.C.M. (C.C.H.) 1655; see also Zfass v. Comm’r,

118 F.3d 184, 189 (4th Cir. 1997).

The Tax Court concluded that taxpayers could not prevail

on a reliance-on-professional defense because they received

advice only from Cohen, an insurance agent who stood to

profit considerably from the participation of Neonatology

and Lakewood in the VEBA program, rather than from a

competent, independent tax professional with sufficient

expertise to warrant reliance. The circumstances here,

including the facts that certified public accountants

prepared taxpayers’ returns, the New Jersey Medical

Society -- a group with dubious tax code proficiency which

in fact received royalties to endorse the SC VEBA 20 --

purportedly endorsed the program, and the engagement

agreement between PES and the employers stated that PES

would submit the trust to the IRS for qualification, 21 do not

_________________________________________________________________

20. See App. at 570-71.

21. Notably, the agreement does not say that the IRS did qualify the

plan. In fact, as the government points out, the IRS expressly disavowed

any opinion as to whether contributions to the plan were deductible. See

App. at 1410.

21

suffice for us to disturb the Tax Court’s negligence finding

on a clear error basis. See Merino v. Comm’r, 196 F.3d 147,

154 (3d Cir. 1999).

In reaching our result, we acknowledge that Dr.

Hirshkowitz deviated from the thoroughly head-in-the-sand

posture of his fellow taxpayers by soliciting his

accountant’s opinion of the SC VEBA. See App. at 6666-67.

Nevertheless, the record supports the court’s finding with

respect to Dr. Hirshkowitz, considering that he did not

introduce into evidence precisely what information he

showed to his accountant, precisely what advice his

accountant gave him, and, more generally, the

qualifications of his accountant.

We also add the following. When, as here, a taxpayer is

presented with what would appear to be a fabulous

opportunity to avoid tax obligations, he should recognize

that he proceeds at his own peril. In this case, PES devised

a program which it marketed as "creat[ing] a tax deduction

for the contributions to the employee welfare benefit plan

going in and a permanent tax deferral coming out." As

highly educated professionals, the individual taxpayers

should have recognized that it was not likely that by

complex manipulation they could obtain large deductions

for their corporations and tax free income for themselves.22

In a final attempt to skirt the additional penalties,

taxpayers argue that a finding of negligence could not in

fairness arise out of a case resolving tax issues of first

impression. In this regard, we point out that the parties

have indicated that this case is indeed without direct

precedent and that other cases are awaiting our disposition.23

_________________________________________________________________

22. It well may be that reliance on the advice of a professional should

only be a defense when the professional’s fees are not dependent on his

opinion. For example, it is not immediately evident why a taxpayer

should be able to take comfort in the advice of a professional promoting

a tax shelter for a fee. After all, that professional would have an interest

in his opinion. Consideration of this point, however, will have to wait for

another day.

23. The Tax Court observed that this case is a test case with the result

resolving other cases involving SC VEBA and NJ VEBA plans and that

the parties in 19 other cases pending before the Tax Court have agreed

to be bound by the decision here. See Neonatology, 115 T.C. at 44.

22

This argument, however, does not sway us for this case

does not involve novel questions of law but rather is

concerned with the application of well-settled principles of

taxation to determine whether certain expenditures made

by close corporations are deductible as ordinary and

necessary business expenses or taxable as constructive

dividends. While the setting in which these principles have

come to bear is no doubt unusual with its VEBAs, C-group

policies, and conversion credits, the law was nevertheless

pellucid that taxpayers should have endeavored to verify

the validity of their deductions before claiming them.24

Moreover, they should have been apprehensive when they

examined the scheme, for experience shows that when

something seems too good to be true that probably is the

case. Overall, we are satisfied that taxpayers now must

abide the consequences of the Commissioner’s audit as

sustained by the Tax Court, including the finding of liability

for accuracy-related penalties under section 6662.

IV. CONCLUSION

For the foregoing reasons, we will affirm the decisions of

the Tax Court.

A True Copy:

Teste:

Clerk of the United States Court of Appeals

for the Third Circuit

_________________________________________________________________

24. We recognize that courts have overlooked negligence penalties in

cases of first impression that involve unclear statutory language. See,

e.g., Mitchell v. Comm’r, T.C. Memo. 2000-145, 79 T.C.M. (C.C.H.) 1954

(recognizing exception in a case of first impression involving the unclear

application of an amendment to the Internal Revenue Code); Hitchins v.

Comm’r, 103 T.C. 711, 720 (1994) (first impression exception applies to

issue not previously considered by the court where the statutory

language is not entirely clear). But nothing in this case hinges on the

interpretation of vague statutory text.

23