The opinion
T.C. Memo. 2011-208
UNITED STATES TAX COURT
ESTATE OF KENNETH L. LAY, DECEASED, LINDA P. LAY, INDEPENDENT
EXECUTRIX AND LINDA P. LAY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15732-09. Filed August 29, 2011.
Charles H. Egerton and Jane Dunlap Callahan, for
petitioners.
Stephen R. Takeuchi, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: This case involves a deficiency of $3,910,000
determined by respondent in the 2001 Federal income tax of
Kenneth L. Lay and Linda P. Lay (the Lays). The deficiency is
based upon respondent’s determination that the Lays received
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income as a result of the sale of two annuity contracts to Enron
Corp. (Enron). For the reasons stated herein, we find that they
did not receive the income determined by respondent and are not
liable for the deficiency.
FINDINGS OF FACT
Some of the facts have been stipulated and those facts are
incorporated herein by this reference. Mrs. Lay resided in Texas
and the estate of Mr. Lay was being administered in Texas at the
time the petition was filed.
The Lays were married in 1982. Mr. Lay was chairman of the
board of directors and chief executive officer of Houston Natural
Gas Corp. when it merged in 1985 with InterNorth, Inc., forming
what became known as Enron. Mr. Lay was chairman of the board of
directors and chief executive officer of Enron from 1986 until
February 2001. In 1990 Enron hired Jeffrey K. Skilling, who
later succeeded Mr. Lay as chief executive officer in 2001.
Enron grew very rapidly during the 1990s into a company with
16,000 employees and became the seventh largest company in the
United States. In the late 1990s the board of directors of Enron
comprised 13 individuals.1
1
The members of the board of directors of Enron were:
Kenneth L. Lay of Enron; Robert A. Belfer of Belfer Oil & Gas;
Norman P. Blake, Jr., of General Electric; John H. Duncan of Gulf
& Western Corp.; Herbert S. Winokur of Capricorn; Dr. John
Mendelson of MD Anderson Cancer Center; Dr. Charles A. LeMaistre,
former chancellor of the University of Texas system and past
(continued...)
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The board of directors of Enron also had committees that reported
to the board of directors, including the Compensation and
Management Development Committee (Compensation Committee). The
Compensation Committee evaluated the compensation and made
recommendations for the compensation paid to top-level officers.
The members of the Compensation Committee in 2001 were board
of directors members Dr. Charles A. LeMaistre, Norman P. Blake,
Jr., John H. Duncan, Dr. Robert K. Jaedicke, and Frank Savage.
The members of the Compensation Committee were not employed by
Enron and were not involved with companies in businesses similar
to Enron’s business. Dr. LeMaistre was the chairman of the
Compensation Committee. Dr. LeMaistre also served on the
executive committee of Enron because of his position as chairman
of the Compensation Committee.
The compensation philosophy at Enron was to pay for and to
reward an executive’s performance that created long-term
shareholder value. Before and during 2001 the Compensation
Committee had developed a pay-for-performance system for the
1
(...continued)
president of MD Anderson Cancer Center in Houston; Dr. Wendy L.
Gramm, economist and professor of economics at Texas A&M
University; Dr. Robert K. Jaedicke, former dean of Stanford Law
School;, Lord John Wakeham, a member of the British Parliament;
Ronnie Chan, a resident of Hong Kong; Paulo V. Ferraz Pereira, an
industrialist from Argentina; and Frank Savage, an industrialist
from the east coast of the United States. The board of directors
of Enron represented the shareholders interests and oversaw the
activities of the company.
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compensation of the senior officers of Enron. The compensation
for senior officers had three elements: A base salary, an annual
bonus, and a long-term incentive grant.
The Compensation Committee used the outside consulting firm
Towers Perrin to provide compensation consulting services. At
the request of the Compensation Committee, Towers Perrin provided
a range of salaries for each position for which the Compensation
Committee established the compensation, using comparable
companies. Towers Perrin used 64 comparable companies to
establish the compensation ranges.
The Compensation Committee established a base salary for
each position based on individual performance as measured against
preestablished individual objectives, set at roughly the 50th
percentile of the pay for that position at the comparable
companies. The annual bonus was calculated on the after-tax net
income of Enron, creating a pool for the annual bonus and payable
to the senior officers on the basis of their individual
performances as measured against preestablished individual
objectives, such that the base salary and the annual bonus would
be up to the 75th percentile of the pay for that position at the
comparable companies. The long-term incentive grant had two
components: Stock options and restricted stock. The restricted
stock was paid out in 4-year tranches, and the 4-year period was
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used as the comparator.2 The restricted stock was paid out only
if Enron’s productivity measured up to the plan developed at the
beginning of each year; i.e., if Enron performed like the top 5
of 12 comparable companies in most years, or the top 3 in some
years.
The Compensation Committee set the compensation for Mr. Lay
as chief executive officer and chairman of the board each year,
using the Enron pay-for-performance methodology for setting
compensation. The Compensation Committee reviewed Mr. Lay’s
salary, bonuses, and long-term incentives over a period of years
together with Mr. Lay’s performance as compared with the plan
of operation adopted for the year and the comparators for CEOs
and chairmen of the board.
In the mid-1990s Mr. Lay was planning his retirement from
the position of CEO of Enron. Initially, the Compensation
Committee and the board of directors considered Rich Kinder, the
chief operating officer (COO) of Enron, as the successor to Mr.
Lay as CEO of Enron. The Compensation Committee determined that
Mr. Kinder was well qualified to run the company on the basis of
his experience as COO but asked Mr. Kinder whether the
Compensation Committee could continue to review his performance
2
A tranche is a number of related securities that are part
of a larger securities transaction. A comparator is a device for
comparing something with a similar thing or with a standard
measure.
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for another year to evaluate his potential as the CEO for Enron.
Mr. Kinder agreed to the additional year of review with the
understanding that he would be able to leave Enron with certain
benefits if he was not elected to the position of CEO at the end
of the 1-year period, and the board of directors approved the
arrangement, following the Compensation Committee’s
recommendation.
At the end of the year the board of directors decided to
continue the arrangement for 1 more year, with Mr. Lay as
CEO/chairman of the board and Mr. Kinder as COO. In accordance
with the prior agreement, Mr. Kinder exercised his option and
left Enron in 1996 in order to become CEO of another company.
After Mr. Kinder resigned from his position as COO, the board of
directors elected Mr. Skilling as president and COO of Enron in
December of 1996. As COO of Enron, Mr. Skilling reported
directly to Mr. Lay, the CEO of Enron. Enron had hired Mr.
Skilling in 1990, and he had been the director of an innovative,
highly successful venture of Enron. The management of Enron
identified Mr. Skilling as the future successor CEO. Mr. Lay
thereafter recommended that Mr. Skilling become the new CEO of
Enron. The Compensation Committee and the board of directors
supported Mr. Lay’s recommendation of Mr. Skilling for the CEO
position.
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In February 2001 Mr. Lay stepped down as CEO and Mr.
Skilling became CEO of Enron. Mr. Lay remained chairman of the
board of directors of Enron. After Enron announced that Mr.
Skilling was taking over as CEO, Mr. Lay received offers from
other companies to take other positions.
In February 2001 stock prices were in general decline,
including the price of Enron stock. Technology stocks in
particular had fallen in the summer of 2000, and stock prices
consequently fell throughout the market. The Compensation
Committee requested a stress test of Enron’s financial condition
because of concern over the falling stock prices. The results of
the stress test in May 2001 indicated that Enron was financially
sound even though Enron stock prices had fallen. Mr. Lay was in
final contract negotiations regarding a position with another
company when Mr. Skilling suddenly resigned from Enron on August
14, 2001.
Upon the unexpected resignation of Mr. Skilling, the board
of directors of Enron immediately and proactively worked to
persuade Mr. Lay to take the CEO position again at Enron. The
board of directors determined that no other senior officer at
Enron was sufficiently trained and ready to step into the CEO
position.
The board of directors of Enron wished to rehire Mr. Lay as
CEO and to retain Mr. Lay for a long period in order to stabilize
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the company. Enron negotiated for Mr. Lay to serve as CEO of
Enron and to remain in the CEO position for a period of years.
Although Mr. Lay had wished to retire as CEO of Enron, he
agreed to return. Mr. Lay held a very large position in Enron
stock because of the long-term incentives earned over the years,
and he had a major requirement for liquidity. Enron and its
advisers developed proposals with incentives to entice Mr. Lay to
reassume his position as CEO and to retain him for a period of
years. The Compensation Committee was interested in an
agreement to retain Mr. Lay for a period of years. The
subsequent sudden collapse of Enron was unanticipated by the
Compensation Committee during the negotiations with Mr. Lay in
August 2001. The instruments that Enron would normally use for
retention, stock options and restricted stock, both were
problematic.
First, because Mr. Lay was over age 55 and had served for
more than 5 years, if he voluntarily retired all of his
restricted stock would immediately vest. Second, Enron’s stock
plan documents limited the number of shares, options, or
restricted shares that could be granted in 1 year in accordance
with a shareholder-approved plan, and there was not time to hold
a shareholder meeting to approve a modification to the plan.
Accordingly, alternatives for retention were considered. At the
request of the Compensation Committee, Towers Perrin prepared
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alternatives for the Compensation Committee to offer to Mr. Lay
for consideration. The alternatives prepared by Towers Perrin
were based on two annuity contracts owned by Mr. Lay and Mrs.
Lay--the contracts which underlie the dispute in the present
case.
Mr. Lay purchased annuity No. 002105676 from the
Manufacturers Life Insurance Co. of North America (ManuLife) on
September 30, 1999 (Kenneth L. Lay Annuity). Mr. Lay paid
premiums in the aggregate amount of $5 million to ManuLife for
the Kenneth L. Lay Annuity as follows:
Date of Payment Premium Payment
Sept. 30, 1999 $2,500,000
May 10, 2000 1,125,000
June 19, 2000 1,375,000
Total 5,000,000
Annuity No. 002155712 issued by ManuLife was purchased for Mrs.
Lay on February 8, 2000 (Linda P. Lay Annuity). Premiums in the
aggregate amount of $5 million were paid to ManuLife for the
Linda P. Lay Annuity as follows:
Date of Payment Premium Payment
Feb. 8, 2000 $2,500,000
May 10, 2000 1,125,000
June 19, 2000 1,375,000
Total 5,000,000
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The annuity contracts were titled “Flexible Purchase Payment
Deferred Combination Fixed and Variable Annuity Contract Non-
Participating”. The owner of each annuity contract could elect
to step up the value of the annuity contract to the market value
of the selected investments of the annuity contract. The annuity
contracts also had a Guaranteed Retirement Income Program
feature, referred to as the “GRIP”, that guaranteed a 6-percent
annual increase on the amounts invested in the annuity.
The owner of the annuity contract could request that the
annuity payments start 7 years after purchase (or, if made, 7
years after an election to step up the value of the annuity to
market value) using the greater of actual market value of the
investments in the account or the GRIP amount. The GRIP amount,
as calculated over time with the 6-percent annual increase to the
amount paid for the policy, was referred to as the “Income Base”.
Mr. Lay elected to step up the value of his annuity contract
on September 30, 2000. The income base of the Kenneth L. Lay
Annuity on September 21, 2001, was $5,854,272.65, and the owner
of the Kenneth L. Lay Annuity on the seventh anniversary of Mr.
Lay’s election to step up the policy value (September 30, 2007)
was entitled to annuitize the guaranteed Income Base of
$8,303,072 pursuant to the terms of the Kenneth L. Lay Annuity.
The income base of the Linda P. Lay Annuity on September 21,
2001, was $5,453,004.77, and the owner of the Linda P. Lay
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Annuity on the seventh anniversary of the issuance of the policy
(February 8, 2007) was entitled to annuitize the guaranteed
income base in the approximate amount of $7,512,482 (the current
income base reflected on the January 1 to March 31, 2007, John
Hancock Statement for the Linda P. Lay Annuity) pursuant to the
terms of the Linda P. Lay Annuity.
The owner of the annuity contract could make withdrawals
from the amounts invested in the contract and could change the
investment elections. The annuity contracts were issued in Texas
and provide that the governing law is Texas law. The annuity
contracts state that “each owner may change the Owner, Annuitant,
or Beneficiary of his or her interest in the Contract by written
request in a form acceptable to us and which is received at our
Annuity Service Office.” The annuity contracts provide:
An Owner may assign his interest in this Contract at
any time prior to the Maturity Date. No assignment
will be binding on us unless it is written in a form
acceptable to us and received at our Annuity Service
Office. We will not be liable for any payments made or
actions we take before the assignment is accepted by us
* * *. We will not be responsible for validity of any
assignment.
Mary K. Joyce was vice president of compensation of Enron in
2001. As vice president, Mrs. Joyce worked closely with the
Compensation Committee. The Compensation Committee set pay
philosophy, particularly regarding executive compensation,
oversaw compensation plans, selected consultants to provide
advice regarding compensation, and oversaw employee benefit
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plans. Mrs. Joyce acted at the direction of the Compensation
Committee. Mrs. Joyce prepared the agenda and materials that
were presented at each meeting of the Compensation Committee,
working directly with Dr. LeMaistre and other members of the
committee. Mrs. Joyce also obtained any reports that the
Compensation Committee requested in connection with compensation
and benefits.
When Enron was developing proposals to attract Mr. Lay to
return as CEO, Dr. LeMaistre instructed Mrs. Joyce to request
proposals from Towers Perrin for use by the Compensation
Committee that would provide liquidity and a retention device.
Accordingly, Mrs. Joyce requested that Towers Perrin prepare
proposals to attract Mr. Lay by providing liquidity and to retain
Mr. Lay for a period of years by structuring a retention device.
The alternatives proposed by Towers Perrin were: (1) To
lend funds to Mr. Lay with the annuity contracts as collateral;
(2) to purchase the annuity contracts for fair market value; or
(3) to purchase the annuity contracts for fair market value and
then use the annuity contracts as a retention device by awarding
the acquired contracts to Mr. Lay with a “cliff vesting”
schedule. The term “cliff vesting” means that the award vests in
its entirety at the end of the vesting period, rather than
vesting ratably over the vesting period.
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The Compensation Committee considered the alternatives and
chose the third alternative to purchase the annuity contracts,
both to provide immediate liquidity to Mr. Lay and to use the
annuity contracts as a retention device by providing Mr. Lay with
the opportunity to have the annuity contracts transferred back to
him if he met certain contractually specified requirements and
subject to a cliff-vesting schedule. The Compensation Committee
rejected the first two options proposed by Towers Perrin because,
although they met Mr. Lay’s requirement for liquidity, the
options did not provide a retention device as required by the
board of directors of Enron. Towers Perrin proposed a 4.25-year
commitment from Mr. Lay.
Enron’s outside counsel, Vinson & Elkins, assisted in
structuring the annuities transaction. At Dr. LeMaistre’s
request, Mrs. Joyce presented the proposed annuities transaction
to the Compensation Committee at its meeting on September 14,
2001. Mrs. Joyce used two spreadsheets, headed “Scenario 1” and
“Scenario 2”, in making her presentation of the Towers Perrin
proposal to the Compensation Committee and to illustrate the
differences of using the annuity contracts as compared to Enron
stock to accomplish the board’s retention objective.
The spreadsheets showed that the Lays had paid a total of
$10 million for the annuity contracts ($5 million for each
policy), that the Lays would receive a total of $4,691,567 if
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they were to liquidate the contracts at that time, and that the
value of the annuity contracts at that time was $11,240,685.3
The only difference between the two spreadsheets presented
at the meeting was the amount that would be paid for the annuity
contracts, $10 million as shown on Scenario 1 and $4,691,567 on
Scenario 2. Because the purchase price reflected on Scenario 2
was the amount that the Lays would receive if they cashed in
their annuity contracts, the Compensation Committee concluded
that it would not provide any incentive for Mr. Lay to return to
Enron as its CEO, a requirement for the transaction.
The spreadsheets showed the benefits to Enron and to Mr. Lay
of using the annuities transaction instead of using Enron stock
for the transaction, especially the fact that the annuities
transaction would not dilute Enron stock and would provide Mr.
Lay with immediate liquidity. The Compensation Committee
determined on the basis of the information provided by Towers
Perrin that the current fair market value of the annuity
contracts at the time of the transaction was $11,240,685.
Following the discussion of the issues at its meeting on
September 14, 2001, the Compensation Committee approved “Scenario
1 of the Ken Lay Insurance Swap Analysis”. The scenario approved
by the Compensation Committee was to acquire the annuity
3
The spreadsheets also showed that the current floor value
was $11,240,685 and that the value in 4.25 years would be
$14,399,344.
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contracts for $5 million each, $10 million total, and also to
provide Mr. Lay the opportunity to earn back the annuities at the
end of a 4.25-year cliff-vesting period (or upon certain
terminations outside Mr. Lay’s control). The Compensation
Committee, therefore, authorized Enron to pay $10 million for two
annuity contracts worth $11,240,685.
The Compensation Committee authorized the officers of Enron
to execute and deliver all documents necessary or appropriate to
carry into effect the approved annuities transaction. The board
of directors of Enron approved the transaction at its meeting on
October 8, 2001. The Compensation Committee concluded that the
proposed purchase of the annuity contracts would provide Mr. Lay
with liquidity and was a good investment for Enron.
The plan approved by the Compensation Committee had two
distinct elements. First, as part of the package of inducements
offered to Mr. Lay in exchange for abandoning his plans to retire
and agreeing to reassume the responsibilities of CEO of Enron,
Enron agreed to purchase both of the annuity contracts from Mr.
and Mrs. Lay for $10 million. Second, as a retention device,
Enron agreed that if Mr. Lay neither resigned without consent nor
was removed for certain specified reasons as chairman of the
board and CEO of Enron before the expiration of a 4.25-year term,
it would reconvey the annuity contracts to Mr. Lay upon
completion of his service commitment.
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The Lays accepted the offer to sell their annuity contracts
for $5 million each, $10 million total, and Mr. Lay accepted the
offer to earn back the annuity contracts as a long-term incentive
award if he remained with Enron for the 4.25-year term (or left
the employment of Enron for certain reasons outside his control).
Following Mr. Skilling’s resignation, the board of directors of
Enron elected Mr. Lay to the position of CEO of Enron. Enron
prepared a Purchase, Sale, and Reconveyance Agreement (agreement)
to memorialize the terms of the agreement that Enron negotiated
with Mr. Lay. The Enron legal staff worked with its outside
counsel, Vinson & Elkins, to prepare the agreement.
Mr. Lay, Mrs. Lay, and Enron entered into the agreement on
September 21, 2001. Mrs. Joyce executed the agreement on
September 21, 2001, on behalf of Enron in her capacity as a vice
president of Enron. The Lays executed and delivered the
agreement to Enron on September 21, 2001. The agreement required
Enron to deliver $10 million by certified check or wire transfer
to the Lays at the closing of the purchase of the annuity
contracts.
The agreement also required the Lays, before or
simultaneously with the tender of the purchase price to them, to:
(i) Complete fully and accurately the Personal Information Change
Form (change form) for each of the contracts directing a change
in ownership of that contract to Enron and designating Enron as
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sole and primary beneficiary to receive any death proceeds paid
under the contracts; (ii) execute and submit the change forms to
Enron, and (iii) transfer the originals and all copies of the
Contracts in their possession to Enron.
The change forms attached to the agreement to be used to
transfer the annuity contracts to Enron are the forms provided by
ManuLife for this purpose. The change form required the
signature of the current owner. The change form also required
the signature of the new owner if the change form was being used
to change the owner. The change form states: “Please complete
this Personal Information Changes form with appropriate
signatures and mail to Manulife North America’s Product
Administration Department.”
In order to transfer the Kenneth L. Lay Annuity to Enron,
Mr. Lay executed the change form to change the owner and
beneficiary of the Kenneth L. Lay Annuity to Enron. Mr. Lay
delivered the executed, original change form with the original
annuity policy contract No. 002105676 to Enron on September 21,
2001. Mrs. Joyce executed the change form for the transfer of
the Kenneth L. Lay Annuity to Enron, on behalf of Enron as the
new owner of the Kenneth L. Lay Annuity, on September 21, 2001.
In order to transfer the Linda P. Lay Annuity to Enron, Mrs.
Lay executed the change form provided by ManuLife to change the
owner and beneficiary of the Linda P. Lay Annuity to Enron. Mrs.
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Lay delivered the executed, original change form with the
original annuity policy contract No. 002155712 to Enron on
September 21, 2001. Mrs. Joyce executed the change form for the
transfer of the Linda P. Lay Annuity to Enron, on behalf of Enron
as the new owner of the Linda P. Lay Annuity, on September 21,
2001. Mrs. Joyce received the original annuity contracts that
the Lays delivered to Enron on September 21, 2001.
Enron transferred $10 million to the bank account of the
Lays by wire transfer on September 21, 2001, in exchange for the
two annuity contracts.
There is an issue regarding the date that the change forms
were submitted by Enron to ManuLife and whether the originals or
copies were transmitted. Mrs. Joyce delegated the responsibility
for submitting the change forms to ManuLife on behalf of Enron
to Aaron Brown, the director of compensation for Enron. Mrs.
Joyce and Mr. Brown both believed that the original change forms
had been submitted to ManuLife on or shortly after September 21,
2001. Mr. Brown stated to a ManuLife employee that he had
provided the original change forms to ManuLife at the time of the
annuities transaction.
After September 21, 2001, Enron representatives asked
ManuLife why it had not yet processed the change of ownership of
the annuity contracts in accordance with the change forms. Mr.
Brown transmitted the fully executed change forms from Enron to
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ManuLife by facsimile on January 12, 2002. The facsimile cover
sheet was addressed by Mr. Brown to Gretchen Swanz of ManuLife,
and contained the following instructions to ManuLife: “Gretchen,
please facilitate the transfer of ownership/beneficiary of these
policies to Enron.” Ms. Swanz then sent an email to Mr. Brown,
on February 19, 2002, requesting that he send the original change
forms. Mr. Brown responded by email dated February 19, 2002,
that certified copies of the originals would be provided.
ManuLife corresponded with Enron regarding the change forms.
ManuLife did not contact Mr. or Mrs. Lay regarding the change
forms.
In 2004 ManuLife acquired and merged with John Hancock Life
Insurance Co. (John Hancock). John Hancock became the wholly
owned subsidiary of ManuLife and succeeded to all of the U.S.
operations of ManuLife and the former John Hancock Life Insurance
Co. John Hancock, therefore, is the insurance company that is
currently the party to the annuity contracts and has the records
regarding the annuity contracts. John Hancock has copies of the
fully executed agreement and the fully executed change forms in
its files.
The Lays reported the annuities transaction on their 2001
tax return on Schedule D, Capital Gains and Losses, as a sale of
each annuity contract for $5 million. Mr. Lay and Mrs. Lay each
had an adjusted basis of $5 million in the annuity contract sold
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by him or her to Enron pursuant to the agreement. The Lays
reported zero gain or loss on the sale of the annuity contracts,
on the basis of a sale price of $5 million for and an adjusted
basis of $5 million in each of the annuity contracts sold to
Enron pursuant to the agreement. Enron issued a Form W-2, Wage
and Tax Statement, to Mr. Lay for the 2001 calendar year to
report the compensation it paid him; that Form W-2 did not
include in Mr. Lay’s compensation any part of the $10 million
that Enron paid for the annuity contracts. However, in 2004
pursuant to an agreement with the Internal Revenue Service
(IRS), Enron issued an amended Form W-2 to Mr. Lay for 2001
reporting the $10 million as compensation.
On January 23, 2002, the board of directors requested that
Mr. Lay resign, and he resigned as chairman of the board of
directors and CEO of Enron with the consent of the board of
directors in February 2002.
Enron filed a petition for chapter 11 bankruptcy on December
2, 2001, in the U.S. Bankruptcy Court for the Southern District
of New York, in a case styled In re Enron, Debtor, chapter 11,
Case No. 01-16034, Jointly Administered (bankruptcy case). Enron
listed the annuity contracts purchased from the Lays as assets on
Schedule B, Personal Property, of its Statement of Financial
Affairs (initial and amended) filed in the bankruptcy case. The
Official Committee of Unsecured Creditors of Enron filed a
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complaint (and an amended complaint) in the bankruptcy case, to
avoid the annuities transaction. The complaint, as amended, has
been consolidated with the remaining insolvency proceedings in
the bankruptcy case and remains pending. On July 15, 2004,
Enron’s fifth amended plan was confirmed in the bankruptcy case.
Pursuant to the fifth amended plan, the Enron Creditors Recovery
Corporation was formed as the successor to Enron. John Hancock
filed a motion to intervene and file its interpleader complaint
in the adversary proceeding on October 20, 2010, alleging that
the ownership of the annuity contracts is disputed between Enron
and Mrs. Lay and requesting that the bankruptcy court determine
the ownership of the annuity contracts.
Because the IRS took the position that the Lays owned the
annuity contracts after the annuities transaction, in order to
test the status of the ownership of the annuities Mrs. Lay
requested a partial withdrawal of $50,000 from the Linda P. Lay
Annuity that she had transferred previously to Enron, in a
withdrawal request form submitted to John Hancock on February 8,
2006. The annuity contracts allow withdrawals from the contract
value. In response to Mrs. Lay’s request, John Hancock did not
pay the requested withdrawal and instead responded with a letter
to Mrs. Lay describing issues regarding the ownership of the
Linda P. Lay Annuity. In its letter dated February 15, 2006,
John Hancock described the agreement, quoting portions regarding
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the transfer to Enron and the reconveyance obligation, the change
form submitted to ManuLife, and the fact that Mr. Lay had ceased
serving as CEO and chairman, then concluding it was unable to
determine whether Mr. Lay or Mrs. Lay had an ownership interest.
On July 5, 2006, Mr. Lay died suddenly. Mrs. Lay is the
Independent Executrix of the Estate of Kenneth L. Lay. The Form
706, United States Estate (and Generation-Skipping Transfer)
Estate Tax Return, filed for Mr. Lay’s estate listed the claim
against Enron for the annuity contracts as a claim on Schedule C,
Mortgages, Notes, and Cash, and listed the claim of Enron for the
annuity contracts on Schedule K, Debts of the Decedent, as a
contested claim. Neither of the annuity contracts had been
conveyed to Mrs. Lay, or to the Estate of Kenneth L. Lay, as of
the trial date in this case. Neither Mr. Lay (or his estate) nor
Mrs. Lay ever received any distributions from either ManuLife or
John Hancock with respect to either of the annuity contracts. No
death benefit has been paid pursuant to the annuity contracts on
account of Mr. Lay’s death.
The Lays timely filed their joint Federal tax return for tax
year 2001. On April 2, 2009, respondent issued a statutory
notice of deficiency to petitioners in which respondent
determined a deficiency in income tax for the year ended December
31, 2001, of $3,910,000. Petitioners timely filed a petition in
this Court on June 23, 2009.
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OPINION
I. Burden of Proof
Petitioners would generally bear the burden of proof in this
case. See Rule 142(a)(1);4 INDOPCO, Inc. v. Commissioner, 503
U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S.
435, 440 (1934). The burden of proof on factual issues that
affect a taxpayer’s liability for tax may be shifted to the
Commissioner where the “taxpayer introduces credible evidence
with respect to * * * such issue.” Sec. 7491(a)(1). On the
record before us, we do not need to reference the burden of proof
to resolve this case as the facts are adequately presented.
Therefore, we need not determine whether section 7491(a)(1) is
applicable.
II. Sale of Annuity Contracts
Respondent argues that the Lays did not sell the annuity
contracts and that the $10 million they received was an employee
cash bonus includable in income for the 2001 taxable year. The
issue, therefore, is whether the Lays sold their annuity
contracts to Enron in September 2001, in accordance with the
agreement. There is no question the agreement was executed and
that the Lays acted in accordance with the agreement. As we
understand respondent’s position, respondent maintains the
4
All Rule references are to the Tax Court Rules of Practice
and Procedure, and all section references are to the Internal
Revenue Code.
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agreement was not made in good faith and that Enron and the Lays
never intended to transfer the annuity contracts, but rather
Enron simply paid Mr. Lay $10 million.
Gross income includes gains from the sale of property.
Secs. 61(a)(3), 1001(a). The gain from the sale of property is
calculated as the amount realized from the sale less the adjusted
basis in the property. Sec. 1001(a). The basis is ordinarily
the cost of the property. Sec. 1012(a). This calculation of
gain allows the taxpayer’s investment in the property to be
recovered tax free before any requirement to report a taxable
gain on the sale. Sec. 1011(a).
Pursuant to the agreement, the Lays sold each of the annuity
contracts to Enron for $5 million, for a total of $10 million.
The amount realized on the sale of each annuity contract,
therefore, was $5 million. The Lays had paid $5 million for each
annuity contract and had not withdrawn any amount or received any
distributions with respect to either of the annuity contracts.
Accordingly, the Lays had an adjusted basis in each annuity
contract of $5 million. The Lays, therefore, reported zero gain
upon the sale of the annuity contracts in 2001.
A. State Law
“The term ‘sale’ is given its ordinary meaning for Federal
income tax purposes and is generally defined as a transfer of
property for money or a promise to pay money.” Grodt & McKay
- 25 -
Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981) (citing
Commissioner v. Brown, 380 U.S. 563, 570-571 (1965)). State law
determines the nature of property rights, and Federal law
determines the appropriate tax treatment of those rights.
Aquilino v. United States, 363 U.S. 509, 513 (1960).
The agreement memorializes a contractual understanding of
the Lays with Enron. The agreement sets forth the sale of the
annuity contracts to Enron. Enron then used the annuity
contracts it purchased as the long-term incentive for Mr. Lay
also provided in the agreement.
The agreement also provides that Enron agrees to make a
future conveyance of the annuity contracts to Mr. Lay should he
remain employed by Enron for 4.25 years or upon certain earlier
terminations of employment outside his control. Only the sale
evidenced by the agreement is directly at issue in this case;
i.e., whether the Lays sold their annuity contracts to Enron in
2001.5
5
Mr. Lay remained employed by Enron through the end of 2001,
and therefore there is no issue of whether the annuity contracts
were reconveyed to Mr. Lay in 2001 in accordance with the
agreement.
The issue of whether Mr. Lay is entitled to the reconveyance
of the annuity contracts arises in 2002 upon the termination of
Mr. Lay’s employment with Enron and is at issue in the Enron
bankruptcy case, in which Enron listed the annuity contracts as
assets and John Hancock has filed a request for the bankruptcy
court to resolve the issue.
- 26 -
The agreement and the annuity contracts all provide that
Texas law governs. The rights and interests of the parties to
the annuity contracts, therefore, must be determined by applying
Texas law. Texas law allows the assignment of any rights under
an annuity contract in accordance with the terms of the contract.
Tex. Ins. Code Ann. art. 21.22-4, sec. 4 (West 1997). State law
permitted the Lays, the owners of the annuity contracts, to
assign the annuity contracts to Enron in accordance with the
terms of the annuity contracts.
The terms of the annuity contracts permitted the transfers
of the annuity contracts. The annuity contracts provide:
An Owner may assign his interest in this Contract at
any time prior to the Maturity Date. No assignment
will be binding on us unless it is written in a form
acceptable to us and received at our Annuity Service
Office * * * We will not be responsible for validity of
any assignment.
The annuity contracts further provide that “each Owner may change
the Owner, Annuitant, or Beneficiary of his or her interest in
the Contract by written request in a form acceptable to us and
which is received at our Annuity Service Office.” Accordingly,
the terms of the annuity contracts permitted the Lays to sell the
annuity contracts to Enron and the sale was allowed pursuant to
Texas law.
B. Enron
Enron and the Lays entered into a contract for the purchase
and sale of the annuity contracts on September 21, 2001. Enron
- 27 -
agreed in the agreement to purchase the annuity contracts for $5
million per contract. The agreement evidencing the annuities
transaction was authorized by the Compensation Committee. The
Compensation Committee of the board of directors, made up of
independent directors, structured, reviewed, and approved the
annuities transaction, and the Committee’s actions were
thereafter reported to Enron’s full board of directors.
Enron developed and proposed the annuities transaction after
the unexpected resignation of Mr. Skilling and the determination
by the board of directors that no one other than Mr. Lay was
ready to step into the CEO position at that time. The board of
directors immediately worked to attract Mr. Lay to return to the
CEO position at Enron. The Compensation Committee requested that
Towers Perrin, Enron’s compensation consultant, develop proposals
to persuade Mr. Lay to reassume the CEO position and to remain at
Enron for a period of years.
The Compensation Committee instructed Towers Perrin that the
proposals should address Mr. Lay’s need for liquidity and the
board of directors’ requirement to include a method for retaining
Mr. Lay in the CEO position for a period of years. Because Mr.
Lay was over age 55 and had served for more than 5 years, any
restricted stock Enron gave him would immediately vest if he
retired and restricted stock was not an acceptable means for
retention from Mr. Lay’s perspective.
- 28 -
Towers Perrin valued the annuity contracts at $11,240,685 in
September 2001. Towers Perrin proposed the following
alternatives for consideration by the Compensation Committee:
(1) To lend funds to Mr. Lay with the annuity contracts as
collateral; (2) to purchase the annuity contracts; or (3) to
purchase the annuity contracts and then use the annuity contracts
as a retention device as an award to Mr. Lay with a cliff-vesting
schedule. The Compensation Committee considered the
recommendations by Towers Perrin and chose the third alternative,
because it accomplished both of the requirements established by
the Compensation Committee. First, the purchase of the annuity
contracts met the requirement to provide liquidity to Mr. Lay as
an inducement to reassume the CEO position. Second, the use of
the annuity contracts as a retention device for Mr. Lay met the
requirement for a retention device. The Compensation Committee
and the board of directors as a whole approved the annuities
transaction in good faith after careful consideration. These
facts are supported by the agreement and the credible testimony
at trial.
C. Annuity Contract Requirements
In order to transfer the annuity contracts to Enron, the
Lays executed the change forms provided by ManuLife and delivered
the executed change forms with the original annuity contracts to
Enron at the closing conference with Mrs. Joyce on September 21,
- 29 -
2001. Mrs. Joyce also executed the change forms on behalf of
Enron on September 21, 2001.
The Lays executed the change forms provided by ManuLife and
made the assignment in a “written request in a form acceptable
to” ManuLife as required by the terms of the annuity contracts.
Each of the Lays executed a change form to transfer his or her
annuity contract to Enron on September 21, 2001, and delivered
the change form to Enron. As required by the change forms for a
change in ownership of an annuity contract, Mrs. Joyce executed
the change forms on September 21, 2001, on behalf of Enron.
Enron thereafter delivered the change forms to ManuLife. Whether
the delivery conformed to ManuLife’s requirements to transfer the
ownership of the annuity contracts is disputed, but we find no
effort to abort the transfer in the actions taken by Enron’s
employees; and we also find the Lays acted in accord with the
agreement to fulfil their contractual obligations to transfer the
annuity contracts. In summary, on September 21, 2001, the Lays
met all the requirements of the agreement to transfer the annuity
contracts, and Enron paid the consideration.
D. Manulife
In connection with the annuities transaction, it is not
clear whether Enron sent the original change forms to ManuLife.
Mrs. Joyce and Mr. Brown both believed the originals were sent to
ManuLife on or shortly after September 21, 2001. Enron did in
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fact send the change forms to ManuLife by facsimile transmission.
ManuLife, however, did not change the ownership of the annuity
contracts on its books. ManuLife stated that the reason it did
not transfer title on its books is that it did not receive the
originals of the fully executed change forms.
The change forms state that the forms should be mailed to
ManuLife, which perhaps could be construed as a request for the
original, but the annuity contracts do not include this
requirement. The annuity contracts require “a written request in
a form acceptable to us”. Enron had all of the legal documents
necessary to perfect its title in the annuity contracts.
Moreover, Enron conducted itself as if it had acquired the
annuity contracts. Mr. Brown of Enron inquired of ManuLife why
the annuity contracts had not been transferred on its books to
Enron. He informed ManuLife that he had submitted the original
change forms. Mr. Brown then transmitted the fully executed
change forms to ManuLife by facsimile. Enron was the beneficial
owner of the annuity contracts in accordance with the agreement
even though ManuLife failed to note the transfer of title on its
books.
The status of the legal title to the annuity contracts does
not control in determining whether a sale occurred. Beneficial
ownership, and not legal title, determines ownership for Federal
income tax purposes. Ragghianti v. Commissioner, 71 T.C. 346
- 31 -
(1978), affd. without published opinion 652 F.2d 65 (9th Cir.
1981); Pac. Coast Music Jobbers, Inc. v. Commissioner, 55 T.C.
866, 874 (1971), affd. 457 F.2d 1165 (5th Cir. 1972). The
Federal income tax consequences of property ownership generally
depend upon beneficial ownership, rather than possession of mere
legal title. Speca v. Commissioner, 630 F.2d 554, 556–557 (7th
Cir. 1980), affg. T.C. Memo. 1979–120; Beirne v. Commissioner, 61
T.C. 268, 277 (1973). “‘[C]ommand over property or enjoyment of
its economic benefits’ * * *, which is the mark of true
ownership, is a question of fact to be determined from all of the
attendant facts and circumstances.” Monahan v. Commissioner, 109
T.C. 235, 240 (1997) (quoting Hang v. Commissioner, 95 T.C. 74,
80 (1990)).
This Court has stated that “a sale occurs upon the transfer
of the benefits and burdens of ownership rather than upon the
satisfaction of the technical requirements for the passage of
title under State law.” Houchins v. Commissioner, 79 T.C. 570,
590 (1982). The determination of whether the benefits and
burdens of ownership have been transferred is one of fact and is
based on the intention of the parties, evidenced by their written
agreements and the surrounding facts and circumstances. Paccar,
Inc. & Subs. v. Commissioner, 85 T.C. 754, 777 (1985), affd. 849
F.2d 393 (9th Cir. 1988); Grodt & McKay Realty, Inc. v.
Commissioner, 77 T.C. at 1237; Ragghianti v. Commissioner, supra
- 32 -
at 349. Beneficial ownership is marked by command over property
or enjoyment of its economic benefits. Yelencsics v.
Commissioner, 74 T.C. 1513, 1527 (1980) (stock was sold in
accordance with an agreement for the sale, even though the title
to the stock was not transferred, in accordance with the
agreement of the parties).
For example, in Pac. Coast Music Jobbers, Inc. v.
Commissioner, supra at 874, this Court considered whether the
individual taxpayer (Hansen) purchased the stock of the corporate
taxpayer (Pacific Coast Music Jobbers) from three other
shareholders in 1962 pursuant to agreements executed in 1962.
Taxpayer Hansen negotiated to acquire all of the stock of Pacific
Coast Music Jobbers and entered into two agreements with the
shareholders whereby the sellers received payments over a 5-year
period during which the stock was held in escrow. The issues in
Pac. Coast Music Jobbers, Inc. were whether Hansen acquired the
stock upon execution of the agreements and thus became a
shareholder required to consent to the corporation’s S election,
and, if Hansen became a shareholder, whether the amounts paid out
to the selling shareholders were constructive dividends to
Hansen. This Court stated:
For purposes of Federal income taxation the
determination of whether a sale has occurred centers
more on the question of which party, as a result of the
transaction, has command or domination over the
property, rather than on the refinements of title. * *
* A court must consider not only when the bare legal
- 33 -
title passed but also when the benefits and burdens of
the property, or the incidents of ownership, were
acquired or disposed of in a closed transaction. * * *
In deciding the question, the court looks to that party
to the transaction who has the greatest number of the
attributes of ownership. * * * A court should look to
practicalities, disregarding merely formal and not
useful rights and attributes. * * * If it is found from
all the facts and surrounding circumstances that the
parties intended an agreement to result in the sale of
property, and the agreement transfers substantially all
the accouterments of ownership, the transaction will be
treated as a sale even though the parties intended the
legal title should not pass until later.
Id.
In Pac. Coast Music Jobbers, Inc. the Court held that Hansen
acquired the stock upon execution of the agreements and not 5
years later when the payments were complete and the stock was
transferred from the escrow. This Court concluded that the total
of the payments that Hansen was required to make to the sellers
established the purchase price and that Hansen acquired the stock
by means of a bootstrap purchase using the profits from the
corporate operations to acquire the business. The escrow
arrangement supported the conclusion that a sale had occurred
because the sellers had nothing further to do but collect the
sale price, and Hansen was getting the benefit of the corporate
dividends.
This Court noted that the sellers gave up significant rights
to alter or end the business of the corporation by their
agreement to continue the corporate business, and the sellers
also lost substantial domination and control because they gave
- 34 -
Hansen their irrevocable proxies. Although the sellers’ attorney
in Pac. Coast Music Jobbers, Inc. v. Commissioner, supra at 877,
retained the stock in escrow, it was reasoned that “the important
fact is not when the parties intended title to change hands but
when they intended the accouterments of ownership to be
transferred.”
The Lays gave up all rights to alter or terminate the
annuity contracts and lost domination and control over them.
After selling the annuity contracts to Enron, the Lays could not
sell them, nor could they liquidate them or borrow against them.
They also could not alter the investment options for the annuity
contracts or make any other elections or decisions regarding
them.
The Lays had delivered the transfer documents and received
the consideration for the sale, and there was nothing else for
them to do in connection with the transfer of the annuity
contracts to Enron. Enron, on the other hand, was able to use
the annuity contracts for the retention agreement. Enron also
could make cash withdrawals and alter the investment options in
the annuity contracts. Enron, therefore, had dominion and
control over the annuity contracts.
Unlike the situation in Pac. Coast Music Jobbers, Inc., the
entire purchase price was paid at the closing of the annuities
transaction, on September 21, 2001. In addition, whereas the
- 35 -
sellers in Pac. Coast Music Jobbers, Inc. placed the stock at
issue in escrow held by their own attorney, the Lays transferred
the annuity contracts with the fully executed change forms to
Enron on September 21, 2001, with no restrictions on the transfer
of legal title. Enron was in control over completing the
transfer of legal title on the books of ManuLife. This is not a
situation where the seller has retained control over the legal
title to the property, with the resulting issue of whether the
seller’s retention of title prevented a sale from occurring. See
Yelencsics v. Commissioner, supra at 1527 (taxpayers purchased
stock pursuant to an agreement with the selling shareholder that
gave the taxpayers unqualified voting proxies, control of the
corporation, and entitlement to all profits and dividends, even
though the selling shareholder remained the owner of record);
Ragghianti v. Commissioner, 71 T.C. 346 (1978) (shareholder
acquired stock upon posting a bond required by State law to
ensure payment of purchase price, even though the selling
shareholders continued to hold the stock).
Enron also used the annuity contracts purchased from Mrs.
Lay for the retention agreement with Mr. Lay. The use of the
annuity contracts as consideration for this agreement, therefore,
confirms that Enron was the beneficial owner of the annuity
contracts. Even after Enron entered into the agreement with Mr.
Lay to reconvey the annuity contracts after his service
- 36 -
commitment, Enron remained the beneficial owner of the annuity
contracts. Enron possessed the annuity contracts and had the
right to possess the annuity contracts and fully received the
benefits of ownership. As the owner of the annuity contracts,
Enron also bore the risk of any loss in connection with owning
the annuity contracts.
The Lays reported the transaction as a sale of the annuity
contracts on their 2001 tax return. Enron did not include the
purchase price on Mr. Lay’s original Form W-2 for 2001. After
purchasing the annuity contracts, Enron filed for bankruptcy on
December 2, 2001, and listed the annuity contracts as assets.
Enron’s position, therefore, was that it had purchased the
annuity contracts.
John Hancock confirmed that it did not consider Mrs. Lay to
be the owner, notwithstanding the legal title on its books.
Enron issued amended Forms W-2c, Corrected Wage and Tax
Statement, to Mr. Lay in 2004 in connection with Enron’s
settlement of an employment tax audit with the IRS Appeals
Office. We do not find this after-the-fact event relevant to the
case before us.
The District Courts in Texas have concluded that the
execution of agreements controls in situations where formal
filings have not been accomplished. Keller v. United States, 104
AFTR 2d 2009-6015, 2009-2 USTC par. 60,579 (S.D. Tex. 2009);
- 37 -
Church v. United States, 85 AFTR 2d 2000-804, 2000-1 USTC par.
60,369 (W.D. Tex. 2000), affd. per curiam 268 F.3d 1063 (5th Cir.
2001). In Church such a partnership agreement executed by the
parties governed, even though a certificate of limited
partnership had not been filed with the State before the death of
one of the parties to the partnership agreement. The court held
that the written partnership agreement was an enforceable
contract and governed the rights of the parties. Church v.
United States, supra. The execution of the partnership agreement
in Church also accomplished the transfer of the beneficial
interest in securities held in the decedent’s Paine Webber
account to the partnership under Texas and Federal law, with no
execution or submission of a change form to Paine Webber. The
court in Keller v. United States, supra, followed Church and held
that the execution of a partnership agreement reflecting certain
bonds as assets of the partnership before the transferor’s death
accomplished the transfer of the bonds to the partnership, even
though no request for a change was submitted to Vanguard, the
company holding the bonds.
The Lays agreed to sell the annuity contracts to Enron and
executed and delivered all documents required to effect the
transfer of legal title to the annuity contracts to Enron, in
accordance with the agreement. The transferor in each of the
Church and Keller cases had not even executed a transfer form to
- 38 -
transfer the ownership of the securities at issue to the
partnership before the transferor’s death, whereas the Lays had
fully executed and delivered the change forms to Enron and Enron
had transmitted the change forms to ManuLife. The reasoning of
Church and Keller, therefore, supports a finding that the Lays
sold the annuity contracts.
E. Conclusion
The Lays sold the Annuity contracts to Enron on September
21, 2001. In doing so, they complied with the requirements of
the agreement and took the steps required to transfer the annuity
contracts to Enron. The benefits and risks of ownership of the
annuity contracts were transferred to Enron in the annuities
transaction. The Lays, therefore, properly reported the
transaction on their Federal income tax return as a sale of the
two annuity contracts.
III. Section 83
Respondent’s first alternative position is that the
agreement provided for the transfer of the annuity contracts by
Enron to the Lays on September 21, 2001, in connection with the
performance of services by Mr. Lay and, therefore, caused the
fair market value of the property to be taxable to Mr. Lay
pursuant to section 83.
Section 83(a) provides, in pertinent part, that if property
is transferred to a taxpayer in connection with the performance
- 39 -
of services, the excess of the fair market value of the property
over the amount, if any, paid for the property shall be included
in the taxpayer’s gross income in the first taxable year in which
the taxpayer’s rights in the property are not subject to a
substantial risk of forfeiture. See Tanner v. Commissioner, 117
T.C. 237, 242 (2001), affd. 65 Fed. Appx. 508 (5th Cir. 2003);
sec. 1.83-7(a), Income Tax Regs.6
Consequently, taxability pursuant to section 83 would result
only if the provision in the agreement that granted Mr. Lay the
opportunity to earn back the Annuity contracts if he remained
with Enron for a period of 4.25 years (or an earlier date if Mr.
Lay’s employment terminated for certain specified reasons beyond
Mr. Lay’s control) constituted (1) property that (2) was
transferred to Mr. Lay in 2001 (3) in connection with his
performance of services and (4) the property was transferable by
Mr. Lay or not subject to a substantial risk of forfeiture in
2001. See sec. 83(a).
The term “property” for purposes of section 83 includes:
real and personal property other than either money or
an unfunded and unsecured promise to pay money or
property in the future. The term also includes a
beneficial interest in assets (including money) which
are transferred or set aside from the claims of
creditors of the transferor, for example, in a trust or
escrow account. * * *
6
Respondent has not alleged that Enron retransferred the
annuity contracts to either Mr. Lay or Mrs. Lay in 2001.
- 40 -
Sec. 1.83-3(e), Income Tax Regs. Property is “transferred” for
purposes of section 83 when a person acquires a beneficial
ownership interest in such property. Sec. 1.83-3(a)(1), Income
Tax Regs. Unfunded and unsecured promises to transfer property
in the future are excepted from the definition of “property” for
purposes of section 83. Sec. 1.83-3(e), Income Tax Regs.
The provisions of the agreement that granted Mr. Lay the
right to earn back the annuity contracts if he continued to
render services for 4.25 years create an unfunded and unsecured
promise to transfer property in the future. Enron agreed to
transfer the annuity contracts to Mr. Lay in the future upon his
completion of 4.25 years of service. The annuity contracts were
not transferred or set aside from the claims of creditors of the
transferor; in fact, Enron listed the annuity contracts as assets
upon filing for bankruptcy. Mr. Lay was required to perform
services before his right to receive the annuity contracts
ripened, and he could not assign his retention agreement. The
promise in the agreement to reconvey the annuities to Mr. Lay
after 4.25 years of service, therefore, is not “property” within
the meaning of section 83. Consequently, the threshold
requirement for application of section 83 (that “property” be
transferred to the service provider) is not met. This
arrangement between Enron and Mr. Lay, for Enron to transfer
property to Mr. Lay if he provided services for a period of
- 41 -
years, is a nonqualified deferred compensation plan not taxed at
inception because the property was not set aside or protected
from the creditors of Enron. See sec. 83; sec. 1.83-3(e), Income
Tax Regs.
Deferred compensation for services is included in gross
income in the taxable year in which it is actually or
constructively received. Sec. 1.451-1(a), Income Tax Regs.
(income is included in income for the taxable year in which
actually or constructively received by the taxpayer); sec. 1.446-
1(c)(1)(i), Income Tax Regs. (under the cash method of
accounting, gross income is included for the taxable year in
which actually or constructively received); Rev. Rul. 60-31,
1960-1 C.B. 174. A mere promise to pay, not represented by notes
or secured in any way, is not a receipt of income for a cash
method taxpayer. Rev. Rul. 60-31, 1960-1 C.B. at 177. Income is
constructively received in the taxable year in which it is
credited to the taxpayer’s account or set apart for the taxpayer
so that he may draw upon it at any time. Sproull v.
Commissioner, 16 T.C. 244 (1951), affg. 194 F.2d 541 (6th Cir.
1952); sec. 1.451-2, Income Tax Regs. “However, income is not
constructively received if the taxpayer’s control of its receipt
is subject to substantial limitations or restrictions.” Sec.
1.451-2(a), Income Tax Regs.
- 42 -
Mr. Lay had no control over the annuity contracts in 2001.
Enron’s listing the annuity contracts as assets when it filed for
bankruptcy confirms that the annuity contracts were not set aside
for Mr. Lay. Mr. Lay would constructively receive the annuity
contracts only after the 4.25 years of service or upon an earlier
termination that triggered the conveyance of the annuity
contracts to Mr. Lay under the terms of the agreement, none of
which occurred in 2001. Section 83 requires inclusion of the
fair market value of the property in income when the property is
first either transferable or not subject to a substantial risk of
forfeiture. Rights of a person in property are “transferable” if
the person may transfer any interest in the property to any
person other than the transferor, but only if the property is not
subject to a substantial risk of forfeiture. Sec. 1.83-3(d),
Income Tax Regs.
Property is not considered to be transferable merely because
the person performing the services may designate a beneficiary to
receive the property in the event of his or her death. Sec.
1.83-3(d), Income Tax Regs. A substantial risk of forfeiture
exists where the right to property is conditioned on the future
performance of substantial services or the occurrence of a
condition related to a purpose of the transfer, and the
possibility of the forfeiture is substantial if such condition is
not satisfied. Sec. 83(c); sec. 1.83-3(c)(1), Income Tax Regs.
- 43 -
Forfeiture of property upon termination of employment before
retirement at a specified age or time, death, or disability
generally constitutes a substantial risk of forfeiture. Sec.
1.83-3(c)(4), Example (1), Income Tax Regs.
Under the terms of the agreement, Mr. Lay would forfeit the
annuity contracts upon termination of his employment before the
end of the 4.25-year service period unless his employment was
terminated because of: (a) Retirement with the consent of the
board; (b) disability; (c) an involuntary termination (other than
termination for cause); or (d) a termination for “Good Reason”
(meaning a substantial change in Mr. Lay’s duties or position
with Enron or a substantial decrease in his salary, without his
consent).
Forfeiture of the annuity contracts if Mr. Lay voluntarily
terminated his employment before the 4.25 years constitutes a
substantial risk of forfeiture. See id.
The board would have had to take a specific action to
trigger Mr. Lay’s right to the annuity contracts upon other
terminations by consenting to Mr. Lay’s retirement, or by
substantially decreasing Mr. Lay’s salary or position without his
consent. The requirement for the board to take an action to
trigger Mr. Lay’s right to the annuity contracts is consistent
with a substantial risk of forfeiture. Because Mr. Lay had to
work 4.25 years for Enron in order to receive the annuity
- 44 -
contracts and could terminate his employment before those 4.25
years only under specific circumstances outside his control
without forfeiting the annuity contracts, there was a
“substantial risk of forfeiture” in 2001. The events in 2002
regarding Mr. Lay’s resignation are not before us.
In conclusion, section 83 does not apply to the deferred
compensation arrangement at issue.
IV. Price of Annuity Contracts
Respondent’s second alternative position is that the $10
million purchase price Enron paid for the annuity contracts was
in excess of their fair market value as of September 21, 2001,
and that the excess represented additional compensation to Mr.
Lay.
This Court has considered whether an amount paid by an
employer to an employee for property was actually in part a
payment for property and in part compensation. In Azar Nut Co.
v. Commissioner, 94 T.C. 455 (1990), affd. 931 F.2d 314 (5th Cir.
1991), an employer purchased the personal residence of an
employee pursuant to an employment contract for a price equal to
the residence’s appraised fair market value of $285,000. The
employer immediately attempted to resell the house and sold the
house 2 years later for $200,000 (at a loss of $111,366 on the
transaction). As its initial argument, the employer claimed an
ordinary and necessary business expense in an amount equal to the
- 45 -
loss, on the theory that this amount represented compensation
deductible under section 162(a). Id. at 459. This Court
rejected this argument, stating:
There is nothing in the record before us to indicate
that any portion of the purchase money * * * [the
employer] paid to * * * [the employee] represented a
premium or additional amount in excess of the fair
market value of the house that would otherwise
constitute “compensation.” * * *
Id.
Similarly, there is nothing in the record to indicate that
any portion of the $10 million that Enron paid the Lays for the
annuity contracts represented a premium or additional amount in
excess of the fair market value of the annuity contracts that
would otherwise constitute compensation. As in Azar Nut Co.,
Enron relied upon a valuation report that indicated that the
value of the annuity contracts was $11.2 million at the time of
the transaction. The Compensation Committee was aware that the
Lays had paid $10 million for the annuity contracts less than 2
years before the Compensation Committee began its deliberation.
In addition, we note that whereas in Azar Nut Co. the employer
suffered a loss with respect to the asset that it purchased,
there is no indication that Enron suffered any loss with respect
to its purchase of the annuity contracts. The income base of the
Kenneth L. Lay Annuity contract on September 21, 2001, was
$5,854,272.65 when Enron paid $5 million for that contract, and
the owner of the Kenneth L. Lay Annuity on September 30, 2007,
- 46 -
was entitled to annuitize the guaranteed income base of
$7,375,160 pursuant to the terms of the Kenneth L. Lay Annuity.
The Commissioner has argued in other cases that sales were
in fact dividend distributions after concluding that the sale
prices exceeded the fair market value of the assets sold. E.g.,
Commissioner v. Brown, 380 U.S. 563 (1965); Palmer v.
Commissioner, 302 U.S. 63 (1937). In these cases, the Court
looked to the intent of the contracting parties to pay a fair
market value price for the assets. See also Rev. Rul. 67-246,
1967-2 C.B. 104 (donor must prove that purchase price exceeded
value of property purchased; intention to make a gift by paying
in excess of value highly relevant to determining whether donor
made gift).
In Commissioner v. Brown, supra, shareholders sold their
stock to a third-party buyer for $1.3 million, and the purchase
price was payable by the buyer over time from the corporate
earnings. The Commissioner argued that the purchase price was
excessive and, therefore, was a device by the sellers to collect
future earnings of the corporation at capital gains rates. This
Court had found that the sale price was arrived at in an arm’s-
length transaction, was the result of real negotiating and was
“within a reasonable range in light of the earnings history of
the corporation and the adjusted net worth of the corporate
assets.” Brown v. Commissioner, 37 T.C. 461, 486 (1961), affd.
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325 F.2d 313 (9th Cir. 1963), affd. 380 U.S. 563 (1965). Even
though the sellers did not receive the full purchase price, this
Court held that the transaction was a sale, partly on the basis
of the finding that the purchase price was within a reasonable
range. In this case, as in Brown, there has been no showing that
the transaction’s purpose was other than a sale (i.e., to pay
compensation to Mr. Lay).
The board of directors of Enron wished for Mr. Lay to return
to Enron as CEO. In order to persuade Mr. Lay to return as CEO,
the Compensation Committee asked the compensation consultant
Towers Perrin for proposals and selected the proposal that
satisfied the requirements of the board of directors. Towers
Perrin proposed that Enron purchase the annuity contracts for $10
million and provided analyses to the Compensation Committee,
showing that the value of the annuity contracts was $11.2
million. With this information, the Compensation Committee
concluded that the value of the annuity contracts was $11.2
million. The Compensation Committee concluded that the purchase
of the annuity contracts was a good investment for Enron. In
addition, the parties to the agreement specifically agreed that
Enron was paying $5 million for each annuity contract.
The record demonstrates that Enron intended to pay $10
million as fair market value for the annuity contracts, and there
is no excess to include in gross income. Intent of the parties
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is important in determining whether a purchase price should be
recharacterized. Enron’s Compensation Committee approved the
purchase of the annuity contracts for $10 million.7 Accordingly,
the board approved a purchase price of $10 million for an asset
valued at $11.2 million. The Lays had paid $10 million for the
annuity contracts; and even though the Towers Perrin report
indicated a value of $11.2 million, they would have received only
$4.691 million if they had liquidated the annuity contracts at
that time. Nevertheless, the Compensation Committee reasonably
found that $10 million was a fair price for the annuity
contracts.
The issue is not whether the value of the annuity contracts
was, in fact, $10 million. The issue is whether the $10 million
that Enron paid to the Lays was intended for the purchase of the
annuity contracts. In determining whether the annuities
transaction was in fact a sale, the Court considers whether the
7
See IRS Publication 561 (for purposes of determining a
charitable contribution deduction “The value of an annuity
contract or a life insurance policy issued by a company regularly
engaged in the sale of such contracts or policies is the amount
that company would charge for a comparable contract.”). For gift
tax purposes, therefore, it appears that the value of the Annuity
contracts would have been $10 million. United States v. Parker,
376 F.2d 402, 408 (5th Cir. 1967); Anselmo v. Commissioner, 80
T.C. 872 (1983) (the valuation test for estate and gift tax
purposes is generally the same as that used for charitable
contribution deduction purposes), affd. 757 F.2d 1208 (11th Cir.
1985).
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purchase price was within a reasonable range. See Commissioner
v. Brown, 380 U.S. at 572.
In order to demonstrate that the purchase price was in fact
within a reasonable range, petitioners introduced expert witness
testimony of the value of the annuity contracts on the sale date,
September 21, 2001, when the income base was $5,854,272.65 for
the Kenneth L. Lay Annuity and $5,453,004.77 for the Linda P. Lay
Annuity. Petitioners’ expert witness, Lawrence Katzenstein,
prepared a report with an appraisal of the annuity contracts at
the time of the annuities transaction. Mr. Katzenstein has
special expertise in valuing annuity contracts.
Mr. Katzenstein used a discount rate provided by
petitioners’ other expert witness, Robert Buchanan, an
experienced appraiser and accredited senior appraiser (business
valuation). In order to determine the discount rate to use to
value the annuity contracts, Mr. Buchanan used evidence of open
market transactions in interests similar to the annuity
contracts. Mr. Buchanan noted that the discount rate would be
used to calculate the value of the annuity contracts as the
present value of the future stream of guaranteed payments based
on the guaranteed income rider. Mr. Buchanan based the discount
rate on two methodologies. The first method was based on the
Actuarial Guideline for Variable Annuities from the National
Association of Insurance Commissioners for purchasing an annuity
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with a guaranteed minimum income benefit and produced a discount
rate of 4.49 percent as of September 21, 2001. The second method
was based on the Standard Valuation Law from the National
Association of Insurance Commissioners for the standard valuation
interest rates for types of annuities such as the annuity
contracts and resulted in a discount rate of 4.50 percent.
Mr. Buchanan weighted all indications equally and concluded
that the appropriate discount rate applicable to the valuation
analysis of the annuity contracts as of September 21, 2001, was
4.67 percent. Mr. Katzenstein then used this fair market
discount rate to determine the fair market value of each of the
annuity contracts on September 21, 2001.8 Mr. Katzenstein used
the information provided by John Hancock regarding the monthly
annuity benefits payable starting on the first date the annuity
option could have been exercised pursuant to each of the annuity
contracts in order to calculate the values of the annuity
contracts. Mr. Katzenstein then performed an actuarial analysis
to determine the value of each of the annuity contracts, using
the discount rate provided by Mr. Buchanan. Mr. Katzenstein
determined that the minimum value of the Kenneth L. Lay Annuity
was $5,109,117, and that the minimum value of the Linda P. Lay
8
Mr. Katzenstein reviewed the annuity contracts and took
note of both the guaranteed minimum income benefit payable on
amounts paid for the contract and the special feature that if the
annuity investment account performed sufficiently well, the
payments could be higher.
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Annuity was $4,432,456, as of September 21, 2001, totaling
$9,541,573. Mr. Katzenstein testified that these values were
minimum values and that the annuity contracts could have had
higher values as of September 21, 2001.
The purchase price in this case, therefore, was within 5
percent of the values that Mr. Katzenstein calculated as the
minimum values of the annuity contracts. That purchase price was
within a reasonable range of values supports the conclusion that
the annuities transaction was in fact a sale. In other words,
even if the $10 million price for the annuity contracts exceeded
the actual values somewhat, the price was within a reasonable
range of values, showing that the parties intended for the
annuities transaction to be a sale transaction for the annuity
contracts.
Respondent offered no evidence with respect to the values of
the annuity contracts as of September 21, 2001. Moreover, in the
event that the sale price is treated as less than $10 million
with the excess treated as taxable, this excess amount also would
be a loss to the Lays. Mr. Lay and Mrs. Lay paid a total of $10
million for the annuity contracts, and their cost basis in the
annuity contracts is $10 million. Accordingly, if the Lays had
sold the annuity contracts for less than $10 million, then they
might have reasonably reported an ordinary loss on the sale equal
to the amount realized less their adjusted basis. See sec. 1001;
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Rev. Rul. 61-201, 1961-2 C.B. 46 (ordinary loss allowed on a
taxpayer’s surrender of a single premium refund annuity contract
for cash consideration).
In summary, Enron paid Mr. and Mrs. Lay $10 million in
exchange for the annuity contracts. Enron intended for the full
amount of its payment to be consideration for the annuity
contracts. The annuities transaction is well documented, and all
actions of the parties to the transaction reflect that Enron
purchased the annuity contracts for $10 million. The Lays
properly reported the transaction on their 2001 tax return as a
sale of their annuity contracts.
To reflect the foregoing,
Decision will be entered
for petitioners.