UNITED STATES TAX COURT
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108 T.C. No. 25
UNITED STATES TAX COURT
ROBERT D. BOOTH AND JANICE BOOTH, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos.
2544-94, 2545-94,
2546-94, 5754-94,
5755-94, 5893-94,
9229-94, 9230-94.
Filed June 17, 1997.
Secs. 419 and 419A, I.R.C., as enacted by the
Deficit Reduction Act of 1984, Pub. L. 98-369,
secs. 511(a), 512(a), 98 Stat. 494, 854, 862, limit an
employer's deductions for contributions made to a
welfare benefits fund for employees. These limitations
do not apply to a welfare benefits fund that is part of
a "10 or more employer plan" described in sec.
419A(f)(6), I.R.C. Under the Prime Plan, in which Ps
1
Cases of the following petitioners are consolidated
herewith: N.L. Booth & Son, Inc., docket No. 2545-94; John N.
Booth & Debra Booth, docket No. 2546-94; Young & Young, Ltd.,
docket No. 5754-94; Howard S. Young & Elaine P. Young, docket
No. 5755-94; Bruce E. Traegde & Patricia Traegde, docket No.
5893-94; Billy J. Johnson & Ruth Johnson, docket No. 9229-94; and
Johnson Systems, Inc., docket No. 9230-94.
- 2 participated, each participating employer made a
one-time, nonrevertible contribution to a single trust,
equal to the amount necessary to fund the dismissal
wage and death benefits of its qualifying employees.
The trust segregated each contribution into a separate
account for payment of benefits to only the
contributing employer's qualifying employees. If an
employer's account did not have enough assets to pay a
promised benefit, the trustee could supplement the
account's assets with assets from a "suspense account"
that was funded primarily by actuarial gains and
amounts forfeited from the employers' accounts in
certain enumerated situations. Each employer selected
options under the Prime Plan, including participation
and vesting requirements. Except through the suspense
account, an employee had no right to receive benefits
from other than his or her employer's account.
Held: The Prime Plan is a "welfare benefit plan"
within the meaning of sec. 419, I.R.C.
Held, further: The Prime Plan is not within the
scope of sec. 419A(f)(6), I.R.C., because it is an
aggregation of separate plans each having an
experience-rating arrangement with the related
employer.
Held, further: None of the corporate Ps are
liable for the accuracy-related penalties determined by
R.
Charles A. Pulaski, Jr., Janet E. Barton, and Tim A. Tarter,
for petitioners.
Katherine H. Ankeny, Anne W. Durning, and Randall P.
Andreozzi, for respondent.
LARO, Judge:
The docketed cases, consolidated for purposes
of trial, briefing, and opinion, consist of four groups of test
cases selected by the parties to resolve their disputes
- 3 concerning the "Prime Financial Benefits Trust Multiple Employer
Welfare Benefit Plan and Trust".2
(We hereinafter refer to this
"plan" as the Prime Plan and the trust as the Trust.3)
Each of
these four groups consists of a closely held corporation and one
or more of its owner/employees.
In regard to each group, the
Commissioner of Internal Revenue (the Commissioner or respondent)
determined that the corporation could not deduct the amounts that
it reported as contributions to the Trust and that the
individual(s) had income to the extent that the contributions
benefited him or her (or them).
Each petitioner petitioned the
Court to redetermine the Commissioner's determination of the
resulting deficiencies in Federal income tax, penalties, and, in
one case, an addition to tax.
Respondent's notices of deficiency
listed the following deficiencies, addition to tax, and
penalties:4
2
We have obtained this name from the underlying trust
agreement, as originally drafted and as later amended on the
first two occasions. The third amended version of the trust
agreement used the name "Prime Financial Benefits Multiple
Employer Welfare Benefit Plan and Trust". The fourth and fifth
amended versions used the name "Prime Financial Multiple Employer
Welfare Benefit Plan and Trust". Our use of the original name
refers to all of these versions.
3
Although we use the word "plan" in the singular to refer
to the Prime Plan, we do not mean to suggest that the Prime Plan
is a single plan. As discussed below, we conclude it is not. We
use the word "plan" merely for clarity and convenience.
4
All of the years refer to the calendar year, except:
(1) N.L. Booth's 1989 and 1990 years refer to its taxable years
ended July 31, 1990 and 1991, respectively, and (2) Systems' 1990
(continued...)
- 4 Robert D. Booth & Janice Booth (R&J Booth), docket No. 2544-94
Addition to Tax
Penalty
Sec.
Sec.
Year
Deficiency
6651(a)(1)
6662(a)
1990
$15,180
--$3,036
1991
8,920
--1,784
N.L. Booth & Son, Inc. (N.L. Booth), docket No. 2545-94
Addition to Tax
Penalty
Sec.
Sec.
Deficiency
6651(a)(1)
6662(a)
Year
1989
$34,000
--$6,800
1990
21,883
--4,377
John N. Booth & Debra Booth (J&D Booth), docket No. 2546-94
Addition to Tax
Penalty
Sec.
Sec.
Deficiency
6651(a)(1)
6662(a)
Year
1990
$17,820
--$3,564
1991
10,263
--2,053
Young & Young, Ltd.(Young & Young), docket No. 5754-94
Addition to Tax
Penalty
Sec.
Sec.
Deficiency
6651(a)(1)
6662(a)
Year
1989
$12,744
$637
$2,549
Howard S. Young & Elaine P. Young (the Youngs),
docket No. 5755-94
Addition to Tax
Penalty
Sec.
Sec.
Year
Deficiency
6651(a)(1)
6662(a)
1989
$14,008
--$2,802
Bruce E. Traegde & Patricia Traegde (the Traegdes),
docket No. 5893-94
Addition to Tax
Penalty
Sec.
Sec.
Year
Deficiency
6651(a)(1)
6662(a)
1989
$14,008
--$2,802
4
(...continued)
year refers to its taxable year ended Sept. 30, 1991.
- 5 Billy J. Johnson & Ruth Johnson (the Johnsons),
docket No. 9229-94
Addition to Tax
Penalty
Sec.
Sec.
Year
Deficiency
6651(a)(1)
6662(a)
1990
$83,972
--$16,794
Johnson Systems, Inc. (Systems), docket No. 9230-94
Addition to Tax
Penalty
Sec.
Sec.
Deficiency
6651(a)(1)
6662(a)
Year
1990
$108,675
--$21,735
We decide the following issues:
1.
Whether the Prime Plan is a welfare benefit plan or a
plan deferring the receipt of compensation.
We hold it is a
welfare benefit plan.5
2.
Whether the Prime Plan is a 10 or more employer plan
described in section 419A(f)(6).
We hold it is not.6
5
In light of a concession by respondent that amounts
attributable to contributions to the Prime Plan are not
includable in the gross income of the individual petitioners
under sec. 83 if the plan is determined to be a welfare benefit
plan, our holding on this issue makes it unnecessary to decide
certain other issues in dispute; namely: (1) Whether the Trust
maintains separate accounts for each employee under sec.
404(a)(5), (2) whether the employees' rights are subject to a
substantial risk of forfeiture under sec. 83, (3) whether the
Traegdes extended the period of limitation for assessment of tax
on income recognizable under sec. 83, and (4) whether the
petitioning individuals are liable for penalties under sec.
6662(a). We express no opinion on these issues.
6
Our holding on this issue moots another issue in dispute;
namely, whether contributions to the Prime Plan are current or
capital expenditures. We express no opinion on this issue.
- 6 3.
Whether the corporate petitioners are liable for the
penalties determined by respondent.7
We hold they are not.
Unless otherwise indicated, section references are to the
Internal Revenue Code applicable to the relevant years, Rule
references are to the Tax Court Rules of Practice and Procedure,
and dollar amounts are rounded to the nearest dollar.
FINDINGS OF FACT
I.
Background
A.
Prime Financial Partners, L.P. (Prime)
Prime is a master limited partnership that was traded on the
American Stock Exchange during most of the relevant years.
Prime
was formed on April 16, 1987, under the laws of the State of
Delaware, to acquire the financial services and real estate
activities of a group of Prime's affiliated entities.
Prime's
general partner is Prime Partners Limited Partnership (Limited),
an Arizona limited partnership, whose general partner is Prime
Financial Partners, Inc. (Financial), an Arizona corporation.
On
December 31, 1988, the outstanding stock of Financial and the
limited partnership units of Limited were held by Thomas G.
Cummings, Jerry P. Franks, Anthony L. Tominac, Marvin D. Brody,
and Donald A. Waldman.
7
Joel Boyarsky and a corporation joined
With respect to the addition to tax under sec. 6651(a)(1),
the parties stipulated that Young & Young filed its 1989 tax
return untimely. Given the additional fact that in petitioners'
brief they do not challenge respondent's determination of this
addition to tax, we sustain respondent's determination without
further discussion. Rule 142(a).
- 7 this list of owners on December 31, 1989, as did William G.
Stalnaker on December 31, 1990.
Mr. Tominac and the corporation
terminated their ownership interests in both entities during
1990, and Messrs. Franks and Stalnaker terminated their ownership
interests in the entities during 1991.
On December 31, 1991, the
outstanding stock of Financial and the limited partnership units
of Limited were held by Messrs. Cummings, Brody, Waldman, and
Boyarsky.
During the relevant years, Prime was an investment banking
and financial services firm that earned revenues mostly by
investing and placing money.
Prime also earned revenues from
commissions and administrative services generated by the Prime
Plan.
Prime researched, developed, and began marketing the Prime
Plan in 1988.
The Prime Plan provided death benefits and
dismissal wage benefits (DWB's) to qualifying employees of
participating employers.
On November 29, 1991, Prime filed for protection under
Chapter 11 of the U.S. Bankruptcy Code.
B.
Development of the Prime Plan
Mr. Brody developed the concept of the Prime Plan in 1988 in
response to 1984, 1986, and 1987 tax legislation that limited the
tax benefits a small business owner derived from a pension plan.
Mr. Brody expected that the Prime Plan would provide meaningful
tax deferral to small businesses with few employees.
The Prime
Plan purported to enable business owners to make tax deductible
- 8 contributions for employee benefits, while allowing them to
accumulate wealth through the appreciation of assets purchased by
the plan with their contributions.
The Prime Plan had some
similarities to a defined benefit pension plan, but the Prime
Plan had fewer limitations on funding, benefits, and
accessibility to funds.
Prime marketed the Prime Plan primarily to highly
compensated small business owners with five to six employees.
These business owners could expect to receive the following
benefits from the Prime Plan, as the plan was advertised to them:
1.
The employer would currently deduct a one-time
contribution that it made to the Prime Plan to fund DWB's and
death benefits, and the contribution would not be taxable to the
employer's employees until received as benefits;
2.
The employer could contribute to pension plans, as well
as to the Prime Plan, but, in the case of the Prime Plan, the
employer would not be subject to the rules limiting contributions
to pension plans;
3.
Contributions to the Prime Plan would earn income
tax-free because the Trust, although not a tax-exempt entity,
would invest each employer's contributions in life insurance and
municipal bonds;
4.
The employee/owners could reap personally most of the
benefits offered by the Prime Plan by basing an employee's
receipt of benefits on compensation and by using vesting
- 9 schedules to limit the benefits payable to employees other than
the owners themselves;
5.
Trust assets would be insulated from creditors;
6.
Death benefits would not be subject to income tax or,
with minimal planning, estate tax.
As of December 31, 1994, approximately 800 employers had
participated in the Prime Plan.
On that date, approximately
625 of these employers continued to participate in the Prime
Plan.
C.
David Weiss
Mr. Weiss is an attorney who was employed during the
relevant years by the law firms of Streich Lang and Snell &
Wilmer.
In early 1988, Prime contacted Mr. Weiss to help create
a welfare benefit plan subject to section 419A(f)(6) and to draft
a tax opinion that would be used to market the plan nationwide.
Mr. Weiss initially refused, believing there was insufficient
guidance on section 419A(f)(6) to allow him to create such a
plan.
Mr. Weiss later agreed to do so.
Mr. Weiss was a
principal architect of the Prime Plan and the Trust, and he wrote
a series of tax opinion letters related thereto.
These letters
included opinions dated June 2, 1988, July 25, 1988, April 12,
1989, June 30, 1990, October 1, 1991, and April 1, 1993.
D.
Dr. William L. Raby
Dr. Raby is an accountant with a national reputation in
areas related to the Prime Plan and the Trust.
At the behest of
- 10 Mr. Weiss, Streich Lang engaged Dr. Raby from February 1988 to
the beginning of 1990, to assist Mr. Weiss in forming the desired
plan and to express a concurring opinion on Mr. Weiss' tax
opinions related thereto.
Prime informed Dr. Raby that it wanted
to develop a plan that offered a front-end reduction of taxes for
small employers and a deferral of income for their employees.
Dr. Raby and Mr. Weiss advised Prime that the plan needed an
element of risk-shifting to qualify for the desired benefits, and
that a "suspense account" could be used to accomplish the
required shifting of risk.
Dr. Raby and Mr. Weiss later
presented Prime with different provisions for the Prime Plan,
some of which Prime found unacceptable for marketability
purposes.
Dr. Raby and Mr. Weiss redrafted the unacceptable
provisions, and Prime found the redrafted provisions more to
their liking.
Dr. Raby wrote an opinion concurring with Mr. Weiss' tax
opinion dated June 2, 1988, and Dr. Raby concurred with
Mr. Weiss' opinion dated April 12, 1989.
Dr. Raby's concurrences
were based on his understanding of the tax law including the
"possible purposes" of section 419A(f)(6).
Dr. Raby's
concurrences, as well as Mr. Weiss' opinions that related
thereto, did not address any version of the Prime Plan that is at
issue herein; they discussed a hypothetical plan that evolved
into the instant versions.
Dr. Raby's name was used to promote
versions of the Prime Plan that were marketed to the public.
- 11 At Mr. Weiss' request, Dr. Raby performed services in
May and June 1993, in connection with respondent's consideration
of issues flowing from the Prime Plan.
Dr. Raby's fees were paid
from the suspense account (the Suspense Account) that was part of
the Trust.
The Suspense Account served primarily as the
depository for amounts forfeited by the employers and employee
groups connected to the Prime Plan.
E.
The Trust
The Trust was a separate, taxable entity apart from Prime
and its affiliates.
The Trust owned all of its assets, and it
was supervised by an independent trustee.
The Trust's assets
consisted of the money and other property contributed by the
participating employers, and any earnings (or less any losses)
thereon, less payments made by the trustee.
The Trust's first trustee was Northern Trust Bank of
Arizona, N.A. (Northern).
Northern was succeeded by Security
Pacific Bank Arizona (Security Pacific) on or about June 30,
1990.
Firstar Metropolitan Bank & Trust (Firstar) succeeded
Security Pacific effective January 2, 1992.
Firstar's trustee
fees included an asset management fee of 1 percent of the market
value up to $2 million per account, with 0.8 percent of the
market value on the balance, plus a $15 per item transaction
charge.
F.
The Administrator of the Prime Plan
- 12 The Prime Plan was overseen by an administrator.
Improved
Funding Techniques, Inc. (IFTI), was the Prime Plan's first
administrator.
On October 24, 1990, Financial's board of
directors approved a letter of intent with IFTI under which IFTI
would assume all plan administration together with related
overhead and expenses in return for existing and projected
administration fees.
Prime entered into an administrative
services agreement with IFTI in July 1991.
In consideration for
providing administrative services to the Prime Plan, IFTI billed
participating employers directly in accordance with the following
fee schedule:
New plan installation:
Annual service costs
First 5 participants:
6 to 10 participants:
11 & over:
Trustee's transaction fees:
Individual benefit certification:
Vested participants:
Non-vested participants:
Plan amendments:
Plan terminations:
Revised plan valuations:
Special projects & consulting:
$250
1050
1450
1650 + $20 per
participant
15 per transaction
50
35
250
650 + $75 per
participant
750
150 per hour junior
250 per hour senior
Under the Agreement with IFTI, Prime received a percentage of
profits equal to 10 percent of IFTI's fees for administration of
each plan where the annual fees (net of actuarial costs) exceeded
$1,000 per plan and 20 percent of the fees for administration of
- 13 each plan where the fees (net of actuarial costs) exceeded $1,500.
In 1992, Prime moved the bankruptcy court to terminate its
agreement with IFTI and to subcontract the administration
services to William M. Mercer, Inc.
II.
The Trust Agreements
A.
Overview
The Prime Plan and the Trust were established and operated
pursuant to the Prime Plan and Trust Agreement, effective
August 31, 1988, as subsequently amended and restated by various
versions of the agreement dated December 31, 1988, December 21,
1989, June 30, 1990, January 2, 1992, and November 1, 1993.
(The
Prime Plan and Trust Agreement and each of these amended versions
are collectively referred to as the Trust Agreement and
separately referred to by the corresponding date.)
Most of the
amendments were made to the language originally used in the
August 31, 1988, Trust Agreement in order to enhance the
marketability of the Prime Plan by increasing an employer's
control over its contributions (and income or loss thereon).
Other amendments were made to comply with changes in the law.
Employers became participants in the Prime Plan by
completing an agreement (Adoption Agreement) that enumerated the
key specifications of the plan and allowed each employer to
tailor the plan to its employees by selecting various options
that would apply to its employees.
An employer could change the
options that applied to its employees, and modify the Adoption
- 14 Agreement in any other regard (e.g., to increase DWB's, death
benefits, or both), with the permission of Prime and the trustee.
An employer's plan year was the 12-month period that was set
forth in the Adoption Agreement, and the employer listed in its
agreement the date that the Prime Plan became effective with
respect to its employees.
Once an employer executed an Adoption
Agreement, the employer was bound to make a one-time contribution
to the Trust, equal to the amount determined by the Prime Plan’s
actuaries to be sufficient to fund the employer's employees'
vested DWB's and level of death benefits selected by the employer
in the Adoption Agreement, as well as to pay miscellaneous
charges on the transaction.8
The employer’s initial contribution
for DWB's was ascertained through actuarial assumptions developed
by the Prime Plan's actuaries.
The actuaries generally employed
the following assumptions prior to 1991:
8
The Prime Plan's initial actuary was Laventhol & Horwath.
Deloitte & Touche replaced Laventhol & Horwath as the Prime
Plan's actuary in 1990.
- 15 Interest:
7% per annum, compounded annually
Salary scale: Average annual salary increases of 7%
Mortality:
Pre-severance forfeiture age:
None
Post-severance forfeiture age:
Assumed rates of
mortality are based on
the Society of Actuaries
1951 Group Annuity
Mortality Table
Terminations:
Each employee was assumed to terminate before
reaching the forfeiture age
The Trust used each employer's contributions to purchase
insurance products to fund the DWB's and death benefits promised
under the Prime Plan.
The employer designated in its Adoption
Agreement the insurance company from which the insurance products
for its employees were to be purchased, as well as the type and
amount of these products.
The employer could designate in its
Adoption Agreement vesting periods and percentages, which
determined the amount of DWB's that would be paid to its
employees.
The employer could designate in its Adoption
Agreement its employees' "Year of Participation" and "Year of
Service", as those terms were defined in the Trust Agreement.
B.
The August 31, 1988, Trust Agreement
1.
Overview
Prime and Northern Trust entered into the August 31, 1988,
Trust Agreement, "establish[ing] a Multiple Employer Welfare
Benefit Fund and Trust for the exclusive benefit of the
participating Employers, their Employees, and in the case of life
benefits, their Beneficiaries".
Under this agreement, each
- 16 participating employer had its own "Employee Group" that
consisted of its employees (the Covered Employees) who met the
minimum age and service requirements set forth by the employer in
the Adoption Agreement.
The Trust Agreement designated each participating employer
as a "Plan Administrator".
Generally, each Plan Administrator
exercised all discretionary and other authority to control and
manage the operation and administration of the Prime Plan.
Under
the Trust Agreement, each Plan Administrator delegated to Prime
most of its duties and responsibilities with respect to the Prime
Plan, including:
(1) Applying rules determining eligibility,
(2) calculating service and compensation credits, (3) preparing
employee communication material, benefit reports, and reports
required by governmental agencies, (4) calculating benefits,
(5) advising employees on their rights and options, (6) applying
contributions, (7) processing claims, (8) recommending decisions
on the Trust's administration and the maintenance of accounts,
and (9) maintaining an account for each Covered Employee.9
Prime
received a fee for performing these services.
9
The Trust Agreement generally required the maintenance of
separate accounts for each Covered Employee to assure each
participating employer that any contributions that it made to the
Prime Plan were segregated and considered assets of its Employee
Group.
- 17 2.
DWB's
A Covered Employee generally received a DWB upon termination
of his or her employment for a reason other than "cause".
The
amount of the DWB, which was set forth by the employer in the
Adoption Agreement, was based on a percentage of the Covered
Employee's compensation in the calendar year immediately
preceding termination as well as his or her years of service at
the time of termination.
In no case could a DWB exceed two times
compensation during the immediately preceding calendar year, and
a DWB could not be greater than the amount shown in the vesting
schedule set forth by the employer in the Adoption Agreement.
If
an employee had severed his or her employment when the employer
made the initial contribution, the employee's DWB generally
equaled the amount shown as his or her "Vested Severance Benefit"
in that year's annual report.
Prime had the sole discretion to pay the DWB in a lump sum
or to pay the DWB in monthly installments not to exceed 24 months
after the Covered Employee's termination date.
The payment of
DWB's was secured by the insurance company that issued insurance
policies on the life of each Covered Employee.
A Covered Employee's DWB generally was forfeited to the
Suspense Account if he or she:
(1) Was discharged for "cause",
(2) terminated employment after attaining a stated age, or
(3) died while employed.
Under the August 31, 1988, Agreement,
employment meant "working as an employee, partner or proprietor
- 18 in the same occupation or profession", and a discharge for
"cause" occurred when the discharge resulted from "a proven
dishonest or criminal act committed in the course of the
Employee's employment with the Employer".
defined:
The same agreement
(1) The stated age as the "Forfeiture Age", which was
defined as "an age which is three years prior to a Covered
Employee's Normal Retirement Date", (2) the "Normal Retirement
Date" as a date set forth by the employer in the Adoption
Agreement, and (3) a "Termination of Employment" as "the earliest
of the date on which an Employee become [sic] Totally Disabled,
resigns or is discharged without Cause."
The Normal Retirement
Age generally was set forth by the employers as (1) the later of
age 65 or completion of 10 years of participation in the Prime
Plan, or (2) if the participating employer had a qualified plan,
the definition given that term under the qualified plan.
DWB's
that were forfeited due to death or the attainment of the
Forfeiture Age were segregated into the Suspense Account to be
used to increase that employer's Covered Employees' DWB's or
death benefits, to provide new welfare benefits, to provide
benefits for replacement employees, or to distribute to the
Covered Employees if and when the employer withdrew from the
Prime Plan.
Contributions made to fund DWB's were invested in flexible
premium adjustable life policies (universal life policies) or, in
the case of a Covered Employee who was determined to be
- 19 uninsurable, in a tax-exempt money market fund.
Prime maintained
commission-sharing arrangements with the insurance companies that
wrote these insurance policies.
Prime usually earned a
commission equal to 22 percent of the amount paid for life
insurance and 1.2 percent of the amount paid to fund DWB's.
Employers typically contributed $50,000 to the Trust.
Generally,
$6,000 of this amount was used to purchase life insurance and the
balance ($44,000) to fund DWB's.
3.
Death Benefits
If a Covered Employee died while employed, a death benefit
became payable to his or her beneficiary in the amount set forth
by the employer in the Adoption Agreement.
This amount was
generally stated as a percentage of the Covered Employee's
compensation or, if higher, a set minimum amount.
For a Covered
Employee who was other than a standard underwriting risk, the
death benefit could be reduced or eliminated, depending on the
provisions of the employer's Adoption Agreement.
Death benefits were typically funded through universal life
policies.
Under such a policy, the premiums in excess of the
amount necessary to fund current mortality and administrative
expenses are typically invested by the carrier at a fixed rate of
return.
This rate of return may vary over time, although
carriers generally guarantee a specified minimum return.
The amounts paid by the Trust for the universal life
policies were generally separated into two amounts:
(1) The
- 20 target premium, which was the cost of the life insurance, and
(2) the excess premium, which was an amount placed into a side
fund for payment of DWB's.
In the cases where second and
subsequent year contributions were made by an employer, the
contributions were usually made to pay a renewal premium on the
life insurance or to increase the side fund.
Contributions were
also sometimes made in years subsequent to the first year to
purchase additional insurance for newly eligible employees or to
increase the amount of insurance for employees with salary
changes so that the plan remained within the terms of the
Adoption Agreement and the provisions of the Code that were
believed related thereto.
If the employer failed to make the
required contributions to keep the policy in force, Prime was
required to make these contributions from assets allocable to the
employer's Employee Group.
Universal life policies offer a policy owner certain options
regarding the cash surrender value of the policy.
Under one
option, the policy's cash surrender value is included in the face
amount paid to the beneficiary upon the insured's death.
Under a
second option, the carrier pays both the face amount and cash
surrender value to the beneficiary upon the insured's death.
Under the Trust Agreement, the Trust had to elect the second
option for each universal life policy that it acquired.
When the
insured died, the carrier paid the beneficiary the policy's face
amount, thus discharging the Prime Plan's obligation to pay the
- 21 deceased employee's vested death benefit, and the carrier paid
the Trust the cash surrender value associated with the policy.
Under the universal life policies acquired by the Trust, the
Trust could obtain a policy's cash surrender value before the
insured died by surrendering the policy.
The amount received was
usually reduced by a surrender charge during the first several
years of the policy.
A death benefit was not payable if a Covered Employee died
on or after the date he or she terminated employment or was
discharged for cause.
In the case of an owner/employee, a death
benefit was not payable when he or she terminated his or her
employment.
A death benefit also was not payable when the
owner/employee continued to work but reached the date that was
the later of age 70-1/2 or the 10th anniversary of his or her
participation in the plan.
Upon termination of employment, a Covered Employee could,
with Prime's approval, elect to convert to individual coverage or
purchase his or her life insurance policy for its cash surrender
value.
Absent such an election, the policy was surrendered or
transferred to the life of another Covered Employee.
The
forfeited proceeds from the sale or surrender of life insurance
were segregated into the Suspense Account and used to increase
the employer's Covered Employee's DWB's or death benefits, to
provide new welfare benefits, to provide benefits for replacement
employees, or to distribute to the Covered Employees if and when
- 22 the employer withdrew from the Prime Plan.
If an employee
severed employment without a vested DWB, the cash surrender value
of his or her life insurance policy, if surrendered, was added to
another policy in the Employee Group.
4.
Obligations and Liabilities
An employer that participated in the Prime Plan was required
to make an actuarially determined contribution in any year in
which one of its employees became eligible for a DWB or the
employer elected to increase the amount payable to its Covered
Employees under the Adoption Agreement.
An employer had no
obligation to make additional contributions to provide for the
payment of DWB's if there were insufficient assets in the Trust
allocable to its Employee Group.
An employee's right to a DWB
extended only to his or her allocable share of Employee Group
assets.
If there were insufficient assets allocable to an
Employee Group to pay a Covered Employee's DWB, procedures were
set forth to pay a smaller benefit commensurate with the
available assets.
The employer relinquished all rights to the contributions
made to the Trust, and no amounts could revert to the employer or
be used for purposes other than the benefit of the Covered
Employees or for the payment of taxes and expenses of the Trust's
administration.
Neither the employer, Plan Administrator, Prime,
or the trustee had any liability to pay any benefits provided
under the Plan beyond the assets in the Trust allocable to the
- 23 applicable Employee Group.
Neither the employer, Plan
Administrator, Prime, or the trustee was responsible for
contributions that were required for any other participating
employer.
5.
Separate Accounting
Prime was required to maintain separate accounts reflecting
the share of each Employee Group and to determine the December 31
value of the insurance contracts and tax-exempt money market bond
fund allocable to each Employee Group.
Prime was required to
keep accurate and detailed accounts of all transactions,
investments, receipts, and disbursements.
Prime was required to
file a written report of this information with each employer
within 60 days after each December 31st.
At the end of each plan year, the Prime Plan's actuaries
were required to calculate experience gains and losses with
respect to each Employee Group, whether or not any gains or
losses had actually occurred.
Experience gains and losses were
measured by comparing each employee's theoretical compensation to
actual compensation and by comparing the expected rate of return
on the assets held in the Employee Group account with the actual
rate of return on these assets.
To the extent that the
theoretical compensation exceeded actual compensation, or the
expected rate of return exceeded the actual rate of return, an
experience gain resulted and the amount of the experience gain
had to be forfeited to the Suspense Account.
- 24 Neither Prime nor its actuaries ever implemented the Trust
provisions requiring an annual calculation of experience gains
and losses.
Prime changed its method of calculating experience
gains and losses effective June 30, 1990, because the unexpected
number of accounts which incurred experience gains created a
significant concern among the plan participants and their
advisers.
Prime believed that this could potentially create non-
recoverable Suspense Account assets and alarm plan participants.
Prime wanted to reduce the amount of experience gain subject to
forfeiture and find a way to allow Suspense Account distribution
on withdrawal.
6.
Employer Withdrawal From the Prime Plan
Employers could withdraw from the Prime Plan at any time by
submitting written notification to Prime, accompanied by
documentation showing that the necessary ownership interest of
the employer had approved the withdrawal.
The necessary
ownership interest was the percentage listed by that employer in
its Adoption Agreement.
If an employer failed to pay Prime's
annual administrative fee, Prime had the sole discretion to force
that employer to withdraw from the Prime Plan.
Upon an employer's withdrawal, assets were distributed to
all living Covered Employees who were employed during the period
that began 18 months before Prime's receipt of the notice.
Excess assets remaining in the Trust allocable to the Employee
Group after payment of all benefits and the employer's share of
- 25 the Trust's tax liability were distributed pro rata using the
aggregate compensation received by each Covered Employee over the
period not to exceed 5 years that was listed by the employer in
the Adoption Agreement.
For an owner/employee who anticipated employment beyond the
Forfeiture Age, the Trust Agreement did not prohibit that owner
from withdrawing his or her company from the Prime Plan and
receiving a withdrawal distribution.
For an owner-employee who
anticipated retiring, the Trust Agreement did not prohibit that
owner from withdrawing his or her company from the Prime Plan and
receiving a withdrawal distribution.
Prime's actuaries assumed
that no employee would forfeit benefits upon retirement, and no
employee ever forfeited a DWB because he or she retired or stayed
employed beyond the Forfeiture Age.
Prime's actuaries assumed
that no payments would come from the Suspense Account to
supplement the payment of benefits from the Trust.
7.
Amendment and Termination of the Prime Plan
Prime retained the right to amend, modify, or delete any
provision of the Trust Agreement.
Prime retained the right to
terminate the Prime Plan in certain circumstances, one of which
was if the plan failed to satisfy section 419A(f)(6).
8.
The Trustee
The trustee was compensated under the terms of a written
agreement that it entered into with Prime.
All reasonable costs
incurred by the trustee in performance of its duties were paid
- 26 from the Trust, as was the case with all taxes levied or assessed
against the Trust.
The trustee and insurer withheld any taxes
that were required to be withheld from any payment to a Covered
Employee and/or beneficiary.
C.
The December 31, 1988, Trust Agreement
Prime amended the Trust Agreement on or about December 31,
1988.
In relevant part, the following amendments were made.
First, Prime deleted the requirement that forfeited DWB's
and forfeited proceeds from the sale or surrender of life
insurance policies be segregated into the Suspense Account to be
used to provide benefits to the corresponding employer's Covered
Employees.
Prime replaced this requirement with a provision
stating that these forfeitures would be experience gains subject
to the existing provisions, except as otherwise modified by the
amendments.
One of these amendments required experience gains to
be allocated annually to the Suspense Account and allowed Prime
to direct the trustee to invest these amounts in tax exempt
securities or leave the amounts in each applicable Employee Group
subject to a lien.
Second, Prime was given the power to use the Suspense
Account assets in any manner consistent with a purpose or
objective of the Prime Plan, including supplementing the payment
of DWB's to an Employee Group with insufficient assets to pay
projected benefits due to experience losses suffered by that
Employee Group.
Another new provision provided that neither
- 27 Prime nor the Trustee had any liability to a Covered Employee for
the manner in which Suspense Account assets were used or
allocated among the Employee Groups.
Third, Prime removed the obligation of an employer to make
an actuarially determined contribution in any subsequent year in
which an employee became eligible for a DWB.
Prime replaced this
obligation with an obligation to do so only if the employer
notified Prime that the employer intended to make such a
contribution.
D.
The December 21, 1989, Trust Agreement
Prime amended the Trust Agreement a second time on or about
December 21, 1989.
Prime made these amendments primarily to
reflect matters affecting the trustee.
None of these amendments
are relevant to our discussion herein.
E.
The June 30, 1990, Trust Agreement
Prime amended the Trust Agreement a third time on or about
June 30, 1990.
In relevant part, Prime made the following
amendments.
First, Prime inserted Security Pacific as the successor
trustee.
Second, Prime added a provision allowing DWB's to be funded
through the purchase of a second to die life insurance policy.
Another new provision allowed the funding of death benefits
through the purchase of term insurance and second to die life
insurance policies.
- 28 Third, Prime added a requirement that an employer had to
make actuarially determined contributions in any subsequent year
in which the employer notified Prime that the employer intended
to make a contribution for an employee who was entitled to a
greater vested percentage of his or her DWB than in the year the
Adoption Agreement was executed.
Fourth, Prime expanded the Trust's existing provisions to
state that the trustee would not be liable to a Covered Employee
or beneficiary with respect to shortfalls in any of the benefits.
The existing provisions were further expanded to provide that
neither Prime nor the trustee would be liable to a Covered
Employee or beneficiary as to decisions on the use of Suspense
Account assets to supplement or not to supplement a DWB.
Other
new provisions reflected limits on the Trust's liability and
stated that Prime's maintenance of separate accounts was not a
separate trust fund.
Fifth, Prime replaced the term "experience gain" with the
term "Asset Gains, Liability Gains and Overfunded Gains", and set
forth a "measurable event" method of allocating gains to the
Suspense Account.
Prime defined a measurable event as:
a
severance, death, or attainment of Forfeiture Age of one or more
Covered Employees, or the withdrawal of the Employee Group.
Prime set forth another new provision that provided an objective
formula under which Prime was allowed to release a portion of the
Suspense Account when a measurable event occurred and an Employee
- 29 Group had insufficient assets to pay DWB's, or an Employee Group
withdrew from the Trust.
fair market
value of
suspense
x
account on
valuation Date
This formula was stated as follows:
theoretical actuarial
actual employer
liability for employee group
contributions
theoretical actuarial
x
theoretical
liability for Trust
employer
contributions
Prime added other provisions that defined the relevant terms in
the formula and gave Prime the absolute discretion not to use the
formula if using it would be inconsistent with a purpose of the
Prime Plan.
Sixth, Prime added a provision that specified that a
withdrawing employer's written notice must list a withdrawal date
no later than 90 days after Prime received the notice.
Prime
added another new provision specifying that it would deliver to
the employer within 60 days of Prime's receipt of the notice an
accounting of the employer's account in the Prime Plan.
Seventh, Prime listed the asset allocation procedures that
it would use to distribute assets to employees of a withdrawing
employer.
Eighth, Prime listed the trustee's rights and duties to
include:
(1) The right to be reimbursed for the employment of
experts that it considered necessary to carry out its
obligations, (2) the right to be held harmless from and against
any loss, liability, or expense incurred without gross
negligence, breach of trust, or violation of the Employee
Retirement Income Security Act of 1974 (ERISA), Pub. L. 93-406,
- 30 88 Stat. 829, arising out of its administration of the Trust, and
(3) the ability to reimburse itself, in certain circumstances,
from amounts held in the Trust, starting with the Suspense
Account.
F.
The January 2, 1992, Trust Agreement
Prime amended the Trust Agreement a fourth time on or about
January 2, 1992.
In relevant part, the following amendments were
made.
First, Prime inserted Firstar as the successor trustee.
Second, Prime added a provision requiring forfeiture of a
DWB upon actual retirement rather than upon reaching the
Forfeiture Age.
Another new provision defined the term
"retirement" to mean "a Covered Employee's severance from service
with an Employer other than for Cause, Death or Total Disability,
where such Covered Employee cannot show proof of subsequent
employment or an attempt to obtain subsequent gainful employment
to Prime".
Another new provision set forth the allocation of
"Employer Withdrawal Gains" to the Suspense Account.
G.
The November 1, 1993, Trust Agreement
Prime amended the Trust Agreement a fifth time on or about
November 1, 1993.
In relevant part, the following amendments
were made.
First, Prime added a provision stating that the amount of
gains allocated to the Suspense Account at the time of a
measurable event would equal the total gains multiplied by the
- 31 ratio of an employer's total contributions made to the Prime Plan
as of December 31 over the total of all contributions which the
employer should have made to fully fund its Employee Group's
benefits.
Prime also amended the measurable event formula to
read as follows:
fair market
value of
suspense
x
account on
valuation date
actual employer
contributions
theoretical
employer
contributions
actual employer contributions
total employer contributions x
to the Trust
Another new provision gave Prime the sole discretion not to use
the measurable event formula wherever Prime concluded that the
formula would give a Covered Employee a larger benefit upon an
employer's withdrawal than he or she would have received as a
DWB.
Second, Prime replaced the phrase "terminated his employment
with the Employer on account of Retirement" with the phrase
"remained in the employ of the Employee Group beyond his
Forfeiture Age".
Third, Prime added a provision allowing the use of Suspense
Account assets to pay all fees and costs incurred in litigating
with the Commissioner issues related to the Prime Plan.
Permissible fees and costs included those of attorneys,
accountants, actuaries, and expert witnesses.
Before this
amendment, Prime had spent $215,000 from the Suspense Account to
pay for legal services rendered mainly by Mr. Weiss and Mr. Brody
in defense of the Commissioner's challenge of the deductibility
- 32 of employers' contributions to the Prime Plan.
Mr. Weiss had
authorized the payment of these amounts.
III.
Prime's Duties in Operation of the Prime Plan
Prime implemented the provisions of each employer's account
in the Prime Plan, issued annual reports and generated tax
filings on each account, and dealt with insurance providers.
Prime's responsibilities also included tracking money by Employee
Group, reviewing advertisements and sales materials, assisting
with tax audits, responding to legal issues, and assisting in
interpreting the Trust's provisions.
Prime computed each Covered Employee's vested DWB by
multiplying:
(1) That employee's compensation listed on his or
her Form W-2 (Wage and Tax Statement) for the year before the
year the employer made the contribution, by (2) the accrual
percentage, by (3) the years of service (or the maximum accrual
years, if applicable), by (4) the employee's vesting percentage
as determined in accordance with the vesting schedule selected by
the employer in the Adoption Agreement.
The accrual percentage
was a "plug" in that the percentage was based on how much money
the employer believed it could afford to spend for a certain
benefit.
- 33 IV.
The Trust's Financial Information
A.
Overview
The Trust began accepting contributions from employers in
November 1988.
As of June 30, 1992, the Trust had received
$92,273,952 in contributions, broken down as follows:
$15,852,213 in 1988, $29,453,541 in 1989, $25,281,057 in 1990,
$14,178,375 in 1991, and $7,508,766 in 1992.
Prime never valued the Trust as a whole, and Prime never
filed a Form 5500 (Annual Return/Report of Employee Benefit Plan)
for the Prime Plan as a whole.
Neither the Prime Plan nor the
Trust had a 1988 Form 1041 (U.S. Fiduciary Income Tax Return)
filed on its behalf.
Norstar Trust Co. of Rochester, New York,
filed 1989 and 1990 Forms 1041 that reported the following items
of income and expense for a complex trust named "Prime Financial
Benefits Trust--New York" (E.I.N. 86-0633138) (the New York
Trust):
Tax-exempt income
Total income
Fiduciary fees
Total deductions
Taxable income
Total tax
1989
1990
$10,905
- 0 500
- 0 - 0 - 0 -
$64,477
- 0 10,623
- 0 - 0 - 0 -
Security Pacific filed 1990 through 1994 Forms 1041 that reported
the following items of income and expense for the Trust, listed
- 34 on the forms as a complex trust named "Prime Financial Benefits
Trust" (E.I.N. 86-6184818):10
1990
Interest income
Other income: forfeitures
Other income: refund trustee fees
Tax exempt income
Total income
Taxes
Fiduciary fees
Attorney, accountant
Other deductions
Other deductions: mgmt/admin fees
Exemption
Taxable Income
Total tax
$232,158
----55,467
232,158
10,306
53,836
13,247
3,500
- 0 100
164,781
46,139
1991
1992
1993
1994
$372,992 $351,722 $106,927 $92,464
9,453
------------4,012
34,812 295,340
118,797
14,498
382,445 351,722
106,927
96,476
- 0 13,572
- 0 7,519
63,293
22,994
- 0 - 0 136,440
96,205
104,764 173,804
- 0 16
1,761
10,547
- 0 - 173,550
79,263 128,000
100
100
100
100
199,276 (20,428) (22,898)(182,687)
61,017
- 0 - 0 - 0 -
The Trust paid no benefits in 1988.
From 1989 through 1994,
the Trust paid $30,420,770 in employer withdrawal benefits and
DWB's as shown below:
DWB's (number)
1989
0
Withdrawal dist. $468,274
DWB's (amount)
0
Total
468,274
B.
1990
6
1991
50
1992
57
1993
87
1994
56
Total
256
$2,292,366
11,985
2,304,351
$3,848,663
682,394
4,531,057
$10,732,521
640,125
11,372,646
$6,227,028
727,947
6,954,975
$4,117,684
671,783
4,789,467
$27,686,536
2,734,234
30,420,770
Suspense Account transactions
The first Suspense Account transaction was a deposit of a
$37,841 death forfeiture on December 21, 1990.
The following
chart is a summary of all Suspense Account activity through
October 31, 1994:
10
We are unable to determine whether the New York Trust is
the same entity as the Trust. The entities have different
E.I.N.'s, and the New York Trust's Forms 1041 reported that it
was created on Aug. 1, 1988, while the Trust's Forms 1041
reported that it was created on Aug. 31, 1988. The 1990 Form
1041 filed for the Trust also reported that the "OLD NAME OF
FIDUCIARY" was "NORTHERN TRUST BANK OF ARIZONA N.A.". Our
Opinion is not affected by whether the New York Trust and the
Trust are the same or different entities.
- 35 Total Out
Total In
$4,184
--192,000
3,398
--22,939
--387,990
2,011
4,203
17,035
633,760
--$252,977
----474,839
--48,581
256
------776,653
Accounting fees
Actuarial gains
Administrative fees
Death benefit
Death forfeitures
Expense allocations
Interest earned
Legal fees
Miscellaneous
Trustee fees
Unrealized loss
Totals
Mr. Weiss approved of the use of Suspense Account assets to
pay legal fees, administrative fees, and trustee fees.
Approximately $280,000 of the legal fees were paid to Snell &
Wilmer and Streich Lang.
V.
Young & Young
A.
Overview
The Youngs are husband and wife, and they resided in Sedona,
Arizona, when they petitioned the Court.
The Youngs owned 100
percent of the stock of Young & Young, a corporation providing
medical care in and around Sedona, during the relevant years.
Young & Young's principal place of business was in Arizona, when
it petitioned the Court.
During the relevant years, Howard Young was a radiologist
working out of a hospital through a partnership in which
Young & Young was a 50-percent partner.
dermatologist with her own practice.
Elaine Young was a
Carleen Garcia was the
nurse and office manager of Elaine Young's practice.
- 36 Young & Young reported its operations for Federal income tax
purposes on a calendar year, and it used the cash receipts and
disbursements method on its relevant Federal income tax returns.
These returns reported the following information:
Total income
Compensation of officers
Salaries & wages
Pension, profit-sharing, plans
Employee benefit programs
Taxable loss
1988
1989
1990
1991
1992
$440,673
164,000
86,551
73,462
17,368
2,444
$571,125
327,000
36,600
77,769
56,230
12,549
$672,543
450,000
42,656
93,556
6,761
24,327
$622,323
315,000
23,247
160,351
9,418
20,945
$639,859
367,000
- 0 102,506
5,425
1,875
Of the reported compensation, Howard Young received $111,500,
$163,500, $225,000, $167,500, and $166,000 during the respective
years.
The Youngs filed timely a joint 1989 Federal income tax
return.
On January 7, 1994, the Commissioner mailed them a
notice of deficiency reflecting a determination that the Youngs'
1989 taxable income was increased by $50,030 on account of a
taxable transfer of property from Young & Young under section 83.
The notice also stated that the Youngs were liable for a $2,802
accuracy-related penalty under section 6662(a) because the
underpayment of tax was due to negligence.
On the same day, the Commissioner mailed Young & Young a
notice of deficiency reflecting a determination that its 1989
taxable income was increased by $50,030 because its contribution
to the Trust was governed by subpart D.11
11
Young & Young had
Subpart D refers to subpart D of subchapter D of chapter
(continued...)
- 37 filed its 1989 tax return on March 23, 1990, 8 days after the due
date.
The notice of deficiency also stated that Young & Young
was liable for:
(1) A $637 addition to tax for delinquency under
section 6651(a)(1), and (2) a $2,549 accuracy-related penalty
under section 6662(a) because its underpayment of income tax was
due to a substantial understatement.
B.
Young & Young's Introduction to the Prime Plan
Donald A. Waldman was the Youngs' tax adviser.
In
December 1989, Mr. Waldman introduced the Youngs to the Prime
Plan, advising Howard Young that the plan provided life insurance
as well as tax deferral.
Howard Young viewed the Prime Plan as a
"wise business investment for the company" because it provided
life insurance, which he needed at that time, and because of "the
tax deferment."
Howard Young relied on Mr. Waldman in choosing
to participate in the Prime Plan and in reporting the tax
ramifications that flowed therefrom.
Mr. Waldman was competent
to give an opinion on the Prime Plan.
C.
Young & Young's Adoption of the Prime Plan
Young & Young joined the Prime Plan by executing an Adoption
Agreement dated and effective as of December 1, 1989, and by
making a $50,030 contribution to the Trust approximately 16 days
later.
Young & Young's $50,030 contribution was applied to the
full accrual of DWB's for its Covered Employees ($42,526) and the
11
(...continued)
I of subtitle A of the Code.
- 38 cost of their death benefits ($7,500).
Young & Young deducted
the full contribution on its 1989 tax return.
Young & Young's three employees (the Youngs and Carleen
Garcia) became Covered Employees under the Prime Plan as of
December 1, 1989.
On January 14, 1992, Elaine Young executed an
addendum to Young & Young's Adoption Agreement electing
retroactively to waive her right to participate in the Prime
Plan.
In all, Young & Young executed the following Adoption
Agreements during its participation in the Prime Plan:
Date effective
DWB percentage
Years of service
Vesting schedule
Normal retirement age
Death benefit multiple
Date executed
D.
12/01/89
Not listed
Not listed
4/40
55
Not listed
12/01/89
12/01/89
Not listed
Not listed
4/40
55
Not listed
12/01/89
12/01/89
1.55%
10
4/40
55
2.320
4/06/90
12/01/89
1.907%
10
4/40
55
3.330
06/23/92
12/01/89
3.814%
10
4/40
65
3.330
12/30/92
Administration of Young & Young's Account in the Prime
Plan
Improved Funding Techniques, Inc. (IFTI), prepared the 1989
annual report for Young & Young's account in the Prime Plan, and
IFTI delivered the report to Howard Young on December 27, 1991.
The report included an actuarial valuation signed by Deloitte &
Touche and provided the following calculation of vested DWB's for
Young & Young's Covered Employees:
Howard Young
Carleen Garcia
1988
Compensation
Accrual
percentage
Years of
Service
Vesting
percent
Vested
DWB
$111,500
11,332
3.814%
3.814
10
2
100%
- 0 -
$42,526
- 0 -
The 1989 report addressed only Young & Young's Employee
Group, and it did not provide any information concerning the
Trust as a whole.
The report used a 3.814 accrual percentage for
- 39 the DWB's which had been unstated in any of the Adoption
Agreements executed by Young & Young before the report was
prepared.
On December 30, 1992, Young & Young executed an
Adoption Agreement allowing for the 3.814 percent accrual
percentage.
Other annual reports prepared for Young & Young's account
reported the following relevant information:
Fund value at yearend
Policy values
Surrender value
Additional contribution available
Date of report
1989
1990
1991
$50,018
- 0 N/A
(4)
12/27/91
$46,185
46,005
38,026
1,467
12/27/91
$48,015
48,026
40,446
3,866
02/12/93
On March 16, 1990, Prime forwarded to Young & Young a copy
of the 1989 summary plan description required by section 102 of
ERISA.
The description was later restated to reflect the
amendments to the Trust Agreement through January 1992.
E.
Forms 5500-C/R (Return/Report of Employee Benefit Plan)
Forms 5500-C/R filed with the Commissioner for Young &
Young's account in the Prime Plan included the following
information:
Yearend assets
Income
Expenses
Contributions
1989
1990
1991
1992
1993
$100,018
103
114
100,030
$38,204
2,853
14,667
- 0 -
$40,435
3,930
1,699
- 0 -
$43,066
4,362
1,731
- 0 -
$43,256
1,913
1,723
- 0 -
These forms also reported the payment of insurance commissions of
zero, $7,793, zero, zero, and zero in the respective years from
1989 through 1993.
- 40 F.
Young & Young's Withdrawal From the Prime Plan
On August 8, 1994, Howard Young requested that an estimate
be calculated for Young & Young's withdrawal from the Prime Plan.
VI.
N.L. Booth
A.
Overview
Robert and Janice Booth (R&J Booth) are husband and wife,
and they resided in Scottsdale, Arizona, when they petitioned the
Court.
John and Debra Booth (J&D Booth) are husband and wife,
and they resided in Scottsdale, Arizona, at the time of their
petition.
During the relevant years, Robert Booth was vice
president and secretary of N.L. Booth, a corporation engaged in
the construction business in Phoenix, Arizona, and he owned 11.1
percent of N.L. Booth's stock.
John Booth was N.L. Booth's
president and treasurer, and he owned 25 percent of N.L. Booth's
stock.
N.L. Booth's remaining stock was owned by Phyllis Booth,
the mother of John and Robert Booth.
N.L. Booth's principal place of business was in Arizona when
it petitioned the Court.
N.L. Booth reported its operations for
Federal income tax purposes on a fiscal year ending July 31, and
it used an accrual method on its relevant tax returns.
These
returns reported the following information:
Taxable year ended
07/31/89
07/31/90
07/31/91
07/31/92 07/31/93
Total income
$612,603 $1,230,318 $1,009,373 $1,235,227 $889,174
Compensation of officers
176,300
274,600
451,200
437,892 239,200
Salaries & wages
49,649
74,655
37,767
52,014
53,296
Pension, profit-shar. plans 40,000
8,500
43,261
152,464 150,696
Employee benefit programs
- 0 100,000
56,739
- 0 - 0 Taxable income
69,279
478,098
95,100
231,648 101,792
- 41 Of the reported compensation, Robert Booth received $92,600,
$139,600, $228,000, $119,746, and $122,000 during his 1989
through 1993 taxable years, respectively, and John Booth received
$85,300, $134,800, $224,800, $314,946, and $117,200 during the
same respective years.
R&J Booth filed timely joint 1990 and 1991 Federal income
tax returns.
On November 16, 1993, the Commissioner mailed them
a notice of deficiency reflecting a determination that R&J
Booth's taxable income for 1990 and 1991 was increased by $46,000
and $26,100, respectively, on account of taxable transfers of
property from N.L. Booth under section 83.
The notice also
stated that R&J Booth were liable for $3,036 and $1,784 in
accuracy-related penalties under section 6662(a) for the
respective years.
On the same day, the Commissioner mailed to J&D Booth a
notice of deficiency reflecting her determination that J&D
Booth's 1990 and 1991 taxable income was increased by $54,000 and
$30,639, respectively, on account of taxable transfers of
property from N.L. Booth under section 83.
J&D Booth had timely
filed a joint Federal income tax return for each of these years.
The notice also stated that J&D Booth were liable for $3,564 and
$2,053 in accuracy-related penalties under section 6662(a) for
the respective years.
The Commissioner also mailed a notice of deficiency to N.L.
Booth on that date, reflecting a determination that its 1989 and
- 42 1990 taxable income was increased by $100,000 and $56,739,
respectively.
The notice stated that N.L. Booth's contribution
to the Prime Plan was governed by subpart D.
The notice also
stated that N.L. Booth was liable for $6,800 and $4,377 in
accuracy-related penalties under section 6662(a) for the
respective years because its underpayments of income tax were due
to substantial understatements.
N.L. Booth filed timely 1989 and
1990 tax returns.
B.
N.L. Booth's Introduction to the Prime Plan
Barclay D. Schultz was N.L. Booth's insurance agent for the
Prime Plan.
On July 17, 1990, Mr. Schultz contacted Prime about
N.L. Booth's possible participation in the Prime Plan.
Sixteen
days later, Joseph P. Waters, N.L. Booth's certified public
accountant, furnished N.L. Booth with computations of projected
earnings from participating in the Prime Plan.
Robert and John
Booth (collectively, the Booths), individually and in their
capacity as officers of N.L. Booth, relied upon competent and
informed tax and investment advisers before joining the Prime
Plan and in reporting the tax ramifications that flowed
therefrom.
C.
N.L. Booth's Adoption of the Prime Plan
N.L. Booth joined the Prime Plan by executing an Adoption
Agreement dated and effective as of July 31, 1990, and by
contributing $25,030 to the Trust 37 days later.
N.L. Booth was
required to make a remaining contribution of $75,000 to the Trust
- 43 by October 15, 1990.
N.L. Booth made this contribution, without
interest, on January 30, 1991.
N.L. Booth's 1989 tax return
claimed a $100,000 deduction for accrued contributions owed the
Trust.
N.L. Booth's 1990 tax return claimed a $56,739 deduction for
accrued contributions owed the Trust.
On February 14, 1992, N.L.
Booth paid Firstar Metropolitan Bank & Trust (Firstar) $55,000 of
this amount; N.L. Booth never paid the remaining $1,739.
Generally, the $55,000 contribution was applied as follows:
(1) An increase in DWB's resulting from the change in the accrual
percentage, (2) an increase in vesting, and (3) the cost of a
death benefit.
In all, N.L. Booth executed the following Adoption
Agreements relating to its participation in the Prime Plan:
07/31/90
Date effective
07/31/90
Dismissal wage benefit percentage
4.196
2.84
Years of service
10
10
Vesting schedule
4/40
4/40
Normal retirement age
Same as 401(a)
Same
Death benefit multiple
4.122
2.692
Date executed
07/31/90
07/31/90
D.
01/01/91
6.54
10
4/40
Same
4.122
07/30/91
07/31/90
4.196
10
4/40
Same
4.122
10/01/91
Administration of N.L. Booth's Account in the Prime Plan
On August 12, 1991, IFTI forwarded the 1990 annual report
for N.L. Booth's account in the Prime Plan to John Booth.
report pertained only to N.L. Booth's Employee Group.
The
The report
included an actuarial valuation signed by Deloitte & Touche and
provided the following calculations of vested DWB's:
- 44 1989
Compensation
Accrual
percent
$84,900
84,900
36,900
37,674
39,900
4.196
4.196
4.196
4.196
4.196
John Booth
Robert Booth
Andrew Alvis
Thomas Geary
Trevor Naugle
Years of
Service
Vesting
percent
Vested
DWB
100
100
- 0 40
100
$35,624
35,624
- 0 2,529
16,742
10
10
2
4
10
The report did not provide any information on the Trust as a
whole.
On September 14, 1992, IFTI forwarded the 1991 annual report
for N.L. Booth's account to John Booth.
This report included
another actuarial valuation signed by Deloitte & Touche.
In
order to accommodate the 1991 contribution, the accrual
percentage for DWB's was increased to 6.54 percent.
In all, the annual reports for N.L. Booth's account in the
Prime Plan included the following information:
1990
Fund value at yearend
$100,281
Contribution in transit
- 0 Policy values
- 0 Surrender value
N/A
Additional contrib. available
3,976
Date of report
08/12/91
E.
1991
1992
1993
1994
$151,615
55,000
96,219
90,412
4,263
09/14/92
$150,370
- 0 149,983
141,438
15,647
02/23/94
$160,563
- 0 160,176
151,632
23,058
12/08/94
$169,572
- 0 169,181
160,636
35,386
01/16/96
Forms 5500-C/R
Forms 5500-C/R for N.L. Booth's account in the Prime Plan
included the following information:
Yearend assets
Income
Expenses
Contributions
1990
1991
1992
1993
$100,282
252
- 0 100,030
$145,808
47,025
1,499
55,000
$141,825
3,892
7,875
- 0 -
$152,019
10,194
1,215
- 0 -
These forms did not list any insurance commissions paid from 1990
through 1993.
- 45 VII. Systems
A.
Overview
The Johnsons are husband and wife, and they resided in Waco,
Texas, when they petitioned the Court.
Systems' principal place
of business was in Waco, Texas, when it petitioned the Court.
Since 1990, Systems' only employees have been the Johnsons and
Robert J. Carr.
Mr. Carr, a certified public accountant
(C.P.A.), is Systems' controller.
Mr. Johnson initially owned 49 percent of Systems' common
stock, and Mrs. Johnson owned the rest.
On December 1, 1990,
Systems canceled the shares of stock initially issued to the
Johnsons and reissued 21 shares to Mr. Carr, 39 shares to
Mr. Johnson, and 40 shares to Mrs. Johnson.
On February 2, 1991,
Mr. Johnson held 79 shares of Systems' stock through a
partnership known as Chief Smokey, Ltd., and Mr. Carr owned the
remaining shares.
Systems reported its operations for Federal income tax
purposes on a fiscal year ending on September 30, and it used the
cash method on its relevant tax returns.
These returns included
the following information:
Taxable year ended
Total income
Compensation of officers
Salaries & wages
Pension, profit-sharing, plans
Employee benefit programs
Taxable income (loss)
09/30/90
$51,643
- 0 20,481
- 0 - 0 (24,159)
09/30/91
$725,000
303,200
1,000
- 0 301,150
35,132
09/30/92
$606,132
102,200
1,000
- 0 300,000
145,384
09/30/93
$909,028
143,000
7,855
- 0 700,000
7,518
Of the reported compensation, Mr. Johnson received zero,
$150,000, $142,500, $120,000, and $130,000 during his respective
- 46 taxable years from 1989 through 1993, and Ms. Johnson received
zero, $9,000, $16,900, $15,500, and $13,000 during the same
respective years.
Johnson Roofing, Inc. (Roofing) is an affiliate of Systems.
Roofing's relevant tax returns included the following
information:
Taxable year ended
10/31/89
Total income
$1,865,045
Compensation of officers
233,988
Salaries & wages
50,495
Pension, profit-sharing, plans
- 0 Employee benefit programs
1,087
Taxable income (loss)
114,719
10/31/90
$1,939,495
300,600
429,644
- 0 - 0 123,189
10/31/91
$1,582,097
10,200
535,298
- 0 - 0 (197,520)
10/31/92
$1,893,945
- 0 603,235
- 0 - 0 (471,113)
Of the reported compensation, Mr. Johnson received $73,000,
$234,988, and $288,000 in his respective taxable years from 1988
through 1990.
Ms. Johnson received $20,580, $31,200, and $15,600
during the same respective years.
Neither of the Johnsons
received any compensation from Roofing during their 1991 through
1993 taxable years.
The Johnsons filed timely their joint 1990 Federal income
tax return.
On March 3, 1994, the Commissioner mailed them a
notice of deficiency reflecting a determination that the
Johnsons' 1990 taxable income was increased by $297,299 on
account of a taxable transfer of property from Systems under
section 83.12
The notice also stated that the Johnsons were
liable for a $16,794 accuracy-related penalty under section
12
The notice also increased the Johnsons' 1990 income by
$184,099 on account of "Agreed Items".
- 47 6662(a) because the underpayment of tax attributable to section
83 was due to negligence.
On the same day, the Commissioner mailed Systems a notice of
deficiency reflecting a determination that its 1990 taxable
income was increased by $300,000 because its contribution to the
Trust was governed by subpart D.
tax return.
Systems filed timely its 1990
The notice also stated that Systems was liable for a
$21,735 accuracy-related penalty under section 6662(a) because
its underpayment of income tax was due to a substantial
understatement.
B.
Systems' Introduction to the Prime Plan
Max Chapman, Systems' independent C.P.A., introduced the
Johnsons to the Prime Plan, stating that it would be "useful in
tax planning".
Mr. Carr was also involved in meetings concerning
Systems' decision to join the Prime Plan, and he reviewed some of
the plan's literature.
One of the main selling features of the
Prime Plan from Mr. Carr's perspective was the "very thick
opinion letter".
Mr. Johnson, individually and on behalf of
Systems, relied upon competent and informed tax and investment
advisers before joining the Prime Plan and in reporting the tax
ramifications that flowed therefrom.
C.
Systems' Adoption of the Prime Plan
Systems joined the Prime Plan by executing an Adoption
Agreement dated and effective as of December 20, 1990, and by
making a $300,000 contribution to the Trust 6 days later.
The
- 48 contribution funded the full accrual of DWB's for Systems' three
employees ($264,000), as well as their death benefits ($36,000).
When Mr. Johnson made that contribution, he believed the money
could not be lost to an employee of another Employee Group.
Systems' three employees became Systems' Covered Employees in
1990.
On March 12, 1991, Mr. Johnson, on behalf of Systems,
amended the 1990 Adoption Agreement effective as of December 31,
1990, to change the DWB accrual percentage to 176 percent and the
years of service multiple to one.
No change was made to the
vesting schedule.
In all, Systems submitted the following Adoption Agreements
relating to its participation in the Prime Plan:
Date Effective
Dismissal wage benefit percentage
Years of service
Vesting schedule
Normal retirement age not listed
Death benefit multiple
Date executed
12/20/90
176
1
Immediate
65
16.275
Not
executed
12/20/90
176
1
Immediate
65
16.275
Not
executed
12/20/90
176
1
Immediate
Not listed
16.275
Not
dated
12/20/90
200
5
4/40
65
15.695
12/20/90
On December 2, 1991, IFTI sent Systems copies of substitute pages
1 and 5 for its Adoption Agreement.
These pages changed the
employer yearend to September 30, the Normal Retirement Date to
65, and the death benefit multiple to 16.275.
D.
Administration of Systems' Account in the Prime Plan
The 1989 annual report on Systems' account in the Prime Plan
pertained only to Systems' Employee Group, and it did not provide
any information regarding the Trust as a whole.
- 49 On March 6, 1991, IFTI forwarded the 1990 annual report for
Systems' account to Mr. Johnson.
The report included an
actuarial valuation signed by Deloitte & Touche and provided the
following calculations of vested severance benefits for Systems'
Covered Employees:
Mr. Johnson
Ms. Johnson
Mr. Carr
1989
Compensation
Accrual
percent
Years of
Service
Vesting
percent
Vested
Severance
$140,000
9,000
1,000
176
176
176
1
1
1
100
100
100
$246,400
15,840
1,760
In the 1990 annual report, the Prime Plan's actuary used a DWB of
176 percent, 1 year of service, 100 percent vesting, and a 16.275
death benefit multiple.
These numbers were different from those
set forth in the Adoption Agreements.
Adoption Agreements with
the percentages and multiples used in the 1990 annual report were
prepared, but never executed by Systems.
IFTI contacted Systems
on numerous occasions in 1991 and 1992, stating that Systems
needed to provide the executed Adoption Agreements.
Mr. Carr
executed, but failed to date, an Adoption Agreement with the
correct percentages and multiples.
The annual reports for Systems' account in the Prime Plan
included the following information:
- 50 -
Fund value at yearend
Policy values
Surrender value
Additional contribution available
Date of report
E.
1990
1991
1992
1993
1994
$300,000
- 0 N/A
- 0 3/06/91
$304,342
303,424
240,440
17,312
11/16/92
$317,443
316,513
255,413
29,863
2/23/94
$326,944
327,064
269,293
44,164
8/15/94
$338,487
338,607
283,222
57,460
6/28/95
Forms 5500-C/R
Forms 5500-C/R filed with the Commissioner on Systems'
account in the Prime Plan reported the following information:
Yearend Assets
Income
Expenses
Contributions
1990
1991
1992
1993
1994
$300,081
81
- 0 300,000
$241,358
21,588
80,311
- 0 -
$256,343
26,324
11,339
- 0 -
$269,173
26,091
13,261
- 0 -
$283,102
24,134
10,205
- 0 -
These forms also reported the payment of zero, $38,546, zero,
zero, and zero in insurance commissions during the respective
years.
VIII.
A.
On-Site Project Management, Inc. (On-Site)
Overview
The Traegdes are husband and wife, and they resided in
Tempe, Arizona, when they petitioned the Court.
On-Site is an
S corporation that was incorporated on July 2, 1984.
Mr. Traegde
was its president, and he owned 98.4022 percent of its stock on
December 31, 1989.
Ms. Traegde was On-Site's vice president, and
she owned the rest of its stock on that date.
The 1989 Federal
income tax returns of On-Site and the Traegdes were filed timely.
- 51 On-Site reported its operations for Federal income tax
purposes on a calendar year, and it used the cash method on its
relevant tax returns.
These returns included the following data:
1988
Total income
$1,130,895
Compensation of officers
120,910
Salaries & wages
234,900
Pension, profit-sharing, plans
104,296
Employee benefit programs
- 0 Ordinary income (loss)
471,158
1989
1990
1991
1992
$1,108,792
213,985
387,389
47,300
- 0 232,440
$923,488
219,621
122,142
1,585
- 0 371,926
$114,270
71,011
135,724
- 0 1,711
(230,453)
$603,522
135,519
86,660
- 0 4,116
213,508
Of the reported compensation, Mr. Traegde received $117,536,
$201,956, $205,870, $56,808, and $125,207 during the respective
years.
B.
On-Site's Introduction to the Prime Plan
Thomas J. Connelly was the Prime Plan's sales agent for
On-Site.
Mr. Connelly introduced Mr. Traegde to the Prime Plan
in late 1988.
Mr. Connelly had observed that Mr. Traegde did not
have a succession plan for his business or any estate planning,
that the Prime Plan offered death benefits for Mr. Traegde, and
that the Prime Plan would give Mr. Traegde a source of funds to
close his business when he decided to leave.
On October 4, 1988, Mr. Connelly wrote to On-Site's C.P.A.,
Thomas P. Joynt, explaining the Prime Plan.
On November 7, 1988,
Mr. Joynt replied with certain questions about the Prime Plan, as
well as On-Site's possible participation therein.
On
November 17, 1988, Mr. Connelly responded to Mr. Joynt's letter.
Mr. Connelly discussed the Prime Plan with Mr. Traegde.
Based on these conversations, and after reading the promotional
- 52 literature on Prime, Mr. Traegde concluded that the risks
involved in the Prime Plan were minimal.
Mr. Traegde expected to
get his DWB if he sold or closed his business, and he knew that
he could withdraw On-Site from the Prime Plan at any time.
Mr. Traegde also discussed Mr. Weiss' opinion letter on the Prime
Plan with Mr. Joynt, and Mr. Traegde relied on Mr. Joynt's advice
with respect thereto.
C.
On-Site's Adoption of the Prime Trust
On-Site joined the Prime Plan by executing an Adoption
Agreement on December 28, 1988, effective as of December 31,
1988, and by contributing $100,026 to the Trust on the same day.
On-Site's contribution was applied primarily as follows: $89,645
to the full accrual of DWB's for its Covered Employees and
$10,340 to the cost of their death benefits.
As of December 31,
1988, On-Site's Covered Employees were Mr. Traegde and four other
employees.
Other On-Site employees became Covered Employees
during 1989, and still others became Covered Employees in
subsequent years.
On December 29, 1989, On-Site made an
additional contribution of $50,030 to the Prime Plan.
On-Site
made no contributions to the Prime Plan in 1990, 1991, or 1992.
On-Site submitted the following Adoption Agreements relating
to its participation in the Prime Plan:
- 53 Date effective
DWB percentage
Years of service
Vesting schedule
Normal retirement date
Death benefit multiple
Date executed
12/31/88
25.07
7
4/40
Same as 401(a)
5.36
12/28/88
Date effective
DWB percentage
Years of service
Vesting schedule
Normal retirement date
Death benefit multiple
Date executed
09/04/90
24
8
N/A
Same as 401(a)
N/A
10/18/90
12/31/88
25.54
7
4/40
Same as 401(a)
5.36
12/28/88
11/01/89
N/A
N/A
N/A
Same as 401(a)
2.86
11/01/89
12/31/88
25.54
7
4/40
Same as 401(a)
2.86
02/11/92
12/31/89
23.82
8
4/40
Same as 401(a)
2.231
12/28/89
01/01/89
27.220
7
4/40
Same as 401(a)
2.86
02/11/92
On-Site's agreement dated November 1, 1989, also reduced the
minimum death benefit from $50,000 to $25,000.
D.
Administration of On-Site's Account in the Prime Plan
On August 15, 1989, Prime forwarded to On-Site a 1988
actuarial valuation for On-Site's account in the Prime Plan,
signed by Laventhol & Horwath.
On March 11, 1991, IFTI forwarded
a 1988 annual report for On-Site's account in the Prime Plan to
Mr. Traegde.
This report included an actuarial valuation signed
by Deloitte & Touche and provided the following calculations of
vested severance benefits for On-Site's Covered Employees:
Employee
1987
Compensation
Accrual
percent
Mr. Traegde
Larry French
Erik Kallstrom
Jeanne Sharon
Norman Burke
Richard Murphy
Michael Brandt
K. Diane Small
Denise Minix
Steve Boyles
$156,000
36,400
35,984
21,840
- 0 - 0 - 0 - 0 - 0 - 0 -
25.54
25.54
25.54
25.54
25.54
25.54
25.54
25.54
25.54
25.54
Years of
Service
Vesting
percent
Vested
Severance
5
1
1
1
N/A
N/A
N/A
N/A
N/A
N/A
45
- 0 - 0 - 0 N/A
N/A
N/A
N/A
N/A
N/A
$89,645
- 0 - 0 - 0 N/A
N/A
N/A
N/A
N/A
N/A
The 1988 report did not refer to another participating Employee
Group, and it did not provide any information on the Trust as a
whole.
The report related only to the On-Site's Employee Group.
- 54 On March 11, 1991, IFTI forwarded the 1989 annual report for
On-Site's account in the Prime Plan to Mr. Traegde.
This report
included an actuarial valuation signed by Deloitte & Touche, and
it listed nine other employees of On-Site, none of whom qualified
for a 1989 vested severance benefit.
In order to accommodate On-
Site's 1989 contribution, the accrual percentage for DWB's was
increased from 25.54 percent to 27.220 percent.
The 1989 report
acknowledged a $50,000 contribution from On-Site, and applied the
$50,000 amount to the increase in DWB's allowed because of the
change in the accrual percentage, the increase due to the
increased vesting of Mr. Traegde, and the increase due to the
cost of death benefits.
The annual reports for On-Site's account in the Prime Plan
listed the following relevant data:
Fund value at yearend
Policy values
Surrender value
Addit. contr. available
Date of report
Fund value at yearend
Policy values
Surrender value
Addit. contr. available
Date of report
1988
1989
1990
1991
$99,996
99,996
Unstated
(11)
03/11/91
$138,653
138,653
Unstated
2
03/11/91
$158,161
157,814
136,959
61,519
07/10/91
$167,047
167,055
147,056
128,443
01/20/93
1992
1992
1993
1993
$177,095
177,103
157,104
202,263
09/94
$177,095
177,103
157,104
197,155
03/95
$184,012
186,612
166,613
248,761
09/94
$176,364
178,964
161,097
243,663
03/95;10/95
1994
$148,625
177,545
162,772
296,318
10/95
On March 31, 1989, Prime forwarded to On-Site its 1988
summary plan description.
On April 4, 1990, Prime forwarded to
On-Site its 1989 summary plan description.
On February 24, 1993,
Prime forwarded to On-Site its summary plan description with
amendments through January 1992.
- 55 E.
Forms 5500-C/R
Forms 5500-C/R filed with the Commissioner on On-Site's
account in the Prime Plan included the following information:
Yearend assets
Income
Expenses
Contributions
1989
1990
1991
1992
1993
$138,653
38,867
241
50,030
$137,306
14,163
15,510
- 0 -
$147,048
13,054
3,312
- 0 -
$157,095 $164,013
13,087
12,434
3,076
5,516
- 0 670
These forms also reported the payment of $11,858, $13,797, $54,
zero, and zero in insurance commissions during the respective
years.
OPINION
We must determine the tax consequences flowing from the
Prime Plan, a purported multiple employer welfare benefit plan
that has been marketed nationwide by its promoters as a viable
tax planning device and subscribed to by hundreds of entities
whose employee/owners have sought primarily the promised tax
benefits.
The designers of the Prime Plan struggled to comply
with section 419A(f)(6)'s exception to the applicability of
subpart D.
The designers followed the evolution of subpart D
through the Congressional committees, and they aspired to create
a valid welfare benefit plan that met the legislative intent for
section 419A(f)(6).
The designers were familiar with the tax and
labor provisions of employee benefit law.
Based on their understanding of the genesis of subpart D,
the drafters concluded that section 419A(f)(6) covered their
- 56 design for the Prime Plan.
One of the designers, Mr. Weiss,
requested a ruling from the Commissioner that the Prime Plan
qualified under section 419A(f)(6).
The Commissioner did not
issue a ruling in reply to Mr. Weiss' ruling request, and, to
date, the Commissioner has not issued regulations construing
section 419A(f)(6).
On May 1, 1995, the Commissioner released
Notice 95-34 (the Notice), 1995-1 C.B. 309, to provide guidance
on "the significant tax problems" raised by certain trust
agreements being promoted as multiple employer welfare benefit
funds exempt from the limits of sections 419 and 419A.
Id.
Although the Notice did not mention the Prime Plan by name, the
Notice indicated that the Commissioner disagreed with Prime that
its plan was within section 419A(f)(6).
Having failed in their attempt to receive the Commissioner's
assurance that the Prime Plan was a 10 or more employer plan
under section 419A(f)(6), Prime nevertheless began marketing the
plan in 1988, relying on the designers' opinions as to the
validity of the promised tax benefits that Prime believed flowed
from the Prime Plan.
The Commissioner now challenges these tax
benefits in the instant litigation.
The Commissioner argues
primarily that the Prime Plan is a plan of deferred compensation.
Petitioners argue that the Prime Plan provides merely welfare
benefits.
The Commissioner argues alternatively that the Prime
Plan is actually an aggregation of plans that is outside the
scope of section 419A(f)(6).
Petitioners argue that the Prime
- 57 Plan is a single 10 or more employer plan within section
419A(f)(6).
We must resolve these disputes.
We do so with the benefit
of a comprehensive and detailed evidentiary record developed by
the parties up to, including, and after trial, as well as with
the aid of the parties' briefs and other voluminous submissions
that have focused on issues which have been in dispute at one
time or another throughout this proceeding.
We analyze the law
that applies to the issues at hand, giving due regard to all
arguments made by the parties with respect to these issues.
1.
Type of Plan:
Welfare Benefit or Deferred Compensation
We pass first on whether the Prime Plan is a plan of welfare
benefit or deferred compensation.
If the Prime Plan is a
deferred compensation plan, section 404(a)(5) prohibits a
participating employer from deducting a contribution until the
year in which an amount attributable to the contribution is
includable in the gross income of employees participating in the
plan, assuming that separate accounts are maintained for each
employee.
If a separate account is not maintained for each
employee, section 404(a)(5) does not allow an employer to deduct
the contribution even in the year in which an attributable amount
is included in the gross income of an employee.
1.404(a)-12(b)(3), Income Tax Regs.
See also sec.
If, on the other hand, the
Prime Plan is a welfare benefit plan, subpart D generally limits
the employer's deduction for its contributions to the amount that
- 58 would have been deductible had it provided the benefits directly
to its employees.
Subpart D's limitations are inapplicable when
section 419A(f)(6) applies.
Section 419A(f)(6) generally lets an
employer fully deduct its contributions in the year made,
although its employees may not have to report these contributions
as income until a later year.
We agree with petitioners that the Prime Plan was a welfare
benefit fund.
See sec. 419(e)(1), (2)(B), (3)(B); sec. 1.162-10,
Income Tax Regs; see also Schneider v. Commissioner, T.C. Memo.
1992-24; Moser v. Commissioner, T.C. Memo. 1989-142, affd. on
other grounds 914 F.2d 1040 (8th Cir. 1990).
Mr. Weiss testified
credibly that he designed the Prime Plan intending entirely to
provide employees with "real" welfare benefits that would not be
subject to abuse, and we read the record to support his
testimony.
The DWB's under the Trust Agreement also are not
payable upon the happening of a certainty, but more closely
resemble insurance payable only in the case of an uncertainty.
See Harry A. Wellons, Jr., M.D., S.C. v. Commissioner, 31 F.3d
569 (7th Cir. 1994), affg. T.C. Memo. 1992-704.
Although the
Prime Plan had features of deferred compensation (e.g., the
payment of DWB's upon an employee's termination from employment
based on his or her compensation and length of service, the
presence of vesting schedules), these features were swallowed up
by the Prime Plan's valid welfare benefit purpose so as to make
- 59 the deferred compensation features incidental and meaningless for
purposes of our analysis.
Respondent argues that this Court's jurisprudence provides
that the DWB's were deferred compensation, citing mainly
Grant-Jacoby, Inc. v. Commissioner, 73 T.C. 700 (1980); New York
Seven-Up Bottling Co. v. Commissioner, 50 T.C. 391, 398 (1968);
New York Post Corp. v. Commissioner, 40 T.C. 882, 888 (1963); and
Harry A. Wellons, Jr., M.D., S.C. v. Commissioner, T.C. Memo.
1992-704.
We disagree.
The plan at issue in each of the cases
cited by respondent is distinguishable from the Prime Plan.
Such
is also true with respect to the benefits provided under each
plan.
Nor do we agree with respondent's reading of the Seventh
Circuit's opinion in Harry A. Wellons, Jr., M.D., S.C. v.
Commissioner, 31 F.3d 569 (7th Cir. 1994), to provide that the
DWB's were deferred compensation because the Prime Plan had some
indicia of a deferred compensation plan.
All welfare benefit
plans bear some element of deferred compensation, see Wheeler v.
United States, 768 F.2d 1333, 1336 (Fed. Cir. 1985); Greensboro
Pathology Associates, P.A. v. United States, 698 F.2d 1196, 1200
(Fed. Cir. 1982), and respondent's reading of the Seventh
Circuit's opinion emasculates the right of a taxpayer to avail
itself of the tax attributes of a welfare benefit plan.
Unlike
the Prime Plan, the plan at issue in Wellons was "more akin to a
deferred compensation plan than the sort of 'welfare benefits'
- 60 arrangement contemplated by the regulations".
Harry A. Wellons,
Jr. M.D., S.C. v. Commissioner, 31 F.3d at 572.
Nor do we agree with respondent's claim that the DWB's were
deferred compensation because an employer could voluntarily
terminate its participation in the Prime Plan.
We are unable to
find any requirement in the applicable statutory and regulatory
provisions that would limit welfare benefits to cases in which an
employer could not voluntarily terminate its participation in a
plan.
We find in the statutory text that the Congress knew how
to say "involuntary separation" when it wanted.
See, e.g., sec.
501(c)(17)(D), which is referenced in sec. 419A(f)(1)(A).
In the
absence of a legislative pronouncement that limits severance
benefits to cases where an employer could not voluntarily
terminate its participation in a plan, we refuse to adopt such a
pronouncement here.
Although respondent is concerned that the
ability of a participating employer to terminate voluntarily its
participation in the Prime Plan allows the employer to control
the timing of income to its employees, we regard that concern as
misplaced.
Respondent's concern could also be expressed with
respect to the pension plan of a corporation owned by a single
shareholder.
Although the shareholder may be the only employee,
it does not necessarily follow that such a pension plan provides
for receipt of deferred compensation merely because the
owner/shareholder has the ability to terminate the pension plan
at will.
- 61 We hold for petitioners on this issue.
2.
10 or More Employer Plan; Experience-Rating Agreements
We turn to the second issue; namely, whether the Prime Plan
is a "10 or more employer plan" that lacks "experience-rating
arrangements with respect to individual employers."
419A(f)(6).
See sec.
Petitioners assert that the Prime Plan is within
section 419A(f)(6); i.e., the Prime Plan is a single plan that
covers more than 10 employers, no one of which made more than 10
percent of the Trust's total contributions, and the plan has no
experience-rating arrangements with respect to individual
employers.
Respondent asserts that the Prime Plan is outside the
scope of section 419A(f)(6); i.e., the Prime Plan is an
aggregation of plans that has experience-rating arrangements with
respect to all participating employers.
We agree with respondent that the Prime Plan does not meet
the requirements of section 419A(f)(6).
The Prime Plan is an
aggregation of separate welfare benefit plans, each of which has
an experience-rating arrangement with the contributing employer.
We start our analysis with a discussion of the history of subpart
D.13
Subpart D, which consists of sections 419 and 419A, was
enacted by the Congress as part of Deficit Reduction Act of 1984,
Pub. L. 98-369, secs. 511(a) and 512(a), 98 Stat. 484, 854-862.
13
In National Presto Indus., Inc. v. Commissioner, 104 T.C.
559 (1995), and General Signal Corp. v. Commissioner, 103 T.C.
216 (1994), supplemented by 104 T.C. 248 (1995), this Court
addressed other issues under subpart D.
- 62 Subpart D limits an employer's deduction for contributions to a
welfare benefit plan.
The Congress enacted subpart D because it
was concerned with the law under which employers received current
deductions for contributions to welfare benefit plans, while the
benefiting employees excluded these amounts from their current
income.
As stated by the House Ways and Means Committee, in
proposing a change to the prior law,
The committee has concluded that the favorable tax
treatment of employer contributions to welfare benefit
plans, as compared with employer payments of wages and
salary, is inappropriate in view of the favorable tax
treatment already provided to employees, i.e., the
exclusion of many of these benefits from adjusted gross
income. In addition, the committee believes that the
current rules under which employers may take deductions
for plan contributions far in advance of when the
benefits are paid allows excessive tax-free
accumulation of funds.
The committee's concern has been caused by recent
discussion among tax practitioners as to the taxshelter potential of welfare benefit plans.
Commentators have pointed out that the combination of
advance deductions for contributions and the
availability of tax exemption for certain employee
benefit organizations (such as the voluntary employees'
beneficiary association or VEBA) provides tax treatment
very similar to that provided to qualified pension
plans, but with far fewer restrictions. * * *
In one article on the use of employee benefit
plans as a tax shelter, an example is given of how a
small professional corporation may utilize the tax
benefits of a severance pay plan funded by a VEBA. In
this example, the employees of the corporation are two
doctors, ages 50 and 55, with annual salaries of
$150,000 and $200,000, respectively, and three other
workers, ages 20 to 36, with annual salaries of $10,000
to $18,000. The example indicates that the corporation
could make tax deductible annual contributions to a
tax-exempt VEBA of more than $55,000 annually under
terms that would make it unlikely that the three lower-
- 63 paid employees would receive substantial benefits from
the plan. * * *
Thus, the committee is concerned that substantial
advance funding of welfare benefits will ultimately
lead to an unacceptable tax burden for many taxpayers
who do not participate in these programs. * * *
[H. Rept. 98-432 (Part 2), at 1275-1276 (1984).]
As reflected in the report of the conference, the Congress
enacted subpart D with the understanding that subpart D's
principal purpose was “to prevent employers from taking premature
deductions, for expenses that have not yet been incurred, by
interposing an intermediary organization which holds assets which
are used to provide benefits to the employees of the employer.”
H. Conf. Rept. 98-861, at 1155 (1984); 1984-3 C.B. (Vol. 2) 1,
409.
The conference report states that
"While in many cases welfare benefit funds are designed
to function in a manner similar to insurance
arrangements, the conference [was] concerned that there
[were] no clear standards of limitations applicable to
such funds that [prevented] their utilization for
substantial nonqualified deferred compensation funding
outside the general pension plan funding, accrual and
vesting rules." [Id. at 1155.]
The conference report commented as follows on the meaning of the
term "funds":
a retired life reserve or premium stabilization account
ordinarily is to be considered a fund or part of a
fund, since such an account is maintained for an
individual employer and that employer has a
determinable right to have the amount in such an
account applied against that employer's future costs of
benefit claims or insurance premiums. A similar
situation exists with respect to premium arrangements,
under which an employer may, in some cases, pay an
insurance company more in a year than the benefit costs
incurred in that year and the employer has an
- 64 unconditional right in a later year to a refund or
credit of the excess of payments over benefit costs.
In contrast, an ordinary disability income policy under
which an employer pays a premium so that employees who
become disabled in that year may collect benefit
payments for the duration of disability is not a fund,
since the employer has no right to recover any part of
the premium payment and the future benefit payments to
an employee whose disability occurs during the period
for which the premium is paid is not contingent on any
further payments by the employer. * * * [Id. at 1155.]
The rules of subpart D, however, do not apply to a
multiemployer plan described in section 419A(f)(6).
Section
419A(f)(6) provides:
(6) Exception for 10-or-More Employer Plans.-(A) In general.--This subpart shall not
apply in the case of any welfare benefit fund
which is part of a 10 or more employer plan.
The preceding sentence shall not apply to any
plan which maintains experience-rating
arrangements with respect to individual
employers.
(B) 10 or more employer plan.--For
purposes of subparagraph (A), the term "10 or
more employer plan" means a plan-(i) to which more than 1
employer contributes, and
(ii) to which no employer
normally contributes more than 10
percent of the total contributions
contributed under the plan by all
employers.
According to the conferees, this exception was prescribed
"because under such a plan, the relationship of a participating
employer to the plan often is similar to the relationship of an
- 65 insured to an insurer."
C.B. (Vol. 2) at 413.
H. Conf. Rept. 98-861, at 1159; 1984-3
The conferees went on to explain that:
"notwithstanding compliance with the 10-percent rule,
and consistent with the discussion above on definition
of a fund, a plan is not exempt from the deduction
limits if the liability of any employer who maintains
the plan is determined on the basis of experience
rating because the employer's interest with respect to
such a plan is more similar to the relationship of an
employer to a fund than an insured to an insurer."
[Id. at 1159.]
Petitioners argue that the Prime Plan is within this
exception, and that any uncertainty should be resolved in their
favor because respondent has not issued proper guidance under
section 419A(f)(6).
Petitioners assert that Mr. Weiss asked the
Commissioner for a ruling on the Prime Plan, and that the
Commissioner refused to accommodate him.
Petitioners assert that
Mr. Weiss was forced to withdraw his request for ruling 18 months
after he submitted it because he was led to believe that the
Commissioner would never rule on his request.
We understand
petitioners to argue that the Commissioner should have issued
Mr. Weiss guidance under section 419A(f)(6), and that the
Commissioner should now be penalized for failing to do so.
Petitioners rely on Gould v. Gould, 245 U.S. 151, 153 (1917), for
the proposition that any doubts as to the reach of section
419A(f)(6) must be resolved in their favor.
We do not agree with petitioners that any ambiguity is to be
resolved in their favor.
See Helvering v. Stockholms Enskilda
- 66 Bank, 293 U.S. 84, 93 (1934).
Subsequent to the Gould case, the
Supreme Court stated as follows:
We are not impressed by the argument that, as the
question here decided is doubtful, all doubts should be
resolved in favor of the taxpayer. It is the function
and duty of courts to resolve doubts. We know of no
reason why that function should be abdicated in a tax
case more than in any other. * * * [White v. United
States, 305 U.S. 281, 292 (1938).]
See United States v. Stewart, 311 U.S. 60, 71 (1940) ("those who
seek an exemption from a tax must rest it on more than a doubt or
ambiguity.
Exemptions from taxation cannot rest upon mere
implications. * * * Exemptions from taxation are not to be
enlarged by implication if doubts are nicely balanced";
(citations and internal quotation marks omitted)).
Section 419A(f)(6) may be interpreted in light of all
pertinent evidence, textual and contextual, as to its meaning.
See Commissioner v. Soliman, 506 U.S. 168, 173 (1993); Crane v.
Commissioner, 331 U.S. 1, 6 (1947); Old Colony R. Co. v.
Commissioner, 284 U.S. 552, 560 (1932); see also Trans City Life
Ins. Co. v. Commissioner, 106 T.C. 274, 300 (1996).
A statute
speaks for itself, and its legislative history will help us
discern the meaning of the words therein when the words are
"'inescapably ambiguous'".
Garcia v. United States, 469 U.S. 70,
76 n.3 (1984)(quoting Schwegmann Bros. v. Calvert Distillers
Corp., 341 U.S. 384, 395 (1951) (Jackson, J., concurring)); see
also Ex parte Collett, 337 U.S. 55 (1949).
Legislative history
will also help us to discern text, which is otherwise
- 67 unambiguous, when the text's plain meaning defeats the statute's
stated purpose.
As observed recently by the Court of Appeals for
the Ninth Circuit, the circuit in which an appeal of this case
lies:
We may not adopt a plain language interpretation of a
statutory provision that directly undercuts the clear
purpose of the statute. In Brooks v. Donovan, 699 F.2d
1010 (9th Cir. 1983), we refused to adopt a plain
language interpretation of a statute governing pension
funds. We reasoned that the "court must look beyond
the express language of a statute where a literal
interpretation 'would thwart the purpose of the overall
statutory scheme or lead to an absurd or futile
result.'" Brooks, 699 F.2d at 1011 (quoting
International Tel. & Tel. Corp. v. General Tel. & Elec.
Corp., 518 F.2d 913, 917-918 (9th Cir. 1975)). In
reaching our conclusion, we followed the Supreme
Court's approach in United States v. American Trucking
Associations, 310 U.S. 534, 60 S.Ct. 1059, 84 L.Ed.
1345 (1940). There the Court noted that "[w]hen [a
given] meaning has led to absurd results * * * this
Court has looked beyond the words to the purpose of the
act. Frequently, however, even when the plain meaning
did not produce absurd results but merely an
unreasonable one 'plainly at variance with the policy
of the legislation as a whole,' this Court has followed
that purpose, rather than the literal words." American
Trucking Associations, 310 U.S. at 543. * * *
[Albertson's, Inc. v. Commissioner, 42 F.3d 537, 545
(9th Cir. 1994), affg. 95 T.C. 415 (1990).]
Accordingly, in interpreting section 419A(f)(6), we look to
the statute as written by the legislators, and we consult the
statute's legislative history to learn its intended purpose and
to resolve ambiguity in the words used therein.
Landgraf v. USI
Film Prods., 511 U.S. 244 (1994); Consumer Prod. Safety Commn. v.
GTE Sylvania, Inc., 447 U.S. 102, 108 (1980).
Petitioners must
prove that the Prime Plan falls within the scope of section
- 68 419A(f)(6), which, as they read it, removes the Prime Plan's
participating employers from the bowels of subpart D.
Rule
142(a); Welch v. Helvering, 290 U.S. 111 (1933); see also
Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593
(1943).
Deductions are strictly construed and allowed only when
a "'clear provision'" allows for one.
INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992)(quoting New Colonial Ice Co.
v. Helvering, 292 U.S. 435, 440 (1934)); Deputy v. du Pont, 308
U.S. 488, 493 (1940).
Petitioners argue that the Prime Plan is a single plan.
Petitioners assert that the word "plan" is construed broadly, and
that the need for the Trust to have a single pool of funds would
make the phrase "experience-rating arrangements with respect to
individual employers" surplusage.
Petitioners assert that the
Congress enacted section 419A(f)(6) "to encourage small employers
to provide on a tax-advantaged basis welfare benefits to their
employees, who, generally speaking, had not received such
benefits in the past."
Petitioners assert that the Prime Plan
satisfies Congressional intent.
Petitioners also argue that the Prime Plan lacked
"experience-rating arrangements with respect to individual
employers".
Petitioners define the relevant phrase by reference
to a footnote in the House committee report; the footnote
indicates that the term "purely experience-rated" means "the
employer is entitled to an automatic rebate if the amount paid
- 69 exceeds the benefit claims and is liable if the benefit claims
exceed the amount paid".
n.18.
H. Rept. 98-432 (Part 2), supra at 1280
Petitioners also look to section 1851(a)(8)(B) of the Tax
Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2860, which
describes an experience-rated insurance policy to mean "the
employer has a contractual right to a refund or dividend based
solely upon the experience of such employer".
Petitioners assert
that the conferees' use of the word "often" in their explanation
of section 419A(f)(6) means that the Prime Plan did not have to
function as a risk-distributing insurer in order to fall within
that section.
Petitioners assert that the Suspense Account
satisfied any risk shifting requirement inherent in section
419A(f)(6) because actuarial gains were pooled to supplement
underfunded benefits of other employers.
We disagree with petitioners' assertion that the Prime Plan
is a single plan for purposes of subpart D.
The Prime Plan is
nothing more than an aggregation of individual, unique plans
formed by separate employers who have:
(1) Delegated to a common
administrator their (the employers') duties and responsibilities
with respect to the respective plans that each employee/owner has
tailored personally for his or her business and (2) contributed
funds to a trust overseen by a common trustee that was required
to disburse each employer's contributions, and earnings thereon,
primarily for the benefit of the contributing employer's
employees.
The fact that Prime structured the Prime Plan to have
- 70 one administrator, one Trust, and a Suspense Account with some
commonality among all employers does not change the fact that
each of the employers separately had the unbridled authority to
select many of the relevant terms under which its employees would
collect benefits from the Prime Plan, that no Employee Group had
a right to any contributions, or earnings thereon, which had been
made by the employer of another Employee Group, and that a
severed employee could end up receiving less than his or her
promised benefit, even though the Prime Plan, as a whole, had
enough assets to compensate the employee for this shortage.
We reject petitioners' claim that the Prime Plan is a "10 or
more employer plan" based on the language and Congressional
purpose of subpart D and section 419A(f)(6).
We interpret the
word "plan" to mean that there must be a single pool of funds for
use by the group as a whole (e.g., to pay the claims of all
participants), and we interpret the phrase "10 or more employer
plan" to mean that 10 or more employers must contribute to this
single pool.
We do not interpret the statutory language to
include a program like the instant one where multiple employers
have contributed funds to an independent party to hold in
separate accounts until disbursed primarily for the benefit of
the contributing employer's employees in accordance with unique
terms established by that employer.
We are unpersuaded that the
word "plan", as it appears in section 419A(f)(6), is satisfied by
Prime's attempt to aggregate multiple plans as a single plan.
- 71 In arguing that the Prime Plan is a unitary "plan" for 10 or
more employers within the scope of section 419A(f)(6),
petitioners rely on the following features:
(1) The Prime Plan
had a common administrator, and the Trust had a single trustee,
neither of whom was accountable to or controlled by any one
participating employer; (2) participating employers irrevocably
delegated to Prime the responsibility for a variety of
administrative and other functions; (3) Prime exercised
unreviewable authority over the calculation of employer
contributions, as well as the determination of benefit
distributions and forfeitures to the Suspense Account; (4) Prime
was responsible for determining the amount of all disbursements
from the Suspense Account in accordance with an objective formula
set forth in the Trust Agreement; and (5) the Suspense Account
served a limited common interest of all participating employers.
We conclude, however, that the foregoing features are outweighed
by the following features that point to the result that we reach
today:
(1) Prime was required to maintain separate accounts and
a separate accounting for each Employee Group; (2) the Trust
Agreement limited an employee's right to benefits under the Prime
Plan to the assets of his or her Employee Group; (3) an annual
valuation was performed for each Employee Group's account, and an
annual valuation has never been performed for the Trust as a
whole; (4) the summary plan description required by section 102
of ERISA was prepared separately for each Employee Group; (5) the
- 72 arrangement and the adoption agreement signed by each employer
were very similar to an arrangement and adoption agreement used
by separate employers' establishing a separate plan under the
terms of a master plan; (6) each employer selected its employees'
level of benefits, vesting schedule, and minimum participation
requirements, separate and apart from the selections made by the
other employers; (7) each employer's contribution benefited
primarily its employees, and not the employees of other
employers; (8) the Trust Agreement provided rules under which an
employee's benefits would be reduced in the event of a shortfall,
and without subsidy from the Trust as a whole; and (9) the Prime
Plan did not pool all claim risks within the Trust.
Petitioners' argument focuses mainly on the fact that a
single trust serviced multiple employers.
Their argument ignores
the fact that the account of each participating employer was kept
separate from that of every other employer, and, most
importantly, that an employer's contributions benefited primarily
its own Employee Group.
The applicability of section 419A(f)(6)
does not rest on whether more than nine employers contribute to a
single trust.
Section 419A(f)(6) requires a single plan, the
existence of which is not established by Prime's sponsorship of a
program under which multiple employers contribute to a single
trust.
But for the fact that a single promoter formed a common
trust and offered many employers the ability to enroll in a
program that was administered by a common overseer, we find
- 73 little meaningful commonality among each participating employer's
participation in the Prime Plan.
Contrary to petitioners' assertion, our interpretation of
the term "10 or more employer plan" does not make surplusage of
the phrase "experience-rating arrangements with respect to
individual employers".
The phrase has meaning, for example, when
a multiple employer trust maintains a single pool of assets from
which all claims could be paid and charges each group of
participants a different premium.
If one were to look solely at
physicians and construction workers, two of the vocations of
employees covered by the Prime Plan, and assume that the turnover
rate of these two groups is different, the Prime Plan, if
structured with a single pool of assets, would almost certainly
have to charge different premiums to the different groups based
on each group's turnover rate in order to lure them into and
retain them in the plan.
In the context of the Prime Plan,
however, a single pool was simply not desirable because
prospective participating employers did not want to accept the
risk that their contributions would be used to pay the severance
claims of other employers' employee groups that possessed
different levels of severance risk.
We find additional support for our interpretation in the
testimony of Charles C. DeWeese, F.S.A., M.A.A.A., an expert on
multiple employer plans, who concluded that each Employee Group
was a separate plan.
Mr. DeWeese testified that the typical
- 74 multiple employer trust allows a participant to collect benefits
from 100 percent of the trust's assets, and petitioners' expert,
E. Paul Barnhart, F.S.A., M.A.A.A., did not disagree.14
Mr.
Barnhart testified that the attributes described by Mr. DeWeese
were found typically in a multiple employer trust, and that,
except for the Trust, he (Mr. Barnhart) had never seen a multiple
employer trust that did not possess those attributes.
Mr.
DeWeese and Mr. Barnhart both testified that the Prime Plan was
dissimilar to a traditional multiple employer plan, mainly
because of its lack of these attributes.
We disagree with petitioners' reading of the legislative
history to indicate that the Congress enacted section 419A(f)(6)
to encourage plans such as the Prime Plan.
We read this history
to point to a legislative intent that is contrary to the intent
espoused by petitioners.
The House committee articulated its
concern about the tax-shelter potential of welfare benefit plans
and about the ability of small business owners to achieve the
effect of a qualified pension plan, but with fewer limitations.
H. Rept. 98-432 (Part 2), supra at 1275.
The committee also
noted that "substantial advance funding of welfare benefits will
14
We were not impressed with the testimony of petitioners'
other expert, Kenneth D. Klingler, F.S.A. We find his testimony
at trial unpersuasive and unhelpful, and we do not rely on it.
Sammons v. Commissioner, 838 F.2d 330, 334 (9th Cir. 1988), affg.
in part and revg. in part on another issue T.C. Memo. 1986-318;
Christ's Estate v. Commissioner, 480 F.2d 171, 174 (9th Cir.
1973), affg. 54 T.C. 493 (1970); Trans City Life Ins. Co. v.
Commissioner, 106 T.C. 274, 301-302 (1996).
- 75 ultimately lead [inappropriately] to an unacceptable tax burden
for many taxpayers who do not participate in these programs."
Id. at 1276.
Bearing these expressions of legislative intent in
mind, we are unable to agree with petitioners that the Congress
was encouraging the type of tax planning techniques promoted in
the Prime Plan.
We also disagree with petitioners' assertion that the Prime
Plan lacked "experience-rating arrangements with respect to
individual employees".
The legislative history of subpart D sets
forth the House committee's intent to disallow the tax benefits
which petitioners claim flow from the Prime Plan, and the
examples of abuse that the House committee cited in its report
describe precisely what Prime is attempting to accomplish through
the Prime Plan.
The legislative history states that section
419A(f)(6) was enacted because the relationship of a
participating employer to a 10 or more employer plan typically
resembles the relationship of an insured to an insurer. H. Conf.
Rept. 98-861, supra at 1159; 1984-3 C.B. (Vol. 2) at 413.
The
legislative history states further that a 10 or more employer
plan is outside the scope of section 419A(f)(6) if "the liability
of any employer who maintains the plan is determined on the basis
of experience rating because the employer's interest with respect
to such a plan is more similar to the relationship of an employer
to a fund than an insured to an insurer."
supra at 1159; 1984-3 C.B. (Vol. 2) at 413.
H. Conf. Rept. 98-861,
- 76 The term "experience-rated" means generally that premiums
(contributions) are adjusted to reflect experience.
See also
United States v. American Bar Endowment, 477 U.S. 105, 107 (1986)
("experience rated * * * means that the cost of insurance to the
group is based on that group's claims experience, rather than
general actuarial tables").
The Congress knew this, as evidenced
by the fact that the House committee defined the term "purely
experience-rated" in its report.
Yet, the Congress declined to
inscribe the term "experience-rated" in section 419A(f)(6),
choosing, instead, to use the term "experience-rating
arrangements".
We believe that the scope of the term
"experience-rating arrangements" is wider than that of
"experience-rated".
The conferees stated that a plan is outside
the scope of section 419A(f)(6) if any employer's liability "is
determined on the basis of experience rating".
If the conferees
had meant to equate the term "experience-rating arrangements"
with the term "experience rated", they could (and we believe
would) have said that a plan is outside the scope of section
419A(f)(6) if any employer's liability "is experience rated".
The conferees did not.
Nor did the Congress provide in section
419A(f)(6)(A) that the first sentence therein "shall not apply to
any plan * * * [that is experience rated] with respect to
individual employers."
The essence of experience rating is the charging back of
employee claims to the employer's account.
The Prime Plan
- 77 accomplished the same result by adjusting the employees' benefits
to equal its employer's contributions.
The Prime Plan charged
back the employees' claims to their employers' accounts by
carrying the accounts' yearend balances over to future years and
limiting an employee's benefits to the amount in his or her
employer's account.
This was an experience-rating arrangement.
Mr. DeWeese concluded that experience-rating may occur by
adjusting benefits, rather than premiums, and Mr. Barnhart
agreed.
Mr. Barnhart also acknowledged that the term
"experience-rating" means that, over time, the premiums less
expenses equal the benefits.
This credible expert testimony
supports our view that the Prime Plan had experience-rating
arrangements with respect to all participating employers.
We also conclude that the Prime Plan had experience-rating
arrangements because each employer's relationship to the Trust
was more akin to the relationship of an employer to a fund, than
of an insurer to an insured.
In the typical setting of a self-
funded welfare benefit plan, an employer contributes to a fund
from which all of its employees' claims are paid; another
employer's employees may not recover amounts from the first
employer's fund.
An insurer in the typical insurer/insured
relationship, on the other hand, usually collects premiums from
many employers and pays the claims of each of the employer's
employees.
The insurer typically spreads the risk of claims
- 78 among all employers by charging each employer a premium
commensurate with its covered risk.
The relationship of the Trust to each participating employer
more closely mirrored self-funding than insurance.
As a matter
of fact, the Trust Agreement provided that each employee's claim
could be funded only from the account of the employee's employer,
and that an employee did not have recourse against the employer,
the Trust, or any other person, to the extent of any shortfall.
It also is relevant that:
(1) Prime accounted for each
employer's account separately; (2) the Trust Agreement provided
rules under which an employee's benefits would be reduced in the
event of a shortfall; (3) the Trust held and invested an
employer's contributions until benefits had to be paid to its
employees; (4) the Prime Plan did not pool all claim risk within
the Trust; and (5) an employer's contributions to the Trust could
pay its employees' claims after the year's end, while an insurer
will not return an insured's premiums to it at the end of the
policy.
Petitioners argue that the Suspense Account provided the
risk shifting necessary for the Prime Plan to qualify under
section 419A(f)(6).
We do not agree.
Notwithstanding the
reasons asserted by petitioners for the Suspense Account, the
record shows clearly that the Suspense Account's primary purpose
was to pay fees and expenses, and that only a de minimis amount
of funds was actually disbursed from the Suspense Account to
- 79 satisfy employee claims.
The record also demonstrates that
amounts were not transferred into the Suspense Account based on
exposure to risk, and that the Suspense Account did not serve to
spread among the participating employers the risk of incurring
DWB's.
Even if one were to assume arguendo that the Suspense
Account did serve to shift some risk, our view would not change.
We are unable to find that any such shift would have been
meaningful.
As a point of fact, the risk of severance never
shifted from the employers to the Trust.15
The Trust never
assumed any risk of loss for any amount placed therein.
Contributions never provided a meaningful benefit to persons
other than the contributing employer's employees.
Although it is
true that actuarial gains were pooled in the Suspense Account to
supplement underfunded benefits of other employers, we do not
believe that this pooling technique shifted risk significantly.
As a point of fact, less than 0.1 percent of the benefits came
from the Suspense Account.
Accordingly, we hold that the Prime Plan is not within the
requirements of section 419A(f)(6).
15
Thus, the participating
In this regard, we disagree with Mr. Barnhart, who
testified that he believed the Suspense Account operated to share
the risk of severance among employers. Relying on this belief,
Mr. Barnhart concluded that the Suspense Account operated to make
the Prime Plan a single plan. Mr. Barnhart agreed, however,
that, absent the shift of severance through the Suspense Account,
the Prime Plan would be an aggregation of separate plans.
- 80 employers are subject to subpart D.
Under section 419, each
employer's deduction for its contribution to its separate plan is
limited to the plan's "qualified cost" for the year, less the
plan's after-tax income.
Sec. 419(a), (b), and (c); see also
National Presto Indus., Inc. v. Commissioner, 104 T.C. 559,
566-567 (1995).
An employer's qualified cost equals the
qualified direct cost for the taxable year, plus an addition to a
qualified asset account.
Sec. 419(c)(1).
Respondent has proffered to the Court calculations of each
corporation's qualified cost and allowable deduction with respect
to its plan.
These calculations show that Young & Young is
entitled to deduct $11 for 1989, and that no other corporation is
allowed a deduction with respect to its plan.
Petitioners do not
dispute the mechanics of respondent's calculations, and
petitioners have not supplied the Court with alternative
calculations of qualified cost.
Petitioners' position, which we
have rejected, is that the corporations can deduct their
contributions in full.
We have reviewed respondent's calculations, and we are
satisfied that they are correct.
Accordingly, we sustain
respondent's determination that the corporations are not allowed
any deduction for the subject years with respect to their
- 81 contributions to the Prime Plan, except for Young & Young which
may deduct $11 for 1989.16
3.
Penalties
Respondent determined that each corporate petitioner was
liable for a penalty under section 6662(a) because it
substantially understated its Federal income tax.
6662(b)(2).
See sec.
As relevant herein, section 6662(a) imposes an
accuracy-related penalty equal to 20 percent of an underpayment
that is due to a substantial understatement of income tax.
In
the case of a corporation, a substantial understatement exists if
its income tax was understated by the greater of 10 percent of
the tax required to be shown on the return or $10,000.
6662(d)(1)(A).
Sec.
For this purpose, tax is not understated to the
extent that the treatment of an item is based on substantial
authority or is adequately disclosed in the return or in a
statement attached to the return.
Sec. 6662(d)(2)(B).
Substantial authority exists when the weight of authority
supporting the treatment of an item is substantial when compared
to the weight of authority supporting contrary treatment.
1.6662-4(d)(3)(i), Income Tax Regs.
Sec.
To determine whether
substantial authority is present, all authorities which are
16
Respondent determined, and petitioners do not dispute,
that Young & Young was a qualified personal service corporation
taxable at a single rate of 34 percent. See sec. 11(b)(2).
Accordingly, Young & Young's $11 deduction reduces its deficiency
by $4.
- 82 relevant to the tax treatment of an item, including those
authorities pointing to a contrary result, are taken into
account.
Id.
Examples of authority include statutory and
regulatory provisions, legislative history, and administrative
interpretations of the Commissioner.
Income Tax Regs.
Sec. 1.6662-4(d)(3)(iii),
Legal opinions are not authority.
The
authorities underlying a legal opinion, however, may give rise to
substantial authority for the tax treatment of an item.
Id.
We conclude that the corporate petitioners are not liable
for the penalties in dispute.
We have agreed with petitioners
that the Prime Plan is not a plan of deferred compensation and
whether the Prime Plan is within the scope of section 419A(f)(6)
is a novel question.
Although we decide the latter question in
favor of respondent, we are persuaded that petitioners' position
is supported by a well-reasoned construction of the relevant
statutory provisions.
Sec. 1.6662-4(d)(3)(iii), Income Tax Regs.
We decline to uphold respondent's determination of the penalties
against the corporate petitioners in the circumstances herein.
- 83 -
We have considered all arguments made by the parties for
contrary holdings and, to the extent not discussed above, find
them to be irrelevant or without merit.
To reflect the foregoing,
Decision will be entered for
petitioners in docket Nos. 2544-94,
2546-94, 5755-94, 5893-94, and
9229-94; decision will be entered
for respondent with respect to the
deficiencies and for petitioners
with respect to the penalties in
docket Nos. 2545-94 and 9230-94; an
appropriate decision for respondent
will be entered in docket No.
5754-94 as to the deficiency and
the addition to tax under section
6651(a)(1) and for petitioner with
respect to the penalty.
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