wrecked attack by the government against a basic and very common estate planning technique known as a private annuity sale john thomas and lee kid through form part of the investable cash value of life insurance policies that citadel insurance company had sold and have been indirectly purchased by irrevocable trusts benefiting the descendants of john thomas and the income tax consequences of this transaction are pretty ordinary it was a fully taxable sale john thomas and lee kidd recognize again so seated with the exchange and they have reported pay taxes on that gain as they perceive the annuity payments over the years from a transfer tax perspective however it was quite a remarkable transaction john thomas and lee kid were able to successfully transfer in appreciating asset that would otherwise have formed part of their process stayed there and as payments were made on those overriding role to interest over the years they were able to transfer a significant amount of wealth transfer tax free to the next generation now this is an important point because we believe this is the real source of the government's discontent and frustration in this case however the government  fired and rather than bring a transfer tax case they actually attacked the private annuity sale on income tax grounds this misfire explains why the government's legal positions which the district court adopted in a very wholesale fashion simply don't fit the income tax issues presented this misfire also explains why on this appeal the government has virtually abandoned the district court's assignment of income determination are here today to ask this court to basically take that square peg out of the round hole and to reverse the district court's determinations on both economic substance and assignment income grounds i have some questions yes they were tasked with maintaining the cash value and the investments inside the life policy that would form part of their business to actually run the check out of the annuity the the private the new the payments disagree with that your honor the segregated accounts the evidence presented at trial show that they were own by the city by city the insurance company that they were maintained by so they don't trust company and there's quite a bit of testimony at trial there was testimony by the head of the insurance company that said that there would have been over twenty four instances that he had recalled or letter which is were denied now the government took issue with the number of times that it was denied but nonetheless it was  i understand your honor i would also point out however that the level of control that was exerted is pretty typical of the government's insurance expert a trial actually testified that the ability to direct the investments inside a universal life policy such as the universe life policies it issued in this case is pretty plain vanilla meffert he called the industry standard he even went so far to say that he didn't have any problems with  variable universal life policies in this case would further note that he testified that he personally owned a variable universal life policy and that he was able to direct the investments inside that policy then your entire argument and you know overturned in the district court backgrounding i disagree your honor because we believe that the district court notwithstanding some kind of conclusion restatements it lifted from the government's post trial brief if we the heirs are the that the people when they otherwise would have had the volatility of their investments in their business is that right absolutely correct or on the district court found that this was done for planning purposes that's kind of a generalized term there was testimony it's hard to trial the show that there was a state not always state planning purposes but retirement planning that the advisers to john thompson lee kid had done a tremendous job of transferring a fair number of their businesses to the next generation through family new partnerships irrevocable trust in basic estate planning and now that john thompson the kids were retiring and looking to exit the business it was now time to create an income stream for them so that they would not have to depend upon their children as they enter their golden years what about the fact though that the annuity payments were deferred and till two thousand and nine doesn't the defer two thousand and six which was after this probably knew the transaction which eliminated that deferral but prior to that time it was not uncommon nor do we believe that it was unlawful to have that level deferral to put those payments out three years so they would have still been deferring if the treasury reg wouldn't have kept them from being able to do that going forward i mean problem is that we ran into the record of in about this the deferring i don't believe so i think that it was set by the new dreams that would be three years they were not aware of the time that there would be a change the regulations but the pricing of the new deal reflected the fact that these payments were going to be delayed by three years so there was an interest factor component and actually increased the amount of the annuity payment by virtue of the fact that the payments would not start for approximately three years you know what got me is the income from from the overriding r of never in any tax paid on the income from the overriding interest and just because they run through several initiatives and wound up in his cash account became available for tax free the income tax benefits are really a function of the involvement of life insurance and again these are well several lost that provide that the inside build up of a variable universal life policy is tax prefer deferred and the overriding ordinarily when you premiums that were paid for the variable universal life policies were after tax dollars i don't believe that's a matter of speed but we're talking about here is the investments inside the cash values or after the premiums have already been paid to an insurance company they're housed in a the court starting with claimants southgate nevada partners all established principles and based upon the court's findings show economic substance here i think one the most significant point is that the district court found that wired the existence of third parties in order for the tax benefits to be cheap and that since no third parties were present that somehow the transaction didn't have substance well that's a missta law this court held in its kimball decision that a transaction that is bonafide between strangers is going to likewise be bonafide between related parties so we think that's a significant point that was lost on the district court we also believe as far as one of the cases that is we think a very helpful and beneficial in showing why the district court cares is also campbell with respect to the holding that it is in a state planing purpose can be a legitimate reason for undertaking a transaction and interestingly the district court found in this case that there was an estate planning purpose to the transaction so it's an estate planning purpose that has a substantial tax benefit but because you're allowed to have a mixed motive so that's why it's legitimate is that your position yes your honor and as you point out south gate made clear that there can be of mixed motives and the court did find that there was an estate planning purpose here yesterday that said that because it was self dealing that that was therefore not acceptable it's not right it's not them you know between related parties yes it's finding is an estate planning purposes is when you read it in context it's a bit strange an odd because the court states that there is an estate planning purpose but it almost states in a way as if it is supporting the non tax determination attack exam plan it doesn't work well let me address your point about control judge davis and that is we have to remember that this case involves a test for partnership and that the real inquiry is did tom effect or worse a current word partnership and we believe that was improper your honor the government never alleged that the tomsk it all production partnership was a sham they never allege that it should be collapsed the district court acted unilaterally  doing so and we believe that there was no basis there was substantial evidence at trial that that was an ongoing concern business had been around for well over a decade in two thousand and six with very substantial operations in the oil and gas business we have to find that's clearly  when i don't believe so because again there are some conclusion restatements that the that the district court lifted from the government's brief but if we really look at the economic substance test we see that  it flows into economic looks to where the economic benefits go and the economic benefits in this case a very clearly and up in the life policies which time scale of production have no relation i see that my time's up my answer the question i keep that it could not once they left do is overriding role to interests became part again of the investable cash value the life policies and tums it all production had no further rights with respect to the first year here this was part of the actual to that use some of the very same segregated accounts set up to the alliance group to accomplish the circular movement of money through related industries in order to avoid tax and  wasn't a legitimate roi transaction for buying an annuity it was a transaction as a district were found between interviews that were under common control when you buy an annuity as a real estate planning endeavor the way to do about it away and never being subject to u s tax but it also created a situation where the city people ultimately in control here thomas and kid could get the money back through policy loans and got a portion of it and a further basis as royalty payments a tax on well they pay tax on the royalty payments on a deferred basis to the extent that royalty payments were coming back in from the segregated account so that the private annuity s percentage comes back as the regular as the royalty payments and they did pay tax with a three year deferral on those royalty payments when they returned but the bulk of the income stays offshore and he's a can record very clearly shows  district court found that the same people who have gotten this income flowing through from the partnership tom as a kid also control what was done with those that money in the segregated accounts they put their accountants and lawyers listed in henderson in the role of  managers of the segregated accounts and they directed them regarding how the investments were made and when money was to be returned through policy loans and then they controlled as joins and one thousand of his best example shows how they controlled not only when the money came back through policy loans but also how that money was to be used whether it went to their own investments or whether it was plowed back into times and good old productions business or one of their other businesses a common industry practice to allow holders of cash value life insurance policy to obtain lines from those policies the problem here your honor is twofold first of all normally when you buy one of these policies you do it with after tax dollars and this ende to do this with with money that had never been subject to tax and it moved into the consideration was moving an income stream that was continuing perpetuity off shore and never putting it making it such a tax the other problem with that problem  love then well they can get loved it's a problem if you believe the initial thing was not subject to tax the initial it's what the opposing counsel said at the beginning of this argument the real problem is that the money was put in there  was put in there pretax and it secondly i think this is really key to the economic substance point is that they were getting a you know a guarantee of a pain in exchange for this money they were and they were getting this sort of guaranteed risk free continuous payment back because they were essentially making this contract with themselves because they control both ends of the transaction so it was a circular flow of funds that let them not pay tax on the money put it offshore for investment bring it back when they wanted to and never pay tax in this whole picture and there was no third party with whom they were contract and there was no arm's length dealing farm is there well i think you know so this sort of transaction your honor i think to be to be a bona fide business transaction it has to be something that that certain parties would have been would have entered into and i think the record require a third party to be involved in scandal and arthur case law require that when it kills a very very different scenario your honor kimball's a situation where money was where it's an estate tax case for in the first place on an income tax case and the issue is whether when a taxpayer has actually put their money into some sort of agreement some sort of structure like a family room in a partnership and campbell that creates a dem and used in value because of the restrictions on it then that that that transaction is that that or that that structure is subject to a lesser valuation for state tax purposes so it's a very different case in this case because no other party is involved this is this is wrong but i think even if there were a third party involved i mean i think there is no third party involved in   it's the opposite question are you saying that you can't do you need a third party in order to make a transaction legitimate or can it be with related parties in still be legitimate i think your honor there could be a situation where it was with were two related parties engaged in a legitimate transaction certainly that you know that situation could arise not require a third party for a transaction to be legitimate but i think you're right that that is correct or on  but i think what's important here is that i mean there's a look at the situation for example like if you know a father leases property to his son and they're going to parties and that fair read is paid that reflects fair market value that would be a legitimate transaction between related parties but that's the key is under class and looking at whether there's objective economic substances and under merryman the court looks to whether this is something that would ordinarily occur in a bona fide business setting whether two non related parties would have looked would have entered into this transaction in that regard the court has looked at whether the transaction was an arm's length whether this is something that actually shifted the risk in exchange for the consideration paid and what when you look at when the district court looked at th transaction here and found on the record very clearly showed that there wasn't the shifting roast to a third party that would have warranted well a third party even if it was a related party there has to be for an annuity for  that's the fundamental basis of the annuity agreement is that you shift the risk you take your volatile income and exchange it for a regular stream of income that did happen in that the company had a volatile income and they gave them an  if you control both entities and there's no and in the annuity context or to in particular i mean you're asked a question about whether a third party had to be involved for a transaction to be legitimate and i don't think that's true but in the annuity context where you're trying to shift loss to you normally to an insurance company you know the insurance company says augury to take this property in exchange for a set payment and you're shifting your volatility to that insurance company  in the context where you control all the entities involved in a new body transaction in particular i think you don't accomplish that shift of loss and so that is the fundamental purpose of an annuity to do the providing the protection against risk and i think you know then that so that's the problem is that that you have the same person on both sides of the transaction so the money you were mover substance arts or substance over form argument your hon  in retrospect price that would have been a good idea but i think that argument was weighed because they didn't assert that argument below they just argued that it a legitimate annuity transaction happened here and i think the economic substance arguments and the beneficial or sheet of ar that the district court judge rely on are correct and lead to the result that the money should be attributed to thomas and cattle production and that that's the correct result here and i think our trial attorneys are looking at that very clearly that the district court got it right and that's why the that ha which is an issue in the royalty transaction is one that the the doesn't happen is the sort of transaction you would have of that would have given them any additional security because they were paying it themselves so they segregated can account that why not actually risk a change to fluctuating minho interest royalty subject to the risk of operating the well write it in so some days you could get a dry hole or the no recovery that wells messed up or something and you don't get any coverage and for a stream of guaranteed annuity payments so they would every time that the payments would be made no matter what no matter whether the wells producing or not the royalty interest it doesn't depend because they already have the guarantee well that the guarantee comes from them that's the problem your honor the guarantee comes from another entity that ultimately is only in control by thomas and kid and th money so it's not it's not subject to newt he still has to be paid whether or not the will ever produces again but it has to be paid out of their money so it doesn't accomplish anything they already put in so that they they chose to purchase  a regular payment that's going to be paid into a bank account be you're just moving your money from account to account and you still in the end at the same amount of money no because minute he's going to give me some guarantee that i might not get my stocks could go broke any day and i could lose everything you got i think you're missing that there is no i mean just to confuse matters they did actually purchase a commercial annuity which is a legitimate transaction on the thompson kid and that is like you saying i'm going to take a i'm going to take my volatile money and put it in bank account a and the bank account is going to pay back to bank account be that royalty payment it's and that's that and that's that's part of the subterfuge they i think like the head of transactions that in cases like south and the james cases where there's a legitimate transaction periphery you can't use that to legitimize taxes avoid it seems as if they just got out with their after tax dollars and bought it and you would be from the third party in the first place this wouldn't be that would be problematic but what happened is that they use these layers of entities to move the money around and bought an annuity from themselves new to from themselves with their after tax dollars with the government being here today and they bought annually for themselves for it with after tax dollars probably not i think because it wouldn't have the tax avoidance aspect of it but it was certainly not have the i mean it certainly would not have the business risk i mean i think it wouldn't i in that respect i'm not sure that i mean as a practical matter under the economic substance you know under the can i was substance analysis it would be a transaction without tax avoidance but whether we would have gone after it because there pending against mr christie and that is the day they were set up in a very unusual way that let the customer direct what they segregated accounts were invested in and so they use them to invest in these circular transactions like this real transaction like the business protection policies that accomplish the tax avoidance goal and most insurance products you know you can you if if i have you go out and buy a universal life policy from a u s insurance company like might be  invest in you know stock market you know wall street things that are going to all that on the dow jones industrial average and things like that or are money market funds but i can invest in insurance and this was an unusual aspect of these and  testimony was was very thorough and in terms of all the experts and and the parties that these were you know and henderson in particular testified that these were unusual because of the amount of control that they gave to the owners to control the investments and so basically it kept the use of this money for the investor because they could control what went into the segregated accounts and once and that that aspect of control is what means the money never really really changed hands  and so the beneficial interest in the property never really shifts and you don't have a real exchange and i think henderson's involvement in this also really demonstrates that this was not the kind of arm's length transaction that that normally would be part of a bona fide transaction between two independent parties because if you were selling a volatile thing like a writing royalty interest in exchange for an annuity normally you would  worth because this is transaction was about a transaction with themselves that would shift the the value of this income stream off shore and avoid tax and i think it's really important to know the both when the business protection policies were promoted which was the reason they initially got into these policies and then with the subsequent royalty transaction the transactions were promoted as tax avoidance transactions listed there whose was their attorney did promote the royalty transaction but he had been taking cuts from alliance for years he earned income to the tune of two point five million dollars from promoting alliance products so the fact that he came up with us and said here's another tax sav and that that doesn't really change matters versus if it work with bill or dial donalson coming in and pitching this and i think that the promotion materials that government exhibit seventy seven make very clear that this was promoted as a just a few points from a bubble government counsel mentioned that it believed that the commercial nudity was legitimate and that had after tax dollars been used to purchase the commercial entity that we probably wouldn't be here today so i think it's important to clarify on the record that we had five million dollars of after tax money used to buy commercial a new nice in december of two thousand and five those commercial annuities the segregated accounts for those commercial knees effectively became segregated accounts for variable universal life policies meaning the annuities commercial knew these were liquidated to purchase new variable universal life policies so the idea that somehow these variable life policies were purchased with pretax dollars is just wrong so we want to clarify that this is not a case where you had pretax dollars going offshore to purchase the variable life policies it was after tax dollars going to a lot of i'm taxed money went into the kerry campaign and then which would use to pray  the taxpayer well that's no different than any other investment for example your honor had that five million dollars been used to purchase stock i don't think we'd be here today talking about whether a dividend on that went into the cash account i think we're starting to mix apples and oranges because the government is trying to bring in the other transaction at issue in this case which we did not appeal so in this case it's very clean as far as there's the purchase of very billion aversive like policies with after tax dollars the investment that was made with those after tax dollars inside the life policy was the purchase of the overriding role to us so again just like any other investment it's going to accrue inside the variable life policy on a deferred tax basis and another point that counsel made was somehow that these were unusual aspects to the level of influence with respect to the investments was somehow unusual with respect to his very life policies that's contrary to the government's own expert at trial dr babbitt testified that these variable universal life policies were industry standard that the features he found were consistent with the elsie's that actually contract with the private nudie but keep in mind that those segregate account else sees had five million dollars and that's part of what it used to purchase the overriding role to you so it wasn't depend upon necessarily the  i don't believe so i don't believe so i keep hearing that as well that there's this circular flow of funds and i think that there's kind of a misunderstanding there because there's no overproduction does not have an interest in direct directly or otherwise in the policyholder which is predominantly the irrevocable trusts and tomsic it all production is not a beneficiary of there's a revocable trust so to say that there is somehow a circular