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# U n ited S ta tes Co urt o f Ap p ea ls

F o rth eS e v e n th C ir cu it

N o. 11

- 2508 B RUCE A. B R OWN an d C AROL A NF I NS ON B ROWN , P et it ioners-A ppell ants , v . C OM MIS S IONEROF I NTERNAL R EV EN UE,R espo nd ent-A pp ellee

.

A pp eal from the United S t ates Tax Cour t No . 6825- 08

—Richar d T . M orri so n, Judge
.
A RG UE D M AY 25, 2012

— D ECI DE D S EP TE MBE R 11, 2012

Befo re P OSNER, F LA UM, a nd W OO D , C ircu it Judges . P OSNER, Cir cu i tJudg e . T he Ta x Co ur t r ul ed tha t th e peti ti oner s, a m arri ed coupl e fi l i ng a j oi nt r etur n, had unde r pai d fede r ali nc o m e ta x f o r 2 00 5 by$ 8,5 53

. The co ur t as se ss ed a defi ci en cye qua l t o tha t amoun t an d tack ed on a p enal ty of$1, 711 ( 20 percentof the defi ci ency, th e IR S a p p aren tly h aving roun d ed off $1 710.60 to $171 1). T he basis of th e d efi cienc y w as th e tax p ayers’ fai lure t o i n c l ud e i n th e i r t a x a b l e in c o me f o r th a ty e a r i n c o me2 N o. 11

- 2508

re al i zed byM r. Bro w n upon the ca ncel l ati on of a $ 100, 000 l i fe i ns ur a nc e p o l i c y tha th e o wne d, a wh o l e l i fe p ol i cy i ssued to hi m byN or thw est ern M utual Li fe Insurance Com pany i n 198 2. I n such a pol i cy the insured pays a c o n s t a n ta n n u a l p r e mi um an d th e p o l i c y p a y s th e s a me d ea th be n efitw h en ev er h e d ies . Sinc e h e is m or e like ly t o d i e w h e n h e g e t s o l d e r ye t th e p o l i c y p r e mi u ms don’ti ncre ase as he a ges, t h e insurance com pany m ust ch ar g e a pr emi um tha t pr o duce s ano verchar g e i n the ear l y y ear s in or der t o bui l d up a sto re o fvalue that w i l l defra y the co st of payi ng the death b enefi t in l ate r y ea r s, wh i c h i s wh e n d e a th i s mo r e l i k e l y, a n d t he death be n efi t there f or e m or e l i kel y t o beco m e payabl e, th an in t h e e ar lier y ea rs . Th e s u m of th e o ve rc h ar ge s is called the pol i cy’ s “ cash v al ue, ” a nd the pol i cyhol der c an bor ro w ag ai nst i t e i therf orper sonalrea sons orto pay future prem i um s. A l ternati vely, bycance l i ng the pol i cy, whi chhe c ando a t an y t i m e, he i s en ti tl ed to rec ei ve the cash v al ue (cal l ed i n that eve nt the “ca sh sur re nd er ” va l ue) l ess any outst anding l oans aga i nst i t. S ee 1 RobertH

. J er ry, II, N e w App lem a n o n Ins uranc eLa w Li b r ary Edi t i on , § 1.08(b)( ii ) (2012). H e is also entit le d t o t he cash surre nd ervalue i fthe in sura nce co m pany, r atherthan he , c a nc e l s the p o l i c y, a s the c o mpa nyi s e nt i t l e d t o do i fhi s bo rr owing f ro m the c om p an y e xceeds the cas h va l ue

— i n whi che ve nt, ho we ver, he wi l l o we the c o mp a n y mo r e th a n i to we s h i m. A n i nsurance c om p an y doe sn’ t j ust s i t o n a pol i cyh o l d e r ’ s p r e mi u m p a y me n t s , o fc o u r s e ; i ti n v e s t s th e m; an d as i s the pra cti ce o fm utual i nsurance com panie s,N o. 11

- 2508 3 N or thw est er n M utual cr edits p art o fthe i ncom e fro m i nv es ting th em to th e po l i cy ho l der ’ s ac co unt w ith the com pany and c alls these cr edi ts “div i dend s. ” N or thw est
er n M utual, “Com p an y Over vi ew : W hat M utual i ty M eans to You, ” ww w . nor thw est er nm utual

. com /aboutn o r t h we s t e r n - mu t u a l / o u r - c o mpa n y / c o mpa n y - o v e r v i e w. aspx#M utual i ty ( vi si ted A ug . 2 1, 2012 ) ; se e Indianapo li s Li f eIns . Co. v. U ni t e d S t ates , 1 1 5 F. 3d 430, 431 (7th Cir. 19 97 ); P rai rie Sta tes Life Ins. C o . v . U nited Sta tes , 82 8 F

. 2d 1 2 2 2 , 1 2 2 3

- 2 4 ( 8 th C i r . 1 9 8 7 )

. B r o wn ’ s p o l i c y g a v e h i m a c h o i c e a mo n g r e c e i v i n g h i s d i v i d e n d s i n c a s h, us i ng them t o p ay future prem i um s, o r

— the def aul t o pti on s pe c i fi e d in the p o l i cy

— buyi ng addit i onall i fe insurance ab ove the f ace am ount of the pol i cy ( $100 , 000 in B row n’ s po l i cy )

. Be ca us e he made no s el ec ti o n a m o ng these al ternati ves, by d efault the di vi dend s were used to i ncre ase hi s l i fe insurance. The pol i cy re quir ed an annualpre m i um o f$1 , 837. Fr om 19 82 to 1986 Bro w n pai d i n cash, but f ro m 19 87 t o 2 0 0 0 he pa i d b y b o r r o wi ng a g a i ns t the po l i c y ’ s ca sh value , w ith th e resu lt th at his ind ebte d ne ss to the i ns urance c om pany i ncre ase d. Fr om 20 01 t h ro ugh 200 3, with his i nd ebte dn ess approa chi ng the pol i cy’ s ca sh va l ue, he pa id h alfthe p rem ium s i n c ash and the rest by borro w i n g from th e c om p an y. N ev er th ele ss in 2 00 4 h is i nde bt edn es s ex ce ed ed th e po l i cy ’ s ca shv al ue , a nd he su rre n dered the addit i onali nsurance that he had obta in ed by ap p lyin g h is div id en d s to th e pu rc h as e of ad d it i o na l i ns ur a nc e a nd h e d i r e c t e d tha tfutur e di v i de nd s be use d to pay pre m i um s a n d p ay backhi s a ccum ula ted4 N o. 11

- 2508 deb t to the c o m pan y . Butb y t he e nd o f2 00 5 th e amoun t h e h ad bo rro w ed from th e in s u r a n c e c om p an y a ga in exceeded the pol i cy’ s ca sh va l ue ( though o nl y b y $30. 42) , and thi s t i m e the i nsuranc e c om pany cancel l ed the pol i cy, as the ter m s o fthe pol i cy enti tl ed i t t o do. T h e $ 3 1 , 0 6 3

. 3 0 o f a d d i t i o n a l i n s u r a n c e th a tBr o wn surr endered i n 200 4 a nd the $4 ,869. 94 ofdi vi dend s s ubs e q u e n t l y a p p l i e d a th i s d i r e c t i o n t o p a y p r e mi u ms a n d r e p a y d e b t i n th a t a n d th e f o l l o wi n g y e a r a r e a tt he hear t o fthe l itig at i on. The posi ti on o fthe I nter nal Revenue S er vi ce, se conded by the Tax Cou rt , i s that th e s e mo n e y s ( to ta l i n g$ 3 5 , 9 3 3

. 2 4 ) a r e v a l u e th a tB r o wn r e c e i v e d fr o m t he p o l i c y b e f o r e i twa s c a nc e l l e d. The r efo r e th ey r edu ce by th i s amoun t hi s ne t “inv es tment i n the [ i nsurance] contra ct” ( the sum of al l p re m i um s that the pol i cyhol der pai d m i nus any am ounts he r ecei ved bef or e he surr endered the pol i cy up on i ts cancell ati on by the i ns ur a nc e c o mpa nyo r b y h i s o wn c ho i ce, 26 U. S

. C. § 72(e) ( 6) )

. Tha t i s a r edu ct i o n in n eti nv es tment fr o m $44,205.00 to $8, 271.76 ($44,205.00 – $35, 933.24). Acc o r di ng to the t e r ms o fthe p o l i c y, the p o l i c y h a d a cash value of $37,356. 06 at th e tim e of su rrend er. A n i nvest m ent of $8, 271. 76 that m ake s the pol i cy w or th $37, 365. 06 on surr ender gener ate s $29, 093. 30 ( $37, 365. 06

– $8, 271. 76) i n taxabl e incom e. But Brown contends that r ea l l y he i nv es te d the ful l $ 44, 20 5 i n the c o nt r ac t ( th e pol i cy) w i thi n the m eani ng of the appli cabl e tax l aw

— that that am ount shoul d no t be dim i ni shed by the $35 , 933. 24 i n additi onali nsurance and divi dend s r ece ived

— an d that ther efo re he r eal i zed a net l oss wh en the pol i cy w asN o. 11

- 2508 5 cancel l ed, and so no tax i s due. N atur al l y h e is loa th to p a y a n y t a x i n r e s p e c t o f th e c a n c e l l a t i o n, s i n ce he re cei ved no m oneyfro m i t. The c as h v al ue o fa s ur r en der ed (w hethe r o r no t vo l unta rily s u rre n d er ed ) life in su ra n c e p oli c y i s inc lu d ab le in gr oss i nc om e “to the e xtent i t e xceeds the [ taxpayer ’ s] i nv est m e nti n the [ i ns ur a nc e ] c o nt r a c t, ” 2 6 U. S

. C. § 7 2(e )(5) (A ), an d is ta x ab le a s o rd in ar y in c om e. Barrv. C o m m ission er, N o. 87 05- 08, 20 09 W L 3 6175 87, at* 3 ( U

. S. Tax Ct. N ov. 3, 20 09) ; se e a l so Wol f f v. Com m i ssion er, 14 8 F

. 3d 1 8 6 , 1 8 9

- 9 0 ( 2 d Ci r . 1 9 9 8 )

. W he n Br o wn’ s po l i cy w as ca nc el l ed, i ts ca shv al ue was $ 37, 36 5. 06

. W ha t ha d he in ve st ed in t h e p olic y? T h at is, w h at w a s h is c os t (h is “bas i s, ” in tax- speak) ? R em em berthat h e had p ai d a to tal of$4 4, 205. 00 i n prem i um s but h ad recei ved $35 , 933. 24 f r o m s ur r en der i ngthe a ddi ti o na l i ns ur an ce i n 2 00 4 an d f ro m usi ng di vi dend s t o pay pre m i um s a n d lo an s in 200 4 and 2005. Th e d iffer ence of$8 , 271. 76 w as the ne t co st to hi m o fthe cash s urr ender val ue o fthe poli cy, and subtr ac tin g t h e $ 8,2 71 .76 co st from th at va lu e re su lte d in t a x a b le gross i nc om e of $29,093.30, j us t as the Tax Cou rt rul ed, ev en tho ugh Brown had r ece i ved no cash b ecause th e ca shv al ue o fthe po l i cyhad b eenus ed to pa y o ffthe l oans that he had go tte n fro m t h e com pany to pay f or h is p re m iu m s. E .g. Fed er v . Co m m ission er, N o. 16 28- 10, 20 12 W L 75 11 4, at *4 (U .S. Ta x C t. Jan . 10, 20 12 ); San de rs v. C o m m ission er, N o. 33 95- 09, 2010 W L 53278 97, at* 2 ( U

. S. Tax C t. D ec . 20, 20 10 ); M cG o w en v. C o m m ission er, N o. 14 116- 07, 2009 W L 47975 38 , a t * 4 ( U

. S. Tax Ct

. De c. 14, 2009), affi rm ed o n o th er g r o unds , 43 8 F ed. Appx. 68 6 ( 10 thCir. 2010 ).6 N o. 11

- 2508 Brown cl ai m s that the $3 5, 933. 24 i n add i ti onali nsurance and divi dend paym ents w as ( or w as equi val ent t o) “div i dend s . . . r eta i ned by the i nsureras a prem i um o r consi derat i on pai d for the [ i nsurance] contr act, ” which 26 U. S

. C. § 7 2( e) ( 4) ( B ) ex cl ude s f r o m g r o ss i nc o m e. But th ats ec ti o n i s in appl i cabl e to pa y m en ts unde r l i fe i ns ur a nc e p o l i c i e s . I ti s capti o ne d “ s pe c i a l r ul e s f o r a ppli c a t i o n o fp a r a g r a ph( 2 ) ( B) , ” a nd tha tp a r a g r a phdoes not apply to non- annuity l i fe i nsurance p aym ents. 26 U

. S. C

. §§ 72(e)( 5)(C), ( e)(5) (A )( i)

. The g r o ss i nc om e ca l cul at ed bythe Ta x Co ur t was the am ount bywh i ch the cas h val ue o fBro w n’s i nsurance pol i cy exceeded w hat he’ d paid for th e pol i cy. The f act that thi s incom e was used t o pay a debt t o the insurance com pany i s i rr el evant, bec ause i t was a perso nal ra therthan a business debt and ther ef or e was notded u c t ible . 26 U .S.C . § 61 (a); 26 U .S.C . §§ 1 63 (a), (h ); Kik al os v. C o m m ission er, 190 F.3d 79 1, 79 3-9 4 (7 th C ir. 19 99 ). I t is a l s o i rr e l e v a nttha tn o mo ne y c ha ng e d h a nd s

— th atthe debt w as pai d b y the cre dit or ’ s w i thhol din g m oney o th er wi se due the debt o r, l i k e a se to ff

. S ee , b es i des the Fed er, Sa nd ers , an d M cG o w en op in ion s c i t ed ab ov e, B a rr v. Com m i s s i oner, s up ra , 2 00 9 W L 3 61 75 87, a t * 2, a nd A tw o o d v . Co m m ission er, N o. 19 748- 97, 1 99 9 W L 10961 7, at *2 ( U

. S. Tax Ct

. M ar. 4, 1999 ). T h e T ax C ou rt ’s re su lt m ay se em od d be c au se it se ems n o t to a cc o untf o r the c o sttha t Br ow n ( an d the benefi ci ar y of the l i fe insurance pol i cy, hi s wife) i ncurr ed w hen he was cr edi ted, up on ca ncel l ati on o fthe pol i cy, w i th the pol i cy’ s c ash s urr ender val ue. The co st i ncurr ed was the v al ue o fthe de ath-be ne fi t co m po ne nto ftheN o. 11

- 2508 7 pol i cy, wh i ch ( obvi ously) eva pora ted wh en the pol i cy wa s c a nc e l l e d. Butthe odd nes s i s su per fi ci al

. As t i m e pas se s an d the ca shs ur r en derv al ue o fa who le- li fe po l i cyg r o ws, the net d e a th b e n e fi t, wh i c h i s th e f a c e a mo u n t o ft he p o l i c y ( th e p r o c e e d s o n d e a th ) min u s th e p r e mi u ms p a i d , s h r i n k s a s a r e s u l t o f th e g r o win g s t o c ko fp r e mi u ms pai d, to the poi nt at w hi ch further prem i u m paym ents ( w hi ch r em em berwere fix ed a t $1, 837 a y ear ) can a c t u a l l y r e d u c e th e n e td e a th b e n e fi t
. B y s u r r e n d er i ng the pol i cy ( albeit in vol untari l y) Bro w n gav e up the pros p e c to fr e c e i v i ng$ 1 0 0 , 0 0 0 i fh e d i e d b u ta tth e s a me ti m e freed him sel ffro m havi ng to pay $1, 837 each y ear to m ai ntai n that pros pect. I t rem ains on ly to con side r the p en alty f or the u nd erst atem ent o fta x. The 20 per cent penal ty f orsubst anti al un d erstate m en t of incom e tax , 26 U

. S. C

. §§ 6662(a), (b)( 2), (d), ha s an ex cep tion for th e c a se in w hich the tax p ayer’s p os itio n w as su p p or te d by “s u b st an tia l au th or ity .” § 66 62( d)( 2) ( B)( i ) ; se e K im v. C o m m ission er, 6 7 9 F

. 3 d 6 23, 62 6 (7 th C ir. 20 12 ); TIFD III-E , Inc. v . U nited Sta tes , 66 6 F. 3d 836, 84 8- 50 ( 2d Cir

. 20 12) . A s d efi ned w i th gr eat speci fi ci ty i n a Tr eas ury Regul ati on th e v al i dity o fwh i ch is n otch alle n ge d , t h e t e rm “s u b st an tia l au th or ity ” is l i m i te d to st atut es , r egul at i o ns , j udi ci alde ci si o ns , c o ngr ess i onal fl oo r sta tem ents and com m i tte e r epor ts, re venue r ulings a nd pro cedures, ta x treati es, pri vate l ett err ulings, and cer tai n I RS publ i cation s. Trea s. Reg. § 1.6662-4(d)(3)( ii i)

. T h er e is a c om p ellin g r ea so n for lim itin g t h e e ligib le author i ti es as ti ghtl y a s the r eg u l ati on does : o ther w i se8 N o. 11

- 2508 d em an d by tax p ayers w ou ld evoke “au th oriti es” for every po si ti o n tha t a ta xpa y ermight w i sht o t ak e. The au th or itie s o n w h ich t h e t ax p ay er s in th is c as e re ly ei therdo notsupport thei r posi ti on o r ar en’ t o n the l i st. E ven i f th ere isn’t sub stan tial au th orit y i n su p p ort of a ta xpa y er ’ s po si ti o n, he c an a vo i d the unde r pay m en t p en alt y if h e m ad e re as on ab le e ffor ts t o d et er m in e h is tax l iabil ity. 2 6 U

. S. C

. § 6 664(c); T reas. Reg. §§ 1.6662-4(a), 1. 6664

- 4( b)

. Genera l l y thi s r equi re s that he h av e obta in ed an op in ion from an ac c ou n ta n t o r law ye r. U n ited State s v. B oyle, 469 U .S. 24 1, 25 0-5 1 (1 98 5); M ul ca hy, P a uritsch , Salv a do r & C o . v. Co m m ission er, 6 8 0 F

. 3 d 8 67, 872 ( 7th C ir. 20 12)

. The ta xpayers i n thi s ca se ar e a n at to r ne y c o upl e who m ade no e ff o r t to r es ea r chthe l ega l bas i s forthei r po sit ion , o r obt ai n an o pini on fro m ana cc o unt an t o r l awy er, until the I nt erna l Re ve nue Se rvic e c hal l enged thei r posi ti on. S o they didn’tr each th e safe harbo r. A FFI RMED
.

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