1 Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

T.C. Summary Opinion 2009-137

UNITED STATES TAX COURT

RICHARD LIU AND BRENDA LEE LIU, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 22677-07S. Filed September 3, 2009.

Richard Liu and Brenda Lee Liu, pro se.

Laura Mullin, for respondent.

PANUTHOS, Chief Special Trial Judge: This case was heard

pursuant to the provisions of section 7463 of the Internal

Revenue Code in effect when the petition was filed.1 Pursuant to

section 7463(b), the decision to be entered is not reviewable by
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2 Petitioners concede that they received $549 in interest

income in 2005 but failed to report that income on their 2005

Federal income tax return.

any other court, and this opinion shall not be treated as

precedent for any other case.

Respondent determined a $3,010 deficiency in petitioners’

2005 Federal income tax and also determined a $602 accuracyrelated penalty.

After a concession by petitioners,2 the issues for decision

are: (1) Whether petitioners are liable for the 10-percent

penalty pursuant to section 72(q) on a premature distribution

from an annuity contract, and (2) whether petitioners are liable

for an accuracy-related penalty due to negligence.

Background

Some of the facts have been stipulated, and we incorporate

the stipulation and the accompanying exhibits by this reference. 

Petitioner Richard Liu was born in 1947. Petitioners were

married to each other at all relevant times, and they lived in

California when they filed the petition. 

Mr. Liu (hereinafter petitioner) purchased an annuity

contract from American General Annuity Insurance Co. (AIG) in

2002, investing $190,000 in the contract in 2002. The AIG

contract stated, in part: 
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Early Withdrawal Charges

An early withdrawal charge will be deducted if you withdraw

more than your accumulated interest within six years of your

last premium payment. A withdrawal prior to age 59-1/2 may

incur an IRS penalty.

Petitioner worked with a financial adviser in selecting and

purchasing the AIG annuity. The adviser informed petitioner of

the penalties AIG would impose if he withdrew his investment in

the contract within the first 6 years but did not advise him

about the tax consequences of a premature distribution from the

annuity.

In October 2005 the accumulated value of the contract was

$218,715.06, and petitioner requested a distribution of the

accumulated earnings on the contract: $28,715.06. Petitioner

submitted an AIG annuity withdrawal request form requesting a

distribution of “all the penalty free amount”. The following

language appeared near the bottom of the first page of the

withdrawal request form: “You and the Internal Revenue Service

will be provided with an informational tax form after the close

of the calendar year. A withdrawal of any type, before age 59 1⁄2,

may subject you to an IRS penalty tax.” Petitioner signed the

withdrawal request form on October 14, 2005. AIG processed the

$28,715.06 distribution on October 17, 2005. At the time of the

distribution, petitioner was 58-3/4 years old.

On October 25 and 26, 2005, petitioner invested the

$28,715.06 annuity distribution as follows: $25,000 into a
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certificate of deposit and $3,715.06 into his existing money

market account, both with Countrywide Bank. Petitioner did not

withdraw any of these funds from the Countrywide accounts before

attaining the age of 59-1/2.

On their joint Federal income tax return for 2005

petitioners reported the distribution from AIG as interest

income. They did not report a 10-percent penalty.

In the notice of deficiency respondent determined that the

withdrawal was a premature distribution from an annuity contract,

subject to the 10-percent penalty imposed by section 72(q). 

Respondent also determined an accuracy-related penalty for

negligence under section 6662(a) and (b)(1).

Discussion

In general, the Commissioner’s determination set forth in a

notice of deficiency is presumed correct, and the taxpayer bears

the burden of proving that the determination is in error. Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Pursuant

to section 7491(a), the burden of proof as to factual matters

shifts to the Commissioner under certain circumstances. Because

the facts in this case are undisputed, section 7491(a) is not at

issue.

Income earned within an annuity is afforded preferential tax

treatment; to wit, tax on that income is deferred until it is

withdrawn from the annuity. Amounts withdrawn from an annuity,
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other than a taxpayer’s investment (basis) in the contract, are

subject to income tax. Sec. 72(a) and (b). Furthermore, section

72(q) generally provides for a penalty equal to 10 percent of

that part of any distribution from an annuity which is includable

in gross income, unless the distribution falls within one of the

10 statutory exceptions enumerated in section 72(q)(2).

Petitioners argue that because: (1) They received the

distribution when petitioner was 58-3/4 years old; (2) they

immediately invested the withdrawn annuity income in a

certificate of deposit and a money market account; and (3) they

left the funds in those investments until after petitioner

attained age 59-1/2, they have satisfied the spirit of the

exception Congress provided in section 72(q)(2)(A).

Section 72(q)(2)(A) provides that the 10-percent penalty

shall not apply to any distribution “made on or after the date on

which the taxpayer attains age 59-1/2”. Petitioner was not yet

59 years old when AIG processed his annuity withdrawal request

and distributed the income earned in his annuity contract. 

Neither petitioner’s being close in age to the clear cutoff

adopted by Congress nor the failure of his advisers to make him

understand that the penalty would apply is an exception to the

section 72(q) penalty. We may not ignore the statute or waive

this penalty for petitioners. See Paxman v. Commissioner, 50

T.C. 567, 576-577 (1968) (the Tax Court is not a court of equity;
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“The power to legislate is exclusively the power of Congress and

not of this Court or any other court.”), affd. 414 F.2d 265 (10th

Cir. 1969).

The legislative history to the enactment of section 72(q)

indicates that Congress intended to defer recognition of annuity

income, provided that the annuity was used for long-term

investment. Congress sought, by imposing the 10-percent penalty,

to discourage the use of annuities for short-term investment and

income tax deferral. S. Conf. Rept. 97-530, at 350 (1982). In

section 1035, however, Congress provided for nonrecognition of

income when a taxpayer exchanges one annuity contract for another

annuity contract. 

Petitioner testified that his understanding was that he had

60 days to reinvest the funds and that so long as the funds were

not expended, there should be no penalty imposed. Petitioner’s

argument is misplaced. He reinvested his distribution of annuity

income into investment vehicles that generated interest income,

but the reinvestment was not an exchange for another annuity that

might qualify for nonrecognition and continued deferral. The

distribution is taxable (as petitioner properly reported) because

there was no like-kind exchange. The distribution was premature,

and the 10-percent penalty under section 72(q) applies because

petitioner does not qualify for any of the enumerated exceptions

under section 72(q)(2).
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3 For the purpose of sec. 6662, negligence includes any

failure to make a reasonable attempt to comply with tax laws, and

disregard includes any careless, reckless, or intentional

disregard of rules or regulations. Sec. 6662(c). 

Respondent determined an accuracy-related penalty under

section 6662(a) and (b)(1). Where section 6662 applies, it

imposes a penalty equal to 20 percent of an underpayment of tax

required to be shown on a return. Sec. 6662(a). Section 7491(c)

requires the Commissioner to produce evidence to show that the

imposition of the accuracy-related penalty is appropriate. The

record reflects that the payor reported the interest income paid

to petitioners in 2005 on a Form 1099-OID, Original Issue

Discount, sent to the IRS and to petitioners, but petitioners

failed to report the income on their 2005 return. In addition,

respondent asserts that the warnings in the annuity contract and

in the annuity withdrawal form which petitioner signed put

petitioner on notice of the premature distribution penalty, and

he further asserts that petitioner’s preparing the joint tax

return and failing to report the interest income and to either

research the tax implications of the annuity distribution or

secure professional assistance demonstrate negligence.3

Respondent has satisfied his burden.

Once the Commissioner meets his burden of production, the

taxpayer must come forward with persuasive evidence that the

Commissioner’s determination is incorrect. Rule 142(a); Higbee
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v. Commissioner, 116 T.C. 438, 447 (2001). To the extent the

taxpayer shows he had reasonable cause for an underpayment and

that he acted in good faith, section 6664(c)(1) prohibits the

imposition of a penalty under section 6662. 

Generally the most important factor in evaluating reasonable

cause and good faith in this context is the extent to which the

taxpayer tried to assess his proper tax liability. Sec. 1.6664-

4(b)(1), Income Tax Regs. Reasonable cause and good faith may be

found with an honest misunderstanding of fact or law that is

reasonable in light of all the facts and circumstances, including

the experience, knowledge, and education of the taxpayer. Id.

Petitioners have not offered any evidence to indicate that

they acted with reasonable cause and good faith with respect to

the unreported interest income they conceded. See supra note 2. 

Thus, they have failed to establish that they are not liable for

the accuracy-related penalty as it applies to the portion of the

deficiency resulting from the conceded interest income. 

As discussed above, petitioners were required to report on

their return the 10-percent premature distribution penalty

provided by section 72(q). Petitioners testified credibly that

they believed they had a limited time to reinvest the proceeds

from the annuity income distribution and avoid the imposition of

a penalty. They also explained that they kept the funds invested
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until after petitioner reached age 59-1/2 to avoid any penalties. 

We are satisfied that they acted in good faith.

Although petitioners failed to qualify under the technical

provisions of the Internal Revenue Code and the regulations for a

nontaxable rollover, under these particular circumstances and

considering the complexity of rules covering taxation, deferral,

and rollover of qualified plans, nonqualified plans, and

annuities and the candor petitioners exhibited, we do not believe

petitioners acted unreasonably or intentionally disregarded rules

and regulations in failing to report the 10-percent penalty.

We sustain the determination that petitioners are liable for

the section 72(q) penalty and for the accuracy-related penalty

with respect to the unreported interest income, but we hold that

they are not liable for the accuracy-related penalty on the

portion of their underpayment attributable to the section 72(q)

penalty.

To reflect the foregoing,

Decision will be entered

under Rule 155.