2002 Decisions

Opinions of the United

States Court of Appeals

for the Third Circuit

7-29-2002

Neonatology Assoc v. Commissioner IRS

Precedential or Non-Precedential: Precedential

Docket No. 01-2862

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"Neonatology Assoc v. Commissioner IRS" (2002). 2002 Decisions. Paper 452.

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PRECEDENTIAL 

 Filed July 29, 2002 

UNITED STATES COURT OF APPEALS 

FOR THE THIRD CIRCUIT 

No. 01-2862 

NEONATOLOGY ASSOCIATES, P.A. 

v. 

COMMISSIONER OF INTERNAL REVENUE 

(Tax Court No. 97-1201) 

JOHN J. and OPHELIA J. MALL 

v. 

COMMISSIONER OF INTERNAL REVENUE 

(Tax Court No. 97-1208) 

ESTATE OF STEVEN SOBO, DECEASED and 

BONNIE SOBO, EXECUTRIX, and 

BONNIE SOBO, SURVIVING WIFE 

v. 

COMMISSIONER OF INTERNAL REVENUE 

(Tax Court No. 97-2795) 

 

AKHILESHI S. and DIPTI A. DESAI 

v. 

COMMISSIONER OF INTERNAL REVENUE 

(Tax Court No. 97-2981) 

KEVIN T. and CHERYL MCMANUS 

v. 

COMMISSIONER OF INTERNAL REVENUE 

(Tax Court No. 97-2985) 

ARTHUR and LOIS M. HIRSHKOWITZ 

v. 

COMMISSIONER OF INTERNAL REVENUE 
(Tax Court No. 97-2994) 

LAKEWOOD RADIOLOGY, P.A. 

v. 

COMMISSIONER OF INTERNAL REVENUE 

(Tax Court No. 97-2995) 

Neonatology Associates, P.A., John J. 

and Ophelia Mall, Estate of Steven Sobo, 

Deceased, and Bonnie Sobo, Executrix, 

and Bonnie Sobo, Surviving Wife, 

Akhilshi S. and Dipti A. Desai, 

Kevin T. and Cheryl McManus, 

Arthur and Lois M. Hirshkowitz and 

Lakewood Radiology, P.A., 

 Appellants 

 2 

 

On Appeal from the United States Tax Court 

(T.C. Nos. 97-1201/1208/2795/2981/2985/2994/2995) 

Tax Court Judge: Honorable David Laro 

Argued: July 11, 2002 

BEFORE: SCIRICA and GREENBERG, Circuit Judges , 

and FULLAM, District Judge* 

(Filed: July 29, 2002) 

 Neil L. Prupis 

 Lampf, Lipkind, Prupis, 

 Petigrow & LaBue 

 80 Main Street 

 West Orange, NJ 07052 

 Kevin L. Smith (argued) 

 Hines Smith 

 3080 Bristol Street, Suite 540 

 Costa Mesa, CA 92626 

 David R. Levin 

 Wiley Rein & Fielding 

 1776 K Street, N.W. 

 Washington, D.C. 20006 

 Attorneys for Appellants 

 Eileen J. O’Connor 

 Assistant Attorney General 

 Kenneth L. Greene 

 Robert W. Metzler (argued) 

 Attorneys Tax Division 

 Department of Justice 

 Post Office Box 502 
 Washington, D.C. 20044 

 Attorneys for Appellee 

_________________________________________________________________ 

* Honorable John P. Fullam, Senior Judge of the United States District 

Court for the Eastern District of Pennsylvania, sitting by designation. 

 3 

 

 Steven J. Fram 

 Archer & Greiner 

 One Centennial Square 

 Haddonfield, NJ 08033 

 Attorneys for Amici Curiae Vijay 

 Sankhla, M.D., Yale Shulman, 

 M.D., Boris Pearlman, M.D., Marvin 

 Cetel, M.D. and Barbara Schneider, 

 M.D. 

OPINION OF THE COURT 

GREENBERG, Circuit Judge. 

I. INTRODUCTION 

This matter comes on before this court on appeal from 

decisions of the United States Tax Court entered April 9, 

2001, in accordance with its opinion filed July 31, 2000, 

upholding the determination of the Commissioner of 

Internal Revenue that contributions made by appellants, 

two professional medical corporations, Neonatology 

Associates, P.A. and Lakewood Radiology, P.A., into 

Voluntary Employees Beneficiary Program (VEBA) plans in 

excess of the cost of term life insurance were taxable 

constructive dividends to the physicians owning the 

corporations and their spouses rather than employer 

deductible expenses. See Neonatology Assoc., P.A. v. 

Comm’r, 115 T.C. 43 (2000). We refer to the corporations 

and individuals collectively as "taxpayers." The 

consequences of the decisions were substantial for the 

taxpayers inasmuch as the professional medical 

corporations were denied deductions they had taken for the 

contributions and the individuals were charged with 

significant additional taxable dividend income. The court 

held further that the individual taxpayers were liable for 

accuracy-related negligence penalties under I.R.C. 

S 6662(a). 

Our examination of the record convinces us that the 

contributions at the heart of this dispute were so far in 

 4 

 

excess of the cost of annual life insurance protection that 

they could not plausibly qualify as ordinary and necessary 

business expenses in accordance with I.R.C. S 162. In 
essence, the physicians adopted a specially crafted 

framework to circumvent the intent and provisions of the 

Internal Revenue Code by having their corporations pay 

inflated life insurance premiums so that the excess 

contributions would be available for redistribution to the 

individual shareholders free of income taxes. As correctly 

recognized by the Tax Court, these contributions were 

taxable disguised dividends and not deductible expenses. 

Moreover, as the individual taxpayers could not in good 

faith avail themselves of the reliance-on-professional 

defense, the Tax Court duly held them liable for the 

accuracy-related negligence penalties. Accordingly, for the 

reasons we elaborate in more detail below, we will affirm 

the decisions of the Tax Court. 

II. BACKGROUND 

The evidence at the trial disclosed the following facts. 

Neonatology is a New Jersey professional corporation owned 

by Dr. Ophelia J. Mall. Lakewood is a New Jersey 

professional corporation owned equally at the times 

material here by Drs. Arthur Hirshkowitz, Akhilesh Desai, 

Kevin McManus, and Steven Sobo until his death on 

September 23, 1993. Subsequently Dr. Vijay Sankhla, who 

is not a party to this action, purchased Sobo’s interest. The 

spouses of the doctors, John Mall, Lois Hirshkowitz, Dipti 

Desai, Cheryl MacManus, and Bonnie Sobo, are parties to 

this action as the doctors and their spouses filed joint 

income tax returns. In addition, Bonnie Sobo is a party as 

executrix of her husband’s estate. 

Following the enactment of the Tax Reform Act of 1986 

(TRA), Pub.L. 99-514, 100 Stat. 2085, insurance salesmen 

Stephen Ross and Donald Murphy formed Pacific Executive 

Services (PES), a California partnership designed to 

provides services to retirement plan administrators and 

employee benefit advisors unfamiliar with the impact of the 

TRA. See App. at 377. Specifically, Ross and Murphy 

devised a program to allow closely held corporations to 

"create a tax deduction for [ ] contributions to [an] employee 

 5 

 

welfare benefit plan going in and a permanent tax deferral 

coming out." App. at 2672. 

To achieve this end, PES created two voluntary 

employees’ beneficiary associations, the Southern California 

Medical Profession Association VEBA (SC VEBA) and the 

New Jersey Medical Profession Association VEBA (NJ VEBA).1 

A VEBA, as defined in I.R.C. S 501(c)(9), is a tax-exempt 

program providing members, their dependents, or 

designated beneficiaries with life, sick, accident, or other 

benefits "if no part of the net earnings of such association 

inures (other than through such payments) to the benefit of 

any private shareholder or individual." 

Under the PES VEBA programs, each participating 

employer adopts its own plan, maintaining a trust account 
and designating a trust administrator with exclusive control 

over all assets. The plan adoption agreement obligates 

employers to make, whether in the form of group insurance 

policies or group annuities, contributions towards the life 

insurance benefits of employees and their beneficiaries, 

based on a multiple of each employee’s annual 

compensation. Benefits payable under any plan are paid 

solely from that plan’s allocable share of the trust fund, 

and the participating employer, administrator, and trustee 

are not liable for any shortfall in the funds required to be 

paid. Upon termination of a plan, all its remaining assets 

are distributed to the employer’s covered employees in 

proportion to their compensation. PES enlisted the services 

of Barry Cohen, a longtime insurance salesman with the 

Kirwan companies, to market the VEBA programs to 

medical professionals. 

The SC VEBA plans at issue in this case, the Neonatology 

Employee Welfare Plan and the Lakewood Employee Welfare 

Plan, shared a common feature: both purchased 

continuous group (C-group) term policy certificates from the 

Inter-American Insurance Co. of Illinois, Commonwealth 

_________________________________________________________________ 

1. Notwithstanding what might be regarded as a geographical anamoly, 

only the SC VEBA is involved here. There was, however, an additional 

petitioner in the Tax Court, not a party on this appeal, Wan B. Lo, d/b/a 

Marlton Pain Control and Acupuncture Center, who established a plan 

under the NJ VEBA. 

 6 

 

Life Insurance Co., and Peoples Security Life Insurance Co. 

The C-group product provided routine group term life 

insurance with an added component, a "special" conversion 

policy through which a covered employee, under certain 

circumstances,2 could opt to convert his or her policy to an 

individual policy, the C-group conversion universalife (UL) 

policy. By converting from a C-group to an individual UL 

policy, the employee could access funds paid by the 

employer to the group policy that exceeded the applicable 

mortality charge, i.e. the cost of insurance. The excess 

funds, depending on the year in which the conversion takes 

place,3 are paid out with interest as so-called "conversion 

credits." 

In addition to being able to access surplus amounts, a 

policyholder upon conversion to the UL policy may borrow 

any amounts against his or her policies not required to 

keep the policies in force.4 When the policyholder dies, the 

loans are to be repaid from the policy death benefits, which 

ordinarily are not subject to income tax. See I.R.C. S 101. 

Of course, by borrowing the money the taxpayer effectively 

would be withdrawing money the medical corporations paid 

for the conversion privilege on a tax free basis. Thus, as if 

_________________________________________________________________ 

2. Under the policies, conversion was allowed when group coverage 

ceased because (1) the employee ceased employment, (2) the employee 
left the class eligible for coverage, (3) the underlying contract terminated, 

(4) the underlying contract was amended to terminate or reduce the 

insurance of a class of insured employees, or (5) the underlying contract 

terminated as to an individual employer or plan. See App. at 1836, 1846. 

3. Under the applicable schedule, none of the conversion credit balance 

is transferred to the C-group conversion UL policy if conversion occurs 

in the C-group term policy’s first year. However, if conversion takes place 

in the C-group term policy’s fourth year or beyond, 95% of the 

conversion credit balance is transferred to the C-group conversion UL 

policy. Policyholders could not receive more than 95% of their conversion 

credit balance because a five percent commission was paid automatically 

to the insurance agent upon conversion. See App. at 2161-62, 4710, 

4713. 

4. Notably, the interest due on any loan policy was equal to the interest 

credited on the asset accumulation. In other words, there were no outof-pocket costs to the debtor-policyholder. See App. at 2164. To hedge 

the attendant C-group product risks, Inter-American and Commonwealth 

reinsured with a third party. 

 7 

 

by magic, cash derived from the corporations would be 

withdrawn without tax. Each of the physician taxpayers, 

other than Dr. Sobo, in fact converted at least one C-group 

term certificate to a special policy providing conversion 

credits. See App. at 426-29, 439-41. 

Neonatology, on the basis of conversations between its 

principal, Dr. Mall, and Cohen, established the Neonatology 

Plan under the SC VEBA on January 31, 1991, effective 

January 1, 1991. Under the plan, each covered employee 

was to receive a life insurance benefit equal to 6.5 times the 

employee’s compensation of the prior year. See App. at 434, 

1807. John Mall, Dr. Mall’s husband, was not a paid 

employee of Neonatology and thus was not eligible to join 

the plan. Nevertheless, Dr. Mall and PES, the plan 

administrator, allowed Mr. Mall to join the plan, making 

him eligible to receive a death amount commensurate to 

that payable under life insurance that he had owned 

outside the plan ($500,000). See Supp. App. at 108-09. The 

Neonatology Plan purchased three C-group life insurance 

policies, two on Dr. Mall’s life and one on Mr. Mall’s life. 

See App. at 434-39. Neonatology contributed to the 

Neonatology Plan during each year from 1991 through 1993 

and, for each subject year, claimed a tax deduction for 

those contributions and other related amounts. 

Lakewood, on the basis of conversations between its 

principals and Cohen, established the Lakewood Plan under 

the SC VEBA on December 28, 1990, effective January 1, 

1990. Under the plan, each covered employee was to 

receive a life insurance benefit equal to 2.5 times his or her 

prior-year compensation. See App. at 387. Lakewood 

amended its plan as of January 1, 1993, to increase the 

compensation multiple to 8.15. The Lakewood Plan 

purchased 12 C-group life insurance policies on the lives of 

Drs. Hirshkowitz, Desai, Sobo, McManus, and Sankhla and 
three group annuities toward future premiums on the 

policies. See App. at 400-26. Lakewood also purchased 

three C-group policies outside of the Lakewood Plan. The 

individual owners on their own behalf determined the 

amounts contributed by Lakewood to the SC VEBA. See 

App. at 1015-16, 3674-87. For each subject year, Lakewood 

claimed a tax deduction for those contributions and other 

related amounts. 

 8 

 

The IRS audited Neonatology’s tax returns for calendar 

years 1992 and 1993 and Lakewood’s tax returns for fiscal 

year 1991 (ending October 31, 1991) and calendar years 

1992 and 1993. As a consequence of the audits, the 

Commissioner made the following determinations. First, 

with respect to the deductions claimed by Neonatology for 

amounts paid to the SC VEBA and by Lakewood for 

amounts paid to the SC VEBA and to the three non-plan Cgroup policies, he allowed only the cost of annual term life 

insurance protection and disallowed the excess amounts of 

$43,615 and $986,826 for Neonatology and Lakewood 

respectively. See App. at 2265-66, 2283-85. The 

Commissioner based his disallowance on alternative bases: 

(1) the excess contributions were not ordinary and 

necessary business expenses under I.R.C. S 162(a); (2) even 

if the amounts constituted ordinary and necessary business 

expenses, they nevertheless were not deductible under 

I.R.C. SS 404(a) and 419(a), which limit the deductibility of 

contributions paid to deferred compensation plans and 

welfare benefit plans. See App. at 2266, 2285.5 

Second, the Commissioner determined with respect to the 

individual owners that amounts paid to the SC VEBA 

program increased personal incomes by $39,343 for Dr. 

Mall and her husband, $219,806 for Dr. Desai, $56,107 for 

Dr. McManus, $601,849 for Dr. Hirshkowitz, and $101,314 

for Dr. Sobo (his estate). See App. at 2271, 2311, 2297, 

2320. The Commissioner included the excess contributions 

as income to the individual taxpayers on alternative bases: 

(1) the amounts were deposited in the plans for the 

economic benefit of the individual taxpayers and as such 

constituted constructive dividends under I.R.C.SS 61(a)(7) 

and 301; (2) assuming that the Neonatology and Lakewood 

Plans constituted deferred compensation plans, the excess 

contributions were includible under section 402(b). See 

_________________________________________________________________ 

5. Specifically, the Commissioner ruled that as deferred compensation 

plans, the Neonatology and Lakewood Plans did not satisfy the I.R.C. 

S 404(a)(5) "separate account" requirement for the contributions to be 

deductible. If the plans were characterized as welfare benefit funds, 

I.R.C. S 419(b) limited the deductions as the plans could not qualify for 

the "10-or-more-employer plans" exception to section 419(b) in I.R.C. 

S 419A(f)(6). 

 9 

 
App. at 2271, 2297, 2311, 2320. Lastly, the Commissioner 

determined that by reason of the underpayment of taxes 

the individual taxpayers were subject to penalties under 

I.R.C. S 6662(a). 

Neonatology, Lakewood, and the individual owners 

petitioned the Tax Court challenging the IRS’s 

determinations. After a bench trial, the court sustained the 

Commissioner on the ground that: 

 The Neonatology Plan and the Lakewood Plan are 

 primarily vehicles which were designed and serve in 

 operation to distribute surplus cash surreptitiously (in 

 the form of excess contributions) from the corporations 

 for the employee/owners’ ultimate use and benefit . . . . 

 The premiums paid for the C-group term policy 

 exceeded by a wide margin the cost of term life 

 insurance . . . . What is critical to our conclusion is 

 that the excess contributions made by Neonatology and 

 Lakewood conferred an economic benefit on their 

 employee/owners for the primary (if not sole) benefit of 

 those employee/owners, that the excess contributions 

 constituted a distribution of cash rather than a 

 payment of an ordinary and necessary business 

 expense, and that neither Neonatology nor Lakewood 

 expected any repayment of the cash underlying the 

 conferred benefit. 

Neonatology, 115 T.C. at 89-91. 

Without addressing the alternative grounds for the 

Commissioner’s conclusions, the court rejected taxpayers’ 

arguments that the possibility of forfeiture in certain 

situations like policy lapse or death rendered all excess 

payments into de facto contributions to life insurance 

protection. Id. at 89-90 ("The mere fact that a C-group term 

policyholder may forfeit the conversion credit balance does 

not mean, as petitioners would have it, that the balance 

was charged or paid as the cost of term life insurance."). 

The court also rejected the idea that contributions which in 

fact did not fund term life insurance were paid as 

compensation for services, rather than dividends, because 

as a factual matter neither Neonatology nor Lakewood had 

the requisite compensatory intent when the contributions 

 10 

 

were made. Id. at 93. Lastly, the court agreed with the 

Commissioner that the individual taxpayers were in fact 

negligent and could not circumvent the accuracy-related 

penalties by asserting a good faith, reliance-on-professional 

defense nor could they do so by claiming that the case 

involved tax matters of first impression. 

The Tax Court entered its decisions on April 9, 2001. 

Taxpayers timely appealed on July 6, 2001. We have 

jurisdiction over this appeal pursuant to I.R.C.S 7482, and 

the Tax Court had jurisdiction over the petitions pursuant 

to I.R.C. SS 6213(a) and 7442. 
III. DISCUSSION 

There are three principal issues before us on appeal: (1) 

whether the Tax Court correctly determined that the 

amounts contributed in excess of the cost of per annum 

term life insurance were not ordinary and necessary 

business expenses and therefore not deductible; if yes, (2) 

whether those amounts constituted dividends, includible as 

taxable individual income, or compensation to the 

individual taxpayers; and, (3) whether the individual 

taxpayers were negligent. Our review of the Tax Court’s 

legal conclusions is plenary and is based on the"clearly 

erroneous" standard for its findings of fact. See ACM P’ship 

v. Comm’r, 157 F.3d 231, 245 (3d Cir. 1998); Pleasant 

Summit Land Corp. v. Comm’r, 863 F.2d 263, 268 (3d Cir. 

1988). Moreover, taxpayers bear the burden of refuting the 

IRS’s determinations. See Welch v. Helvering, 290 U.S. 111, 

115, 54 S.Ct. 8, 9 (1933).6 

A. The Deficiencies 

Section 162(a) of the Internal Revenue Code7 allows for 

_________________________________________________________________ 

6. The burden of proof may be shifted to the Commissioner in certain 

circumstances for audits conducted after July 22, 1998. See I.R.C. 

S 7491. These modifications to the Internal Revenue Code have no 

bearing on this case. 

7. The Internal Revenue Code, I.R.C. S 162(a), provides that "[t]here shall 

be allowed as a deduction all the ordinary and necessary expenses paid 

or incurred during the taxable year in carrying on any trade or 

business." 

 11 

 

the deduction of all ordinary and necessary expenses 

incurred in carrying on a trade or business providing five 

requirements are met: the item claimed as deductible (1) 

was paid or incurred during the taxable year; (2) was for 

carrying on a trade or business; (3) was an expense; (4) was 

a necessary expense; and (5) was an ordinary expense. See 

Comm’r v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 352, 91 

S.Ct. 1893, 1898 (1971). Beyond peradventure, employee 

benefits like life insurance are a form of compensation 

deductible by the employer.8 See Treas. Reg. S 1.162-10(a); 

see also Joel A. Schneider, M.D., S.C. v. Comm’r, 1992 T.C. 

Memo. 992-24, 63 T.C.M. (C.C.H.) 1787. To the extent, 

however, that Neonatology’s and Lakewood’s expenditures 

did not fund term life insurance, the Tax Court found that 

they did not meet the five requirements delineated above 

and therefore were not deductible. This factual finding was 

not clearly erroneous. See Comm’r v. Heininger , 320 U.S. 

467, 475, 64 S.Ct. 249, 254 (1943). 

The record amply supports the conclusion that taxpayers 

paid artificially inflated premiums in a creative bookkeeping 

ploy conceived by their insurance specialists to exploit what 
they thought were loopholes in the tax laws. Indeed, we do 

not see how a court examining this case could conclude 

otherwise. Charles DeWeese, the Commissioner’s expert, 

testified that amounts paid into the C-group policies 

exceeded conventional life insurance premiums by nearly 

500%. See App. at 804-08, 2156.9 Evidence at trial 

_________________________________________________________________ 

8. Of course, the mere fact that the benefit is a form of deductible 

compensation does not necessarily mean that it is taxable to the 

employee. See I.R.C. S 79. We note that the parties do not treat section 

79 as significant here. 

9. It should be noted that the Tax Court made certain credibility 

determinations, finding DeWeese, an independent consulting actuary, to 

be a "reliable, relevant, and helpful" witness whose testimony was 

bolstered by a voluminous record with stipulations to more than 2,000 

facts and with more than 1,500 exhibits. See Neonatology, 115 T.C. at 

86-87. By the same token, the court found that the opinions expressed 

by taxpayers’ sole expert, Jay Jaffe, were of minimal help, considering 

his close relationship to one of the insurance companies that provided 

the C-group product at issue in the case. See id. (experts who act as 

advocates, "can be viewed only as hired guns of the side that retained 

 12 

 

demonstrated that Dr. Mall knew that term life insurance 

was substantially more expensive to buy through the SC 

VEBA than through other plans offered to her under the 

auspices of the American Medical Association and the 

American Academy of Pediatrics. She nevertheless opted to 

form the Neonatology Plan because she believed that it 

offered her the best tax benefits. See App. at 1025. Dr. 

Hirshkowitz testified that Lakewood intentionally paid more 

expensive premiums on the C-group policies than it would 

have for conventional life insurance protection. See App. at 

998. Dr. Desai, another Lakewood owner, testified that his 

independent personal life insurance cost him substantially 

less than the policies issued pursuant to the SC VEBA. See 

App. at 1047. Like Dr. Mall, the Lakewood owners 

nevertheless invested in the SC VEBA program because of 

Cohen’s representation of tax benefits and cash returns 

that they could anticipate receiving. See App. at 1014-15. 

The record also reveals that excess premium amounts did 

not pay for actual current year life insurance protection but 

rather paid for conversion credits. The compliance manager 

of the Providian Corporation, the parent of the 

Commonwealth Life Insurance Company which issued 

policies involved here, stated in a letter to the IRS that the 

"premiums paid for the term policy are higher than the 

traditional term policy because of the conversion privilege 

and the costs of conversion credits." App. at 3690. 

DeWeese, belying taxpayers’ claim that C-group premiums 

were higher than those under ordinary term life policies 

because they were calibrated to the higher risks of longer 

_________________________________________________________________ 

them, and this not only disparages their professional status but 
precludes their assistance to the court in reaching a proper and 

reasonably accurate conclusion") (quoting Jacobson v. Comm’r, T.C. 

Memo. 1989-606, 58 T.C.M. (C.C.H.) 645)). The court also found that 

some of taxpayers’ fact witnesses "testified incredibly with regard to 

material aspects of this case" and that their testimony, for the most part, 

was "self-serving, vague, elusive, uncorroborated, and/or inconsistent 

with documentary or other reliable evidence." Id. These types of 

credibility determinations are ensconced firmly within the province of a 

trial court, afforded broad deference on appeal. See Dardovitch v. 

Haltzman, 190 F.3d 125, 140 (3d Cir. 1999). 

 13 

 

term employees in small markets,10 testified that the bulk of 

the gross premiums went to accumulate assets for 

distribution to the individual participants upon conversion. 

See App. at 2173. In addition, the record supports the 

conclusion that payments made to the Lakewood Plan for 

annuities were made not to fund current life insurance 

protection for employees but rather were made as an 

investment for the trustee to pay premiums on future Cgroup premiums. See App. at 976, 993-94, 1041-42. 

In sum, the evidence fully supports, indeed compels, the 

finding that the contributions in excess of the amounts 

necessary to pay for annual term life insurance protection 

were distributions of surplus cash and not ordinary and 

necessary business expenses. Considering the sound 

reasoning of the Tax Court and our own intensive review of 

the facts here, we conclude that it is implausible that the 

owners of Neonatology and Lakewood, educated and highly 

trained medical professionals, knowingly would have 

overpaid substantially for term life insurance unless they 

contemplated receiving an added boon such as a tax-free 

return of the excess contributions. 

Taxpayers advance two arguments to the effect that the 

court erred by not limiting its consideration to the written 

plan documents and life insurance contracts rather than 

relying on extraneous evidence like the plan marketing 

materials which discuss the availability of conversion 

credits. First, they maintain that the Neonatology and 

Lakewood SC VEBA programs were employee benefit plans 

under the Employee Retirement Income Security Act, 29 

U.S.C. S 1001 et seq., (ERISA). Thus, they contend that 

representations made outside of the plan documents 

cannot be used to consider rights and obligations arising 

out of the plans. See Br. of Appellants at 35. Second, they 

argue that under governing state insurance law, the tax 

implications of a group term life insurance policy are 

determined only on the basis of the policy language itself. 

As the literal provisions of the plans discuss only insurance 

benefits -- that is, a death benefit and an option to convert 

to an individual policy upon termination of employment -- 

_________________________________________________________________ 

10. See Br. of Appellants at 44 and n.30. 

 14 
 

but say nothing about excess contributions returning as 

conversion credits, taxpayers claim that the Tax Court was 

compelled to conclude from the strict form of their plans 

that all contributions in fact went to providing insurance 

benefits. 

Inasmuch as taxpayers did not raise the ERISA issue 

before the Tax Court, we need not consider it on this 

appeal. See Visco v. Comm’r, 281 F.3d 101, 104 (3d Cir. 

2001). While we recognize that in some exceptional 

circumstances an appellate court may review a defaulted 

argument, in this case there are compelling reasons 

militating against our overlooking procedural norms to 

consider whether ERISA governed the SC VEBA programs 

as our determination may prejudice persons not parties to 

this case.11 

In any event, even assuming for purposes of argument 

that the plans were employee benefit plans under ERISA, 

the fact remains that under well-established tax principles 

a court is not limited to plan documents in determining the 

tax consequences of a transaction. See, e.g., Comm’r v. 

Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 708 

(1945) ("The incidence of taxation depends upon the 

substance of a transaction."); ACM P’ship, 157 F.3d at 247 

("we must look beyond the form of the transaction to 

determine whether it has the economic substance that its 

form represents") (citations omitted); Lerman v. Comm’r, 

939 F.2d 44, 54 (3d Cir. 1991) (Commissioner and courts 

have "the power and duty . . . to look beyond the mere 

forms of transactions to their economic substance and to 

_________________________________________________________________ 

11. An amicus brief has been filed in this case on behalf of five 

physician-participants in the VEBA program who have filed a civil 

complaint against the insurance companies that wrote the C-group 

policies, Sankhla v. Commonwealth Life Ins. Co. et al., No. 01-CV-4761 

(U.S.D.C. N.J.). Amici have an interest in the outcome of this case 

because the extent to which we address whether the plans are governed 

by ERISA could affect resolution of the issue of whether their state law 

claims against the insurance companies are preempted. See Amicus Br. 

at 1-2. Rather than needlessly prejudice the rights of litigants in 

separate proceedings, we do not discuss the applicability of ERISA to the 

VEBA plans. 

 15 

 

apply the tax laws accordingly.").12 The cases cited by 

taxpayers,13 on the other hand, involve only disputes over 

_________________________________________________________________ 

12. Taxpayers, conflating the so-called "substance-over-form" doctrine 

with the "economic substance" or "sham transaction" doctrine, 

mistakenly argue as well that a court may not disregard the form of an 

arrangement until it determines that the arrangement lacks any 

economic substance other than obtaining tax deductions. See Br. of 

Appellants at 41 ("If . . . there is any economic substance to the 
arrangement apart from the alteration of tax liabilities, then the form of 

the arrangement must be respected, even if the arrangement was 

motivated by tax avoidance or minimization."). In actuality, the two 

doctrines are distinct. The substance-over-form doctrine is applicable to 

instances where the "substance" of a particular transaction produces tax 

results inconsistent with the "form" embodied in the underlying 

documentation, permitting a court to recharacterize the transaction in 

accordance with its substance. The economic substance doctrine, in 

contrast, applies where the economic or business purpose of a 

transaction is relatively insignificant in relation to the comparatively 

large tax benefits that accrue (that is, a transaction "which actually 

occurred but which exploit[s] a feature of the tax code without any 

attendant economic risk," Horn v. Comm’r, 968 F.2d 1229, 1236 n.8 

(D.C.Cir. 1992)); in that situation, where the transaction was an 

attempted tax shelter devoid of legitimate economic substance, the 

doctrine governs to deny those benefits. See generally Rogers v. United 

States, 281 F.3d 1108, 1113-18 (10th Cir. 2002). The Tax Court in this 

case, however, based its decision solely on the substance-over-form 

doctrine, finding that the form of the VEBA was not reflective of its 

genuine substance. In addition to the evidence we have set forth, the Tax 

Court’s determination further is reinforced, inter alia, by the fact that 

taxpayers were allowed to convert the C-group term policies to individual 

C-group conversion UL policies even though none of the five required 

conditions for conversion were present, see Supp. App. at 106, 111-12, 

and by the fact that the amount of life insurance taken on the Lakewood 

principals did not correspond to the amount of benefits for which they 

were eligible under the plan documents. See, e.g., App. at 389, 400-03 

(Dr. Hirshkowitz had C-group certificates on his life for over a million 

dollars even though he was eligible for life benefits of less than $500,000 

-- 2.5 times his 1991 compensation of $181,199.09). Moreover, even 

under the economic substance doctrine taxpayers would be hard-pressed 

to argue that the transactions involving the excess term life insurance 

payments had sufficient economic substance to be respected for tax 

purposes. 

13. See Br. of Appellants at 29-36 (citing Gruber v. Hubbard Bert Karle 

Weber, Inc., 159 F.3d 780 (3d Cir. 1998); Haberern v. Kaupp Vascular 

Surgeons Ltd. Defined Benefit Pension Plan, 24 F.3d 1491 (3d Cir. 1994); 

Schoonejongen v. Curtiss-Wright Corp., 18 F.3d 1034 (3d Cir. 1994); 

Henglein v. Informal Plan for Plant Shutdown Benefits, 974 F.2d 391 (3d 

Cir. 1992)). 

 16 

 

ERISA benefits between private parties, not disputes over 

tax liabilities between private parties and the 

Commissioner. While the cases lay out certain principles for 

determining rights and obligations under an ERISA plan, 

including the standard contract theory that the literal 

terms of a plan document must guide all analysis, the 

cases say nothing about the proper evidentiary protocol for 

evaluating the tax ramifications of an employer benefit 

plan. In sum, we have no intention of importing ERISA 

principles into this tax dispute. 

Moreover, we reject taxpayers’ contention that the Tax 

Court erred by not limiting its evaluation to the plan 

documents in light of state insurance law. The court did 

not construe or interpret the terms of the individual 

taxpayers’ life insurance policies, but rather characterized 
the contributions made towards those policies for purposes 

of determining tax liabilities. While the former endeavor 

indeed would implicate state law,14 the latter is singularly a 

question of federal law. See, e.g., Thomas Flexible Coupling 

Co. v. Comm’r, 158 F.3d 828, 830 (3d Cir. 1946). 

In view of our conclusion that the contributions in 

dispute were not ordinary and necessary business expenses 

under I.R.C. S 162(a), we next consider whether the district 

court erred in determining that the contributions 

constituted dividends rather than compensation to the 

individual taxpayers and thus deductible to the 

corporations on that basis.15 Under I.R.C. S 316(a), a 

dividend is a distribution of property made by a corporation 

to its shareholders out of its earnings and profits. See 

Comm’r v. Makransky, 321 F.2d 598, 601-03 (3d Cir. 1963). 

_________________________________________________________________ 

14. Curiously, taxpayers fail to specify which state’s insurance law 

applies: New Jersey, where all of the physicians reside, or Pennsylvania, 

where the insurance agents who promoted the VEBA were located. 

15. In their brief, taxpayers indicate that the Tax Court erred in 

characterizing the "disallowed contributions as constructive dividends 

rather than deductible compensation." Br. at 46 (emphasis added). See 

King’s Ct. Mobile Home Park, Inc. v. Comm’r, 98 T.C. 511, 512 (1992) 

("The first question is whether the diversion of $58,365 of petitioner’s 

income by its controlling shareholder for personal use constitutes the 

payment of deductible wages or the distribution of a dividend.") (footnote 

omitted). 

 17 

 

Dividends are taxed as a component of gross income. See 

I.R.C. S 61(a)(7). A shareholder, even if the corporation has 

dispensed with the formalities of declaration, may be 

charged with a disguised or constructive dividend if the 

corporation confers a direct benefit on him from available 

earnings and profits without expectation of repayment. See, 

e.g., Crosby v. United States, 496 F.2d 1388-89 (5th Cir. 

1974); Noble v. Comm’r, 368 F.2d 439, 443 (9th Cir. 1966); 

see also Magnon v. Comm’r, 73 T.C. 980, 993-94 (1980) 

("Where a corporation confers an economic benefit on a 

shareholder without the expectation of repayment, that 

benefit becomes a constructive dividend, taxable to the 

shareholder, even though neither the corporation nor the 

shareholder intended a dividend."). 

In this case, the record fully supports the conclusion of 

the Tax Court that the individual taxpayers were chargeable 

with constructive dividends. Indeed, Neonatology and 

Lakewood, by design surrendering any expectation of 

remuneration, purchased products that generated a 

considerable economic bounty for their shareholders in the 

form of conversion credits. Furthermore, nothing in the 

record illustrates that taxpayers diverted these corporate 

assets with the requisite "compensatory intent." See King’s 

Ct. Mobile Home Park, Inc. v. Comm’r, 98 T.C. 511, 514-15 

(1992) (business expense may be deducted as 
compensation only if the payor intends at the time that the 

payment is made to compensate the recipient for services 

performed).16 Moreover, support for a conclusion, though 

certainly not dispositive, that the excess contributions were 

not paid as compensation for services rendered is supplied 

by the fact that the Neonatology and Lakewood plans were 

made available only to those individuals who owned the 

corporations and not to their non-equity employees. 

Furthermore, Dr. Mall directed Neonatology to purchase the 

C-group product on her husband, a non-employee thirdparty who did not perform any services for the corporation.17 

_________________________________________________________________ 

16. To qualify as deductible compensation, a payment also need be 

reasonable. See Treas. Reg. S 1.162-7(a). We do not need to address this 

point, as the Tax Court correctly determined as a matter of fact that 

taxpayers did not demonstrate compensatory intent. 

17. We are satisfied that the mere fact that Dr. Mall partially diverted the 

benefits to her husband should not change our result. 

 18 

 

In the circumstances, it is therefore not surprising that Dr. 

Desai at trial made the matter-of-fact statement that the 

money contributed by Lakewood to fund insurance 

premiums and conversion credits is "our money. It’s not 

Lakewood[‘s]." App. at 1055. 

Taxpayers again rely on non-tax ERISA jurisprudence for 

the exaggerated proposition that payments made pursuant 

to an employee benefit plan are necessarily compensatory.18 

However, the plain language of I.R.C. S 419(a)(2) explicitly 

contemplates situations where contributions paid or 

accrued by an employer to a welfare benefit fund are not 

deductible (deductions allowed only if "they would 

otherwise be deductible"); see also Treas. Reg. S 1.162-10(a) 

(contributions to employee benefit plans deductible only if 

"they are ordinary and necessary business expenses."). To 

read otherwise inexplicably creates a shelter loophole by 

allowing taxpayers to transform disbursements into 

deductible business expenses merely by funneling them 

through an ERISA plan. 

We recognize that it is axiomatic that taxpayers lawfully 

may arrange their affairs to keep taxes as low as possible.19 

Nevertheless, at the same time the law imposes certain 

threshold duties which a taxpayer may not shirk simply by 

manipulating figures or maneuvering assets to conceal their 

real character. See Court Holding Co., 324 U.S. at 334, 65 

S.Ct. at 708 ("[t]o permit the true nature of a transaction to 

be disguised by mere formalisms . . . would seriously 

impair the effective administration of the tax policies of 

Congress."); see also Saviano v. Comm’r, 765 F.2d 643, 654 

(7th Cir. 1985) ("The freedom to arrange one’s affairs to 

minimize taxes does not include the right to engage in 

_________________________________________________________________ 

18. Taxpayers misread Pediatric Surgical Assoc., P.C. v. Comm’r, 81 
T.C.M. (CCH) 1474, 1479 (2001), for the proposition that anything paid 

by a corporation for an employee’s benefit is presumed legally to be 

compensation. Rather, Pediatric Surgical clearly iterates that intent to 

pay compensation "is a factual question to be decided on the basis of the 

particular facts and circumstances of the case." Id. at 1480. 

19. See Gregory v. Helvering, 293 U.S. 465, 469, 55 S.Ct. 266, 267 

(1935) ("The legal right of a taxpayer to decrease the amount of what 

otherwise would be his taxes, or altogether avoid them, by means which 

the law permits, cannot be doubted."). 

 19 

 

financial fantasies with the expectation that the Internal 

Revenue Service will play along."). Thus, we conclude that 

the Tax Court correctly held that the inflated premiums 

were not allowable corporate business expenses but rather 

allocations in the nature of dividends and thusly taxable. 

B. The Penalties 

Finally, we must consider the aptness of the penalties 

assessed by the Commissioner and upheld by the Tax 

Court. The Internal Revenue Code imposes a 20% tax on 

the portion of an underpayment attributable, among other 

things, to negligence or the disregard of rules and 

regulations. I.R.C. SS 6662(a) and (b)(1)."Negligence" can 

include any failure to make a reasonable attempt to comply 

with the provisions of the Code, to exercise ordinary and 

reasonable care in the preparation of a tax return, to keep 

adequate books and records, or to substantiate items 

properly. I.R.C. S 6662(c); Treas. Reg. S 1.6662-3(b)(1). 

Generally speaking, the negligence standard as in the tort 

context is objective, requiring a finding of a lack of due care 

or a failure to do what a reasonable and prudent person 

would do under analogous circumstances. See, e.g., Schrum 

v. Comm’r, 33 F.3d 426, 437 (4th Cir. 1994). 

On the basis of the record, the Tax Court was justified in 

concluding as a matter of fact that the individual taxpayers 

were liable for the section 6662 accuracy-related penalties 

because they did not meet their burden of proving due care. 

See Hayden v. Comm’r, 204 F.3d 772, 775 (7th Cir. 2000) 

(the Commissioner’s determination of negligence is 

presumed to be correct, and the taxpayer has the burden of 

proving that the penalties are erroneous); accord Pahl v. 

Comm’r, 150 F.3d 1124, 1131 (9th Cir. 1998) (burden of 

disproving negligence on taxpayer); Goldman v. Comm’r, 39 

F.3d 402, 407 (2d Cir. 1994) (once the Commissioner 

determines that a negligence penalty is appropriate, the 

taxpayer bears the burden of establishing the absence of 

negligence). The physician-owners caused their 

corporations to overpay considerably for term life insurance 

knowing that the money could be rerouted circuitously to 

their personal coffers with a net tax savings. Yet, 

notwithstanding the extraordinary financial implications of 

the SC VEBA arrangement, the individual taxpayers did not 

 20 
 

make a proper investigation or exercise due diligence to 

verify the program’s tax legitimacy. See David v. Comm’r, 43 

F.3d 788, 789-90 (2d Cir. 1995); see also Pasternak v. 

Comm’r, 990 F.2d 893, 903 (6th Cir. 1993) (holding that a 

reasonably prudent person should investigate claims when 

they are likely "too good to be true") (quoting McCrary v. 

Comm’r, 92 T.C. 827, 850 (1989)). 

Taxpayers argue that their negligence should have been 

excused because they relied on the advice of professionals. 

While it is true that actual reliance on the tax advice of an 

independent, competent professional may negate a finding 

of negligence, see, e.g., United States v. Boyle, 469 U.S. 

241, 250, 105 S.Ct. 687, 692 (1985), the reliance itself 

must be objectively reasonable in the sense that the 

taxpayer supplied the professional with all the necessary 

information to assess the tax matter and that the 

professional himself does not suffer from a conflict of 

interest or lack of expertise that the taxpayer knew of or 

should have known about. See Treas. Reg.S 1.6664-4(c); 

Ellwest Stereo Theatres, Inc. v. Comm’r, T.C. Memo. 1995- 

610, 70 T.C.M. (C.C.H.) 1655; see also Zfass v. Comm’r, 

118 F.3d 184, 189 (4th Cir. 1997). 

The Tax Court concluded that taxpayers could not prevail 

on a reliance-on-professional defense because they received 

advice only from Cohen, an insurance agent who stood to 

profit considerably from the participation of Neonatology 

and Lakewood in the VEBA program, rather than from a 

competent, independent tax professional with sufficient 

expertise to warrant reliance. The circumstances here, 

including the facts that certified public accountants 

prepared taxpayers’ returns, the New Jersey Medical 

Society -- a group with dubious tax code proficiency which 

in fact received royalties to endorse the SC VEBA 20 -- 

purportedly endorsed the program, and the engagement 

agreement between PES and the employers stated that PES 

would submit the trust to the IRS for qualification, 21 do not 

_________________________________________________________________ 

20. See App. at 570-71. 

21. Notably, the agreement does not say that the IRS did qualify the 

plan. In fact, as the government points out, the IRS expressly disavowed 

any opinion as to whether contributions to the plan were deductible. See 

App. at 1410. 

 21 

 

suffice for us to disturb the Tax Court’s negligence finding 

on a clear error basis. See Merino v. Comm’r, 196 F.3d 147, 

154 (3d Cir. 1999). 

In reaching our result, we acknowledge that Dr. 

Hirshkowitz deviated from the thoroughly head-in-the-sand 

posture of his fellow taxpayers by soliciting his 

accountant’s opinion of the SC VEBA. See App. at 6666-67. 
Nevertheless, the record supports the court’s finding with 

respect to Dr. Hirshkowitz, considering that he did not 

introduce into evidence precisely what information he 

showed to his accountant, precisely what advice his 

accountant gave him, and, more generally, the 

qualifications of his accountant. 

We also add the following. When, as here, a taxpayer is 

presented with what would appear to be a fabulous 

opportunity to avoid tax obligations, he should recognize 

that he proceeds at his own peril. In this case, PES devised 

a program which it marketed as "creat[ing] a tax deduction 

for the contributions to the employee welfare benefit plan 

going in and a permanent tax deferral coming out." As 

highly educated professionals, the individual taxpayers 

should have recognized that it was not likely that by 

complex manipulation they could obtain large deductions 

for their corporations and tax free income for themselves.22 

In a final attempt to skirt the additional penalties, 

taxpayers argue that a finding of negligence could not in 

fairness arise out of a case resolving tax issues of first 

impression. In this regard, we point out that the parties 

have indicated that this case is indeed without direct 

precedent and that other cases are awaiting our disposition.23 

_________________________________________________________________ 

22. It well may be that reliance on the advice of a professional should 

only be a defense when the professional’s fees are not dependent on his 

opinion. For example, it is not immediately evident why a taxpayer 

should be able to take comfort in the advice of a professional promoting 

a tax shelter for a fee. After all, that professional would have an interest 

in his opinion. Consideration of this point, however, will have to wait for 

another day. 

23. The Tax Court observed that this case is a test case with the result 

resolving other cases involving SC VEBA and NJ VEBA plans and that 

the parties in 19 other cases pending before the Tax Court have agreed 

to be bound by the decision here. See Neonatology, 115 T.C. at 44. 

 22 

 

This argument, however, does not sway us for this case 

does not involve novel questions of law but rather is 

concerned with the application of well-settled principles of 

taxation to determine whether certain expenditures made 

by close corporations are deductible as ordinary and 

necessary business expenses or taxable as constructive 

dividends. While the setting in which these principles have 

come to bear is no doubt unusual with its VEBAs, C-group 

policies, and conversion credits, the law was nevertheless 

pellucid that taxpayers should have endeavored to verify 

the validity of their deductions before claiming them.24 

Moreover, they should have been apprehensive when they 

examined the scheme, for experience shows that when 

something seems too good to be true that probably is the 

case. Overall, we are satisfied that taxpayers now must 

abide the consequences of the Commissioner’s audit as 

sustained by the Tax Court, including the finding of liability 
for accuracy-related penalties under section 6662. 

IV. CONCLUSION 

For the foregoing reasons, we will affirm the decisions of 

the Tax Court. 

A True Copy: 

Teste: 

 Clerk of the United States Court of Appeals 

 for the Third Circuit 

_________________________________________________________________ 

24. We recognize that courts have overlooked negligence penalties in 

cases of first impression that involve unclear statutory language. See, 

e.g., Mitchell v. Comm’r, T.C. Memo. 2000-145, 79 T.C.M. (C.C.H.) 1954 

(recognizing exception in a case of first impression involving the unclear 

application of an amendment to the Internal Revenue Code); Hitchins v. 

Comm’r, 103 T.C. 711, 720 (1994) (first impression exception applies to 

issue not previously considered by the court where the statutory 

language is not entirely clear). But nothing in this case hinges on the 

interpretation of vague statutory text. 

 23