TAX COURT OPINION

Case: Dante & Sandi Perano
Docket Number: 5543-06
Judge: Halpern
Opinion Type: reported
Filed: 05/07/2008
Pages: 15

SERVIC E FILE S 130 T . C . No . 8 UNITED STATES TAX C UR T DANTE AND SANDI PERANO , Petitioners v . COMMISSIONER OF INTERNAL REVENJE, Responden t Docket No . 5543-06 . Fled May 7, 2008 . In 1994 and 1996, Ps, the sole shareholders of AG, a controlled foreign corporation as defined in sec . 957, I .R .C ., transferred to AG United States real property and notes secured by such property in exchange for private annuity agreements that provided for the future payment of monthly annuities to Ps for their remaining joint lives . For 1994-2001, AG accrued liabilities with respect to those agreements in amounts that, for 2001, exceeded income and cumulatively, exceeded accumulated earnings and profits as of Dec . 31, 2001 . Relying upon sec . 953, I R .C ., and the regulations thereunder, Ps treated hose accruals as in the nature of life insurance reserves, which reduce earnings and profits, thereby causing Ps not to report income from AG for 2001 under sec . 51(a)(1), I .R .C . See secs . 952(c), 956(b)(1), I .R .C . 1 . Held : Because the transac ions that gave rise to the private annuity agreements c nstituted capital expenditures by AG and because AG's accruals under those agreements constituted reserves for future contingencies, those accruals did n t reduce AG's earnings and profits . SERVED MAY - 7 2008 - 2 - 2 . Held , further , because AG was neither in the insurance business nor in receipt of insurance income, sec . 953, I .R .C ., is inapplicable to AG . 3 . Held , further , Ps improperly failed to report income from AG for 2001 under sec . 951(a)(1), I .R .C . Francis X . Mohan III , for petitioners . Christian A . Speck , for respondent . OPINIO N HALPERN, Judge : By notice of deficiency dated December 22, 2005, respondent determined deficiencies in petitioners' Federal income taxes of $203,939 and $70,815 for 2001 and 2002 , respectively, and accuracy-related penalties of $40,788 and $14,163 for those years, respectively . Unless otherwise indicated, all section references are to the Internal Revenue Code for the years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure . After concessions, the only issue for decision is whether accruals for the future payment of annuities made by a controlled foreign corporation (CFC), as that term is defined in section 957, reduced that CFC's earnings and profits available for the payment of dividends to shareholders . The parties stipulate that, if the Court agrees with respondent that the accruals did not reduce the CFC's earnings and profits, then petitioners must include as items of gross income for 2001 (1) $64,682 under section 951(a)(1)(A), and (2) $392,109 under sections - 3 - 951 (a) (1) (B) and 956 ; 1 and, conversely if the Court agrees wit h petitioners that the accruals did reduce he CFC's earnings an d profits, then petitioners are not require to include any amounts in gross income under the foregoing prov i ions . ' Background This case was submitted fully stipul ted under Rule 122 . The facts stipulated by the parties are s found . The stipulation of facts, with accompanying e hibits, is incorporated herein by this reference . At the time t petition was filed, petitioners resided in the State of Neva a . The following is a summary of the f cts necessary for our discussion . American General Ltd . (American Gen ral) is a corporation formed in the Isle of Man in October 199 . From its incorporation through 2001, 100 percent f the stock of American General was owned by a fiduciary pursuan to an irrevocable trus t 1 Those provisions are part of sub ch . 1, subtit . A of the Internal Revenue Pursuant to those provisions and sec . 95 "United States shareholder"), each Unite controlled foreign corporation (CFC) inc his pro rata share of the CFC's (1) subp in sec . 952) and (2) earnings invested i (as determined under sec . 956) . t . F, pt . III, subch . N , Code (subpt . F) . (b) (defining the term States shareholder of a udes in his gross incom e F income (as defined United States propert y 2 The stipulation actually describ s the issue as whether the CFC properly accrued the future annuity expenses ; but, as discussed infra , it is clear that the issue for decision is more accurately described as whether those accruals reduced the CFC's earnings and profits . (Pursuant to sec . 952(c), income inclusions under sec . 951(a)(1)(A) may of exceed a CFC's earnings and profits for the taxable ye r, and, pursuant to sec . 956(a)(2), income inclusions under sec . 951(a) (1) (B) may not exceed a CFC's "applicable earnings" ; i .e ., its current or accumulated earnings and profits . See ec . (cid:127)956(b)(1) .) - 4 - agreement . For Federal income tax purposes, however, the parties stipulate that "the tax effects are to be treated as though * * * [American General] was owned by petitioners ." At all relevant times, American General (1) was a CFC, and (2) was not regulated as an insurance company under the laws of the Isle of Man, the United States, or any State thereof . On each of American General's Forms 1120-F, U .S . Income Tax Return of a Foreign Corporation,, in evidence, it listed the United States as its principal business location and "Rental and Sales" of "Real Estate" as its " [b]usiness activity" an d " [p]roduct or service" . On March 31 and October 31, 1994, petitioners transferred real property located in Texas to American General in exchange for private annuity agreements (annuity agreements 1 & 2) . On January 1, 1996, petitioners transferred promissory notes secured by real property located in Texas to American General also in exchange for a private annuity agreement (annuity agreement 3) . The annuities payable to petitioners under the annuity agreements (collectively, the annuity agreements) are payable monthly for petitioners' joint lives . The payments are to commence no earlier than April 30, 2006, in the case of annuity agreement 1, November 30, 2010, in the case of annuity agreement 2, and February 1, 2011, in the case of annuity agreement 3 . Under each of the annuity agreements, American General may defer the payment commencement date for up to 5 years . American General's obligation to make annuity payments to petitioners under the - 5 - annuity agreements terminates upon the de th of the survivor, irrespective of the number of payments ma e to that point or whether any payments at all have been mad to either petitioner . American General keeps its books and records on the accrual method of accounting . With respect to each of the annuity agreements, it recorded a liability in t e amount stated in the agreement as the fair market value of th property received in exchange for the agreement . It recorded liabilities in the following amounts : Agreement Amoun t Annuity agreement 1 Annuity agreement 2 Annuity agreement 3 $493,20 0 582,50 0 353,35 5 For the years 1994 through 2001, Am rican General accrue d annuity expenses with respect to the an n ity agreements a s liabilities on its books and records i n he aggregate amount o f $949,119, as follows : Year 1994 1995 1996 1997 1998 1999 2000 2001 Total Amoun t $32,02 1 84,10 3 114,66 5 123,43 1 132,79 7 142,88 5 153,75 6 165,46 1 949,119 - 6 - On the Form 5471, Information Return of U .S . Persons With Respect To Certain Foreign Corporations, attached to petitioners' 2001 Form 1040, U .S . Individual Income Tax Return, petitioners reported negative current and accumulated earnings and profits for American General of $100,779 and $492,328, respectively . For 2001, if the $165,461 accrued for that year for deferred annuities is disregarded, American General would have positive current earnings and profits of $64,682, and, if the $949,119 total accruals for deferred annuities through December 31, 2001, are disregarded, American General would have positive accumulated earnings and profits of $456,791 . 3 American General's average investment in United States property at the end of each quarter in 2001 was $1,360,567 . I . Introductio n Discussio n On two occasions in 1994, petitioners transferred real property to American General, and, on one occasion in 1996, petitioners transferred promissory notes secured by real property to American General . On none of those occasions did American General pay anything immediately for the property it received (the property or properties) . Instead, on each occasion, American General promised to pay for the property by makin g 3 As noted su ra, the parties agree that, if the accruals for deferred annuity payments are disregarded for purposes of determining American General's earnings and profits, petitioners' 2001 income would then include $64,682 of subpt . F income under sec . 951(a)(1)(A) and $392,109 ($456,791 minus $64,682) representing earnings invested in United States property taxable under secs . 951(a) (1) (B) and 956 . - 7 - deferred payments commencing from 12 to 16 years in the future and lasting (if they still survived) fo the lives o f petitioners . The terms of those promis s are manifest in what we have described as annuity agreements 1, 2, and 3 . Recognizing that the present value of its obligatio to make the annuit y payments promised would increase every ear until the annuit y starting dates, American General accrue as an annual expense an addition to an accounting reserve to re lect that increase . We must determine whether those accruals w re a proper charge t o American General's earnings and profits We conclude that the y were not . II . Analysi s A . Introductio n Petitioners summarize their a gument as follows : Petitioners believe that its American General's] accrued annuity expense constitute liquidate its future obligation an Section 953 and the regulations th for estimated expenses for purpose current and accumulated E&P . a reserve t o is allowable under reunder as a reserve of calculating it s Section 953 defines the term "insu~ ance income" for purposes of determining a CFC's subpart F income . See sec . 952(a)(1) . If it were not for petitioners' claim that section 953 applies , their argument that American General pro erly reduced its earnings and profits on account of annua accruals for additions to a reserve reflecting its obligation t make annuity payment s pursuant to the annuity agreements could be disposed of in short order . Generally, annuity payments made for property ar e considered payments made to purchase thel,property . E .g ., Perkins 8 - v . United States , 701 F .2d 771, 775 (9th Cir . 1983) . The payments constitute capital expenditures, which are not deductible, sec . 263(a)(1), regardless of the number of payments made or the total amount to be paid, Perkins v . United States , supra at 775 . The payments give the taxpayer 'a cost basis in the acquired property, sec . 1012, and the taxpayer recovers his investment in the property by way of deductions for depreciation, sec . 167(a), or by way of an offset of any unrecovered basis against the amount realized on a sale or disposition of the property, sec . 1001(a) . "Earnings and profits" is a tax concept that generally relates to the determination of whether a distribution from a corporation to its shareholders is properly treated as a dividend or a return of capital . See secs . 301(c), 316(a) ; Henry C . Beck Co . v . Commissioner , 52 T .C . 1, 6 (1969), affd . per curiam 433 F .2d 309 (5th Cir . 1970) . Capital expenditures do not reduce earnings and profits . Pa . Forge Corp . v . Commissioner , a Memorandum opinion of this Court dated Sept . 6, 1943 ("the accrued interest * * * represented capital expenditures and was not a proper charge against petitioner's earnings and profits") ; Patty v . Commissioner , a Memorandum Opinion of the Board of Tax Appeals dated May 27, 1936 ("Organization expenses are capital expenditures * * * and, therefore, they are not to be considered in determining the earnings or profits available for distribution . i4), revd . on other ground 98 F .2d 717 (2d Cir . - 9 - 1938) . 5 Moreover, even if annuity payment s do not have to b e capitalized, the obligation to commenc e life annuity payments i n the future is contingent and for that r ason does not reduc e earnings and profits absent a special e ception like tha t applicable to life insurance reserves . See Dean v . Commissioner , 9 T .C . 256, 266 (1947) (reserves for c o tingent future expense s do not reduce earnings and profits), f d . 187 F .2d 1019 (3d Cir . 1951) . Professors Bittker and Eustice , in their treatise , Federal Income Taxation of Corporations and Shareholders, poin t out that, in determining whether a dist ibution to shareholder s constitutes a taxable dividend, referen e is made to the distributing corporation's earnings and profits rather tha n to its surplus, in part because surplus, u like earnings and profits, is reduced by reserves for contingencies . Bittker & Eustice, Federal Income Taxation of Corporations an d 4 This result is consistent with se denies 5-year amortization of such expen for purposes of determining a corporati o c . 312 (n) (3) , which litures under sec . 24 8 s earnings and profits . 5 Not permitting capital expenditu~ and profits is justified on the ground tY accomplish a mere change in the form of profits' should then be affected only th i account ." Paul, "Ascertainment of 'Earn Purpose of Determining Taxability of Cor Harv . L . Rev . 40, 45 n .18 (1937) . es to reduce earning s at "capital expenditures ssets, and 'earnings or ough the depreciation ngs or Profits' For orate Distributions", 51 - 10 - Shareholders, par . 8 .03[2], at 8-20 (7th ed . 2000) . The authors describe the problem thus : If these reserves were taken into account, the floodgates would be opened to a stream of tax-free cash distributions for as long as the corporation's directors could conjure up contingencies that would warrant the creation of reserves . It is not surprising, therefore, that accounting surplus was rejected as a criterion and that the phrase "earnings and profits" acquired a meaning more in keeping with its function . [ Id . ] We shall now turn to petitioners' section 953 argument . B . Section 953 Argumen t Life insurance companies are subject to income taxation pursuant to part I, subchapter L, chapter 1, subtitle A of the Internal Revenue Code (part I and subchapter L, respectively) . Part I comprises sections 801 through 818 . For a life insurance company to be taxable pursuant to part I, the company must first be an insurance company within the meaning of section 816(a) . In pertinent part, section 816(a) provides : "the term 'insurance company' means any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts" . A life insurance company includes in its gross income premiums and other consideration received on annuity contracts . See sec . 803(a)(1)(A) . In determining its taxable income, it deducts additions to reserves set aside to pay claims arising under annuity contracts . See secs . 804(a)(1), 805(a)(2), 807(b), (c)(1), 816(b) . Therefore, it reduces its earnings and profits on account of those reserve additions . See sec . 1 .312- 6(a), Income Tax Regs . (providing, in pertinent part, that "the - 11 - amount of the earnings and profits in a y case will be dependent upon the method of accounting properly mployed in computing taxable income") . On brief, petitioners concede that American General is not an insurance company : "Respondent is c rrect in pointing out that[,] as a real estate company, Ameri an General is not an Insurance Company ." They argue, howeve , that that does not matter : "American General * * * [does of need to be an insurance company in the business of se ling insurance] in order to reduce * * * [earnings and profits] y the future annuity obligations ." They rely on section 953, which, in pertinent part, provides : SEC . 953 . INSURANCE INCOME . (a) Insurance Income .-- (1) In general .--For purposes of section 952(a)(1), [which provides that "subpart F income" includes "insurance income"] the term "insurance income" means any income which-- (A) is attributable o the issuing (or reinsuring) of an insuran e or annuity contract, and (B) would * * * [subject to certain modifications] be taxed * * * [as if] such income were the income of a domestic insurance company . As we understand it, the essence of petitioners' argument is that, on account of entering into the annuity agreements, American General had insurance income wi hin the meaning of section 953(a)(1), which allows it to ac rue additions to reserves, and reduce its earnings and pr fits, in anticipation of - 12 - making the annuity payments called for by those agreements, notwithstanding that it is not an insurance company . ' To support their argument, petitioners rely on regulations proposed under section 953 . Proposed regulations are accorded little, if any, deference . Estate of Ratliff v . Commissioner , 101 T .C . 276, 278 (1993) . In any event, those propose d regulations weaken, rather than support, petitioners' argument . Section 1 .953-6(a), Proposed Income Tax Regs ., 56 Fed . Reg . 15560 (April 17, 1991), deals with the applicability of subchapter L to CFCs . In pertinent part, subparagraph (1) of that section provides the following general rule : "A controlled foreign corporation which has insurance income under section 95 3 shall compute its insurance income * * * under part I of subchapter L" . (Emphasis added .) Section 1 .953-6(f), Proposed Income Tax Regs ., 56 Fed . Reg . 15561 (April 17, 1991), deals with CFCs that, if they were domestic corporations, would not qualify to be taxed under subchapter L as insurance companies . In pertinent part, subparagraph (1) of that proposed regulation provides : A controlled foreign corporation will compute its insurance income as if it were a domestic insurance company subject to part I of subchapter L (relating to life insurance companies) only if it can meet the requirements of section 816(a) of the Code taking into account only that portion of its business whic h 6 Petitioners also acknowledge that "American General's obligation to make annuity payments may not qualify as a deductible expense for tax reporting purposes" . Nonetheless, they insist that that obligation "does constitute a reduction of * * * [earnings and profits] ." - 13 - involves the issuing or reinsuring annuity contracts . [Emphasis adde of insurance or . ] Petitioners' first difficulty in f nding support in th e proposed regulations is that they have ailed to prove tha t American General's business was to any xtent the business o f issuing insurance or annuity contracts . The issuance o f insurance, to include annuities, requir s risk shifting and ris k distribution . See Helvering v . Le Gier$e , 312 U .S . 531, 53 9 (1941) ; Wright v . Commissioner , T .C . Me 0 1993-328 ("The amount s in the annuities did not constitute ins rance because no risk shifting or risk distribution occurred .'), modified per order (Oct . 29, 1993), affd . without publishe opinion 73 F .3d 372 (9t h Cir . 1995) . In the case of the annuity agreements, there was no risk distribution (i .e ., the pooling of ossible annuity termination dates) among a broad number f individuals . American General's mortality risk was spread betw en the lives of only two individuals ; viz, petitioners . We said 'n Amerco & Subs . v . Commissioner , 96 T .C . 18, 41 (1991), aff . 979 F .2d 162 (9th Cir . 1992) : "The concept of risk-distributin emphasizes the pooling aspect of insurance : that it is the natu e of an insurance contract to be part of a larger collecti n of coverages, combined to distribute risk between insureds ." M reover, respondent argues that there was no risk shifting ( ne party shifting the risk of a loss to another party), since etitioners are the owners, at least for tax purposes, of Am rican General . To find that there was no insurance, it is sufficient that we find that - 14 - there was no risk distribution, which we do find . It is not necessary that we consider whether there was risk shifting . Even were we to put aside petitioners' failure to prove that American General was in the insurance business, they have failed to prove that American General realized any income in connection with the annuity agreements . American General received the property in exchange for those agreements . On its books and records, it accounted for the obligations imposed on it by the annuity agreements as liabilities . Petitioners do not claim that they reported premium income, or, indeed, any income, as a result of incurring those obligations . ' Petitioners have failed to prove that American General received insurance income within the meaning of section 952(a)(1) . American General does not fall within the ambit of the rules of part I, allowing life insurance companies to deduct additions to reserves set aside to pay claims arising under annuity contracts, nor can it reduce its earnings and profits as a life insurance company could on account of those contingent claims . ' In fact, there is nothing in the record to indicate that American General reported any income other than income from real estate (i .e ., sales income, rentals, and mortgage interest) . III . Conclusion - 15 - Because American General's accrual s for the future paymen t of annuities to petitioners did not re ice its earnings and profits, respondent's adjustments incre sing petitioners' 2001 income under section 951(a)(1) are sust fined . Decision will be entere d under Rule 155 .