t c memo united_states tax_court john j machacek jr and marianne machacek petitioners v commissioner of internal revenue respondent brenda s jones petitioner v commissioner of internal revenue respondent docket nos filed date allen james white for petitioners angela b reynolds david weiner and kathryn e kelly for respondent memorandum opinion laro judge these cases arise out of petitioners’ participation in the sterling benefit plan sbp a purported welfare_benefit_plan consisting of the respective separate plans that each participating employer customizes to apply for its employees alone these cases were consolidated for trial briefing and opinion and were submitted fully stipulated under rule respondent determined deficiencies in petitioners’ federal_income_tax for tax years and as follows machaceks docket no year deficiency sec_6662 accuracy-related_penalty dollar_figure big_number dollar_figure big_number brenda s jones docket no year deficiency accuracy-related_penalty sec_6662 dollar_figure big_number we decide the following issues dollar_figure big_number whether john j machacek jr inc ’s machacek inc and adstracts inc ’s adstracts participation in the sbp constitutes a nonqualified_deferred_compensation arrangement under sec_402 we hold that it does unless otherwise indicated section references are to the internal_revenue_code code applicable to the relevant years rule references are to the tax_court rules_of_practice and procedure we round dollar amounts to the nearest dollar whether the life_insurance_policy purchased by the sbp on the life of john machacek was a part of a compensatory split-dollar_life_insurance arrangement by reason of material modification after date we hold that it was whether ms jones must include in her gross_income any vested accrued_benefits in the sbp pursuant to sec_402 because the adstracts plan failed to cover any eligible non-highly compensated employees with respect to the and tax years we hold that she must whether the machaceks must include in gross_income the economic benefit from participation in a compensatory split-dollar_life_insurance arrangement and vested accrued_benefits in the sbp pursuant to sec_402 for tax years and we hold that they must whether machacek inc may deduct the dollar_figure contribution it paid to the sbp for the tax_year we hold that it may not whether petitioners are liable for the accuracy-related_penalty under sec_6662 for all the years at issue we hold that they are i overview background the parties submitted the cases fully stipulated under rule the stipulations of fact and the facts drawn from stipulated exhibits are incorporated herein the case at docket no is appealable to the court_of_appeals for the sixth circuit absent stipulation of the parties to the contrary the case at docket no is appealable to the court_of_appeals for the fourth circuit absent stipulation of the parties to the contrary ii sbp we have previously described the operation of the sbp in our opinion in our country home enters inc v commissioner t c __ __ slip op pincite- date and we incorporate the facts related to the sbp operation as found therein we briefly reiterate certain relevant facts ronald snyder an attorney and certified_public_accountant together with his colleagues established the sbp in date as a way for employers to fund and pay pension benefits in excess of what was allowed under traditional pension plans in the and tax years the sbp’s trustee was fifth third bank of florida the sbp ostensibly operates as a single welfare_benefit_plan which is an aggregation of separate multiple single employer welfare_benefit plans under sec_419 the sbp offers to pay various benefits including death medical and disability benefits during a participating employee’s current employment and or retirement subject_to an employer-specific vesting schedule the sbp gave participating employers a lot of flexibility in selecting the extent of those benefits they wished to provide through the sbp as well as the general provisions applicable to the plan employee participation requirements and the vesting schedule for the benefits payable under the employer’s plan each employer determined the amount and the frequency of its payments to the sbp employees were allowed to make payments to the sbp if their employer allowed them and any such payment would be credited to the employee’s personal account that was maintained by the plan to fund the benefits under the plan the sbp purchased a variety of life_insurance products including individual and group policies cash_value policies and term policies in addition sometimes sbp held annuities to fund the benefits employers could direct the sbp as to what insurance policies they wanted to use to fund the benefits payable to employees each insurance_policy or annuity funded all of the benefits payable as to the specific employee covered by that policy in other words if there was no insurance_policy or an annuity in an employee’s name that employee would not be entitled to any benefits from the sbp a participating employee could designate the beneficiary or beneficiaries to receive the death_benefits payable under the sbp and the death_proceeds of any life_insurance_policy maintained on the life of the employee the amount of the death_benefit usually was the face_amount of the insurance_policy on the employee’s life and that benefit was payable in accordance with the terms of the insurance_policy an employee retiring from employment with the employer could elect to receive the paid-up life_insurance_policy in lieu of a retirement death_benefit an employer could at any time discontinue making payments to the sbp or terminate its participation after that all amounts credited to an employee’s personal account would become fully vested and the employer could not receive any refund if an employer stopped making payments to the sbp it could direct that the trustee either retain the plan assets for the employees pursuant to the provisions of the plan or transfer the plan assets to a successor trustee or retain the assets for the benefit of the employees however if an employer terminated its participation the administrator could distribute the assets in the employer’s plan to the participants or their beneficiaries as one of the options iii the machaceks and the sbp a the machaceks at the time of filing the petition petitioners john and marianne machacek were married and resided in ohio the machaceks had a son shawn machacek john and marianne machacek held and of the shares in machacek inc an s_corporation respectively the machaceks timely filed their federal_income_tax returns for the and tax years in and john machacek reported dollar_figure and dollar_figure respectively in compensation received from machacek inc marianne machacek received dollar_figure in and dollar_figure in in compensation from machacek inc machacek inc reported dollar_figure in life_insurance payments on john machacek’s life in both and on mr machacek’s forms w-2 wage and tax statement in addition shawn machacek received dollar_figure in and dollar_figure in in reported compensation from machacek inc shawn machacek’s form_w-2 for shows dollar_figure but we note that this is inconsistent with the sbp annual valuation report for which states that shawn machacek’s form_w-2 salary was dollar_figure b machacek inc and its participation in the sbp machacek inc adopted the sbp as of date initially machacek inc elected to provide its employees with preretirement group-term_life_insurance and postretirement group-term_life_insurance as of date machacek inc entered into a new adoption_agreement amending the terms of its participation in the sbp to add a preretirement health expense reimbursement account as a benefit to its employees machacek inc selected a normal_retirement_age of with years_of_service and an early retirement age of with years_of_service compensation_for purposes of the sbp would include only form_w-2 compensation from to the sbp used 10-year cliff_vesting which meant that an employee was not vested before years_of_service and became vested upon reaching this threshold in five of machacek inc ’s eight employees were eligible to participate in the sbp in five of machacek inc ’s seven employees were eligible to participate in the sbp however only three employees--john machacek shawn machacek and matthew beebe--ended up signing employee enrollment and election forms for said participation in and john machacek had over years_of_service and was fully vested under the sbp terms on date machacek inc contributed dollar_figure to the sbp on date machacek inc contributed dollar_figure and dollar_figure to the sbp machacek inc did not make any contributions to the sbp during tax_year machacek inc timely filed a form_1120s u s income_tax return for an s_corporation on its form_1120s machacek inc deducted dollar_figure for contributions paid to the sbp during the year c assets held in trust to fund sbp benefits fifth third bank of florida was the trustee for the sbp and for the machacek inc employee welfare_benefit plan’s trust formed under the sbp provisions machacek trust the parties stipulated that the machacek trust was not a voluntary employee beneficiary association under the provisions of sec_501 and was also not a grantor_trust fifth third bank of florida held the following assets in trust for the benefit of machacek inc employees a life_insurance_policy on the life of john machacek issued by indianapolis life life_insurance_policy or policy a life_insurance_policy in the name of william clymer clymer policy and a western reserve life assurance co annuity with john machacek as the annuitant william clymer was not an employee of machacek inc in and machacek annuity originally purchased in and transferred to fifth third bank of florida on date life_insurance policies fifth third bank of florida purchased the life_insurance_policy on date during the years at issue the annual premium for the policy was dollar_figure payable every months from the date_of_issue the policy provided that each premium must be paid on or by its due_date with a 31-day grace period during which the policy would stay in force the policy lapsed if the premium was not paid during the grace period but it could be reinstated during the life of the insured up to five years after it lapsed if the policy owner wanted to reinstate the policy after days from the grace period expiration the insured person would have to submit evidence of insurability including providing information about his or her medical history in and the face value of the policy was dollar_figure in the sbp failed to make a timely premium payment on the policy and it lapsed on date on date the sbp submitted an application_for reinstatement which included answers of john machacek regarding his medical history and insurability on date after the sbp made the premium payment the policy was reinstated in and the sbp made timely premium payments the cost of john machacek’s death_benefit was dollar_figure in and dollar_figure in in addition the machacek trust held the clymer policy which had no accumulation value the machacek trust did not own any other life_insurance policies on the lives of any other machacek inc employees annuity during the years at issue the machacek trust also held the machacek annuity in and the machacek trust paid the annual annuity fees by surrendering the necessary amounts from the machacek annuity as of date the cash_value of the annuity_contract was dollar_figure on date john machacek requested that the machacek trust use dollar_figure of the funds held in the annuity_contract to pay the premiums for the life_insurance_policy because machacek inc was not likely to be able to pay the premium out of pocket that year on date a net surrender of dollar_figure was made from the machacek annuity resulting in it having zero value as of date d annual valuations and allocation of economic benefit from to the postretirement and preretirement death_benefit payable under the life_insurance_policy on john machacek’s life was dollar_figure in and machacek inc contributed dollar_figure to the sbp which was used to fund the premiums for the life_insurance_policy in machacek inc did not pay any contributions to the plan instead the sbp received a surrender of the proceeds from the annuity and applied them as follows dollar_figure towards life_insurance_policy accumulation value and dollar_figure to the cash on deposit asset the table below summarizes the annual allocation of employer contributions to employee_benefits and accumulation value in the life_insurance_policy year employee_benefits life_insurance_policy allocation accumulation value dollar_figure big_number dollar_figure big_number big_number john machacek was fully vested under the terms of the sbp in and in and he would have been entitled to a preretirement or postretirement death_benefit of approximately dollar_figure the and annual valuations of the sbp for machacek inc did not reflect any allocation of contributions to a health expense reimbursement this amount is based on the formula in the sbp adoption_agreement which was based on employees’ form_w-2 compensation and a multiple of in and john machacek received compensation of dollar_figure and dollar_figure respectively from machacek inc arrangement or to postretirement medical benefits the sbp did not pay any medical benefits or health expense reimbursements during the and tax years iv brenda s jones and the sbp a brenda s jones at the time of filing the petition ms jones resided in raleigh north carolina robert jones and ernest jones were the sons of ms jones ms jones timely filed her and form sec_1040 u s individual_income_tax_return b adstracts and its participation in the sbp adstracts was a c_corporation wholly owned by ms jones during the years at issue adstracts adopted the sbp as of date through an adoption_agreement dated date ms jones signed the adoption_agreement on behalf of adstracts adstracts elected not to provide its employees with any benefits in and adstracts had and employees respectively both in and only employees were eligible to participate in the sbp but none of them signed employee enrollment and election forms with respect to the plan the adoption_agreement provides that adstracts elected to provide its employees with pre- and post-retirement group-term_life_insurance in the amount of annual compensation multiplied by according to the adoption_agreement an employee’s normal_retirement_age would be with years of participation and an employee’s early retirement age would be with years of participation during ms jones was fully vested in the account balance held by the sbp the parties stipulated that the trust for the sbp adopted by adstracts adstracts trust was not a voluntary employee beneficiary association under the provisions of sec_501 c assets held in trust to fund sbp benefits during the years at issue the only asset held by the adstracts trust was an annuity_contract with brenda jones as the annuitant adstracts annuity the annuity was originally purchased on date and as of date the owner and beneficiary of the adstracts annuity was the fifth third bank as trustee of the industry association inc employee_benefits trust a predecessor to the sbp d annual valuations and allocation of economic benefit on date the adstracts annuity had a value of dollar_figure on date the adstracts annuity had a value of dollar_figure adstracts made no contributions to the sbp in the and tax years the annual valuation of the sbp for adstracts did not allocate any contributions to employee_benefits in and the parties stipulated that ms jones was fully vested in the sbp benefits in tax_year as a shareholder of adstracts ms jones had full control_over vesting_schedules and participation requirements for the sbp at all relevant times discussion i overview respondent’s primary argument in these cases is that machacek inc ’s and adstracts’ respective sbps represented discriminatory deferred_compensation arrangements because they failed to provide benefits to anybody except the shareholder-employees and other highly compensated employees in addition in the machaceks’ case respondent argues that the machacek inc sbp is subject_to the split-dollar_life_insurance arrangement regulations although the machacek trust entered into a contract for the insurance_policy on the life of john machacek before date the effective date of sec_1_61-22 income_tax regs respondent argues that the regulation still applies because the lapse and reinstatement of the policy or in the alternative the modification of the sbp to provide for health expense reimbursement benefits constitutes a material modification under sec_1_61-22 income_tax regs we address these arguments in turn followed by discussions of the tax consequences of participation in the sbp to the machaceks and brenda jones and the issue of penalties ii machacek inc ’s and adstracts’ sbps as deferred_compensation arrangements a overview respondent argues that machacek inc ’s and adstracts’ participation in the sbp was a part of a compensatory arrangement whose sole purpose was to compensate selected employees rather than to provide welfare benefits for all of their employees and thus should be treated as payments to a nonqualified_deferred_compensation_plan under sec_402 petitioners in turn contend that this argument was made by the commissioner and rejected by the court in our country home enters inc v commissioner t c at __ slip op pincite thus petitioners urge us to apply only the split-dollar_life_insurance arrangement regulations in these consolidated cases petitioners’ position is flawed in several respects first the holdings of the opinion in our country home enters inc clearly indicate that the split-dollar_life_insurance arrangement regulations do not apply to cases where benefits are not funded by a life_insurance_policy for example we held in our country home enters inc v commissioner t c at __ slip op pincite that when an employer’s participation in the sbp did not involve a purchase of life_insurance it was not a split-dollar_life_insurance arrangement and thus not subject_to the sec_1_61-22 income_tax regs economic benefit provisions instead the payments made to the plan by the corporation-employer were taxable as constructive distributions to its shareholder-employee id at __ slip op pincite citing 115_tc_43 aff’d 299_f3d_221 3d cir second we did not need to apply and did not reach the discussion of the deferred_compensation rules in connection with the consolidated cases discussed in our country home enters inc because we resolved all the issues raised on other theories this does not mean however that we rejected the deferred_compensation theory as petitioners see it finally neither sec_61 nor the regulations thereunder prevent us from applying both the deferred_compensation provisions and split-dollar_life_insurance regulations to the same set of transactions the preamble to sec_1_61-22 income_tax regs states taxpayers should note that in certain cases a separate tax rule may require a non-owner to include an amount in gross_income under an equity split-dollar_life_insurance arrangement at a time earlier than would be required under these regulations an equity split- dollar life_insurance arrangement governed by the economic benefit regime constitutes a deferred_compensation arrangement fed reg date thus the split-dollar_life_insurance regulations were not intended to be the sole set of rules applicable to arrangements similar to petitioners’ for these reasons respondent is not precluded from raising the deferred_compensation theory in the current cases to the extent the arrangements made by machacek inc or adstracts are covered both by deferred_compensation provisions and split-dollar_life_insurance regulations we will follow the principles outlined in sec_1_61-22 income_tax regs including those articulated in the preamble to the regulations and our country home enters inc b whether machacek inc ’s and adstracts’ plans are welfare_benefit plans we now address the issue of whether machacek inc ’s and adstracts’ participation should be treated as participation in a welfare_benefit_plan or a plan of deferred_compensation the code does not define what constitutes a deferred_compensation plan but the regulations provide that an arrangement defers the receipt of compensation or benefits to the extent that under it an employee receives compensation or benefits more than a brief period of time after the end of the employer’s taxable_year in which the services creating the right to such compensation or benefits are performed sec_1_404_b_-1t q a-2 a temporary income_tax regs fed reg date when it comes to determining whether a plan is a welfare_benefit_plan or a deferred_compensation plan courts consider a number of factors such as whether payment of the benefits depends on a contingent event or is guaranteed upon a certain event whether vesting depends on length of service whether benefits are commensurate with salary and the intended purpose of the plan see 31_f3d_569 7th cir stating that when a plan has features of both a welfare_benefit and a deferred_compensation plan the entire plan is evaluated under deferred_compensation plan standards aff’g tcmemo_1992_ see also 108_tc_524 holding that a plan was a welfare_benefit_plan where there was credible_evidence that the intent of the plan’s promoter was to create a legitimate non-abusive welfare_benefit_plan we have previously found in our country home enters inc v commissioner t c at __ slip op pincite that the sbp was never intended to be a legitimate welfare_benefit_plan the plan was designed as a tool that would provide shareholder-employees and in some cases a handful of key employees with a tax-efficient tool for savings and financial planning id in addition the sbp has several hallmarks of a traditional deferred_compensation plan under wellons and booth the payment of death or medical benefits depended on the vesting schedule years_of_service and employee’s annual compensation because the machaceks and brenda jones controlled of the shares in machacek inc and adstracts respectively they could cause the companies to terminate their participation in the sbp at any time moreover john machacek and brenda jones were able at all times to amend the adoption agreements for their companies’ sbps to change the vesting requirements and retirement age in that event under the respective sbp’s terms the trustee would be required to distribute the funds held in trust to the employees or their beneficiaries this provided for a certainty of the payment to the shareholder- employees regardless of whether a specified payout event occurred thus we conclude that machacek inc ’s and adstracts’ sbps are deferred_compensation plans not welfare_benefit plans both machacek inc and adstracts had a 10-year cliff_vesting schedule machacek inc used a multiplier of with a base of an employee’s compensation reported on form_w-2 to determine the amount of benefit adstracts used a multiple of to compute the benefits c whether the sbps for machacek inc and adstracts are nonqualified discriminatory trusts the next step in our analysis is to determine whether machacek inc ’s and adstracts’ respective plans are governed by the provisions of sec_402 as nonqualified discriminatory trusts holding assets of deferred_compensation plans respondent argues that the sbps for machacek inc and adstracts should be governed by sec_402 because both plans fail to meet the requirements set out in sec_410 petitioners in turn argue that the sbp has never purported to be tax exempt under sec_401 and has consistently filed form_1041 u s income_tax return for estates and trusts as a taxable trust with respect to its operations petitioners suggest that for that reason sec_410 does not apply to the sbp sec_402 provides the timing rules for recognition of income by a plan participant from a nonexempt employee_trust sec_402 provides contributions to an employees’ trust made by an employer during a taxable_year of the employer which ends with or within a taxable_year of the trust for which the trust is not exempt from tax under sec_501 shall be included in the gross_income of the employee in accordance with sec_83 relating to property transferred in connection with performance of services we read this section to apply to any employee_trust that is not exempt from tax under sec_501 in a given year sec_501 exempts from taxation an organization described in sec_401 such as a qualified_pension plan thus if an employee_trust does not meet the requirements of sec_401 it is subject_to the sec_402 provisions the parties agree that neither the machacek trust nor the adstracts trust qualified under the provisions of sec_501 as a voluntary employees’ beneficiary association petitioners also stated that the sbp trusts for both companies were never intended to qualify under sec_401 as qualified_retirement_plans and have consistently filed form sec_1041 as taxable trusts with respect to their operations thus according to the plain language of sec_402 machacek inc ’s and adstracts’ trusts are subject_to sec_402 further sec_402 provides special rules for trusts that fail to meet the requirements of sec_410 if one of the reasons that a_trust is not exempt from tax under sec_501 is the failure of the associated plan to meet the requirements of sec_410 b --which essentially provides rules for nondiscrimination in plan coverage--then a highly_compensated_employee must include in income an amount equal to the vested_accrued_benefit of such employee as of the close of the taxable_year of the trust petitioners argue that because the sbp was never intended to be a qualified_retirement_plan under sec_401 and sec_501 the sec_402 rules should not apply at all we disagree with this line of reasoning sec_402 provides that the special rules apply if one of the reasons a_trust is not exempt under sec_501 is the failure of the associated plan to meet the requirements of sec_410 sec_402 in general does not differentiate between the plans that were intended to qualify under sec_501 but failed for some reason and plans that were never intended to qualify under sec_501 the same reasoning applies to the provisions of sec_402 a different reading of sec_402 would result in condoning widespread employee discrimination through the use of nonqualified plans sec_402 thus provides two sets of rules the first set is based on sec_83 principles and applies when an employer establishes a nonqualified employee_trust that meets nondiscrimination requirements set out in sec_410 while the second set of rules applies when a nonqualified employee_trust fails to comply with the requirements of sec_410 under sec_410 a_trust is not a qualified_trust under sec_401 unless the trust is designated by the employer as part of a plan which meets one of respondent points to revrul_2007_48 2007_2_cb_129 for the proposition that the income_recognition rules in sec_402 apply to deferred_compensation plans that were neither qualified_retirement_plans nor intended to be qualified_retirement_plans we note that this pronouncement was not available to guide petitioners during the years at issue the following requirements the plan benefits at least of employees who are not highly compensated employees the plan benefits a percentage of employees who are not highly compensated employees which is at least of the percentage of highly compensated employees benefiting under the plan the plan benefits such employees as qualify under a classification set up by the employer and found by the secretary not to be discriminatory in favor of highly compensated employees and the average_benefit_percentage for employees who are not highly compensated employees is at least of the average_benefit_percentage for highly compensated employees see sec_410 and for purposes of sec_402 a highly_compensated_employee is defined by sec_414 as any employee who was a owner at any time during the year or preceding year or for the preceding year had compensation from the employer in excess of a certain amount and if the employer elects the application of this clause for such preceding year was in the top-paid_group of employees for such preceding year in the threshold compensation that would indicate a highly_compensated_employee was dollar_figure and in it was dollar_figure sec_414 sec_415 notice_2004_72 2004_2_cb_840 notice_2005_ 2005_2_cb_929 petitioners further argue that the benefits provided by the sbp--death benefits and health expense reimbursement benefits--fall squarely under one of the exceptions outlined in sec_409a petitioners’ liability under sec_409a is not at issue in these cases so we need not address or resolve this argument however we note that an arrangement that was never intended to provide any benefits like that of brenda jones and adstracts’ sbp or that served more as a tax-deferred savings account for a company’s shareholders like that of the machaceks and machacek inc ’s sbp is not likely to qualify as a bona_fide death_benefit or health expense reimbursement benefit under sec_409a or sec_1_409a-3 income_tax regs we now discuss whether the specific plans under machacek inc ’s sbp and adstracts’ sbp failed to meet the sec_410 requirements the machaceks and machacek inc in five out of eight employees of machacek inc were eligible to participate in the sbp in five out of seven employees of machacek inc were eligible to participate in the sbp only three employees--john machacek shawn machacek and matthew beebe --signed employee enrollment and election matthew beebe was not vested in the plan benefits in and because there was no life_insurance in mr beebe’s name held by the trust he was continued forms for the sbp of these three employees only john machacek could potentially receive any benefits under the sbp because the machacek trust only held life_insurance with john machacek as a beneficiary and an annuity with john machacek as an annuitant john machacek and marianne machacek were highly compensated employees because they owned and of machacek inc respectively in addition shawn machacek was a highly_compensated_employee in because he received compensation in excess of the threshold of dollar_figure for although both in and there were eligible non-highly compensated employees of machacek inc none of them was entitled to receive any benefit under the sbp terms the notional accounting as reflected in annual valuations was a mere fiction because all of the assets held by the machacek trust except the clymer policy had john machacek as the sole beneficiary thus the machacek inc sbp failed all of the coverage tests provided by sec_410 brenda jones and adstracts brenda jones was a highly_compensated_employee of adstracts because she owned of the company stock in both and out of adstracts continued not eligible for any benefits under the sbp provisions in the years at issue employees eligible to participate in the sbp in and she was the only employee who was entitled to receive any distributions no other employee of adstracts whether highly compensated or not was entitled to any benefits under the sbp adoption_agreement therefore the adstracts’ plan does not meet the requirements of sec_410 d amounts to be included in income under sec_402 in general sec_402 provides that if a plan fails to meet the requirements of sec_410 a highly_compensated_employee shall include in gross_income an amount equal to the vested_accrued_benefit of such employee other than the employee’s investment_in_the_contract as of the close of such taxable_year of the trust we have previously held that the amount to be included under sec_402 is the amount of an employee’s vested_accrued_benefit to the extent it has not been previously taxed to the employee 139_tc_290 petitioners attempt to distinguish yarish from the current cases because in yarish we discussed an employee_stock_ownership_plan that failed to meet nondiscrimination requirements for several years this attempt lacks merit as this court stated in yarish t he purpose of sec_402 is to discourage highly compensated employees from participating in a plan that fails to satisfy certain coverage requirements yarish v commissioner t c pincite citing h_r conf rept no vol ii at ii-416 to ii-417 1986_3_cb_1 consequently applying sec_402 in these cases would serve its intended purpose petitioners further argue that applying sec_402 in the cases at hand would result in violation of petitioners’ constitutional right to be taxed only on instances of undeniable accessions to wealth clearly realized and over which the taxpayers have complete dominion 348_us_426 in yarish v commissioner t c pincite the court rejected a similar argument stating that t he principle that amounts must be included in income for the taxable_year the ‘accession to wealth’ occurs is not absolute congress has consistently made exceptions to achieve various public policy objectives we reaffirm this conclusion here the machaceks we will address the issue of tax consequences for the machaceks later in this opinion after we address respondent’s theory that machacek inc ’s sbp was subject_to the split-dollar_life_insurance arrangement regulations brenda jones similar to the machaceks brenda jones must include in income all previously untaxed accrued vested benefits under the sbp for the and tax years ms jones was a highly_compensated_employee in the and tax years because she owned of adstracts’ stock the parties stipulated that ms jones was fully vested in the sbp benefits in the tax_year in addition we find that ms jones was fully vested in the sbp benefits in because she had full control of the vesting requirements and could cause adstracts to amend the sbp adoption_agreement to fit her needs see our country home enters inc v commissioner t c at __ slip op pincite in addition ms jones met the 10-years-of-service vesting requirements under the adstracts plan because adstracts’ plan did not provide any benefits to other employees and adstracts did not pay any contributions to the plan we find that all of the plan’s assets were held in trust for the benefit of ms jones until the time she would decide to discontinue participation in the sbp and request a distribution of the assets thus for tax_year ms jones must include in income the previously untaxed vested benefit equal to the full value of the annuity held by the adstracts sbp for tax_year ms jones must include in income an additional amount which represents the difference between the value of the annuity taxed in and the value of the annuity as of the end of the tax_year iii machacek inc ’s sbp as a split-dollar insurance arrangement a overview of the split-dollar insurance arrangement regulations respondent’s secondary argument with respect to the machaceks’ and machacek inc ’s participation in the sbp is that the split-dollar insurance arrangement regulations apply to the whole transaction respondent argues that this is so because machacek inc ’s sbp was materially modified after date the effective date of the split-dollar_life_insurance regulations see sec_1_61-22 income_tax regs respondent argues on the basis of two events that the split-dollar_life_insurance arrangement was materially modified the lapse and subsequent reinstatement of the life_insurance_policy on the life of john machacek or in the alternative the addition of the health expense reimbursement benefit to the arrangement in petitioners disagree and argue that neither of these events resulted in a change that is material to trigger the application of the split-dollar_life_insurance arrangement regulations in general a split-dollar_life_insurance arrangement is any arrangement between an owner and a non-owner of a life_insurance_contract that meets the rules set forth in sec_1_61-22 income_tax regs our country home enters inc v commissioner t c at __ slip op pincite in addition the regulations cover arrangements between an owner and a non-owner of a life_insurance_contract if they are compensatory arrangements or shareholder arrangements within the meaning of sec_1_61-22 and iii income_tax regs a split-dollar_life_insurance arrangement that is materially modified after date is treated as a new arrangement entered into on the date of modification for purposes of sec_1_61-22 income_tax regs and is subject_to the split-dollar_life_insurance arrangement regulations sec_1 j i income_tax regs the regulations do not define a material modification that would bring a specific arrangement within the regulation’s reach see id the regulations do however provide a nonexclusive list of changes that are not considered to be material modifications see id subdiv ii the nonexclusive list mostly covers modifications related to changes in the arrangements required to comply with laws ministerial changes such as changes in the mode of premium payment or in the beneficiary of the life_insurance_contract or a change in the owner of a life_insurance_contract when the change resulted from a transaction covered by sec_381 see id respondent argues that because the nonexclusive list in the regulations did not contain specific provisions covering either reinstatement of a life_insurance_policy or an addition of a new benefit under an arrangement these modifications must have been material we reject this argument the regulations explicitly state that the list of changes not considered material is not exclusive id moreover the commissioner can publish revenue rulings notices and other guidance to provide additional guidance with respect to other modifications that are not material id subdiv iii as of the date of this opinion we are not aware of such guidance by the commissioner that would be applicable in the cases here thus we need to consider the substance of the modifications of the machacek inc sbp plan to determine whether the changes are material at trial we asked the parties to address in their briefs what constitutes material modification for purposes of sec_1_61-22 income_tax regs petitioners’ position boils down to suggesting that a material modification affects the life_insurance_policy and its cash_value not any other_benefits under the split-dollar_life_insurance arrangements respondent in turn urges us to use the approach adopted by the u s supreme court in 499_us_554 and hold that a modification is material if it changes legal entitlements of the respective parties to the arrangement respondent argues that materiality cannot be measured by a change in the cash_value of a policy because not all changes bring about an immediate change in value respondent also points out that attempts to quantify what constitutes a material modification may be impractical and burdensome on the parties the regulations state that they apply to any split-dollar_life_insurance arrangement as defined in paragraph b or of this section entered after date sec_1_61-22 income_tax regs emphasis added the specific section dealing with the modified arrangements also states that if an arrangement entered into on or before date is materially modified after date the arrangement is treated as a new arrangement entered into on the date of the modification id subpara emphasis added sec_1_61-22 income_tax regs defines a split-dollar_life_insurance arrangement as any arrangement between an owner and non-owner of a life_insurance_contract that satisfies certain criteria thus the references to arrangement in sec_1_61-22 and income_tax regs contemplate not a life_insurance_contract itself but an arrangement as a whole between an owner and a non-owner of that life_insurance contract--the sbp itself in the machaceks’ case for that reason contrary to petitioners’ suggested interpretation we should look beyond changes to the underlying life_insurance_policy or its cash_value to determine whether the split-dollar_life_insurance arrangement regulations apply further neither petitioners nor respondent offered any authority for a bright-line_rule that would allow us to quantify what modification is material within the meaning of sec_1_61-22 income_tax regs in the absence of any guidance we are reluctant to invent such a rule thus we will look at whether a subsequent modification of a split-dollar_life_insurance arrangement went beyond merely ministerial actions and created different legal entitlements for the owner and non-owner of a life_insurance_policy b whether the life_insurance lapse and reinstatement constituted a material modification of machacek inc ’s sbp respondent argues that machacek inc ’s participation in the sbp is subject_to the split-dollar_life_insurance arrangement regulations because the life_insurance_policy on the life of john machacek lapsed and was subsequently reinstated in which according to respondent constitutes either a new life_insurance_contract or a material modification of the old contract petitioners disagree but do not present any specific arguments on the issue the life_insurance_policy had extensive provisions related to its lapse and reinstatement if the owner of the policy failed to pay a premium timely the policy provided for a 30-day grace period upon expiration of that grace period a policy could be reinstated after the insured provided the insurance_company with a filled-in questionnaire verifying his or her insurability the machacek policy lapsed on date because the machacek trust failed to timely transmit the premium to the insurance_company the life_insurance_policy was reinstated less than two months after its lapse on date after john machacek sent in a questionnaire verifying his insurability and the machacek trust transferred the overdue payment there is no evidence in the record supporting a finding that the parties to the life_insurance_contract entered into a new agreement or changed any provisions related to the policy the machacek trust and mr machacek did not forfeit their rights as to the amounts already contributed to the policy and were entitled to its full cash_value upon reinstatement thus the reinstatement of a life_insurance_policy especially after such a short time was not a new life_insurance_policy contract subject_to the split-dollar_life_insurance arrangement regulations under sec_1_61-22 income_tax regs it also did not constitute a material modification of a life_insurance arrangement under sec_1_61-22 income_tax regs c whether adding a new benefit to the machacek inc sbp constitutes material modification respondent’s second argument supporting his determination that the machacek inc sbp should be subject_to the split-dollar_life_insurance arrangement regulations is that the machacek sbp arrangement was modified in by adding a preretirement health expense reimbursement benefit petitioners in turn argue that because the change did not affect the life_insurance_policy itself it was not material within the meaning of sec_1_61-22 income_tax regs and was more in the nature of the changes contemplated in the nonexclusive list of modifications not considered material in sec_1 j ii income_tax regs as we discussed above we consider a modification of a split-dollar_life_insurance arrangement material if it went beyond a mere ministerial change and created a different legal entitlement for the parties to a split-dollar_life_insurance arrangement here amending the sbp adoption_agreement to add a health expense reimbursement benefit for all the eligible employees resulted in a change that could potentially affect how the benefits were to be funded or how the cash_value in the policy might be used unlike the mostly ministerial changes listed in sec_1_61-22 income_tax regs adding a health expense reimbursement benefit through amending the sbp adoption_agreement resulted in creating a new right under the existing split-dollar_life_insurance arrangement when as here that right essentially unlocked access for a non- owner of a life_insurance_policy to its cash_value regardless of an event such as death or retirement the modification was material within the meaning of sec_1_61-22 income_tax regs because there was a material modification effective as of date machacek inc ’s plan falls under the split-dollar insurance arrangement regulations by reason of sec_1_61-22 income_tax regs d whether the machacek inc sbp was a compensatory arrangement respondent further argues that the machacek inc sbp was a compensatory split-dollar_life_insurance arrangement within the meaning of sec_1 b ii income_tax regs petitioners in response reiterate the same sec_1_61-22 income_tax regs provides the following criteria for compensatory arrangements a the arrangement is entered into in_connection_with_the_performance_of_services and is not part of a group-term_life_insurance plan described in sec_79 b the employer or service_recipient pays directly or indirectly all or any portion of the premiums and continued arguments that we have already discussed and rejected in our country home enters inc v commissioner t c at __ slip op pincite and earlier in this opinion namely that machacek inc ’s sbp constitutes a legitimate welfare_benefit_plan we have previously held in this opinion that machacek inc ’s sbp was not a welfare_benefit_plan with respect to the first prong of the compensatory split- dollar life_insurance arrangement test machacek inc ’s sbp was not a part of a group-term_life_insurance plan described under sec_79 because the policy on the life of john machacek was not a part of a group-term_life_insurance plan and was based on individual selection and assessment of john machacek’s personal insurability see our country home enters inc v commissioner t c at __ slip op pincite in addition eligibility for benefits under the machacek inc sbp adoption_agreement depended at least in part on years_of_service and meeting continued c either-- the beneficiary of all or any portion of the death_benefit is designated by the employee or service provider or is any person whom the employee or service provider would reasonably be expected to designate as the beneficiary or the employee or service provider has any interest in the policy cash_value of the life_insurance_contract other eligibility requirements thus because the machacek inc sbp was an arrangement entered into in_connection_with_the_performance_of_services machacek inc ’s sbp met the first prong of the compensatory split-dollar_life_insurance arrangement test as to the second prong of the test the employer and the formal owner of the life_insurance_policy machacek inc paid the contributions for the insurance_policy on the life of john machacek through its contributions to the sbp this falls squarely within the requirements in sec_1_61-22 income_tax regs finally under machacek inc ’s sbp provisions employees could select beneficiaries of their death_benefits under the plan for these reasons we conclude that machacek inc ’s sbp was a compensatory split-dollar_life_insurance arrangement because john machacek at all relevant times could effect a distribution of the machacek inc ’s trust assets we conclude that john machacek had an interest in the cash_value of the life_insurance_policy on his life e consequences to the machaceks because both sec_402 and the split-dollar_life_insurance arrangement regulations apply to the machacek inc sbp we will apply the split- dollar life_insurance arrangement regulations to the life_insurance_policy and sec_402 to the annuity held by the machacek trustdollar_figure life_insurance_policy the split-dollar_life_insurance arrangement regulations provide that a non- owner of a life_insurance_contract who is a party to a split-dollar_life_insurance arrangement must include in income the value of the economic benefit provided during the relevant tax years the economic benefit is a sum of the cost of current_life_insurance_protection provided to the non-owner during the year as defined in sec_1_61-22 income_tax regs plus the amount of the policy cash_value in which the non-owner has current access during that year as defined in sec_1_61-22 income_tax regs and unreduced by surrender we note that the end result for the machaceks would be consistent with applying only sec_402 under sec_402 the machaceks would include in income any vested_accrued_benefit under the sbp for the and tax years that has not been taxed previously see 139_tc_290 for both years at issue the machaceks would include in income the sum of the accumulation value in the life_insurance_policy and the previously untaxed balance in the annuity account for the machaceks would include only the excess of the vested benefit over the amount already taxed in as a vested benefit however applying the split-dollar_life_insurance arrangement regulations to the life_insurance_policy portion of the sbp would result in denying a corporate-level deduction for the contribution paid_by machacek inc to the sbp in because machacek inc is an s_corporation this would make the contribution taxable to the machaceks charges plus the value of any other economic benefits provided to the non-owner sec_1_61-22 income_tax regs because we previously concluded that john machacek had current access to the cash_value of the insurance_policy in his name the machaceks must include in income for both and the previously unreported and untaxed portions of the accumulation value of the machaceks’ policy and the current cost of the death_benefit petitioners raised during oral argument and on brief the issue that the machaceks have already reported as income the current cost of insurance in each year that they participated in the sbp we find that this contention is not supported by the evidence in the record we observe that forms w-2 for john machacek indeed report certain amounts in box c however these amounts are different from the actual costs of the death_benefits for and as reflected in our findings_of_fact there is no evidence or testimony that would allow us to link the two numbers for that reason the machaceks must include the costs of the death_benefits in income for the and tax years machacek annuity as discussed above john machacek was a highly_compensated_employee of machacek inc by virtue of stock ownership in the corporation the parties stipulated that john machacek was fully vested in the sbp benefits in tax_year we also find that john machacek was fully vested in the sbp benefits in tax_year in our country home enters inc v commissioner t c at __ slip op pincite we found that the shareholder employees were not necessarily bound by the vesting requirements that were initially set in their plans instead at their whim they could accelerate or otherwise change the vesting requirements to their preference this conclusion equally applies in the machaceks’ case thus the machaceks should include in income any vested_accrued_benefit under the plan for the and tax years that has not been taxed previously see yarish v commissioner t c pincite for both years at issue the machaceks should include in income the previously untaxed balance in the annuity account for the machaceks should include only the excess of the vested benefit over the amount taxable in as a vested benefit f consequences to machacek inc respondent argues that machacek inc cannot deduct its contribution to the sbp in because the contribution did not meet the requirements of sec_11 we addressed the inclusion of the life_insurance_policy cash_value in the discussion of the split-dollar_life_insurance arrangement consequences there is no evidence in the record that machacek inc claimed a deduction continued petitioners argue that the payments are deductible under sec_1 income_tax regs as amounts paid for welfare or similar benefit plan and are ordinary and necessary business_expenses we agree with respondent sec_162 is generally the primary hurdle that a taxpayer must clear to deduct a business_expense sec_162 lets taxpayers deduct all the ordinary and necessary expenses paid_or_incurred during the taxable_year in carrying on any trade_or_business under that section an expenditure is deductible if it is an expense an ordinary_expense a necessary expense paid in the case of a cash_method taxpayer or incurred in the case of an accrual_method taxpayer during the taxable_year and made to carry on a trade_or_business see 403_us_345 116_tc_374 in addition because machacek inc ’s participation in the sbp was a split- dollar life_insurance arrangement machacek inc may deduct an expense related to the arrangement only if the deduction meets the rules of sec_1_83-6 income_tax regs see sec_1_61-22 income_tax regs continued for the sbp contribution on its federal tax_return so we do not address this issue here we have previously determined that machacek inc ’s sbp was not a welfare_benefit_plan thus the contributions to the plan do not fall under sec_1_162-10 income_tax regs as petitioners suggest petitioners also do not argue that machacek inc met the requirements for deductibility under sec_1 a income_tax regs there was no transfer of the policy from machacek inc to john machacek the full amount of machacek inc ’s contribution to the sbp was spent on paying a premium on the life_insurance_policy as a result machacek inc may not deduct its contributions to the sbp in iv sec_6662 penalties sec_6662 imposes a accuracy-related_penalty on an underpayment_of_tax required to be shown on a return any portion of an underpayment which is attributable to negligence or disregard of rules or petitioners also suggest that at least a portion of the annual contributions is attributable to providing a group-term_life_insurance benefit covered by sec_79 and health expense reimbursement benefits are covered by sec_106 we reject this argument we have previously concluded that the machacek inc sbp did not provide group-term_life_insurance covered by sec_79 the allocation of funds to the notional accounts to fund the purported health expense reimbursement benefit was illusory because the full amount of the machacek inc annual contribution was spent to pay a premium on john machacek’s life_insurance_policy in addition there is no evidence in the record that any of machacek inc ’s employees knew of or ever used that benefit instead the addition of the benefit merely unlocked to john machacek access to the cash_value of the policy before retirement regulations or a substantial_understatement_of_income_tax is subject_to the accuracy-related_penalty sec_6662 and negligence includes any failure to make a reasonable attempt to comply with the provisions of the code or to exercise ordinary and reasonable care in the preparation of an income_tax return sec_6662 sec_1_6662-3 income_tax regs negligence also includes any failure to maintain adequate books_and_records or to substantiate items properly sec_1_6662-3 income_tax regs disregard includes any careless reckless or intentional disregard of rules or regulations id subpara for individuals a substantial_understatement_of_income_tax exists if the amount of the understatement exceeds the greater of of the tax required to be shown on the return or dollar_figure sec_6662 here these amounts are as follows amount of amount of of tax tax shown on tax required required to petitioner year the tax_return to be shown be shown understatement machaceks jones machaceks jones dollar_figure big_number big_number big_number dollar_figure big_number big_number big_number dollar_figure big_number big_number big_number dollar_figure big_number big_number big_number the understatement amounts here are attributable to the issues covered in this opinion accordingly respondent has met his burden of production under sec_7491 and petitioners’ understatements of income_tax are substantial within the meaning of sec_6662 and b once the commissioner has met the burden of production the taxpayer must come forward with persuasive evidence that the imposition of a penalty is inappropriate because for example the taxpayer acted with reasonable_cause and in good_faith in relying on advice of a competent tax professional sec_6664 469_us_241 neonatology assocs p a v commissioner t c pincite sec_1_6664-4 c income_tax regs to prove that reliance on the advice of a tax professional constitutes reasonable_cause the taxpayer must prove by a preponderance_of_the_evidence that he or she meets the following three requirements the adviser was a competent professional who had sufficient expertise to justify reliance the taxpayer provided necessary and accurate information to the adviser and the taxpayer actually relied in good_faith on the adviser’s judgment neonatology assocs p a v commissioner t c pincite reliance may be unreasonable when it is based on statements of insiders promoters or their offering materials or when the person relied upon has an inherent conflict of interest about which the taxpayer knew or should have known see id pincite in these cases petitioners did not offer evidence to support the finding that their reliance on tax_advice or sbp promoters constitutes reasonable_cause thus we sustain respondent’s determination of the penalty under sec_6662 for each year at issue for all petitioners v conclusion we have considered all of the arguments that petitioners made and to the extent not discussed above conclude that those arguments are irrelevant moot or without merit we have considered respondent’s arguments only to the extent stated herein to reflect the foregoing and concessions by petitioners decisions will be entered under rule


internal_revenue_service national_office technical_advice_memorandum date number release date index uil no case mis no tam-156259-02 cc fip b04 appeals - large mid-size business operating_unit attn appeals team manager lbsp area team taxpayer's name taxpayer's address taxpayer's identification no years involved date of conference legend taxpayer parent state a state b date date date agreement-1 agreement-2 tam-156259-02 x y rate z amount amount issue whether under the facts described the accumulated funds held by taxpayer for certain funding agreements funding agreements agreements constitute amounts necessary to satisfy obligations arising under insurance or annuity_contracts not involving life contingencies as described in sec_807 of the internal_revenue_code or a reserve item described in sec_807 conclusion taxpayer’s funding agreements do not constitute insurance or annuity_contracts for tax purposes accordingly the accumulated funds held by taxpayer with respect to the agreements do not constitute a reserve item under sec_807 or any other reserve item under sec_807 rather taxpayer should account for its obligation to credit guaranteed_interest under the funding agreements through the deduction allowed by sec_805 and sec_163 for interest_paid or accrued within the taxable_year on indebtedness facts taxpayer is a life and health insurance_company domiciled in state a which is taxable as a life_insurance_company under sec_816 during the taxable years involved taxpayer was a wholly-owned subsidiary of parent and joined with parent and other life_insurance and non-insurance members of parent’s affiliated_group in filing a life nonlife consolidated_return pursuant to sec_1504 and sec_1_1502-47 of the income_tax regulations as an outgrowth of its pension fund business taxpayer also markets funding agreements to tam-156259-02 -3- institutional investors such as asset managers state and local_government entities banks and other institutional entities like its gic products taxpayer’s funding agreements provide for an accumulation of the initial consideration at a guaranteed rate of interest for a specified period of time if held to maturity the funding agreements guarantee the return of the initial consideration plus credited interest to the contract holder the term funding agreement is used to differentiate these investment products from gics which are sold to qualified_pension and employee benefit plans and contain benefit-sensitive withdrawal provisions such as the option to use the accumulated funds to purchase retirement annuities the terms of taxpayer’s funding agreements were individually negotiated and the rate of interest could be either a fixed or floating rate the general provisions of taxpayer’s funding agreements may be illustrated by two contracts from the years under examination copies of which were submitted with the technical_advice request both of the agreements were large dollar contracts that were individually negotiated however the general terms of these agreements were representative of taxpayer’s funding agreements during the taxable years involved agreement-1 was issued on date to x a governmental agency of state b under agreement-1 x was to remit a fixed consideration amount which taxpayer would credit to a funding account for x agreement-1 specifically provided that at the end of any day the funding account balance was equal to x’s initial consideration plus credited interest less amounts withdrawn from the funding account agreement-1 also specified that taxpayer was to credit interest to the funding account at a fixed rate of rate z interest accrued on a daily basis and was withdrawn and remitted to x on the first day of each month agreement-1 also specified a scheduled maturity_date approximately thirty-three months after issue at which time taxpayer was required to return the fund account balance plus accrued interest to x finally agreement-1 contained a credit default provision so that in the event that taxpayer’s credit rating was downgraded at any time prior to the scheduled maturity_date x could exercise a put option and obtain the full amount of the fund account balance plus accrued interest prior to the scheduled maturity_date as x was not a natural_person agreement-1 did not contain any provisions relating to mortality or morbidity moreover in agreement-1 taxpayer did not offer to provide any annuity form of settlement either for life or a fixed term and agreement-1 thus did not contain any annuity purchase guarantees agreement-2 was issued to y an investment management company agreement-2 contained terms similar to agreement-1 so that on date the agreement’s effective date y was required to remit an initial consideration amount and taxpayer was to credit this amount to a funding account for y under agreement- interest accrued on the funding account balance at a variable rate equal to one month libor plu sec_15 basis points for each month that the agreement was in effect this interest rate was reset fifteen days after the contract effective date and thereafter tam-156259-02 -4- as of the first wednesday of each succeeding month credited interest was withdrawn from the funding account balance and paid to y on each reset date agreement-2 contained a scheduled maturity_date of date at which point taxpayer was to return the funding account balance plus accrued interest to y however under agreement-2 either party could terminate the arrangement at any time upon seven days advance written notice as y was not a natural_person agreement-2 also did not contain any provisions relating to mortality or morbidity moreover in agreement-2 taxpayer did not offer to provide any annuity forms of settlement either for life or a fixed term and agreement-2 thus did not contain any annuity purchase guarantees in many states however gics including funding agreements are considered insurance contracts for purposes of regulating the issuers of these contracts this classification may also be significant for purposes of determining the priority of claims of contract holders of funding agreements viz a viz the insurer’s other policyholders in the event of an insolvency proceeding for example state a’s insurance code defines a gic as in filing its annual_statement for state regulatory reporting purposes taxpayer reported the initial consideration for the funding agreements in premiums in line 1a annuity and other fund deposits and established a corresponding reserve item for deposit funds and other liabilities without life and disability contingencies in exhibit the change in this reserve flowed through the summary of operations accordingly instead of recording a separate expense for interest_paid or accrued under the funding agreements taxpayer accounted for its obligations under these arrangements through an increase in the related reserves established for the contracts to calculate the statutory reserve for a funding agreement taxpayer used a methodology in which the contract holder’s funding account balance was first projected out to the stated maturity_date using the interest rate guaranteed in the contract and then discounted back using a prescribed state assumed valuation interest rate this reserve_method was substantially_similar to the commissioners annuity reserve_valuation method as applied to annuity_contracts under taxpayer’s reserve_method the statutory reserve for a funding agreement that provided a future guaranteed_interest rate such as agreement-1 could either exceed or be less than the contract holder’s fund account balance depending on whether the guaranteed_interest rate was higher or less than the applicable statutory reserve_valuation rate this discrepancy did not occur in funding agreements similar to agreement-2 because those agreements did not provide a future_interest rate guarantee tam-156259-02 -5- for federal_income_tax purposes taxpayer treated the reserves established with respect to its funding agreements as deductible sec_807 reserves relating to obligations on life and annuity_contracts that do not involve life health or accident contingencies for tax purposes however taxpayer adjusted the reserves for all of its funding agreements to be equal to the contract holder’s funding account balance the examining agent determined that taxpayer had overstated its funding agreement tax_reserves in situations where the fund account balance exceeded the corresponding reserve for the funding agreement as shown on taxpayer’s annual_statement the examining agent’s position is that as a result of the statutory reserve cap under sec_807 taxpayer’s tax_reserves for funding agreements cannot exceed the corresponding reserves shown on the annual_statement the statement filed by the appeals_office supports the examining agent’s position taxpayer argues that the reserves in question are sec_807 reserves and not life_insurance_reserves under sec_807 and therefore that the statutory reserve limitation in sec_807 does not apply alternatively taxpayer contends that the fund account balances are equivalent to a net_surrender_value in the sense that the fund account balance measures the amount of taxpayer’s accrued liability to the contract holder at a given period of time after reviewing taxpayer’s funding agreements and considering the legal arguments made by taxpayer and the appeals_office we have determined that the more basic question before us is whether taxpayer’s funding agreements constitute insurance or annuity_contracts for which premium consideration and a corresponding reserve item should be recognized under the provisions of part i of subchapter_l law and analysis the taxation of insurance and annuity_contracts under part i of subchapter_l differs from the treatment of investment products offered by other financial intermediaries under sec_803 a life_insurance_company includes the gross_amount_of_premiums_and_other_consideration received with respect to an insurance or annuity as an item of the company’s gross_income for this purpose the gross_amount_of_premiums_and_other_consideration includes under sec_803 advance premiums deposits fees assessments consideration in respect of assuming liabilities under contracts not issued by the taxpayer and the amount of policyholder dividends reimbursable to the taxpayer by a reinsurer in respect of reinsured policies to compensate for the inclusion of the full amount of consideration for insurance and annuity_contracts in gross_income a life_insurance_company is allowed deductions for the increase in the related reserves held with respect to its obligations under such contracts the computation of reserve deductions for tax purposes with respect to insurance and annuity_contracts is governed by the rules of sec_807 and sec_811 section tam-156259-02 -6- a provides that net decreases in sec_807 reserves during the taxable_year are included in gross_income under sec_803 while sec_807 provides that net increases in sec_807 reserves during the taxable_year are taken into account as a deduction under sec_805 under sec_807 the amount of the life_insurance_reserves as defined by sec_816 for any contract that is taken into account for purposes of the deduction for net increases in reserves authorized by sec_807 and sec_805 is the greater of the net_surrender_value of the contract or the reserve determined under sec_807 in no event however may the reserve for the contract exceed the amount taken into account with respect to that contract as of that time in determining the statutory_reserves sec_807 flush language see also sec_809 the term life_insurance_reserves is defined in sec_816 as those amounts that are computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest and set_aside to mature or liquidate either by payment or reinsurance future unaccrued claims arising from life_insurance contracts involving at the time with respect to which the reserve is computed life health or accident contingencies sec_816 generally provides that in order to qualify as such for tax purposes life_insurance_reserves must be those required_by_law sec_807 provides that among the reserve and similar items taken into account under sec_807 are amounts necessary to satisfy the obligations under insurance and annuity_contracts but only if such obligations do not involve at the time with respect to which the computation is made life accident or health contingencies sec_807 provides that among the reserve and similar items taken into account under sec_807 are dividend accumulations and other_amounts held at interest in connection with insurance or annuity_contracts including contracts supplementary thereto sec_805 provides that subject_to certain modifications described in sec_805 a life_insurance_company is allowed all of the deductions otherwise provided under subtitle a for purposes of computing taxable_income under sec_805 however in applying sec_163 relating to the deduction for interest no deduction is allowed for interest in respect of a reserve or similar item described in sec_807 whether an insurance_company is taxed under sec_801 as a life_insurance_company is determined using the statutory requirements of sec_816 this section requires that a company’s life_insurance_reserves as defined in sec_816 plus unearned premiums and unpaid_losses on noncancellable life accident_and_health_insurance contracts not included in life_insurance_reserves be compared to its total tam-156259-02 -7- reserves as defined in sec_816 the comparison mandated by sec_816 is referred to as the qualification fraction an insurance_company is a life_insurance_company if the sum of the life_insurance_reserves and unearned premiums and unpaid_losses whether or not ascertained on noncancellable life accident or health policies not included in life_insurance_reserves comprise more than of total_reserves sec_816 provides that for purposes of the qualification fraction amounts set_aside and held at interest to satisfy obligations under contracts which do not contain permanent guarantees with respect to life accident or health contingencies shall not be included in life_insurance_reserves under sec_816 or in all other insurance_reserves_required_by_law under sec_816 this section was added to the code in the deficit_reduction_act_of_1984 pub_l_no 98_stat_494 the senate report concerning this section explains its effect as follows f or purposes of determining whether an insurance_company is a life_insurance_company amounts set_aside and held at interest to satisfy obligations under contracts under contracts which do not contain permanent guarantees with respect to life accident or health contingencies shall not be included in life_insurance_reserves or in total_reserves thus these amounts are not included in either the numerator or the denominator of the qualification fraction when determining whether a company’s life_insurance_reserves and unearned premiums and unpaid_losses on noncancellable accident_and_health_insurance contracts comprise more than half its total_reserves this provision resolves for future years a question under present law as to how certain pension funds that do not contain permanent annuity purchase rate guarantees should be treated the internal_revenue_service has ruled that a reserve for a benefit is not a life_insurance_reserve unless a life benefit is permanently guaranteed under the contract rev_rul c b the provision of the bill substantially adopts this position and extends it to total_reserves also but only for purposes of the qualification fraction senate committee on finance 98th cong 2d sess deficit reduction action of explanation of provisions approved by the committee on date p footnotes omitted the ruling referred to in the senate report revrul_77_286 involves a deposit_administration_contract issued by a life_insurance_company and held by an employer for its employees the life_insurance_company receives the employer’s contributions and accumulates these funds at interest the contract contains annuity purchase rates sec_816 defines total_reserves as life_insurance_reserves unearned premiums and unpaid_losses whether or not ascertained not included in life_insurance_reserves and all other insurance_reserves_required_by_law tam-156259-02 -8- guarantees but the guarantees are not permanent during the employees’ active lives revrul_77_286 holds that since the deposit administration contracts do not provide permanent purchase rate guarantees the subject pension funding contract does not constitute an annuity_contract during its accumulation_phase and accordingly the funds held for the contract do not qualify as life_insurance_reserves under former sec_801 although sec_816 does not address the treatment of contracts that lack permanent guarantees with respect to life accident and health contingencies for purposes other than qualification ratio the senate report states if these contracts have any insurance or annuity purchase guarantees for life or a fixed term then the premiums will be taken into income and the increase in the fund will be treated as increases in a reserve item under sec_807 or if there are no guarantees whatsoever then no income will be taken into account and no reserves will be treated as increased for purposes of the reserve deduction the fact that such funds are not treated as insurance reserves for purposes of the qualification fraction is not intended to have any effect on the characterization of the contracts or the company issuing the contracts rather whether a contract with less than a permanent guarantee should be considered an insurance_or_annuity_contract would depend on the terms of the contract that is it will depend on whether the company has assumed a significant insurance risk or has made an annuity guarantee for life or a fixed period generally the assumption of solely an investment risk would not give rise to an insurance liability senate committee on finance 98th cong 2d sess deficit reduction action of explanation of provisions approved by the committee on date p for purposes of the federal tax law risk shifting is an indispensable characteristic of insurance 312_us_531 1941_1_cb_430 a similar standard has been used both for exemption from federal antitrust laws see 440_us_205 the primary elements of an insurance_contract are the spreading and underwriting of a policyholder’s risk and for federal securities laws see 387_us_202 359_us_65 moreover the opinions in united benefit life u s pincite and in le gierse u s pincite indicate that the transfer of an investment risk cannot by itself create insurance tam-156259-02 -9- in the present case a review of taxpayer’s funding agreements indicates that these agreements do not contain any provisions with respect to life health or accident contingencies moreover although the funding agreements contain an interest guarantee and guarantee the return of the contract holder’s principal on a stated maturity_date the agreements do not provide any annuity forms of settlement either for life or a period certain although the interest guarantee and credit default provisions created certain risks for taxpayer these risk are investment risks and are not insurance risks specifically the risks assumed by taxpayer under the funding agreements are that it will not earn through the reinvestment of the contract holder’s funds to cover the interest rate guarantee or that taxpayer will become illiquid as a result of poor asset management and a credit downgrade causing contract holder’s to withdraw funds prior to the agreements’ stated maturity dates when tested against the federal tax definition of insurance taxpayer’s assumption of these investment risks is insufficient to create an insurance_contract for tax purposes accordingly we conclude that taxpayer’s funding agreements do not constitute insurance contracts for tax purposes for which a reserve item under sec_807 or c would be recognized rather we believe that the taxpayer’s funding agreements are a form of indebtedness for tax purposes inasmuch as the taxpayer agrees to return the contract holder’s initial consideration with interest on a stated maturity_date thus the accumulated funds with respect to the funding agreements are neither sec_807 reserves nor any other type of sec_807 item the taxpayer should account for its obligation to credit guaranteed_interest under the agreements through the deduction allowed by sec_805 and sec_163 for interest_paid or accrued within the taxable_year on indebtedness caveats a copy of this technical_advice_memorandum is to be given to the taxpayer s sec_6110 provides that it may not be used or cited as precedent


internal_revenue_service number release date index number ---------------------------------------------------- ------------------------------------------------ ---------------------------------------- ------------------------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact --------------------------- id no ------------- telephone number --------------------- refer reply to cc psi b01 plr-145837-10 date date legend x -------------------------------------------------- ------------------------------------------------------------------------------------------ country d dear ----------- ---------- -------------------------- this responds to a letter dated ------------------------and subsequent correspondence submitted on behalf of x requesting that the service grant x an extension of time under sec_301_9100-3 of the procedure and administration regulations to file an election under sec_301_7701-3 to be treated as a disregarded_entity for federal tax purposes facts according to the information submitted x was formed under the laws of country x intended to elect be treated as a disregarded_entity for federal tax purposes effective d however x inadvertently failed to timely file form_8832 entity classification election to elect to be treated as a disregarded_entity for federal tax purposes law and analysis sec_301_7701-3 provides in part that a business_entity that is not classified as a corporation under sec_301_7701-2 or an eligible_entity can elect its classification for federal tax purposes an eligible_entity with at least two members can elect to be classified as either an association or a partnership and an plr-145837-10 eligible_entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner sec_301_7701-3 provides guidance on the classification of a foreign eligible_entity for federal tax purposes generally a foreign eligible_entity is treated as an association if all members have limited_liability unless the entity makes an election to be treated otherwise a foreign eligible_entity with a single member having limited_liability may elect to be treated as a disregarded_entity pursuant to the rules of sec_301_7701-3 sec_301_7701-3 provides that an entity classification election must be filed on form_8832 and can be effective up to days prior to the date the form is filed or up to months after the date the form is filed sec_301_7701-3 provides that such an election must be signed by either a each member of the electing entity who is an owner at the time the election is filed or b any officer manager or member of the electing entity who is authorized under local law or the entity’s organization documents to make the election and who represents to having such authorization under penalties of perjury sec_301_9100-1 provides that the commissioner may grant a reasonable extension of time to make a regulatory election or a statutory election but no more than months except in the case of a taxpayer who is abroad under all subtitles of the internal_revenue_code except subtitles e g h and i sec_301_9100-1 defines the term regulatory election as an election whose due_date is prescribed by a regulation published in the federal_register or a revenue_ruling revenue_procedure notice or announcement published in the internal_revenue_bulletin sec_301_9100-1 through provide the standards the commissioner will use to determine whether to grant an extension of time to make the election sec_301_9100-2 provides the rules governing automatic extensions of time for making certain elections sec_301_9100-3 provides the standards the commissioner will use to determine whether to grant an extension of time for regulatory elections that do not meet the requirements of sec_301_9100-2 under sec_301_9100-3 a request for relief will be granted when the taxpayer provides evidence to establish to the satisfaction of the commissioner that the taxpayer acted reasonably and in good_faith and granting relief will not prejudice the interests of the government conclusion based solely on the information submitted and the representations made we conclude that the requirements of sec_301_9100-3 have been satisfied as a result x is granted an extension of time of days from the date of this letter to file a form_8832 with the appropriate service_center to elect to be treated as a disregarded_entity for federal tax purposes effective d a copy of this letter should be attached to the form_8832 a copy is enclosed for that purpose plr-145837-10 this ruling is contingent on the owner of x filing within days of this letter all required returns for all open years consistent with the requested relief these returns may include but are not limited to the following forms i forms information_return of u s persons with respect to certain foreign_corporations ii forms return of u s persons with respect to certain foreign_partnerships and iii forms information_return of u s persons with respect to disregarded entities such that these forms reflect the consequences of the relief granted in this letter a copy of this letter should be attached to any such returns except as specifically set forth above no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter specifically no opinion is expressed regarding the application of sec_1503 and the regulations there under to the transactions described in this ruling this ruling is directed only to the taxpayer requesting it sec_6110 provides that it may not be used or cited as precedent pursuant to a power_of_attorney on file with this office a copy of this letter is being sent to x's authorized representative sincerely associate chief_counsel passthroughs special industries david r haglund by david r haglund branch chief branch passthroughs special industries enclosures copy of this letter copy of this letter for sec_6110 purposes


internal_revenue_service number release date index number ----------------------------- ------------------------------------------ ------------------ ---------------------------------------------------------- -------------------------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact -------------- id no ------------- telephone number --------------------- refer reply to cc psi b02 plr-116713-10 date date legend x country date date ------------------------------------------ ---------------------- --------------------------- ------------------------- --------------------------- dear ----------- this responds to a letter dated date submitted on behalf of x requesting that the service grant x an extension of time under sec_301_9100-3 of the procedure and administration regulations to elect to be treated as a disregarded_entity the information submitted states that x was formed under the laws of country on date x represents that as a foreign eligible_entity x was eligible to elect to be treated as a disregarded_entity effective date however x inadvertently failed to timely file a form_8832 entity classification election sec_301_7701-3 of the income_tax regulations provides that an eligible_entity with at least two members may elect to be classified as either an association and thus a corporation under sec_301_7701-2 or as a partnership and an eligible_entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner plr-116713-10 sec_301_7701-3 further provides that so long as a business_entity is not classified as a corporation under sec_301_7701-2 or an eligible_entity it may elect its classification for federal tax purposes sec_301_7701-3 provides that except as provided in sec_301_7701-3 unless the entity elects otherwise a foreign eligible_entity is a a partnership if it has two or more members and at least one member does not have limited_liability b an association if all members have limited_liability or c disregarded as an entity separate from its owner if it has a single owner that does not have limited_liability sec_301_7701-3 provides that for purposes of sec_301_7701-3 a member of a foreign eligible_entity has limited_liability if the member has no personal liability for the debts of or claims against the entity by reason of being a member sec_301_7701-3 provides that an entity classification election must be filed on form_8832 and can be effective up to seventy-five days prior to the date the form is filed or up to twelve months after the date on which the form is filed sec_301_9100-1 provides that the commissioner may grant a reasonable extension of time to make a regulatory election or a statutory election but no more than months except in the case of a taxpayer who is abroad under all subtitles of the internal_revenue_code except subtitles e g h and i sec_301_9100-1 defines the term regulatory election as an election whose due_date is prescribed by a regulation published in the federal_register or a revenue_ruling revenue_procedure notice or announcement published in the internal_revenue_bulletin sec_301_9100-1 through provide the standards the commissioner will use to determine whether to grant an extension of time to make the election sec_301_9100-2 provides the rules governing automatic extensions of time for making certain elections sec_301_9100-3 provides the standards the commissioner will use to determine whether to grant an extension of time for regulatory elections that do not meet the requirements of sec_301_9100-2 under sec_301_9100-3 a request for relief will be granted when the taxpayer provides evidence to establish to the satisfaction of the commissioner that the taxpayer acted reasonably and in good_faith and granting relief will not prejudice the interests of the government based solely on the information submitted and the representations made we conclude that the requirements of sec_301_9100-3 have been satisfied as a result x is granted an extension of time of days following the date of this letter to file form_8832 and to elect to be treated as a disregarded_entity for federal tax purposes effective date a copy of this letter should be attached to the form_8832 a copy is enclosed for that purpose plr-116713-10 except as specifically set forth above no opinion is expressed concerning the federal tax consequences of the facts described above under any other provision of the code this ruling is directed only to the taxpayer requesting it sec_6110 of the code provides that it may not be used or cited as precedent pursuant to a power_of_attorney on file with this office a copy of this letter is being sent to x’s authorized representative sincerely associate chief_counsel passthroughs special industries by ________________________________ charlotte chyr senior technician reviewer branch office of associate chief_counsel passthroughs special industries enclosures copy of this letter copy for sec_6110 purposes