Court Opinion

ID: 4337084
Source: CourtListenerOpinion
Date Created: 2018-11-14 03:10:02.955486+00
Date Added: 2024-06-11T14:20:45.515067
License: Public Domain

130 T.C. No. 8

                UNITED STATES TAX COURT

        DANTE AND SANDI PERANO, Petitioners v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 5543-06.                Filed 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 those 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. 951(a)(1), I.R.C.
See secs. 952(c), 956(b)(1), I.R.C.

     1. Held: Because the transactions that gave rise
to the private annuity agreements constituted capital
expenditures by AG and because AG’s accruals under
those agreements constituted reserves for future
contingencies, those accruals did not reduce AG’s
earnings and profits.
                               - 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.

                              OPINION

     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 with

petitioners that the accruals did reduce the CFC’s earnings and

profits, then petitioners are not required to include any amounts

in gross income under the foregoing provisions.2

                            Background

     This case was submitted fully stipulated under Rule 122.

The facts stipulated by the parties are so found.   The

stipulation of facts, with accompanying exhibits, is incorporated

herein by this reference.   At the time the petition was filed,

petitioners resided in the State of Nevada.

     The following is a summary of the facts necessary for our

discussion.

     American General Ltd. (American General) is a corporation

formed in the Isle of Man in October 1992.    From its

incorporation through 2001, 100 percent of the stock of American

General was owned by a fiduciary pursuant to an irrevocable trust

     1
        Those provisions are part of subpt. F, pt. III, subch. N,
ch. 1, subtit. A of the Internal Revenue Code (subpt. F).
Pursuant to those provisions and sec. 951(b) (defining the term
“United States shareholder”), each United States shareholder of a
controlled foreign corporation (CFC) includes in his gross income
his pro rata share of the CFC’s (1) subpt. F income (as defined
in sec. 952) and (2) earnings invested in United States property
(as determined under sec. 956).
     2
        The stipulation actually describes 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 not exceed a CFC’s
earnings and profits for the taxable year, 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 sec. 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” and

“[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 death of the survivor,

irrespective of the number of payments made to that point or

whether any payments at all have been made 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 the amount stated in the

agreement as the fair market value of the property received in

exchange for the agreement.   It recorded liabilities in the

following amounts:

           Agreement                          Amount

      Annuity agreement 1                    $493,200
      Annuity agreement 2                     582,500
      Annuity agreement 3                     353,355

     For the years 1994 through 2001, American General accrued

annuity expenses with respect to the annuity agreements as

liabilities on its books and records in the aggregate amount of

$949,119, as follows:

              Year                            Amount

              1994                            $32,021
              1995                             84,103
              1996                            114,665
              1997                            123,431
              1998                            132,797
              1999                            142,885
              2000                            153,756
              2001                            165,461
                Total                         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.

                            Discussion

I.   Introduction

      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 making

      3
        As noted supra, 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) for the lives of

petitioners.     The terms of those promises are manifest in what we

have described as annuity agreements 1, 2, and 3.     Recognizing

that the present value of its obligation to make the annuity

payments promised would increase every year until the annuity

starting dates, American General accrued as an annual expense an

addition to an accounting reserve to reflect that increase.     We

must determine whether those accruals were a proper charge to

American General’s earnings and profits.     We conclude that they

were not.

II.   Analysis

      A.   Introduction

            Petitioners summarize their argument as follows:

           Petitioners believe that its [American General’s]
      accrued annuity expense constitutes a reserve to
      liquidate its future obligation and is allowable under
      Section 953 and the regulations thereunder as a reserve
      for estimated expenses for purposes of calculating its
      current and accumulated E&P.

      Section 953 defines the term “insurance 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 properly reduced its

earnings and profits on account of annual accruals for additions

to a reserve reflecting its obligation to make annuity payments

pursuant to the annuity agreements could be disposed of in short

order.     Generally, annuity payments made for property are

considered payments made to purchase the 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
                                - 9 -

distribution.”4), revd. on other grounds 98 F.2d 717 (2d Cir.

1938).5

     Moreover, even if annuity payments do not have to be

capitalized, the obligation to commence life annuity payments in

the future is contingent and for that reason does not reduce

earnings and profits absent a special exception like that

applicable to life insurance reserves.    See Dean v. Commissioner,
9 T.C. 256, 266 (1947) (reserves for contingent future expenses

do not reduce earnings and profits), affd. 187 F.2d 1019 (3d Cir.

1951).    Professors Bittker and Eustice, in their treatise,

Federal Income Taxation of Corporations and Shareholders, point

out that, in determining whether a distribution to shareholders

constitutes a taxable dividend, reference is made to the

distributing corporation’s earnings and profits rather than to

its surplus, in part because surplus, unlike earnings and

profits, is reduced by reserves for contingencies.    Bittker &

Eustice, Federal Income Taxation of Corporations and

     4
        This result is consistent with sec. 312(n)(3), which
denies 5-year amortization of such expenditures under sec. 248
for purposes of determining a corporation’s earnings and profits.
     5
        Not permitting capital expenditures to reduce earnings
and profits is justified on the ground that “capital expenditures
accomplish a mere change in the form of assets, and ‘earnings or
profits’ should then be affected only through the depreciation
account.” Paul, “Ascertainment of ‘Earnings or Profits’ For
Purpose of Determining Taxability of Corporate Distributions”, 51
Harv. L. Rev. 40, 45 n.18 (1937).
                                 - 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 Argument

     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 any case will be dependent

upon the method of accounting properly employed in computing

taxable income”).

     On brief, petitioners concede that American General is not

an insurance company:    “Respondent is correct in pointing out

that[,] as a real estate company, American General is not an

Insurance Company.”    They argue, however, that that does not

matter:   “American General * * * [does not need to be an

insurance company in the business of selling insurance] in order

to reduce * * * [earnings and profits] by 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 to the issuing (or
                  reinsuring) of an insurance 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 within the meaning of

section 953(a)(1), which allows it to accrue additions to

reserves, and reduce its earnings and profits, in anticipation of
                               - 12 -

making the annuity payments called for by those agreements,

notwithstanding that it is not an insurance company.6

     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 proposed

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 953 * * *

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 which

     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 of insurance or
     annuity contracts. [Emphasis added.]

     Petitioners’ first difficulty in finding support in the

proposed regulations is that they have failed to prove that

American General’s business was to any extent the business of

issuing insurance or annuity contracts.   The issuance of

insurance, to include annuities, requires risk shifting and risk

distribution.   See Helvering v. Le Gierse, 312 U.S. 531, 539

(1941); Wright v. Commissioner, T.C. Memo. 1993-328 (“The amounts

in the annuities did not constitute insurance because no risk

shifting or risk distribution occurred.”), modified per order

(Oct. 29, 1993), affd. without published opinion 73 F.3d 372 (9th

Cir. 1995).   In the case of the annuity agreements, there was no

risk distribution (i.e., the pooling of possible annuity

termination dates) among a broad number of individuals.     American

General’s mortality risk was spread between the lives of only two

individuals; viz, petitioners.   We said in Amerco & Subs. v.

Commissioner, 96 T.C. 18, 41 (1991), affd. 979 F.2d 162 (9th Cir.

1992):   “The concept of risk-distributing emphasizes the pooling

aspect of insurance: that it is the nature of an insurance

contract to be part of a larger collection of coverages, combined

to distribute risk between insureds.”   Moreover, respondent

argues that there was no risk shifting (one party shifting the

risk of a loss to another party), since petitioners are the

owners, at least for tax purposes, of American 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.7

     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.

     7
        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).
                               - 15 -

III.   Conclusion

       Because American General’s accruals for the future payment

of annuities to petitioners did not reduce its earnings and

profits, respondent’s adjustments increasing petitioners’ 2001

income under section 951(a)(1) are sustained.

                                          Decision will be entered

                                     under Rule 155.