GREENBERG, Circuit Judge.
This matter comes on before this court on appeal from decisions of the United States Tax Court entered April 9, 2001, in accordance with its opinion filed July 31, 2000, upholding the determination of the Commissioner of Internal Revenue that contributions made by appellants, two professional medical corporations, Neonatology Associates, P.A. and Lakewood Radiology, P.A., into Voluntary Employees Beneficiary Program (VEBA) plans in excess of the cost of term life insurance were taxable constructive dividends to the physicians owning the corporations and their spouses rather than employer deductible expenses. See Neonatology Assoc., P.A. v. Comm'r, 115 T.C. 43, 2000 WL 1048512 (2000). We refer to the corporations and individuals collectively as "taxpayers." The consequences of the decisions were substantial for the taxpayers inasmuch as the professional medical corporations were denied deductions they had taken for the contributions and the individuals were charged with significant additional taxable dividend income. The court held further that the individual taxpayers were liable for accuracy-related negligence penalties under I.R.C. § 6662(a).
Our examination of the record convinces us that the contributions at the heart of this dispute were so far in excess of the cost of annual life insurance protection that they could not plausibly qualify as ordinary and necessary business expenses in accordance with I.R.C. § 162. In essence, the physicians adopted a specially crafted framework to circumvent the intent
The evidence at the trial disclosed the following facts. Neonatology is a New Jersey professional corporation owned by Dr. Ophelia J. Mall. Lakewood is a New Jersey professional corporation owned equally at the times material here by Drs. Arthur Hirshkowitz, Akhilesh Desai, Kevin McManus, and Steven Sobo until his death on September 23, 1993. Subsequently Dr. Vijay Sankhla, who is not a party to this action, purchased Sobo's interest. The spouses of the doctors, John Mall, Lois Hirshkowitz, Dipti Desai, Cheryl MacManus, and Bonnie Sobo, are parties to this action as the doctors and their spouses filed joint income tax returns. In addition, Bonnie Sobo is a party as executrix of her husband's estate.
Following the enactment of the Tax Reform Act of 1986(TRA), Pub.L. 99-514, 100 Stat.2085, insurance salesmen Stephen Ross and Donald Murphy formed Pacific Executive Services (PES), a California partnership designed to provides services to retirement plan administrators and employee benefit advisors unfamiliar with the impact of the TRA. See App. at 377. Specifically, Ross and Murphy devised a program to allow closely held corporations to "create a tax deduction for [ ] contributions to [an] employee welfare benefit plan going in and a permanent tax deferral coming out." App. at 2672.
To achieve this end, PES created two voluntary employees' beneficiary associations, the Southern California Medical Profession Association VEBA (SC VEBA) and the New Jersey Medical Profession Association VEBA (NJ VEBA).
Under the PES VEBA programs, each participating employer adopts its own plan, maintaining a trust account and designating a trust administrator with exclusive control over all assets. The plan adoption agreement obligates employers to make, whether in the form of group insurance policies or group annuities, contributions towards the life insurance benefits of employees and their beneficiaries, based on a multiple of each employee's annual compensation. Benefits payable under any plan are paid solely from that plan's allocable share of the trust fund, and the participating employer, administrator, and trustee are not liable for any shortfall in the funds required to be paid. Upon termination of a plan, all its remaining assets
The SC VEBA plans at issue in this case, the Neonatology Employee Welfare Plan and the Lakewood Employee Welfare Plan, shared a common feature: both purchased continuous group (C-group) term policy certificates from the Inter-American Insurance Co. of Illinois, Commonwealth Life Insurance Co., and Peoples Security Life Insurance Co. The C-group product provided routine group term life insurance with an added component, a "special" conversion policy through which a covered employee, under certain circumstances,
In addition to being able to access surplus amounts, a policyholder upon conversion to the UL policy may borrow any amounts against his or her policies not required to keep the policies in force.
Neonatology, on the basis of conversations between its principal, Dr. Mall, and Cohen, established the Neonatology Plan under the SC VEBA on January 31, 1991, effective January 1, 1991. Under the plan, each covered employee was to receive a life insurance benefit equal to 6.5 times the employee's compensation of the prior year. See App. at 434, 1807. John Mall, Dr. Mall's husband, was not a paid employee of Neonatology and thus was not eligible to join the plan. Nevertheless, Dr. Mall and PES, the plan administrator, allowed Mr.
Lakewood, on the basis of conversations between its principals and Cohen, established the Lakewood Plan under the SC VEBA on December 28, 1990, effective January 1, 1990. Under the plan, each covered employee was to receive a life insurance benefit equal to 2.5 times his or her prior-year compensation. See App. at 387. Lakewood amended its plan as of January 1, 1993, to increase the compensation multiple to 8.15. The Lakewood Plan purchased 12 C-group life insurance policies on the lives of Drs. Hirshkowitz, Desai, Sobo, McManus, and Sankhla and three group annuities toward future premiums on the policies. See App. at 400-26. Lakewood also purchased three C-group policies outside of the Lakewood Plan. The individual owners on their own behalf determined the amounts contributed by Lakewood to the SC VEBA. See App. at 1015-16, 3674-87. For each subject year, Lakewood claimed a tax deduction for those contributions and other related amounts.
The IRS audited Neonatology's tax returns for calendar years 1992 and 1993 and Lakewood's tax returns for fiscal year 1991 (ending October 31, 1991) and calendar years 1992 and 1993. As a consequence of the audits, the Commissioner made the following determinations. First, with respect to the deductions claimed by Neonatology for amounts paid to the SC VEBA and by Lakewood for amounts paid to the SC VEBA and to the three non-plan C-group policies, he allowed only the cost of annual term life insurance protection and disallowed the excess amounts of $43,615 and $986,826 for Neonatology and Lakewood respectively. See App. at 2265-66, 2283-85. The Commissioner based his disallowance on alternative bases: (1) the excess contributions were not ordinary and necessary business expenses under I.R.C. § 162(a); (2) even if the amounts constituted ordinary and necessary business expenses, they nevertheless were not deductible under I.R.C. §§ 404(a) and 419(a), which limit the deductibility of contributions paid to deferred compensation plans and welfare benefit plans. See App. at 2266, 2285.
Second, the Commissioner determined with respect to the individual owners that amounts paid to the SC VEBA program increased personal incomes by $39,343 for Dr. Mall and her husband, $219,806 for Dr. Desai, $56,107 for Dr. McManus, $601,849 for Dr. Hirshkowitz, and $101,314 for Dr. Sobo (his estate). See App. at 2271, 2311, 2297, 2320. The Commissioner included the excess contributions as income to the individual taxpayers on alternative bases: (1) the amounts were deposited in the plans for the economic benefit of the individual taxpayers and as such constituted constructive dividends under I.R.C. §§ 61(a)(7) and 301; (2) assuming that the Neonatology and Lakewood Plans constituted
Neonatology, Lakewood, and the individual owners petitioned the Tax Court challenging the IRS's determinations. After a bench trial, the court sustained the Commissioner on the ground that:
Neonatology, 115 T.C. at 89-91.
Without addressing the alternative grounds for the Commissioner's conclusions, the court rejected taxpayers' arguments that the possibility of forfeiture in certain situations like policy lapse or death rendered all excess payments into de facto contributions to life insurance protection. Id. at 89-90 ("The mere fact that a C-group term policyholder may forfeit the conversion credit balance does not mean, as petitioners would have it, that the balance was charged or paid as the cost of term life insurance."). The court also rejected the idea that contributions which in fact did not fund term life insurance were paid as compensation for services, rather than dividends, because as a factual matter neither Neonatology nor Lakewood had the requisite compensatory intent when the contributions were made. Id. at 93. Lastly, the court agreed with the Commissioner that the individual taxpayers were in fact negligent and could not circumvent the accuracy-related penalties by asserting a good faith, reliance-on-professional defense nor could they do so by claiming that the case involved tax matters of first impression.
The Tax Court entered its decisions on April 9, 2001. Taxpayers timely appealed on July 6, 2001. We have jurisdiction over this appeal pursuant to I.R.C. § 7482, and the Tax Court had jurisdiction over the petitions pursuant to I.R.C. §§ 6213(a) and 7442.
There are three principal issues before us on appeal: (1) whether the Tax Court correctly determined that the amounts contributed in excess of the cost of per annum term life insurance were not ordinary and necessary business expenses and therefore not deductible; if yes, (2) whether those amounts constituted dividends, includible as taxable individual income, or compensation to the individual taxpayers; and, (3) whether the individual taxpayers were negligent. Our review of the Tax Court's legal conclusions is plenary and is based on the "clearly erroneous" standard for its findings of fact. See ACM P'ship v. Comm'r, 157 F.3d 231, 245 (3d Cir.1998); Pleasant Summit Land Corp. v. Comm'r, 863 F.2d 263, 268 (3d Cir.1988).
A. The Deficiencies
Section 162(a) of the Internal Revenue Code
The record amply supports the conclusion that taxpayers paid artificially inflated premiums in a creative bookkeeping ploy conceived by their insurance specialists to exploit what they thought were loopholes in the tax laws. Indeed, we do not see how a court examining this case could conclude otherwise. Charles DeWeese, the Commissioner's expert, testified that amounts paid into the C-group policies exceeded conventional life insurance premiums by nearly 500%. See App. at 804-08, 2156.
The record also reveals that excess premium amounts did not pay for actual current year life insurance protection but rather paid for conversion credits. The compliance manager of the Providian Corporation, the parent of the Commonwealth Life Insurance Company which issued policies involved here, stated in a letter to the IRS that the "premiums paid for the term policy are higher than the traditional term policy because of the conversion privilege and the costs of conversion credits." App. at 3690. DeWeese, belying taxpayers' claim that C-group premiums were higher than those under ordinary term life policies because they were calibrated to the higher risks of longer term employees in small markets,
In sum, the evidence fully supports, indeed compels, the finding that the contributions in excess of the amounts necessary to pay for annual term life insurance protection were distributions of surplus cash and not ordinary and necessary business expenses. Considering the sound reasoning of the Tax Court and our own intensive review of the facts here, we conclude that it is implausible that the owners of Neonatology and Lakewood, educated and highly trained medical professionals, knowingly would have overpaid substantially for term life insurance unless they contemplated receiving an added boon such as a tax-free return of the excess contributions.
Taxpayers advance two arguments to the effect that the court erred by not limiting its consideration to the written plan documents and life insurance contracts rather than relying on extraneous evidence like the plan marketing materials which discuss the availability of conversion credits. First, they maintain that the Neonatology and Lakewood SC VEBA programs were employee benefit plans under the Employee Retirement Income Security Act, 29 U.S.C. § 1001 et seq., (ERISA). Thus, they contend that representations made outside of the plan documents cannot be used to consider rights and obligations arising out of the plans. See Br. of Appellants at 35. Second, they argue that under governing state insurance law, the tax implications of a group term life insurance policy are determined only on the basis of the policy language
Inasmuch as taxpayers did not raise the ERISA issue before the Tax Court, we need not consider it on this appeal. See Visco v. Comm'r, 281 F.3d 101, 104 (3d Cir.2002). While we recognize that in some exceptional circumstances an appellate court may review a defaulted argument, in this case there are compelling reasons militating against our overlooking procedural norms to consider whether ERISA governed the SC VEBA programs as our determination may prejudice persons not parties to this case.
In any event, even assuming for purposes of argument that the plans were employee benefit plans under ERISA, the fact remains that under well-established tax principles a court is not limited to plan documents in determining the tax consequences of a transaction. See, e.g., Comm'r v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 708, 89 L.Ed. 981 (1945) ("The incidence of taxation depends upon the substance of a transaction."); ACM P'ship, 157 F.3d at 247 ("we must look beyond the form of the transaction to determine whether it has the economic substance that its form represents") (citations omitted); Lerman v. Comm'r, 939 F.2d 44, 54 (3d Cir.1991) (Commissioner and courts have "the power and duty ... to look beyond the mere forms of transactions to their economic substance and to apply the tax laws accordingly.").
Moreover, we reject taxpayers' contention that the Tax Court erred by not limiting its evaluation to the plan documents in light of state insurance law. The court did not construe or interpret the terms of the individual taxpayers' life insurance policies, but rather characterized the contributions made towards those policies for purposes of determining tax liabilities. While the former endeavor indeed would implicate state law,
In view of our conclusion that the contributions in dispute were not ordinary and necessary business expenses under I.R.C. § 162(a), we next consider whether the district court erred in determining that the contributions constituted dividends rather than compensation to the individual taxpayers and thus deductible to the corporations on that basis.
In this case, the record fully supports the conclusion of the Tax Court that the individual taxpayers were chargeable with constructive dividends. Indeed, Neonatology and Lakewood, by design surrendering any expectation of remuneration, purchased products that generated a considerable economic bounty for their shareholders in the form of conversion credits. Furthermore, nothing in the record illustrates that taxpayers diverted these corporate assets with the requisite "compensatory intent." See King's Ct. Mobile Home Park, Inc. v. Comm'r, 98 T.C. 511, 514-15, 1992 WL 80332 (1992) (business expense may be deducted as compensation only if the payor intends at the time that the payment is made to compensate the recipient for services performed).
Taxpayers again rely on non-tax ERISA jurisprudence for the exaggerated proposition that payments made pursuant to an employee benefit plan are necessarily compensatory.
We recognize that it is axiomatic that taxpayers lawfully may arrange their
B. The Penalties
Finally, we must consider the aptness of the penalties assessed by the Commissioner and upheld by the Tax Court. The Internal Revenue Code imposes a 20% tax on the portion of an underpayment attributable, among other things, to negligence or the disregard of rules and regulations. I.R.C. §§ 6662(a) and (b)(1). "Negligence" can include any failure to make a reasonable attempt to comply with the provisions of the Code, to exercise ordinary and reasonable care in the preparation of a tax return, to keep adequate books and records, or to substantiate items properly. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1). Generally speaking, the negligence standard as in the tort context is objective, requiring a finding of a lack of due care or a failure to do what a reasonable and prudent person would do under analogous circumstances. See, e.g., Schrum v. Comm'r, 33 F.3d 426, 437 (4th Cir.1994).
On the basis of the record, the Tax Court was justified in concluding as a matter of fact that the individual taxpayers were liable for the section 6662 accuracy-related penalties because they did not meet their burden of proving due care. See Hayden v. Comm'r, 204 F.3d 772, 775 (7th Cir.2000) (the Commissioner's determination of negligence is presumed to be correct, and the taxpayer has the burden of proving that the penalties are erroneous); accord Pahl v. Comm'r, 150 F.3d 1124, 1131 (9th Cir.1998) (burden of disproving negligence on taxpayer); Goldman v. Comm'r, 39 F.3d 402, 407 (2d Cir.1994) (once the Commissioner determines that a negligence penalty is appropriate, the taxpayer bears the burden of establishing the absence of negligence). The physician-owners caused their corporations to overpay considerably for term life insurance knowing that the money could be rerouted circuitously to their personal coffers with a net tax savings. Yet, notwithstanding the extraordinary financial implications of the SC VEBA arrangement, the individual taxpayers did not make a proper investigation or exercise due diligence to verify the program's tax legitimacy. See David v. Comm'r, 43 F.3d 788, 789-90 (2d Cir.1995); see also Pasternak v. Comm'r, 990 F.2d 893, 903 (6th Cir.1993) (holding that a reasonably prudent person should investigate claims when they are likely "too good to be true") (quoting McCrary v. Comm'r, 92 T.C. 827, 850, 1989 WL 35568 (1989)).
Taxpayers argue that their negligence should have been excused because they
The Tax Court concluded that taxpayers could not prevail on a reliance-on-professional defense because they received advice only from Cohen, an insurance agent who stood to profit considerably from the participation of Neonatology and Lakewood in the VEBA program, rather than from a competent, independent tax professional with sufficient expertise to warrant reliance. The circumstances here, including the facts that certified public accountants prepared taxpayers' returns, the New Jersey Medical Society — a group with dubious tax code proficiency which in fact received royalties to endorse the SC VEBA
In reaching our result, we acknowledge that Dr. Hirshkowitz deviated from the thoroughly head-in-the-sand posture of his fellow taxpayers by soliciting his accountant's opinion of the SC VEBA. See App. at 6666-67. Nevertheless, the record supports the court's finding with respect to Dr. Hirshkowitz, considering that he did not introduce into evidence precisely what information he showed to his accountant, precisely what advice his accountant gave him, and, more generally, the qualifications of his accountant.
We also add the following. When, as here, a taxpayer is presented with what would appear to be a fabulous opportunity to avoid tax obligations, he should recognize that he proceeds at his own peril. In this case, PES devised a program which it marketed as "creat[ing] a tax deduction for the contributions to the employee welfare benefit plan going in and a permanent tax deferral coming out." As highly educated professionals, the individual taxpayers should have recognized that it was not likely that by complex manipulation they could obtain large deductions for their corporations and tax free income for themselves.
In a final attempt to skirt the additional penalties, taxpayers argue that a finding of negligence could not in fairness arise out of a case resolving tax issues of first impression.
For the foregoing reasons, we will affirm the decisions of the Tax Court.