O'connor v. Commissioner of Internal Revenue, 121615 FEDTAX, 5403-08

Docket Nº:5403-08
Opinion Judge:HALPERN, JUDGE.
Party Name:JEREMIAH J. O'CONNOR AND MARY K. O'CONNOR, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Attorney:Ira B. Satchel, for petitioners. Brian J. Bilheimer, Brian E. Derdowski, Jr., and Eugene A. Kornel, for respondent.
Case Date:December 16, 2015
Court:United States Tax Court
 
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T.C. Memo. 2015-244

JEREMIAH J. O'CONNOR AND MARY K. O'CONNOR, Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 5403-08

United States Tax Court

December 16, 2015

In 1998, P-H's wholly owned S corporation, H, became a participating employer in the A Plan, which purported to be a "10 or more employer" welfare benefit plan under I.R.C. sec. 419A(f)(6), providing death benefits to selected employees of an employer participating in the plan. To fund the death benefits for covered employees, each participating employer made cash contributions to a trust associated with the A Plan, which, by and through the plan trustee, used the cash to fund premiums for a life insurance policy on the life of each covered employee. The trustee was both owner and beneficiary of the policies.

In September 2002, B, the plan administrator, advised employer participants that, under anticipated final IRS regulations, they would lose their deductions for payments to fund insurance policy premiums under the A Plan and that it intended to terminate the A Plan in 2003. In October and November 2002, P-H, on behalf of H, attempted, unsuccessfully, to terminate H's participation in the A Plan and have the policy on P-H's life transferred directly from the A Plan to the BS Plan, a separate I.R.C. sec. 419A(f)(6) welfare benefit plan.

On several occasions during 2003, B advised H to voluntarily terminate its participation in the A Plan, which, under the terms of the plan, would entail a distribution of the policies to covered employees, taxation of each employee on the net cash surrender value of his or her policy, and the employee's transfer of the policy to a new plan. B stated that it could not allow a direct transfer of an insurance policy from it to another plan administrator.

Pursuant to that advice, in October 2003, H executed a corporate resolution terminating its participation in the A Plan. After receiving that resolution, B, on October 29, 2003, mailed to P-H a transfer of policy ownership form, signed by the trustee under the A Plan as the "Old Owner" of P-H's policy, and a blank change of beneficiary designation form. On November 11, 2003, a representative of the BS Plan signed the transfer of policy ownership form as the "New Owner" of the policy. The actual transfer of the policy did not occur until January 2004.

Ps argue that (1) they could not have received taxable income with respect to the policy transfer any earlier than 2004 when P-H's policy was actually transferred to the BS Plan and (2) that transfer was exempt from tax under I.R.C. sec. 1035, which provides for nonrecognition of gain on an exchange of life insurance policies. R argues that (1) Ps were taxable in 2003 under I.R.C. sec. 402(b)(1) or (2), either when H terminated its participation in the A Plan or when B provided to P-H the transfer of policy ownership form signed by the A Plan trustee, which allowed P-H to either retain the policy or transfer it to a new owner, and (2) I.R.C. sec. 1035 is inapplicable because there was no exchange of policies. R also seeks to impose a 20% substantial understatement penalty under I.R.C. sec. 6662(a).

1. Held: Ps are taxable, under I.R.C. sec. 402(b)(1), on the net cash or "accumulation" value of P-H's policy in 2003, either when H terminated its participation in the A Plan or when B provided to P-H the transfer of policy ownership form signed by the A Plan trustee. Gluckman v. Commissioner, T.C. Memo. 2012-329, aff'd, 545 F.App'x 59 (2d Cir. 2013), followed.

2. Held, further, I.R.C. sec. 1035 is inapplicable because there was no exchange of life insurance policies.

3. Held, further, I.R.C. sec. 6662(a) penalty sustained.

Ira B. Satchel, for petitioners.

Brian J. Bilheimer, Brian E. Derdowski, Jr., and Eugene A. Kornel, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, JUDGE.

By notice of deficiency (notice), respondent determined a $142, 416 deficiency and a $28, 483 accuracy-related penalty with respect to petitioners' 2003 Federal income tax.1 Respondent's principal adjustment is a $395, 051 increase in petitioners' income for 2003. The issues for decision are (1) whether petitioners received taxable income in 2003 with respect to a cash value life insurance policy on Mr. O'Connor's life held by a trust administered under a plan known as the Advantage Death Benefit Plan (Advantage Plan) sponsored and administered by BISYS Insurance Services, Inc. (BISYS), and (2) if so, whether petitioners are liable for the accuracy-related penalty under section 6662(a).2

FINDINGS OF FACT

This case was submitted fully stipulated under Rule 122. Petitioners resided in Massachusetts when they filed their petition.

Petitioners, who are married, timely filed their joint Federal income tax return for 2003 on April 13, 2004. Petitioner Jeremiah J. O'Connor was an employee of his wholly owned S corporation, 3 J.P. O'Connor Hardware, Inc. (Hardware), throughout the relevant periods discussed herein. It is Hardware's participation in and withdrawal from the Advantage Plan that gives rise to the issues in this case.

The Advantage Plan

The Advantage Plan purported to be a "10-or-more-employer" welfare benefit plan under section 419A(f)(6) providing death benefits to selected employees of an employer participating in the plan. The Advantage Plan was created in 1996 and, beginning in 2001, was administered by BISYS. In order to fund the death benefits for covered employees, each participating employer made cash contributions to the trust associated with the Advantage Plan, which, by and through the plan trustee, used the cash received to fund premiums for a life insurance policy on the life of each covered employee.4 The life insurance policy obtained on the life of each covered employee provided a death benefit in an amount equal to the death benefit provided in the Adoption Agreement executed by the employee's employer. Under the terms of the Advantage Plan, the plan trustee was both the owner and the beneficiary of the life insurance policy for a covered employee. The Advantage Plan did not allow any reversion of plan assets to a participating employer.

Article VI of the Advantage Plan document, entitled "Distribution of Benefits", provides as follows:

Section 6.01: Events Permitting Distribution. The Trustee shall, upon advice of the Plan Sponsor, within a reasonable period of time after notice, make a complete distribution of a Covered Employee's or Participant's interest or commence to distribute such interest upon:

(1) Notification by Employer of entitlement to death benefits by Covered Employee or Participant, together with death certificate and other materials required by Plan Sponsor, or

(2) Discontinuance of the Plan, termination, or partial termination of the Trust.

The Covered Employee or Participant may purchase, upon termination of employment, or an event described in Subsection 6.01(2) above, from the Trustee the benefits provided hereunder, if transferable under applicable law. The purchase price for the benefits shall be the amount set forth under Section 5.07. The Trustee shall take all necessary steps to facilitate the purchase by the Covered Employee or Participant during the thirty (30) day period following termination of employment or event described in Subsection 6.01(2) above. During such thirty day period, all Beneficiary designations shall remain in full force and effect. In the event the Insured does not elect to acquire such coverage, the Trustee may surrender such policy to the Insurer. The proceeds from the sale or surrender of the policy shall be added to the Trust Fund and allocated among Participants in proportion to each Participant's then current salary as compared to all Participants' salaries. In the event such Insured does not elect to acquire any insurance policy and dies prior to the surrendering of the policy by the Trustee but after the expiration of the thirty-day option period, the Trustee shall become the beneficiary and the death proceeds thereof shall be added to the Trust Fund.

Section 6.02: Manner of Distributing Interests. Payment of such benefits may be either:

(a) Payment directly to the Covered Employee or Participant;

(b) Payment to other individual or entity for benefit of the Covered Employee or Participant at the direction of the Plan Sponsor.

(c) Upon an Employer's determination to discontinue participation in the Plan, the Plan Sponsor shall retain an actuary to determine that there are sufficient benefits remaining in the Plan to meet the Trust's benefit requirements. If those liabilities have been currently met, then the Trustee is permitted to distribute policies to the Covered Employees of the Employer. If the Actuary retained by the Plan Sponsor and/or Trustee determines that there are insufficient assets to meet the current liability, then there shall be no distribution to the Covered Employees of the withdrawing Employer. Terminating distribution shall be in-kind or in cash. If in-kind, such distributions may take the form of the cash value life insurance policies maintained by the Trust on the life of the Covered Employees who shall receive the terminating distribution.

Article VII of the Advantage Plan document, entitled "Miscellaneous Provisions", provides, in pertinent part, as follows:

Section 7.01: Amendment or Termination. The Plan Sponsor reserves the right to retroactively or prospectively modify, alter, amend or terminate this Plan or the Trust, at any time, by an instrument in writing to be duly executed and delivered to the Trustee, in the case of the Trust, and that any such instrument shall not revest in the Employer any corpus or income of the Trust. No modification, amendment or termination of the...

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