DOJ Argues Tax Court Correctly Denied Medical Corporations' Deductions for Excess Contributions to VEBAs

Statement of the issues

Statement of the case

Statement of the facts

Statement of the standard or scope of review

Summary of argument

Argument:

Certification of bar membership

Certificate of Compliance

Addendum

ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998)

Accardo v. Commissioner, 942 F.2d 444 (7th Cir. 1991)

Alloy Cast Products, Inc., et al. v. Barret, et al., No. A- 5028-00TS (Superior Ct. N.J.)

B.B. Rider Corp. v. Commissioner, 725 F.2d 945 (3d Cir 1984)

Black Hills Corp. v. Commissioner, 73 F.3d 799 (8th Cir. 1996)

Burke v. United States, 504 U.S. 229 (1992)

C.F. Mueller Co. v. Commissioner, 479 F.2d 678 (3d Cir. 1973)

CM Holdings, Inc., In re, 254 B.R. 578 (D. Del. 2000), appeal pending, 3d Cir. -- No. 00-3875

Catalano v. Commissioner, 240 F.3d 842 (9th Cir. 2001)

Chism, Estate of v. Commissioner, 322 F.2d 956 (9th Cir. 1963)

Commissioner v. Bolyston Market Ass'n, 131 F.2d 966 (1st Cir. 1942)

Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967)

Commissioner v. Heininger, 320 U.S. 467 (1943)

Commissioner v. Lincoln Savs. & Loan Ass'n, 403 U.S. 345 (1971)

Commissioner v. Makransky, 321 F.2d 598 (3d Cir. 1963)

Connelly, Estate of v. United States, 551 F.2d 545 (3d Cir. 1977)

Crosby v. United States, 496 F.2d 1384 (5th Cir. 1974)

Dardovitch v. Haltzman, 190 F.3d 125 (3d Cir. 1999)

David v. Commissioner, 43 F.3d 788 (2d Cir. 1995)

Enoch v. Commissioner, 57 T.C. 781 (1972)

Flamingo Resort, Inc. v. United States, 664 F.2d 1387 (9th Cir. 1982)

Foxman v. Commissioner, 352 F.2d 466 (3d Cir. 1965)

Frank Lyon Co. v. United States, 435 U.S. 561 (1978)

Geftman v. Commissioner, 154 F.3d 61 (3d Cir. 1998)

Girard Inv. Co. v. Commissioner, 122 F.2d 843 (3d Cir. 1941)

Goldman v. Commissioner, 39 F.3d 402 (2d Cir. 1994)

Hayden v. Commissioner, 204 F.3d 772 (7th Cir. 2000)

INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992)

Ireland v. United States, 621 F.2d 731 (5th Cir. 1980)

Jacques v. Commissioner, 935 F.2d 104 (6th Cir. 1991)

Knetsch v. United States, 364 U.S. 361 (1960)

Loftin & Woodard, Inc., v. United States, 577 F.2d 1206 (5th Cir. 1978)

Mellon Bank Corp. v. First Union Real Estate Equity and Mortgage Investments, 951 F.2d 1399 (3d Cir. 1991)

Merino v. Commissioner, 196 F.3d 147 (3d Cir. 1999)

Montgomery Engineering Co. v. United States, 344 F.2d 996 (3d Cir. 1965)

Paramount-Richards Theaters, Inc. v. Commissioner, 153 F.2d 602 (5th Cir. 1946)

Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993)

Pediatric Surgical Associates v. Commissioner, P.C., T.C.M. (CCH) 1474 (2001)

Peters v. Commissioner, 4 T.C. 1236 (1945)

Redding v. Commissioner, 630 F.2d 1169 (7th Cir. 1980)

Richardson v. Commissioner, 125 F.3d 551 (7th Cir. 1997)

Rogers v United States, 281 F.3d 1108 (10th Cir. 2002)

Salley v. Commissioner, 464 F.2d 479 (5th Cir. 1972)

Sankhla v. Commonwealth Life Ins. Co. et al., No. 01-cv-4781 (U.S.D.C. N.J.)

Simon J. Murphy Co. v. Commissioner, 231 F.2d 639 (6th Cir. 1956)

Stewart v. Commissioner, 714 F.2d 977 (9th Cir. 1983)

Strick Corp. v. United States, 714 F.2d 1194 (3d Cir. 1983)

Thomas Flexible Coupling Co. v. Commissioner, 158 F.2d 828 (3d Cir. 1946)

Thompson v. Commissioner, 205 F.2d 73 (3d Cir. 1953)

United Parcel Service v. Commissioner, 254 F.3d 1014 (11th Cir. 2001)

United States v. Court Holding Co., 324 U.S. 331 (1945)

United States v. Phellis, 257 U.S. 156 (1921)

Vesuvius Crucible Co. v. Commissioner, 356 F.2d 948 (3d Cir. 1966)

Visco v. Commissioner, 281 F.3d 101 (3d Cir. 2002)

Weinert's Estate v. Commissioner, 294 F.2d 750 (5th Cir. 1961)

Welch v. Helvering, 290 U.S. 111 (1933)

Weller v. Commissioner, 270 F.2d 294 (3d Cir. 1959)

Whitcomb v. Commissioner, 733 F.2d 191 (1st Cir. 1984)

Zfass v. Commissioner, 118 F.3d 184 (4th Cir. 1997)

Statutes:

Internal Revenue Code of 1986 (26 U.S.C.):

Tax Reform Act of 1984, Pub. L. No. 99-514, 100 Stat. 2085

Miscellaneous:

Fed. R. App. P. 13(a)

H.R. Conf. Rep. No. 98-861 at 1131 et seq., reprinted in 1984- 3 C.B.(Vol. 2) 1, 385 et seq.

H.R. Conf. Rep. No. 99-841 at 373 et seq., reprinted in 1986-3 C.B. (Vol. 4) v, 373 et seq.

K. Black & H. Skipper, Life Insurance 569 (11th ed. 1987)

Rev. Rul. 70-521, 1970-2 C.B. 72

Treasury Regulations on Income Tax (26 C.F.R.):

2. Whether the Tax Court correctly found that such amounts were includible in the income of the individual taxpayers as constructive dividends.

3. Whether the Tax Court correctly found that taxpayers were liable for the accuracy-related penalty for negligence under I.R.C. § 6662.

[6] To implement this program, PES established the Southern California Medical Profession Association. This association has no bylaws and its members have never held a meeting. It exists only so that PES could create the Southern California VEBA (SC VEBA). (A. 7, 378-379.)⁴ Each employer participating in the program devised by PES was supposed to adopt its own plan. The documents executed by the employer provide, among other things, that the employees of that employer are provided with a specified amount of life insurance benefits based upon the employee's compensation and that the employer has his own separate account. (A. 7, 387-388, 434, 1994-2039, 3642-3649.)

[7] A document prepared by PES to promote its VEBA program, entitled "Your Own Special Tax Reduction Act" (A. 366; 5821), gives the following "overview" of the program (A. 5823; see also A. 6, 238, 4781):

[9] Central to the SC VEBA program was a novel life insurance product known as the continuous group (C-group) product. The C-group product is a universal life product consisting of two related policies: (1) a group term life insurance policy, and (2) a "special" conversion policy. ⁵ (A. 8, 813, 2158, 2163, 2744, 2758, 3241-3244, 3690, 4728, 5553, 5849.)

[10] The premiums paid for the group term life insurance policy are at least four times higher than the premiums on a conventional group term life insurance policy. (A. 8-9, 2156, see also A. 998, 1025-1026, 1031-1033, 1046-1051, 3690, 4763, 5553.) The excess of the gross premium over the normal cost of group term insurance is effectively accumulated in a conversion accumulation account and credited with interest. (A. 9, 2156-2160; see also A. 2744- 2754, 2795, 2814-2815, 2831-2832, 3690, 4702, 4895-4902.) ⁶

[11] The operation of the conversion credits is not detailed in the group term life insurance policy or the certificates issued thereunder. (A. 2157.) The policy, however, provides a conversion privilege, which allows "an insured Employee [to] convert his group insurance to an individual policy if coverage ceases" for one of five reasons: (1) the employee is no longer employed, (2) the employee ceases to be a member of a class eligible for insurance under the contract, (3) the contract terminates, (4) the contract is amended so as to terminate or reduce the insurance of any class of insured employees, or (5) the contract terminates with respect to an individual employer or plan. (A. 1836, 1846, 2735; SA 97.) The conversion privilege further states (ibid.):

[13] A conversion credit is a percentage of the conversion accumulation account established for the C-group term life insurance policy (i.e., the means for recording the excess premiums paid on the term policy). (A. 2161-2162, 2795.) The amount of the conversion credit varied depending upon the year in which the conversion took place. For most of the time periods relevant here, the percentage was zero if the conversion took place in the first year and graded to 95 percent⁷ if the conversion took place in the fourth year. In 1993, the credit was changed for newly issued certificates to zero in the first four years and 95 percent thereafter. (A. 9, 2161-2162, 2796, 2832, 4710, 4713.)

[14] The conversion credits are applied to the cash value in the C-group conversion UL policy ratably over a 120-month period. (A. 9-10, 1932, 1936, 3690.) This cash value would allow the participant to borrow as policy loans the amount that was not needed to keep the policy in force. (A. 1941-1942, 2164; SA 88.) If such policy loans, which bore interest equal to the interest credited on the asset accumulation and thus were "wash" loans, were maintained until the policyholder died, they would be repaid with the policy death benefits that are normally not subject to income tax (see I.R.C. § 101). (A. 385, 2164, 3584.) It was on this basis that PES claimed that there was "a permanent tax deferral coming out." (A. 5823; see also A. 2164.)

[15] b. PES united with a longtime insurance salesman, Barry Cohen of the Kirwan Companies, to market its VEBA program to medical professionals. Cohen sold the SC VEBA program to Lakewood and the doctors that owned it and to Neonatology and the doctor that owned it. (A. 6, 386-387, 433-434, 649, 991, 1020, 2687-2690; SA 116-117.)

[16] Illustrations projecting the amount of the conversion credits were prepared by the insurance companies for the participants from both Neonatology and Lakewood. (A. 3576-3599, 3813-3820, 3851- 3873, 5037-5045, 5049-5055.) These illustrations generally stated the following "conversion policy assumptions" (A. 3584, 3813, 3851, 3867, 5045, 5049):

[18] In accordance with the design of the SC VEBA program (see pp. 5-6, supra), Neonatology established its own plan (A. 433, 1994-2016), which provided that each employee received a life insurance benefit equal to 6.5 times the employee's prior year compensation (A. 434, 1807, 3442). The Neonatology plan purchased C- group term policy certificates on Dr. Mall and her husband, John Mall. (A. 10-12, 434-439.) Under the terms of the Neonatology plan, John Mall was not eligible to participate in the VEBA. (A. 10, 64, 1029-1030, 164; taxpayers' Br. 11 n.8, 28.) The $500,000 face amount of John Mall's life insurance policy certificate under the Neonatology plan was based on the amount of life insurance coverage he had on prior policies and had nothing to do with the provisions of the Neonatology Plan specifying the amount of life benefits for an employee. (SA 108-109.) The amount of life insurance selected for Dr. Mall also was not based on the provisions of the Neonatology Plan specifying the amount of life benefits for an employee. (A. 434, 436- 437.) For example, Dr. Mall's compensation in 1991 was $240,000 (A. 434-435), entitling her to life benefits for the year 1992 of $1,560,000 (i.e., 6.5 times $240,000; A. 434, 1807, 3442). The amount of coverage on her under the plans' group term policy in 1992, however, was only $650,000. (A. 11, 380, 437, 555.)

[19] In selling the SC VEBA program to Lakewood, Cohen dealt with Sobo, Desai, and Hirshkowitz. (A. 13; SA 116-117.) Cohen explained to them that the program provided conversion credits and that they were paying a higher premium than they would for pure term insurance because of the credits. (A. 13-14, 998, 1050, 1063.) In paying the higher premiums, the participants were doing something other than trying to buy insurance. (A. 13-14, 1012.) They anticipated getting cash out through the conversion feature. (A. 14, 1014-1015.)

[20] Pursuant to the SC VEBA program (see pp. 5-6, supra), Lakewood established its own plan (A. 386-387, 2017- 2039), which initially provided that each employee received a life insurance benefit equal to 2.5 times the employee's prior year compensation (A. 387.) An amendment dated January 1, 1993, changed the compensation multiple from 2.5 to 8.15 effective January 1, 1990. Hirshkowitz, Desai, and McManus, but not Sobo, executed documents refusing the additional coverage provided by the amendment. (A. 386- 387, 1799-1804.)

[21] The Lakewood plan purchased twelve C-group policy certificates on the lives of its principals. (A. 14-21, 400-413.) It also purchased three annuities in which it deposited over $400,000 during the years at issue (1991-1993). (A. 21-22; 414-426.) These annuities were not used to fund the life insurance under the plan. The Lakewood plan generally purchased these annuities to accumulate wealth to pay future premiums on the C-group policies. (A. 21, 993- 994, 997, 1041-1042, 1344.) ⁸

[22] The amount of life insurance taken out on the Lakewood participants did not correspond to the amount of benefits for which they were eligible under the Lakewood plan. (A. 14, 387-405, 997, 1004, 1057-1058.) For example, Hirshkowitz's compensation in 1991 was $181,994.09 (A. 389), entitling him to life benefits of only $454,985.22 for 1992 (i.e., 2.5 times $181,994.09; see p. 13, supra). During 1992, however, the Lakewood plan had C- group policy certificates with face amounts of $1,000,000 (A. 19, 401), and $150,000 (A. 16, 400-401) in effect on his life, and Hirshkowitz had another certificate for $940,000 (A. 23, 403) outside the plan. Each of the Lakewood employee/owners decided the amount that Lakewood would contribute to the SC VEBA program on his behalf and Lakewood wrote separate checks for each employee/owner's contribution noting on each check the name of the person for whom the contribution was made. (A. 14, 1015-1016, 3674-3687.)

[23] Outside of the Lakewood plan, Lakewood purchased three C- group policy certificates. One of those certificates was on the life of Sankhla, the physician who bought Sobo's interest after his death. (A. 21-24, 402-403, 405-409.)

[24] c. Sobo died on September 23, 1993. (A. 386.) According to the Lakewood plan documents, his beneficiary was entitled to death benefits equal to 8.15 times his prior year compensation of $329,184.82 (A. 14, 387-388, 390-391) or $2,682,856.28. Sobo's beneficiary was paid only $1,150,000, the total amounts of the term life insurance certificates purchased by the plan on Sobo. (A. 431, 1010; Tr. 171.)

[25] d. Each of the individual taxpayers (other than Sobo) has converted at least one C-group term certificate to a special conversion policy providing conversion credits. (A. 38 n.12, 426-429, 439-441.) When those policies were converted, none of the five conditions specified in the C-group term policy for exercising the conversion privilege (see p. 9, supra) was satisfied. (A. 38 n.12; SA 106, 111-112.) In each case, however, the taxpayer was granted the conversion credits in accordance with the table of conversion credit values, consistent with his or her expectations and the prior illustrations. (A. 385, 565, 620-621, 850, 860-861, 868- 870, 956-957, 1023, 1032-1033, 1063-1064, 1153, 1277, 3576-3599, 3813-3820, 3851-3873, 5037-5045, 5049-5055.)

            Desai     McManus    Hirshkowitz    Estate of Sobo

[27] On its income tax returns for the calendar years 1992, and 1993, Neonatology deducted the amounts that it paid with respect to the SC VEBA program. On audit, the Commissioner allowed only the cost of providing current year term life insurance protection and disallowed $23,646 of the deductions claimed for 1992 and $19,969 of the deductions claimed for 1993. (A. 13, 2265-2266.) The Commissioner also audited Dr. Mall and her husband and determined that the amounts paid by Neonatology with respect to the SC VEBA program resulted in additional income to them of $19,374 for 1992 and $19,969 for 1993. (A. 13, 2271.) In addition, the Commissioner determined that both Neonatology and the Malls were liable for the accuracy-related penalty under I.R.C. § 6662(a). (A. 2261, 2264, 2268.)

[28] The Commissioner based his disallowance of the deductions to Lakewood and Neonatology on taxpayers' failure to show that the contributions in excess of the cost of providing current life insurance protection constituted ordinary and necessary expenses under I.R.C. § 162(a). Alternatively, if the amounts disallowed constituted ordinary and necessary business expenses under § 162(a), the Commissioner based his disallowance on I.R.C. §§ 404(a) and 419(a), which limit the deductibility of contributions paid to deferred compensation plans and welfare benefit funds that "would otherwise be deductible." Specifically, if the plans were characterized as deferred compensation plans, the contributions were not deductible because the plans failed to satisfy I.R.C. § 404(a)(5), which contains a "separate account" requirement. If the plans were characterized as welfare benefit funds, the otherwise allowable deductions were limited by I.R.C. § 419(b) and they were not exempted from the limitation by the exception for certain "10-or-more employer plans" in I.R.C. § 419A(f)(6). (A. 13, 24, 2266, 2285.)

[29] The Commissioner included the excess contributions as income to the individual taxpayers on two alternative bases. First, the Commissioner determined that the excess contributions made on behalf of the individual taxpayers by the corporations represented payments for the economic benefit of the individual taxpayers/shareholders and were includible in their income under I.R.C. §§ 61(a)(7) and 301 as constructive dividends. Second, if the Neonatology and Lakewood plans constituted deferred compensation plans, the excess contributions were includible under § 402(b). (A. 13, 24, 2271, 2297, 2311, 2320; SA 52.)

[30] Taxpayers filed petitions in the Tax Court challenging the Commissioner's determinations. (A. 2, 2261-2325.) Taxpayers conceded that Lakewood and Neonatology could deduct the payments at issue "only if the payments satisfy the requirements of § 162(a) of the Internal Revenue Code." (A. 6195.) They argued that the payments satisfied those requirements and that the limitations imposed by § 404(a) on deferred compensation plans and by §§ 419 and 419A on welfare benefit plans did not disallow the deductions. (A. 28-29; 6195-6212, 6214-6219.) Taxpayers further argued that I.R.C. § 83(a) allowed the individual taxpayers to exclude the amounts that the Commissioner had included in their income. Taxpayers asserted a reliance-on-professional defense and made a case-of-first- impression argument in contesting the negligence penalties. (A. 6220- 6224.)

[31] The Tax Court held in favor of the Commissioner. (A. 1-2.) Before addressing the issues, the court found that the opinions expressed by the Commissioner's expert, Charles DeWeese, were reliable (A. 27, 28) and that those expressed by taxpayers' expert, Jay Jaffe, "helped us minimally" (A. 28). In this regard, the court noted that Jaffe's knowledge of critical facts was influenced by his relationship to one of the insurance companies that provided the C- group product that was a critical part of the SC VEBA program, that he relied on erroneous data, and that he conceded that he did not review all pertinent facts. (A. 41 n.25.) The court also found that fact witnesses Desai, Hirshkowitz, Ankner, Ross, and the Malls "testified incredibly with regard to material aspects of this case" and that "[t]heir testimony, as well as the testimony of Mr. Cohen, was for the most part self-serving, vague, elusive, uncorroborated, and/or inconsistent with documentary or other reliable evidence." (A. 28.)

[32] In sustaining the Commissioner's disallowance of the deductions claimed by Neonatology and Lakewood for contributions in excess of those that funded term life insurance (and for similar payments made by Lakewood outside the plan), the court held that these amounts did not meet the threshold requirement of qualifying as ordinary and necessary business expenses under § 162(a), and, that as a consequence, it did not need to consider the Commissioner's alternative positions. (A. 29-31, 41 n.27.) The court explained as follows (A. 29; footnote omitted):

[33] In sustaining the Commissioner's determination that certain disallowed payments should be included in the income of certain taxpayers, the Tax Court held that the payments constituted constructive dividends. (A. 32-33.) The court viewed the excess payments "as passing first through the employee/owners." (A. 33.) The court also rejected taxpayers' argument that the excess contributions were paid as compensation for services, and not as dividends, because the record demonstrated both that "the purpose and operation of the Neonatology Plan and the Lakewood Plan was to serve as a tax-free savings device for the owner/employees" and that Neonatology and Lakewood did not have the requisite compensatory intent at the time that they made the contributions. (A. 31.) The court further held that taxpayers' argument based on I.R.C. § 83 was unavailing because that section does not apply to a case where a corporation makes a cash distribution for the benefit of a shareholder. (A. 33.)

[34] Finally, the Tax Court sustained the Commissioner's imposition of the § 6662 penalties, agreeing that taxpayers were negligent. The court rejected taxpayer's reliance-on-professional defense because taxpayers did not prove that they satisfied even one of the three requirements for successfully asserting such a defense, viz., (1) that the adviser relied on was a competent professional, (2) that the taxpayer provided necessary and accurate information to the adviser, and (3) that there was actual reliance in good faith. (A. 33-35, 43 n.39.) The court further rejected taxpayers' claim that the penalties should be excused because the case involved matters of first impression. The court stated that "[i]t is not new in the arena of tax law that individual shareholders have tried surreptitiously to withdraw money from their closely held corporations to avoid paying taxes on those withdrawals." (A. 35.)

[38] 1. It has long been established that "[t]axation is an intensely practical matter, and it deals with realities not semblances; with substance and not form . . . ." Thompson v. Commissioner, 205 F.2d 73, 78 (3d Cir. 1953). The evidence in the record shows that the corporate taxpayers took deductions for payments attributable to premiums on group term life insurance policies that were at least four times higher than those normally charged for such policies, that the individual taxpayers that owned the corporate taxpayers could access the inflated premiums by taking out a "special" conversion policy in which cash in the form of conversion credits "magically comes into the policy" (A. 867), and that taxpayers did not comply with the form of the VEBA program in many respects. This evidence fully supports the Tax Court's finding (A. 29) that "The Neonatology Plan and the Lakewood Plan are primarily vehicles which were designed and serve in operation to distribute surplus cash surreptitiously (in the form of excess contributions) from the corporations for the employee/owners' ultimate use and benefit." Accordingly, the Tax Court correctly held that the inflated premium payments did not constitute ordinary and necessary business expenses under I.R.C. § 162(a), but rather were constructive dividends to the individual taxpayers.

[39] 2. The record demonstrates that the tax benefits promised to taxpayers -- huge tax deductions and tax free income for funds that were essentially "park[ed]" in the VEBA program -- were too good to be true. Taxpayers have not rebutted the Commissioner's determination that they did not act negligently in claiming the program's promised tax benefits. The evidence that taxpayers cite does not show that they satisfied the requirements for a reliance-on-professional defense. Moreover, their notion that they should be excused from their negligence on the ground that this case is one of first impression is unfounded. As the Tax Court held, well-established tax principles make it abundantly clear that their surreptitious scheme would not be countenanced.

[41] In the case at bar, insurance practitioners devised a tax oriented program for closely held corporations and their principals, which was designed to operate as follows. The corporation, through a purported VEBA, would enroll its owner/employees in a purported group term life insurance policy that contained a provision that allowed the owner/employees to convert their coverage to a "special" conversion policy. The corporation would make contributes to the purported VEBA, which in turn would pay a "premium" that is several times the premium that is normally paid for group term life insurance. The amount in excess of the normal premium effectively would be tracked in a conversion accumulation account, which would be credited with interest. After being enrolled in the group policy for several years, the owner/employee was able to exercise the conversion privilege and receive a "special" conversion policy, which provided universal life coverage (i.e., a type of insurance that had a cash value). So-called "conversion credits," which were based on the conversion accumulation account for the group term policy, then would be credited to the cash value in the special conversion policy.

[42] Under the program, the corporation would take a deduction for the full amount of the group term "premiums" as ordinary and necessary business expenses under I.R.C. § 162(a), relying on the form of the policy, which made it appear that the "premiums" were being paid for insurance policies that would fund current-year term life insurance benefits under the VEBA. The interest that was credited to the accumulation account would not be included as income as it accrued. Further, when the excess premiums and earnings thereon (less fees for the insurance company and brokers) were credited to the cash value of the special conversion policy through conversion credits, the owner/employee would not report any income. The program also contemplated that the owner/employee would access the conversion credits transferred from the group policy to the special conversion policy through policy loans. The policy loans would be repaid from the death benefits when the owner/employee died, which would be excluded from income on the basis the exclusion in I.R.C. § 101(a). According to the program's architect, they had "create[d] a tax deduction for the contributions . . . going in and a permanent tax deferral coming out." (A. 5823.)

[43] Taxpayers participated in this program. The Commissioner disallowed the deductions claimed by Lakewood and Neonatology for payments that exceeded the cost of the current year life insurance protection and included the amount of the disallowed deductions in the income of the individual taxpayers benefitting from the excess payments. ¹¹ The Commissioner based these determinations on several alternative grounds, including his determination that the disallowed amounts did not constitute ordinary and necessary business expenses under I.R.C. § 162(a) and his determination that those amounts constituted constructive dividends to the individual taxpayers. The Tax Court agreed with the Commissioner that amounts paid by Lakewood and Neonatology that exceeded the cost of providing group term life insurance did not constitute ordinary and necessary business expenses and that the individual taxpayers received constructive dividends. As we shall demonstrate, the Tax Court correctly sustained the Commissioner's determinations on that basis.

[45] At the time this case was tried, the Commissioner's determinations in his notices of deficiency were entitled to a presumption of correctness, and taxpayers bore the burden of proving by a preponderance of the evidence that the Commissioner's determinations were incorrect. Welch v. Helvering, 290 U.S. 111, 115 (1933); Geftman v. Commissioner, 154 F.3d 61, 68 (3d Cir. 1998). ¹² Whether an amount paid by a corporation constitutes an ordinary and necessary business expense for the corporation under I.R.C. § 162(a) is a question of fact reviewed under the clearly erroneous standard, ¹³ as is the question whether such an amount constitutes a constructive dividend. ¹⁴The Tax Court's findings that the payments at issue are not ordinary and necessary business expenses and that the excess payments attributed to the individual taxpayers constitute constructive dividends are well supported by the record and are clearly correct.

[48] Similarly, documents in evidence of the insurance companies that wrote the policies here at issue show that the unusually high premiums were not paid for the purchase of current year life insurance protection, but rather for the conversion credits. Product specifications issued by one of the companies state that "[b]eginning at issue, a Conversion Accumulation Account Balance is calculated dependent on premium and an annual charge," that a "conversion credit," which is a percentage of the Conversion Accumulation, is "available to the insured employee to convert to a special universal life policy," and that "this Conversion Credit does not apply to any conversion other than the special universal life policy." (A. 2795; see also A. 1980 (pricing assumptions for the special conversion policy state that "the Conversion Credit amount from the Term product is applied to the Conversion UL in 120 monthly installments").) A product description from another one of the companies explains that "the values [in the special conversion policies] are designed to approximate the results that could have been achieved if a typical universal life policy had been purchased at the time Continuous group was initially issued." (A. 2744; see also A. 77, 3690.) In other words, the premium was designed to mirror the premium paid for a policy with a cash value. (See also A. 3576-3599, 3813-3820, 3851-3873, 5037-5045, 5049-5055 (illustrations prepared by the insurance companies project the conversion credits).) As the parent of two of the insurance companies stated plainly in a letter to the Internal Revenue Service in response to a summons "[t]he premiums paid for the term policy are higher than the traditional term policy because of the conversion privilege and the cost of the conversion credits." (A. 3690.) ¹⁵

[49] Further, that the portion of the unusually high premiums on the group term policy that exceeded the cost of a traditional term life insurance were being paid for the conversion credits was confirmed by expert testimony. The Government's expert, Mr. DeWeese, analyzed the information in the record pertaining to the C-group term policy and the special conversion policy (see A. 2156-2166, 2180-2182) and concluded that "the two policies were linked in operation and in pricing" (A. 2163). He further concluded that the gross premiums for the C-group term polices are composed of a cost of insurance element, which was relatively small, and a savings element that served to accumulate assets to be distributed to the individual participants when they chose to convert to the special conversion UL policy. (A. 2173; see also A. 1352 (taxpayer's expert concedes that reserves were maintained for the amount of the conversion credits).)

[50] In sum, the record shows that the Tax Court correctly found that the excess contributions and premiums were not attributable to current year protection but were in reality disguised payments designed to provide conversion credits that the companies expected to pay to the employee/owners. (A. 29-30.)

[52] An item may be a constructive dividend "even though the corporation has not observed the formalities of dividend declaration, and has not made a pro rata distribution to the entire class of stockholders." Crosby, 496 F.2d at 1389; accord C.F. Mueller Co., 479 F.2d at 683; Makransky, 321 F.2d at 601; Paramount-Richards Theaters, Inc. v. Commissioner, 153 F.2d 602, 604 (5th Cir. 1946). "In determining whether a constructive dividend has been made, the crucial concept is that the corporation conferred an economic benefit on the stockholder without expectation of repayment." Ireland v. United States, 621 F.2d 731, 735 (5th Cir. 1980) (internal punctuation and citations omitted); accord Paramount-Richards Theaters, 153 F.2d at 604 (insurance premiums paid by corporation on policy covering a stockholder held constructive dividends). ¹⁶

[53] Here, the excess payment conferred an economic benefit on the owners of Lakewood and Neonatology. It purchased a product for them that was expected to produce cash in the form of conversion credits. Further, there was no expectation that the excess payments would be repaid by the owners who benefitted from them. Indeed, the whole purpose of the payments was to funnel cash out of the corporations while reaping significant tax benefits.

[54] As noted above, after the Commissioner determined in his notices of deficiency that the individual taxpayers were chargeable with constructive dividends (A. 13, 24, 2271, 2297, 2311, 2320; SA 52), the burden was on the individual taxpayers to prove otherwise. The record demonstrates that the Tax Court did not err in finding that they had failed to meet that burden. First, as the Tax Court observed (A. 30-31), to demonstrate that the disguised payments constituted compensation (as taxpayers contended), taxpayers needed to show that Neonatology and Lakewood intended at the time that payments were made to compensate the recipient for services performed. See Estate of Chism, 322 F.2d at 960. As the Tax Court pointed out, however, taxpayers only asserted on brief that these corporations had the requisite compensatory intent when they made the contributions and did not identify anything in the record that would support such a finding. (A. 31.) While the VEBA documents arguably may demonstrate that the portion of the "premiums" provided for current life term insurance protection were intended as employee compensation in the form of fringe benefits, they do not evidence that the excess "premiums," which as the Tax Court noted were "disguised" payments (A. 30) made through vehicles that operated "surreptitiously" (A. 29), had such a character. To the contrary, it can be inferred from the fact that the VEBA program at issue was designed for closely held corporations (A. 2672, 5823) that the surreptitious benefits were intended for the small group of individuals that owned the corporation, and not for employees.

[55] Moreover, evidence in the record affirmatively demonstrates that the excess payments were being made for the individual taxpayers in their capacities as owners, and not as employees. In the case of Neonatology, the record shows that the corporation was owned entirely by Ophelia Mall. (A. 433.) She directed the Neonatology plan to purchase the C-group product on her husband (A. 435-438), who did not qualify for coverage under the plan. (A. 10, 64, 435-438, 1029-1030, 1684; see taxpayers' Br. 11 n.9, 28.) The life insurance coverage on Dr. Mall's husband was simply based on some prior life insurance that he had, and not on an amount of services. (SA 108-109.) Thus, in directing the corporation to make payments to the Neonatology plan, she plainly was not acting to compensate an employee. Cf. Montgomery Engineering, 344 F.2d at 997 (payment to spouse of controlling shareholder constituted constructive dividend). Similarly, the amount of life insurance selected by Dr. Mall for herself also was not based on the provisions of the Neonatology plan specifying the amount of life benefits for an employee. (A. 434, 436-437.) Again, the court did not clearly err by concluding that she simply exercised her power as sole shareholder to divert corporate assets for her own purposes.

[56] Further, in the case of Lakewood, when Hirshkowitz was queried at trial on how Lakewood decided how much it would contribute, he responded "that was on a individual basis" (A. 1015), later explaining that "each individual contributed whatever he wanted" (A. 1016). In addition, when Desai was asked to explain his claim that he gambled with a million dollars of Lakewood's money for the possibility of conversion credits, he stated, "Well, it's our money. It's not Lakewood['s]." (A. 1055.) And, the evidence also demonstrates that the amount of life insurance taken out on the Lakewood participants did not correspond to the amount for which they were eligible for under the Lakewood plan (A. 14, 387-391, 400-405, 1004, 1057-1058), confirming that the contributions were made to accommodate the wishes of the individual owners. This evidence fully supports the Tax Court's conclusion that Lakewood's excess payments should be viewed "as passing first through the employee/owners." (A. 33; 42 n.31.)

[60] In the first place, taxpayers' premise that payments made to a VEBA necessarily are compensatory is mistaken. Indeed, if that were so, the requirement of I.R.C. § 419(a)(2), that contributions to a VEBA are deductible only "if they would otherwise be deductible" would largely be rendered superfluous. (Emphasis added.) In any event, merely funneling the payments through an employee benefit plan, by itself, obviously does not convert expenses that are not ordinary or necessary into ones that are. As the Tax Court held (A. 29), "[t]he Neonatology Plan and the Lakewood Plan are primarily vehicles which were designed and serve in operation to distribute surplus cash surreptitiously (in the form of excess contributions) from the corporations for the employee/owners' ultimate use and benefit." To the extent that the plans were used as employee benefit plans -- i.e., to provide current life insurance protection -- the court allowed the deduction. To the extent that they were used for a surreptitious purpose, the court correctly found that they did not evidence compensatory intent. Cf. Whitcomb, 733 F.2d at 192-94 (compensatory intent not established by labeling certain amounts as premium payments for a life insurance plan for employees); see also pp. 38-40, supra, discussing evidence demonstrating lack of compensatory intent. ²⁰

[61] Taxpayers further argue (Br. 28) that the payments of taxpayer Neonatology are deductible as compensation because Pediatric Surgical Associates v. Commissioner, P.C., T.C.M. (CCH) 1474, 1479 (2001), establishes a legal "presumption" that anything paid to or on behalf of the only employee of a corporation is compensation and Dr. Mall was the only employee. This argument should not be considered because it was not raised in the Tax Court. (A. 1-44; 6143-6224; Visco v. Commissioner, 281 F.3d 101, 104 (3d Cir. 2002).) In any event, taxpayers' argument is unfounded. Pediatric Surgical does not hold that there is any such presumption. Rather, it recognizes that in addressing the issue of whether the amount of compensation claimed is reasonable that the profit of a sole proprietorship may be the best evidence of the value of the services. 81 T.C.M. at 1479-1480. That issue, however, does not come into play until a taxpayer establishes compensatory intent. ²¹ Indeed, the Tax Court in Pediatric Surgical expressly held that a taxpayer always "must prove its intent . . . to pay compensation" before it can obtain a deduction. 81 T.C.M. at 1480. Here, as we have previously demonstrated, pp. 36-38, supra, Neonatology did not meet that burden.

[62] 2. Taxpayers grasp at straws when they cite a number of non-tax (ERISA) cases (Br. 29-31, 34-36) and argue that "regardless of the context, whenever a court considers the implications of an arrangement to provide benefits, the court must first determine whether the arrangement is an employee benefit plan" (Br. 29). Again, this argument should not be considered because it was not raised in the Tax Court. Visco, 281 F.3d at 104. In any event, it is a red herring. Even if the arrangements are VEBAs, as is noted above, I.R.C. § 419(a)(2) provides that deductions are allowed only "if they would otherwise be deductible." Thus, taxpayers still must jump the § 162 hurdle. Indeed, the Treasury Regulations expressly provide that amounts paid to employee benefit plans are deductible under § 162(a) "if they are ordinary and necessary business expenses." Treas. Reg. § 1.162-10(a). And, as noted above, they are not ordinary and necessary business expenses simply because they are paid to such a plan. Whitcomb, 733 F.2d at 192-94; see also Treas. Reg. § 1.162-7(b)(1) ("An ostensible salary paid by a corporation may be a distribution of a dividend on stock"). Accordingly, taxpayers are flat out wrong when they state (Br. 32) that "the issue is not whether a deduction to the plan is allowable, but rather the timing of the deduction." In fact, taxpayers conceded in the Tax Court that the corporate taxpayers could deduct the payments at issue "only if the payments satisfy the requirements of § 162(a) of the Internal Revenue Code." (A. 6195.)²²

[63] 3. Under the sham transaction doctrine, a tax motivated transaction can be disregarded for tax purposes if its lacks sufficient economic substance. ACM, 157 F.3d at 245-248. Looking to the sham transaction doctrine cases, taxpayers argue (Br. 39-46) that before a court can disregard the form of an arrangement, it must determine that the arrangement has no economic substance other than obtaining tax deductions. This argument has no merit. As the Tenth Circuit recently confirmed in Rogers v United States, 281 F.3d 1108 (10th Cir. 2002), the substance-over-form doctrine is distinct from the sham-transaction doctrine. Indeed, the substance-over-form doctrine has long been recognized as the "cornerstone of sound taxation" (Weinert's Estate v. Commissioner, 294 F.2d 750, 755 (5th Cir. 1961)), and has been consistently applied by this Court (see cases cited at pp. 26- 27, supra).²³

[64] Taxpayers' reliance (Br. 42) on United Parcel Service v. Commissioner, 254 F.3d 1014 (11th Cir. 2001), is misplaced. That case did not involve a life insurance product in which a corporation paid an excessive amount for a group term policy and cash value sprung up in "special" individual policies held by the corporation's owners. Moreover, in United Parcel, the court only held that the sham transaction doctrine did not apply to the insurance transaction before it. Id. at 10. The court remanded the case for consideration of the Government's alternative arguments under the reallocation provisions of I.R.C. §§ 482, 845(a). Since § 482 is a provision which incorporates substance-over-form principles, ²⁴ there is no basis for concluding that the Eleventh Circuit has precluded a reallocation of income in the transaction before it under substance-over-form principles. Here, the Tax Court did not base its decision on the sham transaction doctrine. Rather, it relied on the substance-over-form doctrine.

[65] Finally, taxpayers are not assisted by the old adage that a taxpayer is entitled to arrange his affairs so as to minimize his taxes (see taxpayers' Br. 33-34). As the Supreme Court has recognized with respect to tax-motivated transactions, "the question for determination is whether what was done apart from the tax motive, was the thing that the statute intended." Knetsch v. United States, 364 U.S. 361, 365 (1960). Section 162 does not contemplate that disguised dividends should be treated as ordinary and necessary business expenses. See Treas. Reg. § 1.162- 7(b)(1) ("An ostensible salary paid by a corporation may be a distribution of a dividend on stock") (emphasis added). Nor does the sweeping language of § 61(a) contemplate that disguised dividends should be excluded from gross income. See pp. 36-37, supra.

[66] 4. Taxpayers point out (Br. 10 n.7, 48) that a miniscule part of the nearly $1million in disallowed deductions for Lakewood is attributable to a C-group term premium of $5,750 paid in May 1993 for Dr. Sankhla²⁵ and argue that there can not be a constructive dividend because Sankhla did not become an owner of Lakewood until July 1994.²⁶ Because Sankhla is not a party to this case, whether he received a constructive dividend is not at issue.

[67] Further, to obtain a compensation deduction for the disallowed portion of this payment, Lakewood must prove that it had the compensatory intent required for a deduction under § 162(a)(1). See pp. 30-31, 43-44, 46-47, supra. Taxpayers, however, have cited no evidence demonstrating why this payment was made.²⁷ Moreover, the record demonstrates that the coverage on Sankhla's certificate was $500,000. (A. 403.) If Lakewood intended the payment of the contribution for this coverage to be compensation, it was required to report on Sankhla's W-2 for 1993 the cost of the insurance attributable to the coverage in excess of $50,000. See taxpayer's Br. 31-32 (alleging I.R.C. § 79 applies); Instructions for Forms W-2 and W-3 (Internal Revenue Service); 387-2d Tax Mgmt. Portfolio (BNA) A-7. The record, however, shows that Lakewood on its 1993 W-2 for Sankhla did not report any such compensation. (A. 432.)

[68] 5. Taxpayer's notion (Br. 33-35, 37-38) that the documents drafted by the promoters of the SC VEBA plan are "governing" in this case is unfounded. As the Supreme Court held in Frank Lyon Co., 435 U.S. at 573 (internal quotation marks and citations omitted), "the simple expedient of drawing up papers [is not] controlling for tax purposes when the objective economic realities are to the contrary" and "formal written documents are not rigidly binding." The ERISA cases that taxpayers inaccurately cite in an effort to advance their theory (Br. 34-36) do not override well established tax principles. As this Court held in Danielson, 378 F.2d at 774:

[69] Taxpayers' related argument (Br. 35; see also Br. 37, 39) that the Tax Court "subjugated the plans' governing documents in favor of marketing material" is incorrect. First, the Tax Court based its determinations on a "voluminous record" of which the marketing materials were only a part. (A. 28.) As we have demonstrated, evidence in the record other than marketing materials amply supports the Tax Court's findings.

[70] Moreover, even if, consistent with their testimony, which was found not to be credible by the Tax Court (A. 28), the marketing materials were not shown to taxpayers, it does not matter. The Tax Court reasonably could conclude that the substance of the tax shelter described in the marketing materials possessed by the insurance company's agents was transmitted to taxpayers by those agents through oral sales presentations. Indeed, in view of the testimony demonstrating that taxpayers were well aware that the premiums for the C-group policy were substantially in excess of those normally charged and that they were motivated by tax benefits (see pp. 31-32, supra; A. 1032, 1054, 1063), it is inconceivable that these well-educated doctors would pay the excessive "premiums" unless they were informed of the substance of the tax shelter. See also A. 4723 (State Insurance Commissioner concludes that C-group policyholders' understanding of the operation of the product is substantially consistent with the sales literature).

[71] 6. Taxpayers' contention (Br. 36-39) that state law somehow demonstrates error on the part of the Tax Court has no merit. To begin with, as this Court held with respect to I.R.C. § 162's predecessor in Thomas Flexible Coupling Co. v. Commissioner, 158 F.2d 828, 830 (3d Cir. 1946), whether or not an item constitutes an "ordinary and necessary business expense" is "not a question of state law" but instead "is entirely an issue of federal tax law." Cf. Weller, 270 F.2d at 298 ("That there may be an obligation under local law . . . is not determinative of whether there is a true indebtedness [giving rise to interest deductions] within the meaning of [I.R.C. § 163's predecessor]"). Similarly, it is also well established that state law also does not control the related constructive dividend issue. Jacques v. Commissioner, 935 F.2d 104, 107-08 (6th Cir. 1991); Estate of Chism, 322 F.2d at 959-960.

[72] The mere fact that state insurance commissions accepted the policies is largely irrelevant. State insurance regulators are concerned with policyholder protection, not with making sure that federal taxes are not escaped through devious means. See K. Black & H. Skipper, Life Insurance 569 (11th ed. 1987). If Congress had wanted state insurance practices to be dispositive of the substance of the insurance transactions for tax purposes, it would have said so. Cf. I.R.C. §§ 818(a), 832(b)(1)(A) (delegating a role to state insurance practices in certain matters relating to the taxation of insurance companies).

[73] Furthermore, the conversion credits do not have to be "guaranteed" under state law (see taxpayer's Br. 38) to have tax consequences. Cf. Flamingo Resort, Inc. v. United States, 664 F.2d 1387, 1390 (9th Cir. 1982) (fact that gambling debts could not be enforced under local law did not prevent recognition of income). Here, the individual taxpayers caused their corporations to buy a product that was expected to produce for them substantial cash in the form of conversion credits. As the Tax Court held (A. 33, 42 ns.33, 33), the transaction was in substance one where the excess contributions (and premiums in the case of non-plan payments) passed first through the individual taxpayers who in turn paid the amounts to the plans (or insurance companies) so that they could obtain conversion credits. See Enoch v. Commissioner, 57 T.C. 781, 792-793 (1972) (when a shareholder causes corporate funds to be paid to a third party for his personal benefit, the funds are deemed to pass through the shareholder and then to the third party). ³⁰

[74] Whether or not the product that was purchased actually produced the expected cash benefits does not negate the fact that taxpayers received a benefit. If instead of a product with conversion credits, the individual taxpayers had caused their corporations to purchase stock options for them from a third party, they would have no guarantee of receiving cash. If the market moved adversely nothing would be received; if, however, the market moved favorably, substantial cash would be realized. At the time of the purchase of the option, however, the cost of the option was a substantial benefit and was taxable as a constructive dividend. Rev. Rul. 70-521, 1970-2 C.B. 72; Redding v. Commissioner, 630 F.2d 1169, 1181 (7th Cir. 1980). Similarly, the amounts paid for the expected conversion credits also are constructive dividends. ³¹

[75] In any event, state law demonstrates that the claim to conversion credits that the taxpayers obtained in the instant transaction had value. When one of the insurance companies that provided the C-group product went into receivership, numerous participants in the program submitted claims for the expected conversion credits. Although the claims were opposed, the liquidation proceedings do not demonstrate that the claims were not recoverable under state law. Instead, the liquidator, in a settlement approved by a state court, paid substantial amounts to satisfy the conversion credits. (A. 5557-5563.) Thus, the evidence in the record demonstrates that, under state law, the payments for the conversion credits were for something of value.

[76] 7. Taxpayers' attempt (Br. 44-45) to refute the Tax Court's well supported finding regarding the size of the premiums (see pp. 31-32, supra) based on the testimony of Ankner and Jaffe is unavailing. The Tax Court found (A. 28) that Ankner was not credible. That determination was "quintessentially with the province of the trial court." Dardovitch v. Haltzman, 190 F.3d 125, 140 (3d Cir. 1999). The Tax Court further found that taxpayers' expert Jaffe's knowledge of critical facts was influenced by his relationship to one of the insurance companies that provided the CG product that was a critical part of the tax shelter at issue, that he relied on erroneous data, and that he conceded that he did not review all pertinent facts. (A. 41 n.25.) Those findings are amply supported by the record. (A. 1178-1181, 1185-1186, 1191-1192, 1199-1202, 1218, 1222-1223, 1236-1237, 1249, 1272-1274, 1283, 1305-1307, 1329-1331, 1344.)

[78] When the benefits promised by a tax program seem too good to be true, it is incumbent on the taxpayer to investigate the program's legitimacy. Pasternak, 990 F.2d at 903; David v. Commissioner, 43 F.3d 788, 789 (2d Cir. 1995). Here, the record amply supports the Tax Court's finding (A. 35) that "the represented tax benefits of the C-group product were simply too good to be true." According to the SC VEBA program's architect, taxpayers would receive "a tax deduction for the contributions . . . going in and a permanent tax deferral coming out." (A. 5823.) In other words, taxpayers would take huge tax deductions for funds that were essentially "park[ed]" in the program. (Ibid.) There is ample testimony in the record demonstrating that the taxpayers knew that they were substantially overpaying for the "term insurance," that they expected to get most of their money back, and that they were promised huge tax deductions that, as far as the record shows, were unavailable elsewhere. See pp. 31-35, supra; see also A. 1032, 1054, 1063. There is no credible evidence (see A. 28) demonstrating that taxpayers did anything that would justify their treatment of the too- good-to-be true tax benefits on their tax returns.

[79] 2. Taxpayers argue (Br. 49) that they should be excused from paying the accuracy-related negligence penalties because they relied on the advice of professionals. As the Tax Court held (A. 34- 35), that argument has no merit. While a taxpayer can show an absence of negligence through a reliance-on-professional defense, a mere statement by a taxpayer that he relied upon a professional is not sufficient to do so. Accardo v. Commissioner, 942 F.2d 444, 452 (7th Cir. 1991). To establish such a defense, a taxpayer must prove good faith reliance on a competent professional who is given all the information necessary to evaluate the tax matter at issue. See Treas. Reg. § 1.6664-4(c); Richardson v. Commissioner, 125 F.3d 551, 5559 (7th Cir. 1997); Zfass v. Commissioner, 118 F.3d 184, 189 (4th Cir. 1997); Accardo, 942 F.2d at 452.

[80] The evidence cited by taxpayers (see Br. 49) does not demonstrate that taxpayers have met the requirements for a reliance-on-professional defense. Rather, the evidence that they cite regarding so-called "experienced professionals" (i.e., A. 6660-6662) reveals only that taxpayers were introduced to the program by a life insurance salesman (i.e., Cohen). As the Tax Court found (A. 35), there was no showing that Cohen was a competent tax adviser or that he ever represented himself as such. See Catalano v. Commissioner, 240 F.3d 842, 845 (9th Cir. 2001) (reliance defense requires showing that advisor is competent). Further, the fact that Cohen stood to gain financially from selling the tax shelter would negate any reliance even if he were an otherwise competent tax professional. Goldman v. Commissioner, 39 F.3d 402, 408 (2d Cir. 1994); Pasternak, 990 F.2d at 903.

[81] Taxpayers' claim that the program was endorsed by the New Jersey Medical Society also does not satisfy their burden. Again, there is nothing in the record demonstrating that this medical society was competent to evaluate the instant tax shelter. Nor is there any evidence that shows exactly what it was that the medical society endorsed. Taxpayers do not cite any document issued by the medical society that was given to them. Similarly, taxpayers do not cite any testimony demonstrating that they had meaningful oral communications with the medical society in this regard. Moreover, the record shows that the New Jersey Medical Society was paid substantial royalties by Cohen to endorse the Southern California program in which taxpayers participated. (A. 570-571.) This financial arrangement demonstrates that the society's endorsement "can hardly be described as that of >independent professionals.'" Pasternak, 990 F.2d at 903.

[82] Similarly, the vague and self-serving testimony of Hirshkowitz (i.e., A. 6666-6667) that taxpayers cite is unavailing for several reasons. First, Hirshkowitz's testimony does not show that he disclosed critical facts, such the inflated "premiums" taxpayers paid for the term insurance. Failure to provide complete information to a lawyer or accountant advising a taxpayer negates a reliance-on-professional defense to a tax penalty. Richardson, 125 F.3d at 5559; Zfass, 118 F.3d at 189; Girard Inv. Co. v. Commissioner, 122 F.2d 843, 848 (3d Cir. 1941). Second, Hirshkowitz did not make any showing regarding the qualifications of the "accountant." This is also a critical deficiency in taxpayer's showing. See Catalano, 240 F.3d at 845 . Third, what Hirshkowitz actually said is that the accountant "had no major reservations" regarding the program. The Tax Court was not required to accept Hirshkowitz's characterization of the accountant's reservations as "no[t] major" when Hirshkowitz provided no information about those reservations and when the Tax Court found Hirshkowitz not to be credible (A. 28).

[83] Taxpayers' last ditch effort to establish a reliance-on- professional defense based upon an "engagement agreement" (Br. 49) is also unsuccessful. The only thing that this document states is that PES would "Submit the Trust to the IRS for qualification and make such amendments as may be requested by IRS." (A. 3672 (emphasis added).) It does not state that the IRS had qualified the plan. Moreover, even if it did, it would make no difference. As we have demonstrated above , pp. 45 n.20, supra, the IRS's qualification of the SC VEBA (upon incomplete information) has no bearing on the tax liabilities of the taxpayers here, who are not the VEBA. Indeed, the IRS expressly warned that "no opinion is expressed or implied as to whether employer contributions to [the plan] are deductible." (A. 1410.)

[84] 3. Taxpayers also miss the mark when they contend (Br. 49) that the penalties are inapplicable because this case allegedly involves "issues of first impression." While courts have on occasion declined to apply the negligence addition to tax in a case of first impression involving statutory language that is unclear, ³² the mere fact that an issue is raised for the first time does not establish an absence of negligence.³³ Here, the issues before the Court do not involve the interpretation of a statute with unclear language. Nor, are they matters of first impression. Rather, they involve a straightforward application of the well established substance-over-form principle of taxation. See pp. 26-43, supra. As the Tax Court held (A. 35):

²Sankhla is not a party in this case. The spouses of the doctors are parties to this proceeding because joint income tax returns were filed. Hereinafter, references to the "individual taxpayers" are only to the doctors.

³A VEBA is defined in I.R.C. § 501(c)(9). An organization that qualifies as a VEBA generally is exempt from income tax pursuant to I.R.C. § 501(a).

⁴PES established other non-operational entities, such as the New Jersey Medical Professional Association, to implement its VEBA programs. (A. 379.) Since the appellants in this case all participated in the SC VEBA, we do not discuss them here.

⁵The C-group product was written by three different insurance companies (Inter-American Insurance Company of Illinois, Commonwealth Life Insurance, and Peoples Security Life) during the time period relevant here with different names assigned to the product. Inter-American went into receivership. (A. 380.) The other two companies are affiliates. (A. 382.) Taxpayers concede (Br. 12, 16 n.14) that there is no meaningful difference between the products provided by the different companies. Accordingly, to simplify the discussion, we, like taxpayers, refer to this product as "C-group."

⁶The conversion accumulation account provides a value for the conversion credits that the company expects to pay. (A. 2161, 2795.) In practice, the amount of the conversion credits were typically determined by the insurance companies through tables and a formula. (A. 385, 1135-1137, 1147-1153, 2161, 3152-3199.) Moreover, funds for the conversion credits were set aside in a trust account established pursuant to the reinsurance contracts for the C-group term life policies. (A. 386-387, 1352, 2157, 2865, 5241-5242, 5247, 5261.)

⁷The percentage did not exceed 95 percent because a 5 percent commission was paid to the insurance agent upon conversion. (A. 426-430, 440, 2162.)

⁸The attributes of the various policies and annuities are discussed in the Tax Court's opinion. (A. 15-24; see also A. 11-13 discussing the Neonatology policies.) Taxpayers belatedly served an addendum to their opening brief on February 27, 2002, that purportedly provides schedules of the various policies. These schedules are not properly before the Court. They are not part of the record below. Further, if they are viewed as facts compiled from information in the record, they are not supported by record citations. See 3rd Cir. Rule 28.0(c). At all events, taxpayers do not contest the Tax Court findings in this regard since they concede (Br. 22) that they do not raise any factual issues in this appeal.

⁹ The Commissioner also determined that Lakewood was liable for a late filing penalty for its 1992 year. (A. 36, 2279.) Lakewood does not contest the propriety of this penalty on appeal.

¹⁰The Tax Court also held that the contributions paid by Neonatology for John Mall's C-group product did not satisfy I.R.C. § 162(a). Because taxpayers concede these amounts (A. 64; Br. 11 n.9), we do not discuss them here.

¹¹The life insurance coverage made available under a VEBA generally must be current year protection only. Treas. Reg. § 1.501(c)(9)-3(b). Similarly, employees receiving employer-paid life insurance coverage containing permanent benefits must include the cost of that benefit in income. Treas. Reg. § 1.79-1(d)(1).

¹²Effective for audits beginning after July 2, 1998, the burden of proof can be shifted to the Commissioner in certain circumstances. I.R.C. § 7491.

¹³Commissioner v. Heininger, 320 U.S. 467, 475 (1943); Vesuvius Crucible Co. v. Commissioner, 356 F.2d 948, 949 (3d Cir. 1966); Montgomery Engineering Co. v. United States, 344 F.2d 996, 997 (3d Cir. 1965).

¹⁴Montgomery Engineering, 344 F.2d at 997; Estate of Chism v. Commissioner, 322 F.2d 956, 960-61(9th Cir. 1963); Loftin & Woodard, Inc., v. United States, 577 F.2d 1206, 1215 (5th Cir. 1978).

¹⁵There is nothing unusual about a group term policy providing that an individual covered by the group term policy may convert to an individual policy. In fact, such a provision is usually required by state law. (A. 1220.) When group term policies are converted, the conversion policy does not have cash value. What is unusual here is that money (i.e., conversion credits) "magically comes into the [special conversion] polic[ies]" subsequently issued to the individual owners of the corporation. (A. 867.)

¹⁶An additional requirement is that the earnings and profits of the corporation must be sufficient to pay the constructive dividend asserted (I.R.C. § 316(a); Crosby, 496 F.2d at 1388). Taxpayers conceded in the Tax Court that this requirement was satisfied. (A. 33.)

¹⁷If the Court were to conclude that the Tax Court erred in concluding either that the payments at issue were not deductible as ordinary and necessary business expenses or that the individual taxpayers were chargeable with constructive dividends, the case should be remanded for consideration of the Commissioner's alternative arguments disallowing the deductions based on I.R.C. §§ 404, 419 and including the income under I.R.C. §§ 61(a)(1), 402(b). Those arguments were not addressed by the Tax Court. (A. 37 n.3&4, 41 n.27; see also A. 13, 24, 33.) We also note that the Government did not make the experience rating concession that taxpayers allege (see taxpayers' Br. 8 n.5).

¹⁸Taxpayers' payments-to-a-plan argument obviously cannot make Lakewood's payments outside the plan (see A. 31) ordinary and necessary business expenses.

¹⁹Taxpayers incorrectly contend (Br. 29 n.20) that the benefits and contributions were multiples of compensation. What the record shows is that the "plan" documents provide that the term insurance benefits are supposed to be multiples of compensation. The amount of the life insurance actually obtained, however, did not comply with those provisions. (See pp. 12-15, supra). In addition, the contributions included substantial amounts paid to purchase annuities that did not fund any life insurance benefit. (see pp. 13-14, 42-43, supra.) These contributions further undermine taxpayers' claim.

²⁰Taxpayers' reliance (Br. 31 n.21; see also Br. 3-5) on the favorable determination and no change letters issued by the IRS to the SC VEBA is misplaced. First, those rulings were not issued to the instant taxpayers. Indeed, they expressly state that "no opinion is expressed or implied as to whether employer contributions to you are deductible." (A. 1410.) To bind the IRS, taxpayers here at a minimum would have had to have applied for their own rulings. Treas. Reg. § 601.201(l); Weller v. Commissioner, 270 F.2d 294, 299 (3d Cir. 1959). Second, the rulings given to the SC VEBA were based upon the information supplied and assumed that the SC VEBA's operations would be as stated. (A. 1409.) As the Tax Court found, the SC VEBA was "deviously designed." (A. 6.) The IRS did not have complete information when it made its determinations.

²¹Taxpayers erroneously contend (Br. 27-28) that the Commissioner has conceded the issue of reasonableness. If taxpayers were able to prove that the payments that are alleged to be paid as compensation "are in fact payments purely for services" (including compensatory intent), they still must prove that the payments are "reasonable." Treas. Reg. § 1.162-7(b)(1). The fact that the Commissioner has prevailed on a threshold requirement does not mean that taxpayers are relieved of their burden of proving that they satisfy all of the requirements for a deduction that the Commissioner has disallowed. See INDOPCO, Inc. v. Commissioner, 503 U.S. at 84 (1992).

²²Insurance companies that wrote the C-group product and other parties promoting the product are currently being sued for damages by parties that participated in their programs. See Sankhla v. Commonwealth Life Ins. Co. et al., No. 01-cv-4781 (U.S.D.C. N.J.); Alloy Cast Products, Inc., et al. v. Barret, et al., No. A-5028-00TS (Superior Ct. N.J.). There, the insurance companies are seeking to limit their exposure to damages under state law by arguing that the plans at issue are employee benefit plans within the meaning of ERISA's preemption provision. Taxpayers are incorrect when they assert (Br. 30) that no one disputes that the plans satisfy ERISA's requirements. Indeed, the Department of Labor has filed an amici brief in Alloy Cast Products opposing taxpayers' position that ERISA preempts the area.

²³Even if the applicable doctrine were the sham transaction doctrine, the question would be whether the transaction had "sufficient" economic substance to be respected for tax purposes, not whether the transaction has no economic substance whatsoever. ACM, 157 F.3d at 247. See also footnote 30, infra.

²⁴See Stewart v. Commissioner, 714 F.2d 977, 989 (9th Cir. 1983); Simon J. Murphy Co. v. Commissioner, 231 F.2d 639, 644 (6th Cir. 1956) (interpreting § 482's predecessor).

²⁵Of this amount, $1,245.51 was allowed as a deduction because it represented the cost of the term insurance. (See SA 45.)

²⁶The record cite given by taxpayers, "App. 1911", does not support their assertion that Sankhla became an owner in July 1994. It is stipulated, however, that Sankhla became an owner after Sobo died in September 1993. (A. 386.)

²⁷Although, as discussed above, taxpayers' argument that paying money to a VEBA establishes compensatory intent is wrong, it has no relevance to the $5,750 "premium" payment for Sankhla because that payment was for an insurance policy outside the plan. (A. 22-24, 395-396, 403.)

²⁸In Danielson, this Court considered cases involving the parole evidence rule and concluded that the rule did not bar the Commissioner from challenging a written agreement when the substance of the transaction was not reflected therein. See also Mellon Bank Corp. v. First Union Real Estate Equity and Mortgage Investments, 951 F.2d 1399, 1407 (3d Cir. 1991) (only parties to the written agreement itself are subject to the parole evidence rule). Thus, taxpayer's invocation of the parole evidence rule (Br. 35-36) is unavailing.

²⁹Estate of Connelly v. United States, 551 F.2d 545 (3d Cir. 1977), cited at taxpayers' Br. 24, 39, is readily distinguishable. In Connelly, the issue was whether a decedent possessed substantial incidents of ownership within the meaning of an estate tax provision. There was no indication that form did not match substance in Connelly. Moreover, unlike in Connelly, in the instant case, the evidence shows that taxpayers did not comply with the terms of the documents upon which they rely. See pp. 40-41, supra.

³⁰Taxpayers are not assisted by their argument (Br. 38) that the premium was not be divided into component parts. If, as taxpayers maintain, the premium cannot divided, no deduction should be allowed. As the Tax Court correctly found, the lion's share of the premium was attributable to the conversion credit feature of the product. See pp. 31-35, supra. A tainted transaction cannot be blessed simply because an incidental untainted feature is present. See also Salley v. Commissioner, 464 F.2d 479, 483 (5th Cir. 1972)(sham transaction case in which the sham transaction is the policy loan, and not the entire insurance policy).

³¹Just as the fact that an option may not produce any cash under some circumstances does not prevent the purchase of an option by a corporation for its shareholder from being a constructive dividend, so too the fact that the conversion credit may not produce any cash in some circumstances, such as in the case of policy lapse (see taxpayers' Br. 18), does not prevent its purchase from being a constructive dividend. This is particularly so since policy lapse is within taxpayers' control.

³²See In re CM Holdings, Inc., 254 B.R. 578, 652 (D. Del. 2000), appeal pending, 3d Cir. -- No. 00-3875 (gathering cases).

³³Accardo, 942 F.2d at 452; Cf. CM Holdings, Inc., 254 B.R. at 562 (first impression exception only applies where statutory language is unclear)).

§ 61. Gross income defined

(a) General definition. -- Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

(a) General rule. -- There shall be included in the gross income of an employee for the taxable year an amount equal to the cost of group-term life insurance on his life provided for part or all of such year under a policy (or policies) carried directly or indirectly by his employer (or employers); but only to the extent that such cost exceeds the sum of --

(1) the cost of $50,000 of such insurance, and

(2) the amount (if any) paid by the employee toward the purchase of such insurance.

(a) Taxability of beneficiary of exempt trust. -- Except as otherwise provided in this section, any amount actually distributed to any distributee by any employees' trust described in section 401(a) which is exempt from tax under section 501(a) shall be taxable to the distributee, in the taxable year of the distributee in which distributed, under section 72 (relating to annuities).

(b) Taxability of beneficiary of nonexempt trust. --

(a) General rule. -- If contributions are paid by an employer to or under a stock bonus, pension, profit-sharing, or annuity plan, or if compensation is paid or accrued on account of any employee under a plan deferring the receipt of such compensation, such contributions or compensation shall not be deductible under this chapter; but, if they would otherwise be deductible, they shall be deductible under this section, subject, however, to the following limitations as to the amounts deductible in any year:

(5) Other plans. -- If the plan is not one included in paragraph (1), (2), or (3), in the taxable year in which an amount attributable to the contribution is includible in the gross income of employees participating in the plan, but, in the case of a plan in which more than one employee participates only if separate accounts are maintained for each employee. For purposes of this section, any vacation pay which is treated as deferred compensation shall be deductible for the taxable year of the employer in which paid to the employee.

(a) General rule. -- Contributions paid or accrued by an employer to a welfare benefit fund --

(a) Exemption from taxation. -- An organization described in subsection (c) or (d) or section 401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under section 502 or 503.

§ 6662. Imposition of accuracy-related penalty

(a) Imposition of penalty. -- If this section applies to any portion of an underpayment of tax required to be shown on a return, there shall be added to the tax an amount equal to 20 percent of the portion of the underpayment to which this section applies.

(b) Portion of underpayment to which section applies. -- This section shall apply to the portion of any underpayment which is attributable to 1 or more of the following:

§ 1.79-1 Group-term life insurance -- general rules.

(a) In general. Amounts paid or accrued by a taxpayer on account of injuries received by employees and lump sum amounts paid or accrued as compensation for injuries, are proper deductions as ordinary and necessary expenses. Such deductions are limited to the amount not compensated for by insurance or otherwise. Amounts paid or accrued within the taxable year for dismissal wages, unemployment benefits, guaranteed annual wages, vacations, or a sickness, accident, hospitalization, medical expense, recreational, welfare, or similar benefit plan, are deductible under section 162(a) if they are ordinary and necessary expenses of the trade or business. However, except as provided in paragraph (b) of this section, such amounts shall not be deductible under section 162(a) if, under any circumstances, they may be used to provide benefits under a stock bonus, pension, annuity, profit-sharing, or other deferred compensation plan of the type referred to in section 404(a). In such an event, the extent to which these amounts are deductible from gross income shall be governed by the provisions of section 404 and the regulations issued thereunder.

A-6: (a) Under section 419(c)(3), the "qualified direct cost" of a welfare benefit fund for any taxable year of the fund is the aggregate amount which would have been allowable as a deduction to the employer for benefits provided by such fund during such year (including insurance coverage for such year) if (1) such benefits were provided directly by the employer and (2) the employer used the cash receipts and disbursements method of accounting and had the same taxable year as the fund. In this regard, a benefit is treated as provided when such benefit would be includible in the gross income of the employee if provided directly by the employer (or would be so includible but for a provision of chapter 1, subtitle A, of the Internal Revenue Code excluding it from gross income). Thus, for example, if a calendar year welfare benefit fund pays an insurance company in July 1986 the full premium for coverage of its current employees under a term health insurance policy for the twelve month period ending June 30, 1987, the insurance coverage will be treated as provided by the fund over such twelve month period. Accordingly, only the portion of the premium for coverage during 1986 will be treated as a "qualified direct cost" of the fund for 1986; the remaining portion of the premium will be treated as a "qualified direct cost" of the fund for 1987. The "qualified direct cost" for a taxable year of the fund includes the administrative expenses incurred by the welfare benefit fund in delivering the benefits for such year.

§ 601.201 Rulings and determinations letters.