Life Insurance Premium Payments Not Deductible Business Expenses

December 27, 2007

Citations: V.R. DeAngelis M.D.P.C. & R.T. Domingo M.D.P.C. et al. v. Commissioner; T.C. Memo. 2007-360; Nos. 10634-05, 10635-05, 10636-05, 10637-05, 10638-05

Date: Dec. 5, 2007

These cases were consolidated for purposes of trial, briefing, and opinion. Each couple consisted of a medical doctor and his wife, and each doctor was the sole owner of an S corporation that was a partner in the partnership of V.R. DeAngelis M.D. P.C. & R.T. Domingo M.D. P.C. (VRD/RTD). These cases concerned amounts paid in 1993 and 1994 by the S corporations to VRD/RTD and its ensuing contributions of those amounts to the Severance Trust Executive Program Multiple Employer Supplemental Benefit Plan and Trust (STEP), a plan that was promoted to wealthy professionals as a welfare benefits fund that was part of a 10 or-more-employer plan described in section 419A(f)(6). STEP used the contributions to purchase and pay the premiums on six whole life insurance policies, five of which were each written with respect to one or both spouses of each couple (with the exception of one physician, who had no policy insuring either of their lives) and were each payable to the beneficiaries of the insured’s choosing in the event of the insured’s death. The sixth life insurance policy was written on the life of Kerry Quinn (Ms. Quinn), an employee of VRD/RTD who was its office manager.

For each subject year, the IRS determined in the notice of final partnership administrative adjustment (FPAA) that VRD/RTD could not deduct the $585,000 it paid in that year to the STEP as contributions to a welfare benefits fund. The FPAA stated in part that the payments were not ordinary and necessary business expenses under section 162(a).

The IRS then determined in the notices of deficiency that the physicians had the following deficiencies in their 1993 and 1994 Federal income taxes:

DeAngelises                     246,768                  208,447

Domingos                        185,422                  184,932

Durantes                           29,174                    42,020

Capizzis                              1,957                     1,546

These deficiencies generally were based on two determinations. First, the IRS determined that the payments that the S corporations made to the VRD/RTD partnership for contribution to the STEP plan were not deductible by the S corporations because they were not ordinary and necessary business expenses under section 162(a). The IRS accordingly increased the net amount of passthrough income received by each doctor from his S corporation. Second, respondent determined that each doctor received income under section 61(a) in the amount of the life insurance premiums that were paid by his S corporation on his behalf.

The court was asked to decide whether the S corporations and the medical partnership were entitled to deduct the payments related to the STEP plan as ordinary and necessary business expenses under section 162(a) – The court held they were not to the extent that the payments related to the life insurance written on a life of someone other than Ms. Quinn. The was then asked to decide whether each doctor realized income in the amount of the life insurance premiums that were paid by his S corporation on his behalf. The court held he did not.

The following is the actual ruling on each issue from the court case:

A. Disallowance of Deductions

Section 162(a) generally provides that “There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”. A taxpayer such as VRD/RTD or one of the PCs must meet five requirements in order to deduct an item under this section. The taxpayer must prove that the item claimed as a deductible business expense: (1) Was paid or incurred during the taxable year; (2) was for carrying on its trade or business; (3) was an expense; (4) was a necessary expense; and (5) was an ordinary expense. See Commissioner v. Lincoln Sav. & Loan Association, 403 U.S. 345, 352 (1971); Welch v. Helvering, 290 U.S. 111, 115 (1933); see also Rule 142(a)(1). A determination of whether an expenditure satisfies each of these requirements is a question of fact. See Commissioner v. Heininger, 320 U.S. 467, 475 (1943).

Petitioners argue that section 162(a) allowed VRD/RTD and the PCs to deduct the amounts related to the STEP plan because those amounts represented “dismissal wages” paid to a “welfare or similar benefit plan” within the scope of section 1.162-10(a), Income Tax Regs. We disagree. While the STEP plan may have been cleverly designed to appear to be a welfare benefits fund and marketed as such, the facts of these cases establish that the plan was nothing more than a subterfuge through which the participating doctors, through VRD/RTD, used surplus cash of the PCs to purchase cash-laden whole life insurance policies primarily for the benefit of the participating doctors personally. While employers are not generally prohibited from funding term life insurance for their employees and deducting the premiums on that insurance as a business expense under section 162(a), employees are not allowed to disguise their investments in life insurance as deductible benefit-plan expenses when those investments accumulate cash value for the employees personally. See Neonatology Associates, P.A. v. Commissioner, supra at 88-89.

The insurance premiums at hand pertained to the participating doctors’ personal investments in whole life insurance policies that primarily accumulated cash value for those doctors personally. VRD/RTD’s contributions to the STEP plan were used to pay the initial year’s cost of providing life insurance for each participating doctor and to create an investment fund for the insured within his whole life insurance policy (or policies in the cases of Drs. DeAngelis and Domingo). That fund, when enhanced with expected future dividends, was calculated to be sufficient to pay for the future years’ costs of life insurance protection and to provide for cash values sufficient to allow for a distribution of cash to the insured doctor whenever he opted to claim that he was involuntarily terminated from his business. As to each investment fund (and as to each insurance policy in general), the insured doctor regarded that fund (and policy) as his own, as did the STEP plan trustee, the STEP plan administrator, and MetLife. Very little (if any) value in one participating doctor’s fund was available to pay to another insured, and any distribution of cash from the STEP plan to a participating doctor was directly related to the cash value of his policy. In many instances, a participating doctor dealt with his own insurance agent in selecting and purchasing the policy on his life, received illustrations on an assortment of life insurance investments that could be made through the STEP plan, determined the amount of his investment in his life insurance policy, selected the form of the insurance policy to be issued for him (e.g., single whole life versus survivor whole life), and selected his policy’s face amount. In the latter regard, we note our finding on the basis of the credible evidence in the record that Drs. DeAngelis and Domingo, when dealing with Mr. Rapp, MetLife, and the insurance policies in general, were not acting as agents of VRD/RTD but were acting in their individual capacities. We also note our finding that Dr. Durante was not acting as an agent of VRD/RTD with respect to his policy.

The use of whole life insurance policies and the direct interactions between the participating doctors and the STEP plan representatives support our finding that the participating doctors in their individual capacities fully expected to get their promised benefits and that any receipt of those benefits was not considered by anyone connected with the life insurance transaction to rest on any unexpected or contingent event. Each whole life insurance policy upon its issuance was in and of itself a separate account of the insured doctor, and the insured (rather than the STEP plan) dictated and directed the funding and management of the account and bore most risks incidental to the account’s performance. The STEP plan in essence and in operation was simply an aggregation of separate plans for the participating doctors and not, as petitioners claim, one single plan in which various employers participated. The cash value in a participating doctor’s policy was both intended to be and actually returned to the insured doctor, net of reductions for the cost of current insurance coverage and other de minimis amounts that were payable for charges related to the policies or otherwise incidental to the participation in the STEP plan. In fact, upon learning that their policies had lost the value that they expected to receive, Drs. DeAngelis and Domingo pursued recovery of those losses both directly and aggressively with their insurance agent and with the STEP plan representatives and caused the policies written on their lives to be transferred to them (and the Ms. Quinn policy to be transferred to her) as they had expected from the start of their investment in the STEP plan. As to the DeAngelises survivor whole life policy and the Domingos survivor whole life policy, the retroactive reinstatement and conversion of those policies to APL also rebuts petitioners’ claim that each insurance policy was truly an asset of the STEP plan which the plan had the unfettered right to benefit from, to liquidate, or to dispose of; to the contrary, the cash value theoretically belonging to the STEP plan was converted into death benefits for Drs. DeAngelis and Domingo even though VRD/RTD had stopped making contributions years before the conversion.

We also note the events leading up to the initial purchase of the whole life insurance policies. Through the partnership agreement executed on June 19, 1990, Drs. DeAngelis and Domingo had expressed their intent to retire in the near future. Yet, in connection with the planning of their personal estates and their consideration of ways to reduce the application to their estates of the Federal estate tax, Dr. DeAngelis caused VRD/RTD to join the STEP plan on December 30, 1993. Drs. DeAngelis and Domingo were told that their 1993 and 1994 payments to the STEP plan would suffice to fund the future costs of providing life insurance benefits for the remainder of their lives and to provide future distributions of cash to them at the time of their choosing. From the beginning of their decision to participate in the STEP plan, the participating doctors were most concerned about the amounts of, and their ability to receive, their expected benefits from STEP. In fact, Drs. DeAngelis and Domingo requested calculations and illustrations showing how much they would receive depending upon the number of years that contributions were made to the STEP plan. Drs. DeAngelis and Domingo also wrote to Mr. Katz for assurance that they would receive their benefits and requested a written opinion from the plan sponsor about how to characterize their planned departures from their practices so as to meet the terms of the STEP plan as written. STEP advised the participating doctors on what to say in order to get their promised benefits, and STEP assured the doctors that a protocol was in place to ensure that they would get their money as intended. Because each of the participating doctors’ PCs funded its own employee’s benefits under the STEP plan, STEP was at no significant loss in allowing each PC to remove from the plan the money it invested therein.21

Petitioners rely erroneously on Booth v. Commissioner, 108 T.C. 524 (1997), in arguing that these cases turn primarily not on the application of section 162(a) but on the question of whether the STEP plan meets the requirements of section 419A(f)(6). As discussed herein, our decisions in these cases turn on our factual evaluation of the relationship between the participating doctors and their whole life insurance policies without any regard to the STEP plan’s qualification under section 419A(f)(6), and we decide on the basis of the credible evidence in the record before us that those doctors upon investing in the STEP plan had the primary right to receive the value reflected in the insurance policies written on their lives. We note in this regard that the Court in Booth v. Commissioner, supra, did not decide the issue under section 162(a) that we decide today.

In sum, we find that the PCs’ payments to VRD/RTD were distributions to the doctors personally and that neither those payments nor VRD/RTD’s ensuing contributions to STEP were ordinary and necessary business expenses under section 162(a) (except to the extent they relate to payments of premiums on the Ms. Quinn policy as discussed supra note 3). Accord Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43 (2000). Consequently, we hold that those amounts are not deductible under section 162(a) by either the PCs or VRD/RTD.

B. Inclusion in Income

Respondent determined that the amounts of the life insurance premiums that were paid by each doctor’s PC on his behalf are includable in the doctor’s gross income under section 61(a) as “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). We disagree that those amounts are includable in the doctors’ gross income. While the payments of the premiums were indeed accessions to the doctors’ wealth, our decision on this issue does not rest simply on that finding. Instead, our decision turns on our finding that the doctors’ PCs were S corporations and that the payment of the premiums by the PCs was essentially a distribution to the doctors of corporate profits rather than a payment that the PCs made to the doctors with a compensatory intent. See Neonatology Associates, P.A. v. Commissioner, supra at 91-92, 95-96; see also Neonatology Associates, P.A. v. Commissioner, 299 F.3d at 231-232. In accordance with the Federal income tax law applicable to S corporations, most particularly sections 1367 and 1368, our disallowance of the deductions claimed by the PCs has the effect of increasing pro tanto the net income of those PCs, with corresponding increases to the doctors’ distributive shares of that income. That being so, the payments of the premiums are not taxed a second time to the doctors. Cf. Neonatology Associates, P.A. v. Commissioner, 115 T.C. at 95-96 (tax at the shareholder-level was appropriate where the employer was a C corporation).

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