The U.S. Court of Appeals
for the Third Circuit has affirmed the Tax Court´s holding that two employers
could not deduct their contributions into voluntary employee beneficiary
association (VEBA) plans because they were too high and represented disguised
dividends (see ¶350 of the Handbook). The case is Neonatology
Associates, P.A. v. Commissioner of Internal Revenue.
Paying the Contributions
Two employers, Neonatology
Associates, P.A. and Lakewood Radiology, P.A., participated in VEBAs created by
Pacific Executive Services (PES), a third-party administrator. Under these
VEBAs, the employers adopted their own plans, maintained trust accounts,
designated trust administrators and made contributions toward the life
insurance benefits of their employees and the employees´ beneficiaries.
The employers´
contributions far exceeded the value of employees´ compensation during the
previous year. Neonatology Associates provided contributions 6.5 times as
large; Lakewood Radiology provided contributions 2.5 times as large but then
increased that multiple to 8.15 times the previous year´s compensation. Both
employers also purchased continuous group (C-group) life insurance policies on
the lives of employees and non-employees. For the years at issue, both
employers claimed deductions for the contributions and related amounts.
IRS Action
The IRS audited Neonatology
Associates´ returns for calendar years 1992 and 1993 and Lakewood Radiology´s
returns for fiscal year 1991 and calendar years 1992 and 1993. The IRS allowed
deductions for the cost of the annual life insurance and disallowed the rest of
the claimed deductions because the excess contributions were not ordinary and
necessary business expenses under Code Section 162(a).
The IRS said that the
excess contributions were income to the individual taxpayers since they
constituted constructive dividends under Section 61(a)(7) and Section 301, and
because they were includible under Section 402(b) if the plans could be assumed
to be deferred compensation plans. The IRS also imposed accuracy-related
penalties.
Agreeing with the IRS, the
Tax Court considered both employers´ plans to be "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." Â The excess
contributions constituted cash distributions, not payments of ordinary and
necessary business expenses, the court said, also noting that the employers did
not expect to be repaid for the cash they contributed.
The court rejected the
petitioners´ argument that the contributions were de facto contributions to
life insurance due to the possibility of forfeiture.
The court agreed with the
IRS that the individual taxpayers were negligent and said that they could not
avoid accuracy-related penalties by asserting that they had relied on
professional advice in good faith and that the case involved tax matters of
first impression.
Upholding the Tax Court
ruling, the 3rd Circuit also offered words of caution for employers and
beneficiaries of plans they make available. "When, as here, a taxpayer is
presented with what would appear to be a fabulous opportunity to avoid tax
obligations, he should recognize that he proceeds at his own peril." u Â
At a Glance
Case: Neonatology
Associates, P.A. v. Commissioner of Internal Revenue, No.
01-2862, July 29, 2002, U.S. Court of Appeals for the 3rd Circuit
At Issue: Whether
the contributions two corporations made into VEBAs that exceeded the cost of
term life insurance were constructive dividends for which the corporation
owners and their spouses could be taxed or were expenses the corporations could
deduct as employers.
Court Decision: The contributions
were taxable disguised dividends and not deductible expenses.