130 T.C. No. 8
UNITED STATES TAX COURT
DANTE AND SANDI PERANO, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 5543-06. Filed May 7, 2008.
In 1994 and 1996, Ps, the sole shareholders of AG, a controlled foreign corporation as defined in sec. 957, I.R.C., transferred to AG United States real property and notes secured by such property in exchange for private annuity agreements that provided for the future payment of monthly annuities to Ps for their remaining joint lives. For 1994-2001, AG accrued liabilities with respect to those agreements in amounts that, for 2001, exceeded income and, cumulatively, exceeded accumulated earnings and profits as of Dec. 31, 2001. Relying upon sec. 953, I.R.C., and the regulations thereunder, Ps treated those accruals as in the nature of life insurance reserves, which reduce earnings and profits, thereby causing Ps not to report income from AG for 2001 under sec. 951(a)(1), I.R.C. See secs. 952(c), 956(b)(1), I.R.C.
1. Held: Because the transactions that gave rise to the private annuity agreements constituted capital expenditures by AG and because AG’s accruals under those agreements constituted reserves for future contingencies, those accruals did not reduce AG’s earnings and profits. - 2 -
2. Held, further, because AG was neither in the insurance business nor in receipt of insurance income, sec. 953, I.R.C., is inapplicable to AG.
3. Held, further, Ps improperly failed to report income from AG for 2001 under sec. 951(a)(1), I.R.C.
Francis X. Mohan III, for petitioners.
Christian A. Speck, for respondent.
OPINION
HALPERN, Judge: By notice of deficiency dated December 22,
2005, respondent determined deficiencies in petitioners’ Federal
income taxes of $203,939 and $70,815 for 2001 and 2002,
respectively, and accuracy-related penalties of $40,788 and
$14,163 for those years, respectively.
Unless otherwise indicated, all section references are to
the Internal Revenue Code for the years at issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
After concessions, the only issue for decision is whether
accruals for the future payment of annuities made by a controlled
foreign corporation (CFC), as that term is defined in section
957, reduced that CFC’s earnings and profits available for the
payment of dividends to shareholders. The parties stipulate
that, if the Court agrees with respondent that the accruals did
not reduce the CFC’s earnings and profits, then petitioners must
include as items of gross income for 2001 (1) $64,682 under
section 951(a)(1)(A), and (2) $392,109 under sections - 3 -
951(a)(1)(B) and 956;1 and, conversely if the Court agrees with
petitioners that the accruals did reduce the CFC’s earnings and
profits, then petitioners are not required to include any amounts
in gross income under the foregoing provisions.2
Background
This case was submitted fully stipulated under Rule 122.
The facts stipulated by the parties are so found. The
stipulation of facts, with accompanying exhibits, is incorporated
herein by this reference. At the time the petition was filed,
petitioners resided in the State of Nevada.
The following is a summary of the facts necessary for our
discussion.
American General Ltd. (American General) is a corporation
formed in the Isle of Man in October 1992. From its
incorporation through 2001, 100 percent of the stock of American
General was owned by a fiduciary pursuant to an irrevocable trust
1 Those provisions are part of subpt. F, pt. III, subch. N, ch. 1, subtit. A of the Internal Revenue Code (subpt. F). Pursuant to those provisions and sec. 951(b) (defining the term “United States shareholder”), each United States shareholder of a controlled foreign corporation (CFC) includes in his gross income his pro rata share of the CFC’s (1) subpt. F income (as defined in sec. 952) and (2) earnings invested in United States property (as determined under sec. 956). 2 The stipulation actually describes the issue as whether the CFC properly accrued the future annuity expenses; but, as discussed infra, it is clear that the issue for decision is more accurately described as whether those accruals reduced the CFC’s earnings and profits. (Pursuant to sec. 952(c), income inclusions under sec. 951(a)(1)(A) may not exceed a CFC’s earnings and profits for the taxable year, and, pursuant to sec. 956(a)(2), income inclusions under sec. 951(a)(1)(B) may not exceed a CFC’s “applicable earnings”; i.e., its current or accumulated earnings and profits. See sec. 956(b)(1).) - 4 -
agreement. For Federal income tax purposes, however, the parties
stipulate that “the tax effects are to be treated as though * * *
[American General] was owned by petitioners.” At all relevant
times, American General (1) was a CFC, and (2) was not regulated
as an insurance company under the laws of the Isle of Man, the
United States, or any State thereof.
On each of American General’s Forms 1120-F, U.S. Income Tax
Return of a Foreign Corporation, in evidence, it listed the
United States as its principal business location and “Rental and
Sales” of “Real Estate” as its “[b]usiness activity” and
“[p]roduct or service”.
On March 31 and October 31, 1994, petitioners transferred
real property located in Texas to American General in exchange
for private annuity agreements (annuity agreements 1 & 2). On
January 1, 1996, petitioners transferred promissory notes secured
by real property located in Texas to American General also in
exchange for a private annuity agreement (annuity agreement 3).
The annuities payable to petitioners under the annuity agreements
(collectively, the annuity agreements) are payable monthly for
petitioners’ joint lives. The payments are to commence no
earlier than April 30, 2006, in the case of annuity agreement 1,
November 30, 2010, in the case of annuity agreement 2, and
February 1, 2011, in the case of annuity agreement 3. Under each
of the annuity agreements, American General may defer the payment
commencement date for up to 5 years. American General’s
obligation to make annuity payments to petitioners under the - 5 -
annuity agreements terminates upon the death of the survivor,
irrespective of the number of payments made to that point or
whether any payments at all have been made to either petitioner.
American General keeps its books and records on the accrual
method of accounting. With respect to each of the annuity
agreements, it recorded a liability in the amount stated in the
agreement as the fair market value of the property received in
exchange for the agreement. It recorded liabilities in the
following amounts:
Agreement Amount
Annuity agreement 1 $493,200 Annuity agreement 2 582,500 Annuity agreement 3 353,355
For the years 1994 through 2001, American General accrued
annuity expenses with respect to the annuity agreements as
liabilities on its books and records in the aggregate amount of
$949,119, as follows:
Year Amount
1994 $32,021 1995 84,103 1996 114,665 1997 123,431 1998 132,797 1999 142,885 2000 153,756 2001 165,461 Total 949,119 - 6 -
On the Form 5471, Information Return of U.S. Persons With
Respect To Certain Foreign Corporations, attached to petitioners’
2001 Form 1040, U.S. Individual Income Tax Return, petitioners
reported negative current and accumulated earnings and profits
for American General of $100,779 and $492,328, respectively. For
2001, if the $165,461 accrued for that year for deferred
annuities is disregarded, American General would have positive
current earnings and profits of $64,682, and, if the $949,119
total accruals for deferred annuities through December 31, 2001,
are disregarded, American General would have positive accumulated
earnings and profits of $456,791.3
American General’s average investment in United States
property at the end of each quarter in 2001 was $1,360,567.
Discussion
I. Introduction
On two occasions in 1994, petitioners transferred real
property to American General, and, on one occasion in 1996,
petitioners transferred promissory notes secured by real property
to American General. On none of those occasions did American
General pay anything immediately for the property it received
(the property or properties). Instead, on each occasion,
American General promised to pay for the property by making
3 As noted supra, the parties agree that, if the accruals for deferred annuity payments are disregarded for purposes of determining American General’s earnings and profits, petitioners’ 2001 income would then include $64,682 of subpt. F income under sec. 951(a)(1)(A) and $392,109 ($456,791 minus $64,682) representing earnings invested in United States property taxable under secs. 951(a)(1)(B) and 956. - 7 -
deferred payments commencing from 12 to 16 years in the future
and lasting (if they still survived) for the lives of
petitioners. The terms of those promises are manifest in what we
have described as annuity agreements 1, 2, and 3. Recognizing
that the present value of its obligation to make the annuity
payments promised would increase every year until the annuity
starting dates, American General accrued as an annual expense an
addition to an accounting reserve to reflect that increase. We
must determine whether those accruals were a proper charge to
American General’s earnings and profits. We conclude that they
were not.
II. Analysis
A. Introduction
Petitioners summarize their argument as follows:
Petitioners believe that its [American General’s] accrued annuity expense constitutes a reserve to liquidate its future obligation and is allowable under Section 953 and the regulations thereunder as a reserve for estimated expenses for purposes of calculating its current and accumulated E&P.
Section 953 defines the term “insurance income” for purposes
of determining a CFC’s subpart F income. See sec. 952(a)(1). If
it were not for petitioners’ claim that section 953 applies,
their argument that American General properly reduced its
earnings and profits on account of annual accruals for additions
to a reserve reflecting its obligation to make annuity payments
pursuant to the annuity agreements could be disposed of in short
order. Generally, annuity payments made for property are
considered payments made to purchase the property. E.g., Perkins - 8 -
v. United States, 701 F.2d 771, 775 (9th Cir. 1983). The
payments constitute capital expenditures, which are not
deductible, sec. 263(a)(1), regardless of the number of payments
made or the total amount to be paid, Perkins v. United States,
supra at 775. The payments give the taxpayer a cost basis in the
acquired property, sec. 1012, and the taxpayer recovers his
investment in the property by way of deductions for depreciation,
sec. 167(a), or by way of an offset of any unrecovered basis
against the amount realized on a sale or disposition of the
property, sec. 1001(a).
“Earnings and profits” is a tax concept that generally
relates to the determination of whether a distribution from a
corporation to its shareholders is properly treated as a dividend
or a return of capital. See secs. 301(c), 316(a); Henry C. Beck
Co. v. Commissioner, 52 T.C. 1, 6 (1969), affd. per curiam 433
F.2d 309 (5th Cir. 1970). Capital expenditures do not reduce
earnings and profits. Pa. Forge Corp. v. Commissioner, a
Memorandum Opinion of this Court dated Sept. 6, 1943 (“the
accrued interest * * * represented capital expenditures and was
not a proper charge against petitioner’s earnings and profits”);
Patty v. Commissioner, a Memorandum Opinion of the Board of Tax Appeals dated May 27, 1936 (“Organization expenses are capital
expenditures * * * and, therefore, they are not to be considered
in determining the earnings or profits available for - 9 -
distribution.”4), revd. on other grounds 98 F.2d 717 (2d Cir.
1938).5
Moreover, even if annuity payments do not have to be
capitalized, the obligation to commence life annuity payments in
the future is contingent and for that reason does not reduce
earnings and profits absent a special exception like that
applicable to life insurance reserves. See Dean v. Commissioner, 9 T.C. 256, 266 (1947) (reserves for contingent future expenses
do not reduce earnings and profits), affd. 187 F.2d 1019 (3d Cir.
1951). Professors Bittker and Eustice, in their treatise,
Federal Income Taxation of Corporations and Shareholders, point
out that, in determining whether a distribution to shareholders
constitutes a taxable dividend, reference is made to the
distributing corporation’s earnings and profits rather than to
its surplus, in part because surplus, unlike earnings and
profits, is reduced by reserves for contingencies. Bittker &
Eustice, Federal Income Taxation of Corporations and
4 This result is consistent with sec. 312(n)(3), which denies 5-year amortization of such expenditures under sec. 248 for purposes of determining a corporation’s earnings and profits. 5 Not permitting capital expenditures to reduce earnings and profits is justified on the ground that “capital expenditures accomplish a mere change in the form of assets, and ‘earnings or profits’ should then be affected only through the depreciation account.” Paul, “Ascertainment of ‘Earnings or Profits’ For Purpose of Determining Taxability of Corporate Distributions”, 51 Harv. L. Rev. 40, 45 n.18 (1937). - 10 -
Shareholders, par. 8.03[2], at 8-20 (7th ed. 2000). The authors
describe the problem thus:
If these reserves were taken into account, the floodgates would be opened to a stream of tax-free cash distributions for as long as the corporation’s directors could conjure up contingencies that would warrant the creation of reserves. It is not surprising, therefore, that accounting surplus was rejected as a criterion and that the phrase “earnings and profits” acquired a meaning more in keeping with its function. [Id.]
We shall now turn to petitioners’ section 953 argument.
B. Section 953 Argument
Life insurance companies are subject to income taxation
pursuant to part I, subchapter L, chapter 1, subtitle A of the
Internal Revenue Code (part I and subchapter L, respectively).
Part I comprises sections 801 through 818. For a life insurance
company to be taxable pursuant to part I, the company must first
be an insurance company within the meaning of section 816(a). In
pertinent part, section 816(a) provides: “the term ‘insurance
company’ means any company more than half of the business of
which during the taxable year is the issuing of insurance or
annuity contracts”. A life insurance company includes in its
gross income premiums and other consideration received on annuity
contracts. See sec. 803(a)(1)(A). In determining its taxable
income, it deducts additions to reserves set aside to pay claims
arising under annuity contracts. See secs. 804(a)(1), 805(a)(2),
807(b), (c)(1), 816(b). Therefore, it reduces its earnings and
profits on account of those reserve additions. See sec. 1.312-
6(a), Income Tax Regs. (providing, in pertinent part, that “the - 11 -
amount of the earnings and profits in any case will be dependent
upon the method of accounting properly employed in computing
taxable income”).
On brief, petitioners concede that American General is not
an insurance company: “Respondent is correct in pointing out
that[,] as a real estate company, American General is not an
Insurance Company.” They argue, however, that that does not
matter: “American General * * * [does not need to be an
insurance company in the business of selling insurance] in order
to reduce * * * [earnings and profits] by the future annuity
obligations.” They rely on section 953, which, in pertinent
part, provides:
SEC. 953. INSURANCE INCOME.
(a) Insurance Income.--
(1) In general.--For purposes of section 952(a)(1), [which provides that “subpart F income” includes “insurance income”] the term “insurance income” means any income which-–
(A) is attributable to the issuing (or reinsuring) of an insurance or annuity contract, and
(B) would * * * [subject to certain modifications] be taxed * * * [as if] such income were the income of a domestic insurance company.
As we understand it, the essence of petitioners’ argument is
that, on account of entering into the annuity agreements,
American General had insurance income within the meaning of
section 953(a)(1), which allows it to accrue additions to
reserves, and reduce its earnings and profits, in anticipation of - 12 -
making the annuity payments called for by those agreements,
notwithstanding that it is not an insurance company.6
To support their argument, petitioners rely on regulations
proposed under section 953. Proposed regulations are accorded
little, if any, deference. Estate of Ratliff v. Commissioner,
101 T.C. 276, 278 (1993). In any event, those proposed
regulations weaken, rather than support, petitioners’ argument.
Section 1.953-6(a), Proposed Income Tax Regs., 56 Fed. Reg. 15560
(April 17, 1991), deals with the applicability of subchapter L to
CFCs. In pertinent part, subparagraph (1) of that section
provides the following general rule: “A controlled foreign
corporation which has insurance income under section 953 * * *
shall compute its insurance income * * * under part I of
subchapter L”. (Emphasis added.) Section 1.953-6(f), Proposed
Income Tax Regs., 56 Fed. Reg. 15561 (April 17, 1991), deals with
CFCs that, if they were domestic corporations, would not qualify
to be taxed under subchapter L as insurance companies. In
pertinent part, subparagraph (1) of that proposed regulation
provides:
A controlled foreign corporation will compute its insurance income as if it were a domestic insurance company subject to part I of subchapter L (relating to life insurance companies) only if it can meet the requirements of section 816(a) of the Code taking into account only that portion of its business which
6 Petitioners also acknowledge that “American General’s obligation to make annuity payments may not qualify as a deductible expense for tax reporting purposes”. Nonetheless, they insist that that obligation “does constitute a reduction of * * * [earnings and profits].” - 13 -
involves the issuing or reinsuring of insurance or annuity contracts. [Emphasis added.]
Petitioners’ first difficulty in finding support in the
proposed regulations is that they have failed to prove that
American General’s business was to any extent the business of
issuing insurance or annuity contracts. The issuance of
insurance, to include annuities, requires risk shifting and risk
distribution. See Helvering v. Le Gierse, 312 U.S. 531, 539
(1941); Wright v. Commissioner, T.C. Memo. 1993-328 (“The amounts
in the annuities did not constitute insurance because no risk
shifting or risk distribution occurred.”), modified per order
(Oct. 29, 1993), affd. without published opinion 73 F.3d 372 (9th
Cir. 1995). In the case of the annuity agreements, there was no
risk distribution (i.e., the pooling of possible annuity
termination dates) among a broad number of individuals. American
General’s mortality risk was spread between the lives of only two
individuals; viz, petitioners. We said in Amerco & Subs. v.
Commissioner, 96 T.C. 18, 41 (1991), affd. 979 F.2d 162 (9th Cir.
1992): “The concept of risk-distributing emphasizes the pooling
aspect of insurance: that it is the nature of an insurance
contract to be part of a larger collection of coverages, combined
to distribute risk between insureds.” Moreover, respondent
argues that there was no risk shifting (one party shifting the
risk of a loss to another party), since petitioners are the
owners, at least for tax purposes, of American General. To find
that there was no insurance, it is sufficient that we find that - 14 -
there was no risk distribution, which we do find. It is not
necessary that we consider whether there was risk shifting.
Even were we to put aside petitioners’ failure to prove that
American General was in the insurance business, they have failed
to prove that American General realized any income in connection
with the annuity agreements. American General received the
property in exchange for those agreements. On its books and
records, it accounted for the obligations imposed on it by the
annuity agreements as liabilities. Petitioners do not claim that
they reported premium income, or, indeed, any income, as a result
of incurring those obligations.7
Petitioners have failed to prove that American General
received insurance income within the meaning of section
952(a)(1). American General does not fall within the ambit of
the rules of part I, allowing life insurance companies to deduct
additions to reserves set aside to pay claims arising under
annuity contracts, nor can it reduce its earnings and profits as
a life insurance company could on account of those contingent
claims.
7 In fact, there is nothing in the record to indicate that American General reported any income other than income from real estate (i.e., sales income, rentals, and mortgage interest). - 15 -
III. Conclusion
Because American General’s accruals for the future payment
of annuities to petitioners did not reduce its earnings and
profits, respondent’s adjustments increasing petitioners’ 2001
income under section 951(a)(1) are sustained.
Decision will be entered
under Rule 155.