Dona Elizabeth Conway v. Commissioner

111 T.C. No. 20

• Court: United States Tax Court
• Decided: December 30, 1998
• Docket: 22257-96
• Status: Unknown

Opinion

111 T.C. No. 20

UNITED STATES TAX COURT

DONA ELIZABETH CONWAY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 22257-96. Filed December 30, 1998.

Held: Under the facts of this case, direct transfer of a portion of funds invested in an annuity contract into another annuity contract qualifies as a nontaxable exchange under sec. 1035, I.R.C. Other issues also decided.

Dona Elizabeth Conway, pro se.

Blaine C. Holiday, for respondent.

SWIFT, Judge: Respondent determined a deficiency of

$123,855 and an addition to tax and a penalty with respect to

petitioner's Federal income tax for 1994. - 2 -

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

After settlement of some issues, the primary issue for

decision is whether direct transfer of a portion of funds

invested in an annuity contract into another annuity contract

qualifies as a nontaxable exchange under section 1035.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

When the petition was filed, petitioner resided in

Minneapolis, Minnesota.

Exchange of Portion of Annuity Contract

In 1992, petitioner purchased from Fortis Benefits Insurance

Co. (Fortis) an annuity contract for a total purchase price of

$195,643 (Fortis annuity contract). Payments under the Fortis

annuity contract would not begin until February 4, 2029.

In 1994, petitioner requested Fortis to withdraw $119,000

from the Fortis annuity contract and to issue a check in favor

of, and to transfer the funds directly to, Equitable Life

Insurance Co. of Iowa (Equitable) for purchase of a new annuity

contract from Equitable (Equitable annuity contract). Pursuant

to petitioner's request, Fortis debited petitioner's annuity - 3 -

contract with $119,000, retained $10,000 from the $119,000 as a

"surrender charge", issued a check in the amount of $109,000 in

favor of Equitable, and mailed the check directly to Equitable.

Upon receipt of the $109,000 check from Fortis and upon

simultaneous receipt of petitioner's application to purchase the

Equitable annuity contract, Equitable opened an annuity contract

in favor of petitioner with a principal amount invested of

$109,000. The record does not indicate when payments under the

Equitable annuity contract were to begin, but the terms and

provisions of the annuity contracts are treated by the parties as

substantially equivalent.

On the application form for purchase of the Equitable

annuity contract that petitioner filled out and submitted to

representatives of Equitable, petitioner expressly indicated that

withdrawal of the funds from the Fortis annuity contract and

transfer of the funds to Equitable for purchase of another

annuity contract were to be treated as a section 1035 nontaxable

exchange.

In 1994, Fortis mailed to petitioner and to respondent a

Form 1099-R (Distributions From Pensions, Annuities, Retirement

or Profit-Sharing Plans, IRA's, Insurance Contracts, etc.)

indicating that the above transaction was taxable and that

$30,535 of the $119,000 withdrawn from petitioner’s Fortis

annuity contract represented taxable income to petitioner. - 4 -

Later, on July 30, 1997, Fortis mailed to petitioner a letter

explaining that an incorrect Form 1099-R had been mailed to

petitioner and that petitioner's exchange of a portion of the

Fortis annuity contract for the Equitable annuity contract was

intended to qualify and should have been processed by Fortis as a

nontaxable exchange under section 1035.

Tax Basis in Home, Consulting Fee, and IRA Distribution

In 1971, petitioner and her husband purchased a home in

Wayzata, Minnesota, for $53,500. The home was located on Lake

Minnetonka in an exclusive suburb of Minneapolis.

From 1971 until 1986, petitioner, her husband and children

resided in the home. In 1986, petitioner and her husband

separated and were divorced. From 1986 until 1994, petitioner

and her children continued to reside in the home.

Over the course of the 23 years during which petitioner

resided in the home, numerous capital improvements were made to

the home. With regard to improvements made to the home during

1971 to 1986, petitioner and her former husband testified at

trial and generally described the improvements to the home.

However, billing and payment records relating to improvements

made to the home during 1971 to 1986 are no longer available.

Those records were maintained by petitioner’s former husband, and

he has apparently lost the records. Some of those improvements

are corroborated by copies of building permits. - 5 -

From the time petitioner and her husband divorced in 1986

until petitioner sold the home in 1994 for $375,000, petitioner

maintained records that establish the nature and cost of capital

improvements made to the home.

In 1994, petitioner paid a $10,000 consulting fee relating

to a family business plan and to the acquisition and the sale of

personal property.

In 1994, petitioner received $5,149 as a distribution from

an individual retirement account (IRA) that petitioner maintained

at Great-West Life & Annuity Insurance Co. (Great-West). Great-

West mailed to petitioner and to respondent a Form 1099-R

indicating that $895 of the $5,149 distribution represented

taxable income to petitioner.

1994 Tax Return and Respondent's Audit

On her 1994 Federal income tax return, petitioner did not

report any taxable income relating to the transfer of a portion

of the funds invested in the Fortis annuity contract into the

Equitable annuity contract.

Also on her 1994 Federal income tax return, with regard to

sale of her home petitioner reported a $375,000 selling price, a

tax basis in the home of $335,492, and a taxable gain of $2,578.

Petitioner claimed as miscellaneous itemized deductions $13,250,

consisting of $10,000 for a consulting fee, $2,500 for investment

loss, and $750 for legal fees, and petitioner reported as taxable - 6 -

income the $895 taxable portion of the $5,149 Great-West

distribution. Petitioner, however, reported no additional tax

under section 72(t) with respect to the $895 taxable portion of

the Great-West distribution.

On audit, respondent determined that petitioner’s transfer

of a portion of the funds invested in the Fortis annuity contract

into the Equitable annuity contract did not qualify as a

nontaxable exchange under section 1035 and that petitioner

received $30,535 of unreported taxable income relating thereto.

Respondent also determined that petitioner is liable under

section 72(q) for a 10-percent penalty of $3,054 on the $30,535

portion of the withdrawal from the Fortis annuity contract that

respondent treated as taxable.

Further, in calculating petitioner's taxable gain on the

sale of her home, respondent disallowed entirely petitioner's

claimed tax basis of $335,492. Respondent disallowed

petitioner's claimed miscellaneous itemized deductions of

$13,250, and respondent determined that petitioner is liable for

a 10-percent additional tax of $90 under section 72(t) on the

$895 taxable portion of petitioner's $5,149 Great-West

distribution.

Before trial, respondent allowed petitioner a tax basis in

her home of $221,633, consisting of the purchase price of $53,500

and all of the claimed $168,133 in improvements that were made to - 7 -

the home after 1986 for which petitioner produced what respondent

regarded as adequate documentation.1

On brief, respondent conceded that $9,000 of the $10,000

petitioner paid as a consulting fee is deductible as a

miscellaneous itemized deduction.

OPINION

Under section 72(e)(2)(B)(i), amounts received under an

annuity contract prior to the date on which annuity payments are

to begin are to be included in gross income to the extent

allocable to income earned on the annuity contract.

Under section 1035(a)(3), however, gains or losses are not

to be recognized where an annuity contract is exchanged for

another annuity contract. Section 1035(a)(3) provides as

follows:

SEC. 1035. CERTAIN EXCHANGES OF INSURANCE POLICIES.

(a) General Rules.--No gain or loss shall be recognized on the exchange of--

* * * * * * *

(3) an annuity contract for an annuity contract.

1 Respondent also allowed a $36,930 adjustment to the selling price of the home to reflect a real estate sales commission that petitioner paid. - 8 -

Under regulations promulgated under section 1035, in order

for an exchange to qualify for nonrecognition treatment, it is

required only that the contracts be of the same type, e.g., an

annuity for an annuity and that the obligee under the two

contracts be the same person. No other requirements are set

forth in the applicable regulations. Section 1.1035-1(c), Income

Tax Regs., provides, in part, as follows:

Sec. 1.1035-1. Certain exchanges of insurance policies.--Under the provisions of section 1035 no gain or loss is recognized on the exchange of:

(c) An annuity contract for another annuity contract (section 1035(a)(3)),

but section 1035 does not apply to such exchanges if the policies exchanged do not relate to the same insured. The exchange, without recognition of gain or loss, of an annuity contract for another annuity contract under section 1035(a)(3) is limited to cases where the same person or persons are the obligee or obligees under the contract received in exchange as under the original contract. * * *

Respondent argues that because the entire Fortis annuity

contract was not replaced by the Equitable annuity contract,

petitioner's withdrawal of $119,000 from the Fortis annuity

contract does not qualify as a nontaxable exchange under section

1035 and is taxable to the extent of $30,535, the portion of the

withdrawal allocable to income.

Petitioner argues that because Fortis did not distribute any

funds to her personally but rather transferred the funds directly - 9 -

to Equitable and because she gave up a portion of her Fortis

annuity contract solely in exchange for the new Equitable annuity

contract, the transaction should qualify as a nontaxable exchange

of annuity contracts under section 1035.

We agree with petitioner.

Neither section 1035 nor the regulations condition

nonrecognition treatment upon the exchange of an entire annuity

contract. Respondent cites no authority to support respondent's

position that nonrecognition treatment under section 1035 is

limited to exchanges involving replacement of entire annuity

contracts. Neither the statute nor the regulations contain any

such requirement, either expressly or by any necessary

implication.

Petitioner expressly indicated on her application with

Equitable that the Equitable annuity contract was being acquired

as part of a section 1035 exchange, and Fortis transferred the

$109,000 directly to Equitable. No funds were distributed to

petitioner.

The legislative history under section 1035 states that

section 1035 was enacted to provide nonrecognition treatment for

taxpayers "who have merely exchanged one * * * [annuity contract]

for another better suited to their needs and who have not

actually realized gain." H. Rept. 1337, 83d Cong., 2d Sess. 81

(1954). The funds withdrawn from the Fortis annuity contract - 10 -

(net of the $10,000 surrender fee) were transferred directly into

another annuity contract without petitioner having any personal

use thereof.

In Greene v. Commissioner, 85 T.C. 1024 (1985), an insurance

company distributed to the taxpayer all funds invested in an

annuity contract qualified under section 403(b).2 Upon receipt,

the taxpayer endorsed the check over to another insurance company

to purchase another annuity contract qualifying under section

403(b). In Greene, 85 T.C. at 1028, we concluded that the

exchange was nontaxable, and we set forth a broad definition of

"exchange" within the meaning of section 1035, as follows:

We are satisfied, however, that Congress intended the use of the word [exchange] in the broader sense, as where the taxpayer gives up an insurance contract with one company, in order to procure the same or a comparable contract from another company. Viewed from the standpoint of the insured taxpayer, he has simply "exchanged" one policy for another just like it, albeit with two different companies. * * *

Petitioner herein exchanged a portion of her annuity

contract with Fortis to acquire another annuity contract with

Equitable. Petitioner is in essentially the same position after

the exchange as she was in before the exchange, and the same

2 Annuity contracts qualifying under sec. 403(b) constitute a form of tax-deferred annuity contracts available to employees of certain tax-exempt organizations. - 11 -

funds are still invested in annuity contracts (less the surrender

fee), except that now petitioner owns two annuity contracts.

Petitioner's funds (less the $10,000 surrender charge)

remain invested in a similar annuity contract, and petitioner has

not personally received use or benefit of these funds since they

were originally invested in the Fortis annuity contract in 1992.

We conclude that petitioner's direct exchange of a portion

of her Fortis annuity contract for a new Equitable annuity

contract qualifies under section 1035 and that no gain to

petitioner is to be recognized by reason of the exchange.3

Because the transaction qualifies as a nontaxable exchange,

petitioner is not liable for the 10-percent penalty under section

72(q) on any portion of the $119,000 withdrawal.

Tax Basis in Petitioner's Home

In determining gain or loss on the sale of property, the

cost basis of the property is adjusted by capital improvements

made to such property. Secs. 1001, 1012, 1016.

Generally, taxpayers bear the burden of proving entitlement

to costs and deductions claimed. Bennett Paper Corp. &

3 In Rev. Rul. 90-24, 1990-1 C.B. 97, involving annuity contracts issued under sec. 403(b), a portion of funds invested in one annuity contract is transferred directly to another similar annuity contract, and the transfer is treated as nontaxable. In Rev. Proc. 92-44, 1992-1 C.B. 875, under certain specified situations, partial cash distributions to taxpayers from annuity contracts are treated as nontaxable to the extent reinvested in similar annuity contracts. - 12 -

Subsidiaries v. Commissioner, 699 F.2d 450, 453 (8th Cir. 1983),

affg. 78 T.C. 458 (1982). Under certain circumstances, we may

estimate costs and allowable deductions. Cohan v. Commissioner,

39 F.2d 540, 543-544 (2d Cir. 1930). The estimates, however,

must have a reasonable evidentiary basis. Vanicek v.

Commissioner, 85 T.C. 731, 742-743 (1985).

Respondent argues that petitioner has not adequately

substantiated any costs and capital improvements to her home in

excess of the $221,633 that respondent has agreed to. The

claimed costs and improvements still in dispute relate to the

years 1971 through 1986, for which petitioner has minimal or no

documentation. Respondent argues that petitioner's testimony as

to the costs of the claimed improvements is self-serving and

uncorroborated.

Petitioner claims that the evidence relating to the

improvements allegedly made during 1971 through 1986 is adequate

for the Court to estimate the costs thereof and that she should

be entitled to increase the tax basis in her home by an

additional $156,050 beyond those items allowed by respondent, for

a total tax basis in the home of $377,683.

Credible evidence adequately establishes that, during the

years 1971 through 1986, petitioner and her husband made

extensive capital improvements to the home. In addition to the - 13 -

testimony, several of the improvements are supported by building

permits in evidence.

We accept petitioner's and her former husband's testimony

with regard to a number of the home improvements that are claimed

to have been made during the years 1971 through 1986. Set forth

in the schedule below, we summarize the various improvements that

petitioner claims were made to the home during 1971 through 1986

and the estimated costs that petitioner claims were incurred for

each improvement. Also set forth below with regard to the

improvements are the costs, if any, that we believe can be

reasonably estimated and that we allow with regard to each

improvement.

Petitioner's Claimed Costs Claimed Home Improvements 1971-1986 Costs Allowed New electrical wiring $ 11,000 $ 5,000 New furnace and hot water heater 9,300 5,000 New insulation 8,800 -0- Reconstruction of gazebo and bridge to gazebo 8,000 2,000 Stone steps leading to the lake 1,500 -0- Pool improvements and new wrought-iron fence 8,500 5,000 New two-car garage and removal of old garage 46,800 20,000 New concrete driveway 6,500 4,000 Reconstruction of second floor including a new wall 12,600 10,000 Septic tank removal and city water/sewer hookup 11,150 5,000 Structural improvements to doors and roof supports 8,100 -0- New roof 10,300 -0- Interior remodeling 4,500 -0- Dock improvements 1,500 -0- Kitchen improvements 7,500 -0- Total $156,050 $56,000

Based on the evidence before us, we conclude that

petitioner's tax basis in her home is $277,633, or $56,000 over

the $221,633 allowed by respondent. - 14 -

Miscellaneous Itemized Deductions

With respect to the claimed $1,000 consulting fee in excess

of the $9,000 allowed by respondent, petitioner has failed to

demonstrate that the $1,000 was paid for management,

conservation, or production of income or income-producing

property, and we sustain respondent's disallowance thereof.

With respect to the claimed $2,500 investment loss and the

claimed $750 legal fees, the evidence provides no basis to

support these claimed deductions, and we sustain respondent's

disallowance thereof.

IRA Distribution

With regard to the $5,149 IRA distribution that petitioner

received from Great-West, petitioner has not established that the

10-percent additional tax on the $895 taxable portion of the

$5,149 distribution does not apply, and we sustain this

additional tax.

To reflect the foregoing,

Decision will be entered

under Rule 155.