Opinions of the United
2002 Decisions                                                                                                             States Court of Appeals
                                                                                                                              for the Third Circuit


7-29-2002

Neonatology Assoc v. Commissioner IRS
Precedential or Non-Precedential: Precedential

Docket No. 01-2862




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PRECEDENTIAL

       Filed July 29, 2002

UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT

No. 01-2862

NEONATOLOGY ASSOCIATES, P.A.

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-1201)

JOHN J. and OPHELIA J. MALL

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-1208)

ESTATE OF STEVEN SOBO, DECEASED and
BONNIE SOBO, EXECUTRIX, and
BONNIE SOBO, SURVIVING WIFE

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-2795)




AKHILESHI S. and DIPTI A. DESAI

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-2981)

KEVIN T. and CHERYL MCMANUS

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-2985)

ARTHUR and LOIS M. HIRSHKOWITZ

v.

COMMISSIONER OF INTERNAL REVENUE
(Tax Court No. 97-2994)

LAKEWOOD RADIOLOGY, P.A.

v.

COMMISSIONER OF INTERNAL REVENUE

(Tax Court No. 97-2995)

Neonatology Associates, P.A., John J.
and Ophelia Mall, Estate of Steven Sobo,
Deceased, and Bonnie Sobo, Executrix,
and Bonnie Sobo, Surviving Wife,
Akhilshi S. and Dipti A. Desai,
Kevin T. and Cheryl McManus,
Arthur and Lois M. Hirshkowitz and
Lakewood Radiology, P.A.,

       Appellants

                                 2


On Appeal from the United States Tax Court
(T.C. Nos. 97-1201/1208/2795/2981/2985/2994/2995)
Tax Court Judge: Honorable David Laro

Argued: July 11, 2002

BEFORE: SCIRICA and GREENBERG, Circuit Judges ,
and FULLAM, District Judge*

(Filed: July 29, 2002)

       Neil L. Prupis
       Lampf, Lipkind, Prupis,
        Petigrow & LaBue
       80 Main Street
       West Orange, NJ 07052

       Kevin L. Smith (argued)
       Hines Smith
       3080 Bristol Street, Suite 540
       Costa Mesa, CA 92626

       David R. Levin
       Wiley Rein & Fielding
       1776 K Street, N.W.
       Washington, D.C. 20006

        Attorneys for Appellants

       Eileen J. O’Connor
       Assistant Attorney General
       Kenneth L. Greene
       Robert W. Metzler (argued)
       Attorneys Tax Division
       Department of Justice
       Post Office Box 502
       Washington, D.C. 20044

        Attorneys for Appellee
_________________________________________________________________

* Honorable John P. Fullam, Senior Judge of the United States District
Court for the Eastern District of Pennsylvania, sitting by designation.

                                3


       Steven J. Fram
       Archer & Greiner
       One Centennial Square
       Haddonfield, NJ 08033

        Attorneys for Amici Curiae Vijay
       Sankhla, M.D., Yale Shulman,
       M.D., Boris Pearlman, M.D., Marvin
       Cetel, M.D. and Barbara Schneider,
       M.D.

OPINION OF THE COURT

GREENBERG, Circuit Judge.

I. INTRODUCTION

This matter comes on before this court on appeal from
decisions of the United States Tax Court entered April 9,
2001, in accordance with its opinion filed July 31, 2000,
upholding the determination of the Commissioner of
Internal Revenue that contributions made by appellants,
two professional medical corporations, Neonatology
Associates, P.A. and Lakewood Radiology, P.A., into
Voluntary Employees Beneficiary Program (VEBA) plans in
excess of the cost of term life insurance were taxable
constructive dividends to the physicians owning the
corporations and their spouses rather than employer
deductible expenses. See Neonatology Assoc., P.A. v.
Comm’r, 

(2000). We refer to the corporations
and individuals collectively as "taxpayers." The
consequences of the decisions were substantial for the
taxpayers inasmuch as the professional medical
corporations were denied deductions they had taken for the
contributions and the individuals were charged with
significant additional taxable dividend income. The court
held further that the individual taxpayers were liable for
accuracy-related negligence penalties under I.R.C.
S 6662(a).

Our examination of the record convinces us that the
contributions at the heart of this dispute were so far in

                                4


excess of the cost of annual life insurance protection that
they could not plausibly qualify as ordinary and necessary
business expenses in accordance with I.R.C. S 162. In
essence, the physicians adopted a specially crafted
framework to circumvent the intent and provisions of the
Internal Revenue Code by having their corporations pay
inflated life insurance premiums so that the excess
contributions would be available for redistribution to the
individual shareholders free of income taxes. As correctly
recognized by the Tax Court, these contributions were
taxable disguised dividends and not deductible expenses.
Moreover, as the individual taxpayers could not in good
faith avail themselves of the reliance-on-professional
defense, the Tax Court duly held them liable for the
accuracy-related negligence penalties. Accordingly, for the
reasons we elaborate in more detail below, we will affirm
the decisions of the Tax Court.

II. BACKGROUND

The evidence at the trial disclosed the following facts.
Neonatology is a New Jersey professional corporation owned
by Dr. Ophelia J. Mall. Lakewood is a New Jersey
professional corporation owned equally at the times
material here by Drs. Arthur Hirshkowitz, Akhilesh Desai,
Kevin McManus, and Steven Sobo until his death on
September 23, 1993. Subsequently Dr. Vijay Sankhla, who
is not a party to this action, purchased Sobo’s interest. The
spouses of the doctors, John Mall, Lois Hirshkowitz, Dipti
Desai, Cheryl MacManus, and Bonnie Sobo, are parties to
this action as the doctors and their spouses filed joint
income tax returns. In addition, Bonnie Sobo is a party as
executrix of her husband’s estate.

Following the enactment of the Tax Reform Act of 1986
(TRA), Pub.L. 99-514, 100 Stat. 2085, insurance salesmen
Stephen Ross and Donald Murphy formed Pacific Executive
Services (PES), a California partnership designed to
provides services to retirement plan administrators and
employee benefit advisors unfamiliar with the impact of the
TRA. See App. at 377. Specifically, Ross and Murphy
devised a program to allow closely held corporations to
"create a tax deduction for [ ] contributions to [an] employee

                                5


welfare benefit plan going in and a permanent tax deferral
coming out." App. at 2672.

To achieve this end, PES created two voluntary
employees’ beneficiary associations, the Southern California
Medical Profession Association VEBA (SC VEBA) and the
New Jersey Medical Profession Association VEBA (NJ VEBA).1
A VEBA, as defined in I.R.C. S 501(c)(9), is a tax-exempt
program providing members, their dependents, or
designated beneficiaries with life, sick, accident, or other
benefits "if no part of the net earnings of such association
inures (other than through such payments) to the benefit of
any private shareholder or individual."

Under the PES VEBA programs, each participating
employer adopts its own plan, maintaining a trust account
and designating a trust administrator with exclusive control
over all assets. The plan adoption agreement obligates
employers to make, whether in the form of group insurance
policies or group annuities, contributions towards the life
insurance benefits of employees and their beneficiaries,
based on a multiple of each employee’s annual
compensation. Benefits payable under any plan are paid
solely from that plan’s allocable share of the trust fund,
and the participating employer, administrator, and trustee
are not liable for any shortfall in the funds required to be
paid. Upon termination of a plan, all its remaining assets
are distributed to the employer’s covered employees in
proportion to their compensation. PES enlisted the services
of Barry Cohen, a longtime insurance salesman with the
Kirwan companies, to market the VEBA programs to
medical professionals.

The SC VEBA plans at issue in this case, the Neonatology
Employee Welfare Plan and the Lakewood Employee Welfare
Plan, shared a common feature: both purchased
continuous group (C-group) term policy certificates from the
Inter-American Insurance Co. of Illinois, Commonwealth
_________________________________________________________________

1. Notwithstanding what might be regarded as a geographical anamoly,
only the SC VEBA is involved here. There was, however, an additional
petitioner in the Tax Court, not a party on this appeal, Wan B. Lo, d/b/a
Marlton Pain Control and Acupuncture Center, who established a plan
under the NJ VEBA.

                                6


Life Insurance Co., and Peoples Security Life Insurance Co.
The C-group product provided routine group term life
insurance with an added component, a "special" conversion
policy through which a covered employee, under certain
circumstances,2 could opt to convert his or her policy to an
individual policy, the C-group conversion universalife (UL)
policy. By converting from a C-group to an individual UL
policy, the employee could access funds paid by the
employer to the group policy that exceeded the applicable
mortality charge, i.e. the cost of insurance. The excess
funds, depending on the year in which the conversion takes
place,3 are paid out with interest as so-called "conversion
credits."

In addition to being able to access surplus amounts, a
policyholder upon conversion to the UL policy may borrow
any amounts against his or her policies not required to
keep the policies in force.4 When the policyholder dies, the
loans are to be repaid from the policy death benefits, which
ordinarily are not subject to income tax. See I.R.C. S 101.
Of course, by borrowing the money the taxpayer effectively
would be withdrawing money the medical corporations paid
for the conversion privilege on a tax free basis. Thus, as if
_________________________________________________________________

2. Under the policies, conversion was allowed when group coverage
ceased because (1) the employee ceased employment, (2) the employee
left the class eligible for coverage, (3) the underlying contract terminated,
(4) the underlying contract was amended to terminate or reduce the
insurance of a class of insured employees, or (5) the underlying contract
terminated as to an individual employer or plan. See App. at 1836, 1846.

3. Under the applicable schedule, none of the conversion credit balance
is transferred to the C-group conversion UL policy if conversion occurs
in the C-group term policy’s first year. However, if conversion takes place
in the C-group term policy’s fourth year or beyond, 95% of the
conversion credit balance is transferred to the C-group conversion UL
policy. Policyholders could not receive more than 95% of their conversion
credit balance because a five percent commission was paid automatically
to the insurance agent upon conversion. See App. at 2161-62, 4710,
4713.

4. Notably, the interest due on any loan policy was equal to the interest
credited on the asset accumulation. In other words, there were no out-
of-pocket costs to the debtor-policyholder. See App. at 2164. To hedge
the attendant C-group product risks, Inter-American and Commonwealth
reinsured with a third party.

                                7


by magic, cash derived from the corporations would be
withdrawn without tax. Each of the physician taxpayers,
other than Dr. Sobo, in fact converted at least one C-group
term certificate to a special policy providing conversion
credits. See App. at 426-29, 439-41.

Neonatology, on the basis of conversations between its
principal, Dr. Mall, and Cohen, established the Neonatology
Plan under the SC VEBA on January 31, 1991, effective
January 1, 1991. Under the plan, each covered employee
was to receive a life insurance benefit equal to 6.5 times the
employee’s compensation of the prior year. See App. at 434,
1807. John Mall, Dr. Mall’s husband, was not a paid
employee of Neonatology and thus was not eligible to join
the plan. Nevertheless, Dr. Mall and PES, the plan
administrator, allowed Mr. Mall to join the plan, making
him eligible to receive a death amount commensurate to
that payable under life insurance that he had owned
outside the plan ($500,000). See Supp. App. at 108-09. The
Neonatology Plan purchased three C-group life insurance
policies, two on Dr. Mall’s life and one on Mr. Mall’s life.
See App. at 434-39. Neonatology contributed to the
Neonatology Plan during each year from 1991 through 1993
and, for each subject year, claimed a tax deduction for
those contributions and other related amounts.

Lakewood, on the basis of conversations between its
principals and Cohen, established the Lakewood Plan   under
the SC VEBA on December 28, 1990, effective January   1,
1990. Under the plan, each covered employee was to
receive a life insurance benefit equal to 2.5 times   his or her
prior-year compensation. See App. at 387. Lakewood
amended its plan as of January 1, 1993, to increase   the
compensation multiple to 8.15. The Lakewood Plan
purchased 12 C-group life insurance policies on the   lives of
Drs. Hirshkowitz, Desai, Sobo, McManus, and Sankhla   and
three group annuities toward future premiums on the
policies. See App. at 400-26. Lakewood also purchased
three C-group policies outside of the Lakewood Plan. The
individual owners on their own behalf determined the
amounts contributed by Lakewood to the SC VEBA. See
App. at 1015-16, 3674-87. For each subject year, Lakewood
claimed a tax deduction for those contributions and other
related amounts.

                                8


The IRS audited Neonatology’s tax returns for calendar
years 1992 and 1993 and Lakewood’s tax returns for fiscal
year 1991 (ending October 31, 1991) and calendar years
1992 and 1993. As a consequence of the audits, the
Commissioner made the following determinations. First,
with respect to the deductions claimed by Neonatology for
amounts paid to the SC VEBA and by Lakewood for
amounts paid to the SC VEBA and to the three non-plan C-
group policies, he allowed only the cost of annual term life
insurance protection and disallowed the excess amounts of
$43,615 and $986,826 for Neonatology and Lakewood
respectively. See App. at 2265-66, 2283-85. The
Commissioner based his disallowance on alternative bases:
(1) the excess contributions were not ordinary and
necessary business expenses under I.R.C. S 162(a); (2) even
if the amounts constituted ordinary and necessary business
expenses, they nevertheless were not deductible under
I.R.C. SS 404(a) and 419(a), which limit the deductibility of
contributions paid to deferred compensation plans and
welfare benefit plans. See App. at 2266, 2285.5

Second, the Commissioner determined with respect to the
individual owners that amounts paid to the SC VEBA
program increased personal incomes by $39,343 for Dr.
Mall and her husband, $219,806 for Dr. Desai, $56,107 for
Dr. McManus, $601,849 for Dr. Hirshkowitz, and $101,314
for Dr. Sobo (his estate). See App. at 2271, 2311, 2297,
2320. The Commissioner included the excess contributions
as income to the individual taxpayers on alternative bases:
(1) the amounts were deposited in the plans for the
economic benefit of the individual taxpayers and as such
constituted constructive dividends under I.R.C.SS 61(a)(7)
and 301; (2) assuming that the Neonatology and Lakewood
Plans constituted deferred compensation plans, the excess
contributions were includible under section 402(b). See
_________________________________________________________________

5. Specifically, the Commissioner ruled that as deferred compensation
plans, the Neonatology and Lakewood Plans did not satisfy the I.R.C.
S 404(a)(5) "separate account" requirement for the contributions to be
deductible. If the plans were characterized as welfare benefit funds,
I.R.C. S 419(b) limited the deductions as the plans could not qualify for
the "10-or-more-employer plans" exception to section 419(b) in I.R.C.
S 

, 2297, 2311, 2320. Lastly, the Commissioner
determined that by reason of the underpayment of taxes
the individual taxpayers were subject to penalties under
I.R.C. S 6662(a).

Neonatology, Lakewood, and the individual owners
petitioned the Tax Court challenging the IRS’s
determinations. After a bench trial, the court sustained the
Commissioner on the ground 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 . . . .
       The premiums paid for the C-group term policy
       exceeded by a wide margin the cost of term life
       insurance . . . . What is critical to our conclusion is
       that the excess contributions made by Neonatology and
       Lakewood conferred an economic benefit on their
       employee/owners for the primary (if not sole) benefit of
       those employee/owners, that the excess contributions
       constituted a distribution of cash rather than a
       payment of an ordinary and necessary business
       expense, and that neither Neonatology nor Lakewood
       expected any repayment of the cash underlying the
       conferred benefit.

Neonatology, 

.

Without addressing the alternative grounds for the
Commissioner’s conclusions, the court rejected taxpayers’
arguments that the possibility of forfeiture in certain
situations like policy lapse or death rendered all excess
payments into de facto contributions to life insurance
protection. 

("The mere fact that a C-group term
policyholder may forfeit the conversion credit balance does
not mean, as petitioners would have it, that the balance
was charged or paid as the cost of term life insurance.").
The court also rejected the idea that contributions which in
fact did not fund term life insurance were paid as
compensation for services, rather than dividends, because
as a factual matter neither Neonatology nor Lakewood had
the requisite compensatory intent when the contributions

                                  10


were made. 

Lastly, the court agreed with the
Commissioner that the individual taxpayers were in fact
negligent and could not circumvent the accuracy-related
penalties by asserting a good faith, reliance-on-professional
defense nor could they do so by claiming that the case
involved tax matters of first impression.

The Tax Court entered its decisions on April 9, 2001.
Taxpayers timely appealed on July 6, 2001. We have
jurisdiction over this appeal pursuant to I.R.C.S 7482, and
the Tax Court had jurisdiction over the petitions pursuant
to I.R.C. SS 6213(a) and 7442.
III. DISCUSSION

There are three principal issues before us on appeal: (1)
whether the Tax Court correctly determined that the
amounts contributed in excess of the cost of per annum
term life insurance were not ordinary and necessary
business expenses and therefore not deductible; if yes, (2)
whether those amounts constituted dividends, includible as
taxable individual income, or compensation to the
individual taxpayers; and, (3) whether the individual
taxpayers were negligent. Our review of the Tax Court’s
legal conclusions is plenary and is based on the"clearly
erroneous" standard for its findings of fact. See ACM P’ship
v. Comm’r, 

, 245 (3d Cir. 1998); Pleasant
Summit Land Corp. v. Comm’r, 

, 268 (3d Cir.
1988). Moreover, taxpayers bear the burden of refuting the
IRS’s determinations. See Welch v. Helvering, 

,
115, 

, 9 (1933).6

A. The Deficiencies

Section 162(a) of the Internal Revenue Code7 allows for
_________________________________________________________________

6. The burden of proof may be shifted to the Commissioner in certain
circumstances for audits conducted after July 22, 1998. See I.R.C.
S 7491. These modifications to the Internal Revenue Code have no
bearing on this case.

7. The Internal Revenue Code, I.R.C. S 162(a), provides that "[t]here 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."

                                11


the deduction of all ordinary and necessary expenses
incurred in carrying on a trade or business providing five
requirements are met: the item claimed as deductible (1)
was paid or incurred during the taxable year; (2) was for
carrying on a trade or business; (3) was an expense; (4) was
a necessary expense; and (5) was an ordinary expense. See
Comm’r v. Lincoln Sav. & Loan Ass’n, 

, 352, 

, 1898 (1971). Beyond peradventure, employee
benefits like life insurance are a form of compensation
deductible by the employer.8 See Treas. Reg. S 1.162-10(a);
see also Joel A. Schneider, M.D., S.C. v. Comm’r, 1992 T.C.
Memo. 992-24, 63 T.C.M. (C.C.H.) 1787. To the extent,
however, that Neonatology’s and Lakewood’s expenditures
did not fund term life insurance, the Tax Court found that
they did not meet the five requirements delineated above
and therefore were not deductible. This factual finding was
not clearly erroneous. See Comm’r v. Heininger , 

, 475, 

, 254 (1943).

The record amply supports the conclusion that taxpayers
paid artificially inflated premiums in a creative bookkeeping
ploy conceived by their insurance specialists to exploit what
they thought were loopholes in the tax laws. Indeed, we do
not see how a court examining this case could conclude
otherwise. Charles DeWeese, the Commissioner’s expert,
testified that amounts paid into the C-group policies
exceeded conventional life insurance premiums by nearly
500%. See App. at 804-08, 2156.9 Evidence at trial
_________________________________________________________________

8. Of course, the mere fact that the benefit is a form of deductible
compensation does not necessarily mean that it is taxable to the
employee. See I.R.C. S 79. We note that the parties do not treat section
79 as significant here.

9. It should be noted that the Tax Court made certain credibility
determinations, finding DeWeese, an independent consulting actuary, to
be a "reliable, relevant, and helpful" witness whose testimony was
bolstered by a voluminous record with stipulations to more than 2,000
facts and with more than 1,500 exhibits. See Neonatology, 

. By the same token, the court found that the opinions expressed
by taxpayers’ sole expert, Jay Jaffe, were of minimal help, considering
his close relationship to one of the insurance companies that provided
the C-group product at issue in the case. See 

act as
advocates, "can be viewed only as hired guns of the side that retained

                                12


demonstrated that Dr. Mall knew that term life insurance
was substantially more expensive to buy through the SC
VEBA than through other plans offered to her under the
auspices of the American Medical Association and the
American Academy of Pediatrics. She nevertheless opted to
form the Neonatology Plan because she believed that it
offered her the best tax benefits. See App. at 1025. Dr.
Hirshkowitz testified that Lakewood intentionally paid more
expensive premiums on the C-group policies than it would
have for conventional life insurance protection. See App. at
998. Dr. Desai, another Lakewood owner, testified that his
independent personal life insurance cost him substantially
less than the policies issued pursuant to the SC VEBA. See
App. at 1047. Like Dr. Mall, the Lakewood owners
nevertheless invested in the SC VEBA program because of
Cohen’s representation of tax benefits and cash returns
that they could anticipate receiving. See App. at 1014-15.

The record also reveals that excess premium amounts did
not pay for actual current year life insurance protection but
rather paid for conversion credits. The compliance manager
of the Providian Corporation, the parent of the
Commonwealth Life Insurance Company which issued
policies involved here, stated in a letter to the IRS that the
"premiums paid for the term policy are higher than the
traditional term policy because of the conversion privilege
and the costs of conversion credits." App. at 3690.
DeWeese, belying taxpayers’ claim that C-group premiums
were higher than those under ordinary term life policies
because they were calibrated to the higher risks of longer
_________________________________________________________________

them, and this not only disparages their professional status but
precludes their assistance to the court in reaching a proper and
reasonably accurate conclusion") (quoting Jacobson v. Comm’r, T.C.
Memo. 1989-606, 58 T.C.M. (C.C.H.) 645)). The court also found that
some of taxpayers’ fact witnesses "testified incredibly with regard to
material aspects of this case" and that their testimony, for the most part,
was "self-serving, vague, elusive, uncorroborated, and/or inconsistent
with documentary or other reliable evidence." 

of
credibility determinations are ensconced firmly within the province of a
trial court, afforded broad deference on appeal. See Dardovitch v.
Haltzman, 

, 140 (3d Cir. 1999).

                                13


term employees in small markets,10 testified that the bulk of
the gross premiums went to accumulate assets for
distribution to the individual participants upon conversion.
See App. at 2173. In addition, the record supports the
conclusion that payments made to the Lakewood Plan for
annuities were made not to fund current life insurance
protection for employees but rather were made as an
investment for the trustee to pay premiums on future C-
group premiums. See App. at 976, 993-94, 1041-42.

In sum, the evidence fully supports, indeed compels, the
finding that the contributions in excess of the amounts
necessary to pay for annual term life insurance protection
were distributions of surplus cash and not ordinary and
necessary business expenses. Considering the sound
reasoning of the Tax Court and our own intensive review of
the facts here, we conclude that it is implausible that the
owners of Neonatology and Lakewood, educated and highly
trained medical professionals, knowingly would have
overpaid substantially for term life insurance unless they
contemplated receiving an added boon such as a tax-free
return of the excess contributions.

Taxpayers advance two arguments to the effect that the
court erred by not limiting its consideration to the written
plan documents and life insurance contracts rather than
relying on extraneous evidence like the plan marketing
materials which discuss the availability of conversion
credits. First, they maintain that the Neonatology and
Lakewood SC VEBA programs were employee benefit plans
under the Employee Retirement Income Security Act, 29
U.S.C. S 1001 et seq., (ERISA). Thus, they contend that
representations made outside of the plan documents
cannot be used to consider rights and obligations arising
out of the plans. See Br. of Appellants at 35. Second, they
argue that under governing state insurance law, the tax
implications of a group term life insurance policy are
determined only on the basis of the policy language itself.
As the literal provisions of the plans discuss only insurance
benefits -- that is, a death benefit and an option to convert
to an individual policy upon termination of employment --
_________________________________________________________________

10. See Br. of Appellants at 44 and n.30.

                                14
but say nothing about excess contributions returning as
conversion credits, taxpayers claim that the Tax Court was
compelled to conclude from the strict form of their plans
that all contributions in fact went to providing insurance
benefits.

Inasmuch as taxpayers did not raise the ERISA issue
before the Tax Court, we need not consider it on this
appeal. See Visco v. Comm’r, 

, 104 (3d Cir.
2001). While we recognize that in some exceptional
circumstances an appellate court may review a defaulted
argument, in this case there are compelling reasons
militating against our overlooking procedural norms to
consider whether ERISA governed the SC VEBA programs
as our determination may prejudice persons not parties to
this case.11

In any event, even assuming for purposes of argument
that the plans were employee benefit plans under ERISA,
the fact remains that under well-established tax principles
a court is not limited to plan documents in determining the
tax consequences of a transaction. See, e.g., Comm’r v.
Court Holding Co., 

, 334, 

, 708
(1945) ("The incidence of taxation depends upon the
substance of a transaction."); ACM 

("we must look beyond the form of the transaction to
determine whether it has the economic substance that its
form represents") (citations omitted); Lerman v. Comm’r,

, 54 (3d Cir. 1991) (Commissioner and courts
have "the power and duty . . . to look beyond the mere
forms of transactions to their economic substance and to
_________________________________________________________________

11. An amicus brief has been filed in this case on behalf of five
physician-participants in the VEBA program who have filed a civil
complaint against the insurance companies that wrote the C-group
policies, Sankhla v. Commonwealth Life Ins. Co. et al., No. 01-CV-4761
(U.S.D.C. N.J.). Amici have an interest in the outcome of this case
because the extent to which we address whether the plans are governed
by ERISA could affect resolution of the issue of whether their state law
claims against the insurance companies are preempted. See Amicus Br.
at 1-2. Rather than needlessly prejudice the rights of litigants in
separate proceedings, we do not discuss the applicability of ERISA to the
VEBA plans.

                                15


apply the tax laws accordingly.").12 The cases cited by
taxpayers,13 on the other hand, involve only disputes over
_________________________________________________________________

12. Taxpayers, conflating the so-called "substance-over-form" doctrine
with the "economic substance" or "sham transaction" doctrine,
mistakenly argue as well that a court may not disregard the form of an
arrangement until it determines that the arrangement lacks any
economic substance other than obtaining tax deductions. See Br. of
Appellants at 41 ("If . . . there is any economic substance to the
arrangement apart from the alteration of tax liabilities, then the form of
the arrangement must be respected, even if the arrangement was
motivated by tax avoidance or minimization."). In actuality, the two
doctrines are distinct. The substance-over-form doctrine is applicable to
instances where the "substance" of a particular transaction produces tax
results inconsistent with the "form" embodied in the underlying
documentation, permitting a court to recharacterize the transaction in
accordance with its substance. The economic substance doctrine, in
contrast, applies where the economic or business purpose of a
transaction is relatively insignificant in relation to the comparatively
large tax benefits that accrue (that is, a transaction "which actually
occurred but which exploit[s] a feature of the tax code without any
attendant economic risk," Horn v. Comm’r, 

, 1236 n.8
(D.C.Cir. 1992)); in that situation, where the transaction was an
attempted tax shelter devoid of legitimate economic substance, the
doctrine governs to deny those benefits. See generally Rogers v. United
States, 

, 1113-18 (10th Cir. 2002). The Tax Court in this
case, however, based its decision solely on the substance-over-form
doctrine, finding that the form of the VEBA was not reflective of its
genuine substance. In addition to the evidence we have set forth, the Tax
Court’s determination further is reinforced, inter alia, by the fact that
taxpayers were allowed to convert the C-group term policies to individual
C-group conversion UL policies even though none of the five required
conditions for conversion were present, see Supp. App. at 106, 111-12,
and by the fact that the amount of life insurance taken on the Lakewood
principals did not correspond to the amount of benefits for which they
were eligible under the plan documents. See, e.g., App. at 389, 400-03
(Dr. Hirshkowitz had C-group certificates on his life for over a million
dollars even though he was eligible for life benefits of less than $500,000
-- 2.5 times his 1991 compensation of $181,199.09). Moreover, even
under the economic substance doctrine taxpayers would be hard-pressed
to argue that the transactions involving the excess term life insurance
payments had sufficient economic substance to be respected for tax
purposes.
13. See Br. of Appellants at 29-36 (citing Gruber v. Hubbard Bert Karle
Weber, Inc., 

(3d Cir. 1998); Haberern v. Kaupp Vascular
Surgeons Ltd. Defined Benefit Pension Plan, 

(3d Cir. 1994);
Schoonejongen v. Curtiss-Wright Corp., 

(3d Cir. 1994);
Henglein v. Informal Plan for Plant Shutdown Benefits, 

(3d
Cir. 1992)).

                                16


ERISA benefits between private parties, not disputes over
tax liabilities between private parties and the
Commissioner. While the cases lay out certain principles for
determining rights and obligations under an ERISA plan,
including the standard contract theory that the literal
terms of a plan document must guide all analysis, the
cases say nothing about the proper evidentiary protocol for
evaluating the tax ramifications of an employer benefit
plan. In sum, we have no intention of importing ERISA
principles into this tax dispute.

Moreover, we reject taxpayers’ contention that the Tax
Court erred by not limiting its evaluation to the plan
documents in light of state insurance law. The court did
not construe or interpret the terms of the individual
taxpayers’ life insurance policies, but rather characterized
the contributions made towards those policies for purposes
of determining tax liabilities. While the former endeavor
indeed would implicate state law,14 the latter is singularly a
question of federal law. See, e.g., Thomas Flexible Coupling
Co. v. Comm’r, 

, 830 (3d Cir. 1946).

In view of our conclusion that the contributions in
dispute were not ordinary and necessary business expenses
under I.R.C. S 162(a), we next consider whether the district
court erred in determining that the contributions
constituted dividends rather than compensation to the
individual taxpayers and thus deductible to the
corporations on that basis.15 Under I.R.C. S 316(a), a
dividend is a distribution of property made by a corporation
to its shareholders out of its earnings and profits. See
Comm’r v. Makransky, 

, 601-03 (3d Cir. 1963).
_________________________________________________________________

14. Curiously, taxpayers fail to specify which state’s insurance law
applies: New Jersey, where all of the physicians reside, or Pennsylvania,
where the insurance agents who promoted the VEBA were located.

15. In their brief, taxpayers indicate that the Tax Court erred in
characterizing the "disallowed contributions as constructive dividends
rather than deductible compensation." Br. at 46 (emphasis added). See
King’s Ct. Mobile Home Park, Inc. v. Comm’r, 

, 512 (1992)
("The first question is whether the diversion of $58,365 of petitioner’s
income by its controlling shareholder for personal use constitutes the
payment of deductible wages or the distribution of a dividend.") (footnote
omitted).

                                17


Dividends are taxed as a component of gross income. See
I.R.C. S 61(a)(7). A shareholder, even if the corporation has
dispensed with the formalities of declaration, may be
charged with a disguised or constructive dividend if the
corporation confers a direct benefit on him from available
earnings and profits without expectation of repayment. See,
e.g., Crosby v. United States, 

(5th Cir.
1974); Noble v. Comm’r, 

, 443 (9th Cir. 1966);
see also Magnon v. Comm’r, 

, 993-94 (1980)
("Where a corporation confers an economic benefit on a
shareholder without the expectation of repayment, that
benefit becomes a constructive dividend, taxable to the
shareholder, even though neither the corporation nor the
shareholder intended a dividend.").

In this case, the record fully supports the conclusion of
the Tax Court that the individual taxpayers were chargeable
with constructive dividends. Indeed, Neonatology and
Lakewood, by design surrendering any expectation of
remuneration, purchased products that generated a
considerable economic bounty for their shareholders in the
form of conversion credits. Furthermore, nothing in the
record illustrates that taxpayers diverted these corporate
assets with the requisite "compensatory intent." See King’s
Ct. Mobile Home Park, Inc. v. Comm’r, 

, 514-15
(1992) (business expense may be deducted as
compensation only if the payor intends at the time that the
payment is made to compensate the recipient for services
performed).16 Moreover, support for a conclusion, though
certainly not dispositive, that the excess contributions were
not paid as compensation for services rendered is supplied
by the fact that the Neonatology and Lakewood plans were
made available only to those individuals who owned the
corporations and not to their non-equity employees.
Furthermore, Dr. Mall directed Neonatology to purchase the
C-group product on her husband, a non-employee third-
party who did not perform any services for the corporation.17
_________________________________________________________________

16. To qualify as deductible compensation, a payment also need be
reasonable. See Treas. Reg. S 1.162-7(a). We do not need to address this
point, as the Tax Court correctly determined as a matter of fact that
taxpayers did not demonstrate compensatory intent.

17. We are satisfied that the mere fact that Dr. Mall partially diverted the
benefits to her husband should not change our result.

                                18


In the circumstances, it is therefore not surprising that Dr.
Desai at trial made the matter-of-fact statement that the
money contributed by Lakewood to fund insurance
premiums and conversion credits is "our money. It’s not
Lakewood[‘s]." App. at 1055.

Taxpayers again rely on non-tax ERISA jurisprudence for
the exaggerated proposition that payments made pursuant
to an employee benefit plan are necessarily compensatory.18
However, the plain language of I.R.C. S 419(a)(2) explicitly
contemplates situations where contributions paid or
accrued by an employer to a welfare benefit fund are not
deductible (deductions allowed only if "they would
otherwise be deductible"); see also Treas. Reg. S 1.162-10(a)
(contributions to employee benefit plans deductible only if
"they are ordinary and necessary business expenses."). To
read otherwise inexplicably creates a shelter loophole by
allowing taxpayers to transform disbursements into
deductible business expenses merely by funneling them
through an ERISA plan.

We recognize that it is axiomatic that taxpayers lawfully
may arrange their affairs to keep taxes as low as possible.19
Nevertheless, at the same time the law imposes certain
threshold duties which a taxpayer may not shirk simply by
manipulating figures or maneuvering assets to conceal their
real character. See Court Holding 

, 65
S.Ct. at 708 ("[t]o permit the true nature of a transaction to
be disguised by mere formalisms . . . would seriously
impair the effective administration of the tax policies of
Congress."); see also Saviano v. Comm’r, 

, 654
(7th Cir. 1985) ("The freedom to arrange one’s affairs to
minimize taxes does not include the right to engage in
_________________________________________________________________

18. Taxpayers misread Pediatric Surgical Assoc., P.C. v. Comm’r, 

, 1479 (2001), for the proposition that anything paid
by a corporation for an employee’s benefit is presumed legally to be
compensation. Rather, Pediatric Surgical clearly iterates that intent to
pay compensation "is a factual question to be decided on the basis of the
particular facts and circumstances of the case." 

19. See Gregory v. Helvering, 

, 469, 

, 267
(1935) ("The legal right of a taxpayer to decrease the amount of what
otherwise would be his taxes, or altogether avoid them, by means which
the law permits, cannot be doubted.").

                                19


financial fantasies with the expectation that the Internal
Revenue Service will play along."). Thus, we conclude that
the Tax Court correctly held that the inflated premiums
were not allowable corporate business expenses but rather
allocations in the nature of dividends and thusly taxable.

B. The Penalties

Finally, we must consider the aptness of the penalties
assessed by the Commissioner and upheld by the Tax
Court. The Internal Revenue Code imposes a 20% tax on
the portion of an underpayment attributable, among other
things, to negligence or the disregard of rules and
regulations. I.R.C. SS 6662(a) and (b)(1)."Negligence" can
include any failure to make a reasonable attempt to comply
with the provisions of the Code, to exercise ordinary and
reasonable care in the preparation of a tax return, to keep
adequate books and records, or to substantiate items
properly. I.R.C. S 6662(c); Treas. Reg. S 1.6662-3(b)(1).
Generally speaking, the negligence standard as in the tort
context is objective, requiring a finding of a lack of due care
or a failure to do what a reasonable and prudent person
would do under analogous circumstances. See, e.g., Schrum
v. Comm’r, 

, 437 (4th Cir. 1994).

On the basis of the record, the Tax Court was justified in
concluding as a matter of fact that the individual taxpayers
were liable for the section 6662 accuracy-related penalties
because they did not meet their burden of proving due care.
See Hayden v. Comm’r, 

, 775 (7th Cir. 2000)
(the Commissioner’s determination of negligence is
presumed to be correct, and the taxpayer has the burden of
proving that the penalties are erroneous); accord Pahl v.
Comm’r, 

, 1131 (9th Cir. 1998) (burden of
disproving negligence on taxpayer); Goldman v. Comm’r, 

, 407 (2d Cir. 1994) (once the Commissioner
determines that a negligence penalty is appropriate, the
taxpayer bears the burden of establishing the absence of
negligence). The physician-owners caused their
corporations to overpay considerably for term life insurance
knowing that the money could be rerouted circuitously to
their personal coffers with a net tax savings. Yet,
notwithstanding the extraordinary financial implications of
the SC VEBA arrangement, the individual taxpayers did not

                                20
make a proper investigation or exercise due diligence to
verify the program’s tax legitimacy. See David v. Comm’r, 

, 789-90 (2d Cir. 1995); see also Pasternak v.
Comm’r, 

, 903 (6th Cir. 1993) (holding that a
reasonably prudent person should investigate claims when
they are likely "too good to be true") (quoting McCrary v.
Comm’r, 

, 850 (1989)).

Taxpayers argue that their negligence should have been
excused because they relied on the advice of professionals.
While it is true that actual reliance on the tax advice of an
independent, competent professional may negate a finding
of negligence, see, e.g., United States v. Boyle, 

, 250, 

, 692 (1985), the reliance itself
must be objectively reasonable in the sense that the
taxpayer supplied the professional with all the necessary
information to assess the tax matter and that the
professional himself does not suffer from a conflict of
interest or lack of expertise that the taxpayer knew of or
should have known about. See Treas. Reg.S 1.6664-4(c);
Ellwest Stereo Theatres, Inc. v. Comm’r, T.C. Memo. 1995-
610, 70 T.C.M. (C.C.H.) 1655; see also Zfass v. Comm’r,

, 189 (4th Cir. 1997).

The Tax Court concluded that taxpayers could not prevail
on a reliance-on-professional defense because they received
advice only from Cohen, an insurance agent who stood to
profit considerably from the participation of Neonatology
and Lakewood in the VEBA program, rather than from a
competent, independent tax professional with sufficient
expertise to warrant reliance. The circumstances here,
including the facts that certified public accountants
prepared taxpayers’ returns, the New Jersey Medical
Society -- a group with dubious tax code proficiency which
in fact received royalties to endorse the SC VEBA 20 --
purportedly endorsed the program, and the engagement
agreement between PES and the employers stated that PES
would submit the trust to the IRS for qualification, 21 do not
_________________________________________________________________

20. See App. at 570-71.

21. Notably, the agreement does not say that the IRS did qualify the
plan. In fact, as the government points out, the IRS expressly disavowed
any opinion as to whether contributions to the plan were deductible. See
App. at 1410.

                                21


suffice for us to disturb the Tax Court’s negligence finding
on a clear error basis. See Merino v. Comm’r, 

,
154 (3d Cir. 1999).

In reaching our result, we acknowledge that Dr.
Hirshkowitz deviated from the thoroughly head-in-the-sand
posture of his fellow taxpayers by soliciting his
accountant’s opinion of the SC VEBA. See App. at 6666-67.
Nevertheless, the record supports the court’s finding with
respect to Dr. Hirshkowitz, considering that he did not
introduce into evidence precisely what information he
showed to his accountant, precisely what advice his
accountant gave him, and, more generally, the
qualifications of his accountant.

We also add the following. 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. In this case, PES devised
a program which it marketed as "creat[ing] a tax deduction
for the contributions to the employee welfare benefit plan
going in and a permanent tax deferral coming out." As
highly educated professionals, the individual taxpayers
should have recognized that it was not likely that by
complex manipulation they could obtain large deductions
for their corporations and tax free income for themselves.22

In a final attempt to skirt the additional penalties,
taxpayers argue that a finding of negligence could not in
fairness arise out of a case resolving tax issues of first
impression. In this regard, we point out that the parties
have indicated that this case is indeed without direct
precedent and that other cases are awaiting our disposition.23
_________________________________________________________________

22. It well may be that reliance on the advice of a professional should
only be a defense when the professional’s fees are not dependent on his
opinion. For example, it is not immediately evident why a taxpayer
should be able to take comfort in the advice of a professional promoting
a tax shelter for a fee. After all, that professional would have an interest
in his opinion. Consideration of this point, however, will have to wait for
another day.

23. The Tax Court observed that this case is a test case with the result
resolving other cases involving SC VEBA and NJ VEBA plans and that
the parties in 19 other cases pending before the Tax Court have agreed
to be bound by the decision here. See Neonatology, 

.

                                22


This argument, however, does not sway us for this case
does not involve novel questions of law but rather is
concerned with the application of well-settled principles of
taxation to determine whether certain expenditures made
by close corporations are deductible as ordinary and
necessary business expenses or taxable as constructive
dividends. While the setting in which these principles have
come to bear is no doubt unusual with its VEBAs, C-group
policies, and conversion credits, the law was nevertheless
pellucid that taxpayers should have endeavored to verify
the validity of their deductions before claiming them.24
Moreover, they should have been apprehensive when they
examined the scheme, for experience shows that when
something seems too good to be true that probably is the
case. Overall, we are satisfied that taxpayers now must
abide the consequences of the Commissioner’s audit as
sustained by the Tax Court, including the finding of liability
for accuracy-related penalties under section 6662.

IV. CONCLUSION

For the foregoing reasons, we will affirm the decisions of
the Tax Court.

A True Copy:
Teste:

       Clerk of the United States Court of Appeals
       for the Third Circuit
_________________________________________________________________

24. We recognize that courts have overlooked negligence penalties in
cases of first impression that involve unclear statutory language. See,
e.g., Mitchell v. Comm’r, T.C. Memo. 2000-145, 79 T.C.M. (C.C.H.) 1954
(recognizing exception in a case of first impression involving the unclear
application of an amendment to the Internal Revenue Code); Hitchins v.
Comm’r, 

, 720 (1994) (first impression exception applies to
issue not previously considered by the court where the statutory
language is not entirely clear). But nothing in this case hinges on the
interpretation of vague statutory text.

                                23