108 T.C. 524">*525 LARO, Judge: The docketed cases, consolidated for purposes of trial, briefing, and opinion, consist of four groups of test cases selected by the parties to resolve their disputes concerning the "Prime Financial Benefits Trust Multiple Employer Welfare Benefit Plan and Trust". ² (We hereinafter refer to this "plan" as the Prime Plan and the trust as the Trust. ³) Each of these four groups consists of a closely held corporation and one or more of its owner/employees. In regard to each group, the Commissioner of Internal Revenue (the Commissioner or respondent) determined that the corporation could not deduct the amounts that it reported as contributions to the Trust and that the individual(s) had income to the extent that the contributions benefited him or her (or them). Each petitioner petitioned the Court to redetermine the Commissioner's determination of the resulting deficiencies in Federal income tax, penalties, and, in one case, an addition to tax. Respondent's notices of deficiency listed the following deficiencies, 1997 U.S. Tax Ct. LEXIS 32">*39 addition to tax, and penalties: ⁴

1997 U.S. Tax Ct. LEXIS 32">*41 108 T.C. 524">*527 We decide the following issues:

1. Whether the Prime Plan is a welfare benefit plan or a plan deferring the receipt of compensation. We hold it is a welfare benefit plan. ⁵

2. Whether the Prime Plan is a 10 or more employer plan described in section 419A(f)1997 U.S. Tax Ct. LEXIS 32">*42 (6). We hold it is not. ⁶

3. Whether the corporate petitioners are liable for the penalties determined by respondent. ⁷ We hold they are not.

Unless otherwise indicated, section references are to the Internal Revenue Code applicable to the relevant years, Rule references are to the Tax Court Rules of Practice and Procedure, and1997 U.S. Tax Ct. LEXIS 32">*43 dollar amounts are rounded to the nearest dollar.

FINDINGS OF FACT

I. Background

A. Prime Financial Partners, L.P. (Prime)

Prime is a master limited partnership that was traded on the American Stock Exchange during most of the relevant years. Prime was formed on April 16, 1987, under the laws of the State of Delaware, to acquire the financial services and real estate activities of a group of Prime's affiliated entities. Prime's general partner is Prime Partners Limited Partnership (Limited), an Arizona limited partnership, whose general 108 T.C. 524">*528 partner is Prime Financial Partners, Inc. (Financial), an Arizona corporation. On December 31, 1988, the outstanding stock of Financial and the limited partnership units of Limited were held by Thomas G. Cummings, Jerry P. Franks, Anthony L. Tominac, Marvin D. Brody, and Donald A. Waldman. Joel Boyarsky and a corporation joined this list of owners on December 31, 1989, as did William G. Stalnaker on December 31, 1990. Mr. Tominac and the corporation terminated their ownership interests in both entities during 1990, and Messrs. Franks and Stalnaker terminated their ownership interests in the entities during 1991. On December 31, 1991, 1997 U.S. Tax Ct. LEXIS 32">*44 the outstanding stock of Financial and the limited partnership units of Limited were held by Messrs. Cummings, Brody, Waldman, and Boyarsky.

During the relevant years, Prime was an investment banking and financial services firm that earned revenues mostly by investing and placing money. Prime also earned revenues from commissions and administrative services generated by the Prime Plan. Prime researched, developed, and began marketing the Prime Plan in 1988. The Prime Plan provided death benefits and dismissal wage benefits (DWB's) to qualifying employees of participating employers.

On November 29, 1991, Prime filed for protection under Chapter 11 of the U.S. Bankruptcy Code.

B. Development of the Prime Plan

Mr. Brody developed the concept of the Prime Plan in 1988 in response to 1984, 1986, and 1987 tax legislation that limited the tax benefits a small business owner derived from a pension plan. Mr. Brody expected that the Prime Plan would provide meaningful tax deferral to small businesses with few employees. The Prime Plan purported to enable business owners to make tax deductible contributions for employee benefits, while allowing them to accumulate wealth through the1997 U.S. Tax Ct. LEXIS 32">*45 appreciation of assets purchased by the plan with their contributions. The Prime Plan had some similarities to a defined benefit pension plan, but the Prime Plan had fewer limitations on funding, benefits, and accessibility to funds.

Prime marketed the Prime Plan primarily to highly compensated small business owners with five to six employees. These business owners could expect to receive the following 108 T.C. 524">*529 benefits from the Prime Plan, as the plan was advertised to them:

1. The employer would currently deduct a one-time contribution that it made to the Prime Plan to fund DWB's and death benefits, and the contribution would not be taxable to the employer's employees until received as benefits;

2. The employer could contribute to pension plans, as well as to the Prime Plan, but, in the case of the Prime Plan, the employer would not be subject to the rules limiting contributions to pension plans;

3. Contributions to the Prime Plan would earn income tax-free because the Trust, although not a tax-exempt entity, would invest each employer's contributions in life insurance and municipal bonds;

4. The employee/owners could reap personally most of the benefits offered by the Prime Plan by1997 U.S. Tax Ct. LEXIS 32">*46 basing an employee's receipt of benefits on compensation and by using vesting schedules to limit the benefits payable to employees other than the owners themselves;

5. Trust assets would be insulated from creditors;

6. Death benefits would not be subject to income tax or, with minimal planning, estate tax.

As of December 31, 1994, approximately 800 employers had participated in the Prime Plan. On that date, approximately 625 of these employers continued to participate in the Prime Plan.

C. David Weiss

Mr. Weiss is an attorney who was employed during the relevant years by the law firms of Streich Lang and Snell & Wilmer. In early 1988, Prime contacted Mr. Weiss to help create a welfare benefit plan subject to section 419A(f) (6) and to draft a tax opinion that would be used to market the plan nationwide. Mr. Weiss initially refused, believing there was insufficient guidance on section 419A(f) (6) to allow him to create such a plan. Mr. Weiss later agreed to do so. Mr. Weiss was a principal architect of the Prime Plan and the Trust, and he wrote a series of tax opinion letters related thereto. These letters included opinions dated June 2, 1988, July 25, 1988, April 12, 1989, 1997 U.S. Tax Ct. LEXIS 32">*47 June 30, 1990, October 1, 1991, and April 1, 1993.

108 T.C. 524">*530 D. Dr. William L. Raby

Dr. Raby is an accountant with a national reputation in areas related to the Prime Plan and the Trust. At the behest of Mr. Weiss, Streich Lang engaged Dr. Raby from February 1988 to the beginning of 1990, to assist Mr. Weiss in forming the desired plan and to express a concurring opinion on Mr. Weiss' tax opinions related thereto. Prime informed Dr. Raby that it wanted to develop a plan that offered a front-end reduction of taxes for small employers and a deferral of income for their employees. Dr. Raby and Mr. Weiss advised Prime that the plan needed an element of risk-shifting to qualify for the desired benefits, and that a "suspense account" could be used to accomplish the required shifting of risk. Dr. Raby and Mr. Weiss later presented Prime with different provisions for the Prime Plan, some of which Prime found unacceptable for marketability purposes. Dr. Raby and Mr. Weiss redrafted the unacceptable provisions, and Prime found the redrafted provisions more to their liking.

Dr. Raby wrote an opinion concurring with Mr. Weiss' tax opinion dated June 2, 1988, and Dr. Raby concurred with Mr. Weiss' 1997 U.S. Tax Ct. LEXIS 32">*48 opinion dated April 12, 1989. Dr. Raby's concurrences were based on his understanding of the tax law including the "possible purposes" of section 419A(f) (6). Dr. Raby's concurrences, as well as Mr. Weiss' opinions that related thereto, did not address any version of the Prime Plan that is at issue herein; they discussed a hypothetical plan that evolved into the instant versions. Dr. Raby's name was used to promote versions of the Prime Plan that were marketed to the public.

At Mr. Weiss' request, Dr. Raby performed services in May and June 1993, in connection with respondent's consideration of issues flowing from the Prime Plan. Dr. Raby's fees were paid from the suspense account (the Suspense Account) that was part of the Trust. The Suspense Account served primarily as the depository for amounts forfeited by the employers and employee groups connected to the Prime Plan.

E. The Trust

The Trust was a separate, taxable entity apart from Prime and its affiliates. The Trust owned all of its assets, and it was supervised by an independent trustee. The Trust's assets consisted of the money and other property contributed by the 108 T.C. 524">*531 participating employers, and any earnings (or less any1997 U.S. Tax Ct. LEXIS 32">*49 losses) thereon, less payments made by the trustee.

The Trust's first trustee was Northern Trust Bank of Arizona, N.A. (Northern). Northern was succeeded by Security Pacific BankArizona (Security Pacific) on or about June 30, 1990. Firstar Metropolitan Bank & Trust (Firstar) succeeded Security Pacific effective January 2, 1992. Firstar's trustee fees included an asset management fee of 1 percent of the market value up to $ 2 million per account, with 0.8 percent of the market value on the balance, plus a $ 15 per item transaction charge.

F. The Administrator of the Prime Plan

The Prime Plan was overseen by an administrator. Improved Funding Techniques, Inc. (IFTI), was the Prime Plan's first administrator. On October 24, 1990, Financial's board of directors approved a letter of intent with IFTI under which IFTI would assume all plan administration together with related overhead and expenses in return for existing and projected administration fees. Prime entered into an administrative services agreement with IFTI in July 1991. In consideration for providing administrative services to the Prime Plan, IFTI billed participating employers directly in accordance with the following1997 U.S. Tax Ct. LEXIS 32">*50 fee schedule:

Under the Agreement with IFTI, Prime received a percentage of profits equal to 10 percent of IFTI's fees for administration of each plan where the annual fees (net of actuarial costs) exceeded $ 1,000 per plan and 20 percent of the fees for 108 T.C. 524">*532 administration of each plan where the fees (net of actuarial costs) exceeded $ 1,500.

In 1992, Prime moved the bankruptcy court to terminate its agreement with IFTI and to subcontract the administration services to William M. Mercer, Inc.

II. The Trust Agreements

A. Overview

The Prime Plan and the Trust were established and operated pursuant to the Prime Plan and Trust Agreement, effective August 31, 1988, as subsequently amended and restated by 1997 U.S. Tax Ct. LEXIS 32">*51 various versions of the agreement dated December 31, 1988, December 21, 1989, June 30, 1990, January 2, 1992, and November 1, 1993. (The Prime Plan and Trust Agreement and each of these amended versions are collectively referred to as the Trust Agreement and separately referred to by the corresponding date.) Most of the amendments were made to the language originally used in the August 31, 1988, Trust Agreement in order to enhance the marketability of the Prime Plan by increasing an employer's control over its contributions (and income or loss thereon). Other amendments were made to comply with changes in the law.

Employers became participants in the Prime Plan by completing an agreement (Adoption Agreement) that enumerated the key specifications of the plan and allowed each employer to tailor the plan to its employees by selecting various options that would apply to its employees. An employer could change the options that applied to its employees, and modify the Adoption Agreement in any other regard (e.g., to increase DWB's, death benefits, or both), with the permission of Prime and the trustee.

An employer's plan year was the 12-month period that was set forth in the Adoption 1997 U.S. Tax Ct. LEXIS 32">*52 Agreement, and the employer listed in its agreement the date that the Prime Plan became effective with respect to its employees. Once an employer executed an Adoption Agreement, the employer was bound to make a one-time contribution to the Trust, equal to the amount determined by the Prime Plan's actuaries to be sufficient to fund the employer's employees' vested DWB's and level of death benefits selected by the employer in the Adoption Agreement, as well as to pay miscellaneous charges on 108 T.C. 524">*533 the transaction. ⁸ The employer's initial contribution for DWB's was ascertained through actuarial assumptions developed by the Prime Plan's actuaries. The actuaries generally employed the following assumptions prior to 1991:

1997 U.S. Tax Ct. LEXIS 32">*53 The Trust used each employer's contributions to purchase insurance products to fund the DWB's and death benefits promised under the Prime Plan. The employer designated in its Adoption Agreement the insurance company from which the insurance products for its employees were to be purchased, as well as the type and amount of these products. The employer could designate in its Adoption Agreement vesting periods and percentages, which determined the amount of DWB's that would be paid to its employees. The employer could designate in its Adoption Agreement its employees' "Year of Participation" and "Year of Service", as those terms were defined in the Trust Agreement.

B. The August 31, 1988, Trust Agreement

1. Overview

Prime and Northern Trust entered into the August 31, 1988, Trust Agreement, "establishing a Multiple Employer Welfare Benefit Fund and Trust for the exclusive benefit of the participating Employers, their Employees, and in the case of life benefits, their Beneficiaries". Under this agreement, each participating employer had its own "Employee Group" that consisted of its employees (the Covered Employees) who met the minimum age and service requirements set forth1997 U.S. Tax Ct. LEXIS 32">*54 by the employer in the Adoption Agreement.

The Trust Agreement designated each participating employer as a "Plan Administrator". Generally, each Plan Administrator exercised all discretionary and other authority 108 T.C. 524">*534 to control and manage the operation and administration of the Prime Plan. Under the Trust Agreement, each Plan Administrator delegated to Prime most of its duties and responsibilities with respect to the Prime Plan, including: (1) Applying rules determining eligibility, (2) calculating service and compensation credits, (3) preparing employee communication material, benefit reports, and reports required by governmental agencies, (4) calculating benefits, (5) advising employees on their rights and options, (6) applying contributions, (7) processing claims, (8) recommending decisions on the Trust's administration and the maintenance of accounts, and (9) maintaining an account for each Covered Employee. ⁹Prime received a fee for performing these services.

1997 U.S. Tax Ct. LEXIS 32">*55 2. DWB's

A Covered Employee generally received a DWB upon termination of his or her employment for a reason other than "cause". The amount of the DWB, which was set forth by the employer in the Adoption Agreement, was based on a percentage of the Covered Employee's compensation in the calendar year immediately preceding termination as well as his or her years of service at the time of termination. In no case could a DWB exceed two times compensation during the immediately preceding calendar year, and a DWB could not be greater than the amount shown in the vesting schedule set forth by the employer in the Adoption Agreement. If an employee had severed his or her employment when the employer made the initial contribution, the employee's DWB generally equaled the amount shown as his or her "Vested Severance Benefit" in that year's annual report.

Prime had the sole discretion to pay the DWB in a lump sum or to pay the DWB in monthly installments not to exceed 24 months after the Covered Employee's termination date. The payment of DWB's was secured by the insurance company that issued insurance policies on the life of each Covered Employee.

A Covered Employee's DWB generally was1997 U.S. Tax Ct. LEXIS 32">*56 forfeited to the Suspense Account if he or she: (1) Was discharged for "cause", (2) terminated employment after attaining a stated age, or 108 T.C. 524">*535 (3) died while employed. Under the August 31, 1988, Agreement, employment meant "working as an employee, partner or proprietor in the same occupation or profession", and a discharge for "cause" occurred when the discharge resulted from "a proven dishonest or criminal act committed in the course of the Employee's employment with the Employer". The same agreement defined: (1) The stated age as the "Forfeiture Age", which was defined as "an age which is three years prior to a Covered Employee's Normal Retirement Date", (2) the "Normal Retirement Date" as a date set forth by the employer in the Adoption Agreement, and (3) a "Termination of Employment" as "the earliest of the date on which an Employee become [sic] Totally Disabled, resigns or is discharged without Cause." The Normal Retirement Age generally was set forth by the employers as (1) the later of age 65 or completion of 10 years of participation in the Prime Plan, or (2) if the participating employer had a qualified plan, the definition given that term under the qualified plan. DWB's that1997 U.S. Tax Ct. LEXIS 32">*57 were forfeited due to death or the attainment of the Forfeiture Age were segregated into the Suspense Account to be used to increase that employer's Covered Employees' DWB's or death benefits, to provide new welfare benefits, to provide benefits for replacement employees, or to distribute to the Covered Employees if and when the employer withdrew from the Prime Plan.

Contributions made to fund DWB's were invested in flexible premium adjustable life policies (universal life policies) or, in the case of a Covered Employee who was determined to be uninsurable, in a tax-exempt money market fund. Prime maintained commission-sharing arrangements with the insurance companies that wrote these insurance policies. Prime usually earned a commission equal to 22 percent of the amount paid for life insurance and 1.2 percent of the amount paid to fund DWB's. Employers typically contributed $ 50,000 to the Trust. Generally, $ 6,000 of this amount was used to purchase life insurance and the balance ($ 44,000) to fund DWB's.

3. Death Benefits

If a Covered Employee died while employed, a death benefit became payable to his or her beneficiary in the amount set 108 T.C. 524">*536 forth by the employer in the Adoption1997 U.S. Tax Ct. LEXIS 32">*58 Agreement. This amount was generally stated as a percentage of the Covered Employee's compensation or, if higher, a set minimum amount. For a Covered Employee who was other than a standard underwriting risk, the death benefit could be reduced or eliminated, depending on the provisions of the employer's Adoption Agreement.

Death benefits were typically funded through universal life policies. Under such a policy, the premiums in excess of the amount necessary to fund current mortality and administrative expenses are typically invested by the carrier at a fixed rate of return. This rate of return may vary over time, although carriers generally guarantee a specified minimum return.

The amounts paid by the Trust for the universal life policies were generally separated into two amounts: (1) The target premium, which was the cost of the life insurance, and (2) the excess premium, which was an amount placed into a side fund for payment of DWB's. In the cases where second and subsequent year contributions were made by an employer, the contributions were usually made to pay a renewal premium on the life insurance or to increase the side fund. Contributions were also sometimes made in years1997 U.S. Tax Ct. LEXIS 32">*59 subsequent to the first year to purchase additional insurance for newly eligible employees or to increase the amount of insurance for employees with salary changes so that the plan remained within the terms of the Adoption Agreement and the provisions of the Code that were believed related thereto. If the employer failed to make the required contributions to keep the policy in force, Prime was required to make these contributions from assets allocable to the employer's Employee Group.

Universal life policies offer a policy owner certain options regarding the cash surrender value of the policy. Under one option, the policy's cash surrender value is included in the face amount paid to the beneficiary upon the insured's death. Under a second option, the carrier pays both the face amount and cash surrender value to the beneficiary upon the insured's death. Under the Trust Agreement, the Trust had to elect the second option for each universal life policy that it acquired. When the insured died, the carrier paid the beneficiary the policy's face amount, thus discharging the Prime 108 T.C. 524">*537 Plan's obligation to pay the deceased employee's vested death benefit, and the carrier paid the Trust the cash1997 U.S. Tax Ct. LEXIS 32">*60 surrender value associated with the policy. Under the universal life policies acquired by the Trust, the Trust could obtain a policy's cash surrender value before the insured died by surrendering the policy. The amount received was usually reduced by a surrender charge during the first several years of the policy.

A death benefit was not payable if a Covered Employee died on or after the date he or she terminated employment or was discharged for cause. In the case of an owner/employee, a death benefit was not payable when he or she terminated his or her employment. A death benefit also was not payable when the owner/employee continued to work but reached the date that was the later of age 70-1/2 or the 10th anniversary of his or her participation in the plan.

Upon termination of employment, a Covered Employee could, with Prime's approval, elect to convert to individual coverage or purchase his or her life insurance policy for its cash surrender value. Absent such an election, the policy was surrendered or transferred to the life of another Covered Employee. The forfeited proceeds from the sale or surrender of life insurance were segregated into the Suspense Account and used to increase1997 U.S. Tax Ct. LEXIS 32">*61 the employer's Covered Employee's DWB's or death benefits, to provide new welfare benefits, to provide benefits for replacement employees, or to distribute to the Covered Employees if and when the employer withdrew from the Prime Plan. If an employee severed employment without a vested DWB, the cash surrender value of his or her life insurance policy, if surrendered, was added to another policy in the Employee Group.

4. Obligations and Liabilities

An employer that participated in the Prime Plan was required to make an actuarially determined contribution in any year in which one of its employees became eligible for a DWB or the employer elected to increase the amount payable to its Covered Employees under the Adoption Agreement. An employer had no obligation to make additional contributions to provide for the payment of DWB's if there were insufficient assets in the Trust allocable to its Employee Group. An 108 T.C. 524">*538 employee's right to a DWB extended only to his or her allocable share of Employee Group assets. If there were insufficient assets allocable to an Employee Group to pay a Covered Employee's DWB, procedures were set forth to pay a smaller benefit commensurate with the available1997 U.S. Tax Ct. LEXIS 32">*62 assets.

The employer relinquished all rights to the contributions made to the Trust, and no amounts could revert to the employer or be used for purposes other than the benefit of the Covered Employees or for the payment of taxes and expenses of the Trust's administration. Neither the employer, Plan Administrator, Prime, or the trustee had any liability to pay any benefits provided under the Plan beyond the assets in the Trust allocable to the applicable Employee Group. Neither the employer, Plan Administrator, Prime, or the trustee was responsible for contributions that were required for any other participating employer.

5. Separate Accounting

Prime was required to maintain separate accounts reflecting the share of each Employee Group and to determine the December 31 value of the insurance contracts and tax-exempt money market bond fund allocable to each Employee Group. Prime was required to keep accurate and detailed accounts of all transactions, investments, receipts, and disbursements. Prime was required to file a written report of this information with each employer within 60 days after each December 31st.

At the end of each plan year, the Prime Plan's actuaries were required1997 U.S. Tax Ct. LEXIS 32">*63 to calculate experience gains and losses with respect to each Employee Group, whether or not any gains or losses had actually occurred. Experience gains and losses were measured by comparing each employee's theoretical compensation to actual compensation and by comparing the expected rate of return on the assets held in the Employee Group account with the actual rate of return on these assets. To the extent that the theoretical compensation exceeded actual compensation, or the expected rate of return exceeded the actual rate of return, an experience gain resulted and the amount of the experience gain had to be forfeited to the Suspense Account.

108 T.C. 524">*539 Neither Prime nor its actuaries ever implemented the Trust provisions requiring an annual calculation of experience gains and losses. Prime changed its method of calculating experience gains and losses effective June 30, 1990, because the unexpected number of accounts which incurred experience gains created a significant concern among the plan participants and their advisers. Prime believed that this could potentially create non-recoverable Suspense Account assets and alarm plan participants. Prime wanted to reduce the amount of experience1997 U.S. Tax Ct. LEXIS 32">*64 gain subject to forfeiture and find a way to allow Suspense Account distribution on withdrawal.

6. Employer Withdrawal From the Prime Plan

Employers could withdraw from the Prime Plan at any time by submitting written notification to Prime, accompanied by documentation showing that the necessary ownership interest of the employer had approved the withdrawal. The necessary ownership interest was the percentage listed by that employer in its Adoption Agreement. If an employer failed to pay Prime's annual administrative fee, Prime had the sole discretion to force that employer to withdraw from the Prime Plan.

Upon an employer's withdrawal, assets were distributed to all living Covered Employees who were employed during the period that began 18 months before Prime's receipt of the notice. Excess assets remaining in the Trust allocable to the Employee Group after payment of all benefits and the employer's share of the Trust's tax liability were distributed pro rata using the aggregate compensation received by each Covered Employee over the period not to exceed 5 years that was listed by the employer in the Adoption Agreement.

For an owner/employee who anticipated employment beyond1997 U.S. Tax Ct. LEXIS 32">*65 the Forfeiture Age, the Trust Agreement did not prohibit that owner from withdrawing his or her company from the Prime Plan and receiving a withdrawal distribution. For an owner-employee who anticipated retiring, the Trust Agreement did not prohibit that owner from withdrawing his or her company from the Prime Plan and receiving a withdrawal distribution. Prime's actuaries assumed that no employee would forfeit benefits upon retirement, and no employee ever forfeited a DWB because he or she retired or 108 T.C. 524">*540 stayed employed beyond the Forfeiture Age. Prime's actuaries assumed that no payments would come from the Suspense Account to supplement the payment of benefits from the Trust.

7. Amendment and Termination of the Prime Plan

Prime retained the right to amend, modify, or delete any provision of the Trust Agreement. Prime retained the right to terminate the Prime Plan in certain circumstances, one of which was if the plan failed to satisfy section 419A(f)(6).

8. The Trustee

The trustee was compensated under the terms of a written agreement that it entered into with Prime. All reasonable costs incurred by the trustee in performance of its duties were paid from the Trust, as was1997 U.S. Tax Ct. LEXIS 32">*66 the case with all taxes levied or assessed against the Trust. The trustee and insurer withheld any taxes that were required to be withheld from any payment to a Covered Employee and/or beneficiary.

C. The December 31, 1988, Trust Agreement

Prime amended the Trust Agreement on or about December 31, 1988. In relevant part, the following amendments were made.

First, Prime deleted the requirement that forfeited DWB's and forfeited proceeds from the sale or surrender of life insurance policies be segregated into the Suspense Account to be used to provide benefits to the corresponding employer's Covered Employees. Prime replaced this requirement with a provision stating that these forfeitures would be experience gains subject to the existing provisions, except as otherwise modified by the amendments. One of these amendments required experience gains to be allocated annually to the Suspense Account and allowed Prime to direct the trustee to invest these amounts in tax exempt securities or leave the amounts in each applicable Employee Group subject to a lien.

Second, Prime was given the power to use the Suspense Account assets in any manner consistent with a purpose or objective of1997 U.S. Tax Ct. LEXIS 32">*67 the Prime Plan, including supplementing the payment of DWB's to an Employee Group with insufficient assets to pay projected benefits due to experience losses suffered by 108 T.C. 524">*541 that Employee Group. Another new provision provided that neither Prime nor the Trustee had any liability to a Covered Employee for the manner in which Suspense Account assets were used or allocated among the Employee Groups.

Third, Prime removed the obligation of an employer to make an actuarially determined contribution in any subsequent year in which an employee became eligible for a DWB. Prime replaced this obligation with an obligation to do so only if the employer notified Prime that the employer intended to make such a contribution.

D. The December 21, 1989, Trust Agreement

Prime amended the Trust Agreement a second time on or about December 21, 1989. Prime made these amendments primarily to reflect matters affecting the trustee. None of these amendments are relevant to our discussion herein.

E. The June 30, 1990, Trust Agreement

Prime amended the Trust Agreement a third time on or about June 30, 1990. In relevant part, Prime made the following amendments.

First, Prime inserted Security Pacific1997 U.S. Tax Ct. LEXIS 32">*68 as the successor trustee.

Second, Prime added a provision allowing DWB's to be funded through the purchase of a second to die life insurance policy. Another new provision allowed the funding of death benefits through the purchase of term insurance and second to die life insurance policies.

Third, Prime added a requirement that an employer had to make actuarially determined contributions in any subsequent year in which the employer notified Prime that the employer intended to make a contribution for an employee who was entitled to a greater vested percentage of his or her DWB than in the year the Adoption Agreement was executed.

Fourth, Prime expanded the Trust's existing provisions to state that the trustee would not be liable to a Covered Employee or beneficiary with respect to shortfalls in any of the benefits. The existing provisions were further expanded to provide that neither Prime nor the trustee would be liable to a Covered Employee or beneficiary as to decisions on the use of Suspense Account assets to supplement or not to 108 T.C. 524">*542 supplement a DWB. Other new provisions reflected limits on the Trust's liability and stated that Prime's maintenance of separate accounts was not a 1997 U.S. Tax Ct. LEXIS 32">*69 separate trust fund.

Fifth, Prime replaced the term "experience gain" with the term "Asset Gains, Liability Gains and Overfunded Gains", and set forth a "measurable event" method of allocating gains to the Suspense Account. Prime defined a measurable event as: a severance, death, or attainment of Forfeiture Age of one or more Covered Employees, or the withdrawal of the Employee Group. Prime set forth another new provision that provided an objective formula under which Prime was allowed to release a portion of the Suspense Account when a measurable event occurred and an Employee Group had insufficient assets to pay DWB's, or an Employee Group withdrew from the Trust. This formula was stated as follows:

fair market value of suspense account on valuation Date x theoretical actuarial liability for employee group/theoretical actuarial liability for Trust x actual employer contributions/theoretical employer contributions

Prime added other provisions that defined the relevant terms in the formula and gave Prime the absolute discretion not to use the formula if using it would be inconsistent with a purpose of the Prime Plan.

Sixth, Prime added a provision that specified that a withdrawing1997 U.S. Tax Ct. LEXIS 32">*70 employer's written notice must list a withdrawal date no later than 90 days after Prime received the notice. Prime added another new provision specifying that it would deliver to the employer within 60 days of Prime's receipt of the notice an accounting of the employer's account in the Prime Plan.

Seventh, Prime listed the asset allocation procedures that it would use to distribute assets to employees of a withdrawing employer.

Eighth, Prime listed the trustee's rights and duties to include: (1) The right to be reimbursed for the employment of experts that it considered necessary to carry out its obligations, (2) the right to be held harmless from and against any loss, liability, or expense incurred without gross negligence, breach of trust, or violation of the Employee Retirement Income Security Act of 1974 (ERISA), Pub. L. 93-406, 88 Stat. 829, 108 T.C. 524">*543 arising out of its administration of the Trust, and (3) the ability to reimburse itself, in certain circumstances, from amounts held in the Trust, starting with the Suspense Account.

F. The January 2, 1992, Trust Agreement

Prime amended the Trust Agreement a fourth time on or about January 2, 1992. In relevant part, the following 1997 U.S. Tax Ct. LEXIS 32">*71 amendments were made.

First, Prime inserted Firstar as the successor trustee.

Second, Prime added a provision requiring forfeiture of a DWB upon actual retirement rather than upon reaching the Forfeiture Age. Another new provision defined the term "retirement" to mean "a Covered Employee's severance from service with an Employer other than for Cause, Death or Total Disability, where such Covered Employee cannot show proof of subsequent employment or an attempt to obtain subsequent gainful employment to Prime". Another new provision set forth the allocation of "Employer Withdrawal Gains" to the Suspense Account.

G. The November 1, 1993, Trust Agreement

Prime amended the Trust Agreement a fifth time on or about November 1, 1993. In relevant part, the following amendments were made.

First, Prime added a provision stating that the amount of gains allocated to the Suspense Account at the time of a measurable event would equal the total gains multiplied by the ratio of an employer's total contributions made to the Prime Plan as of December 31 over the total of all contributions which the employer should have made to fully fund its Employee Group's benefits. Prime also amended the1997 U.S. Tax Ct. LEXIS 32">*72 measurable event formula to read as follows:

fair market value of suspense account valuation date x actual employer contributions/total employer contributions to the Trust x actual employer contributions/theoretical employer contributions

Another new provision gave Prime the sole discretion not to use the measurable event formula wherever Prime concluded that the formula would give a Covered Employee a larger 108 T.C. 524">*544 benefit upon an employer's withdrawal than he or she would have received as a DWB.

Second, Prime replaced the phrase "terminated his employment with the Employer on account of Retirement" with the phrase "remained in the employ of the Employee Group beyond his Forfeiture Age".

Third, Prime added a provision allowing the use of Suspense Account assets to pay all fees and costs incurred in litigating with the Commissioner issues related to the Prime Plan. Permissible fees and costs included those of attorneys, accountants, actuaries, and expert witnesses. Before this amendment, Prime had spent $ 215,000 from the Suspense Account to pay for legal services rendered mainly by Mr. Weiss and Mr. Brody in defense of the Commissioner's challenge of the deductibility of employers' 1997 U.S. Tax Ct. LEXIS 32">*73 contributions to the Prime Plan. Mr. Weiss had authorized the payment of these amounts.

III. Prime's Duties in Operation of the Prime Plan

Prime implemented the provisions of each employer's account in the Prime Plan, issued annual reports and generated tax filings on each account, and dealt with insurance providers. Prime's responsibilities also included tracking money by Employee Group, reviewing advertisements and sales materials, assisting with tax audits, responding to legal issues, and assisting in interpreting the Trust's provisions.

Prime computed each Covered Employee's vested DWB by multiplying: (1) That employee's compensation listed on his or her Form W-2 (Wage and Tax Statement) for the year before the year the employer made the contribution, by (2) the accrual percentage, by (3) the years of service (or the maximum accrual years, if applicable), by (4) the employee's vesting percentage as determined in accordance with the vesting schedule selected by the employer in the Adoption Agreement. The accrual percentage was a "plug" in that the percentage was based on how much money the employer believed it could afford to spend for a certain benefit.

108 T.C. 524">*545 IV. The Trust's1997 U.S. Tax Ct. LEXIS 32">*74 Financial Information

A. Overview

The Trust began accepting contributions from employers in November 1988. As of June 30, 1992, the Trust had received $ 92,273,952 in contributions, broken down as follows: $ 15,852,213 in 1988, $ 29,453,541 in 1989, $ 25,281,057 in 1990, $ 14,178,375 in 1991, and $ 7,508,766 in 1992.

Prime never valued the Trust as a whole, and Prime never filed a Form 5500 (Annual Return/Report of Employee Benefit Plan) for the Prime Plan as a whole. Neither the Prime Plan nor the Trust had a 1988 Form 1041 (U.S. Fiduciary Income Tax Return) filed on its behalf. Norstar Trust Co. of Rochester, New York, filed 1989 and 1990 Forms 1041 that reported the following items of income and expense for a complex trust named "Prime Financial Benefits Trust--New York" (E.I.N. 86-0633138) (the New York Trust):

Security Pacific filed 1990 through 1994 Forms 1041 that reported the following items of income and expense for the Trust, listed on the forms as a complex trust 1997 U.S. Tax Ct. LEXIS 32">*75 named "Prime Financial Benefits Trust" (E.I.N. 86-6184818): ¹⁰

1997 U.S. Tax Ct. LEXIS 32">*76 108 T.C. 524">*546 The Trust paid no benefits in 1988. From 1989 through 1994, the Trust paid $ 30,420,770 in employer withdrawal benefits and DWB's as shown below:

B. Suspense Account transactions

The first Suspense Account transaction was a deposit of a $ 37,841 death forfeiture on December 21, 1990. The following chart is a summary of all Suspense Account activity through October 31, 1994:

Mr. Weiss1997 U.S. Tax Ct. LEXIS 32">*77 approved of the use of Suspense Account assets to pay legal fees, administrative fees, and trustee fees. Approximately $ 280,000 of the legal fees were paid to Snell & Wilmer and Streich Lang.

108 T.C. 524">*547 V. Young & Young

A. Overview

The Youngs are husband and wife, and they resided in Sedona, Arizona, when they petitioned the Court. The Youngs owned 100 percent of the stock of Young & Young, a corporation providing medical care in and around Sedona, during the relevant years. Young & Young's principal place of business was in Arizona, when it petitioned the Court.

During the relevant years, Howard Young was a radiologist working out of a hospital through a partnership in which Young & Young was a 50-percent partner. Elaine Young was a dermatologist with her own practice. Carleen Garcia was the nurse and office manager of Elaine Young's practice.

Young & Young reported its operations for Federal income tax purposes on a calendar year, and it used the cash receipts and disbursements method on its relevant Federal income tax returns. These returns reported the following information:

1997 U.S. Tax Ct. LEXIS 32">*78 Of the reported compensation, Howard Young received $ 111,500, $ 163,500, $ 225,000, $ 167,500, and $ 166,000 during the respective years.

The Youngs filed timely a joint 1989 Federal income tax return. On January 7, 1994, the Commissioner mailed them a notice of deficiency reflecting a determination that the Youngs' 1989 taxable income was increased by $ 50,030 on account of a taxable transfer of property from Young & Young under section 83. The notice also stated that the Youngs were liable for a $ 2,802 accuracy-related penalty under section 6662(a) because the underpayment of tax was due to negligence.

On the same day, the Commissioner mailed Young & Young a notice of deficiency reflecting a determination that its 1989 taxable income was increased by $ 50,030 because its 108 T.C. 524">*548 contribution to the Trust was governed by subpart D. ¹¹Young & Young had filed its 1989 tax return on March 23, 1990, 8 days after the due date. The notice of deficiency also stated that Young & Young was liable for: (1) A $ 637 addition to tax for delinquency under section 6651(a)(1), and (2) a $ 2,549 accuracy-related penalty under section 6662(a) because its underpayment of income tax was due to a substantial1997 U.S. Tax Ct. LEXIS 32">*79 understatement.

B. Young & Young's Introduction to the Prime Plan

Donald A. Waldman was the Youngs' tax adviser. In December 1989, Mr. Waldman introduced the Youngs to the Prime Plan, advising Howard Young that the plan provided life insurance as well as tax deferral. Howard Young viewed the Prime Plan as a "wise business investment for the company" because it provided life insurance, which he needed at that time, and because of "the tax deferment." Howard Young relied on Mr. Waldman in choosing to participate in the Prime Plan and in reporting the tax ramifications that flowed therefrom. Mr. Waldman was competent to give an opinion on the Prime Plan.

C. Young & Young's Adoption of the Prime Plan

Young & Young joined the Prime Plan by executing an Adoption Agreement dated and effective as of December 1, 1989, and by making a $ 50,030 contribution to the Trust approximately 16 days later. Young & Young's $ 50,030 contribution1997 U.S. Tax Ct. LEXIS 32">*80 was applied to the full accrual of DWB's for its Covered Employees ($ 42,526) and the cost of their death benefits ($ 7,500). Young & Young deducted the full contribution on its 1989 tax return.

Young & Young's three employees (the Youngs and Carleen Garcia) became Covered Employees under the Prime Plan as of December 1, 1989. On January 14, 1992, Elaine Young executed an addendum to Young & Young's Adoption Agreement electing retroactively to waive her right to participate in the Prime Plan. In all, Young & Young executed the following Adoption Agreements during its participation in the Prime Plan:

D. Administration of Young & Young's Account in the Prime Plan

Improved Funding Techniques, Inc. (IFTI), prepared the 1989 annual report for Young & Young's account in the Prime1997 U.S. Tax Ct. LEXIS 32">*81 Plan, and IFTI delivered the report to Howard Young on December 27, 1991. The report included an actuarial valuation signed by Deloitte & Touche and provided the following calculation of vested DWB's for Young & Young's Covered Employees:

The 1989 report addressed only Young & Young's Employee Group, and it did not provide any information concerning the Trust as a whole. The report used a 3.814 accrual percentage for the DWB's which had been unstated in any of the Adoption Agreements executed by Young & Young before the report was prepared. On December 30, 1992, Young & Young executed an Adoption Agreement allowing for the 3.814 percent accrual percentage.

Other annual reports prepared for Young & Young's account reported the following relevant information:

1997 U.S. Tax Ct. LEXIS 32">*82 On March 16, 1990, Prime forwarded to Young & Young a copy of the 1989 summary plan description required by section 102 of ERISA. The description was later restated to reflect the amendments to the Trust Agreement through January 1992.

108 T.C. 524">*550 E. Forms 5500-C/R (Return/Report of Employee Benefit Plan)

Forms 5500-C/R filed with the Commissioner for Young & Young's account in the Prime Plan included the following information:

These forms also reported the payment of insurance commissions of zero, $ 7,793, zero, zero, and zero in the respective years from 1989 through 1993.

F. Young & Young's Withdrawal From the Prime Plan

On August 8, 1994, Howard Young requested that an estimate be calculated for Young & Young's withdrawal from the Prime Plan.

VI. N.L. Booth

A. Overview

Robert and Janice Booth (R&J Booth) are husband and wife, and they resided in Scottsdale, Arizona, when they petitioned the Court. John and Debra Booth (J&D1997 U.S. Tax Ct. LEXIS 32">*83 Booth) are husband and wife, and they resided in Scottsdale, Arizona, at the time of their petition. During the relevant years, Robert Booth was vice president and secretary of N.L. Booth, a corporation engaged in the construction business in Phoenix, Arizona, and he owned 11.1 percent of N.L. Booth's stock. John Booth was N.L. Booth's president and treasurer, and he owned 25 percent of N.L. Booth's stock. N.L. Booth's remaining stock was owned by Phyllis Booth, the mother of John and Robert Booth.

N.L. Booth's principal place of business was in Arizona when it petitioned the Court. N.L. Booth reported its operations for Federal income tax purposes on a fiscal year ending July 31, and it used an accrual method on its relevant tax returns. These returns reported the following information:

1997 U.S. Tax Ct. LEXIS 32">*84 Of the reported compensation, Robert Booth received $ 92,600, $ 139,600, $ 228,000, $ 119,746, and $ 122,000 during his 1989 through 1993 taxable years, respectively, and John Booth received $ 85,300, $ 134,800, $ 224,800, $ 314,946, and $ 117,200 during the same respective years.

R&J Booth filed timely joint 1990 and 1991 Federal income tax returns. On November 16, 1993, the Commissioner mailed them a notice of deficiency reflecting a determination that R&J Booth's taxable income for 1990 and 1991 was increased by $ 46,000 and $ 26,100, respectively, on account of taxable transfers of property from N.L. Booth under section 83. The notice also stated that R&J Booth were liable for $ 3,036 and $ 1,784 in accuracy-related penalties under section 6662(a) for the respective years.

On the same day, the Commissioner mailed to J&D Booth a notice of deficiency reflecting her determination that J&D Booth's 1990 and 1991 taxable income was increased by $ 54,000 and $ 30,639, respectively, on account of taxable transfers of property from N.L. Booth under section 83. J&D Booth had timely filed a joint Federal income tax return for each of these years. The notice also stated that J&D Booth 1997 U.S. Tax Ct. LEXIS 32">*85 were liable for $ 3,564 and $ 2,053 in accuracy-related penalties under section 6662(a) for the respective years.

The Commissioner also mailed a notice of deficiency to N.L. Booth on that date, reflecting a determination that its 1989 and 1990 taxable income was increased by $ 100,000 and $ 56,739, respectively. The notice stated that N.L. Booth's contribution to the Prime Plan was governed by subpart D. The notice also stated that N.L. Booth was liable for $ 6,800 and $ 4,377 in accuracy-related penalties under section 6662(a) for the respective years because its underpayments of income tax were due to substantial understatements. N.L. Booth filed timely 1989 and 1990 tax returns.

108 T.C. 524">*552 B. N.L. Booth's Introduction to the Prime Plan

Barclay D. Schultz was N.L. Booth's insurance agent for the Prime Plan. On July 17, 1990, Mr. Schultz contacted Prime about N.L. Booth's possible participation in the Prime Plan. Sixteen days later, Joseph P. Waters, N.L. Booth's certified public accountant, furnished N.L. Booth with computations of projected earnings from participating in the Prime Plan. Robert and John Booth (collectively, the Booths), individually and in their capacity as officers 1997 U.S. Tax Ct. LEXIS 32">*86 of N.L. Booth, relied upon competent and informed tax and investment advisers before joining the Prime Plan and in reporting the tax ramifications that flowed therefrom.

C. N.L. Booth's Adoption of the Prime Plan

N.L. Booth joined the Prime Plan by executing an Adoption Agreement dated and effective as of July 31, 1990, and by contributing $ 25,030 to the Trust 37 days later. N.L. Booth was required to make a remaining contribution of $ 75,000 to the Trust by October 15, 1990. N.L. Booth made this contribution, without interest, on January 30, 1991. N.L. Booth's 1989 tax return claimed a $ 100,000 deduction for accrued contributions owed the Trust.

N.L. Booth's 1990 tax return claimed a $ 56,739 deduction for accrued contributions owed the Trust. On February 14, 1992, N.L. Booth paid Firstar Metropolitan Bank & Trust (Firstar) $ 55,000 of this amount; N.L. Booth never paid the remaining $ 1,739. Generally, the $ 55,000 contribution was applied as follows: (1) An increase in DWB's resulting from the change in the accrual percentage, (2) an increase in vesting, and (3) the cost of a death benefit.

In all, N.L. Booth executed the following Adoption Agreements relating to its participation1997 U.S. Tax Ct. LEXIS 32">*87 in the Prime Plan:

108 T.C. 524">*553 D. Administration of N.L. Booth's Account in the Prime Plan

On August 12, 1991, IFTI forwarded the 1990 annual report for N.L. Booth's account in the Prime Plan to John Booth. The report pertained only to N.L. Booth's Employee Group. The report included an actuarial valuation signed by Deloitte & Touche and provided the following calculations of vested DWB's:

The report did not provide any information on the Trust as a whole.

On September 14, 1992, IFTI forwarded the 1991 annual1997 U.S. Tax Ct. LEXIS 32">*88 report for N.L. Booth's account to John Booth. This report included another actuarial valuation signed by Deloitte & Touche. In order to accommodate the 1991 contribution, the accrual percentage for DWB's was increased to 6.54 percent.

In all, the annual reports for N.L. Booth's account in the Prime Plan included the following information:

E. Forms 5500-C/R

Forms 5500-C/R for N.L. Booth's account in the Prime Plan included the following information:

These forms did not list any insurance commissions paid from 1990 through 1993.

108 T.C. 524">*554 VII. Systems

1997 U.S. Tax Ct. LEXIS 32">*89 A. Overview

The Johnsons are husband and wife, and they resided in Waco, Texas, when they petitioned the Court. Systems' principal place of business was in Waco, Texas, when it petitioned the Court. Since 1990, Systems' only employees have been the Johnsons and Robert J. Carr. Mr. Carr, a certified public accountant (C.P.A.), is Systems' controller.

Mr. Johnson initially owned 49 percent of Systems' common stock, and Mrs. Johnson owned the rest. On December 1, 1990, Systems canceled the shares of stock initially issued to the Johnsons and reissued 21 shares to Mr. Carr, 39 shares to Mr. Johnson, and 40 shares to Mrs. Johnson. On February 2, 1991, Mr. Johnson held 79 shares of Systems' stock through a partnership known as Chief Smokey, Ltd., and Mr. Carr owned the remaining shares.

Systems reported its operations for Federal income tax purposes on a fiscal year ending on September 30, and it used the cash method on its relevant tax returns. These returns included the following information:

1997 U.S. Tax Ct. LEXIS 32">*90 Of the reported compensation, Mr. Johnson received zero, $ 150,000, $ 142,500, $ 120,000, and $ 130,000 during his respective taxable years from 1989 through 1993, and Ms. Johnson received zero, $ 9,000, $ 16,900, $ 15,500, and $ 13,000 during the same respective years.

Johnson Roofing, Inc. (Roofing) is an affiliate of Systems. Roofing's relevant tax returns included the following information:

108 T.C. 524">*555 Of the reported compensation, Mr. Johnson received $ 73,000, $ 234,988, and $ 288,000 in his respective taxable years from 1988 through 1990. Ms. Johnson received $ 20,580, $ 31,200, and $ 15,600 during the same respective years. Neither of the Johnsons received any compensation from Roofing during their 1991 through 1993 taxable years.

The Johnsons filed timely their joint1997 U.S. Tax Ct. LEXIS 32">*91 1990 Federal income tax return. On March 3, 1994, the Commissioner mailed them a notice of deficiency reflecting a determination that the Johnsons' 1990 taxable income was increased by $ 297,299 on account of a taxable transfer of property from Systems under section 83. ¹² The notice also stated that the Johnsons were liable for a $ 16,794 accuracy-related penalty under section 6662(a) because the underpayment of tax attributable to section 83 was due to negligence.

On the same day, the Commissioner mailed Systems a notice of deficiency reflecting a determination that its 1990 taxable income was increased by $ 300,000 because its contribution to the Trust was governed by subpart D. Systems filed timely its 1990 tax return. The notice also stated that Systems was liable for a $ 21,735 accuracy-related penalty under section 6662(a) because its underpayment of income tax was due to a substantial understatement.

B. Systems'1997 U.S. Tax Ct. LEXIS 32">*92 Introduction to the Prime Plan

Max Chapman, Systems' independent C.P.A., introduced the Johnsons to the Prime Plan, stating that it would be "useful in tax planning". Mr. Carr was also involved in meetings concerning Systems' decision to join the Prime Plan, and he reviewed some of the plan's literature. One of the main selling features of the Prime Plan from Mr. Carr's perspective was the "very thick opinion letter". Mr. Johnson, individually and on behalf of Systems, relied upon competent and informed tax and investment advisers before joining the Prime Plan and in reporting the tax ramifications that flowed therefrom.

108 T.C. 524">*556 C. Systems' Adoption of the Prime Plan

Systems joined the Prime Plan by executing an Adoption Agreement dated and effective as of December 20, 1990, and by making a $ 300,000 contribution to the Trust 6 days later. The contribution funded the full accrual of DWB's for Systems' three employees ($ 264,000), as well as their death benefits ($ 36,000). When Mr. Johnson made that contribution, he believed the money could not be lost to an employee of another Employee Group. Systems' three employees became Systems' Covered Employees in 1990.

On March 12, 1991, 1997 U.S. Tax Ct. LEXIS 32">*93 Mr. Johnson, on behalf of Systems, amended the 1990 Adoption Agreement effective as of December 31, 1990, to change the DWB accrual percentage to 176 percent and the years of service multiple to one. No change was made to the vesting schedule.

In all, Systems submitted the following Adoption Agreements relating to its participation in the Prime Plan:

On December 2, 1991, IFTI sent Systems copies of substitute pages 1 and 5 for its Adoption Agreement. These pages changed the employer yearend to September 30, the Normal Retirement Date to 65, and the death benefit multiple to 16.275.

D. Administration of Systems' Account in the Prime Plan

The 1989 annual report on Systems' account in the Prime Plan pertained only to Systems' Employee Group, and it did not provide any information regarding the Trust1997 U.S. Tax Ct. LEXIS 32">*94 as a whole.

On March 6, 1991, IFTI forwarded the 1990 annual report for Systems' account to Mr. Johnson. The report included an actuarial valuation signed by Deloitte & Touche and provided the following calculations of vested severance benefits for Systems' Covered Employees:

In the 1990 annual report, the Prime Plan's actuary used a DWB of 176 percent, 1 year of service, 100 percent vesting, and a 16.275 death benefit multiple. These numbers were different from those set forth in the Adoption Agreements. Adoption Agreements with the percentages and multiples used in the 1990 annual report were prepared, but never executed by Systems. IFTI contacted Systems on numerous occasions in 1991 and 1992, stating that Systems needed to provide the executed Adoption Agreements. Mr. Carr executed, but failed to date, an Adoption Agreement with the correct percentages and multiples.

The annual reports for Systems' account in the Prime Plan included the following1997 U.S. Tax Ct. LEXIS 32">*95 information:

E. Forms 5500-C/R

Forms 5500-C/R filed with the Commissioner on Systems' account in the Prime Plan reported the following information:

These forms also reported the payment of zero, $ 38,546, zero, zero, and zero in insurance commissions during the respective years.

VIII. On-Site Project Management, Inc. (On-Site)

A. Overview

The Traegdes are husband and wife, and they resided in Tempe, Arizona, when they petitioned the Court. On-Site is an S corporation that was incorporated on July 2, 1984. Mr. Traegde was its president, and he owned1997 U.S. Tax Ct. LEXIS 32">*96 98.4022 percent of 108 T.C. 524">*558 its stock on December 31, 1989. Ms. Traegde was On-Site's vice president, and she owned the rest of its stock on that date. The 1989 Federal income tax returns of On-Site and the Traegdes were filed timely.

On-Site reported its operations for Federal income tax purposes on a calendar year, and it used the cash method on its relevant tax returns. These returns included the following data:

Of the reported compensation, Mr. Traegde received $ 117,536, $ 201,956, $ 205,870, $ 56,808, and $ 125,207 during the respective years.

B. On-Site's Introduction to the Prime Plan

Thomas J. Connelly was the Prime Plan's sales agent for On-Site. Mr. Connelly introduced Mr. Traegde to the Prime Plan in late 1988. Mr. Connelly had observed1997 U.S. Tax Ct. LEXIS 32">*97 that Mr. Traegde did not have a succession plan for his business or any estate planning, that the Prime Plan offered death benefits for Mr. Traegde, and that the Prime Plan would give Mr. Traegde a source of funds to close his business when he decided to leave.

On October 4, 1988, Mr. Connelly wrote to On-Site's C.P.A., Thomas P. Joynt, explaining the Prime Plan. On November 7, 1988, Mr. Joynt replied with certain questions about the Prime Plan, as well as On-Site's possible participation therein. On November 17, 1988, Mr. Connelly responded to Mr. Joynt's letter.

Mr. Connelly discussed the Prime Plan with Mr. Traegde. Based on these conversations, and after reading the promotional literature on Prime, Mr. Traegde concluded that the risks involved in the Prime Plan were minimal. Mr. Traegde expected to get his DWB if he sold or closed his business, and he knew that he could withdraw On-Site from the Prime Plan at any time. Mr. Traegde also discussed Mr. Weiss' 108 T.C. 524">*559 opinion letter on the Prime Plan with Mr. Joynt, and Mr. Traegde relied on Mr. Joynt's advice with respect thereto.

C. On-Site's Adoption of the Prime Trust

On-Site joined the Prime Plan by executing an Adoption Agreement1997 U.S. Tax Ct. LEXIS 32">*98 on December 28, 1988, effective as of December 31, 1988, and by contributing $ 100,026 to the Trust on the same day. On-Site's contribution was applied primarily as follows: $ 89,645 to the full accrual of DWB's for its Covered Employees and $ 10,340 to the cost of their death benefits. As of December 31, 1988, On-Site's Covered Employees were Mr. Traegde and four other employees. Other On-Site employees became Covered Employees during 1989, and still others became Covered Employees in subsequent years. On December 29, 1989, On-Site made an additional contribution of $ 50,030 to the Prime Plan. On-Site made no contributions to the Prime Plan in 1990, 1991, or 1992.

On-Site submitted the following Adoption Agreements relating to its participation in the Prime Plan:

1997 U.S. Tax Ct. LEXIS 32">*99 On-Site's agreement dated November 1, 1989, also reduced the minimum death benefit from $ 50,000 to $ 25,000.

D. Administration of On-Site's Account in the Prime Plan

On August 15, 1989, Prime forwarded to On-Site a 1988 actuarial valuation for On-Site's account in the Prime Plan, signed by Laventhol & Horwath. On March 11, 1991, IFTI forwarded a 1988 annual report for On-Site's account in the Prime Plan to Mr. Traegde. This report included an actuarial valuation signed by Deloitte & Touche and provided the following calculations of vested severance benefits for On-Site's Covered Employees:

108 T.C. 524">*560 The 1988 report did not refer to 1997 U.S. Tax Ct. LEXIS 32">*100 another participating Employee Group, and it did not provide any information on the Trust as a whole. The report related only to the On-Site's Employee Group.

On March 11, 1991, IFTI forwarded the 1989 annual report for On-Site's account in the Prime Plan to Mr. Traegde. This report included an actuarial valuation signed by Deloitte & Touche, and it listed nine other employees of On-Site, none of whom qualified for a 1989 vested severance benefit. In order to accommodate On-Site's 1989 contribution, the accrual percentage for DWB's was increased from 25.54 percent to 27.220 percent. The 1989 report acknowledged a $ 50,000 contribution from On-Site, and applied the $ 50,000 amount to the increase in DWB's allowed because of the change in the accrual percentage, the increase due to the increased vesting of Mr. Traegde, and the increase due to the cost of death benefits.

The annual reports for On-Site's account in the Prime Plan listed the following relevant data:

On March 31, 1989, Prime forwarded to On-Site its 1988 summary plan description. On April 4, 1990, Prime forwarded to On-Site its 1989 summary plan description. On 108 T.C. 524">*561 February 24, 1993, Prime forwarded to On-Site its summary plan description with amendments through January 1992.

E. Forms 5500-C/R

Forms 5500-C/R filed with the Commissioner on On-Site's account in the Prime Plan included the following information:

These forms also reported the payment of $ 11,858, $ 13,797, $ 54, zero, and zero in insurance commissions during the respective years.

OPINION

We must determine1997 U.S. Tax Ct. LEXIS 32">*102 the tax consequences flowing from the Prime Plan, a purported multiple employer welfare benefit plan that has been marketed nationwide by its promoters as a viable tax planning device and subscribed to by hundreds of entities whose employee/owners have sought primarily the promised tax benefits. The designers of the Prime Plan struggled to comply with section 419A(f) (6)'s exception to the applicability of subpart D. The designers followed the evolution of subpart D through the Congressional committees, and they aspired to create a valid welfare benefit plan that met the legislative intent for section 419A(f) (6). The designers were familiar with the tax and labor provisions of employee benefit law.

Based on their understanding of the genesis of subpart D, the drafters concluded that section 419A(f) (6) covered their design for the Prime Plan. One of the designers, Mr. Weiss, requested a ruling from the Commissioner that the Prime Plan qualified under section 419A(f) (6). The Commissioner did not issue a ruling in reply to Mr. Weiss' ruling request, and, to date, the Commissioner has not issued regulations construing section 419A(f) (6). On May 1, 1995, the Commissioner released 1997 U.S. Tax Ct. LEXIS 32">*103 Notice 95-34 (the Notice), 1995-1 C.B. 309, to provide guidance on "the significant tax problems" raised by certain trust agreements being promoted as multiple employer welfare benefit funds exempt from the limits of sections 108 T.C. 524">*562 419 and 419A. Id. Although the Notice did not mention the Prime Plan by name, the Notice indicated that the Commissioner disagreed with Prime that its plan was within section 419A(f) (6).

Having failed in their attempt to receive the Commissioner's assurance that the Prime Plan was a 10 or more employer plan under section 419A(f) (6), Prime nevertheless began marketing the plan in 1988, relying on the designers' opinions as to the validity of the promised tax benefits that Prime believed flowed from the Prime Plan. The Commissioner now challenges these tax benefits in the instant litigation. The Commissioner argues primarily that the Prime Plan is a plan of deferred compensation. Petitioners argue that the Prime Plan provides merely welfare benefits. The Commissioner argues alternatively that the Prime Plan is actually an aggregation of plans that is outside the scope of section 419A(f) (6). Petitioners argue that the Prime Plan1997 U.S. Tax Ct. LEXIS 32">*104 is a single 10 or more employer plan within section 419A(f) (6).

We must resolve these disputes. We do so with the benefit of a comprehensive and detailed evidentiary record developed by the parties up to, including, and after trial, as well as with the aid of the parties' briefs and other voluminous submissions that have focused on issues which have been in dispute at one time or another throughout this proceeding. We analyze the law that applies to the issues at hand, giving due regard to all arguments made by the parties with respect to these issues.

1. Type of Plan: Welfare Benefit or Deferred Compensation

We pass first on whether the Prime Plan is a plan of welfare benefit or deferred compensation. If the Prime Plan is a deferred compensation plan, section 404(a) (5) prohibits a participating employer from deducting a contribution until the year in which an amount attributable to the contribution is includable in the gross income of employees participating in the plan, assuming that separate accounts are maintained for each employee. If a separate account is not maintained for each employee, section 404(a) (5) does not allow an employer to deduct the contribution even1997 U.S. Tax Ct. LEXIS 32">*105 in the year in which an attributable amount is included in the gross income of an employee. See also sec. 1.404(a)-12(b) (3), Income Tax 108 T.C. 524">*563 Regs. If, on the other hand, the Prime Plan is a welfare benefit plan, subpart D generally limits the employer's deduction for its contributions to the amount that would have been deductible had it provided the benefits directly to its employees. Subpart D's limitations are inapplicable when section 419A(f) (6) applies. Section 419A(f) (6) generally lets an employer fully deduct its contributions in the year made, although its employees may not have to report these contributions as income until a later year.

We agree with petitioners that the Prime Plan was a welfare benefit fund. See sec. 419(e) (1), (2) (B), (3) (B); sec. 1.162-10, Income Tax Regs; see also Schneider v. Commissioner, T.C. Memo. 1992-24; Moser v. Commissioner, T.C. Memo. 1989-142, affd. on other grounds 914 F.2d 1040">914 F.2d 1040 (8th Cir. 1990). Mr. Weiss testified credibly that he designed the Prime Plan intending entirely to provide employees with "real" welfare benefits that would not be subject to 1997 U.S. Tax Ct. LEXIS 32">*106 abuse, and we read the record to support his testimony. The DWB's under the Trust Agreement also are not payable upon the happening of a certainty, but more closely resemble insurance payable only in the case of an uncertainty. See Harry A. Wellons, Jr., M.D., S.C. v. Commissioner, 31 F.3d 569">31 F.3d 569 (7th Cir. 1994), affg. T.C. Memo. 1992-704. Although the Prime Plan had features of deferred compensation (e.g., the payment of DWB's upon an employee's termination from employment based on his or her compensation and length of service, the presence of vesting schedules), these features were swallowed up by the Prime Plan's valid welfare benefit purpose so as to make the deferred compensation features incidental and meaningless for purposes of our analysis.

Respondent argues that this Court's jurisprudence provides that the DWB's were deferred compensation, citing mainly Grant-Jacoby, Inc. v. Commissioner, 73 T.C. 700">73 T.C. 700 (1980); New York Seven-Up Bottling Co. v. Commissioner, 50 T.C. 391">50 T.C. 391, 50 T.C. 391">398 (1968); New York Post Corp. v. Commissioner, 40 T.C. 882">40 T.C. 882, 40 T.C. 882">888 (1963);1997 U.S. Tax Ct. LEXIS 32">*107 and Harry A. Wellons, Jr., M.D., S.C. v. Commissioner, T.C. Memo. 1992-704. We disagree. The plan at issue in each of the cases cited by respondent is distinguishable from the Prime Plan. Such is also true with respect to the benefits provided under each plan.

Nor do we agree with respondent's reading of the Seventh Circuit's opinion in Harry A. Wellons, Jr., M.D., S.C. v. 108 T.C. 524">*564 Commissioner, 31 F.3d 569">31 F.3d 569 (7th Cir. 1994), to provide that the DWB's were deferred compensation because the Prime Plan had some indicia of a deferred compensation plan. All welfare benefit plans bear some element of deferred compensation, see Wheeler v. United States, 768 F.2d 1333">768 F.2d 1333, 768 F.2d 1333">1336 (Fed. Cir. 1985); Greensboro Pathology Associates, P.A. v. United States, 698 F.2d 1196">698 F.2d 1196, 698 F.2d 1196">1200 (Fed. Cir. 1982), and respondent's reading of the Seventh Circuit's opinion emasculates the right of a taxpayer to avail itself of the tax attributes of a welfare benefit plan. Unlike the Prime Plan, the plan at issue in Wellons was "more akin to a deferred compensation plan than the sort of 'welfare benefits' 1997 U.S. Tax Ct. LEXIS 32">*108 arrangement contemplated by the regulations". Harry A. Wellons, Jr. M.D., S.C. v. Commissioner, 31 F.3d 569">31 F.3d at 572.

Nor do we agree with respondent's claim that the DWB's were deferred compensation because an employer could voluntarily terminate its participation in the Prime Plan. We are unable to find any requirement in the applicable statutory and regulatory provisions that would limit welfare benefits to cases in which an employer could not voluntarily terminate its participation in a plan. We find in the statutory text that the Congress knew how to say "involuntary separation" when it wanted. See, e.g., sec. 501(c) (17) (D), which is referenced in sec. 419A(f) (1) (A). In the absence of a legislative pronouncement that limits severance benefits to cases where an employer could not voluntarily terminate its participation in a plan, we refuse to adopt such a pronouncement here. Although respondent is concerned that the ability of a participating employer to terminate voluntarily its participation in the Prime Plan allows the employer to control the timing of income to its employees, we regard that concern as misplaced. Respondent's concern could also1997 U.S. Tax Ct. LEXIS 32">*109 be expressed with respect to the pension plan of a corporation owned by a single shareholder. Although the shareholder may be the only employee, it does not necessarily follow that such a pension plan provides for receipt of deferred compensation merely because the owner/shareholder has the ability to terminate the pension plan at will.

We hold for petitioners on this issue.

108 T.C. 524">*565 2. 10 or More Employer Plan; Experience-Rating Agreements

We turn to the second issue; namely, whether the Prime Plan is a "10 or more employer plan" that lacks "experience-rating arrangements with respect to individual employers." See sec. 419A(f) (6). Petitioners assert that the Prime Plan is within section 419A(f) (6); i.e., the Prime Plan is a single plan that covers more than 10 employers, no one of which made more than 10 percent of the Trust's total contributions, and the plan has no experience-rating arrangements with respect to individual employers. Respondent asserts that the Prime Plan is outside the scope of section 419A(f) (6); i.e., the Prime Plan is an aggregation of plans that has experience-rating arrangements with respect to all participating employers.

We agree with respondent that1997 U.S. Tax Ct. LEXIS 32">*110 the Prime Plan does not meet the requirements of section 419A(f) (6). The Prime Plan is an aggregation of separate welfare benefit plans, each of which has an experience-rating arrangement with the contributing employer. We start our analysis with a discussion of the history of subpart D. ¹³ Subpart D, which consists of sections 419 and 419A, was enacted by the Congress as part of Deficit Reduction Act of 1984, Pub. L. 98-369, secs. 511(a) and 512(a), 98 Stat. 484, 854-862. Subpart D limits an employer's deduction for contributions to a welfare benefit plan. The Congress enacted subpart D because it was concerned with the law under which employers received current deductions for contributions to welfare benefit plans, while the benefiting employees excluded these amounts from their current income. As stated by the House Ways and Means Committee, in proposing a change to the prior law,

The committee has concluded that the favorable tax treatment of employer contributions to welfare benefit plans, as compared with employer payments of wages and salary, is inappropriate in view of the favorable tax treatment already provided to employees, i.e., the exclusion of many of these benefits1997 U.S. Tax Ct. LEXIS 32">*111 from adjusted gross income. In addition, the committee believes that the current rules under which employers may take deductions for plan contributions far in advance of when the benefits are paid allows excessive tax-free accumulation of funds.

The committee's concern has been caused by recent discussion among tax practitioners as to the tax-shelter potential of welfare benefit plans. 108 T.C. 524">*566 Commentators have pointed out that the combination of advance deductions for contributions and the availability of tax exemption for certain employee benefit organizations (such as the voluntary employees' beneficiary association or VEBA) provides tax treatment very similar to that provided to qualified pension plans, but with far fewer restrictions. * * *

In one article on the use of employee benefit plans as a tax shelter, an example is given of how a small professional corporation may utilize the tax benefits of a severance pay plan funded by a VEBA. In this example, the employees of the corporation are two doctors, ages 50 and 55, with annual salaries of $ 150,000 and $ 200,000, respectively, and three other workers, ages 20 to 36, with annual salaries of $ 10,000 to $ 18,000. The example indicates1997 U.S. Tax Ct. LEXIS 32">*112 that the corporation could make tax deductible annual contributions to a tax-exempt VEBA of more than $ 55,000 annually under terms that would make it unlikely that the three lower-paid employees would receive substantial benefits from the plan. * * *

Thus, the committee is concerned that substantial advance funding of welfare benefits will ultimately lead to an unacceptable tax burden for many taxpayers who do not participate in these programs. * * * [H. Rept. 98-432 (Part 2), at 1275-1276 (1984).]