An appropriate order and decision will be entered.
HOLMES,
Howard Barnhorst was born in October 1948, and had a life well lived. He became a lawyer, and his success in law was coupled with success in marriage to Marnie Barnhorst. She was also a highly regarded lawyer, and they were wed for 44 years and reared four children. Howard worked for much of his career at the law firm of Seltzer, Caplan, McMahon, and Vitek until he decided to hang a shingle of his own. That firm became Barnhorst, Schreiner & Goonan, Inc. (BSG), and Howard devoted his time as an attorney to BSG through 2000. After leaving2016 Tax Ct. Memo LEXIS 176">*177 BSG in 2001, Howard returned to Seltzer.
Early in his career, Howard met another attorney, Ernest Ryder. Ryder specializes in tax planning and retirement benefits and was United States counsel for American Specialty Insurance Group, Ltd. (American Specialty), a company organized under the laws of the Turks and Caicos Islands. BSG hired Ryder to write a policy to insure Howard. The policy was called Policy Number 1994-004. Ryder opened a Charles Schwab account under the name American Specialty Insurance Group, Ltd. Policy No. 1994-004 and had signature authority over it. *179 He also billed BSG for policy fees. It is this unusual feature--an insurance policy with its own brokerage account--that the reader should focus on, because neither the IRS nor the Court has ever seen the policy itself.
We do have in the record the policy that is central to this case, Policy No. 1999-001. Ryder also drafted this policy, and it was issued by American Specialty in 1999. The policy's title was "Disability Income Insurance Policy," and it listed Howard as the insured and BSG as the employer and policyholder. It states that American Specialty has never been authorized to do business by any insurance commissioner2016 Tax Ct. Memo LEXIS 176">*178 of any state in the United States and that it doesn't transact any insurance business in the United States. It asserts instead that it is governed by Turks and Caicos law.
The policy provided benefits to Howard if he became totally or partially disabled. It defined "total disability" as Howard's inability to "perform the substantial and material duties of his regular occupation" that was caused by "accident, sickness, injury, or physical, mental or emotional condition." The policy defined "partial disability" as the ability to do some, but not all, of Howard's substantial and material duties in his regular occupation if as a result his pay was at least 20% less than he otherwise would have received at full working capacity. In the event of total disability, Howard could claim a fixed monthly *180 disability-income benefit originally set at $5,612.92 a month but which was updated on an annual basis. These payments would last for 150 months or until Howard died. In the event of partial disability, Howard could claim the same monthly benefit, less 50% of his annual earnings from BSG. The policy also defined a third type of disability: "catastrophic disability." The policy defined this type2016 Tax Ct. Memo LEXIS 176">*179 of disability as total disability that was caused by a specific injury or sickness. In the event of a catastrophic disability, Howard could claim a lump-sum benefit.
The policy listed many kinds of catastrophic disabilities with apparently different payouts. The loss of an eye, hand, foot, arm, or leg; permanent brain damage; or permanent loss of hearing in both ears entitled Howard to the lesser of 97% of the cash value of the policy or 10 times his highest annual earnings for any fiscal year of BSG. The loss of the use of any internal body organ, including any heart or kidney dysfunction, or the permanent loss of hearing in only one ear, entitled him to the lesser of 97% of the cash value of the policy or eight times his highest annual earnings from BSG. Permanent disfigurement of the body or skin caused by external or internal bodily injury, damage or disease, entitled him to 97% of the cash value or six times earnings. And finally, if total disability resulted from "any other condition which qualifies for the exclusion under
These different categories of catastrophic injuries would seem to trigger different payouts (depending on the value of the policy and what he was making at BSG)--except for one important clause. Provision 2.4(e) stated that "to the extent 97% of the cash value of the policy exceeds [Howard's] catastrophic disability benefit as based on a multiple of [Howard's] highest annual earnings * * * such excess shall be divided by the number of months in the maximum benefit period, and the resulting amount shall thereupon become the monthly disability income benefit." In other words, if Howard didn't get the full 97% cash value from a lump-sum payment from any type of catastrophic injury, he'd get the rest of it in monthly installments over the course of the benefit period, regardless of the type of "catastrophic disability" he suffered.
To get these benefits, the policy said Howard had to file a claim with American Specialty. If Howard were to die while the policy was in effect, American Specialty would pay 97% of the cash value to Howard's designated beneficiaries. The policy would automatically renew each year if BSG paid the *182 2016 Tax Ct. Memo LEXIS 176">*181 required premium. The premiums would go to a segregated account that Ryder maintained. Ryder invested the premiums in a diversified portfolio of mutual stock and bond funds where they could build value over the years until benefits had to be paid. This segregated account turned out to be the one titled for Policy 1994-004, the policy that never made it into the record. The initial premium on the policy that is at issue was $701,614.57, with additional premiums of $100,000 in 2001 and $170,000 in 2003. There were no premiums in any other year of the policy, though the potential monthly benefit was updated with each renewal rider. Howard was also able to borrow from the account to finance his home, which he did several times and in amounts that sometimes exceeded $100,000. Howard would occasionally pay back the loans, but he also deducted the interest he paid on them as mortgage interest for 2009.
The policy had another important clause: It would terminate upon the earliest of: (1) Howard's turning 60; (2) his death; or (3) his no longer being an employee of BSG. If the policy terminated for either the first or third reason, Howard had the right to convert the coverage into a life-insurance2016 Tax Ct. Memo LEXIS 176">*182 policy with a cash surrender value equal to 97% of the cash value of the disability policy on the date of termination. Termination for the second reason would result in an immediate payout of 97% of the cash value to Howard's beneficiaries. Howard *183 turned 60 in October 2008, thus presumably triggering a termination. But American Specialty continued to send renewal riders through a policy period ending February 1, 2010.
The policy became important to the Barnhorst family when Howard had cancer-related surgery. According to Marnie, because the cancer had spread beyond his prostate, the surgeon had to remove much more than that organ, which led to a permanent loss of several bodily functions. Howard fought the cancer as hard as he could, endured whatever treatment his doctors recommended, and traveled out of town and abroad for treatment. He also somehow managed to work at Seltzer throughout it all, recording more than 2,000 hours in both 2009 and 2010.
In March 2010, however, he filed a claim with American Specialty under the policy for a "catastrophic disability" benefit. Seven days later Ryder authorized a check to be drawn for nearly $500,000 from the American Specialty account. This2016 Tax Ct. Memo LEXIS 176">*183 is what was left after repaying the loans Howard had taken from the account. Ryder authorized this payout despite not reviewing any documentation *184 of Howard's medical condition. He also kept more than $30,000 from the account as his fee.2
Between 2010 and 2013 Howard's health continued to deteriorate. After a wrenching discussion with his wife and children, he decided against further heroic but futile treatments, and he died in April 2014. The Barnhorsts reported the entire amount received from American Specialty in 2010 (including the loan setoff and Ryder's fee) as nontaxable pension and annuities income on their return for that year. The IRS issued a notice of deficiency to them that determined the amount was taxable compensation. The Commissioner asserted in the notice of deficiency a
Marnie, a California resident, timely filed a petition for herself and as successor to Howard's interest. She moved for summary judgment, and the Commissioner answered and cross-moved.
We apply the usual rules of summary judgment.
We see two substantive issues. First, is the policy an accident or health plan as defined in
We'll address these in turn.
The Code does not define the term "accident or health plan." The regulations do: "In general, an accident or health plan is an arrangement for the payment of amounts to employees in the event of personal injuries or sickness. A plan may cover one or more employees, and there may be different plans for different employees or classes of employees." • a statement in a written plan that its purpose is to qualify as an accident or health plan within the meaning of the Code and that the benefits are eligible for income tax exclusion; • specification in a plan that the benefits payable are those amounts incurred for medical care in the event of personal injury or sickness; • terms in a plan that the benefits payable are limited to legitimate medical expenses; and • a provision allowing an employee to be compensated for specific2016 Tax Ct. Memo LEXIS 176">*186 injuries or illness, such as the loss of a limb.
The first factor is unquestionably met here, and both parties agree about that. Provision 5.18 of the policy specifically says "[t]his policy is intended to qualify as an accident and health plan within the meaning of
The second and third factors--which are so similar that we'll treat them together--are a bit more complicated. Assuming the policy didn't terminate, Marnie is right that the only way Howard could get money out of the policy was if he sustained some kind of injury or illness. This is in stark contrast to a typical deferred-compensation plan that might involve some vesting and that could be paid out for non-health-related reasons. But payouts under this policy had no correlation with Howard's actual medical expenses--under its terms he would receive either a lump sum or a fixed monthly benefit.2016 Tax Ct. Memo LEXIS 176">*187 The amount of this payment *188 had nothing to do with his actual expenses. He would, for example, be entitled to the same amount if he lost hearing in one ear or the use of both his kidneys. Medical expenses for these two conditions would quite likely be different, but payout under the policy would be the same.
That's a crucial distinction. The cases tell us to ask whether a plan pays for actual medical expenses, not whether its payee suffers from some triggering condition. In
The policy purports to distinguish between types of injuries and illnesses, thus seemingly meeting the final factor easily. But the policy's distinctions don't make any real difference. The policy, for example, seems to consider permanent brain injury more significant than the loss of hearing in one ear--one would get Howard up to 10 times his annual earnings, the other2016 Tax Ct. Memo LEXIS 176">*189 only 8--but Provision 2.4(e) ensures that for any type of catastrophic injury Howard would get the entire 98% cash value of the policy and nothing more.5 Admittedly, it was possible that the timing of the payments could differ, depending on Howard's highest annual *190 earnings from BSG and the value of the policy. But we don't believe this potential (and uncertain) difference in timing outweighs the fact that Howard would get the same money in the end.
Our skepticism is only whetted by some other sharp observations that the Commissioner makes. The Commissioner is certainly correct that the policy's terms say it terminates automatically when Howard turns 60 or is no longer an employee of BSG. Howard turned 60 in October 2008, about a year and a half
The Commissioner also argues that Howard was no longer an employee of BSG when he made the claim. A number of cases have dealt with questions of whether a plan was for employees or shareholders, but it's clear a plan must be for "employees".
We won't make the outcome of these motions turn on these facts, but they can't help but sway us in the Commissioner's direction because they too support his characterization of the policy as a disguised form of deferred compensation. We, however, need only2016 Tax Ct. Memo LEXIS 176">*192 figure out if the policy is an accident or health plan. It does lack some qualities of a typical deferred-compensation plan, namely, that Howard didn't have a vesting period for the benefits. And, even though payouts for the most part were conditioned on some sort of injury or illness, the policy did not provide for reimbursement of medical expenses; and its distinctions between types of disabilities were effectively meaningless (except maybe for a potential difference in the timing, if not the amount, of the payouts). Most important, Howard (or his beneficiaries in the event of death) was guaranteed to get the 98% cash value
We therefore find that the policy was not an accident or health plan under
Even if it were, the Commissioner also wins on one of his alternative arguments. To be excludable from income, payments from an accident2016 Tax Ct. Memo LEXIS 176">*193 or medical plan must "constitute payment for the permanent loss or loss of use of a member or function of the body, or the permanent disfigurement, of the taxpayer, his spouse, or a dependent", and "
*194 Howard had his prostate removed in 2009. The Commissioner2016 Tax Ct. Memo LEXIS 176">*194 argues that neither this loss, nor his cancer diagnosis, is enough to meet the conditions of
The Commissioner, however, also argues that the payments weren't calculated with reference to the nature of the injury and thus fail
*195 This is critical. "Computed" is not synonymous with "triggered". As the Ninth Circuit held in
Marnie argues that the policy meets this variable-payment requirement because it did distinguish partial, total, and catastrophic injuries and because it also distinguished different types of catastrophic disabilities. But the policy did so only superficially. Provision 2.4(d) includes in its definition of2016 Tax Ct. Memo LEXIS 176">*196 "catastrophic disability" any totally disabling condition not included in provisions 2.4(a)-(c) that "qualifies for the exclusion under
Marnie still wants us to believe that catastrophic disabilities were further broken down into subcategories.
That still leaves the category of "partial disability" as perhaps distinct from "total disability" and "catastrophic disability." The policy defined "partial2016 Tax Ct. Memo LEXIS 176">*198 disability" as a disability that reduced his annual earnings but did not leave him unable to work as a lawyer. But the policy defined the benefit Howard would receive if partially disabled to be the same monthly benefit as total disabilities "reduced by 50% of the Annual Earnings the Insured receives while he is Partially Disabled." But then "Annual Earnings" is defined as the taxable compensation reported on his Form W-2, Wage and Tax Statement, from BSG, a defunct law firm. Without that offset, the payouts for partial disabilities become equal to those for total disabilities, thus clearly not meeting the requirement that the payments be made in reference to the nature of the injury.
We do not doubt that Howard's cancer and surgery might have qualified him for income exclusion under an accident or health plan that met all of the requirements of
The Commissioner affirmatively pleaded in his answer that an accuracy-related penalty under
An understatement of tax is substantial if it exceeds the greater of 10% of the amount of tax required to be shown on the return or $5,000.
The Commissioner asserts many reasons why Howard did not have reasonable cause. He is quick to point out that Howard and Marnie both were experienced and accomplished attorneys, meaning they should've been more aware than most that this policy did not meet the requirements of the Code. Second, and more important, he argues that if Howard placed any reliance on a professional, he placed it on Ryder. Ryder was extensively involved in the policy, from drafting the documents to accepting payments made to American Specialty. He also had a financial interest in the transaction in the form of biannual fees. Therefore, Howard could not justifiably rely on someone who would personally profit.
We therefore grant2016 Tax Ct. Memo LEXIS 176">*201 summary judgment to the Commissioner on the issues of the taxability of the disability-policy payments and the accuracy-related penalty. Because the Commissioner conceded the
1. The 97% was changed to 98% throughout all the clauses of the policy in the 2004 policy renewal and then remained at 98%.
2. This amount represents around 3% of the account's value. It's unclear why Ryder didn't get only 2%, as the payouts were changed to 98% from 97% in 2003.↩
3. All section references are to the Internal Revenue Code in effect for the year at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
4. We are mindful that this may seem inconsistent with
5. We note that the inclusion of "partial" disabilities might seem to make the policy distinguish between injuries, but the distinction between partial and total disabilities the policy draws in vague language about Howard's ability to work is not very specific. Also, because Howard left BSG and BSG later became defunct, the payment for a partial disability would be the same as a total disability, as discussed in more detail later.↩
6. We note that the timing difference could potentially cause a small difference in total payout between catastrophic injuries. If Howard suffered a disability that only qualified him for the lesser of 98% cash value of the policy or 4 times his highest annual earnings, and this resulted in a lower payment than one that paid out 10 times his highest annual earnings, the remaining cash left in the account (less Ryder's fee) would be paid out as a monthly disability benefit to Howard. As the cash remaining in the account continued to earn a return, it could prolong the monthly benefits and increase the total payout to Howard. We don't believe this to be of any practical significance. And provision 2.10 may make even this tiny distinction disappear. It states that "[n]otwithstanding anything herein to the contrary, benefits to which an Insured . . . is otherwise entitled hereunder may be payable under whichever of the following methods . . . as the Insured or his Beneficiary shall elect within 60 days after becoming entitled to the benefits hereunder: (a) A single lump sum distribution in cash."