PLOTKIN v. COMMISSIONER

T.C. Memo. 2001-71

UNITED STATES TAX COURT

CLAYTON W. PLOTKIN, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 13365-99. Filed March 23, 2001.

Wayne A. Smith, for petitioner.

Charles B. Burnett and J. Robert Cuatto, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge: Respondent determined a $12,188 deficiency

in petitioner’s 1994 Federal income tax as well as a $2,437.60

section 6662(a)1 accuracy-related penalty. The first issue for

decision is whether the amount which petitioner received as a

1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
 - 2 -

loan from his employer’s pension plan constitutes a taxable

distribution under section 72(p). If so, we must determine

whether petitioner is liable for the 10-percent additional tax

under section 72(t) by reason of such distribution as well as

whether petitioner is liable for the section 6662(a) accuracy-

related penalty.

FINDINGS OF FACT

Certain facts have been stipulated and are so found. The

stipulation of facts and the exhibits are incorporated herein by

this reference. At the time the petition was filed, petitioner

resided in Phoenix, Arizona.

Petitioner is an attorney who practices primarily in the

fields of civil litigation and domestic relations. During the

year at issue, petitioner conducted his law practice through a

professional corporation, Clayton W. Plotkin, P.C. (the

corporation). Petitioner was the corporation’s sole director,

officer, and shareholder.

In 1982, the corporation adopted the Clayton W. Plotkin,

P.C. Money Purchase Plan (the plan), a pension plan exempt from

income taxation pursuant to sections 401(a) and 501(a). After

hiring an attorney to establish the plan, petitioner hired E.A.

Edberg and Associates (Edberg) to administer the plan. The plan

was restated in 1989, amended in 1993, and ultimately terminated

in 1999.
 - 3 -

In 1990, Edberg prepared a loan policy for the plan which

was adopted by petitioner as the sole member of the plan’s

Advisory Committee. Pursuant to the policy, a plan participant

could apply for a loan in an amount not to exceed one-half of the

participant’s nonforfeitable accrued benefit. The maximum

aggregate dollar amount of loans outstanding to any one

participant, when aggregated with all participant loans from

other employer qualified plans, could not exceed $50,000.2 All

loans were subject to approval by the plan’s Advisory Committee.

In November 1994, petitioner’s nonforfeitable accrued benefit in

the plan was $74,376. There is no evidence that he had

previously borrowed from the plan.

With respect to loans the proceeds of which were to be used

by a plan participant to acquire a dwelling that the participant

would use as his principal residence, the loan policy permitted a

repayment term of up to 15 years. With respect to all other

loans, the repayment term could not exceed 5 years. The loan

policy specifically provided as follows:

Participants should note the law treats the amount
of any loan (other than a “home loan”) not repaid five
years after the date of the loan as a taxable
distribution on the last day of the five year period
or, if sooner, at the time the loan is in default. If

2
The $50,000 figure was required to be reduced by the
excess of the participant’s highest outstanding loan balance
during the 12-month period ending on the date of the loan over
the participant’s current outstanding loan balance on the loan
date.
 - 4 -

a participant extends a non-home loan having a five
year or less repayment term beyond five years, the
balance of the loan at the time of the extension is a
taxable distribution to the participant.

During November of 1994, petitioner sought to borrow against

his accrued benefit under the plan. Pursuant to Edberg’s

recommendation, petitioner authorized the loan transaction on

behalf of the corporation’s board of directors as well as the

shareholders. The minutes of the board and shareholders meeting,

held on November 16, 1994, provide as follows:

The meeting was held because the Pension Plan
Administrators (Edberg’s people) indicate that there
must be corporate approval in order for Clayton W.
Plotkin to borrow from the Pension Plan. According to
Annie at Edberg’s office, Plotkin is able to borrow up
to $50,000 but he only wants to borrow $25,000. The
loan must be secured, must be payable at least
quarterly of principal and interest, it can be
amortized over any length but it must be paid off at
five years with a balloon payment balance, and interest
should be prime plus one or two percent. If there have
been no other loans or changes Plotkin can borrow again
at the end of the five years in the amount needed to
pay off the balance of the loan.

* * * * * * *

RESOLVED that Clayton W. Plotkin, be allowed to
borrow $25,000 from the Pension and that there be
a note with a deed of trust secured to Plotkin’s
house * * *. The interest rate on the loan is to
be 9% with monthly payments of principal and
interest of $253.57. Payments are to be due the
1st day of the month and will be late if not
received by the 15th day of the month. Payments
start 01/01/95. The loan payments will be based
on a 15 year payment with a balloon payment due
when the loan is supposed to be paid off. If he
is able Plotkin may borrow from the Pension Plan
to pay off the balance due but must meet the
requirements at that time. We will get a schedule
 - 5 -

from the CPA on the 15 years with each year on it
so that we will know the balance to be paid when
the loan is supposed be paid off.

Also on November 16, 1994, petitioner executed a promissory

note which he prepared evidencing the terms of the loan. The

note provided that petitioner was borrowing $25,000 from the plan

at an annual interest rate of 9 percent. With respect to

repayment terms, the note provided that petitioner was to make

monthly payments at the rate of $253.57. Petitioner

inadvertently omitted from the promissory note the term requiring

a balloon payment at the end of 5 years. Nonetheless, at the

time of signing the promissory note, petitioner intended to repay

the loan at the end of 5 years through a balloon payment of the

then outstanding principal balance.3

In order that he would know the proper amount of the balloon

payment, petitioner requested the accounting firm of Hill,

D’Amore & Co., Ltd., to prepare an amortization schedule for the

loan. The amortization schedule, bearing the letterhead of

petitioner’s accountant and dated November 21, 1994, reflected

the following items: A loan date of November 16, 1994; a loan

balance of $25,000; a nominal annual interest rate of 9 percent;

3
Respondent does not dispute petitioner’s assertion that
at the time the promissory note was executed, petitioner intended
to satisfy the loan through a balloon payment at the end of 5
years.
 - 6 -

monthly payments of $253.57;4 a 15-year term; and a principal

balance of $20,119.89 at the end of the initial 5 years of the

loan. The same accountant who prepared the amortization schedule

prepared petitioner’s 1994 income tax return.

The loan was secured by petitioner’s principal residence, as

evidenced by a deed of trust which petitioner prepared and

executed in favor of the plan. Although the loan was secured by

petitioner’s residence, petitioner did not use the proceeds of

the loan to acquire his residence.

The plan was terminated during February of 1999. At that

time, petitioner satisfied the loan by recognizing as a

distribution the outstanding balance on the promissory note.

Petitioner reported the distribution together with an early

distribution penalty on his 1999 income tax return.

OPINION

A. Distributions from the Plan

Section 402(a) provides generally that distributions from a

qualified plan are taxable to the distributee, in the taxable

year of the distributee in which distribution occurs, pursuant to

section 72. Section 72(p)(1)(A) provides the general rule that

proceeds of a loan from a qualified employer plan to a plan

participant are treated as a taxable distribution to the

4
The first monthly payment reflected on the amortization
was actually $346.40, due on Jan. 1, 1995.
 - 7 -

participant in the year in which the loan proceeds are received.

See Patrick v. Commissioner, T.C. Memo. 1998-30, affd. 181 F.3d

103 (6th Cir. 1999); Prince v. Commissioner, T.C. Memo. 1997-324;

Estate of Gray v. Commissioner, T.C. Memo. 1995-421. Section

72(p)(2), however, provides an exception to this general rule.

Under this exception, a loan is not treated as a taxable

distribution if: (1) The principal amount of the loan (when

added to the outstanding balance of all other loans from the same

plan) does not exceed a specified limit, see sec. 72(p)(2)(A);

(2) the loan, by its terms, must be repaid within 5 years from

the date of its inception or is made to finance the acquisition

of a home which is the principal residence of the participant,

see sec. 72(p)(2)(B); and (3) the loan must have substantially

level amortization with quarterly or more frequent payments

required over the term of the loan, see sec. 72(p)(2)(C).

Respondent argues that the loan at issue did not qualify for

the exception provided by section 72(p)(2). Accordingly,

respondent determined that distribution of the loan proceeds from

the plan constituted a taxable distribution pursuant to section

72(p)(1)(A). Petitioner, on the other hand, contends that the

loan satisfies each requirement of the section 72(p)(2)

exception.
 - 8 -

1. Repayment Term

We begin with the repayment term of petitioner’s loan. In

order for a loan to be excepted from being treated as a taxable

distribution under section 72(p)(1)(A), the loan generally must

require, by its terms, repayment within 5 years.5 See sec.

72(p)(2)(B)(i). With respect to repayment provisions, the

promissory note executed by petitioner called for monthly

payments of $253.57. At the 9 percent rate of annual interest

stated in the note, satisfaction of the loan would not have

occurred until the fifteenth year of the loan. Respondent points

out that the loan, by its terms, did not require repayment within

5 years. Accordingly, respondent argues that the loan failed to

satisfy section 72(p)(2)(B)(i).

Petitioner concedes that the promissory note, as drafted,

omitted the 5-year repayment provision. Petitioner testified

that he intended the promissory note to contain a provision

calling for a balloon payment at the end of the fifth year of the

loan to satisfy the then outstanding principal balance, and that

the omission of such provision was a product of a drafting

mistake on his part. In support of his testimony, petitioner

5
While an exception exists for loans the proceeds of which
are used to purchase a principal residence, see sec.
72(p)(2)(B)(ii), the proceeds of the loan which petitioner took
from the plan were not used by petitioner for this purpose.
Accordingly, the exception to the 5-year repayment term
requirement does not apply in this case.
 - 9 -

notes that (1) the loan policy adopted by the plan’s Advisory

Committee did not permit a repayment term in excess of 5 years

under the circumstances, (2) the board minutes authorizing the

loan required that the loan be paid off at the end of 5 years

through a balloon payment, and (3) petitioner instructed his

accountant to provide him with an amortization of the loan so

that he would know the proper amount of the necessary balloon

payment. Petitioner therefore requests this Court to treat the

promissory note as if it had been reformed to explicitly include

the 5-year balloon payment provision.6

We need not resolve the issue of whether petitioner’s loan

constitutes a taxable distribution under section 72(p)(1)(A)

based on the failure of the loan to meet the 5-year repayment

requirement of section 72(p)(2)(B). Even if we were to find (as

petitioner requests) that the loan, by its terms, was required to

be paid off in its fifth year through a balloon payment of the

then outstanding principal balance, the loan would fail to

satisfy the requirements of section 72(p)(2)(C). We discuss this

point below.

6
Petitioner contends that a court of equity could have
reformed the promissory note to comply with the intent of the
parties, citing Boone v. Grier, 688 P.2d 1070 (Ariz. App. 1984).
Petitioner argues that formal reformation of the note was not
necessary in this context, because petitioner treated the note as
so reformed in both his capacity as plan trustee and plan
participant/obligor.
 - 10 -

2. Substantially Level Amortization

In order for a loan to qualify for the section 72(p)(2)

exception to taxable distribution treatment, the loan must

provide for substantially level amortization over its term. See

sec. 72(p)(2)(C). The substantially level amortization

requirement under section 72(p)(2)(C) has been interpreted as

requiring that payment of principal and interest be made in

substantially level amounts over the term of the loan. See

Estate of Gray v. Commissioner, T.C. Memo. 1995-421. If we treat

the promissory note as requiring a balloon payment in the fifth

year, then the promissory note would call for 59 monthly payments

of $253.57 and a final balloon payment of $20,119.89. The

balloon payment is more than 79 times larger than the regular

monthly payment, and more than 80 percent of the initial

principal balance. From a textual standpoint, these payments

simply cannot be characterized as substantially level. From a

policy standpoint, one of the stated purposes behind the

enactment of section 72(p)(2)(C) was to prevent taxpayers from

currently enjoying plan assets through the use of balloon payment

loans:

The rules governing the tax treatment of loans
from certain tax-favored plans are intended to limit
the extent to which an employee may currently use
assets held by a plan for nonretirement purposes and to
ensure that loans are actually repaid within a
reasonable period. However, there is concern that the
present rules do not prevent an employee from
effectively maintaining a permanent outstanding $50,000
 - 11 -

loan balance through the use of balloon repayment
obligations * * * from third parties. [H. Rept. 99-
426, at 735 (1985), 1986-3 C.B. (Vol. 2) 1, 735; S.
Rept. 99-313, at 618 (1986) 1986-3 C.B. (Vol. 3) 1,
618; Emphasis added.]

Accordingly, we hold that the balloon payment provision which

petitioner requests we incorporate into the promissory note would

cause the loan to violate the requirements of section

72(p)(2)(C).

3. Conclusion as to Section 72(p)

If we were to interpret the promissory note according to its

express provisions, then petitioner’s loan would violate the 5-

year repayment requirement of section 72(b)(2)(B)(i). If we

incorporate into the promissory note a provision calling for a

balloon payment at the end of the fifth year of the loan, then

the loan fails to provide for substantially level amortization as

required by section 72(b)(2)(C). Thus, under either possible

interpretation of the promissory note, petitioner’s loan fails to

qualify for the section 72(p)(2) exception. The loan therefore

constitutes a taxable distribution pursuant to section

72(p)(1)(A).

B. Tax on Early Distributions

Section 72(t)(1) provides for a 10-percent additional tax on

early distributions from a qualified pension plan. See Chapman

v. Commissioner, T.C. Memo. 1997-147. Section 72(t)(2) sets

forth specific exemptions. Petitioner does not argue that any of

the statutory exceptions applies to him. Accordingly, we sustain
 - 12 -

respondent’s determination as to the section 72(t) additional

tax.

C. Accuracy-Related Penalty

Pursuant to section 6662(a), respondent determined an

accuracy-related penalty of 20 percent of the amount of the

underpayment attributable to a substantial understatement of tax.

In the alternative, respondent imposed the accuracy-related

penalty on the amount of the underpayment due to negligence or

disregard of the rules and regulations. Respondent’s

determinations are presumed to be correct, and petitioner bears

the burden of proving that the accuracy-related penalty does not

apply. See Rule 142(a).

A substantial understatement of tax is defined as an

understatement of tax that exceeds the greater of 10 percent of

the tax required to be shown on the return or $5,000. See sec.

6662(d)(1)(A). The understatement is reduced to the extent the

taxpayer has (1) adequately disclosed his or her position and has

a reasonable basis for the tax treatment of the item, or (2) has

substantial authority for the tax treatment of the item. See

sec. 6662(d)(2)(B). Section 6662(c) defines “negligence” as any

failure to make a reasonable attempt to comply with the

provisions of the Internal Revenue Code, and “disregard” as any

careless, reckless, or intentional disregard.
 - 13 -

Whether applied based on a substantial understatement of tax

or negligence or disregard of the rules or regulations, the

accuracy-related penalty is not imposed with respect to any

portion of the underpayment as to which the taxpayer acted with

reasonable cause and in good faith. See sec. 6664(c)(1). The

decision as to whether the taxpayer acted with reasonable cause

and in good faith depends upon all the pertinent facts and

circumstances. See sec. 1.6664-4(b)(1), Income Tax Regs.; see

also Hickman v. Commissioner, T.C. Memo. 1997-545. Relevant

factors include the taxpayer’s efforts to assess his proper tax

liability, including the taxpayer’s reasonable and good-faith

reliance on the advice of a professional such as an accountant.

See Jorgenson v. Commissioner, T.C. Memo. 2000-38; sec. 1.6664-

4(b)(1), Income Tax Regs.

Petitioner cites his intent to comply with section 72(p) for

the purpose of showing that he acted with reasonable cause and

good faith in not reporting the loan as a taxable distribution on

his 1994 income tax return. Petitioner hired a qualified plan

administrator on whose advice he relied at the time of entering

into the loan. The minutes of the board meeting that were

prepared contemporaneously with the loan indicate that petitioner

relied upon information from “Annie in Edberg’s office” for the

proposition that he could amortize the loan over 15 years as long

as it was repaid with a balloon payment within 5 years.
 - 14 -

Furthermore, petitioner provided his accountant with the

relevant loan documents. As reflected in the amortization

schedule prepared by petitioner’s accountant, the accountant was

aware that petitioner borrowed $25,000 from the plan the payment

of which was to be amortized over 15 years. The same accountant

prepared petitioner’s 1994 income tax return.

Based on the record before us, we find that petitioner acted

with reasonable cause and in good faith in reporting his 1994

income tax liability. Accordingly, the accuracy-related penalty

does not apply.

In reaching our holdings herein, we have considered all

arguments made by the parties, and to the extent not mentioned

above, we find them to be irrelevant or without merit.

To reflect the foregoing,

Decision will be entered under

Rule 155.