T.C. Summary Opinion 2003-43
UNITED STATES TAX COURT
DENNIS W. FARLEY, JR. AND JANICE J. FARLEY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 7920-01S. Filed April 22, 2003.
Dennis W. Farley, Jr. and Janice J. Farley, pro se.
Dennis R. Onnen, for respondent.
COUVILLION, Special Trial Judge: This case was heard
pursuant to section 7463 of the Internal Revenue Code in effect
at the time the petition was filed.1 The decision to be entered
1
Unless otherwise indicated, subsequent section
references are to the Internal Revenue Code in effect for the
years at issue. Rule references are to the Tax Court Rules of
Practice and Procedure.
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is not reviewable by any other court, and this opinion should not
be cited as authority.
In the notice of deficiency, respondent determined the
following deficiencies in Federal income taxes against
petitioners for the years indicated:
Year Deficiency
1995 $6,713
1996 8,000
1997 8,200
The sole issue for decision is whether petitioners are liable for
the 10-percent additional tax on early distributions from
qualified retirement plans under section 72(t)(1) for the years
at issue and, more particularly, whether the distributions in
question constitute “part of a series of substantially equal
periodic payments (not less frequently than annually) made for
the life (or life expectancy) of the employee” within the intent
and meaning of section 72(t)(2)(A)(iv).2
Some of the facts were stipulated. Those facts, with the
annexed exhibits, are so found and are made part hereof.
2
Respondent also determined that a $17,125 loan to
petitioners from one of their qualified plans during 1995
constituted a deemed distribution under sec. 72(p) and was also
subject to the additional tax under sec. 72(t)(1). Petitioners
did not challenge that adjustment at trial; consequently, the
Court considers that adjustment as conceded by petitioners.
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Petitioners’ legal residence at the time the petition was filed
was Albuquerque, New Mexico.
Dennis W. Farley, Jr. (petitioner) was born December 25,
1942. In January 1994, he retired from United Missouri Bank in
Kansas City, where he had been employed for more than 31 years.3
At the time of his retirement, petitioner was 52 years of age.
Upon retirement, petitioner received lump-sum distributions from
qualified pension and profit-sharing accounts totaling $274,610.
These funds were timely rolled over into self-directed individual
retirement accounts (IRA accounts) pursuant to section 402(c).
During 1995, petitioner commenced receiving periodic
distributions from his IRA accounts.
Petitioner calculated the amount of his periodic
distributions by first calculating an amortized growth rate of
his IRA accounts based on a life expectancy of 30.4 years. After
determining the projected growth of the accounts over this
period, petitioner concluded he could withdraw (or receive
distributions) from his accounts of $80,040 annually. He rounded
3
Paragraph 4 of the stipulation states that petitioner
retired from United Missouri Bank in 1995. However, petitioner
testified that the actual date was Jan. 1994. The Court is not
bound by a stipulation of fact that appears contrary to the facts
disclosed by the record. Rule 91(e); Blohm v. Commissioner, 994
F.2d 1542, 1553 (11th Cir. 1993), affg. T.C. Memo. 1991-636;
Estate of Eddy v. Commissioner, 115 T.C. 135 (2000). The
difference in the dates is not material to the issue in this
case.
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this figure to $80,000. The amortized growth rate petitioner
used to determine the value of his accounts 30.4 years hence was
29 percent per year.4 The sole purpose of this process was to
determine the maximum amount that could be distributed to
petitioner from his qualified plans that would avoid imposition
of the 10-percent additional tax under section 72(t) and would
satisfy the provisions of section 72(t)(2)(A)(iv).
Petitioner used the 29-percent annual growth rate by
analyzing the performances of various mutual funds and their
rates of return over a given period of years. From a group of 83
funds, he selected seven mutual funds in which he would invest
his IRA account funds. Using rates of return for these funds
that he obtained from the Internet, petitioner took the
cumulative return of each of the seven funds, which he divided by
the relevant number of years to arrive at that fund’s average
annual return. He used data dating back 5 years for five of the
funds, 3 years for one fund, and 1 year for another fund.
Petitioner then added up these averages and divided by seven,
resulting in an overall average annual return of 34.65 percent
4
At trial, petitioner introduced a schedule based on an
assumed life expectancy of 27 years for purposes of calculating
his periodic distribution amount. However, respondent pointed
out, and petitioner did not dispute, that petitioner actually
used a life expectancy factor of 30.4 years as set forth in Table
V of sec. 1.72-9, Income Tax Regs. Respondent did not challenge
petitioner’s use of a life-expectancy factor of 30.4 years.
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for the seven funds. Petitioner reduced that figure to 29
percent to allow for a “margin of error”. He used 5-year rates
of return, where available, even when a fund had been in
existence longer because, as he stated: “I figured a five-year
return was reasonable for my purposes, you know, simply because
the markets change considerably over time.”
Petitioner began making monthly withdrawals out of his
qualified accounts based on these calculations. He received
distributions of $50,000 in 1995, $80,000 in 1996, and $82,000 in
1997. Petitioner admitted that the 1997 distribution of $82,000
was in error, and he corrected that error by reducing his
distribution to $78,000 the following year, which year is not
before the Court. In subsequent years, petitioner resumed his
scheduled periodic distributions of $80,000 per year.
On their Federal income tax returns for 1995, 1996, and
1997, petitioners reported the periodic distributions as income.
The deemed distribution of $17,125 in 1995 was also reported as
income on their 1995 return. Respondent thereafter determined
that the distributions were subject to the 10-percent additional
tax under section 72(t).
Petitioner contends that the additional tax is not owed
because the distributions were “part of a series of substantially
equally periodic payments (not less frequently than annually)
made for the life (or life expectancy) of the employee or the
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joint lives (or joint life expectancies) of such employee and his
designated beneficiary.” Sec. 72(t)(2)(A)(iv). Petitioners must
prove they are not liable for the 10-percent additional tax.
Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).5
Section 72(t)(2)(A)(iv) does not provide how to determine or
calculate a series of substantially equal periodic payments to
qualify for the exception. However, the IRS has provided three
permissible methods for calculating such a series. IRS Notice
89-25, Q&A-12, 1989-1 C.B. 662, 666. Petitioner chose the second
of the three methods, known as the fixed amortization method.
Rev. Rul. 2002-62, 2002-42 I.R.B. 710. The fixed amortization
method involves amortizing a taxpayer’s IRA account balance over
the account owner’s life expectancy at an interest rate that does
not exceed a reasonable rate of interest on the date that
payments commence. IRS Notice 89-25, Q&A-12, 1989-1 C.B. supra
at 666. The parties agree that the fixed amortization method
provided in IRS Notice 89-25 is a permissible way to calculate a
series of substantially equal periodic payments.6
5
Sec. 7491, under certain circumstances, places the
burden of proof on respondent with respect to a taxpayer’s
liability for taxes in court proceedings arising in connection
with examinations commencing after July 22, 1998. In this case,
the examination of petitioners’ returns commenced before the
effective date; therefore, the burden remains with petitioners.
6
Although the Court is not bound by IRS Notice 89-25,
1989-1 C.B. 662, its methodology will be applied based on the
(continued...)
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Respondent determined that petitioner did not use a
reasonable rate of interest in calculating the amortizable growth
of his qualified plan accounts. Respondent also contends that,
even if the interest growth rate used was reasonable, the $82,000
distribution in one year impermissibly modified a series of
payments that were required to be substantially equal in order to
escape the additional tax.
The fixed amortization method utilized by petitioner
requires that a taxpayer use a reasonable rate of interest in
calculating a schedule of substantially equal payments.
Respondent argued that petitioner’s rate of interest of 29
percent was not reasonable because of three “fallacies”,
summarized as follows: Petitioner miscalculated the average
annual return of the seven funds,7 high short-term returns cannot
be sustained over a longer period, and past performance is not
predictive of future performance. Rejecting petitioner’s
methodology, respondent recalculated the average annual returns
of the seven funds used by petitioner. Respondent determined
6
(...continued)
agreement of the parties.
7
Respondent argued that, by taking the cumulative return
of each fund and dividing it by the relevant number of years to
arrive at an average annual return, petitioner ignored the
effects of compounding and overstated each fund’s rate of return.
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that the funds in question had an average rate of return of 23.01
percent rather than the 34.65 percent claimed by petitioner.
Petitioner admitted at trial to having made the
computational errors claimed by respondent in calculating the
average rates of return. However, he argued that he did not
intend for the money in his IRA accounts to remain invested in
those seven funds indefinitely. Rather, he intended to maintain
investments in funds that were performing to his satisfaction.
He stated: “I don’t leave the money in the same mutual fund all
the time. I move it to whoever is doing the best job at any
given time. Money is portable. So I can take it out of fund A
and put it in fund B.” He further explained: ”the idea is to
stay on top of the situation enough so you move your money to the
funds that are performing.” Petitioner also admitted that the
funds he selected in 1995 did not all continue to earn a rate of
return higher than 29 percent. However, he argued that such a
rate was still sustainable and gave current examples of high
performance funds. At trial, petitioner was invested in only one
of the original seven funds considered in calculating the
periodic withdrawal amount. He attributed this to having
followed the approach of moving money around when necessary to
maximize his rate of return to try to attain the growth-rate
percentage used in calculating the amount of allowable
distribution that could be made each year.
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The Court agrees with respondent that petitioner did not use
a reasonable growth rate in calculating the periodic
distributions. Neither party cited any case law directly on
point that would establish a means by which a reasonable growth
rate can be determined to calculate a series of substantially
equal periodic payments within the meaning of section
72(t)(2)(A)(iv). However, with reference to the fixed
amortization method, IRS Notice 89-25 cites one example that
assumes that an interest rate of 8 percent is reasonable for a
50-year old individual with a life expectancy of 33.1. The
record fails to persuade the Court that a 21-percent departure
from this example is reasonable. Petitioner’s age at the time of
the first distribution was approximately 52, and his life
expectancy was 30.4 years. These factors are comparable to the
example in IRS Notice 89-25. The interest rate petitioner used
differed significantly. In effect, his use of such a generous
growth rate would allow premature distributions in contravention
of the legislative purpose underlying the section 72(t) tax,
namely, to discourage premature distributions from IRA’s. Arnold
v. Commissioner, 111 T.C. 250, 255 (1998). Although petitioner
presented evidence to establish the basis upon which he arrived
at the chosen growth rate, that evidence fails to establish that
such a rate was “reasonable” within the intent and meaning of
section 72(t)(2)(A)(iv).
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Because petitioner’s interest rate was not reasonable, the
10-percent additional tax is due on the periodic distributions.
The Court finds it unnecessary to address respondent’s
alternative contention that the annual distributions to
petitioner were not equal.
Reviewed and adopted as the report of the Small Tax Case
Division.
Decision will be entered
for respondent.