Barr v. Comm'r

T.C. Memo. 2009-250

UNITED STATES TAX COURT

HARVEY S. AND WILLYCE BARR, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 8705-08. Filed November 3, 2009.

Harvey S. Barr, for petitioners.

Steven N. Balahtsis, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge: Respondent determined a $39,608 deficiency

in petitioners’ 2005 Federal income tax and a $7,922 accuracy-

related penalty under section 6662(a).1 After a concession by

1
Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code) in effect for the year in issue.
 - 2 -

petitioners,2 the issues for decision are: (1) Whether

petitioners recognize ordinary income or capital gain from the

surrender of a life insurance policy; and (2) whether petitioners

are liable for the section 6662(a) penalty. We hold that

petitioners’ gain is ordinary income. We hold further that

petitioners are liable for the accuracy-related penalty.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The first stipulation of facts, the second stipulation of facts,

and the attached exhibits are incorporated herein by this

reference. Petitioners resided in New York at the time they

filed their petition.

Harvey S. Barr (petitioner) has been an attorney since 1964

and currently is a partner at the law firm Barr, Post &

Associates PLLC. Petitioner specializes in complex commercial

transactions and bankruptcy law and is admitted to practice

before the U.S. Tax Court, several U.S. District Courts, the U.S.

Court of Appeals for the Second Circuit, and the Supreme Court of

the United States. Willyce Barr is petitioner’s wife.

2
Petitioners concede a $304.20 dividend from the life
insurance policy shown on Form 1099-DIV, Dividends and
Distributions, should be included in their gross income and
treated as ordinary income.
 - 3 -

Petitioner’s mother, Lillian Barr (Ms. Barr), is a retired

schoolteacher and currently resides in New York. She taught in

Arizona, where she lived from the mid-1960s until 2006.

In 1980 Ms. Barr wanted to purchase a life insurance policy

to help her children pay the anticipated estate tax liability

after her passing. Petitioner convinced Ms. Barr to meet and

discuss the issue with Jack Tilden of New England Mutual Life

Insurance Co. in New York (New England Mutual), with whom

petitioner shared office space. Ms. Barr agreed, and she and

petitioner met with Mr. Tilden.

On December 13, 1980, New England Mutual issued a life

insurance policy (the policy) insuring the life of Ms. Barr. The

policy was a whole life policy with a face amount of $200,000.

It was not an annuity. Petitioner and his sister, Susan Roe (Ms.

Roe), were coowners and beneficiaries of the policy. Under the

terms of the policy all communications including premium notices

were sent to petitioner’s Spring Valley, New York, address.

The annual premium due under the policy was $8,929. For the

first 8 or 9 years Ms. Barr indirectly paid the premiums by

gifting half of the amount to petitioner and half to Ms. Roe.

Petitioner and Ms. Roe then paid the premiums directly. No

additional payments were made by petitioner, Ms. Roe, or Ms. Barr

after the first 8 or 9 years. Thereafter, the policy borrowed

against itself to pay the premiums; i.e., premiums were
 - 4 -

automatically paid from dividend accumulations and loans against

the cash value of the policy (policy loans). Other than

automatic policy loans used to pay the premiums, no one ever

borrowed against the policy.

By 2005 the policy was held by New England Financial, a

Metropolitan Life Insurance Co. (MetLife) affiliate. On July 25,

2005, New England Financial sent a letter to petitioner

explaining the tax consequences of the policy along with a

statement of gain. The letter stated in pertinent part:

According to federal tax law, a policy contains taxable gain
to the extent that its cash value (including loaned cash
value) exceeds its Total Net Investment.

Generally, gain must be recognized as taxable income to the
extent any cash received or loan extinguished exceeds Total
Net Investment. * * * We are required to report any taxable
income to the Internal Revenue Service on Form 1099-R.

You may wish to consult with your tax advisor if you have
any doubt concerning the tax treatment of this contract.

New England Financial provided a second statement of gain to

petitioners dated September 13, 2005. According to the statement

of gain, the net investment in the policy at the time was

$225,390.14, the total cash value was $361,353.58, the total

indebtedness was $354,399.25, and the taxable gain was

$135,963.44.
 - 5 -

On October 10, 2005, New England Financial sent a letter to

petitioner notifying him that the policy was in overloan.3 In

order to continue the policy in force petitioner was required to

pay both the overloan amount, $1,541, and the premiums due at the

time, $2,286.38. The letter included the following language:

“Should you allow the Policy to terminate through failure to pay

the overloan amount, New England Financial is required by Federal

law to report any taxable gain to the Internal Revenue Service.”

Petitioner reviewed one or more of the letters received from

New England Financial in 2005 and discussed their contents with

Ms. Barr. They decided the policy was no longer necessary and

allowed it to terminate. Petitioner surrendered the policy

effective December 20, 2005. He was the sole owner and

beneficiary at the time.4

In 2005 petitioner received and cashed a check from MetLife

for $11,648.33 as well as a check for a $304.20 dividend. In

January 2006 petitioner received a Form 1099-R, Distributions

From Pensions, Annuities, Retirement or Profit-Sharing Plans,

IRAs, Insurance Contracts, etc., from MetLife showing a gross

3
The letter was mistakenly addressed to Harvey S. Roe
rather than Harvey S. Barr. We assume this was a clerical error
as the letter was also sent to the attention of petitioner’s
sister, Susan Roe.
4
At some point before termination Ms. Roe became ill and
transferred her ownership interest to petitioner. The exact date
petitioner became the sole owner is unknown.
 - 6 -

distribution and taxable amount of $135,963.44 for 2005.

Petitioner also received a Form 1099-DIV showing a $304.20

taxable dividend from the surrender of the policy.

Petitioners timely filed their joint Federal income tax

return for 2005. Petitioners did not include either the

$135,963.44 shown on Form 1099-R or the $304.20 shown on Form

1099-DIV in their gross income reported on their return.5

OPINION

Amount Included in Gross Income

Gross income includes all income from whatever source

derived, including income from life insurance contracts. Sec.

61(a)(10). Any amount received upon the surrender of a life

insurance contract which is not received as an annuity is

specifically included in gross income to the extent that it, when

added to amounts previously received under the contract and

excluded from gross income, exceeds the investment in the

contract.6 Sec. 72(e)(5)(A), (C); sec. 1.72-11(d)(1), Income Tax

Regs.

5
The income also was not reported on any other taxpayer’s
Federal income tax return.
6
This rule applies if sec. 72(e)(2)(A) does not apply.
Sec. 72(e)(2)(A) refers to amounts received on or after the
annuity starting date and thus does not apply under the facts of
this case. Sec. 72(e)(5) also supersedes the application of sec.
72(e)(2)(B) and (4)(A) to any amount received under the insurance
contract.
 - 7 -

When the policy terminated, petitioner received a net

distribution of $11,648.33. This amount represents the total

cash value, $361,353.58, plus a terminal dividend, $4,694, less

$354,399.25 which was withheld to repay the outstanding policy

loan balance. The satisfaction of the loans had the effect of a

pro tanto payment of the policy proceeds to petitioner and

constituted income to him at that time. See Atwood v.

Commissioner, T.C. Memo. 1999-61. Thus, petitioner

constructively received the policy’s cash value of $361,353.58

without reduction for outstanding loans upon surrender.

Petitioner’s net investment at the time of surrender was

$225,390.14. Accordingly, despite receiving a check for only

$11,648.33, petitioner is taxable under section 72(e) on the

$135,963.44 gross distribution MetLife reported to the IRS on

Form 1099-R. See id.; cf. Dean v. Commissioner, T.C. Memo. 1993-

226 (holding policy loan remaining unpaid when an annuity

contract is terminated constitutes taxable income at that time).

Character of Gain Recognized

To recognize a capital gain or loss, petitioner must have

engaged in a “sale or exchange” of a capital asset. Sec. 1222(1)

through (4); Nahey v. Commissioner, 111 T.C. 256, 262 (1998)

affd. 196 F.3d 866 (7th Cir. 1999). Though the Code does not

define what is a sale or exchange, the terms “sale” and

“exchange” are given their ordinary meaning. Helvering v.
 - 8 -

William Flaccus Oak Leather Co., 313 U.S. 247, 249 (1941).

Generally, the lapse, cancellation, surrender, or termination of

a contract does not equate to a sale or exchange.7 Wolff v.

Commissioner, 148 F.3d 186, 190 (2d Cir. 1998), revg. Estate of

Israel v. Commissioner, 108 T.C. 208 (1997).

The surrender of an insurance policy is not a “sale or

exchange” of a capital asset and thus does not result in capital

gain. See Hellman v. Commissioner, 33 B.T.A. 901, 902 (1936)

(holding the phrase ‘sale or exchange’ does not include the

surrender of a life insurance contract); see also Perkins v.

Commissioner, 41 B.T.A. 1225, 1228-1229 (1940), affd. 125 F.2d

150 (6th Cir. 1942); Chapin v. McGowan, 271 F.2d 856, 858 (2d

Cir. 1959); Blum v. Higgins, 150 F.2d 471, 474 (2d Cir. 1945);

First Natl. Bank of Kansas City v. Commissioner, 309 F.2d 587,

589 (8th Cir. 1962), affg. Estate of Katz v. Commissioner, T.C.

Memo. 1961-270; Gallun v. Commissioner, 327 F.2d 809 (7th Cir.

1964), affg. T.C. Memo. 1963-167; Avery v. Commissioner, 111 F.2d

19, 23 (9th Cir. 1940); Bodine v. Commissioner, 103 F.2d 982, 987

(3d Cir. 1939) (“it is entirely clear that the sums received by

7
Petitioners do not argue and we do not decide whether
sec. 1234A applies to these facts. That section applies to
property acquired or positions established after June 23, 1981.
Economic Recovery Tax Act of 1981, Pub. L. 97-34, sec. 508(a), 95
Stat. 333; see also Wolff v. Commissioner, 148 F.3d 186 (2d Cir.
1998), revg. Estate of Israel v. Commissioner, 108 T.C. 208
(1997). The policy was issued Dec. 13, 1980.
 - 9 -

the taxpayer from the insurance company were not received by

virtue of the sale or exchange of capital assets”).

Petitioners acknowledge the legal precedent; i.e., gain

recognized from the surrender of a life insurance policy receives

ordinary income treatment. Nevertheless, petitioners argue that

the facts here are so exceptional as to require capital gain

treatment. To support this position, petitioner cites

Commissioner v. Phillips, 275 F.2d 33, 36 n.3 (4th Cir. 1960),

revg. 30 T.C. 866 (1958), which states:

On reargument, counsel for the Commissioner conceded that
there may be exceptional circumstances requiring a
modification of this rule [ordinary income treatment]. For
example, if a policyholder had an amount receivable
thereunder which was in excess of his cost, but policyholder
was afflicted with a disease which would result in his death
in the near future, he could, if in need of cash, assign his
policy for an amount in excess of that receivable under the
policy and, as to such excess, treat the same as a capital
gain.

Petitioner did not assign his policy. Nothing about the policy

or the manner in which it was surrendered is exceptional.

Finally, petitioner argues that, despite the legal

precedent, “maybe it’s time for a change in the law.” We need

not decide the merits of this argument. It should be raised

before Congress, not the Tax Court.

The surrender of the life insurance policy did not

constitute the sale or exchange of a capital asset. Accordingly,

we find the resultant gain is ordinary income and sustain

respondent’s determination.
 - 10 -

Accuracy-Related Penalty

Section 7491(c) provides that the Commissioner bears the

burden of production with respect to the liability of any

individual for additions to tax and penalties. “The

Commissioner’s burden of production under section 7491(c) is to

produce evidence that it is appropriate to impose the relevant

penalty, addition to tax, or additional amount”. Swain v.

Commissioner, 118 T.C. 358, 363 (2002); see Higbee v.

Commissioner, 116 T.C. 438, 446 (2001). The Commissioner,

however, does not have the obligation to introduce evidence

regarding reasonable cause or substantial authority. Higbee v.

Commissioner, supra at 446-447. The taxpayer bears the burden of

proof with regard to those issues. Once the Commissioner has met

his burden of production, the taxpayer must come forward with

evidence sufficient to persuade a Court that the Commissioner’s

determination is incorrect. Id.

Pursuant to section 6662(a), a taxpayer may be liable for a

penalty of 20 percent on the portion of an underpayment of tax

(1) attributable to a substantial understatement of income tax8

or (2) due to negligence or disregard of rules or regulations.

See sec. 6662(b). A substantial understatement of income tax is

8
Understatement means the excess of the amount of the tax
required to be shown on the return over the amount of the tax
imposed which is shown on the return, reduced by any rebate.
Sec. 6662(d)(2)(A).
 - 11 -

defined as an understatement of tax that exceeds the greater of

10 percent of the tax required to be shown on the tax return or

$5,000. See sec. 6662(d)(1)(A). The understatement is reduced

to the extent that the taxpayer has (1) adequately disclosed his

or her position and has a reasonable basis for such position or

(2) has substantial authority for the tax treatment of the item.

See sec. 6662(d)(2)(B). In addition, section 6662(c) defines

“negligence” as any failure to make a reasonable attempt to

comply with the provisions of the Code, and “disregard” means any

careless, reckless, or intentional disregard. Negligence is

strongly indicated where a taxpayer fails to include on an income

tax return an amount of income shown on an information return, as

defined in section 6724(d)(1). Sec. 1.6662-3(b)(1)(i), Income

Tax Regs.

Whether otherwise applied because of a substantial

understatement of income tax or negligence or disregard of 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. Relevant factors include the taxpayer’s efforts to assess

his proper tax liability, including the taxpayer’s reasonable and
 - 12 -

good faith reliance on the advice of a professional such as an

accountant. See id. Further, an honest misunderstanding of fact

or law that is reasonable in light of the experience, knowledge,

and education of the taxpayer may indicate reasonable cause and

good faith. See Remy v. Commissioner, T.C. Memo. 1997-72.

For the 2005 tax year respondent determined that petitioners

are liable for an accuracy-related penalty attributable to a

substantial understatement of income tax or, in the alternative,

due to negligence or disregard of rules or regulations. With

regard to the substantial understatement of income tax,

respondent has met his burden of production under section

7491(c). The tax required to be shown on petitioners’ return is

$59,209. The deficiency (or understatement), $39,608, exceeds

the greater of 10 percent of the amount required to be shown,

$5,921, and $5,000. Petitioners did not offer any authority for

not reporting the income from the surrender of the policy on

their return. Consequently, we conclude that respondent has met

his burden of production for his determination of the

accuracy-related penalty based on substantial understatement of

income tax. Additionally, because petitioners failed to include

the amount of income shown on Form 1099-R on their return,

respondent has met his burden of production with regard to

negligence.
 - 13 -

Petitioners have failed to meet their burden of proving that

they acted with reasonable cause and in good faith. Despite

being the owner and beneficiary of the policy and receiving

numerous letters and statements informing him of the tax

consequences of the policy in general and upon surrender,

petitioner argues that he was unaware that the gain on the policy

upon surrender was taxable to him. He claims he immediately

forwarded all mail related to the policy, including Form 1099-R,

to Ms. Barr and that he has no recollection of ever seeing Form

1099-R. Petitioner testified that he believed Ms. Barr was

responsible for any tax obligations arising from the policy and

he was unaware that she had not taken care of her own tax

liability. These claims, to the extent they are relevant, do not

constitute reasonable cause.

Petitioner is an experienced attorney admitted to practice

before the Tax Court. Petitioner’s testimony that he called Ms.

Barr to discuss letters and statements he received in 2005 is

contradictory to his testimony that he automatically forwarded

all mail to Ms. Barr without opening it. He received a check for

$11,648.33, which he did not forward to Ms. Barr but deposited

into a bank account. Even if petitioner forwarded Form 1099-R to

his mother without viewing it, he is not excused. Negligence

does not require a bad intent or a willful act. Petitioner knew,

or should have known, that because he was the owner and
 - 14 -

beneficiary of the policy, any proceeds paid out or gain

recognized would be taxable to him. Petitioner’s failure to

report income shown on Form 1099-R was not on account of

reasonable cause and good faith.

We therefore sustain respondent’s determination that

petitioners are liable for the accuracy-related penalty on the

underpayment associated with petitioners’ failure to report

taxable income from the surrender of the policy discussed above.

Conclusion

Based on the foregoing, petitioners recognized $135,963.44

of ordinary income in 2005 from the surrender of a life insurance

policy. Petitioners also are liable for the accuracy-related

penalty.

In reaching all of 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

for respondent.