Mallory v. Comm'r

T.C. Memo. 2016-110

UNITED STATES TAX COURT

KENNETH L. MALLORY AND LARITA K. MALLORY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 14873-14. Filed June 6, 2016.

Joseph A. Flores, for petitioners.

G. Chad Barton, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

MORRISON, Judge: The respondent (referred to here as the “IRS”) issued

a notice of deficiency to the petitioners, Kenneth L. Mallory and Larita K.

Mallory, for the 2011 taxable year. In this notice, the IRS determined an income-

tax deficiency of $40,486, an addition to tax for failure to timely file under section
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[*2] 6651(a)(1) of $10,122, and an accuracy-related penalty under section 6662(a)

of $8,097.1

The Mallorys timely filed a petition under section 6213(a) for

redetermination of the deficiency, the addition to tax, and the penalty.2 We have

jurisdiction under section 6214(a).

At issue are:

(1) Whether Kenneth Mallory received a life insurance distribution of

$237,897.25, of which $150,397.25 was includable in the Mallorys’ gross

income for the 2011 taxable year. We hold that he did.

(2) Whether the Mallorys are liable for an addition to tax under section

6651(a)(1) for failure to timely file a return for the 2011 taxable year. We

hold that they are.

(3) Whether the Mallorys are liable for an accuracy-related penalty under

section 6662(a) and (b)(2) for an underpayment due to a substantial

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
The Mallorys resided in Oklahoma when they filed their petition.
Therefore, an appeal of our decision in this case would go to the U.S. Court of
Appeals for the Tenth Circuit unless the parties designate the Court of Appeals for
another circuit. See sec. 7482(b)(1) and (2).
 -3-

[*3] understatement of income tax for the 2011 taxable year. We hold that they

are.

FINDINGS OF FACT

On October 1, 1987, Kenneth Mallory purchased a modified single premium

variable life insurance policy with Monarch Life Insurance Company. He made a

single premium payment of $87,500. The policy named Kenneth Mallory as the

insured and as the policy’s owner, and it named Larita Mallory as the direct

beneficiary.

The policy provided that Kenneth Mallory, as the owner, could borrow from

Monarch Life and that the loans were secured by the policy. The policy provided

that interest accrued on the loans, that the interest was payable by Kenneth

Mallory annually, and that any unpaid interest would be added to the outstanding

loan amount (i.e., that the unpaid interest would be “capitalized”). The

outstanding loan amount (including capitalized interest) was defined as “policy

debt”. The policy provided that, if the policy debt ever exceeded the cash value of

the policy (defined as the premiums and earnings on premiums), Monarch Life

would terminate the policy after giving Kenneth Mallory notice of the pending

termination and an opportunity to pay down the policy debt to avoid termination.
 -4-

[*4] Kenneth Mallory signed a form authorizing Monarch Life to accept

telephone requests for policy loans. From June 1991 through December 2001,

Kenneth Mallory took out numerous loans against the policy in amounts ranging

from $1,000 to $12,000. These loans are listed below:

Loan date Amount

June 11, 1991 $3,000
Dec. 23, 1991 5,000
June 5, 1992 1,000
June 15, 1992 2,300
Dec. 21, 1992 5,000
Nov. 1, 1994 5,000
Dec. 8, 1994 3,000
Feb. 6, 1995 4,000
Dec. 27, 1996 3,500
Sept. 10, 1998 10,000
Sept. 30, 1999 8,000
Mar. 13, 2000 6,000
May 17, 2000 11,000
June 27, 2000 5,000
Aug. 7, 2000 5,000
Oct. 30, 2000 10,000
Dec. 22, 2000 5,000
Feb. 8, 2001 10,000
May 8, 2001 3,000
June 6, 2001 8,000
July 16, 2001 2,500
Aug. 6, 2001 12,000
Sept. 27, 2001 2,000
Oct. 30, 2001 2,500
Dec. 12, 2001 2,000
Total (without interest) 133,800
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[*5] Monarch Life regularly issued Kenneth Mallory several types of statements

relating to the policy and the loans, including: (1) loan activity confirmations for

each loan when the loan was made, (2) yearly notices requesting payment of

interest and notifying Kenneth Mallory that any unpaid interest would be

capitalized, and (3) quarterly reports of the policy debt and the cash value of the

policy. The Mallorys received these statements.

As indicated in the statements, the cash value of the policy increased

substantially. This increase was due to earnings on the investment of the initial

premium. However, the policy debt also grew as Kenneth Mallory took out loans

from Monarch Life against the policy without repaying the loans or paying the

interest on those loans.

On October 17, 2011, Monarch Life sent Kenneth Mallory a letter informing

him that the policy debt had exceeded the cash value. The letter also informed

him that to avoid termination of the policy he had to make a minimum payment of

$26,061.67 by December 17, 2011. The letter further explained that termination

of the policy would result in a taxable event and that Monarch Life would report

any taxable gain to Kenneth Mallory and the IRS on a Form 1099-R,

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

IRAs, Insurance Contracts, etc.”. The letter noted that, as of October 17, 2011, the
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[*6] taxable gain was $155,119.16. The Mallorys received this letter, but Kenneth

Mallory did not make the required payment, and Monarch Life terminated the

policy on December 17, 2011.

Monarch Life issued Kenneth Mallory a Form 1099-R for 2011 showing a

gross distribution of $237,897.25, insurance premiums of $87,500, and a taxable

amount of $150,397.25. The Mallorys received the Form 1099-R before the April

15, 2012 filing deadline.

Before filing their 2011 income-tax return, Larita Mallory spoke with Steve

Miller of Liberty Tax Services about the income that Monarch Life had reported

on the Form 1099-R. Miller told Larita Mallory that she “was going to owe a

bunch of money”. Miller prepared the Mallorys’ 2011 Form 1040, “U.S.

Individual Income Tax Return”. The Mallorys did not file their 2011 Form 1040

until around March 8, 2013. The Mallorys did not report income from the Form

1099-R on their 2011 Form 1040. They did, however, attach to their income-tax

return the Form 1099-R and a handwritten note that said:

Paid hundreds of $. No one knows how to compute this using the
1099R from Monarch--IRS could not help when called--Pls send me a
corrected 1040 explanation + how much is owed. Thank you

Larita Mallory’s testimony clarifies the meaning of the note attached to the return.

She testified that before the Mallorys filed their return, she telephoned several
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[*7] persons other than Miller to ascertain whether the Form 1099-R was correct.

The persons she telephoned consisted of two groups: (1) people who advertised

themselves in the telephone directory as tax professionals (and whom she did not

pay, unlike Miller) and (2) various IRS personnel. None of the persons she

contacted was willing to confirm whether the Form 1099-R was correct.

OPINION

1. The IRS correctly determined that Kenneth Mallory received a life
insurance distribution of $237,897.25, of which $150,397.25 was includable
in the Mallorys’ gross income for the 2011 taxable year.

The IRS argues that the termination of the policy in 2011 resulted in the

extinguishment of Kenneth Mallory’s $237,897.25 policy debt, that this

extinguishment was a $237,897.25 constructive distribution to him, and that

$150,397.25 (the amount by which the constructive distribution exceeded his

investment in the life insurance contract) is includable in the Mallorys’ gross

income for the 2011 taxable year.

The Mallorys deny that they had any policy debt. They contend that the

amounts Kenneth Mallory received from 1991 to 2001 were distributions of the

cash value of the policy that he did not have to pay back. Because there was no

policy debt to extinguish (in their view) and because Kenneth Mallory did not

physically receive any payments from Monarch Life in 2011, the Mallorys contend
 -8-

[*8] they had no income from Monarch for 2011. In the alternative the Mallorys

argue that, if the termination of the policy did give rise to income, they may claim

interest deductions.

The burden of proof rests on the Mallorys. See Rule 142(a) (burden of

proof generally rests on the taxpayer). They have not contended that the

conditions set forth in section 7491(a) (shifting the burden of proof to the IRS)

have been satisfied. Nor does the record show that the conditions have been

satisfied.

The evidence shows that the $133,800 transferred from Monarch Life to

Kenneth Mallory from 1991 to 2001 was policy loans, that, when combined with

accrued interest, eventually resulted in a policy debt of $237,897.25. The policy’s

underlying terms allowed Kenneth Mallory to borrow against the cash value of the

policy and provided that these policy loans would result in the accrual of interest.

The policy loans were bona fide debt. See Minnis v. Commissioner, 71 T.C. 1049,

1054 (1979). Kenneth Mallory signed a form authorizing Monarch Life to accept

telephone requests for policy loans. Whenever Monarch Life made a transfer to

Kenneth Mallory, it sent him a loan activity confirmation. It sent him yearly

notices requesting payment of interest and notifying him that any unpaid interest

would be capitalized. It sent him quarterly reports of the policy debt and the cash
 -9-

[*9] value of the policy. The Mallorys admit that they received these

confirmations and notices, all of which unambiguously refer to the amounts

transferred by Monarch Life to Kenneth Mallory from 1991 to 2001 as loans and

not distributions.

As the proceeds of loans, the amounts that Kenneth Mallory received from

1991 to 2001 were not includable in the Mallorys’ income for those years. See

Commissioner v. Tufts, 461 U.S. 300, 307 (1983). In 2011, when Kenneth

Mallory’s policy terminated, his policy debt--including capitalized interest--was

extinguished. This extinguishment of his policy debt had the effect of a

constructive distribution of the cash value in the policy to Kenneth Mallory. See

Atwood v. Commissioner, T.C. Memo. 1999-61, slip op. at 5.

We now turn to the tax treatment of the $237,897.25 constructive

distribution. Any amounts received under a life insurance contract that were paid

because of the death of the insured are excludable from the gross income of the

recipient; that is, they are not taxable. Sec. 101(a)(1). The tax treatment of

amounts received under a life insurance contract before the death of the insured is

found in section 72. Section 72(e)(5) governs nonannuity amounts received. Sec.

72(e)(5)(C). The $237,897.25 was received before Kenneth Mallory’s death, and

therefore section 72 governs its tax treatment. Because the amount was not
 -10-

[*10] received as an annuity, section 72(e)(5) governs its tax treatment. Section

72(e)(5)(A) provides that (with certain exceptions not applicable here) an amount

received under a life insurance contract is “included in gross income, but only to

the extent it exceeds the investment in the contract.” Therefore, the $237,897.25

is includable in gross income to the extent it exceeds the investment in the

contract.

Investment in the contract is (i) the total premiums or other consideration

paid minus (ii) the total amount received under the contract that was excludable

from gross income. Sec. 72(e)(6). At the time that the policy was terminated,

Kenneth Mallory’s investment in the contract was $87,500 (i.e., his single

premium payment). That portion of the constructive distribution was nontaxable.

See sec. 72(e)(5)(A). But the balance of the constructive distribution, or

$150,397.25, constitutes gross income (i.e., $237,897.25 ! $87,500 =

$150,397.25). Therefore, we hold that the Mallorys must include the $150,397.25

in their gross income.3 See Brown v. Commissioner, 693 F.3d 765 (7th Cir. 2012),

aff’g T.C. Memo. 2011-83.

3
Under sec. 1.6013-4(b), Income Tax Regs., if a joint return is made, the
gross income of the spouses on the joint return is computed in the aggregate. The
Mallorys eventually filed a joint income return for 2011. For 2011 their aggregate
gross income must include the taxable portion of the constructive distribution from
Monarch Life to Kenneth Mallory.
 -11-

[*11] The Mallorys argue in the alternative that, if the termination of the life

insurance policy gave rise to income, then “[d]eductions of paid interest and other

losses would be available” and lower their taxable income. This argument is

untimely raised and without merit.

When Kenneth Mallory’s life insurance policy was terminated in 2011, the

cash value of the policy was used to extinguish his policy debt. This policy debt

included accrued interest. The Mallorys contend that there should be a deduction

for their payment of interest. The Mallorys did not raise the issue of an interest

deduction in their petition. Any issues not raised in the petition are deemed

conceded. Rule 34(b)(4). Therefore, the issue of deductibility of interest is

deemed conceded and we need not address this issue.

Moreover, even if the Mallorys had properly raised the issue of deductibility

of interest, they would still not be entitled to a deduction. Section 163(a)

generally allows a deduction of all interest paid or accrued during the taxable year.

As an exception to this general rule, however, in the case of a taxpayer other than

a corporation, section 163(h) generally disallows any deduction for “personal

interest”, defined to include any interest expense that does not fall within one of

the five categories listed in section 163(h)(2). These categories are: (1) trade or

business interest; (2) investment interest; (3) interest used to compute passive
 -12-

[*12] income or loss; (4) qualified residence interest; and (5) interest payable on

certain deferred estate tax payments. Sec. 163(h)(2)(A)-(E). The Mallorys

presented no evidence to show that the interest expenses would fall within any of

these five enumerated categories. To the contrary, Kenneth Mallory testified that

the loans were taken out to cover short-term financial needs, and the record does

not indicate that these needs were anything other than living expenses. The

Mallorys have not shown that the interest they paid to Monarch Life was not

personal interest. Any interest paid on their life insurance loans is not deductible.

See sec. 163(h); Atwood v. Commissioner, slip op. at 8-9.

2. The Mallorys are liable for an addition to tax under section 6651(a)(1) for
failure to timely file a return for the 2011 taxable year.

The IRS determined that the Mallorys are liable for the section 6651(a)(1)

addition to tax for the 2011 taxable year. Section 6651(a)(1) imposes an addition

to tax for failure to file a tax return by its filing deadline (determined by taking

into account any extensions of that deadline) unless the taxpayer can establish that

the failure to file is due to reasonable cause and not due to willful neglect. The

section 6651(a)(1) addition to tax is 5% of the amount required to be shown as tax

on the return for each month the failure to file continues, not to exceed 25% in the

aggregate. Sec. 6651(a)(1) and (b)(1).
 -13-

[*13] The IRS bears the burden of production for additions to tax determined

under section 6651(a)(1). See sec. 7491(c); Higbee v. Commissioner, 116 T.C.

438, 446-447 (2001). The IRS satisfies its burden of production for the section

6651(a)(1) addition to tax by producing sufficient evidence to establish that the

taxpayer failed to timely file a required federal-income-tax return. See Wheeler v.

Commissioner, 127 T.C. 200, 207-208 (2006), aff’d, 521 F.3d 1289 (10th Cir.

2008); Higbee v. Commissioner, 116 T.C. at 447.

The Mallorys’ return for 2011 was due on April 15, 2012. See sec. 6072(a).

They did not request an extension of time to file the return. The IRS received the

Mallorys’ tax return on March 8, 2013, nearly a year after the filing deadline.

These facts are sufficient to satisfy the IRS’s burden of producing evidence that

imposing the addition to tax under section 6651(a)(1) is appropriate for the 2011

taxable year. See, e.g., Wheeler v. Commissioner, 127 T.C. at 207-208.

Once the IRS satisfies its burden of production, the burden of proof is on

the taxpayer to show that the failure to file was due to reasonable cause and not to

willful neglect. See Higbee v. Commissioner, 116 T.C. at 447. The Mallorys are

liable for the section 6651(a)(1) addition to tax for the 2011 taxable year unless

there is sufficient evidence to persuade the Court that they had reasonable cause

for their failure and that their failure to file their 2011 returns was not due to
 -14-

[*14] willful negligence. See sec. 6651(a)(1); Higbee v. Commissioner, 116 T.C.

at 447. Reasonable cause excusing a failure to timely file exists if the taxpayer

exercised ordinary business care and prudence but nevertheless was unable to file

the return by the deadline. See sec. 301.6651-1(c)(1), Proced. & Admin. Regs.

Willful neglect means a conscious, intentional failure or reckless indifference.

United States v. Boyle, 469 U.S. 241, 245 (1985).

The Mallorys did not address the addition to tax for their failure to timely

file a return for the 2011 taxable year at trial or in their opening brief. Issues that

are not addressed in the opening brief are deemed conceded. See Rule 151(e)(4)

and (5); Petzoldt v. Commissioner, 92 T.C. 661, 683 (1989); Money v.

Commissioner, 89 T.C. 46, 48 (1987). It is only in their answering brief (a brief to

which the IRS has had no opportunity to respond) that the Mallorys finally explain

their view as to why the addition to tax for failure to timely file should not be

imposed. They contend that the addition to tax should not be imposed because an

accountant (Miller) prepared the return they filed. The Mallorys do not explain

why the fact that an accountant prepared the return is reasonable cause for their

late filing of the return. Thus, their argument would be unpersuasive even if

timely made.
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[*15] Accordingly, we hold that the Mallorys are liable for the addition to tax

under section 6651(a)(1).

3. The Mallorys are liable for an accuracy-related penalty under section
6662(a) and (b)(2) for an underpayment due to a substantial understatement
of income tax for the 2011 taxable year.

Section 6662(a) imposes a 20% “accuracy-related penalty” on an

underpayment of tax attributable to any of the causes listed in section 6662(b).

These causes include “[a]ny substantial understatement of income tax.” Sec.

6662(b)(2). An understatement is defined as the excess of the correct amount of

tax over the amount of the tax which is shown on the return. Sec. 6662(d)(2)(A).

For an understatement to be substantial it must exceed 10% of the tax required to

be shown on the return. Sec. 6662(d)(1). It also must exceed $5,000. Id. Section

6662(d)(2)(B)(ii) provides that the amount of the understatement is to be reduced

by that portion of the understatement which is attributable to any item if the

relevant facts affecting the item’s tax treatment are adequately disclosed on the

return or in a statement attached to the return and there is a reasonable basis for

the tax treatment of such item by the taxpayer. Section 1.6662-3(b)(3), Income

Tax Regs., provides that the reasonable basis standard is a relatively high standard

that is significantly higher than not frivolous. Id. sec. 1.6662-4(e)(2)(i). A return

position that is merely arguable does not satisfy the reasonable basis standard. Id.
 -16-

[*16] sec. 1.6662-3(b)(3). A position generally has a reasonable basis if the

position is reasonably based on one or more authorities listed in section 1.6662-

4(d)(3)(iii), Income Tax Regs., which includes the Internal Revenue Code,

temporary and final regulations, revenue procedures and revenue rulings, and

court decisions. Sec. 1.6662-4(e)(2)(i), Income Tax Regs.; id. sec. 1.6662-3(b)(3).

The penalty under section 6662(a) does not apply if the taxpayer can

demonstrate that he or she: (1) had reasonable cause for the underpayment and (2)

acted in good faith with respect to the underpayment. Sec. 6664(c)(1). The

regulations provide that reasonable cause and good faith are determined on a case-

by-case basis, taking into account all pertinent facts and circumstances. Sec.

1.6664-4(b)(1), Income Tax Regs. The most important factor is the extent of the

taxpayer’s effort to assess his or her proper tax liability. Id.

With respect to any penalty imposed on an individual under title 26, section

7491(c) imposes the burden of production on the IRS. This requires the IRS to

come forward with evidence indicating that it is appropriate to impose the relevant

penalty. Sec. 7491(c); Higbee v. Commissioner, 116 T.C. at 446. Once the IRS

has met this burden, the taxpayer bears the burden of proving that the penalty is

inappropriate because the taxpayer had reasonable cause for the underpayment and

acted in good faith with respect to the underpayment or because the amount of the
 -17-

[*17] understatement should be reduced because of adequate disclosure. Higbee

v. Commissioner, 116 T.C. at 447.

In the notice of deficiency the IRS determined that the Mallorys were liable

for an accuracy-related penalty under section 6662(a) of $8,097 for 2011. The IRS

contends that the Mallorys’ underpayment of tax is attributable to a substantial

understatement of income tax. The Mallorys’ understatement of income tax is

$40,486. This $40,486 understatement exceeds 10% of the tax required to be

shown on their return. See sec. 6662(d)(1). The tax required to be shown on the

Mallorys’ return was $50,405 which, multiplied by 10%, is $5,041, which exceeds

$5,000. Therefore, the Mallorys’ understatement of income tax was substantial.

The Mallorys attached a copy of the Form 1099-R to their return and

referred to the Form 1099-R in a handwritten note they attached to their return.

The note said:

Paid hundreds of $. No one knows how to compute this using the
1099R from Monarch--IRS could not help when called--Pls send me a
corrected 1040 explanation + how much is owed. Thank you

The Mallorys did not argue that the exception for disclosure and reasonable basis

given by section 6662(d)(2)(B)(ii) applies to this case. But if they had, we would

still find the exception inapplicable because the Mallorys’ failure to report income

from Monarch Life is not supported by reasonable basis. See sec. 1.6662-3(b)(3),
 -18-

[*18] Income Tax Regs. The Mallorys neither based their position on any of the

authorities listed in section 1.6662-4(d)(3)(iii), Income Tax Regs., nor had any

other reasonable basis for their understatement of income tax. We offer no view

as to whether the handwritten note was an adequate disclosure of the relevant

facts.

The Mallorys assert a defense to the section 6662(a) penalty based on

reasonable cause and good faith. However, we are not convinced that the

Mallorys did enough to determine their proper tax liability. The Mallorys received

the letter from Monarch Life informing them that the policy debt on Kenneth

Mallory’s variable life insurance policy had exceeded its cash value, that the

termination of the policy would result in a taxable event, and that any taxable gain

in the policy would be reported to Kenneth Mallory and the IRS on a Form 1099-

R. The Mallorys received the Form 1099-R from Monarch Life before the April

15, 2012 filing deadline. The only tax adviser that they paid, Miller, suggested

there would be a tax liability. Although various IRS employees and unpaid tax

professionals declined to confirm whether the Monarch Life Form 1099-R was

correct, it was unreasonable for the Mallorys to conclude from this unwillingness

that they had no income from Monarch Life. We hold that the Mallorys did not
 -19-

[*19] have reasonable cause for, and did not act in good faith with respect to, the

position on their tax return for the year 2011.

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

In reaching our holdings, we considered all arguments made, and, to the

extent not mentioned, we conclude that they are moot, irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered for

respondent.