1996 U.S. Tax Ct. LEXIS 31">*31 Decision will be entered for respondent.
P created a voluntary employees' beneficiary association (VEBA) trust designed to fund P's future holiday pay obligations to its employees. On or about Dec. 27, 1985, P contributed $ 20 million to the VEBA. This $ 20 million contribution significantly exceeded the amount of P's average annual holiday pay obligation, which was approximately $ 2 million. P deducted the entire $ 20 million contribution as an ordinary and necessary business expense on its 1985 Federal income tax return.
Held: P's $ 20 million contribution to the VEBA in 1985 provided P with substantial future benefits. P is therefore not entitled to deduct its $ 20 million contribution in 1985.
106 T.C. 445">*446 RUWE, Judge: Respondent determined a deficiency of $ 7,372,712 in petitioner's 1985 Federal income tax. The sole issue for decision is whether petitioner is entitled to a 1985 deduction for its $ 20 million contribution to a voluntary employees' beneficiary 1996 U.S. Tax Ct. LEXIS 31">*32 association (VEBA) trust. In order to prevail, petitioner must establish that the $ 20 million contribution was an ordinary and necessary business expense under section 162(a). 1
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts is incorporated herein by this reference. At the time its petition was filed, petitioner maintained its principal office in Hartford, Connecticut.
During all relevant periods, petitioner was a mutual life insurance corporation subject to tax under the provisions of sections 801-818. Petitioner filed its Federal income tax returns on a calendar year basis using the accrual method of accounting.
During 1984, two of petitioner's officers -- Richard Bush 2 and Robert Chamberlain 3 -- initiated discussions regarding VEBA's. These discussions began1996 U.S. Tax Ct. LEXIS 31">*33 with an analysis of the benefits of using VEBA's to fund employee welfare benefits and eventually led to a recommendation that a VEBA be created.
VEBA IOn December 28, 1984, petitioner established a VEBA trust entitled the "Connecticut Mutual Life Insurance Company Voluntary Employee Beneficiary Trust". This VEBA trust (VEBA I) was established to fund the cost of certain medical and group life insurance benefits. Petitioner's $ 7,293,225 contribution to VEBA I funded benefits for 1 year. Petitioner106 T.C. 445">*447 claimed a Federal income tax deduction for the entire contribution on its 1984 income tax return.
VEBA IISince its incorporation in 1846, petitioner has provided its employees with annual fixed paid holidays. Petitioner1996 U.S. Tax Ct. LEXIS 31">*34 has never failed to pay any employee for a fixed holiday when the employee was entitled to holiday pay under petitioner's employment policies.
Petitioner believed that the use of a VEBA to fund its holiday pay obligations would produce tax savings and allow petitioner to provide employee benefits more efficiently. In particular, petitioner anticipated that tax savings would result from the income tax benefit to be gained from an up-front deduction for the entire contribution to the VEBA, the reduction of surplus tax, 41996 U.S. Tax Ct. LEXIS 31">*35 and the income tax saved because the VEBA's investment earnings would be tax exempt pursuant to section 501(c)(9). 5 Assuming that petitioner was allowed a complete deduction in 1985, and that the VEBA was not liquidated until 1998, Mr. Bush estimated that the present value of petitioner's tax savings on December 27, 1985, was $ 5,455,000.
106 T.C. 445">*448 On December 24, 1985, petitioner established the Connecticut Mutual Life Insurance Company Holiday Pay Plan 6 (holiday pay plan), and on December 27, 1985, petitioner established the Connecticut Mutual Life Insurance Company Employee Welfare Benefit Trust (referred to herein as VEBA II or VEBA II trust). Petitioner created the trust as a funding medium1996 U.S. Tax Ct. LEXIS 31">*36 for its holiday pay plan. On or about December 27, 1985, petitioner contributed $ 20 million to the trust and deducted the entire contribution on its 1985 Federal income tax return as an ordinary and necessary business expense.
The holiday pay plan and the VEBA II trust essentially provided for the following:
(1) Membership in the holiday pay plan consisted of petitioner's employees, with minor exceptions that are not relevant to our decision.
(2) Members would receive holiday pay benefits for 8 fixed holidays 7 designated by petitioner for each plan year, commencing with the Memorial Day holiday on May 26, 1986. However, if petitioner altered the number of fixed holidays designated for a particular plan year, the plan would only provide holiday pay benefits for the number of holidays then so designated by petitioner.
1996 U.S. Tax Ct. LEXIS 31">*37 (3) The trustees of VEBA II were to hold, invest, and distribute the trust fund in accordance with the terms in the trust agreement. Petitioner was to make an initial contribution to the trust in 1985, and such additional contributions in subsequent plan years as petitioner deemed appropriate, to pay for plan benefits and administrative expenses on a continuing basis. In the event there was an excessive accumulation of fund earnings in a particular plan year after payment of plan benefits and administrative expenses for that plan year, and the accumulation of fund earnings attributable to that plan year was not used to pay plan benefits or administrative expenses in the immediately succeeding plan year, then petitioner would direct the trustees to use these accumulated earnings to pay for other types of permissible benefits under section 501(c)(9) within a reasonable amount of time thereafter.
106 T.C. 445">*449 (4) It was not permissible for any part of the trust fund to be diverted to purposes other than the benefit of the members as provided under the plan or for payment of administrative expenses of the trust fund.
(5) The trustees were to invest the assets of the trust fund as a single fund, without1996 U.S. Tax Ct. LEXIS 31">*38 distinction between principal and income, in common stocks, preferred stocks, bonds, notes, debentures, savings bank deposits, commercial paper, mutual funds, and in such other property as the trustees deemed suitable for the trust fund.
(6) Petitioner was entitled to amend or terminate the plan and the trust agreement at any time. Under no circumstances, however, could any assets of the fund revert to petitioner unless the contribution was made due to mistake of fact and returned within 1 year after such mistake became known.
(7) Upon termination of the plan, the trustees were to apply all the remaining income and assets of the trust fund in a uniform and nondiscriminatory manner toward the provision of plan benefits or other life, sickness, accident, or similar benefits permissible under section 501(c)(9).
The trust agreement named the following officers of petitioner as trustees: Robert W. Rulevich, vice president; Robert E. Casey, senior vice president, and Walter J. Gorski, senior vice president and general counsel.
The Operation and Administration of VEBA IIPetitioner's employee population during the period 1985 through 1994 was as follows:
| Year | Employee Population |
| 1985 | 2,069 |
| 1986 | 2,165 |
| 1987 | 2,244 |
| 1988 | 2,118 |
| 1989 | 2,160 |
| 1990 | 2,082 |
| 1991 | 2,150 |
| 1992 | 2,076 |
| 1993 | 2,177 |
| 1994 | 1,765 |
1996 U.S. Tax Ct. LEXIS 31">*39 106 T.C. 445">*450 The number of petitioner's employees eligible to receive benefits and whose holiday pay was funded pursuant to the holiday pay plan during 1986 and subsequent years was as follows:
| Year | Employees |
| 1986 | 2,106 |
| 1987 | 2,186 |
| 1988 | 2,012 |
| 1989 | 1,876 |
| 1990 | 1,728 |
| 1991 | 1,746 |
| 1992 | 1,664 |
| 1993 | 1,813 |
| 1994 | 1,645 |
The assets in VEBA II consisted of cash, State and municipal securities, and shares of a regulated investment company. These assets were held in custodial accounts. The amounts of investment earnings produced by the principal in the VEBA II trust were as follows:
| Year | Dividends and Interest |
| 1986 | $ 1,642,171 |
| 1987 | 1,643,649 |
| 1988 | 1,649,955 |
| 1989 | 1,650,062 |
| 1990 | 1,641,441 |
| 1991 | 1,637,590 |
| 1992 | 1,633,604 |
| 1993 (per Form 990) | 1,605,327 |
| (per Form 5500) | 1,591,961 |
| 1994 | 1,536,469 |
Petitioner paid holiday pay directly to its employees who were covered by VEBA II. The amounts of holiday pay benefits for fixed holidays paid to employees covered by the holiday pay plan were as follows:
| Year | Holiday Pay Plan Benefits Paid |
| 1986 | $ 1,523,997 |
| 1987 | 1,896,719 |
| 1988 | 1,800,515 |
| 1989 | 2,041,601 |
| 1990 | 2,101,084 |
| 1991 | 2,150,267 |
| 1992 | 2,209,211 |
| 1993 | 2,287,228 |
| 1994 | 1,768,692 |
1996 U.S. Tax Ct. LEXIS 31">*40 106 T.C. 445">*451 The investment earnings of the VEBA II trust were distributed from the trust to petitioner to reimburse petitioner for the amounts of holiday pay it paid to employees. No portion of the $ 20 million principal in the VEBA II trust has been distributed. After 1986, the investment earnings from VEBA II were insufficient to reimburse petitioner completely for its holiday pay obligations. During the years 1987 through 1994, the difference between petitioner's fixed holiday pay obligations covered by VEBA II and the investment earnings from VEBA II was supplied from the following sources:
| Petitioner's Holiday | ||
| Payments for which it | Transfers from | |
| Year | Received no Reimbursement | VEBA I or III |
| 1987 | $ 214,948 | |
| 1988 | 150,845 | |
| 1989 | 391,426 | |
| 1990 | $ 459,140 | |
| 1991 | 547,128 | |
| 1992 | 550,869 | 2,100 |
| 1993 | 626,750 | |
| 1994 | 161,275 |
On petitioner's annual statement filed with the State of Connecticut Insurance Department for 1985, petitioner treated the $ 20 million contribution to VEBA II as an expense and charged the contribution directly to its capital and surplus account. In 1992, petitioner sought and received approval from the State Insurance Department to report the $ 20 million 1996 U.S. Tax Ct. LEXIS 31">*41 principal in VEBA II as an asset. Thereafter, petitioner reported the VEBA II trust as an admitted asset on its annual statements. The change in petitioner's annual statement reporting resulted from its desire to change to an accounting106 T.C. 445">*452 practice similar to that adopted in the Statement of Financial Accounting Standards No. 87.
VEBA IIISubsequent to the establishment of the holiday pay plan and the VEBA II trust, petitioner established a third VEBA trust (VEBA III) in order to fund its wellness program and health services plans. Petitioner contributed $ 10 million to VEBA III in 1986 but claimed no Federal income tax deduction in the year of contribution. 81996 U.S. Tax Ct. LEXIS 31">*42 In 1991 and 1992, petitioner liquidated VEBA III because of expense problems and capital and surplus management considerations. Petitioner used the funds from VEBA III to pay employee benefits other than those provided under the wellness and health services plans. 9 Over $ 1 million, for instance, was used to fund vacation pay for petitioner's employees. By using the assets of VEBA III to pay employee benefit expenses, petitioner's expenses for the year were reduced, and petitioner was able to maintain surplus growth.
OPINION
The issue for decision is whether petitioner is entitled to a section 162(a) deduction for its $ 20 million contribution to the voluntary employees' beneficiary association (VEBA II) trust established to provide holiday pay to its employees.
Section 162(a) allows a deduction for all ordinary and necessary business expenses paid or incurred during the taxable year. With respect to deductions for employee benefits,
Amounts paid or accrued within the taxable year for dismissal wages, unemployment benefits, guaranteed annual wages, vacations, or a sickness, accident, hospitalization, medical expense, recreational, welfare, or similar benefit plan, are deductible under section 162(a) if they are ordinary and necessary expenses of the trade or business. * * * [Emphasis added.]
In order to qualify for deduction under section 162(a), five requirements must be satisfied. The item must: (1) Be paid or incurred during the taxable year; (2) be for 1996 U.S. Tax Ct. LEXIS 31">*43 carrying on a trade or business; (3) be an expense; (4) be a "necessary" 106 T.C. 445">*453 expense; and (5) be an "ordinary" expense.
The principal effect of characterizing a payment as either a business expense or a capital expenditure concerns the timing of the taxpayer's cost recovery. A business expense is currently deductible, while a capital expenditure is normally amortized and depreciated over the life of the relevant asset, or, if no specific asset or useful life can be ascertained, is deductible upon dissolution of the enterprise.
The Supreme Court's1996 U.S. Tax Ct. LEXIS 31">*44 decision in
Petitioner has provided its employees with fixed paid holidays for the past 150 years. This holiday pay was a quid pro quo for the employees' services. Petitioner's employees were paid for a designated holiday only if they were employed by petitioner on the working days immediately preceding and following the holiday.
Through its contribution to the VEBA II trust, petitioner effectively prefunded a substantial portion of its anticipated holiday pay obligations for many years to come. Petitioner's own expert witness, Stanley B. Rossman, opined that petitioner's $ 20 million contribution in 1985 was sufficient to pay holiday pay benefits for 8 to 10 years. Mr. Rossman assumed that both income and principal 1996 U.S. Tax Ct. LEXIS 31">*46 from VEBA II would be used to fund the full amount of petitioner's annual holiday pay obligations. We believe this is a very conservative estimate considering the fact that average annual holiday pay covered by the plan for the years 1986 through 1994 was approximately $ 2 million. At that rate, the $ 20 million fund would last for 10 years even if it generated no investment income. In fact, investment earnings from VEBA II have covered over 80 percent of petitioner's holiday pay obligations between 1986 and 1994. 10
Petitioner, nevertheless, argues that its contribution should be deductible because it is the employees, rather than petitioner, 1996 U.S. Tax Ct. LEXIS 31">*47 who benefited from the creation of the VEBA and that any future benefit to petitioner was merely incidental. In support of its position, petitioner relies on two prior decisions of this Court in which we permitted employers to deduct VEBA contributions pursuant to section 162(a).
In
In addition, we determined that the Strothmans did not possess "total unfettered control" over the VEBA's assets, despite the fact that the Strothmans, via their controlling interest in the employer-corporation, could effect amendments1996 U.S. Tax Ct. LEXIS 31">*48 or termination of the VEBA. We explained:
"We realize the [employer] could at any time terminate or alter the plan although the monies of the trust could never revert to or inure to the [employer's] benefit. This minimal retention of control is not sufficient to make the benefits of the plan in any way illusory. Employers need to retain rights to alter or terminate plans to meet the changing needs of the employees and employer. This flexibility may be required with numerous types of plans including the medical, vacation and other welfare benefit plans specified by regulation." * * * [
Finally, in
In
At the outset, this Court explained that "We have traditionally analyzed the deductibility of an employer's contributions to a welfare benefit plan by taking into consideration, among other things, both the degree of control which an employer retains over the plan and the degree to which the employees, as opposed to the employer, are benefited."
if an expenditure results in a substantial benefit to the taxpayer, as distinguished from an incidental benefit, which can be expected to produce returns to the taxpayer for a period of time in the future, then the expenditure is deemed capital and cannot be currently deducted. See
1996 U.S. Tax Ct. LEXIS 31">*52 106 T.C. 445">*457 Applying these principles to the facts in
Second, we found that the employer's contributions to these plans directly benefited its employees and that any future benefit that the employer would derive from its contributions was based solely on the expectation that its employees were more likely to remain loyal and perform to the best of their abilities if their economic needs were satisfied. In our view, such a benefit was only an incidental or indirect benefit, and therefore not controlling. See
We also rejected the Commissioner's argument that the taxpayer's1996 U.S. Tax Ct. LEXIS 31">*53 contributions were essentially prepaid expenses, which were required to be capitalized. We found that the annual contributions were computed by an independent actuary who determined the amounts necessary to fund the plans for 1 year. We concluded that "the evidence in this case supports petitioner's contention that its contribution to each plan for a particular year relates only to the year in which the payment was made."
In our view,
The benefit plans at issue in
In contrast, VEBA II was the funding medium for petitioner's future holiday pay obligations. These future obligations were contingent upon the future performance of services by petitioner's employees. Holiday pay is closely akin to salary, the most basic obligation any employer undertakes. The $ 20 million contribution to VEBA II provided funds to reimburse1996 U.S. Tax Ct. LEXIS 31">*55 petitioner for holiday pay obligations that it expected to incur for many years into the future.
The employees in
In
Nevertheless, petitioner contends that deductions of this sort must necessarily be allowed for taxable years prior to 1986. Petitioner argues that Congress enacted sections 419 and 419A, applicable to years after 1985, to prohibit the type of deduction at issue here. Sections 419 and 419A generally restrict deductions for contributions made to welfare benefit funds to the year that benefits are actually paid out to employees. See
The discussion of sections 419 and 419A in
Petitioner has failed to prove that its $ 20 million contribution to VEBA II in 1985 constitutes an ordinary and necessary business expense pursuant to section 162(a). Rule 142(a);
Decision will be entered for respondent.
Footnotes
1. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the taxable year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
2. Mr. Bush had been an assistant counsel in petitioner's legal department since 1981. In April 1985, Mr. Bush became an assistant vice president in the corporate tax department.↩
3. During 1984, Mr. Chamberlain served as an assistant vice president in petitioner's human resources department.↩
4. Surplus tax is a term used in the life insurance industry to refer to the reduction that sec. 809(a)(1) imposes on a life insurance company's policyholder dividends deduction under sec. 808(c). The parties have stipulated that petitioner's use of VEBA II to fund holiday pay benefits saved petitioner surplus tax under sec. 809 in the following amounts:
↩Year Amount 1985 $ 117,318 1986 -0- 1987 594,394 1988 64,260 1989 -0- 1990 60,112 1991 -0- 1992 -0- 1993 -0- 5. Sec. 501(a) exempts from taxation VEBA's that provide for the payment of life, sick, accident, or other benefits to employees, or their dependents or designated beneficiaries, provided that no part of the net earnings of the employer inures (other than through such payments) to the benefit of any private shareholder or individual. Sec. 501(c)(9).
On May 13, 1986, petitioner transmitted to the Internal Revenue Service a completed Form 1024 (Application for Recognition of Exemption Under Section 501(a) or for Determination Under Section 120) for the VEBA II trust. On Jan. 13, 1988, the IRS recognized the tax-exempt status of the VEBA II trust, determining that it qualified as a voluntary employees' beneficiary association pursuant to sec. 501(c)(9).↩
6. Petitioner amended the holiday pay plan on Dec. 31, 1985.↩
7. During 1985, petitioner provided 10 paid holidays to its employees, of which 8 were fixed holidays on days specified by petitioner and 2 were floating holidays on days chosen by the individual employee.↩
8. See infra↩ p. 22.
9. Petitioner did not terminate these plans; they remained intact but were unfunded.↩
10. Petitioner has avoided using any of the original principal to pay its holiday pay obligations. Since 1987, the annual investment earnings from the VEBA II trust have been insufficient to cover the total annual cost of petitioner's holiday pay obligations. To make up the difference, petitioner has either transferred funds from VEBA I or VEBA III or funded the difference itself.↩
11. See
Anesthesia Serv. Medical Group, Inc. v. Commissioner, 85 T.C. 1031">85 T.C. 1031 , 85 T.C. 1031">1044-1045 (1985), affd.825 F.2d 241">825 F.2d 241↩ (9th Cir. 1987) (holding that a trust established to provide protection against the malpractice claims of the employer's physician-employees was concerned primarily with the interests of the employer, which was jointly and severally liable for the negligence of its employees).12. On Jan. 1, 1995, petitioner adopted a new "paid time away from work policy". As a result, only 6 holidays are now covered under the holiday pay plan and funded through the VEBA II trust.↩