                         106 T.C. No. 27



                   UNITED STATES TAX COURT



  CONNECTICUT MUTUAL LIFE INSURANCE COMPANY AND CONSOLIDATED
SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE,
                          Respondent



   Docket No. 4291-94.                       Filed June 26, 1996.


        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. INDOPCO, Inc. v. Commissioner,
   503 U.S. 79 (1992), applied.
                               - 2 -

     Matthew J. Zinn, J. Walker Johnson, and Tracy L. Rich,

for petitioner.

     Jill A. Frisch and Randall P. Andreozzi, for respondent.


     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 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




     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.
                                - 3 -

returns on a calendar year basis using the accrual method of

accounting.

     During 1984, two of petitioner’s officers--Richard Bush2 and

Robert Chamberlain3--initiated discussions regarding VEBA's.

These discussions began 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 I


     On 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.    Petitioner claimed a Federal

income tax deduction for the entire contribution on its 1984

income tax return.


VEBA II


     Since its incorporation in 1846, petitioner has provided its

employees with annual fixed paid holidays.    Petitioner has never

     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 -

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,4 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

     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,
                                                   (continued...)
                               - 5 -

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.

     On December 24, 1985, petitioner established the Connecticut

Mutual Life Insurance Company Holiday Pay Plan6 (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 medium 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:




     5
      (...continued)
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.
                               - 6 -

     (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

holidays7 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.

     (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

     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.
                               - 7 -

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.

     (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, without 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;
                               - 8 -

Robert E. Casey, senior vice president, and Walter J. Gorski,

senior vice president and general counsel.


The Operation and Administration of VEBA II


     Petitioner’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


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
                               - 9 -

     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
                                - 10 -

     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 principal in VEBA
                                - 11 -

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 accounting practice similar to that

adopted in the Statement of Financial Accounting Standards No.

87.


VEBA III


      Subsequent 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.8    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.

      8
       See infra p. 22.
      9
      Petitioner did not terminate these plans; they remained
intact but were unfunded.
                                - 12 -


                                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, section

1.162-10(a), Income Tax Regs., provides as follows:


     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 carrying on a trade

or business; (3) be an expense; (4) be a "necessary" expense; and

(5) be an "ordinary" expense.     Commissioner v. Lincoln Sav. &

Loan Association, 403 U.S. 345, 352 (1971).     A capital

expenditure, in contrast, is not an "ordinary" expenditure within

the meaning of section 162(a) and is therefore not currently

deductible.     Id. at 353; see sec. 263(a).   Deductions from gross
                                - 13 -

income are a matter of legislative grace, and taxpayers bear the

burden of demonstrating that they are entitled to the deductions

they claim.   Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S.

79, 84 (1992).

     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.      INDOPCO, Inc. v.

Commissioner, supra at 83-84.

     The Supreme Court's decision in INDOPCO, Inc. v.

Commissioner, supra, serves as the starting point for any

discussion on the distinction between ordinary and necessary

business expenses and capital expenditures.     The Court emphasized

at the outset "that the 'decisive distinctions' between current

expenses and capital expenditures 'are those of degree and not of

kind'".    Id. at 86 (quoting Welch v. Helvering, 290 U.S. 111, 114

(1933)).   As a result, "the cases sometimes appear difficult to

harmonize."   Id.   The Court then rejected the argument that the

creation or enhancement of a separate and distinct asset is a

prerequisite to capitalization, explaining that "the creation of

a separate and distinct asset well may be a sufficient, but not a

necessary, condition to classification as a capital expenditure."
                                 - 14 -

Id. at 87.    The Supreme Court went on to hold that capitalization

is also required when the expenditure provides the taxpayer with

significant benefits beyond the year in which the expenditure is

incurred.     Id. at 87-89.   The Court cautioned, however, that "the

mere presence of an incidental future benefit--'some future

aspect'--may not warrant capitalization".      Id. at 87.   Applying

these principles to the case at hand, we must inquire into the

duration and extent of any benefits that petitioner received as a

result of its $20 million contribution to the VEBA II trust in

1985.     See Black Hills Corp. v. Commissioner, 73 F.3d 799, 806

(8th Cir. 1996), affg. 102 T.C. 505 (1994); A.E. Staley

Manufacturing Co. v. Commissioner, 105 T.C. 166, 194 (1995).

        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 from VEBA II would be used to fund the full amount
                              - 15 -

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, 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 Moser v. Commissioner, T.C. Memo. 1989-142, affd. on

other grounds 914 F.2d 1040 (8th Cir. 1990), we held that a

corporation was entitled to a deduction pursuant to section

162(a) for a $200,000 contribution to a VEBA created to provide

members with death benefits, sick and accident benefits, and


     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.
                               - 16 -

severance pay benefits.    Since the benefits provided by the VEBA

were commensurate with the salaries and ages of its members, we

rejected the Commissioner's initial argument that the VEBA was

actually nothing more than a private investment fund created for

the benefit of petitioner's president, Berkley B. Strothman, and

his wife.

     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 amendments 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." * * * [Moser v.
     Commissioner, T.C. Memo. 1989-142 (quoting Greensboro
     Pathology Associates, P.A. v. United States, 698 F.2d
     1196, 1203 n.6 (Fed. Cir. 1982)).]


A critical inquiry, therefore, was whether the funds in the plan

could ever revert to the employer, and this question was

"integrally related" to any analysis of whether the plan was

truly a "welfare or other similar benefit plan" to which

contributions are deductible by employers as ordinary and
                               - 17 -

necessary business expenses pursuant to section 162(a).    Our

review of the plan documents in question indicated that the

reversion of any assets from the VEBA was clearly prohibited.

     Finally, in Moser v. Commissioner, supra, we disagreed with

the Commissioner's argument that the corporation's contribution

was excessive, and, therefore, the corporation should not be

allowed a deduction for the full amount.   The corporation's

$200,000 contribution was based on calculations made by a

financial consultant to ascertain the full amount of all

potential severance benefits and the life insurance and medical

insurance premiums that were necessary to fund death, disability,

and accident benefits for 1 year.   We found that the

corporation's original $200,000 contribution had "provided for

full funding of the severance benefits and generated income

sufficient to fund the annual costs of providing VEBA benefits -

no more, no less."    Moser v. Commissioner, supra.

     In Schneider v. Commissioner, T.C. Memo. 1992-24, we held

that a personal service corporation was entitled to deduct

contributions made to three employee welfare benefit plans

established to provide death, disability, and termination

benefits to employees and educational benefits to the children of

eligible employees.   The Commissioner argued that the

contributions at issue were capital expenditures because they

created a benefit for the taxpayer that lasted substantially

beyond the taxable year in which the contributions were made.
                                - 18 -

     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."

Schneider v. Commissioner, supra; see also Weil Clothing Co. v.

Commissioner, 13 T.C. 873, 879-880 (1949).    Regarding the first

consideration, we stated that in the context of an employee

benefit plan, an employer does not necessarily retain too much

control when it retains the right to terminate or alter the plan,

so long as the funds in the plan may never revert to or inure to

the benefit of the employer.    Schneider v. Commissioner, supra.

Similarly, concerning the second consideration, we stated that

the employer's contributions must directly benefit its employees

rather than the employer.11    With respect to taxpayer

contributions that produce future benefits for the taxpayer, we

stated:


     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

     11
      See Anesthesia Serv. Medical Group, Inc. v. Commissioner,
85 T.C. 1031, 1044-1045 (1985), affd. 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).
                              - 19 -

     the taxpayer for a period of time in the future, then
     the expenditure is deemed capital and cannot be
     currently deducted. See National Starch & Chemical
     Corp. v. Commissioner, 918 F.2d 426 (3d Cir. 1990),
     affg. 93 T.C. 67 (1989), cert. granted INDOPCO, Inc. v.
     Commissioner, 500 U.S. ___, 59 U.S.L.W. 3769 (May 13,
     1991). [Schneider v. Commissioner, supra.]


     Applying these principles to the facts in Schneider v.

Commissioner, supra, we determined that the taxpayer was entitled

to a deduction pursuant to section 162(a).   First, we found that

the assets contributed by the employer were held in trust to

provide the benefits discussed above, and none of the employee

benefit plans allowed for the reversion of assets to the employer

in the event the plan was amended or terminated.

     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 Weil v. Commissioner, supra at 879-880;

Elgin Natl. Watch Co. v. Commissioner, 17 B.T.A. 339, 358 (1929),

affd. 66 F.2d 344 (7th Cir. 1933).

     We also rejected the Commissioner's argument that the

taxpayer's contributions were essentially prepaid expenses, which

were required to be capitalized.   We found that the annual
                               - 20 -

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."    Schneider v. Commissioner, supra.

     In our view, Moser v. Commissioner, T.C. Memo. 1989-142, and

Schneider v. Commissioner, supra, are distinguishable from the

case at hand.   The critical distinctions involve the particular

nature of the benefits funded as well as their permanence and

extent.    See INDOPCO, Inc. v. Commissioner, 503 U.S. at 87; A.E.

Staley Manufacturing Co. v. Commissioner, 105 T.C. at 194-195.

     The benefit plans at issue in Moser v. Commissioner, supra,

and Schneider v. Commissioner, supra, funded death, disability,

and severance benefits for the employees and, in Schneider,

educational benefits for the employees' children.   The most

significant benefits payable under the plans involved in Moser

and Schneider were payable to employees upon the occurrence of an

event, which would terminate their services for the employer.

Employer contributions to these plans tended to boost employee

morale, but we found that the employer's only benefit was its

expectation that its employees were more likely to remain loyal

and perform to the best of their abilities.    Schneider v.

Commissioner, T.C. Memo. 1992-24.    As a result, we found that

these benefits provided the employer with only incidental or
                                 - 21 -

indirect future benefits, which do not require capitalization.

See INDOPCO, Inc. v. Commissioner, supra at 87.

     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 reimburse

petitioner for holiday pay obligations that it expected to incur

for many years into the future.

     The employees in Moser v. Commissioner, supra, and Schneider

v. Commissioner, supra, generally had a vested right to the

severance, disability, or death benefits at the time the employer

made the contribution.     The occurrence of a qualifying event,

such as the death, disability, or termination of an employee,

entitled the employee to benefits regardless of the fact that the

employee would no longer be providing services to the employer.

In contrast, the creation of the VEBA II trust to fund holiday

pay benefits did not provide petitioner's employees with a vested

right to future holiday pay.     Petitioner could reduce its holiday

pay benefits or even liquidate the VEBA II trust without

incurring any liability to its employees for future holiday

pay.12     The right to holiday pay did not vest unless and until an

     12
          On Jan. 1, 1995, petitioner adopted a new "paid time away
                                                       (continued...)
                              - 22 -

employee was employed by petitioner on the working days

immediately preceding and following the holiday.   Thus, the

prefunding of petitioner's future holiday pay obligations was

inextricably linked to acquiring the future benefits that

petitioner would reap from its employees' services in subsequent

years.

     In Moser v. Commissioner, supra, the contribution was an

amount that provided for full funding of the vested severance

benefits.   This funding also generated income sufficient to pay

relatively small annual insurance premiums for other VEBA

benefits.   In Schneider v. Commissioner, supra, the taxpayer's

contribution to each plan for a particular year related only to

the year in which the payment was made.   Petitioner's

contribution, on the other hand, did not fund benefits that were

already vested and was not calculated to fund benefits for a

specific period.   Petitioner established VEBA II to prefund its

holiday pay obligations for many years, and the future benefits

from this prefunding were far from incidental.   Between 1986 and

1994, petitioner's annual holiday pay expenses covered by the

plan ranged from approximately $1.5 million to $2.2 million.

Petitioner's original $20 million contribution produced

investment earnings sufficient to cover over 80 percent of these


     12
      (...continued)
from work policy". As a result, only 6 holidays are now covered
under the holiday pay plan and funded through the VEBA II trust.
                              - 23 -

expenses.   It is clear that petitioner's $20 million contribution

to VEBA II for the purpose of funding its future holiday pay

obligations resulted in a substantial future benefit.

Contributions that provide taxpayers with substantial, as opposed

to merely incidental, future benefits must be capitalized.

INDOPCO, Inc. v. Commissioner, supra at 87.

     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

Schneider v. Commissioner, supra.   Petitioner points to a

discussion at the end of our opinion in Schneider v.

Commissioner, supra, where we rejected the Commissioner's

argument that the taxpayer's contributions were not deductible

until paid out by the plans as benefits.   We remarked that "the

statute [section 162] was amended by the enactment of sections

419 and 419A to bring about that result in the case of

contributions made after 1985", Schneider v. Commissioner, supra,

and we quoted from the House report, which explained that the

enactments resulted from Congress' belief "'that the current

rules under which employers may take deductions for plan

contributions far in advance of when the benefits are paid allows
                              - 24 -

excessive tax-free accumulation of funds.'"     Schneider v.

Commissioner, supra (quoting H. Rept. 98-432 (Pt. 2), at 1275

(1984)).   We also referred to the conference report accompanying

the enactment of sections 419 and 419A, which stated that "'An

employer's contribution to a fund that is a part of a welfare

benefit plan may be deductible in the year it is made rather than

at the time the benefit is provided.'"     Schneider v.

Commissioner, supra (quoting H. Conf. Rept. 98-861, at 1154

(1984), 1984-3 C.B. (Vol. 2) 408).

     The discussion of sections 419 and 419A in Schneider v.

Commissioner, supra, is not inconsistent with our holding in the

instant case.   Under the law applicable to pre-1986 years, there

simply was no requirement that deductions for contributions to

VEBA's be delayed until benefits were actually paid to the

employees.   Sections 419 and 419A imposed this requirement for

contributions made after 1985.   However, as we recognized in

Schneider, there had always been a requirement that an

expenditure be capitalized if the expenditure provided the

taxpayer with substantial future benefits.    In Schneider v.

Commissioner, supra, we found that the expenditures in issue had

not provided the taxpayer with substantial future benefits.     In

the instant case, we have found that petitioner's contribution to

VEBA II did result in substantial future benefits.    Our decision

today, therefore, is consistent with Schneider v. Commissioner,

supra, and the state of the law in 1985.    As the Supreme Court
                             - 25 -

explained in INDOPCO, Inc. v. Commissioner, 503 U.S. at 86-87, it

was not articulating any new legal standard in holding that

capitalization is required when expenditures provide the taxpayer

with significant future benefits.

     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); INDOPCO, Inc. v. Commissioner, supra at 84.     Respondent's

determination is, therefore, sustained.




                                           Decision will be entered

                                      for respondent.
