                               T.C. Memo. 2013-45



                         UNITED STATES TAX COURT



              ALAN R. PINN AND TONI A. PINN, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent

              DAVID R. PINN AND DIANE PINN, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



       Docket Nos. 767-07, 768-07.1                Filed February 11, 2013.



       Jerold A. Reiton, Aaron M. Valanti, and Christian E. Picone,

for petitioners.

       Jason W. Anderson, David S. Weiner, and Angela B. Friedman,

for respondent.




       1
         We consolidated Alan R. Pinn and Toni A. Pinn v. Commissioner, docket
No. 767-07; and David R. Pinn and Diane Pinn v. Commissioner, docket No. 768-
07, for trial, briefing, and opinion.
                                           -2-

[*2]         MEMORANDUM FINDINGS OF FACT AND OPINION


       HOLMES, Judge: Alan and David Pinn borrowed money from a welfare

benefit fund in 1999 and 2000, and haven’t paid it all back. The Commissioner says

they should have reported cancellation-of-debt (COD) income for 2002 when the

fund listed the loans as in default on an information return that it filed with the

federal government. The Pinns and the lender disagree, arguing that the loans

remain in force and are fully collateralized.

                                 FINDINGS OF FACT

I.     Beginnings and Businesses

       The Pinn brothers started out as high-school teachers in the Santa Clara Valley

south of San Francisco. The pay wasn’t great, so they decided to supplement their

income with summer projects. One summer they headed up to Lake Tahoe to build

and sell a cabin. To their great amazement, and with the help of low-cost student

labor, their profit on the sale was greater than their yearly teaching salaries. The next

summer they built another cabin and succeeded again. Their success led them to

abandon teaching and pursue homebuilding full time. Within seven years the

brothers were building 300 houses a year. And over the last 35 years, the company

they founded has built 6,000 homes.
                                         -3-

[*3] The Pinns also stitched together a number of different business entities:

      •      Pinn Brothers Construction, Inc. (PBC), which builds the homes;

      •      BWS, Inc. (BWS), which repairs PBC-built homes that are subject to an
             implied warranty;2

      •      Development Sales Concepts, Inc. (DSC), which markets homes built
             by PBC;

      •      White Oaks Investors, Inc., which provides warranties for certain
             homes and insulates PBC from liability; and

      •      Pfeiffer Ranch Investors, Inc., which owns the land on which PBC
             builds.

      With the exception of Pfeiffer Ranch, which implemented an employee

stock-ownership plan, each corporation’s shares were quartered among Alan,

David, and their wives. Alan was president and David was vice president of each

company until 2007, when Alan’s son Greg became president of all the companies.

The various entities had a total of about 140 employees in 1999, about 10% of


      2
         California courts created an implied warranty that new buildings are
“designed and constructed in a reasonably workmanlike manner.” Pollard v. Saxe &
Yolles Dev. Co., 525 P.2d 88, 91 (Cal. 1974). Although the statute of limitations for
claims involving construction defects varies depending upon the nature of the claim
or defect, no claim for breach of an implied warranty can be brought against a
builder if more than ten years has passed since the “substantial completion of the
project.” See Cal. Civ. Proc. Code secs. 337.1, 337.15, 338(b) (West 2006). (These
cases involve a lot of nontax authorities. Our references to just plain “sections” are
to the Internal Revenue Code in effect for 2002.)
                                         -4-

[*4] whom were in management with the rest out in the field actually building

homes. And about 90% of all these employees worked full time. Although each

corporation was separate from PBC, payroll for all the corporations was

administered through PBC under a common-paymaster agreement.3

II. The Death-Benefits-Only (DBO) Plan4

      In 1999 the Pinns met with their accountants at Crawford, Pimental & Co.,

Inc., and Bret Petrick--an “insurance expert” who advised the Pinns on employee-

benefit plans. Marshall Katzman, one of Petrick’s business associates, presented a

slideshow entitled “American Workers Benefit Fund, THE ‘419’ PLAN WITH A

DIFFERENCE!” 5 The slides outlined how the Pinns could obtain preretirement



      3
         If two or more related corporations employ the same individual, one of the
corporations can serve as the common paymaster for all of the related corporations.
See sec. 31.3121(s)-1, Employment Tax Regs. This allows the group of companies
to be treated as a single employer, which prevents them from having to pay more in
total Social Security and Medicare taxes than a single employer would have to pay.
Id. The firm that’s chosen to be the common paymaster pays all employees, files
information and tax returns, and issues Forms W-2 for wages that it pays. Id.
      4
        As the name implies, a death-benefits-only (DBO) plan gives only death
benefits to covered employees.
      5
        A “419 plan” refers to a “welfare benefit fund” that is governed by sections
419 and 419A--sections that limit the deduction employers can take for
contributions made to a welfare benefit fund. A welfare benefit fund is defined as a
fund “which is part of a plan of an employer, and through which the employer
provides welfare benefits to employees or their beneficiaries.” Sec. 419(e).
                                         -5-

[*5] life insurance through a union-sponsored welfare benefit fund. According

to the slideshow, life-insurance premiums would be fully deductible to the

sponsoring employer, and very little current income would have to be recognized by

the employee-participants. The Pinns liked what they heard, and decided to sign

PBC up.

      A. The Union Arrives

      Signing up meant that PBC had to sign some kind of union contract, which it

did with Local 707 of the National Production Workers Union (Local 707),6 on

December 18, 1999, when it recognized Local 707 as the exclusive bargaining agent

for its “full-time office personnel.” As we’ve already mentioned, most PBC

employees were job-site laborers, and many of PBC’s other employees were




      6
        Local 707 operates out of Oak Brook, Illinois. It is not a very large union
and has had some problems. See, e.g., Prod. Workers Union, Local 707 v. NLRB,
161 F.3d 1047, 1055 (7th Cir. 1998) (union persuaded employer to terminate
employees for nonpayment of union dues without telling them of their right to
object); JMB, Inc., 349 N.L.R.B. 866, 866-69 (2007) (union alleged to have
improperly procured union membership).
                                          -6-

[*6] professionals, guards, and supervisors7--all excluded as well.8 This left very

few PBC employees eligible to join Local 707, and only four actually did.

      B. The Collective-Bargaining Agreement

      On or about December 16, 1999, PBC also joined the American Workers

Master Contract Group. The American Workers Group was an organization which

represented all the employers of Local 707 members. The American Workers Group

was responsible for negotiating the master contract9 with the union. And PBC, as a

member of the Group, was bound by the terms of the master contract with respect to

its four union employees.




      7
         The National Labor Relations Act (NLRA) defines a supervisor as an
individual who acts as an employer to other employees; he can hire, give
instructions to, promote, and fire employees who are under his leadership. National
Labor Relations Act of 1935, 29 U.S.C. sec. 152(11) (2006).
      8
         This exclusion was clearly drafted to comport with federal labor law and to
avoid any procedural hangups. For example, managers and supervisors cannot join
unions and are not protected by the NLRA. See, e.g., NLRB v. Yeshiva Univ.
Faculty Ass’n, 444 U.S. 672 (1980). Professional and nonprofessional employees
also can’t be in the same union unless a majority of the professional employees vote
for it. 29 U.S.C. sec. 159(b). And security guards can only be in unions with other
security guards. Id.
      9
        A master contract is a collective-bargaining agreement that describes the
terms of employment for all union workers within a particular company, market, or
industry. See 20 Williston on Contracts, sec. 55:19 (4th ed. 2010).
                                         -7-

[*7] One of the most important of those terms was the master contract’s provision

for the DBO plan. The master contract stipulated that “the benefits program * * * be

administered through the American Workers Benefit Fund in accordance with the

terms of the Fund and the rules and regulations created thereunder.” The same

provision appears in the later master contracts PBC signed on December 19, 2000;

December 19, 2003; and December 19, 2006, except that the United Employee

Benefit Fund (United Fund) was substituted for the American Workers Benefit Fund

(American Fund).

      C. Selection of the Trust

      Local 707 and the American Workers Group had set up the American Fund in

December 1995, well before the Pinns signed on, to provide the Local’s members

with their purportedly bargained-for death benefits. The American Fund was crafted

to be a voluntary employees’ beneficiary association (VEBA),10 a tax-exempt trust

under section 501(c)(9), and a welfare benefit fund under section 419(e).

      Since PBC recognized Local 707, the American Fund was supposed to

administer PBC’s DBO plan (as stipulated in the master contract operating when



      10
         The Employee Retirement Income Security Act of 1974 (ERISA), Pub. L.
No. 93-406, sec. 3(1), 88 Stat. at 833 (current version at 29 U.S.C. sec. 1002
(2006)), generally applies to VEBAs.
                                          -8-

[*8] PBC joined the American Workers Group). But the United Fund11--a purported

VEBA trust with essentially the same terms and employer-trustee12--actually ended

up administering it.13

      D. Eligibility for Death Benefits

      The Pinns were the owners of PBC and so they couldn’t join the union

representing their employees--or at least the tiny fraction of their employees who had

joined Local 707. But they could, curiously enough, share some of the benefits of

union membership. There was a provision in the master contract requiring the

Trust14 (the American Fund, and later the United Fund) to run PBC’s DBO



      11
         The United Fund was set up by another master-contract group, the
Professional Workers Master Contract Group and Local 2411 of the Union of
Needletrades, Industrial and Textile Employees.
      12
         The American Fund and the United Fund had two trustees--one appointed
by the association of employers and another by the sponsoring union. David Fensler
was the employer-trustee for both the American Fund and the United Fund.
      13
         The American Fund did, however, at least initially administer the welfare
benefit funds sponsored by the Pinns’ two other companies, BWI and DSC. We
have no idea why PBC chose the United Fund over the American Fund, but the
switcheroo is of no consequence. Once the American Fund merged into the United
Fund on December 18, 2000--about a year after PBC began its DBO plan, but
before the tax year at issue--PBC’s possible breach of the master contract was
cured.
      14
         The “Trust” refers to both the United Fund and the American Fund,
separately and collectively.
                                          -9-

[*9] program. According to the Trust’s Plan,15 nonunion PBC employees who are

designated in an appendix can also get the death benefits. But this appendix isn’t

in the record.

      What we got instead was the testimony of David Fensler, the Fund’s trustee

representing the employers,16 that the Pinns were--in addition to being PBC’s

owners and managers--full-time employees who had voluntarily elected to

participate in the Plan. Finding that the Pinns were eligible based only on this

testimony thus depends on inference, but we think it more likely than not true given

the exceptionally management-friendly terms of the contract between PBC (through

the American Workers Group) and Local 707 and the course of conduct of everyone

involved.




      15
        The “Plan” refers to the DBO plan offered by the Trust. The terms and
conditions governing the Plan--described generally in a booklet known as the
Summary Plan Description (SPD)--were set forth in the United Employee Benefit
Fund Trust Agreement. Summary descriptions, such as the SPD, “provide
communication with beneficiaries about the plan, but * * * their statements do not
themselves constitute the terms of the plan” for ERISA purposes. CIGNA Corp. v.
Amara, ___ U.S. ___, 131 S. Ct. 1866, 1878 (2011).
      16
          There are monthly reporting statements in the record from Local 707 that
suggest two other Pinn companies, BWS and DSC, also set up DBO plans. There
are also documents showing that BWS and DSC paid fees to the Trust to administer
their respective welfare benefit funds. Fensler testified that both BWS and DSC
recognized Local 707 and were employer-participants.
                                           -10-

[*10] E. Allotment of Death Benefits

      Under the Plan, the Trust promises to provide death benefits to eligible and

enrolled employees in the amount agreed to by their employer. To fund the death

benefits, the Trust buys and maintains life-insurance policies with money from the

participating employer. The employer also has to pay all of the Trust’s costs in

providing the death benefits to its covered employees. Employees, however, become

ineligible for Plan benefits when their jobs end (for reasons other than death)17 or if

their employer drops out of the Plan18 or if the Plan itself dissolves.19

      PBC agreed to provide both David and Alan Pinn with a death benefit equal to

ten times their annual salary up to a ceiling of $6 million and the Trust bought

enough life insurance to fund those obligations. The Trust owned these policies but

allowed the Pinns to irrevocably designate beneficiaries of their death benefits.20


      17
         Upon termination, however, an employee has the right to purchase the
policy on his life for its current net value.
      18
          Although an employer may not unilaterally terminate its participation in the
Plan, it may negotiate out of it through collective bargaining.
      19
         All Plan assets, however, would be distributed to currently participating
employees on a pro rata basis according to an actuarial determination of the
reserves then being held to provide the benefits.
      20
         It’s likely the Trust allowed a beneficiary designation to be irrevocable so
that an employee-participant could designate a beneficiary and still have the death

                                                                            (continued...)
                                           -11-

[*11] The paperwork is quite unclear. The Plan makes it seem as though the Pinns’

beneficiaries were to receive the death benefits directly from the Trust; but the life-

insurance policies and annuities also list the Pinns’ trusts as the beneficiaries of the

life-insurance policies and annuities themselves. It seems possible, then--though we

refrain from even guessing about its probability or consequences--that if David or

Alan died, their beneficiaries could collect directly from the insurance companies.

      Here’s a summary of the annuities and life-insurance policies the Trust

purchased for the benefit of Alan Pinn:




      20
        (...continued)
benefits excluded from his estate for federal estate-tax purposes. See generally sec.
2042(2); Morton v. United States, 457 F.2d 750, 753 (4th Cir. 1972); sec. 20.2042-
1(c), Estate Tax Regs. Cf. Estate of Thompson v. Commissioner, T.C. Memo.
1981-200, 1981 Tax Ct. Memo LEXIS 547, at *18-*21 (rejecting taxpayer’s
argument that beneficiary designation was intended to be irrevocable--and thus not
an “incident of ownership” under section 2042(2)--after finding that taxpayer
couldn’t establish that designation was, in fact, irrevocable).
                                            -12-

[*12]

   Policy #        Listed owner    Face value      Listed employer     Beneficiary
 Ameritas1        American            N/A              BWS           Pinn Ultra Trust
  #2477            Fund                                                 (may have
                                                                      changed after
                                                                          1998)
 Ameritas         American            N/A               DSC          Alan R. & Toni
 #2479             Fund                                              Ann Pinn Trust
 Lincoln2         American         $2,750,000          BWS           Alan R. & Toni
  #2943            Fund                                              Ann Pinn Trust
 Lincoln          American          6,000,000           DSC          Alan R. & Toni
  #2944            Fund                                              Ann Pinn Trust
 Lincoln          United Fund       6,000,000           PBC               N/A
  #0285
        1
            Ameritas refers to Ameritas Life Insurance Corp.
        2
            Lincoln refers to Lincoln Benefit Life Co.

And the life-insurance policies covering David Pinn:
                                            -13-

[*13]

  Policy #         Listed owner     Face value     Listed employer      Beneficiary
 Southland1         American       $2,000,000       White Oaks        Pinn Insurance
   #4378              Fund                                                Trust
 Southland          American        3,000,000           DSC           Pinn Insurance
    #4381             Fund                                                Trust
 Southland         United Fund      6,000,000           PBC           Pinn Insurance
    #3389                                                                 Trust
 Lafayette2        American           750,000          BWS            Pinn Insurance
    #732U             Fund                                           Trust (since Aug.
                                                                          1999)
                                                                      David R. Pinn
                                                                        Ultratrust
 Lafayette         American         3,000,000           DSC           Pinn Insurance
    #735U             Fund                                           Trust (since April
                                                                           2000)
                                                                      David R. Pinn
                                                                        Ultratrust

        1
            Southland refers to Southland Life Insurance Co.
        2
            Lafayette refers to Lafayette Life Insurance Co.

        David Fensler, the employer-trustee for the Trust, wasn’t the best at

recordkeeping; and he didn’t get around to updating all of the insurance

documentation to reflect United Fund’s ownership of the policies until 2009, about

nine years after the merger.
                                         -14-

[*14] F. The Plan Loans

       According to the Plan, the Trust can provide loans to employee-participants in

the event of an emergency or serious financial hardship. All loans, however, must be

secured by a pledge of the employee-participant’s death benefits. The Plan required

the borrowing employee to “sign[] a Promissory Loan Note pledging as collateral the

actuarially determined present value of the death benefit to which his or her

beneficiary is entitled.”21

       In May 1999, Alan applied for a $500,000 hardship loan, and stated that his

hardship was a much higher-than-anticipated tax bill. The Trust withdrew a total of

$500,000 from two deferred variable-annuity contracts that the Trust had bought from

Ameritas. Here’s a summary of those withdrawals:

                    Listed        Withdrawal        Cash value        Cash value on
   Policy #        employer        amount          before loan       12/02, after loan
                                                   withdrawal           was made
 Ameritas            BWS           $167,000           $291,329            $98,246
  #2477


 Ameritas             DSC           333,000            547,023            173,200
  #2479




       21
        The SPD clarified that “[p]olicy cash values may not be pledged or
assigned, because the participant has no right to them.”
                                         -15-

[*15] The Trust cut Alan two checks: one for $167,000, and the other for $333,000.

In June 1999, Alan gave the Trust a $500,000 promissory note in exchange for the

money. The note gave the Trust two ways to be repaid--with $50,000 quarterly

payments plus 1% interest22 or with a reduction in his death benefits by the amount

of the outstanding loan obligation (including principal and interest). If Alan had

stuck to the quarterly repayment schedule, he would have made his final payment in

July 2002.

      David Pinn followed with a similar loan application in February 2000, and the

Trust sent him a $500,000 check in April. The Trust got the money for David’s loan

by borrowing against three life-insurance policies:




       22
         To finance Alan’s loan, the Trust borrowed against the cash value of two
annuities. The amounts withdrawn no longer accrued interest under the annuity
contracts. Therefore, instead of charging interest to the Trust rate, Ameritas (the
company that issued the annuities) just let less interest income accumulate,
reflecting the fact that there was less money in the account earning interest. The
Trust, therefore, obtained the $500,000 loan without incurring any additional costs
other than the lost opportunity costs associated with the decrease in interest income.
The Trust set Alan’s interest rate at 1%, which represented the premium it was
required to charge for its loans.
                                         -16-

[*16]

                  Listed        Loan        Cash value at     Cash value in excess
   Policy #      employer      amount       time of loan       of loan balance at
                                                                  12/021
 Southland         White      $125,000          $243,515            $245,154
  #4378            Oaks



 Southland         DSC         250,000          283,043              462,697
  #4381



 Lafayette         BWS         125,000          177,321              336,153
  #735U



        1
         If the loans were outstanding when David died or the contracts were
terminated, the insurance companies would keep the proceeds or reduce the cash
values of the policies to make sure that they got repaid. Therefore to estimate the
cash value for each policy as of December 2002, we had to reduce its stated value
(as listed on the policy statements) by the outstanding loan balance.

        The Trust funded David’s loan with $375,000 from Southland, and $125,000

from Lafayette. Because the Trust got its financing from two different sources

that had two different interest rates, David executed two promissory notes instead of

one.

        In 2004, a few years after the merger of the American and United Funds, the

trustee discovered that David Pinn’s promissory notes were incorrect. The Trust
                                         -17-

[*17] was required to charge David Pinn 1% more in interest than what it was

charged by the insurance companies. Because David’s promissory notes didn’t

include enough interest, the Trust asked David to sign new promissory notes--one for

$125,000 at 8.5% interest, and another for $375,000 at 7% interest later that year.

What we find odd--though perhaps the parties thought it a reformation of the

paperwork to match their original deal--is that the new notes stated that they were

executed on February 16, 2000, just like the old ones.

      If David made all the scheduled quarterly payments, he would have paid back

his loan by December 2002. But just as with Alan’s notes, David’s say that if he

doesn’t repay the borrowed money within the time prescribed, the “Trustees of the

Fund are instructed to deduct the unpaid principal and interest” from his death

benefits. We find the parties to have intended to use this language, as well as other

language used in the Pinns’ notes, to effect an assignment of the Pinns’ death

benefits as security for the loans.

      The Pinns and the Commissioner stipulated that the loans are valid. Cf. Todd

v. Commissioner, T.C. Memo. 2011-123, 2011 WL 2183767, at *8, aff’d, 486 Fed.

Appx. 423 (5th Cir. 2012). Yet Alan made only one loan payment--in 2007, and

David has made none at all. Both parties also agree that the Trust hasn’t taken any

action against the Pinns to collect any missed payments.
                                         -18-

[*18] III.   Form 5500

       Form 5500, Annual Return/Report of Employee Benefit Plan, including its

schedules and attachments, is used to report information about employee-benefit

plans to both the IRS and the Department of Labor. Both ERISA and the Code

generally require any administrator or sponsor of an employee-benefit plan to file a

Form 5500 every year. See sec. 6058; 29 U.S.C. secs. 1021-1031 (2006); sec.

301.6058-1, Proced. & Admin. Regs.

       The Trust, as a “large welfare plan” (one with 100 or more employee-

participants), had to file a Form 5500 for 2002 and include several schedules and

attachments--one of which was Schedule H, Financial Information. See 29 U.S.C.

sec. 1023(a)(1); 29 C.F.R. secs. 2520.103-1, 2520.103-10 (2002). ERISA also

required the Trust to hire an “independent qualified public accountant” to opine as to

whether the required schedules (including Schedule H) were presented in conformity

with generally accepted accounting principles, and attach that opinion to the Form

5500. See 29 U.S.C. sec. 1023(a)(3); 29 C.F.R. secs. 2520.103-1(b), 2520.103-2(b)

(2002).

       This is where the happy arrangement between the Pinns, the Local, the Trust,

and the Funds began to tilt into the Commissioner’s sights: The independent CPA

refused to sign off on the report called for by Schedule H unless the Trust included
                                           -19-

[*19] the loans to the Pinns on Part I of Schedule G, Financial Transaction

Schedules--a list of the Plan’s loans that were either in default or uncollectible. The

CPA concluded that the loans were in default because the Pinns had never made any

loan payments, though he did conclude that they were not uncollectible because they

were fully secured by the Pinns’ death benefits.

      The Trust disagreed with the independent accountant, but it needed to file the

Form 5500 so it did list the loans on its Schedule G. But it also attached a document

that it labeled “Overdue Loan Explanation.” In it, the Trust explained its position

that the loans were neither uncollectible nor in default:

      The Schedule G loans are not in default because the collateral for each
      Schedule G loan, the participant-borrower’s death benefit provided
      under the terms of the plan of benefits of the Fund, will provide a
      payment or distribution to pay the underlying Schedule G loan
      obligation upon maturity. For the same reasons, the Schedule G loans
      are not uncollectible since, each Schedule G loan is supported by
      collateral which is sufficient to repay the Schedule G loan upon
      maturity.

IV.   The Notices of Deficiency for 2002

      What made this a sweet deal is that the Code doesn’t limit the deduction

employers can take for contributions they make to a welfare benefit fund

negotiated under a collective-bargaining agreement. See sec. 419A(f)(5).23


       23
            This exception is based, in part, on the assumption that deductions for
                                                                           (continued...)
                                         -20-

[*20] One might think that the sequence of contribution to deduction to purchase of

life insurance to tax-free receipt of loan proceeds would attract the Commissioner’s

attention. It did. PBC claimed a deduction of more than $300,000 for its fiscal year

ending January 31, 2003. The Commissioner determined that PBC shouldn’t have

taken the deduction and sent the company a notice of deficiency. PBC didn’t contest

the deficiency notice. The Commissioner then shifted his gaze to the Pinns.

      In October 2006, the Commissioner sent David and Alan notices of deficiency

for 2002. In them he increased their income by $153,315 each, for payments made

by PBC to the Trust covering the cost of the Pinns’ life-insurance protection for

2002.24 The notices also made computational adjustments, and imposed accuracy-

related penalties under section 6662.


      23
        (...continued)
contributions to a fund negotiated based on a collective-bargaining agreement will
not be excessive because parties to a collective-bargaining agreement are usually
adverse to each other. It is easy to imagine an abusive transaction where the
bargaining agent for the employees acts in concert with the bargaining agent for the
employer, allowing many of the benefits provided to employees who are also
owners to be more favorable than the benefits provided to employees who are not
owners. The IRS figured this out, too, and in Notice 2003-24, 2003-1 C.B. 853,
identified some purportedly collectively bargained arrangements--marketed to
business owners by promoters--that not only failed to satisfy section 419A(f)(5)’s
requirements for deductibility but also were now classified as listed transactions.
       24
        We believe the Commissioner got his numbers by taking the deduction he
disallowed PBC, and dividing it by two--asserting a $153,315 deficiency against
each Pinn.
                                          -21-

[*21] The Pinns filed their petitions, but the cases stumbled on their way to trial.

Before the first trial date, the Commissioner moved for leave to amend his answers

to increase the Pinns’ 2002 deficiencies to more than $500,000 each for failure to

report COD income. The Commissioner argued that the Trust’s 2002 Form 5500,

which he got only in pretrial discovery, was what led him to conclude that the Pinns

had COD income. Because we found delaying the trial meant that the Pinns

wouldn’t suffer undue prejudice, we allowed the Commissioner to amend his

answers.

         The parties then settled the remaining issues, leaving only the COD-income

issue for us to try. The Commissioner has the burden of proof in these cases because

he didn’t raise the COD-income issue until he amended his answers. See Rule

142(a). We consolidated the two cases and tried them in San Francisco--the Pinns

were residents of Northern California when they filed their petitions, as they remain

today.

                                       OPINION

I.       Cancellation-of-Debt Income

         The Code normally treats the discharge of indebtedness as income. Sec.

61(a)(12). The reason is this: When a taxpayer borrows money untaxed, and
                                          -22-

[*22] doesn’t have to pay it all back, he gets an economic benefit that resembles

other income. See, e.g., United States v. Kirby Lumber Co., 284 U.S. 1, 3 (1931);

Colonial Sav. Ass’n & Subs. v. Commissioner, 854 F.2d 1001 (7th Cir. 1988), aff’g

85 T.C. 855 (1985). Our task, when COD income is at issue, is to answer two

questions: (1) is the taxpayer off the hook for any part of the debt? and (2) if so, in

what year?

      We answer the first question by looking at the “facts and circumstances

relating to the likelihood of payment” and deciding whether some or all of the debt

will never have to be repaid. Cozzi v. Commissioner, 88 T.C. 435, 445 (1987). We

look to the actions of the parties, and not just what they say, to gauge their intent.

See id. at 446. We do not, however, rely on remote possibilities or the mere hopes

of those involved. See Milenbach v. Commissioner, 318 F.3d 924, 936 (9th Cir.

2003), aff’g in part, rev’g in part 106 T.C. 184 (1996).

      The result is a necessary fuzziness that becomes fuzzier still because the

Code requires taxpayers to make an annual accounting, and even if a debt has clearly

become uncollectible, it’s not always clear exactly when. We don’t require

extreme precision, but our cases do tell us to find some identifiable event fixing the

COD amount with certainty in the tax year we’re examining. Cozzi, 88 T.C. at

445; see also Friedman v. Commissioner, 216 F.3d 537, 547-49 (6th Cir. 2000),
                                          -23-

[*23] aff’g T.C. Memo. 1998-196. This identifiable event doesn’t have to be a

single overt act, but can be any event that falls within a reasonable range of events or

times. We know that “it will often be impossible to find one, and only one, event

that clearly establishes the tim[ing] of [the discharge].” Cozzi, 88 T.C. at 447.

      We now look at the facts of their case in light of those rules.

      A.     Likelihood That the Pinns Would Pay Back Their Loans

             1.     The Lack of Collection Action

      The first question, then, is whether it’s more likely than not either of the Pinns

will have to pay back their loans. The parties are far apart: The Commissioner

points to the Trust’s lack of any collection action as proof that the debts will never

have to be repaid. The Pinns concede the Trust hasn’t taken any collection action,

but argue that that’s because they’re not even in default under the terms of the loans.

They argue that those terms gave them two equally acceptable ways to repay--

periodic payments through 2002, or waiting till they die, when the Trust could collect

by withholding part of their death benefit.

      Without a default--as the loan documents define that term--the Trust isn’t

allowed to collect on the loans through other means. But even if the loans were

in default, the lack of collection action would not all by itself create COD income.
                                          -24-

[*24] See Coburn v. Commissioner, T.C. Memo. 2006-118, 2006 WL 1627897,

at *4.

         The Commissioner argues that the Trust had a collection policy requiring that

a demand letter be mailed to a delinquent borrower and, if necessary, Forms 1099

would be issued to borrowers who failed to comply. The Commissioner correctly

notes that the Trust sent no demand letter to either Pinn in 2002, from which he

concludes the Trust must have intended to forgive the loans.

         Hmm. There’s something to this logic. A creditor’s decision not to try to

collect a debt may be persuasive evidence of its cancellation, especially when the

creditor has a policy or custom of trying to collect its debts in a particular way or at a

particular time after default. But there is one problem here: The Trust didn’t have a

settled policy for collecting on delinquent loans in 2002. The Trustees did discuss

whether to adopt one, but never actually did. We are convinced by the credible

testimony of Fensler, and the Trust’s Board minutes which confirm that it just wasn’t

the Trust’s policy in 2002 to send demand letters; therefore, we don’t think the

failure to send them is as significant as the Commissioner argues.
                                           -25-

[*25]         2.     The Death Benefit as Collateral

        The key question here is whether these loans remained fully collateralized

throughout 2002. The Pinns argue that the loans were, and that this means the loans

were not discharged. The Commissioner tries to undermine the foundation of their

argument by alleging that the collateral was illusory because

        •     the collateral could not be death benefits from the Trust because the
              Pinns are not legally entitled to them under the Plan;

        •     even if the Pinns are entitled to death benefits under the Plan, those
              benefits cannot be collateral because their entitlement to those benefits
              is contingent;

        •     the collateral can’t be the life-insurance policies, because the Pinns
              don’t own the policies and property not owned by the debtor cannot
              serve as collateral; and

        •     even if the policies were the Trust’s collateral, there is no way for the
              Trust to use them to secure the Pinns’ debts because the Trust allowed
              them to designate beneficiaries.

        Before poking around into whether the Pinns could use their death benefits or

life-insurance policies as collateral, we must address whether a fully collateralized

debt can be treated as discharged. The answer is a familiar one in this nook of tax

law--it depends. Cozzi, 88 T.C. at 445.

        Our cases do tell us that there’s no discharge if the debtor’s obligation is

exchanged for services or is simply replaced with another obligation of equal or
                                          -26-

[*26] greater value. Caton v. Commissioner, T.C. Memo. 1995-80, 1995 WL

73451, at *15 (citing United States v. Centennial Sav. Bank FSB, 499 U.S. 573, 581-

82 n.7 (1991)). That’s reasonable--substituting one obligation for another doesn’t, at

least in many circumstances, free up assets. See Kirby Lumber Co., 284 U.S. at 3.

It follows that if a reduction in the Pinns’ death benefits or capture of insurance

proceeds owed (in some way) to them is an adequate alternative form of repayment,

there should be no COD income just because the Pinns failed to make their quarterly

payments--any more than we would find COD income only because a homeowner

stopped making payments on a $50,000 mortgage secured by a house worth a

million. See, e.g., 2925 Briarpark, Ltd. v. Commissioner, T.C. Memo. 1997-298,

1997 WL 357880, at *7, aff’d, 163 F.3d 313 (5th Cir. 1999). A default therefore

doesn’t necessarily result in COD income.

      We have certainly held this to be true for nonrecourse debt. A nonrecourse

loan is discharged when the creditor seizes the collateral and then uses it to satisfy

the debt.25 See, e.g., Gershkowitz v. Commissioner, 88 T.C. 984, 1014 (1987).

Recourse debt can be a little different--actually seizing the collateral upon the


       25
         The Court also doesn’t value the collateral to determine whether there is
COD income until the property is actually taken from the debtor to satisfy the
obligation. Commissioner v. Tufts, 461 U.S. 300, 308-09 (1983); Coburn v.
Commissioner, T.C. Memo. 2005-283, 2005 WL 3298877, at *1 n.3.
                                           -27-

[*27] debtor’s default doesn’t necessarily extinguish the underlying liability. See,

e.g., Lockwood v. Commissioner, 94 T.C. 252, 260 (1990). In Coburn v.

Commissioner, T.C. Memo. 2005-283, 2005 WL 3298877, at *4-*5, we found that

there was no COD income in the year the taxpayer defaulted on his recourse debt

because the lender had several years to enforce the obligation, and hadn’t waived his

rights to the collateral.

       Even if the Trust seized the Pinns’ collateral and discharged their debts, it still

wouldn’t create taxable COD income. In Caton, we held that when a profit-sharing

trust offsets the amount of the taxpayer’s outstanding loan obligation against his

vested-trust benefits, it was a payment of the debt by the taxpayer and not a

forgiveness of the debt. Caton, 1995 WL 73451, at *15. We therefore found the

discharge of the debt to be taxable as a constructive distribution from a profit-sharing

trust under section 402(a), and not COD income under section 61(a)(12). Id.

       We therefore hold that when a debt is collectible and fully secured (where the

fair market value of the collateral exceeds the loan balance), default alone will not

result in COD income.
                                          -28-

[*28]               a.     Are the Pinns entitled to a Death Benefit

        The Commissioner attacks the death-benefit-as-collateral theory by arguing

that there’s no evidence in the record showing that the Pinns are entitled to any death

benefits. We agree that the plan documentation is a mess, making it difficult to link

the death benefits to the Pinns. However, we have found as a fact that the Pinns

were eligible for death benefits. And the Commissioner has failed to prove

otherwise.

                    b.     Whether the Death Benefit Is Contingent

        The Commissioner’s next argument is that even if the Pinns’ were eligible for

death benefits, their rights to the death benefits were too contingent to be a valid

form of collateral. We do find the benefits contingent: The Pinns won’t get them if

PBC ceases to participate in the Trust, or if they stop working for PBC, or if the

master contract group and Local 707 fail to renew the master agreement. But the

Commissioner argues from this that the repayment of the loans through a set off of

those benefits is “highly contingent.” And, according to the Commissioner, this

means that they need to recognize COD income when they were scheduled to fully

repay their loans, but didn’t.

        The Commissioner relies on a pair of cases, Zappo v. Commissioner, 81 T.C.

77 (1983), and Jelle v. Commissioner, 116 T.C. 63 (2001). In Zappo, the taxpayer
                                         -29-

[*29] settled with a group of investors who had lent his company money on his

guarantee. They agreed to forgive the loans in exchange for some cash and stock in

the company. The money was supposed to come from a third-party purchaser who

had received certain assets from Zappo’s company. But Zappo also gave the

investors another guarantee, making him secondarily liable if the third-party failed to

make all the payments within five years. On those facts we concluded that Zappo’s

liability under that agreement was “highly contingent,” given the nature of guarantees

in general. We also held that there is no real continuation of indebtedness when a

highly contingent obligation is substituted for true debt. See Zappo, at 81 T.C. at 89

(“The very uncertainty of the highly contingent replacement obligation prevents it

from reencumbering assets freed by discharge of the true debt until some

indeterminable date when the contingencies are removed”).

      Jelle was similar. In that case a lender agreed to write off some of the

taxpayers’ debt, but if the taxpayers sold certain property within ten years, they

would have to pay back the lender all or some of the amount written off. We

explained that if an arrangement effects a present cancellation of debt but provides a

replacement obligation, the mere chance of some future repayment does not delay

the recognition of COD income when the replacement liability is “highly contingent

or of a fundamentally different nature.” Jelle, 116 T.C. at 69.
                                          -30-

[*30] But we are careful to distinguish these as exceptions to a more general rule

that “[i]f there exists only an agreement to cancel prospectively, the debt is

discharged not at the time the agreement is made but at the time conditions specified

therein are satisfied.” Id. at 68; see also Seay v. Commissioner, T.C. Memo. 1974-

305, 1974 Tax Ct. Memo LEXIS 14, at *8-*10. We conclude here that the

Commissioner’s timing is off. Either of the Pinns might or might not lose his death

benefit in the future. See supra p. 11. If and when that happened, the benefits’

usefulness as collateral for the loan would disappear. But that hadn't happened in

2002. And we don’t find that the pledge of their death benefits to be a “highly

contingent replacement obligation.” A highly contingent replacement obligation is

one where it is highly unlikely, or is impossible to estimate, whether and when the

debt will be repaid. Zappo, 81 T.C. at 88. We don’t have that here. At least not

during the year at issue. Cf. Todd, 2011 WL 2183767, at *6 (pledge of similar death

benefit could serve as security even if not proof that loan was bona fide).

                    c.     Ownership of the Life Insurance Policies

      The Commissioner also argues that neither Alan nor David had any

ownership rights to the insurance policies or to their cash values. The

Commissioner goes on to say that “property owned by the creditor cannot be the
                                           -31-

[*31] debtor’s collateral.” Though generally true, we don’t even need to address this

argument. Although the Trust provided the death benefits by purchasing insurance,

the Trust would still be obligated to pay out the death benefits according to the terms

of the DBO plan, whether or not the life-insurance policies were in place. And any

money that flowed directly from the insurance companies to the Pinns’ beneficiaries

was to flow only in the amount that the Trust authorized. The amount that the trust

could authorize was dictated by the terms of the DBO plan, so we find that it was the

death benefits, not the life-insurance policies, that served as the collateral.

                    d.     Designation of Beneficiaries

      The Commissioner also points to the fact that the Pinns aren’t the beneficiaries

of the life-insurance policies, alleging that Trust won’t be able to recoup the

proceeds to satisfy their loans. We disagree.

      Based on the record alone we hold that the Trust (through the trustee) could

collect the full value of the loans with a reduction of the Pinns’ death benefits. The

Trust had “endorsements” delivered to the insurance companies ensuring that the life

insurance would not be paid out without the approval of the trustee. These

documents also require the insurance company to follow the Trust’s determination
                                          -32-

[*32] of the beneficiaries’ rights under the Plan. But even if such documents were

not in place, we would still disagree with the Commissioner.

      A welfare benefit fund--like the one in these cases--is considered an

“employee welfare benefit plan” subject to ERISA. See 29 U.S.C. sec. 1002(1)

(2006) (defining “employee benefit welfare plan” as “any plan, fund, or program

* * * established or maintained by an employer * * * to the extent that such plan,

fund, or program was established or is maintained for the purpose of providing for its

participants or their beneficiaries, through the purchase of insurance * * * benefits in

the event of * * * death”).

      ERISA requires that an “‘employee benefit plan [to] be established and

maintained pursuant to a written instrument,’ ‘specify[ing] the basis on which

payments are made to and from the plan.’” Kennedy v. Plan Adm’r for DuPont Sav.

& Inv. Plan, 555 U.S. 285, 300 (2009) (quoting 29 U.S.C. sec. 1102(a)(1) and

(b)(4)). ERISA preempts any state law that “relate[s] to any employee benefit plan,”

29 U.S.C. sec. 1144(a) (2006), but does not preempt state laws “which

regulate[] insurance,” id. sec. 1144(b)(2); see also Ky. Ass’n of Health Plans, Inc. v.

Miller, 538 U.S. 329, 333-34 (2003).
                                           -33-

[*33] ERISA does not preclude the assignment or alienation of welfare-plan

benefits.26 Davidowitz v. Delta Dental Plan of Cal., Inc., 946 F.2d 1476, 1478 (9th

Cir. 1991). And whether such benefits are assignable is left up to the “free

negotiations and agreement of the contracting parties.” St. Francis Reg’l Med. Ctr.

v. Blue Cross & Blue Shield, 49 F.3d 1460, 1464 (10th Cir. 1995); Davidowitz, 946

F.2d at 1480-81. The assignment of the Pinns’ death benefits was made pursuant to

the terms of the Plan.

      ERISA allows the trustee of the United Fund to bring a civil action, “‘to

enjoin any act or practice which violates any * * * terms of the plan, or (B) to

obtain other appropriate equitable relief (i) to redress such violations or (ii) to

enforce any* * * terms of the plan.’” Sereboff v. Mid. Atl. Med. Servs., Inc., 547

U.S. 356, 361 (2006) (quoting 29 U.S.C. sec. 1132(a)(3)). The trustee may only

obtain relief under section 1132(a)(2), however, if the relief sought falls within

“‘those categories of relief that were typically available in equity’” before the

merger of law and equity.27 Sereboff, 547 U.S. at 361 (quoting Mertens v. Hewitt

       26
       It does preclude the assignment of pension-plan benefits. See, e.g.,
Mackey v. Lanier Collection Agency & Serv., Inc., 486 U.S. 825, 836 (1988).
       27
        Examples of relief “typically available in equity” include an “injunction,
mandamus, and restitution, but not compensatory damages.” Mertens v. Hewitt
Assocs., 508 U.S. 248, 256 (1993). Although--in many situations--a court of equity
                                                                        (continued...)
                                          -34-

[*34] Assocs., 508 U.S. 248, 256 (1993)). When a fiduciary of a plan governed by

ERISA seeks “to impose a constructive trust or equitable lien on particular funds or

property in the [nonfiduciary’s] possession,” it seeks relief of a type that has

typically been available in equity. Id. at 362 (quoting Great-West Life & Annuity

Ins. Co. v. Knudson, 534 U.S. 204, 213 (2002)). Since the United Fund trustee

would be seeking “‘specifically identifiable’ funds that were ‘within the possession

and control’” of either the beneficiaries or the insurance companies, id. at 362-63

(quoting Mid. Atl. Med. Servs., LLC v. Sereboff, 407 F.3d 212, 218 (4th Cir. 2005),

aff’d, 547 U.S. 356 (2006))--as opposed to simply seeking “to impose personal

liability * * * for a contractual obligation to pay money,” id. at 363 (quoting

Knudson, 534 U.S. at 210)--we find that the Trust could properly secure repayment

of the loans under ERISA.

       B.    Was There Some “Identifiable Event” in 2002?

      Even if we were wrong in our finding that the existence of adequate

collateral meant that the Trust had not canceled their debts, the Commissioner

would still need some theory--some “identifiable event”--to pin that cancellation to

      27
       (...continued)
did have the power to “establish purely legal rights and grant legal remedies which
would otherwise be beyond the scope of its authority,” id. (citation and internal
quotations marks omitted), the Supreme Court has interpreted 29 U.S.C. sec.
1102(a)(3) not to incorporate such legal remedies, see id. at 256-57.
                                          -35-

[*35] the 2002 tax year. The Commissioner argues that the “identifiable event” was

the Trust’s filing of the Form 5500. We agree that the “identifiable event” doesn’t

have to be one overt act, but can be any event that falls within a reasonable range of

events or times. See Cozzi, 88 T.C. at 446; see also L & C Springs Assocs. v.

Commissioner, 188 F.3d 866, 870 (7th Cir. 1999), aff’g T.C. Memo. 1997-469. We

nevertheless find the Trust’s reporting of the Pinn loans as “in default or

uncollectible” on Schedule G of Form 5500 was ambiguous. The schedule doesn’t

distinguish between default and uncollectibility. And there’s a difference between

the two.

       The dictionary defines default as “the failure to pay a debt when due.”

Black’s Law Dictionary 480 (9th ed. 2009). A loan in default, however, may very

well be collectible by seizing collateral. Missing a car payment puts a driver in

default. But when the repo man takes the car back the loan is satisfied and therefore

was collectible, assuming the fair market value of the repossessed car exceeds the

loan balance. The finding of the Trust’s accountant that the loans were in default,

yet collectible, highlights this distinction. We find Schedule G’s classification of the

loans too ambiguous to find the filing of the Trust’s Form 5500 to be the “identifiable

event which fixes the loss with certainty.” See Cozzi v. Commissioner, 88 T.C. at

445.
                                            -36-

[*36] II.       Conclusion

          We therefore find that the Commissioner has failed to prove that the Pinns had

COD income in 2002. This may strike learned observers as unusual--there was some

evidence in the record that the union associated with the Trust marketed similar plans

widely, touting their benefits as including immediate deductions, tax-free loan

proceeds, and a long-deferred recognition of income. See Todd, 2011 WL 2183767,

at *2. When this is true, a decent respect for the opinions of informed mankind

requires an explanation of why we believe our holding will not have a pernicious

effect.

          The chief of these is that here the parties agreed that the loans were bona

fide. Under very similar circumstances, we found in Todd that a similar

distribution did not create a loan but taxable income. See id. at *8. Yet even if our

reading and rereading and rerereading of the arguments actually made in these

cases allowed us to call the loans income to the Pinns, the Commissioner would

still be stuck. Alan received his loan in 1999, and David received his in 2000.

These are not the tax years at issue in these cases.28 And the Pinns may well have


          28
         If the taxation of the split-dollar life insurance regulation that went into
effect for all arrangements entered into or materially modified after September 17,
2003, was applicable here, the loan proceeds the Pinns received might well have
been classified as taxable income under section 61 to them in the years they
                                                                             (continued...)
                                          -37-

[*37] to pay taxes on the loans if they become ineligible for their death benefits, or

when their death benefits are used to satisfy their debts. See Old Colony Trust Co.

v. Commissioner, 279 U.S. 716, 729 (1929); Sanders v. Commissioner, T.C. Memo.

2010-279, 2010 WL 5327897, at *2; McGowen v. Commissioner, T.C. Memo.

2009-285, 2009 WL 4797538, at *3-*5, aff’d, 438 Fed. Appx. 686 (10th Cir. 2011);

Barr v. Commissioner, T.C. Memo. 2009-250, 2009 WL 3617587, at *3-*4; Miller

v. Commissioner, T.C. Memo. 2006-125, 2006 WL 1652681, at *16 (taxpayer

taxable on COD income when guarantor paid off balance of loan); Atwood v.

Commissioner, T.C. Memo. 1999-61, 1999 WL 109617, at *2.

      All these possibilities we leave for different records and different years. The

parties settled many other issues, so



                                                       Decisions will be entered

                                                 under Rule 155.




      28
        (...continued)
received their respective proceeds. See sec. 1.61-22, Income Tax Regs. But we
will leave that possibility for another day--or tax year.
