                               T.C. Memo. 2012-244



                         UNITED STATES TAX COURT



            G. STEVEN NEFF AND CARRIE J. NEFF, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent

          BRADLEY T. JENSEN AND TERRI JENSEN, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 6000-09, 6449-09.1              Filed August 27, 2012.



            Held: The termination or rollout of equity split-dollar life
      insurance arrangements triggered Ps’ realization of $710,376 in
      compensation income for 2003.




      1
       These two consolidated cases were part of a consolidated group of cases that
were the subject of a separate opinion filed June 13, 2012. See Love v.
Commissioner, T.C. Memo. 2012-166. In Love we rejected respondent’s
adjustment under I.R.C. sec. 269 relating to petitioners’ acquisition of an S
corporation.
                                          -2-

[*2] W. Waldan Lloyd, David R. York, and Daniel S. Daines, for petitioners.

      Charles B. Burnett and Milan H. Kim, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      SWIFT, Judge: In these consolidated cases, respondent determined

deficiencies of $120,097 and $135,994 in the Neffs’ and Jensens’ respective Federal

income tax for 20032 and penalties under section 6662(a).3

      The primary issue for decision is whether equity split-dollar life insurance

arrangements were terminated and whether, when, and to what extent petitioners

G. Steven Neff and Bradley T. Jensen are taxable thereon.

                                FINDINGS OF FACT

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

      At the time of filing their petitions, petitioners resided in Utah.




      2
       Respondent has stipulated reductions in his deficiency determinations due to
miscalculations made in his notices of deficiency. Above, we reflect respondent’s
deficiencies as recalculated by respondent.
      3
       Unless otherwise indicated, all section references are to the Internal Revenue
Code (Code) in effect for the year in issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure.
                                         -3-

[*3] Hereinafter, references to petitioners are generally to G. Steven Neff and

Bradley T. Jensen.

        Since 1979 petitioners each have owned a 50% interest in a Utah regular

corporation named Neff & Jensen Construction, Inc. (N & J Construction).

N & J Construction has engaged in the business of commercial concrete work.

Also, for many years petitioners together and separately have owned and operated a

number of other related companies and partnerships.

        On February 20, 2002, petitioners formed Neff & Jensen Leasing, Inc., as a

Utah subchapter S corporation (N & J Management) to provide management,

personnel, and accounting services for a number of related companies and

businesses, including N & J Construction. All of the stock in N & J Management

was owned by an employee stock ownership plan (ESOP), also formed in February

2002.

        Petitioners were the officers of N & J Management. Mr. Jensen was

president; Mr. Neff was vice president, treasurer, secretary, and director.

        Petitioners were the only trustees of the ESOP.

        After formation of N & J Management the employees of N & J Construction

and the related companies continued doing the same work but they became

employees of N & J Management and participants in the ESOP.
                                         -4-

[*4] During 2002 and 2003 N & J Management made premium payments due on

six life insurance policies issued by the Lincoln National Life Insurance Co.

covering the lives of petitioners. The life insurance policies were entered into for

business and estate planning purposes--namely, to fund cross-purchase buy-sell

stock agreements entered into between petitioners and to provide estate liquidity

upon the deaths of petitioners.

      N & J Management’s agreement to pay premiums due on the six life

insurance policies on petitioners’ lives was based on and related to the employment

relationship they had with and the services they provided for N & J Management.

      Technically, the life insurance policies were owned by petitioners and by

GSN Investment, Ltd. (GSN) and TerSen, Ltd. (TerSen), family limited

partnerships owned by petitioners and immediate family members. Mr. Steven

Neff owned one of the life insurance policies. Mr. Bradley Jensen owned one of

the life insurance policies. GSN owned two of the life insurance policies, and

TerSen owned the other two life insurance policies. Hereinafter, only limited
                                         -5-

[*5] references are made to GSN and TerSen, and references to petitioners

occasionally and where appropriate include GSN and TerSen.4

      The obligation of N & J Management to pay premiums due on the six life

insurance policies was part of four equity split-dollar life insurance arrangements

(hereinafter sometimes referred to as SDLIA or SDLIAs) that were memorialized in

four essentially identical written SDLIA agreements that were entered into on

March 6, 2002, between petitioners and N & J Management.

      As stated, under the SDLIA agreements formal ownership rights in the six

life insurance policies were held by petitioners, not N & J Management. As

employer, however, N & J Management agreed and was obligated to pay the

premiums due on the life insurance policies, and petitioners agreed that upon

either termination of the life insurance policies (such as upon the deaths of

petitioners) or upon termination of the SDLIAs for some other reason (such as

upon a third-party sale of N & J Management and regardless of whether the life

insurance policies were canceled), N & J Management would have the right to be

reimbursed an amount equal to the lesser of the total premiums it had paid on the


      4
        Petitioners Steven and Carrie Neff owned a 2% interest in GSN, and the
remaining 98% interest in GSN was owned beneficially by their children.
Petitioners Bradley and Terri Jensen owned a 2% interest in TerSen, and the
remaining 98% in TerSen was owned beneficially by their children.
                                          -6-

[*6] six life insurance policies or the total cash surrender value of the policies.

Paragraph (2) of the SDLIA agreements provided in part as follows:

       (b) [N & J Management] shall have no incidents of ownership over the
       Policies and shall only have the right to collect * * * its interest in the
       proceeds of the Policies * * * upon the death of * * * [petitioners],
       termination of this Agreement for any reason whatsoever, or upon the
       lapse, cancellation, or surrender of the Policies. [Emphasis added.]

       Paragraph (3) of the SDLIA agreements acknowledged that N & J

Management’s life insurance policy premium payments created “indebtedness” from

petitioners to N & J Management.

       Paragraph (4) described N & J Management’s premium payments as

“advances” as follows:

       (4) Policy Interest

              (a) [N & J Management Company’s] Interest

                    [N & J Management] has the right to receive back an
                    amount equal to the premium advances it has made on
                    the Policies. [Emphasis added.]

       If petitioners died when the SDLIAs and life insurance policies were still in

effect, paragraph (6) of the SDLIA agreements provided the obvious--namely, that

the life insurance policy proceeds would be paid “after the death of * * *

[petitioners].”
                                         -7-

[*7] Paragraph (7)(a) added that if the life insurance policies were terminated or

canceled before the deaths of petitioners, N & J Management was to receive

reimbursement of the policy premiums it had paid out of the cash value of the

policies (death policy proceeds not yet being available).

      Apart from the life insurance policies covering the lives of petitioners and

regardless of whether the policies remained in effect, the SDLIA agreements

provided that the SDLIAs themselves could be terminated by agreement of

petitioners and N & J Management. Paragraph (8) provided as follows:

      (8) Termination of Agreement

      This Agreement shall terminate for any of the following reasons:

             (a) Performance of its terms following the death of the Insured;

             (b) Written agreement of all of the parties hereto specifically
             terminating this Agreement.

The SDLIA agreements did not state that the parties to the agreement (namely,

petitioners and N & J Management) could not terminate the agreement by mutual

oral agreement.

      Paragraph (9) of the SDLIA agreements reiterated that in the event of a

termination of the SDLIAs other than by the deaths of petitioners reimbursement
                                          -8-

[*8] to N & J Management of the policy premiums it had paid would be made out of

the cash values of the insurance policies.

      Paragraph (10) of the SDLIA agreements expressly provided that

N & J Management’s interest in the policies could be either “satisfied” (by full

reimbursement of premiums paid ) or “released” by N & J Management.

      Under paragraph 3(b) of written collateral assignment agreements relating to

the SDLIA agreements that petitioners executed, death benefits from the six life

insurance policies and the cash surrender value thereof were pledged in favor of

N & J Management to provide security for N & J Management’s premium

reimbursement rights and petitioners’ “liabilities * * * to [N & J Management] for

premium advances” N & J Management had made.

      Paragraph 5(c) of the collateral assignment agreements stated that N & J

Management had the right to reimbursement of the premiums it paid “in the event of

termination” of the SDLIAs.

      Nothing in the SDLIA agreements and the collateral assignment agreements

suggests that--upon termination of the SDLIAs for reasons other than the deaths of

petitioners--reimbursement to N & J Management of the premiums it paid on the

policies would be put off until the deaths of petitioners and receipt of the life

insurance proceeds.
                                         -9-

[*9] As beneficiaries, petitioners (and their heirs) retained the right to access cash

values and to receive proceeds of the life insurance policies but only to the extent

they exceeded premium reimbursements owed and paid to N & J Management.

      The cash surrender value of the six life insurance policies increased with the

passage of time and as the premiums paid were invested by the insurance company.

      Under the life insurance policies and the SDLIAs from March 2002 through

the end of December 2003 a total of $842,345 in premiums on the six policies was

paid by N & J Management to the Lincoln Life Insurance Co. As of December 31,

2003, the total cash surrender value of the policies was $877,432.

      Because of a new regulatory scheme the Commissioner adopted in 2002 for

split-dollar life insurance arrangements (explained more fully below), in late 2003

and on advice of counsel petitioners decided to terminate the SDLIAs. In December

2003 by agreement of petitioners and N & J Management the four SDLIA

arrangements between petitioners and N & J Management relating to the six life

insurance policies were terminated.5




      5
       The precise date in December 2003 on which the SDLIA arrangements were
terminated is not established in the record.
                                        - 10 -

[*10] After December 2003 N & J Management made no further payments on the

six life insurance policies. N & J Management released its interest in the policies

(namely, its premium reimbursement rights) with respect to which N & J

Management in less than two years had paid $842,345 in premiums.

      Upon termination of the SDLIA arrangements in December 2003 N & J

Management had fixed rights to receive reimbursement of $842,345 (the lesser of

the total premiums paid or the total cash surrender value of the policies). This

$842,345 represented the total premium “advances” N & J Management had made

on the life insurance policies and petitioners’ total indebtedness to N & J

Management with regard thereto.

      At the request of petitioners’ counsel, individuals at petitioners’ accounting

firm calculated what they regarded as the “December 2003” fair market value of

N & J Management’s rights to be reimbursed the $842,345 premiums paid.

However, apparently on advice of petitioners’ counsel, the individuals at

petitioners’ accounting firm treated N & J Management’s reimbursement rights as

the right to be reimbursed the $842,345 only upon the deaths of petitioners. The

accounting firm applied a present value discount for the $842,345--using an
                                         - 11 -

[*11] assumed life expectancy for each petitioner of 85 and an interest rate of 6%.6

Petitioners’ advisers calculated the December 2003 present value of N & J

Management’s $842,345 reimbursement rights at $131,969.

      In December 2003 petitioners and N & J Management agreed that N & J

Management would be reimbursed only the $131,969, as calculated above, and

N & J Management agreed to release its interests in the present cash surrender

value of the policies, future death benefits from the policies, and petitioners from

any reimbursement obligation to N & J Management with regard to the $710,376

balance of the premiums N & J Management paid on the life insurance policies.7

      On the basis of the above agreement and calculation, on January 11 and 12,

2004, petitioners wrote personal checks totaling $131,969 in favor of N & J

Management. The checks were deposited into N & J Management’s bank account

on January 13, 2004.

      Funding for the $131,969 petitioners paid to N & J Management came from

their draw on the accumulated cash value of the six underlying life insurance

policies.


      6
          On December 31, 2003, each petitioner was 51.
      7
      Total premiums paid of $842,345 less $131,969 reimbursed equals
$710,376.
                                        - 12 -

[*12] As between petitioners and N & J Management, as of the end of December

2003 N & J Management was treated as having no obligation to make additional

premium payments on the six life insurance policies and the SDLIA arrangements

were treated as having been released, ended, or terminated. Upon the above

termination of the SDLIA arrangements, petitioners had sole rights to the remaining

$745,463 balance in the cash surrender value of the life insurance policies.8

      Apparently, no contemporaneous documentation exists (or was offered into

evidence) relating to the December 2003 agreement between petitioners and

N & J Management that ended or terminated the SDLIA arrangements. No written

termination letter or agreement between petitioners and N & J Management with

regard to the SDLIAs was offered into evidence. No written contract of any kind

was offered into evidence relating to the above December 2003 agreement to end

the SDLIAs. Further, no contemporaneous documentation refers to a sale by

N & J Management to petitioners of “contract rights”.




      8
      Total cash surrender value of $877,432 less $131,969 received equals
$745,463.
                                        - 13 -

[*13] After December 2003 the six life insurance policies insuring petitioners’ lives

apparently remained in effect, and petitioners individually apparently made premium

payments due thereon.

      The evidence in these cases does not indicate that (during the short life of the

SDLIA--March 2002 through December 2003) petitioners for 2002 and 2003, as

well as for 2004, included in their taxable income any amount relating to the life

insurance premiums N & J Management paid, the value of the policies, the

dividends, the paid-up additions, or any other amount or value.9

      Further, on the basis of their advisers’ $131,969 present value calculation of

N & J Management’s premium reimbursement rights under the SDLIAs, petitioners

did not report on their respective Federal income tax returns for 2003 or 2004 any

income regarding the $710,376 difference between the $131,969 petitioners

reimbursed N & J Management and the $842,345 N & J Management paid in

premiums on the policies.

      On audit respondent determined that in December 2003 on termination of

the SDLIA arrangements petitioners realized taxable compensation income of


      9
        If petitioners for 2002 or 2003 had reported any taxable income relating to
the economic benefits of the SDLIAs and the insurance policies, they could have
asserted and would have been entitled to a reduction in respondent’s adjustments
herein for their resulting tax bases therein.
                                         - 14 -

[*14] $710,376, the difference between what they reimbursed N & J Management

and what N & J Management paid in premiums on the policies.

      In spite of the four life insurance policies owned by GSN and TerSen and the

SDLIAs relating thereto, respondent did not make any reduction in the income

charged to petitioners, did not charge any income to GSN or TerSen, and did not

issue notices of deficiency to GSN or TerSen. The $710,376 in compensation

income respondent determined was charged to and allocated solely to and between

Mr. Steven Neff and Mr. Bradley Jensen.

      In letters to respondent’s revenue agent of July 27 and November 15, 2007, in

their petition, and in their opening statement at trial, petitioners’ counsel described

the transaction before us as involving a “termination” of the SDLIAs.

      Through audit and up until the time of trial petitioners and their attorneys,

accountants, and experts, as well as respondent, treated the transaction before us as

occurring in December 2003.

      On February 17, 2011, petitioners’ accounting firm provided a written

calculation or report of N & J Management’s premium reimbursement rights. Again

apparently on advice of counsel, this written calculation treated

N & J Management’s reimbursement rights as not effective until the death of each

petitioner some 30 years after December 2003.
                                         - 15 -

[*15] The above calculation that the accounting firm prepared for petitioners in

February 2011 described what happened to the SDLIAs and the timing thereof, as

follows:

      In December 2003, as a result of split-dollar tax regulations and the
      proposed section 409(p) regulations * * * the plan was ended.
      [Emphasis added.]

      Not until trial herein (which occurred on September 6, 2011) did petitioners’

counsel raise the argument and take the position that because petitioners’ premium

reimbursement checks to N & J Management were not executed by them and not

cashed by N & J Management until January 2004, if any compensation income is to

be charged to them it should be charged for 2004, not 2003, and that any effort by

respondent now to move the income to 2004 would be untimely and should not be

allowed.

      Petitioners’ counsel states that not until just before trial did he review the

bank records and realize that petitioners’ reimbursement payments occurred in

2004, as follows:

             The exact date of the Transactions was not known to petitioners’
      counsel until just prior to the trial date on September 6, 2011, when
      petitioners’ counsel was able to obtain and review from the bank
      copies of the cancelled checks that * * * [petitioners] * * * used to pay
      the management Company.
                                          - 16 -

[*16] No explanation is provided as to why petitioners’ counsel was not able to

obtain and review the 2004 bank records and canceled checks before September

2011.

                                        OPINION

        In the life insurance industry, the term “rollout” is used to describe

termination of an SDLIA other than by death of the insured employee that results in

cancellation of the employer’s premium payment obligation relating to the life

insurance policy and that leaves the insured employee as the sole owner and interest

holder in the policy.

        When a rollout of an SDLIA occurs, the employer generally is entitled to be

reimbursed by the insured employee or owner of the insurance policy the lesser of

the total premiums the employer paid on the related life insurance policy or the cash

surrender value of the policy at the time of the rollout.

        Exit strategies from SDLIAs have been described as follows:

        Split-dollar exit strategies traditionally are known as “roll-out” spilt-
        dollar arrangements--perhaps better described as an unwinding of the
        split-dollar arrangement during the insured’s lifetime, or a release of
        the employer’s interest in the policy under the arrangement during the
        insured’s lifetime. These strategies contemplate termination of the
        arrangement by a transfer of the policy or a release of the employer’s
        interest in the policy to the insured or to a third-party owner sometime
        during the insured’s lifetime, after repayment to the corporation of its
        “interest” in the policy. Normally, repayment is accomplished by
                                       - 17 -

      [*17] having the policy owner withdraw from or borrow against the
      policy to generate the cash needed to repay the employer, which
      cannibalizes the policy. * * * Withdrawals for collateral assignment
      arrangements are tax-free only up to the owner’s basis--i.e., the
      contributed or taxed economic benefit amounts * * * [Lawrence Brody,
      et al., Insurance-Related Compensation, 386-4th Tax Mgmt. (BNA), at
      A-118-A-119 (2009).]

      Over the years the Commissioner provided little and somewhat confusing

administrative guidance on the income tax treatment to corporate executives of the

economic benefits associated with SDLIA arrangements. See, e.g., Rev. Rul. 55-

713, 1955-2 C.B. 23; Rev. Rul. 64-328, 1964-2 C.B. 11; Rev. Rul. 66-110, 1966-1

C.B. 12; IRS Notice 2001-10, 2001-1 C.B. 459.

      In 2002 and 2003, as SDLIAs became popular, the Commissioner issued a

number of additional rulings, notices, and proposed regulations. See Rev. Rul.

2003-105, 2003-2 C.B. 696; IRS Notice 2002-8, 2002-1 C.B. 398; secs. 1.61-22,

1.7872-15, Proposed Income Tax Regs., 67 Fed. Reg. 45414 (July 9, 2002),

published as final Income Tax Regs., 68 Fed. Reg. 54344 (Sept. 17, 2003).

      On September 17, 2003, the Commissioner issued final regulations clarifying

and changing how taxpayers prospectively should account annually for their

incremental gain in equity SDLIAs. See sec. 1.61-22(d)(2), Income Tax Regs.

These final regulations, however, were made inapplicable to SDLIAs
                                        - 18 -

[*18] entered into on or before September 17, 2003, and not materially modified

thereafter. See sec. 1.61-22(j), Income Tax Regs.

      Because the SDLIAs in these cases were entered into on March 6, 2002, and

were not substantially modified before termination, the Commissioner’s final

regulations do not apply.10 Instead, Rev. Ruls. 64-328 and 66-110, supra, and IRS

Notice 2002-8, supra, apply to the SDLIAs involved in these cases (i.e., those

entered into after January 27, 2002, but on or before September 17, 2003).

Thereunder, for each year an SDLIA was in effect, an employee was required to

include in taxable income the total value or cost of the economic benefit received

each year by the employee, less any amount contributed by the employee. As

indicated, petitioners did not include in their taxable income any amount with regard

to the economic benefits they received in 2002, 2003, or 2004 with regard to the

SDLIAs.

      Petitioners now contend that no termination or rollout of the SDLIAs

occurred, that they purchased from N & J Management for a discounted present

value only “contract rights,” that they paid fair value therefor, that the SDLIAs




      10
        Respondent has chosen not to treat the December 2003 transaction involved
herein as a modification of the SDLIAs.
                                         - 19 -

[*19] remain in effect, that they were not released from any indebtedness, and that

they realized no compensation income relating thereto.

       To the contrary, we believe it obvious that a cancellation, an unwinding, a

release, or a rollout of N & J Management’s interests in the SDLIAs occurred. The

formal SDLIA agreements may not have been technically or formally terminated by

a written document, but as of the end of December 2003, the SDLIA arrangements

were unwound, and N & J Management was released from its obligation as

employer to provide further funding on the life insurance policies. Petitioners have

stipulated that after and as a result of the transaction at issue in these cases, N & J

Management had no continuing interest or reimbursement rights with regard to the

underlying life insurance policies.

      We find that the transaction before us constituted an effective rollout of the

SDLIAs and that the equity split-dollar life insurance arrangements were terminated

during December 2003, even in the absence of a formal written termination of the

SDLIA agreements.

      No evidence before us (other than the absence of formal written termination

documents) suggests that the SDLIAs had any existence beyond December 2003.

Petitioners’ own advisers treated the transaction before us as a termination of the
                                       - 20 -

[*20] SDLIAs and as occurring in December 2003, as did petitioners and

petitioners’ counsel.

      In December 2003 N & J Management was entitled to reimbursement of

the $842,345 in premiums N & J Management had paid. Petitioners were obligated

or indebted to N & J Management to make the reimbursement, and the cash value of

the policies was secured in favor of N & J Management to fund the reimbursement.

      N & J Management, however, was reimbursed by petitioners only $131,969,

and the $710,376 difference was effectively realized by petitioners (not including

GSN and TerSen) as compensation income--namely, petitioners realized the

economic benefit of the $710,376 in premiums N & J Management had paid to the

life insurance companies on petitioners’ behalf and that no longer was encumbered

by the reimbursement rights of N & J Management.

      The above-cited BNA Tax Management portfolio provides the following

additional explanation:

            Under Notices 2001-10 and 2002-8, a policy rollout of an
      arrangement entered into before the effective date of the final
      regulations has income tax consequences for the employee if there is
      any policy equity at that point.

           *            *      *          *         *          *         *
                                       - 21 -

      [*21] It is unclear whether repaying the * * * [employer] for its
      advances on rollout with either a paid-up policy with a face amount
      (but no current cash value) equal to its interest in the policy or a
      discounted amount of cash, based on the likely repayment at the
      insured’s death, would be enough to stop the ongoing economic benefit
      of the arrangement to the employee.

             Given the rationale of Rev. Rul. 64-328, neither action may
      work because they do not appear to repay the employer’s “investment”
      in the policy; if either action did work to stop the ongoing economic
      benefit of the arrangement, the “shortfall” likely would be taxed to the
      employee at rollout as some sort of compensation-related debt
      forgiveness. [Brody, et al., supra, at
      A-119-A-120.]

      Section 61 provides that gross income includes all income from whatever

source derived. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955).

Generally, an employee who receives an economic benefit under an arrangement

with an employer must include in gross income the value of the benefit received.

Commissioner v. Smith, 324 U.S. 177, 181 (1945). Under section 1.61-2(d),

Income Tax Regs., premiums paid by an employer for life insurance on the life of

an employee are treated as taxable income to the employee if the life insurance

proceeds are payable to the employee or a beneficiary designated by the employee.

      Section 61(a)(12) provides generally that gross income includes income

from discharge or release of indebtedness. See United States v. Kirby Lumber

Co., 284 U.S. 1 (1931). However, section 61(a)(12) does not apply if a
                                         - 22 -

[*22] cancellation or release of indebtedness is simply the medium for payment of

some other form of income such as compensation for services being paid by an

employer to an employee.

       [C]ancellation of indebtedness can be simply the medium through
       which other types of income arise. For example, if an employee owes
       his employer $100 and renders $100 worth of services for the employer
       in return for the employer’s cancellation of the indebtedness, the
       employee has received personal service income of $100. Sec. 61(a)(1).
       That income is not cancellation of indebtedness income because the
       cancellation is merely the medium for payment of other income, and is
       not the source of the income itself. * * * [Spartan Petroleum Co. v.
       United States, 437 F. Supp. 733, 736 (D.S.C. 1977).]

See also OKC Corp. v. Commissioner, 82 T.C. 638, 649-650 (1984).

       Under section 83(a) and the regulations thereunder, when property is

transferred in connection with the performance of services, the excess of the fair

market value of the property over the amount paid for the property is to be included

in the gross income of the person who performed the services in the first taxable

year in which the rights of that person are transferable or not subject to a substantial

risk of forfeiture.

       Under section 1.83-3(a), Income Tax Regs., a transfer of property occurs

when a person acquires a beneficial ownership interest in the property. Under

section 1.83-3(e), Income Tax Regs., in the case of a life insurance contract which
                                        - 23 -

[*23] was part of a split-dollar arrangement entered into on or before September 17,

2003, and not materially modified after that date, the cash surrender value of the

contract is considered property.

      In December 2003 upon rollout of the SDLIAs, the income petitioners

realized under section 61 or alternatively the taxable value of property transferred to

them under section 83 was the $710,376 difference between the $842,345 that N &

J Management paid in premiums on their behalf and that was owed by them and the

$131,969 they reimbursed N & J Management. Clearly, petitioners realized an

accession to wealth of $710,376 for the additional premiums N & J Management

paid. This occurred in the context of and related to petitioners’ employment with N

& J Management, and the $710,376 constitutes compensation income to them.

      Following the termination of the SDLIA arrangements, petitioners had no risk

of forfeiture of the economic benefit of the $710,376 not reimbursed to N & J

Management. Petitioners had complete ownership of the policies and were free to

transfer the cash value of the polices free of encumbrances. Petitioners had no

service requirements or other employment-related conditions that they needed to

fulfill with regard thereto. See sec. 1.83-3(c) and (d), Income Tax Regs.
                                         - 24 -

[*24] We reject petitioners’ vigorous and well-intentioned efforts, through counsel,

to cast the transactions before us as a mere sale of “contract rights” at fair value.

Their actions, their conduct, their understanding, and their representations among

themselves and to respondent consistently treated the transactions as a termination

of the SDLIAs.

      There is no credible evidence that the focus by petitioners and by their

attorneys was on the purchase by petitioners of mere contract rights. Indeed, the

calculation by petitioners’ accountants does not even talk about or mention contract

rights; rather, it addresses and attempts to value N & J Management’s

reimbursement rights under the SDLIAs that were triggered by termination of the

SDLIAs.

      Alternatively, petitioners contend that at most “a freeze” of the SDLIAs

occurred and that the SDLIAs remained in effect. In making this argument,

petitioners seem to forget that N & J Management was paid $131,969 and that the

parties regarded and treated as ended or terminated, and in fact ended or terminated,

the SDLIA arrangements, with N & J Management retaining no further interest in or

claim on the policies and with petitioners owing nothing further to

N & J Management with regard thereto. We reject petitioners’ argument that a

mere freeze of the SDLIAs occurred.
                                         - 25 -

[*25] Petitioners contend that no property was transferred to them that could be

taxed under section 83(a). Petitioners focus on their preexisting ownership

interests in the life insurance policies and argue that no additional property was

transferred to them when N & J Management received the $131,969 payment, was

relieved of its obligation to make additional premium payments, and released its

rights to reimbursement of the additional premiums it had paid. We disagree.

      Petitioners did own the policies, but the total $842,345 in premiums paid by

N & J Management and the cash surrender value thereof (namely, $877,432) were

encumbered by N & J Management’s reimbursement rights and petitioners’

indebtedness with regard thereto. Petitioners could not access the cash surrender

value and could not sell or dispose of or otherwise transfer their ownership

interests in the policies or access the cash surrender value until N & J

Management was either reimbursed the $842,345 or gave up its reimbursement

rights. N & J Management gave up its reimbursement rights to the $710,376

balance and released petitioners from any further indebtedness on the amount not

reimbursed. In essence, the economic benefit of the $710,376 was transferred to

petitioners in December 2003 when the SDLIA arrangements were terminated,

when N & J Management gave up its additional reimbursement rights, and when
                                         - 26 -

[*26] N & J Management was removed from the picture relating to the life

insurance policies. These facts are not changed by the possibility that future

premiums to be paid on the life insurance policies, if paid by N & J Management,

might trigger a revival of the SDLIA arrangement with regard to future premiums

paid.

        If we sustain respondent’s deficiency determinations against petitioners on

the merits, as we do, petitioners make a number of procedural arguments that we

briefly address. Petitioners contend that respondent’s notices of deficiency were

vague and inadequate because they did not reference a specific Code section in

support of the determination to treat the $710,376 as compensation income to

petitioners. On the facts of these cases, we believe respondent’s brief explanation

in the notices of deficiency (namely, “compensation income”) was sufficient to give

petitioners notice of the income adjustments at issue herein.

        Petitioners contend that respondent’s audit adjustments should have been

made for 2004, not 2003, because they paid the $131,969 to N & J Management in

2004. We disagree. Regardless of when petitioners paid the $131,969, the

$710,376 not paid by petitioners and with respect to which petitioners had no

further obligation to make repayment was realized as income by petitioners in

December 2003 when the SDLIA arrangements were terminated and petitioners
                                         - 27 -

[*27] realized the value of the $842,345 (reduced by the $131,969 to be paid by

petitioners).11 As we have held, the evidence is clear that the release by

N & J Management of its reimbursement rights, the termination of the SDLIAs, and

the vesting in petitioners of full and unrestricted rights to the $710,376 occurred in

December 2003.

       The fact that the $131,969 petitioners paid N & J Management was not

transferred into N & J Management’s bank account until January 13, 2004, does not

move the realization by petitioners of the $710,376 into 2004. In December 2003,

when the rollout was agreed to, when the rollout took effect, when N & J

Management was released of its obligation to further fund the policies, and when N

& J Management agreed to be reimbursed only $131,969, petitioners realized the

economic benefit of the $710,376 that N & J Management paid as premiums on

their behalf.



       11
       We also note that petitioners’ 2004 tax year is still open because of audit
adjustments respondent made against them for 2004 that remain pending in this
Court.

      Further, if 2004 were now a closed year for petitioners and if we were to
determine that 2004 were the correct year to charge petitioners with the income in
dispute, it would appear that respondent would be allowed to open up petitioners’
2004 tax years for the appropriate income adjustments under the mitigation
provisions of the Code. See secs. 1311-1314, particularly sec. 1312(3)(B).
                                        - 28 -

[*28] Petitioners contend that the income adjustments regarding the $710,376

should have been charged not just to them but also to GSN and TerSen, the family

limited partnerships that owned four of the life insurance policies. Again, we

disagree with petitioners. Mr. Steven Neff and Mr. Bradley Jensen were the

employees of N & J Management. Their employment relationship with N & J

Management was the raison d’être for the SDLIAs. N & J Management paid the

premiums on the life insurance policies as part of a compensation package relating

to the services of Mr. Steven Neff and Mr. Bradley Jensen.

      GSN and TerSen had no employment relationship with N & J Management.

GSN and TerSen were simply the designees of petitioners. Any income relating to

the premiums N & J Management paid on behalf of petitioners and to the SDLIAs is

properly charged to petitioners, not to their family limited partnerships. As

explained in Rev. Rul. 78-420, 1978-2 C.B. 67, in the context of SDLIAs, premiums

an employer pays on a policy covering the life of an employee are to be included in

the income of the employee, regardless of whom the employee designates as owner

of the policy.

      Other arguments made by petitioners and not specifically discussed herein

have been considered and rejected.
                                         - 29 -

[*29] In light of the complex nature of the transaction before us, the difficult tax

issues presented, and the testimony and trial record before us, we exercise our

discretion not to sustain the section 6662(a) penalties respondent determined. See

Nelson v. Commissioner, 130 T.C. 70, 78-79 (2008), aff’d, 568 F.3d 662 (8th Cir.

2009). We believe petitioners acted with reasonable cause and in good faith in

relying on their professional tax advisers in omitting from their 2003 income the

difference between the amount petitioners paid to N & J Management and the

amount N & J Management paid on the six life insurance policies. See sec.

6664(c)(1).

      For the reasons stated,


                                                        Decisions will be entered

                                                  under Rule 155.
