                         T.C. Memo. 2011-208



                       UNITED STATES TAX COURT



 ESTATE OF KENNETH L. LAY, DECEASED, LINDA P. LAY, INDEPENDENT
           EXECUTRIX AND LINDA P. LAY, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15732-09.               Filed August 29, 2011.



     Charles H. Egerton and Jane Dunlap Callahan, for

petitioners.

     Stephen R. Takeuchi, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     GOEKE, Judge:    This case involves a deficiency of $3,910,000

determined by respondent in the 2001 Federal income tax of

Kenneth L. Lay and Linda P. Lay (the Lays).      The deficiency is

based upon respondent’s determination that the Lays received
                                 - 2 -

income as a result of the sale of two annuity contracts to Enron

Corp. (Enron).     For the reasons stated herein, we find that they

did not receive the income determined by respondent and are not

liable for the deficiency.

                           FINDINGS OF FACT

         Some of the facts have been stipulated and those facts are

incorporated herein by this reference.     Mrs. Lay resided in Texas

and the estate of Mr. Lay was being administered in Texas at the

time the petition was filed.

     The Lays were married in 1982.      Mr. Lay was chairman of the

board of directors and chief executive officer of Houston Natural

Gas Corp. when it merged in 1985 with InterNorth, Inc., forming

what became known as Enron.     Mr. Lay was chairman of the board of

directors and chief executive officer of Enron from 1986 until

February 2001.     In 1990 Enron hired Jeffrey K. Skilling, who

later succeeded Mr. Lay as chief executive officer in 2001.

Enron grew very rapidly during the 1990s into a company with

16,000 employees and became the seventh largest company in the

United States.     In the late 1990s the board of directors of Enron

comprised 13 individuals.1


     1
      The members of the   board of directors of Enron were:
Kenneth L. Lay of Enron;   Robert A. Belfer of Belfer Oil & Gas;
Norman P. Blake, Jr., of   General Electric; John H. Duncan of Gulf
& Western Corp.; Herbert   S. Winokur of Capricorn; Dr. John
Mendelson of MD Anderson   Cancer Center; Dr. Charles A. LeMaistre,
former chancellor of the   University of Texas system and past
                                                     (continued...)
                                 - 3 -

The board of directors of Enron also had committees that reported

to the board of directors, including the Compensation and

Management Development Committee (Compensation Committee).     The

Compensation Committee evaluated the compensation and made

recommendations for the compensation paid to top-level officers.

     The members of the Compensation Committee in 2001 were board

of directors members Dr. Charles A. LeMaistre, Norman P. Blake,

Jr., John H. Duncan, Dr. Robert K. Jaedicke, and Frank Savage.

The members of the Compensation Committee were not employed by

Enron and were not involved with companies in businesses similar

to Enron’s business.   Dr. LeMaistre was the chairman of the

Compensation Committee.   Dr. LeMaistre also served on the

executive committee of Enron because of his position as chairman

of the Compensation Committee.

     The compensation philosophy at Enron was to pay for and to

reward an executive’s performance that created long-term

shareholder value.   Before and during 2001 the Compensation

Committee had developed a pay-for-performance system for the



     1
      (...continued)
president of MD Anderson Cancer Center in Houston; Dr. Wendy L.
Gramm, economist and professor of economics at Texas A&M
University; Dr. Robert K. Jaedicke, former dean of Stanford Law
School;, Lord John Wakeham, a member of the British Parliament;
Ronnie Chan, a resident of Hong Kong; Paulo V. Ferraz Pereira, an
industrialist from Argentina; and Frank Savage, an industrialist
from the east coast of the United States. The board of directors
of Enron represented the shareholders interests and oversaw the
activities of the company.
                                - 4 -

compensation of the senior officers of Enron.    The compensation

for senior officers had three elements:    A base salary, an annual

bonus, and a long-term incentive grant.

     The Compensation Committee used the outside consulting firm

Towers Perrin to provide compensation consulting services.    At

the request of the Compensation Committee, Towers Perrin provided

a range of salaries for each position for which the Compensation

Committee established the compensation, using comparable

companies.    Towers Perrin used 64 comparable companies to

establish the compensation ranges.

     The Compensation Committee established a base salary for

each position based on individual performance as measured against

preestablished individual objectives, set at roughly the 50th

percentile of the pay for that position at the comparable

companies.    The annual bonus was calculated on the after-tax net

income of Enron, creating a pool for the annual bonus and payable

to the senior officers on the basis of their individual

performances as measured against preestablished individual

objectives, such that the base salary and the annual bonus would

be up to the 75th percentile of the pay for that position at the

comparable companies.    The long-term incentive grant had two

components:    Stock options and restricted stock.   The restricted

stock was paid out in 4-year tranches, and the 4-year period was
                                - 5 -

used as the comparator.2   The restricted stock was paid out only

if Enron’s productivity measured up to the plan developed at the

beginning of each year; i.e., if Enron performed like the top 5

of 12 comparable companies in most years, or the top 3 in some

years.

     The Compensation Committee set the compensation for Mr. Lay

as chief executive officer and chairman of the board each year,

using the Enron pay-for-performance methodology for setting

compensation.   The Compensation Committee reviewed Mr. Lay’s

salary, bonuses, and long-term incentives over a period of years

together with Mr. Lay’s performance as compared with the plan

of operation adopted for the year and the comparators for CEOs

and chairmen of the board.

     In the mid-1990s Mr. Lay was planning his retirement from

the position of CEO of Enron.   Initially, the Compensation

Committee and the board of directors considered Rich Kinder, the

chief operating officer (COO) of Enron, as the successor to Mr.

Lay as CEO of Enron.   The Compensation Committee determined that

Mr. Kinder was well qualified to run the company on the basis of

his experience as COO but asked Mr. Kinder whether the

Compensation Committee could continue to review his performance



     2
      A tranche is a number of related securities that are part
of a larger securities transaction. A comparator is a device for
comparing something with a similar thing or with a standard
measure.
                               - 6 -

for another year to evaluate his potential as the CEO for Enron.

Mr. Kinder agreed to the additional year of review with the

understanding that he would be able to leave Enron with certain

benefits if he was not elected to the position of CEO at the end

of the 1-year period, and the board of directors approved the

arrangement, following the Compensation Committee’s

recommendation.

     At the end of the year the board of directors decided to

continue the arrangement for 1 more year, with Mr. Lay as

CEO/chairman of the board and Mr. Kinder as COO.    In accordance

with the prior agreement, Mr. Kinder exercised his option and

left Enron in 1996 in order to become CEO of another company.

After Mr. Kinder resigned from his position as COO, the board of

directors elected Mr. Skilling as president and COO of Enron in

December of 1996.   As COO of Enron, Mr. Skilling reported

directly to Mr. Lay, the CEO of Enron.    Enron had hired Mr.

Skilling in 1990, and he had been the director of an innovative,

highly successful venture of Enron.    The management of Enron

identified Mr. Skilling as the future successor CEO.    Mr. Lay

thereafter recommended that Mr. Skilling become the new CEO of

Enron.   The Compensation Committee and the board of directors

supported Mr. Lay’s recommendation of Mr. Skilling for the CEO

position.
                                - 7 -

     In February 2001 Mr. Lay stepped down as CEO and Mr.

Skilling became CEO of Enron.    Mr. Lay remained chairman of the

board of directors of Enron.    After Enron announced that Mr.

Skilling was taking over as CEO, Mr. Lay received offers from

other companies to take other positions.

     In February 2001 stock prices were in general decline,

including the price of Enron stock.     Technology stocks in

particular had fallen in the summer of 2000, and stock prices

consequently fell throughout the market.     The Compensation

Committee requested a stress test of Enron’s financial condition

because of concern over the falling stock prices.     The results of

the stress test in May 2001 indicated that Enron was financially

sound even though Enron stock prices had fallen.     Mr. Lay was in

final contract negotiations regarding a position with another

company when Mr. Skilling suddenly resigned from Enron on August

14, 2001.

     Upon the unexpected resignation of Mr. Skilling, the board

of directors of Enron immediately and proactively worked to

persuade Mr. Lay to take the CEO position again at Enron.       The

board of directors determined that no other senior officer at

Enron was sufficiently trained and ready to step into the CEO

position.

     The board of directors of Enron wished to rehire Mr. Lay as

CEO and to retain Mr. Lay for a long period in order to stabilize
                               - 8 -

the company.   Enron negotiated for Mr. Lay to serve as CEO of

Enron and to remain in the CEO position for a period of years.

     Although Mr. Lay had wished to retire as CEO of Enron, he

agreed to return.   Mr. Lay held a very large position in Enron

stock because of the long-term incentives earned over the years,

and he had a major requirement for liquidity.   Enron and its

advisers developed proposals with incentives to entice Mr. Lay to

reassume his position as CEO and to retain him for a period of

years.   The Compensation Committee was interested in an

agreement to retain Mr. Lay for a period of years.   The

subsequent sudden collapse of Enron was unanticipated by the

Compensation Committee during the negotiations with Mr. Lay in

August 2001.   The instruments that Enron would normally use for

retention, stock options and restricted stock, both were

problematic.

     First, because Mr. Lay was over age 55 and had served for

more than 5 years, if he voluntarily retired all of his

restricted stock would immediately vest.   Second, Enron’s stock

plan documents limited the number of shares, options, or

restricted shares that could be granted in 1 year in accordance

with a shareholder-approved plan, and there was not time to hold

a shareholder meeting to approve a modification to the plan.

Accordingly, alternatives for retention were considered.   At the

request of the Compensation Committee, Towers Perrin prepared
                               - 9 -

alternatives for the Compensation Committee to offer to Mr. Lay

for consideration.   The alternatives prepared by Towers Perrin

were based on two annuity contracts owned by Mr. Lay and Mrs.

Lay--the contracts which underlie the dispute in the present

case.

     Mr. Lay purchased annuity No. 002105676 from the

Manufacturers Life Insurance Co. of North America (ManuLife) on

September 30, 1999 (Kenneth L. Lay Annuity).     Mr. Lay paid

premiums in the aggregate amount of $5 million to ManuLife for

the Kenneth L. Lay Annuity as follows:

          Date of Payment              Premium Payment

          Sept. 30, 1999                 $2,500,000

          May 10, 2000                    1,125,000

          June 19, 2000                   1,375,000

            Total                         5,000,000

Annuity No. 002155712 issued by ManuLife was purchased for Mrs.

Lay on February 8, 2000 (Linda P. Lay Annuity).       Premiums in the

aggregate amount of $5 million were paid to ManuLife for the

Linda P. Lay Annuity as follows:

          Date of Payment              Premium Payment

          Feb. 8, 2000                   $2,500,000

          May 10, 2000                    1,125,000

          June 19, 2000                   1,375,000

             Total                        5,000,000
                              - 10 -

The annuity contracts were titled “Flexible Purchase Payment

Deferred Combination Fixed and Variable Annuity Contract Non-

Participating”.   The owner of each annuity contract could elect

to step up the value of the annuity contract to the market value

of the selected investments of the annuity contract.   The annuity

contracts also had a Guaranteed Retirement Income Program

feature, referred to as the “GRIP”, that guaranteed a 6-percent

annual increase on the amounts invested in the annuity.

     The owner of the annuity contract could request that the

annuity payments start 7 years after purchase (or, if made, 7

years after an election to step up the value of the annuity to

market value) using the greater of actual market value of the

investments in the account or the GRIP amount.   The GRIP amount,

as calculated over time with the 6-percent annual increase to the

amount paid for the policy, was referred to as the “Income Base”.

     Mr. Lay elected to step up the value of his annuity contract

on September 30, 2000.   The income base of the Kenneth L. Lay

Annuity on September 21, 2001, was $5,854,272.65, and the owner

of the Kenneth L. Lay Annuity on the seventh anniversary of Mr.

Lay’s election to step up the policy value (September 30, 2007)

was entitled to annuitize the guaranteed Income Base of

$8,303,072 pursuant to the terms of the Kenneth L. Lay Annuity.

     The income base of the Linda P. Lay Annuity on September 21,

2001, was $5,453,004.77, and the owner of the Linda P. Lay
                               - 11 -

Annuity on the seventh anniversary of the issuance of the policy

(February 8, 2007) was entitled to annuitize the guaranteed

income base in the approximate amount of $7,512,482 (the current

income base reflected on the January 1 to March 31, 2007, John

Hancock Statement for the Linda P. Lay Annuity) pursuant to the

terms of the Linda P. Lay Annuity.

     The owner of the annuity contract could make withdrawals

from the amounts invested in the contract and could change the

investment elections.   The annuity contracts were issued in Texas

and provide that the governing law is Texas law.    The annuity

contracts state that “each owner may change the Owner, Annuitant,

or Beneficiary of his or her interest in the Contract by written

request in a form acceptable to us and which is received at our

Annuity Service Office.”    The annuity contracts provide:

     An Owner may assign his interest in this Contract at
     any time prior to the Maturity Date. No assignment
     will be binding on us unless it is written in a form
     acceptable to us and received at our Annuity Service
     Office. We will not be liable for any payments made or
     actions we take before the assignment is accepted by us
     * * *. We will not be responsible for validity of any
     assignment.

     Mary K. Joyce was vice president of compensation of Enron in

2001.   As vice president, Mrs. Joyce worked closely with the

Compensation Committee.    The Compensation Committee set pay

philosophy, particularly regarding executive compensation,

oversaw compensation plans, selected consultants to provide

advice regarding compensation, and oversaw employee benefit
                               - 12 -

plans.   Mrs. Joyce acted at the direction of the Compensation

Committee.   Mrs. Joyce prepared the agenda and materials that

were presented at each meeting of the Compensation Committee,

working directly with Dr. LeMaistre and other members of the

committee.   Mrs. Joyce also obtained any reports that the

Compensation Committee requested in connection with compensation

and benefits.

     When Enron was developing proposals to attract Mr. Lay to

return as CEO, Dr. LeMaistre instructed Mrs. Joyce to request

proposals from Towers Perrin for use by the Compensation

Committee that would provide liquidity and a retention device.

Accordingly, Mrs. Joyce requested that Towers Perrin prepare

proposals to attract Mr. Lay by providing liquidity and to retain

Mr. Lay for a period of years by structuring a retention device.

     The alternatives proposed by Towers Perrin were:   (1) To

lend funds to Mr. Lay with the annuity contracts as collateral;

(2) to purchase the annuity contracts for fair market value; or

(3) to purchase the annuity contracts for fair market value and

then use the annuity contracts as a retention device by awarding

the acquired contracts to Mr. Lay with a “cliff vesting”

schedule.    The term “cliff vesting” means that the award vests in

its entirety at the end of the vesting period, rather than

vesting ratably over the vesting period.
                               - 13 -

     The Compensation Committee considered the alternatives and

chose the third alternative to purchase the annuity contracts,

both to provide immediate liquidity to Mr. Lay and to use the

annuity contracts as a retention device by providing Mr. Lay with

the opportunity to have the annuity contracts transferred back to

him if he met certain contractually specified requirements and

subject to a cliff-vesting schedule.    The Compensation Committee

rejected the first two options proposed by Towers Perrin because,

although they met Mr. Lay’s requirement for liquidity, the

options did not provide a retention device as required by the

board of directors of Enron.   Towers Perrin proposed a 4.25-year

commitment from Mr. Lay.

     Enron’s outside counsel, Vinson & Elkins, assisted in

structuring the annuities transaction.   At Dr. LeMaistre’s

request, Mrs. Joyce presented the proposed annuities transaction

to the Compensation Committee at its meeting on September 14,

2001.   Mrs. Joyce used two spreadsheets, headed “Scenario 1” and

“Scenario 2”, in making her presentation of the Towers Perrin

proposal to the Compensation Committee and to illustrate the

differences of using the annuity contracts as compared to Enron

stock to accomplish the board’s retention objective.

     The spreadsheets showed that the Lays had paid a total of

$10 million for the annuity contracts ($5 million for each

policy), that the Lays would receive a total of $4,691,567 if
                                - 14 -

they were to liquidate the contracts at that time, and that the

value of the annuity contracts at that time was $11,240,685.3

     The only difference between the two spreadsheets presented

at the meeting was the amount that would be paid for the annuity

contracts, $10 million as shown on Scenario 1 and $4,691,567 on

Scenario 2.   Because the purchase price reflected on Scenario 2

was the amount that the Lays would receive if they cashed in

their annuity contracts, the Compensation Committee concluded

that it would not provide any incentive for Mr. Lay to return to

Enron as its CEO, a requirement for the transaction.

     The spreadsheets showed the benefits to Enron and to Mr. Lay

of using the annuities transaction instead of using Enron stock

for the transaction, especially the fact that the annuities

transaction would not dilute Enron stock and would provide Mr.

Lay with immediate liquidity.    The Compensation Committee

determined on the basis of the information provided by Towers

Perrin that the current fair market value of the annuity

contracts at the time of the transaction was $11,240,685.

     Following the discussion of the issues at its meeting on

September 14, 2001, the Compensation Committee approved “Scenario

1 of the Ken Lay Insurance Swap Analysis”.    The scenario approved

by the Compensation Committee was to acquire the annuity


     3
      The spreadsheets also showed that the current floor value
was $11,240,685 and that the value in 4.25 years would be
$14,399,344.
                                - 15 -

contracts for $5 million each, $10 million total, and also to

provide Mr. Lay the opportunity to earn back the annuities at the

end of a 4.25-year cliff-vesting period (or upon certain

terminations outside Mr. Lay’s control).    The Compensation

Committee, therefore, authorized Enron to pay $10 million for two

annuity contracts worth $11,240,685.

     The Compensation Committee authorized the officers of Enron

to execute and deliver all documents necessary or appropriate to

carry into effect the approved annuities transaction.    The board

of directors of Enron approved the transaction at its meeting on

October 8, 2001.   The Compensation Committee concluded that the

proposed purchase of the annuity contracts would provide Mr. Lay

with liquidity and was a good investment for Enron.

     The plan approved by the Compensation Committee had two

distinct elements.   First, as part of the package of inducements

offered to Mr. Lay in exchange for abandoning his plans to retire

and agreeing to reassume the responsibilities of CEO of Enron,

Enron agreed to purchase both of the annuity contracts from Mr.

and Mrs. Lay for $10 million.    Second, as a retention device,

Enron agreed that if Mr. Lay neither resigned without consent nor

was removed for certain specified reasons as chairman of the

board and CEO of Enron before the expiration of a 4.25-year term,

it would reconvey the annuity contracts to Mr. Lay upon

completion of his service commitment.
                              - 16 -

     The Lays accepted the offer to sell their annuity contracts

for $5 million each, $10 million total, and Mr. Lay accepted the

offer to earn back the annuity contracts as a long-term incentive

award if he remained with Enron for the 4.25-year term (or left

the employment of Enron for certain reasons outside his control).

Following Mr. Skilling’s resignation, the board of directors of

Enron elected Mr. Lay to the position of CEO of Enron.   Enron

prepared a Purchase, Sale, and Reconveyance Agreement (agreement)

to memorialize the terms of the agreement that Enron negotiated

with Mr. Lay.   The Enron legal staff worked with its outside

counsel, Vinson & Elkins, to prepare the agreement.

     Mr. Lay, Mrs. Lay, and Enron entered into the agreement on

September 21, 2001.   Mrs. Joyce executed the agreement on

September 21, 2001, on behalf of Enron in her capacity as a vice

president of Enron.   The Lays executed and delivered the

agreement to Enron on September 21, 2001.   The agreement required

Enron to deliver $10 million by certified check or wire transfer

to the Lays at the closing of the purchase of the annuity

contracts.

     The agreement also required the Lays, before or

simultaneously with the tender of the purchase price to them, to:

(i) Complete fully and accurately the Personal Information Change

Form (change form) for each of the contracts directing a change

in ownership of that contract to Enron and designating Enron as
                               - 17 -

sole and primary beneficiary to receive any death proceeds paid

under the contracts; (ii) execute and submit the change forms to

Enron, and (iii) transfer the originals and all copies of the

Contracts in their possession to Enron.

     The change forms attached to the agreement to be used to

transfer the annuity contracts to Enron are the forms provided by

ManuLife for this purpose.    The change form required the

signature of the current owner.    The change form also required

the signature of the new owner if the change form was being used

to change the owner.   The change form states:   “Please complete

this Personal Information Changes form with appropriate

signatures and mail to Manulife North America’s Product

Administration Department.”

     In order to transfer the Kenneth L. Lay Annuity to Enron,

Mr. Lay executed the change form to change the owner and

beneficiary of the Kenneth L. Lay Annuity to Enron.    Mr. Lay

delivered the executed, original change form with the original

annuity policy contract No. 002105676 to Enron on September 21,

2001.   Mrs. Joyce executed the change form for the transfer of

the Kenneth L. Lay Annuity to Enron, on behalf of Enron as the

new owner of the Kenneth L. Lay Annuity, on September 21, 2001.

     In order to transfer the Linda P. Lay Annuity to Enron, Mrs.

Lay executed the change form provided by ManuLife to change the

owner and beneficiary of the Linda P. Lay Annuity to Enron.      Mrs.
                              - 18 -

Lay delivered the executed, original change form with the

original annuity policy contract No. 002155712 to Enron on

September 21, 2001.   Mrs. Joyce executed the change form for the

transfer of the Linda P. Lay Annuity to Enron, on behalf of Enron

as the new owner of the Linda P. Lay Annuity, on September 21,

2001.   Mrs. Joyce received the original annuity contracts that

the Lays delivered to Enron on September 21, 2001.

     Enron transferred $10 million to the bank account of the

Lays by wire transfer on September 21, 2001, in exchange for the

two annuity contracts.

     There is an issue regarding the date that the change forms

were submitted by Enron to ManuLife and whether the originals or

copies were transmitted.   Mrs. Joyce delegated the responsibility

for submitting the change forms to ManuLife on behalf of Enron

to Aaron Brown, the director of compensation for Enron.   Mrs.

Joyce and Mr. Brown both believed that the original change forms

had been submitted to ManuLife on or shortly after September 21,

2001.   Mr. Brown stated to a ManuLife employee that he had

provided the original change forms to ManuLife at the time of the

annuities transaction.

     After September 21, 2001, Enron representatives asked

ManuLife why it had not yet processed the change of ownership of

the annuity contracts in accordance with the change forms.    Mr.

Brown transmitted the fully executed change forms from Enron to
                                - 19 -

ManuLife by facsimile on January 12, 2002.    The facsimile cover

sheet was addressed by Mr. Brown to Gretchen Swanz of ManuLife,

and contained the following instructions to ManuLife:    “Gretchen,

please facilitate the transfer of ownership/beneficiary of these

policies to Enron.”   Ms. Swanz then sent an email to Mr. Brown,

on February 19, 2002, requesting that he send the original change

forms.   Mr. Brown responded by email dated February 19, 2002,

that certified copies of the originals would be provided.

ManuLife corresponded with Enron regarding the change forms.

ManuLife did not contact Mr. or Mrs. Lay regarding the change

forms.

      In 2004 ManuLife acquired and merged with John Hancock Life

Insurance Co. (John Hancock).    John Hancock became the wholly

owned subsidiary of ManuLife and succeeded to all of the U.S.

operations of ManuLife and the former John Hancock Life Insurance

Co.   John Hancock, therefore, is the insurance company that is

currently the party to the annuity contracts and has the records

regarding the annuity contracts.    John Hancock has copies of the

fully executed agreement and the fully executed change forms in

its files.

      The Lays reported the annuities transaction on their 2001

tax return on Schedule D, Capital Gains and Losses, as a sale of

each annuity contract for $5 million.    Mr. Lay and Mrs. Lay each

had an adjusted basis of $5 million in the annuity contract sold
                              - 20 -

by him or her to Enron pursuant to the agreement.   The Lays

reported zero gain or loss on the sale of the annuity contracts,

on the basis of a sale price of $5 million for and an adjusted

basis of $5 million in each of the annuity contracts sold to

Enron pursuant to the agreement.   Enron issued a Form W-2, Wage

and Tax Statement, to Mr. Lay for the 2001 calendar year to

report the compensation it paid him; that Form W-2 did not

include in Mr. Lay’s compensation any part of the $10 million

that Enron paid for the annuity contracts.   However, in 2004

pursuant to an agreement with the Internal Revenue Service

(IRS), Enron issued an amended Form W-2 to Mr. Lay for 2001

reporting the $10 million as compensation.

     On January 23, 2002, the board of directors requested that

Mr. Lay resign, and he resigned as chairman of the board of

directors and CEO of Enron with the consent of the board of

directors in February 2002.

     Enron filed a petition for chapter 11 bankruptcy on December

2, 2001, in the U.S. Bankruptcy Court for the Southern District

of New York, in a case styled In re Enron, Debtor, chapter 11,

Case No. 01-16034, Jointly Administered (bankruptcy case).     Enron

listed the annuity contracts purchased from the Lays as assets on

Schedule B, Personal Property, of its Statement of Financial

Affairs (initial and amended) filed in the bankruptcy case.     The

Official Committee of Unsecured Creditors of Enron filed a
                               - 21 -

complaint (and an amended complaint) in the bankruptcy case, to

avoid the annuities transaction.    The complaint, as amended, has

been consolidated with the remaining insolvency proceedings in

the bankruptcy case and remains pending.    On July 15, 2004,

Enron’s fifth amended plan was confirmed in the bankruptcy case.

Pursuant to the fifth amended plan, the Enron Creditors Recovery

Corporation was formed as the successor to Enron.    John Hancock

filed a motion to intervene and file its interpleader complaint

in the adversary proceeding on October 20, 2010, alleging that

the ownership of the annuity contracts is disputed between Enron

and Mrs. Lay and requesting that the bankruptcy court determine

the ownership of the annuity contracts.

     Because the IRS took the position that the Lays owned the

annuity contracts after the annuities transaction, in order to

test the status of the ownership of the annuities Mrs. Lay

requested a partial withdrawal of $50,000 from the Linda P. Lay

Annuity that she had transferred previously to Enron, in a

withdrawal request form submitted to John Hancock on February 8,

2006.    The annuity contracts allow withdrawals from the contract

value.    In response to Mrs. Lay’s request, John Hancock did not

pay the requested withdrawal and instead responded with a letter

to Mrs. Lay describing issues regarding the ownership of the

Linda P. Lay Annuity.   In its letter dated February 15, 2006,

John Hancock described the agreement, quoting portions regarding
                               - 22 -

the transfer to Enron and the reconveyance obligation, the change

form submitted to ManuLife, and the fact that Mr. Lay had ceased

serving as CEO and chairman, then concluding it was unable to

determine whether Mr. Lay or Mrs. Lay had an ownership interest.

     On July 5, 2006, Mr. Lay died suddenly.   Mrs. Lay is the

Independent Executrix of the Estate of Kenneth L. Lay.    The Form

706, United States Estate (and Generation-Skipping Transfer)

Estate Tax Return, filed for Mr. Lay’s estate listed the claim

against Enron for the annuity contracts as a claim on Schedule C,

Mortgages, Notes, and Cash, and listed the claim of Enron for the

annuity contracts on Schedule K, Debts of the Decedent, as a

contested claim.   Neither of the annuity contracts had been

conveyed to Mrs. Lay, or to the Estate of Kenneth L. Lay, as of

the trial date in this case.   Neither Mr. Lay (or his estate) nor

Mrs. Lay ever received any distributions from either ManuLife or

John Hancock with respect to either of the annuity contracts.    No

death benefit has been paid pursuant to the annuity contracts on

account of Mr. Lay’s death.

     The Lays timely filed their joint Federal tax return for tax

year 2001.   On April 2, 2009, respondent issued a statutory

notice of deficiency to petitioners in which respondent

determined a deficiency in income tax for the year ended December

31, 2001, of $3,910,000.   Petitioners timely filed a petition in

this Court on June 23, 2009.
                                 - 23 -

                                 OPINION

I.    Burden of Proof

       Petitioners would generally bear the burden of proof in this

case.      See Rule 142(a)(1);4 INDOPCO, Inc. v. Commissioner, 503

U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S.

435, 440 (1934).      The burden of proof on factual issues that

affect a taxpayer’s liability for tax may be shifted to the

Commissioner where the “taxpayer introduces credible evidence

with respect to * * * such issue.”        Sec. 7491(a)(1).   On the

record before us, we do not need to reference the burden of proof

to resolve this case as the facts are adequately presented.

Therefore, we need not determine whether section 7491(a)(1) is

applicable.

II.    Sale of Annuity Contracts

       Respondent argues that the Lays did not sell the annuity

contracts and that the $10 million they received was an employee

cash bonus includable in income for the 2001 taxable year.         The

issue, therefore, is whether the Lays sold their annuity

contracts to Enron in September 2001, in accordance with the

agreement.      There is no question the agreement was executed and

that the Lays acted in accordance with the agreement.         As we

understand respondent’s position, respondent maintains the


       4
      All Rule references are to the Tax Court Rules of Practice
and Procedure, and all section references are to the Internal
Revenue Code.
                                - 24 -

agreement was not made in good faith and that Enron and the Lays

never intended to transfer the annuity contracts, but rather

Enron simply paid Mr. Lay $10 million.

     Gross income includes gains from the sale of property.

Secs. 61(a)(3), 1001(a).     The gain from the sale of property is

calculated as the amount realized from the sale less the adjusted

basis in the property.    Sec. 1001(a).   The basis is ordinarily

the cost of the property.     Sec. 1012(a).   This calculation of

gain allows the taxpayer’s investment in the property to be

recovered tax free before any requirement to report a taxable

gain on the sale.     Sec. 1011(a).

     Pursuant to the agreement, the Lays sold each of the annuity

contracts to Enron for $5 million, for a total of $10 million.

The amount realized on the sale of each annuity contract,

therefore, was $5 million.     The Lays had paid $5 million for each

annuity contract and had not withdrawn any amount or received any

distributions with respect to either of the annuity contracts.

Accordingly, the Lays had an adjusted basis in each annuity

contract of $5 million.    The Lays, therefore, reported zero gain

upon the sale of the annuity contracts in 2001.

     A.   State Law

     “The term ‘sale’ is given its ordinary meaning for Federal

income tax purposes and is generally defined as a transfer of

property for money or a promise to pay money.”      Grodt & McKay
                              - 25 -

Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981) (citing

Commissioner v. Brown, 380 U.S. 563, 570-571 (1965)).   State law

determines the nature of property rights, and Federal law

determines the appropriate tax treatment of those rights.

Aquilino v. United States, 363 U.S. 509, 513 (1960).

     The agreement memorializes a contractual understanding of

the Lays with Enron.   The agreement sets forth the sale of the

annuity contracts to Enron.   Enron then used the annuity

contracts it purchased as the long-term incentive for Mr. Lay

also provided in the agreement.

     The agreement also provides that Enron agrees to make a

future conveyance of the annuity contracts to Mr. Lay should he

remain employed by Enron for 4.25 years or upon certain earlier

terminations of employment outside his control.   Only the sale

evidenced by the agreement is directly at issue in this case;

i.e., whether the Lays sold their annuity contracts to Enron in

2001.5




     5
      Mr. Lay remained employed by Enron through the end of 2001,
and therefore there is no issue of whether the annuity contracts
were reconveyed to Mr. Lay in 2001 in accordance with the
agreement.

     The issue of whether Mr. Lay is entitled to the reconveyance
of the annuity contracts arises in 2002 upon the termination of
Mr. Lay’s employment with Enron and is at issue in the Enron
bankruptcy case, in which Enron listed the annuity contracts as
assets and John Hancock has filed a request for the bankruptcy
court to resolve the issue.
                              - 26 -

     The agreement and the annuity contracts all provide that

Texas law governs.   The rights and interests of the parties to

the annuity contracts, therefore, must be determined by applying

Texas law.   Texas law allows the assignment of any rights under

an annuity contract in accordance with the terms of the contract.

Tex. Ins. Code Ann. art. 21.22-4, sec. 4 (West 1997).   State law

permitted the Lays, the owners of the annuity contracts, to

assign the annuity contracts to Enron in accordance with the

terms of the annuity contracts.

     The terms of the annuity contracts permitted the transfers

of the annuity contracts.   The annuity contracts provide:

     An Owner may assign his interest in this Contract at
     any time prior to the Maturity Date. No assignment
     will be binding on us unless it is written in a form
     acceptable to us and received at our Annuity Service
     Office * * * We will not be responsible for validity of
     any assignment.

The annuity contracts further provide that “each Owner may change

the Owner, Annuitant, or Beneficiary of his or her interest in

the Contract by written request in a form acceptable to us and

which is received at our Annuity Service Office.”   Accordingly,

the terms of the annuity contracts permitted the Lays to sell the

annuity contracts to Enron and the sale was allowed pursuant to

Texas law.

     B. Enron

     Enron and the Lays entered into a contract for the purchase

and sale of the annuity contracts on September 21, 2001.     Enron
                               - 27 -

agreed in the agreement to purchase the annuity contracts for $5

million per contract.    The agreement evidencing the annuities

transaction was authorized by the Compensation Committee.    The

Compensation Committee of the board of directors, made up of

independent directors, structured, reviewed, and approved the

annuities transaction, and the Committee’s actions were

thereafter reported to Enron’s full board of directors.

     Enron developed and proposed the annuities transaction after

the unexpected resignation of Mr. Skilling and the determination

by the board of directors that no one other than Mr. Lay was

ready to step into the CEO position at that time.    The board of

directors immediately worked to attract Mr. Lay to return to the

CEO position at Enron.    The Compensation Committee requested that

Towers Perrin, Enron’s compensation consultant, develop proposals

to persuade Mr. Lay to reassume the CEO position and to remain at

Enron for a period of years.

     The Compensation Committee instructed Towers Perrin that the

proposals should address Mr. Lay’s need for liquidity and the

board of directors’ requirement to include a method for retaining

Mr. Lay in the CEO position for a period of years.    Because Mr.

Lay was over age 55 and had served for more than 5 years, any

restricted stock Enron gave him would immediately vest if he

retired and restricted stock was not an acceptable means for

retention from Mr. Lay’s perspective.
                              - 28 -

     Towers Perrin valued the annuity contracts at $11,240,685 in

September 2001.   Towers Perrin proposed the following

alternatives for consideration by the Compensation Committee:

(1) To lend funds to Mr. Lay with the annuity contracts as

collateral; (2) to purchase the annuity contracts; or (3) to

purchase the annuity contracts and then use the annuity contracts

as a retention device as an award to Mr. Lay with a cliff-vesting

schedule.   The Compensation Committee considered the

recommendations by Towers Perrin and chose the third alternative,

because it accomplished both of the requirements established by

the Compensation Committee.   First, the purchase of the annuity

contracts met the requirement to provide liquidity to Mr. Lay as

an inducement to reassume the CEO position.   Second, the use of

the annuity contracts as a retention device for Mr. Lay met the

requirement for a retention device.    The Compensation Committee

and the board of directors as a whole approved the annuities

transaction in good faith after careful consideration.   These

facts are supported by the agreement and the credible testimony

at trial.

     C.   Annuity Contract Requirements

     In order to transfer the annuity contracts to Enron, the

Lays executed the change forms provided by ManuLife and delivered

the executed change forms with the original annuity contracts to

Enron at the closing conference with Mrs. Joyce on September 21,
                                - 29 -

2001.     Mrs. Joyce also executed the change forms on behalf of

Enron on September 21, 2001.

     The Lays executed the change forms provided by ManuLife and

made the assignment in a “written request in a form acceptable

to” ManuLife as required by the terms of the annuity contracts.

Each of the Lays executed a change form to transfer his or her

annuity contract to Enron on September 21, 2001, and delivered

the change form to Enron.     As required by the change forms for a

change in ownership of an annuity contract, Mrs. Joyce executed

the change forms on September 21, 2001, on behalf of Enron.

Enron thereafter delivered the change forms to ManuLife.     Whether

the delivery conformed to ManuLife’s requirements to transfer the

ownership of the annuity contracts is disputed, but we find no

effort to abort the transfer in the actions taken by Enron’s

employees; and we also find the Lays acted in accord with the

agreement to fulfil their contractual obligations to transfer the

annuity contracts.     In summary, on September 21, 2001, the Lays

met all the requirements of the agreement to transfer the annuity

contracts, and Enron paid the consideration.

     D.     Manulife

        In connection with the annuities transaction, it is not

clear whether Enron sent the original change forms to ManuLife.

Mrs. Joyce and Mr. Brown both believed the originals were sent to

ManuLife on or shortly after September 21, 2001.     Enron did in
                               - 30 -

fact send the change forms to ManuLife by facsimile transmission.

ManuLife, however, did not change the ownership of the annuity

contracts on its books.   ManuLife stated that the reason it did

not transfer title on its books is that it did not receive the

originals of the fully executed change forms.

     The change forms state that the forms should be mailed to

ManuLife, which perhaps could be construed as a request for the

original, but the annuity contracts do not include this

requirement.    The annuity contracts require “a written request in

a form acceptable to us”.    Enron had all of the legal documents

necessary to perfect its title in the annuity contracts.

Moreover, Enron conducted itself as if it had acquired the

annuity contracts.   Mr. Brown of Enron inquired of ManuLife why

the annuity contracts had not been transferred on its books to

Enron.   He informed ManuLife that he had submitted the original

change forms.   Mr. Brown then transmitted the fully executed

change forms to ManuLife by facsimile.   Enron was the beneficial

owner of the annuity contracts in accordance with the agreement

even though ManuLife failed to note the transfer of title on its

books.

     The status of the legal title to the annuity contracts does

not control in determining whether a sale occurred.   Beneficial

ownership, and not legal title, determines ownership for Federal

income tax purposes.    Ragghianti v. Commissioner, 71 T.C. 346
                               - 31 -

(1978), affd. without published opinion 652 F.2d 65 (9th Cir.

1981); Pac. Coast Music Jobbers, Inc. v. Commissioner, 55 T.C.

866, 874 (1971), affd. 457 F.2d 1165 (5th Cir. 1972).    The

Federal income tax consequences of property ownership generally

depend upon beneficial ownership, rather than possession of mere

legal title.    Speca v. Commissioner, 630 F.2d 554, 556–557 (7th

Cir. 1980), affg. T.C. Memo. 1979–120; Beirne v. Commissioner, 61

T.C. 268, 277 (1973).    “‘[C]ommand over property or enjoyment of

its economic benefits’ * * *, which is the mark of true

ownership, is a question of fact to be determined from all of the

attendant facts and circumstances.”     Monahan v. Commissioner, 109

T.C. 235, 240 (1997) (quoting Hang v. Commissioner, 95 T.C. 74,

80 (1990)).

     This Court has stated that “a sale occurs upon the transfer

of the benefits and burdens of ownership rather than upon the

satisfaction of the technical requirements for the passage of

title under State law.”    Houchins v. Commissioner, 79 T.C. 570,

590 (1982).    The determination of whether the benefits and

burdens of ownership have been transferred is one of fact and is

based on the intention of the parties, evidenced by their written

agreements and the surrounding facts and circumstances.    Paccar,

Inc. & Subs. v. Commissioner, 85 T.C. 754, 777 (1985), affd. 849

F.2d 393 (9th Cir. 1988); Grodt & McKay Realty, Inc. v.

Commissioner, 77 T.C. at 1237; Ragghianti v. Commissioner, supra
                               - 32 -

at 349.   Beneficial ownership is marked by command over property

or enjoyment of its economic benefits.   Yelencsics v.

Commissioner, 74 T.C. 1513, 1527 (1980) (stock was sold in

accordance with an agreement for the sale, even though the title

to the stock was not transferred, in accordance with the

agreement of the parties).

     For example, in Pac. Coast Music Jobbers, Inc. v.

Commissioner, supra at 874, this Court considered whether the

individual taxpayer (Hansen) purchased the stock of the corporate

taxpayer (Pacific Coast Music Jobbers) from three other

shareholders in 1962 pursuant to agreements executed in 1962.

Taxpayer Hansen negotiated to acquire all of the stock of Pacific

Coast Music Jobbers and entered into two agreements with the

shareholders whereby the sellers received payments over a 5-year

period during which the stock was held in escrow.   The issues in

Pac. Coast Music Jobbers, Inc. were whether Hansen acquired the

stock upon execution of the agreements and thus became a

shareholder required to consent to the corporation’s S election,

and, if Hansen became a shareholder, whether the amounts paid out

to the selling shareholders were constructive dividends to

Hansen.   This Court stated:

          For purposes of Federal income taxation the
     determination of whether a sale has occurred centers
     more on the question of which party, as a result of the
     transaction, has command or domination over the
     property, rather than on the refinements of title. * *
     * A court must consider not only when the bare legal
                               - 33 -

      title passed but also when the benefits and burdens of
      the property, or the incidents of ownership, were
      acquired or disposed of in a closed transaction. * * *
      In deciding the question, the court looks to that party
      to the transaction who has the greatest number of the
      attributes of ownership. * * * A court should look to
      practicalities, disregarding merely formal and not
      useful rights and attributes. * * * If it is found from
      all the facts and surrounding circumstances that the
      parties intended an agreement to result in the sale of
      property, and the agreement transfers substantially all
      the accouterments of ownership, the transaction will be
      treated as a sale even though the parties intended the
      legal title should not pass until later.

Id.

      In Pac. Coast Music Jobbers, Inc. the Court held that Hansen

acquired the stock upon execution of the agreements and not 5

years later when the payments were complete and the stock was

transferred from the escrow.   This Court concluded that the total

of the payments that Hansen was required to make to the sellers

established the purchase price and that Hansen acquired the stock

by means of a bootstrap purchase using the profits from the

corporate operations to acquire the business.   The escrow

arrangement supported the conclusion that a sale had occurred

because the sellers had nothing further to do but collect the

sale price, and Hansen was getting the benefit of the corporate

dividends.

      This Court noted that the sellers gave up significant rights

to alter or end the business of the corporation by their

agreement to continue the corporate business, and the sellers

also lost substantial domination and control because they gave
                               - 34 -

Hansen their irrevocable proxies.    Although the sellers’ attorney

in Pac. Coast Music Jobbers, Inc. v. Commissioner, supra at 877,

retained the stock in escrow, it was reasoned that “the important

fact is not when the parties intended title to change hands but

when they intended the accouterments of ownership to be

transferred.”

        The Lays gave up all rights to alter or terminate the

annuity contracts and lost domination and control over them.

After selling the annuity contracts to Enron, the Lays could not

sell them, nor could they liquidate them or borrow against them.

They also could not alter the investment options for the annuity

contracts or make any other elections or decisions regarding

them.

     The Lays had delivered the transfer documents and received

the consideration for the sale, and there was nothing else for

them to do in connection with the transfer of the annuity

contracts to Enron.    Enron, on the other hand, was able to use

the annuity contracts for the retention agreement.     Enron also

could make cash withdrawals and alter the investment options in

the annuity contracts.    Enron, therefore, had dominion and

control over the annuity contracts.

     Unlike the situation in Pac. Coast Music Jobbers, Inc., the

entire purchase price was paid at the closing of the annuities

transaction, on September 21, 2001.     In addition, whereas the
                              - 35 -

sellers in Pac. Coast Music Jobbers, Inc. placed the stock at

issue in escrow held by their own attorney, the Lays transferred

the annuity contracts with the fully executed change forms to

Enron on September 21, 2001, with no restrictions on the transfer

of legal title.   Enron was in control over completing the

transfer of legal title on the books of ManuLife.   This is not a

situation where the seller has retained control over the legal

title to the property, with the resulting issue of whether the

seller’s retention of title prevented a sale from occurring.     See

Yelencsics v. Commissioner, supra at 1527 (taxpayers purchased

stock pursuant to an agreement with the selling shareholder that

gave the taxpayers unqualified voting proxies, control of the

corporation, and entitlement to all profits and dividends, even

though the selling shareholder remained the owner of record);

Ragghianti v. Commissioner, 71 T.C. 346 (1978) (shareholder

acquired stock upon posting a bond required by State law to

ensure payment of purchase price, even though the selling

shareholders continued to hold the stock).

     Enron also used the annuity contracts purchased from Mrs.

Lay for the retention agreement with Mr. Lay.   The use of the

annuity contracts as consideration for this agreement, therefore,

confirms that Enron was the beneficial owner of the annuity

contracts.   Even after Enron entered into the agreement with Mr.

Lay to reconvey the annuity contracts after his service
                              - 36 -

commitment, Enron remained the beneficial owner of the annuity

contracts.   Enron possessed the annuity contracts and had the

right to possess the annuity contracts and fully received the

benefits of ownership.   As the owner of the annuity contracts,

Enron also bore the risk of any loss in connection with owning

the annuity contracts.

     The Lays reported the transaction as a sale of the annuity

contracts on their 2001 tax return.    Enron did not include the

purchase price on Mr. Lay’s original Form W-2 for 2001.     After

purchasing the annuity contracts, Enron filed for bankruptcy on

December 2, 2001, and listed the annuity contracts as assets.

Enron’s position, therefore, was that it had purchased the

annuity contracts.

     John Hancock confirmed that it did not consider Mrs. Lay to

be the owner, notwithstanding the legal title on its books.

     Enron issued amended Forms W-2c, Corrected Wage and Tax

Statement, to Mr. Lay in 2004 in connection with Enron’s

settlement of an employment tax audit with the IRS Appeals

Office.   We do not find this after-the-fact event relevant to the

case before us.

     The District Courts in Texas have concluded that the

execution of agreements controls in situations where formal

filings have not been accomplished.    Keller v. United States, 104

AFTR 2d 2009-6015, 2009-2 USTC par. 60,579 (S.D. Tex. 2009);
                              - 37 -

Church v. United States, 85 AFTR 2d 2000-804, 2000-1 USTC par.

60,369 (W.D. Tex. 2000), affd. per curiam 268 F.3d 1063 (5th Cir.

2001).   In Church such a partnership agreement executed by the

parties governed, even though a certificate of limited

partnership had not been filed with the State before the death of

one of the parties to the partnership agreement.   The court held

that the written partnership agreement was an enforceable

contract and governed the rights of the parties.   Church v.

United States, supra.   The execution of the partnership agreement

in Church also accomplished the transfer of the beneficial

interest in securities held in the decedent’s Paine Webber

account to the partnership under Texas and Federal law, with no

execution or submission of a change form to Paine Webber.      The

court in Keller v. United States, supra, followed Church and held

that the execution of a partnership agreement reflecting certain

bonds as assets of the partnership before the transferor’s death

accomplished the transfer of the bonds to the partnership, even

though no request for a change was submitted to Vanguard, the

company holding the bonds.

     The Lays agreed to sell the annuity contracts to Enron and

executed and delivered all documents required to effect the

transfer of legal title to the annuity contracts to Enron, in

accordance with the agreement.   The transferor in each of the

Church and Keller cases had not even executed a transfer form to
                                 - 38 -

transfer the ownership of the securities at issue to the

partnership before the transferor’s death, whereas the Lays had

fully executed and delivered the change forms to Enron and Enron

had transmitted the change forms to ManuLife.     The reasoning of

Church and Keller, therefore, supports a finding that the Lays

sold the annuity contracts.

       E.   Conclusion

       The Lays sold the Annuity contracts to Enron on September

21, 2001.     In doing so, they complied with the requirements of

the agreement and took the steps required to transfer the annuity

contracts to Enron.      The benefits and risks of ownership of the

annuity contracts were transferred to Enron in the annuities

transaction.     The Lays, therefore, properly reported the

transaction on their Federal income tax return as a sale of the

two annuity contracts.

III.    Section 83

       Respondent’s first alternative position is that the

agreement provided for the transfer of the annuity contracts by

Enron to the Lays on September 21, 2001, in connection with the

performance of services by Mr. Lay and, therefore, caused the

fair market value of the property to be taxable to Mr. Lay

pursuant to section 83.

       Section 83(a) provides, in pertinent part, that if property

is transferred to a taxpayer in connection with the performance
                              - 39 -

of services, the excess of the fair market value of the property

over the amount, if any, paid for the property shall be included

in the taxpayer’s gross income in the first taxable year in which

the taxpayer’s rights in the property are not subject to a

substantial risk of forfeiture.     See Tanner v. Commissioner, 117

T.C. 237, 242 (2001), affd. 65 Fed. Appx. 508 (5th Cir. 2003);

sec. 1.83-7(a), Income Tax Regs.6

     Consequently, taxability pursuant to section 83 would result

only if the provision in the agreement that granted Mr. Lay the

opportunity to earn back the Annuity contracts if he remained

with Enron for a period of 4.25 years (or an earlier date if Mr.

Lay’s employment terminated for certain specified reasons beyond

Mr. Lay’s control) constituted (1) property that (2) was

transferred to Mr. Lay in 2001 (3) in connection with his

performance of services and (4) the property was transferable by

Mr. Lay or not subject to a substantial risk of forfeiture in

2001.       See sec. 83(a).

     The term “property” for purposes of section 83 includes:

     real and personal property other than either money or
     an unfunded and unsecured promise to pay money or
     property in the future. The term also includes a
     beneficial interest in assets (including money) which
     are transferred or set aside from the claims of
     creditors of the transferor, for example, in a trust or
     escrow account. * * *



        6
      Respondent has not alleged that Enron retransferred the
annuity contracts to either Mr. Lay or Mrs. Lay in 2001.
                               - 40 -

Sec. 1.83-3(e), Income Tax Regs.    Property is “transferred” for

purposes of section 83 when a person acquires a beneficial

ownership interest in such property.    Sec. 1.83-3(a)(1), Income

Tax Regs.   Unfunded and unsecured promises to transfer property

in the future are excepted from the definition of “property” for

purposes of section 83.   Sec. 1.83-3(e), Income Tax Regs.

     The provisions of the agreement that granted Mr. Lay the

right to earn back the annuity contracts if he continued to

render services for 4.25 years create an unfunded and unsecured

promise to transfer property in the future.    Enron agreed to

transfer the annuity contracts to Mr. Lay in the future upon his

completion of 4.25 years of service.    The annuity contracts were

not transferred or set aside from the claims of creditors of the

transferor; in fact, Enron listed the annuity contracts as assets

upon filing for bankruptcy.    Mr. Lay was required to perform

services before his right to receive the annuity contracts

ripened, and he could not assign his retention agreement.    The

promise in the agreement to reconvey the annuities to Mr. Lay

after 4.25 years of service, therefore, is not “property” within

the meaning of section 83.    Consequently, the threshold

requirement for application of section 83 (that “property” be

transferred to the service provider) is not met.    This

arrangement between Enron and Mr. Lay, for Enron to transfer

property to Mr. Lay if he provided services for a period of
                               - 41 -

years, is a nonqualified deferred compensation plan not taxed at

inception because the property was not set aside or protected

from the creditors of Enron.   See sec. 83; sec. 1.83-3(e), Income

Tax Regs.

     Deferred compensation for services is included in gross

income in the taxable year in which it is actually or

constructively received.   Sec. 1.451-1(a), Income Tax Regs.

(income is included in income for the taxable year in which

actually or constructively received by the taxpayer); sec. 1.446-

1(c)(1)(i), Income Tax Regs. (under the cash method of

accounting, gross income is included for the taxable year in

which actually or constructively received); Rev. Rul. 60-31,

1960-1 C.B. 174.   A mere promise to pay, not represented by notes

or secured in any way, is not a receipt of income for a cash

method taxpayer.   Rev. Rul. 60-31, 1960-1 C.B. at 177.   Income is

constructively received in the taxable year in which it is

credited to the taxpayer’s account or set apart for the taxpayer

so that he may draw upon it at any time.   Sproull v.

Commissioner, 16 T.C. 244 (1951), affg. 194 F.2d 541 (6th Cir.

1952); sec. 1.451-2, Income Tax Regs.   “However, income is not

constructively received if the taxpayer’s control of its receipt

is subject to substantial limitations or restrictions.”   Sec.

1.451-2(a), Income Tax Regs.
                               - 42 -

     Mr. Lay had no control over the annuity contracts in 2001.

Enron’s listing the annuity contracts as assets when it filed for

bankruptcy confirms that the annuity contracts were not set aside

for Mr. Lay.   Mr. Lay would constructively receive the annuity

contracts only after the 4.25 years of service or upon an earlier

termination that triggered the conveyance of the annuity

contracts to Mr. Lay under the terms of the agreement, none of

which occurred in 2001.   Section 83 requires inclusion of the

fair market value of the property in income when the property is

first either transferable or not subject to a substantial risk of

forfeiture.    Rights of a person in property are “transferable” if

the person may transfer any interest in the property to any

person other than the transferor, but only if the property is not

subject to a substantial risk of forfeiture.   Sec. 1.83-3(d),

Income Tax Regs.

     Property is not considered to be transferable merely because

the person performing the services may designate a beneficiary to

receive the property in the event of his or her death.    Sec.

1.83-3(d), Income Tax Regs.   A substantial risk of forfeiture

exists where the right to property is conditioned on the future

performance of substantial services or the occurrence of a

condition related to a purpose of the transfer, and the

possibility of the forfeiture is substantial if such condition is

not satisfied.   Sec. 83(c); sec. 1.83-3(c)(1), Income Tax Regs.
                               - 43 -

Forfeiture of property upon termination of employment before

retirement at a specified age or time, death, or disability

generally constitutes a substantial risk of forfeiture.    Sec.

1.83-3(c)(4), Example (1), Income Tax Regs.

     Under the terms of the agreement, Mr. Lay would forfeit the

annuity contracts upon termination of his employment before the

end of the 4.25-year service period unless his employment was

terminated because of:    (a) Retirement with the consent of the

board; (b) disability; (c) an involuntary termination (other than

termination for cause); or (d) a termination for “Good Reason”

(meaning a substantial change in Mr. Lay’s duties or position

with Enron or a substantial decrease in his salary, without his

consent).

     Forfeiture of the annuity contracts if Mr. Lay voluntarily

terminated his employment before the 4.25 years constitutes a

substantial risk of forfeiture.    See id.

     The board would have had to take a specific action to

trigger Mr. Lay’s right to the annuity contracts upon other

terminations by consenting to Mr. Lay’s retirement, or by

substantially decreasing Mr. Lay’s salary or position without his

consent.    The requirement for the board to take an action to

trigger Mr. Lay’s right to the annuity contracts is consistent

with a substantial risk of forfeiture.    Because Mr. Lay had to

work 4.25 years for Enron in order to receive the annuity
                               - 44 -

contracts and could terminate his employment before those 4.25

years only under specific circumstances outside his control

without forfeiting the annuity contracts, there was a

“substantial risk of forfeiture” in 2001.    The events in 2002

regarding Mr. Lay’s resignation are not before us.

        In conclusion, section 83 does not apply to the deferred

compensation arrangement at issue.

IV.    Price of Annuity Contracts

       Respondent’s second alternative position is that the $10

million purchase price Enron paid for the annuity contracts was

in excess of their fair market value as of September 21, 2001,

and that the excess represented additional compensation to Mr.

Lay.

       This Court has considered whether an amount paid by an

employer to an employee for property was actually in part a

payment for property and in part compensation.    In Azar Nut Co.

v. Commissioner, 94 T.C. 455 (1990), affd. 931 F.2d 314 (5th Cir.

1991), an employer purchased the personal residence of an

employee pursuant to an employment contract for a price equal to

the residence’s appraised fair market value of $285,000.    The

employer immediately attempted to resell the house and sold the

house 2 years later for $200,000 (at a loss of $111,366 on the

transaction).    As its initial argument, the employer claimed an

ordinary and necessary business expense in an amount equal to the
                              - 45 -

loss, on the theory that this amount represented compensation

deductible under section 162(a).   Id. at 459.   This Court

rejected this argument, stating:

      There is nothing in the record before us to indicate
      that any portion of the purchase money * * * [the
      employer] paid to * * * [the employee] represented a
      premium or additional amount in excess of the fair
      market value of the house that would otherwise
      constitute “compensation.” * * *

Id.

      Similarly, there is nothing in the record to indicate that

any portion of the $10 million that Enron paid the Lays for the

annuity contracts represented a premium or additional amount in

excess of the fair market value of the annuity contracts that

would otherwise constitute compensation.    As in Azar Nut Co.,

Enron relied upon a valuation report that indicated that the

value of the annuity contracts was $11.2 million at the time of

the transaction.   The Compensation Committee was aware that the

Lays had paid $10 million for the annuity contracts less than 2

years before the Compensation Committee began its deliberation.

In addition, we note that whereas in Azar Nut Co. the employer

suffered a loss with respect to the asset that it purchased,

there is no indication that Enron suffered any loss with respect

to its purchase of the annuity contracts.   The income base of the

Kenneth L. Lay Annuity contract on September 21, 2001, was

$5,854,272.65 when Enron paid $5 million for that contract, and

the owner of the Kenneth L. Lay Annuity on September 30, 2007,
                               - 46 -

was entitled to annuitize the guaranteed income base of

$7,375,160 pursuant to the terms of the Kenneth L. Lay Annuity.

     The Commissioner has argued in other cases that sales were

in fact dividend distributions after concluding that the sale

prices exceeded the fair market value of the assets sold.      E.g.,

Commissioner v. Brown, 380 U.S. 563 (1965); Palmer v.

Commissioner, 302 U.S. 63 (1937).    In these cases, the Court

looked to the intent of the contracting parties to pay a fair

market value price for the assets.      See also Rev. Rul. 67-246,

1967-2 C.B. 104 (donor must prove that purchase price exceeded

value of property purchased; intention to make a gift by paying

in excess of value highly relevant to determining whether donor

made gift).

     In Commissioner v. Brown, supra, shareholders sold their

stock to a third-party buyer for $1.3 million, and the purchase

price was payable by the buyer over time from the corporate

earnings.   The Commissioner argued that the purchase price was

excessive and, therefore, was a device by the sellers to collect

future earnings of the corporation at capital gains rates.      This

Court had found that the sale price was arrived at in an arm’s-

length transaction, was the result of real negotiating and was

“within a reasonable range in light of the earnings history of

the corporation and the adjusted net worth of the corporate

assets.”    Brown v. Commissioner, 37 T.C. 461, 486 (1961), affd.
                              - 47 -

325 F.2d 313 (9th Cir. 1963), affd. 380 U.S. 563 (1965).    Even

though the sellers did not receive the full purchase price, this

Court held that the transaction was a sale, partly on the basis

of the finding that the purchase price was within a reasonable

range.   In this case, as in Brown, there has been no showing that

the transaction’s purpose was other than a sale (i.e., to pay

compensation to Mr. Lay).

     The board of directors of Enron wished for Mr. Lay to return

to Enron as CEO.   In order to persuade Mr. Lay to return as CEO,

the Compensation Committee asked the compensation consultant

Towers Perrin for proposals and selected the proposal that

satisfied the requirements of the board of directors.    Towers

Perrin proposed that Enron purchase the annuity contracts for $10

million and provided analyses to the Compensation Committee,

showing that the value of the annuity contracts was $11.2

million.   With this information, the Compensation Committee

concluded that the value of the annuity contracts was $11.2

million.   The Compensation Committee concluded that the purchase

of the annuity contracts was a good investment for Enron.     In

addition, the parties to the agreement specifically agreed that

Enron was paying $5 million for each annuity contract.

     The record demonstrates that Enron intended to pay $10

million as fair market value for the annuity contracts, and there

is no excess to include in gross income.   Intent of the parties
                              - 48 -

is important in determining whether a purchase price should be

recharacterized.   Enron’s Compensation Committee approved the

purchase of the annuity contracts for $10 million.7   Accordingly,

the board approved a purchase price of $10 million for an asset

valued at $11.2 million.   The Lays had paid $10 million for the

annuity contracts; and even though the Towers Perrin report

indicated a value of $11.2 million, they would have received only

$4.691 million if they had liquidated the annuity contracts at

that time.   Nevertheless, the Compensation Committee reasonably

found that $10 million was a fair price for the annuity

contracts.

     The issue is not whether the value of the annuity contracts

was, in fact, $10 million.   The issue is whether the $10 million

that Enron paid to the Lays was intended for the purchase of the

annuity contracts.   In determining whether the annuities

transaction was in fact a sale, the Court considers whether the




     7
      See IRS Publication 561 (for purposes of determining a
charitable contribution deduction “The value of an annuity
contract or a life insurance policy issued by a company regularly
engaged in the sale of such contracts or policies is the amount
that company would charge for a comparable contract.”). For gift
tax purposes, therefore, it appears that the value of the Annuity
contracts would have been $10 million. United States v. Parker,
376 F.2d 402, 408 (5th Cir. 1967); Anselmo v. Commissioner, 80
T.C. 872 (1983) (the valuation test for estate and gift tax
purposes is generally the same as that used for charitable
contribution deduction purposes), affd. 757 F.2d 1208 (11th Cir.
1985).
                               - 49 -

purchase price was within a reasonable range.    See Commissioner

v. Brown, 380 U.S. at 572.

     In order to demonstrate that the purchase price was in fact

within a reasonable range, petitioners introduced expert witness

testimony of the value of the annuity contracts on the sale date,

September 21, 2001, when the income base was $5,854,272.65 for

the Kenneth L. Lay Annuity and $5,453,004.77 for the Linda P. Lay

Annuity.   Petitioners’ expert witness, Lawrence Katzenstein,

prepared a report with an appraisal of the annuity contracts at

the time of the annuities transaction.    Mr. Katzenstein has

special expertise in valuing annuity contracts.

     Mr. Katzenstein used a discount rate provided by

petitioners’ other expert witness, Robert Buchanan, an

experienced appraiser and accredited senior appraiser (business

valuation).    In order to determine the discount rate to use to

value the annuity contracts, Mr. Buchanan used evidence of open

market transactions in interests similar to the annuity

contracts.    Mr. Buchanan noted that the discount rate would be

used to calculate the value of the annuity contracts as the

present value of the future stream of guaranteed payments based

on the guaranteed income rider.    Mr. Buchanan based the discount

rate on two methodologies.    The first method was based on the

Actuarial Guideline for Variable Annuities from the National

Association of Insurance Commissioners for purchasing an annuity
                              - 50 -

with a guaranteed minimum income benefit and produced a discount

rate of 4.49 percent as of September 21, 2001.   The second method

was based on the Standard Valuation Law from the National

Association of Insurance Commissioners for the standard valuation

interest rates for types of annuities such as the annuity

contracts and resulted in a discount rate of 4.50 percent.

     Mr. Buchanan weighted all indications equally and concluded

that the appropriate discount rate applicable to the valuation

analysis of the annuity contracts as of September 21, 2001, was

4.67 percent.   Mr. Katzenstein then used this fair market

discount rate to determine the fair market value of each of the

annuity contracts on September 21, 2001.8   Mr. Katzenstein used

the information provided by John Hancock regarding the monthly

annuity benefits payable starting on the first date the annuity

option could have been exercised pursuant to each of the annuity

contracts in order to calculate the values of the annuity

contracts.   Mr. Katzenstein then performed an actuarial analysis

to determine the value of each of the annuity contracts, using

the discount rate provided by Mr. Buchanan.   Mr. Katzenstein

determined that the minimum value of the Kenneth L. Lay Annuity

was $5,109,117, and that the minimum value of the Linda P. Lay


     8
      Mr. Katzenstein reviewed the annuity contracts and took
note of both the guaranteed minimum income benefit payable on
amounts paid for the contract and the special feature that if the
annuity investment account performed sufficiently well, the
payments could be higher.
                              - 51 -

Annuity was $4,432,456, as of September 21, 2001, totaling

$9,541,573.   Mr. Katzenstein testified that these values were

minimum values and that the annuity contracts could have had

higher values as of September 21, 2001.

     The purchase price in this case, therefore, was within 5

percent of the values that Mr. Katzenstein calculated as the

minimum values of the annuity contracts.   That purchase price was

within a reasonable range of values supports the conclusion that

the annuities transaction was in fact a sale.   In other words,

even if the $10 million price for the annuity contracts exceeded

the actual values somewhat, the price was within a reasonable

range of values, showing that the parties intended for the

annuities transaction to be a sale transaction for the annuity

contracts.

     Respondent offered no evidence with respect to the values of

the annuity contracts as of September 21, 2001.   Moreover, in the

event that the sale price is treated as less than $10 million

with the excess treated as taxable, this excess amount also would

be a loss to the Lays.   Mr. Lay and Mrs. Lay paid a total of $10

million for the annuity contracts, and their cost basis in the

annuity contracts is $10 million.   Accordingly, if the Lays had

sold the annuity contracts for less than $10 million, then they

might have reasonably reported an ordinary loss on the sale equal

to the amount realized less their adjusted basis.   See sec. 1001;
                              - 52 -

Rev. Rul. 61-201, 1961-2 C.B. 46 (ordinary loss allowed on a

taxpayer’s surrender of a single premium refund annuity contract

for cash consideration).

     In summary, Enron paid Mr. and Mrs. Lay $10 million in

exchange for the annuity contracts.    Enron intended for the full

amount of its payment to be consideration for the annuity

contracts.   The annuities transaction is well documented, and all

actions of the parties to the transaction reflect that Enron

purchased the annuity contracts for $10 million.    The Lays

properly reported the transaction on their 2001 tax return as a

sale of their annuity contracts.

     To reflect the foregoing,


                                           Decision will be entered

                                      for petitioners.
