                              T.C. Memo. 2015-164



                         UNITED STATES TAX COURT



     EDWARD N. TOBIAS AND SUZANNE M. KOEGLER, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 21510-13.                          Filed August 18, 2015.



      Edward N. Tobias and Suzanne M. Koegler, pro sese.

      Kristina L. Rico, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      LAUBER, Judge: The Internal Revenue Service (IRS or respondent) deter-

mined a deficiency of $76,359 in petitioners’ 2010 Federal income tax.1 After



      1
        All statutory references are to the Internal Revenue Code (Code) in effect
for the tax year at issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure. We round most monetary amounts to the nearest dollar.
                                         -2-

[*2] concessions,2 the issues for decision are: (1) whether petitioners are taxable

on a withdrawal from a variable annuity contract; (2) whether petitioners are liable

under section 72(q) for a 10% penalty for a premature distribution from that annu-

ity contract; and (3) whether respondent may amend his answer to assert, and whe-

ther petitioners are liable for, the accuracy-related penalty. We resolve all issues

in respondent’s favor.

                               FINDINGS OF FACT

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

the stipulation of facts and the accompanying exhibits here by reference.

Petitioners resided in New Jersey when they petitioned this Court.

      In 2010 petitioner-husband was self-employed as an attorney and petitioner-

wife was employed full time as a school administrator. Petitioner-husband holds

an inactive C.P.A. license. Petitioner-wife suffers from rheumatoid arthritis, with

which she was diagnosed before 2010. Her illness caused her to retire from full-

time work in late 2013.

      In April 2003 petitioners purchased a variable annuity from Allstate Life

Insurance Company (Allstate) for an initial investment of $228,800. In order to


      2
       Respondent determined, and petitioners concede, that petitioners omitted
from their 2010 return $55 of interest income and $20 of dividend income.
                                         -3-

[*3] make this purchase, petitioners sold, at a loss of $158,000, securities that peti-

tioner-wife had inherited from her parents several years previously. Between 2003

and 2006 petitioners made additional after-tax investments of $346,154 in the

Allstate annuity contract.

      In March 2007 petitioners surrendered the Allstate annuity and transferred

the proceeds to a variable annuity from ING USA Annuity & Life Insurance Com-

pany (ING). The value of the Allstate annuity at that time was $794,493, reflect-

ing petitioners’ investment of $574,954 ($228,800 + $346,154) and $219,539 in

accrued earnings. Because Allstate passed the proceeds directly to ING, this

transfer qualified as a nontaxable like-kind exchange under section 1035.

Petitioners thus retained the same principal and accrued earnings amounts in the

ING annuity, which had an annuity starting date of February 3, 2047.

      On November 16, 2010, petitioners withdrew $525,000 from the ING annu-

ity to fund the purchase of (and later improvements to) their current residence. At

the time of this distribution, the cash value of the annuity was $761,256 and the

accrued earnings were $186,302. When making this withdrawal, petitioners de-

clined to have any tax withheld. At year end 2010 ING issued to petitioners a

Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-

Sharing Plans, IRAs, Insurance Contracts, etc., reflecting this withdrawal. The
                                        -4-

[*4] Form 1099-R reported the taxable amount as $186,302 and listed the

distribution code for “early distribution, no known exception.”

      Petitioners jointly filed their 2010 Federal income tax return on October 21,

2011. They did not report any retirement income on this return. Instead, they in-

cluded a Form 4852, Substitute for Form W-2, Wage and Tax Statement, or Form

1099-R, noting the $525,000 withdrawal and checking the box for “taxable

amount not determined.” They offered this explanation:

      The [ING annuity] account was funded with after-tax funds and all
      withdrawals have been made prior to annuitization. Accordingly, any
      potential gains should be applied to the prior capital loss carry-
      forward, which is approximately ($148,000). Additionally, this
      account has not recouped losses incurred in prior years and has
      incurred substantial withdrawal penalties; the calculation made by
      ING is incorrect and is contested.

Petitioners did not attach to their return Form 5329, Additional Taxes on Qualified

Plans (Including IRAs) and Other Tax-Favored Accounts, which provides the ve-

hicle for claiming an exception to the section 72(q) penalty for premature distribu-

tions from annuity contracts.

      Petitioners’ 2010 return included a Schedule D, Capital Gains and Losses,

that reported a $148,396 long-term capital loss carryforward from prior years. On

line 13 of their 2010 return petitioners deducted $3,000 of this loss against ordi-

nary income. They had done the same every year since 2003.
                                        -5-

[*5] The IRS initiated an examination of petitioners’ 2010 return due to the mis-

match between their reported retirement income and the amount shown on the

Form 1099-R that ING supplied. Upon completion of the audit, the IRS increased

petitioners’ taxable retirement income by $186,3013 and imposed under section

72(q) a penalty of $18,630 on the premature distribution. The IRS mailed peti-

tioners a timely notice of deficiency, and they timely petitioned this Court.

      In his pretrial memorandum respondent indicated that he intended to file a

motion for leave to amend the answer to assert under section 6662 a 20%

accuracy-related penalty for a substantial understatement of income tax. When

making this motion at trial, respondent did not offer any reason for failing to assert

the penalty previously. Petitioners objected, contending that their return position

was legally justified; they did not argue or present evidence that they would be

prejudiced if we granted respondent’s motion, which we took under advisement.

                                     OPINION

I.    Burden of Proof

      The Commissioner’s determinations in a notice of deficiency are generally

presumed correct, and the taxpayer has the burden of proving them erroneous.


      3
       The retirement income reported on the Form 1099-R was $186,301.59, and
the IRS evidently rounded this down to $186,301.
                                         -6-

[*6] Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Petitioners do

not contend, and the evidence does not establish, that the burden of proof shifts to

respondent under section 7491(a) as to any issue of fact.4

II.   Taxability of Annuity Withdrawals

      A.     Statutory Background

      The Code provides that “gross income means all income from whatever

source derived, including (but not limited to) * * * [a]nnuities.” Sec. 61(a)(9). An

annuity is a contract to receive future periodic payments; the purchaser pays

premiums that the annuity provider invests, generating income to cover the

promised future payments. See sec. 1.72-2(b)(2), Income Tax Regs. Gains on

investments within an annuity are not taxed until the purchaser receives

distributions; this allows earnings within the annuity to build up at a faster rate.

See sec. 72; 1 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income,

Estates, and Gifts, para. 12.1.2, at 12-5 (3d ed. 1999).


      4
       Section 6201(d) provides that the IRS in certain circumstances cannot rely
solely on information returns to establish unreported income but “shall have the
burden of producing reasonable and probative information” in addition thereto.
This provision applies only where the taxpayer “asserts a reasonable dispute with
respect to any item of income reported on an information return.” Petitioners have
not asserted a “reasonable dispute” concerning the amount of the distribution they
received from ING. Nor have they alleged that ING made any factual error in
calculating the taxable portion of this distribution.
                                        -7-

[*7] Every annuity has an “annuity starting date” on which regular annuity pay-

ments are scheduled to begin. See sec. 1.72-4(b), Income Tax Regs. Payments

received after the annuity starting date are taxed in a manner allowing the tax-

payer’s “investment in the contract” to be recovered on a pro rata basis as each

annuity payment is received. Sec. 72(a) and (b); secs. 1.72-1(c), 1.72-4(a), Income

Tax Regs. The taxpayer’s “investment in the contract” is “the aggregate amount

of premiums or other consideration paid for the contract,” less any amounts

already received under the contract that were excluded from gross income. Sec.

72(c)(1), (e)(6).

      Payments received under an annuity contract before the annuity starting date

are likewise included in the recipient’s income, but the taxable portion is calcula-

ted differently. The “income-first” rule of section 72(e) provides that payments

received before the annuity starting date “shall be included in gross income to the

extent allocable to income on the contract.” Sec. 72(e)(2)(B). This amount is

calculated by subtracting the recipient’s “investment in the contract” from the cash

value of the contract immediately before the distribution is received, disregarding

any surrender charges. Sec. 72(e)(3)(A). The recipient is thus taxed on the full

amount of the distribution or the full amount of earnings accrued in the annuity
                                         -8-

[*8] contract, whichever amount is less. If the distribution exceeds the accrued

earnings, the balance is treated as a tax-free return of basis. Sec. 72(e)(3)(B).

      B.     Taxability of Petitioners’ Withdrawal

      The ING annuity contract is subject to section 72. The parties stipulated

that the contract had an annuity starting date of February 3, 2047. Because peti-

tioners received the 2010 distribution before the annuity starting date, it is

governed by the income-first rule of section 72(e).

      Petitioners paid total premiums of $574,954 toward the Allstate annuity.

After surrendering the Allstate annuity, petitioners paid no premiums and made no

contributions toward the ING annuity, and they received no distributions from

either annuity prior to 2010. Consequently, petitioners’ “investment in the con-

tract” under the ING annuity was $574,954 at the time of their withdrawal.5

      On November 16, 2010, the day petitioners made their withdrawal, the cash

value of the ING annuity contract was $761,256. Petitioners thus had $186,302 of

“income on the contract” (cash value of $761,256 minus their “investment in the

contract” of $574,954). Because the amount of the withdrawal, or $525,000, ex-


      5
        When Allstate passed the full value of the surrendered annuity to ING on
petitioners’ behalf, they recognized no gain or loss under section 1035 and re-
tained the same basis (principal) and accrued earnings amounts in the new annuity.
See secs. 1.1031(d)-1(a), 1.1035-1(c), Income Tax Regs.
                                         -9-

[*9] ceeded their “income on the contract,” section 72(e)(2)(B)(i) required that

they include the latter amount in gross income for 2010. The balance of the

distribution constituted a tax-free recovery of basis.

      Petitioners urge that this calculation fails to take into account the $158,000

capital loss they realized in 2003 when they sold securities to raise funds to ac-

quire the Allstate annuity. Much of the “income on the contract,” they say, likely

results from capital gains realized by Allstate and ING. Petitioners insist that they

“made no money” on the entire set of transactions and that the $158,000 capital

loss from 2003 should therefore serve to offset the income inclusion that the 2010

distribution would otherwise generate.

      This argument is unpersuasive for at least two reasons. Petitioners’ “invest-

ment in the contract,” which determines the amount taxable under section 72(e)(2),

is “the aggregate amount of premiums or other consideration paid for the con-

tract.” Sec. 72(e)(6)(A). The aggregate amount of premiums petitioners paid for

the contract was $574,954. They have suggested no statutory rationale for in-

creasing this figure to $732,954 on account of losses they incurred when gene-

rating funds to make the initial premium payment.6

      6
       Petitioners’ argument that their investment in the contract should be in-
creased to account for their prior capital losses also contradicts their own return
                                                                          (continued...)
                                        - 10 -

[*10] There is likewise no support for petitioners’ contention that their 2010 with-

drawal should be characterized as capital gain rather than ordinary income. It is

irrelevant to what extent petitioners’ “income on the contract” may have derived

from capital gains realized by Allstate or ING. Section 72 mandates the inclusion

of annuity payments in petitioners’ hands as ordinary income. Their assertion that

section 72 is inapplicable because they intended to use the annuity as an “invest-

ment vehicle” rather than as a source of retirement income is without merit.

Section 72 explicitly applies to all annuities regardless of the purchasers’ intent.

III.   Section 72(q) Penalty

       In the case of any premature distribution from an annuity contract, section

72(q)(1) generally imposes a penalty “equal to 10% of the portion of such amount

which is includible in gross income.” Petitioners argue that this penalty does not

apply because their distribution falls within the exception set forth in section

72(q)(2)(C) for distributions “attributable to the taxpayer’s becoming disabled

within the meaning of subsection (m)(7).” Section 72(m)(7) provides that a

person shall be considered “disabled” if he or she is:


       6
        (...continued)
position. On their 2010 Schedule D they reported the $148,396 remnant of the
2003 capital loss as a long-term capital loss carryforward and deducted $3,000 of
this loss, the maximum amount allowed, against ordinary income. See sec. 1211.
                                       - 11 -

      [*11] unable to engage in any substantial gainful activity by reason of
      any medically determinable physical or mental impairment which can
      be expected to result in death or to be of long-continued and
      indefinite duration. An individual shall not be considered to be
      disabled unless he furnishes proof of the existence thereof in such
      form and manner as the Secretary may require.

      The regulations provide that “[a]n individual will not be deemed disabled if,

with reasonable effort and safety to himself, the impairment can be diminished to

the extent that the individual will not be prevented by the impairment from

engaging in his customary or any comparable substantial gainful activity.” Sec.

1.72-17A(f)(4), Income Tax Regs.; see Dwyer v. Commissioner, 106 T.C. 337

(1996); Dollander v. Commissioner, T.C. Memo. 2009-187. Whether an

impairment constitutes a “disability” is to be determined by considering all of the

facts in the case. Sec. 1.72-17A(f)(2), Income Tax Regs.

      Petitioners contend that petitioner-wife was “disabled” in 2010 by her rheu-

matoid arthritis. However, she was employed full time throughout 2010 as a

school administrator. Petitioners’ tax return shows that, apart from the annuity

withdrawal, her employment was petitioners’ primary source of income during

2010. Although her illness undoubtedly placed certain limits on her, she clearly

was not “prevented by the impairment from engaging in * * * substantial gainful

activity.” Sec. 1.72-17A(f)(4), Income Tax Regs. Petitioner-wife during 2010
                                       - 12 -

[*12] was therefore not “disabled” within the meaning of section 72(q)(2)(C).

Because petitioners do not urge that any other exception applies, we will sustain

respondent’s imposition of an $18,630 penalty under section 72(q)(1).

IV.   Accuracy-Related Penalty

      Respondent did not determine an accuracy-related penalty in the notice of

deficiency or assert one in his answer. At the start of trial, respondent moved to

amend his answer to assert this penalty. The Court took that motion under

advisement.

      Rule 41(a) provides that, when more than 30 days have passed after an an-

swer has been served, “a party may amend a pleading only by leave of Court or by

written consent of the adverse party, and leave shall be given freely when justice

so requires.” Whether a party may amend his pleading lies within the sound dis-

cretion of the Court. Estate of Quick v. Commissioner, 110 T.C. 172, 178 (1998).

In determining whether to allow a proposed amendment, the Court must consider

(among other things) whether an excuse for the delay exists and whether the

opposing party would suffer unfair surprise, substantial inconvenience, or other

prejudice. See Foman v. Davis, 371 U.S. 178, 182 (1962); Estate of Ravetti v.

Commissioner, T.C. Memo. 1992-697. The Court looks with disfavor on untimely

requests for amendment that, if granted, would prejudice the other party. See, e.g.,
                                        - 13 -

[*13] Farr v. Commissioner, 11 T.C. 552, 566-567 (1948), aff’d sub nom. Sloane

v. Commissioner, 188 F.2d 254 (6th Cir. 1951); Estate of Lee v. Commissioner,

T.C. Memo. 2009-303.

      Although respondent has not explained his delay in asserting the penalty, he

notified petitioners in his pretrial memorandum of his intent to assert it. That

memorandum was filed two weeks before this case was called for trial. Petitioners

were thus given sufficient notice to prepare for trial on this issue, and they had a

full opportunity to address the penalty in post-trial briefing. They do not contend

that respondent’s delay prejudiced them, and they presented no evidence of sur-

prise or inconvenience. Finding no prejudice, we will grant respondent’s motion.

See Phillips v. Commissioner, T.C. Memo. 2013-215 (granting post-trial motion to

amend answer to assert accuracy-related penalty).

      The Code imposes a 20% penalty upon the portion of any underpayment of

tax that is attributable (among other things) to “[a]ny substantial understatement of

income tax.” Sec. 6662(a), (b)(2). An understatement of income tax is “substan-

tial” if it exceeds the greater of $5,000 or 10% of the tax required to be shown on

the return. Sec. 6662(d)(1)(A). Under section 7491(c), the Commissioner bears

the burden of production with respect to the liability of an individual for any

penalty. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001).
                                       - 14 -

[*14] The notice of deficiency determined an understatement of income tax in

excess of $76,000, which we have sustained. This amount comfortably exceeds

$5,000 and 10% of the total tax required to be shown on petitioners’ 2010 return.

Respondent has thus carried his burden of production by demonstrating a “sub-

stantial understatement of income tax.” See sec. 7491(c).

      Section 6664(c)(1) provides that the accuracy-related penalty shall not be

imposed with respect to any portion of an underpayment “if it is shown that there

was a reasonable cause for such portion and that the taxpayer acted in good faith

with respect to * * * [it].” Once the Commissioner has carried his burden of

production, the taxpayer bears the burden of proving reasonable cause and good

faith. Higbee, 116 T.C. at 446-447. The decision as to whether the taxpayer acted

with reasonable cause and in good faith is made on a case-by-case basis, taking

into account all pertinent facts and circumstances. See sec. 1.6664-4(b)(1),

Income Tax Regs. Circumstances that may signal reasonable cause and good faith

“include an honest misunderstanding of fact or law that is reasonable in light of all

the facts and circumstances, including the experience, knowledge, and education

of the taxpayer.” Id.

      Petitioner-husband prepared petitioners’ 2010 joint return. He did not testi-

fy to having received any advice from a tax professional regarding the proper tax
                                        - 15 -

[*15] treatment of the $525,000 withdrawal. ING sent petitioners a Form 1099-R

stating that $186,302 of this distribution was taxable, but they chose not to report

any part of the distribution as taxable or attach this document to their return. Their

cryptic explanation that “any potential gains should be applied to the prior capital

loss carryforward” had no plausible legal basis. And because petitioner-wife was

employed full time throughout 2010, petitioners had no factual basis for claiming

exemption from the section 72(q) penalty on the theory that she was “disabled.”

       Petitioners did not have “substantial authority” or a “reasonable basis” for

either of these positions. See sec. 6662(d)(2)(B)(i) and (ii). We likewise find that

their arguments are too lacking in legal and factual basis to constitute a reasonable

misunderstanding of law, particularly in light of petitioner-husband’s education

and occupation as a licensed attorney and former C.P.A. See sec. 1.6664-4(b)(1),

Income Tax Regs. Petitioners have thus not shown that there was reasonable

cause for their underpayment. We will accordingly sustain the accuracy-related

penalty with respect to the full amount of the underpayment.

      To reflect the foregoing,


                                                 An appropriate order and

                                       decision will be entered for respondent.
