Dona Elizabeth Conway v. Commissioner , 111 T.C. No. 20 ( 1998 )

111 T.C. No. 20
UNITED STATES TAX COURT
DONA ELIZABETH CONWAY, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 22257-96. Filed December 30, 1998.
Held: Under the facts of this case, direct
transfer of a portion of funds invested in an annuity
contract into another annuity contract qualifies as a
nontaxable exchange under sec. 1035, I.R.C. Other
issues also decided.
Dona Elizabeth Conway, pro se.
Blaine C. Holiday, for respondent.
SWIFT, Judge: Respondent determined a deficiency of
$123,855 and an addition to tax and a penalty with respect to
petitioner's Federal income tax for 1994.
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Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
After settlement of some issues, the primary issue for
decision is whether direct transfer of a portion of funds
invested in an annuity contract into another annuity contract
qualifies as a nontaxable exchange under section 1035.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
When the petition was filed, petitioner resided in
Minneapolis, Minnesota.
Exchange of Portion of Annuity Contract
In 1992, petitioner purchased from Fortis Benefits Insurance
Co. (Fortis) an annuity contract for a total purchase price of
$195,643 (Fortis annuity contract). Payments under the Fortis
annuity contract would not begin until February 4, 2029.
In 1994, petitioner requested Fortis to withdraw $119,000
from the Fortis annuity contract and to issue a check in favor
of, and to transfer the funds directly to, Equitable Life
Insurance Co. of Iowa (Equitable) for purchase of a new annuity
contract from Equitable (Equitable annuity contract). Pursuant
to petitioner's request, Fortis debited petitioner's annuity
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contract with $119,000, retained $10,000 from the $119,000 as a
"surrender charge", issued a check in the amount of $109,000 in
favor of Equitable, and mailed the check directly to Equitable.
Upon receipt of the $109,000 check from Fortis and upon
simultaneous receipt of petitioner's application to purchase the
Equitable annuity contract, Equitable opened an annuity contract
in favor of petitioner with a principal amount invested of
$109,000. The record does not indicate when payments under the
Equitable annuity contract were to begin, but the terms and
provisions of the annuity contracts are treated by the parties as
substantially equivalent.
On the application form for purchase of the Equitable
annuity contract that petitioner filled out and submitted to
representatives of Equitable, petitioner expressly indicated that
withdrawal of the funds from the Fortis annuity contract and
transfer of the funds to Equitable for purchase of another
annuity contract were to be treated as a section 1035 nontaxable
exchange.
In 1994, Fortis mailed to petitioner and to respondent a
Form 1099-R (Distributions From Pensions, Annuities, Retirement
or Profit-Sharing Plans, IRA's, Insurance Contracts, etc.)
indicating that the above transaction was taxable and that
$30,535 of the $119,000 withdrawn from petitioner’s Fortis
annuity contract represented taxable income to petitioner.
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Later, on July 30, 1997, Fortis mailed to petitioner a letter
explaining that an incorrect Form 1099-R had been mailed to
petitioner and that petitioner's exchange of a portion of the
Fortis annuity contract for the Equitable annuity contract was
intended to qualify and should have been processed by Fortis as a
nontaxable exchange under section 1035.
Tax Basis in Home, Consulting Fee, and IRA Distribution
In 1971, petitioner and her husband purchased a home in
Wayzata, Minnesota, for $53,500. The home was located on Lake
Minnetonka in an exclusive suburb of Minneapolis.
From 1971 until 1986, petitioner, her husband and children
resided in the home. In 1986, petitioner and her husband
separated and were divorced. From 1986 until 1994, petitioner
and her children continued to reside in the home.
Over the course of the 23 years during which petitioner
resided in the home, numerous capital improvements were made to
the home. With regard to improvements made to the home during
1971 to 1986, petitioner and her former husband testified at
trial and generally described the improvements to the home.
However, billing and payment records relating to improvements
made to the home during 1971 to 1986 are no longer available.
Those records were maintained by petitioner’s former husband, and
he has apparently lost the records. Some of those improvements
are corroborated by copies of building permits.
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From the time petitioner and her husband divorced in 1986
until petitioner sold the home in 1994 for $375,000, petitioner
maintained records that establish the nature and cost of capital
improvements made to the home.
In 1994, petitioner paid a $10,000 consulting fee relating
to a family business plan and to the acquisition and the sale of
personal property.
In 1994, petitioner received $5,149 as a distribution from
an individual retirement account (IRA) that petitioner maintained
at Great-West Life & Annuity Insurance Co. (Great-West). Great-
West mailed to petitioner and to respondent a Form 1099-R
indicating that $895 of the $5,149 distribution represented
taxable income to petitioner.
1994 Tax Return and Respondent's Audit
On her 1994 Federal income tax return, petitioner did not
report any taxable income relating to the transfer of a portion
of the funds invested in the Fortis annuity contract into the
Equitable annuity contract.
Also on her 1994 Federal income tax return, with regard to
sale of her home petitioner reported a $375,000 selling price, a
tax basis in the home of $335,492, and a taxable gain of $2,578.
Petitioner claimed as miscellaneous itemized deductions $13,250,
consisting of $10,000 for a consulting fee, $2,500 for investment
loss, and $750 for legal fees, and petitioner reported as taxable
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income the $895 taxable portion of the $5,149 Great-West
distribution. Petitioner, however, reported no additional tax
under section 72(t) with respect to the $895 taxable portion of
the Great-West distribution.
On audit, respondent determined that petitioner’s transfer
of a portion of the funds invested in the Fortis annuity contract
into the Equitable annuity contract did not qualify as a
nontaxable exchange under section 1035 and that petitioner
received $30,535 of unreported taxable income relating thereto.
Respondent also determined that petitioner is liable under
section 72(q) for a 10-percent penalty of $3,054 on the $30,535
portion of the withdrawal from the Fortis annuity contract that
respondent treated as taxable.
Further, in calculating petitioner's taxable gain on the
sale of her home, respondent disallowed entirely petitioner's
claimed tax basis of $335,492. Respondent disallowed
petitioner's claimed miscellaneous itemized deductions of
$13,250, and respondent determined that petitioner is liable for
a 10-percent additional tax of $90 under section 72(t) on the
$895 taxable portion of petitioner's $5,149 Great-West
distribution.
Before trial, respondent allowed petitioner a tax basis in
her home of $221,633, consisting of the purchase price of $53,500
and all of the claimed $168,133 in improvements that were made to
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the home after 1986 for which petitioner produced what respondent
regarded as adequate documentation.1
On brief, respondent conceded that $9,000 of the $10,000
petitioner paid as a consulting fee is deductible as a
miscellaneous itemized deduction.
OPINION
Exchange of Portion of Annuity Contract
Under section 72(e)(2)(B)(i), amounts received under an
annuity contract prior to the date on which annuity payments are
to begin are to be included in gross income to the extent
allocable to income earned on the annuity contract.
Under section 1035(a)(3), however, gains or losses are not
to be recognized where an annuity contract is exchanged for
another annuity contract. Section 1035(a)(3) provides as
follows:
SEC. 1035. CERTAIN EXCHANGES OF INSURANCE POLICIES.
(a) General Rules.--No gain or loss shall be
recognized on the exchange of--
* * * * * * *
(3) an annuity contract for an annuity
contract.
1
Respondent also allowed a $36,930 adjustment to the selling
price of the home to reflect a real estate sales commission that
petitioner paid.
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Under regulations promulgated under section 1035, in order
for an exchange to qualify for nonrecognition treatment, it is
required only that the contracts be of the same type, e.g., an
annuity for an annuity and that the obligee under the two
contracts be the same person. No other requirements are set
forth in the applicable regulations. Section 1.1035-1(c), Income
Tax Regs., provides, in part, as follows:
Sec. 1.1035-1. Certain exchanges of insurance
policies.--Under the provisions of section 1035 no gain or
loss is recognized on the exchange of:
* * * * * * *
(c) An annuity contract for another annuity
contract (section 1035(a)(3)),
but section 1035 does not apply to such exchanges if the
policies exchanged do not relate to the same insured. The
exchange, without recognition of gain or loss, of an annuity
contract for another annuity contract under section
1035(a)(3) is limited to cases where the same person or
persons are the obligee or obligees under the contract
received in exchange as under the original contract. * * *
Respondent argues that because the entire Fortis annuity
contract was not replaced by the Equitable annuity contract,
petitioner's withdrawal of $119,000 from the Fortis annuity
contract does not qualify as a nontaxable exchange under section
1035 and is taxable to the extent of $30,535, the portion of the
withdrawal allocable to income.
Petitioner argues that because Fortis did not distribute any
funds to her personally but rather transferred the funds directly
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to Equitable and because she gave up a portion of her Fortis
annuity contract solely in exchange for the new Equitable annuity
contract, the transaction should qualify as a nontaxable exchange
of annuity contracts under section 1035.
We agree with petitioner.
Neither section 1035 nor the regulations condition
nonrecognition treatment upon the exchange of an entire annuity
contract. Respondent cites no authority to support respondent's
position that nonrecognition treatment under section 1035 is
limited to exchanges involving replacement of entire annuity
contracts. Neither the statute nor the regulations contain any
such requirement, either expressly or by any necessary
implication.
Petitioner expressly indicated on her application with
Equitable that the Equitable annuity contract was being acquired
as part of a section 1035 exchange, and Fortis transferred the
$109,000 directly to Equitable. No funds were distributed to
petitioner.
The legislative history under section 1035 states that
section 1035 was enacted to provide nonrecognition treatment for
taxpayers "who have merely exchanged one * * * [annuity contract]
for another better suited to their needs and who have not
actually realized gain." H. Rept. 1337, 83d Cong., 2d Sess. 81
(1954). The funds withdrawn from the Fortis annuity contract
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(net of the $10,000 surrender fee) were transferred directly into
another annuity contract without petitioner having any personal
use thereof.
In Greene v. Commissioner, 85 T.C. 1024 (1985), an insurance
company distributed to the taxpayer all funds invested in an
annuity contract qualified under section 403(b).2 Upon receipt,
the taxpayer endorsed the check over to another insurance company
to purchase another annuity contract qualifying under section
403(b). In Greene, 85 T.C. 1028, we concluded that the
exchange was nontaxable, and we set forth a broad definition of
"exchange" within the meaning of section 1035, as follows:
We are satisfied, however, that Congress intended the
use of the word [exchange] in the broader sense, as
where the taxpayer gives up an insurance contract with
one company, in order to procure the same or a
comparable contract from another company. Viewed from
the standpoint of the insured taxpayer, he has simply
"exchanged" one policy for another just like it, albeit
with two different companies. * * *
Petitioner herein exchanged a portion of her annuity
contract with Fortis to acquire another annuity contract with
Equitable. Petitioner is in essentially the same position after
the exchange as she was in before the exchange, and the same
2
Annuity contracts qualifying under sec. 403(b) constitute a
form of tax-deferred annuity contracts available to employees of
certain tax-exempt organizations.
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funds are still invested in annuity contracts (less the surrender
fee), except that now petitioner owns two annuity contracts.
Petitioner's funds (less the $10,000 surrender charge)
remain invested in a similar annuity contract, and petitioner has
not personally received use or benefit of these funds since they
were originally invested in the Fortis annuity contract in 1992.
We conclude that petitioner's direct exchange of a portion
of her Fortis annuity contract for a new Equitable annuity
contract qualifies under section 1035 and that no gain to
petitioner is to be recognized by reason of the exchange.3
Because the transaction qualifies as a nontaxable exchange,
petitioner is not liable for the 10-percent penalty under section
72(q) on any portion of the $119,000 withdrawal.
Tax Basis in Petitioner's Home
In determining gain or loss on the sale of property, the
cost basis of the property is adjusted by capital improvements
made to such property. Secs. 1001, 1012, 1016.
Generally, taxpayers bear the burden of proving entitlement
to costs and deductions claimed. Bennett Paper Corp. &
3
In Rev. Rul. 90-24, 1990-1 C.B. 97, involving annuity
contracts issued under sec. 403(b), a portion of funds invested
in one annuity contract is transferred directly to another
similar annuity contract, and the transfer is treated as
nontaxable. In Rev. Proc. 92-44, 1992-1 C.B. 875, under certain
specified situations, partial cash distributions to taxpayers
from annuity contracts are treated as nontaxable to the extent
reinvested in similar annuity contracts.
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Subsidiaries v. Commissioner, 699 F.2d 450, 453 (8th Cir. 1983),
affg. 78 T.C. 458 (1982). Under certain circumstances, we may
estimate costs and allowable deductions. Cohan v. Commissioner,
39 F.2d 540, 543-544 (2d Cir. 1930). The estimates, however,
must have a reasonable evidentiary basis. Vanicek v.
Commissioner, 85 T.C. 731, 742-743 (1985).
Respondent argues that petitioner has not adequately
substantiated any costs and capital improvements to her home in
excess of the $221,633 that respondent has agreed to. The
claimed costs and improvements still in dispute relate to the
years 1971 through 1986, for which petitioner has minimal or no
documentation. Respondent argues that petitioner's testimony as
to the costs of the claimed improvements is self-serving and
uncorroborated.
Petitioner claims that the evidence relating to the
improvements allegedly made during 1971 through 1986 is adequate
for the Court to estimate the costs thereof and that she should
be entitled to increase the tax basis in her home by an
additional $156,050 beyond those items allowed by respondent, for
a total tax basis in the home of $377,683.
Credible evidence adequately establishes that, during the
years 1971 through 1986, petitioner and her husband made
extensive capital improvements to the home. In addition to the
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testimony, several of the improvements are supported by building
permits in evidence.
We accept petitioner's and her former husband's testimony
with regard to a number of the home improvements that are claimed
to have been made during the years 1971 through 1986. Set forth
in the schedule below, we summarize the various improvements that
petitioner claims were made to the home during 1971 through 1986
and the estimated costs that petitioner claims were incurred for
each improvement. Also set forth below with regard to the
improvements are the costs, if any, that we believe can be
reasonably estimated and that we allow with regard to each
improvement.
Petitioner's
Claimed Costs
Claimed Home Improvements 1971-1986 Costs Allowed
New electrical wiring $ 11,000 $ 5,000
New furnace and hot water heater 9,300 5,000
New insulation 8,800 -0-
Reconstruction of gazebo and bridge to gazebo 8,000 2,000
Stone steps leading to the lake 1,500 -0-
Pool improvements and new wrought-iron fence 8,500 5,000
New two-car garage and removal of old garage 46,800 20,000
New concrete driveway 6,500 4,000
Reconstruction of second floor including a new wall 12,600 10,000
Septic tank removal and city water/sewer hookup 11,150 5,000
Structural improvements to doors and roof supports 8,100 -0-
New roof 10,300 -0-
Interior remodeling 4,500 -0-
Dock improvements 1,500 -0-
Kitchen improvements 7,500 -0-
Total $156,050 $56,000
Based on the evidence before us, we conclude that
petitioner's tax basis in her home is $277,633, or $56,000 over
the $221,633 allowed by respondent.
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Miscellaneous Itemized Deductions
With respect to the claimed $1,000 consulting fee in excess
of the $9,000 allowed by respondent, petitioner has failed to
demonstrate that the $1,000 was paid for management,
conservation, or production of income or income-producing
property, and we sustain respondent's disallowance thereof.
With respect to the claimed $2,500 investment loss and the
claimed $750 legal fees, the evidence provides no basis to
support these claimed deductions, and we sustain respondent's
disallowance thereof.
IRA Distribution
With regard to the $5,149 IRA distribution that petitioner
received from Great-West, petitioner has not established that the
10-percent additional tax on the $895 taxable portion of the
$5,149 distribution does not apply, and we sustain this
additional tax.
To reflect the foregoing,
Decision will be entered
under Rule 155.