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Tax Court Holds Transfer of Annuities from Kenneth Lay to Enron Was Not Taxable

Wednesday, September 7, 2011

Rebecca L. Tsai | Bloomberg Law Estate of Kenneth L. Lay v. Commissioner of Internal Revenue, No. 15732-09, 2011 BL 222153 (T.C. Aug. 29, 2011) The U.S. Tax Court determined on August 29, 2011, that the Internal Revenue Service (IRS) was not entitled to collect an alleged $3,910,000 deficiency in income tax from the estate of former Enron CEO Kenneth L. Lay, finding that the sale challenged by the IRS was valid and entered into in good faith.

Kenneth Lay's Compensation Package with Enron

Mr. Lay served as chairman of the board of directors and CEO of Enron Corp. from 1986 until February 2001, when Jeffrey Skilling took over as CEO. Skilling resigned that August, prompting the board to attempt to persuade Mr. Lay to resume his position as CEO. As part of the compensation package it proposed, the board offered to purchase two annuities from Mr. Lay and his wife for $10 million. If Mr. Lay remained CEO for 4.25 years, Enron would then reconvey the annuities to him at the end of the term. The Lays accepted the offer, and the agreement was executed on September 2001. The Lays included the transaction on their 2001 income tax return, reporting zero gain or loss on the sale of the annuities, based on the $10 million sale of the annuities to Enron and an adjusted basis of $10 million in the two annuity contracts. Mr. Lay resigned from Enron on July 23, 2002. At the time, Enron had already filed for bankruptcy in the U.S. Bankruptcy Court for the Southern District of New York. The two annuities were listed as assets in the bankruptcy proceeding. On April 2, 2009, the IRS issued a statutory notice of deficiency to the Lays, claiming that there was a deficiency in their income tax for the 2001 tax year. The IRS maintained that the Lays never sold the annuities to Enron, but rather, the Lays entered into the agreement with Enron in bad faith and never intended to carry out the transaction. In response, Mrs. Lay filed the instant petition in the U.S. Tax Court individually and as executrix of Mr. Lay's estate.

The Lays Properly Reported the Annuities Transaction on Their Tax Return

The single issue before the Tax Court was "whether the Lays sold their annuity contracts to Enron in September 2001, in accordance with the agreement." As a preliminary matter, the Court determined that both Texas law and the terms of the annuities themselves permitted the sale of the annuities. Next, the Court found that the trial testimony established that Enron had entered into the agreement in good faith. The record indicated that the annuities transaction was one of several options considered by Enron's compensation committee to hire back and to retain Mr. Lay. Additionally, the transaction had been proposed by an outside consultant and had been reviewed by Enron's outside counsel. Turning to the annuities themselves, the Court noted that the Lays had properly executed and delivered the change form required to effectuate the transfer. While it was unclear whether Enron had properly forwarded the original executed change form to the insurance company, the Court found that this was not dispositive on the issue of whether a sale had occurred. As it explained, "[b]eneficial ownership, and not legal title, determines ownership for Federal income tax purposes." The test of whether a sale occurred was whether there was a "transfer of the benefits and burdens of ownership," which, in turn, "is based on the intention of the parties, evidenced by their written agreements and the surrounding facts and circumstances." Here, the Lays had clearly relinquished their rights to the annuities. After the transaction, "the Lays could not sell [the annuities], nor could they liquidate them or borrow against them." Moreover, they "could not alter the investment options for the annuity contracts or make any other elections or decisions regarding them." By contrast, Enron could alter the investment options and make cash withdrawals from the annuities, and therefore, had "dominion and control over the annuity contracts." It was thus the "beneficial owner" of the annuities. This was further evidenced by Enron's listing of the annuities as assets in bankruptcy. Accordingly, the Court determined that the Lays had properly reported the annuities transaction as a sale on their 2001 federal tax return.

Court Rejects the IRS's Section 83 Argument

The IRS argued that even if the annuities transaction constituted a sale, it was nevertheless taxable under 26 U.S.C. § 83, which provides that if property is transferred to a taxpayer in exchange for certain 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." In other words, taxability in this case turned on whether the promise to transfer the annuities back to the Lays if Mr. Lay served as Enron's CEO for 4.25 years constituted property that "was transferable by Mr. Lay or not subject to a substantial risk of forfeiture in 2001." The Court first determined that the relevant contractual provisions were not "property." For purposes of Section 83, the term "property" excludes "an unfunded and unsecured promise to pay money in the future." In the Court's view, the compensation agreement fell within this exception. It reasoned that the agreement was not secured because the annuities "were not transferred or set aside from the claims of creditors of the transferor" and, in fact, were listed as company assets in the bankruptcy proceeding. Additionally, even if the compensation agreement did constitute "property," there was a "substantial risk of forfeiture." The Court stated that a "substantial risk of forfeiture exists where the right to property is conditioned on the future performance of substantial services." Here, Mr. Lay would not receive the annuities if he did not serve as Enron's CEO for the entire 4.25-year term, subject to specific exceptions. Given this condition, the Court concluded that there was a "substantial risk of forfeiture" and the IRS's Section 83 argument therefore failed.

IRS's Argument that the $10 Million Payment Was Additional Compensation Also Failed

Next, the IRS contended that the $10 million purchase price paid by Enron for the annuities exceeded the fair market price, and thus the excess constituted "additional compensation" to Mr. Lay. The Court also rejected this theory, finding it unsupported by the record. It noted that 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." Moreover, Enron's position was supported by expert testimony. The Court concluded that Enron intended for the full amount of the $10 million payment "to be consideration for the annuity contracts." The Court therefore held that there was no deficiency on the Lays' 2001 income tax return.
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