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JEROME MIRZA & ASSOC., LTD. v. U.S.

August 12, 1988

JEROME MIRZA & ASSOCIATES, LTD., AN ILLINOIS CORPORATION, PLAINTIFF,
v.
UNITED STATES OF AMERICA, DEFENDANT.



The opinion of the court was delivered by: Richard Mills, District Judge:

OPINION

    L. Hand, The Spirit of Liberty: Papers & Addresses of
    Learned Hand, 213 (I. Dilliard ed. 1960).

A tax case of first impression.

At issue:

  (1) Whether 26 U.S.C. § 404(a)(1)(A)(iii) required the
    taxpayer/professional corporation to allocate between
    current and past service costs the benefits accruing to
    its sole shareholder in 1980 under a defined benefit
    pension plan?
  (2) Whether the actuarial assumptions the
    taxpayer/professional corporation utilized in 1980 for the
    defined benefit pension plan, principally the
    pre-retirement 5% interest rate assumption, were
    reasonable in the aggregate as required by
    26 U.S.C. § 412(c)(3)?

The answers:

(1) Yes

(2) No

BACKGROUND

The taxpayer, Jerome Mirza & Associates, Ltd., is a professional corporation in the business of providing legal services and is controlled by its sole shareholder, Jerome Mirza. On December 31, 1980, the taxpayer adopted the "Jerome Mirza & Associates, Ltd., Defined Benefit Pension Plan" with an effective date of January 1, 1980.

Article I, § A of the Plan states that the taxpayer desired to create a scheme of deferred compensation consistent with § 401 of the Internal Revenue Code, and all provisions should be construed so as to comply with the tax code's requirements for qualification. The plan provides, inter alia, that an employee is eligible to participate after three years of service but may accrue benefits only after completing a fourth year of service. Eligible individuals then receive an accrued benefit equal to 30% of the participant's compensation for the first year of participation on or after January 1, 1980, plus 5% of his or her salary for each of the next three years, reduced by 37% of social security benefits ratably earned over the initial four years of plan participation. Each participant is entitled to his or her accrued benefit upon reaching the retirement age of 55 and attaining 10 years of plan participation. The plan also provides that the normal retirement benefit may not exceed the lesser of $110,625 per year or 100% of the participant's total annual income averaged over the high consecutive three years of participation.

The plan covered two employees in 1980. Jerome Mirza had been employed by the taxpayer for seven years and was 43 years old. David Dorris had been employed for five years and was 33 years old. During 1980, Mr. Mirza's compensation totalled $275,000. Mr. Dorris' income was $27,000 of which he elected $9,760 to be considered for pension purposes. Based upon the plan's provisions, the annual accrued benefit was calculated as $80,927 and $1,215 for Mr. Mirza and Mr. Dorris respectively. In other words, upon their retirement at the plan retirement age of 55, Mr. Mirza and Mr. Dorris would receive those respective sums each year even if no benefits accrued in later years.

To fund enough money to pay the yearly benefits, the plan's actuary, The Wyatt Company, then prepared an actuarial valuation report for the plan using the unit credit cost method. The actuarial assumption for the 1980 valuation included an interest rate of 5% for the pre-retirement period. This assumption was the actuary's estimate of the rate the plan would earn on its investments. Because of existing circumstances, mortality, turnover and salary increase assumptions were unnecessary. Employing the actuarial assumptions, the actuary determined the present value of Mr. Mirza's accrued benefit to be $619,925 and Mr. Dorris' to be $6,000. The total of $625,925 was reported as the normal cost for the year. The unfunded past service liability was recorded as zero for the December 31, 1980, valuation.

The taxpayer's 1980 tax return reported a deduction of $625,925 attributable to the pension plan. The amounts contributed in the plan year and how they were invested are as follows:

Date      Amount         Investment
9/15/80     $100,000     6 month CD@11.65%
9/15/80     $200,000    36 month CD@12.4%
1/5/81      $100,000     6 month CD@15.5%
1/8/81      $100,000     6 month CD@15.5%
3/3/81      $100,000     6 month CD@15.75%
3/3/81      $18,007     6 ...

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