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Ninth Circuit Holds that Surrender Value of Policies Can be Considered in Taxing Distributions. (Parker's Federal Tax Bulletin: May 13, 2013)

The Ninth Circuit recently affirmed a Tax Court decision in which the court rejected the IRS's argument that surrender charges of a variable life insurance policy must be ignored in determining the value of the policy received on its distribution. In Schwab v. Comm'r, 2013 PTC 80 (9th Cir. 4/24/13), the policies distributed to the taxpayers had surrender charges that exceeded the stated policy value. The IRS tried to use Code Sec. 402(b)(2) to assess tax the stated value of the policies distributed. The Ninth Circuit held that there was no provision in the Code or regulations that provided an automatic bar to considering surrender charges.


On the advice of their accountant, in 2000, Michael Schwab and his wife, Kathryn Kleinman, each purchased a variable universal life insurance policy through Angels & Cowboys, Inc. The policies were held in a multiple-employer welfare benefit trust administered by a third-party company as part of a nonqualified employee benefit plan. The plan was aimed at small-business owners and was, according to its promotional materials, designed to allow qualified professionals, entrepreneurs, and owners of closely held businesses to obtain life insurance for themselves and for key employees on a tax-deductible basis.

The policies were of a type called variable universal life, a relatively new type of contract for this old industry. A key characteristic of universal life-insurance policies is that they disconnect to some degree a life-insurance feature (i.e., payment of money upon death) from an investment feature (i.e., the use of premiums to acquire assets that fund the insurance payment). The insurer selling a universal life policy typically segregates payments from its customers in separate investment accounts from which it makes deductions to pay for the insurance component of the policy. At death, the customer's beneficiary gets what's left in the separate account. Under a variable universal life insurance contract, the customer typically can choose from a menu of different investments (often set up to closely resemble mutual funds) with varying returns and thus varying payouts upon death, though there is (as was true under the contracts at issue) a minimum death-benefit guaranty.

The insurance policies were subject to surrender charges. The surrender charge was the fee that Schwab and Kleinman would incur if they allowed their policies to lapse, or otherwise terminated the policies, before a contractually specified date. The surrender charges on the policies lasted 11 years and would be reduced by 20 percent a year only in years 812 (starting in 2008).

In addition, each policy had a no-lapse provision. That provision specified that the policy would not lapse in the first three years of coverage, provided that the sum of all premiums paid was greater than the no lapse premium multiplied by the number of months the policy has been in force, . . . even if the net cash surrender value is zero or less.

The policy value of each policy was defined as premiums less policy loads, plus net investment return, less policy charges, partial surrenders, and any indebtedness. The net cash surrender value of each policy was the stated policy value minus the applicable surrender charge. The net cash surrender value represents the sum of money the insurance company will pay to the policyholder should he allow the policy to lapse or voluntarily terminate the policy before his death.

Angels & Cowboys paid the initial premiums on the policies, which were originally more than $136,000 per year for Schwab's policy, and $120,000 for Kleinman's. Both Schwab and Kleinman elected to invest their premium payments in funds whose value was tied to the value of the Standard & Poor's 500 index. Had Schwab's and Kleinman's expectations been met, they would eventually have been able to stop paying premiums on their policies because the premiums would have been covered by the returns on their investments. Unfortunately for Schwab and Kleinman, during the three-year period beginning in September 2000, the S & P 500 index declined nearly 34 percent, and their policy values dropped by a similar percentage.

Around the same time that Schwab and Kleinman purchased the variable universal life insurance policies, the IRS had begun to assert more aggressively its position that the type of employee benefit plan in which Angels & Cowboys was participating was not entitled to receive the favorable tax treatment that constituted the plan's entire reason for being. By 2003, it became clear that the IRS would adopt regulations with which the plan would be unable to comply.

Plan Distributes Policies to Taxpayers Anticipating what would soon occur, the plan's administrator terminated the plan, and in October 2003, Schwab and Kleinman took ownership of their respective policies. The stated policy value of Schwab's policy was $48,667 and the surrender charges were $49,225, leaving a net surrender value of ($558). The stated policy value of Kleinman's policy was $32,576 and the surrender charges were $46,599, leaving a net surrender value of ($14,023).

From the date of the distribution, Schwab's policy was set to lapse within 54 days, and Kleinman's would lapse in 24 days. Accordingly, unless the Standard & Poor's 500 Index surged in that time period, the negative net cash surrender values of the policies made clear that Schwab and Kleinman would receive nothing if their policies lapsed. Thus, Schwab and Kleinman had a choice: They could continue paying premiums on their respective policies, and thus continue their coverage, or they could allow their respective policies to lapse, and potentially receive nothing. Kleinman allowed her policy to lapse rather than pay the $108,031 premium. By contrast, the policy value of Schwab's policy rebounded modestly, and Schwab decided for a time to continue paying the required premiums, and keep his policy in force.

The distribution of the policies from the trust to Schwab and Kleinman was a taxable event under Code Sec. 402(b)(2), which provides for the taxation of assets distributed from a nonqualified employees' trust, such as the one in which Angels & Cowboys participated. Believing they were required to pay taxes only on the net cash surrender values of their policieswhich were negative at the time of the taxable eventSchwab and Kleinman did not report any taxable income as result of the distribution of their policies.

The IRS disagreed with the couple's tax treatment of their policy distributions, maintaining that, under Code Sec. 402(b)(2), the full stated policy values had to be treated as income. Code Sec. 402(b)(2) provides that the amount actually distributed or made available to any distributee by any trust that is not tax-exempt under Code Sec. 501(a) is taxable to the distributee, in the tax year in which so distributed or made available, under Code Sec. 72 (relating to annuities). The IRS issued a notice of deficiency to Schwab and Kleinman.

Tax Court's Decision

Schwab and Kleinman took their case to the Tax Court, arguing that they actually received nothing of value and therefore should pay no taxes on the distribution. The IRS asserted that surrender charges may never be considered under Code Sec. 402(b), and maintained that Schwab and Kleinman actually received the full stated policy values of their respective insurance policies.

In a decision it later characterized as coming down in the middle, the Tax Court in Schwab v. Comm'r, 136 T.C. 120 (2011), read Code Sec. 402(b) to say that a court could consider surrender charges, but only as part of a more general inquiry into a policy's fair market value. In Schwab and Kleinman's case, the Tax Court accounted for surrender charges, and held that the only taxable value the policies had at the time of distribution was the small amount of the insurance coverage that was attributable to the single premium that Angels & Cowboys had paid on each policy three years earlier. The IRS appealed to the Ninth Circuit.

Ninth Circuit's Analysis

The Ninth Circuit began its analysis by noting that the application of Code Sec. 402(b)(2) to Schwab's and Kleinman's policies presented a quandary. The word amount implies a quantifiable sum. But Schwab and Kleinman did not receive an amount; they received their respective life insurance policies. The Tax Court, the Ninth Circuit noted, resolved the tension between the language of Code Sec. 402(b)(2) and its application to the Schwab-Kleinman policies by holding that the term amount actually distributed means the fair market value of what was actually distributed.

In evaluating the IRS's argument that surrender charges may never be considered when determining the amount actually received from an employees' trust under Code Sec. 402(b)(2), the Ninth Circuit looked to the Code and regulations to see if either expressly forbid the consideration of surrender charges under Code Sec. 402(b)(2). The court could find no such prohibition. One problem the court found with the IRS's interpretation of Code Sec. 402(b)(2) was that it reads the phrase amount actually distributed or made available entirely out of Code Sec. 402(b)(2). The IRS's assertion that Code Sec. 72(e)(3)(A)(i) dictates how insurance policies distributed from nonqualified trusts should be taxed, the court noted, completely bypassed the reference in Code Sec. 402(b)(2) to the amount actually distributed.

The Ninth Circuit found Reg. Sec. 1.402(b)1(c) useful in its analysis because the regulation parrots nearly verbatim the text of Code Sec. 402(b)(2), providing that [a]ny amount actually distributed or made available to any distributee . . . shall be taxable under section 72. The Ninth Circuit found the regulation to correspond to the Tax Code and to support its interpretation of the language in Code Sec. 402(b)(2).

The Ninth Circuit also looked at whether the Tax Court correctly held that the amount actually received means the fair market value of what was actually received, and if so, whether surrender charges may ever affect the fair market value of a variable universal life insurance policy.

The Ninth Circuit also addressed the IRS's argument that it should reject the Tax Court's treatment of distributions from qualified benefit plans because that approach creates unwarranted anomalies with the taxation of variable life insurance policies while they are held in trust, and with the tax treatment of distributions from qualified investment plans.

The Ninth Circuit noted that an employer's contributions to an employees' trust are taxed according to a different subsection of Code Sec. 402(b)Code Sec. 402(b)(1)than are distributions from the trust. Under Reg. Sec. 1.402(b)-1(b)(1), pertaining to Code Sec. 402(b)(1), contributions to an employee trust are valued and taxed without regard to any lapse restriction. And, the Ninth Circuit observed, the Tax Court has, in a different case, interpreted surrender charges on a variable life insurance policy to be a type of lapse restriction under Reg. Sec. 1.402(b)1(b)(1).

The Ninth Circuit rejected the IRS's argument that surrender charges should be treated identically when taxing contributions to and distributions from an employees' trust, because words in different sections of the same statute should be construed similarly. The Ninth Circuit noted that neither the contributions and distributions subsections of the tax code, nor the two corresponding subsections of the applicable regulations, have any meaningful words in common. In particular, as the Tax Court noted in the instant case, Reg. Sec. 1.402(b)1(c), does not even mention lapse restrictions. And because it was only the inclusion of that phrase in the regulations relating to employer contributions that led the Tax Court to value employer contributions without respect to surrender charges, the Ninth Circuit said that nothing in Code Sec. 402(b)(1), or the regulations interpreting it, suggested to the Ninth Circuit that it needed to adopt that approach relating to distributions. The court concluded that the possibility that the surrender charge could be disregarded when taxing contributions to an employees' trust, but be taken into account when the assets are later distributed, was not so anomalous as to require the court to ignore the statutory and regulatory text that produced such a result. Contributions and distributions are, the court noted, taxed according to two entirely separate subsections of Code Sec. 402(b).

The Ninth Circuit thus affirmed the Tax Court's holding and rejected the IRS's arguments.

Staff Editor Parker Tax Publishing


Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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