July 30, 2013
Authored by: Kathy Sherby, Linsey Glosier and Larry Brody
Taxpayers/insureds are often surprised when they are taxed on the value of an old policy that was underwater, when it was transferred to them, causing them to assume that the policy had no value for the government to tax. Here again, the taxpayers in Schwab v. Commissioner (9th Cir. 2013), were surprised that they had recognized taxable income on the distribution to them of life insurance policies from their non-qualified plan, which had surrender charges that exceed their cash value.
Michael and Kathryn, a married couple, were employees of Angels and Cowboys, Inc., which sponsored a non-qualified multi-employer welfare benefit plan that was administered by a third party. Each of them caused the plan to purchase, with a single premium, a variable universal life insurance policy with a three-year no lapse guarantee. Just prior to the end of the three year no lapse period, due to a change in requirements for such an employee benefit plan, the plan terminated and the life insurance policies were distributed to Michael and Kathryn. However, the policies were both subject to substantial surrender charges at the time of the distribution that exceeded the policy cash value, so that nothing would be paid to either of them on a cancellation or lapse of the policy. At the time of the distribution, Michael’s policy would lapse in 54 days and Kathryn’s policy would lapse in 24 days unless each continued to pay the premiums due on the policies. $108,031 in premiums would need to be paid on Kathryn’s policy to keep it from lapsing, so she elected to let it lapse, and received nothing on the policy. Michael elected to pay premiums on his policy for a time to keep it in force.
Because neither Michael nor Kathryn would receive anything from the policies if the policies lapsed or were cancelled immediately after the distribution of the policies from the plan, they believed that the policies distributed to them from the plan had no value. Therefore, they did not report any taxable income from this distribution on their income tax return. The government assessed a deficiency on their income tax return for the $81,000 cash value of the policies—unreduced by the surrender penalties—for the year in which the policies were distributed.
Section 402(b)(2) of the Internal Revenue Code provides that “the amount actually distributed or made available to any distributee” by any plan is taxable income to the distributee in the year of the distribution. The Tax Court held that “the amount actually distributed” meant the “fair market value of what was actually distributed.” The government strenuously disagreed and appealed to the Ninth Circuit, which reviewed the case de novo. The government argued that surrender charges could never be considered in determining “the amount actually received” from a plan.
At the government’s urging, the Court reviewed the provisions of § 402(b)(2) and § 72(e)(3)(A) of the Code and the Regulations under § 402, and found no provision requiring that in all circumstances the surrender charges must be ignored in determining the fair market value of a policy distributed from a plan. Instead the Court found “fair market value of insurance contracts” to be a “slippery concept” since “a particular method for ascertaining value may be appropriate in one situation and inappropriate in another.”
Having rejected the government’s argument that surrender charges may never be taken into account in determining the value of a life insurance policy and therefore that the fair market value must always be the full stated cash value of the policy, the Court then set out to determine the appropriate measure of value of the taxpayer’s policies. First the Court observed that fair market value is generally based on a willing buyer willing seller analysis stating that Congress never
“intended to tax the distributee on some amount greater (or lesser) than what a rational person would pay for what the taxpayer actually received.”
Thus the Court ruled that (1) the taxpayer would be taxed on the “fair market value” of the policies when distributed, (2) surrender charges can affect the fair market value of policies in some circumstances, (3) there is no one-size fits all measure of a life insurance policy’s fair market value, and (4) the tax court’s determination of value in this case, as being equal to the remaining value of the life insurance coverage until the lapse, was a fair determination of the value of the policy that should be subject to tax.
The Court reflected on the fact that the policies at issue here, variable universal life insurance policies with a stated no lapse guarantee period, did not exist when many of the prior court cases were decided and when the regulations were promulgated. Further, if the taxpayers had been successful in the investments made inside the policies, a far different result would have been obtained and the policies would have had a large positive cash surrender value, which would have then been subject to tax on distribution.
There are various methods for valuing a policy, which can vary drastically from one another. For example, the value of a policy can be based on cash surrender value, cash value, the insurance company’s reserve value (which itself can vary drastically from company to company), the interpolated terminal reserve value, life settlement value, the IRS safe harbor value for some income tax purposes, with the valuation method depending in part on the reason for the valuation and in part on how the policy is structured.
While this case does not provide the taxpayer with an easy rule of thumb for valuing life insurance policies, this case does remind us that because of the many ways a policy can be structured, there is no single method for valuing life insurance policies for tax purposes. Whenever the value of a life insurance policy is important in a transaction, it is imperative for the taxpayer to determine the value prior to the transaction. While this can be done through the insurance company, with a Form 712, valuation of the policy should be done informally first before requesting a Form 712 on which the insurance company reports values, in order to have the opportunity to work with the insurance company on determining the method of valuing the policy before the Form 712 is issued.