Tax Court Rules on Valuation of Life Insurance Policy in Bargain Sale

In a case of first impression, the Tax Court held that where the profit-sharing plan of an S corporation wholly owned by the taxpayers distributed to them a life insurance policy on their lives, the taxpayers could not reduce the taxable value of the policy by the amount of the surrender charge for purposes of determining their income from the transfer.

Background

The Matthies, a married couple, consulted with their longtime attorney about estate planning. The attorney, along with his insurance agent son, advised the couple to use a plan (marketed by a life insurance company and a financial advisory firm) that, according to promotional material, would allow the Matthies to transfer IRA funds to their family without significant taxation. Under the plan, the Matthies created a wholly owned S corporation and set up a profit-sharing plan for the S corporation. The profit-sharing plan bought a life insurance policy on the Matthies’s lives and made the premium payments on the insurance policy using money rolled over from the husband’s IRA.

Later, the profit-sharing plan transferred the insurance contract to Mr. Matthies; on the same day he transferred $315,023 to the plan. According to the Matthies, the policy had an “account value” of $1,368,327 at the time of the sale, but when reduced by a $1,062,461 surrender charge specified in the policy, its cash value was $305,866—less than the $315,023 Mr. Matthies paid for the policy. Thus, the Matthies reported no taxable gain on the transaction.

On audit, the IRS determined that the insurance policy should be valued at its full fair market value (FMV) for purposes of the transfer and that the transfer was a bargain sale of the insurance contract. Consequently, the Matthies should have reported the $1,053,304 bargain element of the sale (the difference between the policy’s FMV and the amount paid by Mr. Matthies) in gross income from the transfer. The IRS also determined that the Matthies were liable for a $58,985 accuracy-related penalty under Sec. 6662. The Matthies challenged the IRS’s determination in Tax Court.

The Code and Regs.

Under the Code and regulations, amounts distributed by an employer’s trust, such as the profit-sharing plan in this case, are taxable to the distributee at FMV. Under Regs. Sec. 1.402(a)-1(a)(2), the entire cash value of an annuity contract distributed to an employee by an employer’s trust is includible in the distributee’s gross income. However, the regulations did not define “entire cash value” and the tax treatment of a bargain sale from a qualified plan to a plan participant.

Therefore, the IRS issued additional regulations in August 2005 clarifying that the entire cash value did not include a reduction for surrender charges and that the bargain element in a sale is treated as part of a distribution under Sec. 402(a). For transfers before the effective date of these regulations, the regulations stated that in the case of a transfer of a life insurance contract to a plan participant before the effective date, the excess FMV of the contract over the consideration received by the plan is includible in the income of the participant receiving the contract.

The Tax Court’s Decision

The Tax Court analyzed two issues about how those regulations applied to the transfer of the insurance contract to the Matthies: (1) the taxation under Sec. 61 of the bargain sale element of the distribution of the insurance policy and (2) the proper standard for valuing the policy for purposes of determining the gain on the transfer. The Tax Court sided with the IRS on both issues and held that the Matthies had to include the bargain sale portion of the transfer in income in the year it occurred. However, the Tax Court also held that the Matthies were not liable for the accuracy-related negligence penalty.

With respect to the first issue, the Tax Court explained, citing LoBue, 351 U.S. 243 (1956), that income may result from a bargain sale when the parties have a special relationship and the transaction is not at arm’s length. The Tax Court found that given that the transfer was part of a totally prearranged transaction specifically for the purpose of ultimately transferring the life insurance contract to the Matthies, the transfer was not at arm’s length. Therefore, it held that the bargain element of the transfer must be included in income.

With respect to the valuation issue, the Tax Court looked to the history of the relevant regulations (first issued in 1955) as well as the use of the terms “cash surrender value” and “net surrender value” in Secs. 72 and 7702 in making its determination. It noted that both Secs. 72(e)(3)(A)(i) and 7702(f)(2)(A) state that cash value is determined without regard to any surrender charge, whereas Sec. 7702(f)(2)(B) states that net surrender value is determined with regard to surrender charges. Therefore, the Tax Court held that the cash value of the Matthies’s policy did not include an adjustment for surrender charges and that the Matthies should have used the entire FMV of the insurance policy (which in this case was its account value) in computing the gain on the transfer. Accordingly, they should have included the entire $1,053,304 bargain element of the transfer, which was equal to the surrender value of the contract, in gross income.

The Matthies fared better, however, on the negligence penalty imposed by the IRS. Because the Tax Court has never before addressed the tax treatment of a bargain sale of a life insurance policy or the application of the entire cash value standard, and because of subsequent amendments to the regulations and modifications to the IRS’s arguments during the case, the court held that the taxpayers had a reasonable basis for their position and were not liable for the accuracy-related penalty.

Reflections

The result of this case is hardly surprising, given that the plan that was employed had no motive or justification outside the tax benefits it purportedly offered. The Matthies should consider themselves lucky that their first in time status saved them from a hefty negligence penalty.

Matthies, 134 T.C. No. 6