The U.S. Cour of Appeals for the Ninth Circuit recently affirmed the Tax Court’s position on the use of surrender charges in the valuation equation when a nonqualified employee benefit plan that holds a life insurance policy distributes that policy to a taxpayer upon winding up of the plan.
When these life insurance policies are distributed to the taxpayer-employees under such a plan, the taxpayers are responsible for paying taxes on the value of the policies. According to the IRS, the policy value equals the cash value of the policy without regard to any surrender charges. So what do your clients have to include in income if the actual cash surrender value of their life insurance policy is negative?
Schwab: The Facts
The life insurance policy at issue in Schwab v. Commissioner was a variable universal life policy held in a multi-employer welfare benefit trust, under which the policy premiums were paid by the taxpayers’ employer. In addition to the traditional life insurance component, this type of policy contains an investment element so that the policy premiums were used to invest in the stock market in an attempt to increase the policy value. In this case, the policies were tied to the performance of the S&P 500 stock index.
The policies were also subject to surrender charges (fees that the taxpayers would incur if they allowed their policies to lapse or terminate before a certain date specified in the policy). Further, the policies contained “no lapse” provisions that prevented the policies from lapsing during the first three years of coverage as long as premiums paid exceeded a certain level—even if the stated policy value was negative.
Because the value of the S&P 500 dropped dramatically during the time period in which the policies were held by the trust (2000-2003), the value of the life insurance policies dropped, as well. When the welfare benefit trust was terminated, the life insurance policies were distributed to their respective owners, including the taxpayers in this case. Unfortunately, by the time the taxpayers took ownership of the policies, the surrender charges exceeded the stated value of the policies, which were also about to lapse after the initial three years of coverage.
If the taxpayers had allowed their policies to lapse, they would have received nothing because the cash surrender value of each policy was negative. Under IRC Section 402(b)(2), the distribution of the policies from the nonqualified benefit plan would have been taxable, but, because each of the policies’ surrender values were negative, the taxpayers did not report income on their tax returns as a result of the distribution.
The IRS argued that the full stated value of the policies should have been reported as income upon distribution to the taxpayers regardless of the negative cash surrender values.
According to the IRS’s argument, surrender charges are not a factor in determining the taxable value of a life insurance policy distributed from a nonqualified benefit plan.
The Ninth Circuit, agreeing with the Tax Court, disagreed with the IRS’s reasoning and found that the fair market value of a distributed life insurance policy should be impacted by any surrender charges applicable under the terms of the policy. Because the fair market value of the policies was the proper benchmark for determining the amounts includable in income, the court found it logical to assume that a reasonable person would pay less for a policy with surrender charges that impacted the cash value of the policies than for a policy with no similar restrictions.
Further, the court rejected the IRS’s argument that surrender charges must be disregarded when determining the tax treatment of the distributions because they were disregarded when taxing contributions to the trust. The court found that the tax treatment of contributions and distributions was provided under two different code provisions, so there was nothing unusual about formulating the tax treatment of each differently.
This opinion rejected the IRS’s reasoning that your clients would be required to include the (potentially large) stated value of a life insurance policy in income even if the policy features, coupled with market performance, would render the policy worthless. According to the courts, as surrender charges impact the value of what your client actually receives, they are properly considered in determining fair market value.
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