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Tax Court Confirms Surrender Charges Reduce FMV of Life Policy

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The Tax Court recently determined that the fair market value (FMV) of a life insurance policy distributed by a terminated 419 welfare benefit plan is reduced by surrender charges. [Lowe v. C.I.R., T.C. Memo. 2011-106 (2011)]

This ruling further cements the Tax Court’s position on surrender charges that was enunciated in Schwab v. Commissioner [Michael P. Schwab et ux. v. C.I.R., 136 T.C. No. 6 (2011)]. Although the IRS continues to challenge taxpayers who apply surrender charges to reduce or eliminate their tax liability when a policy is distributed to them by a welfare benefit plan, this ruling adds another degree of certainty to the FMV calculation.

The Facts of the Case

The taxpayer in this case, Mr. Lowe, was the sole shareholder of an S corporation, Smart Money Strategies, Inc. (Smart Money). The company adopted a 419 welfare benefit plan called the National Variable Benefit Plan and Trust as an employee benefit. Mr. Lowe and his wife were the only employees of the company.

The plan provided death and severance benefits to Mr. and Mrs. Lowe. These benefits were funded with a cash value variable universal life insurance policy on Mr. Lowe’s life and a term life insurance policy on Mrs. Lowe’s life. The policy on Mr. Lowe’s life had a $4,213,485 value and an annual premium of $75,000. A surrender charge was applicable to Mr. Lowe’s policy for the first 14 years after its effective date.

Smart Money participated in the welfare benefit plan for only two years, 2002 & 2003, and then terminated its participation. The cash value policy was transferred to Mr. Lowe.

On the date of distribution, the policy had a cash value of $140,901, but the policy had zero value after surrender charges were taken into account.

Mr. Lowe was issued a 1099-R (Distributions From Pensions, Annuities, Retirement or Profit–Sharing Plans, IRAs, Insurance Contracts, etc.) in the amount of $4,426.10, the value of life insurance coverage provided by the policy in the present year and the Lowes reported that amount on their 2003 income tax return.

The IRS Position

The IRS issued the Lowes a notice of deficiency saying that the Lowes had unreported income equal to $140,901—the


cash value of the policy without regard to surrender charges. The IRS also held that the taxpayers were liable for an accuracy related penalty of $10,050.

Although both the IRS and the Lowes agreed that the distribution of the policy was a taxable event, they disagreed about the amount of income the Lowes realized on the policy’s distribution.

The Tax Court’s Analysis

The Lowes took their dispute with the IRS to the Tax Court.

The IRS asked the Court to hold that “the value of the policy is its accumulated value on the date of distribution determined without regard to surrender charges.”

The taxpayer disagreed with the IRS, and responded to the IRS’s motion, summary judgment (without trial), and asked the Tax Court to find that the value of the policy should take into consideration surrender charges.

Under the Tax Code, the amount that should be included in gross income in this situation is no more than “the cash value of the contract (determined without regard to any surrender charge) immediately before the amount is received” reduced by the taxpayer's “investment in the contract.” [IRC Sec. 72(e)(3)(A)]

Mr. Lowe did not make any investment in the contract, so the maximum amount that he could be required to include in gross income would be the cash value of the contract without regard to surrender charges–$140,901 in this case.

Here, the Tax Court applied the reasoning it used in the recent case of Schwab v. Commissioner [Michael P. Schwab et ux. v. Commissioner, 136 T.C. No. 6 (2011)]; discussed in the Advisor’s Journal article: Tax Court Calculates FMV of Policies Distributed from Terminated 419 Plan (CC 11-35).] Like the Lowes, “the taxpayers in Schwab received distributions of life insurance policies from a nonexempt employee trust and challenged the Commissioner's determination that the values of those policies should be determined without regard to surrender charges.”

In Schwab, the Tax Court held that, for purposes of the welfare benefit plan at issue in the case, the “amount actually distributed” meant the fair market value of the policy that was distributed to the taxpayer. As a result, the only value that the taxpayer received in the distribution was the small amount of life insurance coverage that the employer had already paid for when the policy was distributed.

Conclusion Uncertain, but Taxpayer May Prevail

The court decided that surrender charges may be taken into account. But because the court was only deciding a motion for summary judgment brought by the IRS and decided against the Service in its ruling, the case will proceed. Although by no means certain, it is very likely the taxpayer will prevail, considering the Tax Court’s posture in this ruling and its previous ruling in Schwab.


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See also The Law Professor's blog at AdvisorFYI.