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
What Your Peers Are Reading
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.