• Ninth Circuit considers surrender charges in valuation of life insurance for income tax purposes—In Schwab v. Commissioner, Tax Court No. 10525-07 (April 24, 2013), the U.S. Court of Appeals for the Ninth Circuit addressed the issue of how to value life insurance for purposes of Internal Revenue Code Section 402(b)(2). A married couple, Michael Schwab and Kathryn Kleinman, were employees and sole shareholders of a family business. The couple each purchased a variable universal life insurance policy through the company; these policies were held by a multiple employer welfare benefit trust administered by an outside company as part of a nonqualified employee benefit plan. The policies were subject to surrender charges if they lapsed or were otherwise terminated. However, there was also a no-lapse provision that provided that in the first three years, the policies wouldn’t lapse as long as the sum of all premiums paid was greater than a certain amount.

Premiums in excess of $100,000 per year were paid on each policy. The investment component of the policies suffered during the economic downturn, and by October 2003, the plan’s administrator terminated the plans and distributed the policies to the couple. At the time of distribution, Michael’s policy had a value (that is, premiums, less policy loads, plus net investment return, less policy charges, partial surrenders and any indebtedness) of $48,667, subject to surrender charges of $49,225. Kathryn’s policy had a value of $32,576, subject to surrender charges of $46,599. Both policies, therefore, had a negative net cash surrender value.

The distribution of the policies was a taxable event under IRC Section 402(b)(2), which requires that the “amount actually distributed or made available to any distributee by [certain employee trusts] shall be taxable to the distributee, in the taxable year in which so distributed or made available under Section 72…” However, Michael and Kathryn didn’t report any taxable income because they believed the net cash surrender values, which were negative, meant that they didn’t recognize any income. The IRS issued a notice of deficiency, asserting that the amounts distributed to the couple were the full policy values, not the net cash surrender values that incorporated the surrender charges. 

The IRS argued that the interpretation of policy values under IRC Section 72 and the amount actually distributed under IRC Section 402(a) both disregarded surrender charges. But, the Ninth Circuit held that the IRS’ reliance on those sections was misplaced. Ultimately, the court held that the “amount actually distributed” under Section 402(b)(2) was the fair market value (FMV) of the policies and that such FMV may consider surrender charges, if appropriate (and found that it was appropriate to do so in this case). The Ninth Circuit determined that there was no hard and fast rule regarding how to value life insurance policies, and it refused to adopt a rule that surrender charges should always be ignored. It also noted that life insurance policies vary, and new types of insurance products are frequently introduced, bolstering its refusal to draw a hard and fast line.

This case demonstrates the complexity of valuing life insurance policies and how the components determining the value may change, depending on the relevant IRC section. Life insurance policies are valued differently for income tax purposes than for estate and gift tax purposes (which values are usually based on the interpolated terminal reserve or the unearned premium). For both income tax and estate and gift tax purposes, because different factors may have to be considered based on the circumstances and the type of insurance, valuation of complicated life insurance may be more of an art than a science. 


• Tax Court holds against taxpayers for using IRAs to make alternative investments—In Peek v. Comm’r, 140 T.C. No. 12 (May 9, 2013), Darrell Fleck and Lawrence Peek decided to enter into a joint venture to purchase an alarm and fire safety company. On the advice of an accountant, they each established an individual retirement account (funded from existing IRAs). They set up a new corporation (FP Company, Inc.), of which the IRAs purchased shares. The funds in the new company were then used to buy the alarm and fire safety
company, Abbott Fire & Safety, Inc. (AFS). The accountant advised them that the corporation had to be managed at arm’s length, in a business fashion and that any actions taken on behalf of the corporation must be taken by Darrell and Lawrence as agents, rather than by them personally. Otherwise, transactions with the IRA could be “prohibited transactions” under IRC Sec-
tion 4975, which would subject them to additional income tax and penalties.

AFS was acquired by FP Company, Inc. in 2001 for $1.1 million, consisting of cash derived from various loans to FP Company, Inc. One of the loans taken out by FP Company, Inc. was secured by personal guarantees from Darrell and Lawrence. As part of the guarantees, deeds of trust on their personal residences were granted to the sellers of AFS.

In 2003, Darrell and Lawrence converted their IRAs to Roth IRAs, so that each of their respective Roth IRAs owned 50 percent of FP Company, Inc., which, in turn, owned AFS. Then, in 2006, the IRAs sold FP Company, Inc. to a third party, and each IRA received, in total during 2006 and 2007, more than $1.6 million.

The IRS audited Darrell’s and Lawrence’s 2006 and 2007 income tax returns and issued notices of deficiency that asserted tax on the gains on the sale of the business. The IRS argued that the personal guarantees made by the taxpayers were prohibited transactions under IRC Section 4975(c)(1)(B), which caused the accounts to cease qualifying as IRAs. This would cause the IRA assets to be deemed to have been distributed to the taxpayers, who would then be liable for the income tax on the gain from the sale.

The Tax Court agreed. Even though the guarantees were made by the taxpayers to FP Company, Inc., rather than directly to the IRA, the statute includes as a prohibited transaction “any direct or indirect… extension of credit between a plan and a disqualified person.” The broad language of the statute was sufficient to include the guarantee to the company owned by the plans. In addition, because their accountant had advised the taxpayers about the existence of prohibited transactions, the Tax Court agreed with the IRS that the taxpayers were negligent; therefore, accuracy-related penalties under IRC Section 6662 were appropriate.

Peek illustrates the risk of entering into transactions with IRAs when courts read the definition of prohibited transactions broadly.