Clarity Regarding Valuation of Life Insurance for Income Tax Purposes… or Not.

Re: United States Tax Court case 10525-07 Schwab v. Commissioner and US Court of Appeals for the Ninth Circuit case 11-71957

One question I am regularly asked when I meet with advisors at conferences is regarding policy appraisals and valuations for income tax and charitable purposes. Obviously this is something which frustrates many and they are finding it difficult to come to conclusions.

In case of debt recovery and payment of tax, creditors can also consult experts from moorcroft as they are seeking to reclaim the money that you owe to one or more person.Well, I will go into little detail regarding this case which was decided earlier this year but you can easily Google “Schwab v. Commissioner” or the case numbers above and review the details for yourself.

In this situation the taxpayers were involved in a transaction where a life insurance policy was distributed to them and it doesn’t appear any party is making a claim that it was not a taxable transaction. The question is; are there taxes due as a result of this particular transaction?

The main issue in play is that the cash surrender value and the gross cash value was substantively different. The Commissioner is arguing for taxation on the gross cash value while the Taxpayers are arguing for taxation on the surrender value which, in this case, is zero.

The key issue is; what is the “amount actually distributed” as defined in IRC Section 402(b)(2)? The Commissioner is appropriately observing that there is no case law directly on point and subsequently argues that the policies should be treated as though they were annuities and, of course, cites code and other cases which bolster his argument.

The Court ultimately decides that “amount actually distributed” means fair market value so this is where they head. However, the concept of “fair market value of life insurance contracts can be a slippery slope and is not necessarily synonymous with net cash surrender value.” I have previously written about this and the case summary references the disparity of approaches.

In the end the Court calculated how many days the policies would last without additional premiums and backed into a fair market value based on the cost per $1,000 of insurance for the individual taxpayers. These were very small dollars, roughly $1,900 and $765 respectively compared to the $48,667 and $32,575 respective gross cash values.

Furthermore, since the tax due does not qualify as a “significant underpayment” and “We believe that (the taxpayers) made a reasonable attempt to comply with the provisions of the code, and that they were not careless, reckless or in intentional disregard of the rules or regulations” the court would not sustain the Commissioner’s determination of penalty.

My personal take is that the universally accepted textbook definition of fair market value would not be supported by the Court’s determination though it is significantly more appropriate than the Commissioner’s position. While the values the Court came up with may realistically approximate the value of the policy to the existing policy owner from a purely mathematical perspective, would a willing buyer and willing seller in an arm’s length transaction, each knowing all of the facts and neither being under any compulsion to buy or sell have paid the amount for the policies? Of course not. Therefore, it is not the fair market value. I should probably stop being surprised by Court decisions by which parties must abide which are simply wrong and cannot be factually supported and simply be pleased with outcomes which are more right than wrong.

What does this all mean for those of us who are continually seeking out guidance on how to value policies? Not as much as we hoped for. We’ve seen a variety of points and arguments made regarding the definition of a policy’s value; cash value, surrender value, interpolated terminal reserve, the 712 number, cash purchase price, replacement cost, life settlement value, etc. What we do seem to know is that the type of policy, the amount of time which has elapsed since it was issued, the particular transaction at the heart of the matter, whether it is for income tax, estate tax, gifting or charitable purposes all play a role.

What the Courts did say is that they would refuse to state that surrender charges should either always or never be taken into consideration. It held that surrender charges may be considered under section 402(b)(2). The rulings did, in fact, affirm that the “amount actually distributed” means the fair market value of what was actually distributed.

The Courts have once again proven to have little interest in laying out solid guidance that any of us can rely on in the future. While acknowledging that any defined case law is regarding cases from many decades ago and policies available today did not exist back then, it further states “ever-creative financial institutions are liable to devise new life insurance instruments that we cannot contemplate today.”

The good news is that the Courts seem willing to take into account facts at hand of individual cases. The Court of Appeals states “We agree with the tax court that ‘the variety of insurance policies is too great to adopt as a general rule either the Commissioner’s simple proposition that surrender charges should never count, or (the taxpayer’s proposition) that such charges should always count, in determining a policy’s value.’ We hold instead that surrender charges may be considered under section 402(b)(2), ‘but only as part of a more general inquiry into a policy’s fair market value.’”

“We disagree with the Commissioner that cases in which courts have ignored surrender charges require us to adopt a rule that a court may never consider a surrender charge in determining the fair market value of a life insurance policy for tax purposes.”

In the end, we see again that there is no hard and fast rule regarding valuation of life insurance policies and this complicated issue may be more of an art than a science.


This material is for informational purposes only and should not be considered tax or legal advice. Any person needing tax or legal assistance should contact their respective advisors.

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