Tax Court Rules on Valuation of Life Insurance Policy in Bargain Sale


In a case of first impression, the Tax Court has held that where taxpayers purchased a life insurance policy on their lives from their profit-sharing plan, they could not reduce the taxable value of the policy by the amount of the policy’s surrender charge ( Matthies, 134 T.C. no. 6).

The taxpayers, a married couple, wholly owned an S corporation, and the S corporation’s profit-sharing plan bought a life insurance policy on their lives using money rolled over from the husband’s IRA. This transaction was part of an estate plan marketed by a financial adviser and a life insurance company. The profit-sharing plan later sold the life insurance policy to the husband for $315,023.

The policy was worth $1,368,327 at the time of the sale, but when reduced by a $1,062,461 surrender charge specified in the policy, its cash value was less than the $315,023 the husband paid for the policy. The taxpayers reported no taxable gain on the transaction, valuing the policy at its cash surrender value minus the surrender charge.

The IRS determined that the taxpayers should have reported $1,053,304 in gross income from the transfer of the insurance policy to the husband (the difference between the policy’s fair market value and the amount paid by the husband). The IRS also determined that the taxpayers were liable for a $58,985 accuracy-related penalty under IRC § 6662.

Under the Code and regulations, amounts distributed by an employer’s trust, such as the profit-sharing plan in this case, are taxable to the distributee at fair market value. Under Treas. Reg. § 1.402(a)-1(a)(2), the “entire cash value” of an annuity contract distributed to an employee by an employer’s trust is includible in the distributee’s gross income. The issue for the Tax Court was whether “entire cash value” included the amount of the surrender charge.

The court looked to the history of the relevant regulations (first issued in 1955) as well as the use of the terms “cash surrender value” and “net surrender value” in IRC §§ 72 and 7702 to determine that “cash value” is properly construed to mean “cash value determined without regard to any surrender charge.” Therefore, the court held that the taxpayers should have recognized $1,053,304 in gross income from the bargain sale of the insurance policy.

Because the Tax Court has never before addressed the tax treatment of a bargain sale of a life insurance policy or the application of the “entire cash value” standard, and because of subsequent amendments to the regulations and modifications to the IRS’s arguments during the case, the court held that the taxpayers had a reasonable basis for their position and were not liable for the accuracy-related penalty.

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