Michael P. Schwab and Kathryn J. Kleinman v. Commissioner , 136 T.C. 120 ( 2011 )

MICHAEL P. SCHWAB AND KATHRYN J. KLEINMAN,
PETITIONERS v. COMMISSIONER OF INTERNAL
REVENUE, RESPONDENT
Docket No. 10525–07. Filed February 7, 2011.
Ps received life-insurance policies from a nonqualified
employee-benefit plan that had surrender charges in excess of
their stated values. Ps did not report the distributions on
their joint return. R issued a notice of deficiency based on the
unreported stated policy values. Held: Pursuant to sec. 402(b),
I.R.C., Ps must include in income the fair market value of
each of these insurance policies as of the date of distribution.
Held, further, on the facts of this case, the fair market values
of these insurance policies properly reflect surrender charges
and other conditions imposed on Ps by the insurance company
and include paid-up insurance coverage remaining on the poli-
cies as of the date of distribution.
Jay Weill, for petitioners.
Brian E. Derdowski, Jr., and Brian Bilheimer, for
respondent.
OPINION
HOLMES, Judge: When a company winds up an employee-
benefit plan and distributes its assets, section 402(b) 1 says
1 Unless otherwise noted, all section references are to the Internal Revenue Code for the year
120
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(120) SCHWAB v. COMMISSIONER 121
an employee receiving his share of those assets has to pay
tax on ‘‘the amount actually distributed.’’ Michael Schwab
and his wife Kathryn Kleinman both received life-insurance
policies as their share of an employee-benefit plan that was
ending. They argue that surrender charges on both the poli-
cies made them worth nothing at the time of their receipt.
The Commissioner argues that we must consider only what
the insurance company calculated to be the policies’ ‘‘stated
values’’ in figuring out what the ‘‘amount actually received’’
by Schwab and Kleinman was. The dispute is a novel one.
Background
Schwab and Kleinman are the sole shareholders of Angels
& Cowboys, Inc. 2 They are also employees of the corporation;
Schwab works as a graphic designer and Kleinman as a
photographer. Schwab has created award-winning logos and
posters for clients that include Major League Baseball, the
Muhammad Ali Center, Nike, Pebble Beach, Polo Ralph
Lauren, Robert Redford, and the San Francisco Opera. One
collector described Schwab’s work: ‘‘Like a clearing in a dark,
unfathomable forest, or an island in a turbulent sea, the
graphic art of Michael Schwab is a welcome sight, a safe
harbor, amidst the enigmatic and increasingly illegible pool
of contemporary art and design.’’ Merrill C. Berman, Michael
Schwab Studio—About Michael, Michael Schwab Studio,
http : / / www.michaelschwab. com / studio / studio—about. html
(last visited Jan. 1, 2011). Kleinman is also highly talented
and has done photography for such high-profile clients
as Apple Computer, the GAP, Microsoft, and Wolfgang
Puck Foods. Studio-Clients, Kathryn Kleinman Studio,
http: / / www.kathrynkleinman.com/ html / studio—clients.html
(last visited Jan. 1, 2011).
Accountants follow success, and George Stameroff, a Marin
County CPA, was the couple’s accountant until 2001. He pre-
pared Schwab and Kleinman’s tax returns throughout the
‘90s and also gave them financial-planning advice. In 2000,
he recommended that the couple buy life-insurance policies
through a multiple-employer welfare-benefit trust adminis-
at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
2 Schwab occasionally does design work for the Sundance Institute and is a native Oklahoman.
We therefore infer that Kleinman is the Angel.
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122 136 UNITED STATES TAX COURT REPORTS (120)
tered by Benistar. The trust was an employee-benefit plan
known as the ‘‘Advantage 419 Trust,’’ because it was
designed to conform with section 419A(f)(6). 3 Benistar was
aimed at small-business owners and was the nation’s largest
administrator of such plans. Stameroff gave Schwab and
Kleinman the Benistar marketing brochures that claimed the
plan allowed ‘‘qualified professionals, entrepreneurs, and
closely-held business owners to obtain life insurance for
themselves and for key employees on a tax-deductible basis.’’
These promotional materials emphasized that the plan assets
(invested, in Schwab and Kleinman’s case, in an S&P 500
stock-index fund) would grow tax-free and that the death
benefits would be income-tax free. According to Stameroff
and the Benistar marketing materials, if the plan were
terminated, the policies would be distributed to the partici-
pants and their value net of surrender charges would be tax-
able.
Schwab and Kleinman liked what Stameroff had to say
about the Advantage 419 Trust and decided to adopt it. But
their relationship with Stameroff would soon come to an end.
They found out that he was an authorized agent of Benistar
and decided to look for another accountant because Schwab
felt they ‘‘didn’t have a clear rapport with him.’’ In 2001,
Sander Stadtler replaced Stameroff as the couple’s CPA.
Stadtler consulted with the couple regarding tax-return
preparation and other financial matters. Part of his consulta-
tion included an extensive review of the Advantage 419
Trust. He asked Stameroff several questions about the plan
to ‘‘better understand the various costs and charges in the
plan, required contributions, and projected results.’’ On
Stadtler’s recommendation, in 2002 Schwab and Kleinman
reduced their death benefits from $5.5 million to $2.4 million.
Stadtler also opined that if the couple terminated the plan
they would be taxed on the net cash-surrender value of the
life-insurance policies.
All seemed well. But roiling in the background was the
IRS’s view, which it had held since at least 1995, that most
3 Sections 419 and 419A are special rules limiting the deductibility of employer contributions
to welfare-benefit funds. Section 419 generally limits deductions to the cost of providing current
benefits, plus a very limited prefunding of benefits allowable under section 419A. But these lim-
its do not apply to plans that comply with section 419A(f)(6). Thus, the allure of the Advantage
419 Trust was the ability to set money aside in a way that would allow its value to grow without
being immediately taxed.
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(120) SCHWAB v. COMMISSIONER 123
trust arrangements promoted as multiple-employer welfare-
benefit funds ‘‘do not satisfy the requirements of the section
419A(f)(6) exemption.’’ Notice 95–34, 1995–1 C.B. 309, 310.
In Booth v. Commissioner, 108 T.C. 524 (1997), the Commis-
sioner successfully challenged a plan’s reliance on section
419A(f)(6) by showing that it was really a series of single-
employer plans rather than a true multiple-employer plan. In
spite of Notice 95–34 and the Commissioner’s litigation suc-
cess, most taxpayers continued to take the position that their
419 plans were allowable under the Code. The Commissioner
raised the stakes in 2000 by designating 419 plans described
in Notice 95–34 as ‘‘listed transactions.’’ Notice 2000–15,
2000–1 C.B. 826. 4 Taxpayers are required to disclose listed
transactions on their returns, and promoters of such trans-
actions have to register them with the IRS. But many tax-
payers took the position that their particular plans weren’t
described in Notice 95–34 and so were not ‘‘listed trans-
actions.’’ The IRS then issued proposed regulations on section
419A(f)(6) plans in 2002, sec. 1.419A(f)(6)–1, Proposed
Income Tax Regs., 67 Fed. Reg. 45938 (July 11, 2002), that
more or less tracked its litigation position.
The proposed regulations caught the attention of BISYS, the
plan’s new administrator, who hired outside counsel in 2002
to assess the situation. BISYS eventually concluded that the
Advantage 419 Trust would not be able to comply with the
proposed regulations. By 2003 it became clear that the
Treasury Department would adopt the regulations substan-
tially as proposed; BISYS terminated the plan for all
employers, including Angels & Cowboys. The plan then
distributed the life-insurance policies to Schwab and
Kleinman in October 2003. At the time of distribution,
Schwab’s policy had a ‘‘policy value’’ of $48,667 and
Kleinman’s had one of $32,576. ‘‘Policy value’’ is an impor-
tant term in this case, and it’s defined in the plan documents
as ‘‘premiums less policy loads, plus net investment return,
less policy charges, partial surrenders, and any indebted-
ness.’’ Schwab and Kleinman had two options upon distribu-
tion—continue paying premiums to keep their life-insurance
4 This Notice has been supplemented and superseded several times since. For the most recent
changes, see Notice 2009–59, 2009–31 I.R.B. 170.
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124 136 UNITED STATES TAX COURT REPORTS (120)
coverage, or surrender the policies for their value less any
surrender charges.
But there was a catch. The policies were of a type called
variable universal life, a relatively new type of contract for
this old industry. A key characteristic of universal life-insur-
ance policies is that they disconnect to some degree a life-
insurance feature (i.e., payment of money upon death) from
an investment feature (i.e., the use of premiums to acquire
assets that fund the insurance payment). The insurer selling
a universal-life policy typically segregates payments from its
customers in separate investment accounts from which it
makes deductions to pay for the insurance component of the
policy. At death, the customer’s beneficiary gets what’s left in
the separate account. Under a variable universal life-insur-
ance contract, the customer typically can choose from a menu
of different investments (often set up to closely resemble
mutual funds) with varying returns and thus varying pay-
outs upon death, though there is (as was true under the con-
tracts here) a minimum death-benefit guaranty.
The expected premiums for Schwab and Kleinman on their
variable universal-life policies were quite steep. For Schwab,
the premium was originally more than $136,000 a year; for
Kleinman, it was $120,000. In some of the illustrations that
the insurance company used, Angels & Cowboys would be
paying such premiums for decades; in some, the firm would
pay premiums for only ten years. But we find that the firm
paid the premiums only for the policies’ first year. 5 The poli-
cies nevertheless remained in effect pursuant to a ‘‘no-lapse
provision.’’ This provision states: 6
During the first 3 policy years if the sum of all premiums paid on this
policy * * * is greater than the no lapse premium multiplied by the
number of months the policy has been in force, the policy is guaranteed
not to lapse even if the net cash surrender value is zero or less. If less
than the no-lapse premium is paid during the first 3 policy years, the
policy will not necessarily lapse provided the net cash surrender value is
greater than zero.
5 The parties did not stipulate this. But the only record evidence of any payments is of the
first, there is no evidence of any further payments, and the stated policy values by the end of
2003 would make no sense had there been later payments.
6 The quoted matter is actually from material from the insurance company that was part of
Stameroff ’s sales presentation. The parties unaccountably introduced only a part of the insur-
ance contracts themselves. We nevertheless find the definitions in the presentation materials
more likely than not to apply to the same terms in the contracts.
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(120) SCHWAB v. COMMISSIONER 125
Schwab’s ‘‘no-lapse’’ premium was set at $3,548.77. This
meant that the policy wouldn’t lapse for the first three
years—even if no more premiums were paid—so long as the
initial premium payment of $136,000 remained greater than
$3,548.77 × N (where N = the number of months the policy
had been in effect) or the net cash-surrender value remained
greater than zero. 7 Kleinman’s ‘‘no-lapse’’ premium was
$3,776.69. With the initial premium payment of only
$120,000, the net cash-surrender value of her policy would
have to exceed zero after only 31 months to avoid a lapse or
incur an obligation to pay more premiums.
When in 2002 Schwab and Kleinman elected to reduce the
coverage, those scheduled premiums shrank as well, but in
both cases to more than $22,000 a year. The ‘‘no-lapse’’ pre-
miums shrank as well: Schwab’s to $2,498.31; and
Kleinman’s to $2,510.34. 8 One thing did not change: Both
Schwab and Kleinman had directed that their premium pay-
ments be segregated into accounts whose value fluctuated
with the S&P 500 stock index. The death benefit and cash-
surrender value depend on those fluctuations in investment
returns. 9 And the policies’ surrender charges were greater
than their stated policy values in October 2003, meaning
Schwab and Kleinman wouldn’t get any cash if they imme-
diately surrendered their policies upon receipt. Here’s how
the numbers looked at distribution:
Schwab Kleinman
Stated policy value $48,667 $32,576
Surrender charges 49,225 46,599
Net cash-surrender value (558) (14,023)
The surrender charges lasted eleven years and would be
reduced by 20 percent a year only in years 8–12 (starting in
2008). But if the S&P 500 were to go up or if further pre-
miums were paid, the policy values would increase as well.
that at the end of three years, N = 36 and $3,548.77 × 36 = $127,755.72.
7 Note
8 The
changes were effective on May 17, 2002, which was 21 months into the first three-year
period of the contract. Kleinman’s reduced ‘‘no-lapse’’ premium meant that, like her husband,
she could keep the policy in force for that first three-year period without worrying about the
net cash-surrender value of her policy: (21)($3,776.69) + (15)($2,510.34) = $116,965.59.
9 We say ‘‘fluctuations’’, but for the three-year period beginning in September 2000, ‘‘swoon’’
might be more accurate: The S&P 500 index declined nearly 34 percent. See Standard and Poor’s
Index Services: S&P 500 Monthly Returns, https://www2.standardandpoors.com/spf/xls/index/
MONTHLY.xls (last visited Jan. 1, 2011).
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126 136 UNITED STATES TAX COURT REPORTS (120)
Schwab’s policy seemed more worthwhile—it could poten-
tially be in the black in a matter of weeks. And by December
2, 2003, when Schwab asked to surrender his policy, he was
ahead by approximately $1,100. But he then changed his
mind and contacted the insurance company in mid-December
to reverse his termination request. The value of the policy
net of surrender charges increased in the interim, reaching
$1,630 by December 16. Schwab continued to hold the policy
and pay his premiums at least until the trial.
Kleinman’s policy was so deeply under water that she let
it lapse shortly after distribution by not paying the required
$108,031 premium. 10 She didn’t get any money from the
insurance company because her policy’s net cash-surrender
value was negative.
BISYS did not issue any 1099 forms after it distributed the
policies, so when Stadtler prepared the couple’s 2003 return,
he did not report any income from their distribution. We find
that in taking this position the couple was also relying on
Stammeroff ’s, the plan administrator’s, and Stadtler’s 2001
conclusion that they would be taxed only to the extent of the
net cash-surrender value. Schwab provided all the materials
that Stadtler asked for and answered all of his questions in
the course of preparing the return. (Though we do find that
he did not specifically ask Stadtler about the tax con-
sequences of the distributions.)
The Commissioner issued a notice of deficiency asserting
increases in tax and penalties for Schwab and Kleinman’s
failure to include the stated policy values as income. They
timely petitioned the Tax Court as residents of California.
We tried the case in San Francisco.
Discussion
This case is about the rules for taxability of property
distributed after the termination of employee-benefit plans.
Such plans come in ‘‘qualified’’ and ‘‘nonqualified’’ varieties.
Qualified plans must meet the requirements of section 401,
10 BYSIS advised Schwab and Kleinman that this amount was necessary to maintain the pol-
icy, but the Commissioner points out that a smaller payment might have kept the policy alive
for some time. It’s not clear from the record what minimum amount would have been necessary
to keep Kleinman’s policy afloat—nor did the parties explain why the premium BYSIS requested
was almost five times Kleinman’s reduced annual premium, though it is possible that it had
something to do with the nonpayment of any premiums after the first.
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(120) SCHWAB v. COMMISSIONER 127
and all the complicated regulations governing their funding,
nondiscriminatory terms, employee coverage, distribution,
and other requirements. Meeting such requirements allows
for favorable tax treatment of qualified plans, but not all
plans can comply; hence the existence of nonqualified plans.
Nonqualified plans are generally subject to fewer statutory
and regulatory requirements, but they also receive less favor-
able tax treatment. The rules for taxing distributions from
qualified and nonqualified plans differ as well. Section 402(a)
governs distributions from qualified plans, and section 402(b)
governs distributions from nonqualified plans.
I. Determining the Amount Actually Distributed
The Advantage 419 Trust was a nonqualified plan, so we
apply section 402(b)(2). That section reads:
The amount actually distributed or made available to any distributee by
any trust described in paragraph (1) shall be taxable to the distributee, in
the taxable year in which so distributed or made available, under section
72 (relating to annuities) * * * [Emphasis added.]
But what amount was ‘‘actually distributed’’ when BISYS
transferred the life-insurance policies to Schwab and
Kleinman? The Commissioner claims $81,243—their total
stated policy value. Schwab and Kleinman see things dif-
ferently and claim that nothing of value was ‘‘actually
distributed.’’ They rely first and most insistently on the plain
language of the Code. The words ‘‘amount actually distrib-
uted’’ appeared in the Code as far back as 1921 in section
219(f), Revenue Act of 1921, ch. 136, sec. 219(f), 42 Stat. 227,
247, which became section 165 in 1928, Revenue Act of 1928,
ch. 852, sec. 165, 45 Stat. 791, 839. 11 Schwab and Kleinman
point out that the committee reports for both the 1928 and
1932 Acts don’t address taxing the stated value of an insur-
ance policy. 12 See S. Rep. No. 72–665, sec. 165 (1932),
11 The words did not appear in the 1928 statute, but Congress added them back in 1932. Rev-
enue Act of 1932, ch. 209, sec. 165, 47 Stat. 169, 221.
12 While this is true, that doesn’t mean the reports had nothing to say about the meaning of
‘‘amount actually distributed.’’ Section 219(f) (and later section 165) told us that distributions
from employer-created trusts for stock bonus, pension, or profit-sharing plans, less any contribu-
tions made by employees, were taxable to employees when distributed. And in these early years,
Congress was fiddling with how to value a distribution when it took the form of stock rather
than cash—or in other words, how to determine the ‘‘amount actually distributed.’’ The 1926
version taxed not only the employer’s contributions and any dividends and interest distributed
but also the appreciation of the stock, even though that amount hadn’t been realized by the em-
Continued
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128 136 UNITED STATES TAX COURT REPORTS (120)
reprinted in 1939–1 C.B. (Part 2) 496, 520; H.R. Rep. No. 70–
2, sec. 165 (1927), reprinted in 1939–1 C.B. (Part 2) 384,
398–99.
Finding no esoteric meaning in the legislative history,
Schwab and Kleinman point us to the dictionary, which
defines ‘‘actually’’ as ‘‘in fact; in reality.’’ American Heritage
Dictionary 18 (4th ed. 2000). Because they are cash-basis
taxpayers, Schwab and Kleinman argue they would have to
actually or constructively receive income before they would
incur any tax liability. See sec. 1.451–1(a), Income Tax Regs.;
see also United States v. George, 420 F.3d 991, 996 (9th Cir.
2005). There’s no actual receipt here, and no constructive
receipt because no income was credited and made available
to them without restriction: In the words of the regulation,
Schwab and Kleinman could not ‘‘draw upon it at any time,’’
and their control of the policy’s value (if ‘‘control’’ is the right
word) was ‘‘subject to substantial limitations or restrictions.’’
Sec. 1.451–2(a), Income Tax Regs. The stated policy values,
they argue, had no cash equivalence or economic value upon
distribution. Schwab and Kleinman admit that the insurance
policies that they got showed ‘‘policy values,’’ but reasonably
point out that that ‘‘value’’ is not what they could actually
have gotten in hand at the time of distribution. They con-
clude, therefore, that they received something that had ‘‘no
economic, monetary or cash surrender value.’’
The Commissioner’s argument is not nearly as straight-
forward. He begins with the incontestably true observation
that there is no regulation or caselaw directly on point. He
then argues that:
ployee at that time. H.R. Rep. No. 70–2, sec. 165 (1927), reprinted in 1939–1 C.B. (Part 2) 384,
398–99. Congress decided in 1928 to postpone the employees’ recognition of the unrealized stock
appreciation until the stock was sold, so the taxable amount at distribution then became the
employers’ contributions plus dividends and interest distributed. See id.; Olstad v. Commis-
sioner, 32 B.T.A. 670, 674 (1935) (‘‘Congress was concerned with an alleviation of what it re-
garded as an undue tax burden upon the employee resulting from the treatment as gain in his
hands of the unrealized increment in the value of the trust property’’). The purpose was to re-
lieve the taxpayer of ‘‘all possibility of tax upon appreciation in the value of trust securities be-
fore such appreciation came to his hand by sale.’’ Olstad, 32 B.T.A. at 674.
But that still didn’t settle the matter. This definition was also troublesome because employees
could be caught paying tax on their employers’ contributions, even if the stocks were worthless
by the time the employees received them. S. Rep. No. 72–665, sec. 165 (1932), reprinted in 1939–
1 C.B. (Part 2) 496, 520. Congress came back to the table in 1932 to correct this ‘‘distinct hard-
ship’’ by implicitly redefining the amount actually distributed as the ‘‘fair market value of the
stock received,’’ less contributions made by the employee. Id. Although these sections don’t men-
tion life-insurance policies, it appears that—at least at this point—Congress decided ‘‘amount
actually distributed’’ was best read as ‘‘fair market value at the time of distribution.’’
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(120) SCHWAB v. COMMISSIONER 129
• The insurance policies should be treated as if they were
annuities;
• treating them as if they were annuities means including
in Schwab and Kleinman’s income their ‘‘entire value;’’ and
• ‘‘entire value’’ does not include any surrender charges.
The first problem is that section 402(b)(2) says that the
‘‘amount actually distributed * * * shall be taxable to the
distributee * * * under section 72 (relating to annuities).’’
This does not mean that any ‘‘amount actually distributed’’
is an annuity, but only that the taxability of whatever
amount was ‘‘actually distributed’’ has to be computed by
using section 72’s rules on recovery of the taxpayer’s invest-
ment in the contract. The Commissioner nevertheless points
to section 1.402(b)–1(c)(1), Income Tax Regs. Like the Code,
that regulation includes the phrase ‘‘actually distributed,’’
but it continues with an example of the distribution of an
annuity contract:
If, for example, the distribution from such a trust consists of an annuity
contract, the amount of the distribution shall be considered to be the entire
value of the contract at the time of distribution. * * * [Id.]
This tells us something: When an annuity contract is distrib-
uted, it’s the ‘‘entire value’’ of the contract that is taxable
under the rules governing the taxation of annuities.
And the Commissioner’s argument rests in a subtle way on
extending the regulation’s command that an annuity con-
tract’s ‘‘entire value’’ is the ‘‘amount actually distributed’’ to
the valuation of life-insurance policies like Schwab’s and
Kleinman’s.
The Commissioner’s shifting of our focus to the meaning of
the phrase ‘‘entire value’’—remember, a term taken from an
example in the regulation about the valuation of an annuity
contract—and away from the phrase ‘‘amount actually
distributed’’ aims to take advantage of a regulation that
defines ‘‘entire value’’ in a somewhat unusual way. That
regulation, section 1.402(b)–1(b)(2)(i), Income Tax Regs., pro-
vides that the ‘‘entire value’’ does not take into account what
the regulations call a ‘‘lapse restriction.’’ The Commissioner
then continues his argument by asserting that surrender
charges on a life-insurance policy are a type of lapse restric-
tion, an argument he recently won in Cadwell v. Commis-
sioner, 136 T.C. 38 (2011). In Cadwell, we disregarded sur-
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130 136 UNITED STATES TAX COURT REPORTS (120)
render charges after looking to Revenue Procedure 2005–25’s
safe-harbor definition of fair market value for a formula to
apply in default of the taxpayer’s failure to offer any reason
we shouldn’t. Id. at 58–59.
That revenue procedure became effective only after the dis-
tributions here. And looking to the regulation the Commis-
sioner points us toward, section 1.402(b)–1(b)(2)(i), Income
Tax Regs., we see that it uses the word ‘‘value’’ and provides
that
The net fair market value of all the assets in the trust is the total amount
of the fair market values (determined without regard to any lapse restric-
tion, as defined in § 1.83–3(h)) of all the assets in the trust, less the
amount of all the liabilities (including taxes) to which such assets are sub-
ject or which the trust has assumed * * * as of the date on which some
or all of the employee’s interest in the trust becomes substantially vested.
[Emphasis added.]
The thing to notice about the Commissioner’s argument on
this point is that it is based on language in the part of the
regulation governing the valuation of an employee’s rights to
assets still held in trust at the time those rights become
vested. But Schwab’s and Kleinman’s policies were distrib-
uted—they were not still held in trust. The relevant regula-
tion for this situation is not section 1.402(b)–1(b), but section
1.402(b)–1(c), Income Tax Regs., which doesn’t even mention
‘‘lapse restrictions.’’
That leaves us back where we started—trying to find the
meaning of the phrase ‘‘amount actually distributed.’’ Schwab
and Kleinman point us to regulatory language for qualified
plans, telling us that the taxable value of an insurance con-
tract ‘‘actually distributed’’ to a plan’s participant is its
‘‘policy cash value.’’ Sec. 1.402(a)–1(a)(1)(iii), Income Tax
Regs. (Remember that the Schwab-Kleinman distribution
was from a nonqualified plan—like the Commissioner they’re
also pointing to a facially inapplicable regulation and arguing
by analogy.)
That’s not quite right—it’s not just the ‘‘policy cash value’’
but ‘‘all other rights under such contract’’ that count toward
fair market value. They do argue by analogy, however, that
we should take surrender charges into account here because
on this point there is no reason the distribution of a life-
insurance contract from a qualified plan should be treated
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(120) SCHWAB v. COMMISSIONER 131
differently from a nonqualified distribution. But there’s a
problem with the cited regulation—it’s effective as of August
29, 2005. The prior version of the regulation—which would
have applied to distributions from qualified plans at the time
Schwab and Kleinman received their distribution—makes no
reference to ‘‘policy cash value.’’ Instead, it provided that the
‘‘entire cash value’’ of a life-insurance contract distributed
from a qualified plan is taxable. Sec. 1.402(a)–1(a)(2), Income
Tax Regs. And in a development that Schwab and Kleinman
couldn’t foresee, we recently construed that language to mean
something different from ‘‘fair market value.’’ See Matthies v.
Commissioner, 134 T.C. 141, 150–51 (2010) (construing pre-
2005 regulations under section 402(a) as requiring that the
‘‘entire cash value’’ of life insurance policies be determined
without regard to surrender charges).
This difference in the regulations may seem odd—both sec-
tion 402(a) and 402(b) contain the phrase ‘‘amount actually
distributed,’’ yet the regulations interpreting each subsection
differed before 2005 and continue to differ today. We must
apply them as written. In the absence of regulatory guidance,
we hold that the ‘‘amount actually distributed’’ means the
fair market value of what was actually distributed. One tex-
tual clue in the regulation itself that supports this is in the
illustration of an annuity contract that is distributed. Section
1.402(a)–1(a)(2) used to say that, in such a case, it’s the
‘‘entire cash value of such contract at the time of distribu-
tion’’ that is included in income; section 1.402(b)–1(c) says
that, if a nonqualified plan distributes an annuity contract,
the value of the distribution is the contract’s ‘‘entire value.’’
In Matthies, we suggested that this latter phrase—‘‘entire
value’’—‘‘might plausibly be construed as synonymous with
‘fair market value’ ’’ and represented ‘‘a generalized valuation
standard.’’ Matthies, 134 T.C. at 150–51.
But the fair market value of insurance contracts can be a
slippery concept, and is not necessarily synonymous with net
cash-surrender value. Consider, for instance, the case of a
taxpayer who buys a single-premium life-insurance contract
and immediately gives it to her children. The purchase price
obviously represents one good measure of its value but, as is
true of many life-insurance contracts, the surrender charges
that would apply for a number of years would make the net
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132 136 UNITED STATES TAX COURT REPORTS (120)
cash-surrender value less than the purchase price. The
Supreme Court analyzed the problem:
Surrender of a policy represents only one of the rights of the insured or
beneficiary. Plainly that right is one of the substantial legal incidents of
ownership. But the owner of a fully paid life insurance policy has more
than the mere right to surrender it; he has the right to retain it for its
investment virtues and to receive the face amount of the policy upon the
insured’s death. That these latter rights are deemed by purchasers of
insurance to have substantial value is clear from the difference between
the cost of a single-premium policy and its immediate or early cash-sur-
render value * * * [Guggenheim v. Rasquin, 312 U.S. 254, 257 (1941);
citations omitted.]
In Guggenheim, the Court held that the time between pur-
chase and gift was short enough that ‘‘cost is cogent evidence
of value’’ and so it was the purchase price of the insurance
policy that was the best measure of its value. Id. at 257–58.
But in another case that same term, the Court also held
that a paid-up policy that had been in effect for a much
longer time—five years—had a value best measured by the
cost of a replacement policy on the then-current age of the
insured. United States v. Ryerson, 312 U.S. 260, 261 (1941).
In the case of single-premium policies, we summarized the
state of the law sixty years ago:
The cash surrender value is the market value only of a surrendered
policy and to maintain that it represents the true value of the policy is to
confuse its forced liquidation value at an arbitrary figure with the amount
realizable in an assumed market where such policies are frequently bought
and sold. * * *
The rule is, then, that the fair market value of a single premium life
insurance policy for the purpose of determining taxable gain derived from
exchange of insurance policies is the same price that any person of the
same age, sex, and condition of health as the insured, would have to pay
for a life policy with the same insurance company on the date the
exchange took place. * * *
[Parsons v. Commissioner, 16 T.C. 256, 262 (1951).]
But this caselaw all involves paid-up policies. The Schwab-
Kleinman policies were not paid up, but instead required
years more of steep premium payments. And substantial
parts of their values were tied to the fluctuations of a broad
stock-market index. How should a court measure their fair
market values? At least in the context of the gift tax, 13 the
13 We recognize that the life-insurance-policy distribution at issue wasn’t a gift subject to the
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(120) SCHWAB v. COMMISSIONER 133
regulations offer some guidance. For life-insurance policies
that have ‘‘been in force for some time and on which further
premium payments are to be made,’’ the insurer’s policy
reserves are used to approximate the value. 14 Sec. 25.2512–
6(a), Gift Tax Regs. But this method is not permitted when
‘‘the unusual nature of the contract’’ results in a valuation
‘‘not reasonably close to the full value.’’ Id. And the IRS, in
Notice 89–25, 1989–1 C.B. 662, modified by Notice 98–49,
1998–2 C.B. 365, and Rev. Rul. 2002–62, 2002–2 C.B. 710took the position that in the case of distributions from a
qualified plan (which, remember, the distribution here was
not), taxpayers could use the ‘‘stated cash surrender value’’
unless total policy reserves were ‘‘a much more accurate
approximation of the fair market value of the policy.’’ Id.Q&A–10, 1989–1 C.B. at 665.
Lacking evidence of the insurer’s policy reserves, 15 we
begin our look for the fair market value of each policy with
what the insurer called its stated policy value, which was
$48,667 for Schwab and $32,576 for Kleinman. But, unlike a
traditional life-insurance policy’s value (which only grows
over time), these policy values fluctuated with the stock
market. They look more like the net asset value of a mutual
fund (with the obvious difference that a mutual fund invest-
ment does not provide a death benefit), and the surrender
charges look very much like a back-end load. Just as we
wouldn’t ignore such charges in calculating the value of
shares, 16 we don’t ignore them here.
The policies had been in effect for three years before dis-
tribution, meaning that in eight years the surrender charges
gift-tax regulations.
14 The valuation calls for ‘‘adding to the interpolated terminal reserve at the date of the gift
the proportionate part of the gross premium last paid before the date of the gift which covers
the period extending beyond that date.’’ Sec. 25.2512–6(a), Gift Tax Regs. The interpolated ter-
minal reserve ‘‘ ‘is not cash surrender value; it is the reserve which the insurance company en-
ters on its books against its liability on the contracts. * * * The word ‘‘interpolated’’ simply indi-
cates adjustment of the reserve to the specific date in question.’ ’’ Matthies v. Commissioner, 134
T.C. 141, 153 n.12 (2010) (quoting Commissioner v. Edwards, 135 F.2d 574, 576 (7th Cir. 1943),
affg. 46 B.T.A. 815 (1942)).
15 The record contains no evidence of the policies’ interpolated terminal reserve values; the
Commissioner does not expressly argue that we should take into account any such values, and
Schwab and Kleinman do not rely on or address the policies’ interpolated terminal reserve val-
ues. Consequently, we do not consider this issue further. Cf. sec. 25.2512–6(a), Gift Tax Regs.
16 See United States v. Cartwright, 411 U.S. 546, 552–53 (1973) (invalidating regulation that
failed to value mutual fund shares by using the redemption price—‘‘the only price that a share-
holder may realize and that the fund—the only buyer—will pay’’); sec. 25.2512–6(b), Gift Tax
Regs.
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134 136 UNITED STATES TAX COURT REPORTS (120)
would expire. During that time, with the ups and down of
the stock market, the stated values of the policies could rise
or fall.
The relevant point in time for our analysis is the time of
distribution. The policies here were flexible-premium poli-
cies—that’s one of the reasons why not paying any but the
first year’s premium didn’t end the policy in year two. But
by the end of year three—when Angels & Cowboys distrib-
uted the policies to Schwab and Kleinman—the ‘‘no-lapse’’
premium period had expired and the fall in the broad stock
market meant that they had no positive net cash-surrender
value. As the Commissioner admits in his brief, flexible-pre-
mium policies like these generally ‘‘will not lapse if pre-
miums are paid such that the net cash surrender value
remains greater than zero.’’
But the net cash-surrender values here were less than
zero. And because the parties fought mostly about whether
surrender charges could be considered at all, they introduced
little evidence specifically directed at establishing the fair
market values for the policies. What we had was the policies’
stated values, the amount of premiums to be paid and the
amount of any surrender charges, the terms of the contracts
to the extent the parties introduced evidence about them,
and the observed behavior of the taxpayers (e.g., the lapse of
Kleinman’s policy and the greatly reduced coverage for
Schwab for which he picked up the premiums himself). The
variety of insurance policies is too great to adopt as a general
rule either the Commissioner’s simple proposition that sur-
render charges should never count, or Schwab and
Kleinman’s that such charges should always count, in deter-
mining a policy’s value. The particular facts of this case fea-
ture neither the dramatically springing cash value described
in Notice 89–25, Q&A–10, 1989–1 C.B. at 665, nor the ability
to use the distributed policy as consideration for a new policy
without regard to surrender charges.
The Commissioner proposes that we find as fact that the
Schwab-Kleinman policies had value in addition to surrender
value because ‘‘accumulated cash value can be used to pay
costs relating to maintaining the policies in force, can be bor-
rowed against, or can be obtained in exchange for surren-
dering the policy, as the policy owner may choose.’’ But the
evidence does not convince us that such options were avail-
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(120) SCHWAB v. COMMISSIONER 135
able to Schwab and Kleinman under the policies so long as
the policies had negative net cash-surrender value, as they
did on the date of distribution. Cf. Matthies, 134 T.C. at 152(holding that the insurer’s acceptance of the stated account
value of a life insurance policy as payment in full of a single
premium due on a replacement policy supported the conclu-
sion that the entire cash value of the exchanged policy
should be determined without regard to surrender charges).
On this record we are not persuaded that at the time of
distribution to Schwab and Kleinman the policies had signifi-
cant value apart from the small amount of the insurance cov-
erage that was attributable to the single premium that
Angels & Cowboys had paid on each policy some three years
earlier. Though the value is small, the calculation is
daunting because of ambiguity in the record, and we make
only a tentative effort to ascertain exact figures. 17 After dis-
tribution, the premiums covered Schwab for up to 54 days 18
and Kleinman for 24 days 19—in Schwab’s case, until he paid
a premium to keep the policy going, and in Kleinman’s, until
her policy lapsed. By applying the base rates for the guaran-
teed maximum monthly cost of insurance rates ($.446 for
Schwab, $.4043 for Kleinman) 20 to the days covered, we
attribute the following amounts: to Schwab, $1,900.33; to
Kleinman, $765.62—a total of $2,665.95. 21 Section 72 gen-
erally treats as taxable the amount distributed less any
amount allocable to a taxpayer’s investment in the contract—
and for Schwab and Kleinman, whose corporation had paid
the premiums without including them in their income, the
amounts invested in their contracts were zero. We therefore
conclude that $2,665.95 is the ‘‘amount actually distributed’’
17 If the parties find the underlying information inadequate feed for our number crunching,
they may move to reopen the record when they submit computations under Rule 155.
18 Angels & Cowboys apparently distributed the policies to Schwab and Kleinman on October
24, 2003. From the record, we find that Schwab made a premium payment in 2003, but can’t
determine when in 2003. Because this omission is of Schwab’s own making, for our tentative
calculations we treat Schwab as paying a premium in the last month of the year, on the date
a premium would have been due—December 17, 2003—and treat the coverage attributable to
the Angels & Cowboys premium as running through the day prior. Cf. Barnes v. Commissioner,
T.C. Memo. 1992–275 n.6 (estimating an officer’s annual pay in light of insufficient records).
19 The premiums covered Kleinman through November 16, 2003.
20 The base rate is for each $1,000 of insurance, and under each policy tracks the ‘‘attained
age’’ of the insured.
21 During the relevant period, both Schwab and Kleinman had $2,400,000 in coverage. Be-
cause the base rate is based on $1,000 of insurance, we multiply the base rate by 2,400 to get
the monthly benefit, then by 12 to get the yearly, and finally by a fraction representing the days
during 2003 the coverage benefited the insured. Thus for Schwab: .446 * 2,400 * 12 * (54/365).
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136 136 UNITED STATES TAX COURT REPORTS (120)
under section 402(b) and therefore included in taxable
income under section 72.
II. Penalties
The Commissioner wants us to impose section 6662(a)’s 20-
percent penalty on Schwab and Kleinman’s understatement
of tax, either because it’s a substantial underpayment—in
this case, more than $5,000 22—or because it arose from their
negligence or disregard of rules or regulations. See sec.
6662(b)(1) and (2).
But the Commissioner miscalculated. Our tentative cal-
culations is that the understatement of income is less than
$5,000. It’s clear that although the parties still must make
Rule 155 computations, the understatement of tax will not
exceed $5,000.
We also believe that Schwab and Kleinman made a reason-
able attempt to comply with the provisions of the Code, and
that they were not careless, reckless, or in intentional dis-
regard of rules or regulations. See sec. 6662(c). Section
1.402(b)–1(c), Income Tax Regs., did not mandate that
Schwab and Kleinman relinquish consideration of surrender
charges in determining tax. And while they did not account
for the lingering benefit of Angels & Cowboys’s premium pay-
ment, its effect on their income was minimal. We will not
sustain the Commissioner’s determination of the penalty.
Decision will be entered under Rule 155.
f
22 Based on the Commissioner’s assertions, 10 percent of the amount required of Schwab and
Kleinman to have shown on the return is only $3,158. Section 6662 requires that we take the
greater of the two numbers.
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