Read the Ninth Circuit’s decision [PDF 124 KB]
The taxpayers (a married couple) were employees and sole shareholders of their design company. They each purchased variable universal life insurance policies, with the policies held in a multiple-employer welfare benefit trust that was administered as part of a nonqualified employee benefit plan.
The insurance policies were used to invest in the stock market, and were subject to surrender charges (i.e., a fee that the taxpayers would incur if they allowed the policies to lapse or to terminate before a specific date).
In response to an IRS position that the type of employee-benefit plan in which the taxpayers were participating was not entitled to receive favorable tax treatment, the taxpayers terminated the plan and took ownership of their insurance policies. Because the surrender charges exceeded the policies’ stated value, the taxpayers did not include any amounts from the policies in income.
The IRS disagreed, and asserted that under section 402(b)(2), the taxpayers must include the full stated policy values in income.
Tax Court’s findings
The taxpayers petitioned the Tax Court, which in February 2011 concluded that taxpayers must include in income the fair market value of each life insurance policy as of the date of distribution, but rejected the IRS position that surrender charges could not be considered. Instead, the Tax Court concluded that the surrender charges could be considered as part of a more general inquiry into the policy’s fair market value.
Accordingly, the Tax Court held that the only taxable value the policies had at the time of distribution was “the small amount of insurance coverage that was attributable to the single premium that [the company] had paid on each policy, some three years earlier.”
Ninth Circuit affirms
The IRS appealed, and today the Ninth Circuit affirmed the Tax Court’s decision.
The Ninth Circuit agreed with the Tax Court that under section 402(b)(2), the “amount actually distributed” means the fair market value of what was actually distributed and that the determination looks to what is the appropriate income tax on that amount under section 72. The appeals court found that the surrender charges may affect the fair market value of the variable life insurance policies received by the taxpayers.