Tax Court rules on valuation of life insurance policy in bargain sale.

• Author: Beavers, James A.

In a case of first impression, the Tax Court held that where the profit-sharing plan of an S corporation wholly owned by the taxpayers distributed to them a life insurance policy on their lives, the taxpayers could not reduce the taxable value of the could not reduce the taxable value of the policy by the amount of the surrender charge for purposes of determining their income from the transfer.

Background

The Matthies, a married couple, consulted with their longtime attorney about estate planning. The attorney, along with his insurance agent son, advised the couple to use a plan (marketed by a life insurance company and a financial advisory firm) that, according to promotional material, would allow the Matthies to transfer IRA funds to their family without significant taxation. Under the plan, the Matthies created a wholly owned S corporation and set up a profit-sharing plan for the S corporation. The profit-sharing plan bought a life insurance policy on the Matthies's lives and made the premium payments on the insurance policy using money rolled over from the husband's IRA.

Later, the profit-sharing plan transferred the insurance contract to Mr. Matthies; on the same day he transferred $315,023 to the plan. According to the Matthies, the policy had an "account value" of $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 $305,866--less than the $315,023 Mr. Matthies paid for the policy. Thus, the Matthies reported no taxable gain on the transaction.

On audit, the IRS determined that the insurance policy should be valued at its full fair market value (FMV) for purposes of the transfer and that the transfer was a bargain sale of the insurance contract. Consequently, the Matthies should have reported the $1,053,304 bargain element of the sale (the difference between the policy's FMV and the amount paid by Mr. Matthies) in gross income from the transfer. The IRS also determined that the Matthies were liable for a $58,985 accuracy-related penalty under Sec. 6662. The Matthies challenged the IRS's determination in Tax Court.

The Code and Regs.

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 FMV. Under Regs. Sec. 1.402(a)-l(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...