Schwab v. Commissioner , 715 F.3d 1169 ( 2013 )

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
MICHAEL P. SCHWAB; KATHRYN J. No. 11-71957
KLEINMAN ,
Petitioners-Appellees, Tax Ct. No.
10525-07
v.
COMMISSIONER OF INTERNAL OPINION
REVENUE ,
Respondent-Appellant.
Appeal from a Decision of the
United States Tax Court
Argued and Submitted
February 15, 2013—San Francisco, California
Filed April 24, 2013
Before: Michael Daly Hawkins and Milan D. Smith, Jr.,
Circuit Judges, and James G. Carr, District Judge.*
Opinion by Judge Milan D. Smith, Jr.
*
The Honorable James G. Carr, Senior District Judge for the U.S.
District Court for the Northern District of Ohio, sitting by designation.
2 SCHWAB V . CIR
SUMMARY**
Tax
The panel affirmed the tax court’s partial grant of a
petition by taxpayers challenging the Commissioner of
Internal Revenue’s determination of a deficiency in their
federal income tax.
Taxpayers each purchased a variable universal life
insurance policy that was subject to surrender charges (fees
that taxpayers would incur if the policies were terminated
prior to a contractually specified date). The distribution of
taxpayers’ policies to them was a taxable event, for which the
Commissioner contended that the full stated policy values
must be treated as income, even though the net cash surrender
values were negative. The panel held that the “amount
actually distributed” when taxpayers received ownership of
the life insurance policies was “the fair market value of what
was actually distributed,” and that surrender charges
associated with a variable universal life insurance policy may
be considered as part of the general inquiry into a policy’s
fair market value.
**
This summary constitutes no part of the opinion of the court. It has
been prepared by court staff for the convenience of the reader.
SCHWAB V . CIR 3
COUNSEL
Teresa E. McLaughlin (argued), Tamara W. Ashford, and
Damon W. Taaffe, Tax Division, Department of Justice, for
Appellant.
Jay R. Weill (argued), Sideman & Bancroft LLP, San
Francisco, California, for Appellee.
OPINION
M. SMITH, Circuit Judge:
The tax court determined that the “amount actually
distributed”1 when a couple received ownership of two life
insurance policies after their employer wound down their
employees’ benefit trust was “the fair market value of what
was actually distributed.” Schwab v. Comm’r., 136 T.C. 120,
131 (2011). It further held that surrender charges associated
with a variable universal life insurance policy may
permissibly be considered as part of the general inquiry into
a policy’s fair market value. Id. at 134. We agree with the
tax court on both determinations, and we affirm.
BACKGROUND
Michael Schwab and Kathryn Kleinman, a married
couple, are employees and the sole shareholders of Angels &
Cowboys, Inc. Schwab works as a graphic designer and
Kleinman is a photographer.
1
Internal Revenue Code § 402(b)(2). The Internal Revenue Code is
referred to hereafter as I.R.C., tax code, or code.
4 SCHWAB V . CIR
On the advice of their accountant, Schwab and Kleinman
each purchased a variable universal life insurance policy
through Angels & Cowboys. The policies were held in a
multiple-employer welfare benefit trust administered by a
third party company as part of a nonqualified employee
benefit plan.2 The plan was “aimed at small-business
owners” and was, according to its promotional materials,
designed to allow “qualified professionals, entrepreneurs, and
closely-held business owners to obtain life insurance for
themselves and for key employees on a tax-deductible basis.”
Schwab, 136 T.C. at 122.
The tax court provides a succinct description of the
policies Schwab and Kleinman purchased:
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-insurance
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
2
“Such plans come in ‘qualified’ and ‘nonqualified’ varieties. Qualified
plans must meet the requirements of [I.R.C.] section 401, and all the
complicated regulations governing their funding, nondiscriminatory terms,
employee coverage, distribution, and other requirements. M eeting 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 favorable tax treatment.” Schwab,
136 T.C. at 126–27.
SCHWAB V . CIR 5
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-insurance 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 payouts upon death, though there is
(as was true under the contracts here) a
minimum death-benefit guaranty.
Id. at 124. Two provisions of the insurance policies are
particularly relevant to this case. First, the policies were
subject to surrender charges—the primary focus of the
Commissioner of Internal Revenue’s (Commissioner)
concern on appeal. The surrender charge in this case is the
fee that Schwab and Kleinman would incur if they allowed
their policies to lapse, or otherwise terminated them, prior to
a contractually specified date. The surrender charges on
Schwab and Kleinman’s policies “lasted eleven years and
would be reduced by 20 percent a year only in years 8–12
(starting in 2008).” Id. at 125.
Another salient feature of the policies was the no-lapse
provision present in each of them. That provision specified
that the policy would not lapse in the first three years of
coverage, provided that the sum of all premiums paid was
“greater than the no lapse premium multiplied by the number
of months the policy has been in force, . . . even if the net
cash surrender value is zero or less.” Id. at 124.
6 SCHWAB V . CIR
Two values associated with the policies are also pertinent
to this case. The first is the “policy value,” which the plan
documents define as “premiums less policy loads, plus net
investment return, less policy charges, partial surrenders, and
any indebtedness.” Id. at 123. The second is the net cash
surrender value, which is a standard industry term, and is the
stated policy value minus the applicable surrender charge.
The net cash surrender value represents the sum of money the
insurance company will pay to the policyholder should he
allow the policy to lapse or voluntarily terminate the policy
before his death.
Angels & Cowboys paid the initial premiums on the
policies, which were originally more than $136,000 per year
for Schwab’s policy, and $120,000 for Kleinman’s. Both
Schwab and Kleinman elected to invest their premium
payments in funds whose value was tied to the value of the
Standard & Poor’s 500 index. Had Schwab and Kleinman’s
expectations been met, they would eventually have been able
to stop paying premiums on their policies because the
premiums would have been covered by the returns on their
investments. Unfortunately for Schwab and Kleinman, their
investment hopes were dashed. During “the three-year period
beginning in September 2000 . . . [t]he S & P 500 index
declined nearly 34 percent,” Schwab, 136 T.C. at 125 n.9,
and their policy values dropped by a similar percentage.
Meanwhile, the Internal Revenue Service (IRS) began
more aggressively asserting its position that the type of
employee-benefit plan in which Angels & Cowboys was
participating was not entitled to receive the favorable tax
treatment that was the plan’s entire raison d'être. “By 2003
it became clear that the Treasury Department would adopt . . .
regulations” with which that employee-benefit plan would be
SCHWAB V . CIR 7
unable to comply. Id. at 123. Anticipating what would soon
occur, the plan’s administrator terminated the plan, and in
October 2003, Schwab and Kleinman took ownership of their
respective policies.
The relevant policy values at the time of their distribution
are summarized below:3
Schwab Kleinman
Stated policy value $48,667 $32,576
Surrender charges 49,225 46,599
Net cash surrender value (558) (14,023)
From the date of the distribution, Schwab’s policy was set
to lapse within 54 days, and Kleinman’s would lapse in 24
days. Accordingly, unless the Standard & Poor’s 500 Index
surged in that time period, the negative net cash surrender
values of the policies made clear that Schwab and Kleinman
would receive nothing if their policies lapsed. Thus, Schwab
and Kleinman had a choice: they could continue paying
premiums on their respective policies, and thus continue their
coverage, or they could allow their respective policies to
lapse, and potentially receive nothing. Kleinman allowed her
policy, which remained far “in the red,” to lapse rather than
pay the $108,031 premium. By contrast, the policy value of
Schwab’s policy rebounded modestly, and Schwab decided
for a time to continue paying the required premiums, and
keep his policy in force.
3
The table is reproduced from Schwab, 136 T.C. at 125.
8 SCHWAB V . CIR
The distribution of the policies from the trust to Schwab
and Kleinman was a taxable event under I.R.C. § 402(b)(2),
which provides for the taxation of assets distributed from a
nonqualified employees’ trust, such as the one in which
Angels & Cowboys participated. Believing they were only
required to pay taxes on the net cash surrender values of their
policies—which were negative at the time of the taxable
event—Schwab and Kleinman did not report any taxable
income as result of the distribution of their policies.4 The
Commissioner disagreed with Schwab and Kleinman’s tax
treatment of their policy distributions, maintaining that the
full stated policy values must be treated as income. He issued
a notice of deficiency to Schwab and Kleinman.
Schwab and Kleinman petitioned the tax court, arguing
that they “actually received” nothing of value and therefore
should pay no taxes on the distribution. The Commissioner
asserted that surrender charges may never be considered
under section 402(b), and maintained that Schwab and
Kleinman actually received the full stated policy values of
their respective insurance policies. In a decision it later
characterized as “[coming] down in the middle,” the tax court
read “section 402(b) to say that a court could consider
[surrender charges], but only as part of a more general inquiry
into a policy’s fair market value.”5 In Schwab and
Kleinman’s case, the tax court accounted for surrender
4
The tax court found that “Schwab and Kleinman made a reasonable
attempt to comply with the provisions of the Code” and that they relied on
multiple representations made by their accountants and the administrator
of the trust. Schwab, 136 T.C. at 126, 136.
5
Order, Schwab v. Comm’r, March 22, 2011, Docket No. 10525-07.
(hereinafter, Order Denying Reconsideration).
SCHWAB V . CIR 9
charges, and held that the only taxable value the policies had
at the time of distribution was “the small amount of the
insurance coverage that was attributable to the single
premium that Angels & Cowboys had paid on each policy
some three years earlier.” Id. at 135. The Commissioner
timely appealed to our court. We have jurisdiction under
I.R.C. § 7482.
STANDARD OF REVIEW
“A tax court’s conclusions of law and construction of the
Internal Revenue Code are reviewed de novo.” Estate of
Rapp v. Comm’r, 140 F.3d 1211, 1215 (9th Cir. 1998)
(internal citation omitted). The facts of this case are
undisputed, and the Commissioner appeals only questions of
law.
DISCUSSION
A.
Schwab and Kleinman received two insurance contracts
from a nonqualified employees’ trust. The distribution from
that trust is taxed according to section 402(b)(2) of the tax
code, which reads in relevant part:
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) . . . .
10 SCHWAB V . CIR
The application of section 402(b)(2) to Schwab’s and
Kleinman’s policies presents a quandary. The word
“amount” implies a quantifiable sum.6 But Schwab and
Kleinman did not receive an “amount”; they received their
respective life insurance policies. The tax court resolved the
tension between the language of section 402(b)(2) and its
application to the Schwab-Kleinman policies by holding that
“the ‘amount actually distributed’ means the fair market
value of what was actually distributed.” Schwab, 136 T.C. at
131. That holding necessitates a two-step analysis. First, the
court had to determine the fair market value of Schwab and
Kleinman’s life insurance policies, and then it was required
to determine the appropriate tax on that amount under section
72.
The Commissioner strenuously disagrees with the tax
court’s conclusion. The gravamen of his argument is that
surrender charges may never be considered when determining
the “amount actually received” from an employees’ trust
under section 402(b)(2). To evaluate the Commissioner’s
argument, we first ascertain whether the tax code and its
accompanying regulations forbid the consideration of
surrender charges under section 402(b)(2), as the
Commissioner contends. Second, we determine whether the
tax court correctly held that the “amount actually received”
means “the fair market value of what was actually received,”
and if so, whether surrender charges may ever affect the fair
market value of a variable universal life insurance policy.
6
See, e.g., W ebster’s Third New Int’l Dictionary (defining “amount” as
“the total number or quantity”).
SCHWAB V . CIR 11
B.
The Commissioner commences his argument with the text
of section 402(b)(2) itself. He contends that because the
“amount actually distributed . . . shall be taxable to the
distributee . . . under section 72 (relating to annuities),” and
because section 72 contemplates the “cash value” of a non-
annuity “without regard to any surrender charge,” I.R.C.
§ 72(e)(3)(A)(i), then section 402(b)(2) must also apply
without regard to any surrender charge. As the
Commissioner phrased it in his brief, under section 402(b)(2),
“[life insurance] policies are to be valued in the same manner
as they would be under § 72(e)(3)(A).” The tax court, he
urges, therefore erred by supplanting a fair market valuation
standard in place of the statutorily-mandated methodology
supplied by § 72(e)(3)(A).
Section 72(e)(3)(A) reads as follows:
Any amount to which this subsection applies
shall be treated as allocable to income on the
contract to the extent that such amount does
not exceed the excess (if any) of —
(i) the cash value of the contract
(determined without regard to any surrender
charge) immediately before the amount is
received, over
(ii) the investment in the contract at the
time.
The Commissioner relies upon subsection (i), which explains
that for purposes of section 72, the cash value of the contract
12 SCHWAB V . CIR
is to be determined without regard to any surrender charge.
Thus, the Commissioner contends, Schwab and Kleinman
must pay taxes on the stated policy values. But he misses a
step. The Commissioner offers no reason to believe that the
“cash value” of the policy under section 72(e)(3)(A) is the
“amount actually received” under section 402(b)(2).7 Nor is
section 72(e)(3)(A) a freestanding method for valuing life
insurance policies. Rather, in this context it is “a guide to
allocating that value between taxable income and nontaxable
return of the investment on the contract.”8 The title of
paragraph (e)(3) is, after all, “Allocation of amounts to
income and investment.” And paragraph (i) simply sets forth
the method for computing one of the two numbers in that
formula.
The other problem with the Commissioner’s interpretation
of section 402(b)(2) is that it reads the phrase “amount
actually distributed or made available” entirely out of section
402(b)(2). See Beisler v. Comm’r., 814 F.2d 1304, 1307 (9th
Cir. 1987) (“We should avoid an interpretation of a statute
that renders any part of it superfluous and does not give effect
to all of the words used by Congress.”). The Commissioner’s
assertion that section 72(e)(3)(A)(i) dictates how insurance
policies distributed from nonqualified trusts should be taxed
completely bypasses the reference in section 402(b)(2) to the
“amount actually distributed.” In contrast, the tax court’s
interpretation of the interplay of sections 402(b)(2) and
72(e)(3)(A)(i) gives effect to all of the language in both
statutory provisions. Under that interpretation, the “amount
to which this subsection applies” in subsection 72(e)(3)(A)(i)
7
W e discuss this further in Part D, infra.
8
Order Denying Reconsideration at 2.
SCHWAB V . CIR 13
is the “amount actually distributed” in section 402(b)(2). We
thus conclude that the tax court advances the better
interpretation of the plain text of section 402(b)(2).
C.
This is not the end of our inquiry, however. Section 402
is the subject of a number of Treasury regulations, and, as a
general matter, “we defer to the Treasury’s interpretation of
the statute” if the applicable regulations prove dispositive.
See Pac. First Fed. Sav. Bank v. Comm’r, 961 F.2d 800, 805
(9th Cir. 1992) (citing Nat’l Muffler Dealers Ass’n, Inc. v.
United States, 440 U.S. 472, 488 (1979)).
As a result, the Commissioner appeals for support beyond
the text of section 402(b)(2). He first argues that the Treasury
regulation interpreting section 402(b), Treas. Reg.
§ 1.402(b)–1, supports his interpretation of that section. The
Commissioner directs our attention to an example in that
regulation, which reads as follows: “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.” Treas.
Reg. § 1.402(b)–1(c).9 We first note, as did the tax court, that
the example refers to annuity contracts, rather than life
insurance policies. Nonetheless, the Commissioner focuses
upon the phrase “entire value of the contract,” arguing that
such language “draws upon” the Supreme Court’s reasoning
in a trio of cases (all delivered the same day), in which the
Court considered “the proper method for valuation” of a
9
Unless otherwise stated, all references herein to Treasury regulations
refer to the version that was current when Schwab and Kleinman filed
their tax returns.
14 SCHWAB V . CIR
single-premium life insurance policy for gift tax purposes.
See, e.g., Guggenheim v. Rasquin, 312 U.S. 254, 255 (1941).
In Guggenheim, the Court held that the fair market value of
the policy10 was not its cash surrender value, but rather the
purchase price, because “[c]ost is cogent evidence of value”
when the purchaser assigned the policy to three of her
children at “substantially the same time” as the purchase. Id.
at 256, 258; see also Powers v. Comm’r, 312 U.S. 259 (1941)
(affirming same). By contrast, in United States v. Ryerson,
312 U.S. 260 (1941), five years had elapsed between the
purchase of the policy and its assignment. The Court
therefore held that the replacement cost of the policy at that
time of the assignment, rather than the policy’s original
purchase price, was the correct valuation of the policy for gift
tax purposes. Id. at 261.
Even if we assume that the regulation’s use of “entire
value” is an oblique allusion to the reasoning of these gift tax
cases, the three cases do not suggest, as the Commissioner
urges, that surrender charges may never be taken into account
when valuing a life insurance policy. Rather, when read
together, they suggest that “the fair market value of insurance
contracts can be a slippery concept,” Schwab, 136 T.C. at
131, and that a particular method for ascertaining value may
be appropriate in one situation but inappropriate in another.
We are therefore not persuaded that the example relating to
annuities in Treasury regulation section 1.402(b)–1(c)
suggests that surrender charges may never be considered
10
Gifts were taxed at their fair market value under the relevant statute.
See Guggenheim, 312 U.S. at 257 n.4 (“Art. 19(1) provided: ‘* * * The
value of property is the price at which such property would change hands
between a willing buyer and a willing seller, neither being under any
compulsion to buy or to sell. . . .’”).
SCHWAB V . CIR 15
when valuing a life insurance policy distributed from an
employees’ trust.
On the other hand, there is a different clause in section
1.402(b)–1(c) that proves useful to our analysis: the
regulation parrots nearly verbatim the text of section
402(b)(2), providing that “[a]ny amount actually distributed
or made available to any distributee . . . shall be taxable under
section 72.” Treas. Reg. § 1.402(b)–1(c). We have explained
our interpretation of this language, and we conclude that it
bears the same meaning in the Treasury regulation that it does
in the corresponding tax code provision. So rather than
overriding what we understand to be the plain meaning of
section 402(b)(2), as the Commissioner believes it should, the
regulation in fact reaffirms our interpretation of the tax
code.11
D.
The Commissioner next argues that we should reject the
tax court’s treatment of distributions from qualified benefit
plans because that approach creates unwarranted anomalies
with the taxation of variable life insurance policies while they
are held in trust, and with the tax treatment of distributions
from qualified investment plans. We discuss each in turn.
An employer’s contributions to an employees’ trust are
taxed according to a different subsection of section
11
Because we find that the text of the regulation is not ambiguous and
that the interpretation the Commissioner advances in his briefs are
“inconsistent with the regulation,” we do not grant deference to those
views apart from their inherent ability to persuade. See Auer v. Robbins,
519 U.S. 452, 461 (1997).
16 SCHWAB V . CIR
402(b)—section 402(b)(1)—than are distributions from the
trust. Under the regulations pertaining to section 402(b)(1),
contributions to the employee trust are valued and taxed
“without regard to any lapse restriction.” Treas. Reg.
§ 1.402(b)–1(b)(1). And the tax court has, in a different case,
interpreted surrender charges on a variable life insurance
policy to be a type of lapse restriction under section
1.402(b)–1(b)(1). See Cadwell v. Comm’r, 136 T.C. 38,
58–60 (2011), aff'd, 483 Fed. App’x 847 (4th Cir. 2012).
The Commissioner argues, therefore, that surrender
charges should be treated identically when taxing
contributions to and distributions from an employees’ trust,
because “words in different sections of the same statute
should be construed similarly.” Miranda v. Anchondo,
684 F.3d 844, 849 (9th Cir. 2011). But therein lies the rub:
neither the “contributions” and “distributions” subsections of
the tax code, nor the two corresponding subsections of the
applicable Treasury regulation, have any meaningful words
in common. In particular, as the tax court noted in this case,
the subsection of the regulation applicable to distributions,
section 1.402(b)–1(c), “doesn’t even mention ‘lapse
restrictions.’” Schwab, 136 T.C. at 130. And because it was
only the inclusion of that phrase in the regulations relating to
employer contributions that led the tax court to value
employer contributions without respect to surrender
charges,12 nothing in section 402(b)(1), or the regulations
interpreting it, suggests we need to adopt that approach
relating to distributions. We conclude that the possibility that
the surrender charge could be disregarded when taxing
contributions to an employees’ trust, but be taken into
account when the assets are later distributed, is not so
12
See Cadwell, 136 T.C. at 58–60.
SCHWAB V . CIR 17
anomalous as to require us to ignore the statutory and
regulatory text that produces such a result. Contributions and
distributions are, after all, taxed according to two entirely
separate subsections of section 402(b).
In his next argument, the Commissioner relies on a
different provision of the tax code that does share wording
with section 402(b)(2). Section 402(a) prescribes the tax
treatment of qualified (rather than nonqualified) benefit plans.
Much like section 402(b)(2), section 402(a) provides that
any amount actually distributed to any
distributee by any employees’ trust described
in section 402(a) which is exempt from tax
under section 501(a) shall be taxable to the
distributee . . . under section 72 (relating to
annuities).
I.R.C. § 402(a) (emphasis added). In Matthies v. Comm’r,
134 T.C. 141 (2010), the tax court concluded that, under the
pre-2005 regulations, surrender charges should not be
considered when valuing a life insurance policy under section
402(a). Id. at 151–52. Treasury regulation section
1.402(a)–1 interprets tax code section 402(a), and the pre-
2005 version of that regulation stated that “the entire cash
value of such contract at the time of distribution must be
included in the distributee’s income in accordance with the
provisions of section 402(a) . . . .” Treas. Reg. § 1.402(a)–1
(emphasis added). The tax court noted that the proposed
regulations in 1955 originally referred to the “entire value of
such contract,” a phrase which the court believed “might
plausibly be construed as synonymous with ‘fair market
value.’” Matthies, 134 T.C. at 150–51 (citing Proposed
Income Tax Regs., 20 Fed. Reg. 6460 (Sept. 1, 1955)). The
18 SCHWAB V . CIR
final version of the regulations substituted the phrase “entire
cash value” for “entire value of such contract,” though, and
the tax court reasoned that “the regulations purposefully
departed from a generalized valuation standard . . . in favor of
a more particularized (and possibly more objective and more
easily administered) valuation standard.” Id. at 151. The tax
court concluded in Matthies, therefore, that the phrase “cash
value” in Treasury regulation section 1.402(a)–1 is “properly
construed . . . to refer to cash value determined without regard
to any surrender charge.” Id. at 151.13
Returning to the Commissioner’s argument, it is true that
section 402(a) shares the phrase “amount actually distributed”
with section 402(b)(2), and that the tax court in Matthies
interpreted that provision not to account for surrender
charges. It is also accurate that we would normally presume
that “a legislative body generally uses a particular word with
a consistent meaning in a given context.” Erlenbaugh v.
United States, 409 U.S. 239, 243 (1972). But the tax court
reached its interpretation of section 402(a) in Matthies
because of the applicable regulation’s command to account
for the “entire cash value” of the policy; the regulation
interpreting section 402(b)(2) contains no such language. As
the tax court explained, “the regulations interpreting each
subsection differed before 2005 and continue to differ today.
We must apply them as written.” Schwab, 136 T.C. at 120.
To the extent that the Commissioner finds the results
anomalous, it is a problem of his own making.
13
See also Part B, discussing the appearance of the phrase “cash value”
in tax code section 72(e)(3)(A)(i).
SCHWAB V . CIR 19
E.
Neither the regulations interpreting section 402(b)(2), the
neighboring provisions of the code, nor the regulations
interpreting those neighboring provisions have persuaded us
that we must adopt the Commissioner’s view that life
insurance policies must always be taxed with reference to
their “cash value” according to section 72(e)(3)(A)(i) when
they are distributed from an employees’ trust. Nor has the
Commissioner persuaded us that any authority categorically
requires that surrender charges always be ignored.
But a puzzle remains. How should the Commissioner
quantify insurance policies as an “amount actually
distributed” that can be taxed? We conclude that the tax
court correctly equated the “amount” in section 402(b)(2)
with the fair market value of the policies that were actually
distributed. Fair market value is generally understood to be
“[t]he price that a seller is willing to accept and a buyer is
willing to pay on the open market and in an arm’s-length
transaction; the point at which supply and demand intersect.”
Black’s Law Dictionary (9th ed.). In other words, the fair
market value of a thing is the amount of consideration
someone would pay to acquire it. We do not believe that in
drafting section 402(b)(2), Congress intended to tax the
distributee on some amount greater (or lesser) than what a
rational person would pay for what the taxpayer actually
received.
It would also be reasonable to say that the fair market
value standard is as close to a generalized valuation standard
20 SCHWAB V . CIR
as there is in the tax code.14 As the tax court has explained,
“the concept of fair market value has always been part of the
warp and woof of our income, estate, and gift tax laws, and
concomitantly the necessity of determining the fair market
values of numerous assets for equally numerous purposes has
always been a vital and unavoidable function of the tax
administrative and judicial process.” Nestle Holdings, Inc. v.
Comm’r, 94 T.C. 803, 815 (1990). To be sure, the term “fair
market value” appears “in about 200 sections of the Internal
Revenue Code . . . , and in about 900 sections of the
supporting Treasury regulations.” John A. Bogdanski,
Federal Tax Valuation par. 1.01 (2012). We affirm the tax
court’s holding that “the ‘amount actually distributed’ means
the fair market value of what was actually distributed.”
Schwab, 136 T.C. at 131.
F.
The only questions remaining in this case are whether, as
a general matter, surrender charges in life insurance policies
can affect the fair market value of those policies, and whether
the tax court erred in accounting for them here. We agree
with the tax court that “[t]he 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,
14
The tax court supported its holding with the observation that the
example in section 1.420(b)–1(c) requiring an annuity to be taxed at its
“entire value,” and that the tax court postulated in Matthies that “this . . .
phrase— ‘entire value’— ‘might plausibly be construed as synonymous
with “fair market value”’ and represented ‘a generalized valuation
standard.’” Schwab, 136 T.C. at 131 (citing Matthies, 134 T.C. at
150–51). W hile the tax court’s opinion in Matthies is non-binding and
represents only a “clue,” Schwab, 136 T.C. at 131, it certainly points in the
right direction.
SCHWAB V . CIR 21
or Schwab and Kleinman’s that such charges should always
count, in determining a policy’s value.” Schwab, 136 T.C. at
134. 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.”15
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. As explained in Part C, the divergent
methodologies the Supreme Court used to value paid-up term
life insurance policies in Guggenheim and Ryerson counsel us
against adopting a one-size-fits-all methodology for
ascertaining the fair market value of a life insurance policy.
And while the Supreme Court did not find surrender
charges relevant when valuing the particular policies at issue
in Guggenheim and Ryerson, more recent cases of other
circuits illustrate that in other contexts, surrender charges can
affect the fair market value of a life insurance policy. In
1962, then-Judge Blackmun distinguished Guggeinheim, and
held that the fair market value of the life insurance policy in
that case was the cash surrender value of the policy. See
Gravois Planning Mill Co. v. Comm’r, 299 F.2d 199, 211 (8th
Cir. 1962). There, the taxpayer, Charles Beckemeier, was an
officer of the Gravois Planning Mill Company, and Gravois
held an insurance policy on Beckemeier’s life. Id. at 201.
Upon his retirement, Beckemeier purchased the insurance
policy from the company at its cash surrender value. Id. The
court held that the price paid—which was the surrender value
15
Order Denying Reconsideration at 1.
22 SCHWAB V . CIR
of the policy—was controlling as to the fair market value of
the policy. Id. at 211.16
In another case, the Second Circuit explained that “[c]ash
surrender value is the more appropriate valuation when it
appears that no one is interested in keeping the policy in
effect and that anyone receiving the policy would be likely to
surrender it to the company for the cash surrender value.”
Tuttle v. United States, 436 F.2d 69, 71 (2d Cir. 1970).
There, the court reasoned that a charitable organization
receiving a paid-up life insurance policy as a gift would not
be expected, when it had no relationship to the insured donee,
to hold the policy as an investment. Id. at 72. It therefore
held that the cash surrender value of the policy, rather than its
replacement value, reflected its fair market value in that case.
Id.While neither Gravois nor Tuttle is a perfect analog to this
case, both illustrate that surrender charges can, in some cases,
appropriately be factored into the fair market value of a life
insurance policy. A simple thought experiment bears out the
relevance of surrender charges to Schwab and Kleinman’s
policies here. Consider Kleinman’s policy as compared to an
identical policy with no surrender charge. At the time of the
distribution, Kleinman’s policy was set to lapse in 24 days if
she did not pay a $108,031 premium. Kleinman allowed the
policy to lapse, and because there were applicable surrender
16
In Gravois, the Commissioner made arguments strikingly similar to
those he makes in this case, claiming that “the right to turn a policy in for
cash is only one of the rights an owner possesses; that in addition he has
the right to retain it for investment purposes and the right to receive its
face amount on the insured’s death; and that all these rights demonstrate
a value greater than mere cash surrender value.” Id. at 211.
SCHWAB V . CIR 23
charges that exceeded the accumulated policy value, “[s]he
didn’t get any money from the insurance company because
her policy’s net cash-surrender value was negative.” Schwab,
136 T.C. at 126. Under the hypothetical policy with no
surrender charge, assuming the value of Kleinman’s
investments remained constant, Kleinman would instead have
received the stated policy value, $32,576, when the policy
lapsed. Clearly, any rational person would be willing to pay
more for a contract that pays out $32,576 in 24 days than a
contract that pays out nothing. In this light, it seems difficult
to believe, under the facts of this case, that the surrender
charges had no effect on the fair market value of the policies.
Finally, prudence counsels us against adopting the
Commissioner’s proposed ban on considering surrender
charges under section 402. Just as variable universal life
insurance policies did not exist when the Court decided
Guggenheim and its companion cases in 1941, ever-creative
financial institutions are liable to devise new life insurance
instruments that we cannot contemplate today. We therefore
decline to tie the hands of the tax court now, or in the future,
by adopting the Commissioner’s proposed blanket prohibition
on considering surrender charges when valuing life insurance
policies under section 402.
In light of the foregoing, we affirm the tax court’s finding
that Schwab and Kleinman’s policies did not have
“significant value apart from the small amount of the
insurance coverage that was attributable to the single
premium that Angels & Cowboys had paid on each policy
24 SCHWAB V . CIR
some three years earlier.” Schwab, 136 T.C. at 135.17 The
Commissioner fails to identify any other economic benefits
of the policies at the time of their distribution, apart from the
insurance coverage they provide. Aside from arguing that
surrender charges may never be considered under section
402(b)(2), the Commissioner does not meaningfully
challenge the particulars of the tax court’s calculations.
Therefore, we will not disturb the tax court’s valuation of the
Schwab-Kleinman policies.
AFFIRMED.
17
W hen they were before the tax court, the parties “fought mostly about
whether surrender charges could be considered at all,” and “they
introduced little evidence specifically directed at establishing the fair
market values for the policies.” Schwab, 136 T.C. at 134. This proved
problematic for the Commissioner. For example, he argued before the tax
court that “accumulated cash value can be used to pay costs relating to
maintaining the policies in force, can be borrowed against, or can be
obtained in exchange for surrendering the policy, as the policy owner may
choose.” Id. Regardless of whether this is true as a general matter, the
Commissioner apparently failed to prove this fact to the tax court with
respect to Schwab and Kleinman’s policies, and does not renew that
argument on appeal. Id. at 135–36. Moreover, both parties apparently
declined the tax court’s invitation to move to reopen the record to supply
data for more detailed calculations, id. at 135 n.17, and the Commissioner
does not point us to any evidence on record of the policies’ value that the
tax court failed to consider.