Although normal activity in much of Louisville seems to be temporarily suspended this weekend due to one of the most impressive logistical enterprises since the Berlin Airlift, the children’s swimming City Meet, the T&E Community still needs tax updates, and KYEstates is happy to share this report on Matthies v. Comm’r, 134 T.C. No. 6 (Feb. 22, 2010). In Matthies, the Tax Court ruled against taxpayers who had used a IRA funds to buy life insurance through a “Pension Asset Transfer” plan marketed by a life insurance underwriter.
New Jersey tax attorney Maureen P. Dougherty explained what the taxpayers had hoped to achieve in the transaction quite nicely:
Taxpayer had accumulated substantial funds in an IRA account. If taxpayer did nothing, the funds in the IRA would be subject to income tax if withdrawn during taxpayer’s lifetime, would be includable in taxpayer’s estate to the extent remaining at his death and would retain that taxable character in the hands of his beneficiaries after his death. When offered an opportunity to avoid these tax outcomes, taxpayer undertook the … PAT strategy to move funds out of his IRA … into a second to die life insurance policy held in an existing Irrevocable Life Insurance Trust. If the strategy worked all income, gift and estate taxes would be avoided.
While there are variations, the typical arrangement involved the creation of a pension plan in a closely-held entity, which received a roll-over distribution from the taxpayer’s IRA. The plan would then purchase a substantial life insurance policy. A feature of the policy would be that the insurance company would receive a substantial surrender charge if the policy was surrendered. The policy would then be sold to an insurance trust established by the taxpayer, removing the policy from the pension plan. The insurance trust would be buying the policy at a substantial discount in price – getting the insurance out of the pension plan at a reduced cost, and thus moving assets out of the plan without incurring an income tax. The insurance trust would often then convert the policy to one that did not have the surrender charge feature.
As Rubin explains: “The planning makes sense in theory. However, as one would expect, the IRS was not pleased with the technique.”
And so the hammer dropped on the taxpayers in Matthies, who closely followed the general transaction format described by Rubin. First, the taxpayers established a wholly-owned S corporation, “Bellagio Partners, Inc.” Five days after forming the S corporation, the taxpayers a profit-sharing plan for it, based on the insurance company’s prototype plan. The taxpayers were the sole trustees and committee members for the profit-sharing plan, which received a favorable determination letter from the IRS in October, 1999 (about one year after it was formed).
Meanwhile, in January 1999 the profit-sharing plan had purchased a second-to-die insurance policy in the face amount of $80 million. In 1999 and 2000, the taxpayer made two separate transfers of $1.25 million each from his IRA to the profit-sharing plan. In turn, the profit-sharing plan made two separate insurance policy premium payments of $1.25 million. In late December 2000, the profit-sharing plan transferred the insurance policy to the taxpayer. In exchange, on the same day, the taxpayer transferred approximately $315,000 to the profit-sharing plan. In January 2001, the taxpayer transferred ownership of the policy to an ILIT. One day after the transfer, the ILIT exchanged the policy for a different survivorship policy issued by the same insurance underwriter with a face value of almost $19.5 million. Perhaps not surprisingly, the insurance company waived surrender charges on the exchange of the policy, and the replacement policy had no surrender charges. The insurance company accepted the full account value of the old policy (without surrender charge) as payment in full of the single premium due on the replacement policy. Thereafter, no premiums were paid on the replacement policy.
At the time the profit-sharing plan transferred the policy to the taxpayer, the policy’s account value was approximately $1.37 million. The policy, however, was subject to a surrender charge of approximately $1.06 million, with the result that the policy’s cash value net of surrender charges was approximately $315,000.
When the taxpayers filed their income tax returns for the year of the policy transfer, they reported no income from the transfer of the policy from the profit-sharing plan to the taxpayer. In its notice of deficiency, the IRS argued that the taxpayers had approximately $1.05 million in gross income from the transfer of the insurance policy and were liable for $59,000 in accuracy-related penalties under § 662(a).
The Tax Court succinctly identified the issue in dispute between the taxpayers and the IRS: “The nub of their disagreement is the proper valuation of the insurance policy as of the date it was transferred to petitioner…the parties disagree as to whether in valuing the insurance policy, reduction should be made for the surrender charge.”
The Tax Court discussed life insurance valuation regulations (see, e.g., T.D. 9223, 2005-2 C.B. 591) under § 402(a) in effect before and after 2005. (Rubin provides a useful summary of those regulations here.) It then reviewed general principles under § 61(a) and the bargain-sale rule of Comm’r v. LoBue, 351 U.S. 243 (1956).
The Tax Court then began to apply its analysis to the facts of the case, and it wasn’t hard to tell where the Court was going. Observing that the “transfer from the profit-sharing plan to petitioner was pursuant to a prearranged plan for him to use IRA funds to buy life insurance through the profit-sharing plan, which was established for this purpose and with the expectation that it would shortly thereafter distribute the policy to petitioner,” it concluded that the “transaction was in no sense arm’s length,” and had been undertaken with the “objective of minimizing petitioners’ taxes on the transfer of the insurance policy to petitioner”.
Accordingly, the Tax Court concluded that “insofar as petitioner purchased the life insurance policy from the profit-sharing plan at a bargain price, the bargain element is includable in his gross income pursuant to section 61.”
To find the amount of the bargain sale, the Tax Court then evaluated whether the insurance policy’s value at the time of the transfer included the surrender charge. The Court found that it did, citing § 7702(f)(2)(A), which defines the “cash surrender value” of a life insurance contract as the “cash value determined without regard to any surrender charge.”
Although it did not expressly cite the economic substance doctrine, the Tax Court was clearly influenced by the substance of the transaction because it noted the fact that the insurance company had credited the ILIT for the amount of a single premium payment on the replacement policy that included the surrender charge, only two weeks after the profit-sharing plan had transferred the policy to the taxpayer.
Therefore, the Tax Court found that the taxpayer had paid the profit-sharing plan $1.05 million less for the life insurance policy than its value of $1.37 million at the date of the transfer, and that this bargain element of the sale was includible in the taxpayer’s gross income pursuant to section 61.
The outcome for the taxpayer could have been worse. Because the Tax Court had not previously addressed the tax treatment of a bargain sale of a life insurance policy under § 61 or § 402(a) or the definition of “entire cash value” under the applicable regulations, it found that the taxpayers had a reasonable basis for their return and declined to impose accuracy-related penalties.
Matthies calls to mind the old adage that “there’s no such thing as a free lunch.” (Non-Roth) IRA balances are ordinary income, and the IRS wants to be sure it ultimately has the opportunity to tax that income. Shifting IRA balances into life insurance and then temporarily depressing the value of that life insurance based on surrender charges that then aren’t actually applied by the insurance company….if you were an IRS agent, wouldn’t that seem somewhat abusive to you? (At the very least, it invites an economic substance attack.) At KYEstates we support creative tax planning, but we’re not surprised at the outcome in Matthies. Occasionally, the IRS does have to win at least a case or two, and it doesn’t seem unreasonable that they won this case under these facts.