Matthies v. Comm'r of Internal Revenue

• Decision Date: 22 February 2010
• Docket Number: No. 22196–07.,22196–07.
• Citation: 134 T.C. 141,134 T.C. No. 6
• Parties: Karl L. MATTHIES and Deborah Matthies, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

134 T.C. 141
134 T.C. No. 6

Karl L. MATTHIES and Deborah Matthies, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 22196–07.

United States Tax Court.

Feb. 22, 2010.

[134 T.C. 141]

A profit-sharing plan of Ps' wholly owned S corporation bought a life insurance policy on Ps' lives with funds rolled over from H's IRA. The profit-sharing plan later sold the policy to H for $315,023, which slightly exceeded the policy's cash surrender value, net of a $1,062,461 surrender charge. For income tax purposes, Ps valued the policy at its net cash surrender value and reported no gain on the transaction. R determined that the policy should be valued without any reduction for surrender charges and that the bargain sale of the insurance policy gave rise to taxable income to Ps.

Held: Pursuant to sec. 1.402(a)–1(a)(2), Income Tax Regs., as in effect before amendment in 2005, the value of the insurance policy is determined by reference to its “entire cash value”, which allows no reduction for surrender charges. Held, further, the bargain element of the sale of the insurance policy represented taxable income to H pursuant to sec. 61, I.R.C. Held, further, because they had a reasonable basis for their return position, Ps are not liable for the accuracy-related penalty for negligence under sec. 6662(a), I.R.C.

Richard A. Sirus, for petitioners.

Naseem J. Khan and David S. Weiner, for respondent.

THORNTON, Judge:

[134 T.C. 142]

For each of petitioners' taxable years 2000 and 2001, respondent determined a $294,925 deficiency and a $58,985 accuracy-related penalty for negligence under section 6662(a).¹ After concessions, the issues for decision are: (1) Whether in 2000 petitioners realized $1,053,304 of taxable income from a bargain sale to Karl L. Matthies (petitioner) of a life insurance policy by a profit-sharing plan created for petitioners' wholly owned S corporation; and (2) whether for 2000 petitioners are liable for the section 6662(a) accuracy-related penalty for negligence.

FINDINGS OF FACT

When they filed their petition, petitioners resided in California. At all relevant times, petitioner was a stock analyst.

In 1998 petitioners employed an attorney of their long acquaintance, Philip Spalding, Sr., to help plan their estate. Philip Spalding, Sr., introduced petitioner to his son, Philip Spalding, Jr., who was an insurance agent. The Spaldings proposed, among other things, that petitioner use some of his IRA funds to buy life insurance through a profit-sharing plan pursuant to a so-called Pension Asset Transfer (PAT) plan marketed by GSL Advisory Service (GSL) and Hartford Life Insurance Co. (Hartford Life).

Pension Asset Transfer Plan

In 1997 Edwin Lichtig and Larry Weiss, the principals of GSL, had published an article in a pension plan guide, which described the PAT plan as a strategy to “transfer qualified pension assets or IRA dollars to the participant or the participant's family without significant taxation.” The article suggested moving IRA funds to a profit-sharing plan to buy life insurance. The article and other GSL promotional materials that were provided to the Spaldings recommended these steps to implement the PAT plan: Creating a profit-sharing plan using GSL's nonstandardized prototype plan; getting a positive Internal Revenue Service (IRS) determination letter; purchasing a life insurance policy inside the profit-sharing plan; paying the premiums through the profit-sharing plan;

[134 T.C. 143]

transferring the policy from the plan to the client; paying tax on the policy value when it is transferred; and giving the policy to the client's heirs or to a trust.

Bellagio Partners and Profit–Sharing Plan

Petitioners, assisted by GSL, Philip Spalding, Sr., and Philip Spalding, Jr., implemented a plan following essentially the steps just described. On October 22, 1998, they incorporated Bellagio Partners, Inc., an S corporation. At all relevant times petitioners were 100–percent owners of Bellagio Partners, Inc.

On October 27, 1998, pursuant to the provisions of GSL's prototype plan, petitioners created for Bellagio Partners, Inc., a profit-sharing plan (the profit-sharing plan). Petitioners were the sole trustees and committee members of the profit-sharing plan. On October 26, 1999, the profit-sharing plan received a favorable determination letter from the IRS.

The Life Insurance Policy

In January 1999 the profit-sharing plan purchased through Philip Spalding, Jr., a Hartford Life last survivor interest-sensitive life insurance policy (the insurance policy). The face amount of the insurance policy was $80,224,252.

In 1999 and 2000 petitioner made two transfers of $1,250,000 from his IRA to the profit-sharing plan; in 2001 he made a $25,500 cash contribution. On February 4, 1999, and again on February 4, 2000, the profit-sharing plan paid a $1,250,003.63 premium on the insurance policy, for total premiums paid of $2,500,007.26.

Effective December 29, 2000, the profit-sharing plan transferred ownership of the insurance policy to petitioner. On the same date, petitioner transferred $315,023 to the profit-sharing plan. At the time of the transfer, the “account value” of the insurance policy, as defined therein, was $1,368,327.33.² The “cash value” of the insurance policy, as defined therein, was $305,866.74. The insurance policy defined the “cash value” to be the account value minus any

[134 T.C. 144]

applicable surrender charge. The surrender charge, as stated in the insurance policy, was $1,062,460.59 during the first 3 policy years. After the third policy year, the surrender charge declined each year at an increasing rate until being phased out entirely in the 20th policy year.

The Replacement Policy

On January 11, 2001, petitioner transferred ownership of the insurance policy to his family irrevocable trust (the trust), of which Bruce G. Potter was trustee. On January 12, 2001, the trust exchanged the insurance policy for a Hartford Life variable last survivor policy (the replacement policy) with a face amount of $19,476,516. Hartford Life waived surrender charges on the exchange, and the replacement policy provided for no surrender charges. Petitioners paid no commissions on the transferred account value. Hartford Life accepted the $1,368,327.33 account value of the insurance policy as payment in full of the $1,368,327.33 single premium due on the replacement policy. Thereafter, no additional premiums were paid on the replacement policy.

Petitioners' Income Tax Returns

On their joint Federal income tax returns, petitioners reported no income from the transfer of the insurance policy from the profit-sharing plan to petitioner. In the notice of deficiency respondent determined that for 2000 petitioners had $1,053,304 gross income from the transfer of the insurance policy and were liable for a $58,985 accuracy-related penalty for negligence pursuant to section 6662(a).³

OPINION

On December 29, 2000, the profit-sharing plan transferred the insurance policy to petitioner, and he transferred $315,023 to the profit-sharing plan. The parties disagree as to whether this transaction resulted in taxable income to petitioners. The nub of their disagreement is the proper valuation

[134 T.C. 145]

of the insurance policy as of the date it was transferred to petitioner.

A. The Parties' Contentions

Respondent asserts that on the date the profit-sharing plan transferred the insurance policy to petitioner, it was worth $1,368,327.33, which respondent asserts represents the policy's fair market value. Respondent further asserts that the $1,053,304 (rounded) bargain element of the sale ($1,368,327.33 fair market value minus $315,023 of consideration paid) represents taxable income to petitioner.

Petitioners counter that there was no bargain sale because the $315,023 that petitioner paid to the profit-sharing plan for the insurance policy exceeded its $305,866.74 net cash value and interpolated terminal reserve value as reported by Hartford Life for the date of the transfer. Under petitioners' view, because there was no bargain sale, the transfer of the insurance policy to petitioner resulted in no taxable income to him.

The $1,062,460.59 difference between the parties' respective valuation figures exactly equals the surrender charge stated in the insurance policy. In essence, then, the parties disagree as to whether in valuing the insurance policy, reduction should be made for the surrender charge.

B. Burden of Proof

As a general matter, the Commissioner's determination is presumptively correct, and the taxpayers bear the burden of proving that they did not receive additional income as determined by the Commissioner. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115, 54 S.Ct. 8, 78 L.Ed. 212 (1933). In certain circumstances, the burden of proof with respect to any factual issue may be shifted to the Commissioner. Sec. 7491(a). The parties disagree as to whether petitioners have met the requirements to shift the burden of proof to respondent. Because we do not decide this case by reference to the placement of the burden of proof, we need not and do not decide whether petitioners have met the requirements under section 7491(a) to shift the burden of proof to respondent.

[134 T.C. 146]

C. Taxation of Property Distributions Under Section 402(a)

Section 402(a) provides:

Except as otherwise provided in this section, any amount actually distributed to any distributee by an employees' trust described in section 401(a) which is exempt from tax under section 501(a) shall be taxable to the distributee, in the taxable year of the distributee in which distributed, under section 72 (relating to annuities).

The regulations under section 402(a) provide generally that “distribution of property * * * shall be taken into account by the distributee at its fair market value.” Sec. 1.402(a)1(a)(1)(iii), Income Tax Regs. The section 402(a) regulations as in existence before amendment in 2005 (hereinafter, the applicable regulations)...