Schwab v. Comm'r of Internal Revenue

• Decision Date: 24 April 2013
• Docket Number: No. 11–71957.,11–71957.
• Parties: Michael P. SCHWAB; Kathryn J. Kleinman, Petitioners–Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

715 F.3d 1169

Michael P. SCHWAB; Kathryn J. Kleinman, Petitioners–Appellees,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellant.

No. 11–71957.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted Feb. 15, 2013.

Filed April 24, 2013.

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.

Appeal from a Decision of the United States Tax Court. Tax Ct. No. 10525–07.

Before: MICHAEL DALY HAWKINS and MILAN D. SMITH, JR., Circuit Judges, and JAMES G. CARR, District Judge.^*

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.

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 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.

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 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

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.

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 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)....

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...