At issue in Matthies was whether taxable income resulted from the sale of a second-to-die life insurance policy by the profit-sharing plan of the taxpayers’ wholly owned subchapter S corporation to the taxpayers.
In October of 1998, the taxpayers incorporated their subchapter S corporation and formed its profit-sharing plan. In January of 1999. the plan purchased an $80 million second-to-die life insurance policy on the lives of the taxpayers. During 1999 and 2000, the taxpayers transferred over $2.5 million from an IRA to the profit-sharing plan. These contributions were used to pay the premiums on the life insurance policy. Then, in December of 2000, the profit-sharing plan sold the policy to the taxpayers for about $315,000. At the time of the sale, the “cash value” of the policy was about $306,000, but the “account value” was almost $1.4 million. The difference between the “cash value” and the “account value” was a result of a surrender charge that would be imposed upon the policy if surrendered within the three years after issuance.
The taxpayers then transferred the policy to a “family irrevocable trust.” In January of 2001, the trust exchanged the policy for another survivor policy with a face amount of $19.5 million. As part of the exchange, the life insurance company waived the surrender charge and accepted the $1.4 million “account value” as full payment for the new policy.
Because the sale of the policy was not negotiated at arm’s length, the Tax Court considered the proper method for valuing the policy for purposes of determining whether the taxpayer’s realized taxable income from a bargain sale. In this regard, the essential question was whether the surrender charge should be taken into account in valuing the policy, or, in other words, whether fair market value of the policy was its “cash value” or its “account value.” The court reviewed statutory and regulatory language from IRC Sections 72, 402 and 7702 and determined that for purposes of calculating the taxpayers’ income from the bargain sale, the value of the policy should be determined without reference to the cash surrender value. Accordingly, the court held that the taxpayers recognized about $1.1 million of taxable income from the transaction. However, in light of ambiguity as to the proper tax treatment of the transaction, the court declined to assess a negligence penalty against the taxpayers.