Schwab v. CIR

The term "amount actually distributed" in a life insurance policy, for purposes of calculating what is taxable, means the fair market value of the what was distributed under the policy, and "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."

Michael Schwab and his wife, Kathryn Kleinman, each purchased a variable universal life insurance policy for their small business. For variable universal life insurance policies, the insurer 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 . . . beneficiary gets what’s left in the separate account.” The policies were subject to surrender charges if Schwab and Kleinman allowed the policies to lapse or if they terminated prior to a specific date. According to I.R.C. § 402(b)(2), the policies’ distribution is taxable. After distribution, Schwab and Kleinman did not report taxable income as a result of their policies’ distribution because the “net cash surrender values” of the policies were negative at the time of taxation. The Ninth Circuit upheld the district court’s interpretation of “amount actually distributed” as meaning the fair market value of what was actually distributed. Further, the panel found that the tax code does not forbid the consideration of surrender charges in determining a policy’s fair market value. The panel therefore struck down numerous attempts by the Commissioner to consider surrender charges otherwise. In reading the tax code, specifically Section 402(b), Treasury regulations, and recent circuit court cases Gravois Planning Mill Co. v. Comm’r and Tuttle v. United States, the panel found that surrender charges can “appropriately be factored into the fair market value of a life insurance policy.” Because of the vast variety of insurance policies, there is no one answer as to whether surrender charges may always be calculated into a policy’s fair market value. Instead, the panel held that “surrender charges may be considered under section 402(b)(2), . . . as part of a [] general inquiry into the policy’s fair market value.” AFFIRMED.