120

1 Unless otherwise noted, all section references are to the Internal Revenue Code for the year 

MICHAEL P. SCHWAB AND KATHRYN J. KLEINMAN, 

PETITIONERS v. COMMISSIONER OF INTERNAL

REVENUE, RESPONDENT

Docket No. 10525–07. Filed February 7, 2011. 

Ps received life-insurance policies from a nonqualified 

employee-benefit plan that had surrender charges in excess of 

their stated values. Ps did not report the distributions on 

their joint return. R issued a notice of deficiency based on the 

unreported stated policy values. Held: Pursuant to sec. 402(b), 

I.R.C., Ps must include in income the fair market value of 

each of these insurance policies as of the date of distribution. 

Held, further, on the facts of this case, the fair market values 

of these insurance policies properly reflect surrender charges 

and other conditions imposed on Ps by the insurance company 

and include paid-up insurance coverage remaining on the policies as of the date of distribution. 

Jay Weill, for petitioners. 

Brian E. Derdowski, Jr., and Brian Bilheimer, for 

respondent. 

OPINION 

HOLMES, Judge: When a company winds up an employeebenefit plan and distributes its assets, section 402(b) 1 says 

(120) SCHWAB v. COMMISSIONER 121

at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. 

2Schwab occasionally does design work for the Sundance Institute and is a native Oklahoman. 

We therefore infer that Kleinman is the Angel. 

an employee receiving his share of those assets has to pay 

tax on ‘‘the amount actually distributed.’’ Michael Schwab 

and his wife Kathryn Kleinman both received life-insurance 

policies as their share of an employee-benefit plan that was 

ending. They argue that surrender charges on both the policies made them worth nothing at the time of their receipt. 

The Commissioner argues that we must consider only what 

the insurance company calculated to be the policies’ ‘‘stated 

values’’ in figuring out what the ‘‘amount actually received’’ 

by Schwab and Kleinman was. The dispute is a novel one. 

Background

Schwab and Kleinman are the sole shareholders of Angels 

& Cowboys, Inc. 2 They are also employees of the corporation; 

Schwab works as a graphic designer and Kleinman as a 

photographer. Schwab has created award-winning logos and 

posters for clients that include Major League Baseball, the 

Muhammad Ali Center, Nike, Pebble Beach, Polo Ralph 

Lauren, Robert Redford, and the San Francisco Opera. One 

collector described Schwab’s work: ‘‘Like a clearing in a dark, 

unfathomable forest, or an island in a turbulent sea, the 

graphic art of Michael Schwab is a welcome sight, a safe 

harbor, amidst the enigmatic and increasingly illegible pool 

of contemporary art and design.’’ Merrill C. Berman, Michael 

Schwab Studio—About Michael, Michael Schwab Studio, 

http : / / www.michaelschwab. com / studio / studio—about. html 

(last visited Jan. 1, 2011). Kleinman is also highly talented 

and has done photography for such high-profile clients

as Apple Computer, the GAP, Microsoft, and Wolfgang

Puck Foods. Studio-Clients, Kathryn Kleinman Studio,

http: / / www.kathrynkleinman.com/ html / studio—clients.html 

(last visited Jan. 1, 2011). 

Accountants follow success, and George Stameroff, a Marin 

County CPA, was the couple’s accountant until 2001. He prepared Schwab and Kleinman’s tax returns throughout the 

‘90s and also gave them financial-planning advice. In 2000, 

he recommended that the couple buy life-insurance policies 

through a multiple-employer welfare-benefit trust adminisVerDate 0ct 09 2002 11:25 May 30, 2013 Jkt 372897 PO 20009 Frm 00002 Fmt 2847 Sfmt 2847 V:\FILES\SCHWAB.136 SHEILA
122 136 UNITED STATES TAX COURT REPORTS (120) 

3Sections 419 and 419A are special rules limiting the deductibility of employer contributions 

to welfare-benefit funds. Section 419 generally limits deductions to the cost of providing current 

benefits, plus a very limited prefunding of benefits allowable under section 419A. But these limits do not apply to plans that comply with section 419A(f)(6). Thus, the allure of the Advantage 

419 Trust was the ability to set money aside in a way that would allow its value to grow without 

being immediately taxed. 

tered by Benistar. The trust was an employee-benefit plan 

known as the ‘‘Advantage 419 Trust,’’ because it was 

designed to conform with section 419A(f)(6). 3 Benistar was 

aimed at small-business owners and was the nation’s largest 

administrator of such plans. Stameroff gave Schwab and 

Kleinman the Benistar marketing brochures that claimed the 

plan allowed ‘‘qualified professionals, entrepreneurs, and 

closely-held business owners to obtain life insurance for 

themselves and for key employees on a tax-deductible basis.’’ 

These promotional materials emphasized that the plan assets 

(invested, in Schwab and Kleinman’s case, in an S&P 500 

stock-index fund) would grow tax-free and that the death 

benefits would be income-tax free. According to Stameroff 

and the Benistar marketing materials, if the plan were 

terminated, the policies would be distributed to the participants and their value net of surrender charges would be taxable. 

Schwab and Kleinman liked what Stameroff had to say 

about the Advantage 419 Trust and decided to adopt it. But 

their relationship with Stameroff would soon come to an end. 

They found out that he was an authorized agent of Benistar 

and decided to look for another accountant because Schwab 

felt they ‘‘didn’t have a clear rapport with him.’’ In 2001, 

Sander Stadtler replaced Stameroff as the couple’s CPA. 

Stadtler consulted with the couple regarding tax-return 

preparation and other financial matters. Part of his consultation included an extensive review of the Advantage 419 

Trust. He asked Stameroff several questions about the plan 

to ‘‘better understand the various costs and charges in the 

plan, required contributions, and projected results.’’ On 

Stadtler’s recommendation, in 2002 Schwab and Kleinman 

reduced their death benefits from $5.5 million to $2.4 million. 

Stadtler also opined that if the couple terminated the plan 

they would be taxed on the net cash-surrender value of the 

life-insurance policies. 

All seemed well. But roiling in the background was the 

IRS’s view, which it had held since at least 1995, that most 

(120) SCHWAB v. COMMISSIONER 123

4This Notice has been supplemented and superseded several times since. For the most recent 

changes, see Notice 2009–59, 2009–31 I.R.B. 170. 

trust arrangements promoted as multiple-employer welfarebenefit funds ‘‘do not satisfy the requirements of the section 

419A(f)(6) exemption.’’ Notice 95–34, 1995–1 C.B. 309, 310. 

In Booth v. Commissioner, 108 T.C. 524 (1997), the Commissioner successfully challenged a plan’s reliance on section 

419A(f)(6) by showing that it was really a series of singleemployer plans rather than a true multiple-employer plan. In 

spite of Notice 95–34 and the Commissioner’s litigation success, most taxpayers continued to take the position that their 

419 plans were allowable under the Code. The Commissioner 

raised the stakes in 2000 by designating 419 plans described 

in Notice 95–34 as ‘‘listed transactions.’’ Notice 2000–15, 

2000–1 C.B. 826. 4 Taxpayers are required to disclose listed 

transactions on their returns, and promoters of such transactions have to register them with the IRS. But many taxpayers took the position that their particular plans weren’t 

described in Notice 95–34 and so were not ‘‘listed transactions.’’ The IRS then issued proposed regulations on section 

419A(f)(6) plans in 2002, sec. 1.419A(f)(6)–1, Proposed 

Income Tax Regs., 67 Fed. Reg. 45938 (July 11, 2002), that 

more or less tracked its litigation position. 

The proposed regulations caught the attention of BISYS, the 

plan’s new administrator, who hired outside counsel in 2002 

to assess the situation. BISYS eventually concluded that the 

Advantage 419 Trust would not be able to comply with the 

proposed regulations. By 2003 it became clear that the 

Treasury Department would adopt the regulations substantially as proposed; BISYS terminated the plan for all 

employers, including Angels & Cowboys. The plan then 

distributed the life-insurance policies to Schwab and 

Kleinman in October 2003. At the time of distribution, 

Schwab’s policy had a ‘‘policy value’’ of $48,667 and 

Kleinman’s had one of $32,576. ‘‘Policy value’’ is an important term in this case, and it’s defined in the plan documents 

as ‘‘premiums less policy loads, plus net investment return, 

less policy charges, partial surrenders, and any indebtedness.’’ Schwab and Kleinman had two options upon distribution—continue paying premiums to keep their life-insurance 

124 136 UNITED STATES TAX COURT REPORTS (120) 

5The parties did not stipulate this. But the only record evidence of any payments is of the 

first, there is no evidence of any further payments, and the stated policy values by the end of 

2003 would make no sense had there been later payments. 

6The quoted matter is actually from material from the insurance company that was part of 

Stameroff ’s sales presentation. The parties unaccountably introduced only a part of the insurance contracts themselves. We nevertheless find the definitions in the presentation materials 

more likely than not to apply to the same terms in the contracts. 

coverage, or surrender the policies for their value less any 

surrender charges. 

But there was a catch. 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 lifeinsurance 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. 

The expected premiums for Schwab and Kleinman on their 

variable universal-life policies were quite steep. For Schwab, 

the premium was originally more than $136,000 a year; for 

Kleinman, it was $120,000. In some of the illustrations that 

the insurance company used, Angels & Cowboys would be 

paying such premiums for decades; in some, the firm would 

pay premiums for only ten years. But we find that the firm 

paid the premiums only for the policies’ first year. 5 The policies nevertheless remained in effect pursuant to a ‘‘no-lapse 

provision.’’ This provision states: 6

During the first 3 policy years if the sum of all premiums paid on this 

policy * * * is greater than the no lapse premium multiplied by the 

number of months the policy has been in force, the policy is guaranteed 

not to lapse even if the net cash surrender value is zero or less. If less 

than the no-lapse premium is paid during the first 3 policy years, the 

policy will not necessarily lapse provided the net cash surrender value is 

greater than zero. 

(120) SCHWAB v. COMMISSIONER 125

7 Note that at the end of three years, N = 36 and $3,548.77 × 36 = $127,755.72. 

8The changes were effective on May 17, 2002, which was 21 months into the first three-year 

period of the contract. Kleinman’s reduced ‘‘no-lapse’’ premium meant that, like her husband, 

she could keep the policy in force for that first three-year period without worrying about the 

net cash-surrender value of her policy: (21)($3,776.69) + (15)($2,510.34) = $116,965.59. 

9We say ‘‘fluctuations’’, but for the three-year period beginning in September 2000, ‘‘swoon’’ 

might be more accurate: The S&P 500 index declined nearly 34 percent. See Standard and Poor’s 

Index Services: S&P 500 Monthly Returns, https://www2.standardandpoors.com/spf/xls/index/

MONTHLY.xls (last visited Jan. 1, 2011).

Schwab’s ‘‘no-lapse’’ premium was set at $3,548.77. This 

meant that the policy wouldn’t lapse for the first three 

years—even if no more premiums were paid—so long as the 

initial premium payment of $136,000 remained greater than 

$3,548.77 × N (where N = the number of months the policy 

had been in effect) or the net cash-surrender value remained 

greater than zero. 7 Kleinman’s ‘‘no-lapse’’ premium was 

$3,776.69. With the initial premium payment of only 

$120,000, the net cash-surrender value of her policy would 

have to exceed zero after only 31 months to avoid a lapse or 

incur an obligation to pay more premiums. 

When in 2002 Schwab and Kleinman elected to reduce the 

coverage, those scheduled premiums shrank as well, but in 

both cases to more than $22,000 a year. The ‘‘no-lapse’’ premiums shrank as well: Schwab’s to $2,498.31; and 

Kleinman’s to $2,510.34. 8 One thing did not change: Both 

Schwab and Kleinman had directed that their premium payments be segregated into accounts whose value fluctuated 

with the S&P 500 stock index. The death benefit and cashsurrender value depend on those fluctuations in investment 

returns. 9 And the policies’ surrender charges were greater 

than their stated policy values in October 2003, meaning 

Schwab and Kleinman wouldn’t get any cash if they immediately surrendered their policies upon receipt. Here’s how 

the numbers looked at distribution: 

Schwab Kleinman

Stated policy value $48,667 $32,576

Surrender charges 49,225 46,599

Net cash-surrender value (558) (14,023)

The surrender charges lasted eleven years and would be 

reduced by 20 percent a year only in years 8–12 (starting in 

2008). But if the S&P 500 were to go up or if further premiums were paid, the policy values would increase as well. 

126 136 UNITED STATES TAX COURT REPORTS (120) 

10 BYSIS advised Schwab and Kleinman that this amount was necessary to maintain the policy, but the Commissioner points out that a smaller payment might have kept the policy alive 

for some time. It’s not clear from the record what minimum amount would have been necessary 

to keep Kleinman’s policy afloat—nor did the parties explain why the premium BYSIS requested 

was almost five times Kleinman’s reduced annual premium, though it is possible that it had 

something to do with the nonpayment of any premiums after the first. 

Schwab’s policy seemed more worthwhile—it could potentially be in the black in a matter of weeks. And by December 

2, 2003, when Schwab asked to surrender his policy, he was 

ahead by approximately $1,100. But he then changed his 

mind and contacted the insurance company in mid-December 

to reverse his termination request. The value of the policy 

net of surrender charges increased in the interim, reaching 

$1,630 by December 16. Schwab continued to hold the policy 

and pay his premiums at least until the trial. 

Kleinman’s policy was so deeply under water that she let 

it lapse shortly after distribution by not paying the required 

$108,031 premium. 10 She didn’t get any money from the 

insurance company because her policy’s net cash-surrender 

value was negative. 

BISYS did not issue any 1099 forms after it distributed the 

policies, so when Stadtler prepared the couple’s 2003 return, 

he did not report any income from their distribution. We find 

that in taking this position the couple was also relying on 

Stammeroff ’s, the plan administrator’s, and Stadtler’s 2001 

conclusion that they would be taxed only to the extent of the 

net cash-surrender value. Schwab provided all the materials 

that Stadtler asked for and answered all of his questions in 

the course of preparing the return. (Though we do find that 

he did not specifically ask Stadtler about the tax consequences of the distributions.) 

The Commissioner issued a notice of deficiency asserting 

increases in tax and penalties for Schwab and Kleinman’s 

failure to include the stated policy values as income. They 

timely petitioned the Tax Court as residents of California. 

We tried the case in San Francisco. 

Discussion

This case is about the rules for taxability of property 

distributed after the termination of employee-benefit plans. 

Such plans come in ‘‘qualified’’ and ‘‘nonqualified’’ varieties. 

Qualified plans must meet the requirements of section 401, 

(120) SCHWAB v. COMMISSIONER 127

11The words did not appear in the 1928 statute, but Congress added them back in 1932. Revenue Act of 1932, ch. 209, sec. 165, 47 Stat. 169, 221. 12While this is true, that doesn’t mean the reports had nothing to say about the meaning of 

‘‘amount actually distributed.’’ Section 219(f) (and later section 165) told us that distributions 

from employer-created trusts for stock bonus, pension, or profit-sharing plans, less any contributions made by employees, were taxable to employees when distributed. And in these early years, 

Congress was fiddling with how to value a distribution when it took the form of stock rather 

than cash—or in other words, how to determine the ‘‘amount actually distributed.’’ The 1926 

version taxed not only the employer’s contributions and any dividends and interest distributed 

but also the appreciation of the stock, even though that amount hadn’t been realized by the emContinued

and all the complicated regulations governing their funding, 

nondiscriminatory terms, employee coverage, distribution, 

and other requirements. Meeting such requirements allows 

for favorable tax treatment of qualified plans, but not all 

plans can comply; hence the existence of nonqualified plans. 

Nonqualified plans are generally subject to fewer statutory 

and regulatory requirements, but they also receive less favorable tax treatment. The rules for taxing distributions from 

qualified and nonqualified plans differ as well. Section 402(a) 

governs distributions from qualified plans, and section 402(b) 

governs distributions from nonqualified plans. 

I. Determining the Amount Actually Distributed

The Advantage 419 Trust was a nonqualified plan, so we 

apply section 402(b)(2). That section reads: 

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) * * * [Emphasis added.] 

But what amount was ‘‘actually distributed’’ when BISYS

transferred the life-insurance policies to Schwab and 

Kleinman? The Commissioner claims $81,243—their total 

stated policy value. Schwab and Kleinman see things differently and claim that nothing of value was ‘‘actually 

distributed.’’ They rely first and most insistently on the plain 

language of the Code. The words ‘‘amount actually distributed’’ appeared in the Code as far back as 1921 in section 

219(f), Revenue Act of 1921, ch. 136, sec. 219(f), 42 Stat. 227, 

247, which became section 165 in 1928, Revenue Act of 1928, 

ch. 852, sec. 165, 45 Stat. 791, 839. 11 Schwab and Kleinman 

point out that the committee reports for both the 1928 and 

1932 Acts don’t address taxing the stated value of an insurance policy. 12 See S. Rep. No. 72–665, sec. 165 (1932), 

128 136 UNITED STATES TAX COURT REPORTS (120) 

ployee at that time. H.R. Rep. No. 70–2, sec. 165 (1927), reprinted in 1939–1 C.B. (Part 2) 384, 

398–99. Congress decided in 1928 to postpone the employees’ recognition of the unrealized stock 

appreciation until the stock was sold, so the taxable amount at distribution then became the 

employers’ contributions plus dividends and interest distributed. See id.; Olstad v. Commissioner, 32 B.T.A. 670, 674 (1935) (‘‘Congress was concerned with an alleviation of what it regarded as an undue tax burden upon the employee resulting from the treatment as gain in his 

hands of the unrealized increment in the value of the trust property’’). The purpose was to relieve the taxpayer of ‘‘all possibility of tax upon appreciation in the value of trust securities before such appreciation came to his hand by sale.’’ Olstad, 32 B.T.A. at 674. 

But that still didn’t settle the matter. This definition was also troublesome because employees 

could be caught paying tax on their employers’ contributions, even if the stocks were worthless 

by the time the employees received them. S. Rep. No. 72–665, sec. 165 (1932), reprinted in 1939–

1 C.B. (Part 2) 496, 520. Congress came back to the table in 1932 to correct this ‘‘distinct hardship’’ by implicitly redefining the amount actually distributed as the ‘‘fair market value of the 

stock received,’’ less contributions made by the employee. Id. Although these sections don’t mention life-insurance policies, it appears that—at least at this point—Congress decided ‘‘amount 

actually distributed’’ was best read as ‘‘fair market value at the time of distribution.’’

reprinted in 1939–1 C.B. (Part 2) 496, 520; H.R. Rep. No. 70–

2, sec. 165 (1927), reprinted in 1939–1 C.B. (Part 2) 384, 

398–99. 

Finding no esoteric meaning in the legislative history, 

Schwab and Kleinman point us to the dictionary, which 

defines ‘‘actually’’ as ‘‘in fact; in reality.’’ American Heritage 

Dictionary 18 (4th ed. 2000). Because they are cash-basis 

taxpayers, Schwab and Kleinman argue they would have to 

actually or constructively receive income before they would 

incur any tax liability. See sec. 1.451–1(a), Income Tax Regs.; 

see also United States v. George, 420 F.3d 991, 996 (9th Cir. 

2005). There’s no actual receipt here, and no constructive 

receipt because no income was credited and made available 

to them without restriction: In the words of the regulation, 

Schwab and Kleinman could not ‘‘draw upon it at any time,’’ 

and their control of the policy’s value (if ‘‘control’’ is the right 

word) was ‘‘subject to substantial limitations or restrictions.’’ 

Sec. 1.451–2(a), Income Tax Regs. The stated policy values, 

they argue, had no cash equivalence or economic value upon 

distribution. Schwab and Kleinman admit that the insurance 

policies that they got showed ‘‘policy values,’’ but reasonably 

point out that that ‘‘value’’ is not what they could actually 

have gotten in hand at the time of distribution. They conclude, therefore, that they received something that had ‘‘no 

economic, monetary or cash surrender value.’’

The Commissioner’s argument is not nearly as straightforward. He begins with the incontestably true observation 

that there is no regulation or caselaw directly on point. He 

then argues that: 

(120) SCHWAB v. COMMISSIONER 129

• The insurance policies should be treated as if they were 

annuities; 

• treating them as if they were annuities means including 

in Schwab and Kleinman’s income their ‘‘entire value;’’ and 

• ‘‘entire value’’ does not include any surrender charges. 

The first problem is that section 402(b)(2) says that the 

‘‘amount actually distributed * * * shall be taxable to the 

distributee * * * under section 72 (relating to annuities).’’ 

This does not mean that any ‘‘amount actually distributed’’ 

is an annuity, but only that the taxability of whatever 

amount was ‘‘actually distributed’’ has to be computed by 

using section 72’s rules on recovery of the taxpayer’s investment in the contract. The Commissioner nevertheless points 

to section 1.402(b)–1(c)(1), Income Tax Regs. Like the Code, 

that regulation includes the phrase ‘‘actually distributed,’’ 

but it continues with an example of the distribution of an 

annuity contract: 

If, for example, the distribution from such a trust consists of an annuity 

contract, the amount of the distribution shall be considered to be the entire 

value of the contract at the time of distribution. * * * [Id.] 

This tells us something: When an annuity contract is distributed, it’s the ‘‘entire value’’ of the contract that is taxable 

under the rules governing the taxation of annuities. 

And the Commissioner’s argument rests in a subtle way on 

extending the regulation’s command that an annuity contract’s ‘‘entire value’’ is the ‘‘amount actually distributed’’ to 

the valuation of life-insurance policies like Schwab’s and 

Kleinman’s. 

The Commissioner’s shifting of our focus to the meaning of 

the phrase ‘‘entire value’’—remember, a term taken from an 

example in the regulation about the valuation of an annuity 

contract—and away from the phrase ‘‘amount actually 

distributed’’ aims to take advantage of a regulation that 

defines ‘‘entire value’’ in a somewhat unusual way. That 

regulation, section 1.402(b)–1(b)(2)(i), Income Tax Regs., provides that the ‘‘entire value’’ does not take into account what 

the regulations call a ‘‘lapse restriction.’’ The Commissioner 

then continues his argument by asserting that surrender 

charges on a life-insurance policy are a type of lapse restriction, an argument he recently won in Cadwell v. Commissioner, 136 T.C. 38 (2011). In Cadwell, we disregarded surVerDate 0ct 09 2002 11:25 May 30, 2013 Jkt 372897 PO 20009 Frm 00010 Fmt 2847 Sfmt 2847 V:\FILES\SCHWAB.136 SHEILA
130 136 UNITED STATES TAX COURT REPORTS (120) 

render charges after looking to Revenue Procedure 2005–25’s 

safe-harbor definition of fair market value for a formula to 

apply in default of the taxpayer’s failure to offer any reason 

we shouldn’t. Id. at 58–59. 

That revenue procedure became effective only after the distributions here. And looking to the regulation the Commissioner points us toward, section 1.402(b)–1(b)(2)(i), Income 

Tax Regs., we see that it uses the word ‘‘value’’ and provides 

that 

The net fair market value of all the assets in the trust is the total amount 

of the fair market values (determined without regard to any lapse restriction, as defined in § 1.83–3(h)) of all the assets in the trust, less the 

amount of all the liabilities (including taxes) to which such assets are subject or which the trust has assumed * * * as of the date on which some 

or all of the employee’s interest in the trust becomes substantially vested. 

[Emphasis added.] 

The thing to notice about the Commissioner’s argument on 

this point is that it is based on language in the part of the 

regulation governing the valuation of an employee’s rights to 

assets still held in trust at the time those rights become 

vested. But Schwab’s and Kleinman’s policies were distributed—they were not still held in trust. The relevant regulation for this situation is not section 1.402(b)–1(b), but section 

1.402(b)–1(c), Income Tax Regs., which doesn’t even mention 

‘‘lapse restrictions.’’

That leaves us back where we started—trying to find the 

meaning of the phrase ‘‘amount actually distributed.’’ Schwab 

and Kleinman point us to regulatory language for qualified 

plans, telling us that the taxable value of an insurance contract ‘‘actually distributed’’ to a plan’s participant is its 

‘‘policy cash value.’’ Sec. 1.402(a)–1(a)(1)(iii), Income Tax 

Regs. (Remember that the Schwab-Kleinman distribution 

was from a nonqualified plan—like the Commissioner they’re 

also pointing to a facially inapplicable regulation and arguing 

by analogy.) 

That’s not quite right—it’s not just the ‘‘policy cash value’’ 

but ‘‘all other rights under such contract’’ that count toward 

fair market value. They do argue by analogy, however, that 

we should take surrender charges into account here because 

on this point there is no reason the distribution of a lifeinsurance contract from a qualified plan should be treated 

(120) SCHWAB v. COMMISSIONER 131

differently from a nonqualified distribution. But there’s a 

problem with the cited regulation—it’s effective as of August 

29, 2005. The prior version of the regulation—which would 

have applied to distributions from qualified plans at the time 

Schwab and Kleinman received their distribution—makes no 

reference to ‘‘policy cash value.’’ Instead, it provided that the 

‘‘entire cash value’’ of a life-insurance contract distributed 

from a qualified plan is taxable. Sec. 1.402(a)–1(a)(2), Income 

Tax Regs. And in a development that Schwab and Kleinman 

couldn’t foresee, we recently construed that language to mean 

something different from ‘‘fair market value.’’ See Matthies v. 

Commissioner, 134 T.C. 141, 150–51 (2010) (construing pre2005 regulations under section 402(a) as requiring that the 

‘‘entire cash value’’ of life insurance policies be determined 

without regard to surrender charges). 

This difference in the regulations may seem odd—both section 402(a) and 402(b) contain the phrase ‘‘amount actually 

distributed,’’ yet the regulations interpreting each subsection 

differed before 2005 and continue to differ today. We must 

apply them as written. In the absence of regulatory guidance, 

we hold that the ‘‘amount actually distributed’’ means the 

fair market value of what was actually distributed. One textual clue in the regulation itself that supports this is in the 

illustration of an annuity contract that is distributed. Section 

1.402(a)–1(a)(2) used to say that, in such a case, it’s the 

‘‘entire cash value of such contract at the time of distribution’’ that is included in income; section 1.402(b)–1(c) says 

that, if a nonqualified plan distributes an annuity contract, 

the value of the distribution is the contract’s ‘‘entire value.’’ 

In Matthies, we suggested that this latter phrase—‘‘entire 

value’’—‘‘might plausibly be construed as synonymous with 

‘fair market value’ ’’ and represented ‘‘a generalized valuation 

standard.’’ Matthies, 134 T.C. at 150–51. 

But the fair market value of insurance contracts can be a 

slippery concept, and is not necessarily synonymous with net 

cash-surrender value. Consider, for instance, the case of a 

taxpayer who buys a single-premium life-insurance contract 

and immediately gives it to her children. The purchase price 

obviously represents one good measure of its value but, as is 

true of many life-insurance contracts, the surrender charges 

that would apply for a number of years would make the net 

132 136 UNITED STATES TAX COURT REPORTS (120) 

13We recognize that the life-insurance-policy distribution at issue wasn’t a gift subject to the 

cash-surrender value less than the purchase price. The 

Supreme Court analyzed the problem: 

Surrender of a policy represents only one of the rights of the insured or 

beneficiary. Plainly that right is one of the substantial legal incidents of 

ownership. But the owner of a fully paid life insurance policy has more 

than the mere right to surrender it; he has the right to retain it for its 

investment virtues and to receive the face amount of the policy upon the 

insured’s death. That these latter rights are deemed by purchasers of 

insurance to have substantial value is clear from the difference between 

the cost of a single-premium policy and its immediate or early cash-surrender value * * * [Guggenheim v. Rasquin, 312 U.S. 254, 257 (1941); 

citations omitted.] 

In Guggenheim, the Court held that the time between purchase and gift was short enough that ‘‘cost is cogent evidence 

of value’’ and so it was the purchase price of the insurance 

policy that was the best measure of its value. Id. at 257–58. 

But in another case that same term, the Court also held 

that a paid-up policy that had been in effect for a much 

longer time—five years—had a value best measured by the 

cost of a replacement policy on the then-current age of the 

insured. United States v. Ryerson, 312 U.S. 260, 261 (1941). 

In the case of single-premium policies, we summarized the 

state of the law sixty years ago: 

The cash surrender value is the market value only of a surrendered 

policy and to maintain that it represents the true value of the policy is to 

confuse its forced liquidation value at an arbitrary figure with the amount 

realizable in an assumed market where such policies are frequently bought 

and sold. * * *

The rule is, then, that the fair market value of a single premium life 

insurance policy for the purpose of determining taxable gain derived from 

exchange of insurance policies is the same price that any person of the 

same age, sex, and condition of health as the insured, would have to pay 

for a life policy with the same insurance company on the date the 

exchange took place. * * *

[Parsons v. Commissioner, 16 T.C. 256, 262 (1951).] 

But this caselaw all involves paid-up policies. The SchwabKleinman policies were not paid up, but instead required 

years more of steep premium payments. And substantial 

parts of their values were tied to the fluctuations of a broad 

stock-market index. How should a court measure their fair 

market values? At least in the context of the gift tax, 13 the 

(120) SCHWAB v. COMMISSIONER 133

gift-tax regulations. 

14The valuation calls for ‘‘adding to the interpolated terminal reserve at the date of the gift 

the proportionate part of the gross premium last paid before the date of the gift which covers 

the period extending beyond that date.’’ Sec. 25.2512–6(a), Gift Tax Regs. The interpolated terminal reserve ‘‘ ‘is not cash surrender value; it is the reserve which the insurance company enters on its books against its liability on the contracts. * * * The word ‘‘interpolated’’ simply indicates adjustment of the reserve to the specific date in question.’ ’’ Matthies v. Commissioner, 134 

T.C. 141, 153 n.12 (2010) (quoting Commissioner v. Edwards, 135 F.2d 574, 576 (7th Cir. 1943), 

affg. 46 B.T.A. 815 (1942)). 

15The record contains no evidence of the policies’ interpolated terminal reserve values; the 

Commissioner does not expressly argue that we should take into account any such values, and 

Schwab and Kleinman do not rely on or address the policies’ interpolated terminal reserve values. Consequently, we do not consider this issue further. Cf. sec. 25.2512–6(a), Gift Tax Regs. 

16See United States v. Cartwright, 411 U.S. 546, 552–53 (1973) (invalidating regulation that 

failed to value mutual fund shares by using the redemption price—‘‘the only price that a shareholder may realize and that the fund—the only buyer—will pay’’); sec. 25.2512–6(b), Gift Tax 

Regs. 

regulations offer some guidance. For life-insurance policies 

that have ‘‘been in force for some time and on which further 

premium payments are to be made,’’ the insurer’s policy 

reserves are used to approximate the value. 14 Sec. 25.2512–

6(a), Gift Tax Regs. But this method is not permitted when 

‘‘the unusual nature of the contract’’ results in a valuation 

‘‘not reasonably close to the full value.’’ Id. And the IRS, in 

Notice 89–25, 1989–1 C.B. 662, modified by Notice 98–49, 

1998–2 C.B. 365, and Rev. Rul. 2002–62, 2002–2 C.B. 710 

took the position that in the case of distributions from a 

qualified plan (which, remember, the distribution here was 

not), taxpayers could use the ‘‘stated cash surrender value’’ 

unless total policy reserves were ‘‘a much more accurate 

approximation of the fair market value of the policy.’’ Id.

Q&A–10, 1989–1 C.B. at 665. 

Lacking evidence of the insurer’s policy reserves, 15 we 

begin our look for the fair market value of each policy with 

what the insurer called its stated policy value, which was 

$48,667 for Schwab and $32,576 for Kleinman. But, unlike a 

traditional life-insurance policy’s value (which only grows 

over time), these policy values fluctuated with the stock 

market. They look more like the net asset value of a mutual 

fund (with the obvious difference that a mutual fund investment does not provide a death benefit), and the surrender 

charges look very much like a back-end load. Just as we 

wouldn’t ignore such charges in calculating the value of 

shares, 16 we don’t ignore them here. 

The policies had been in effect for three years before distribution, meaning that in eight years the surrender charges 

134 136 UNITED STATES TAX COURT REPORTS (120) 

would expire. During that time, with the ups and down of 

the stock market, the stated values of the policies could rise 

or fall. 

The relevant point in time for our analysis is the time of 

distribution. The policies here were flexible-premium policies—that’s one of the reasons why not paying any but the 

first year’s premium didn’t end the policy in year two. But 

by the end of year three—when Angels & Cowboys distributed the policies to Schwab and Kleinman—the ‘‘no-lapse’’ 

premium period had expired and the fall in the broad stock 

market meant that they had no positive net cash-surrender 

value. As the Commissioner admits in his brief, flexible-premium policies like these generally ‘‘will not lapse if premiums are paid such that the net cash surrender value 

remains greater than zero.’’

But the net cash-surrender values here were less than 

zero. And because the parties fought mostly about whether 

surrender charges could be considered at all, they introduced 

little evidence specifically directed at establishing the fair 

market values for the policies. What we had was the policies’ 

stated values, the amount of premiums to be paid and the 

amount of any surrender charges, the terms of the contracts 

to the extent the parties introduced evidence about them, 

and the observed behavior of the taxpayers (e.g., the lapse of 

Kleinman’s policy and the greatly reduced coverage for 

Schwab for which he picked up the premiums himself). The 

variety of insurance policies is too great to adopt as a general 

rule either the Commissioner’s simple proposition that surrender charges should never count, or Schwab and 

Kleinman’s that such charges should always count, in determining a policy’s value. The particular facts of this case feature neither the dramatically springing cash value described 

in Notice 89–25, Q&A–10, 1989–1 C.B. at 665, nor the ability 

to use the distributed policy as consideration for a new policy 

without regard to surrender charges. 

The Commissioner proposes that we find as fact that the 

Schwab-Kleinman policies had value in addition to surrender 

value because ‘‘accumulated cash value can be used to pay 

costs relating to maintaining the policies in force, can be borrowed against, or can be obtained in exchange for surrendering the policy, as the policy owner may choose.’’ But the 

evidence does not convince us that such options were availVerDate 0ct 09 2002 11:25 May 30, 2013 Jkt 372897 PO 20009 Frm 00015 Fmt 2847 Sfmt 2847 V:\FILES\SCHWAB.136 SHEILA
(120) SCHWAB v. COMMISSIONER 135

17 If the parties find the underlying information inadequate feed for our number crunching, 

they may move to reopen the record when they submit computations under Rule 155. 

18 Angels & Cowboys apparently distributed the policies to Schwab and Kleinman on October 

24, 2003. From the record, we find that Schwab made a premium payment in 2003, but can’t 

determine when in 2003. Because this omission is of Schwab’s own making, for our tentative 

calculations we treat Schwab as paying a premium in the last month of the year, on the date 

a premium would have been due—December 17, 2003—and treat the coverage attributable to 

the Angels & Cowboys premium as running through the day prior. Cf. Barnes v. Commissioner, 

T.C. Memo. 1992–275 n.6 (estimating an officer’s annual pay in light of insufficient records). 

19The premiums covered Kleinman through November 16, 2003. 

20The base rate is for each $1,000 of insurance, and under each policy tracks the ‘‘attained 

age’’ of the insured. 

21During the relevant period, both Schwab and Kleinman had $2,400,000 in coverage. Because the base rate is based on $1,000 of insurance, we multiply the base rate by 2,400 to get 

the monthly benefit, then by 12 to get the yearly, and finally by a fraction representing the days 

during 2003 the coverage benefited the insured. Thus for Schwab: .446 * 2,400 * 12 * (54/365). 

able to Schwab and Kleinman under the policies so long as 

the policies had negative net cash-surrender value, as they 

did on the date of distribution. Cf. Matthies, 134 T.C. at 152 

(holding that the insurer’s acceptance of the stated account 

value of a life insurance policy as payment in full of a single 

premium due on a replacement policy supported the conclusion that the entire cash value of the exchanged policy 

should be determined without regard to surrender charges). 

On this record we are not persuaded that at the time of 

distribution to Schwab and Kleinman the policies had significant value apart from 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. Though the value is small, the calculation is 

daunting because of ambiguity in the record, and we make 

only a tentative effort to ascertain exact figures. 17 After distribution, the premiums covered Schwab for up to 54 days 18

and Kleinman for 24 days 19—in Schwab’s case, until he paid 

a premium to keep the policy going, and in Kleinman’s, until 

her policy lapsed. By applying the base rates for the guaranteed maximum monthly cost of insurance rates ($.446 for 

Schwab, $.4043 for Kleinman) 20 to the days covered, we 

attribute the following amounts: to Schwab, $1,900.33; to 

Kleinman, $765.62—a total of $2,665.95. 21 Section 72 generally treats as taxable the amount distributed less any 

amount allocable to a taxpayer’s investment in the contract—

and for Schwab and Kleinman, whose corporation had paid 

the premiums without including them in their income, the 

amounts invested in their contracts were zero. We therefore 

conclude that $2,665.95 is the ‘‘amount actually distributed’’ 

136 136 UNITED STATES TAX COURT REPORTS (120) 

22 Based on the Commissioner’s assertions, 10 percent of the amount required of Schwab and 

Kleinman to have shown on the return is only $3,158. Section 6662 requires that we take the 

greater of the two numbers. 

under section 402(b) and therefore included in taxable 

income under section 72. 

II. Penalties

The Commissioner wants us to impose section 6662(a)’s 20-

percent penalty on Schwab and Kleinman’s understatement 

of tax, either because it’s a substantial underpayment—in 

this case, more than $5,000 22—or because it arose from their 

negligence or disregard of rules or regulations. See sec. 

6662(b)(1) and (2). 

But the Commissioner miscalculated. Our tentative calculations is that the understatement of income is less than 

$5,000. It’s clear that although the parties still must make 

Rule 155 computations, the understatement of tax will not 

exceed $5,000. 

We also believe that Schwab and Kleinman made a reasonable attempt to comply with the provisions of the Code, and 

that they were not careless, reckless, or in intentional disregard of rules or regulations. See sec. 6662(c). Section 

1.402(b)–1(c), Income Tax Regs., did not mandate that 

Schwab and Kleinman relinquish consideration of surrender 

charges in determining tax. And while they did not account 

for the lingering benefit of Angels & Cowboys’s premium payment, its effect on their income was minimal. We will not 

sustain the Commissioner’s determination of the penalty. 

Decision will be entered under Rule 155

f .