Court Opinion

ID: 4338497
Source: CourtListenerOpinion
Date Created: 2018-11-14 03:55:35.441549+00
Date Added: 2024-06-11T07:49:37.934676
License: Public Domain

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 poli-
                                                 cies 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 employee-
                                      benefit plan and distributes its assets, section 402(b) 1 says
                                           1 Unless   otherwise noted, all section references are to the Internal Revenue Code for the year

                                      120

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                                      (120)                         SCHWAB v. COMMISSIONER                                           121

                                      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 poli-
                                      cies 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 pre-
                                      pared 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 adminis-
                                      at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
                                        2 Schwab occasionally does design work for the Sundance Institute and is a native Oklahoman.

                                      We therefore infer that Kleinman is the Angel.

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                                      122                136 UNITED STATES TAX COURT REPORTS                                         (120)

                                      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 partici-
                                      pants and their value net of surrender charges would be tax-
                                      able.
                                         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 consulta-
                                      tion 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

                                         3 Sections 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 lim-
                                      its 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.

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                                      (120)                         SCHWAB v. COMMISSIONER                                           123

                                      trust arrangements promoted as multiple-employer welfare-
                                      benefit 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 Commis-
                                      sioner successfully challenged a plan’s reliance on section
                                      419A(f)(6) by showing that it was really a series of single-
                                      employer plans rather than a true multiple-employer plan. In
                                      spite of Notice 95–34 and the Commissioner’s litigation suc-
                                      cess, 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 trans-
                                      actions have to register them with the IRS. But many tax-
                                      payers took the position that their particular plans weren’t
                                      described in Notice 95–34 and so were not ‘‘listed trans-
                                      actions.’’ 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 substan-
                                      tially 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 impor-
                                      tant 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 indebted-
                                      ness.’’ Schwab and Kleinman had two options upon distribu-
                                      tion—continue paying premiums to keep their life-insurance
                                        4 This Notice has been supplemented and superseded several times since. For the most recent

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

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                                      124                136 UNITED STATES TAX COURT REPORTS                                         (120)

                                      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-insur-
                                      ance 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-insur-
                                      ance 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 pay-
                                      outs upon death, though there is (as was true under the con-
                                      tracts 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 poli-
                                      cies 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.

                                         5 The 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.
                                         6 The 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 insur-
                                      ance contracts themselves. We nevertheless find the definitions in the presentation materials
                                      more likely than not to apply to the same terms in the contracts.

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                                      (120)                          SCHWAB v. COMMISSIONER                                           125

                                        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’’ pre-
                                      miums 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 pay-
                                      ments be segregated into accounts whose value fluctuated
                                      with the S&P 500 stock index. The death benefit and cash-
                                      surrender 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 imme-
                                      diately 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 pre-
                                      miums were paid, the policy values would increase as well.
                                               that at the end of three years, N = 36 and $3,548.77 × 36 = $127,755.72.
                                           7 Note
                                           8 The
                                              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.
                                        9 We 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).

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                                      Schwab’s policy seemed more worthwhile—it could poten-
                                      tially 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 con-
                                      sequences 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,
                                        10 BYSIS advised Schwab and Kleinman that this amount was necessary to maintain the pol-

                                      icy, 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.

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                                      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 favor-
                                      able 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 dif-
                                      ferently 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 distrib-
                                      uted’’ 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 insur-
                                      ance policy. 12 See S. Rep. No. 72–665, sec. 165 (1932),
                                         11 The words did not appear in the 1928 statute, but Congress added them back in 1932. Rev-

                                      enue Act of 1932, ch. 209, sec. 165, 47 Stat. 169, 221.
                                         12 While 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 contribu-
                                      tions 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 em-
                                                                                                    Continued

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                                      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 con-
                                      clude, therefore, that they received something that had ‘‘no
                                      economic, monetary or cash surrender value.’’
                                        The Commissioner’s argument is not nearly as straight-
                                      forward. He begins with the incontestably true observation
                                      that there is no regulation or caselaw directly on point. He
                                      then argues that:
                                      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. Commis-
                                      sioner, 32 B.T.A. 670, 674 (1935) (‘‘Congress was concerned with an alleviation of what it re-
                                      garded 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 re-
                                      lieve the taxpayer of ‘‘all possibility of tax upon appreciation in the value of trust securities be-
                                      fore 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 hard-
                                      ship’’ 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 men-
                                      tion 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.’’

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                                         • 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 invest-
                                      ment 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 distrib-
                                      uted, 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 con-
                                      tract’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., pro-
                                      vides 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 restric-
                                      tion, an argument he recently won in Cadwell v. Commis-
                                      sioner, 136 T.C. 38 (2011). In Cadwell, we disregarded sur-

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                                      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 dis-
                                      tributions here. And looking to the regulation the Commis-
                                      sioner 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 restric-
                                      tion, 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 sub-
                                      ject 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 distrib-
                                      uted—they were not still held in trust. The relevant regula-
                                      tion 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 con-
                                      tract ‘‘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 life-
                                      insurance contract from a qualified plan should be treated

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                                      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 pre-
                                      2005 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 sec-
                                      tion 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 tex-
                                      tual 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 distribu-
                                      tion’’ 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

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                                      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-sur-
                                      render value * * * [Guggenheim v. Rasquin, 312 U.S. 254, 257 (1941);
                                      citations omitted.]

                                      In Guggenheim, the Court held that the time between pur-
                                      chase 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 Schwab-
                                      Kleinman 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
                                           13 We   recognize that the life-insurance-policy distribution at issue wasn’t a gift subject to the

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                                      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 invest-
                                      ment 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 dis-
                                      tribution, meaning that in eight years the surrender charges
                                      gift-tax regulations.
                                        14 The 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 ter-
                                      minal reserve ‘‘ ‘is not cash surrender value; it is the reserve which the insurance company en-
                                      ters on its books against its liability on the contracts. * * * The word ‘‘interpolated’’ simply indi-
                                      cates 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)).
                                        15 The 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 val-
                                      ues. Consequently, we do not consider this issue further. Cf. sec. 25.2512–6(a), Gift Tax Regs.
                                        16 See 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 share-
                                      holder may realize and that the fund—the only buyer—will pay’’); sec. 25.2512–6(b), Gift Tax
                                      Regs.

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                                      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 poli-
                                      cies—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 distrib-
                                      uted 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-pre-
                                      mium policies like these generally ‘‘will not lapse if pre-
                                      miums 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 sur-
                                      render charges should never count, or Schwab and
                                      Kleinman’s that such charges should always count, in deter-
                                      mining a policy’s value. The particular facts of this case fea-
                                      ture 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 bor-
                                      rowed against, or can be obtained in exchange for surren-
                                      dering the policy, as the policy owner may choose.’’ But the
                                      evidence does not convince us that such options were avail-

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                                      (120)                         SCHWAB v. COMMISSIONER                                           135

                                      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 conclu-
                                      sion 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 signifi-
                                      cant value apart from the small amount of the insurance cov-
                                      erage 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 dis-
                                      tribution, 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 guaran-
                                      teed 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 gen-
                                      erally 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’’
                                        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).
                                        19 The premiums covered Kleinman through November 16, 2003.
                                        20 The base rate is for each $1,000 of insurance, and under each policy tracks the ‘‘attained

                                      age’’ of the insured.
                                        21 During the relevant period, both Schwab and Kleinman had $2,400,000 in coverage. Be-

                                      cause 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).

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                                      136                136 UNITED STATES TAX COURT REPORTS                                         (120)

                                      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 cal-
                                      culations 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 reason-
                                      able attempt to comply with the provisions of the Code, and
                                      that they were not careless, reckless, or in intentional dis-
                                      regard 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 pay-
                                      ment, 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

                                        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.

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