Filed: Feb. 22, 2010
Latest Update: Mar. 03, 2020
Summary: KARL L. MATTHIES AND DEBORAH MATTHIES, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT Docket No. 22196–07. Filed February 22, 2010. A profit-sharing plan of Ps’ wholly owned S corporation bought a life insurance policy on Ps’ lives with funds rolled over from H’s IRA. The profit-sharing plan later sold the policy to H for $315,023, which slightly exceeded the policy’s cash surrender value, net of a $1,062,461 surrender charge. For income tax purposes, Ps valued the policy at its net
Summary: KARL L. MATTHIES AND DEBORAH MATTHIES, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT Docket No. 22196–07. Filed February 22, 2010. A profit-sharing plan of Ps’ wholly owned S corporation bought a life insurance policy on Ps’ lives with funds rolled over from H’s IRA. The profit-sharing plan later sold the policy to H for $315,023, which slightly exceeded the policy’s cash surrender value, net of a $1,062,461 surrender charge. For income tax purposes, Ps valued the policy at its net ..
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KARL L. MATTHIES AND DEBORAH MATTHIES, PETITIONERS v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Docket No. 22196–07. Filed February 22, 2010.
A profit-sharing plan of Ps’ wholly owned S corporation
bought a life insurance policy on Ps’ lives with funds rolled
over from H’s IRA. The profit-sharing plan later sold the
policy to H for $315,023, which slightly exceeded the policy’s
cash surrender value, net of a $1,062,461 surrender charge.
For income tax purposes, Ps valued the policy at its net cash
surrender value and reported no gain on the transaction. R
determined that the policy should be valued without any
reduction for surrender charges and that the bargain sale of
the insurance policy gave rise to taxable income to Ps. Held:
Pursuant to sec. 1.402(a)–1(a)(2), Income Tax Regs., as in
effect before amendment in 2005, the value of the insurance
policy is determined by reference to its ‘‘entire cash value’’,
which allows no reduction for surrender charges. Held, fur-
ther, the bargain element of the sale of the insurance policy
represented taxable income to H pursuant to sec. 61, I.R.C.
Held, further, because they had a reasonable basis for their
return position, Ps are not liable for the accuracy-related pen-
alty for negligence under sec. 6662(a), I.R.C.
Richard A. Sirus, for petitioners.
Naseem J. Khan and David S. Weiner, for respondent.
141
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142 134 UNITED STATES TAX COURT REPORTS (141)
THORNTON, Judge: For each of petitioners’ taxable years
2000 and 2001, respondent determined a $294,925 deficiency
and a $58,985 accuracy-related penalty for negligence under
section 6662(a). 1 After concessions, the issues for decision
are: (1) Whether in 2000 petitioners realized $1,053,304 of
taxable income from a bargain sale to Karl L. Matthies (peti-
tioner) of a life insurance policy by a profit-sharing plan cre-
ated for petitioners’ wholly owned S corporation; and (2)
whether for 2000 petitioners are liable for the section 6662(a)
accuracy-related penalty for negligence.
FINDINGS OF FACT
When they filed their petition, petitioners resided in Cali-
fornia. At all relevant times, petitioner was a stock analyst.
In 1998 petitioners employed an attorney of their long
acquaintance, Philip Spalding, Sr., to help plan their estate.
Philip Spalding, Sr., introduced petitioner to his son, Philip
Spalding, Jr., who was an insurance agent. The Spaldings
proposed, among other things, that petitioner use some of his
IRA funds to buy life insurance through a profit-sharing plan
pursuant to a so-called Pension Asset Transfer (PAT) plan
marketed by GSL Advisory Service (GSL) and Hartford Life
Insurance Co. (Hartford Life).
Pension Asset Transfer Plan
In 1997 Edwin Lichtig and Larry Weiss, the principals of
GSL, had published an article in a pension plan guide, which
described the PAT plan as a strategy to ‘‘transfer qualified
pension assets or IRA dollars to the participant or the partici-
pant’s family without significant taxation.’’ The article sug-
gested moving IRA funds to a profit-sharing plan to buy life
insurance. The article and other GSL promotional materials
that were provided to the Spaldings recommended these
steps to implement the PAT plan: Creating a profit-sharing
plan using GSL’s nonstandardized prototype plan; getting a
positive Internal Revenue Service (IRS) determination letter;
purchasing a life insurance policy inside the profit-sharing
plan; paying the premiums through the profit-sharing plan;
1 Unless otherwise noted, all section references are to the Internal Revenue Code (Code) in
effect for the year at issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure.
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(141) MATTHIES v. COMMISSIONER 143
transferring the policy from the plan to the client; paying tax
on the policy value when it is transferred; and giving the
policy to the client’s heirs or to a trust.
Bellagio Partners and Profit-Sharing Plan
Petitioners, assisted by GSL, Philip Spalding, Sr., and
Philip Spalding, Jr., implemented a plan following essentially
the steps just described. On October 22, 1998, they incor-
porated Bellagio Partners, Inc., an S corporation. At all rel-
evant times petitioners were 100-percent owners of Bellagio
Partners, Inc.
On October 27, 1998, pursuant to the provisions of GSL’s
prototype plan, petitioners created for Bellagio Partners, Inc.,
a profit-sharing plan (the profit-sharing plan). Petitioners
were the sole trustees and committee members of the profit-
sharing plan. On October 26, 1999, the profit-sharing plan
received a favorable determination letter from the IRS.
The Life Insurance Policy
In January 1999 the profit-sharing plan purchased through
Philip Spalding, Jr., a Hartford Life last survivor interest-
sensitive life insurance policy (the insurance policy). The face
amount of the insurance policy was $80,224,252.
In 1999 and 2000 petitioner made two transfers of
$1,250,000 from his IRA to the profit-sharing plan; in 2001 he
made a $25,500 cash contribution. On February 4, 1999, and
again on February 4, 2000, the profit-sharing plan paid a
$1,250,003.63 premium on the insurance policy, for total pre-
miums paid of $2,500,007.26.
Effective December 29, 2000, the profit-sharing plan trans-
ferred ownership of the insurance policy to petitioner. On the
same date, petitioner transferred $315,023 to the profit-
sharing plan. At the time of the transfer, the ‘‘account value’’
of the insurance policy, as defined therein, was
$1,368,327.33. 2 The ‘‘cash value’’ of the insurance policy, as
defined therein, was $305,866.74. The insurance policy
defined the ‘‘cash value’’ to be the account value minus any
2 The insurance policy defined the ‘‘account value’’ on any policy anniversary as the account
value on the previous policy anniversary (with an initial account value of zero); plus the net
annual premium for the last policy year; minus the deduction amount for the last policy year;
plus interest credited since the last policy anniversary. According to the insurance policy, the
‘‘deduction amount’’ includes the cost of insurance and the expense charge.
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144 134 UNITED STATES TAX COURT REPORTS (141)
applicable surrender charge. The surrender charge, as stated
in the insurance policy, was $1,062,460.59 during the first 3
policy years. After the third policy year, the surrender charge
declined each year at an increasing rate until being phased
out entirely in the 20th policy year.
The Replacement Policy
On January 11, 2001, petitioner transferred ownership of
the insurance policy to his family irrevocable trust (the
trust), of which Bruce G. Potter was trustee. On January 12,
2001, the trust exchanged the insurance policy for a Hartford
Life variable last survivor policy (the replacement policy)
with a face amount of $19,476,516. Hartford Life waived sur-
render charges on the exchange, and the replacement policy
provided for no surrender charges. Petitioners paid no
commissions on the transferred account value. Hartford Life
accepted the $1,368,327.33 account value of the insurance
policy as payment in full of the $1,368,327.33 single premium
due on the replacement policy. Thereafter, no additional pre-
miums were paid on the replacement policy.
Petitioners’ Income Tax Returns
On their joint Federal income tax returns, petitioners
reported no income from the transfer of the insurance policy
from the profit-sharing plan to petitioner. In the notice of
deficiency respondent determined that for 2000 petitioners
had $1,053,304 of gross income from the transfer of the
insurance policy and were liable for a $58,985 accuracy-
related penalty for negligence pursuant to section 6662(a). 3
OPINION
On December 29, 2000, the profit-sharing plan transferred
the insurance policy to petitioner, and he transferred
$315,023 to the profit-sharing plan. The parties disagree as
to whether this transaction resulted in taxable income to
petitioners. The nub of their disagreement is the proper valu-
3 In the notice of deficiency respondent made identical determinations with respect to peti-
tioners’ 2000 and 2001 taxable years. On brief respondent explains that this was because ini-
tially he did not know whether the life insurance contract had been transferred to petitioner
in 2000 or 2001. The parties have stipulated that the transfer of the life insurance policy oc-
curred Dec. 29, 2000. Respondent concedes that there is no deficiency or penalty due from peti-
tioners for taxable year 2001.
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(141) MATTHIES v. COMMISSIONER 145
ation of the insurance policy as of the date it was transferred
to petitioner.
A. The Parties’ Contentions
Respondent asserts that on the date the profit-sharing plan
transferred the insurance policy to petitioner, it was worth
$1,368,327.33, which respondent asserts represents the pol-
icy’s fair market value. Respondent further asserts that the
$1,053,304 (rounded) bargain element of the sale
($1,368,327.33 fair market value minus $315,023 of consider-
ation paid) represents taxable income to petitioner.
Petitioners counter that there was no bargain sale because
the $315,023 that petitioner paid to the profit-sharing plan
for the insurance policy exceeded its $305,866.74 net cash
value and interpolated terminal reserve value as reported by
Hartford Life for the date of the transfer. Under petitioners’
view, because there was no bargain sale, the transfer of the
insurance policy to petitioner resulted in no taxable income
to him.
The $1,062,460.59 difference between the parties’ respec-
tive valuation figures exactly equals the surrender charge
stated in the insurance policy. In essence, then, the parties
disagree as to whether in valuing the insurance policy,
reduction should be made for the surrender charge.
B. Burden of Proof
As a general matter, the Commissioner’s determination is
presumptively correct, and the taxpayers bear the burden of
proving that they did not receive additional income as deter-
mined by the Commissioner. Rule 142(a); Welch v. Helvering,
290 U.S. 111, 115 (1933). In certain circumstances, the bur-
den of proof with respect to any factual issue may be shifted
to the Commissioner. Sec. 7491(a). The parties disagree as to
whether petitioners have met the requirements to shift the
burden of proof to respondent. Because we do not decide this
case by reference to the placement of the burden of proof, we
need not and do not decide whether petitioners have met the
requirements under section 7491(a) to shift the burden of
proof to respondent.
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146 134 UNITED STATES TAX COURT REPORTS (141)
C. Taxation of Property Distributions Under Section 402(a)
Section 402(a) provides:
Except as otherwise provided in this section, any amount actually distrib-
uted to any distributee by an employees’ trust described in section 401(a)
which is exempt from tax under section 501(a) shall be taxable to the dis-
tributee, in the taxable year of the distributee in which distributed, under
section 72 (relating to annuities).
The regulations under section 402(a) provide generally that
‘‘distribution of property * * * shall be taken into account by
the distributee at its fair market value.’’ Sec. 1.402(a)–
1(a)(1)(iii), Income Tax Regs. The section 402(a) regulations
as in existence before amendment in 2005 (hereinafter, the
applicable regulations) provide special rules that apply when
a tax-exempt employees’ trust described in section 401(a)
(such as the profit-sharing plan) purchases for and distrib-
utes to an employee an annuity contract that contains a
‘‘cash surrender value’’ which may be available to the
employee by surrendering the contract. Sec. 1.402(a)–1(a)(2),
Income Tax Regs. In such circumstances, the ‘‘cash surrender
value’’ will not be considered income until the contract is
surrendered. Id. These special rules also provide that if the
distributed contract is a life insurance contract and the dis-
tribution occurs after 1962, then (subject to an exception not
relevant to this discussion) the ‘‘entire cash value’’ of the con-
tract is includable in the distributee’s gross income. Id. The
applicable regulations do not define the terms ‘‘fair market
value’’, ‘‘cash surrender value’’, or ‘‘entire cash value’’. Nor do
these regulations expressly address the tax treatment of a
bargain sale from a qualified plan to a plan participant.
On February 13, 2004, the IRS sought to clarify these mat-
ters when it proposed amendments to the section 402(a)
regulations. See Notice of Proposed Rulemaking and Notice
of Public Hearing, 69 Fed. Reg. 7385 (Feb. 17, 2004), which
states: ‘‘The current regulations do not define ‘fair market
value’ or ‘entire cash value’ and questions have arisen
regarding the interaction between these two provisions and
whether ‘entire cash value’ includes a reduction for surrender
charges.’’ This notice explains that the proposed amendments
were intended to clarify that ‘‘the requirement that a dis-
tribution of property must be included in the distributee’s
income at fair market value is controlling in those situations
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(141) MATTHIES v. COMMISSIONER 147
where the existing regulations provide for the inclusion of
the entire cash value.’’ Id. The proposed regulations also pro-
vided that if a qualified plan transfers property to a plan
participant for consideration that is less than the property’s
fair market value, the transfer will be treated as a distribu-
tion by the plan to the participant to the extent the prop-
erty’s fair market value exceeds the amount received in
exchange. Id. at 7386. Consequently, under the proposed
regulations, any ‘‘bargain element’’ in the sale is treated as
a distribution under section 402(a). Id.
The amended regulations, as made final on August 29,
2005, are effective as of that date. T.D. 9223, 2005–2 C.B.
591. The amended regulations also provide that if a qualified
plan transfers a life insurance contract (among various other
types of property) to a plan participant or beneficiary before
August 29, 2005, the excess of the fair market value of the
contract over the value of the consideration received by the
trust is includable in the participant’s or beneficiary’s gross
income under section 61, but the transfer ‘‘is not treated as
a distribution for purposes of applying the requirements of
subchapter D of chapter 1 of subtitle A of the Internal Rev-
enue Code’’, which contains sections 401 through 424. Sec.
1.402(a)–1(a)(1)(iii), Income Tax Regs.
D. Applicability of the Amended Regulations
In his opening brief respondent states that the new rules
in the amended section 402(a) regulations ‘‘do not apply in
this case’’. On supplemental brief (in response to the Court’s
inquiry) respondent clarifies his position by stating that the
amended regulations apply in this case to the extent that
they ‘‘clarify’’ the law as it applied during taxable year 2000
with respect to transfers of property occurring before August
29, 2005. 4
4 On supplemental brief respondent states that the amended sec. 402(a) regulations are inap-
plicable to this case to the extent that they changed the law effective as of Aug. 29, 2005. Re-
spondent states:
Respondent notes that whether the transfer was or was not a distribution for purposes of the
requirements of Subchapter D is not at issue in this case. Because Treas. Reg. § 1.402(a)–
1(a)(1)(iii) as amended provides that the excess of the fair market value of the property trans-
ferred by the trust over the value of the consideration received by the trust is includible in the
gross income of the participant or beneficiary under section 61, the fact that the transfer did
not represent a distribution for purposes of the requirements under Subchapter D is irrelevant
to the resolution of this case.
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148 134 UNITED STATES TAX COURT REPORTS (141)
Without expressly challenging the validity of the amended
regulations, on supplemental brief petitioners suggest that
the amended regulations as applicable to pre-August 29,
2005, transfers should not be construed to effect a retroactive
change in the law. Petitioners contend that ‘‘for purposes of
the sale of the policy and the determination of any income
related thereto, the policy valuation must be determined on
the basis of statutory and regulatory guidance and case
precedent in existence at the time of such sale and IRC § 402
is not the sole determinative provision for such determina-
tion.’’
Insofar as the parties have any disagreement about the
applicability of the amended section 402(a) regulations, then,
it would appear to be a fairly nuanced disagreement as to
whether the amended regulations correctly ‘‘clarified’’ the law
in existence at the time of the transfer in question, in par-
ticular as pertains to: (1) The taxation under section 61 of a
bargain sale of a life insurance policy from a qualified plan
to a plan beneficiary; and (2) the proper standard for valuing
the life insurance policy. We address each of these issues in
turn.
E. Bargain Sale of the Life Insurance Policy
Section 61(a) provides that gross income includes ‘‘all
income from whatever source derived’’. It is well established
that income may result from a bargain sale when the parties
have a special relationship such as stockholders or
employees. For instance, in Commissioner v. LoBue, 351 U.S.
243, 248 (1956), the Supreme Court observed that although
‘‘our taxing system has ordinarily treated an arm’s length
purchase of property even at a bargain price as giving rise
to no taxable gain in the year of purchase * * * that is not
to say that when a transfer which is in reality compensation
is given the form of a purchase the Government cannot tax
the gain’’. In LoBue, the Supreme Court held that a taxpayer
realized taxable gain when he exercised an option to pur-
chase stock from his employer at less than fair market value
pursuant to an arrangement that ‘‘was not an arm’s length
transaction between strangers. Instead it was an arrange-
ment by which an employer transferred valuable property to
his employees in recognition of their services.’’ Id.; see also
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(141) MATTHIES v. COMMISSIONER 149
Commissioner v. Smith, 324 U.S. 177 (1945) (holding that the
bargain element of an employer’s bargain sale of stock to an
employee represented taxable income to the employee);
Lowndes v. United States, 384 F.2d 635 (4th Cir. 1967); Haag
v. Commissioner, 40 T.C. 488 (1963), affd.
334 F.2d 351 (8th
Cir. 1964); Waldheim v. Commissioner, 25 T.C. 839, 850–851
(1956), affd. 244 F.2d 1 (7th Cir. 1957); Strake Trust v.
Commissioner, 1 T.C. 1131 (1943).
The transfer from the profit-sharing plan to petitioner was
pursuant to a prearranged plan for him to use IRA funds to
buy life insurance through the profit-sharing plan, which was
established for this purpose and with the expectation that it
would shortly thereafter distribute the policy to petitioner.
Insofar as the record reveals, the transaction was in no sense
arm’s length. There is no suggestion of any negotiations
between the profit-sharing plan (whose sole trustees were
petitioners) and petitioner as to the amount of the consider-
ation he paid for the insurance policy. Rather, the price
appears to have been set by petitioners’ advisers in further-
ance of the so-called PAT plan with the objective of mini-
mizing petitioners’ taxes on the transfer of the insurance
policy to petitioner.
We conclude that insofar as petitioner purchased the life
insurance policy from the profit-sharing plan at a bargain
price, the bargain element is includable in his gross income
pursuant to section 61. 5 The amount, if any, of the bargain
element depends upon the value properly assigned to the
insurance policy. We turn to that issue.
F. Valuation of the Life Insurance Policy
Respondent suggests that the amended section 402(a) regu-
lations, as applicable to pre-August 29, 2005, transfers,
reflect the ‘‘fair market value’’ standard as contained in the
applicable regulations before amendment in 2005. See sec.
1.402(a)–1(a)(1)(iii), Income Tax Regs. Citing cases involving
valuation of insurance policies for purposes of applying the
gift tax, see Guggenheim v. Rasquin, 312 U.S. 254 (1941), or
5 We find it unnecessary to decide whether any bargain element might also be characterized
as an ‘‘amount actually distributed’’ within the meaning of sec. 402(a) and thus taxable to the
distributee under sec. 72. Treating the bargain element as a distribution under sec. 402(a) might
well entail collateral consequences; for instance, it might affect qualification of the trust under
sec. 401(a). It would appear that the amended sec. 402(a) regulations were designed to provide
dispensation from such collateral consequences, at least for pre-Aug. 29, 2005, transfers.
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150 134 UNITED STATES TAX COURT REPORTS (141)
for purposes of determining taxable gain on the exchange of
property, see Parsons v. Commissioner, 16 T.C. 256, 261
(1951), respondent contends that under general principles
the fair market value of the insurance contract should be
determined by reference to total policy reserves. 6 Respondent
contends that under these principles the fair market value of
the life insurance policy, as of the date of its transfer to peti-
tioner, was $1,368,327.33. We agree with respondent’s bot-
tom line but arrive there by a somewhat different route.
Valuation of the life insurance policy under the applicable
regulations must take into account, we believe, the special
rules thereunder that generally require the ‘‘entire cash
value’’ of a life insurance contract to be included in the
distributee’s gross income. Sec. 1.402(a)–1(a)(2), Income Tax
Regs. The regulations do not define ‘‘entire cash value’’. 7
When originally proposed in 1955, the section 402(a) regula-
tions referred to the ‘‘entire value of such contract’’. Sec.
1.402(a)–1(a)(2), Proposed Income Tax Regs., 20 Fed. Reg.
6460 (Sept. 1, 1955). That term might plausibly be construed
as synonymous with ‘‘fair market value’’. When the proposed
regulations were finalized in 1956, however, the term was
6 Similarly, citing Notice 89–25, Q&A–10, 1989–1 C.B. 662, 665, respondent argues that the
life insurance policy should be valued by reference to total policy reserves. Notice 89–25, Q&A–
10, states that in determining gross income under sec. 402(a) from the distribution of an insur-
ance contract by a qualified plan, individuals ‘‘use the stated cash surrender value’’ but that
this practice is not appropriate where the total policy reserves together with any reserves for
advance premiums, accumulations, etc., ‘‘represent a much more accurate approximation of the
fair market value of the policy than does the policy’s stated cash surrender value.’’ Id. Notice
89–25, Q&A–10, illustrates these principles with an example of a life insurance policy with a
low initial cash surrender value that increases dramatically after a specified period to become
greater than the aggregate premiums. On brief the parties argue at length as to whether the
insurance policy at issue in this case represents the same type of ‘‘springing policy’’ described
in this example. In the light of our holding today, we need not address this issue or otherwise
opine on the potential application of Notice 89–25, Q&A–10, in other circumstances or, more gen-
erally, on the degree of deference that might be owed to Notice 89–25, supra. Cf. Taproot Admin.
Servs., Inc., v. Commissioner, 133 T.C. 202, 209 n.16 (2009) (stating that the various types of
pronouncements issued by the Department of the Treasury and the Internal Revenue Service
warrant ‘‘varying levels of judicial deference’’).
7 ‘‘Cash value’’ is a general concept relevant to whole (permanent) life insurance policies. As
the insured gets older, premiums remain constant but mortality costs increase. The premiums
in the early years are greater than the mortality costs and the excess premium creates a policy
‘‘reserve’’ that covers the shortfall in later years. If the policy owner surrenders the policy, the
insurance company can release the reserve to the policy owner. The policy builds cash value as
a direct result of the reserve. The ‘‘cash value’’ increases every year but grows slowly in the
early years in part because in the early years the insurer recovers the costs of commissions,
underwriting, and other administrative expenses. If the policy owner surrenders the policy, he
or she receives the ‘‘net cash surrender value’’, which is the ‘‘gross cash value’’ minus surrender
charges, adjusted for certain other amounts. See Zaritsky & Leimberg, Tax Planning With Life
Insurance: Analysis With Forms, pars. 1.02(3)(c), 1.03(1) (2d ed. 2009).
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(141) MATTHIES v. COMMISSIONER 151
changed to ‘‘entire cash value’’ of the contract. Sec. 1.402(a)–
1(a)(2), Income Tax Regs., T.D. 6203, 1956–2 C.B. 219, 235.
With this change it appears that the regulations purposefully
departed from a generalized valuation standard (‘‘entire
value of such contract’’) in favor of a more particularized (and
possibly more objective and more easily administered) valu-
ation standard (‘‘entire cash value of such contract’’).
Section 402(a) provides that distributions to which it
applies are taxable under the rules of section 72. See sec.
1.402(a)–1(a)(1)(ii), Income Tax Regs. Section 72(e) prescribes
the tax treatment of any amount received under an annuity,
endowment, or life insurance contract that is not received as
an annuity. As a general rule, any nonannuity amount
received before the annuity starting date is includable in
gross income to the extent allocable to income on the con-
tract. Sec. 72(e)(2)(B). 8 Under this general rule, the amount
allocable to income on the contract is determined by ref-
erence to the ‘‘cash value of the contract (determined without
regard to any surrender charge)’’. Sec. 72(e)(3)(A)(i). Simi-
larly, for purposes of defining life insurance contracts, section
7702(f)(2)(A) defines the ‘‘cash surrender value’’ of a life
insurance contract as the ‘‘cash value determined without
regard to any surrender charge’’. The Code distinguishes
‘‘cash surrender value’’ from ‘‘net surrender value’’, which is
determined ‘‘with regard to surrender charges’’. See sec.
7702(f)(2)(B).
Particularly in the light of the express cross-references
between sections 72 and 402 and the applicable regulations,
we believe that the term ‘‘cash value’’ is properly construed
consistently under these various provisions to refer to cash
value determined without regard to any surrender charge. 9
8 Sec. 72(e)(5) generally supersedes the applicability of sec. 72(e)(2)(B) with respect to life in-
surance contracts and endowment contracts (other than modified endowment contracts). Sec.
72(e)(5)(A), (C), (10). For these contracts, any amount not received as an annuity is generally
included in gross income to the extent it exceeds the investment in the contract. Sec. 72(e)(5)(A)
(flush language). Notwithstanding these provisions of sec. 72(e)(5), however, in the case of non-
annuity amounts received from, among other things, a trust (such as the profit-sharing plan in
this case) that is described in sec. 401(a) and is exempt from tax under sec. 501(a), the general
rule of sec. 72(e)(2)(B) is applicable. Sec. 72(e)(8).
9 In reaching this conclusion, we are mindful that in Guggenheim v. Rasquin, 312 U.S. 254,
256 (1941), the Supreme Court stated that ‘‘Cash-surrender value is the reserve less a surrender
charge.’’ As discussed supra, however, Guggenheim involved valuation of insurance policies for
gift tax purposes and did not entail application of the rules under sec. 72(e) or sec. 402(a). The
relevant provisions of sec. 72(e) were enacted in 1982 as part of the Tax Equity and Fiscal Re-
Continued
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152 134 UNITED STATES TAX COURT REPORTS (141)
Moreover, we do not believe that the appearance of the adjec-
tive ‘‘entire’’ before the words ‘‘cash value’’ in the applicable
regulations can sensibly be read to connote any lesser value
than ‘‘cash value’’ under section 72(e)(3)(A) or ‘‘cash sur-
render value’’ under section 7702(f)(2)(A).
According to Hartford Life, on the date of the transfer from
the profit-sharing plan to petitioner, the cash value of the
insurance policy was $305,866.74 after taking into account a
$1,062,460.59 surrender charge. Accordingly, without reduc-
tion for the surrender charge, the entire cash value of the
insurance policy for purposes of section 402(a) was
$1,368,327.33—the same amount that respondent asserts as
the policy’s fair market value.
A valuation of $1,368,327.33 is strongly supported by the
fact that Hartford Life credited the trust with a
$1,368,327.33 premium payment on the exchange of the
insurance policy on January 12, 2001, 2 weeks after the
profit-sharing plan transferred the insurance policy to peti-
tioner.
The authorities petitioners cite do not compel any different
result. In particular, petitioners rely upon regulations under
section 83, which provide that ‘‘In the case of a transfer of
a life insurance contract * * * only the cash surrender value
of the contract is considered to be property’’ for purposes of
section 83. Sec. 1.83–3(e), Income Tax Regs. Section 83 and
the regulations thereunder are by their terms inapplicable to
the transaction in question. 10 But even by analogy, these
regulations are not helpful to petitioners since, as just dis-
cussed, section 7702(f)(2)(A) defines cash surrender value as
allowing no reduction for surrender charges. 11
sponsibility Act of 1982, Pub. L. 97–248, sec. 265, 96 Stat. 544. These amendments were in-
tended to discourage the use of deferred annuity contracts for short-term investment and income
tax deferral. See Staff of Joint Comm. on Taxation, General Explanation of the Revenue Provi-
sions of the Tax Equity and Fiscal Responsibility Act of 1982, at 361 (J. Comm. Print 1982).
Sec. 7702 was enacted in 1984 as part of the Deficit Reduction Act of 1984, Pub. L. 98–369,
sec. 221(a), 98 Stat. 767. Although these statutory amendments postdate the promulgation of
the applicable regulations in 1956, for the reasons discussed supra we believe that the cross-
reference to sec. 72 in sec. 402(a), in particular, counsels that the applicable regulations be con-
strued in a manner that is consonant with these subsequent statutory provisions.
10 Sec. 83 governs transfers of property in connection with the performance of services. Sec.
83 does not apply to transfers to or from a trust described in sec. 401(a), such as the profit-
sharing plan. Sec. 83(e)(2).
11 For similar reasons, petitioners’ reliance upon Prohibited Transaction Exemption 77–8 (PTE
77–8), 1977–2 C.B. 425, is misplaced. PTE 77–8 granted an exemption from the prohibited
transaction rules under tit. I of the Employee Retirement Income Security Act of 1974 and sec.
4975 for, among other transactions, the sale of a life insurance policy by a plan to a plan partici-
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(141) MATTHIES v. COMMISSIONER 153
Relying on Rev. Rul. 59–195, 1959–1 C.B. 18, petitioners
argue that the interpolated terminal reserve value is the
proper method of valuing the insurance policy. This revenue
ruling concluded that when an employer purchases and pays
premiums on an insurance policy on the life of an employee
and later sells the policy to the employee when further pre-
miums must be paid, the value of the policy for purposes of
computing taxable gain to the employee is the ‘‘interpolated
terminal reserve value’’ as of the date of sale. Id. We are not
convinced that Rev. Rul. 59–195, supra, displaces the provi-
sions of the applicable regulations that look to the ‘‘entire
cash value’’ of the insurance contract. In any event, the evi-
dence does not persuade us that the interpolated terminal
reserve value of the insurance policy was in fact only
$305,866.74, as petitioners assert. 12
In sum, we conclude and hold that petitioner paid the
profit-sharing plan $1,053,304 less for the life insurance
policy than its $1,368,327.33 value as of the date of the
transfer and that this bargain element is includable in peti-
tioners’ gross income pursuant to section 61.
pant in certain situations. If the conditions of the exemption are met, the exemption allows the
plan participant to purchase the insurance policy from the profit-sharing plan at its cash sur-
render value. One condition is that ‘‘the contract would, but for the sale, be surrendered by the
plan’’. 1977–2 C.B. at 428. The record does not show that this condition was met. More fun-
damentally, as just discussed, cash surrender value, as defined under sec. 7702(f)(2), does not
include any reduction for surrender charges. Moreover, PTE 77–8 specifically states that ‘‘for
Federal income tax purposes, a purchase of an insurance policy at its cash surrender value may
be a purchase of property for less than its fair market value. The Federal income tax con-
sequences of such a bargain purchase must be determined in accordance with generally applica-
ble Federal income tax rules.’’ 1977–2 C.B. at 427.
12 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 ‘in-
terpolated’ simply indicates adjustment of the reserve to the specific date in question.’’ Commis-
sioner v. Edwards, 135 F.2d 574, 576 (7th Cir. 1943) (valuing a gift of annuity contracts under
a regulation that allowed the interpolated terminal reserve value to be used as an approxima-
tion), affg. 46 B.T.A. 815 (1942). Attempting to establish the interpolated terminal reserve value
of the insurance policy, petitioners rely on a one-page document from Hartford Life dated Dec.
21, 2000, captioned ‘‘INTERPOLATED TERMINAL RESERVE AS OF DECEMBER 15, 2000,
DATE OF QUOTE CALCULATION DECEMBER 21, 2000’’. Without ever again using the term
‘‘interpolated terminal reserve’’, this document indicates: (1) That the prior yearend reserve was
zero; (2) that the yearend reserve as of Jan. 12, 2001, was $305,866.76; and (3) that the ‘‘Annual
Reserve Increase’’ was $305,866.76. Petitioners’ own brief indicates that at the end of policy year
2, Hartford Life’s reserves in the insurance policy were $1,035,030. Petitioners have offered no
explanation why the interpolated terminal reserve value was purportedly only $305,866.74 in
the light of their representation that Hartford Life maintained a reserve of $1,035,030.
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154 134 UNITED STATES TAX COURT REPORTS (141)
G. Accuracy-Related Penalty for Negligence
Section 6662(a) and (b)(1) imposes a 20-percent penalty on
any portion of an underpayment that is attributable to neg-
ligence or disregard of rules or regulations. The term ‘‘neg-
ligence’’ includes any failure to make a reasonable attempt to
comply with the provisions of the Code; the term ‘‘disregard’’
includes any careless, reckless, or intentional disregard. Sec.
6662(c). Negligence is the lack of due care or failure to do
what a reasonable and ordinarily prudent person would do
under the circumstances. Allen v. Commissioner, 92 T.C. 1,
12 (1989), affd. 925 F.2d 348 (9th Cir. 1991); Neely v.
Commissioner, 85 T.C. 934, 947 (1985).
A return that has a ‘‘reasonable basis’’ is not negligent.
Sec. 1.6662–3(b)(1), Income Tax Regs. The ‘‘reasonable basis’’
standard is ‘‘significantly higher than not frivolous or not
patently improper.’’ Sec. 1.6662–3(b)(3), Income Tax Regs.
This standard is satisfied if the return position is reasonably
based on various types of enumerated authorities, including
statutory provisions, regulations, revenue rulings, and
notices published by the IRS, taking into account the rel-
evance and persuasiveness of the authorities and subsequent
developments. Secs. 1.6662–3(b)(3), 1.6662–4(d)(3)(iii),
Income Tax Regs. The ‘‘reasonable basis’’ standard is less
stringent than the ‘‘substantial authority’’ standard (which
entails ‘‘an objective standard involving an analysis of the
law and application of the law to relevant facts’’), which in
turn is less stringent than the ‘‘more likely than not
standard’’ (which asks whether there is ‘‘a greater than 50-
percent likelihood of the position being upheld’’). Secs.
1.6662–3(b)(3), 1.6662–4(d)(2), Income Tax Regs. The neg-
ligence penalty may be inappropriate where an issue to be
resolved by the Court is one of first impression involving
unclear statutory language. Bunney v. Commissioner, 114
T.C. 259, 266 (2000); Lemishow v. Commissioner,
110 T.C.
110, 114 (1998); Hitchins v. Commissioner,
103 T.C. 711,
719–720 (1994); see Everson v. United States, 108 F.3d 234,
238 (9th Cir. 1997) (stating that ‘‘When a legal issue is
unsettled, or is reasonably debatable’’ a negligence penalty is
generally not appropriate).
This Court has not previously addressed the tax treatment
of a bargain sale of a life insurance policy under section 61
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(141) MATTHIES v. COMMISSIONER 155
or 402(a) or the application of the ‘‘entire cash value’’
standard under the applicable regulations. In adopting the
2005 final section 402(a) regulations, the IRS stated that it
was responding to the question under the then-existing regu-
lations of whether ‘‘entire cash value’’ includes a reduction
for surrender charges. T.D. 9223, 2005–2 C.B. 591. Further-
more, the amended section 402(a) regulations, which dis-
pense with the ‘‘entire cash value’’ standard, indicate that for
a bargain sale of an insurance contract that occurs before
August 29, 2005, the bargain element is includable in income
under section 61 but is not treated as a ‘‘distribution’’ under
the subchapter of the Code that includes section 402. Sec.
1.402(a)–1(a)(1)(iii), Income Tax Regs. On supplemental brief
respondent has modified his original position as to the
applicability of this amended regulation. Respondent’s shift
in this regard, together with his explanation of his reasons
for promulgating the amended section 402(a) regulations, is
indicative of the uncertainty under the applicable regulations
of the tax consequences of the transaction in question. We
conclude that petitioners had a reasonable basis for their
return position. 13 We hold that petitioners are not liable for
the accuracy-related penalty for negligence.
Other contentions raised by the parties but not addressed
in this Opinion we deem to be moot or without merit. 14
13 Notice 89–25, Q&A–10, states ambiguously that individuals who receive an insurance policy
as a distribution from a qualified plan ‘‘use the stated cash surrender value’’ for purposes of
determining the amount includable in their gross income under sec. 402(a), but that this prac-
tice is not appropriate where the total policy reserves ‘‘represent a much more accurate approxi-
mation of the fair market value’’. We believe that petitioners had a reasonable basis for differen-
tiating the insurance policy in question in this case from the type of ‘‘springing policy’’ discussed
in Notice 89–25, Q&A–10, and consequently for concluding that they could use the ‘‘stated cash
surrender value’’ to value the insurance policy.
14 For the first time, in their reply brief petitioners argue that they are entitled to a waiver
of interest. As a general rule, this Court will not consider issues first asserted on brief. See
Sundstrand Corp. & Subs. v. Commissioner, 96 T.C. 226, 346–349 (1991). When issues are pre-
sented in the reply brief only, there is even stronger reason to disregard them. See Estate of
Sparling v. Commissioner, 60 T.C. 330, 350 (1973), revd. on another issue
552 F.2d 1340 (9th
Cir. 1977). In any event, petitioners have not alleged and the record does not suggest that re-
spondent has made any final determination not to abate interest that this Court would have
jurisdiction to review pursuant to sec. 6404(h).
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156 134 UNITED STATES TAX COURT REPORTS (141)
To reflect the foregoing and concessions by respondent,
An appropriate decision will be entered.
f
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