Schwab v. Commissioner

FOR PUBLICATION

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

MICHAEL P. SCHWAB; KATHRYN J. No. 11-71957

KLEINMAN ,

Petitioners-Appellees, Tax Ct. No.

10525-07

v.

COMMISSIONER OF INTERNAL OPINION

REVENUE ,

Respondent-Appellant.

Appeal from a Decision of the

United States Tax Court

Argued and Submitted

February 15, 2013—San Francisco, California

Filed April 24, 2013

Before: Michael Daly Hawkins and Milan D. Smith, Jr.,

Circuit Judges, and James G. Carr, District Judge.*

Opinion by Judge Milan D. Smith, Jr.

*

The Honorable James G. Carr, Senior District Judge for the U.S.

District Court for the Northern District of Ohio, sitting by designation.

2 SCHWAB V . CIR

SUMMARY**

Tax

The panel affirmed the tax court’s partial grant of a

petition by taxpayers challenging the Commissioner of

Internal Revenue’s determination of a deficiency in their

federal income tax.

Taxpayers each purchased a variable universal life

insurance policy that was subject to surrender charges (fees

that taxpayers would incur if the policies were terminated

prior to a contractually specified date). The distribution of

taxpayers’ policies to them was a taxable event, for which the

Commissioner contended that the full stated policy values

must be treated as income, even though the net cash surrender

values were negative. The panel held that the “amount

actually distributed” when taxpayers received ownership of

the life insurance policies was “the fair market value of what

was actually distributed,” and that surrender charges

associated with a variable universal life insurance policy may

be considered as part of the general inquiry into a policy’s

fair market value.

**

This summary constitutes no part of the opinion of the court. It has

been prepared by court staff for the convenience of the reader.

SCHWAB V . CIR 3

COUNSEL

Teresa E. McLaughlin (argued), Tamara W. Ashford, and

Damon W. Taaffe, Tax Division, Department of Justice, for

Appellant.

Jay R. Weill (argued), Sideman & Bancroft LLP, San

Francisco, California, for Appellee.

OPINION

M. SMITH, Circuit Judge:

The tax court determined that the “amount actually

distributed”1 when a couple received ownership of two life

insurance policies after their employer wound down their

employees’ benefit trust was “the fair market value of what

was actually distributed.” Schwab v. Comm’r., 136 T.C. 120,

131 (2011). It further held that surrender charges associated

with a variable universal life insurance policy may

permissibly be considered as part of the general inquiry into

a policy’s fair market value. Id. at 134. We agree with the

tax court on both determinations, and we affirm.

BACKGROUND

Michael Schwab and Kathryn Kleinman, a married

couple, are employees and the sole shareholders of Angels &

Cowboys, Inc. Schwab works as a graphic designer and

Kleinman is a photographer.

1

Internal Revenue Code § 402(b)(2). The Internal Revenue Code is

referred to hereafter as I.R.C., tax code, or code.

4 SCHWAB V . CIR

On the advice of their accountant, Schwab and Kleinman

each purchased a variable universal life insurance policy

through Angels & Cowboys. The policies were held in a

multiple-employer welfare benefit trust administered by a

third party company as part of a nonqualified employee

benefit plan.2 The plan was “aimed at small-business

owners” and was, according to its promotional materials,

designed to allow “qualified professionals, entrepreneurs, and

closely-held business owners to obtain life insurance for

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

Schwab, 136 T.C. at 122.

The tax court provides a succinct description of the

policies Schwab and Kleinman purchased:

The policies were of a type called variable

universal life, a relatively new type of

contract for this old industry. A key

characteristic of universal life-insurance

policies is that they disconnect to some degree

a 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

2

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

plans must meet the requirements of [I.R.C.] section 401, and all the

complicated regulations governing their funding, nondiscriminatory terms,

employee coverage, distribution, and other requirements. M eeting such

requirements allows for favorable tax treatment of qualified plans, but not

all plans can comply; hence the existence of nonqualified plans.

Nonqualified plans are generally subject to fewer statutory and regulatory

requirements, but they also receive less favorable tax treatment.” Schwab,

136 T.C. at 126–27.

SCHWAB V . CIR 5

segregates payments from its customers in

separate investment accounts from which it

makes deductions to pay for the insurance

component of the policy. At death, the

customer’s beneficiary gets what’s left in the

separate account. Under a variable universal

life-insurance contract, the customer typically

can choose from a menu of different

investments (often set up to closely resemble

mutual funds) with varying returns and thus

varying payouts upon death, though there is

(as was true under the contracts here) a

minimum death-benefit guaranty.

Id. at 124. Two provisions of the insurance policies are

particularly relevant to this case. First, the policies were

subject to surrender charges—the primary focus of the

Commissioner of Internal Revenue’s (Commissioner)

concern on appeal. The surrender charge in this case is the

fee that Schwab and Kleinman would incur if they allowed

their policies to lapse, or otherwise terminated them, prior to

a contractually specified date. The surrender charges on

Schwab and Kleinman’s policies “lasted eleven years and

would be reduced by 20 percent a year only in years 8–12

(starting in 2008).” Id. at 125.

Another salient feature of the policies was the no-lapse

provision present in each of them. That provision specified

that the policy would not lapse in the first three years of

coverage, provided that the sum of all premiums paid was

“greater than the no lapse premium multiplied by the number

of months the policy has been in force, . . . even if the net

cash surrender value is zero or less.” Id. at 124.

6 SCHWAB V . CIR

Two values associated with the policies are also pertinent

to this case. The first is the “policy value,” which the plan

documents define as “premiums less policy loads, plus net

investment return, less policy charges, partial surrenders, and

any indebtedness.” Id. at 123. The second is the net cash

surrender value, which is a standard industry term, and is the

stated policy value minus the applicable surrender charge.

The net cash surrender value represents the sum of money the

insurance company will pay to the policyholder should he

allow the policy to lapse or voluntarily terminate the policy

before his death.

Angels & Cowboys paid the initial premiums on the

policies, which were originally more than $136,000 per year

for Schwab’s policy, and $120,000 for Kleinman’s. Both

Schwab and Kleinman elected to invest their premium

payments in funds whose value was tied to the value of the

Standard & Poor’s 500 index. Had Schwab and Kleinman’s

expectations been met, they would eventually have been able

to stop paying premiums on their policies because the

premiums would have been covered by the returns on their

investments. Unfortunately for Schwab and Kleinman, their

investment hopes were dashed. During “the three-year period

beginning in September 2000 . . . [t]he S & P 500 index

declined nearly 34 percent,” Schwab, 136 T.C. at 125 n.9,

and their policy values dropped by a similar percentage.

Meanwhile, the Internal Revenue Service (IRS) began

more aggressively asserting its position that the type of

employee-benefit plan in which Angels & Cowboys was

participating was not entitled to receive the favorable tax

treatment that was the plan’s entire raison d'être. “By 2003

it became clear that the Treasury Department would adopt . . .

regulations” with which that employee-benefit plan would be

SCHWAB V . CIR 7

unable to comply. Id. at 123. Anticipating what would soon

occur, the plan’s administrator terminated the plan, and in

October 2003, Schwab and Kleinman took ownership of their

respective policies.

The relevant policy values at the time of their distribution

are summarized below:3

Schwab Kleinman

Stated policy value $48,667 $32,576

Surrender charges 49,225 46,599

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

From the date of the distribution, Schwab’s policy was set

to lapse within 54 days, and Kleinman’s would lapse in 24

days. Accordingly, unless the Standard & Poor’s 500 Index

surged in that time period, the negative net cash surrender

values of the policies made clear that Schwab and Kleinman

would receive nothing if their policies lapsed. Thus, Schwab

and Kleinman had a choice: they could continue paying

premiums on their respective policies, and thus continue their

coverage, or they could allow their respective policies to

lapse, and potentially receive nothing. Kleinman allowed her

policy, which remained far “in the red,” to lapse rather than

pay the $108,031 premium. By contrast, the policy value of

Schwab’s policy rebounded modestly, and Schwab decided

for a time to continue paying the required premiums, and

keep his policy in force.

3

The table is reproduced from Schwab, 136 T.C. at 125.

8 SCHWAB V . CIR

The distribution of the policies from the trust to Schwab

and Kleinman was a taxable event under I.R.C. § 402(b)(2),

which provides for the taxation of assets distributed from a

nonqualified employees’ trust, such as the one in which

Angels & Cowboys participated. Believing they were only

required to pay taxes on the net cash surrender values of their

policies—which were negative at the time of the taxable

event—Schwab and Kleinman did not report any taxable

income as result of the distribution of their policies.4 The

Commissioner disagreed with Schwab and Kleinman’s tax

treatment of their policy distributions, maintaining that the

full stated policy values must be treated as income. He issued

a notice of deficiency to Schwab and Kleinman.

Schwab and Kleinman petitioned the tax court, arguing

that they “actually received” nothing of value and therefore

should pay no taxes on the distribution. The Commissioner

asserted that surrender charges may never be considered

under section 402(b), and maintained that Schwab and

Kleinman actually received the full stated policy values of

their respective insurance policies. In a decision it later

characterized as “[coming] down in the middle,” the tax court

read “section 402(b) to say that a court could consider

[surrender charges], but only as part of a more general inquiry

into a policy’s fair market value.”5 In Schwab and

Kleinman’s case, the tax court accounted for surrender

4

The tax court found that “Schwab and Kleinman made a reasonable

attempt to comply with the provisions of the Code” and that they relied on

multiple representations made by their accountants and the administrator

of the trust. Schwab, 136 T.C. at 126, 136.

5

Order, Schwab v. Comm’r, March 22, 2011, Docket No. 10525-07.

(hereinafter, Order Denying Reconsideration).

SCHWAB V . CIR 9

charges, and held that the only taxable value the policies had

at the time of distribution was “the small amount of the

insurance coverage that was attributable to the single

premium that Angels & Cowboys had paid on each policy

some three years earlier.” Id. at 135. The Commissioner

timely appealed to our court. We have jurisdiction under

I.R.C. § 7482.

STANDARD OF REVIEW

“A tax court’s conclusions of law and construction of the

Internal Revenue Code are reviewed de novo.” Estate of

Rapp v. Comm’r, 140 F.3d 1211, 1215 (9th Cir. 1998)

(internal citation omitted). The facts of this case are

undisputed, and the Commissioner appeals only questions of

law.

DISCUSSION

A.

Schwab and Kleinman received two insurance contracts

from a nonqualified employees’ trust. The distribution from

that trust is taxed according to section 402(b)(2) of the tax

code, which reads in relevant part:

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) . . . .

10 SCHWAB V . CIR

The application of section 402(b)(2) to Schwab’s and

Kleinman’s policies presents a quandary. The word

“amount” implies a quantifiable sum.6 But Schwab and

Kleinman did not receive an “amount”; they received their

respective life insurance policies. The tax court resolved the

tension between the language of section 402(b)(2) and its

application to the Schwab-Kleinman policies by holding that

“the ‘amount actually distributed’ means the fair market

value of what was actually distributed.” Schwab, 136 T.C. at

131. That holding necessitates a two-step analysis. First, the

court had to determine the fair market value of Schwab and

Kleinman’s life insurance policies, and then it was required

to determine the appropriate tax on that amount under section

72.

The Commissioner strenuously disagrees with the tax

court’s conclusion. The gravamen of his argument is that

surrender charges may never be considered when determining

the “amount actually received” from an employees’ trust

under section 402(b)(2). To evaluate the Commissioner’s

argument, we first ascertain whether the tax code and its

accompanying regulations forbid the consideration of

surrender charges under section 402(b)(2), as the

Commissioner contends. Second, we determine whether the

tax court correctly held that the “amount actually received”

means “the fair market value of what was actually received,”

and if so, whether surrender charges may ever affect the fair

market value of a variable universal life insurance policy.

6

See, e.g., W ebster’s Third New Int’l Dictionary (defining “amount” as

“the total number or quantity”).

SCHWAB V . CIR 11

B.

The Commissioner commences his argument with the text

of section 402(b)(2) itself. He contends that because the

“amount actually distributed . . . shall be taxable to the

distributee . . . under section 72 (relating to annuities),” and

because section 72 contemplates the “cash value” of a non-

annuity “without regard to any surrender charge,” I.R.C.

§ 72(e)(3)(A)(i), then section 402(b)(2) must also apply

without regard to any surrender charge. As the

Commissioner phrased it in his brief, under section 402(b)(2),

“[life insurance] policies are to be valued in the same manner

as they would be under § 72(e)(3)(A).” The tax court, he

urges, therefore erred by supplanting a fair market valuation

standard in place of the statutorily-mandated methodology

supplied by § 72(e)(3)(A).

Section 72(e)(3)(A) reads as follows:

Any amount to which this subsection applies

shall be treated as allocable to income on the

contract to the extent that such amount does

not exceed the excess (if any) of —

(i) the cash value of the contract

(determined without regard to any surrender

charge) immediately before the amount is

received, over

(ii) the investment in the contract at the

time.

The Commissioner relies upon subsection (i), which explains

that for purposes of section 72, the cash value of the contract

12 SCHWAB V . CIR

is to be determined without regard to any surrender charge.

Thus, the Commissioner contends, Schwab and Kleinman

must pay taxes on the stated policy values. But he misses a

step. The Commissioner offers no reason to believe that the

“cash value” of the policy under section 72(e)(3)(A) is the

“amount actually received” under section 402(b)(2).7 Nor is

section 72(e)(3)(A) a freestanding method for valuing life

insurance policies. Rather, in this context it is “a guide to

allocating that value between taxable income and nontaxable

return of the investment on the contract.”8 The title of

paragraph (e)(3) is, after all, “Allocation of amounts to

income and investment.” And paragraph (i) simply sets forth

the method for computing one of the two numbers in that

formula.

The other problem with the Commissioner’s interpretation

of section 402(b)(2) is that it reads the phrase “amount

actually distributed or made available” entirely out of section

402(b)(2). See Beisler v. Comm’r., 814 F.2d 1304, 1307 (9th

Cir. 1987) (“We should avoid an interpretation of a statute

that renders any part of it superfluous and does not give effect

to all of the words used by Congress.”). The Commissioner’s

assertion that section 72(e)(3)(A)(i) dictates how insurance

policies distributed from nonqualified trusts should be taxed

completely bypasses the reference in section 402(b)(2) to the

“amount actually distributed.” In contrast, the tax court’s

interpretation of the interplay of sections 402(b)(2) and

72(e)(3)(A)(i) gives effect to all of the language in both

statutory provisions. Under that interpretation, the “amount

to which this subsection applies” in subsection 72(e)(3)(A)(i)

7

W e discuss this further in Part D, infra.

8

Order Denying Reconsideration at 2.

SCHWAB V . CIR 13

is the “amount actually distributed” in section 402(b)(2). We

thus conclude that the tax court advances the better

interpretation of the plain text of section 402(b)(2).

C.

This is not the end of our inquiry, however. Section 402

is the subject of a number of Treasury regulations, and, as a

general matter, “we defer to the Treasury’s interpretation of

the statute” if the applicable regulations prove dispositive.

See Pac. First Fed. Sav. Bank v. Comm’r, 961 F.2d 800, 805

(9th Cir. 1992) (citing Nat’l Muffler Dealers Ass’n, Inc. v.

United States, 440 U.S. 472, 488 (1979)).

As a result, the Commissioner appeals for support beyond

the text of section 402(b)(2). He first argues that the Treasury

regulation interpreting section 402(b), Treas. Reg.

§ 1.402(b)–1, supports his interpretation of that section. The

Commissioner directs our attention to an example in that

regulation, which reads as follows: “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.” Treas.

Reg. § 1.402(b)–1(c).9 We first note, as did the tax court, that

the example refers to annuity contracts, rather than life

insurance policies. Nonetheless, the Commissioner focuses

upon the phrase “entire value of the contract,” arguing that

such language “draws upon” the Supreme Court’s reasoning

in a trio of cases (all delivered the same day), in which the

Court considered “the proper method for valuation” of a

9

Unless otherwise stated, all references herein to Treasury regulations

refer to the version that was current when Schwab and Kleinman filed

their tax returns.

14 SCHWAB V . CIR

single-premium life insurance policy for gift tax purposes.

See, e.g., Guggenheim v. Rasquin, 312 U.S. 254, 255 (1941).

In Guggenheim, the Court held that the fair market value of

the policy10 was not its cash surrender value, but rather the

purchase price, because “[c]ost is cogent evidence of value”

when the purchaser assigned the policy to three of her

children at “substantially the same time” as the purchase. Id.

at 256, 258; see also Powers v. Comm’r, 312 U.S. 259 (1941)

(affirming same). By contrast, in United States v. Ryerson,

312 U.S. 260 (1941), five years had elapsed between the

purchase of the policy and its assignment. The Court

therefore held that the replacement cost of the policy at that

time of the assignment, rather than the policy’s original

purchase price, was the correct valuation of the policy for gift

tax purposes. Id. at 261.

Even if we assume that the regulation’s use of “entire

value” is an oblique allusion to the reasoning of these gift tax

cases, the three cases do not suggest, as the Commissioner

urges, that surrender charges may never be taken into account

when valuing a life insurance policy. Rather, when read

together, they suggest that “the fair market value of insurance

contracts can be a slippery concept,” Schwab, 136 T.C. at

131, and that a particular method for ascertaining value may

be appropriate in one situation but inappropriate in another.

We are therefore not persuaded that the example relating to

annuities in Treasury regulation section 1.402(b)–1(c)

suggests that surrender charges may never be considered

10

Gifts were taxed at their fair market value under the relevant statute.

See Guggenheim, 312 U.S. at 257 n.4 (“Art. 19(1) provided: ‘* * * The

value of property is the price at which such property would change hands

between a willing buyer and a willing seller, neither being under any

compulsion to buy or to sell. . . .’”).

SCHWAB V . CIR 15

when valuing a life insurance policy distributed from an

employees’ trust.

On the other hand, there is a different clause in section

1.402(b)–1(c) that proves useful to our analysis: the

regulation parrots nearly verbatim the text of section

402(b)(2), providing that “[a]ny amount actually distributed

or made available to any distributee . . . shall be taxable under

section 72.” Treas. Reg. § 1.402(b)–1(c). We have explained

our interpretation of this language, and we conclude that it

bears the same meaning in the Treasury regulation that it does

in the corresponding tax code provision. So rather than

overriding what we understand to be the plain meaning of

section 402(b)(2), as the Commissioner believes it should, the

regulation in fact reaffirms our interpretation of the tax

code.11

D.

The Commissioner next argues that we should reject the

tax court’s treatment of distributions from qualified benefit

plans because that approach creates unwarranted anomalies

with the taxation of variable life insurance policies while they

are held in trust, and with the tax treatment of distributions

from qualified investment plans. We discuss each in turn.

An employer’s contributions to an employees’ trust are

taxed according to a different subsection of section

11

Because we find that the text of the regulation is not ambiguous and

that the interpretation the Commissioner advances in his briefs are

“inconsistent with the regulation,” we do not grant deference to those

views apart from their inherent ability to persuade. See Auer v. Robbins,

519 U.S. 452, 461 (1997).

16 SCHWAB V . CIR

402(b)—section 402(b)(1)—than are distributions from the

trust. Under the regulations pertaining to section 402(b)(1),

contributions to the employee trust are valued and taxed

“without regard to any lapse restriction.” Treas. Reg.

§ 1.402(b)–1(b)(1). And the tax court has, in a different case,

interpreted surrender charges on a variable life insurance

policy to be a type of lapse restriction under section

1.402(b)–1(b)(1). See Cadwell v. Comm’r, 136 T.C. 38,

58–60 (2011), aff'd, 483 Fed. App’x 847 (4th Cir. 2012).

The Commissioner argues, therefore, that surrender

charges should be treated identically when taxing

contributions to and distributions from an employees’ trust,

because “words in different sections of the same statute

should be construed similarly.” Miranda v. Anchondo,

684 F.3d 844, 849 (9th Cir. 2011). But therein lies the rub:

neither the “contributions” and “distributions” subsections of

the tax code, nor the two corresponding subsections of the

applicable Treasury regulation, have any meaningful words

in common. In particular, as the tax court noted in this case,

the subsection of the regulation applicable to distributions,

section 1.402(b)–1(c), “doesn’t even mention ‘lapse

restrictions.’” Schwab, 136 T.C. at 130. And because it was

only the inclusion of that phrase in the regulations relating to

employer contributions that led the tax court to value

employer contributions without respect to surrender

charges,12 nothing in section 402(b)(1), or the regulations

interpreting it, suggests we need to adopt that approach

relating to distributions. We conclude that the possibility that

the surrender charge could be disregarded when taxing

contributions to an employees’ trust, but be taken into

account when the assets are later distributed, is not so

12

See Cadwell, 136 T.C. at 58–60.

SCHWAB V . CIR 17

anomalous as to require us to ignore the statutory and

regulatory text that produces such a result. Contributions and

distributions are, after all, taxed according to two entirely

separate subsections of section 402(b).

In his next argument, the Commissioner relies on a

different provision of the tax code that does share wording

with section 402(b)(2). Section 402(a) prescribes the tax

treatment of qualified (rather than nonqualified) benefit plans.

Much like section 402(b)(2), section 402(a) provides that

any amount actually distributed to any

distributee by any employees’ trust described

in section 402(a) which is exempt from tax

under section 501(a) shall be taxable to the

distributee . . . under section 72 (relating to

annuities).

I.R.C. § 402(a) (emphasis added). In Matthies v. Comm’r,

134 T.C. 141 (2010), the tax court concluded that, under the

pre-2005 regulations, surrender charges should not be

considered when valuing a life insurance policy under section

402(a). Id. at 151–52. Treasury regulation section

1.402(a)–1 interprets tax code section 402(a), and the pre-

2005 version of that regulation stated that “the entire cash

value of such contract at the time of distribution must be

included in the distributee’s income in accordance with the

provisions of section 402(a) . . . .” Treas. Reg. § 1.402(a)–1

(emphasis added). The tax court noted that the proposed

regulations in 1955 originally referred to the “entire value of

such contract,” a phrase which the court believed “might

plausibly be construed as synonymous with ‘fair market

value.’” Matthies, 134 T.C. at 150–51 (citing Proposed

Income Tax Regs., 20 Fed. Reg. 6460 (Sept. 1, 1955)). The

18 SCHWAB V . CIR

final version of the regulations substituted the phrase “entire

cash value” for “entire value of such contract,” though, and

the tax court reasoned that “the regulations purposefully

departed from a generalized valuation standard . . . in favor of

a more particularized (and possibly more objective and more

easily administered) valuation standard.” Id. at 151. The tax

court concluded in Matthies, therefore, that the phrase “cash

value” in Treasury regulation section 1.402(a)–1 is “properly

construed . . . to refer to cash value determined without regard

to any surrender charge.” Id. at 151.13

Returning to the Commissioner’s argument, it is true that

section 402(a) shares the phrase “amount actually distributed”

with section 402(b)(2), and that the tax court in Matthies

interpreted that provision not to account for surrender

charges. It is also accurate that we would normally presume

that “a legislative body generally uses a particular word with

a consistent meaning in a given context.” Erlenbaugh v.

United States, 409 U.S. 239, 243 (1972). But the tax court

reached its interpretation of section 402(a) in Matthies

because of the applicable regulation’s command to account

for the “entire cash value” of the policy; the regulation

interpreting section 402(b)(2) contains no such language. As

the tax court explained, “the regulations interpreting each

subsection differed before 2005 and continue to differ today.

We must apply them as written.” Schwab, 136 T.C. at 120.

To the extent that the Commissioner finds the results

anomalous, it is a problem of his own making.

13

See also Part B, discussing the appearance of the phrase “cash value”

in tax code section 72(e)(3)(A)(i).

SCHWAB V . CIR 19

E.

Neither the regulations interpreting section 402(b)(2), the

neighboring provisions of the code, nor the regulations

interpreting those neighboring provisions have persuaded us

that we must adopt the Commissioner’s view that life

insurance policies must always be taxed with reference to

their “cash value” according to section 72(e)(3)(A)(i) when

they are distributed from an employees’ trust. Nor has the

Commissioner persuaded us that any authority categorically

requires that surrender charges always be ignored.

But a puzzle remains. How should the Commissioner

quantify insurance policies as an “amount actually

distributed” that can be taxed? We conclude that the tax

court correctly equated the “amount” in section 402(b)(2)

with the fair market value of the policies that were actually

distributed. Fair market value is generally understood to be

“[t]he price that a seller is willing to accept and a buyer is

willing to pay on the open market and in an arm’s-length

transaction; the point at which supply and demand intersect.”

Black’s Law Dictionary (9th ed.). In other words, the fair

market value of a thing is the amount of consideration

someone would pay to acquire it. We do not believe that in

drafting section 402(b)(2), Congress intended to tax the

distributee on some amount greater (or lesser) than what a

rational person would pay for what the taxpayer actually

received.

It would also be reasonable to say that the fair market

value standard is as close to a generalized valuation standard

20 SCHWAB V . CIR

as there is in the tax code.14 As the tax court has explained,

“the concept of fair market value has always been part of the

warp and woof of our income, estate, and gift tax laws, and

concomitantly the necessity of determining the fair market

values of numerous assets for equally numerous purposes has

always been a vital and unavoidable function of the tax

administrative and judicial process.” Nestle Holdings, Inc. v.

Comm’r, 94 T.C. 803, 815 (1990). To be sure, the term “fair

market value” appears “in about 200 sections of the Internal

Revenue Code . . . , and in about 900 sections of the

supporting Treasury regulations.” John A. Bogdanski,

Federal Tax Valuation par. 1.01 (2012). We affirm the tax

court’s holding that “the ‘amount actually distributed’ means

the fair market value of what was actually distributed.”

Schwab, 136 T.C. at 131.

F.

The only questions remaining in this case are whether, as

a general matter, surrender charges in life insurance policies

can affect the fair market value of those policies, and whether

the tax court erred in accounting for them here. We agree

with the tax court that “[t]he variety of insurance policies is

too great to adopt as a general rule either the Commissioner’s

simple proposition that surrender charges should never count,

14

The tax court supported its holding with the observation that the

example in section 1.420(b)–1(c) requiring an annuity to be taxed at its

“entire value,” and that the tax court postulated in Matthies that “this . . .

phrase— ‘entire value’— ‘might plausibly be construed as synonymous

with “fair market value”’ and represented ‘a generalized valuation

standard.’” Schwab, 136 T.C. at 131 (citing Matthies, 134 T.C. at

150–51). W hile the tax court’s opinion in Matthies is non-binding and

represents only a “clue,” Schwab, 136 T.C. at 131, it certainly points in the

right direction.

SCHWAB V . CIR 21

or Schwab and Kleinman’s that such charges should always

count, in determining a policy’s value.” Schwab, 136 T.C. at

134. We hold instead that surrender charges may be

considered under section 402(b)(2), “but only as part of a

more general inquiry into a policy’s fair market value.”15

We disagree with the Commissioner that cases in which

courts have ignored surrender charges require us to adopt a

rule that a court may never consider a surrender charge in

determining the fair market value of a life insurance policy

for tax purposes. As explained in Part C, the divergent

methodologies the Supreme Court used to value paid-up term

life insurance policies in Guggenheim and Ryerson counsel us

against adopting a one-size-fits-all methodology for

ascertaining the fair market value of a life insurance policy.

And while the Supreme Court did not find surrender

charges relevant when valuing the particular policies at issue

in Guggenheim and Ryerson, more recent cases of other

circuits illustrate that in other contexts, surrender charges can

affect the fair market value of a life insurance policy. In

1962, then-Judge Blackmun distinguished Guggeinheim, and

held that the fair market value of the life insurance policy in

that case was the cash surrender value of the policy. See

Gravois Planning Mill Co. v. Comm’r, 299 F.2d 199, 211 (8th

Cir. 1962). There, the taxpayer, Charles Beckemeier, was an

officer of the Gravois Planning Mill Company, and Gravois

held an insurance policy on Beckemeier’s life. Id. at 201.

Upon his retirement, Beckemeier purchased the insurance

policy from the company at its cash surrender value. Id. The

court held that the price paid—which was the surrender value

15

Order Denying Reconsideration at 1.

22 SCHWAB V . CIR

of the policy—was controlling as to the fair market value of

the policy. Id. at 211.16

In another case, the Second Circuit explained that “[c]ash

surrender value is the more appropriate valuation when it

appears that no one is interested in keeping the policy in

effect and that anyone receiving the policy would be likely to

surrender it to the company for the cash surrender value.”

Tuttle v. United States, 436 F.2d 69, 71 (2d Cir. 1970).

There, the court reasoned that a charitable organization

receiving a paid-up life insurance policy as a gift would not

be expected, when it had no relationship to the insured donee,

to hold the policy as an investment. Id. at 72. It therefore

held that the cash surrender value of the policy, rather than its

replacement value, reflected its fair market value in that case.

Id.

While neither Gravois nor Tuttle is a perfect analog to this

case, both illustrate that surrender charges can, in some cases,

appropriately be factored into the fair market value of a life

insurance policy. A simple thought experiment bears out the

relevance of surrender charges to Schwab and Kleinman’s

policies here. Consider Kleinman’s policy as compared to an

identical policy with no surrender charge. At the time of the

distribution, Kleinman’s policy was set to lapse in 24 days if

she did not pay a $108,031 premium. Kleinman allowed the

policy to lapse, and because there were applicable surrender

16

In Gravois, the Commissioner made arguments strikingly similar to

those he makes in this case, claiming that “the right to turn a policy in for

cash is only one of the rights an owner possesses; that in addition he has

the right to retain it for investment purposes and the right to receive its

face amount on the insured’s death; and that all these rights demonstrate

a value greater than mere cash surrender value.” Id. at 211.

SCHWAB V . CIR 23

charges that exceeded the accumulated policy value, “[s]he

didn’t get any money from the insurance company because

her policy’s net cash-surrender value was negative.” Schwab,

136 T.C. at 126. Under the hypothetical policy with no

surrender charge, assuming the value of Kleinman’s

investments remained constant, Kleinman would instead have

received the stated policy value, $32,576, when the policy

lapsed. Clearly, any rational person would be willing to pay

more for a contract that pays out $32,576 in 24 days than a

contract that pays out nothing. In this light, it seems difficult

to believe, under the facts of this case, that the surrender

charges had no effect on the fair market value of the policies.

Finally, prudence counsels us against adopting the

Commissioner’s proposed ban on considering surrender

charges under section 402. Just as variable universal life

insurance policies did not exist when the Court decided

Guggenheim and its companion cases in 1941, ever-creative

financial institutions are liable to devise new life insurance

instruments that we cannot contemplate today. We therefore

decline to tie the hands of the tax court now, or in the future,

by adopting the Commissioner’s proposed blanket prohibition

on considering surrender charges when valuing life insurance

policies under section 402.

In light of the foregoing, we affirm the tax court’s finding

that Schwab and Kleinman’s policies did not have

“significant value apart from the small amount of the

insurance coverage that was attributable to the single

premium that Angels & Cowboys had paid on each policy

24 SCHWAB V . CIR

some three years earlier.” Schwab, 136 T.C. at 135.17 The

Commissioner fails to identify any other economic benefits

of the policies at the time of their distribution, apart from the

insurance coverage they provide. Aside from arguing that

surrender charges may never be considered under section

402(b)(2), the Commissioner does not meaningfully

challenge the particulars of the tax court’s calculations.

Therefore, we will not disturb the tax court’s valuation of the

Schwab-Kleinman policies.

AFFIRMED.

17

W hen they were before the tax court, the parties “fought mostly about

whether surrender charges could be considered at all,” and “they

introduced little evidence specifically directed at establishing the fair

market values for the policies.” Schwab, 136 T.C. at 134. This proved

problematic for the Commissioner. For example, he argued before the tax

court that “accumulated cash value can be used to pay costs relating to

maintaining the policies in force, can be borrowed against, or can be

obtained in exchange for surrendering the policy, as the policy owner may

choose.” Id. Regardless of whether this is true as a general matter, the

Commissioner apparently failed to prove this fact to the tax court with

respect to Schwab and Kleinman’s policies, and does not renew that

argument on appeal. Id. at 135–36. Moreover, both parties apparently

declined the tax court’s invitation to move to reopen the record to supply

data for more detailed calculations, id. at 135 n.17, and the Commissioner

does not point us to any evidence on record of the policies’ value that the

tax court failed to consider.