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Thursday, February 25, 2010


For awhile, “springing” insurance was a popular method of avoiding tax on IRA and qualified retirement plan assets. A recent case hammered the taxpayer who entered into such an arrangement.

While there are variations, the typical arrangement involved the creation of a pension plan in a closely-held entity, which received a roll-over distribution from the taxpayer’s IRA. The plan would then purchase a substantial life insurance policy. A feature of the policy would be that the insurance company would receive a substantial surrender charge if the policy was surrendered. The policy would then be sold to an insurance trust established by the taxpayer, removing the policy from the pension plan. The insurance trust would be buying the policy at a substantial discount in price – getting the insurance out of the pension plan at a reduced cost, and thus moving assets out of the plan without incurring an income tax. The insurance trust would often then convert the policy to one that did not have the surrender charge feature.

The taxpayer justified the sale of the policy at a reduced price by reducing the value of the policy by the potential surrender charge. For example, if the policy was purchased for $1.3 million and had a cash surrender value of $1.3 million and a $1 million surrender charge applied, the policy would be sold for the net $300,000 value. The “springing” part of the plan comes about when the policy is converted by the insurance trust to one that allows more direct access to the $1.3 million value without the surrender charge – thus springing the value back up.

The planning makes sense in theory. However, as one would expect, the IRS was not pleased with the technique. The Tax Court has now accepted the IRS’ theory that the value of the policy should be determined without reduction for the surrender value. Thus, the taxpayer in the case was deemed to have received about $1 million in taxable income attributable to the discount taken on the insurance policy that was sold that was attributable to the surrender charge on the policy.

I don’t know how many other similar cases are pending with the Service, but the Tax Court’s determination does not bode well for the taxpayers in those cases.

Karl L. Matthies, et ux. v. Commissioner,  134 T.C. No. 6 (2010)

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