News & Information

 

FEATURED PRODUCT

5500 Preparer's Manual for 2012 Plan Years
The premier resource in the field of Form 5500 preparation, 5500 Preparer's Manual will help you handle the required annual Form 5500 filings for both pension benefits and welfare benefit plans.

Learn More »

CCH® PENSION — 04/30/10

Bargain element of sale of life insurance policy by profit-sharing plan to participant was includable in participant's gross income

In a case of first impression, a participant who purchased a life insurance policy from his wholly owned S corporation's profit-sharing (PS) plan at a bargain price was required to include the bargain element of the sale in his gross income, according to the U.S. Tax Court in Matthies v. Commissioner of Internal Revenue.

As part of a "Pension Asset Transfer (PAT) plan," a stock analyst created a wholly owned S corporation and established a PS plan under the S corporation. After the plan was established, the plan purchased a life insurance policy and the stock analyst/participant transferred money from his IRA to the PS plan, which was used to pay the policy's premiums. Later, the PS plan transferred ownership of the insurance policy to the participant and the participant transferred $315,023 in consideration for the policy to the PS plan. At the time of transfer, the policy's account value was $1,368,327, with a net cash value (account value minus surrender charge) of $305,867.

For income tax purposes, the participant valued the policy at its net cash value, reporting no income from the transfer of the insurance policy from the PS plan to the participant on his return. The IRS issued a notice of deficiency for year 2000, determining that the participant had $1,053,304 gross income from the transfer of the insurance policy and was liable for an accuracy-related penalty for negligence. The IRS contended that the policy was worth $1,368,327, which the IRS asserted was the policy's fair market value. According to the IRS, the $1,053,304 bargain element of the sale (fair market value minus consideration paid) represented taxable income to the participant. The participant argued that there was no bargain sale and no taxable income because the amount that the participant paid to the PS plan exceeded the policy's net cash value. The difference between the IRS's and the participant's figures equaled the policy's surrender charge, $1,062,461.

The Tax Court concluded that if the participant purchased the life insurance policy from the PS plan at a bargain price, the bargain element of the sale was includable in the participant's gross income. Code Sec. 61 provides that gross income includes "all income from whatever source derived." The court explained that it was well established that income can result from a bargain sale when the parties have a special relationship and the transaction is not an arm's length transaction. The sale of the insurance policy to the participant pursuant to a pre-arranged plan involving the transfer of IRA funds to the PS plan for the purpose of purchasing the policy and, shortly thereafter, reselling it to the participant was not an arm's length transaction, according to the court.

The court concluded that, under IRS Reg. §1.402(a)-1(a)(2) (as in effect at the time of the transaction), the policy's value must be determined by reference to its "entire cash value." Reg. §1.402(a)-1(a)(2) provided, among other things, that if a distributed contract was a life insurance contract, the "entire cash value" of the contract was includable in the distributee's gross income. The regulations did not define "entire cash value." However, the court noted that Code Sec. 402(a) provides that distributions to which the section applies are taxable under the rules of Code Sec. 72. Under Code Sec. 72(e), the income on a life insurance contract is determined by reference to cash value without regard to any surrender charges. Using the insurance company's figures, the court found that the entire cash value of the insurance policy for purposes of Code Sec. 402(a) was $1,368,327. The court held that the participant paid the PS plan $1,053,304 less for the insurance policy than its $1,368,327 value on the date of transfer and that this bargain element was includable in the participant's gross income pursuant to Code Sec. 61.

The court decided that the participant was not liable for the accuracy-related penalty for negligence. The court explained that it had not previously addressed the tax treatment of a bargain sale of a life insurance policy under Code Sec. 61 or Code Sec. 402(a) or the application of the "entire cash value" standard under the applicable regulations. The court noted that, in adopting 2005 final regulations under Code Sec. 402(a), the IRS stated that it was responding to questions concerning whether "entire cash value" included a reduction for surrender charges under the prior regulations. Uncertainty under the regulations regarding the tax consequences of the type of transaction in question was indicated, according to the court. Thus, the participant had a reasonable basis for his position.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer's Benefits Reports.

Visit our News Library to read more news stories.