Peter Katt
Peter Katt
Irrevocable Life Insurance Trusts

An analysis of Schwab v. Commissioner.

September 22, 2011
by Peter Katt, CFP, LIC

The valuation of life insurance policies is primarily associated with gifting or selling policies to irrevocable life insurance trusts (ILIT) and measuring the income tax amount when they are distributed from qualified pension plans and welfare benefit trusts. This column isn’t intended to provide a historical or complete discussion. It provides snippets on the subject that I believe are quite revealing.

Valuing Distributions

Aside from permanent life insurance being inherently complex, its valuation is more challenging because as the battleground between purveyors of qualified and non-qualified plans and the Internal Revenue Service (IRS), a lot of partisan argument can interfere with a logical approach.

The operative issue in these partisan encounters has been springing-cash-values. In the good ol’ days (five to 10 years ago) the vendors would sell high income customers on such things as welfare benefit trusts (Sec. 419), qualified defined benefit plans [412(e)] and voluntary employees’ beneficiary associations (VEBAs) that would be fully funded with tax-deductible premiums and then distributed from the plan at a very low cash value that would magically roar up in value the next few years.

Springing-cash-values set the stage for battles over whether a policy’s account value (offset by large surrender charges) or the much lower cash surrender value should be reported as income when policies are transferred to the insured. Buyers, administrators and sellers have been convinced that the correct amount to be used is the cash surrender value that is often zero at the time of distributions. The IRS argues for using the much higher account value. The arguments swirl around Code Sections 402, 83 and 72 and such terms as “amounts actually distributed,” “entire cash value” and “fair market value.”

The bottom line for asset valuation is to ascertain its fair market value (FMV). For life insurance this has been supplemented by a safe-harbor method provided in regulations under Code Section 402(a) in August 2005. An important aspect of the safe harbor is that an insureds’ health should not be taken into account. With this as a quick background let’s get into some valuation specifics.

To start let’s critique Schwab v. Commissioner (136 T.C. No. 6 — 2/7/11). In Schwab, two variable universal life (VUL) insurance policies were distributed from a multi-employer welfare benefit plan in 2003. Schwab claimed zero income by using the cash surrender value. The IRS asserted that in fact the policies’ value was $80,000. One of the policies was terminated shortly after distribution and the other one was continued. After considerable discussion the Court decided that values should be based on the guaranteed cost of insurance to the date the one policy was terminated and until the other’s premium was paid some months later. This amounted to $2,666. During the trial the Commissioner proposed that the policies had value because “accumulated cash value can be used to pay costs relating to maintaining the policies in force — The Court responded that the evidence does not convince us that such options were available — I don’t know if the Commissioner made a weak presentation on this point or the Court didn’t interpret it correctly. In my experience, the accumulation value can and is used to pay cost of insurance, which is in essence an extended term option that has real value to the taxpayer. Based on my reading of the opinion and 30 years of analyzing life-insurance pricing, I believe the Court erred in its valuation. If $80,000 was available to pay future cost of insurance charges, this is the value of the policies. This could have been easily determined. All I would need to know is the company name and policy series and with one phone call I could have it figured this out. Further it seems the Court allowed the voluntary termination of one policy, when the first premium post-distribution was paid on the other policy to influence its decision. The policy value should be set on the day of distribution without regard to what happened later. Finally, I don’t know why the Commissioner didn’t obtain the Interpolated Terminal Reserve (ITR) from the insurance company in this case as further evidence of the value.

The decision seems to be based more on the Court admitting what it doesn’t know or understand than on a good valuation. I’m not sure why the Court was flying so blind on the question of whether the accumulation account could be used to pay for the cost of insurance. Why don’t courts retain a Special Master to give it guidance on such technical issues?

It is frustrating that the simple assignment of valuing a policy becomes so convoluted. As in Schwab, the only question is whether the accumulation account can be used to pay future costs of insurance or not. If it can, the value is $80,000. If it can’t, the value is zero dollars. Schwab is precedence for individual taxpayers and their attorneys and a potential setback for citizens in general and the IRS.

Note that if the accumulation account could be used to pay the cost of insurance charges, using the safe harbor, (remember distribution was in 2003, IRS originated safe harbor in 2005 and case in 2010) the value would be in the $68,000 range and the IRS would have probably accepted it.

The Schwab Court did correctly observe that — fair market value of insurance contracts can be a slippery concept — It is. Let’s consider several possible situations.

Harold (51) wishes to fund an ILIT in order for it to buy his $5 million UL policy to immediately get it out of his estate. The funds gifted to the ILIT will be subject to gift taxes but the policy will not be subject to the three-year rule. Harold retains me to value the policy. The first question I ask is what is Harold’s current health? An issue not mentioned in Schwab. If an insured’s health has significantly deteriorated since the policy was purchased this can dramatically change the value of a policy. Let’s examine three circumstances:

  • Assume Harold is in the same good health as when the policy was purchased. I obtain from the insurance company the ITR, which is $349,835. This is close to the cash surrender value so I sign off on this as the policy’s value for its purchase by the ILIT.
  • Harold has terminal cancer, with a maximum of three years to live. This could increase the fair market value of the policy to nearly $4 million because it is expected to pay its $5 million death benefit in a short period of time. However, there is a better alternative for Harold. The valuation method described under Section 402(a) regulations allows me to ignore Harold’s health, so I can use the greater of ITR or a calculation known as adjusted PERC (prices are adjusted for inflation). Under adjusted PERC the value of Harold’s policy is $391,580. This is the safe harbor valuation that I believe the IRS would accept.
  • Harold has terminal cancer but instead of wishing to move it to an ILIT he wants to use it for collateral with his bank to provide him with living funds for the next few years (until he dies) since he can no longer work. I would be able to justify a value of around $3.5 million to the bank’s loan committee. Taking into account all of the factors the value of Harold’s policy could legitimately be any of the three amounts.


Since life insurance is so complex, it has been used for various tax schemes that have made setting logical valuation methods by the IRS like a game of whack-a-mole. This has added many obscure IRS pronouncements and rulings just to keep up. Unfortunately I believe that Schwab has further muddied the waters.

 Rate this article 5 (excellent) to 1 (poor). Send your responses here.

Peter Katt, CFP, LIC, is a fee-only life insurance advisor since 1983, he has written insurance columns for AAII Journal and Journal of Financial Planning since 1991.

* DISCLOSURE: Readers should assume that all insurance advice mentioned in this column are the author’s and/or his firm’s unless otherwise noted and does not necessarily reflect the views of the AICPA or the AICPA Wealth Management Insider.