TOPIC: Court Rules That Section 419A(f)(6) Plan Sponsor Made Taxable Distribution of Life Insurance Policies
CITES: Gluckman v. Comm'r, No. 13-761, 2013 WL 6124391 (2nd Cir. Nov. 22, 2013); Gluckman v. Comm'r, T.C.M. 2012-329, 2012 WL 5951351 (T.C. Nov. 28, 2012); I.R.C. § 419A(f)(6) (2012); I.R.C. § 6662(b)(2) (2012); Schwab v. Comm'r, 111 AFTR-2d 2013-667 (9th Cir. 2013).
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SUMMARY: The Second Circuit upheld a Tax Court decision that the insured taxpayers, a husband and wife, received a taxable distribution of life insurance policies from a Section 419A multi-employer welfare benefit plan. The court found in favor of the IRS even though the policies were transferred directly to a second welfare benefit plan and not to the taxpayers. Because the taxpayers were the majority shareholders, the only directors and one served as President of the plan sponsor, the court found that, once the plan was terminated and withdrawal authorized by plan administrator, the taxpayers exercised actual control over the policies with no "substantial risk of forfeiture."
FACTS: The Gluckmans ("taxpayers") were majority shareholders of Fownes Brothers & Co., Inc. ("corporation"). The taxpayers each owned 28.94% of the stock of the corporation, with the balance shared equally by the taxpayers' two children. The taxpayers were the only directors of the corporation and Mr. Gluckman was also the corporate President. In 1999, the corporation adopted a "10 or more employer" welfare benefit plan ("the initial plan") under IRC Section 419A(f)(6) offering pre-retirement life insurance to employees. The initial plan was not a tax-exempt trust. The taxpayers were covered employees under the initial plan.
In 2003, the IRS issued regulations under Section 419A that necessitated restructuring of the initial plan. During 2003, the administrator of the initial plan advised participating employers to terminate their participation in the initial plan, notifying them of their options. The letter from the administrator specifically stated that "a trustee-to-trustee transfer . . . is not permitted under the applicable IRS regulations."
In October 2003, the corporation sent the plan administrator a resolution authorizing a distribution of the policies, effective November 28, 2003. The administrator sent the corporation change of ownership forms, endorsed by the administrator, listing the initial plan administrator as the "current owner" and leaving a blank for the new owner(s). The administrator asked the taxpayer as corporate President to fill in the blank specifying the new owner(s) and forward the completed forms to the insurance carrier.
On December 17, 2003, the corporation entered into an agreement (signed by the taxpayer) to participate in a new "10 or more employer" welfare benefit plan ("the new plan"). As of January 22, 2004, the change of ownership forms listed the new plan as the new owner of the insurance policies. The issuing insurance company acknowledged the change of ownership on February 9. Taxpayers were not listed as owners of the policies at any relevant time.
Taxpayers did not include the value of the policies as income in 2003.
RESULT: The Tax Court determined, and the Second Circuit affirmed, that "in 2003 the [taxpayers'] interest in the policies was 'substantially vested' within the meaning of the Code, and therefore required to be included as income." A twenty percent accuracy related penalty under I.R.C Section 6662 was also upheld.
The parties did not dispute at either the Tax Court or the Second Circuit that the proper measure of the value of the underlying policies was the policies' accumulation account values.
Though the Second Circuit and the Tax Court discussed a number of different theories, they placed greatest reliance on the taxpayers' actual control of the corporation. This was based on specific facts:
The taxpayers owned a majority of the stock.
The balance of the company stock was owned by the taxpayers' two children.
The taxpayers made up the entire corporate board of directors.
The husband was the corporate President.
Taxpayers argued that there was no substantial vesting because the policies were at all times owned by a welfare benefit plan and subject to a substantial risk of forfeiture, and that the transfer from the initial plan to the new plan was a non-taxable trustee-to-trustee transfer.
The Tax Court decided that the taxpayers became vested in the policies upon termination of the initial plan because of their control over the corporate sponsor. The taxpayers argued that a substantial risk of forfeiture existed because the corporation, not the taxpayers, decided where to transfer the policies. The Tax Court rejected that argument, again focusing on the facts surrounding ownership and control of the corporation.
[I]n determining whether an employee's interest in transferred property is subject to a substantial risk of forfeiture the following factors are taken into account: (i) the employee's relationship to other stockholders and the extent of their control, potential control and possible loss of control of the corporation, (ii) the position of the employee in the corporation and the extent to which he is subordinate to other employees, (iii) the employee's relationship to the officers and directors of the corporation, (iv) the person or persons who must approve the employee's discharge, and (v) past actions of the employer in enforcing the provisions of the restrictions . . . . (Citations omitted).
The Second Circuit upheld the Tax Court's conclusion that the taxpayers "clearly had the ability to control [the corporation's] decision-making process and thus had the ability to control their underlying policies."
RELEVANCE: In various contexts, the court and the IRS have historically questioned the substantiality of vesting limitations as applied to controlling shareholders. This case is another example that the substantiality of a risk of forfeiture of rights to compensation may be called into question if the employee has substantial control over the plan sponsor. This case indicates that the courts will look at multiple examples of actual control (e.g., stock ownership, board seats, corporate offices and job responsibilities) to determine whether, in fact, the employee has control over corporate decision making such that there is in reality no substantial risk of forfeiture.
Finally, the case is also interesting to life insurance professionals because the parties agreed that the proper valuation of a life policy for this tax purpose is its accumulation value. That conclusion seems inconsistent with that of the Schwab decision from earlier this year in which the Ninth Circuit decided that surrender charges may be considered in determining the value of a life insurance policy.
WRNewswire #13.12.04 was written by Marla Aspinwall of Loeb & Loeb, LLP.