But I do nonetheless know enough to slightly modify one thing that Judge Milan Smith says.
In rejecting the I.R.S.'s position, Judge Smith concludes his opinion by arguing the following:
"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."
I understand that as a general principle. When dealing with innovation, you often don't want to make bright-line rules.
But I'm not as confident as Judge Smith that this doctrine is applicable in this particular context. Indeed, a contrary principle might well apply.
The basic reason is this: This is a tax case. There is, indeed, a lot of "financial innovation." But particularly in the modern era, a lot of that "innovation" relates primarily -- if not exclusively -- to the (purportedly "legal") evasion of taxes. And there's good reason -- real good reason -- to believe that that's not just true in general, but particularly here.
Notice what the "life insurance" policy does here. It's got a monster "premium" of six-figures a year. So that's how much the "policyholder" invests. The "amount" of the "life insurance" depends highly upon the return of the "investment vehicle" the "policyholder" chooses. Here, that's the S&P 500. A policyholder gets to stop paying "premiums" once the S&P 500 goes up a certain amount. And while the investment has to stay in the account for a limited period of time -- 8 to 12 years -- the "balance" of the life insurance policy is deliberately designed to be withdrawn not only upon death, but instead whenever the investor feels like realizing his investment returns.
What's the difference between (A) this "life insurance" policy, and (B) a straightforward mutual fund (or hedge fund) that similarly invests in the S&P 500 and requires investments to stay in the fund for years? None. None whatsoever. Except that, according to the taxpayers -- as well as the company that set up the "policy" -- the increase in value the fund (e.g., capital gains) are taxable in (B) but not in (A). By calling it a "life insurance" policy, you get all the benefits of an investment but avoid the consequent taxes that everyone else pays.
Could the IRS say that's okay? Sure. If Congress or the IRS wants to allow people to so easily avoid capital gains taxes, they're free to do so. Indeed, I'm happy to sign up. I'd probably vote against such a taxation regime (at least without knowing more), but if it were allowed, I'd gladly participate. Only a few want to pay more taxes than are due.
But, at the same time, the IRS clearly doesn't want these tax shelters to operate. Which is, indeed, how this particular case came about. Because once the IRS got wind of what was going on in this area, and started to clamp down, the "life insurance" company here terminated the plan, which led to the "surrender value" dispute involving the present taxpayers.
I say all of this for a simple reason. Flexibility may be good in some areas. But in others -- and tax law comes to mind -- there may well be value even in admittedly overbroad and inflexible rules. The ability of taxpayers to find "creative" ways to avoid taxes is exceptionally high. Particularly when assisted by highly compensated accountants, lawyers and financial advisors who can readily obtain a healthy chunk of whatever money gets diverted from the public fisc. The IRS might understandably, and properly, want to create bright-line rules precisely to preclude the type of "financial innovation" to which Judge Smith refers, and that is amply present in this case.
It's possible, of course, that mankind's several centuries of experience with life insurance and the financial preparations for death have nonetheless left undiscovered beneficial ways to make sure that dependents are cared for upon death. But I'm pretty sure at least the basics here are covered. By contrast, I'm quite confident that there are legions of creative ways not yet identified to try to get around paying taxes. New ones crop up every year. Always have. Always will. When deciding whether a bright-line rule like the one proposed by the IRS is beneficial, I'm not so sure a policy that favors innovation is necessarily a valuable one. Sometimes the best rules are the ones that are the clearest. Even when they're potentially overbroad.
I understand that as a general principle. When dealing with innovation, you often don't want to make bright-line rules.
But I'm not as confident as Judge Smith that this doctrine is applicable in this particular context. Indeed, a contrary principle might well apply.
The basic reason is this: This is a tax case. There is, indeed, a lot of "financial innovation." But particularly in the modern era, a lot of that "innovation" relates primarily -- if not exclusively -- to the (purportedly "legal") evasion of taxes. And there's good reason -- real good reason -- to believe that that's not just true in general, but particularly here.
Notice what the "life insurance" policy does here. It's got a monster "premium" of six-figures a year. So that's how much the "policyholder" invests. The "amount" of the "life insurance" depends highly upon the return of the "investment vehicle" the "policyholder" chooses. Here, that's the S&P 500. A policyholder gets to stop paying "premiums" once the S&P 500 goes up a certain amount. And while the investment has to stay in the account for a limited period of time -- 8 to 12 years -- the "balance" of the life insurance policy is deliberately designed to be withdrawn not only upon death, but instead whenever the investor feels like realizing his investment returns.
What's the difference between (A) this "life insurance" policy, and (B) a straightforward mutual fund (or hedge fund) that similarly invests in the S&P 500 and requires investments to stay in the fund for years? None. None whatsoever. Except that, according to the taxpayers -- as well as the company that set up the "policy" -- the increase in value the fund (e.g., capital gains) are taxable in (B) but not in (A). By calling it a "life insurance" policy, you get all the benefits of an investment but avoid the consequent taxes that everyone else pays.
Could the IRS say that's okay? Sure. If Congress or the IRS wants to allow people to so easily avoid capital gains taxes, they're free to do so. Indeed, I'm happy to sign up. I'd probably vote against such a taxation regime (at least without knowing more), but if it were allowed, I'd gladly participate. Only a few want to pay more taxes than are due.
But, at the same time, the IRS clearly doesn't want these tax shelters to operate. Which is, indeed, how this particular case came about. Because once the IRS got wind of what was going on in this area, and started to clamp down, the "life insurance" company here terminated the plan, which led to the "surrender value" dispute involving the present taxpayers.
I say all of this for a simple reason. Flexibility may be good in some areas. But in others -- and tax law comes to mind -- there may well be value even in admittedly overbroad and inflexible rules. The ability of taxpayers to find "creative" ways to avoid taxes is exceptionally high. Particularly when assisted by highly compensated accountants, lawyers and financial advisors who can readily obtain a healthy chunk of whatever money gets diverted from the public fisc. The IRS might understandably, and properly, want to create bright-line rules precisely to preclude the type of "financial innovation" to which Judge Smith refers, and that is amply present in this case.
It's possible, of course, that mankind's several centuries of experience with life insurance and the financial preparations for death have nonetheless left undiscovered beneficial ways to make sure that dependents are cared for upon death. But I'm pretty sure at least the basics here are covered. By contrast, I'm quite confident that there are legions of creative ways not yet identified to try to get around paying taxes. New ones crop up every year. Always have. Always will. When deciding whether a bright-line rule like the one proposed by the IRS is beneficial, I'm not so sure a policy that favors innovation is necessarily a valuable one. Sometimes the best rules are the ones that are the clearest. Even when they're potentially overbroad.
