Life insurance contracts have traditionally been accorded highly favorable income tax treatment. One of the most important of these benefits is the tax-free inside build-up of cash value in a policy (as long as it satisfies the Code's definitional parameters for a life insurance contract). Not only may the cash value accumulate within the policy without current taxation, but this untaxed income may even be utilized by the policy owner, still without income recognition for tax purposes, in the form of a policy loan.
The non-recognition of this income will become permanent when the insured dies, and the death benefit (net of any policy loan balance) is paid. Under the general rule of IRC §101, the death benefit under a life insurance contract is excluded from gross income.
However, this avoidance of income recognition will not be permanent when a policy loan is effectively retired by offset against the cash value in connection with cancellation of the contract. In such event the income recognition will have only been deferred, and it must be recognized at the time of cancellation (or lapse) of the policy. This, of course, makes complete sense; to the extent that the policy owner has withdrawn from the policy an aggregate amount in excess of his or her cash input (cost basis in the policy), and no longer has any obligation to repay such funds, there has been a net benefit which would ordinarily be taxable income. Only in the event of death while the policy is in force, would such net economic benefit escape income taxation, because of the special rule of IRC §101.
The Reinert case
On July 17, 1958, Mr. Reinert purchased a life insurance policy from Northwestern Mutual Life Insurance Company ("Northwestern"). The death benefit was $10,000, and the $52.40 premium was payable every 4 months until July 17, 2035, or until his 65th birthday, at which time the policy would be fully paid-up.
As the cash value increased, Mr. Reinert borrowed against that value. As of 2005 the cash value of the policy was $29,933.78. At the same time, Mr. Reinert's outstanding loan balance against the cash value was $28,492.40, and the premiums he paid totaled $8,685.60. Northwestern treated the interest on the loans, under the terms of the policy, as additional loans against the cash value of the policy.
Under the terms of the policy, "If indebtedness equals or exceeds the cash value at any time, [the] policy shall terminate thirty-one days after a notice of termination has been mailed to the last known address of the Owner". The policy terms also provided that "Upon receipt at the Home Office of this policy and of a full and valid surrender of all claims, the insurance shall terminate and the Company will pay, as directed, the cash value less any indebtedness." At the end of December 2004, Northwestern sent Mr. Reinert a notice that the loan amount would soon exceed the cash value and that the policy would "terminate". The notice also advised that termination would trigger a taxable event and would result in reportable ordinary income. At that point Mr. Reinert owed $1,356.78 interest on his loan against the cash value of the policy and chose not to pay the interest, resulting in the loan balance exceeding the cash value. Mr. Reinert apparently communicated his belief to Northwestern that if the policy "terminated" it was not a taxable event, whereas if the policy was "surrendered" it was a taxable event. Mr. Reinert chose not to pay the interest, the loan amount exceeded the policy cash value, and the policy was terminated. Mr. Reinert did not physically surrender the policy.
On February 21, 2005, Mr. Reinert received a form entitled "Surrender of Policy for Cash Value" along with a $1,269.57 check from Northwestern representing the net cash value after offsetting his outstanding loan balance. Mr. Reinert signed the form and endorsed and cashed the $1,269.57 check.
Because of the termination, Mr. Reinert lost the $10,000 of life insurance coverage. In January 2006 Mr. Reinert received a Form 1099-R for his 2005 tax year from Northwestern reflecting a gross distribution of $29,933.78 and a taxable amount of $21,248.18. The $8,685.60 difference between the gross distribution and the taxable amount equaled the total amount he had paid in premiums.
Income tax effect when policy is cancelled
Ordinarily, when a life insurance contract having a cash value is cancelled or surrendered, there are potential tax consequences. Such transactions are governed by rules contained within IRC §72, which deals primarily with annuities and living proceeds of life insurance policies. Section 72(e) deals with payments received with respect to insurance contracts, which are not received as an annuity. This includes amounts received upon a cancellation of the contract. In general, such amounts are treated first as recovery of the policy owner's investment in the contract, and amounts received in excess of the amount invested are treated as ordinary income. IRC §72(e)(1)(A), 5(A) and 5(C). Northwestern was, in effect, applying this rule, when they issued the required 1099-R form to Mr. Reinert.
Before the Tax Court Mr. Reinert argued that his policy was "terminated" not "surrendered" and thus no taxable event occurred because IRC §72, and the regulations thereunder, only references the word "surrender" (without any mention of the word "termination"). The court quickly dismissed this argument:
"Section 72(e) causes the increases in value of insurance contracts to be taxable when the policy ends prior to the payment of an annuity. This situation is one that permits the deferral of the reporting of income until a triggering event occurs. We see no distinction between the termination and surrender of an insurance policy for this purpose. The physical act of submitting the policy is of no import in this setting. The policy has been terminated and no contractual relationship continued between Mr. Reinert and Northwestern. In reality, Mr. Reinert was allowed to defer the increases in value of his policy for many years, a fact that he fails to focus upon. We accordingly hold that petitioner had $21,248.18 of income as determined by respondent. [Reinert v. Commissioner, T.C. Summ. Op. 2008-163.]"
Pro Se taxpayers had no viable position
In representing himself pro se
in the Tax Court Mr. Reinert took the position that the policy termination did not give rise to income, since he did not voluntarily surrender the policy. This, of course, conveniently ignores the fact that he had received and spent funds from the insurance company in excess of the amounts originally invested in the policies.
The Court also sustained a 20 percent accuracy-related penalty which the IRS had imposed for substantial understatement of tax. Such a penalty may be imposed when the tax liability is understated by at least the greater of 10 percent of the reported tax or $5,000, unless the understatement was attributable to an item that was adequately disclosed and has a reasonable basis, or which was based upon a position for which there was substantial authority. The Court pointed out that Mr. Reinert failed to meet the test for avoidance of the penalty.
Financial advisors should be sure that clients understand the potential tax consequences when loan-encumbered policies "lapse", are "surrendered", or are simply "terminated" as in the Reinert case.
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