Policy loan triggers substantial taxable incomeArticle added by Sonya King on January 28, 2010
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Sonya King

Joined: October 01, 2008

The Tax Court recently held that a taxpayer would have to recognize $135,963 in ordinary income, a result that was triggered by the surrender of a life insurance policy with a large loan.

The $200,000 policy (purchased in 1980) was issued on the life of the taxpayer's mother with the taxpayer and his sister named as co-owners and co-beneficiaries. For the first eight or nine years, the annual premium ($8,929) was paid by the mother gifting one-half of each premium payment to the taxpayer and his sister, followed by both of them paying the premiums directly. Thereafter, the premiums were automatically paid from dividend accumulations and loans against the cash value of the policy.

On July 25, 2005, the insurance company mailed a letter to the taxpayer explaining the tax consequences of the policy along with a statement of gain. According to a second statement of gain (dated September 13, 2005), the net investment in the policy was $225,390.14, the total cash value was $361,353.58, the total loan indebtedness was $354, 399.25, and the taxable gain was $135,963.44. On October 10, 2005, the insurance company sent a letter to the taxpayer notifying him that the policy was in "overloan" and that in order to continue the policy he was required to pay both the overloan amount ($1,541.00) and the premium due at that time ($2,286.38). After conferring with his mother and deciding that the policy was no longer needed, the taxpayer surrendered the policy effective December 20, 2005 (at which time he was the sole owner and beneficiary of the policy). The taxpayer cashed a check for $11,648.33 and a check for a $304.20 dividend. In January 2006, the taxpayer received a form 1099-R showing a gross distribution and taxable amount of $135,963.44 for 2005 and a Form 1099-DIV showing a taxable dividend of $304.20. The taxpayer and his wife did not include the amount shown on the Form 1009-R or the Form 1099-DIV on their tax return. The Service assessed a $39,608 deficiency and a $7,922 accuracy-related penalty on the taxpayer and his wife.

Under the Code and Treasury regulations, the law is well-settled that any amount received upon the surrender of a life insurance contract that is not received as an annuity is specifically included in gross income to the extent that it, when added to amounts previously received under the contract and excluded from gross income, exceeds the investment in the contract.

Initially, the Tax Court noted that when the policy terminated, the taxpayer had received a net distribution of $11,648.33, an amount that represented the total cash value ($361,353.58), plus a terminal dividend ($4,694), minus $354,399.25, which was withheld to repay the outstanding policy loan. According to the court, the satisfaction of the loans had the effect of a pro tanto payment of the policy proceeds to the taxpayer and, therefore, constituted income to him at that time. Thus, the taxpayer constructively received the policy's cash value ($361,353.58) without reduction for outstanding loans upon surrender. The taxpayer's net investment at the time of surrender was $225,390.14. Accordingly, despite having received a check for only $11,648.33, the taxpayer was taxable (under IRC Section 72(e)) on the $135,963.44 gross distribution reported to the IRS on Form 1099-R. With regard to the character of the gain, the court stated that generally the lapse, cancellation, surrender, or termination of a policy does not equate to a sale or exchange. Because the surrender of an insurance policy is not a "sale or exchange" of a capital asset, it does not result in capital gain. Accordingly, the court held, the gain recognized from the taxpayer's policy surrender received ordinary income treatment. In addition, the court upheld the Service's assessment of the $7,922 accuracy-related penalty--most likely owing to the fact that the taxpayer was an experienced attorney admitted to practice before the Tax Court.

Barr v. Comm., TC Memo 209-250.

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