Borrowing against a life policy and you don't pay it back: What next?
By Nick Paleveda MBA J.D. LL.M
National Pension Partners
On February 12, 2014, Tax Court Memo. 2014-27 Boyd J. Black and Janice C. Black, Petitioners v. Commissioner of Internal Revenue, Respondent answered the question as to what happens if you borrow against a life policy, terminate the policy and do not pay back the loan.
Borrowing against a life policy: The rules are black and white
The taxpayer borrowed against a life insurance policy but failed to repay the loans. The policy was terminated, and the loans were satisfied by policy proceeds and extinguished. The IRS contends that the amount realized upon termination of the policy includes both loan principal and capitalized interest. The taxpayer contended that the amount realized includes only loan principal.
The Tax Court held that capitalized interest which had accrued on the loans against his life insurance policy was includible in determining the gross distribution and the taxable amount arising from the termination of the policy. Held further, the taxpayer is liable for the I.R.C. sec. 6662(a) accuracy penalty.
What could the taxpayer do? The key is to hold the policy until date of death. Life insurance contracts receive a step-up in basis at the date of death. For example, if you pay $10,000 a year for your life insurance policy and in 10 years pay only $100,000, and then you die, your beneficiary receives a $500,000 death benefit. What does your beneficiary owe in income tax on the $400,000 gain? How about zero.