Beware of phantom income when policies lapse

By Julius Giarmarco

Giarmarco, Mullins & Horton, P.C.


When a life insurance policy lapses and there are loans against the cash value, the owner of the policy may incur an income tax. The “phantom income” is the difference between the policy loan and the premiums paid. For example, a $100,000 loan minus $80,000 in past premiums paid equates to $20,000 of ordinary income. Many insurance companies default to an automatic payment schedule if the owner stops paying premiums. These “payments” are deducted from the policy’s cash value, and those deductions are considered an internal loan.

In a recent case, Black v. Commissioner, No. 6402-12, T.C. Memo 2014-27, the Tax Court held that the amount realized on the lapse of the policy subject to the loan must include not only the loan principal, but also all of the accrued interest. The Tax Court stated that the extinguishment of the loan (on the lapse of the policy) by application of the cash value was a taxable event under IRC Section 72.

When a policy lapses, the carrier will issue a Form 1099R reflecting the taxable amount. One possibility to avoid the problem is to negotiate with the carrier to reduce the face amount of the policy so that the premiums are less to maintain. But it may prove difficult to get the carrier to cooperate. Another option is to hold the policy until the insured dies. The insured’s death eliminates the phantom income.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.