Policy loan triggers taxArticle added by Sonya King on February 12, 2009
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Sonya King

Joined: October 01, 2008

The Tax Court recently held that a taxpayer was liable for $21, 248.18 in taxes because his life insurance policy terminated due to a loan that exceeded the policy's cash value.

The taxpayer (Kenneth Reinert) purchased a $10,000 life insurance policy in 1958 from Northwestern Mutual. The premium ($52.40) was payable every four months until July 17, 2035 or until Reinert's 65th birthday, at which time the policy would be paid in full. The policy's cash surrender value continued to increase and as it increased, Reinert borrowed against it. Consequently, in 2005 the cash surrender value of the policy was $29,933.78, the outstanding loan balance was $28,492.40, and the premiums that had been paid totaled $8,685.60.

Over the years, Reinert did not pay interest whatsoever on the loans outstanding against the cash value. Northwestern Mutual treated the interest on the loans (under the terms of the policy) as additional loans against the cash value of the policy. Reinert's policy provided that if the indebtedness equaled or exceeded the cash value at any time, the policy would terminate 31 days after a notice of termination has been mailed to Reinert's last known address. The policy also provided that upon the insurance company's receipt of a full and valid surrender of all claims, the insurance policy would terminate, and the company would pay as directed the cash value less any indebtedness.

At the end of December 2004, Northwestern notified Reinert that the loan amount would soon exceed the cash value and that the policy would terminate. The notice also advised Reinert that termination would trigger a taxable event and would result in reportable ordinary income. At that point, Reinert owed $1,356.78 interest on his loan against the cash value of the policy. Reinert chose not to pay the interest, resulting in the loan balance exceeding the cash value of the policy. Reinert advised Northwestern that if the policy "terminated" it was not a taxable event, whereas if the policy was "surrendered" it was a taxable event. Since Reinert chose not to pay the interest, and because the loan amount exceeded the policy cash value, Northwestern terminated Reinert's policy -- even though Reinert never physically surrendered the policy.

On February 21, 2005, Reinert received a form from Northwestern titled "Surrender of Policy for Cash Value" along with a $1,269.57 check, representing the residual cash value after considering the outstanding loan balance. Reinert signed the form and endorsed and cashed the check. In January 2006, Reinert received a Form 1099-R for 2005 from Northwestern reflecting a gross distribution of $29,933.78 and a taxable amount of $21,248.18. The difference between the gross distribution and the taxable amount was $8,685.60, the total amount Reinert had paid in premiums on the policy. The Service assessed a $5,368 income tax deficiency and a $1,074 accuracy-related penalty for Reinert's 2005 tax year.

Before the Tax Court, Reinert contended that a "termination" of a policy in this manner -- that is, when the loan balance exceeds the threshold for termination -- is not a taxable event because the pertinent statutes and regulations expressly apply to a "surrender" of a policy. The court summarily dispensed with this argument and Reinert's emphasis on dictionary definitions, pointing out that Reinert had not provided any reference to legislative history in support of his contention.

The Tax Court then observed that Reinert did not question the amounts in dispute, only the legal question of whether the excess over investment in the contract is taxable. The court noted that it had already addressed a substantially similar set of circumstances in Atwood v. Comm., TC Memo. 1999-61. In Atwood, as with Reinert, the insurance contracts provided for the termination or lapse of the policy when the total loan, including unpaid interest, exceeded the policy cash value (or a similar threshold). Likewise in Atwood, the taxpayers failed to repay any portion of the loans or interest, their insurance policy contracts were terminated, and they were sent a small check reflecting the amount of the cash surrender value after considering the outstanding loans. In Atwood, as in Reinert's case, the termination resulted in the outstanding loans being satisfied by the cash value of the policy. In Atwood the excess of the cash surrender value over the total premiums paid was held to be ordinary income.

The Tax Court noted that even though Reinert complained that he received only $1,269.57 and thus had not "surrendered" his policy, nevertheless, when Reinert's policy terminated he was relieved of $28,664.21 in outstanding loans, which he had taken out during the 47 years the policy was in force. So, in effect, the court observed, Reinert had received $29,933.78 (i.e., $1,269.57 in cash and $28,664.21 in payment or credit against his outstanding loan obligations). The court further remarked that Reinert could have: (1) further deferred reporting this income by paying interest on or reducing the principal of his loan to an amount that would not have caused termination; and (2) maintained his paid-up life insurance coverage by maintaining the loan balance below the threshold amount.

The Tax Court noted that 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; thus, deferral of the reporting of income is permitted until a triggering event occurs. The court saw no distinction between the "termination" and "surrender" of an insurance policy for this purpose, and determined that the physical act of submitting the policy was of no import in this setting. In the court's opinion, Reinert's policy had been terminated and no contractual relationship continued between him and Northwestern. In reality, the court stated, Reinert had been allowed to defer the increases in value of his policy for many years, a fact that he failed to focus upon. The $21,248.18 represented the $29,933.78 cash value less Reinert's investment/basis of $8,685.60 in premiums paid. Accordingly, the Tax Court held that Reinert had $21,248.18 of income.

Reinert v. Comm., TC Summ. Op. 2008-163.

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