Offer in Compromise

I.R.C. Section 7122

The United States Tax Court in Swanberg v. Comm’r of Internal Revenue handed down an opinion on August 25, 2020, as docket No. 10266-19L, in which it ruled that the IRS had properly included taxpayer’s Veterans Affairs benefit and excluded his life insurance premium in calculating an ability to pay for Offer in Compromise purposes. This matter was started in a Collection Due Process hearing filed as a result of the issuance of a Final Notice of Intent to Levy. The taxpayer submitted a collection information statement reflecting monthly income of $6,352 and expenses of $6,854. On review, the Settlement Officer noted that the taxpayer’s bank statements reflected a disability benefit from the VA. The Officer increased his income by the amount of this benefit. Further, she disallowed a $600 per month expense for whole life insurance. The Taxpayer argued that his VA benefit should not be included since it was not taxable. The Court ruled that the Settlement Officer had abided by the provisions of the Internal Revenue Manual (IRM) regarding these issues. The IRM provides that all household income will be used to determine taxpayer’s ability to pay. Income is included even if not subjected to taxation. Furthermore, the IRM supports disallowance of the whole life insurance expense. No abuse of discretion was found by the Court. 

Income Tax Consequences of Terminating a Whole Life Insurance Policy

The United States Tax Court just handed down a decision in Black v. Commissioner of Internal Revenue, T.C. Memo 2014-27, that explains what the income tax consequences are when this situation occurs.  In the opinion, the taxpayer had been the owner of a whole life insurance policy for over twenty years.  The policy had both cash value and loan features.  The policy allowed the taxpayer to borrow up to the cash value of the policy.  Loans from the policy would accrue interest and if the policy holder did not pay the interest then it would be capitalized as part of the overall debt against the policy.

The taxpayer had the right to surrender the policy at any time and receive a distribution of the cash value less any outstanding debt, which could include capitalized interest.  If the loans against the policy exceeded the cash value, the policy would terminate.  In this case, the taxpayer invested $86,663 in the life insurance policy, his total premiums paid for the policy.  Prior to the termination the total the taxpayer had borrowed from the policy was $103,548, however with capitalized interest over time the total debt on the policy was $196,230. The policy proceeds retired the policy debt at termination.

The taxpayers in this case were issued a 1099-R showing a gross distribution of $196,230 and a taxable amount of $109,567.  The non-taxable difference of $86,663 was the taxpayers’ investment in the policy – premiums paid. None of the information was included on the taxpayers’ return.  The taxpayers eventually amended their return and included as income the amount of $16,885 which represented the difference between the loan principal amount borrowed of $103,548 and the amount of premiums paid of $86,663.  Ultimately, the IRS disagreed with the taxpayers’ representation of the tax consequences of the life insurance policy termination.

The primary issue in the case then centered around whether or not the capitalized interest from the outstanding policy loans should be included in income. The Court explained that the money borrowed from the policy was a true loan with the policy used as collateral.  There were no income tax consequences on distribution of loan proceeds from the insurance company to the taxpayers.  Further, the Court explained that this is true of any loan as the taxpayers’ were obligated to re-pay the insurance company the debt owed.

The Court explained that when a policy is terminated then the loan is treated as if the proceeds were paid out to the taxpayers and the taxpayers then retired the outstanding loan by paying it back to the insurance company. The Internal Revenue Code provides that proceeds paid from an insurance company, when not part of an annuity, are generally taxable income for payments in excess of the total investment.  The insurance policy at issue treated the capitalized interest as principal on the loan. Therefore, when the policy is terminated, the loan, including capitalized interest, is charged against the proceeds and the remainder is income. This outcome makes sense or else the return on investment inside of the policy would never be taxed.

The taxpayers ended up with a large tax bill and a tough pill to swallow.  Ultimately, the result is logical in the context of capturing deferred income tax consequences.  Clearly, it would have been beneficial for the taxpayers to have consulted with counsel prior to preparing their tax return in order to avoid an unwelcome tax bill, penalties and interest.

Should you have transactions that you are unsure of when it comes to their income tax consequences, feel free to contact our office.  If you find yourself in receipt of an adjustment to your tax return based on exam action that you disagree with, or an assessment has been made and you have simply decided you were incorrect in your analysis, call us, we can help.