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.
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
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.
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.
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.
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.