Case — Reimbursed Insurance Premiums and Recourse Notes

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TL Case Summ

THE QUESTION

Are funds provided for the reimbursement of insurance premiums taxable income when a recourse promissory note is issued for the amount of the premiums?

THE DISPUTE

Taxpayer Says: The money is not taxable income because a promissory note was issued to the insurance broker.

Internal Revenue Service Says: The money is a rebate of insurance premiums and is taxable income in the year received.

THE LAW

From Wentz v. Commissioner, 105 T.C. 1, 12-14 (1995): When a taxpayer purchases insurance coverage but, pursuant to a rebating scheme, receives a reimbursement of his premium payment from an insurance broker, the taxpayer has received income within the meaning of Internal Revenue code section 61, measured by the amount of the premium reimbursement, or rebate, received. The income must be recognized in the year the rebate is received.

From Sutter v. Commissioner, T.C. Memo. 1998-250: Where the taxpayer receiving a premium-reimbursing rebate from the insurance broker gives the broker a nonrecourse note, secured by the policy, in the amount of the reimbursement, such a note has not precluded a determination that the rebate is income to the taxpayer where the note did not constitute genuine indebtedness..

From Fisher v. Commissioner, 54 T.C. 905, 909 (1970): Determining whether a promissory note constitutes genuine indebtedness requires an examination of all of the facts and circumstances. A good faith intent of the debtor to repay and a good faith intent of the creditor to enforce repayment are the most important elements of this determination.

THE CAUSE OF THE DISPUTE

When you borrow money and have a genuine obligation to repay the lender, you’re not required to include the loan proceeds in income at the time of the loan. A debt is genuine if it arises from a debtor-creditor relationship based on a valid and enforceable obligation to repay a fixed or determinable sum of money.

In this case, the taxpayer bought three life insurance policies from the same broker in November and December of 2001, and wrote checks to pay for the first year premiums. The broker earned commissions on each of the policies that were more than the initial premiums and provided funds to the taxpayer in the amount of the first year premiums, reducing the taxpayer’s outlay to zero.

On December 1, 2001, the taxpayer signed a one-year interest bearing recourse promissory note to the broker for the approximate amount of the premiums. The taxpayer made no payments on the note, and the broker did not demand repayment. The taxpayer cancelled the three policies during 2003 and 2004.

The taxpayer says the recourse note (for which he was personally liable) was a genuine obligation to repay the premium reimbursements to the broker and therefore the reimbursements were not income. In addition, the taxpayer says no payments were made on the note because he had lent other amounts to the broker that had not been repaid.

The IRS says there was never any good faith intention to repay, or to demand repayment of, the note, and so it did not constitute genuine indebtedness. Because there was no genuine indebtedness, the premium reimbursements were income.

Editorial note: Generally, when you receive a reduction in the purchase price of something you buy, you do not realize income. For instance, when an automobile manufacturer offers a rebate to the general public, you do not recognize income on receipt of the rebate when you purchase a car from the manufacturer.

In the case of insurance policies, the courts have found that “rebating”, where a broker offers to pay the initial premium on an insurance policy (or provides some other consideration not authorized by the policy itself) to induce a buyer to purchase the policy from that broker, the rebates are income. (They’re also “unfair trade practices” and are illegal.)

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 15KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
For the IRS. There is no evidence of a demand for repayment or of any other action by the purported debtor or creditor occasioned by the failure to make payment when due. Moreover, taxpayer had not made any payment of principal or interest on the note at the time of trial, some 5-1/2 years after the note became due. We find there was no genuine indebtedness offsetting the receipt of the premium rebates. Taxpayers received taxable income.