Decisions — Cashing in, cashing out

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Image source: Free Picture: Glass Jar With Coins ID: 169902 © Piotr Majka Dreamstime Stock Photos

Image source: Free Picture: Glass Jar With Coins ID: 169902 © Piotr Majka Dreamstime Stock Photos

The trouble with life insurance is that you have to be dead to enjoy the payout—unless your policy has a cash surrender value and the terms of the policy allow you to receive money based on that value. But what are the tax consequences of the money you withdraw?

In T.C. Memo. 2016-110 (Mallory), the taxpayer paid $87,500 for a modified single premium variable life insurance policy in 1987. The taxpayer was the insured as well as the owner of the policy, and his wife was the direct beneficiary.

Under the terms of the policy, the taxpayer could borrow against the cash value of the policy. Interest on the borrowed money would accrue, and was payable annually by the taxpayer. Unpaid interest would be added to the outstanding balance. Once this “policy debt” exceeded the cash value, the policy would terminate, after the insurance company gave the taxpayer notice and an opportunity to pay down the policy debt to avoid the termination.

From June 1991 through December 2001, the taxpayer borrowed $133,800 before interest. He used the money to cover short-term financial needs, and did not repay the money or pay interest on the money. The insurance company issued (and the taxpayer received) a loan activity confirmation for each withdrawal, annual notices requesting payment of the interest and reminding the taxpayer that unpaid interest would be added to the debt, and quarterly reports of the amount of the debt and the cash value of the policy.

In 2011, the insurance company sent the taxpayer a notice telling him the policy debt had exceeded the cash value. The letter said the taxpayer had to make a minimum payment of $26,061.67 within two months or the policy would be terminated. The letter also explained that if he didn’t make the payment, the termination would be a taxable event, and the insurance company would report the gain on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.. As of the date of the letter, the taxable gain was $155,119.16.

The taxpayer did not make the required payment, and the insurance company terminated the policy in December 2011. The insurance company issued a 2011 Form 1099-R showing a gross distribution of $237,897.25, insurance premiums of $87,500, and a taxable amount of $150,397.25. [Editorial note: No explanation was given for the difference between this taxable amount and the taxable amount mentioned in the letter the insurance company had sent earlier.]

The taxpayer filed the 2011 Form 1040 around March 8, 2013. The taxpayer did not report income from the Form 1099-R.

The IRS says the termination of the policy in 2011 resulted in the cancellation of the policy debt. The total amount ($237,897.25) was a constructive distribution, and the amount by which the constructive distribution exceeded the investment in the policy ($150,397.25) was taxable income.

The taxpayer says the amounts he received from 1991 to 2001 were distributions of the cash value of the policy that he did not have to pay back. Because there was no policy debt to cancel, and because he did not physically receive any payments in 2011, he says he had no income from the life insurance company for 2011. Alternatively, he argues that, if the termination of the policy did result in income, he can claim interest deductions.

QUESTIONS

1.

Based on the policy terms described above, were the distributions to the taxpayer bona fide debt?

WHAT WOULD YOU DECIDE?

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THE COURT’S DECISION

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2.

Should the amounts the taxpayer received from 1991 to 2001 have been included in his income for those years?

WHAT WOULD YOU DECIDE?

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THE COURT’S DECISION

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3.

If the distributions to the taxpayer were bona fide debt, what would be the tax consequences of the cancellation of the policy?

Here are the relevant internal revenue code sections.

From Internal Revenue Code Section 101(a)(1): Any amounts received under a life insurance contract that were paid because of the death of the insured are excludable from the gross income of the recipient; that is, they are not taxable.

From Internal Revenue Code Section 72(e): This section governs nonannuity amounts received, and provides that (with certain exceptions) an amount received under a life insurance contract is “included in gross income, but only to the extent it exceeds the investment in the contract.” Investment in the contract is (i) the total premiums or other consideration paid minus (ii) the total amount received under the contract that was excludable from gross income.

 

WHAT WOULD YOU DECIDE?

or

 

THE COURT’S DECISION

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4.

Do you agree with the taxpayer’s alternative argument that if the termination of the policy did result in income, he could claim an interest deduction?

Here is the relevant internal revenue code section.

From Internal Revenue Code Section 163(a): Generally allows a deduction of all interest paid or accrued during the taxable year. As an exception to this general rule, however, in the case of a taxpayer other than a corporation, section 163(h) generally disallows any deduction for “personal interest”, defined to include any interest expense that does not fall within one of the five categories listed in section 163(h)(2). These categories are: (1) trade or business interest; (2) investment interest; (3) interest used to compute passive income or loss; (4) qualified residence interest; and (5) interest payable on certain deferred estate tax payments.

 

WHAT WOULD YOU DECIDE?

Make your selection, then hover your mouse
over the link beneath “The Court’s Decision”

or

 

THE COURT’S DECISION

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***

Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

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!
Sorry, wrong answer :(

Yes, the distributions were bona fide debt.

The evidence shows that the $133,800 distributed to the taxpayer from 1991 to 2001 was policy loans, that, when combined with accrued interest, eventually resulted in a policy debt of $237,897.25.

The policy’s underlying terms allowed the taxpayer to borrow against the cash value of the policy and provided that these policy loans would result in the accrual of interest. The policy loans were bona fide debt.

Whenever the insurance company made a transfer to the taxpayer, it sent him a loan activity confirmation. It sent him yearly notices requesting payment of interest and notifying him that any unpaid interest would be capitalized. It sent him quarterly reports of the policy debt and the cash value of the policy.

The taxpayer admits that he received these confirmations and notices, all of which unambiguously refer to the amounts transferred from 1991 to 2001 as loans and not distributions.

Sorry, wrong answer :(
Right answer!

As the proceeds of loans, the amounts the taxpayer received from 1991 to 2001 were not includable in his income for those years.
Sorry, wrong answer :(
Right answer!

The taxpayer would have a constructive distribution in the amount of $150,397.25.

In 2011, when the policy terminated, the policy debt, including capitalized interest, was extinguished. This extinguishment of policy debt had the effect of a constructive distribution of the cash value in the policy.

Any amounts received under a life insurance contract that were paid because of the death of the insured are excludable from the gross income of the recipient; that is, they are not taxable.

The tax treatment of amounts received under a life insurance contract before the death of the insured is found in section 72. Section 72(e)(5) governs nonannuity amounts received.

The $237,897.25 was received before the taxpayer’s death, and therefore section 72 governs its tax treatment. Because the amount was not received as an annuity, section 72(e)(5) governs its tax treatment.

Section 72(e)(5)(A) provides that (with certain exceptions not applicable here) an amount received under a life insurance contract is “included in gross income, but only to the extent it exceeds the investment in the contract.” Therefore, the $237,897.25 is includable in gross income to the extent it exceeds the investment in the contract.

Investment in the contract is (i) the total premiums or other consideration paid minus (ii) the total amount received under the contract that was excludable from gross income. Sec. 72(e)(6).

At the time the policy was terminated, the taxpayer’s investment in the contract was $87,500 (his single premium payment). That portion of the constructive distribution was nontaxable. (See section 72(e)(5)(A).)

But the balance of the constructive distribution, or $150,397.25, constitutes gross income ($237,897.25 – $87,500 = $150,397.25). Therefore, we hold that the taxpayer must include the $150,397.25 in gross income.

Sorry, wrong answer :(
Right answer!

No, the taxpayer would not have an interest deduction.

The taxpayer argues in the alternative that, if the termination of the life insurance policy gave rise to income, then “[d]eductions of paid interest and other losses would be available” to lower his taxable income.

Section 163(a) generally allows a deduction of all interest paid or accrued during the taxable year.

As an exception to this general rule, however, in the case of a taxpayer other than a corporation, section 163(h) generally disallows any deduction for “personal interest”, defined to include any interest expense that does not fall within one of the five categories listed in section 163(h)(2).

These categories are: (1) trade or business interest; (2) investment interest; (3) interest used to compute passive income or loss; (4) qualified residence interest; and (5) interest payable on certain deferred estate tax payments. (See section 163(h)(2)(A)-(E).)

The taxpayer presented no evidence to show that the interest expenses would fall within any of these five enumerated categories. To the contrary, the taxpayer testified that the loans were taken out to cover short-term financial needs, and the record does not indicate that these needs were anything other than living expenses. The taxpayer has not shown that the interest paid was not personal interest.

Any interest paid on the life insurance loans is not deductible.

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