Constructive Income When Insurance Policy with Loan Terminated
In Mallory, 1 the Tax Court held that the termination of a life insurance policy resulted in a constructive distribution equal to the outstanding policy loans, which was taxable income to the extent it exceeded the taxpayer's investment in the contract.
In 1987, Kenneth Mallory purchased a variable life insurance policy with Monarch Life Insurance Company with a single premium payment of $87,500. The policy provided that Kenneth, as the owner, could borrow from Monarch and that the loans would be secured by the policy. The policy provided that interest accrued on the loans, that the interest was payable annually, and that any unpaid interest would be capitalized (i.e., added to the outstanding loan amount). The policy provided that if the policy debt (including capitalized interest) ever exceeded the cash value of the policy (defined as the premiums and earnings on premiums), Monarch would terminate the policy after giving Kenneth notice of the pending termination and an opportunity to pay down the policy debt to avoid termination. From June 1991 through December 2001, Kenneth took out 25 loans against the policy in amounts ranging from $1,000 to $12,000. The aggregate amount of the loans excluding interest was $133,800.
Monarch regularly issued, and Kenneth received, several types of statements related to the policy and the loans, including:
1) Loan activity confirmations for each loan when the loan was made.
2) Yearly notices requesting payment of interest and providing notice that any unpaid interest would be capitalized.
3) Quarterly reports of the policy debt and the cash value of the policy.
The cash value of the policy increased substantially due to earnings on the investment of the initial premium. However, the policy debt also grew as Kenneth took out loans from Monarch against the policy without repaying the loans or paying the interest on those loans. In October 2011, Monarch sent Kenneth a letter informing him that the policy debt of $237,897.25 exceeded the cash value. The letter also informed him that to avoid termination of the policy he had to make a minimum payment of $26,061.67 by December. The letter further explained that termination of the policy would result in a taxable event and that Monarch would report any taxable gain to Kenneth and the IRS on a Form 1099-R, "Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc." The letter noted that as of October, the taxable gain was $155,119.16.
Kenneth did not make the required payment, and Monarch terminated the policy in December. Monarch issued a Form 1099-R for 2011 showing a gross distribution of $237,897.25, insurance premiums paid of $87,500, and a taxable amount of $150,397.25. Before filing their 2011 income tax return, Kenneth's wife spoke with an accountant about the income that Monarch had reported on the Form 1099-R. The accountant told Kenneth's wife that they were going to owe tax on that amount. Kenneth's wife testified at trial that she telephoned several other tax professionals to ascertain whether the Form 1099-R was correct. The persons she telephoned consisted of two groups: (1) people who advertised themselves in the telephone directory as tax professionals (and whom she did not pay) and (2) various IRS personnel. None of the persons she contacted was willing to confirm whether the Form 1099-R was correct.
The accountant that Kenneth's wife originally contacted prepared Kenneth's 2011 income tax return. Kenneth did not report as income the amount shown on the Form 1099-R, but he did attach a copy of the Form 1099-R to the return. The IRS issued a notice of deficiency and imposed accuracy-related penalties.
The IRS contended that the termination of the policy in 2011 resulted in the extinguishment of Kenneth's policy debt of $237,897.25, that this extinguishment was a constructive distribution to him of $237,897.25, and that $150,397.25 (the amount by which the constructive distribution exceeded his $87,500 investment in the life insurance contract) was includable in Kenneth's gross income for 2011.
Kenneth denied that he had any policy debt. He contended that the amounts received from 1991 to 2001 were distributions of the cash value of the policy that he did not have to pay back. Kenneth argued that he had no income from Monarch for 2011 because there was no policy debt to extinguish and he did not physically receive any payments from Monarch in 2011. In the alternative Kenneth argued that if the termination of the policy did give rise to income, he was entitled to claim an interest deduction.
The first issue considered by the court was whether the funds received by Kenneth were loans or policy distributions. The court found that the evidence established that the $133,800 transferred from Monarch to Kenneth from 1991 to 2001 were policy loans, that, when combined with accrued interest, eventually resulted in a policy debt of $237,897.25. The policy's underlying terms allowed Kenneth to borrow against the cash value of the policy and also provided that these policy loans would result in the accrual of interest.
The court found that whenever Monarch made a transfer to Kenneth, it sent him a loan activity confirmation. In addition, Monarch sent Kenneth yearly notices requesting payment of interest and notifying him that any unpaid interest would be capitalized. Furthermore, Monarch sent Kenneth quarterly reports of the policy debt and the cash value of the policy. The court held that these confirmations and notices unambiguously refer to the amounts transferred by Monarch to Kenneth as loans and not distributions.
Next the court stated that as the proceeds of loans, the amounts that Kenneth received from Monarch were not includable in Kenneth's income for those years. The court noted, however, that when Kenneth terminated his policy, the policy debt, including capitalized interest, was extinguished. The court concluded that the extinguishment of his policy debt had the effect of a constructive distribution of the cash value in the policy to Kenneth.
Finally, the court considered the tax treatment of the $237,897.25 constructive distribution. Section 72 governs the tax treatment of amounts received under a life insurance contract before the death of the insured, and Section 72(e)(5) governs nonannuity amounts received before the death of the insured. The tax treatment of the constructive distribution of $237,897.25 is governed by Section 72(e)(5) because it was received before Kenneth's death and it was not received as an annuity. Section 72(e)(5)(A) provides that 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 court held that the $237,897.25 constructive distribution was includable in Kenneth's gross income to the extent it exceeded his investment in the contract.
Section 72(e)(6) provides that the investment in the contract is (1) the total premiums or other consideration paid minus (2) the total amount received under the contract that was excludable from gross income. Kenneth's investment in the contract was his single premium payment of $87,500 and, therefore, that portion of the constructive distribution was nontaxable. But the balance of the constructive distribution of $150,397.25 was gross income which the court held must be included in Kenneth's gross income.
The court rejected Kenneth's alternative argument that if the termination of the life insurance policy gave rise to income, then a deduction for interest paid should be allowed to lower his taxable income because the cash value of the policy was used to extinguish the policy debt and the policy debt included accrued interest. Kenneth did not raise the issue of an interest deduction in his petition and, therefore, the court held that the issue was deemed conceded.
The court also stated, however, that even if Kenneth had properly raised the issue of the deductibility of the interest, he would still not be entitled to a deduction under the facts of this case because the interest would be personal interest. In the case of a taxpayer other than a corporation, Section 163(h)(2) disallows any deduction for personal interest, which is defined to include any interest expense that does not fall within one of the following five categories:
1) Trade or business interest.
2) Investment interest.
3) Interest used to compute passive income or loss.
4) Qualified residence interest.
5) Interest payable on certain deferred estate tax payments.
The court found that Kenneth presented no evidence to show that the interest expenses fell within any of these five enumerated categories. To the contrary, Kenneth testified that the loans were taken out to cover short-term financial needs, and the record did not indicate that these needs were anything other than living expenses. The court therefore held that the interest paid on their life insurance loans was not deductible.
The holding in this case is not surprising because it is a clear application of the law to the facts presented. It appears from the facts of this case that the taxpayers did not like the advice given to them by the accountant who prepared their tax return and therefore, prior to finalization of the tax return, contacted other tax professionals hoping to obtain advice more to their liking. When the taxpayers did not receive desired advice, they apparently directed their accountant to take a middle ground-not report the income shown on the 1099-R but rather simply attach a copy of the 1099-R to the return. This course of action did not turn out well for the taxpayers, nor should it have.
1 TC Memo. 2016-110.
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets his clients have accumulated and minimizing federal and state tax liability. These clients range from homeowners whose property has appreciated to people with significant investment, retirement, business, and real estate holdings. For more on constructive income when an insurance policy with a loan is terminated, contact Frank at (301) 657-0175 or email@example.com.
This article originally appeared in the October 2016 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.