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Income But No Debt Discharge From Life Insurance Policy Surrender

Estate Planning Journal

In Brach,  the Tax Court held that a policy loan that is paid-off in full upon the surrender of the life insurance policy does not give rise to cancellation of debt (COD) income under Section 108, but rather the policy proceeds are subject to taxation under Section 72.

Facts

In 1984, Mr. Brach acquired an insurance policy on his life from Guardian Life Insurance Company. The policy had a cash value portion and paid dividends. Under the terms of the policy, Mr. Brach was permitted to borrow against the policy in an amount not in excess of its cash value. The policy permitted Mr. Brach to terminate the policy and receive a distribution of the cash value of the policy plus any accrued dividends minus any outstanding debts against the policy. In 1995 Mr. Brach borrowed against the cash value of the policy.

In 2010 Mr. Brach surrendered the policy. Upon surrender of the policy, a portion of the policy proceeds paid the outstanding loan in full, and Mr. Brach received the balance of the policy proceeds. At the time of the surrender of the policy, the policy proceeds were $65,903, the loan was $62,117, and Mr. Brach's investment in the contract was $32,778. Following the surrender of the policy, Guardian issued a Form 1099-R reporting taxable income of $33,125.

Mr. Brach retained Mr. Neuman, an enrolled agent, to prepare his 2010 income tax return. On the basis of Mr. Brach's income and expenses, assets, and various loan liabilities, Mr. Neuman determined that Mr. Brach was insolvent and was not required to report on his 2010 income tax return COD income in respect of the surrender of the life insurance policy.

In 2012, the IRS issued to Mr. Brach a notice of deficiency for 2010 that determined a deficiency and imposed an accuracy-related penalty.

Analysis

Mr. Brach contended that the surrender of the life insurance policy gave rise to COD income and that because he was insolvent at the time, no part of the distribution was includable in his gross income by virtue of Section 108(a)(1)(B). The IRS on the other hand argued that since Guardian was paid in full and did not forgive any part of Mr. Brach's debt, Section 72 set forth the applicable rules regarding the tax treatment of the policy proceeds upon surrender of the policy.

The court began its analysis by reviewing the relevant law. The court noted that where an insurance policy is terminated and the proceeds are used to satisfy a loan against the policy, the payment against the loan is treated as if the taxpayer received the payment and applied it against the outstanding loan.1 In addition, the court noted that generally the tax treatment of a distribution from a life insurance policy is governed by Section 72 which provides that an amount received in connection with a life insurance contract generally is gross income to the extent that the amount received exceeds the investment in the insurance contract.2 The investment in the contract is defined generally as the aggregate premiums or other consideration paid for the contract less aggregate amounts previously received under the contract.3

The court next turned to an examination of the facts of this case. The court noted that upon surrender of the policy, the distribution proceeds were first used to satisfy Mr. Brach's outstanding loan against the policy. The court found that Guardian did not forgive any part of the loan because the loan was paid in full. The court stated that COD occurs when the debtor is no longer legally required to satisfy his or her debt either in part or in full. The court found that in this case, the loan to Mr. Brach was not discharged. Rather, it was extinguished after Guardian applied the distribution proceeds against Mr. Brach's debt. Furthermore, applying Section 72, the court then found that the portion of the policy proceeds equal to Mr. Brach's investment in the contract was nontaxable but the balance of the policy proceeds was taxable income.

Next the court examined the imposition of the accuracy-related penalty. Sections 6662(a) and (b)(2) impose an accuracy-related penalty equal to 20% of any underpayment of tax that is attributable to a substantial understatement of income tax. An understatement is defined as the excess of the tax required to be shown on the tax return over the tax actually shown on the return.4 An understatement of income tax is "substantial" if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return.5

Mr. Brach contended that he had reasonable cause and acted in good faith in relying on the advice of his tax return preparer, Mr. Neuman, an enrolled agent. Section 6664(c)(1) provides an exception to the imposition of the accuracy-related penalty if the taxpayer establishes that there was reasonable cause and the taxpayer acted in good faith. The decision as to whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account the pertinent facts and circumstances, including the taxpayer's knowledge, education, and experience, as well as the taxpayer's reliance on professional advice.6
Reliance on a professional tax advisor's advice may demonstrate reasonable cause and good faith.Reliance on a tax advisor may be reasonable and in good faith if the taxpayer establishes:

  1.  The advisor was a competent professional with sufficient expertise to justify reliance.
  2.  The taxpayer provided necessary and accurate information to the advisor.
  3. The taxpayer actually relied in good faith on the advisor's judgment. 8

 

The court found that each of these three requirements was satisfied. First, the court found that the status of enrolled agent tends to show competence.9 Next, the court found that Mr. Brach provided to Mr. Neuman complete and accurate information regarding the surrender of the life insurance policy. Finally, Mr. Brach relied in good faith on Mr. Neuman's judgment and had no reason not to accept Mr. Neuman's advice. Accordingly, the court concluded that Mr. Brach acted in good faith and reasonably relied on Mr. Neuman and, therefore, the court held that Mr. Brach came within the reasonable cause exception and was not liable for the accuracy-related penalty.

Comments

More than anything else, this case serves as a good reminder of the general tax rules regarding the taxation of policy proceeds upon surrender of the policy. It is important for advisors to remember that the surrender of a life insurance policy may give rise to taxable income. While Mr. Neuman's position may have been creative, it was not supported by established law.

1 See McGowen, ; Atwood, ; Brown, , aff'd (CA-7, 2012); Barr, .

2 See Sections 72(e)(1)(A) and (5)(A) and (C); Feder, .

3 See Section 72(e)(6); Feder, supra note 3; Reg. 1.72-6(a).

4 Section 6662(d)(2)(A).

5 Section 6662(d)(1)(A).

6 See Thomas, ; Neonatology Associates, P.A., (2000); aff'd (CA-3, 2002); Reg. 1.6664-4(b)(1).

7 See Regs. 1.6664-(4)(b)(1) and (c)(1).

8 See Neonatology Associates, P.A., supra note 7; Reg. 1.6664-4(b)(1).

9 See Mills, ; Mortensen, (CA-6, 2006), aff'g.
 

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 of high net worth individuals to minimize federal and state tax liability. For more on insurance policies as part of the tax planning process, contact Frank at (301) 657-0175 or fsbaldino@lerchearly.com.

This article originally appeared in the April 2014 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. 

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