SUMMARY: A taxpayer with modest income surrendered a policy on his life. On that date, the policy was subject to a significant loan. The Tax Court held that the amount of the loan in excess of the taxpayer’s investment in the contract was includible in his income and was not excludible as a discharge of indebtedness even though he was insolvent. The judge then applied a three-factor test in finding taxpayer was not liable for an accuracy-related penalty because of good faith and reasonable reliance on professional advice.
BACKGROUND: In 1984, Samuel Brach acquired an insurance policy on his life. In 1995, he borrowed a significant sum against the policy cash value. Interest payments accrued on the loan. In 2010, unable to pay premiums or make loan payments, he surrendered the policy. The total surrender amount was $65,903. After paying off the outstanding loan, Brach received a check for only $3,786, the policy’s net value. At the time of the surrender, Brach’s investment in contract was $32,778. The insurance carrier issued a Form 1099-R showing taxable income from the surrender of $33,125.
Mr. and Mrs. Brach consulted an enrolled agent who prepared their 2010 income tax return providing him with Mrs. Bach’s W-2, both of their Forms 1099-SSA and Form 1099-R. The enrolled agent determined that the couple was insolvent and that the discharge of the policy loan was not income under Code Section 108(a)(1)(B). The agent also determined that none of Mr. and Mrs. Brach’s Social Security benefits were taxable since they had insufficient other income. Mr. and Mrs. Brach filed the return prepared by the enrolled agent without attaching Forms 1099-SSA and Form 1099-R or even Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, even though they were claiming a discharge because of insolvency.
The IRS issued a notice of deficiency of $6,949 and an accuracy-related penalty of $1,390.
The taxpayers argued that, because the policy loan was a discharged while they were insolvent, it was not includable income.
The IRS countered that Mr. and Mrs. Brach failed to prove that they were insolvent (perhaps because they failed to file Form 982 showing insolvency in excess of the indebtedness). In the alternative the IRS argued that the loan was extinguished by payment from the surrender proceeds and thus was not discharged within the meaning of IRC Section 108.
RESULT: Gross Income From Surrender. The Special Trial Judge agreed with the IRS that the policy loan was repaid from the surrender proceeds rather than being discharged without payment. Without a discharge of indebtedness, the exclusion under Code Section 108 with its insolvency issues was not relevant.
Income from insurance is included in gross income under IRC Section 61(a)(10). The amount included in gross income upon surrender of a life insurance policy is determined under Code Section 72(e)(5). The amount received is included in gross income to the extent it exceeds the taxpayer’s investment in the contract. Investment in the contract is defined as the aggregate amount of premiums or other consideration paid for the contract less aggregate amounts received under the contract to the extent such amounts were excludable from gross income. Loans against the cash value of an insurance policy are not distributions. Thus, when the policy is surrendered and the proceeds are used to satisfy the loan, the payment is treated as if the taxpayers received a distribution at that time and then applied it against the outstanding loan.
The judge held that Mr. and Mrs. Brach received a gross distribution of $65,903 upon surrender of the policy ($62,117 in repayment of the loan and $3,786 in cash). The gross distribution less their investment in the contract of $32,778 resulted in gross income of $33,125.
Accuracy-Related Penalty. The Special Trial judge held that Mr. and Mrs. Brach were not liable for an accuracy-related penalty under IRC Section 6662(a) and (b)(2) since they met the three prong test for reasonable cause by acting in good faith reliance on the advice of a tax professional:
1. The adviser was a competent professional since he was an enrolled agent.
2. The taxpayer gave the enrolled agent complete and accurate information including Mrs. Brach’s W-2 and all Forms 1099.
3. The taxpayers relied in good faith on the enrolled agent’s judgment since they were not experienced in tax matters and had no reason not to accept the advice.
RELEVANCE:
1. This is a sad tale of the surrender of a policy subject to a loan in excess of investment in contract resulting in $62,117 of phantom income. To further exasperate the problem, the phantom income resulted in taxation of Social Security benefits and disallowance of earned income tax credit and a child tax credit. If Mr. Brach had held the policy to death and not been forced to surrender the policy, the payment of the loan proceeds with death proceeds would not have resulted in any taxable income.
2. Policy owners should always be cautioned against borrowing too large of a sum against the cash value and risking lapse if the loan eventually equals cash value. There should be a sufficient cash value cushion to protect against a lapse. If at all possible, the policy owner should have a plan to repay the loan. If policy dividends are used to pay interest or repay the loan, the dividends would reduce the investment in contract and any excess dividends used for such purpose would be taxable income.
3. Note that if the policy had been a modified endowment contract, unlike policies which are not MECs, the loans would have been a distribution at the date of the loan resulting in immediate taxable income if the policy had cash value in excess of investment in the contract.
4. The interest on a loan against a personally owned contract is not deductible as personal interest. Since Mr. Brach’s policy was issued before June 9, 1997, it was grandfathered from this interest deduction prohibition. However, to deduct the interest, he would have to have met the requirements of IRC Sections 264(a)(2) and (3) and 163(h).
Mr. and Mrs. Brach consulted an enrolled agent who prepared their 2010 income tax return providing him with Mrs. Bach’s W-2, both of their Forms 1099-SSA and Form 1099-R. The enrolled agent determined that the couple was insolvent and that the discharge of the policy loan was not income under Code Section 108(a)(1)(B). The agent also determined that none of Mr. and Mrs. Brach’s Social Security benefits were taxable since they had insufficient other income. Mr. and Mrs. Brach filed the return prepared by the enrolled agent without attaching Forms 1099-SSA and Form 1099-R or even Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, even though they were claiming a discharge because of insolvency.
The IRS issued a notice of deficiency of $6,949 and an accuracy-related penalty of $1,390.
The taxpayers argued that, because the policy loan was a discharged while they were insolvent, it was not includable income.
The IRS countered that Mr. and Mrs. Brach failed to prove that they were insolvent (perhaps because they failed to file Form 982 showing insolvency in excess of the indebtedness). In the alternative the IRS argued that the loan was extinguished by payment from the surrender proceeds and thus was not discharged within the meaning of IRC Section 108.
RESULT: Gross Income From Surrender. The Special Trial Judge agreed with the IRS that the policy loan was repaid from the surrender proceeds rather than being discharged without payment. Without a discharge of indebtedness, the exclusion under Code Section 108 with its insolvency issues was not relevant.
Income from insurance is included in gross income under IRC Section 61(a)(10). The amount included in gross income upon surrender of a life insurance policy is determined under Code Section 72(e)(5). The amount received is included in gross income to the extent it exceeds the taxpayer’s investment in the contract. Investment in the contract is defined as the aggregate amount of premiums or other consideration paid for the contract less aggregate amounts received under the contract to the extent such amounts were excludable from gross income. Loans against the cash value of an insurance policy are not distributions. Thus, when the policy is surrendered and the proceeds are used to satisfy the loan, the payment is treated as if the taxpayers received a distribution at that time and then applied it against the outstanding loan.
The judge held that Mr. and Mrs. Brach received a gross distribution of $65,903 upon surrender of the policy ($62,117 in repayment of the loan and $3,786 in cash). The gross distribution less their investment in the contract of $32,778 resulted in gross income of $33,125.
Accuracy-Related Penalty. The Special Trial judge held that Mr. and Mrs. Brach were not liable for an accuracy-related penalty under IRC Section 6662(a) and (b)(2) since they met the three prong test for reasonable cause by acting in good faith reliance on the advice of a tax professional:
1. The adviser was a competent professional since he was an enrolled agent.
2. The taxpayer gave the enrolled agent complete and accurate information including Mrs. Brach’s W-2 and all Forms 1099.
3. The taxpayers relied in good faith on the enrolled agent’s judgment since they were not experienced in tax matters and had no reason not to accept the advice.
RELEVANCE:
1. This is a sad tale of the surrender of a policy subject to a loan in excess of investment in contract resulting in $62,117 of phantom income. To further exasperate the problem, the phantom income resulted in taxation of Social Security benefits and disallowance of earned income tax credit and a child tax credit. If Mr. Brach had held the policy to death and not been forced to surrender the policy, the payment of the loan proceeds with death proceeds would not have resulted in any taxable income.
2. Policy owners should always be cautioned against borrowing too large of a sum against the cash value and risking lapse if the loan eventually equals cash value. There should be a sufficient cash value cushion to protect against a lapse. If at all possible, the policy owner should have a plan to repay the loan. If policy dividends are used to pay interest or repay the loan, the dividends would reduce the investment in contract and any excess dividends used for such purpose would be taxable income.
3. Note that if the policy had been a modified endowment contract, unlike policies which are not MECs, the loans would have been a distribution at the date of the loan resulting in immediate taxable income if the policy had cash value in excess of investment in the contract.
4. The interest on a loan against a personally owned contract is not deductible as personal interest. Since Mr. Brach’s policy was issued before June 9, 1997, it was grandfathered from this interest deduction prohibition. However, to deduct the interest, he would have to have met the requirements of IRC Sections 264(a)(2) and (3) and 163(h).
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