Cancellation Of Policy Subject To Loan Can Generate Taxable Income

A recent Tax Court Summary Opinion is a useful reminder of the income tax consequences which can accompany the lapsing or cancellation of a life insurance policy whose cash value has previously been depleted through policy loans. [Julie J. Revolinski et al. v. Commissioner; T.C. Summ. Op. 2005-26; Docket No. 3860-04S.]

Life insurance contracts have traditionally been accorded highly favorable income tax treatment. One of the most important of these benefits is the tax-free inside build-up of cash value in a policy (as long as it satisfies the Internal Revenue Code`s definition of life insurance). Not only may the cash value accumulate within the policy without current taxation, but this untaxed income may even be utilized by the policy owner, still without income recognition for tax purposes, in the form of a policy loan.

The non-recognition of this income will become permanent when the insured dies, and the death benefit (net of any policy loan balance) is paid. Under the general rule of I.R.C. §101, the death benefit under a life insurance contract is excluded from gross income.

However, this avoidance of income recognition will not be permanent when a policy loan is effectively retired by offset against the cash value in connection with surrender or cancellation (or lapse) of the contract. In such event the income recognition will have only been deferred, and it must be recognized at the time of surrender or cancellation (or lapse) of the policy. This, of course, makes complete sense; to the extent that the policy owner has withdrawn from the policy an aggregate amount in excess of his or her cash input (cost basis in the policy), and no longer has any obligation to repay such funds, there has been a net benefit which would ordinarily be taxable income. Only in the event of death while the policy is in force, would such net economic benefit escape income taxation, because of the special rule of I.R.C §101.

Facts In The Revolinski Case

On July 17, 1987, Mr. White acquired a universal life insurance policy issued by Pacific Mutual Life Insurance Co. (Pacific Life). The policy entitled White to borrow against the policy as collateral up to the loan value available. Between 1987 and 1992, White paid premiums on the policy. Between December 1993 and October 1994, White obtained policy loans.  On August 7, 2001, White surrendered the policy. As of that date, White’s investment in the policy was $14,565, the accumulated value was $23,509, the outstanding loans plus accrued interest payable was $23,125, and the cash surrender value totaled $384 (i.e., $23,509 less $23,125), which White received in cash.

White reported nothing in his 2001 income tax return with respect to the policy cancellations, despite the fact that Pacific Life had issued Forms 1099-R reporting a taxable gain. The Form 1099-R reflected an accumulated value of $23,509 (of which $23,125 had been borrowed), an investment in the contract of $14,565, and a net taxable gain of $8,944.

Income Tax Effect When A Policy Is Cancelled

Ordinarily, when a life insurance contract having a cash value is cancelled or surrendered, there are potential tax consequences. Such transactions are governed by rules contained within IRC §72, which deals with annuities and living proceeds of life insurance policies.  Section 72(e) deals with payments received with respect to insurance contracts, which are not received as an annuity. This includes amounts received upon a cancellation of the contract. In general, such amounts are treated first as recovery of the policy owner`s investment in the contract, and amounts received in excess of the amount invested are treated as ordinary income. I.R.C §72(e)(1)(A), 5(A) and 5(C). Pacific Life was, in effect, applying this rule, when they issued the required 1099 forms to the taxpayers.

Taxpayers Had No Viable Position

The taxpayers took the position that the cancellations did not give rise to income, but rather, were merely "paper transactions" on the books of the insurance companies. This, of course, conveniently ignores the fact that at some point prior to the time of these "paper transactions" the taxpayers had received and spent funds from the policy in excess of the amounts originally invested in the policies. The Court quite correctly reasons that when the policy terminated, policy loans, including capitalized interest, were charged against the available proceeds at that time. This satisfaction of the loans represented a partial payment of the policy proceeds to White [which he  then, in effect, repaid to Pacific Life], thus constituting taxable income to him at that time.

Conclusion

The surrender or cancellation of a life insurance policy subject to an outstanding policy loan can trigger a material amount of taxable income---sometimes with little or no cash received.  Financial advisors should be sure that clients understand the potential consequences when loan-encumbered policies are surrendered or lapse.

Cross Reference—UL And VUL - Tax Advantaged Asset Accumulation

Life insurance contracts represent an important vehicle for tax-advantaged asset accumulation.  In this important respect a life insurance contract is a tax “shelter”: earnings can accumulate and compound tax-free as long as they remain within the shelter of the insurance contract.  Thus, for the reasons discussed above it is of vital importance that the insurance contract, particularly if it is subject to substantial outstanding loans, be properly structured so as to avoid lapses to the fullest extent possible. 

See Section 25, Subdivision C  - UL And VUL - Tax Advantaged Asset Accumulation which analyzes the benefits of life insurance contracts’ “living proceeds.”

(Posted 03/16/2005)

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