Taxation & Estate Planning

INCOME ON SURRENDER OF LIFE INSURANCE POLICY

By Charles Rubin

Taxpayers often borrow funds from their life insurance policies. If the loans are not repaid, the insurance company may apply the cash surrender value of the policy to the loan balance (including accrued interest on the loans) when the total loan balance gets close to or exceeds the cash surrender value. This is often done in conjunction with a cancellation of the policy at that time. To the extent that the policy loan exceeds the owner?s ?investment in the contract,? the owner will have to recognize income at that time.

This is what happened to Carolyn McGowen, and she had to recognize over $565,000 in income when her loan balance of over $1.065 million on a variable life policy exceeded the cash surrender value of the policy, prompting the carrier to cancel the policy and apply the cash surrender value to the loan balance.

Carolyn did not dispute that she had income from the surrender of the policy. She instead claimed that the income was ?income from discharge of indebtedness,? and that she could then apply a special exclusion for income from discharge of indebtedness that was otherwise available to her under Code Section 108.

The Tax Court reviewed the situation and noted that the policy loan was in fact a genuine loan (which is how Carolyn was able to receive the loan advances without them being income to her at that time).  However, the Court noted that ?income from discharge of indebtedness? occurs when the ?debtor is no longer legally required to satisfy his debt either in part or in full.? This did not occur when the policy was cancelled ? instead, the loan was actually paid in full through credit of the policy cash surrender value to the loan balance. Carolyn?s income was not from discharge of indebtedness, but arose directly under Code Section 72(e). Section 72(e) treats distributions from insurance policies to owners as income to the extent that the distributions exceed the investment in the contract. Thus, Code Section 108 (and its exceptions to income from discharge of indebtedness) could not be used by Mrs. McGowen.

Bill S. McGowen, et ux., TC Memo 2009-285

Full post as published by Rubin on Tax on April 18, 2010 (boomark / email).