Life insurance is an income tax advantaged investment. The build-up in value of a whole life policy is not subject to current taxation. Proceeds paid as the result of the death of the insured are income tax free. Given those advantages, I always find it annoying when people use life insurance to manufacture phantom income for themselves. There have been several cases, two in the last month, where people have paid into a whole life policy for a period of time and then years later been blindsided by unexpected phantom income. The deferred income on the policy is used to pay non-deductible interest. When the net policy value is eroded, the company issues a 1099 for many years worth of earnings. In some cases, it has been on policies that taxpayers thought had been long ago cancelled.
The case of Ronald Webster Moore, decided August 23, is the first time I have seen the Tax Court cut a taxpayer a break in one of these cases. Mr. Moore bought a $20,000 policy from Nationwide in 1975. The premium was $26 per month. He made 18 payments totaling $472 and stopped paying.
Petitioner argues that the automatic premium loan provision did not prevent his policy contract from terminating after he ceased making payments. He believes that the nonforfeiture provisions operated to convert the policy to term insurance when he ceased making payments unless he took affirmative steps to reinstate the original policy. On the basis of his interpretation of the life insurance policy contract, petitioner stopped making premium payments in 1977 and considered the policy abandoned.
You have to give Nationwide a little bit of credit, here. It seems that the policy really performed. It generated enough dividends to keep itself in force by policy loans until 2008, when it finally terminated. Nationwide sent Mr. Moore a 1099 for $17,941. As is usual in these cases, IRS thought Mr. Moore should pay tax on the income. Mr. Moore, on the other hand, did not think he should have to pay $2,768 in federal tax (almost six times what he had paid in premiums) on a policy that he thought was cancelled nearly thirty years ago.
The Tax Court looked closely at the transaction record and determined that the policy should have been cancelled more than once by its own terms long before 2008:
We are not persuaded that petitioner’s life insurance policy terminated in 2008 resulting in a taxable deemed distribution. Respondent’s argument would have us construct a multitude of inferences in his favor and simultaneously turn a blind eye to several unexplained discrepancies in the record. This we will not do. We believe a plain reading of the terms in the life insurance contract signifies that the policy should have terminated and been converted to extended term insurance on several occasions before 2008.
The other decision was an appeal to the Seventh Circuit of a Tax Court decision (Bruce Brown). I had highlighted the Tax Court decision as one of the eight unfair decisions of 2011. I analyzed the Tax Court decision in this piece on my old blog. It is a little complicated but here are the high points:
In total Mr. Brown paid $44,205 in premiums: $11,999 by check, $28,532 by loans, and $3,674 by dividends.
He received no cash, but had a taxable gain of $29,093 resulting in addtional tax of $8,553. Tax Court upheld the deficiency and allowed the IRS to tack on an accuracy penalty. The Browns between them have two law degrees and an LLM in taxation, which did not help them in the penalty argument. In sustaining the Tax Court, the Seventh Circuit explained:
But the oddness is superficial. As time passes and the cash surrender value of a whole-life policy grows, the net death benefit, which is the face amount of the policy (the proceeds on death) minus the premiums paid, shrinks as a result of the growing stock of premiums paid, to the point at which further premium payments (which remember were fixed at $1,837 a year) can actually reduce the net death benefit. By surrendering the policy (albeit involuntarily) Brown gave up the prospect of receiving $100,000 if he died but at the same time freed himself from having to pay $1,837 each year to maintain that prospect.
I feel better now with that explanation. Don’t you ?
It is encouraging that the Tax Court found for at least one taxpayer in one of these cases. They are similar in some ways to debt discharge cases like that of David and Carla Stewart who received a 1099 from Portfolio Recovery Associates concerning credit card debt that was over ten years old. If you receive a seemingly inexplicable 1099, do not ignore it, but also do not assume that it is valid taxable income for the year of issue. You may end up reporting it to avoid a document mismatch notice, but then back it out if you have a reasonable position for not recognizing income in that year. The other lesson to be drawn is to really understand what you are doing when you have loans accumulate on whole life policies. The tax end game can be very ugly.
You can follow me on twitter @peterreillycpa.
Originally published on Forbes.com on September 15th, 2012