Originally published on Forbes.com.
Life insurance is actually a rather sweet tax deal. That is why I find it so distressing when someone manages to use life insurance to manufacture phantom income for themselves that produces a tax liability that is quite real. Such is the sad story of Kenneth Mallory who received bad news from the Tax Court earlier this month. My view is that that problems like this are a the result of agents selling policies as if they are the Swiss utility knives of financial planning rather than ways of providing for people dependent on you after you are, you know, dead.
A Single Premium Policy
The story starts in 1987 and you youngsters might have trouble following along, because back then money earned interest and that helped policies perform. Mr. Mallory bought a single premium life insurance policy naming his wife Larita as the primary beneficiary. The face amount of the policy is not indicated in the decision and is, in a way, not relevant, although I would think that it would make the story more interesting.
The policy was issued by Monarch Life and included a borrowing provision.
The policy provided that Kenneth Mallory, as the owner, could borrow from Monarch Life and that the loans were secured by the policy. The policy provided that interest accrued on the loans, that the interest was payable by Kenneth Mallory annually, and that any unpaid interest would be added to the outstanding loan amount (i.e., that the unpaid interest would be “capitalized”). The outstanding loan amount (including capitalized interest) was defined as “policy debt”. The policy provided that, if the policy debt ever exceeded the cash value of the policy (defined as the premiums and earnings on premiums), Monarch Life would terminate the policy after giving Kenneth Mallory notice of the pending termination and an opportunity to pay down the policy debt to avoid termination.
Mr. Mallory held out for nearly four years, but those increases in cash value finally started burning a hole in his pocket. Beginning in June 1991, he began taking loans in amounts varying from $1,000 to $12,000. The last withdrawal in December 2001 brought the total principal on the loan to $133,000 and, of course, interest had been accumulating. Still, it was a pretty sweet deal up till then. Mr. Mallory had drawn out $46,300 more than he had put in and he still had life insurance coverage and had not incurred a tax liability. Yet.
For the next decade, everything seemed fine, but a grim mathematical truth was grinding away. Both the cash surrender value of the policy and the loan balance were increasing. And, since Monarch is presumably in business to make money, the rate on that the loan balance was higher than the rate by which the cash value was going up. Eventually the loan balance is bound to catch up. So in 2011, Mr. Mallory needed to make a payment of $26,061.67 in order to keep the policy in force. He didn’t make the payment. So that was the end of the of policy which was eaten by the loan.
Now if all that meant was that Mr. Mallory finally paid tax on the $46,300 that he had drawn out over and above his premium, that would have been painful, but really not so bad. That is not the way it works though. The policy loan which liquidated the policy includes all the accumulated interest giving Mr. Mallory proceeds of $237,897.25 which works out to a taxable amount of $150,397.25 yielding a tax of $40,846. That would be 88% of the the $46,300. Even Bernie Sanders doesn’t want people to be paying that much.
The problem of course is that the policy return is taxable, while the policy loan interest is not deductible.
Problems With The Return
This was all spelled out for Mr. and Mrs. Mallory on the 1099-R from Monarch, but they had a hard time believing it. Steve Miller of Liberty Tax Service told Mrs. Mallory that they were going to owe “a bunch of money”. They ended up not filing their 2011 Form 1040 until March 8, 2013 and did not include the income from the 1099-R. There was a note attached:
“Paid hundreds of $. No one knows how to compute this using the 1099R from Monarch—IRS could not help when called—Pls send me a corrected 1040 explanation + how much is owed. Thank you.”
Larita Mallory’s testimony clarifies the meaning of the note attached to the return. She testified that before the Mallorys filed their return, she telephoned several persons other than Miller to ascertain whether the Form 1099-R was correct. The persons she telephoned consisted of two groups: (1) people who advertised themselves in the telephone directory as tax professionals (and whom she did not pay, unlike Miller) and (2) various IRS personnel. None of the persons she contacted was willing to confirm whether the Form 1099-R was correct.
I’m pretty sure she did not call my firm’s office, because calls like that had a way of ending up with me.
Arguments Go Nowhere
The Mallorys argued that there wasn’t really a loan, but rather return of cash value and they did not receive anything in 2011. In the alternative they argued for an interest deduction. Neither argument went anywhere.
The Mallorys argued that they should not be subject to late file, because an accountant prepared their return. They had not raised that argument in a timely manner and it would not have worked if they had.
They were also hit with the accuracy penalty, which in my mind was rubbing it in a bit.
The Mallorys assert a defense to the section 6662(a) penalty based on reasonable cause and good faith. However, we are not convinced that the Mallorys did enough to determine their proper tax liability. The Mallorys received the letter from Monarch Life informing them that the policy debt on Kenneth Mallory’s variable life insurance policy had exceeded its cash value, that the termination of the policy would result in a taxable event, and that any taxable gain in the policy would be reported to Kenneth Mallory and the IRS on a Form 1099-R. The Mallorys received the Form 1099-R from Monarch Life before the April 15, 2012 filing deadline. The only tax adviser that they paid, Miller, suggested there would be a tax liability. Although various IRS employees and unpaid tax professionals declined to confirm whether the Monarch Life Form 1099-R was correct, it was unreasonable for the Mallorys to conclude from this unwillingness that they had no income from Monarch Life. We hold that the Mallorys did not have reasonable cause for, and did not act in good faith with respect to, the position on their tax return for the year 2011.
For whatever it is worth the bolt from the blue 1099-R life insurance cases almost always result in the taxpayer losing. The only victory I have ever seen was by Jeffrey J Furnish, an actuary, who showed flaws in the computation which shifted the burden of proof to the IRS, a burden it could not carry,
Other Coverage
Vidya Kauri had a summary of the decision in Law360. Current Federal Tax Developments focused on the penalty issue.
A taxpayer can only escape that penalty if the position of the taxpayer had substantial authority (not an argument the taxpayer made in this case—and not one they would have succeeded with anyway), was disclosed and had a reasonable basis (the Court noted the rather odd disclosure but found the position had no reasonable basis under the law) or if the taxpayer had reasonable cause for the understatement and acted in in good faith.
Lew Taishoff has his usual humorous take with something titled – “Paid Hundreds Of Dollars”. Lew also mentioned Jeff Furnish.
Remember Jeff Furnish? No? Well, see my blogpost “Ambiguity is the Best Policy – Redivivus,” 10/23/13. Jeff did it right. Ken and Larita didn’t.
What Ken and Larita didn’t do was save every statement, find a number-cruncher with a killer instinct, and have said person go over every minute of the last thirty years looking for any discrepancy. It might cost a “bunch of money,” but would likely be cheaper than the chops Ken and Larita got.
I don’t know if they actually could have found somebody to do the number crunching for them, but it is a thought.