One thing I learned over the years practicing law is that few clients ever understood life insurance, or more accurately the tax implications of borrowing against their life insurance policy and never repaying their loan. The Tax Court provided a not-so-surprising decision this past summer that is a helpful reminder that borrowing against the cash surrender value of a life insurance policy can create major income tax problems for the policy owner who operates under the assumption that the policy’s cash surrender value is the equivalent of their private bank account, and thus taking the cash surrender value money is tax-free event in their life.

In Mallory, TCM 2016-110, the Tax Court found that the life insurer’s termination of a variable whole life insurance policy resulted in a constructive distribution equal to the outstanding policy loans and interest. The extent to which the outstanding loan balance exceeded the policy owner’s investment in the life insurance policy, i.e. the aggregate premiums paid on the policy plus growth, the taxpayer had to recognize taxable income. Note that this results in phantom income to the policy owner since nothing was received by the policy owner when the policy was terminated by the insurer, yet income taxes still had to be paid.

The facts are pretty straight-forward. Ken purchased the policy in 1987 with a lump sum premium payment of $87,000. That may be why Ken viewed the policy’s cash surrender value as his private ‘bank account’ since there was only a one-time premium payment to purchase the policy. [An aside: in the past I have suggested to some physician clients that lump sum premium payments to purchase a whole life insurance policy on their life was a great asset protection strategy. Michigan has an old-time statute (I am generalizing) that provides the cash surrender value of a whole life insurance policy is protected from the policy owner’s creditors if the insured-owner’s spouse or children, or other close relatives,  are the designated beneficiaries of that life insurance policy. The statute does not distinguish between annual premium payments or a big-ticket single premium payment.  I ignore the fact that beginning in 1989 a single premium whole life policy is treated as a modified endowment contract with ‘bad’ income tax consequences if distributions are taken from the policy’s cash surrender value- that unique classification as a modified endowment life contract was not at issue in this Tax Court case.]

Ken paid $87,500 in a single premium to purchase the policy insuring his life. From 1991 to 2001 Ken took out 25 separate loans against his policy ranging from $1,000 to $12,000 (which sounds like Ken viewed the cash surrender values as a bank account). In total, Ken borrowed $133,800 against the policy’s cash surrender value over the years. All this time the life insurer, Monarch, assessed interest on these policy loans taken by Ken. By 2011 the aggregate amount owed by Ken on the policy loans [amounts borrowed plus accrued capitalized interest, since Ken never bothered to pay the interest charges invoiced annually] was $237,897.25, which by that time exceeded the policy’s cash surrender value. Monarch gave notice to Ken that if he did not pay $26,061 in premiums to keep the policy ‘alive’ that it would terminate the policy. Ken ignored this last opportunity to keep the policy going (maybe Ken has a policy of not opening his mail?); accordingly, Monarch finally terminated the insurance policy and promptly issued Ken a 1099-R. This amount was calculated by taking the amount Ken owned on the policy loans- $237,897- and subtracting from it the amount Ken initially paid in premiums $87,500 added to which was the amount of growth in the variable life policy’s underlying investments accumulated over the years, or $150,397 net. Consequently,  Ken received a 1099-R from Monarch for $150, 000+ but no money with which to pay the income tax liability.

To make matters worse, Ken ignored the advice of his CPA that he had to pay income taxes on the $150,397, although to his credit Ken did at least attach a copy of the 1099-R to his 1040 income tax return- it is unclear what Ken was thinking when he disclosed the 1099-R with his tax return, but chose to pay no income tax on that amount- maybe it was a compromise Ken negotiated with his CPA. In any event, it is no surprise that the IRS promptly issued Ken a notice of deficiency and also imposed accuracy related penalty.

Ken’s arguments in the Tax Court sounded pretty desperate, which by this time he was. Ken argued that the amounts distributed to him between 1991 and 2001 from the policy were actually distributions of the policy’s cash surrender values and not loans to him- like many, Ken claimed that he viewed his life insurance policy’s cash surrender value as the equivalent of a personal bank account that held ‘his’ money, available at any time without any strings attached. Ken’s argument was a ‘non-starter’ with the Tax Court, in part because Monarch regularly sent to Ken a ‘loan activity statement’ each time he took money from the policy, and each calendar quarter Monarch sent to Ken a policy report on which it showed the amount of the growing debt on Ken’s policy and the accrued interest on that debt amount. From this documentation it was easy for the Court to find  Ken’s argument disingenuous, concluding that Ken had taken loans against his policy’s cash surrender value, and the amounts distributed to Ken over the years were not policy cash surrender distributions. Oh, and if the amounts taken had been considered distributions (not loans) to Ken, then why did Ken not report any of the investment income recognized along with those periodic distributions on Ken’s 1040 income tax returns over the years? As I said, Ken was pretty desperate, brazen but desperate.

In a fall back argument, Ken then claimed that if part of the amount that he owed Monarch under the policy loan balance was the accrual of interest charged on the policy loans over the years, Ken should be able to claim an income tax deduction interest payments are deductible, right? The Tax Court responded, ‘nice try.’ Ken was not entitled to claim any interest deduction to mitigate his tax liability because the interest accrued on the policy loans was personal interest to Ken for which an income tax deduction is disallowed to individuals. IRC 163(h)(2)

The Court found that the extinguishment of Ken’s policy debt had the effect of a constructive distribution of the policy’s cash value to Ken. This income tax treatment is controlled by IRC 72(e)(5) because the amounts Ken received under the policy were received prior to his death; that code section makes it clear that the amount received from a life insurance contract is included in gross income prior to the insured’s death and thus it is taxable, but only to the extent the amount received exceeds the owner’s investment in the policy or contract (the investment amount is defined at IRC 72(e)(6).)

To repeat what I started this summary with, many folks who purchase cash value life insurance policies often get confused about the tax treatment of their life insurance policy and ultimately find themselves alongside Ken.

  • If the life insurance policy is maintained until the insured’s death, with a notable exception when the life insurance policy is transferred for value [its way to technical to get into here- hold on that topic for another day], most death benefits paid pursuant to a life insurance policy are income tax free to the beneficiaries of the death benefit. IRC 101(a).
  • But dividends declared and retained inside a cash surrender value life insurance policy, or the growth in value of underlying investments held  in a variable life insurance contract,  are only income tax deferred. If the policy is surrendered while the insured is still alive, then all that deferred income built-up inside the life insurance policy has to be recognized and taxes paid.
  • Thus,  while the death benefit paid is usually income tax free, which is stressed by those who sell life insurance products, the growth in cash surrender values may be taxed if that growth is ‘harvested’ before the insured’s death.
  • While the policy is owned,  the owner has immediate access to the cash surrender value inside the policy usually with few or no questions asked by the insurer, just like a bank account. But if that amount is taken as a policy loan, it will be treated as a loan [despite Ken’s revisionist history], so that the policy owner always has to balance taking a current policy distribution and paying an immediate income tax on the distribution, or deferring income recognition by taking a policy loan, but know then that with that loan comes the accrual of non-deductible interest.
  • Really bad things happen when there is an outstanding policy loan and the policy is surrendered, and the accumulated cash surrender value is less than the outstanding loan balance. That was Ken’s situation- he received a 1099-R but no money with which to pay the income tax on $150,000 phantom income; and
  • We have recently endured a very long time of historically low interest rates, More and more concerns are being raised about ‘under-performing’ whole life insurance products as a result. Policies purchased 10 to 15 years ago carried with them extraordinary cash value increase projections based upon the presumed growth of dividends declared by the insurer on the policies that it issued, so long as the policy remained in-force. Assumptions like interest on the insurer’s bond portfolio that annually paid 8% or 9% a year would lead to handsome dividends that could be expected to be declared annually on whole life policies issued by those companies. But most companies are ratcheting back their dividends due to the historically low interest rate environment, and some major life insurers have even stopped declaring policy dividends. The result is that all those projected cash surrender value increases trotted out when someone sold the life insurance policy are way off the mark these days. And with that under-performing policy comes the reality that many policy owners who borrowed against their policies thinking that the cash surrender values would continue to increase are now finding that their outstanding policy loans exceed the policy’s actual cash surrender value [far under the initial policy projections] which then exposes them, like Ken, to possible income tax liabilities if the decision is made to surrender the policy. In sum, there may be hidden income tax liabilities on an individual’s personal financial statement that they are unaware of at this time if they borrowed against their life insurance policy.

The next time you run across a client who has borrowed against their life insurance policy- assuming that they even tell you about it, or they remember borrowing against the cash surrender value years ago- you need to explore exactly how the policy is performing and if it carries with it income tax liabilities if the policy is surrendered. The outcome of Ken’s journey to the Tax Court was not really much of a surprise, but it could be for many of your clients who have life insurance policies.