Loans Discharged by Cancellation of Life Insurance Result in Taxable Distributions

(Parker Tax Publishing August 2023)

The Tax Court held that a taxpayer who took out loans against two life insurance policies and later stopped paying the premiums on the policies, resulting in the termination of the policies and the loans, received a constructive distribution equal to the excess of the taxpayer's investment in the life insurance contracts over the outstanding loan amounts. The court reasoned that the application of the cash value of a life insurance policy against an outstanding loan is no different from distributing the proceeds of the policy to the taxpayer to permit the taxpayer to use those proceeds to pay off the loan. Doggart v. Comm'r, T.C. Summary 2023-25.

Background

Robert Doggart was incarcerated in February of 2017. Before 2017, Doggart took out a series of loans against two life insurance policies that he held with Prudential Insurance Co. of America (Prudential). The cash value of his policies served as collateral for the loans. While incarcerated, Doggart stopped paying premiums on the two policies. As a result, each policy lapsed, and Prudential used the cash values of the policies to repay the loans plus interest due. Prudential subsequently issued Doggart a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for 2017 with respect to each policy and reported taxable distributions from life insurance to the IRS. The amounts reported as taxable on the Forms 1099-R were $13,214 and $5,366, calculated with respect to each policy as the outstanding loan amount repaid by the cash value of the policy less the total premiums Doggart paid with respect to the policy.

Doggart failed to file an income tax return for 2017. The IRS prepared a substitute for return for that year showing tax due on the distributions as reported by Prudential on the Forms 1099-R. In 2020, the IRS issued Doggart a notice of deficiency for 2017. Doggart challenged the notice in the Tax Court. He contended that termination of his life insurance policies should not result in income for 2017 because he did not actually receive any money at the time the policies were terminated. Doggart argued that distributions were instead taxable, if at all, when he initiated the loans with Prudential and received cash.

Code Sec. 61(a)(9) provides that gross income includes income derived from life insurance contracts. Under Code Secs. 72(b) and 101(a), amounts received from life insurance contracts other than as a death benefit or annuity are included in gross income to the extent that they exceed the investment in the contract. The taxpayer's "investment in the contract" is defined in Code Sec. 72(e)(6) as the aggregate amount of the premiums paid less amounts previously received as income from the contract but excluded from gross income calculations.

Analysis

The Tax Court held that Doggart received and failed to report income from the two lapsed policies as Prudential calculated and reported on Form 1099-R.

According to the Tax Court, a taxpayer can receive a constructive distribution from the termination of his life insurance policy, which must be included in gross income, even if the taxpayer does not physically receive cash or other property from the policy during the tax year. The court explained that the termination of both a life insurance policy and indebtedness against the policy functions as the application of the cash value of the insurance policy against the debt owed. The application of the cash value of a life insurance policy against an outstanding loan, the court reasoned, is no different from distributing the proceeds of the policy to the taxpayer to permit the taxpayer to use those proceeds to pay off the loan. A constructive distribution is included in gross income insofar as it exceeds the taxpayer's investment in the life insurance contract.

The court noted that when Doggart stopped paying the premiums on his two life insurance policies, Prudential notified him that the lack of payments resulted in the termination of his loans and underlying policies. According to the court, the terminations effectively applied the cash values of his policies against the loans in extinction of both. Doggart's investment in the two contracts equaled the sum of his premiums paid. When the policies were terminated and the cash values of the policies were taken to repay the loans, the court found that Doggart constructively received the cash values of the policies. The amounts constructively received in excess of his investments in the contracts were therefore includible in gross income.

The court rejected Doggart's argument that distributions were taxable, if at all, when he initiated the loans with Prudential and received cash. The court noted that Doggart did not argue that his policy loans were not true loans. And the court said it is well established that the receipt of cash in the form of a bona fide loan does not constitute income so long as an obligation to repay the borrowing remains. The court explained that, because Doggart's borrowings had an obligation of repayment at the time they were taken, they did not constitute income when initially received. While Doggart did not physically receive money upon the lapse of his policies, the court explained that he no longer had to repay the loans, so it was irrelevant that no money changed hands. The court concluded that, since physical receipt of cash does not dictate taxability, the initial disbursement of the loans was not taxable and likewise, the lack of distribution of cash to Doggart did not render untaxable the termination of his life insurance policies.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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