Income Recognition from Cancellation of an Insurance Contract

The general rule is that that the proceeds of a life insurance contract, payable on the death of the insured, does not create taxable income. Consequently, even though the beneficiaries of a life insurance policy may realize a substantial economic gain by the receipt of the proceeds, this gain will not generally be taxable. However, one should be careful in dealing with an insurance policy during the lifetime of the insured. Some policy owners will borrow the cash surrender value prior to death to pay premiums, which may create a tax problem, as illustrated by a recent Tax Court decision.

In that case, a taxpayer purchased a life insurance policy and made premium payments for the first 13 years of the policy. The taxpayer elected an automatic loan premium provision in the event that the owner stopped making premium payments. Eventually, the taxpayer stopped making premium payments and the insurance company used the automatic loan premium provision to borrow the cash surrender value prior to death to pay the premiums. The policy provided it would lapse if its cash value could no longer cover the premium payments. This would occur if the outstanding loan balance and interest exceeded the policy's cash value.  The insurance company notified the taxpayer that the policy had lapsed because the outstanding loan balance and interest exceeded the policy's cash value.

To understand the consequences of this action it is important to understand that Internal Revenue Code Section 61(a) defines gross income as “all income from whatever source derived,” unless otherwise provided. Generally, any amount that is received under a life insurance contract prior to death is included in gross income to the extent it exceeds the investment in the contract. The phrase “investment in the contract” is defined generally as the aggregate amount of premiums or other consideration paid for the contract less the aggregate amount previously received under the contract, to the extent it was excludible from gross income. In the case at hand, the difference between the outstanding loan balance and the investment in the contract was $37,981, and the insurance company issued a Form 1099-R showing this taxable amount.

The taxpayer timely filed his personal income tax return but did not report the taxable amount shown on the Form 1099-R. The IRS eventually sent the taxpayer a notice of deficiency showing an adjustment to income of $37,981 for pensions and annuities. The taxpayer argued the amount was not income for purposes of income taxation.

The Tax Court determined that for Federal income tax purposes, loans against the cash value of a life insurance contract are true loans from the insurance company to the policyholder with the policy serving as collateral and thus not taxable distributions when received. When the insurance company terminated the policy, it charged the amounts of policy loans and capitalized interest against the proceeds from termination made available at that time. This constructive distribution in satisfaction of the loans had the effect of a payment of the policy proceeds to the taxpayer constituting income to the taxpayer to the extent it exceeded his investment in the policy.  In this case, of the Tax Court agreed with the IRS in charging penalties as well as interest because the taxpayer had knowledge of the income because he received the Form 1099-R.

When clients have financial difficulties, they will often use premium policy loans to carry the policy in difficult times, or may cancel the policy altogether. Due to the potential for unintended tax consequences clients considering these actions should seek professional help to determine policy parameters and tax consequences. 

Alan Ferrara