Borrowing from a life insurance policy is a tax-advantaged method of obtaining funds. Generally, a policy owner can borrow against the cash surrender value of non-term life insurance policies. The receipt of the loan proceeds is not a taxable event to the owner, even though part of the cash surrender value was created by untaxed earnings that accumulated in the life insurance policy. If the owner dies while the loan is outstanding, the owner does not typically have to repay the loan, although the beneficiary of the life insurance will have its policy proceeds reduced by the outstanding loans. Note that loans do not always come from direct loans from a policy – sometimes loan balances arise when premiums are not paid on the policy and the life insurance company charges the cash surrender value as a loan to pay the premiums.
The policy owner will often incur tax consequences relating to the loan if the policy is surrendered back to the company. At that time, the loan balance is treated as having been distributed to the policy owner. If the amount of the deemed loan distribution, plus any cash paid out to the owner by the insurance company, exceeds the total premiums paid by the owner (his or her “investment in the contract”), gain results.
This is what happened to the taxpayer in a recent Tax Court case. The taxpayer did not object to this gain treatment, but the taxpayer was not too pleased to learn that the gain was taxed as ordinary income and not capital gain (which would have received the benefit of lower capital gains rates).
The Tax Court schooled the taxpayer in the surrender of life insurance contracts. While such contracts may be capital assets, the surrender of a contract is not considered a “sale or exchange,” so no capital gains treatment is allowed (although there are exceptions for terminally ill or chronically ill individuals).
The taxpayer might have done better by selling the policy to a third party, instead of surrendering it back to the insurance company. This would allow for capital gains treatment. However, two important limitations apply for such sales, at least in the IRS’ opinion. First, the taxpayer’s basis in computing gain would not be all premium payments made, but only premium payments made that were not paid for the cost of insurance (that is, premium payments made in excess of cost of insurance that were used to build-up cash surrender value). Therefore, there would be more gain in this scenario than in the surrender scenario. Second, the IRS would still tax the owner at ordinary income rates on the portion of the cash surrender value attributable to earnings that had built up in the policy that were not previously subject to income tax. Therefore, numbers would have to be crunched to see if a sale of the policy would yield better tax results for the owner.
Barr, TC Memo 2009-250