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Thursday, November 08, 2012


Life insurance policies can be great vehicles for income tax deferral. Part of this arises from the fact that earnings growth that occurs inside the policy is not subject to current income tax (and may never be taxed if the policy is maintained in force until the death of the insured). Another part of this comes from the ability of an insured to “borrow” from the cash surrender value of the policy, and thus access policy value and growth, without paying a current income tax.

However, some insureds learn the hard way that unexpected income tax consequences can arise. A recent Tax Court case illustrates a common trigger for taxable income to an insured policy owner.

The tax principle involved relates to the termination of the policy during the lifetime of the insured. This can happen because the owner ceases to pay premiums, cashes in the policy, or the policy otherwise lapses. In this circumstance, if there are loans against the policy, the loan balance is treated as having been paid to the owner at the termination of the policy (principally by the insurance company applying any remaining cash surrender value towards repayment of the loan balance). If this loan amount exceeds the owner’s “investment in the contract” (generally, the total premiums paid by the owner less distributions made to the owner), the taxpayer has to include that excess in its income.

Thus, borrowing against a life insurance policy opens the door to this income, if the policy is cancelled during the owner’s lifetime before the death of the insured. Of course, if the total loan amount, plus additional cash value returned to the taxpayer, does not exceed the premiums previously paid, such income will not arise.

The problem is that there are two sources of policy loan growth that are not immediately obvious. The first is that if there are loans, interest is charged on the loan balance by the insurance company so that the loan balance increases over time just from interest alone. The second is that if some of the policy cash values are used to pay premiums in whole or in part, these are booked as policy loans. These increases can push the policy loan balance beyond the amount that had been paid into the policy in premiums, and an owner may not even be aware of the growing loan balance.

A secondary problem is that insurance companies may cancel a policy of their own accord when the loan balances approach the cash surrender value of the policy. The company then repays itself from the cash surrender value. This loan repayment is treated as a distribution to the owner, thus triggering the potential income recognition described above.

In White, a Tax Court Memorandum decision, this was painfully illustrated to the taxpayer. In the case, the life insurance company canceled the policy when the loan balance exceeded the cash surrender value. The loan balance came about from premium payments being made from the cash value of the policy. The insurance company applied the cash surrender value to the loan balance, and that amount exceeded the owner’s investment in the policy. Thus, the owner incurred income to the extent of that excess. To make matters worse, this income was “phantom” income – that is, the taxpayer picked up income without receiving any actual dollars, and thus had to pay the tax bill out of other funds.

Note that these problems typically go away at the death of the insured, since the loan balance is effectively paid off from the death benefits without an income tax consequence. It is the earlier termination of the policy before the death of the insured that gives rise to these problems.

White, TC Summary Opinion 2012-108

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