This blog post is about the taxation of cash value life insurance policies upon termination. For a good explanation of the insurance terminology used in this opinion click here.
Question for the Tax Court
Does surrender of a whole life insurance policy with a cash value greater than the net investment in the policy create ordinary income or capital gain? (2, 4).
In 1980, Harvey Barr, took out a whole life insurance policy on the life of his mother, Lillian Barr. (3). The face amount of the policy was $200,000 and the annual premiums were $8,929. (3). For the first 8 or 9 years, Lillian paid the premiums indirectly by gifting the amount to Harvey. (3). At the end of that time, "the policy borrowed against itself to pay the premiums; i.e. premiums were automatically paid from dividend accumulations and loans against the cash value of the policy." (4).
By 2005, the cash value of the policy was $361,353, the total indebtedness was $354,399, and the net investment in the policy was $225,390. (4). Mr. Barr "surrendered the policy effective December 20, 2005." (5) (the net investment in the policy approximately equals Mr. Barr's cumulative premium payments, e.g. $8,929 x 25 = $223,225).
The insurance co. mailed Mr. Barr a check for $11,648.33. Then the insurance co. issued Mr. Barr a 1099-R from the insurance company "showing a gross distribution and taxable amount of $135,963.44 for 2005." (6) He did not include this amount on his 2005 individual income tax return. (6). The $135,963 is calculated by subtracting the net investment in the policy from the cash value of the policy.(wait! how come I am taxed on $135k but only got cash of $11k?)
Does the Taxpayer have Income?
Before determining whether the taxpayer's gain is ordinary or capital, the tax court first determines whether the taxpayer realized a gain at all. (6-7).
Section 72(e)(5)(A) states that "[a]ny amount received upon the surrender of a life insurance contract which is not received as an annuity is specifically included in gross income to the extent that it . . . exceeds the investment in the contract." (6).
[Here], the total cash value, $361,353.58 . . . was withheld to repay the outstanding policy loan balance. The satisfaction of the loan had the effect of a pro tanto [i.e. partial] payment of the policy proceeds to Mr. Barr and constituted income to him at that time. Thus, Mr. Barr constructively received the policy's cash value of $361,353.58. Mr. Barr's net investment at the time he surrendered the policy was $225,390.14 Accordingly, . . . he is taxable under section 72(e) on the [difference], $135,963.44
And if so, is it Ordinary or Capital Gain?
To recognize a capital gain or loss, Mr. Barr must have engaged in a "sale or exchange" of a capital asset. Sec. 1222(1)-(4). Generally, the lapse, cancellation, surrender, or termination of a contract does not equate to a sale or exchange. (8). [Our cases hold that] the surrender of an insurance policy is not a "sale or exchange" of a capital asset and thus do not result in capital gain. (8).
Accordingly, we find the resultant gain is ordinary income . . . (9).
The Effect of Tax Free Build-up on the U.S. Treasury Coffers
Mr. Barr paid cash to insurance co. for nine years in the form of premiums. He then took a loan, albeit from insurance co., and used the proceeds of the loan to continue paying cash premiums to insurance co. from approximately 1989 to 2005. When all is said and done, he has paid insurance co. approximately $225,390.
Next, insurance co. invests the premiums received from Mr. Barr and generates an investment return of $135,963 (called the "inside build-up"). Neither the insurance co. nor Mr. Barr pays taxes on this investment return while the insurance contract is in effect. Quite a coup, but legal! It is similar to a qualified retirement plan where the investment gains build-up tax free.
Mr. Barr, however, had a problem. He owed the insurance co. $354,399 for the loans he took out to pay the policy premiums. Where does he get the money from to pay this loan? The cash value of the contract.
At the time he cashed out the policy, the insurance co. applied the cash value against Mr. Barr' outstanding debts. As the court points out, this constituted "constructive receipt" of the policy's cash value. It is as if the insurance co. paid Mr. Barr $361,353 and Mr. Barr then used that money to pay off his debt. Because Mr. Barr's contract cost, i.e. net investment, was $225,390, he is only taxed on the difference between the cash value and his cost. see Section 72(e).
Is it fair that Mr. Barr is credited with having received $135,963 but only $11,648.33 in cash was actually paid to him? Indeed it is. Had Mr. Barr paid the premiums with his own cash, instead of borrowing against the policy, he would have received $135,963 in cash when he surrendered the policy. But because he borrowed money from the insurance co., he had to pay it back. He could have forked over $354,399 to the insurance co. out of his own pocket, but presumably he did not have the money. Therefore, he used the cash value of the life insurance contract to pay of his debt.
In effect, Mr. Barr held a life insurance policy for the better part of 20 years without having to pay single penny towards premiums. It is now time to pay the piper. Of course, Mr. Barr still has a great deal. His tax bill is only $39,608 plus an accuracy penalty of $7,922 for a total of $47,530. If you recall, his yearly premiums were $8,929. He held the insurance contract from 1980 to 2005, or 25 years. Dividing the $47,530 by 25 = $1,901. Effectively, his cost of the life insurance contract is reduced significantly.
Who pays the difference between the $1,901 and the $8,929? You and me of course! Without the tax-free inside build-up, the cash value of Mr. Barr's insurance contract would have been reduced significantly. Most likely, there would not be enough cash value to cover the policy loans, therefore Mr. Barr would have to pay this himself. Instead, "We The People" help Mr. Barr pay for the life insurance contract on his Mother.
I think it's a bad deal for We The People, especially where the purpose was to pay for "the anticipated estate tax liability [on his Mom's estate]." (3). So why doesn't Congress fix this? Answer first this question: who stands to get hurt the most if Congress starts taxing the inside build-up? Insurance Companies. Answer second this question: do insurance companies lobby congress? Need I say more?