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The Internal Revenue Code provides a basic exclusion from income taxation of the proceeds of a life insurance policy. However, what happens if a taxpayer surrenders the life insurance policy with loans against the cash value? The formal rule is that amounts received upon the surrender of a life insurance contract which are not received as an annuity are specifically included in gross income to the extent that they, when added to amounts previously received under the contract and excluded from gross income, exceed the investment in the contract. How this works was illustrated in the sad news which the United States Tax Court delivered to Mr. and Mrs. Harvey Barr earlier this year.
Mr. Barr’s mother purchased a life insurance policy in anticipation of helping her children pay the estate tax liability when she passed away. She bought a whole life policy in the face amount of $200,000, which was not an annuity. However, Mr. Barr and his sister were the co-owners and the beneficiaries. The senior Mrs. Barr paid the premiums each year for the first eight or nine year, and then no premiums were paid, but the policy instead borrowed against its cash value to pay the annual premium. In other words, premiums were automatically paid from dividend accumulations and the cash value of the policy. Once Mr. Barr and his mother decided that the policies were no longer necessary, they allowed the policy to terminate, surrendering it in December 2005, and received a check from the insurer of $11,648.33, as well as a $304.20 dividend. The Form 1099-R, Distributions from Pensions, Annuities, Retirement of Profit Sharing Plans, etc., from the insurance company showed a gross distribution and taxable amount of $135,963.44. However, the Barrs did not include that latter amount on their income tax return.
The IRS determined that this entire amount was taxable to them, and the Tax Court agreed. Mr. Barr’s net distribution of $11,648.33 represented the total cash value, plus a terminal dividend, less the amounts withheld to pay the outstanding policy loan balances. The satisfaction of the loans, according to the Tax Court “had the effect of a pro tanto payment of the policy proceeds” to Mr. Barr and constituted income to him. To make matters “worse,” the Court held that this was ordinary income to the Barrs, rather than a capital gain, because there was no “sale or exchange” of a capital asset. The surrender of an insurance policy was held not to be a capital asset in cases going back to 1936.
The two morals of the story are these. When one receives a Form 1099-R that reflects a result different than what was expected, the sooner one gets to a tax advisor the better. A secondary lesson is that like many other situations, one should visit with a tax advisor before proceeding with any financial transaction of this sort.