Capitalized interest on defaulted policy loans includible in taxable amount

21 Mar

In Black v. Commissioner of Internal Revenue, Docket No. 6406-12. Feb. 12, 2014, the U.S. Tax Court has determined that capitalized interest accrued on taxpayer’s loans against his life insurance policy, is includible in determining the gross distribution and the taxable amount arising from the termination of the policy. The taxpayer borrowed against a life insurance policy but failed to repay the loans. The policy was terminated, and the loans were satisfied by policy proceeds and extinguished.

In June 1989, the husband of the taxpayer couple acquired an insurance policy on his life from Northwestern Mutual Life Insurance Co. (Northwestern). The policy was a whole life policy, having both cash value and loan features.

Taxpayer was permitted to borrow against the policy. “Policy debt” consisted of outstanding loans and accrued interest. Unpaid interest was added to loan principal. Taxpayer could surrender the policy and receive as a distribution the cash value of the policy, minus any outstanding policy debt. The policy terminated, if policy debt exceeded the cash value.

Over time, taxpayer borrowed $103,548 against the policy, which he did not repay. In 2009, the policy was terminated. The combined balance of the loans, including principal and interest, was $196,230, and taxpayer’s investment in the contract (aggregate premiums paid) was $86,663.

Northwestern issued to taxpayer a Form 1099-R, Distributions From Pensions, Annuities, etc. reflecting a gross distribution of $196,230 and a taxable amount of $109,567. The latter represented the difference between the combined balance of the loans, and taxpayer’s investment in the contract, i.e., $86,663.

Taxpayers did not report any part of the taxable income on Form 1099-R, nor did they acknowledge the policy on their return.

In 2011, taxpayers nervously amended their 2009 return, to reflect an increase in income of $16,885, attributable to the difference between the principal of the policy loans less premiums paid. The amended return was not accepted. The Service issued a notice of deficiency of $30,571 and assessed an accuracy-related penalty.

The parties agreed that the taxable amount of the gross distribution that arose on termination of the policy did not include taxpayer’s investment in the contract of $86,663, and that the taxable amount takes into account the outstanding loans totaling $103,548. The Service contended that the taxable amount also takes into account capitalized interest.

Internal Revenue Code section 61 specifically includes in gross income, income from life insurance contracts and from discharge of indebtedness.

The Court regarded taxpayer’s policy loans as true loans. Taxpayers would not have had to recognize these loan proceeds as taxable income upon receipt. When an insurance policy is terminated and the proceeds are used to satisfy a policy loan, the transaction is treated as if the taxpayers received the proceeds and applied them against the outstanding loan.

Under Code section 72, an amount received in connection with a life insurance contract, which is not received as an annuity, generally constitutes gross income to the extent that the amount exceeds the investment in the insurance contract. The investment in the contract is defined generally as the premiums or other consideration paid, less amounts received under the contract, to the extent excludable from gross income.

The Court held that the capitalized interest was properly treated as part of the principal of the indebtedness. Capitalized interest is includible in determining the amount of a taxpayer’s gross distribution when an insurance policy is terminated. The policy loans, including capitalized interest, were charged against the available proceeds at that time. This satisfaction of the loans had the effect of a pro tanto payment of the policy proceeds to taxpayers, and constituted income to them. A contrary result would permit policy proceeds, including previously untaxed investment returns, to escape tax altogether and found no basis in the law.

Taxpayers argued that the termination of the life insurance policy gave rise to a discharge of indebtedness. The Court could not so characterize the source of taxpayers’ income. The loans to taxpayer were not discharged; rather, they were extinguished after Northwestern applied the cash value of the insurance policy toward the debt owed. Even if the income were discharge of indebtedness income, taxpayers did not allege that any exception under Code section 108 applied to exclude the amount from gross income.

Code section 6662(a) imposes an accuracy-related penalty equal to 20% of the amount of any underpayment of tax that is attributable to a substantial understatement of income tax. An understatement of income tax is “substantial”, if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return. There is an exception to the accuracy-related penalty with respect to any portion of an underpayment, if the taxpayer establishes that there was reasonable cause for such portion, and the taxpayer acted in good faith with respect to such portion. Taxpayers self-prepared their 2009 Federal income tax return, and nothing in the record suggests that they consulted with a professional adviser in connection therewith. Taxpayer is an attorney, yet failed to cite any case holding that interest on loans made against an insurance policy is not includible in the gross distribution when the policy is terminated for nonpayment. The only authorities taxpayers cited were Code sections and Treasury regulations that were inapposite. The Court held therefore that taxpayers failed the reasonable cause exception, nor could they invoke the “substantial authority” provision to reduce the amount of the understatement for penalty computation purposes.


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