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Cancellation of Life Insurance Policy Results in Taxable Income

Published: March 14th, 2011

By: Brian M. Malec

In Sanders v. U.S., T.C. Memo 2010-279, petitioner purchased a whole life policy in 1979 and paid premiums until March 2006. The policy allowed petitioner to borrow up to the policy’s cash value, using the policy as security. Interest accrued on the loans at 8%. By its terms, the policy terminated if any unpaid loan, including accrued interest, exceeded the sum of the policy’s cash value and dividend accumulations.

Between 1990 and 2004, petitioner borrowed $7,136 against the policy but did not repay the loans. The loan balance, including interest, grew to $17,203, which exceeded the policy’s cash value by $517. Petitioner was notified that the policy would be cancelled unless petitioner paid at least $517 within 30 days. He did not pay and the policy was cancelled.

The insurance company issued a 1099-R for 2006 reporting a distribution to petitioner of $17,292 and a taxable amount of $7,175 after taking into account the premiums paid by petitioner of $10,117.

Petitioner argued he could not be taxed on any distribution in 2006 because he did not receive any cash or property from the insurance company in that year. The Tax Court stated that 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 received exceeds the investment in the contract. The Tax Court treated the cancellation of the policy as a constructive distribution of the policy’s cash value to the petitioner in 2006 followed by the repayment of such proceeds to the policy loans. Accordingly, petitioner was charged with $7,175 of taxable income in 2006.

This case should serve as a reminder that individuals and advisers should always consider the tax consequences prior to selling, surrendering or otherwise terminating a life insurance policy.