Policy Loans Can Bite You

by Charles (Chuck) Rubin
Contact

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

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Charles (Chuck) Rubin, Gutter Chaves Josepher Rubin Forman Fleisher P.A. | Attorney Advertising

Written by:

Charles (Chuck) Rubin
Contact
more
less

Gutter Chaves Josepher Rubin Forman Fleisher P.A. on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.