National Association of Estate Planners and Councils

July, 2009 Newsletter
Provided by Leimberg Information Services

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Chambers - Policy Loans are Income

One of the major advantages of cash value life insurance is that current tax law permits the deferral of the reporting of otherwise taxable income that builds up inside the policy - until a "triggering event" occurs.

But the increases in value of life insurance contracts become currently taxable when the policy "ends" during the insured's lifetime prior to the payment of an annuity.

In an early 2009 case called Reinert, the tax court held that a taxpayer had reportable income upon the termination (treated as a surrender) of his life insurance policy.  We reported Reinert in LISI Estate Planning Newsletter # 1403.  Reinert focused on "when" cash obtained from a life insurance policy during the policy owner's lifetime becomes taxable.

Chambers is another case that serves as a reminder – and a warning – that policy loans can have tax consequences – and that the termination (even by expiration) of the contract between the policy owner and the insurer can – even if inadvertent – can have severe tax consequences.

EXECUTIVE SUMMARY:

A summary opinion (the decision is not reviewable by any other court, and can't be treated as precedent for any other case) by the Tax Court held an individual had gross income when life insurance policy loans were satisfied. The court noted that she did not take proper measures to cancel the policy and her insurance agent was unable to unilaterally cancel the contract under its terms. She was therefore held to have received a deemed distribution under her life insurance contract which resulted in gross income.

FACTS:

In 1981 Ms. Chambers obtained whole life insurance from Nationwide Life Insurance Co. She had previously procured home and car insurance through him, and she relied on the agent's recommendation in choosing this particular life insurance policy. In her application she elected the Automatic Premium Loan (APL) provision. Nationwide issued the policy on April 27, 1981. The premiums were automatically paid through a monthly debit on Ms. Chambers's checking account.

In early 1986 Ms. Chambers moved to Philadelphia, Pennsylvania, and moved her checking account to a different bank. When her former bank declined the next automatic debit payment, Nationwide wrote to her regarding the unpaid premium. Ms. Chambers informed Nationwide of the change in address and the switch to a new bank, requested a change to a quarterly payment schedule, and included a check for the missed premium payment.

Ms. Chambers made the next quarterly payment on March 28, 1986. However, she then received a whole benefits package from her employer and no longer needed life insurance from Nationwide.

She therefore orally instructed Mr. Travis, her Nationwide agent, to cancel the policy.

He indicated the policy was being canceled, telling her he was sorry to lose her as a customer.

He did not advise her that she needed to take any further action to cancel the policy.

Believing her policy had been canceled, Ms. Chambers ceased making payments.

In fact, Nationwide had not canceled her policy. However, the nonpayment of premiums triggered the APL provision of the policy. Starting from September 9, 1986, Nationwide automatically granted her loans (policy loans) to cover the unpaid premiums.

Nationwide subsequently sent Ms. Chambers correspondence that should have alerted her to the fact that the policy had not been canceled. A letter dated April 8, 1991, requested verification of her current address and included the most recent bill. Another billing statement was sent to her on March 30, 2001.

A letter dated January 10, 2002, acknowledged her request to terminate the policy, explained the consequences of surrendering the policy, and listed her available options. The letter also included a surrender application which she never completed or returned.

A notice dated March 30, 2003, advised that the annual premium had been reduced to $260.20. A confirmation of her change of address was sent to her on May 5, 2003. Ms. Chambers claims that she did not receive some of this correspondence because she moved several times during this period.

Ms. Chambers disregarded most of the correspondence she did receive, believing it had been sent in error. However, on one occasion she did call Nationwide to question why she was continuing to receive the notices. When she insisted that she had already canceled the policy, the Nationwide representative indicated that the notices must have been sent by mistake.

Nationwide continued granting Ms. Chambers policy loans under the APL provision until June 26, 2003. When the next premium came due the following year, the APL provision ceased to apply because the next policy loan would have caused her total indebtedness to exceed the cash value of the policy. Instead, under the policy's nonforfeiture provisions, her coverage was converted from whole life insurance to extended term insurance for a period based on the policy's net cash value.

On November 7, 2005, Nationwide notified Ms. Chambers that the extended term insurance would expire without value on December 7, 2005.

On December 11, 2005, Nationwide informed her that she had gross income of $8,753.33 as a result of the expiration of her policy.

On March 20, 2006, Nationwide sent her a corrected Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., which reported a gross distribution of $8,753.33 and income of $3,005.63.

She and her husband did not include these amounts on their 2005 return.

The IRS issued a statutory notice of deficiency determining that Mr. and Mrs. Chambers failed to report as gross income the deemed distribution of the cash value of Ms. Chambers's life insurance policy.

 COMMENT:

In general, any amount received upon the surrender, redemption, or maturity of a life insurance contract which is not received as an annuity is gross income to the extent that it, when added to amounts previously received under the contract and excluded from gross income, exceeds the aggregate of premiums or other consideration paid.[i]

When Ms. Chambers's policy terminated, Nationwide applied the policy's cash value to the outstanding balance on the policy loans. That constructive distribution is gross income to the extent it exceeds the sum of the premiums paid by Ms. Chambers.[ii]

Mrs. Chambers argued that she canceled her insurance contract with Nationwide in 1986 before any policy loan had been granted under the APL provision. Since no policy loans would have been outstanding, there would have been no deemed distribution to satisfy that nonexistent debt.

But she did not comply with the requirements for termination under the contract. The contract required her to give written notice and surrender the policy in order to terminate the contract and receive payment of the policy's net cash value. She never did so, and the contract did not give her the right to unilaterally terminate the contract by giving oral notice to Mr. Travis.

Though parties to a contract can agree to mutually rescind the contract, Mr. Travis's assent to cancellation of the insurance contract is not binding on Nationwide unless Mr. Travis possessed the requisite authority.[iii] Mr. Travis lacked actual, implied, or apparent authority to enter into that agreement because the contract expressly stated that "only the President or Secretary of the Company may make or change a contract on its behalf".

According to the court, the agreement was not ratified because Nationwide continued to send Ms. Chambers correspondence indicating that it considered the policy still effective.

At the time Ms. Chambers instructed Mr. Travis to cancel the contract, the policy had a significant cash value. The Chambers did not account for the disposition of that cash value upon the purported termination of the contract.

So the court held that Mr. and Mrs. Chambers have gross income from the satisfaction of the policy loans granted under Ms. Chambers's life insurance contract.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Steve Leimberg

CITE AS:

LISI Estate Planning Newsletter #1478  (June 11, 2009) at http://www.leimbergservices.com  Copyright 2009 Leimberg Information Services, Inc. (LISI).

CITES:

Reid Chambers et al. v. Commissioner; T.C. Summ. Op. 2009-63; No. 28946-07S, May 4, 2009; IRC SEC. 72.  See


[i] Sec. 72(e)(1)(A), (5)(A), (C), (6); sec. 1.72-11(d)(1), Income Tax Regs.

[ii] See Atwood v. Commissioner, T.C. Memo. 1999-61; Dean v. Commissioner, T.C. Memo. 1993-226.

[iii] See Prillaman v. Century Indem. Co., 49 F. Supp. 197, 202 (W.D. Va. 1943), affd. 138 F.2d 821 (4th Cir. 1943); Zurich Gen. Accident & Liab. Ins. Co. v. Baum, 165 S.E. 518, 519 (Va. 1932).

 

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