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Life insurance policy loans can generally be taken without income tax consequences, but there are circumstances where a “loan” is immediately taxable. We’ve covered situations where a policy is surrendered with a loan outstanding, resulting in taxable income. This article discusses another case where a policy “loan” will be treated as taxable income.
In Frederick D. Todd II et ux. v. Commissioner (T.C. Memo. 2011-123), the Tax Court considered whether a distribution from a welfare benefit fund to a fund participant was a policy loan or a taxable distribution.
The taxpayer, Frederick D. Todd, II, was a neurosurgeon operating his business as a professional corporation. The corporation’s employees were eligible to participate in an employee death benefit welfare benefit fund. The professional corporation made annual contributions to the fund and the fund promised to make a payment to the employee’s beneficiaries in the event the employee died.
As part of his participation in the fund, Todd applied for a $6 million life insurance policy on behalf of the fund. The policy was issued to and owned by the fund.
The fund document gave employer and employee trustees the discretionary authority to make loans to fund participants on a showing of emergency or serious financial hardship by the employee; reasonable interest was required to be paid on the loans. Todd took advantage of the loan provision, applying for a $400,000 loan from the fund for “unexpected housing costs.”
The fund trustees didn’t investigate Todd’s hardship claim – it simply approved the loan. But after receiving the check, Todd decided instead to make a partial surrender of the owned-policy due to the 4.76% interest rate on the loan. The fund administrator sent a check for $400,000 to Todd and the face value of the fund-owned policy was reduced accordingly. Shortly after the partial surrender, Todd’s corporation made its annual contribution to the fund but never made another contribution.
Six months after Todd received the $400,000 check from the fund, the fund administrator provided Todd with an amortization schedule and Todd signed a promissory note in the amount of $400,000 with a
stated interest rate of 1%. Quarterly payments were due under the note. The promissory note and fund document also recognized another means of repayment, called the “dual-repayment mechanism,” which allowed the fund to deduct the outstanding balance of any “loan” from distributions due the fund participant or his beneficiaries.
Todd never made any payments on the loan from the fund.
The IRS’ Claim
In 2005 Todd filed his delinquent 2002 and 2003 tax returns, and the IRS found deficiencies on Todd’s return, although it was not made immediately aware of the payment from the fund to Todd. But in preparation for trial on those issues, the IRS discovered the $400,000 payment.
The IRS claimed that the $400,000 distribution from the fund was taxable when received because it was not a valid loan. The IRS also argued that even if the payment was a valid loan, the debt was discharged in 2003 and Todd should have reported discharge of indebtedness income. Penalties were assessed against Todd.
The Tax Court’s Reasoning
The Tax Court considered whether the $400,000 payment to Todd was a loan for income tax purposes. According to the court, “a distinguishing characteristic of a loan is the intention of the parties that the money advanced be repaid.”
The court listed seven factors it considers when determining whether a loan is a bona fide loan and whether the parties intended to form a creditor-debtor relationship, as follows: (1) whether the loan is evidenced by a note; (2) whether interest is charged; (3) whether there is a schedule of payments; (4) whether payment of the loan was secured by collateral; (5) whether payments were actually made on the loan; (6) whether “the borrower had a reasonable prospect of repaying the loan, and whether the lender had sufficient funds to advance the loan”; and (7) whether the parties acted as if the payment was a loan.
In this case, the first four hallmarks of a loan that are listed above were at least arguably present; there was a note, 1% interest was charged, an amortization schedule was produced, and payment of the loan was secured by any future obligations of the fund to Todd and his beneficiaries.
The court, however, disregarded most of these factors. The promissory note was disregarded because it was not produced at the time the $400,000 payment was made. And although the fund document required a reasonable rate of interest to be charged on any loans made to participants, the 1% interest rate was less than a quarter of what the fund charged on a similar loan—4.76%. Finally, although a payment schedule was produced, payments were never made according to the schedule.
The Tax Court found that only two of the seven factors listed above tended to indicate that the parties intended to form a bona fide debtor-creditor relationship. The dual-repayment mechanism by which repayment of the loan was secured by future benefits tended to show that a debtor-creditor relationship existed. Also, Todd had a reasonable prospect of repaying the loan – another indicator that the loan was bona fide. But after weighing the above factors, the court found that there was little evidence that a debtor-creditor relationship existed between Todd and the fund.
Based on its weighing of the seven factors, the court held that the distribution from the fund was immediately taxable to Todd at the time it was made. The court also found that Todd was liable for accuracy-related penalties.
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See also The Law Professor's blog at AdvisorFYI.