February 10, 2012

Long-Lost Insurance Policy Returns to Bite Couple

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Is there any harm in walking away from an insurance policy without receiving confirmation that the policy was canceled by the carrier?

Walking away from a policy without following the cancellation procedure specified in the contract may not be enough to terminate the policy and could come back to bite the insured years down the road. We find a poignant example of the dangers of failing to properly cancel a policy in a recent Tax Court case that considered whether taxpayers were correctly taxed on a canceled policy loan when the couple did not specifically authorize the loan and believed that the policy had been canceled for more than 20 years. [Feder v. Commissioner of Internal Revenue, T.C. Memo. 2012-10 (2012)].

As we have seen, if a policy is terminated and a policy loan forgiven, the insured will be on the hook for the amount of debt that is canceled, less their investment in the contract. What is unique about this case is that the Feders were not aware that the policy was still in existence or that they had taken a policy loan, as the loan was automatically funded due to a clause in the contract that kicked in when the couple stopped making premium payments.

Taxpayers are usually taken aback by the tax liability when their policy is canceled with an outstanding loan, but the Feders had twice the surprise because they weren’t aware that the loan had been made or that the policy was even in existence.

Cancellation of Debt Income

Income from a discharge of indebtedness is generally taxed. Cash received from a loan is not taxed–the borrower will have to pay back the loan, so it is not income to the borrower. But if the loan is forgiven and the borrower is no longer required to repay, the borrower has received income.

The general principle that a forgiveness of debt equals income is applicable when a taxpayer’s life insurance policy is terminated when a policy loan is outstanding.

There are exceptions to the rule that a forgiveness of debt is includable in a taxpayer’s gross income. Under IRC Section 108, a forgiveness of debt is not includable in a taxpayer’s gross income to the extent that the taxpayer is insolvent immediately before the loan is forgiven. The Feders did not argue that this applied to their case.

In 1982, the Feders purchased a life insurance policy with a $50,000 death benefit and $73 quarterly premium payments from Northwestern Mutual Life Insurance Co. The Feders paid the premiums for about five years. Shortly thereafter, they sent Northwestern Mutual a letter asking that the policy be canceled, effective immediately, and informing the carrier of the couple’s new address. No further communication was received from Northwestern until 2008, when the policy was actually canceled.

Between 1987 and 2007, the carrier made premium payments on behalf of the Feders through

the policy’s automatic policy loan feature. Then, in May 2007, the policy was canceled when its cash value dropped to the point where the premium payments could no longer be made from cash value. The policy then lapsed, and Northwestern Mutual used the policy’s $12,654 cash value to pay off the loan. The Feders’ investment in the contract, $7,029, was subtracted from that amount to arrive at a taxable distribution of $5,625.

The Feders argued that their 1988 letter to the carrier asking that the policy loan be canceled was sufficient to terminate the policy and that they could not have taken policy loans from a canceled policy. But what the Feders didn’t do is introduce the policy as evidence or show that they complied with the procedure required to cancel the policy. Because they didn’t show that they followed correct procedure to terminate the policy, the Tax Court held that the policy was not canceled until the carrier terminated it in 2007 when the couple failed to make required premium payments.

Conclusion

Do your clients have stray life insurance policies sitting around in a long-forgotten file cabinet in the attic? Feder reminds us that even policies that a client believes are long-canceled can come back to haunt them. If they cannot document that the policy has been canceled, the most prudent course of action would be to contact the carrier for confirmation that the policy has indeed been terminated.

For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s Summit Business Media partner, AdvisorFX, for a free trial.

You may also be interested in signing up for a free trial with another Summit Business Media partner, Tax Facts Online.

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