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.