A recent 10 U.S. Circuit Court of Appeals considered whether taxpayers could avoid a $171,631 tax bill after their life insurance policy was terminated by the carrier [McGowen v. Commissioner, No. 10-9000 (2011)].

As we’ve seen before, if a policy is terminated and a policy loan forgiven, the insured will be on the hook for the amount of debt that is cancelled. What’s unique about this case is the McGowens’ argument that they did not owe tax on the debt forgiveness because they were insolvent at the time the debt was forgiven.

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 isn’t 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 where 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 Section 108 of the Tax Code, a forgiveness of debt is not includable in a taxpayer’s gross income to the extent the taxpayer is insolvent immediately before the loan is forgiven. For example, if taxpayer in the first example has a net worth of $50 at the time a $100 debt is forgiven, half the $100 debt cancellation is includable in the taxpayer’s gross income. The other $50 of debt forgiveness can be excluded from the taxpayer’s gross income under the insolvency exception.

In the case, Mrs. McGowen purchased a life insurance policy on her life for a single $500,000 premium payment. The McGowens took significant loans on the policy, and when the loan balance of $1,064,784.86 surpassed the cash value of the policy, the carrier informed Mrs. McGowen that the policy would be canceled if she didn’t pay $108,313.42 to keep the policy active. She did not make the payment and the policy was terminated.

The McGowens acknowledged on their income tax return that they received income from a cancellation of debt. But the McGowens argued that, like the taxpayer in the example above, they were insolvent when their aggregate assets were offset by their aggregate liabilities, including the policy loan.

The 10th Circuit didn’t agree with their assessment. The court held that the amount of the policy loan could not be considered a liability immediately before the loan was canceled because the couple would have owed nothing if the policy had not been terminated. As a result, the court did not view the policy loan as a liability immediately before the policy was canceled. The carrier’s recovery on the loan was limited to the premiums paid on the policy plus any investment proceeds earned in the policy.

The implication of the case is that, although the insolvency exception can be used to avoid a big tax bill when a policy is terminated while a policy loan is outstanding, the insolvency calculus can’t take into consideration the policy loan if the insurance company could not pursue the taxpayer for payment of the loan prior to the time when the policy is terminated. This means that, in order to avoid all cancellation of debt income from the policy loan, the McGowens would have had to be at least $562,746.04 in the hole, not including the amount of the policy loan, immediately prior to when the policy was terminated.

Life insurance is commonly thought of as a tremendous income tax shelter, but insureds need to be educated about life insurance’s many tax traps. Poor life insurance planning landed the McGowens a $171,631 tax trap—which would be enough to obliterate many taxpayers’ hopes for a secure retirement.

Although the insolvency exception is good news for some taxpayers, few will be in such a bad position.

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

See also The Law Professor’s blog at AdvisorFYI.