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.