A U.S. Tax Court judge ruled earlier this month that the former owner of a failed printing business must pay income taxes on the surrender value of a terminated life insurance policy, even though all of the value went toward paying off an $80,000 policy loan.
But Judge Elizabeth Copeland found that the taxpayer, Jonathan Sawyer, had invested the cash from the loan in an effort to save the printing business, Henry N. Sawyer Co.
The judge let Jonathan Sawyer treat the interest payments owed on the policy loan as investment interest.
The judge also found that Sawyer had a reasonable cause for not paying the taxes on the policy surrender value when the taxes were due.
"There is ample evidence that Mr. Sawyer had neither the assets nor the income to pay his 2015 tax," Copeland wrote in a memorandum discussing her ruling.
Representatives for Jonathan Sawyer could not immediately be reached for comment.
The IRS declines to comment on active litigation.
What it means: The Sawyer case may help provide an example of the kind of scenario in which the U.S. Tax Court will treat the interest on a life insurance policy loan as being used for investment purposes.
Case details: Jonathan Sawyer belonged to a family that had owned and managed Henry N. Sawyer since 1835.
He began working for the company as a sales executive in 1976 and became the company's chief executive officer in 1979.
In 1982, Sawyer bought a $200,000 cash value life insurance policy from Northwestern Mutual Life.
He used a personal guarantee to buy a $1.5 million printing press for the printing company in 1999. The company then lost a customer that accounted for one-third of the company's sales in 2004.
"Mr. Sawyer was often required to intervene to keep the company afloat by interjecting cash to pay wages and payroll taxes, and to purchase necessary supplies and printing equipment for the business," the judge wrote.
Sawyer kept the business going by liquidating his 401(k) plan account, borrowing about $100,000 from his and his wife's credit cards, and borrowing $750,000 from his uncle, according to the memorandum.
When Sawyer borrowed $80,000 against his life insurance policy, he asked his bookkeeper to transfer ownership of the policy to the printing company, so that the company would be the official recipient of any policy value distributions.
The company was liquidated in 2010. When it moved, many of its records were lost or destroyed.
The Form 1099-R: Northwestern Mutual sent Jonathan Sawyer a Form 1099-R tax notice for 2015 showing that, in 2015, when the life insurance policy was terminated, the policy had a total cash surrender value of $205,434.
Sawyer had not received any cash directly, but the Form 1099-R showed that he had received a taxable distribution of $160,900.
The taxable distribution included the amount of policy value used to pay off the $80,000 policy loan, $42,750 in loans used to pay premiums that Sawyer skipped, and $82,684 in accrued interest.
"Because he believed the Form 1099-R to be inaccurate, Mr. Sawyer consulted with a number of tax attorneys concerning the proper tax reporting with respect to the constructive distribution," Copeland wrote. "However, he did not receive a clear answer and ultimately did not file a federal income tax return."
Instead, the IRS prepared and sent Copeland a substitute for return.
The policy: Sawyer believed he had transferred ownership of his policy to his company, but Northwestern Mutual found Sawyer had not taken the necessary steps to complete the transfer of the policy.
The court ruling: The judge agreed that Sawyer owned the policy when it was terminated.
Sawyer owed income taxes on the $80,000 policy loans, on the $42,750 in policy value used to pay policy premiums, and on the interest on the premium financing, according to the memorandum.
Even though Sawyer received no cash distributions directly from the policy termination, "a taxpayer is required to recognize an indirect distribution of an insurance policy's cash surrender value as gross income," the judge wrote.
Because Northwestern Mutual used the life insurance policy's value to pay off the policy loan, "the loan repayment is treated as if the cash value of the policy was transferred to Mr. Sawyer and he in turn repaid the outstanding loans," the judge said.
But, because Sawyer invested the $80,000 in the printing company, the $40,108 in interest on the $80,000 counts as investment interest, and Sawyer can use the investment interest owed to offset any net investment income he earned in 2015, the judge said.
The failure-to-pay penalty: The judge concluded that Sawyer owed a penalty for failing to file an income tax return for 2015 but no penalty for failing to pay the taxes he owed.
Sawyer had only $35,687 in earned wages in 2015 and owed the IRS $50,150.
A failure-to-pay penalty could have amounted to 25% of the unpaid taxes.
But the deficiency was "over 140% of Mr. Sawyer's wages," the judge said. "Mr. Sawyer's financial difficulties did not arise because of negligence or lavish spending. Nor could Mr. Sawyer realistically borrow to satisfy the tax liability, given his financial history, default on the loan for which his home was collateral, and the lack of other assets. Accordingly, reasonable cause existed with respect to the failure to pay."
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